Business OrganizationsFall 2003

Prof. StoneHans Schmidt

Agency Principles

In analyzing agency problems, if a 3d party is trying to reach a principle, the 3d party must do 2 things:1. First the 3d party must prove the existence of the agency relationship. See Part I below.2. the 3d party must then prove either a contractual or tort legal vehicle:

a. Contract – the agent with who the 3d party entered the agreement must have had the authority to act as representative of P to bind to agreement. See Part II (Binding the principle)

b. Tort – the agent must have been acting within the scope of the employment and must consider other factors, such as whether agent was servant or independent contractor. See Part III below.

I. The Creation of the Agency Relationship – Rest § 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. Necessary to break into component parts:

A. Manifestation of Consent – the manifestation by the principal must reach the agent, must be something for the agent to consent to. Once agent has consented, an agency relationship has been established, even though principle may be unaware of the agent’s consent.

1. Objective test – look to outward actions/conduct. Have there been actions that the other party could reasonably interpret as manifestation or consent to enter into agency relationship.

2. Because of objective test, could have agency relationship even though one party subjectively did not want agency

3. Agency – legal concept, will apply even though parties did not contemplate attaching legal concept to their actions.

a. Not a contractual relation. Does not require consideration to be exchanged. Could be a gratuitous agent.

b. Does not require formal exchange of consent4. Rest § 15. Manifestations of Consent – an agency relation exists only if there has been a manifestation by

the principal to the agent that the agent may act on his account, and consent by the agent so to act.B. Fiduciary Relation – this requirement encompasses several different duties that the agent owes to the principal,

including a duty of loyalty, to act within authority, to obey instructions, provide info1. Rest § 13. Agent as a Fiduciary – agent is a fiduciary with respect to matters within scope of agency. 2. Rest § 387. General Principle – unless otherwise agreed, an agent is subject to a duty to his principal to act

solely for the benefit of the principal in all matters connected with his agency.3. Duty of Loyalty – applies to all instances of principal-agent relationships:

a. Unapproved benefits – agent breaches duty if he acts either to benefit himself or 3d party other than principal. Usually P will compensate A for efforts.

b. Confidential Info – A has duty to safeguard info, and not to use for A’s benefit. Includes trade secrets, customer lists, unique business methods, business plans. Relates to any such info obtained during relationship whether used for subject matter of agency. Duty remains after termination of agency

4. No competition – duty only during the agency relationshipa. Rest § 396. Using confidential information after termination of agency. Unless otherwise agreed,

after termination of the agency, the agent:i. No duty not to compete with the principal

ii. Has a duty to principle not to use or to disclose to third persons in competition with principle trade secrets, or other confidential matters given to him only for the principle’s use. Agent entitled to use general info if not acquired in violation of his duty as agent.

iii. Account for profitsiv. Has a duty to principal not to take advantage of still subsisting confidential relation created

during the prior agency relation.

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b. No acting for others with conflicting interest – instances of dual agency, (consider later in p’ship when attorney acts for both partners). In some cases P may rescind when dual agency exists.

5. Duty to Act within Authority – although A has power to act beyond scope of actual authority, does not have right to do so and may be liable to P for resulting damages.

6. Duty to Obey Instructions – P always has power to instruct as part of control over A. This duty applies even if P has contracted away the right to instruct

7. Rest § 379. Duty of Care and Skill. Unless otherwise agreed, paid agent is subject to duty to act with standard care and with the skill which is standard in the locality for the kind of work which he is employed to perform.

8. Duty to provide information – info in A’s possession which A knows or has reason to know would be important to P, has duty to inform P.

9. P’s remedies for A’s breach of duty – P may seek damages from A when breach causes damage to P. If A breaches duty of loyalty, P may recover damages and disgorgement of any profits derived by A from disloyal transaction, and recission of any transaction between P and A. These two are considered equitable remedies and do not need proof of damages to P. Ct will order even though would put P in better position than would have been

C. Control – the reciprocal consents of agent and principle must include understanding that principle is in control of the relationship. Doesn’t have to be total or continuous but must be recognition that principle is in charge of direction/ goals.

1. Rest § 2. Master, Servant, Independent Contractor. Different levels of control.a. Master – 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.b. Servant – 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 of control by the master.c. Independent Contractor – 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.

2. Old distinctions between labels may be useful, but sometimes difficult to qualify:a. Principal & Agent – the agent after finding of authority represents and binds the P contractually. A is

not working for P physically, nor physical actions subject to control by P. Ex: real estate agent and home buyer.

b. Master & Servant – S is one who does work physically for another, with all actions under control, or right of control. S may not bind M in contract, but may create liability in tort. Ex: delivery company’s driver is S while driving the truck, but may also be agent when accepting deliveries. See (III)(A) below.

c. Employer & Independent contractor – An IC is one who is neither agent or servant, but still does work for another, but the P has no right to control & the IC may not bind the P in contract.

3. Rest § 14. Control by Principal – principal has right to control the conduct of the agent with respect to matters entrusted to him.

4. Important to distinguish this aspect of consent to control as element of creation of agency relationship from other issues concerning control:

a. Constructive agency – where extent of control is substitute method for establishing agency statusb. Control over conduct – in regards to tort liability, whether acting in scope of employment or whether

considered independent contractor.c. Control as consequence – once agency relationship established, principal has right to control, even

though agent only thought gave limited control.D. Relationship between Agency and Contract – creation of agency relationship is not equivalent to creation of contractual

relationship. Although many agency relationships use contracts to clarify rights and duties between A and P. However, only have limited impact and may not abrogate certain powers stemming from the agency status conferred on parties:

1. principle always has right to control2. agent may have certain powers to bind the principal3. both agent and principal have power to end agency at any time.

II. Binding the Principal (Contractually) – the consequence of the agency relationship is that the agent through its status may bind the principle of its behalf. Has the power to affect legal rights and duties. Power to act is known as agent’s authorityA. Actual Authority – power of the agent to deal with others as a representative of the principal.

1. Creation of Actual Authority – involves similar requirements as creation of agency:

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a. Objective manifestation by principleb. Followed by agent’s reasonable interpretation of manifestationc. Which leads agent to believe that he is authorized to act for the principle.

2. Rest § 26. Creation of Authority – except for certain transactions, authority to do an act can be created by written or spoken words or other conduct of the principle which, reasonably interpreted, causes the agent to believe that the principal desires him so to act on the principal’s account.

3. Source and nature of principal’s manifestationa. Could reach agent directly or indirectly, still creates authorityb. Principle’s inaction could constitute manifestation when silence is reasonably interpreted by agent as

consent. Ex: if agent takes action, principle becomes aware of action and makes no objection, could be authority to repeat action.

4. Necessity, source and nature of agent’s belief – agent must reasonably believe that authority exists based on a manifestation by principle. REASONABLE important, and subjective beliefs do not count.

5. Rest § 34. Circumstances Considered in Interpreting Authority – an authorization is interpreted in light of all accompanying circumstances, including:

a. The situation of the parties, their relations to one another, and the business in which they are engaged;b. The general usages of business, trades or employments of the kind to which the authorization relates,

and business methods of the principal;c. Facts of which the agent has notice respecting the objects which the principle desires to accomplishd. The nature of the subject matter, the circumstances under which the act is to be performed and legality

or illegality of the act;e. The formality or informality, the care or lack of it with which an instrument evidencing the authority

is drawn.6. Principal’s control of agent’s interpretation – P can always cut back or countermand A’s authority by making

manifestation to A, or so that the manifestation reaches A, where A can then no longer reasonably believe that he has the authority to act for P.

7. Express & Implied Authority – creation of authority without the use of express manifestations.a. Rest § 35. When Incidental Authority is Inferred – unless otherwise agreed, authority to conduct a

transaction includes authority to do acts which are incidental to it, usually accompany it, or are reasonably necessary to accomplish it.

b. Implication could arise from custom or past dealingsc. Gap filling where P has given objective but may not have given specific instruction or authority for

the series of acts necessary to accomplish goal.

B. Apparent Authority – the appearance of legitimate authority1. Rest § 8. Apparent Authority – the power to affect the legal relations of another person, by transactions

with third persons, professedly as agent for the other, arising from and in accordance with the other’s manifestation to such third persons.

2. Creation of apparent authority – a. Objective manifestation from one party (apparent principle)b. Which reaches a 3d party, andc. Which causes the 3d party to reasonably believe that another party (apparent agent) is indeed

authorized to act for 1st party.3. Rest § 27. Creation of Apparent Authority: General Rule – except for the execution of transactions

required by statute to be authorized in a particular way, apparent authority to do an act is created as to a third person by written or spoken words or any other conduct of the principle which, reasonably interpreted, causes the third person to believe that the principal consents to have the act done on his behalf by the person purporting to act for him.

4. Apparent authority can coexist and be coextensive with actual authority. It may also extend actual A’s power to bind P beyond scope of original authority

a. Ex: P tells 3d party that A has authority to act on his behalf in auction. P tells A that he may only bid up to $25,000, but does not communicate this to 3d party. In Past A, on behalf of P has bid $50,000, so that in terms of 3d party, A has apparent authority of $50,000.

b. Agent always has actual authority to truthfully describe extent of authority. This may in some circumstances be sufficient to create apparent authority, but P can always remove authority so that A cannot represent his authority.

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5. Question of reliance – not necessarily an explicit requirement in the Rest, but the inference of authority must in some way be attributable to the P’s manifestation.

a. The 3d party must be able to point to at least a “peppercorn” of manifestation attributable to apparent principle. 3d party must be able to form reasonable belief from this “peppercorn” that apparent agent is actually authorized

b. Apparent authority cannot be created by actions/ manifestations of agent 6. Modes of Manifestations –

a. Through intermediaries, such as letter or other agent of apparent principle, although it is not required that it be an agent.

b. By position – putting the agent in a particular position. In light of business custom or practice, placement may cause 3d party to believe that A has certain authority. Ex: manager working in store, may have apparent authority to make promises or statements that bind P.

c. Apparent authority by positions within organizations – in large organizations, job titles may influence apparent authority.

i. Purchasing manager – may have authority relating to job functionsii. VP of development

iii. Human resource directord. By acquiescence – P making necessary manifestation by acquiescing in A’s conduct

7. Third party’s interpretation – several factors must be considered before 3d party may bind apparent principlea. Mere belief insufficient, 3d party must have reasonable belief. The same factors are considered here

as if it were the agent considering P’s manifestations.b. 3d party’s duty of inquiry – still may be unreasonable belief without 3d party knowing more info

8. Situation by Situation Analysis – each claim of apparent authority is analyzed separately, so must go through steps for each claim, even if from same 3d party:

a. Manifestation had occurred that was attributable to apparent Principleb. Manifestation reached 3d partyc. Which caused 3d party to believe apparent agent was authorizedd. 3d party’s belief was reasonable

9. Rest § 49. Interpretation of Apparent Authority Compared with Interpretation of Authority – the rules applicable to the interpretation of authority are applicable to the interpretation of apparent authority except that:

a. Manifestations of the principal to the other party to the transaction are interpreted in light of what the other party knows or should know instead of what the agent knows or should know…

10. Rest § 124A Effect of Termination of Authority upon Apparent Authority and Other Powers – the termination of authority does not thereby terminate apparent authority. All other powers of the agent resulting from the relation terminate except powers necessary for the protection of his interests or of those of the principal.

11. Rest § 125 [Termination of Apparent Authority] – Apparent authority, not otherwise terminated, terminates when the third person has notice of:

a. The termination of the agent’s authority;b. A manifestation by the principal that he no longer consents; orc. Facts, the failure to reveal which, were the transaction with the principal in person, would be ground

for recession by the principal.

C. Agency by Estoppel – instances where there is an absence of manifestation by the asserted principle, but by inaction or failure to deny agency have led third party to believe to extend credit, or incur costs or in some way detrimentally change position. Also important that principle may have become aware of purported agent’s representations but does nothing to inform 3d party that no agency relationship exists

1. Rest § 8B – a transaction purported to be done on his account… to persons who have changed their positions because of their belief that the transaction was entered into by him or for him, if:

a. He intentionally or carelessly caused such belief; orb. Knowing of such belief and that others might change their positions because of it, he did not take

reasonable steps to notify them of the facts.2. different from apparent authority because P can still be liable even though 3d party cannot point to any

manifestation by P. Also suggested that for estoppel, the 3d party must show that he changed his position on reliance of manifestations so that P is estopped from denying them. In apparent authority the 3d party doesn’t have to prove change in position.

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3. Although not addressed in Rest, 3d party cannot unreasonably or carelessly rely on statements made, must have justifiable reliance, same as regular estoppel doctrine.

4. Rest § 141 Liability based on Other than Agency Principles – a principal, although not subject to liability because of principals of agency, may be liable to a third person on account of a transaction with an agent, because of the principles of estoppel, restitution or negotiability.

D. Ratification – the absence of authority, but 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. For it to occur, there must be certain preconditions and purported principle must purposely embrace the previously unauthorized act (affirmance) However, if K was nullity from start (no consideration), then ratification cannot create valid obligation. Rest § 82. Ratification –

1. Preconditions – can occur only in context of these circumstances:a. ‘purported agent’ must have either expressly or impliedly purported to act on behalf of ‘purported

principle’ in a transaction with 3d party.b. ‘purported agent’ must have acted with no agency authority, power and estoppel must not applyc. at time of act ‘purported principle’ must have existed and must have had capacity to originally

authorize act; andd. at time of attempted ratification, 3d party must not have indicated desire to either ‘purported agent or

principle’ an intention to withdraw from transactione. ‘purported principle must have knowledge of all material facts concerning transaction.

2. Affirmance – the act of ratification by ‘purported principle’a. Making a manifestation, viewed objectively, indicates choice to treat unauthorized act as if it had been

authorizedb. Engaging in conduct that is justifiable only if ‘purported principle’ has made such a choice

3. Rest § 94 Failure to Act as Affirmance – an affirmance of an unauthorized transaction can be inferred from a failure to repudiate it. Failure to repudiate “under such circumstances that, according to the ordinary experience and habits of men, one would naturally be expected to speak if he did not consent.”

4. can also ratify by accepting or retaining benefits from transaction, while knowing that they result from the unauthorized act.

a. If P does know, 3d party may seek restitution or quantum meruit, but ratification preferred because of full expectation interest rather than value of services rendered.

5. Ratification operates on an All or Nothing basis. P cannot ratify a single part of a transaction, either the entire transaction is ratified or none of it is.

E. Inherent Agency Authority – a catch-all doctrine. This type of authority arises from the agency itself and without regard to either actual or apparent authority. May be viewed as arising by implication from the authority actually or apparently granted.

1. Ex: P hires A to manage/ operate branch store of P’s retail operation. A has authority to manage store on day-to-day basis, but is expressly told has no authority to mark down prices. A does so anyway on slow moving goods. Neither actual or apparent authority yet P is still bound to honor price reduction to 3d party because A has inherent authority based on position as manager. Known as enterprise liability.

2. Enterprise Liability and General Agents – where P has entrusted A with ongoing responsibilities. General agent – where P has authorizes an agent to conduct a series of transactions involving a continuity of service

3. If agent is general agent w/ actual authority to conduct certain transactions:a. Agent acting in interests of P, andb. Agent does act usual or necessary w/ regard to authorized transactions, thenc. Act binds P regardless of whether A had actual authority and even if expressly forbidden.

4. Important in instances where undisclosed or partially disclosed principle is involved because apparent authority doesn’t help because no manifestation by P.

5. Special agent – authorized to act only for specific transaction6. Rest § 161 Unauthorized Acts of General Agent – a general agent for a disclosed or partially disclosed

principal subjects his principle to liability for acts done on his account which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized.

F. Attribution of Information – treating the principal as if he knows, receives, or communicates information actually known, received or communicated by an agent.

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1. Attribution of Notice or Notification – if agent has actual or apparent authority to receive notice, then sending it to agent has same effect as if sent to P. Occurs whether the A actually informs P, unless when A received notice:

a. A was acting adversely to P, andb. 3d party knew or had reason to know that A was so acting.

2. Attribution of Facts – if an agent has actual knowledge of a fact concerning a matter within the agent’s actual authority, the agent’s knowledge is attributed to P. Occurs whether the A actually informs P, unless when A received knowledge of fact:

a. A was acting adversely to P, andb. 3d party knew or had reason to know that A was so acting.

3. Problems arise when A receives knowledge of fact ‘off job’, either before A officially becomes A for P, or while off duty. P still charged with knowledge of fact, because it is A’s duty to inform P of any info which A has reason to know may be of interest to P

4. Info A should know but does not is NOT attributed to P5. Info communicated by agent to 3d party. If A acting w/ actual or apparent authority:

a. Gives notice to 3d party, makes statement or promise, or misrepresentation b. The info conveyed to 3d party under contract law as if P conveyed himself.

6. Attribution works in only one direction – upward from A to P. What a P knows is not attributed to A.

G. Agents, Principles and Contracts – whether an agent becomes a party to a contract may depend on the whether the agent is disclosed or not. Several different cases:

1. Rest § 320. Principal Disclosed – Unless otherwise agreed, a person making or purporting to make a contract with another as agent for a disclosed principal does not become a party to the contract.

2. Rest § 321. Principal Partially Disclosed – Unless otherwise agreed, a person purporting to make a contract with another for a partially disclosed principal is a party to the contract. (either P or A, at election of 3d party) may be held liable.

3. Rest § 322. Principal Undisclosed – An agent purporting to act upon his own account, but in fact making a contract on account of an undisclosed principal, is a party to the contract. (either P or A, at election of 3d party) may be held liable.

4. Rest § 326. Principal Known to be Nonexistent or Incompetent – Unless otherwise agreed, a person who, in dealing with another, purports to act as agent for a principal whom both know to be nonexistent or wholly incompetent, becomes a party to such a contract. (Only A is responsible).

5. Rest § 330. Liability for Misrepresentation of Authority – A person who tortiously misrepresents to another that he has authority to make a contract, conveyance, or representation on behalf of a principal whom he has no power to bind, is subject to liability to the other in an action of tort for loss caused by reliance upon such misrepresentation.

