business organizations outline

BUSINESS ORGANIZATIONS OUTLINE

AGENCY

CONTRACT LIABILITY

I. OVERARCHING ISSUE : The first issue is whether [principal] is liable to [third party] for [agent’s contract].

II. OVERARCHING RULE : In assessing contract liability, [third party] must prove an agency relationship existed between [principal] and [agent] and [agent] had authority to do what he did. An agency relationship exists where: (1) the principal manifests desire for the agent to act on his behalf; (2) the agent accepts; and (3) it is understood between the parties that the principal will control the relationship.

III. APPLICATION : [Look to the amount of control the principal had over the agent.] a. Cargill – Farmers sell grain to Warren. Warren defaults on payment. Farmers sue Cargill alleging that

Warren was acting as Cargill’s agent. i. The court finds an agency relationship. Cargill loaned money to Warren and even though not

even lender is a principal, Cargill was because they had a ton of control over Warren. This control was evidenced by:

1. Cargill’s constant recommendations2. Cargill’s right of first refusal on grain3. Cargill’s right to audit Warren4. Cargill financed all of Warren’s operations and had a right to discontinue financing

ii. Courts look to: 1. P’s right to control agent2. Alleged agent’s duty to act for primary benefit of the P3. Alleged agent’s power to alter legal relations of P

iii. Lender is liable if its control affects borrower’s management decisions beyond those necessary merely to protect lender’s investment

b. Buyer-Supplier: one who contracts to acquire property from X and convey it to Buyeri. Supplier is Buyer’s agent only if it agreed that he is to act primarily for the benefit of the other

and not for himself; factors:1. Supplier receives fixed price for property regardless of what supplier paid to X2. Supplier acts in his own name and receives title to property that he transfers3. Supplier has independent business in buying/selling similar property

IV. ISSUE TWO : Because there was an agency relationship between [principal] and [agent], the next issue is whether [agent] had authority [to do what it did], such that [principal] is liable. Therefore, we must determine whether there is: (1) actual express authority; (2) actual implied authority; (3) apparent authority; (4) inherent agency power; or (5) ratification.

** APPLY MORE THAN ONE UNLESS IT IS VERY CLEAR **

a. SUB-ISSUE/RULE ONE : The issue is whether there is ACTUAL EXPRESS AUTHORITY. This exists when the principal expressly tells the agent to do something. [Look for communication between P and A] Here…

i. CONCLUSION : Therefore, there is (not) actual express authority.

b. SUB-ISSUE/RULE TWO : The next issue is whether there is ACTUAL IMPLIED AUTHORITY. This exists where either: (1) the agent acts in a way that is necessary, usual and/or proper to carry out their express responsibilities/actions incidental to P’s objectives; or (2) the principal acts in a way that causes the agent to reasonably believe he had authority to act. Here…

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i. Note : For there to be actual implied authority, it still must be clear that the principal wanted the agent to do something.

ii. EX for (1) : Eli (principal) tells Tim (agent) to re-sod the Arizona Diamondback’s field. Tim has actual express authority to re-sod the field. Tim has actual implied authority to buy a plane ticket to travel to Arizona.

iii. For (2), look at :1. The principal’s past and present conduct 2. The existence of prior similar practices3. The nature of the task delegated

a. Mill Street Church – Church (P) hires Bill (A) to paint the church. Bill needs help so he hires his brother Sam (TP), which he had done on prior occasions. Sam gets hurt and sues the Church.

i. Looking at what Bill (A) reasonably believed - Bill had actual implied authority because based on the Church’s past conduct (allowing him to hire Sam for past jobs), Bill reasonably believed he could hire Sam again.

iv. CONCLUSION : Therefore, there is (not) actual implied authority.

c. SUB-ISSUE/RULE THREE : [P is disclosed] The next issue is whether there is APPARENT AUTHORITY. This exists where: (1) a principal acts in such a way that causes a third party to reasonably believe the agent had authority to do what the agent did; and (2) the third party relied on that holding out. [Look at:]

Scenario: 1) persons appear to be agents and are not (2) agents act beyond the scope of actual authority

i. The agent’s title:1. 370 Corp. v. Ampex – Joyce (TP) was an officer at 370 Corporation. Kays (A) was a

salesman at Ampex. Mueller (P) was Kays’ boss. Kays signed a sales agreement with Joyce on Mueller’s behalf.

a. Looking at what Joyce (TP) reasonably believed - Kays (A) had apparent authority to enter into an agreement with Joyce (TP) because it was reasonable for Joyce to assume someone with the title “salesman” could enter into a sales agreement with a third party.

b. If the sales order was for a HUGE amount, the outcome might be different because Joyce was smart and would know Kays does not have that much authority to bind Ampex in that situation.

c. AA trumps bylaws if conduct is within ordinary course of business

ii. The principal’s written or oral statements to manifest assent to 3rd party:1. Mill Street Church – see above

a. Looking at what Sam (TP) reasonably believed – Bill had apparent authority because Sam reasonably believed that Bill could hire him based on the Church’s past conduct (allowing him to hire Sam for past jobs).

iii. CONCLUSION : Therefore, there is (not) apparent authority.

iv. Note : Apparent authority is different than apparent employee/employer (estoppel) because here, there IS an actual agency relationship and this just expands the agent’s authority. Whereas for apparent employee/employer, there is no actual agency relationship but the court finds one based on the principal’s holding out, does not give any rights against third party.

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d. SUB-ISSUE/RULE FOUR :[Look for undisclosed P] The next issue is whether there is inherent agency power. Under Watteau v. Fenwick, INHERENT AGENCY POWER (rare) exists when undisclosed principal clothes an agent with power and the agent acts in a manner that is usual for the business, even if prohibited by the principal. However, Restatement 3d adds a notice requirement: liability only attaches if the principal is aware of the agent’s conduct and that a third party might rely on the agent’s conduct, but failed to take reasonable steps to notify the third party of the fact. Here…

i. Public Policy : It would be unfair to let an undisclosed principal escape liability when they are benefiting from the business

1. Watteau – Manager (agent) of D’s (principal) bar only had authority to buy ales, but he bought cigars without D knowing. There was inherent agency power because: (1) D entrusted the agent with management of the business; and (2) buying cigar was a usual transaction for the business.

a. NOTE : If Restatement 3d was the law, D would not be liable because D did not know his agent was buying cigars.

b. Limits P liability to actions by agent reasonable under the circumstances even if expressly forbidden by P

ii. CONCLUSION: Therefore, there is (not) inherent agency power.

e. SUB-ISSUE/RULE FIVE : The next issue is whether [principal] ratified [agent’s] conduct. RATIFICATION occurs where the principal subsequently agrees with the actions of its agent, even if the agent did not have authority at the time to act. In order to prove ratification, a party must show: (1) intent by the principal to ratify the agreement; and (2) the principal’s knowledge of all the material circumstances surrounding the deal. Here…

i. Botticello – Mary and Walter owned farm as tenants in common and leased to Botticello. Walter gave Botticello and option to buy, without Mary’s consent. Years later, Botticello tried to exercise the option and Mary objected, saying she never consented to the deal. Botticello argued that Mary ratified the agreement by accepting his rent payments and allowing him to make improvements to the property.

1. Mary did not ratify the option. Mary didn’t have the requisite knowledge because she didn’t know there was an option to buy.

a. NOTE : Walter was not acting as Mary’s authorized agent because marriage is not enough to create an agency relationship.

ii. CONCLUSION : Therefore, [principal] did (not) ratify [agent’s] conduct.

V. OVERARCHING CONCLUSION : Therefore, [principal] is (not) liable to [third party] for [agent’s contract].

TORT LIABILITY

I. OVERARCHING ISSUE : The first issue is whether [principal] is liable to [third party] for [agent’s tort].

II. OVERARCHING RULE : A principal may be liable when: (1) there is an employer/employee relationship; (2) there is an apparent employer/employee relationship; (3) an independent contractor is engaged in an inherently dangerous activity; (4) the principal negligently hired an independent contractor; or (5) the act is done at the principal’s direction.

a. SUB ISSUE/RULE ONE : The next issue is whether there is an EMPLOYER/EMPLOYEE RELATIONSHIP between [principal] and [agent], or whether [agent] is an independent contractor. There is no bright line test to determine whether an employer/employee relationship exists. Rather, the court will make a fact-intensive inquiry focusing on the amount of control the principal exercises over the day-to-day

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operations of the job. The more control, the more likely an employer/employee relationship exists. Here, considering the totality of the circumstances there was (not) an employer/employee relationship because . . . [analyze amount of control]

1. Note : An employer/employee relationship is a subset of principal/agent. You can be an agent without being an employee. For example, if you hire a lawyer, the lawyer is your agent, but not your employee.

ii. CONCLUSION IF NOT EMPLOYEE : Thus, there is no employee/employer relationship and the [principal] will not be liable unless: (2) there is an apparent employer/employee relationship; (3) an independent contractor is engaged in an inherently dangerous activity; (4) the principal negligently hired an independent contractor; or (5) the act is done at the principal’s direction.

iii. CONCLUSION IF EMPLOYEE (Respondeat Superior) : Thus, [agent] is an employee. Therefore, [principal] is liable so long as the employee’s act was within the scope of [agent’s] employment. In making this determination, courts primarily focus on the intent of the employee. For example, courts look to whether: (1) the employee’s actions intended to benefit the employer; (2) the employee’s actions were the sort of thing the employee was hired to do; and (3) the employee’s actions were within the authorized timeframe and space limitations of the employer. Here . . .

1. Ira Bushey v. US – Drunken sailor turned a wheel and flooded a dry-docked and ship. Owner of the dock (TP) sued Coast Guard (P) for sailor’s (A) negligence.

a. Even though the court found the sailor’s conduct was outside the scope of their duties, the court made the policy argument saying it is fair to hold a Principal liable if an agent’s conduct is foreseeable to the principal.

i. Note : Sailors go on leave all the time and get drunk so P knew this type of behavior could happen.

1. If the sailor was ashore and set a car of fire, the CG would not have been liable because the sailor’s conduct was not foreseeable.

2. If the sailor came back to ship, recognized his lover’s wife and shot him, the Coast Guard would not have been liable because the sailor’s conduct related to his personal life.

2. Manning v. Grimsley – Orioles (P) were liable when Grimsley (A) threw a pitch at heckling fans (TP).

a. Court said a Principal will be liable for an employee’s tort where the tort was in response to a third party’s interference with the employee’s ability to do his job.

i. Here, Grimsley was trying to silence the hecklers so he could pitch more effectively (i.e. benefit the employer).

3. Miller Case – Porter (A) at Filene’s Basement (P) slapped a customer (TP) who annoyed him while he was mopping floors.

a. Distinguished from Grimsley because in Miller, the court said the agent’s tort was not an effort by an employee to stop a third party from interfering with his job duties. In Grimsley it was.

iv. CONCLUSION FOR SCOPE OF EMPLOYMENT : Therefore [agent’s] tort was (not) within the scope of his employment such that [principal] will (not) be liable to [third party].

1. RECOMMENDATION : Get insurance to protect against agent’s torts (car crashes)!

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b. SUB ISSUE/RULE TWO : The next issue is whether there is an APPARENT EMPLOYER/EMPLOYEE RELATIONSHIP. A court will impose an apparent employer/employee relationship when: (1) the employer holds someone out as their employee; and (2) a third party relies on that holding out. Here…

i. Note : Apparent authority is different than apparent employee/employer because there, there IS an actual agency relationship in the former and this just expands the agent’s authority. Whereas for apparent employee/employer, there is no actual agency relationship but the court finds one based on the principal’s holding out.

ii. CONCLUSION : Therefore, there is (not) an apparent employee/employer relationship.

c. SUB ISSUE/RULE THREE : Because no actual or apparent employee/employer relationship existed, [name] is an independent contractor. Non-delegable duty to ensure the work is not done in a negligent manner. Therefore, [principal] will be liable if what [name] was hired to do was an INHERENTLY DANGEROUS ACTIVITY. Here…

i. Majestic Realty v. Toti – Parking Authority (P) hired Toti Construction (A) to demolish a bunch of buildings. Wrecking ball accidentally struck and knocked over part of Majestic’s (TP) building.

1. Court said Principal was liable for the acts of an independent contract where the independent contractor was engaged in an inherently dangerous activity even where the Principal has NO control over the IC’s operations.

a. Public Policy : We want people to be careful when they hire contractors to do dangerous stuff.

d. SUB ISSUE FOUR : Although [name] was not hired to conduct an inherently dangerous activity, [principal] may still be liable if they NEGLIGENTLY HIRED [name] as an independent contractor. Should have known IC does not have skill to do work then liable for that IC’s negligence. Here…

i. EX – Exxon Mobile wants to transport oil. They hire an alcoholic captain to transport the oil and the ship crashes. Exxon (P) will be liable for negligently hiring the captain (IC) even if Exxon doesn’t own the ship.

e. SUB ISSUE/RULE FIVE : The issue is whether [the act] was DONE AT THE PRINCIPAL’S DIRECTION. When an act is done at a principal’s direction, the principal will be liable regardless of whether the agent is an employee or independent contractor. Here…

III. OVERARCHING CONCLUSION : Therefore, [principal] is (not) liable to [third party] for [agent’s tort].

FRANCHISES

I. OVERARCHING ISSUE : Here, the facts indicate a franchisor/franchisee relationship exists between [franchisor] and [franchisee]. Although this is a grey area of the law and may not constitute agency, a franchisor will typically be liable for the acts of a franchisee when: (1) an actual employer/employee relationship exists; or (2) where an apparent employer/employee relationship exists.

II. RULE for ACTUAL EMPLOYER/EMPLOYEE : An actual employer/employee relationship exists when the franchisor: (1) maintains the right to control the day-to-day operations of the franchisee; or (2) the franchisor maintains the right to control the particular aspect of the day-to-day operations that led to the injury. Here…

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a. Murphy v. Holliday Inns – Betsy-Lynn (A) owned a Holiday Inn (P) franchise. Plaintiff (TP) slipped and fell at Betsy-Lynn’s hotel. Betsy-Lynn was broke so Plaintiff tried to sue Holiday Inn, arguing the franchise agreement established a franchisor/franchisee relationship.

i. The court said the franchise agreement did not create an employer/employee relationship because Holiday Inn had no right to control Betsy-Lynn’s day-to-day operations.

b. Humble Oil v. Martin – Humble (P) owned gas station and leased it to Schneider (A) and sold him gasoline and other products. Car was left at station for repairs and Schneider didn’t secure it. Car rolled down hill and hit Martin and his kids (TP). Plaintiff sued Humble Oil (P).

i. The court said Humble (P) was liable because the language in the contract made is such that Humble exercised financial control over Schneider.

1. Humble paid ¾ of all the utility bills, which was the most important operational expense. 2. The title to all the products remained in Humble’s name until a customer actually

purchased them. 3. Humble controlled the hours of operation 4. Schneider’s right to occupy the premises was terminable at the will of Humble.

c. Hoover v. Sun Oil – Sun Oil (P) owned gas station and leased it to Barone (A). Barone’s employee caused fire. Plaintiff (TP) sued Sun Oil (P).

i. The court said even in the absence of actual control, where the Principal reserves the right to control the details of the day-to-day operations, the principal will be liable.

1. Here, the court found there was no right to control because Barone: (1) determined how much to pay his employees; (2) set the working conditions at the gas station; and (3) determined the gas station’s operating hours.

a. Note : Professor disagrees because the lease gave Sun Oil the right to terminate Barone’s (A) lease with just 30 days’ notice giving them substantial control. For example, if Barone was not staying open long enough, Sun Oil could just terminate the lease.

d. CONCLUSION : Therefore, an actual employee/employer relationship does (not) exist. i. RECOMMENDATION : The franchisor should get insurance to protect against torts by franchisees.

For McDonalds and similar business chains, it is very important for them to have control in order to maintain uniformity between restaurants. So, since the business will likely be held liable, they should just get insurance.

III. RULE for APPARENT EMPLOYER/EMPLOYEE : However, there might still be an apparent employee/employer relationship if: (1) the franchisor held the franchisee out as an agent; and (2) the third-party relied on that holding out. Here…

a. Miller v. McDonalds – Plaintiff (TP) bit into a stone while eating her Big Mac at a McDonald’s (P) owned and operated by 3K Restaurants (A). (TP) realized 3K didn’t have any money so she tried to sue McDonald’s.

i. The court remanded for more fact finding. Two theories of liability:

1. Actual Employer/Employee a. Right to Control Test – Where the practical effect of the franchisor/franchisee

relationship goes beyond setting standards and gives the franchisor the right to control, an actual agency relationship exists and the franchisor is probably liable. APPLY FACTS!

2. Apparent Employer/Employee a. A jury could find: (1) 3K was held out to the TP as an agent; and (2) the TP relied

on the principal’s holding out.

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b. CONCLUSION : Therefore, [Principal] will [not] be liable because [it] did [not] exercise sufficient control to create an agency relationship.

i. Recommendation : The franchisor should get insurance to protect against torts by franchisees. For McDonalds and similar business chains, it is very important for them to have control in order to maintain uniformity between restaurants. So, since the business will likely be held liable, they should just get insurance.

FIDUCIARY OBLIGATIONS OF AGENTSScenario: Comes up when P is suing agent (not plaintiff suing Principal because o agent)

** IF DEALING WITH A PARTNERSHIP OR CORPORATION SKIP TO BELOW **

I. OVERARCHING ISSUE : Because there is an agency relationship, [agent] owes a fiduciary duty of loyalty to [principal]. Thus, the issue is whether [agent] breached its fiduciary obligation to [principal].

II. OVERARCHING RULE : Unless otherwise agreed, an agent has a duty to act solely for the benefit of the principal in all matters connected to his agency. He cannot use his position of confidence or trust to further his private interests. Further, he must disclose to the principal any matter affecting the principal’s interest.

III. APPLICATION : Here, [agent] did (not) breach his fiduciary duty to [principal] because an agent can’t:

a. Divert business from the principal for the agent’s own use without disclosing; (Corp. opportunity) i. EX : An agent can’t say “principal’s company can’t do it, but my company can do it.”

b. Sell assets to the principal without key disclosing (Rash);i. EX : President of P’s company sells land that he owns to principal’s company without disclosing.

c. Leave and take the principal’s employees or confidential information (business) with you (Town and Country)

i. EX : Improperly soliciting former clients

d. RECOMMENDATIONS :i. If you want to do a deal that you have an interest in with your principal, disclose it to your

principal. ii. When entering into a non-compete agreement, remember that they are generally not

enforceable (in IL). In order to be enforceable courts look for: (1) Duration; (2) Geography; (3) Scope; (4) Context; (5) Subject Matter.

e. Rash v. JV International, Ltd. – Rash managed JVIC’s Oklahoma plants. While managing JVIC, he then started a scaffolding business and didn’t tell JVIC. His scaffolding company bid on jobs for the plant and won and JVIC paid them almost $1 million.

i. The court said the duty of an agent is to disclose to the principal any matter affecting the principal’s interests.

1. Here, Rash breached his fiduciary duty to JVIC because JVIC had a right to know about Rash’s relationship with the scaffolding company. A way for Rash to avoid this is for Rash to have disclosed this information in a letter to JVIC.

a. Note : it doesn’t matter whether Rash’s company was the best company or offered the lowest price, Rash had a duty to let JVIC know.

b. Note : People can form other businesses, but they cannot do business with the company they currently work for unless they tell the company.

f. Town and County v. Newberry – Plaintiff’s owned a cleaning service. Defendant’s worked for them.

Defendants quit, started own business, and called old clients to get them to switch.

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i. The court said Plaintiff is entitled to damages. Agents have a duty to protect their principal’s trade secrets even after their employment ends. Here, the Plaintiffs had formulated the client list through much effort so it was a secret and Defendants couldn’t use it for their own benefit.

