Business Associations Outline



A principle is liable for the acts of his agent which are committed within the scope of his agency. Applies to sole proprietorship – simplest form of business organization.

Comes about by CONDUCT, not INTENT, of the parties

define agency relationship understand different legal concepts of authority issues of liability of agent & principle fiduciary duty distinguished from contract and arm’s length dealing

I. Introduction

R2d of Agency 1: The fiduciary relationship that results from the manifestation of consent by one person to another that the other shall act on his behalf, and subject to his control and consent by the other so to act.

R2d of Agency 13: An agent is a fiduciary with respect to matters within the scope of the agency.

1. Agreement (not necessarily a contract/parties do not have to intend to create such a relationship / Consent of parties (objectively manifested --may be implied) 2. A acts on P’s behalf 3. P exercises control over A

**Always ask: 1. Is there an agency relationship? (see 1-3 above) 2. What is its scope? (is the activity giving rise to liability within the scope of the agency)

II. Definitions

Principle—the one for whom action is taken Agent—the one who acts General Agent—one authorized to conduct a series of transactions Special Agent—one authorized to conduct a single transaction or series; no continuity of service Disclosed Principle – principle whose existence and identity are known to third persons Partially Disclosed Principle – principle whose existence but not identity is known to third party Undisclosed Principle—principle whose existence and identity are unknown to third party Master- employer; one type of principle Servant – employee; one type of agent Independent Contractor – one who contracts to do something for another but who is not a servant (not subject to direct control with respect to physical conduct); may or may not be an agent

1 Agency; Principle; Agent (1) Agency is the fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other to so act. (2) The one for whom action is to be taken is the principle. (3) The one who is to act is the agent.

7 Authority Authority is the power of the agent to affect the legal relations of the principle by acts done in accordance with the principle’s manifestation of consent to him.

8 Apparent Authority Apparent authority is the power to affect the legal relations of another person by transactions with third persons, professedly as agent for the other, arising from & in accordance with the other partys manifestation to such third persons.

8(a) Inherent Agency Power Inherent agency power is a term used in the restatement of this subject to indicate the power of an agent which is derived not from authority, apparent authority, or estoppel, but solely from the agency relation and exists for the protection of persons harmed by or dealing with a servant or other agent.

26 Creation of Authority: General Rule Except for the execution of instruments under seal or for the performance of transactions required by statute to be authorized in a particular way, authority to do an act can be created by written or spoken words or other conduct of the principle which, reasonably interpreted, causes the agent to believe that the principle desires him so to act on the principle’s account.

27 Creation of Apparent Authority: General Rule Except for the execution of instruments under seal or for the conduct of transactions required by statute to be authorized in a particular way, apparent authority to do an act is created as to a third person by written or spoken words or any other conduct of the principle which , reasonably interpreted, causes the third person to believe that the principle consents to have the act done on his behalf by the person purporting to act for him.

140 Liability Based Upon Agency Principles The liability of a principle to a third person upon a transaction conducted by an agent, or the transfer of his interests by an agent, may be based on the fact that: (a) the agent was authorized; (b) The agent was apparently authorized (c) the agent had a power arising from the agency relation and not dependent upon authority or apparent authority.

III. Authority

PRINCIPLE is liable to THIRD PARTY if A had actual authority, apparent authority, was an agent by estoppel, or had inherent authority, or if principle ratified the act.

AGENT is liable to THIRD PARTY T if no agency exists, also on common law tort misrepresentation theory (Implied Warranty of Authority). Agent is liable if P is undisclosed or partially disclosed (although P is also liable)

THIRD PARTY is liable to PRINCIPLE if Principle would b liable to third party, except the third party is not liable to an undisclosed principle if the agent or principle knew the third party would not have dealt with the principle.


1. Actual Authority Actual authority exists if P’s words or conduct would lead a reasonable person in A’s position to believe that the principle had authorized A to so act; binds P even if third party didn’t know authority existed or thought that A was P -Express- -Implied – (“sell my car” implies the authority to transfer title, give possession, maybe extand credit) – more common than express Scope: to the extent necessary to perform authorized acts

2. Incidental Authority (a type of implied actual authority) Authority to do acts reasonably necessary to the accomplishment of the authorized act. (??) Scope: to extent necessary to perform authorized acts

3. Apparent Authority Where A is apparently authorized by P’s word or conduct measured from the standpoint of a reasonable person in T’s position. “Ordinary habits of person in locality, trade, or profession” (ask: are disputed acts normal or “ordinarily incident” to authorized acts?) Scope: to the extent normally incident to authorized acts