III. Binding the Principle in Tort – the actions of A may create liability in P if A was acting within the scope of his employment and was a servant of P.A. Rest § 219. When 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, orb. the master was negligent or reckless, orc. the conduct violated a non-delegable duty of the master, ord. the servant purported to act or to speak on behalf of the principle and there was reliance upon

apparent authority, or he was aided in accomplishing the tort by the existence of the agency relationship.

B. Servant v. Independent Contractor. The focus is on whether the agent was a servant acting within scope of employment. Rest § 220. Definition of a 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;

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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, ad the place of work for

the person doing the workf. 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 a part of the regular business of the employer;i. whether or not the parties believe they are creating the relation of master and servant; andj. whether the principal is or is not in business.

C. Scope of Employment – the second area of contention, whether the servant was acting within the scope of employment. The Rest provides a general definition. Rest § 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, andd. if force is intentionally used by the servant against another, the use of force is not unexpectable by the

master.2. Conduct of a servant is not within the scope of employment if it is different in kind from that authorized, far

beyond the authorized time or space limits, or too little actuated by a purpose to serve the master.D. Rest § 229. Kind of Conduct within Scope of Employment –

1. To be within the scope of employment, conduct must be of the same general nature as that authorized, or incidental to the conduct authorized.

2. In determining whether or not the conduct, although not authorized, is nevertheless so similar to or incidental to the conduct authorized as to be within the scope of employment, the following matters of fact are to be considered:

a. whether or not the act is one commonly done by such servants;b. the time, place and purpose of the act;c. the previous relations between the master and the servant;d. the extent to which the business of the master is apportioned between different servants;e. whether or not the act is outside the enterprise of the master or, if within the enterprise, has not been

entrusted to any servant;f. whether or not the master has reason to expect that such an act will be done;g. the similarity in quality of the act done to the act authorized;h. whether or not the instrumentality by which the harm is done has been furnished by the master to the

servant;i. the extent of departure from the normal method of accomplishing an authorized result; andj. whether or not the act is seriously criminal.

E. A servant’s travels: commuting, special errand exception, and necessary travel1. Commuting – a servant’s trips back and forth to work are not considered to be within scope of employment.2. Exception, Special Errand – if at request of master, the servant does a special errand for master while on way

to/from work, may be considered within scope of employment3. In transit – where servant’s work necessarily involves travel from place to place, and master establishes

schedule that effectively controls time and place of travel4. Tangential Acts ‘ Frolic and Detour’ – a tangential act may be within scope if it is somehow related to

authorized work, but an act that is done purely for servant’s reasons, outside scope.a. when does the detour begin and is it for purely personal reasons or still sufficiently related to be

considered within scope.b. when does the frolic end, at what point should the servant be considered acting within the scope; both

questions involve factual determinations. Has not returned merely be deciding that it is time to return. F. Miscellaneous provisions

1. Rest § 230. Forbidden Acts – an act, although forbidden or done in a forbidden manner may be within scope of employment

2. Rest § 231. Criminal or Tortious Acts – an act may be within the scope of employment although consciously criminal or tortuous.

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IV. Termination of the Agency Relationship – A. Ending of Relationship – may occur by several different ways:

1. Through express will of either the P or the A – both parties have the power to end relationship at any time. Each party may exercise this power by communicating desire to other party. P=power of revocation; A=power of renunciation. These manifestations determined by objective standard.

2. Through expiration of a specified term – P and A may agree that agency will only last for a specified length of time. If so, agency automatically terminates at the end of this time period, unless both parties agree to renewal or extension (may be inferred from conduct)

3. Through Accomplishment of Agency Purpose – if agency entered into for specific objective, achieving objective terminates. Afterwards, without further manifestations by P, A has no basis for believing that agency & authority continue. (this may involve ratification, if after achievement of objective, A continues to act for P, P may ratify by accepting benefit, or may consent to continuation of agency relationship)

4. By occurrence of event or condition – similar to objective, once event or condition occurs terminates agency5. By destruction of or end of the P’s legal interest in Property – if A’s role predicated on property and P no

longer has interest, agency ends.6. By death, bankruptcy, or mental incapacity of A or P – this was the common law rule. However modern

statutes may change outcome and Rest 3d (A’s authority continues until A becomes aware of P’s death7. By expiration of reasonable time – where original manifestations set no time limit, the agency will

automatically expire after a reasonable time. Factors to consider:a. manifestation of parties when agency createdb. extent and nature of communications between parties after agency createdc. particular objective of agencyd. past dealings, between A and P.e. custom, if any, in the locality with regard to agency relationships of the same or similar type.

B. Power versus Right in Termination – both parties always have power to terminate, but whether either has the right to do so depends upon any contract that overlays the relationship

1. An agency contract can always modify the default rules and set specific limits on duration, set objectives, provide for mechanism for termination that must be followed or be considered a breach of contract. If breach may seek damages on the contract, but may not avoid the destruction of the agency relationship. Same contract rules apply for determining damages.

C. Effect of Termination – according to common law rules, agent’s actual authority terminates when agency terminates. Inherent authority also ends. However, apparent authority depends on reason why agency terminated: If P dies or becomes incompetent, A’s authority ends immediately.

1. In other cases, A’s authority ends as to a 3d party when:a. 3d party learns that agency has ended, orb. in light of other information, the 3d party can no longer reasonably believe A is authorized to act.

2. See above, modern statutes have changed common law rules. 3. A’s obligation to cease acting for P – A may be liable for damages if continues to act.4. P’s duty to indemnify A – P must still pay and is liable for right of indemnity for events that occurred before

termination of agency.5. Agent has right to compete w/ P after termination, but under limits laid out above concerning confidential

information.

The Law of PartnershipI. The Nature and Creation of a Partnership –

A. The Definition & Elements of a Partnership – the primary law on partnerships will be the UPA, which contains two sections on what constitutes a partnership:

1. UPA § 6. Partnership Defined – (1) a partnership is an association of two or more persons to carry on as co-owners a business for profit.

2. ‘Association’ – this word implies both voluntariness and intent, parties must agree to arrangement either expressly or by conduct.

a. But, not required that parties agree to legal label of partners. May exist even though parties have no knowledge that they have created a partnership.

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3. ‘Co-owners’ – means something more than any form of joint ownership, see UPA § 7(2). Also implies that both parties will jointly control property

4. ‘to carry on’ – implies that goal is more than a single or isolated transaction, but suggests continuity in business operations. Contrast with notion of joint venture.

B. The Sharing of Profits and Losses as proof of existence. Note that there is a difference between sharing of profits and sharing of gross revenure. UPA § 7. Rules for Determining the Existence of a Partnership – In determining whether a partnership exists, these rules shall apply:

1. Except as provided by section 16 persons who are not partners as to each other are not partners as to third persons.

2. Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property, or part ownership does not of itself establish a partnership, whether such co-owners do or do not share any profits made by the use of the property.

3. The sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived.

4. The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business, but no such inference shall be drawn if such profits were received in payment:

a. As a debt by installment or otherwise,b. As wages of an employee or rent to a landlord,c. As an annuity to a widow or representative of a deceased partner,d. As interest on a loan, though the amount of payment vary with the profits of the business,e. As the consideration for the sale of a good-will of a business or other property by installment or

otherwise.C. Partnership Types and Joint Ventures – categorized on when it comes to an end:

1. Partnership at Will – each partner has right to cause it to end at any time and without having to state or have cause.

2. Partnership for a term – comes to an end at the conclusion of a specific period of time as provided in the p’ship agreement.

3. P’ship for a particular undertaking – comes to an end when particular objective or goal is reached, as provided for in the p’ship agreement.

4. Joint Venture – difference sometimes hard to distinguish but, generally more limited in scope, focus is on one business transaction

D. Entity or Aggregate Approach – is a partnership a separate legal person, with legal identity separate from its partners or is it an aggregation of its individual partners, with no separate legal identity.

1. UPA – incorporates both approaches, some provisions view as entity (UPA § 9(1)), while others view as aggregate (UPA § 29).

2. RUPA § 201. Partnership as Entity (UPA 1997) – a partnership is an entity distinct from its partners. Clarified the issue.

E. UPA § 8. Partnership Property – 1. All property originally brought into the partnership stock or subsequently acquired by purchase or otherwise,

on account of the partnership is p’ship property.2. Unless the contrary intention appears, property acquired with p’ship funds is p’ship property.3. Any estate in real property may be acquired in the p’ship name. Title so acquired can be conveyed only in

the p’ship name.4. A conveyance to a p’ship in the p’ship name, though without words of inheritance, passes the entire estate of

the grantor unless a contrary intent appears.F. A critical factor in establishing existence of a partnership is sharing of profits. Several factors may be helpful, in

addition to UPA § 7(4).1. Control – equal management right is key characteristic of p’ship. But must consider this in debtor- creditor

relationship:a. UPA § 7(4)(a) – says that profits received as payment for debt does not create inference of p’ship.

Dispute may focus on extent of control creditor seeks to exert in order to receive these payments.b. UPA §7(4)(d) – Martin v. Peyton concerns profit-sharing as interest on loan. Facts: Insolvent

brokerage firm had to borrow money from ∆. Π was a creditor of insolvent firm and was seeking to establish p’ship in order reach ∆’s ‘deep pockets.’ ∆s entered into several agreements which provided ∆s would receive 40% of profits until loan was repaid, ∆s were to be advised of conduct of business, and had veto power over decisions which were thought to be too speculative. ∆ placed person in charged felt would better run firm and insured his life; also given option to become partner in future. Do these facts indicate that an inadvertent p’hsip was created? Court held no,

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because ∆s were acting merely to protect interest in loan. Held that never in actual control, (never had power to bind firm to 3d parties).

i. Importance of decision is that facilitates loaning of money, without lenders having to be concerned about being labeled partners merely by trying to protect loan interest.

2. Contributions of property to business – may be useful if purely a capital contribution, but what if other partner contributes labor, and also receives a salary before the distribution of profits. Again focus could be on degree of control.

a. Smith v. Kelley – working at firm and held out to be partner, but had no control over business decisions and not obligated to suffer any losses of firm. Made no other contributions of property. Held: no p’ship exists.

3. Agreements to Share Losses – written agreement to share losses strong proof that p’ship exists.G. Inadvertent Partnership and Partnerships by Estoppel – difference both parties intend to work together, but not

necessarily aware of legal relations they have created versus a person who holds himself out to be a partner in a p’ship to a 3d person who then transacts business with this ‘purported partner’. This is only used for contractual disputes not for torts. UPA § 16. Partner by Estoppel

1. When a person by words spoken or written or by conduct, represents himself, or consents to another representing him to any one, as a partner in an existing partnership or with one or more persons not actual partners, he is liable to any such person to whom such representation has been made, who has on the faith of such representation given credit to the actual or apparent partnership, and if he has made such representation or consented to its being made in a public manner he is liable to such person, whether the representation has or has not been made or communicated to such person giving credit…

a. When partnership liability results, he is liable as though he were an actual member of the p’ship.b. When no partnership liability results, he is liable jointly with the other persons, if any, so

consenting to the contract or representation as to incur liability, otherwise separately.c. When a person has been thus represented to be a partner in an existing p’ship, he is an agent of the

persons consenting to such representation to bind them to the same extent and in the same manner as though he were a partner in fact, with respect to persons who rely upon the representation…

II. Relations between Partners to Persons Dealing with PartnershipA. The Partner as an Agent of the Partnership – Two different theoretical approaches based on the different views of

partnership: aggregate – partner general agent of every other partner and as principal w/joint interest in the p’ship property. Entity – partner is agent of partnership, so that partner acting w/ authority can create right in 3d person to obtain judgment if necessary out of p’ship property including other partners. This is approach taken by UPA: §9. Partner Agent of Partnership as to Partnership Business –

1. 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 p’ship name of any instrument, for apparently carrying on in the usual way the business of the p’ship of which he is a member binds the p’ship, 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 authority.

2. An act of a partner which is not apparently for the carrying on of the business of the partnership in the usual way does not bind the partnership unless authorized by the other partners.

3. Unless authorized by the other partners or unless they have abandoned the business, one or more but less than all the partners have no authority to:

a. Assign the p’ship property in trust for creditors or on the assignee’s promise to pay the debts of the p’ship.

b. Dispose of the good-will of the businessc. Do any other act which would make it impossible to carry on the business of a partnership.d. Confess a judgmente. Submit a p’ship claim or liability to arbitration

4. no act of a partner in contravention of a restriction on authority shall bind the p’ship to persons having knowledge of the restriction.

B. Agent as Partner under the UPA (1997)1. The revised acts attempts to clarify the muddy language in §9 UPA (1914), by clearly defining the authority

of partners. §301. Partner Agent of Partnership – Subject to statement in § 303:a. (1) each partner is an agent of the p’ship for the purpose of its business. An act of a partner, including

the execution of an instrument in the p’ship name, for apparently carrying on in the ordinary course of the p’ship business or business of the kind carried on by the p’ship binds the p’ship, unless the partner

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had no authority to act for the p’ship in the particular matter and the person with whom the partner was dealing knew or had received a notification that the partner lacked authority.

b. (2) An act of a partner which is not apparently for carrying on in the ordinary course the p’ship business or business of the kind carried on by the p’ship binds the p’ship only if the act was authorized by the partners.

C. Determining authority of partner – similar to the analysis in agency law regarding apparent authority. Major focus in partnership: what is ‘ordinary course of business of p’ship.’

1. There are 3 major areas:a. The partnership agreement – as with other parts of UPA, look to the actual agreement to determine

what type of authority is granted as well as the purpose of the p’ship. UPA states has authority to do acts for ‘apparently carrying on’, creates a similar type of apparent authority as in agency:

i. National Biscuit – partner had apparent authority to buy bread, in the business of running a grocery store.

ii. Rouse v. Pollard – P in law firm who invest/ manages money for client. No authority b/c law firm not in business of investing & not usual/ordinary business of law firms in the area.

b. Course of business of the particular partnershipi. Smith v. Dixon – example of broad scope of partner authority. Look to past transactions of

p’ship, grants apparent authority for current transactionc. Course of business of similar partnerships in the locality

2. Issues that may arise in determining the authority of partner in a dispute:a. Of (b) and (c) above which one would control if each party to the transaction had a different view

regarding the course of business of p’shipb. In order to bind p’ship under apparent authority, p’ship must be disclosed, 3d party cannot bind

undisclosed p’ship based on actions of partner. Action has to appear to be for carrying on business of p’ship of which he is a member. Similar to agency in that partner could bind undisclosed p’ship if partner had actual authority.

c. P’ship could be bound even if transaction benefits the partner and not the p’ship as long as reasonably purporting to act for p’ship

d. Some actions may be so extraordinary probably never considered ‘apparently/usual’:I. Having p’ship guarantee debts of some other person

II. Paying or assuming debt of partnerIII. Giving away significant p’ship property

3. Statement of Authority in UPA (1997) - §303. allows a p’ship to file a statement of authority that clearly states the limits and authority that each partner has to enter into transactions on behalf of the p’ship. Has real effect on transfers of real property. If filed could give 3d parties constructive notice of authority of partner conducting transaction. Could also effect credit transactions like that in NABISCO.

4. Other acts which may bind other partners:a. §11. P’ship bound by admission of partner – an admission or representation made by any partner

concerning p’ship affairs within the scope of his authority as conferred by this act is evidence against the p’ship.

b. §12. P’ship charged with Knowledge of or Notice to Partner – notice to any partner of any matter relating to p’ship affairs, and knowledge of the partner acting in the particular matter, acquired while a partner or then present to his mind, and the knowledge of any other partner who reasonably could and should have communicated it to the acting partner, operate as notice to or knowledge of the partnership, except in the case of a fraud on the partnership committed by or with the consent of that partner.

5. Enforcement of Rights and Liabilities against Partnershipa. § 15. Nature of Partner’s Liability – All partners are liable:

I. (a) jointly and severally for everything chargeable to the partnership under §§13, 14.II. (b) Jointly for all other debts and obligations of the partnership; but any partner may enter into

a separate obligation to perform a p’ship contract. b. §13. P’ship bound by partner’s wrongful act – Where, by any wrongful act or omission of any

partner acting in the ordinary course of the business partnership or with the authority of his co-partners, loss or injury is caused to any person, not being a partner in the p’ship or any penalty is incurred, the p’ship is liable therefore to the same extent as the partner so acting or omitting to act.

c. §14. P’ship bound by partner’s breach of trust – The p’ship is bound to make good the loss:

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I. where one partner acting within scope of his apparent authority receives money or property of a third person and misapplies it; and

II. where the p’ship in the course of its business receives money or property of a third person and the money or property so received is misapplied by any partner while it is in the custody of the p’ship.

d. §17. Liability of Incoming Partner – a person admitted as a partner into an existing p’ship is liable for all the obligations of the p’ship arising before his admission as though he had been a partner when such obligations were incurred, except that this liability shall be satisfied only out of p’ship property.

III. Relations of Partners to One Another A. Once the existence of a partnership established, certain consequences follow that affect each partner:

1. Partner as Agent (see above)2. Partner’s Right to Indemnity (UPA § 18(a), (b))

a. Can be disputes about whether contribution is capital or merely loan. 3. Partner’s Right to Compensation (UPA §18(f))

a. Clearly states that no partner is entitled to receive compensation for working on partnership business4. Right to Control and Manage

a. Duty to discloseb. Duty to account

5. Partner as FiduciaryB. A partner has an abundance of rights regarding the management of the partnership. The existence of these rights is

significant when looking to find the existence of a partnership. Regarding all rights between partners, the partners themselves can create contracts or agreements to clearly define. In absence, several UPA provisions define default rights:

1. §18. Rules Determining Rights and Duties of Partners – 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:

a. each partner shall be repaid his contributions, whether by way of capital or advances to the p’ship property and share equally in the profits and surplus remaining after liabilities, including those to partners, are satisfied; and must contribute toward the losses sustained by p’ship according to his share in the profits.

b. P’ship must indemnify every partner in respect of payments made and personal liabilities reasonably incurred by him in ordinary and proper conduct of its business, or for preservation of its business or property.

c. A partner, who in aid of p’ship makes any payment or advance beyond the amount of capital which he agreed to contribute, shall be paid interest from date of payment.

d. A partner shall receive interest on capital contributed by him only from the date repayment should be made.

e. All partners have equal rights in the management and conduct of the p’ship businessf. No partner is entitled to remuneration for acting in the p’ship business, except that surviving partner is

entitled to reasonable compensation for his services in winding up p’ship affairs.g. No person can become a member of p’ship without the consent of all of the partnersh. Any difference arising as to ordinary matters connected with the p’ship 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.