1. Note : Defendants didn’t have to stop their cleaning services because Plaintiff’s cleaning methods were not too secretive to merit protection

2. Note : Lawyers cannot persuade clients to hire them until after they have left the firm.

IV. CONCLUSION : Therefore [agent] did [not] breach its fiduciary duty to [principal].

FORMS OF BUSINESSI. PARTNERSHIPS

a. Taxation : Good. Taxation occurs at the individual partner level (conduit taxation). b. Limited Liability : Bad. Each partner is personally liable for partnership debt regardless how much they

put in

II. CORPORATIONS a. Taxation : Bad. Corporations are taxed twice: (1) at the shareholder level; and (2) at the corporate level

i. Recommendation: form an S corporation to avoid double taxations (only shareholders pay taxes and one class of stock and less than 75 SH).

b. Limited Liability : Good. Shareholders are not liable for business debts and can only lose what they put in (unless PCV)

III. LIMITED LIABILITY COMPANIES a. Taxation : Good. Conduit taxation – taxation occurs at the shareholder level.b. Limited Liability : Good. Shareholders are not liable for business debts and can only lose what they put in

PARTNERSHIPS

DOES A PARTNERSHIP EXIST?I. OVERARCHING ISSUE : The first issue is whether a partnership exists between ___ and ___.

II. RULE FOR PARTNER vs. EMPLOYEE : A partnership is an association of two or more people established to carry on as co-owners of a business for a profit. No formality is required and there are many factors the court will consider to determine whether a partnership exists including: [PICK FROM BELOW] (internal rules can be changed by agreement)

a. Intent of the partiesi. Relevant but not controlling. People may think of themselves as a partnership, but that doesn’t

mean they are one. b. Language of the agreementc. Right to share profits – partners share equally in profits and losses regardless of investment amount,

unless agreed to otherwise i. Prima facie evidence of partnership unless it is for wages

d. Obligation to share losese. Indemnification of partners – partnership must indemnify for payments made and personal liability in

ordinary and proper course of business f. Conduct of the parties towards third parties – estoppel

i. i.e. did the people hold themselves out as partners? g. Ownership and control of the partnership property

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i. Default Rule - Each partner has one vote regardless of how much money they invest in the partnership. But, the partnership agreement can alter this.

h. Right of dissociation – even if violates partnership agreement; may be liable for damages or bought out

i. Fenwick v. UCC1. Fenwick owned a beauty shop and his receptionist wanted a raise; offered to make her

partner. They entered into an agreement where the receptionist received salary plus 20% of the profits if the business did well. The UCC is arguing partnership because they want to collect the unemployment taxes.

a. The court found no partnership by analyzing: i. Control : the receptionist’s role didn’t change because Fenwick retained

exclusive control over the business; ii. Intent of the Parties : the intent of the agreement was to give the

receptionist more money, not make her partner.iii. Right to Share Profits : The receptionist had a right to share profits only if

the business did well.iv. Obligation to Share Losses : The receptionist had no obligation for losses.

2. Note : This is an unusual case. It is generally a creditor arguing that there was a partnership so they can go after the deep pockets of one of the partners.

i. CONCLUSION : Therefore, ____ and ____ are [not] partners. [IF NOT PARTNERS GO TO ESTOPPEL]

III. RULE FOR PARTNER vs. LENDER : A partnership is an association of two or more people established to carry on as co-owners of a business for a profit. No formality is required and there are many factors the court will consider to determine whether a partnership exists including [PICK FROM BELOW]:

a. Look to factors above that establish a partnership; if present, likely not a lenderb. Lenders have an unconditional right to repayment (this is the BIG ISSUE)

i. Payment can relate to profits, but it does not establish a partnership if the payment is unconditional. Equity kicker may allow bank to participate in profits.

ii. Covenant controls does not mean partnership c. Lenders are not responsible for losses/debts of the borrower. d. Lenders are entitled to a certain level of control, but not too much control (Martin v. Peyton)

i. Lenders can veto transactions, but can’t initiate transactionsii. Lenders can inspect the firm’s books

1. Cargill – Martin is different from Cargill because in Cargill, the lenders had total control over operations.

e. Consequences: If lender is partner then loan is subordinate to claims of creditors

f. CONCLUSION : Therefore, ____ and ____ are [not] partners. [IF NOT PARTNERS GO TO ESTOPPEL]

IV. RULE FOR PARTNERSHIP BY ESTOPPEL : Here, even though no actual partnership existed between ____ and ____, a court still might find partnership by estoppel if: (1) [defendant] represented ____ and D were partners; and (2) plaintiff relied on this representation. P can establish partner ship between A and B and B will be liable for A. If one person purports to be acting with another then partnership by estoppel. Here… [common sense argument].

a. Young v. Jones – Plaintiffs hired PW-Bahamas to do their audit. PW-Bahamas did a bad job and P wants to sue the deep pockets of PW-US. Since there is no actual partnership, P claims that PW-US represented that PW-Bahamas was its partner.

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i. The court found no partnership by estoppel because P did not rely on defendant’s representation. There was a brochure that made it seem like there was a representation of a partnership but plaintiff didn’t rely on it.

FIDUCIARY OBLIGATIONS OF PARTNERS

I. OVERARCHING ISSUE/RULE : (Similar to agency) Because there is a partnership, the issue is whether [partner] breached [his/her] fiduciary duty to the partnership. As Chief Judge Cardozo stated in Meinhard, joint-venturers and co-partners owe “the duty of finest loyalty” to one another. Further, UPA § 404 says that partners owe a duty of care and loyalty to one another.

***IF GRABBING AND LEAVING OR EXPULSION SKIP TO NEXT RULE***

a. APPLICATION/CONCLUSION : Here [partner] did (not) breach [his/her] duty of (loyalty and/or care) when he [ ] because…

i. Duty of Loyalty - A partner can’t: 1. Take a partnership opportunity for himself (can’t profit yourself from a deal without your

other partners profiting); (corporate opportunity 2. Participate in self-dealing and profit without disclosure to the partnership; or3. Compete with the partnership. Duty of loyalty trumps self-interest

ii. Duty of Care – A partner can’t:1. Act recklessly or grossly negligent;2. Intentionally harm the partnership;3. Knowingly violate the law.

iii. Meinhard v. Salmon - Salmon leased a building from Gerry. Salmon managed and operated it. Meinhard gave him money to renovate it. They agreed to share profits and losses (as joint venturers). As the lease was expiring, Gerry and Salmon entered into a bigger deal without telling Meinhard. Meinhard sued for being cut out of deal.

1. The court said Salmon had a duty to disclose the business opportunity to Meinhard. a. Dissent – the venture had a defined end date so Salmon had no obligation to

involve Meinhard in future deals. But Professor disagreed because this was essentially an extension of the same deal. It would have been different if this was a separate property a block away.

II. SUB-RULE IF GRABBING AND LEAVING PARTNERSHIP : When leaving a partnership, there are certain things a partner can and cannot do.

a. APPLICATION/CONCLUSION : Here, [partner] did (not) breach their fiduciary duty when they [insert what they did before leaving] prior to leaving the partnership.

i. SOLICITING CLIENTS :1. CAN:

a. Tell partnership who you are going to solicit so that they have an opportunity to try and keep those clients.

i. How much notice you have to give old partnership depends on circumstances; (ARGUE WHAT IS A FAIR TIMEFRAME)

2. CANNOT: a. Solicit your old partnership’s clients in secret while still at the partnership

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i. If you do, this is a breach of fiduciary duty b/c you would be stealing assets from your old partnership (i.e. can’t undercut old partnership)

ii. RECOMMENDATION : Even though you can solicit while still with the partnership if you disclose that you are leaving and plan to solicit. But the safest thing to do is wait until after you’ve already left because then no disclosure is needed. Not necessary to leave partnership.

b. Cannot bad mouth old partnershipi. Recommendation: play up your new business

c. Give one-sided notice to the client that you are leaving i. Cannot say: “I have left and I want you to come with me.”

ii. Can say: “Of course I want you to come with me, but it is your choice.”

d. Give short notice period to old partnership that you are leavingi. If, you tell them today that you are leaving tomorrow, and you start

soliciting business today, it does not give partnership a fair chance to figure out how to retain business

1. Note: you are more likely to be sued if you are taking big business

e. Use confidential information to assist in your effort of moving clients from your old partnership to your new venture (Town and Country).

f. Use the company computers or other facilities in your efforts to switch clients.

ii. SOLICITING PARTNERS :1. CAN:

a. Solicit other partners to leave with you (even if made in secret)

iii. SOLICITING ASSOCIATES :1. Soliciting associates is unclear b/c they are viewed as more vulnerable

iv. MISC .1. CAN

a. Prepare without telling old firm (i.e. enter into new lease; hire secretary; get stationary; obtain malpractice insurance)

2. CANNOTa. Meehan – affirmatively lied when partners asked if he was leavingb. Dowd – Steal old firm’s line of credit;

III. SUB RULE FOR EXPULSION : Generally, partners can agree to anything they want related to expulsion. However, the UPA imposes certain limitations on the general rule; for example, partners cannot: (1) agree to anything that affects third parties; (2) vary the court’s right to expel a partner; or (3) vary a partner’s right to disassociate. [RULPA retained this provision and adds that partners can be expelled by the unanimous vote of remaining partners regardless of the reason.]

a. APPLICATION/CONCLUSION : Here, [partners] did (not) breach their duty when they expelled [partner] by [action] because...

i. Note : Some states, including Illinois, require expulsion be made in good faith and fair dealing.

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1. Lawlis – Lawlis was a drunken lawyer and got fired. He claimed that his firm violated his duty of good faith because they fired him to increase the partner/lawyer ratio.

a. The court said Lawlis loses because Indiana doesn’t have a duty of good faith requirement so the partners could agree to whatever they want (and here they agreed partners could be fired for any reason with a 2/3 vote). Therefore, if they fired him because he was gay, it wouldn’t matter because the partnership agreement said they could fire him for any reason.

IV. Raising Additional Capitala. There is no obligation on partners to contribute more money to the partnershipb. Often times, additional funds will be needed

i. All investors would be better off if each provided a pro rata share of the amount neededii. However, each investor may act out of self-interest and decline to invest more money (if this

happens, everyone will lose b/c business will not raise the money needed to continue and business will fail)

c. Solutions:i. Pro rata Dilution: a common provision permits the managing partner to issue a call for additional

funds and provides that if any partner does not provide the funds called for, her share is reduced according to a formula

ii. Penalty Dilution

PARTNERSHIP MANAGEMENT

I. ISSUE IF WITHIN PARTNERSHIP : The issue is whether [partner] had authority to [do what he did].

II. RULE : Generally, partners have an equal share in management and bind the partnership when acting within the ordinary course of business. However, a partner’s authority can be limited by either: (1) the partnership agreement; or (2) a vote of a majority of partners to strip the partner’s power. [When a partner acts outside of the ordinary course of business, 100% vote of the partners is needed to authorize the partner’s actions.]

a. APPLICATION/CONCLUSION : Here…i. Step 1 : Did partner act within the ordinary course of business?

1. If so, partner had authority unless partners agreed to something else.ii. Step 2 : What did the partners agree to? (Summers and Day)

iii. Step 3 : Did the partners vote to change anything? iv. Step 4 : If so what percentage was required?

1. 100% vote needed to amend the partnership agreement. 2. UPA section 401(j) – A majority is not measured on percentage of ownership, but

literally measured per person. (50% of partners plus 1 partner is a majority).

b. Summers v. Dooley – Summers and Dooley had an equal share in a trash collection partnership. Summers decided they needed a third employee, but Dooley disagreed. Summers hired one anyway and tried to get the partnership to foot the bill. Partnership agreement said 100% vote needed to hire someone.

i. The court said hiring an employee unilaterally violated the terms of the partnership agreement and Summers couldn’t change the agreement because neither partner was a majority.

1. Note : A partnership may add new partners, but absent the partnership agreement saying differently, such additions require a unanimous vote of existing partners.

a. Policy : The partnership is a personal relationship and one partner cannot require the others to accept a new co-owner.

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c. Day v. Sidley Austin – Day was head of new Washington Office but not on executive committee. Sidley merged and promised no partner would be worse off as a result of the merger. After the merger, Day sued because he was forced to share his leadership of Washington office with new partner (he claims he was worse off).

i. The court said the partnership agreement gave the executive committee sole discretion to determine heads of offices. Sidley could have fired Day before the merger so the merger didn’t change anything.

III. ISSUE IF INVOLVING THIRD PARTY : The issue is whether [partnership] is liable to [third party] for [partner’s] act/omission.

IV. RULE : Generally, each partner is an agent of the partnership and a partner’s act is binding on the partnership if done in the ordinary course of business. A partnership cannot absolve itself of liability to third parties simply by agreement among the partners, unless: (1) [partner] didn’t have authority, and (2) [third party] knew [partner] lacked authority.

a. Policy – The reason partners cannot agree to something that affects third parties is because third parties have no way of knowing of the agreement.

i. Example of affecting third parties: saying partners are not liable for unpaid debts of the partnership

ii. No authority stems from partnership agreement or from UPA where majority needed to bind.

b. APPLICATION : Here… i. Step One : Analyze whether the partner acted within the ordinary course of business.

1. Note : If the partner acted outside the ordinary course, the partnership is never liable.

ii. Step Two : If he did, did the partners strip him of his authority and did the TP know?

c. NABISCO case - Stroud and Freeman started a partnership. Stroud told NABISCO he would not be personally liable for any bread sold to the store. Freeman ordered more bread, NABISCO delivered and sued Stroud for payment.

i. The court said that Freeman buying bread was within the ordinary course of business. There were no restrictions on his actual authority. Stroud could not limit Freeman’s authority because the partnership agreement was silent and because there were only two partners, there could not be a majority.

1. SHOULD HAVE – In the agreement, “Stroud has the sole authority to buy X Y Z…” If NABISCO knew this, they lose.

d. HYPO – If there was a third partner involved and third partner owned 5%; Stroud owned 5%; Freeman owned 90%, then Stroud and third partner could vote to strip Freeman of his authority. The partnership would not be liable if NABISCO knew Freeman lacked authority.

e. HYPO – Same facts as Summers but employee sues the partnership for his salary. i. Partnership is liable because Summers had apparent authority to hire the employee. If the

employee knew the partner had no authority, the partnership would not be liable (same situation as NABISCO).

f. CONCLUSION : Therefore, the partnership is (not) liable to [third party]

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DISSOCIATION OF A PARTNER

I. OVERARCHING ISSUE : Here, [partner] dissociated himself from the partnership therefore the issue is whether his/her dissociation was wrongful such that he is liable for damages.

II. RULE/APPLICATION : A partner has the right to dissociate from a partnership at any time, rightfully or wrongfully. In an at-will partnership, the dissociated partner will not be liable for damages, while in a term partnership, it is more likely he/she will be liable for damages. Here…

a. NOTE : After the dissociation, the partner is not liable for new partnership debts, but liable for old debts.

b. NOTE : After the dissociation, the partnership can continue (other partners might want to continue).i. *Look to Buyout section if necessary*

c. RECOMMENDATION : Dissociating partner should seek judicial dissolution instead of dissociating. This is a way to shield partner from liability in case his dissociation would be wrongful.

III. CONCLUSION : Therefore, [partner’s] dissociation was (rightful/wrongful), and [partner] will (not) be liable for damages.

JUDICIAL DISSOLUTION OF A PARTNERSHIP

I. OVERARCHING ISSUE : Here, the issue is whether the court will grant []’s request to dissolve the partnership.

IV. RULE : Judicial dissolution is a high bar and you can’t ask the courts to get you out of something you agreed to do. (Collins). Under section 801(5), a court will order dissolution of a partnership and a partnership must be wound up when the court determines that: [PICK ONE]

a. the economic purpose of the partnership is likely to be unreasonably frustrated;

b. another partner has engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with that partner; or

c. It is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement.

V. APPLICATION/CONCLUSION : Here, the court will (not) order dissolution because…a. Order of Liabilities: creditors, debts to partners, capital to partners, profits to partners

b. Owen v. Cohen – Owen and Cohen entered into a partnership to own a bowling alley. Owen sought dissolution of the partnership claiming Cohen belittled him in front of customers.

i. The court dissolved the partnership because, this was more than petty discord; Owen behaved so badly that cooperation and confidence between the parties had been destroyed.

c. Collins v. Lewis – Collins and Lewis entered into a partnership to build and operate a cafeteria. Collins was supposed to put up the money and Lewis was supposed to be the manager. Initially estimates were $300,000 but once the cost rose to $600,000, had enough and sued for dissolution and repayment of the debt.

i. The court said Collins had no right to dissolve the partnership and no right to judicial dissolution.

d. RECOMMENDATION : Get a cap. Collins had a crappy lawyer and the agreement had no cap. Collins had to put up as much money as was necessary to build the cafeteria so Collins was stuck with it.

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BUYOUT AGREEMENTS IN A PARTNERSHIP

Two reasons for buyout agreements: - To restrict who can become a fellow owner- To give partners the ability to exit

I. OVERARCHING ISSUE : The issue is whether [partnership] has an obligation to buyout [partner’s] interest.

II. RULE : A buyout is an agreement that allows a partner (or his estate) to end his relationship with the partnership and receive an asset in return for his interest. A partnership’s obligation to buyout an investor is triggered when: (1) a partner dies; (2) a partner is disabled; or (3) at the will of any partner.

III. APPLICATION :

a. Restrict who can be a fellow owner and give yourself and opportunity to exit. Cannot bring in new partner without consent of 100% of partners under UPA.

b. In agreement, think about triggering event and price. What is the method of payment? Collateral if going to be paid overtime.

c. Here, the agreement states that [partnership] must…

IV. CONCLUSION : Therefore, the partnership does (not) have an obligation to buyout [partner’s] interest and can do so by paying either the book value or set value in cash or installments. a. Note : Is there any protection against debts of the partnership? Look to agreement.

LIMITED LIABILITY PARTNERSHIPI. OVERARCHING ISSUE : The issue is whether [limited partner] is liable to [third party].

II. RULE : Typically, general partners are subject to personal liability, and limited partners are only liable for the amount of money they put into the partnership. However, limited partners can become liable if they act as general partners by exercising sufficient control over the business.

a. **In Illinois: [If a contract suit and RULPA applies say: In addition to control, RULPA requires a plaintiff prove he: (1) transacted business with the limited partner, and (2) reasonably believed the limited partner was a general partner.]

i. Note : RULPA helps limited partners a lot. There is no tort exposure and even if the limited partner has control, they still will not be liable unless there was reliance by a third party.

ii. Note : A general partner can be a corporation. iii. Only contract creditors can sue pg under RULPA

III. APPLICATION : Here...

a. Holzman v. De Escamilla – Russell and Andrews were limited partners in a farm. De Escamilla was the general partner. Farm went bankrupt and creditors wanted to hold Russell and Andrews personally liable.

i. The court held that Russell’s and Andrews were acting general partners because they:

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1. Decided what was planted on the farm;2. Had full access to the partnership’s bank account;3. Escamilla could not withdraw checks without the two limited partners;4. Russell and Andrews asked that Escamilla resign.

ii. Note : if RULPA was in effect, Russell and Andrews would not have been liable because the creditors did not have a reasonable belief that Russell and Andrews were general partners (they did not know about the four things above).

b. HYPO – What if the farm truck ran someone over and you represent that person. Could you collect from the limited partners under RULPA? NO! RULPA says you have to transact business with the limited partners.

i. RULPA is limited to contract situations, not torts.