4. Inherent Authority Authority that is not actual, apparent, or based on estoppel. EXISTS for the protection of T (acts still have to “usually accompany” or be incidental to authorized acts) if disclosed or partially disclosed, P is bound by acts of A if (1) act usually accompanies or is incidental to authorized transaction AND, (2) T reasonably believes A is so authorized if undisclosed P, no reasonable belief requirement (can be none) liability can attach even if acts are forbidden – test is T’s reasonable belief

5. Agency by Estoppel (R2d of Agency 8B) Where T has changed position because of a belief that A was authorized, when 1) P recklessly or intentionally caused the belief, or 2) P knew of T’s belief and knew that T might change position in reliance but did not reasonably try to inform T of the facts

6. Ratification P is bound by the acts of A if A purported to act for P and either: 1) P affirms conduct by manifesting intent to treat A’s acts as authorized (express ratification) 2) P engages in conduct that is only justifiable if P has such an intention (implied ratification)

7. Acquiescence if A performs a series of acts not objected to by P, consent to performance of similar acts in future

IV. Alternatives to Agency

1. Creditor/Debtor – To find agency there must be “management” Veto power is not enough – ask “how much control is exerted?”

2. Buyer/Supplier – ask: (1) does supplier receive a fixed price? (2) does supplier act in his own name and receive and thereafter transfer title to property?, (3) does supplier have independent business buying & selling – other customers?

See Jensen Farms v. Cargill. Critical question is degree of control.

3. Contract – no fiduciary relationship; only arm’s length contract duties.

V. Fiduciary Duty


RULE: An aggrieved P may recover from a breaching A: 1) any damages sustained as a result of breach 2) any benefit received by P in the course of the agency

Very serious duties; breach of fiduciary duty = breach of trust A may not profit from his position as P’s agent Even if P is not injured he is entitled to all benefit gained by A

VI. Business Associations Cases on Agency

Jenson Farms Co. v. Cargill, Inc (Sup. Ct. Minn, 1981). Casrgill laons $ to Warren’s business & later intervenes in a paternalistic way. A creditor who assumes control of debtors business becomes liable as a principle for the acts of the debtor. Court finds on agency—emphasized degree of control. Fixed price – acts in own name—has independent business. More like buyer/supplier or creditor/debtor—but this is Minnesota! Farm state – protect farmers interests.

Tarnowski v. Resop (Sup. Ct. Minn, 1952) Agent represents juke box business & misrepresents facts to take a secret commission. If an agent receives a benefit as a result of violating duty of loyalty, the principle is entitled to recover what he has received plus damages. (Restatement of Agency §407(1)) Agency is fiduciary relationship

Nogales Service Center v. Atlantic Richfield (Ct. of Appeals, AZ, 1980) Oral agreement to lend $100,000 for construction of at the truck stop& across the board discount. . . Then, in reliance they used own money to contruct. The loan was approved, but the discount was not. Inherent agency power is best defined by looking at this case – it is sometimes just fairer that the risk of loss should fall upon principle rather than 3rd party. Inherent authority can make the principle liable for conduct which he did not desire or direct when (1) a general agent does something similar to what he is authorized to do but in violation of orders, (2) when agent acts purely for his own purposes in an action which would be authorized if motives were proper, or (3) when agent is authorized to dispose of goods & does so in the wrong way.


I. Introduction

California Corporations Code §16100 et seq serves as statutory source governing California general partnerships. = California Uniform Partnership Act of 1994 – applies to all partnerships whether or not they were created before or after the date of this act. *Sometimes referred to as RUPA b/c it is similar to the national standard version (Revised Uniform Partnership Act).

A partnership is an association of two or more persons to carry on a business as co-owners for profit. (a partnership cannot be formed for non-profit purposes.) A more complex form than agency Joint venture—assoc. of two or more usually agreeing to share profits. More limited than partnership – usually for single transaction & not he complete business of individuals involved. RIGHTS & LIABILITIES ARE SAME AS FOR P-SHIP.

II. Formation

A partnership is a voluntary association. Must find express or implied agreement in order to find formation. 1) duration – if no term is specified, p-ship is terminable at will of any partner 2) capacity to become partner – must have capacity to contract. 3) consent of other partners – a prospective partner must have the consent of other partners. (UPA §18(g) – Calif § _____) 4) Intent of parties – intent of parties is determined from all circumstances (including sharing of profits of bus.—see UPA §7 and Calif. § ______) --- ask: will a community of profits be shared?