C. Sharing of Profits and Losses – an important right of the partners1. Profits - Default rule is that each partner receives equal share regardless of amount invested or size of

interest, but different ways the profits may be shared among the partners:a. Share by flat percentage; could be done by partnership unitsb. Fixed weekly or monthly ‘salary’. Could be computed as cost subtracted before profit, or it could be

considered an advance to be credited against partner’s sharec. Computed by percentage of amount invested in p’shipd. Computed by percentage of income, sales or billings of partners

2. Losses – absent agreement, default rule is same as for profits, each partner must contribute equally for lossesa. Richert v. Handly – important case because focuses on distribution of losses when partnership goes

bad. No agreement between parties regarding distribution of losses. Richert paid for the stand of timber, while Handly was to log and bring the timber to market. Venture ended up losing money, so that there was an overall loss. Handly received expenses for logging. In final ruling, court viewed Richert as having put up all of the capital contribution, with no credit being given Handly for his labor

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contribution. Handly ended up having to reimburse Richert remaining capital contribution minus half of losses.

3. Timing - generally profits are not determined until after all liabilities have been satisfied. Mostly a matter of agreement between parties.

D. Management of the Partnership – UPA § 18(e) states that each partner has equal right to manage and control partnership. This is the default rule, the p’ship can alter this through contrary agreements. In connection with this each partner has specific duties to the other partners:

1. Right to Know and Render Information – a. UPA §19. Partnership Books – Partnership books shall be kept, subject to any agreement, at the

principal place of business of the partnership, and every partner shall at all times have access to and may inspect and copy any of them

b. UPA § 20. Duty of Partners to Render Information – Partners shall render on demand true and full information of all things affecting the partnership to any partner or the legal representative of any deceased partner or partner under legal disability.

c. UPA § 403. Partner’s Rights and Duties with Respect to Information . Similar to the old UPA provisions. Distinguishes between types of information that are to be disclosed on demand versus without demand:

i. §403(c)(1) Without demand, any information concerning the p’ship’s business and affairs reasonably required for the proper exercise of the partner’s rights and duties.

ii. §403(c)(2) On demand, any other information concerning the p’ship’s business and affairs, except to the extent the demand or the information demanded is unreasonable or otherwise improper under the circumstances.

2. Duty to Account – important because usually involved in disputes about each partner’s capital accounts. The UPA provides for this right in certain circumstances: §22. Right to an Account – any partner shall have the right to a formal account as to partnership affairs:

a. If he is wrongly excluded from the partnership business or possession of its property by his co-partners,

b. If the right exists under the terms of the agreement,c. As provided by § 21 (fiduciary duty)d. Whenever other circumstances render it just and reasonable.

3. Voting and Decisions – Under UPA § 9(3) unanimous consent is required in most cases, but §18(h) provides for a rule of majority consent in deciding differences arising to ordinary matters

E. Partner as Fiduciary – a very important duty required of every partner. However, debate on the extent and scope of this duty. This is a duty of loyalty.

1. Meinhard v. Salmon – dispute between two joint adventurers regarding the lease of a building. Salmon held 20 yr lease w/ 3d party on bldg that was a hotel, but entered into separate agreement with Meinhard to renovate the bldg into offices and shops. Salmon was to pay a percentage of net profits during life of lease. Near end of lease, 3d party owner entered into new expanded lease of current property and new property with Salmon, but Salmon never mentioned it to Meinhard. Meinhard sued on theory that Salmon under duty to inform him of the new lease so he could continue to share in profits. Cardozo wrote majority opinion that is often quoted for description of the fiduciary duty owed, while Andrews wrote the dissent saying while high fiduciary duty owed to partners not the same when concerning joint venture.

2. UPA § 21. Partner Accountable as a Fiduciary – a. (1) Every partner must account to the partnership any benefit, and hold as trustee for it any profits

derived by him without the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the partnership or from any use by him of its property.

b. (2) This section applies also to the representatives of a deceased partner engaged in the liquidation of the affairs of the partnership as the personal representatives of the last surviving partner.

3. The RUPA changes or codifies this duty in several different ways. Under UPA (1914) defining the duty mostly involved case law, while the revised provision seems to limit to clearly defined circumstances. Major difference is that under no duty during the formation of the p’ship only during conduct and winding up. UPA (1997) §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:i. (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

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from a use by the partner of p’ship property, including the appropriation of a p’ship opportunity;

ii. (2) to refrain from dealing with the p’ship in the conduct or winding up of the p’ship business as or on behalf of a party having an interest adverse to the p’ship;

iii. (3) to refrain from competing with the p’ship in the conduct of the p’ship business before the dissolution of the p’ship.

c. A partner’s duty of care to the p’ship 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 the law.

d. A partner shall discharge the duties to the p’ship and other partners… 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 section or under p’ship agreement merely b/c the partner’s conduct furthers the partner’s own interest.

4. The duty in action. How does this duty affect actions of partners:a. Partner v. Partnership – generally a partner may not profit at the expenses of the p’ship. Includes not

competing w/ p’ship, taking business opportunities, using p’ship property for personal gain.i. Can this duty be modified by express agreement? Singer v. Singer – p’ship agreement

included clause that allowed each partner freedom to enter into separate transactions that may be in conflict with partnership. Two partners formed new p’ship to purchase land before old p’ship could buy and court said no breach of duty b/c of the agreement. Partners had a contract right to do what they did.

b. Partner v. Partner – although the RUPA and the UPA differ slightly in some regards both require have similar requirements in this regard, continues even during winding up:

i. Full disclosure – a partner buying or selling a partnership interest to a fellow partner has an affirmative duty to disclose any material information that:

D. Relates to the value of the p’ship interest or p’ship itself;E. And could not be learned by the examining the p’ship books.

ii. Fair dealing – idea involves both process and substance:1) Process – obliged to deal with each other candid noncoercive manner. Really has

no effect on dissolving or expelling a partner. Any partner may dissolve by manifesting express will. Must minimally comply with any process provisions in p’ship agreement when expelling partner.

2) Substance – duty to provide ‘fair price’ ??? Partner may not expel or dissolve for purpose of deriving benefits, if partner had right to expect benefits, naturally would have accrued to partner absent exercise of discretion, and exercise of discretion then transfers benefits to partner exercising discretion

c. Remedies – if partner breaches this duty, court could order damages, disgorgement of benefit (constructive trust) or recession. May involve concept of unjust enrichment.

F. Effectiveness of Inter Se Agreements that Restructure Management – 1. Under UPA, these agreements face three constraints:

a. Although agreements can waive certain fiduciary duties and define others, no agreement can totally remove fiduciary obligations between partners

b. More fundamental obligation, more likely to face judicial scrutiny. Restriction likely to be upheld if it:

i. has some important justificationii. is not overbroad

iii. does not leave partners who lack access vulnerable to oppressionc. Partners may have nondelegable right to consent to fundamental changes in p’ship agreement.

2. Under RUPA - § 103. Effect of Partnership Agreement; Non Waivable Provisionsa. Except as otherwise provided in subsection (b), relations among the partners and between the partners

and the p’ship are governed by the p’ship agreement. b. The partnership agreement may not:

1)Vary rights and duties under § 105 [filing requirements]2)Unreasonably restrict the right of access to books and records under §403(b);3)Eliminate the duty of loyalty under §404(b), but:

i. The p’ship agreement may identify specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable; or

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ii. All of the partners or a number or percentage specified in the p’ship agreement may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that would otherwise violate the duty of loyalty;

4)Unreasonably reduce the duty of care;5)Eliminate the obligation of good faith and fair dealing, but p’ship agreement may prescribe

the standards by which the performance of the obligation is measured;6)Vary power to dissociate as partner

G. Partnership Property – Reflecting the entity approach, a partnership may own property. Yet UPA is conflicted because of combination of entity and aggregate approaches. Both RUPA and UPA reach same conclusion regarding partner’s interest in p’ship property, rules are stated very differently:

1. UPA § 24. Extent of Property Rights of a Partner – The property rights of a partner are (1) his rights in specific p’ship property, (2) his interest in the p’ship, and (3) his right to participate in the management.

2. UPA § 25. Nature of a Partner’s Right in Specific Partnership Property – a. (1) a partner is co-owner with his partners of specific p’ship property holding as a tenant in

partnership.b. (2) the incidents of this tenancy are such that:

I. a partner, subject to the provisions of this act and to any agreement between them, has an equal right with his partners to possess specific p’ship property for p’ship purposes; but he has no right to possess such property for any other purpose without consent of partners.

II. A partner’s right in specific p’ship property is not assignable except in connection with the assignment of rights of all partners in the same property.

III. A partner’s right in specific p’ship property is not subject to execution or attachment, except on a claim against the p’ship

IV. On the death of a partner his right in specific p’ship property vests in the surviving partner or partners, except where the deceased was the last surviving partner, when his right in such property vests in his legal representative. Such surviving partners or legal rep. has no right to possess the p’ship property for any but a p’ship purpose.

V. A partner’s right in specific p’ship property is not subject to dower, courtesy or allowances to widows, heirs, or next of kin.

3. UPA § 26. Nature of Partner’s Interest in the Partnership – A partner’s interest in the partnership is his share of the profits and surplus, and the same is personal property.

4. UPA § 27. Assignment of Partner’s Interest – A conveyance by a partner of his interest in the p’ship does not itself dissolve the p’ship, nor, as against the other partners in the absence of agreement, entitle the assignee, during the continuance of the p’ship, to interfere in the management or administration of the p’ship business or affairs, or to require any info or account of p’ship transactions, or to inspect the p’ship books; but it merely entitles the assignee to receive in accordance with his contract the profits to which the assigning partner would otherwise be entitled.

5. UPA § 28. Partner’s Interest Subject to Charging Order – (1) On due application to a competent court by any judgment creditor of a partner, the court which entered the judgment, order, or decree, or any other court, may charge the interest of the debtor partner with payment of the unsatisfied amount of such judgment debt with interest

a. (2) The interest charged may be redeemed at any time before foreclosure, or in case of a sale being directed by the court may be purchased without causing dissolution:

I. with separate property, by any one or more of the partners, orII. with p’ship property, by any one or more of the partners with the consent of all the partners

whose interest are not so charged or sold.III. Nothing in this act shall be held to deprive a partner of his right, if any, under the exemption

laws, as regards his interest in the p’ship.6. UPA (1997) § 501. Partner Not Co-owner of Partnership Property – a partner is not a co-owner of p’ship

property and has no interest in p’ship property which can be transferred, either voluntarily or involuntarily.7. UPA (1997) § 502. Partner’s Transferable Interest in Partnership – the only transferable interest of a

partner in the p’ship is the partner’s share of the profits and losses of the p’ship and the partner’s right to receive distributions. The interest is personal property.

IV. Dissolution of PartnershipA. Four fundamental concepts involved under the UPA (1914):

1. the dissociation of any partner causes dissolution of a UPA p’ship; see IV(C) below

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2. dissolution does not end the p’ship but instead puts p’ship into period of winding up;a. involves liquidating the assets, settling outside obligations and the settling of accounts between the

partnersb. at the conclusion of winding up, the p’ship is legally at an end

3. the eventual end of p’ship is not necessarily the end of ‘ship’s business;a. focus is on p’ship agreement and arrangements made for post-dissolution continuation of the business,

buying of leaving partner’s interest, etc.4. under the UPA a partner always has the power (not necessarily the right) to dissolve the p’ship

a. manifested by express will of partner;b. power cannot be eliminated by agreement; thus a dissolving partner who breaches agreement did not

have ‘right’ to dissolve and may be liable to other partners for damages. “wrongful” B. Definitions of Important terms under the UPA (1914). Important to note definitions that deal with this area of

partnership, dissolution is not the equivalent of termination of the p’ship. RUPA treats this subject differently.1. UPA § 29. Dissolution Defined – The dissolution of a partnership is the change in the relation of the

partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.

a. Basically means the point at which the partners cease doing business together, from this point until the p’ship is terminated, the p’ship is winding up the business

2. UPA § 30. Partnership not Terminated by Dissolution – on dissolution the partnership is not terminated, but continues until the winding up of partnership affairs is completed.

C. Causes of Dissolution – the UPA (1914) creates two categories of causes:1. When these event occur, there is a dissolution by operation of law under § 31. Causes:

a. (1) without violation of the agreement between the partners,I. by the termination of the definite term or particular undertaking specified in the agreement,

II. by the express will of any partner when no definite term or particular undertaking is specified,III. 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,

IV. by the expulsion of any partner form the business bona fide in accordance with such a power conferred by the agreement between the partners;

b. (2) In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of the section, by the express will of any partner at any time; [see UPA § 38(2)

c. (3) by any event which makes it unlawful for the business of the partnership be carried on or for the members to carry it on in p’ship;

d. (4) by the death of any partner;e. (5) by the bankruptcy of any partner or the p’ship;f. (6) by decree of court under § 32.

2. UPA § 32. Dissolution by Decree of Court:a. (1) on application by or for a partner the court shall decree a dissolution whenever:

I. a partner has been declared a lunatic in any judicial proceeding or is shown to be of unsound mind,

II. a partner becomes in any other way incapable of performing his part of the p’ship contract,III. a partner has been guilty of such conduct as tend to affect prejudicially the carrying on of the

business,IV. a partner willfully or persistently commits a breach of the p’ship agreement or otherwise so

conducts himself in matters relating to the p’ship business that it is not reasonable practicable to carry on the business in p’ship with him,

V. the business of the p’ship can only be carried on at a loss,VI. other circumstances render a dissolution equitable.

b. (2) on the application of the purchaser of a partner’s interest under § 27 or 28;I. after the termination of the specified term or particular undertaking,

II. at any time if the p’ship was a partnership at will when the interest was assigned or when the charging order was issued.

D. Consequences of Dissolution on the Management of the Partnership1. Effect on Authority of Partners – generally dissolution terminates the authority of partners to act except for

the winding up of the p’ship’s affairs. Two important sections:

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a. Winding up: § 37. Right to Wind Up – Unless otherwise agreed the partners who have not wrongfully dissolved the p’ship or legal rep. of the last surviving partner, not bankrupt, has the right to wind up the p’ship affairs; provided, however, that any partner, his legal rep. or assignee upon cause shown, may obtain winding up by the court.

I. What constitutes ‘cause shown’ – waste, fraud, gross mismanagement, but what about deadlock between partners making decisions;

II. Presume that §18(h) in effect (majority vote) for ordinary matters; does this work for extraordinary matters faced in winding up. Possibly treat extraordinary matters as ordinary during dissolution

b. New business: the end of authority depends on notice of dissolution: §33. General Effect of Dissolution on Authority of Partner – Except so far as necessary to wind up p’ship affairs or to complete transactions begun but not then finished, dissolution terminates all authority of any partner to act for the p’ship, (1) with respect to the partners,

I. When the dissolution is not by the act, bankruptcy or death of a partner; orII. When the dissolution is by such act, bankruptcy or death of a partner, in cases where § 34 so

requires.c. Transactions concerning a partner who did not know of dissolution. § 34. Right of Partner to

Contribution from co-partners after Dissolution – Where the dissolution is caused by the act, death or bankruptcy of a partner, each partner is liable to his co-partners for his share of any liability created by any partner acting for the p’ship as if the p’ship had not been dissolved unless

I. The dissolution being by act of any partner, the partner acting for the p’ship had knowledge of the dissolution, or

II. The dissolution being by the death or bankruptcy of a partner, the partner acting for the partnership had knowledge or notice of the death or bankruptcy.