IV. CONCLUSION : Therefore, [limited partner] is (not) liable to [third party].

LIMITED LIABILITY COMPANIESI. Attributes of a Limited Liability Companies (LLC)

a. Owners are called members, not shareholders or partners b. No Board of Directors – LLCs have Board of Managers or can choose to run the business themselves

and have no managers. i. Managers may be members or non-members

1. Note : Managers/Members can act either formally or informally. Regardless, to pass a measure or to approve something, only a majority vote is needed.

a. Different from corporation – corporations need unanimity when acting informally.

II. Default Rules – In absence of an agreement or contract, look to the DE Rules because they are sensible.

a. Delaware Rules – Similar to corporate law in that you get one vote per share. Profits distributed according to shares owned.

b. Illinois Rules – Professor doesn’t like these.

i. In Illinois, you have one vote per member. Even if one puts in 90% of the money and the other puts in 10%, they have equal voting rights. Likewise, all members receive equal payment on distribution (like a dividend).

ii. You need 100% vote for new members. If there are 10 members and someone new wants to invest, they can’t unless all 10 members agree.

III. RECOMMENDATIONS WHEN DECIDING WHETHER TO FORM AN LLC:

a. Advantages –i. It’s a hybrid. It has the best feature of a partnership (no double tax) and the best feature of a

corporation (limited liability).

b. Disadvantages – i. It costs more to create an LLC than a corporation

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ii. It is more unpredictable because there is a lack of case law. 1. Note : No matter what, if you are negligent and hurt someone, you are liable. It

doesn’t matter if you were acting as president of the company. There are a lot of benefits of the LLC, but protecting you from torts is not one of them.

c. If you do form an LLC, have an agreement, especially in Illinois to counteract the bad rules.

Piercing the LLC Veil

I. ISSUE : The issue is whether [Plaintiff] can pierce the LLC’s veil to hold [Defendant Member(s)] personally liable.

II. RULE : As the court stated in Kaycee, piercing an LLC’s veil is possible. Just like piercing the corporate veil, a plaintiff must show: (1) total dominion; and (2) that a failure to pierce would permit a fraud or promote injustice. Proving total dominion is more difficult in this scenario because LLCs are not required to have the same level of formality as corporations. However, like piercing the corporate veil, this is a fact intensive inquiry to determine whether piercing is equitable.

III. APPLICATION : Here…

a. There is (not) total dominion because :

i. The members did (not) ignore formalities [Judicial reluctance to use this factor]1. Not relevant that LLC does not observe formalities 2. Did the company fail to maintain adequate records?

ii. The members did (not) commingle the LLC’s funds1. Was there a distinction between LLC and personal bank accounts?

a. Did the members pay for personal expenses out of the business account?

iii. The members did (not) undercapitalize the LLC at the time the LLC was formed 1. An LLC should be formed with enough capital to cover all foreseeable issues.2. Members should have enough “skin in the game” to have an incentive to run the

business with care. a. Note : A lack of capital at the time of the lawsuit, alone, is not sufficient to

pierce. Obviously, if there was enough capital there would be no lawsuit because the creditors would get paid.

b. Note : Amount of money for adequate capitalization depends on the business.

b. Failure to pierce would (not) permit a fraud or promote injustice because :

i. The members did (not) undercapitalize the LLC 1. An LLC should be formed with enough capital to cover all foreseeable claims.2. Members should have enough “skin in the game” to have an incentive to run the

business with care. a. Note : A lack of capital at the time of the lawsuit, alone, is not sufficient to

pierce. Obviously, if there was enough capital there would be no lawsuit because the creditors would get paid.

b. Note : Amount of money for adequate capitalization depends on the business.

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ii. The members did (not) mislead creditors 1. Before investing in an LLC, it is wise for creditors to look into the business’s financial

records. If members mislead creditors (i.e. by filing false statements), creditors can likely PCV.

iii. The members did (not) engage in asset stripping 1. Where the LLC pays members and, as a result, the LLC doesn’t have any money to

pay creditors. It’s like the LLC is hiding money from the creditors who have a legal right to it.

iv. Not enough that there are common directors and officers in a parent/subsidiary relationship1. This shouldn’t be relevant (Silicone Breast Implants mentioned this as a factor, but

Professor said they were wrong to do so).

IV. CONCLUSION : Therefore, [Plaintiff] can (not) pierce the LLC’s veil to hold [Defendant Member(s)] personally liable.

CORPORATIONS

INTRODUCTIONI. Types of Corporations

a. Publicly Owned – A corporation whose shares are traded on a public market (i.e. NYSE)b. Privately Owned – A corporation where no market exists for its shares and relatively few shareholders

II. Structurea. Separate Legal Entity –

i. A corporation’s assets and liabilities are its ownii. Creditor of a corporation has no claim against a shareholders for a corporation’s debt (unless

PCV)iii. Creditor of a shareholder has no claim against a corporation for a shareholder’s debt

b. Shareholders – i. These are the owners of corporations. Their main job is to elect the Directors.

ii. Shareholders also amend the articles of incorporation when needed.iii. Stock:

1. Common Stock – There is always common stock2. Preferred Stock – Stock slip can say many things, but usually: (1) no dividend can be paid

on common stock until it is paid on preferred stock; and (2) the preferred stock gets par value back in liquidation before common stock.

iv. Shareholders can act formally meetings or informally through written consent c. Directors –

i. They manage the corporation. Their main job is appointing the Officers and setting their salaries. ii. They do not run the day-to-day operations, but set corporate policies and do major transactions.

iii. Make enterprise decisions iv. Directors can act formally at meetings or informally through written consent. Typically 100%

consent is needed because directors have a right to know what other directors are doing. v. Vote in meeting: Majority of Dir’s constitutes quorum and majority of quorum is needed for

decision. vi. Directors have authority to set up committees.

1. The executive committee is typically given all the powers of the board itself because it is inconvenient to have the entire board get together all the time.

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d. Officers – i. Employees who are hired by the Directors to run the day-to-day operations of the corporation.

ii. Officers are actual agents of the corporation and MIGHT have actual and apparent authority. 1. EX : Officers have actual authority to borrow money. But how much they can borrow is a

different question.

III. How to Form a Corporationa. Filing –

i. You need to obtain a form from the secretary of state, called articles of incorporation and send it in.

ii. Fill in the name of the company, number of authorized shares, initial board of directors b. Bylaws –

i. After filing the corporation sets bylaws which set forth internal procedures. ii. Bylaws contain things like: (1) how corporation will call meetings; (2) requirements for a quorum;

(3) percentages required for shareholder/director actions; and (4) how to amend the bylaws.

IV. Recommendations: What Should People Discuss When Setting Up a Corporation? a. Where will you incorporate your business?

i. You should incorporate in Delaware because:1. The law is more predictable because there is a special court for business litigation2. Plaintiffs like Delaware because courts rarely dismiss lawsuits and directors of DE

corporations are automatically subject to its jurisdiction.3. Defendants like Delaware because Delaware has no juries.

ii. Note : No matter where you incorporate, you can do business in any state. b. How will you capitalize your business?

i. You should have enough “skin in the game” to prevent a PCV claim. c. How to allocate control

i. Typically one share one vote, but this can be alteredd. Different classes of stock? Preferred, common, voting/non-voting etc.e. Form a close corporation?

i. If so, how will you run it? (Will you have a board of directors or will shareholders run the business?)

ii. How will you ensure you will be a director 1. Pooling Agreement2. Shareholder Agreement

iii. How will you ensure you will be an officer 1. Can agree if no minority 2. In Illinois, can agree if no objecting minority3. Employment agreement guaranteeing position and salary

iv. Whether unanimous consent of directors will be needed for action1. Minority shareholder should require unanimous consent (maintains veto power) 2. If not, will other director need notice?

v. What happens if someone wants to leave?1. Right of first refusal2. All shareholders should get a buyout provision to avoid litigation

vi. Freeze-out protection (for minority shareholders)1. Minority veto power 2. Russian Roulette agreement3. Employment agreement4. Buyout Agreement

a. What will the trigger be?b. How will you determine the price – Appraisal rights

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f. What happens to shares in event of death or incapacity? i. Buyout Agreement

1. What will the trigger be?2. How will you determine the price – Appraisal rights

g. You should probably form an S corporation – Professor loves these because of taxation and limited liability

CORPORATIONS BY ESTOPPEL (promoters)

Scenario 1 in Contract: Bob thinks he created a corporation, but in reality, he didn’t because he messed up the paperwork. Bob enters into a contract with Steve and Bob defaults on the contract. Steve finds out there is no real corporation and tries to hold Bob personally liable (because Bob has deep pockets). STEVE CAN’T!

Scenario 2 in Contract: Same facts but Steve defaults. Bob sues Steve and Steve tries to defend by saying the contract was void because there was no corporation. STEVE CAN’T!

Scenario in Tort: Bob thinks he created a corporation, but in reality, he didn’t because he messed up the paperwork. Bob’s delivery driver runs Steve over. Steve wants to hold Bob personally liable. STEVE CAN!

I. ISSUE : The issue is whether [plaintiff/defendant] is estopped from denying the existence of a corporation.

II. RULE : Where a party has contracted with a corporation, and is sued upon contract, neither party is permitted to deny the existence or the legal validity of such corporation. In tort, however, the plaintiff can deny the existence of a corporation and hold the defendant personally liable.

a. Corporation by estoppel doctrine – one who contracts with what he acknowledges to be and treats as a corporation, incurring obligations in its favor, is estopped from denying its corporate existence


a. Southern Gulf Marine – P held himself out as a corporation even though he had not yet filed his corporation papers. P’s “corporation” entered into a contract with D who then defaulted on the contract. When sued for breach, D argued that the contract was void because no such corporation existed.

i. The court upheld the contract and estopped D from denying the existence of the contract.

b. RECOMMENDATION : D should have put the wealthy owner on the contract. Just because a corporation is formed by a credit-worthy person, it does not mean the corporation is credit-worthy because the corporation, itself, might not have any money. Must keep the wealthy individual on the hook.

c. Promoters: Person that identifies a business opportunity and puts together a deal, forming a corporation as a vehicle for investment by other people.

i. Fiduciary duties to TP for pre-incorporation commitments1. If promoter knows corp has not been formed, he is personally liable if it has not 2. If promoter believes corp has been formed but is not, corp does not exist and he may be

relieved of personal liability ii. Courts may treat as corp if promoter:

1. Acted in good faith in trying to incorporate 2. Legal right to incorporate and 3. Acted like a corporation

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d. De facto corporation doctrine: i. Courts may treat a not properly incorporated as a properly incorporated Corp, if the promoter:

ii. In good faith tried to incorporate;iii. Legal right to incorporate; andiv. Acted like a corporation

v. Advice to seller: require time to incorporate and limit terms in order to get out if the deal becomes unattractive; make sure corp is adequately capitalized

vi. Advice to buyer: specify in new agreement when corp is formed; specify what occurs if corp never forms at all

IV. CONCLUSION : Therefore [plaintiff/defendant] is (not) estopped from denying the existence of a corporation.

PIERCING THE CORPORATE VEIL

IN PUBLIC CORPRORATIONS – This applies to directors, officers, or major shareholders (those who control the board). This is a form of “partial piercing” to get at the inner-core of ownership and control.

a. Note: Stockholders of a public company will never be personally liable.

IN PRIVATE CORPORATIONS – This may apply to shareholders, directors or officers

TRADITIONAL SCENARIO: Creditor of a subsidiary goes upstream to pierce a parent.

REVERSE PIERCING SCENARIO: Parent owns S1 and S2. Creditor of S1 pierces upstream to the parent and then reverse pierces downstream to S2.

ENTERPRISE SCENARIO: Parent has multiple subsidiaries. Plaintiff sues one of the subsidiaries, but they have no assets, so P wants to pierce to get at the parent’s assets. If Plaintiff is unable to pierce, he can try an alternative theory: the enterprise theory. This won’t allow him to get at the parent’s assets but it will allow him to get at the assets of ALL the subsidiaries because this theory treats all the subsidiaries as one company.

I. OVERARCHING ISSUE : The issue is whether [Plaintiff] can pierce the corporate veil to hold [Defendant] personally liable.

II. RULE : In order to pierce the corporate veil, a plaintiff must show: (1) total dominion; and (2) that a failure to pierce would permit a fraud or promote injustice. Courts sometimes use the enterprise theory to disregard multiple incorporations of the same business under common ownership. This is a fact intensive inquiry and there is a strong presumption against piercing the corporate veil.

III. APPLICATION : Here . . .

a. There is (not) total dominion (alter-ego) because : [parent-subsidiary piercing]

i. The defendant did (not) ignore corporate formalities1. Did the corporation fail to maintain adequate records?2. Did the shareholders sign corp, agreements with their own names/not use corp. titles?3. Did the corporation hold meetings in shareholder/directors offices?4. Did the corporation fail to hold annual shareholder meetings? 5. Application: 1) if disregard corp form = should not benefit from limited liability, (2)

disregard corp. form = may indicate that creditors were misled (3) no formalities = SH disregard corp. obligations

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ii. The defendant did (not) commingle corporate funds1. Was there a distinction between corporate and personal bank accounts?

a. Did the corporation (parent) pay the salaries and expenses of the subsidiary?b. Did the corporation (parent) use the subsidiary’s property as its own? c. Did the shareholders (sometimes this is a parent company) pay for personal

expenses out of the corporate account? 2. Application: commingling accounts = disregard creditor interests

iii. The defendant did (not) undercapitalize the corporation at the time the corporation was formed

1. Amount of money for adequate capitalization depends on the business. A riskier business needs more money, but no bright-line test.

2. A corporation should be formed with enough capital to cover all foreseeable issues.3. Shareholders should have enough “skin in the game” to have an incentive to run the

business with care.

iv. All of the following are proper and don’t indicate total dominion 1. The parent and the subsidiary have common directors and officers

a. This is very common in a parent/subsidiary relationship and is almost automatic. 2. The parent and the subsidiary have common business departments

a. EX : having one legal department for both the parent and the subsidiary. It’s more cost effective to have one department and share them.

3. The parent and the subsidiary file consolidated financial statements and tax returnsa. This is frequently required by law

4. The parent finances the subsidiarya. Common practice

5. The parent caused incorporation of the subsidiarya. Common practice. This is what happens when you form a subsidiary

6. The subsidiary receives no business except that given to it by the parenta. Where a subsidiary’s business is closely related to the parent, the parent often

sends business to the subsidiary.

b. Failure to pierce would (not) permit a fraud or promote injustice because : [Look for abuse of creditor expectations or excessive business risk]

i. The defendant did (not) undercapitalize the corporation 1. A corporation should be formed with enough capital to cover all foreseeable claims.2. Shareholders should have enough “skin in the game” to have an incentive to run the

business with care. a. Note : A lack of capital at the time of the lawsuit, alone, is not sufficient to pierce.

Obviously, if there was enough capital there would be no lawsuit because the creditors would get paid.

b. Note : Amount of money for adequate capitalization depends on the business. 3. Shell Corporation – formed just to take on liability4. Recommendation for corp: at least have minimum required insurance insurance

ii. The defendant did (not) mislead creditors 1. RECOMMENDATION for corp : Don’t incur more debt when insolvent. 2. RECOMMENDATION for creditor : Before investing in a corporation, it is wise for

creditors to look into the business’s financial records. If shareholders mislead creditors (i.e. by filing false statements), creditors can likely PCV.

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iii. The defendant did (not) engage in asset stripping 1. Where the corporation pays stockholders or the board of directors and, as a result, the

corporation doesn’t have any money to pay creditors. It’s like the corp. is hiding money from the creditors who have a legal right to it.

2. Continuing to take on debt in time of insolvency 3. RECOMMENDATION : Don’t make distributions of assets while insolvent.

iv. Not enough that there are common directors and officers in a parent/subsidiary relationship1. This shouldn’t be relevant (Silicone Breast Implants mentioned this as a factor, but

Professor said they were wrong to do so).c. 3rd Prong for Piercing Corp Veil: First 2 are mandatory, but there may be an optional 3rd:

i. Total dominance by shareholders -> unity of interest and ownership such that separate personalities of corp and shareholder no longer exist

d. Piercing the corporate veil is HARDER in contract claims and EASIER in tort claims

i. Contract Claims – Contract creditors have a hard time PCV since they entered into the agreement and could have found out about the total dominion or fraud/injustice (Frigidaire).

1. RECOMMENDATION : The creditors should have looked into the situation and at the very least, got a shareholder guarantee before they gave the corporation money.

2. This is especially the case if the plaintiff is sophisticated (not a babe in the woods).

ii. Tort Claims – Corporate veil is more likely to be pierced because individuals were harmed or injured. Ex: corporation owes a tort judgment and retail customers.

iii. Enterprise Theory: Walkovszky v. Carlton – D was the sole shareholder of 10 different cab companies that he set up as different corporations. One of the cabs hit P. Since the cabs only carried minimum insurance, P wanted to hold D personally liable.

1. DISSENT – D set up the 10 corporations this way to avoid liability and that the cabs were intentionally undercapitalized. So, it is equitable to allow P to go after D.

a. Professor agrees with the dissent

2. RECOMMENDATION : PCV under the enterprise theorya. Enterprise theory is more likely when the mangers who run the “asset”

corporation also run the “risk” corporation

iv. Sea-Land Services v. Pepper – Pepper Source defaulted on a shipping contract with Sea-Land. Pepper Source had no assets so Sea-Land sued Pepper Source’s owner, Marchase, and all other corporations Marchase owned (this was reverse piercing).

1. Sea-Land proved total dominion becausea. The corporations never held a single corporate meetingb. Marchase “borrowed” corporate money interest-free to pay personal expensesc. Marchase never passed bylaws, articles of incorporation or other agreementsd. The physical facilities for all of Marchese’s corporations were the same.

2. Court remanded for more facts on fraud or injustice elementa. Judge Bauer stated that injustice means something less than fraud, but more

than simply not being able to pay your debt.

3. RECOMMENDATION : Reverse pierce to become a creditor of the owner’s other corporation. This will put you in a senior position to receive the money owed to you.

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Otherwise, you are basically just garnishing the owner’s wages and he doesn’t get paid until all the other creditors get paid.

v. Estoppel Theory: refers to situations where there has been an abuse of corporate privilege, because of which the equitable owner of a corporation will be held liable for the actions of the corporation

1. In re Silicone Gel Breast Implants Case - Bristol Corporation (parent) bought MEC (subsidiary). P bought a breast implant made by MEC. MEC had minimal assets so P sued Bristol Corp.

2. P proved total dominion becausea. MEC went a long periods without board meetingsb. Bristol made financial decisions for MEC and approved MEC’s budget c. Bristol set up MEC’s employment policies d. Bristol paid MEC employee salaries e. Bristol used MEC’s property as its ownf. MEC was undercapitalized

3. Court didn’t analyze the second element, but it was WRONG to do so.

vi. Frigidaire Sales v. Union Properties – Frigidaire entered into a contract with Commercial LLP and Commercial breached.

1. Commercial’s general partner = Union Properties Corporation 2. Commercial’s limited partners = B and M3. Union Properties Corporation Sole Shareholders = B and M

a. The court said that Frigidaire is not allowed to pierce Union’s veil and hold B and M liable. This is an example of hesitance to PCV in a contracts case. Frigidaire would have known Commercial was set up this way had they used due diligence.

i. Note : You are deemed to know what you could have found out if you used due diligence.

ii. When SHs of a corporation, who are also the corporation’s officers and directors, conscientiously keep the affairs of the corporation separate from their personal affairs, and no fraud or manifest injustice is perpetrated upon third persons who deal with the corporation, the corporation’s separate entity should be respected

IV. CONCLUSION : Therefore, [Plaintiff] can (not) pierce the corporate veil to hold [Defendant] personally liable.

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DERIVATIVE OR CLASS ACTION?