III. Legal Nature of P-Ship (UPA/RUPA) A p-ship is treated both as a separate entity of the partners and also as merely an aggregate of individual partners. For example, partners are jointly & severally liable for the obligations of the partnership (UPA §15 and Calif. § ____) but for federal income tax, the income & losses of p-ship are attributed to indiv. partners. Entity – p-ship can generally sue or be sued and can hold property in name of p-ship.

IV. Management of P-Ship Equal Share. All partners have equal share in management (even if sharing of profits is unequal) (UPA § 18(c), Calif. § _____) Profits & Losses – each partner in absence of agreement, shares profits & losses equally (UPA §18(a) & Calif. §____)  Salary – no partner is entitled to acting in the partnership business unless there is an agreement to the contrary  Obligations. Each partner is liable to partnership creditors IN FULL. But between partners each is liable only for his share of partnership obligations. (If one partner pays off obligation, he is entitled to indemnification from other partners) UPA §18 and Calif. § ____.

V. P-ship Finance/Distribution Limitations

*Partners may agree to share profits or losses. “Loss or gain at liquidation”

“capital accounts” = internal bookkeeping of ownership interests for p-ship. Its only among partners, not regarding the rest of the world. Capital accounts are adjusted according to the pro rata contribution of partners. “Draw” reduces a partners capital account. Each partners capital account goes up with profits, down with losses.

*Capital requirements may be changed by agreement or under terms of the agreement. The agreement may require periodic capital contributions

If you don’t agree then statute kicks in – you split evenly. See 16401. You agree as to what capital accounts are worth. Two partners put in capital assets. Decide what capital assets are worth. At dissolution each gets capital investment back. then, in absence of agreement, they split the rest 50/50 – regardless of what capital investments of each were!

VI. Authority/Liability

1. Every partner is an agent of the partnership for the purpose of the business and the act of every partner binds the partnership. . . unless partner has no authority to act in that matter & person he is dealing with knows it. (UPA 9(1) 2. Rules of Agency Apply – that is any K made by partner on behalf of p-ship which is related to basic business is within apparent authority & is binding. 3. Contract: Partners are jointly but not severally liable on all partnership debts and contracts. (UPA §15(b) and Calif. § ____) Creditor cant sue just one partner, and if that happens, the partner can join others as necessary parties. 4. Tort: Partners are jointly and severally liable on torts & breaches of trust injuring 3rd parties. (UPA §15(a) and Calif. §_______). 5. Partnership property – (UPA §8(1) and Calif. § _____) 6. Partners interest in partnership is her share of profits and surplus, which is personal property. (UPA 26)

VII. Fiduciary Duty highest obligation of loyalty is due to partners this includes an obligation not to usurp opportunities

VIII. Dissolution & Winding Up

1. Dissolution of a partnership does not mean termination, partnership continues until all affairs are wound up. (UPA 30) 2. Distribution of assets: Debts are paid first then capital accounts are applied to pay the partners their capital accounts—capital contributions + accumulated earnings – accumulated loss) If anything is left the partners receive their agreed share of current partnership earnings Distributions in kind – partnership assets can be sold or distributed to partners in kind. Liabilities—where liabilities exceed assets the partners must contribute their agreed shares to make up the difference.

IX. Statutory Language

16101. Definitions. As used in this chapter, the following terms & phrases have the following meanings: (1) “Business” includes every trade, occupation & profession. (7) ”Partnership” means an association of two or more persons to carry on as co-owners a business for profit formed under §16202, predecessor law, or comparable law of another jurisdiction, and includes for all purposes of the laws of this state, a registered limited liability partnership (8) “Partnership Agreement” means the agreement, whether written, oral or implied, among the partners concerning the partnership, including amendments to the partnership agreement.

16103. Partnership agreement; limitations

Relations among the partners and between the partners and the partnership are governed by the partnership agreement. To the extent the partnership agreement does not otherwise provide, this chapter governs relations among the partners and between the partners and the partnership. Partnership agreement may not: vary rights & duties under 16105 unreasonably restrict right of access to books and records eliminate duty of loyalty (except may identify specific types of activities that do not violate duty of loyalty, or all partners may ratify a specific transaction) Unreasonably reduce duty of care Eliminate obligation of good faith & fair dealing vary the power to dissociate as a partner vary the right of court to expel a partner vary the requirement to wind up the partnership business restrict rights of third parties vary the law applicable to a registered limited liability partnership.