2. Effect on the Power of a Partner to Bind Partnership to 3d Party after Dissolution – the UPA provision is structured so that a postdissolution act may bind p’ship if it qualifies under the rules of §35(1) and is not disqualified under any rule in §35(3).

a. Empowering rule distinguishes between two types of transactions:I. § 35(1)(a) – by any act appropriate for winding up p’ship affairs or completing transactions

unfinished at dissolution;II. §35(1)(b) – by any transaction which would bind the p’ship if dissolution had not taken place,

provided the other party to the transaction D. had extended credit to the p’ship prior to dissolution and had no knowledge or notice of the dissolution; orE. though he had not so extended credit, had nevertheless known of the p’ship prior to dissolution, and having no

knowledge or notice of dissolution, the fact of dissolution had not been advertised in a newspaper of general circulation in the place at which the p’ship business was regularly carried on.

b. Constraining Rules: § 35(3): The partnership is in no case bound by any act of a partner after dissolution

I. Where the p’ship is dissolved because it is unlawful to carry on the business, unless the act is appropriate for winding up p’ship affairs; or

II. Where the partner has become bankrupt; orIII. Where the partner has no authority to wind up p’ship affairs; except by a transaction with one

whoD. Had extended credit to the p’ship prior to dissolution, and had no knowledge or notice of his want of authority; orE. Had not extended credit to the p’ship prior to dissolution, and having no knowledge or notice of his want of authority,

the fact of his want of authority has not been advertised in the manner provided for advertising the fact of dissolution in § 35(1)(b)(II).

c. How to protect against a partner’s unauthorized post-dissolution transactions. Important to create notice to all 3d parties of the p’ship’s dissolution:

I. Run advertisement in newspaper of general circulation published in p’ship’s regular places of business stating dissolution and authority of partners; and

II. Send letter containing same info to all prior suppliers or vendors, that have provided goods or services to the p’ship

E. The Partnership Business – To liquidate or not? In many cases the liquidation results in a quick sale of the assets of the p’ship. The UPA rules differ depending on whether the dissolution was rightful or wrongful. Difference b/c if wrongful dissolution by one partner, the remaining partners may want to continue the p’ship and not terminate, but must be unanimous decision among remaining partners. UPA provisions are default rules and may be modified by agreement

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1. Rightful dissolution - § 38(1) When dissolution is caused in any way, except in contravention of the p’ship agreement, each partner, as against his co-partners… unless otherwise agreed, may have the p’ship property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners…

2. Wrongful dissolution - § 38(2) When dissolution is caused in contravention of the p’ship agreement the rights of the partners shall be as follows:

a. Each partner who has not caused dissolution wrongfully shall have, I. (I) All the rights specified in §38(1), and

II. (II) The right, as against each partner who has caused the dissolution wrongfully, to damages for breach of the agreement.

b. The partners who have not caused the dissolution wrongfully, if they all desire to continue the business in the same name, either by themselves or jointly with others, may do so, during the agreed term for the partnership and for that purpose may possess the p’ship 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 p’ship at the dissolution, less any damages recoverable above and in like manner indemnify him against all present or future liabilities.

c. A partner who has caused the dissolution wrongfully shall have have:I. (I) if business not continued, all right stated in §38(1) [subject to damages for the breach], or

II. (II) if business continued to be paid in cash the value of his interest minus any damages caused by his wrongful dissolution, and to be released from all existing liabilities of the p’ship. The value of his interest will not include the goodwill of the p’ship

3. Continuation of the Partnership Business – what are the rights and obligations of partners that wish to continue the p’ship business and those that are exiting: In most cases p’ship agreements are essential to provide for smooth transition in this area and this provision would only apply in absence of any agreement. Again UPA provides default rules. General rule is that creditors of old p’ship become creditors of new p’ship automatically. § 41. Liability of Persons Continuing the business in Certain Cases –

a. (1) When any new partner is admitted into an existing p’ship, or when any partner retires and assigns his rights in p’ship property to two or more of the partners, or to one or more of the partners and one or more third persons, if the business is continued without liquidation of the p’ship affairs, creditors of the first or dissolved p’ship are also creditors of the p’ship so continuing the business.

b. (2) When all but one partner reitre and assign their rights in partnership property to the remaining partner, who continues the business without liquidation of p’ship affairs, either alone or with others, creditors of the dissolved p’ship are also creditors of the person or p’ship so continuing the business.

c. (3) When any partner retires or dies and the business of the dissolved p’ship is continued as set forth in (1) and (2) above, with the consent of the retired partners or the rep. of any deceased partner, but without any assignment of his right in p’ship property, rights of creditors of the dissolved p’ship and of the creditors of the person or p’ship continuing the business shall be as if such assignment had been made.

d. (4) When all the partners or reps assign their rights in p’ship property to one or more third person who promise to pay the debts and who continue the business of the dissolved p’ship, creditors of the dissolved p’ship are also creditors of the person or p’ship so continuing the business.

e. (5) When any partner wrongfully causes a dissolution and the remaining partners continue the business under the provisions of § 38(2)(b), either alone or with others, and without liquidation of the p’ship affairs, creditors of the dissolved p’ship are also creditors of the person or p’ship so continuing the business.

f. (6) When a partner is expelled and the remaining partners continue the business either alone or with others, without liquidation of the p’ship affairs, creditors of the dissolved p’ship are also creditors of the person or p’ship so continuing the business.

g. (7) The liability of third persons becoming a partner in the p’ship continuing business, under this section, to the creditors of the dissolved p’ship shall be satisfied out of p’ship property only.

h. (8) When the business of a p’ship after dissolution is continued under any conditions set forth in this section the creditors of the dissolved p’ship, as against the separate creditors of the retiring or deceased partner have a prior right to any claim of the retired partner or rep of deceased partner against the person or p’ship continuing the business, on account of the retired or deceased partner’s interest in the dissolved p’ship or on account of any consideration promised for such interest or for his right in p’ship property.

i. (9) Nothing in this section shall be held to modify any right of creditors to set aside any assignment on the ground of fraud.

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j. (10) The use by the person or p’ship continuing the business of the p’ship name or the name of the deceased partner, shall not of itself make the individual property of the deceased partner liable for any debts contracted by such person or p’ship.

4. Effect of Continuation of Business on Deceased or Retired Partner - § 42. Rights of Retiring or Estate of Deceased Partner when the Business Is Continued – if the business continues under conditions set forth in § 41 (1, 2, 3, 5, 6) or 38(2)(b) without any settlement of accounts between the retiring or deceased partner and the person or p’ship continuing the business, then:

a. Provides for an election: the retiring partner or estate is entitle to an amount equal to his interest on the date of dissolution plus interest ‘as ordinary creditor’ or in lieu of interest, may opt for profits attributable to the use of his interest in the continuing business; and

b. Also provides that creditors of the dissolved p’ship shall have priority against the separate creditors, or the retired partner or estate, but does protect value of retiring partner’s interest against other partners. See § 40: § 42 election makes partner’s claim category II, while co-partners are in categories III and IV, while outside creditors remain category I.

c. § 43. Accrual of Actions – The right to an account shall accrue to any partner… at the date of dissolution, in the absence of any agreement to the contrary. This section related because § 42 recognizes that this may not be done immediately and protects the retiring or deceased partners interest in the winding up period.

d. § 42 suggests valuation at FMV, but agreement may specify another standard of value or alternate fixed amount

e. § 42 not available if p’ship being wound up, only available if business contiuesf. Basically it allows partners who wish to continue after retirement or death of partner to buy out that

partner’s interest, but § 42 leaves unanswered questions that should be considered in any p’ship agreement:

I. How long may the successor p’ship wait to cash out the retired or deceased (dissociated) partner?

II. Must the successor p’ship make interim payments to the dissociated partner pending the cash out?

III. When does the dissociated partner elect between the interest option and the profit sharing option?

IV. May the dissociated partner change the election?V. How is the interest rate determined?

VI. How is the profit share calculated?VII. How long may the business continue before fully cashing out the dissociated partner?

F. Impact of Dissolution of the Partners1. Impact on Personal Liability – The general rule is that dissolution has no effect on the liabilities of any

partner. However, discharge may occur in two situation as provided for in this provision. § 36. Effect of Dissolution on Partner’s Existing Liability -

a. (1) The dissolution of the p’ship does not of itself discharge the existing liability of any partner.b. Postdissolution discharge by agreement with the creditor - § 36(2) provides: ‘A partner is discharged

from any existing liability upon dissolution of the p’ship agreement to that effect between himself, the p’ship creditor and the person or p’ship continuing the business…’

I. Assumes that person continuing business will assume responsibility of the discharged partner’s obligations,

II. § 36(2) provides that ‘such agreement may be inferred from the course of dealing between the creditor having knowledge of the dissolution and the person or p’ship continuing the business.

c. Discharge by material alteration in the obligation - § 36(3) Where a person agrees to assume the existing obligations of a dissolved p’ship, the partners whose obligations have been assumed shall be discharged from any liability to any creditor of the partnership who, knowing of the agreement, consents to a material alteration in the nature or time of payment of such obligations.

I. Debate over what is ‘material alteration’D. Material: time extension on payment, renewal of noteE. Not material: failure of creditor to immediately sue on ovedue account

2. Settling of Accounts between Partners when Business is Liquidated – the UPA provides the default rule that governs in the absence of a p’ship agreement between the partners. § 40. Rules for Distribution – In settling accounts between the partners after dissolution, the following rules shall be observed, subject to any agreement to the contrary:

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a. The assets of the partnership are:I. The p’ship property,

II. The contributions of the partners necessary for the payment of all the liabilities specified in clause (b) of this paragraph.

b. The liabilities of the p’ship shall rank in order of payment, as follows:I. Those owing to creditors other than partners,

II. Those owing to partners other than for capital and profits,III. Those owing to partners in respect of capital,IV. Those owing to partners in respect of profits.

c. The assets shall be applied in the order of their declaration in clause (a) of this paragraph to the satisfaction of the liabilities.

d. The parties shall contribute, as provided by § 18(a) the amount necessary to satisfy the liabilities; but if any, but not all, of the partners are insolvent, or not being subject to process, refuse to contribute, the other partners shall contribute their share of the liabilities, and, in the relative proportions in which they share the profits, the additional amount necessary to pay the liabilities.

e. An assignee for the benefit of the creditors or any person appointed by the court shall have the right to enforce the contributions specified in clause (d) of this paragraph.

f. Any partner or his legal rep shall have the right to enforce the contributions specified in clause (d) of this paragraph, to the extent of the amount which he has paid in excess of his share of the liability.

g. The individual property of a deceased partner shall be liable for the contributions specified in clause (d) of this paragraph.

h. When p’ship property and the individual properties of the partners are in possession of a court for distribution, p’ship creditors shall priority on p’ship property and separate creditors on individual property, saving the rights of lien or secured creditors as heretofore.

i. Where a partner has become bankrupt or his estate is insolvent the claims against his separate property shall rank in the following order:

I. Those owing to separate creditors,II. Those owing to p’ship creditors,

III. Those owing to partners by way of contribution.

V. Continuation Agreements and Other Tools to Reduce Risks – A. Does the UPA allow private agreements to supplant the dissolution provisions, two ways of looking:

1. yes, UPA default rule that can be modified by agreement & continuation agreement is such a modification; or

2. Death or retirement, does dissolve p’ship, but that the agreement has modified the right of retired or estate of deceased partner to force liquidation

B. Continuation Agreements – attempts by partners to plan ahead. Several important primary issues must be settled if the agreement is to be effective at dealing with continuation after dissolution:

1. Type of dissolution that will trigger the clause – most common death, retirement, or other types of dissolution, could include provisions for wrongful dissolution;

2. What to do with outgoing interest – other partners, the p’ship itself, or acceptable 3d parties could purchase; or outgoing interest may continue to share in future earnings

3. Is the disposition to be optional or mandatory from the standpoint of the remaining partners; ie may the remaining partners elect to terminate regardless of the agreement.

4. How much is the withdrawing interest to receive? Valuation is probably the most difficult issue to resolve in the agreement as to avoid future litigation. Several methods:

a. Fixed sum, usually w/ provisions for periodic adjustment;b. Book value: historical cost minus depreciation; not the same as fair market valuec. Appraisald. Capitalization of earnings in the past

I. Value of any business must be based on capacity to produce income; approach basically the estimate of the present value of a stream of income. Agreement must specify how earnings are calculated and the multiplier. Steady stream of income use a high multiplier, unstable income stream use low multiplier, could use average

e. A fraction of future earnings over specified period of timef. Use of an arbitrator, after the fact (but is this very helpful if the arbitrator does not have guidelines)g. A sum based on a fraction of the partner’s income from the partnership during the previous years or

an average of several years

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5. Is payment to be made in a lump sum or over a period of time?6. How is cash to be raised to meet required payments:

a. Life insurance, b. Reserve fund created for this contingencyc. Borrowing the funds and repaying from future earnings

7. Inclusion of non-compete clauses8. Does retiring interest have power to inspect books and records or demand an audit

C. Buy-Sell Agreements – most likely would provide for continuation, but makes it contractual that the remaining partner control the business so as to avoid liquidation

D. Important to remember that provisions may not be binding that force a new 3d party on the remaining partners. No one is required to accept a new partner against his will. May occur only be consent of all remaining partners. Same conceptually as disfavoring specific performance of service contracts, considered too personal in nature.

The Law of CorporationsI. Formation of a Corporation –

A. Process of Incorporation: How, where and problems that may arise if not done correctly1. Articles of Incorporation – most statutes dictate what it must say, MBCA included:

a. Name of Corporation – must state complete name w/ designation of corporate status (Corp., Inc, etc). MBCA § 4.01 – ‘must be distinguishable upon the records’

b. Registered Office & Agent - § 2.02, must state registered agent for service of processc. Capital Structure – must describe various classes of authorized shares, numbers and privileges, rights

and limitations. §6.01d. Purpose and Powers of Corp. – may but not necessary to state purposes and powers. Modern

presumption and structure of § 3.01 is Inc can engage in any lawful business. §3.02 Inc has same powers as individuals

e. Size/Composition of Board of Directors – most have abandoned detailed requirements, § 8.03 requires only that board be composed of one or more individuals

f. Other provisions – may included specific provisions that are specific, including: voting provisions, membership, management provisions

2. Organizational Meeting and By-Lawsa. Opportunity to elect directors of corop

3. State of Incorporation – a corp can be formed in any state regardless of where it may conduct business. Some consideration important, because state of incorporation will dictate governing law.

a. Internal Affairs Doctrine – state of inc governs relationship of parties within the corp. ‘Internal affairs’ relates to legal relations of corporate participants: shareholders, directors and procedures for corporate action. State courts are bound to accept corporate law of incorporating state

B. Doctrine of Ultra Vires – lost some relevance as articles of incorporation now have broad statements of purpose. 1. Primarily applies today in limited circumstances:

a. Corporate parties create restrictions in articles on corporate activitiesb. Corporation engages in activities not directly related to profit-seeking (charitable giving)c. Board takes actions that undermine shareholder power

2. Gratuitous activities – when is giving too much and when does it have a business purposea. Test: is the amount reasonable and is the purpose reasonableb. Power stems from:

i. MBCA § 3.02(13) – to make donations for the public welfare or for charitable, scientific, or educational purposes;

ii. § 3.02(15) – to make payments or donations, or do any other act, not inconsistent with law, that furthers the business and affairs of the corporation.

c. Criticism of corporate charitable giving – allowed, but not a profit making actionsi. Who gets to decide which charities to support;

ii. Could it be better to save money and distribute in form of dividends and allow shareholders to decide which to support

3. Procedure to attack action on these grounds. MBCA § 3.04. Ultra Vires – a. Except as provided in subsection (b), the validity of corporate action may not be challenged on the

ground that the corporation lacks or lacked power to act.b. A corporation’s power to act may be challenged:

i. (1) in a proceeding by a shareholder against the corporation to enjoin the act;

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ii. (2) in a proceeding by the corporation, directly, derivatively, or through a receiver, trustee, or other legal representative, against an incumbent or former director, officer, employee, or agent of the corporation; or

iii. in a proceeding by the attorney general under § 14.30 (dissolve corporation)c. In a shareholder’s proceeding under subsection (b)(1) to enjoin an unauthorized corporate act, the

court may enjoin or set aside the act, if equitable and if all affected persons are parties to the proceeding, and may award damages for loss (other than anticipated profits) suffered by the corporation or another party because of enjoining the unauthorized act.

C. Premature Commencement of Business – involves two primary types of situations: 1) corporation yet to be formed, and 2) defective incorporation. Called promoter contracts.

1. Corporation’s Rights and Obligations – prior to formal incorporation, the corp is not bound to any contract entered into by the promoter b/c it was not in existence, but

a. If corp wishes to bind itself to the contract, it may adopt the contract and become liable upon it. A novation, when the 3d party discharges the promoter and substitutes the newly formed corporation

b. If corp does not wish, may refuse to adopt, but court may find that i. Implied adoption when the corporation in some way gets the benefits of the contract or

ii. Merely acquiesces iii. If already received benefit but no K, 3d party could sue for quantum meruit

2. Promoter Liability when corporation has yet to be formed – in process of creating corp, the promoter may enter into contracts before the articles of incorporation have been filed. Who can be held liable on the contract when both parties know that the corporation is not in existence yet:

a. Important distinction from agency law – promoter does not have actual authority to bind corporation (not acting as an agent) because the corporation (the principal) is not officially in existence. Default rule of agency Rest. § 326 – a purported agent acting for a nonexistent principal becomes a party to the contract, absent a contrary intent.

b. Parties’ Intent and Options regarding contract - i. No intent to create contract – 3d party has no intent to contract w/ 3d party, more in nature of

offer to future corporation that can be withdrawn by 3d party before acceptance by corporation if created

ii. Default rule – if no intent discernable, contract is binding between the 3d party and promoteriii. Contract within contract – promoter agrees to be bound and 3d party will grant novation. So,

instead of post-incorporation, the 3d party enters advance agreement to accept corporation’s promise as novation of promoter’s obligation. Involves understanding that promoter off hook even if corp. breaches promise

iv. View the future offer to corp as option contract – promoter could pay consideration to 3d party to keep offer open until incorporation

c. Discerning Parties’ Intent – generally promoter has burden of proving intent to overcome default rule that he is liable

i. Language of the contract, how was contract signed, who drafted K, ambiguities resolved against drafter

a) Signing on behalf of corp, orb) Corp ‘who will be obligor’ may not be sufficient to rebut presumption

ii. K calls for performance before corporation formed – why would party begin on non-existent contract

iii. Negotiationsd. How does the promoter protect against default rule - express of clear intent:

i. Nonrecourse agent – promoter merely carrying offer to corp, no contract unless corp formed and adoption of K.

ii. ‘Best effort’ agent – promoter using best effort to incorp, but no contract unless corp formed and adoption of K.

iii. Interim contracting party – after incorp, promoter to be substituted – novationD. Defective Incorporation – previous discussion both promoter and 3d party knew that no corporation was in existence,

this area involves one or both parties not knowing corporation defective. De jure means a legally valid corporation. Involves several theories of liability, two common law defenses and the MBCA (1984).

1. Consequences of Defective Incorporation and Theories of liability – a. If party failed to create corporation, what is default business organization: perhaps have an association

of two or more individuals carrying-on as co-owners a business for profit – partnership. Each partner is jointly and severally liable. Yet who can be considered partner

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b. Promoter could arguably have misled 3d party about existence of corporation, breach of an implied warranty regarding extent of authority. Rest §329 liability for representation of nonexistent authority unless disclaimer or 3d party knowledge

c. Pre-1984 model act (strict approach) – no limited liability protection until valid articles of incorporation on file, everyone purporting to act for corp will be jointly and severally liable.

2. De facto corporation – one defense to above theory of liability. Court will treat venture as if it was a corporation for determining rights and liabilities of parties. Will grant protection of limited liability to actors. The doctrine requires these elements:

a. Valid law allowing incorporation,b. A colorable or good faith attempt to incorporate under law,c. Actual use of the corporate form.

3. Corporation by Estoppel – outsiders who rely on appearances or representations that a corporation exists and act accordingly are estopped from denying corporate existence in order to hold actors liable directly. Considered upside-down estoppel because it keeps the misleading party from using that fact against them. Useful when there has been no attempt to incorporate.

4. The middle road, the MBCA. (1984)a. § 2.04 Liability for Preincorporation Transactions – All persons purporting to act as or on behalf of a

corporation, knowing there was no incorporation under this Act, are jointly and severally liable for all liabilities created while so acting.

b. Definite liability when defective liability w/knowledge, but no liability if had no knowledge of defectc. Focus on insider’s knowledge not outsider’s understandingd. Electronic disclosure – everybody has knowledge?