I. OVERARCHING ISSUE : Because this is a suit by shareholders against directors of a corporation, the first issue is whether the suit is a derivative action or a class action.

II. RULE/APPLICATION : A class action is a private right of action where shareholders sue the directors of the corporation for their own personal benefit (the directors harmed shareholders personally), whereas a derivative action is where shareholders sue the directors on behalf of the corporation for its benefit (the directors harmed the corporation). Here . . .

i. Note : If some but not all shareholders are hurt, this would be a class action, not a derivative suit.ii. Note : In rare cases a derivative suit can result in plaintiff getting their own damages. This

happens when the bad guy owns most of the stock so money to the corporation is really like money to him and he should not recover. (Pearlman v. Feldmann)

iii. Two ways of solving a derivative action: (1) non-monetary judgment; and (2) indemnification.1. Collusive Settlement – When the lawyer is the real winner, the plaintiff’s recovery is just

window dressing and the lawyer gets his big fee paid for by the corporation. a. Lawyers do not want to risk losing so they are incentivized to settleb. Directors do not care because corp. indemnifies them for fees and there is no

monetary judgment

III. OVERARCHING CONCLUSION IF CLASS ACTION : Therefore, because this is a class action, the procedural issues involved in a derivative suit are inapplicable, and we can proceed to the merits of the case.

IV. OVERARCHING CONCLUSION IF DERIVATIVE SUIT : Therefore, because this is a derivative suit, the next issue is whether [Plaintiff] has met the procedural requirements.

DERIVATIVE SUIT PROCEDURAL REQUIREMENTS

I. OVERARCHING ISSUE/RULE : In order to properly bring a derivative suit, [Plaintiffs] must: (1) make a demand or show such a demand would be futile (if the state permits); and (2) post security if required by state law.

II. APPLICATION FOR DEMAND : Here [Plaintiff] did (not) make a demand. [In DERec. no demand]

Demand required Board decides fate of claim, subject to review under BJR

Demand Excused Claim goes forward; board cannot dismiss

a. Option if Demand Made – Because the board rejected the demand, in Delaware, Plaintiff cannot argue the futility exception because it is waived. Therefore, if Plaintiff decides to continue with the derivative suit, they must allege specific facts to show the board is not entitled to the business judgment rule and the suit will likely be dismissed.

i. DE 102(b)(7) – In Delaware, the exculpation provision provides that directors are not personally liable for negligence (duty of care) so the plaintiff would have to allege the directors’ breach of the duty of loyalty to show futility (Stone v. Ritter).

1. Cannot sue for being careless 2. If all P is alleging that BOD is negligent and not capable of making independent then

CANNOT overcome exculpation provision 3. Must allege breach of loyalty

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b. Option if No Demand Made – Because demand was never made, Plaintiff must argue demand is excused because of futility. In a state that recognizes the futility exception (DE), a demand is futile if there is a reasonable doubt that (1) the majority of the board is incapable of making an independent decision on whether to bring the claim or (2) doubt that the challenged transaction was protected by BJR by showing conflict of interest, bad faith, grossly uninformed decision making, or significant failure of oversight. Look to:

i. Interested Transaction. Does the board have a financial or familial interest?1. Would a majority of the board be financially harmed by the action? 2. BOD not independent because someone has control over them?

a. EX : A lawsuit is saying CEO is doing terrible things. A majority of directors are under the CEO’s thumb. So if you can show that a majority of the board will do whatever the CEO says, demand would be futile.

ii. Waste. Is the underlying transaction the product of a valid exercise of business judgment? iii. Futility is not satisfied just because the plaintiff sues all directors. There must be a substantial

likelihood that they would all be liable (Grimes v. Donald).

c. CONCLUSION : Therefore, [plaintiff] did (not) prove demand would have been futile and this procedural requirement is (not) met.

i. ISSUE/RULE IF FUTILITY MET (INDEPENDENT COMMITTEE) : Even though the plaintiff has proven futility, this exception can be abused (forcing a corporation to spend a lot of time and money to fight the suit). Thus, a corporation can form an independent litigation committee to make a decision on whether to recommend to the court that the derivative suit be terminated.

1. Option if no committee formed – Here, the corporation never formed an independent committee. Therefore, the next issue is whether [plaintiff] was required to post security.

2. Option if the Committee does not recommend dismissal – Here the committee recommended the case proceed. Therefore, the next issue is whether [plaintiff] was required to post security.

3. Option if the Committee recommends dismissal – Here, the committee recommended dismissal. Therefore, the court will look to whether the committee was in fact independent. The committee has a very high burden of establishing its independence. [Moreover, because we are in Delaware, the second step established in Zapata requires the court apply its own business judgment to determine whether the decision of the committee was made in good faith pg. 247.]

i. Note : New York does not have the second step and Professor thinks the second step is ridiculous because the court requiring a committee be independent but then does not trust the committee’s recommendation is silly. Committees know more about business than judges do.

b. APPLICATION : Here, the court will likely find the committee was (not) independent because…

i. If independent : recommendation entitled to full judicial deference under the BJR

c. CONCLUSION : Therefore, the court will likely (not) dismiss the derivative action based on the committee’s recommendation.

ii. RECOMMENDATION TO CORPORATION :1. Form a truly independent committee because if the independent committee

recommends dismissal, the court will likely dismiss the case against you.

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III. ISSUE/RULE FOR SECURITY : Many state statutes require certain shareholders provide security for the corporation’s expenses in a derivative action.

i. Application/Conclusion if State Statute : Here, the [state] statute requires [certain shareholder] post ______ security to cover the corporation’s expenses. Therefore [plaintiff] did (not) meet this requirement because he did (not) post the requisite security.

1. Note : The policy reasons for requiring security is twofold: (1) to prevent frivolous lawsuits; and (2) shareholders bringing a derivative suit are taking on a fiduciary duty to act in the best interest of the corporation and must be held accountable if they cause the corporation to incur costs.

ii. Application/Conclusion if No State Statute : Here, the facts do not indicate that there is any such statute, such that we assume that no security is required.

iii. RECOMMENDATION : Recommend that a plaintiff see if security is required and see if the plaintiff wants to pay for this requirement.

IV. OVERARCHING CONCLUSION : Therefore [Plaintiffs] did (not) clear the procedural requirements of a derivative suit [and the case can proceed to the merits].

MERITS #1 - ROLE AND PURPOSE OF CORPORATIONS

I. OVERARCHING ISSUE : The issue is whether [what the corporation did] was proper.

II. RULE : The purpose of corporations is to make money for shareholders. Therefore, a court will likely overrule actions that are made for non-business purposes (i.e. personal or moral reasons).

III. APPLICATION : Here…a. Did the corporation make a charitable donation? (AP Smith)

i. Can’t be a pet charityii. Can’t be anonymous

b. What was the corporation’s stated purpose? (Dodge, Shlensky, and Salami Hypo)i. RECOMMENDATION it’s very important how the corporation frames the decision to do what it

did. As a lawyer, it is important to tell your client to be careful with the corporation’s words. ii. Note: corp. has the power to make donations; good for PR/community relations

c. AP Smith v. Barlow – Corporation donated $1,500 to Princeton. Shareholder challenged the donation.i. The court allowed the donation because: (1) charitable donations increase good will; and (2)

Princeton has a great business program and by donating, the corporation is really recruiting. 1. Note : anonymous donations are not allowed because you are not building good will. 2. Donations to “pet charities” are also not allowed.

a. EX : your Company’s earnings are about $1 million and you make a $100,000 donation to your best friend’s charity. This is probably a pet charity because it’s the guy’s friend and that is a lot of money to give away for a company making $1 million.

d. Dodge v. Ford – Ford lowered the price of cars and withheld profits in order to use the money to build a new plant. Both of these actions resulted in lower dividends.

i. The court allowed Ford to withhold money for the new plant because there was a legitimate business purpose (i.e. to increase efficiency).

ii. The court did not allow the lowered car price because Ford did not state a business reason (i.e. that it would increase sales), but rather said that “every man should own a car.”

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e. Shlensky v. Wrigley – Shareholder of the Cubs sues Wrigley for refusing to put in lights. He says the Cubs are losing profits because night games are more profitable.

i. The court allowed Wrigley’s actions because he said that night games would lower the neighborhood property values and therefore potentially decrease attendance and revenue. This was a legitimate business concern.

f. Salami HYPO – Bill only wants to use high quality, expensive ingredients in his salami. Shareholder sues saying he should use the cheaper ingredients to increase profit margin. How should an attorney advice Bill?

i. Say “if we don’t make a high quality product, customers will leave and we will lose money.”ii. Don’t say “this is my family’s business and I just can’t sleep if we don’t make a high quality

product.”

MERITS #2 - DUTY OF CARE OF OFFICERS AND DIRECTORS

Duty of care cases occur when there is no adverse interest. The directors are not “feathering their own nest.” If “feathering nest” is a concern – analyze duty of loyalty also!

I. OVERARCHING ISSUE : The issue is whether [director/officer] breached his/her fiduciary duty of care when [they did what they did].

II. RULE : Generally, directors and officers receive the benefit of the business judgment rule, which creates a presumption that the directors acted with procedural due care and loyalty. However, a plaintiff has burden to overcome this presumption if they prove a breach of due care by showing: (1) waste; (2) irrational behavior; or (3) uninformed decisions. Pg. 356.

a. Policy – Directors’ and Officers’ decisions are discretionary and because judges are not business experts, they will not second-guess their decisions if they used the proper procedural steps.

i. Note : It is very hard for plaintiffs to overcome the presumption of procedural due care because it doesn’t matter if the directors or officers made a bad decision or mistake. What matters is whether they took reasonable procedural steps to reach that decision.

1. It strikes a balance between businessmen running their business and dishonest directors.2. BOD not liable for ordinary negligence, must be gross negligence

b. Overcoming presumption: i. Plaintiff must show fraud, conscious disregard of duties, condoning of illegal activity, or conflict

of interest

III. APPLICATION : Here, Plaintiff did (not) overcome the presumption of care created by the BJR because the board did [say the procedural things that they did or failed to do with care when making their decision]. a. Did the board :

i. Make an informed decision?1. Acquiring a rudimentary understanding about the business2. Keeping informed about the corporation’s activities

a. This doesn’t inspection of day to day activities, but just a general monitoring of corporate policies and affairs.

i. EX : Directors don’t have to audit corporate books, but they should maintain familiarity with the financial statements

b. Inquire about management’s competencies and loyalty 3. Shop around4. Hire an investment banking firm to make sure the offer is for a good price

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ii. Act in good faith?1. DE 141(e) – If directors or officers rely on good faith on corporate records or informal

reports, they will be protected under the business judgment rule.

iii. Have an honest belief?1. DE 141(e) – If directors or officers have an honest belief based on corporate records or

informal reports, they will be protected under the business judgment rule.

iv. Waste – “removed from the realm of reason” 1. Board approves transaction in which corp. gets no benefit

v. Was there board inattentive to corporate illegality?1. Failure to be attentive to corporate illegality may beach duty of good faith (subset of

duty of loyalty) 2. When there are indications corporate activities may be illegal, the case for having a

monitoring system is strong.

b. Kamin v. AmEx – AmEx bought stock of a company for $30 million. The stock was now worth $4 million. AmEx distributed stock to shareholders. Shareholders sued because they disagreed with AmEx’s decision.

i. The court gave AmEx the benefit of the business judgment rule because alleging that some other course of action would have been more advantageous is not enough to overcome the presumption.

c. Smith v. Van Gorkom – Van Gorkom wanted to sell his company. He met with one buyer and they agreed on a deal. Van Gorkom then called a special board meeting to approve the sale and provided the board with a short 20-minute presentation but no documentation. The directors approved the deal and shareholders sued saying that Van Gorkom breached his duty of care.

i. The court held the directors personally liable and did not give them the benefit of the business judgment rule because the board’s decision making process (procedure) was flawed because they were not adequately informed.

1. RECOMMENDATION : the board should have hired an investment banker to review the offer and shop for other buyers.

a. Note : The company didn’t need to get the best price possible for the sale, but needed to take the proper steps to make a well-advised decision.

ii. Legislative Response to Van Gorkom (DE Section 102(b)(7))1. Now, in DE, directors (not officers) won’t be personally liable for a breach of the duty

of care to the corporation (i.e. in derivative actions not class actions). a. The directors can still be personally liable to:

i. third parties (i.e. shareholders in class actions) because there is no exculpation in these situations

ii. breaches of duty of loyalty iii. acts or ommissions not in good faith or that involve intentional

misconduct or knowing illegality iv. approval of illegal distributions v. obtaining a personal benefit (insider trading

b. This change works to induce other directors to work for DE corporations because they won’t face losing all of their assets in a derivative action.

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2. Note: exculpation statute does not affect equitable relief or officers who can still be liable for their gross negligence

d. In re Walt Disney – Disney shareholders brought a derivative suit because Disney paid Ovitz a ton of money to be their president and then fired him a year later giving him a $130 million severance package.

i. No breach of duty of care1. Distinguished from Van Gorkom – Unlike the directors in Van Gorkom, here, the Disney

Board had done enough homework and reviewed enough expert analysis to be protected by the BJR.

ii. No breach of duty of loyalty (good faith)iii. RECOMMENDATION TO THE DISNEY BOARD

1. The board should have had meetings, written material presenting the implications of the agreement and should have documented this information in the minutes.

a. Note : This was a compensation decision and is the “inner sanctum” of what the board was designed to do. The court is not going to second guess the board’s decision.

iv. RECOMMENDATION TO THE DISNEY SHAREHOLDERS 1. Sell your shares if you don’t like the decision.

e. Francis v. United Jersey Bank – Father and sons ran a business. Father died and mother elected to the board. While the mother was bedridden, sons stole money. The corporation’s bankruptcy trustee sued the mother for breach of care.

i. The court did not give the mother the benefit of the business judgment rule because the mother: (1) knew nothing about the business; (2) didn’t attend meetings; and (3) didn’t attempt to learn anything about the business.

1. Note : the mother need not inspect the corporation’s day to day activities, but just needed generally monitor the corporation’s policies and affairs.

a. The mother should have resigned because she owed the corporation a duty of care from day one so on the job training would not have made a difference.

ii. Note : If the company had adopted the DE legislative language, the mother would not have been liable because you cannot hold directors liable for breach of duty of care to the corporation (but to third parties you can).

IV. CONCLUSION : Therefore, the directors did (not) breach their duty of care and the BJR does (not) apply.

a. IF BREACH ISSUE/APPLICATION :

i. Option One : Here, even though it appears BJR doesn’t apply, if the corporation had put in its charter the language from DE Section 102(b)(7), it is likely the board of directors won’t be personally liable for a breach of the duty of care to the corporation.

ii. Option Two : Here, even though it appears BJR doesn’t apply, under In re Wheelabrator, the board of directors would be shielded from liability if the director’s actions were subsequently RATIFIED by a majority of shareholders. Here there was (not) ratification…

b. IF BREACH CONCLUSION : Despite [director’s] breach, the corporation may still indemnify or exculpate [officer/director] unless [officer/director] also breached their duty of loyalty.

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DUTY OF LOYALTYRECOMMENDATION: If you are doing any transaction that might be second guessed, get it looked at by an

independent third party. Such parties may include: (1) an independent banking firm; (2) a committee of independent directors; or (3) compensation experts. This will make it very hard for Plaintiff to be successful.

MERITS #3 - DUTY OF LOYALTY TO THE CORPORATION (interested transaction)

I. ISSUE : The issue is whether [director/officer] breached his duty of loyalty to [corporation] when he entered into a contract with [third party] to [what the contract was for]. a. Examples : Officer/Director/Major SH on both sides of the deal. beneficial financial interested, transaction

that would reasonably be expected to influence judgment

II. RULE FOR COMMON LAW : In a jurisdiction that adheres to “unadulterated common law” such “interested transactions” are per-se void regardless of their fairness and the [director/officer] does not get the benefit of the business judgment rule. However, the directors can argue that the court should follow Bayer v. Beran and uphold the contract so long as they can prove the fairness of the deal.

a. Bayer v. Beran (NY Court) – Director hired his wife to star in his corporation’s commercials.i. The court said D breached his duty of loyalty to the corporation because his relationship with

his wife potentially influenced his judgment. However, the court approved the contract because D proved fairness.

III. RULE FOR DELAWARE 144 : [safe harbor] In Delaware, or any jurisdiction with a statute similar to Delaware §144, such “interested transactions” may be upheld so long as (1) the insider’s relationship with the person is disclosed (fully informed); (2) a majority of disinterested directors or shares held by stockholders approved the transaction; and (3) that approval was made in good faith (see below).

a. APPLICATION/CONCLUSION : Here [did they meet the 3 requirements?]

i. IF REQUIREMENTS MET : Therefore, because the three requirements are met, the directors receive the BJR and the “interested transaction” will likely be upheld. Here… [enough procedure to satisfy BJR?]

1. Challenger has burden to prove invalidity of transaction2. Disinterested – BOD have no pecuniary interest and not related to someone with

pecuniary interest; directors who have neither a direct nor indirect interest in the transaction and are not dominated by the interested director (independent)

a. QUORUM: Majority of disinterested directors constitute quorum in self-dealing b. BJR protects disinterested directors who approve self-dealing transaction in good

faith c. Outside counsel director may be interested bc of “conflicting interest” fees

3. Majority disinterested SH Ratification (In DE, must be non-controlling shareholder that self-dealed)

a. Judicial review limited to waste

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ii. IF REQUIREMENTS NOT MET : Therefore, because the three requirements are not met, the directors must prove that the transaction was fair and reasonable. Here… [Fair and reasonable?]

1. ENITRE FAIRENESS:

a. Substantive Fairness i. Objective – self-dealing transaction must replicate arm’s length

transaction by falling into range of reasonableness ii. Value to Corp. – must be of value as judged by need’s and scope of

business iii. More personal interest = more scrutiny

b. Procedural Fairness i. Full Disclosure – there cannot be fraud

ii. Board/Committee Composition – disinterested directors. Burden shifts to plaintiff to prove unfairness if self-dealing approved by disinterested directors

iii. No improper pressure

IV. CONCLUSION : Therefore, [director/officer] did (not) breach his/her duty of loyalty, and the “interested transaction” will (not) be upheld.

MERITS #4 - DUTY OF LOYALTY TO THE CORPORATION (corporate opportunity)

I. ISSUE : [Look for director/officer getting opportunity due to his position in corp.] The issue is whether [director/officer] breached his duty of loyalty to the corporation when he took a corporate opportunity away from [corporation].a. Note: This occurs when the director/officer is in the same business the company is in OR the opportunity

came to the person based on their position in the company.

II. RULE : A director/officer breaches his duty of loyalty to the corporation when they take an opportunity that rightly belongs to the corporation and uses it for their own benefit.