E. Piercing the Corporate Veil – instances where there is a properly incorporated entity, but still attempting to hold individuals liable for corporate liabilities. Disregard of limited liability. Occurs with closely held corporations. Involves a very tangled web of undefined language: sham, mere instrumentality. Must recognize equitable remedy to avoid injustice

1. Factors that courts have cited as reasons to pierce, yet unclear about relationship between all of them:a. Control or domination – is this really an important factor

i. courts have applied a two-part test:1) ‘Unity of interest and ownership that the separate personalities of the corp &

individual no longer exist2) Adherence to corporate fiction would sanction a fraud or promote injustice

ii. Although irrational to say shareholder over controlled, still important factor to distinguish between majority (presumed to caused fraud or injustice) and minority (passive) shareholders.

b. Disregard of Corporate Formalities – many times this factor incorporates issues best stated as distinct problems (ex: undercapitalization, or self-dealing).

i. Conduct: failure to issue stock, failure to have meetings, prepare minutes, carefully documenting transactions between corporation and shareholder

ii. Reality – these factors mostly irrelevant when trying to decide whether to pierceiii. Maybe useful as evidence of systematic disregard of corporate obligations

c. Commingling of Assets and Affairs – similar to formalities. If one person corp, is this sign of other more substantive problems. If so, define them, do use this as rationale

2. Other Factors that seem to carry more weight – a. Wrongful dealings with Creditor (Fraud) – clearly a valid reason to pierce. What constitutes it:

i. Representation regarding corporation’s financial status. Misrepresentation should lead to liability. What if creditor didn’t seek info, probably won’t pierce for contract creditor

ii. Representation regarding corporate performance – key issue is there fraud in the promise or merely breach of contract. If shareholder when making promise has no intent to fulfill, then fraud. How to determine intent – could there be inferences that defendant knows corporation will be unable to perform

iii. Representations that lead creditor to believe 3d party standing behind debt – if in writing no need to pierce, so could be oral, 3 issues:

1) Statute of frauds or parol evidence problem2) Should there be clear statement that lead creditor to believe 3d party guarantee?3) If merely confusion, who should bear cost – probably party most able to avoid

confusion, defendant

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b. Wrongful dealings with Corporation’s Assets – many times the real justification for piercing, formalities windowdressing. What should be considered wrongful:

i. Consider unfair self-dealing as fraud, did the corporation receive a fair exchangeii. Fraudulent conveyance

iii. But not every transaction is abusive self-dealing, Home Owners Coop – building houses at cut rate

c. Inadequate Capitalization – important reason cited, but standing alone should not be sufficient justification to pierce

i. Cases represent both extremes:1) Minton v. Cavaney – undercapitalization alone sufficient to pierce, when

inadequate for corporation’s purpose2) Walkovszky v. Carlton – dividing up cab company into several corporations with

one or two cabs per company ii. Definition of: enough capital to meet a ‘fair’ share of the risks, enough capital to create an

incentive for controlling shareholders to make reasonable business decisions (i.e., to avoid excessive risk-taking

iii. Disfavor for contract – sophisticated business person should seek info, for large transactions if concern about repayment, or seek personal guarantees

d. Enterprise Liability / Multiple Corporations – disregard of multiple incorporations, or parent-subsidiary arrangements.

i. Some courts look to see if parent dominated subsidiary, so that they acted as single economic entity. Yet isn’t that purpose behind these structures.

F. Deep Rock Doctrine – Equitable subordination, when a court will subordinate (move down priority list for payment) a loan to the corporation made by a shareholder. General rule is that a shareholder can make part of investment to corporation a loan, and have it treated as though it were any other loan from outside creditor.

1. Rationale for rejecting rule that all shareholder loan’s should be subordinated – does not make economic sense. Not desirable to deter shareholders from making loans to own corporations. Shareholder may provide better terms, shareholder may be only source of loan

2. Usually found in cases where there was inequitable conduct to the advantage of the shareholder. Primary example:

a. Pepper v. Litton – Litton sole shareholder of company. Pepper brought suit to collect unpaid royalties. Litton then determined that corporation owed him unpaid salary which it had not paid him over years. Litton had corporation confess judgment to him. After Pepper also obtained judgment, Litton executed his judgment bought all assets of company at execution sale and then had company file for bankruptcy. Litton also filed claim in bankruptcy for remaining amount of judgment. Court citing fiduciary duty of controlling director and shareholder held that Litton’s claim should be subordinated. Considered an abusive transaction, unfair self-dealing

b. Relationship to piercing corporate veil – similar in that it is a milder remedy than a finding of individual liability.

E. Successor Liability – in an asset acquisition none of the liabilities transfer unless the parties agree. But successor liability doctrine steps in to impose liability on successor corporation in certain instances. General rule has four generally recognized exceptions:

1. Exceptions, no liability unless:a. There is an express or implied agreement to assume the liabilities,b. Transaction amount to a consolidation or mergerc. The successor entity is a mere continuation or reincarnation of the predecessor entityd. The transaction was fraudulent, not made in good faith, or made without sufficient consideration.

2. Nissen Corp. v. Miller – want to add another exception for ‘continuity of enterprise’ – focus is on continuation of business operation where there is no continuation of ownership.

II. Management and Control of the Closely Held CorporationA. Shareholders – basic function is not to manage the corporation, but rather to elect the directors, who have ultimate

responsibility to manage the corporation. Also given limited opportunity to vote on fundamental corporate transactions (not clear where this limit lies)

1. Mechanics of Shareholders’ Meetings – primary manner by which shareholders act

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a. Meetings – i. Annual – MBCA § 7.01 requires annual meeting, time/place usually specified in by-laws,

some statutes may give power to shareholders force meeting1. BUT, § 7.01(c) – failure to hold meeting at stated time… does not effect the

validity of any corporate action.ii. Special – MBCA § 7.02 allows them to be called by the board, persons authorized in by-

laws, or shareholders holding 10% of voting shares1. only business that may be transacted at special meeting is what is described in the

noticeb. Notice – all shareholders entitled to vote must receive timely notice of the annual and special

meetings. Covered under §§ 7.05 and 7.06c. Quorum – for any action taken at meeting, must be a quorum. § 7.25(a) provides that unless

otherwise agreed to, a quorum is a majority of the votes entitled to votei. § 7.27 Greater Quorum of Voting Rights – the articles of incorporation may provide for a

greater quorum than is provided for aboveii. §7.25(b) – once share is represented for any purpose, deemed present for the remainder of

meeting. Means that disgruntled shareholder cannot leave in middle and break quorumiii. §7.25(c) – once quorum exists, action is approved if the votes cast within the voting group

favoring it exceed the votes cast opposing it.1. Ex: 1000 shares, 600 attend meeting. Vote is 280 for and 225 opposed, with 95

abstaining. Vote passes under this provision. Old rule said not pass b/c fewer than majority (600) approved. Simple majority

2. Absolute majority – means that an vote abstaining is treated like a vote against. State statutes may vary depending on the action being voted on.

d. Who gets to Vote – general rule is one share one vote. Problems arise when the corporation issues different classes of shares that have different voting rights.

i. Record / Beneficial Owners – only the shareholders of record can vote, but the beneficial owner can direct how those shares are to be voted

ii. § 7.21(b) – does not allow a subsidiary to vote the shares of a parent corporation that holds a majority of the subsidiary’s voting shares.

e. Election Inspectors - §7.29 provides for inspectors to verify the validity of the election.2. Shareholders’ Role in Governance - generally given the power to vote on fundamental transactions, only

have power in other limited circumstances. In areas S/H have no power, don’t have power to command action. Also shareholders have certain informational rights.

a. Election and Removal of Directors: this is the primary power of shareholders. § 8.03(c) – directors elected at first meeting and annually thereafter.

i. Directors – MBCA § 8.02 sets default qualifications, director doesn’t need to be resident of state of the corporation. § 8.03(a) – allows for a board of directors to consist of only one director, old statutes used to require 3.

ii. Removal of Directors - § 8.08 provides:1. (a) The shareholders may remove one or more directors with or without cause

unless the articles of incorporation provide that the directors may be removed only for cause.

2. (b) If a director is elected by a voting group of shareholders, only the shareholders of that voting group may participate in the vote to remove him.

3. (c) If cumulative voting is authorized, a director may not be removed if the number of votes sufficient to elect him under cumulative voting is voted against his removal. If cumulative voting is not authorized, a director may be removed only if the number of votes cast to remove him exceeds the number of votes cast not to remove him.

4. (d) A director may be removed by the shareholders only at a meeting called for the purpose of removing him and the meeting notice must state that is the purpose of the meeting.

iii. Voting Methods – difference between straight voting v. cumulative voting1. Straight voting – this is general rule, which means that a majority shareholder can

elect the entire board of directors. § 7.28(a) – directors are elected by a plurality of the votes cast by the shares entitled to vote. § 7.28(b) – shareholders do not

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have a right to cumulate their votes for directors unless the articles of incorporation provide

2. Cumulative voting – a technique to give minority shareholders sufficient voting power to elect a director to the board. Allows min shareholder to allocate all votes for one or a very few candidates. Must be allowed by law or by articles of incorporation, § 7.28(c) states must have words to that effect, but requires advance notice of any intent to vote this way.

3. Ways to undermine cumulative voting – a. Staggering Board - Limit the number of directors on board up for

election by. Creating groups of directors each with a different term. § 8.06 Staggered Terms for Directors – articles of incorporation may provide for staggering the terms of directors by dividing the total number of directors into two or three groups.

i. Minority may argue that this is ilegal if explicitly given right to cumulate votes

ii. What does state constitution say? b. Class Voting – issues different classes of stocks that elect their own

directors. MBCA § 8.04 b. Approval of Board-Initiated Transactions – in certain circumstances, shareholders have limited

powers to approve transaction:i. Fundamental Corporate Changes – amendments to the articles of incorporation; mergers

w/ other corps; sale of substantially all corp assestsii. Conflicting Interest Transactions – can vote to approve indemnification of directors,

officers, or othersc. Shareholder-Initiated Changes – very narrow powers to initiate changes on their own:

i. Amendment of by-laws – generally shareholders given power to adopt, amend and repeal bylaws. Statute could limit ability of board to amend shareholder enacted by-laws if expressly so provides.

ii. Amendment of Articles – limited cases this power granted by statute, but most limit this power to the board.

iii. Nonbinding Resolution – can make recommendations to board3. Shareholder’s Informational Rights – to facilitate voting power, statutes give shareholders right to received

information from corporation. a. Financial Reports - § 16.20 provides that the corp must provide to the shareholders annual financial

info, including balance sheets, income statementsb. Inspection of Corporate Books and Records - § 16.02 entitles a shareholder to inspect and copy

corporate books. § 16.02(f) allows beneficial owners same right as record owners.i. Articles of incorp, bylaws, minutes available as of right

ii. Board minutes, accounting records, shareholder lists – available for inspection only if demand is ‘made in good faith and for a proper purpose’ and must describe this purpose with ‘reasonable particularity’. Courts have found proper purpose to include

1. shareholders seeking to solicit proxies2. viewing list in order to contact shareholder for a derivative suit3. Investigating for mismanagement a much closer case and may not be considered a

proper purpose. Delaware states that a S/H w/ this purpose must show be preponderance of evidence a credible basis exists

c. Concerns over burden placed on corporation to comply with shareholder info requests – several ways to reduce the possible burden:

i. Grant disclosure subject to injunction against improper purposeii. Limit the shareholders who can make info demands

1. classify by amount of investment, or time of ownership2. limit by type of document requested – recognition of difference between

shareholder list or by-laws and secret formulas, etc.4. Fiduciary Duties of Controlling Shareholders – generally considered the majority shareholder, one that can

determine the outcome of shareholder voting.

B. Directors – the board of directors is the primary entity controlling the corporation and the primary source of all authority. Elected annually by the shareholders. Board of directors gains its authority from the corporate statute.

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1. Board Decision-Making – the directors operate as a board, not as individuals. Individual directors have virtually no power. Acts by majority vote at a properly noticed director’s meeting with a quorum.

a. Quorum § 8.24 – by-laws or statute may set the number needed for quorum. Could be majority or less depending on state statute or by-laws. Action taken without quorum is invalid.

i. § 8.24(b) sets one-third of directors as minimum requiredii. § 8.24(c) requires a majority of directors

b. Notice – § 8.22 does not require notice be given for regular meeting of the board. Requires two day notice for any special meeting, but does not require description of purpose of meeting. The by-laws or articles of incorporation can modify either of these default rules.

2. Decision-Making without Meeting - § 8.21(a) allows actions to be taken without a meeting, but only if each director signs a consent to the proposed action. May be revoked if revocation is received before all signed consents.

3. Delegating Board Function to Committees - § 8.25 allows the board to delegate functions to committees that are comprised of some of the directors.

a. § 8.25(e) states that a committee does not have the authority to approve distributions or share repurchases, issue shares, approve mergers, amend by-laws, or fill vacancies on the board.

b. Committees are bound by same requirements § 8.20-24, as the entire board of directors.

C. Officers – legally considered the agent of the corporation whose authority comes from a delegation by the board. May be delegated through a by-law, by resolution of the board, or by implication. Generally the president will be found to have some inherent authority to conduct day-to-day affairs, but no officer has authority to bind corporation to a major transaction without board approval.

1. States sometimes require a specific number and type of officers: President, Treasurer, Secretary and any number of vice-presidents.

2. When determining an officer’s authority, apply the basics of agency law: actual, apparent, etc. 3. Finding authority can be complicated b/c corporation is not actually a person. To find express authority

must look to:a. Bylaws or articlesb. Resolution by board of directorsc. Actions of superior officials.

4. Example of official’s title and position creating implied or apparent authority – Lee v. Jenkins Bros. – court determined whether president of corporation had the authority to promise the plaintiff that if plaintiff came to work for the corporation he would receive a pension at age 60 even if plaintiff did not work for corporation until age 60. No evidence of express authority in by-laws or board resolution granting authority. Issue was whether president position alone granted apparent authority.

a. Court said pres could bind corporation to contracts in ordinary course of business, but not extraordinary contracts. Yet determine this by looking to industry practice or course of dealing.

b. Modern approach: whether party dealing w/ pres reasonably believed pres had authority to make contract

5. Verifying Board Approval of Officer Transactions – can 3d party rely on corporate officer’s representations that board has approved action?

a. In re Drive-In Development Corp – case involved a bank loan to Drive-In’s parent company and bank wanted guarantee and resolution from Drive-In approving the deal. Corporate secretary gave bank a purported copy of such a resolution, but later discovered that no resolution was in the corporate minutes.

b. Court found that corp was estopped from denying authority of secretary to sign guarantee. Those who deal w/ corp should be able to rely on representations of officers with apparent authority to enter transactions without having to go behind these representations.

III. Duties of Directors and OfficersA. General Theory – universal statement is that officers and directors owe a fiduciary duty to the corporation and the

shareholders. Some modern statutes have expanded the constituencies that the corporation may consider. Penn’s states that director may consider in addition to the traditional groups, suppliers, customers, creditors, communities in which offices or establishments of the corporation and short & long term interests of the corporation. The fiduciary duty is really 1) a duty to exercise care in avoiding harm to corporation and 2) a duty of loyally placing corporation’s interests ahead of one’s own.

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B. Duty of Care – addresses the attentiveness and prudence of managers in performing their decision-making and supervisory functions.

1. This duty is codified in § 8.30 and is comprised of three standards: the director shall act in good faith and in a manner the director reasonably believes to be in the best interests of the corporation:

a. Good faith – requires a director to be: honest, not have a conflict of interest, and not approve illegal activity

b. Reasonable belief – involves the substance of director decision-making. Board decision must be related to furthering corporation’s interests. Action could be invalid if it lacks any rational business purpose.

c. Reasonable care – informed basis and ordinary care involve procedures of decision-making. § 8.30(b) creates a ‘like position’ standard that requires a director to discharge duties with care that a person in ‘like position’ would reasonable believe appropriate under circumstances.

2. The Business Judgment Rule – idea that courts should exercise restraint in holding directors liable for business decisions which produce poor results or with which reasonable minds might disagree.

a. Operates at two levels: i. Shield directors from personal liability, and

ii. Insulates board decisions from judicial reviewb. Reliance Corollary – offshoot of rule allows directors to rely on information and advice from other

directors (including committees of the board), officers, employees, and outside experts such as accountants and lawyers. § 8.30(c)-(e). To claim, the director must have become familiar with the info or advice and must have reasonably believed that it merited confidence.

c. Overcoming Business Judgment Presumption – i. burden is on the challenger and must prove:

I. Fraud, illegality, or conflict of interest (lack of good faith)II. Lack of rational business purpose (waste) (substance), or

III. Gross negligence in discharging duties to supervise and to become informed (procedure)

ii. MBCA § 8.31 standards of liability – a director can become liable for:I. Action not in good faith,

II. A decision the director did not reasonably believe to be in the corporation’s best interest or as to which the director was not adequately informed,

III. Conduct resulting from the director’s lack of objectivity or independence,IV. A sustained failure to be informed in discharging the director’s oversight functionsV. Receipt of an improper financial benefit.

d. Meaning of Fraud, Illegality, and Conflict of Interest – not in good faithi. Fraud – examples could be knowingly disseminating false or misleading info. Same

elements as common law fraud.ii. Conflict of Interest – rule does not shield a director, if that director is personally interested

in a corporate action b/c he stands to receive a personal or financial benefit. Validity of action depends on fairness test, see below.

iii. Illegality – cannot shield directors. Courts have ruled that directors can be liable for:I. Bribery of state officials or of foreign government officials to facilitate business

II. Business plan that created incentives to commit fraudIII. Dismantling of corporate equipment to discipline unruly employees in violation of

labor laws.3. Merits or Substance of the Board Action – an absence of a rational basis, classified as waste. Use the

rational purpose test.a. So long as the business judgment was not:

i. Improvident beyond explanation or ii. removed from the realm of reason

b. Could be corporate waste if:i. Issuance of stock without consideration, or

ii. Payment of personal obligations with corporate fundsc. Courts don’t usually disturb business judgments – Shlensky v. Wrigley. Wrigley refused to play

night baseball and was sued on claim of bad business judgment. Court said Wrigley’s decision didn’t meet test

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d. Failures to Act – difficult to distinguish between inaction due to the press of other business matters and inaction due to sheer inattention. MBCA § 8.31(a)(2)(iv) states that any failure not to take action creates liability only in case of a sustained failure of the director to be informed, or other material failure when facts materialize that would alert a reasonably attentive director to the need for action.