III. APPLICATION : Here…a. In re eBay – eBay hired Goldman Sachs to handle its IPO. Because this was a very lucrative deal, Goldman

secretly allocated some of the initial shares to eBay officers as a gift. i. The court said the officers breached their duty of loyalty because they took eBay’s corporate

opportunity. If the shares had not been given to the officers, eBay would have sold them on the market and made a ton of money.

ii. RECOMMENDATION : Have the board of directors approve the allocation of stock to the officers. This would be viewed as officer compensation which the directors have the right to set and it would have all been disclosed.

b. Corp MUST get first choice. If rejected by disinterested BOD of SH, then officer can take the opportunity

i. To determine whether an opportunity properly belongs to the corporation, ask:1. Does the corp have a need for it?2. Has the corporation actively considered taking the opportunity?3. Did the director discover the opportunity while acting as a director, and were any corp

funds involved in the discovery?4. Expansion: Line of business test – compare new biz w/ corp. existing operations

a. Competitive or synergistic overlap is evidence of corp. opportunity 5. 2 variables:

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a. The higher you are in the corp., higher scrutiny is applied by the Ctb. If you learned about it at the job, more likely a corp opportunity

6. If you have an opportunity, take it to the board and they may decline the opportunity and you may be allowed to take the opportunity

ii. Possible self-dealing because of conflict between manager and corp’s interest 1. BOD informed, considered refusal creates safe harbor

IV. CONCLUSION : Therefore, [director/officer] did (not) take a corporate opportunity away from [corporation].

MERITS #5 - DUTY OF LOYALTY TO THE CORPORATION (dominant shareholders)

I. ISSUE : The issue is whether [parent] breached its duty of loyalty to [subsidiary].

II. RULE : Generally, shareholders do not owe a duty of loyalty to other shareholders. Controlling SH controls BOD and any self-dealing that controlling SH has burden to prove entire fairness. However, a dominant shareholder (parent) owes a duty of loyalty to the minority shareholders of the corporation it dominates (subsidiary). Normally, an alleged breach of this duty is analyzed under the BJR. However, when the dominant shareholders are engaged in self-dealing, the dominant shareholders (parent) have the burden to prove the entire fairness of the transaction.

a. NOTE: § 144 does not apply

b. Sub-Issue : Here, [parent] was a dominant shareholder because it owned sufficient voting shares to determine the outcome of a shareholder vote over [subsidiary]. Therefore we must determine whether [parent] was engaged in self-dealing.

i. Note : If control is an issue argue what counts as control – see Transfer of Control Judge Lumbard v. Judge Friendly.

1. In re Wheelabrator – Waste (parent) owns 22% of WTI (subsidiary). Waste and WTI negotiate a “merger” where Waste acquires an additional 33%. So Waste now owns 55% total. WTI shareholders sued for breach of loyalty, claiming that WTI directors did not disclose relevant information prior to approving the merger.

a. The court held that even though the parent was on both sides of the transactions, the parent was not in control of the subsidiary because it only owned 22%. Therefore, the business judgment rule, rather than the entire fairness rule applied.

c. Sub-Rule : Self-dealing occurs when the parent is on both sides of the transaction and receives a benefit to the detriment of the subsidiary’s minority shareholders.

d. Application : Here (talk about how the parent has an interest on both sides and detriment to the subsidiary) [Look for parent preferring itself at minority’s expense].

i. If wholly owned subsidiary then not subject to fairness because no minority shareholders.

ii. Sinclair Oil – Sinclair is parent and owns 97% of Sinven. Two issues:1. Dividend Payout – Sinclair needed cash and forced Sinven to payout huge dividends. This

dividend payout made it so that Sinven could not develop. a. Court held there was no self-dealing because even though Sinclair was

benefiting, the minority shareholders of Sinven were benefiting too because they received these large dividend payments (no detriment to minority shareholders).

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b. Difficult burden to show dividends preferred parent. 2. Breach of k – Sinclair created Sinclair Int’l which contracted with Sinven. Sinclair Int’l

breached k by failing to pay Sinven on time. a. Court held that this was self-dealing because Sinclair was on both sides of the

transaction and received the benefit of Sinven’s product while Sinven’s minority shareholders received nothing (Sinclair did not meet burden to prove that failing to pay was entirely fair).

3. Takeaways:a. Key is whether the minority SH could show a clear parental preference

detrimental to the subsidiary b. The burden is on the minority SH to show the dealings were NOT those that

might be expected in an arm’s length relationship, rather than on the parent to show that they were

c. In absence of preferential of preferential treatment, SH must show action was not protected by BJR

iii. Zahn v. Transamerica –AF (subsidiary) had two classes of stock: A and B. Transamerica (Parent)

owned almost all of the class B stock and controlled AF’s board of directors. The Class A stock slip said that holders could convert their class A stock into class B stock at anytime, but it also gave AF the right to call all class A shares at anytime for a certain price. When Transamerica found out about a secret tobacco supply that was worth a ton of money, they told AF’s board to call all the shares. Transamerica then sold all the tobacco, which increased which made the value of the company skyrocket. So the Class A stockholders sued for breach of loyalty, because if Transamerica had disclosed the tobacco supply, the Class A holders would have converted to class B so that they could stay in the company.

1. The court remanded to see if the subsidiary’s board was acting as the parent’s puppet. If they were, the parent was essentially on both sides of the transaction. So the parent would be liable because they benefited at the expense of the subsidiary.

a. Note : The charter allowed the subsidiary’s board to call stock so it wasn’t their actions that caused the problem. It was the withholding of information.

III. CONCLUSION IF SELF-DEALING : Therefore, [parent] engaged in self-dealing and the court will apply the entire fairness standard to the transaction. Under the entire fairness test, the burden is on the parent to show entire fairness: (1) fair procedure; and (2) fair price.

a. However, if the deal is approved by sanitized voting, the burden shifts to the plaintiff to prove: (1) unfair procedure; and (2) unfair price. Here, [parent] did (not) show entire fairness because (fair procedure? Fair price?) .... Therefore, the transaction will (not) be upheld.

i. If parent discloses the conflict and terms and is approved by a majority of disinterested SH the challenger must show waste (no rational business justification).

IV. CONCLUSION IF NO SELF-DEALING/NO PREFERENCE TO PARENT : Therefore, [parent] did not engage in self-dealing and the court will give the parent the benefit of the BJR. In this instance, the BJR creates a presumption the parent acted with procedural due care unless the subsidiary can show disloyalty or irrationality (show waste) or approval was grossly uninformed. Here, [subsidiary] did (not) show [parent’s] disloyalty or irrationality because... Therefore, the transaction will (not) be upheld.

MERITS #6 - DUTY OF LOYALTY TO THE CORPORATION (good faith)

I. ISSUE : Here, [plaintiffs] have alleged a breach of the duty of good faith by [officers/directors/dominant shareholder].

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II. RULE : [Relates to §144 above] The duty of good faith is a subset of the duty of loyalty. Although the Court in In re Walt Disney said that there is no concrete definition of all acts that could constitute bad faith, the court did identify two categories of bad faith: (1) subjective bad faith (acting with an intent to do harm), and (2) intentional dereliction of duty (a conscious disregard for one’s responsibilities). Importantly, the Court noted that gross negligence alone cannot constitute bad faith because it concerns the duty of care, not loyalty.

III. APPLICATION : Here, [defendant] did (not) show…a. Examples of Subjective Bad Faith :

i. Intentionally violating the law ii. Purposely acting in a way that doesn’t advance the interests of the corporation

b. Examples of Intentional Dereliction of Duty :i. Caremark Claim: Directors knew they had a duty to create a system of oversight and monitor that

system, but failed to do so. These directors would not be exculpated.1. Note : This will arise when employees are doing something bad and plaintiffs claim the

board should have known about it.

c. Stone v. Ritter: A bank’s employees were violating money laundering statutes, so the bank had to pay $40 million in fines. Plaintiffs brought a Caremark Claim derivative suit to make the directors pay the fine instead of the corporation.

i. Court held that the directors did not act in bad faith and thus were not personally liable. They hired KPMG to create a reporting system, and they monitored the system because they had a “reporting officer” make presentations to the directors.

IV. CONCLUSION IF NO BREACH : Therefore, [defendant] did not act with bad faith, and thus did not breach their duty of loyalty. Defendant can thus be exculpated and indemnified even if they acted with gross negligence.

V. CONCLUSION IF BREACH : Therefore, [defendant] acted with bad faith and thus breached their duty of loyalty. Because of this breach, [defendant] does not receive the benefit of the business judgment rule, [defendant] can be held personally liable, and the corporation will not indemnify or exculpate them.

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SECURITIES

REGISTRATION ISSUES

I. ISSUE ONE : The first issue is whether [the investment] is a security.

a. RULE : Section 2 of the ’33 Act provides two broad categories of securities. The first lists specific instruments including stocks, notes, and bonds. The second is a broad list of catch-all phrases including evidence of indebtedness and investment contracts. To determine whether an atypical instrument falls into one of these broad categories, courts will look to the amount of control an individual has over their investment. If an individual is able to exercise meaningful control over their investment, it is unlikely to be considered a security interest.

b. APPLICATION : Here, [the investor] [talk about how much control they had].

i. Characteristics of stock (security) 1. Right to receive dividends contingent on profits2. Ability to be pledged as security (collateral)3. Negotiability of sale price 4. Conferring of voting rights5. Capacity to appreciate in value

ii. Investment Contract - Where a person: 1. Invests money or other form2. in a common enterprise and

a. can be managed pool of investors (horizontal) or single investor (vertical)3. is led to expect profits (from earnings not additional capital)4. solely from the benefit of others

a. someone other than investor contributed predominant managerial effort

iii. Robinson v. Glynn: Robinson invested in Geophone, and later sued Glynn saying Glynn made misrepresentations and Robinson wouldn’t have invested if he knew the truth about Geophone’s capabilities.

1. Court said there was no jurisdiction under the Act because the membership investment wasn’t a security. Robinson had a lot of control (he served as treasurer, could appoint two directors, etc.).

a. Note : Court said it doesn’t matter that Robinson didn’t consider his membership interest to be a security when he invested. “Can’t call a cactus a rose and make it a rose.”

iv. Note : When LLC members are passive, and have only tangential involvement in management, courts have found a security. When LLC investors have significant management oversight, courts have refused to find a security.

1. Same with a partnership interest, however, a limited partner’s interest in an LLP is probably a security because they don’t have any real control, but ARGUE FACTS!

c. CONCLUSION : Therefore, [the investment] is (not) a security. i. Note : If not a security stop.

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I. ISSUE TWO : Because we are dealing with a security, the next issue is whether [defendant] was required to register the security with the SEC.

a. RULE : Section 5 of the ’33 Act makes it illegal to sell a security in interstate commerce without a registration statement. However, there are a number of exceptions to this rule, and it is beneficial for companies to satisfy these exemptions in order to avoid the high costs associated with SEC registration.

b. APPLICATION FOR EXEMPTION : Here, [company] appears to fall into _____ exemption because… [Prof says we don’t have to know details of how to satisfy each exception].

i. Major Exemptions :1. Municipal Bonds or commercial paper

2. Transactions by a person other than an underwriter, issuer or dealer a. i.e. people selling their own stock on the secondary market (broker transactions)b. underwriter = purchaser from issuer “with a view” to resell to public

3. §3(a)(11) – Intrastate Sales are exempt – must all be residents of same state4. §4(2) – Exemption: private offerings (MAIN) – Doran pg. 408

1. Even where an offering of securities is relatively small and is made informally to just a few sophisticated investors, it will not be deemed a “private offering” exempt from the registration requirements of the 1933 Act absent proof that each offeree had been furnished, or had access to, such information about the issuer that a registration statement would have disclosed

2. 4 factors relevant to deciding whether an offering qualifies for an exemption:a. Number of offerees and their relationship to each other and the issuer;b. The number of units offered;c. The size of the offering;d. The manner of the offering

3. Key inquiry: whether the persons affected need the protection of the Act4. Doran test: If ALL offerees are

e. Sophisticated ANDf. Offerees were furnished with or had opportunity to learn all the

information that a registration statement would have disclosed,g. THEN the Ralston Purina inquiry is probably satisfied, because none of

the offerees needed the protection of the act5. Reg. D – Safe Harbors to get to Private Placement Exemption &

Avoid/Reduce Required Disclosure:h. 504: If an issuer raises no more than $1m through the securities, the

issuer may sell to an unlimited # of buyers without having to register. No general solicitation

i. Skipped. 505: if an issuer raises no more than $5m through the securities, the issuer may sell to no more than 35 non-accredited investors without having to register. Restricted security

j. 506: Permits up to 35 investors and accredited investors are not counted in that number or non-accredited . if an issuer raises over $5m through the securities, the issuer may sell to up to 35 buyers who must pass various tests of financial sophistication without having to register. No general solicitation

k. NOTE: “accredited investors” – banks, brokers, and other financial institutions and wealthy buyers

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l. Reg D generally exempts only the initial sale; most buyers can resell the securities ONLY IF they find another exemption

m. Issuers must give some info about the company to the buyers, depending upon the amount of money at stake

5. The Jobs Act of 2012a. Section 4(a)(6) permits up to $1 million/year can be sold via Internet or social

media (does not have to be to accredited investors).b. Section 3(b)(2) permits up to $5 million/year pursuant to an offering statement.c. 506(c) – unlimited # of investors if all are accredited. Allows general solicitation d. Note : Professor says this is a horrible law because the courts will be clawed with

retirees who are suckered in to making investments.

c. APPLICATION IF NO EXEMPTION : Here, [company] does not appear to fall into an exemption and thus, registration is required. The NEXT ISSUE is whether [defendant] properly registered the security.

i. SUB RULE : Under §5 of Sec. Act, Proper registration requires a registration statement, including a prospectus, to be filed with the SEC. Under §11(a), If the registration statement contains material misstatements or omissions, the company (issuer) is absolutely liable. Further, all officers, directors, accountants involved in preparation of the certified financial statements, all underwriters, and anyone who signed the registration statement could be personally liable if they are unable to assert the due diligence defense.

ii. MATERIAL APPLICATION : Here, plaintiff alleges that ____ was a material misstatement or omission. A misstatement/omission is material if it is something that an average prudent investor ought to know before investing. Here ___ was (not) material because…

*** If not material misstatement, STOP ***

iii. DUE DILIGENCE APPLICATION : [Not available to issuer]. Because defendant’s misstatement was material, the company (issuer) is absolutely liable and the next issue is whether [people who worked on the registration] can establish the due diligence defense. To do so, a defendant must prove under §11(b): (1) they conducted a reasonable investigation, (2) after the investigation, they had reasonable ground to believe the statement was accurate, and (3) after the investigation, they actually believed the statement was accurate. Here, the [defendant(s)] can (not) establish the due diligence defense because [what did they do? ARGUE]

1. Reasonable Investigation = § 11(c), An investigation a prudent man would have done in managing his own funds.

2. Just asking if something is true is not enough – you can’t rely on what people tell you – you must verify!

a. Exception : the standard of reasonableness is different for the expertised portions.

Expertised Portion Non-expertised portionExpert Must investigate and believe

information is true (ignorance is no excuse

No liability

Nonexpert No reasonable ground to believe information is false (ignorance is excuse

Must investigate and believe information is true (ignorance is no excuse)

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i. EX : If the material omission occurs on the accounting statement, it might be more reasonable for the director to rely on the accountant, because the director is not an accounting expert.

3. RECOMMENDATION : If you are the lawyer in charge of drafting the statement, it is going to be very hard to wiggle out of liability. Courts think more is required of the lawyer by way of reasonable investigation.

a. Note : Don’t let your partner serve on a board of directors. Your partnership could be on the hook.

4. Escott v. BarChris: BarChris constructed bowling alleys. It went bust. Before it did, it issued debentures and in statements for debentures it misstated financial condition of company. People who bought the debentures sued. All defendants asserted the due diligence defense.

a. Reasonable investigation varies according to position and relationship to issuer. The court held that none of the defendants could establish the due diligence defense because a reasonable investigation was not conducted. Didn’t matter that some defendants had no education, no lower standard for them.

d. CONCLUSION : Therefore, the security was (not) properly registered with the SEC. If the arrangement was an unregistered, non-exempt offering, the purchaser can seek a recission under §12(a)(1).

Material Misstatement under Rule 10b-5 (press release)

Scenario: Tim is a CEO at a company and his company publishes nationwide press release saying “we are not merging with X.” This statement was untrue but Steve traded on this information in reliance on this information. Is Tim liable under 10b-5?

I. OVERARCHING ISSUE : Here, [plaintiffs] have brought a claim under Rule 10b-5, which creates a private right of action for a buyer or seller alleging fraud in connection with the sale or purchase of securities. In order for a plaintiff to prove a 10b-5 violation, the plaintiff must show: (1) plaintiff was a buyer or seller of a security; (2) defendant made a material misstatement or omission in connection with the sale; (3) plaintiff relied on the misstatement or omission, and (4) the misstatement or omission was made with intent to deceive (scienter).

i. Policy : Rule 10b-5 seeks to prohibit deception by encouraging full disclosure. So, a transaction that is adequately disclosed cannot be attacked under rule 10b-5, even if the transaction is unfair.

ii. RECOMMENDATION : There are legitimate reasons for companies to withhold secrets. To avoid making a material misstatement or omission, say “no comment.”

1. Corporate officials who make false statements expose the corp.

II. ISSUE ONE : Therefore, the first issue is whether [plaintiff] was the buyer or seller of a security.

a. RULE : Section 2 of the ’33 Act provides two broad categories of securities. The first lists specific instruments including stocks, notes, and bonds. The second is a broad list of catch-all phrases including evidence of indebtedness and investment contracts. To determine whether an atypical instrument falls into one of these broad categories, courts will look to the amount of control an individual has over their investment. If an individual is able to exercise meaningful control over their investment, it is unlikely to be considered a security interest.

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b. APPLICATION : Here, [investor] [talk about how much control they had AND whether they bought or sold a security.]

i. Characteristics of stock (security) 1. Right to receive dividends contingent on profits2. Ability to be pledged as security (collateral)3. Negotiability of sale price 4. Conferring of voting rights5. Capacity to appreciate in value

ii. Robinson v. Glynn: Robinson invested in Geophone, and later sued Glynn saying that Glynn made misrepresentations and that Robinson wouldn’t have invested if he knew the truth about Geophone’s capabilities.

1. Court said there was no jurisdiction under the Act because the membership investment wasn’t a security. Robinson had a lot of control (he served as treasurer, could appoint two directors, etc.).

a. Note : Court said it doesn’t matter that Robinson didn’t consider his membership interest to be a security when he invested. “Can’t call a cactus a rose and make it a rose.”

iii. Note : Generally, a membership interest in an LLC is not a security because you are not dependent on the efforts of others. However, if there is a contract that says the member had no power whatsoever, it may be a security.

1. Same with a partnership interest, however, a limited partner’s interest in an LLP is probably a security because they don’t have any real control, but ARGUE FACTS!

iv. Note : applies to sale of business of structured as a stock purchase.

c. CONCLUSION : Therefore, [plaintiff] did (not) (buy/sell) a security when they (bought/sold) [the investment at issue].

*** IF NOT A SECURITY, STOP ***

III. ISSUE TWO : The next issue is whether [defendant] made material misstatements or omissions in connection with the sale.

i. Note : “In connection with” the sale or purchase of security means the defendant doesn’t have to be the one buying or selling so long as their behavior affects buying or selling

b. RULE : A misstatement or omission or silent in the face of fiduciary duty to disclose is material if it is something that an average prudent investor ought to know before investing. [In the context of a merger, an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. No one factor is enough, courts must look to the probability of the merger happening and the magnitude of the transaction.]

i. Higher Probability = more likely to be material; Larger Magnitude = more likely to be material

ii. Note : Under 10b-5 there is no private right of action based on aiding and abetting. This protects lawyers unless they are SO DEEPLY involved that they can be considered co-tortfeasors engaging in fraudulent behavior not merely substantial assistance. Recklessly.

c. APPLICATION : Common sense application – would you consider it important??i. Materiality: if disclosure would affect the price of the company’s stock it is material

ii. Safe harbor: if forward looking information as meaningful cautionary statement iii. Duty to Speak: Duff Phelps case – D liable to shareholder-employee for remaining silent when the

firm purchased shares from employee who quit on the eve of lucrative merger

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iv. Duty to Update : if plans change that affect prior statement then update

d. CONCLUSION : Therefore, the [misstatement/omission] was (not) material.

IV. ISSUE THREE : Because there was a material [misstatement/omission], the next issue is whether plaintiff relied on the [misstatement/omission].

a. RULE : Typically, individual shareholders have the burden of proving actual reliance in order to succeed on a 10b-5 claim. [In class action cases, however, Basic v. Levinson established the fraud on the market theory, which creates a rebuttable presumption of reliance by any individual stockholder. The theory is that stock prices are a function of ALL material information in the marketplace, and therefore any material misstatement or omission affects stock prices.]

i. Policy for Fraud on the Market: If a showing of actual reliance was required, then stockholders could never bring a class action. When you have thousands of stockholders, some relied and some didn’t.

1. Rebutting: (1) challenged information did not affect stock price OR (2) the particular plaintiff would have traded regardless.

ii. In cases involving a duty to speak, courts dispense reliance if the undisclosed information was material.

iii. In cases involving transactions on impersonal trading markets, courts infer reliance from the dissemination of misinformation in the trading market. (fraud on the market)

b. APPLICATION/CONCLUSION : Here, Plaintiff did (not) satisfy the reliance element of their 10b-5 claim because…

V. ISSUE FOUR : The next issue is whether material misstatement or omissions were made with intent to deceive

or gross recklessness.

a. RULE/APPLICATION : Use common sense argument – ARGUE FACTS.i. Show D was aware of the true state of affairs and appreciated the propensity of his misstatement

or omission to mislead. ii. Recklessness is sufficient – misrepresentations were so obvious that D must have been aware

1. Provide facts to suggest actual knowledge

b. CONCLUSION : Therefore, plaintiff did (not) satisfy 10b-5’s scienter requirement.

VI. OVERARCHING CONCLUSION : Therefore, P did (not) establish 10b-5 liability.

Insider Trading under Rule 10b-5

Traditional Scenario: If insider knows material, non-public info then must abstain or wait until disclosure. Tim is a CEO of a company. He knows that the company is about to tank so he sells all his shares.

Misappropriation Scenario: Tim is a CEO of a company. Tim meets Eli on the golf course and tells Eli “Yo man, we are merging with X.” That night, Eli buys a bunch of stock in Tim’s company. Is Tim liable as a tipper? Is Eli liable as a tippee?

Who is harmed by insider trading? No one. We have the rules in place as to avoid people losing confidence in the marketplace. If you do, then they will not buy securities because they view the marketplace as rigged.

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I. ISSUE : Here, [plaintiff] is alleging [defendant] misused insider information.

II. RULE : Courts have interpreted 10b-5 to create two theories of liability. Under the traditional theory, an insider is liable if he purchases or sells securities based on material nonpublic information. Additionally, under the misappropriation theory, an insider and/or an outsider can be liable if he breaches a fiduciary duty by using non-public information to buy or sell securities for his own benefit.

a. RECOMMENDATIONS FOR INSIDERS :i. If you have non-public information: (1) abstain from trading; or (2) disclose the information. After

disclosure, you must wait until the information until it is adequately disseminated. But with the Internet, this is not a very long wait.

ii. Under 10b5-1, if you are insider and want to legitimately trade your stock, make a trading plan (i.e. “I will sell X shares on the first of each month for the next 10 months.”)

III. TRADITIONAL APPLICATION : Here, the traditional theory does (not) apply because [defendant] [owed/did not owe] a fiduciary duty to the corporation. Further, he is (not) liable under the traditional theory because… [(1) material?; (2) non-public information?; and (3) he himself traded?]

a. Note : General employees (janitors, secretaries, etc.) owe a fiduciary duty to the corporation because they are agents.

b. Note : Material = information a reasonably prudent investor would like to consider before investing. c. Must breach fiduciary of duty to be liable as an insider .

d. Texas Gulf Sulphur- TGS discovers oil and starts buying up land. Before disclosing the oil discovery to the public, insiders bought stock in TGS themselves. i. The court said that the insiders were liable because they used material non-public information

to buy securities. 1. RECOMMENDATION : The insiders would have been okay if they: (1) disclosed the

information; and (2) provided a reasonable waiting period prior to trading.

e. TRADITIONAL CONCLUSION : Thus, the defendant will be liable for insider trading under 10b-5 if they directly traded on insider information. Therefore, defendant is (not) liable because…

IV. MISAPPROPRIATION of CI APPLICATION (golf course) : Even though [tipper] is (not) liable under the traditional theory, he may still be liable under the misappropriation theory because there is a tipper/tippee relationship. Liability arises when a person trades on confidential information in breach of duty owed to the source of the information, even if the source is a stranger to the traded securities. Further, the tippee might be liable because he traded on the tipper’s information under the misappropriation theory (O’Hagan).

a. TIPPER RULE/APPLICATION : In assessing the liability of a tipper, the issue is whether the tipper breached a fiduciary duty to the corporation by receiving a personal benefit from their tip. Further, to satisfy the scienter requirement of 10b-5, the tipper must know the information is material and non-public and that the tippee is likely to trade on the information. Here… [so we need: (1) material non-public information; (2) personal benefit (breach of fiduciary duty); (3) knowledge tippee will trade; and (4) tippee traded.]

i. Note : Personal Benefit (very broadly defined) = reputation enhancement, bragging, boasting and gifting; spouse trades then insider is benefitted.

1. Dirks – exposed fraud but no expectation of personal benefit… no liability ii. Scienter requirement: tipper must know info is material and non-public and reasonable

likelihood that tippee will trade 1. “I know” requirement

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iii. TIPPER CONCLUSION : Therefore, the tipper is (not) liable [because tippee traded]. 1. Note : The tippee must trade for the tipper to be liable.

b. TIPPEE RULE/APPLICATION : When a tippee trades on insider information, they can be liable in two situations: (1) where the tippee owed a fiduciary duty to the tipper; or (2) where the tippee knew or had reason to know that the tipper was breaching the tipper’s fiduciary duty to the original source of the information.

i. APPLICATION TIPPEE’S Fiduciary DUTY : Here, [tippee] (owed/did not owe) a fiduciary duty to [tipper] under 10b5-2 because [pick one of four]: pg 492 10b5-2

1. (1) Whenever someone agrees to maintain information in confidence; 2. (2) whenever the tipper and tippee have a pattern of sharing confidences such that the

recipient of the information knows, or reasonably should know, that the speaker expects the recipient to maintain the information’s confidentiality;

3. (3) when two people are a spouse, parent, child, or sibling.4. (4) none of the duties listed 10b5-2 applies.

ii. Note: Difference between an outsider who misappropriates information from a source unrelated to the company in whose securities the outsider trade and a tippee who receives information from a fiduciary inside a company in whose securities the tippee trades.

1. The outsider’s duty is to the “outside” source; the tippee’s duty is derived from the duty of the “insider” who tips improperly.

iii. Misappropriation Application: [Look for agreement of confidentiality of outside source] 1. Employee could be liable for misappropriating the information in breach of his

employer’s expectation of confidentiality. Trading would be breach of duty to his employer aka the outside source.

2. O’Hagan case – O’Hagan is a partner at the law firm handling Pillsbury’s merger (target company). O’Hagan bought Pillsbury stock on material non-public information and made a huge profit.

a. The court said that O’Hagan was liable because he breached his duty to both his law firm and their client (the tippers – the source of the information). Unauthorized use of client confidences was deceptive and “in connection” with securities trading.

iv. TEMPORARY INSIDER : retained temp. by the company in whose securities they trade – such as accountants, lawyers, and investment bankers – have the same 10b-5 duties as corp. insiders.

1. whenever the tipper and tippee have a pattern of sharing confidences such that the recipient of the information knows, or reasonably should know, that the speaker expects the recipient to maintain the information’s confidentiality

v. [CONCLUSION: Because tippee has a fiduciary duty, they violated rule 10b-5 when they traded on the tipper’s information.]

vi. APPLICATION TIPPEE’S KNOWLEDGE : Even though [tippee] does not owe a fiduciary duty to [tipper], the tippee may be liable under the second situation. Here, [tippee] did (not) know, or had reason to know that [tipper] was breaching his fiduciary duty to the original source of the information because…

1. CONCLUSION : Therefore, the tippee is (not) liable.

Insider Trading under 14e-3 (only for tender offers)43


Note: Tim is a janitor at a corporation. While cleaning, Tim sees a bunch of papers on the company’s upcoming tender offer. While drinking at a bar, he tells Eli what he saw. Tim and Eli both trade. Are Tim and Eli liable under 14e-3? Yes – because ANYONE can be liable under 14e-3 regardless of fiduciary duty.

I. ISSUE : Here, [plaintiff] is alleging [defendant] misused insider information relating to a tender offer so the issue is whether [defendant] is liable under 14e-3.

II. RULE : Anyone can be liable under 14e-3 for purchasing or selling securities based upon nonpublic information in connection with a tender offer. In order to establish 14e-3 liability, a plaintiff must show: (1) there was a tender offer; (2) defendant obtained material non-public information relating to the tender offer; and (3) defendant knew or had reason to know that the information was obtained from an insider.

a. May not be valid because Does not require breach of fiduciary duty (SC said in Dirks that there must be breach but SEC disagrees)

b. EXCEPTION : A raider can trade based on their own intentions. i. EX : A raider who makes a tender offer obviously has knowledge of non-public information

relating to a tender offer. They can still trade on this information and not be liable.

III. APPLICATION : Here … [analyze all three elements]

a. Tender Offer – It’s a way to buy a company. The prospective buyer makes a formal offer to shareholders for them to sell their shares at a specified price. Directors cannot prohibit prospective buyers from doing this.

b. Note : The court in O’Hagan said that it is unclear whether 14e-3 is constitutional because breach of a fiduciary duty is not a required element. So you can be a guy at a bar who overhears a conversation about a tender offer and if you trade on this information, you are liable.

IV. CONCLUSION : Therefore, [defendant] is (not) liable under 14e-3, assuming that 14e-3 is constitutional.

Short-Swing Profits under 16(b)

I. ISSUE : The issue is whether [defendant] is liable for short swing profits under section 16(b) of the ’34 Act.

II. RULE : Section 16(b) prohibits: (1) directors; (2) officers; or (3) shareholders with more than 10% of any class of stock, from profiting off of the purchase or sale of company securities within a six month period of purchasing or selling the securities.

a. Note: Only applies to Public Companies trading in the equity securities of a corporation that has a class of equity stock registered under §12 of the Exchange Act

i. Ex: common stock is registered and preferred stock is not, still subject to § 16 b. Equity: options, convertible securities, and other equity derivatives

III. DIRECTOR/OFFICERS : In determining 16(b) liability, the court will look to whether the defendant is a director or officer at the time of the first transaction. Here, [defendant] was (not) an [director/officer] at the time of the first transaction. Therefore, if the second transaction occurred within six months of the first transaction, and [defendant] profited, he is liable under 16(b). a. Note : If defendant was not a [director/officer] at the first transaction, but was a [director/officer] at

the second transaction, this does not count; so ignore trades that were made before the person became a director or officer.

IV. SHAREHOLDERS : In determining 16(b) liability, the court will look to whether the defendant owned more than 10% of the SAME class of stock immediately before the first transaction.

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a. EX : If you own 11% of class B stock, but this only totals 5% of ALL company stock (including A stock), section 16(b) applies.

b. Timing : The shareholder must own more than 10% before the first transaction. In other words , the purchase that causes someone to become more than a 10% shareholder does not count. Owns 10% of the shares of a corporation at the time of purchase AND at the time of sale.

i. APPLIES : You own 20%. You sell 5% (first transaction). One month later, you buy another 5%.

1. Here, there is a “matching transaction”

ii. DOESN’T APPLY : You own 20%. You sell 15% (first transaction). One month later, you buy another 15%.

iii. does not matter if the ∆’s shares dipped below 10% at any time during the 6 months. Just look to whether at the second before the purchase the ∆ was a 10% SH

c. Match any transactions that produce a profit: any purchases and sales in which the sales price is higher than purchase price in 6 month period.

d. Deputization: firm’s employees serve as director of other firm, §16b may apply to the first firm’s trades in the stock of the second

i. Ex: X corp asks one of its officers to serve on the BOD of Y Corp; if X profits on Y stock within a 6 month period, X may be liable under §16(b) on the theory that it deputized the officer

e. Policy : Section 16(b) is a prophylactic rule put in place to minimize the risk that insider information is being used

f. Note : Does not apply to “unconventional transactions” (i.e. forced sale of shares in a hostile takeover).

V. CONCLUSION : Therefore, [defendant] is (not) liable for short swing profits under section 16(b) of the ’34 Act.

Indemnification and InsuranceI. INDEMNIFICATION UNDER DELAWARE LAW

a. The corporation may (not must) indemnify an officer/director for:

i. Derivative Suits : settlements, attorney’s fees, but never judgments.1. It wouldn’t make sense for the corp. to win a judgment and have to pay for that

judgment.

ii. Class action : settlements, attorney’s fees, and judgments if the corporation gets consent from the court.

b. Del. Gen. Corp Law:i. §145(a) indemnification in 3rd Party Actions: Del. Allows indemnification by the Corp for BOD,

officers, agents, employees, etc., for legal fees in defending against suits by 3rd parties (unless the person acted illegally or in bad faith)

ii. §145(b) Indemnification in Derivative Suits: The comp CAN indemnify D&O for costs of legal fees but not for the settlement costs

iii. The code gives the power to indemnify, but the Comp HAS to say it wants to do that*The company MUST state in bylaws that D&O are indemnified to the fullest extent allowable by law

iv. Del. Allows indemnification by the Corp for BOD, officers, agents, employees, etc. for legal expenses in defending a derivative lawsuit, but NOT for the cost of settlement

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c. Rec: HAVE an indemnification by law

II. RECOMMENDATIONS FOR A DIRECTOR OR OFFICER CLIENT

a. Get three levels of protection:i. Level One : make indemnification obligatory – see above

ii. Level Two : Get D&O insurance – Very important in derivative actions. There are two parts:1. First part protects the corporation because it reimburses the corporation for what they

had to pay to indemnify the director/officer in a class action suit. 2. Second part protects the director/officer for situations where the corporation can’t pay

such as: (1) in derivative suits; (2) where the corporation is insolvent; (3) if the court declines to give consent for indemnification; or (4) where indemnity agreement is unenforceable because the director/officer violated securities laws.

a. Note: This does not cover intentional wrongdoing. So if the director/officer stole money, this will not help them.

iii. Level Three : Get an exculpation provision 1. Note : Exculpation provisions only protect directors. If this provision is in the company

charter and the company sues you for breach of duty of care, you will not be personally liable.

PROXY RULE VIOLATIONS (public corporations only)

MISTATEMENTS OR OMISSIONSScenario: SH sues after management undertakes a merger or other control transaction accomplished with an allegedly false or misleading proxy statement. (NOTE: these elements are different than 10b-5 securities fraud

I. ISSUE : Here, [Plaintiff] alleges there was a material misstatement or omission in the proxy statement. a. Note : Anyone can issue a proxy including the corporation and other shareholders.

II. RULE : § 14a-9: A misstatement or omission is material when a reasonably prudent investor would consider it important when deciding how to vote their shares. Under Mills, as long as the statement or omission is material, then it is undoubted that shareholders might have been misled, and therefore there is a causal relationship (so plaintiff need not separately prove causation). a. Exception to Causation: However, plaintiff’s claim will fail if management owns enough shares to

approve the transaction without any votes from the proxy at issue (indicating there was no causation). If controlling SH had enough votes to make proxy solicitation pro forma then there is no causation, may still be violation of state law. 574?


a. Silence is actionable: applies to any statement in proxy solicitation that is “false or misleading … or which omits to state any material fact necessary in order to make the statements not false or misleading.”

b. Statement of reasons, opinions, motives for approving merger can be actionable i. Only if board: 1) misstates its true beliefs AND 2) misleads about the subject matter of the

statement c. Materiality: not material if redundant or otherwise available to SH

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d. Causation: No recovery if transaction did not depend on the shareholder votee. State Law: In DE, duty of disclosure prohibits false and misleading statements in any management

communication with public shareholders. i. Individual SH reliance required

IV. CONCLUSION : Therefore, [defendant] is (not) liable for a misstatement or omission in the proxy statement.

SHAREHOLDER PROPOSALS

Two types of proposals:Social/Environmental – Affirmative action programs and environmental proposalsCorporate Governance – Removal of a poison pill, require a certain number of independent directors

I. ISSUE : The issue is whether the corporation can refuse to include [plaintiff shareholder’s] proposal in its proxy materials.

II. RULE : As a general rule, a public corporation must include shareholder proposals in its proxy statements. However, a corporation can refuse to include: (1) irrelevant proposals; (2) proposals that are not in accordance with state law; (3) proposals relating to the corporation’s management functions; and (4) proposals the corporation lacks power or authority to implement.

a. RELEVANCE SUB-RULE : Under Rule 14a-8(i)(5), a proposal is irrelevant when it relates to operations which account for less than 5% of the company’s total assets, net earnings, and gross sales. However, shareholders can get around this by showing the proposal is otherwise ethically or socially significant.

i. APPLICATION/CONCLUSION : Here, the proposal is (not) irrelevant because… Pg 328 of rules 1. Lovenheim – Shareholder proposal sought to prevent pâté from being served. Pâté

production was less than 1% of the company’s business, but court remanded to determine whether it was a socially important issue.

a. Note : Significant social proposals are usually must be included.

b. STATE LAW SUB-RULE : Under Rule 14a-8(i)(1), a shareholder violates state law when it attempts to bind the company.

i. APPLICATION/CONCLUSION : Here, the proposal does (not) violate state law because…1. Note : Look to whether the proposal says “must” or “recommends.”

a. EX : Can’t make a proposal that says “the board of directors must pay dividends” and can’t make a proposal that says “company must open an office in Des Moines.”

c. MANAGEMENT FUNCTIONS SUB-RULE : Under Rule 14a-8(i)(7), a proposal relates to a corporation’s management functions when it concerns ordinary business operations

i. APPLICATION/CONCLUSION : Here, the proposal does (not) relate to the corporation’s management functions because.

1. i.e. employment policies: hiring and firing. Exception: EE policies that raise significant social policy issues

2. Related to nomination or election to office

d. ABSENCE OF POWER/AUTHORITY : Here, under Rule 14a-8(i)(6), the corporation lacks power or authority to implement the shareholder proposal because... [Some bullshit]

III. CONCLUSION : Therefore, the corporation must (not) include the shareholder proposal in its proxy materials.

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PROXY FIGHTS

I. ISSUE : Here, [plaintiff] is challenging [incumbent management’s -OR- successful insurgent’s] use of funds during the proxy fight.

II. RULE FOR MANAGEMENT : Management is permitted to use corporate funds in a proxy fight so long as the dispute is about differences in business policy and the expenses are reasonable. If this is true, management will be reimbursed regardless of whether management wins or loses.

a. APPLICATION : Here . . . [BOTH PRONGS ARE EASY TO SATISFY]

i. Note : Look to what management said. 1. RECOMMENDATION : You have to be very careful what you say in a proxy fight. But,

once you prove a genuine policy dispute, you can spend almost any amount of money.a. EX : “The insurgents are probably good business people, but I really need this

salary.”

ii. Note : In Rosenfeld, the court found that management’s use of entertainment, chartered air planes, public relations counsel, proxy solicitors and limos were reasonable expenses.

iii. Public Policy : If directors were not allowed to spend a lot of money on proxy fights, they would just have to surrender. It is best for the company to let management defend itself when there are legitimate policy disputes.

III. RULE FOR INSURGENTS : Successful insurgents can be reimbursed for reasonable and bona fide expenditures during a proxy fight so long as they had a legitimate business purpose and the shareholders approved the reimbursement.

a. APPLICATION : Here . . .i. Legitimate purpose = making money or accomplishing goals

ii. Illegitimate purpose = personal vendetta

IV. CONCLUSION : Therefore, the use of funds was valid.

SHAREHOLDER INSPECTION RIGHTS

I. ISSUE : The issue is whether the corporation must provide [plaintiff shareholder] with [the corporation’s shareholder list -OR- other documents they have requested].