4. Decision-Making Failure – Procedural Gross Negligence – when making decisions a director must make reasonable efforts to inform themselves of facts & circumstances surrounding the decision. Means diligent board deliberation, but difficult to measure and who is ultimate judge.

a. Issue: if a court does scrutinize a procedural business judgment question, what is the standard that should be applied. The standard may be reflected in the language of rational basis for decision and the reasonably basis used to arrive at that decision:

i. Assume that rationally believes test offers greater protection to director, more deference to judgments of business people

ii. Reasonable test may not offer as much protection, and may lead to closer judicial scrutiny.b. Impact of Smith v. Van Gorkom – Case involved a cash-out merger, negotiated by Van Gorkom, the

CEO of Trans Union, shortly before he was to retire. The deal was initiated, negotiated, and advocated by Van Gorkom to sell stock at $55 cash to holding company controlled by Pritzker. Deal required approval by board directors of both companies. Trans Union approved in a 2hr meeting after a 20 minute oral presentation and after failing to actually read the merger agreement. Shareholders brought action suggesting that manner decision was made was negligent and suggested deal favored Pritzker without considering outside offers.

i. Court found pointed to several failures of the board’s duties:I. Failed to inquire into Van Gorkom’s role in setting merger terms

II. Failed to review or read the merger agreementIII. Did not inquire into the fairness of the $55 price and the value of the company’s

assets (investment tax credits)IV. Accepted without inquiry the view of company’s chief financial officer that the $55

price was within a fair range.V. Did not seek outside fairness opinion from investment bankers

VI. Acted at 2hr meeting without prior notice and without there being an emergency. ii. Director’s response – argued that they were entitled to rely on representations made by

Van Gorkom and the financial officer Romans. Could clearly argue that board was comprised of highly experienced and sophisticated business people and some who were very knowledgeable of mergers and acquisitions.

iii. Court focused on fact that Van Gorkom had first settled on the $55 price and did not inform board of his role. But what about fact that deal was later reapproved after a longer period of review.

c. Is Smith the new standard - could argue that case had overtones of self-dealing that court did not like and viewed the board as having been somewhat mislead. Cash-out mergers require heightened scrutiny. Meant to promote board discretion in takeover cases. Either way, boards must be aware of gross negligence standard as a possibility.

d. Statutory response to Smith - Delaware and other states enacted ‘raincoat provisions’ to protect directors against money damages. Only protects directors. They generally provide:

i. The articles of incorporation may contain a provision that eliminates or limits the personal liability of directors for breaching their duty of care, except for;

I. Financial benefits received but not entitled toII. Intentional infliction of harm on corporation or shareholders,

III. Approving illegal distributionsIV. Intentional violation of criminal law.

ii. Effect of provisions – disputes around operation and scope of statute. Difficult to draw lines between possible breaches of duties of care, loyalty, or good faith. Is it an affirmative defense that the director has the burden of proving?

5. Oversight failures – directors have oversight over more than just meetings but also day-to-day operations. a. Inattention to Mismanagement – reluctant to hold directors liable for this. Impossible to know if

attention would have changed outcome.b. Inattention to Management Abuse – less forgiving in these instances. Could have repercussions in

the Enron, World Com and HealthSouth world.

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6. Causation and Damages – just b/c there may be a breach of the duty of care doesn’t automatically mean there will be liability. The breach must be the cause of damages and there must actually be damages. The MBCA § 8.31(b)(2) has provided that any party wishing to hold the director liable has the burden of establishing:

a. Harm to the corporation has been suffered, and b. Harm suffered was proximately caused by director’s challenged conduct,

7. To whom do Directors owe a duty – generally said to owe a duty to the corporation. Duty to maximize the profits of the corporation. Alternatively could say that directors owe a duty to shareholders as well. In pursuing these goals, do directors have obligations to other constituencies.

a. Legally enforceable duty? – great concern over expanding duty toward these groups b/c of fear that result will be complete paralysis. Board may not be able to complete any transaction without fear of offending some group.

b. Creditors, employees, and customers can protect their interests through contract. c. Voluntarily taking other constituencies into account: Dodge v. Ford Motor Co. – Ford did not want

to pay a dividend and use the money to invest in a smelter plant in order to grow the business. Ford suggested reasons for expansion were to lower price of cars, increasing production and the creation of new jobs.

d. Ultimate result is that courts generally do not scrutinize if argument can be made that actions are in long-term interests of the corporation and the stockholders.

C. Duty of Loyalty – instances where directors put their own financial interests ahead of the corporation. Involves instances of self-dealing, conflict of interest, taking of corporate opportunities

1. Conflict of Interest Transactions or Self-Dealing – transactions where an officer and director is on both sides of a transaction. Acting for himself as well as an agent of the corporation. Fundamental conflict of interest in that both parties seek the best deal. Business judgment rule does not apply where a director may be self-dealing.

a. Falls into two broad categories:i. Direct Interest – corporation and director are parties to same transaction. § 8.60(1)(i).

(a) Could include:(i) Sales and purchases of property, including stock(ii) Loans to/from the corporation(iii) Furnishing of services by non-management director

(b) Not considered conflict of interest:(i) Declaring of dividends if director is also a shareholder is not self-dealing

when the dividend is the same to all shareholders ii. Indirect Interest – a transaction with a corporate director and another person or entity that

director has personal or financial interest. Could include transactions with:(a) Director’s close relatives(b) Another entity in which the director has a significant financial interest, could be

another director, partner, or agent, etc(c) Between companies with interlocking directors.

b. Over time there have been a variety of tests the courts have used in analyzing these problems. Early rules flatly prohibited any conflict of interest transactions with them being voidable at the election of any shareholder. More modern tests have included:

i. Approval by disinterested directorsii. Approval by shareholders, oriii. Proof that the transaction is fair.

c. The Fairness test can be subdivided into substantive and procedural fairness. Similar to the criteria used for the business judgment rule, except for the scrutiny of each is reversed. In these transactions, more scrutiny is given to the substantive merits of the transaction.

i. Procedural fairness – an inquiry into the board decision making process over a conflict of interest transaction. In Weinberger v. UOP, Inc., Delaware required both fair price and fair dealing. Court may review three procedural elements:

(a) Disclosure about the transaction to the board(i) Concept of full disclosure necessary for fairness, or(ii) Disclosure of just conflict to put board on notice, or(iii) Disclosure of only material info (amount of profit the interested director

may stand to gain in the transaction).(b) Composition of the board that approved the transaction

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(i) Could apply a less exacting standard of fairness if approved by disinterested directors, or

(ii) Presumption of fairness if approved and shift burden to challenger to prove unfairness

(iii) Definition of ‘disinterested director’ – I. Not directly or indirectly interested in the transaction, no financial

or family ties to the transaction that affect judgmentII. Not dominated by the interested director. Domination means

more than being selected by the interested director to serve on board. Rather its acting w/o independent judgment

(c) Role of Interested director in the transaction’s initiation, negotiation, and approval. Court may look for domination of other directors by interested director.

ii. Substantive Fairness – was the transaction in the best interest of the corporation. (a) Has two separate aspects:

(i) Objective test - To decide whether the transaction was in best interest, court may consider the value of what it gave up in the transaction versus the value of what it received. Must be viewed as an arms-length transaction. Not necessarily the profit the interested director receives.

(ii) Corporate Value - May also look to see if the transaction serves a corporate purpose. Does it serve needs or scope of business.

(b) When to measure the value of the transaction? Must measure from the moment the contract was entered into. Ex ante. Improper to look back and determine the value b/c what actually occurred may be very different.

(i) But if events were foreseeable, may effect fairness. If foreseeable and result in especially favorable outcome for interested director, may be voided.

(c) Measuring value – easy when dealing with property that has a prevailing market price, but more difficult if non-standardized or unique property. Arguing about adequacy of consideration???

iii. Burden of proof – different than in the business judgment rule where the burden was on the challenger. In conflict of interest challenges, the burden shifts to the interested director to prove that the deal was fair to the corporation.

d. Disinterested Director Approval - this approach usually involves statutes outlining the requirements:

i. Definition of disinterested director – see aboveii. How many votes are needed – MBCA requires a majority (but not less than two) of

qualified directors. Some require a majority without the interested director voting.iii. When must the vote occur – MBCA allows for the vote to take place at any time.

But some require only before-hand while others allow for ratification.iv. Obligations of interested director – primarily must disclosure material information.

Impact of failure to disclose. Issue is whether the interested director can still save the transaction by arguing its fair to corporation:

(a) NY says fairness can cure non-disclosure, while(b) MBCA suggests that nondisclosure will make deal unfair regardless of terms

v. Problems – what if transaction receives disinterested director approval, may a court still review the transaction for fairness.

(a) Since most tests are either disinterested director approval or fairness test, not and, an unsuccessful vote doesn’t necessarily doom transaction, but a court may still review.

(b) If transaction approved there is no conflict of interest and the courts must apply the business judgment rule and not the fairness test. End result is less judicial scrutiny of the transaction.

(c) MBCA suggest no judicial review if approved by directors. e. Shareholder Ratification – where a majority of the shares are cast by informed shareholders who

neither have an interest in the transaction nor are dominated by those who do, most court do not require a showing of fairness. Rather courts will review under the business judgment rule and shift burden to plaintiff to prove waste (no ordinary person of ordinary sound business judgment would say that the consideration was fair).

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i. MBCA – shares voted by interested shareholder are not counted for purposes shareholder ratification § 8.63(b). Tension between counting these shares and recognizing that shareholders are allowed to ‘vote their pocketbooks’

ii. Review of this type of approval may focus on the independence of the directors from a controlling shareholder.

2. Corporate Opportunity Doctrine – instances where officers or directors take for themselves business opportunities which could be of use to the corporation. Duty to place the interests of the corporation above their interests. A director is not flatly prohibited from taking opportunities, but rather must offer to corporation and can only take them if the corporation consents.

a. Definition of Corporate Opportunity – i. Official versus individual capacity – generally considered a corporate opportunity if

discovered while acting in official capacity. Director can never take these w/o consent.ii. Line of business – must turn over opportunities in the same line of business as the

corporation.(a) Lots depends on the characterization of the business(b) Does this contemplate corporate expansion(c) Look to see if new opportunity is functionally related to existing business.

iii. Interest or expectancy test – if the corporation has an existing expectancy in a business opportunity, the director must seek corporate consent before taking the opportunity.

(a) Usually an opportunity the corporation has a tentative claim to or is actively negotiating for

(b) Also includes property that the corporation needs to operate. b. Triangulating corporate opportunities – three important factors:

i. Manner of learning about the opportunity:(a) Corporate agent who actively seeks opportunities, then purchases for himself –

Clear breach of duty, labeled a corporate opportunity(b) Corporate official receives opportunity from 3d party who expects the corporate

official to pass opportunity to corporation – Considered a corporate opportunity.(c) Neither case above, not active seeking and no receipt by 3d party, but being agent

puts person in right place to learn of opportunity. Meinhard: considered a corporate opportunity by focusing on iv(b) & (c) below.

(d) Corporate official learns of opportunity completely independent of official capacity. Two factors below must be strongly in corporation’s favor in order to classify as corporate opportunity.

ii. Position of the person learning of the opportunityiii. The nexus between the opportunity and the existing business

c. Relationship of Agent (Director, Officer or Employee) to Corporation –possible to say that higher up the corporate ladder the greater responsibility of giving over opportunities

i. Outside directors – must hand over only if discovered while working in official capacity for the corporation.

ii. Full-time v. part-time: part-time, greater expectation that part-time employee will seek out opportunities for 2d business, need more connection to label corporate opportunity.

d. Corporate rejection – justification for taking corporate opportunity. i. Instance where the corporate rejection itself may be self-dealing – director claiming corp

has rejected and then takes opportunity. May apply the same tests for conflict of interest: disinterested director approval or proof of fairness in order to validate rejection. Many issues same as C-o-I.

ii. Inherent conflict if a director states that opportunity probably isn’t profitable so that corporation rejects it, yet takes it for himself and it does turn out profitable.

e. Corporate Incapacity – taking of opportunity after corporation states it doesn’t have the money. i. Irving Trust – broad proposition that financial incapacity is never a defense for taking

corporate opportunity. Justification is that if officers can take opportunities whenever the corporation cannot afford them, they might lose incentive to do best to gain necessary financing for the corporation.

3. Executive Compensation – one of the most frequent conflict of interest transactions is compensation of services for officers and directors of corporation. Typically the board of directors decides the compensation level of officers.

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a. Courts usually grant deference to compensation decisions. b. Same as regular, if disinterested board approves, then the business judgment test applies.

i. Must be aware of all material info about compensation packageii. Interested officer cannot dominate boardiii. Under business judgment, challenger must show:

(a) either that board was grossly uninformed, or(b) compensation was a waste of assets

iv. Courts defer to board and judicial scrutiny is minimal.c. If no approval, the fairness tests will be applied. Here, judicial scrutiny is substantial. Court takes

over function of the board and will assess challenged compensation and will consider:i. Relation of compensation to executive’s qualifications, abilities, responsibilitiesii. Corporation’s revenues, earnings, profits and complexity.iii. Likelihood that incentive compensation would fulfill objectivesiv. Compensation paid similar executives in comparable companies.

D. Indemnification and Insurance – ways to protect directors and officers from liability stemming from their participation in the corporation.

1. Indemnification – a promise to reimburse the director for litigation expenses and personal liability if the director is sued. Usually extend after director has left the corporation. Indemnifying for expenses may depend on the outcome of the litigation.

a. Mandatory Indemnification – if director defends a suit successfully, the corporation is obligated to indemnify for all expenses, including attorney’s fees. § 8.52 Question becomes when is the defense successful:

i. Success on the merits – statutes require success on merits but may also include procedural success ‘otherwise’ language. Not deemed success on merits if settled out of court.

ii. To extent successful – some statutes only require this. But may create incentives to plead some away.

b. Permissive Indemnification – cases where director is not successful. Under MBCA whether a corporation will indemnify may depend on who brought the action:

(a) Third party actions – a director must be deserving to be entitled to indemnification.

(i) §8.51 sets out certain standards of conduct:I. Director must have acted in good faith –

a. did not know conduct was illegalb. did not act for improper personal gainc. must reasonably believe her actions were in corporation’s best

interestII. In Criminal proceedings – had no reasonable cause to believe her

actions were unlawful. A higher standard than good faith.(ii) Coverage – director sued may be indemnified for reasonable litigation

expenses and any personal liability from a court judgment, settlements(b) Actions by or on behalf of corporation – most statutes do not allow indemnify if

director adjudged liable to the corporation. May do so for a director who settles suit.

c. Advancement of litigation expenses – most statutes allow corporation to advance money during the proceeding. Involves several steps:

i. Director must:(a) Affirm his good faith belief that he would be entitled to permissive

indemnification, and(b) Undertake to repay if he is not entitled to indemnification

ii. Disinterested directors must then authorize advance2. Insurance – corporations commonly purchase D & O insurance. Premium payments on behalf of director

reflect additional compensation.a. Many policies exclude coverage for:

i. Improper personal benefits (self-dealing)ii. Actions in bad faithiii. Illegal compensationiv. Knowing violations of law, or other misconduct.

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IV. Problems of Control in the Closely Held CorporationA. Shareholder-Level Control Devices –

1. Minority control rights – several ways minority shareholders may protect or effect operation of corporation:a. Supermajority provisions – may give veto power that doesn’t exist under regular majority. Majority

rule is default rule and the charter must specify supermajority. May be used for:i. Director quorum, or voting § 8.24ii. Shareholder quorum or voting requirements § 7.27.

(1) A supermajority quorum requirement means that a minority shareholder may vote by being absent. Cannot break quorum once represented. § 7.25(b) once represented, shareholder is present for duration.

(2) Gearing v. Kelly – court did not recognize quorum requirement, when shareholder purposefully was absent to prevent quorum.

b. Vote-pooling agreements – this can be cumulative voting. See above. Also entails specific arrangements to vote in certain way. These used to be considered against public policy but now are enforceable. Are considered valid if they relate to a matter on which shareholders may vote. Must be in writing. Subject to normal contract rules on construction and interpretation.

i. Considered invalid if beyond shareholder power: McQuade v. Stoneham – three shareholders agreed as shareholders to elect themselves as directors and as directors to appoint themselves as officers. Court upheld part of agreement dealing with election of directors, but struck down part of agreement were the shareholders were attempting to limit director discretion.

ii. Enforcement – generally agreement specifically enforceable due to the difficulty in estimating money damages. Must be cautious to draft as mutual promises and not attempts to alter the voting power of shares. This cannot be done by contract only be the articles of the corporation.

c. Classes of stock – issuing of different classes of stock with different voting rights. Must be authorized in the articles.

2. Share Transfer Restrictions – tension between the desire to control the close knit nature of ownership between shareholders in these corporations and the sanctity of property rights, the ability to liquidate those rights through alienation or sale. Courts will enforce the restraint only if it is reasonable, determined by looking at the purpose of the restraint.

a. Generally divided into two broad categories:i. Consent restraints or restrictive covenants:

(1) Prior approval – upheld if procedure for gaining approval is not manifestly unreasonable.

(2) Factors considered in determining validity of this type:(a) Does restriction state that non-selling shareholder cannot withhold

consent unreasonably(b) How long does the restraint last – perpetually, or at some point able to

sell without consent. ii. Advance buy-out agreements:

(1) Rights of first refusal – obligates the shareholder to first offer shares to the corporation (or other shareholders) at the price and the terms offered by the outsider. Price set at time offer is made by outsider. Outsider making offer assures fairness. Different from

(2) Purchase Options – obligates shareholder to first offer to corporation at pre-set option price. The decision to accept or decline is a self-dealing transaction subject to fairness review.