II. RULE/APPLICATION IF FEDERAL LAW : The federal law, § 14a-7 provides that a corporation must either give a shareholder its shareholder list or it can send out a shareholder’s proxy materials for them. Either option is at the expense of the shareholder. a. RECOMMENDATION : Neither route is useful because sending materials under either option will break

the bank. Find a way to get under state law. Do not want to send to everybody.

III. RULE/APPLICATION IF STATE STATUTE : Generally, state statutes control when a shareholder is entitled to a corporation’s shareholder list or other documents. Here, the statute says…

a. DE/NY statutes – If the shareholder has a proper purpose they are entitled to the shareholder list, the seed list, and the NOBO list (if the corporation already has a NOBO list).

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i. Identify specific, already-existing documents and show how they are essential to stated purpose ii. Proper Purpose = reasonably related to their interest as a shareholder (i.e. making money)

1. Note : there is a presumption that this is why you want the list.

b. Note : The controlling law is the state in which the plaintiff resides.

c. State ex rel Pillsbury v. Honeywell – During Vietnam, Honeywell made napalm and materials for shrapnel bombs. Pillsbury requested the shareholders list and company records. He publicly stated that he only cared about the morality of Honeywell’s work.

i. Court held that morality was not a proper purpose – the DE statute required the purpose relate to increasing the company’s profits.

1. SHOULD HAVE ALLEGED ECONOMIC RISK : If we were Pillsbury’s lawyer, we should have told him to say: “Making bombs hurts the company’s image, and this hurts the company’s ability to sell other products and make profits.”

IV. RULE/APPLICATION IF NO STATE STATUTE : Because there is no state statutory language to the contrary, a shareholder is likely entitled to the shareholder list so long as their purpose is to communicate with other shareholders about corporate affairs; the corporation can properly withhold the list by showing the shareholder has an improper purpose. [However, if the shareholder requests other documents, the shareholder will bear the burden to prove a proper purpose.] Here…

a. Policy : Other documents contain confidential information that could potentially harm the corporation if it gets into the wrong hands.

i. SH burden to show credible evidence of mismanagement for books and records

b. Want seed list and NOBO List i. Non objecting beneficial owners – contact info from record owner brokers

c. Crane Co. v. Anaconda – Crane wanted to buy Anaconda and made a tender offer. After 11% of shareholders accepted the tender offer, Crane (as Anaconda’s largest shareholder) requested a shareholder list. Anaconda argued improper purpose (to obtain control of the business).

i. Court held that Crane had a proper purpose: the tender offer was a big deal – it was important to Anaconda’s stockholders. Furthermore, Crane met the procedural requirements of the NY statute because they gave written notice and an affidavit saying they had a proper purpose.

1. Note : Would have come out different if Crane was a competitor of Anaconda and wanted Anaconda’s business papers in addition to the list. This request would be against Anaconda’s interest and Crane could probably only get the list.

CLOSELY HELD CORPORATIONS

SHAREHOLDER VOTING CONTROL

Scenario 1: You are advising someone who is considering buying shares in a closely held corporation regarding their potential shareholder agreement.

Scenario 2: Shareholders agreeing to vote for certain directors and/or directors agreeing to vote a certain way.

Notes on Quorums

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Directors: A majority of directors must be present to voteShareholders: a Majority of shares must be represented to vote

EX: Corporation has 20,000 shares and 700 shareholders. 10,001 shares must be present for quorum. Note: These are default rules. The bylaws can amend.

I. ISSUE : The issue is whether [what the shareholders agreed to] is valid.

a. RULE : Generally, shareholders can agree to whatever they want, including how they will vote their shares in order to elect directors. Shareholders can even choose to have no directors whatsoever. However, shareholders cannot agree to anything that would bind the hands of the directors unless 100% of the shareholders agree.

i. EX : So if there are only two shareholders and they agree, they can bind directors.ii. Note : Once a shareholder is elected as director, they are free to vote in any way they want-

regardless of the shareholder agreement. (They take off their shareholder hat and put on their director hat).

1. Validity of management agreement is unclear unless 100% SH approval a. If no 100% then must vote as directors to approve.

b. [Additionally, in Illinois, Galler v. Galler modified this rule so that 100% SH approval is no longer needed to bind directors. Rather, majority shareholders can agree to whatever they want so long as: (1) no minority shareholder objects, and (2) the agreement doesn’t endanger other stockholders, creditors, or the public, or violate the law.]

i. EX : Can’t agree to do something inconsistent with the Illinois Closed Corporation Act – that would violate the law.

ii. In DE: Majority SH can agree to management agreement but become liable for duties imposed; cannot adversely affect non-party interest

c. APPLICATION : Here…i. Possible recommendations to a shareholder client :

1. Minority veto power :a. Step One – Have a shareholder (pooling) agreement to make you a directorb. Step Two – Have the bylaws of the corporation say that 100% vote of the

directors is needed to act or amend the bylaws.(veto power at the director level) c. Step Three – If shareholders can amend bylaws, say the bylaws cannot be

amended without 100% shareholder approval (veto power at shareholder level). 2. Buyout agreement – Allows a shareholder to end his relationship with the corporation

and receive cash in return for his shares upon certain triggering events.a. Note : You never want an estate to be a shareholder because they have much

different goals. 3. Employment contract – You should get an employment agreement that ensures your

salary and provides that if you are terminated without cause, you will get severance pay and the corporation is required to buy your shares (mandatory repurchase agreement).

4. Russian Roulette Provision – This works best when there are only two shareholders.a. EX : One shareholder tells you that he wants to buy your shares for X price. You

can either: (1) accept the offer; or (2) turn the tables and purchase the other shareholders shares at the stated price. This will ensure that you offer a fair price because if you don’t, you can be bought out for cheap.

ii. Ringling Bros. – Edith and Aubrey each owned 315 shares of Ringling. North owned 370. Aubrey and Edith agreed to always vote the same way for directors so that they could out-vote John (pooling agreement). Court upheld this agreement.

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iii. McQuade v. Stoneham – Stoneham was the majority shareholder of the Giants and McQuade was one of the minority shareholders. Stoneham, McQuade, and McGraw had a shareholder agreement to vote for each other as directors, and then once they were directors to hire each other as officers. Stoneham got mad and fired McQuade. McQuade sued to enforce the agreement.

1. Court held the agreement invalid. Agreement to elect each other as directors was perfectly fine, but absent 100% shareholder approval (or silent minorities in Illinois), an agreement can’t dictate who directors hire as officers.

a. Policy : Directors owe a fiduciary duty to ALL shareholders, so tying their hands to benefit certain shareholders is inconsistent with that duty.

i. Counterargument : Case law does not agree with this, but professor says to get people to invest in closely held corporations, they will want assurances as to how the business will be run. So we should let them bind directors, and then if the directors behave badly we can still sue for breach of care and loyalty.

2. SHOULD HAVE : McQuade’s lawyer should have told him not to invest until he gets an employment contract guaranteeing his salary as an officer. Since he isn’t a director yet, he wouldn’t be breaching any duty.

iv. Clark v. Dodge – Clark owned 25% and Dodge owned 75% of a drug company. Clark had the secret formula for a drug, and to get him to share it Dodge promised him a seat on the board and a position as general manager, which paid him 25% of all profits. After Clark handed over the formula, Dodge fired him, and Clark sued to enforce the agreement.

1. Court held the agreement was valid. Because they made up 100% of the shareholders, they could agree to whatever they want. They weren’t hurting any other minority shareholders.

v. Ramos v. Estrada – Broadcast Group (including Estrada and Ramos) owned 51% of Television. Broadcast Group had agreement to vote together so that they could maintain control of the company. The agreement said that if anyone breached, they have to sell their shares to the non-breaching members at a low price. Estrada breached and was forced to sell his shares.

1. Court upheld the agreement – forced sale provisions are ok. Estrada argued unconscionability, but the court said she was an astute businesswoman and knew what she was doing.

d. CONCLUSION : Therefore, [whatever the shareholders agreed to] is (void/enforceable).

SHAREHOLDER ABUSE OF CONTROLLook for: Minority SH in closely held corp.Scenario 1: Where someone invests in a close corporation in anticipation of working there (employee or officer). But then the shareholder gets fired. So his money is locked into a corporation with no market to sell. Can he sell the shares to other shareholders? Can the other shareholders freeze him out?

Scenario 2: Where a close corporation buys stocks from one of its shareholders and they do not disclose material facts to that shareholder prior to the purchase.

I. ISSUE : The issue is whether [the majority shareholders] breached a fiduciary duty to [minority shareholder] when they [freeze out -OR- Failed to disclose].

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a. FREEZE OUT RULE : As the court held in Wilkes (Mass.), the majority shareholders typically have the burden to prove they were acting for a legitimate business purpose, and not simply trying to freeze out the minority. However, the law is not entirely clear in this area because other courts, such as the Ingle court (NY), have declined to hold majority shareholders liable in similar situations.

i. APPLICATION/CONCLUSION : Here, the majority shareholder’s conduct was [a freeze out -OR- made with a legitimate business purpose] because…

1. Possible recommendations to a MINORITY shareholder :a. Minority veto power :

i. Step One – Have a shareholder (pooling) agreement to make you a director

ii. Step Two – Have the bylaws of the corporation say that 100% vote of the directors is needed to act or amend the bylaws (veto power at the director level)

iii. Step Three – If shareholders can amend bylaws, say the bylaws cannot be amended without 100% shareholder approval (veto power at shareholder level).

b. Buyout agreement – Allows a shareholder to end his relationship with the corporation and receive cash in return for his shares upon certain triggering events.

c. Employment contract – You should get an employment agreement that ensures your salary and provides that if you are terminated without cause, you will get severance pay and the corporation is required to buy your shares (mandatory repurchase agreement).

2. Possible recommendations to a MAJORITY shareholder :a. State a legitimate business reason in letters, corporate minutes, emails, or other

conversations.b. Go to the minority and say “we are really sorry about this, but we do not have

the money for four people’s salaries and you are the least important.”c. Don’t offer a low ball price; make it fair – it’s not worth the cost of litigation. d. All in all, it is important what you say in email, minutes notes, etc. IF all of this

was done properly, then the result will likely be in your favor. i. Note : Make sure there was no smoking gun so no one confesses as to

what the real reason for the freeze out was.

3. Wilkes v. Springside – Wilkes and three others formed a corporation. They each collected salaries and the corporation didn’t pay dividends. The other three fired Wilkes which severed his salary so he had no money coming in on his investment. The other three offered to buy his shares at a really low price.

4. Ingle v. Glamore Motor Sales – Ingle was an employee of Glamore and Glamore sold him 40 shares. The agreement said that if Ingle ceased to be a Glamore employee, he must sell his shares to Glamore. Ingle got fired. Glamore bought his shares for a fair price. Ingle sued Glamore for breach of fiduciary duty.

a. Breach in Wilkes; No breach in Ingle because :i. Ingle was being offered a fair price; Wilkes was getting lowballed.

ii. Ingle had a buyout provision in the agreement; Wilkes did not.

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iii. Ingle’s agreement said he could be fired for any reason; Wilkes didn’t have an agreement

iv. Ingle was simply an employee before he bought shares; Wilkes was one of the original owners getting thrown overboard.

b. FAILURE TO DISCLOSE RULE : Generally, shareholders do not owe a fiduciary duty toward one another. However, in Jordan v. Duff & Phelps, the Seventh Circuit stated that shareholders should not take “opportunistic advantage” of one another. In other words, the court imposed a duty of good faith where a shareholder agreement is silent as to the particular issue.

i. Jordan v. Duff and Phelps – Jordan was an at will employee for Duff. He bought stock and the purchase agreement said if his employment agreement was terminated for any reason, Duff would buy his stock at book value. Jordan decided to move to Houston (meaning he would have to sell his stock) and Duff failed to disclose merger negotiations that made his stock more valuable.

1. The court said Duff breached its duty by failing to disclose this information.

II. OVERARCHING CONCLUSION : Therefore, the majority shareholders did (not) breach their fiduciary duty to the minority shareholder. [If breach: Thus, the next issue is whether the minority shareholder has a remedy.]

a. APPLICATION IF SHAREHOLDER AGREEMENT : Here, the shareholder agreement provides …

i. Minority veto power :1. Step One – Have a shareholder (pooling) agreement to make you a director2. Step Two – Have the bylaws of the corporation say that 100% vote of the directors is

needed to act or amend the bylaws.(veto power at the director level) 3. Step Three – If shareholders can amend bylaws, say the bylaws cannot be amended

without 100% shareholder approval (veto power at shareholder level). ii. Buyout agreement – Allows a shareholder to end his relationship with the corporation and

receive cash in return for his shares upon certain triggering events.iii. Employment contract – You should get an employment agreement that ensures your salary and

provides that if you are terminated without cause, you will get severance pay and the corporation is required to buy your shares (mandatory repurchase agreement).

b. APPLICATION IF NO SHAREHOLDER AGREEMENT OR IF AGREEMENT SILENT : Here, there is no shareholder agreement addressing remedies. This was a mistake because [pick one]:

i. RULE FOR ILLINOIS : Generally, state statutes are unsatisfactory in resolving this issue. In Illinois, Section 12.56 of the Illinois Business Corporation Act requires one of the following triggers for judicial intervention: (1) the directors must be deadlocked and irreparable injury is threatened; (2) illegal, oppressive, fraudulent conduct or; (3) the corporation’s assets are being misapplied or wasted. If any of these events trigger the statute, the court may, but is not required, to order a remedy.

1. NOTE : Remedies include: (1) buying back the shares at a fair price; (2) removing any officer and director; or (3) appointing any officer or director.

ii. RULE OUTSIDE ILLINOIS : state statutes are unsatisfactory in resolving this issue for three reasons. First, state statutes often have an extreme trigger (typically “irreparable harm”). Second, judges often have complete discretion in deciding an applicable course of action. Finally, unclear remedy. In some statutes, the remedies are like an “atomic bomb” where all the court can do is blow up the corporation.

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1. Alaska Plastics case – Muir was a minority shareholder who alleged the majority was not giving her notice of meetings and taking excessive directors fees. Muir wanted the court to order the company to buy her out.

a. The court refused to buy Muir out because if they did, Muir would be treated better than other shareholders. For the court to buy her out, Muir needed to prove that the company: (1) did something illegal, oppressive, or fraudulent; or (2) that the company paid a constructive dividend.

i. Constructive Dividend = Company only wants to give dividends to directors and not shareholders so they disguise the dividends as directors fees.

b. RECOMMENDATION :i. Alaska Plastics should have offered Muir a fair price for her stock. The

lowball offer supports her argument that the company was just trying to squeeze her out and lacked a legitimate business purpose.

ii. Alaska Plastics should have given Muir notice of the shareholder meetings.

2. Stuparich v. Harbor Furniture – Malcolm was a majority shareholder of the voting shares. Malcolm’s two sisters were the minority shareholders of the voting shares. The company had two businesses and the sisters wanted to set them up as subsidiaries. Malcolm refused. Sisters sought involuntary dissolution under California law.

a. The court found for Malcolm. The California test for involuntary dissolution of a closed corporation requires: (1) less than 35 shareholders; and (2) plaintiff has to show that dissolution is reasonably necessary.

i. Note: The California test is easier to meet than the typical test. ii. Note: What should have been in the agreement for a different outcome?

A buyout provision or some sort of veto power.

TRANSFER OF CONTROL

Scenario: There are two shareholders in a close corporation. One owns 80% the other owns 20%. The only reason the minority has invested is because he loves the way the majority shareholder runs the business. The majority shareholder decides to sell all of his shares to someone who will not run the corporation as well. The minority shareholder would not have invested if he knew this. What can the minority shareholder do? Can he get out?

I. ISSUE : Here, the minority shareholders is alleging [controlling bloc] improperly [sold shares at a premium or sold board of directors or violated shareholders agreement]. Because a controlling bloc is allowed to sell their shares at a premium [and/or sell the board of directors] (unless the shareholders’ agreement states otherwise), the issue is whether [controlling bloc’s] shares are the controlling shares of the corporation.

II. RULE : There are differing viewpoints on what is considered control of a corporation. In Essex Universal Corp. v. Yates, Chief Judge Lumbard explained that the controlling shares of a corporation don’t have to constitute 51% of the shares of the corporation. Rather, he found that ownership of 28.3% of the shares “was tantamount to control.” On the other hand, Judge Friendly argued that a buyer must obtain more than half of the corporation’s stock in order to establish control.

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a. Exception : Can’t sell at a premium to a looter. Looter = someone the majority shareholder knows or believes will exercise his control to the detriment to the remaining shareholders (e.g. runs the company as his private piggy bank); basically sucks assets out of the company for his own person benefit.

i. Look for past recordii. Note : If the majority sells to a looter, the majority will be liable to the minority for the premium

they received. 1. Solution : Allow the minority to sell their shares with the majority’s.

iii. Sale of Office: Sale cannot be conditioned on control SH improperly selling corporate offices 1. Challenger must show:

a. The buyer did not acquire control to elect own BOD (Essex), ORb. The sales prices exceeds the premium the control block alone commands,

suggesting the price included sale of office (Perlman)

III. APPLICATION :

a. If Large Corporation : Here, the court should side with Judge Lumbard because having more than 51% of a large corporation is illogical. (Professor agrees with Lumbard). On balance, since the burden is on the challenging party to establish percentage of shares isn’t control, _____ will likely succeed.

b. If Small Corporation : Here, while Judge Lumbard’s opinion makes more sense in a large corporation, in a small corporation, such as the one at issue here, a court is more likely to side with Judge Friendly. On balance, since the burden is on the challenging party to establish percentage of shares isn’t control, _____ will likely succeed.

c. Note : Selling the officers of the corporation is a more difficult issue than the directors. However, in light of Judge Lumbard’s opinion, this is really a minor point. Judge Friendly is “the only fly in the ointment.”

d. Possible recommendations to a MINORITY shareholder

i. Right of First Refusal ( Frandsen ) : If the controlling bloc is given an offer to sell its shares, it must give the minority the right to buy the shares at the offer price.

1. However, if the client does not want to buy the shares and become a majority shareholder, recommend the client get a second layer of protection: having the shareholder agreement state: “If the minority declines, the majority bloc must offer to buy the minority’s shares at the same price at which it sold its own shares.”

a. EX : Eli owns 92% and Bob owns 8%. If Eli wants to sell his shares at a premium price to Steve and Bob declines his right of first refusal, Bob can force Eli to buy his shares and then sell 100% of the company to Steve.

2. Note : Also, make sure the client is aware that a merger does not qualify as a sale of shares for the purposes of the right of first refusal.

ii. Appraisal Rights – determine price that buyer must offer to buy minority’s shares at.

IV. CONCLUSION : Therefore, [controlling bloc] did (not) have control of the corporation and could (not) [do what they did].

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MERGERS AND ACQUISITIONSSELLER (TARGET) APPROVAL

NEEED FROM:BUYER APPROVAL

NEEED FROM:BUYER TAKES ON

SELLERS:APPRAISAL RIGHTS

BOARD SHAREHOLDERS BOARD SHAREHOLDERS Liability All Assets SELLER BUYER

MERGER Y Y Y Y (except short form) Y Y Y Y

ASSET TRANSFER Y Y Y N N N N N

STOCK TRANSFER N N Y N N Y N N

PLAINTIFF CLAIMING DE FACTO MERGER (not an asset or stock purchase)

Scenario: Where a target corporation immediately liquidates following the sale of its assets or stock and:

Target’s unpaid creditors want a de facto merger because a merger allows the creditors to get at the buyer’s (subsidiary’s) assets whereas in an asset or stock purchase they can only get at the target’s assets (and the target no longer has any assets).

Target’s shareholders want a de facto merger because they want appraisal rights which they don’t get under asset/stock purchases. Also some state statutes give them more rights.

I. ISSUE : Here, Plaintiff [target’s unpaid creditor or target’s shareholder] claims the asset purchase or stock purchase is actually a de facto merger. [Look for immediate liquidation]

II. RULE : Illinois and a minority of states recognize de facto mergers when a target corporation immediately liquidates following the sale of its assets or stock. However, in Delaware the Hariton case rejected the de facto merger doctrine and instead applied the equal dignity doctrine. It reasoned that there are two distinct paths a corporation can follow (asset/stock purchase OR merger) and the court will not second guess a corporation’s decision.

III. APPLICATION : Here, because we are in [state], Plaintiff [unpaid creditor or minority shareholder of target]’s argument will [succeed/fail] because… a. Note : If the target has liquidated right away in a jurisdiction that has the de facto doctrine and the

majority of what the target received was stock, it will likely be a de facto merger. i. In IL in will be unpaid creditors

IV. CONCLUSION : Therefore, the asset purchase or stock purchase is (not) a de facto merger

PLAINTIFF CLAIMING ASSET OR STOCK PURCHASE (not a merger)

Scenario: Companies is calling their transaction a merger, but the shareholders want it to be called an asset or stock purchase because that way they can redeem their shares.

I. ISSUE : Here, Plaintiff [target’s shareholders] claims the merger was actually an asset purchase or stock purchase.

II. RULE : If a corporation’s articles of incorporation provide that shareholders are entitled to redemption, the corporation will often try to structure the transaction as a merger so that the corporation does not have to redeem the shares. In Delaware, a plaintiff attempting to argue against the merger will fail because the

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Rauch case held the equal dignity doctrine favors form over substance. If the corporation chooses to structure the deal as a merger, the court will not second guess this. a. Note : “Can’t call a cactus a rose and make it a rose.”

III. APPLICATION : Here… a. Recommendations for the Target Corporation :

i. Hire an Investment Banking House – The Corporation should hire an investment banking house to tell them how much to pay for the stock. If they do, Section 144(e) protects them from liability.

b. Rauch v. RCA – RCA merged into GE. RCA had common and preferred shareholders. Certificate of incorporation said that RCA could redeem the preferred stock for $100.00/share. If GE had bought the assets for cash and then RCA liquidated, this could involve the redemption of the preferred stock. Instead, they merged and paid preferred shareholders $40.00/share and common stockholders got $66.50/share.

i. The court denied plaintiff’s claim and said that the merger was valid under the equal dignity doctrine.

IV. CONCLUSION : Therefore, the merger is (not) an asset purchase or stock purchase.

LLC MERGER

I. ISSUE : Here, we are dealing with a merger of an LLC. Therefore, the first issue is whether plaintiff can void the merger.

II. RULE : In a contested merger, the company will generally get the benefit of the business judgment rule. However, where the members breach their duty of loyalty, as seen in Castiel, the managers will not get the benefit of the business judgment rule and the court will likely block the merger.

III. APPLICATION : Here . . . argue whether the members breached their duty of loyalty.

a. VGS Inc. v. Castiel – Castiel and Sahagen formed an LLC where Castiel owned 75% and Sahagen owned 25% of the membership interest. They hired a three person board of managers. Castiel could hire/fire two of the three and Sahagen could hire/fire one. Castiel appointed himself and Quinn and Sahagen appointed himself. Sahagen had secret meetings with Quinn and got him to turn on Castiel. Sahagen and Quinn secretly voted for a merger which diluted Castiel’s shares and turned him into a minority member.

i. Even though only two managers were needed to approve the merger, the court blocked it anyway because the secret meetings violated the duty of loyalty. If Castiel knew about their plans, he would have exercised his right to fire Quinn and appoint someone loyal to him.

1. It doesn’t matter if Castiel was incompetent because the business judgment rule protects him.

SQUEEZE OUT MERGER (always a parent and a subsidiary)

Scenario: Majority shareholders attempting to get rid of minority shareholders. Minority shareholders don’t like it.

I. ISSUE : Here we are dealing with a squeeze out merger, therefore the issue is whether plaintiff is entitled to damages.

II. RULE : In a squeeze out merger, the business judgment rule does not apply because the same people are on both sides of the deal. Generally, as the court in Weinberger explained, the burden is on the majority

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shareholders to pass the entire fairness test by showing: (1) fair procedure; and (2) fair price. However, if the merger is approved by sanitized voting, the burden shifts to the plaintiff minority shareholder to prove: (1) unfair procedure; and (2) unfair price. [The Coggins court reaffirmed that in Massachusetts, courts apply the business purpose test and uphold mergers so long as there is a valid corporate objective. (But there needs to be some other purpose than just getting rid of people).]

a. EXCEPTION : Short-Form Mergers – Under Delaware law, if the parent owns 90% of the subsidiary, all you need is the approval of the parent company’s board of directors. The court in Glassman further clarified that the subsidiary doesn’t have to jump through the hoops of entire fairness.

i. Recommendation to Parent 1. If the parent owns close to 90%, tell them to buy enough shares to get to 90%. You only

need to disclose why you are buying up shares.


a. Things that indicate Fair Procedure i. Sanitized voting = parent company voting the same as the majority of minority shareholders

approve the deal. ii. Subsidiary forming an independent committee of the board to negotiate the transaction

iii. Subsidiary getting an independent investment banking house and lawyer to say the price is fair

b. Things that indicate Fair Price i. Hire a totally independent investment banking firm

ii. Have the independent committee do the hiring of the investment banking firm

IV. CONCLUSION : Therefore, plaintiff’s claim will (not) succeed. [Because we are in Delaware, plaintiff is only entitled to appraisal rights, not damages, unless he can show fraud, waste, or self-dealing.]

TAKEOVERS

Scenario: Company wants to acquire another company so they talk to the target board. Target board says no deal. So the raider makes a tender offer to the target shareholders. The target shareholders want to take the deal, but the target board of directors does not want to take the deal. Did the board act proper in fending off the sale? Note: The raider OR target shareholders can bring the suit

**Note: Green-mailers were people who would buy up a bunch of shares, and then offer to sell them back to the company at a higher price. There was a dispute over whether the corporation could use their funds to buy back the shares. Corps had to show good faith and reasonableness. This is no longer an issue because Congress taxes green-mail profits, so no one green-mails anymore. **

I. ISSUE : Here, we are dealing with a hostile takeover because the [target] board rejected the [raider’s] initial offer to buy [target] and the [raider] made a tender offer to [target’s] shareholders. In assessing whether the target board acted properly, the first issue is whether the [target] board is entitled to the business judgment rule or the enhanced business judgment rule.

II. RULE : The enhanced business judgment rule is triggered where: (1) there is a sale of control; (2) the breakup of a company is inevitable; or (3) defensive measures are in place.

III. APPLICATION : Here, the enhanced business judgment rule does (not) apply because … [pick one of four]

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a. SALE OF CONTROL ( QVC ) – There was a sale of control in the target corporation. Here, there was a sale because [someone] acquired ___ percentage of target. [Look to whether P becomes minority in surviving corp] [Argue what counts as control – see Transfer of Control Judge Lumbard v. Judge Friendly].

i. ENHANCED BJR RULE : When dealing with the sale of control of a target corporation, the court in QVC stated that the Enhanced BJR requires the target’s board satisfy its Revlon duties: (1) that it acted reasonably; and (2) the goal of the transaction was to maximize the present value for shareholders (no need to get competing bid, only best price).

1. APPLICATION : Here, the target did (not) act reasonably and did (not) maximize the present value because…

a. Reasonably : [adequacy of decision making process] if the board acted as protector of the target shareholders (to fend off the raider) then it did not act reasonably. The board needs to stop playing defense and start playing offense to get the most money now. Be informed of all material information.

i. Ex : auction, canvas the market, no single blueprint ii. Reasonable decision, not perfect ; balance

b. Maximizing Value : “maximizing present value” means that the target board sought the best price for target shareholders right now. Long-term goals are irrelevant. Once control shifts, the current stockholders have no leverage in future to demand another control premium and that is why max value is significant.

i. Cannot contract out of fiduciary duty : (QVC) Board cannot use defensive measures (No-shop) in a merger agreement to effectively remove their duties to shareholders, therefore agreement is invalid and Corp can get other offers (fiduciary out).

ii. Even if make higher bid, other measures still in place to void deal. Where measures prevent board from maximizing value then it is invalid.

iii. Possible cap stock option to reach reasonable levels

2. CONCLUSION : Therefore, the enhanced business judgment rule is (not) satisfied and the target board did (not) breach their fiduciary duty to the target corporation.

b. BREAKUP/SALE INEVITABLE ( Revlon ) – the breakup/sale of the target corporation was inevitable. The breakup became inevitable when: pg. 777

i. The target company shops around after a raider makes an offerii. the target company makes a counteroffer to a raider’s offer

iii. Heavy leverage buyout – the raider borrowed so much money to acquire the target that they will have to sell off parts of the target corporation to pay back the money.

iv. Where there is a bidding war v. In response to raider’s offer, target abandons long-term strategy and seeks alternative

transaction involving break up

vi. ENHANCED BJR RULE : When dealing with the sale of control of a target corporation, the court in Revlon stated that the Enhanced BJR triggers two duties for the target board: (1) to act reasonably; and (2) to maximize the present value for shareholders (no need to get competing bid, only best price).

1. APPLICATION : Here, the target did (not) act reasonably and did (not) maximize the present value because…

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a. Reasonably : If the board acted as protector of the target shareholders (to fend off the raider) then it did not act reasonably. The board needs to stop playing defense and start playing offense to get the most money now.

b. Maximizing Value : “maximizing present value” means that the target board sought the best price for target shareholders right now. Long-term goals are irrelevant.


c. DEFENSIVE MEASURES (Unocal and Time-Warner) – defensive measures were in place to prevent a hostile takeover. Here… [three below]

i. Poison Pill – When target management gives its shareholders an option to acquire stock. This right is not given to the raider. The price starts very high, but when someone acquires a threshold amount of the target’s shares (usually 15% to 20%), the stock price drops drastically, causing dilution of the raider’s ownership interest in the target.

1. EX : Tim, Eli and Steve each own 100 shares in a corporation. They are also the board of directors. Bob, the raider, asks to buy the company. The board rejects the offers and puts a poison pill in place. Bob buys all of Steve’s shares (so now he owns 33%) and the poison pill is triggered. Tim and Eli now have the right to buy 100 additional shares each for the price of 50 shares. This right does not extend to Bob. So now Bob only owns 16.50% of the corporation.

ii. Restructuring the Deal – Instead of A merging into B, B makes a tender offer to A so that A’s shareholders do not get a vote.

1. EX : Time and Warner wanted to merger. The initial plan was for Warner to buy all of Time’s shares, but Paramount made an unexpected tender offer to buy Time’s shares at a much higher price than Warner. Because Time’s board did not want to take the Paramount deal, they restructured the Warner deal so that Time would buy Warner’s shares instead of the other way around. This way, Time’s shareholders could not vote on the merger.

iii. State Anti-Takeover Statute – States put these in place to prevent companies from leaving.

1. Delaware Statute – Requires a three year wait between the raider’s tender offer and when the raider can actually consummate the merger.

a. Note : If the raider can eliminate the three year wait period if they are able to acquire 85% of the target through the tender offer.

iv. ENHANCED BJR RULE : In this instance, under Unocal, the Enhanced BJR requires the target’s board to show it: (1) reasonably believed there was a threat to the company or shareholders; and (2) its response was proportional.

1. APPLICATION : Here it was (not) reasonable for the target board to be threatened by [threat]. Further, the board’s response was (not) proportional because…

a. THREATS i. Inadequate offer price

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1. RECOMMENDATION : Have an investment banking firm verify that the offer price is inadequate.

2. Note : A target can claim a price is inadequate if it believes the long term prospects look good. This is different than Revlon where there is a duty to maximize present value.

ii. Coercive offer (Unocal) – “if you don’t accept this tender offer now, I am going to make another tender offer for $1.” (T. Boone Pickens)

iii. 11th hour offer – tender offer; shareholders can be tricked if they don’t have time to analyze last minute offer.

1. EX : There is a deal on the table to merger with shareholders getting $10/share. At the last minute, a raider comes in and offers $11/share. The target is worried that shareholders might make a rash decision and accept the raider’s offer even though the $10 offer is better for them.

a. Counterargument – Professor thinks this assumes shareholders are stupid and risks judges telling them what is best for them.

b. PROPORTIONAL RESPONSE i. There must be a reasonable time limit on the poison pill.

1. i.e. there is a poison pill in place. There have been a few offers but the bidding process has run out of steam. So there is no justification for keeping the poison pill.


d. NONE OF THE ABOVE APPLY – none of those three scenarios are present and therefore, we apply the BJR.

i. BJR RULE : In this instance, the BJR creates a presumption the target board acted with procedural due care in rejecting the raider’s offer. The raider can only overcome this presumption by showing: (1) disloyalty; or (2) irrationality.

1. APPLICATION : Here, the target rejected the raider’s offer because…

a. Recommendations to Target Board :i. Consult an investment bank who said the raider’s offer was inadequately

priced.

ii. State that you are focusing on the long term interests of shareholders (this is good)

1. Note : Even if a raider makes an offer for a premium price, the target does not have to take it if they can prove the offer is not in the long-term interest of its shareholders.

a. EX : Time is a respected for its journalistic integrity. Directors were worried that merging with Paramount, a fictional movie company, would harm Time’s image and ultimately be bad for the company. So even though Paramount offered a premium price, Time was allowed to reject it.

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ii. CONCLUSION : Therefore, applying the BJR, the court will likely [uphold/void] the target board’s actions.

CORPORATE DEBT** Corporations issue bonds (debentures), but in reality, corporations are just borrowing money **

ALL OR SUBSTANTIALLY ALL ASSETS

SCENARIO: Company A issued a $1000 bond to creditor. When Company A sells its assets, including the bond obligation to Company B, Company B will argue that the sale was all or substantially all. Otherwise, the creditor can call the bond for accelerated payments.

I. OVERARCHING ISSUE : Here, [Company A] originally issued a debenture to creditor. [Company B] bought [Company A’s] assets and undertook the obligation of the original debenture. Therefore, the issue is whether the creditor can call the debenture from [Company B] to accelerate payment.

a. RULE : Where a company purchases all or substantially all of the assets of another company, the debentures do not become due and payable. Whether a purchase involved all or substantially all of a company’s assets is determined at the time the selling company made the plan to liquidate its assets. (Sharon Steel)

b. APPLICATION : Here, at the time [company A’s] liquidation was planned, the assets purchased by [Company B] made up ____ percent of [company A].

i. Note : Under Delaware law, if the purchased asset was the most valuable part or most profitable part of company A, this may be enough to satisfy the all or substantially all requirements (value over volume).

c. CONCLUSION : Thus, [company B’s] purchase of [company A’s] assets did (not) involve all or substantially all of [company A’s] assets and therefore the creditor can (not) call the debenture from [Company B] to accelerate payment.

LEVERAGED BUYOUT

SCENARIO: Company A issued a $1000 bond to creditor. Company B borrowed a ton of money to buy Company A in an LBO. Company A merges into Company B. Now, Company A’s creditor is in a junior position and wants to call the

bond.

II. OVERARCHING ISSUE : Here, [Company A] originally issued a debenture to creditor. [Company A] then incurred additional debt when it was purchased in a leveraged buyout by [Company B]. Therefore, the issue is whether the creditor can call the bond from [Company B] to accelerate payment.

a. RULE : Generally, creditors are limited to the four corners of the indenture. Therefore, unless the indenture says otherwise, incurrence of additional debt through a leverage buyout does not permit a creditor to call the bond. (Metlife)

b. APPLICATION : Here, the text of the indenture states…

i. Recommendation for Creditors

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1. Try to get the debenture to provide that “if a change of control occurs, each debenture holder may require that the issuer redeem its debenture for 101% of the principal amount plus accrued interest.”

a. Metlife didn’t insist on this because they were greedy. They wanted the high interest and didn’t want RJR to pull out of the deal.

ii. Note : Courts are more likely to imply protection of a shareholder than for a creditor because a creditor has a contract that it can use to protect itself.

1. Policy – The court is only going to imply something if they can assume the parties would have included in their written agreement had their attention been called to it.

c. CONCLUSION : Therefore, the creditor can (not) call the bond from [Company B] to accelerate payment.

EXCHANGE OFFERS

SCENARIO: Company A issued a $1,000 bond to investor. Company A is in financial trouble so it makes an exchange offer seeking to switch the $1,000 bond with an $800 bond and the offer contains an exit consent (meaning the

investor loses their covenants if they chose to keep the $1,000 bond). What should the investor do?

III. OVERARCHING ISSUE : Here, [public company A] has made an exchange offer to its bond holders, which contains an exit clause. Because the court in Katz v. Oak Industries upheld the legality of exit clauses, the only remaining issue is whether the bond holder (the investor) should accept the exchange.

a. APPLICATION : Argue pros/cons of accepting the exchange offer (prisoner’s dilemma) i. EX : Company A issued a $1,000 bond to investor. Company A is in financial trouble so it makes

an exchange offer seeking to switch the $1,000 bond with an $800 bond and the offer contains an exit consent (meaning the investor loses their covenants if they chose to keep the $1,000 bond). What should the investor do?

ii. Possible outcomes for the investor :

1. BEST OUTCOME : Reject the exchange offer and lose your original covenants in the indenture, but enough other investors accept the offer such that company A’s financial position improves and it can now pay the investor the full $1,000.

2. MIDDLE OUTCOME : Take the $800 exchange offer (haircut) with the original covenants (protections) agreed to. **RECOMMEND THE HAIRCUT – LEAST RISK**

3. WORST OUTCOME : Reject the exchange offer and lose your original covenants in the indenture, but enough other investors also think like you and don’t take the exchange. Company goes under and you get nothing.

b. CONCLUSION : Therefore, investor should (not) accept the exchange offer.

REDEMPTION AND CALL PROTECTION

SCENARIO: Company A issued a $1,000 bond to investor at 5% interest for a 30-year term. The indenture states that it cannot be paid back with money borrowed at anything less than 5%. Interest rates drop drastically, so Company A goes and borrows $1,000 from someone else at 1% and wants to pay off the original debenture right away. The investor wants to prevent this because if the bond is paid off, they will have to reinvest in someone at the current interest rates.

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IV. OVERARCHING ISSUE : Here, [Company A] originally issued a debenture to creditor. The indenture contained a provision that the debenture may not be redeemed with money borrowed at an interest rate less than the interest rate of the debenture. Therefore, the issue is whether the redemption violated this provision.

a. RULE : As the court held in Morgan Stanley v. ADM, if money borrowed at a lower interest rate is not comingled with other corporate funds, then the company can use those other corporate funds to redeem the bonds.

b. APPLICATION : Here…

i. RECOMMENDATION for Company: 1. Don’t indirectly use bad money (money borrowed at a lower rate) to facility the

redemption. Tell investor that company used “good” money to pay off the investor. a. EX : Company A has $1 million of good money and $1 million of bad money. It

needs $1 million for operating expenses. The company uses the good money to redeem $1 million of old bonds and uses the bad cash to pay for the operating expenses. Here, the company indirectly uses the bad money to facilitate the redemption because they would not be able to redeem the bond without the bad money.

2. Instead, issue shares of stock to get good money. Don’t comingle it. Then use the good money to pay back the debenture. Now you can get a new debenture at the lower rate.

c. CONCLUSION : Therefore, [company A’s] redemption did (not) violate the indenture.

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