(3) Buy-Sell Agreements – usually in cases of death, withdrawal, deadlock, divorce, or other specified events, shareholder or estate is obligated to sell to corporation at specified price.

b. Drafting Issues – failure to address can cause problemsi. What are restrictions and who is subject to them.ii. What triggers buy-sell provisionsiii. Who has the option to purchaseiv. If corporation purchases, who participates in the decision

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v. If more than one party is to purchase, what proportion and order do the purchases take place

vi. How is the price for the shares to be determined (most contested issue)(1) Fixed price – price paid originally(2) Book value – the value of the shares as shown on the corporation’s balance

sheet. But book value not same as real value.(3) Independent appraisal – yet what method should be used(4) Future earnings based valuation(5) Outside purchaser

vii. What if corporation cannot repurchase shares (corporate opportunity doctrine)B. Board-Level Control Devices –

1. Management agreements – contractual in nature, limits or outlines scope of directorial power. Yet may run into problems with the fundamental tenet that corporation’s business be managed by the board of directors.

a. MBCA – authorizes shareholders’ agreement that govern the exercise of corporate powers or the management of the business affairs of the corporation or the relationship among shareholders, the directors and the corporation, if:

i. Approved by all shareholders, (either in the articles or signed by current shareholders), ii. Made known to the corporationiii. Not contrary to public policy.

C. Dispute Resolution in Close Corporations – 1. Majority Abuse of Minority Shareholders –

a. Freezeouts – a strategy of attrition. Forcing the minority to sell (or to buy) to the majority on unfavorable terms. Accomplished by: removing minority participants from office, denying compensation, imposing a no-dividend policy, and excluding them from new stock issues or stock redemptions.

b. Forceouts – involves the majority manipulating the structure of the corporation to forcibly eliminate minority interests. Accomplished through squeeze-out mergers or recapitalizations.

2. Minority Shareholder Option – actually somewhat limited due to nature of close corporation:a. Market Out – somewhat difficult since there is no ready market for minority shares in a close

corporation. Corporate law does not create any liquidity rights unless they enter into the buy-sell agreements discussed above.

b. Dissolution – a minority shareholder cannot dissolve the corporation. Requires board approval and majority shareholder approval.

c. Involuntary dissolution – asking the court to intervene to dissolve and have a distribution of the assets after liquidation. Court may order on one of these statutory grounds:

i. Board deadlock – the directors cannot agree and the shareholders have been unable to break impasse and deadlocks threatens irreparable injury to corporation

ii. Shareholder deadlock – Under MBCA defined as a failure to elect new directors for a period of at least two consecutive annual meeting dates.

iii. Misconduct – expressed in various ways:(1) Those in control have acted in a way that is illegal, oppressive, or fraudulent(2) Corporate assets are being wasted or misapplied.

3. Involuntary Dissolution – based on the oppression casesa. Oppression – frustration of the reasonable expectations of the minority shareholder seeking

dissolution. Reasonable expectation test shifts away from subjective criteria to a approach similar to implied contract.

i. Reasonable expectation – an expectation the majority knew or should have known that the minority shareholder had at the time he bought his stock. Could be:

(1) Employment with corporation; (2) Position on board of directors;(3) Payment of dividends

b. Remedy – majority may avoid dissolution by electing to buy out ‘at fair value’ the share of shareholder who wants dissolution. Same problems with valuation as discussed above.

i. Is there a control premium or discount for minority shares (no control).ii. May be discounted further b/c of lack of liquidity.

4. Fiduciary Protection – a minority who doesn’t want dissolution, just relief from freeze-out etc.:

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a. Business Purpose Rule – minority has burden of proving that majority’s actions were motivated by fraud, self-interest, bad faith. Protects majority if there is a rational business purpose for actions. A business justification may be sufficient to protect: expansion plans, personal incompatibility.

D. Squeeze-Out Transactions – another method of eliminating minority shareholder interest.1. Different methods –

a. Squeeze-out merger – parent and subsidiary agree to merger under which the minority shareholders receive cash for shares. The parent becomes the sole shareholder of the subsidiary.

b. Liquidation – subsidiary sells all of its assets to the parent and dissolves. Minority shareholders receive pro rata distributions

c. Stock split – subsidiary declares a reverse stock split (1 for 2,000) that greatly reduces the number of outstanding shares. If no minority owns more that the minimum (2,000), then minority holds fractional shares, which are then subject to mandatory redemption under statutes

2. Clearly conflict of interest transactions and courts have developed test besides ones used under self-dealing area to review them:

a. Business Purpose test – a purpose besides eliminating the minority. Delaware has abandoned for the:b. Entire Fairness test – a two prong test focusing on both price and process:

i. Fair price – evaluation must take into consideration all relevant factors.ii. Fair dealing – relates to:

(1) When transaction timed\(2) How it was initiated, structured, negotiated, disclosed to directors(3) How approvals were obtained.

iii. Courts now recommend subsidiary board form independent negotiating committee of outside directors to act as representatives of minority shareholders.

c. After Weinberger (case creating entire fairness test) court has clarified Fair Dealing cases:i. Outside negotiating committee creates strong presumption of procedural fairnessii. Approval by this committee shifts burden to challenger to show lack of entire fairness

d. Post-Weinberger ‘Fair Price’ cases:i. Fair price opinions can be based on parent’s investment banker.

V. Securities Regulation –A. Federal Regulation of Proxy Voting – in public corporation most shareholders vote by proxy. Federal regulations deal with

management responsibilities and requirements in area of proxy voting. Primary regulation is § 14(a). It applies to proxy solicitations involving publicly traded securities. Any solicitation must comply with SEC rules regarding filing, disclosure and distribution. The jurisdictional reach of § 14(a) is as broad as the Constitution will allow. General concepts of the rule:

1. Public Corporations – Companies Registered under Act – proxy rule applies to two categories of companies:a. Listed companies – companies whose securities are listed on a national stock exchange. Listing is

voluntary and each exchange may have its own requirements.b. OTC companies – securities that are traded over-the-counter markets. Includes companies w/over

500 shareholders and over $10 million in assets.2. Definition of Proxy Solicitation – rules only apply to solicitations. Generally it is the formal document that

accompanies management’s request for shareholders to return proxy card. a. But Rule 14a-1(1) also includes:

i. Any request for a proxy even if a proxy card does not accompany it.ii. Any request not to sign or revoke a proxyiii. Any other communication ‘under circumstances reasonably calculated to result in’

shareholders signing, not signing, or revoking a proxy.b. Some communications are exempt from rules:

i. Shareholder solicitation plans – excludes communications between shareholders so long as they don’t seek to act as proxy and no proxy card is furnished or asked for.

(1) Exemption does not apply to communications by management(2) Rule is response to Studebaker where court ruled that seeking authorizations to

view stockholder lists was part of a continuous plan that would result in formal proxy solicitation and was therefore subject to rules.

ii. Public Criticism of Management – public communications or opinions of corporation are exempt if speaker neither seeks authority to act as proxy nor requests card. Ex: public interest group commenting on upcoming shareholder vote.

(1) Also excludes public announcement by unaffiliated shareholder on voting intentions.

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(2) Rule in response to Long Island Lighting, where court applied ‘chain of communications’ theory to hold newspaper ad could be a solicitation. Ad was reasonably calculated to influence shareholders and was a solicitation. Bumps up against 1st amendment and new rule avoids problem.

B. Formal Requirements of Proxy Rules – the rules dictate the disclosure required, specifies the form of the proxy card, the filing of proxies and prohibits false or misleading solicitations.

1. Mandatory disclosure – every proxy solicitation must be accompanied by a ‘proxy statement’. The information required depends on who is doing the solicitation:

a. Management – requires info about the corporation, the background of all director nominees, management’s compensation and conflicts of interest or any other matters being voted on. If annual election of directors requires corporation’s annual report.

b. Non-management – requires info about the group or individuals seeking proxy, the background of nominees, or any other matter being voted on.

2. Form of Proxy card – must state who is soliciting and the matters to be acted on. Shareholders must have chance to vote for or against each matter to be acted on.

3. Filing and Distribution of Proxy Statement – no proxy solicitation can be made unless the solicitor sends each solicited shareholder a copy of the statement. Must file preliminary copies of proxy statement and card with the SEC 10 days before being sent. Rule 14a-6. May be sent electronically. All final material must be filed at or before they are sent to shareholders.

4. Prohibition against proxy fraud – proxy statement must also fully disclose all material info about the matters on which the shareholders are to vote.

a. Three types of falsity:i. A false or misleading statementii. An omission of fact which makes a statement misleadingiii. Failure to correct statement which subsequent events have rendered false.

b. Must also be material – a fact is material if ‘there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.’

5. Exemptions from Rules – exempts some from filing and disclosure requirements, but not fraud and some from all rules:

a. Exempt solicitations subject to fraud provisions – i. Solicitations by persons not seeking authority and without substantial interest in matter,ii. Non-management solicitations to less than 10 personsiii. Advice by financial advisors in normal course of business.

b. Exempt altogether from proxy rules – i. Communications by brokers to beneficial owners seeking instructions on how to vote the

owners’ shares.ii. Requests by beneficial owners to obtain proxy cards & other info from brokersiii. Newspaper advertisements that identify proposal and tell shareholders how to obtain it.

C. Shareholder Initiatives – these proposals face large obstacles due to financial constraints and management control of proxy mechanism. Proxy rules attempt to level field. Generally rules overcomes obstacles in two ways: 1) compelling management to help shareholders communicate w/ fellow shareholders at shareholder expense; and 2) must include ‘proper’ shareholder proposals in company’s proxy mailings to shareholders – at corporate expense.

1. ‘Common Carrier’ Obligation under Rule 14a-7 – management must mail, either separately or together with corporation’s proxy materials, any shareholder’s soliciting materials if the shareholder agrees to defray the corporation’s reasonable expenses. Corporation can avoid requirement by providing soliciting shareholder with a current list of names and addresses of shareholders.

2. Shareholder Proposals – a proposal is your recommendation on a course of policy. The SEC rules outline:a. Procedures – any shareholder who owns 1% or $2,000 worth of public company’s shares for at least

a year may submit a ‘proper proposal’. Management may decide to exclude submitted proposal but must give opportunity to cure defects.

b. Proper Proposal – Rule 14a-8 contains a list of reason for management to exclude a shareholder proposal. May exclude if it fits into any of the categories specified. Exclusions created for 3 central purposes and can be divided into categories:

i. Proposal inconsistent with centralized management – 4 exclusions aim at proposals that interfere w/ traditional structure of corporate governance:

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(1) Not ‘proper subject’ – subject that is outside shareholder action under state law. Attempts to exercise power unavailable to the shareholders. Probably okay if termed as recommendations or request rather than mandates.

(2) Not ‘significantly related’ – exclusion when not related to company’s business. To be significant, the proposal must relate to operations that account for at least 5% of total assets, net earnings, or gross sales.

(3) ‘Ordinary business operations’ – issues about what is included: has included proposals dealing with construction of nuclear power plants but has excluded employment policies. SEC takes case by case approach

(4) Related to dividend amount – recognizes fundamental feature of corporate law that board has discretion to declare dividends without shareholder interference.

ii. Proposals that interfere w/ management’s proxy solicitations – management may exclude 4 proposals that could disrupt orderly proxy voting:

(1) Related to election to office – prevents dissidents w/ clogging company’s proxy statement with their own candidates.

(2) Conflicts w/ management proposal – can exclude any one that is in ‘directly conflicts’.

(3) Duplicative – excludes proposals that are already included by other shareholders.

(4) ‘Recidivist’ – can exclude any proposal that has failed in the past that deals with ‘substantially the same subject matter’ as proposals submitted within last 5 years.

iii. Proposals that are illegal, deceptive, or confused – meant to exclude spurious or scandalous proposals –

(1) Violation of law – any law including violations of proxy rules. Allows management to exclude proposals it views as materially false or misleading.

(2) Personal grievances – self explanatory(3) Beyond power – excludes proposals beyond the corporation’s power to

effectuate.(4) Moot – corporation already doing what proposal asks.

D. Proxy Fraud – shareholders have a right to bring a private action when the corporation violates any of the above proxy regulations. Distinguish between traditional state actions and implied federal actions under § 14(a).

1. Traditional state remedies – a. State law of deceit – action against those who fraudulently misrepresent material facts on which

shareholder relies.b. Breach of corporate fiduciary duties – c. Procedure – Shareholder would have to bring derivative suit on behalf of corporation. Would have

to overcome the business judgment rule. The shareholder has to prove:i. The proxy statement contained an actual misrepresentation of fact,ii. Management actually knew of the falsity of the representation,iii. Actually read the proxy disclosures and relied on them,iv. Shareholder suffered losses because of their reliance.

2. Implied Federal Action – securities law does not explicitly provide for private enforcement of its rules. Under J.I. Case Co. v. Borak – Court held that shareholder has an implied cause of action under proxy rules. The elements of the action are court-created. Since it’s an implied federal action, the shareholder gets to avoid the substantive and procedural obstacles of a fiduciary challenge under state law, meaning most importantly no business judgment rule. Elements of the cause of action:

a. Misrepresentation or Omission – any statement in proxy solicitation that is false or misleading or is a half-truth

b. Statements of Opinions, Motives, or Reasons – court somewhat reluctant to make these actionable. Created test for opinion statements, must prove all three:

i. Speaker believes statement to be correctii. Speaker has some basis for making it,iii. Speaker knows of nothing that contradicts it.

c. Materiality – the challenged misrepresentation be with respect to material fact. Must be a fact that would be important to a reasonable shareholder when deciding how to vote.

d. Culpability – Supreme Court silent on issue, but lower courts have not required scienter.

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e. Reliance – under common law deceit justifiable reliance was a requirement. Court has rejected this requirement and stated that if fact is material, that is sufficient.

f. Causation – was the misrepresentation the cause of loss. Court have required two showings:i. Loss causation – that the transaction caused harm to the shareholder.ii. Transaction causation – the proxy solicitation be an essential link to the accomplishment

of the transaction. No recovery if the transaction did not depend on the shareholder vote.

g. Prospective or Retrospective Relief – relief can be either one, which means a federal court can either enjoin the vote, enjoin the shareholder meeting, rescind the transaction, or award damages.

E. Securities Fraud – Rule 10b-5 – every securities trade is covered by this rule. Rule makes it illegal to commit fraud in connection with the purchase or sale of a security. To fall within the prohibition, the fraud must involve the use of either the mail, means or instrumentalities of interstate commerce. Three main contexts were rule is seen: 1) misrepresentations, 2) insider trading, and 3) breaches of fiduciary duty.

1. Scope of Private 10b-5 Action – while similar to common law deceit, the courts have imposed several requirements and altered some procedures.

a. Standing – only actual purchasers or sellers may recover damages in private 10b-5 action. Even if the false or misleading statements leads a person NOT to buy, there is no liability. Reaffirmed in Blue Chip Stamps which held that non-purchasers who would have purchased have no standing.

i. PSLRA – seeks to restrain 10b-5 class actions brought by ‘professional plaintiffs.’ Establishes procedures for appointment of ‘most adequate plaintiff’ by the court, which statute presumes would be the investor with the largest financial interest.

b. Primary violators – any person who makes false or misleading statements and induces others to trade to their detriment can become liable. Could include accountants and underwriters for role in drafting or editing documents that contain false statements even though disseminated by others.

c. No aiding and abetting liability – Supreme Court has stated that statute requires actual fraudulent behavior, not just collateral assistance.

2. Fraud Elements of Private 10b-5 action – the following elements are judge created based on common law fraud. The plaintiff has the burden of proving the following:

a. Material deception – the defendant affirmatively misrepresented a material fact, or omitted a material fact that made his statement misleading or remained silent in fact of fiduciary duty to disclose material fact. Included are half-truths, which means a true but incomplete statement may be actionable if it omits material info that renders statement misleading. But not all deception is actionable, must be:

i. Materiality – a fact is material if there is a substantial likelihood that a reasonable investor would consider it important when deciding whether to buy or sell. If disclosure of the info would affect the price of the stock, then it is material

ii. Duty to Speak – Normally silence is not actionable under rule. Courts have imposed duties to speak when defendant has relationship of trust and confidence with plaintiff.

iii. Duty to Update – some statement accurate when made can become inaccurate or misleading because of subsequent events. Courts have found a duty to supply new info when it becomes available.

iv. Corporate Mismanagement – can be a rule 10b-5 violation if the mismanagement involves fraudulent securities transactions that injure the corporation. In Santa Fe Industries the Supreme Court held that rule only regulates deception and not unfair corporate transactions

b. Scienter – in Ernst & Ernst v. Hochfelder, the Supreme Court held that mere negligence is insufficient for a 10b-5 action. Plaintiff must prove scienter, a mental state embracing intent to deceive, manipulate, or defraud. Court based its opinion on § 10(b) which banned manipulative or deceptive devices or contrivances. Several factors have bearing on this element:

i. Intent or Meaning of Scienter – intent refers to either a purpose to achieve outcome or knowledge that outcome is substantially certain to occur. Courts have also held recklessness can satisfy.

ii. Easier to frame analysis as defendant’s knowledge of falsity, which allows use of recklessness. More understandable to say that recklessness should lead to liability if there were facts that if defendant had paid attention would have given clues to falsity.

iii. Other problems when statement by defendant is an opinion. Highlights the problems with:

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iv. Pleading Scienter - allegations of fraud must be plead with particularity. Under the PSLRA plaintiff’s complaint must state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.

c. Reliance – tests the link between alleged misinformation and the plaintiff’s buy-sell decision. Weeds out claims where misinformation had little or no impact on plaintiff’s decision. Treated as an element in all cases, but the burden of proof may be relaxed:

i. Nondisclosure – when defendant fails in a duty to speak, court dispense of proof of reliance if undisclosed facts were material. Because fact was material suggest it would have considered it important and may have changed decision.

ii. Omitted information – courts divided, but PSLRA makes reasonable reliance an explicit condition.

iii. Fraud on the market – courts have created a rebuttable presumption of reliance. Theory is that those who trade in public markets rely on integrity of the stock’s market price. Assumed that material misinformation distorts market price and investors have then relied on the misinformation. Assumes that if info disclosed, investors would not have traded at non-disclosure price. Defendant can rebut presumption by proving either:

(1) Trading market was not efficient and challenged misrepresentation did not in fact affect stock’s price, or

(2) Particular plaintiff would have traded regardless of the misrepresentation.d. Causation – similar to that discussed above:

i. Transaction causation – requires plaintiff to show ‘but for’ defendant’s fraud, plaintiff would not have entered the transaction or entered under different terms.

ii. Loss causation – must show that the fraud produced the claimed losses to plaintiff. (a proximate cause requirement – cannot be attributed to extraneous causes).

e. Damages – plaintiffs have full range of equitable and legal remedies. Only two limitations: recovery cannot exceed actual damages (no punitive damages) and damages capped by formula meant to disregard post-transaction price volatility.

i. Damages could include:(1) Rescission – allows defrauded plaintiff to cancel the transaction. If bought,

return shares and get money back. If sold, gets stock back(2) Disgorgement – rescissionary damages where plaintiff recovers the purchaser’s

profits (difference between purchase and resale price) or defrauded buyer recovers his losses.

(3) Cover damages – difference between price at which plaintiff transacted and price at which plaintiff could have transacted once fraud revealed.

(4) Out-of-pocket damages – difference between purchase price and the true ‘value’ of the stock at time of purchase.

(5) Contract damages – loss of the benefit of the bargainii. If recovery based on market price of stock (out-of-pocket & cover damages), the PSLRA

imposes damages cap. Capped at difference between transacted price and the average daily prices during 90-day period after corrective disclosure.

3. Nature of 10b-5 Liability – courts have traditionally imposed liability jointly and severally. Different result under PSLRA which eliminates joint and several liability who do not ‘knowingly’ commit violations of rules. Creates a system of proportionate liability based on each ‘unknowing’ defendant’s proportion of responsibility.

a. Knowing – an untrue statement or factual omission on which others are likely to reasonably rely made with actual knowledge of the falsehood. Reckless conduct does not constitute knowing violation.

4. Defenses in 10b-5 Private Action – a. Statute of Limitations – federal limitation for action. Sarbanes-Oxley expanded limitation. Must be

brought no later than the earlier of 1) two years after the discovery of the facts constituting the violations; or 2) five years after such violation.

b. Indemnification – courts have recognized a right of indemnification by ‘passive’ or ‘secondary’ 10b-5 defendants against more culpable participants.

c. Contribution – PSLRA expressly authorizes contribution actions by jointly and severally liable defendants. Contribution shares are computed according to percentage of responsibility.

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F. Insider Trading – The application of rule 10b-5 to insider trading is based on implied duties of confidentiality. Federal duty to ‘Abstain or Disclose’ Any person in the possession of material, nonpublic info has the duty to disclose the info or abstain from trading, if the person obtains the info in a relation of trust and confidence.

1. Parity of Information – anyone in possession of material inside info must either abstain from trading or disclose to the investing public. But when is silence okay. Strategic silence is different than outright lying. Over disclosure might dampen stock market activity.

2. Fiduciary Duty of Confidentiality – Court has clarified the abstain or disclose duty in a series of cases. Court has extended this duty to cover trading by outsiders who breach duty to persons or entities unrelated to the corporation in whose securities they trade.

a. Supreme Court cases that have defined duty.i. Chiarella v. United States – Chiarella was employed in composing room of a financial

printer. Used his access to confidential documents that firm printed for corporate raiders, he determined the identity of certain takeover targets. He then bought stock in those companies, contrary to advisories from his employer. Later sold at a profit. Supreme Court reversed conviction and held that 10b-5 does not cover instances of trading on the basis of nonpublic material info and he had no duty to abstain or disclose. Chiarella had no duty to the shareholders with whom he traded, b/c he had no fiduciary relationship to the target companies or their shareholders.

ii. Dirks v. SEC – Dirks was securities analyst who followed the insurance industry. When he learned of an insurance company’s massive fraud and imminent collapse from company insider he passed info on to his clients. Clients then dumped stock before it became public. Court held that Dirks did not violate 10b-5 because company insider did not disclose info to Dirks for personal advantage and thus no fiduciary breach and Dirks cannot be liable just for passing info on to his clients. For breach to occur an insider must gain directly or indirectly.

iii. United States v. O’Hagan – O’Hagan was partner in law firm retained by company planning to make tender offer for target company. He purchased common stock and call options on target company’s stock before the bid. Both bidder and law firm had taken precautions to protect bid’s secrecy. When bid announced O’Hagan made huge profit. Court of appeals reversed conviction on grounds that misappropriation did not violate 10b-5. Supreme Court reversed and validated misappropriation theory. See below for elements.

b. Satisfying the Disclosure Duty – a fiduciary may trade on confidential info by first disclosing the info to the person to whom he owes the duty. Texas Gulf Sulphur Co. (insiders should wait 24 to 48 hours after info disclosed to give time for dissemination before trading).

c. State of Mind – cases were split on whether the person had to be in knowing possession of insider info or had to actually use info in trading. SEC adopted new rule in 2000: a person trades ‘on the basis’ of material, nonpublic info if the trader is ‘aware’ of the info when making a purchase or sale. Aware means or implies conscious knowledge.

3. Insider Trading Rules under 10b-5 – general rule: the knowing misuse of material, nonopublic info entrusted to a person with duties of confidentiality. Important definitions and concept within the rules:

a. Insiders – directors, officers, employees, shareholders who through their positions gain info have clearest duty not to trade.

b. Constructive Insiders – people who are retained temporarily by company in whose securities they trade (accountants, lawyers, and investment bankers) have same duty as corporate insiders.

c. Outsiders – Outsiders with no relationship to company whose securities they trade also have abstain or disclose duty when aware of material, nonpublic info obtained in relationship, trust or confidence. This breach of confidence to the info source is deemed deception that occurs ‘in connection with’ securities trading.

d. Tippers – Tips is improper if tipper anticipates reciprocal benefits and insiders/outsiders with confidentiality duty who knowingly make them can be liable. Extends to sub-tippers who know that tip was received from someone who tipped improperly.

e. Tippees – Even those without confidentiality duty inherit abstain or disclose duty if they trade on improper tips.

f. Strangers – someone with no relationship to source of material, nonpublic info has no duty to disclose or abstain. Strangers who overhear info or develop on own have no 10b-5 duties.

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4. Outsider Trading – under the misappropriation theory, there is 10b-5 liability when a person trades on confidential info in breach of a duty owed to the source of info, even if source is complete stranger to the traded securities. Known as ‘fraud on the source’.

a. Misappropriation Theory – confidential info is misappropriated in breach of an established business relationship. SEC has clarified instances when the recipient of material, nonpublic info is deemed to owe a duty of trust or confidence to the source:

i. Recipient agreed to maintain info in confidence.ii. Person involved in communication have history, pattern or practice of sharing

confidences, so recipient had reason to know he should maintain info’s confidentialityiii. Communicator of info was spouse, parent, child or sibling of recipient, unless recipient

can show there was no reasonable expectation of confidentiality.5. Remedies for Insider Trading – full range of penalties:

a. SEC injunctions and disgorgement – SEC can seek injunction that enjoins the trader or tippee from further insider trading and compels disgorgement of any profits.

b. Civil Liability to Contemporaneous Traders – congressional act limits recovery to traders whose trades were contemporaneous with the insider’s. Requires disgorgement of insider’s actual profits realized or losses avoided.

c. Civil Recovery by ‘Defrauded’ source of confidential info – owners of confidential info can bring private action unde 10b-5 against insider traders and tippees who adversely affect their trading prices.

d. Civil Penalties – civil fines paid to the US treasury.e. “Watchdog” Penalties – can be imposed against employers who control insider traders and tippees.

6. State Insider Trading Laws – three major approaches under state law:a. Special Facts doctrine – a duty on insiders not to trade with corporate shareholders in face-to-face

transactions while in possession of highly material, nonpublic corporate info. i. Insider (officer or director) purchased from existing shareholder.ii. Insider was in privity with selling shareholder (face-to-face transaction)iii. Insider knew of highly material corporate info (Ex: declaration of dividend)iv. Secrecy was critically important to sale – must be clear that shareholder would not have

sold had he known info.b. Strict (Kansas) Rule – a duty on insiders not to trade with corporate insiders in face-to-face

transactions, regardless of existence of special facts. Expansion of special facts doctrine. c. Liability to Corporation – a duty on insiders to the corporation not to advance their own pecuniary

position using corporate info. Breach of duty creates liability to the corporation which can be enforced in derivative suit.

G. Disgorgement of Short-Swing Profits – Section 16(b) requires specified insiders to report their trading in their company’s securities and authorizes the corporation to recover from these insiders any profits made on stock transactions in narrow six month period

1. Coverage of § 16 – only applies to trading in equity securities of registered companies. Only applies to directors, officers and shareholders who own more than 10% of equity securities.

2. Mechanical Test – imposes strict liability on any director, officer or 10% shareholder who makes a profit in short-swing transactions. No proof of intent is required. Rule provides:

a. Match any transactions that produce profit – the statute requires the matching of any sales price that is higher than any purchase price, regardless of order. Many times this results in matching the lowest-cost purchase with earlier highest-cost sales.

b. No offset is necessary – no offset of losses. c. Officer or director status must exist at either sale or purchase – either or fulfills requirement, a

director or officer does not have to be both. Theory is that they had access to insider info.d. Shareholder status (10%) must exist immediately before both transactions -

VI. Fundamental Corporate Changes A. Sales of Control – the price for a block of controlling shares will contain a control premium. This becomes important when

a purchaser seeks to acquire control of the corporation from the controlling shareholder. Results in interplay of two important principles: 1) shareholders have no fiduciary duty when acting as shareholder and can sell their shares at whatever price a buyer will pay, including a control premium, and 2) Directors do have fiduciary duty to corporation, which is supplemented by idea that a controlling shareholder who tells directors what to do will pick up the duties of a director. This result in several limitations on selling control of corporation.

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1. General No-Sharing Rule – a shareholder can sell shares at whatever price they can get, including the control premium and controlling shareholders do not have to share this premium with other shareholders.

a. Equal Opportunity Rule – principle that the control premium should be shared pro rata with all shareholders. Argue that control should be viewed as corporate asset. Most courts have rejected this rule.

2. Exceptions to No-sharing rule – to discourage harmful transfers of control, courts have recognized exception to rule of free transferability. Controlling shareholders cannot sell their control block in three situations:

a. Sale to looters – a controlling shareholder cannot sell control if the seller has reason to suspect the buyer will loot the company. Looting refers to misappropriate corporate assets, engage in self-dealing transactions. If looting occurs, the shareholder who sold the shares becomes liable for damages caused to the corporation. Most cases the liability of seller will depend upon whether facts surfaced which should have alerted the seller the need for further investigation. How does someone know a prospective buyer is a looter, consider:

i. Price too good – could be difficult to discern between optimistic view of company versus view that purchasers is paying the control premium.

ii. Buyer cannot afford – the buyer buys on credit and will use assets or earnings of company to repay the debt.

iii. Buyer dishonest or hurried – could be signal to seller to investigate further.iv. Buyer had bad business reputation – buyer has significant debts, outstanding liens, etc.

b. Sale of office – occurs when the seller of a control block will promise to give the buyer working control of the board. This occurs by the serial resignation of the seller’s directors with each vacancy filled by the buyer’s director. Outright sale of office is prohibited.

i. Court will treat ‘board succession’ promise as prohibited sale of office if challenger shows, either:

(1) Buyer did not acquire working control and could not have elected his own slate, or

(2) The sales price exceeds the premium the control block alone commands, suggesting the price included prohibited sale of office.

ii. Dispute over whether control is acquired when less than 50% of stock is purchased. Argue that buyer should have to demonstrate working control in board of director’s election at shareholders meeting. Courts have not imposed requirement.

c. Usurpation of Corporate Opportunities – a controlling shareholder cannot convert an offer made to the corporation into one to the shareholder alone. If control buyer offers to deal with all shareholders on equal basis, the controlling shareholder cannot diver ‘corporate opportunity’ to himself. Some view as failure to disclose.

B. Proxy Fights – an attempt of the non-management group owning a small minority of shares (the insurgents) competed with management in an effort to obtain sufficient proxy votes to elect a majority of the board of directors and take control of the company. Usually involved the insurgents trying to acquire a shareholder list (see above). The solicitation of proxies is governed by the rules outlined above. Generally a very expensive way to attempt to take control. Management got to charge costs of proxy solicitation to corporation, while insurgents had to fund out of own pocket.

C. Tender Offers – a takeover strategy where the acquirer makes an offer to purchase shares of a target company at a certain price with the intent of becoming majority shareholder. Prior to federal regulation, very limited oversight. Acquirer could make offer on Sat. for a specific amount of shares (first-come, first-served) and state that the offer will close on Sunday night. Left no opportunity for management to respond and gave little time to shareholders to evaluate deal. Provisions added that now regulate these offers. Regulation meant to ensure that shareholders have sufficient info about offer and have adequate time to evaluate it.

1. Tender Offer Disclosure – bidder must file disclosure document with SEC on day it commences the tender offer. The target must cooperate in distributing bidder’s offer to shareholders. The document must include:

a. Info about tender offerb. Past negotiations between bidder and targetc. Bidder’s financial statements (if material)d. Any regulatory requirements that may be applicable to bide. Any other material info

2. What is a tender offer – rule does not define. Courts have created several factors, the existence of them signifies a tender offer:

a. Active and widespread solicitation of public shareholders for their stock

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b. Solicitation was for a substantial percentage of the corporation’s stockc. Offered price represented a substantial premium over current market priced. Terms of offer were firm rather than negotiablee. Acceptance of the shares was contingent on the tender of a certain number of shares, and subject to a

maximum number to be purchased.f. Offer was open only for a limited timeg. Solicited shareholders were subjected to pressure to sell their stockh. Publicity about the offer.

3. Substantive Terms of Offer – rules prescribes how the tender offer must be carried out. Target management must make statement to offer within 10 business days after the offer commences. Rule requires:

a. Minimum open period – tender offer must be left open a minimum of 20 days. Any changes in offer require offer being open an additional 10 days after change.

b. Withdrawal Rights – shareholders can withdraw shares at any time while offer is open.c. All holders – offer must be open to all shareholders of the same class and not exclude any

shareholders from tendering.d. Best Price – each shareholder must be paid the best price paid to any other shareholdere. Pro rata purchases – when bidder seeks only a portion of all the shares and shareholders tender more

than the bidder seeks, the bidder must purchase the tendered shares on a pro rata basis.f. No outside purchases – bidder cannot purchase outside the tender offer while it is pending.

4. Regulation of Issuer Self-Tender – an issuer may defend against hostile tender offer by buying back their own stock. Rule also regulate these transactions the same way as 3d party tender offers. Only two major differences between them:

a. Outside purchases – issuer may purchase stock outside the terms of its self-tender. Open-market purchases are not subject to prohibition applicable to 3d party tender offers. Only requirement is disclosure.

b. Cooling-off period – for 10 days after a self-tender terminates, the issuer is prohibited from making any purchases. Prevents an issuer from starting tender offer, withdrawing it and then purchasing stock in resulting depressed market.

5. Regulation of Deception – 14(e) prohibits any false or misleading statement as well as any fraudulent, deceptive or manipulative act in connection with any tender offer or any solicitation for or against tenders. Rule based on 10b-5, but 14(e) doesn’t contain ‘sale or purchase’ language.

a. Insider Trading – 14(e) prohibits trading during the course of a tender offer by anybody (other than the bidder) who has material, nonpublic info about the offer that he knows (or has reason to know) was obtained from either the bidder or the target. No need under rule to prove that a tipper breached a fiduciary duty for personal benefit.

6. Enforcement of Rules – rules expressly authorizes SEC enforcement but courts have implied a private cause of action. Two issues: 1) who has standing and 2) what remedies?

a. Standing – courts have held that target shareholders have standing. Could include nontendering shareholders and nonpurchasing investors (as long as comply w/ 10b-5 elements) since rule does not have ‘sale or purchase’ language.

b. Remedies – damages or injunctive relief – i. Damages – courts have awarded damages. Supreme Court has held that a frustrated

bidder cannot sue under 14(e) for damages arising from fraudulent statements made by the target in opposing the bidder’s tender offer.

ii. Injunctive relief – target cannot sue to disenfranchise a bidder unless the traditional showing for injunctive relief (irreparable injury) has been made.

D. Defenses to Takeovers – takeover offers highlight tensions between management and shareholder. State law determines the propriety of takeover defenses. Federal securities laws only deal with disclosure, not management fairness to shareholders. Issue is whether under state law the board consistent with its fiduciary duties to corporation and shareholders adopt takeover defenses. Courts have responded in several ways:

1. Dominant Motive Review – court accepted defensive action if incumbent board could point to reasonable investigation into a plausible business purpose for the defense. Business judgment rule will apply unless primary motive of directors was to preserve control, rather than advance interests of shareholders. Challenger had to then prove board’s dominate motive was entrenchment.

2. Intermediate Due Care review – imposes heightened standards of deliberative care3. Intermediate Proportionality Review – adoption of intermediate substantive and procedural standards.

a. Delaware had created a two-prong test Unocal test –

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i. Board must reasonably perceive the bidder’s action as a threat to corporate policy, andii. Any defensive measure the board adopts ‘must be reasonable in relation to the threat

posed’ – a proportionality test.b. Specific defenses and Delaware cases:

i. Moran v. Household Finance – upholds use of poison pill. Court held that use of such a device was a reasonable response to takeover concerns by establishing board’s preeminent negotiating position. What is a poison pill?

(1) A series of convertible preferred stock which corporation issues to its common shareholders. Poison because of conversion rights within shares.

(2) Triggers – could be triggered when an acquirer buys a certain percentage of the company’s shares, the board has a period of time to redeem rights for nominal amount. If target fails to take antidote, then become poison to acquirer b/c:

(3) Allows the holder of right to convert preferred shares into the acquirer’s common stock at a highly favorable ratio, such as paying half of current market price for acquirer’s common stock.

(4) Forces any bidder to attempt to gain the support of the current board, the holder of the antidote.

ii. Lock-up defense – a tactic to encourage a ‘white knight’ to enter or increase a bid to foil the attempt of a hostile bidder. As encouragement, the target company will grant an option or enter into a contract to sell a prized asset of the target corporation, at an favorable price, in the event that the white knight losses out to the hostile bidder.

(1) Revlon – case involved a lock-up agreement. Board argued that hostile bidder planned to bust up company and lock-up was necessary to induce higher bid. Court held that board must assume position of auctioneer once takeover inevitable. Must seek the highest bid which will be most beneficial to shareholders.

4. Must remember that a court could apply the above tests, or others such as the business judgment rule, the fairness test (conflict of interests) as well.

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