16202. Formation of partnership; rules (a) . . . the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership. (b) as association formed under a statute other than this chapter, a predecessor statute, or a comparable statute of another jurisdiction is not a partnership under this chapter (c) in determining whether a partnership is formed, the following rules apply: 1) Joint tenancy etc. does not = partnership even if coowners share profits made by the use of the property 2) sharing of gross returns does not itself establish a partnership 3) A person who receives a share of the profits of a business is presumed to be a partner unless profits were received in payment of a debt, in payment for services as an indep. contractor, in payment of rent, in payment of an annuity or retirement benefit, in payment of interest or other charges on a loan, or in payment for sale of the goodwill of a business.

§16301. Partner as agent of partnership (1) Each partner is an agent of the partnership for the purpose of its business. An act of a partner, including the execution of an instrument in the partnership name, for apparently carrying on in the ordinary course the partnership business or business of the kind carried on by the partnership binds the partnership, unless the partner had no authority to act for the partnership in the particular matter and the person with whom the partner was dealing knew or had received a notification that the partner lacked authority. (2) An act of a partner that is not apparently for carrying on in the ordinary course the partnership business or business of the kind carried on the partnership binds the partnership only if the act was authorized by the other partners.

§16306. Joint & several liability; personal liability; registered limited liability partnerships (a) . . . all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law (b) a person admitted as a partner into an existing partnership is not personally liable for any partnership obligation incurred before the persons admission as a partner. (c) . . .

§16401. Partner accounts; share of profits; reimbursements; conduct of partnership business; becoming a partner Each partner deemed to have an account which is credited and debited with the assets/liabilities of the partnership. Each partner entitled to an equal share of the profits of the partnership. etc. see page 461

§16404. Fiduciary Duties (a) the fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care set forth in subdivisions (b) and (c) (b) A partners duty of loyalty to the partnership and the other partners includes all of the following: (1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the p-ship business or derived from a use of p-ship property or information (including the appropriation of a p-ship opportunity (2) To refrain from dealing with the partnership in the conduct or winding up of the p-ship business as or on behalf of a party having an interest adverse to the p-ship. (3) Refrain from competing with the p-ship. . . (c) A partner’s duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law.

§16807. Application of assets; settlement of accounts; partner contributions (p. 467) (a) in winding up. . . the assets of the p-ship including the contributions of partners. . shall be applied to discharge its obligations to creditors (b) each partner is entitled to a settling of p-ship accounts upon winding up the p-ship business. (c) Etc. . .

Business Association Cases on on Partnerships

Martin v, Peyton (NY Ct. of Appeals, 1927) Implied partnerships. Complicated lending arrangement for the loan of securities; lender exercised veto power over business decisions, required life insurance for borrower w/lender as beneficiary, had option to join firm by purchase of 50% of assets. Held: not a partnership; terms not comprehensive enough. Lambert: must be more of a control relationship. (sharing of profits is considered but is not determinative, nor is language saying no partnership is intended. In this case all features are consistent with a loan agreement).

Lupien v. Malsbenden (Sup. Ct. of Maine, 1984) Malsabenden was sued on a contract he made with Cragin (not a party/disappeared) for a Bradley kit car, alleged that Malsbenden was a partner with Cragin and therefore liable on the p-ship debt. Held: He is a partner, in spite of his contention that he was only a lender. Community of profits to be shared. Remember that the formation of a p-ship is objectively measured. We don’t care what, if anything, Malsbenden thinks. *Rule= if you want to escape partner liability don’t involve yourself in the daily operation of the business and don’t agree to share in profits.

Summers v. Dooley (Sup. Ct. Idaho, 1971) All partners have equal rights in management even if profit sharing is unequal. Two partners had garbage business; one hired an employee. Paid for it with his own funds & sued for reimbursement from p-ship funds for half of the wages. In a two person partnership can one person, over the objection of the other, take action that will bind the partnership? No. Must be decided by a majority of the partners.

Meinhard v. Salmon (NY Ct. of Appeals, 1928) Duty of loyalty. Joint venture (co-adventurers) for lease of commercial property-hotel, one negotiated a new lease near the end of the first lease term. Held: breach of fiduciary duty. Co-adventurers owe each other a duty of undivided loyalty, includes a duty of disclosure of opportunities. Managing co-adventurer under a heavier duty. Essentially an agency relationship. DISSENT: this is a joint venture, not a genl’ partnership. Limited purpose, not violated by execution of a new lease. Lambert: disclosure or consent of co-adventurer would have saved him. Fiduciary duty is the glue that holds this all together.


I. General

Limited Partnerships are entities created by modern statutes. developed to facilitate commercial investments by those who want a financial interest but do not want the responsibilities or liabilities of partnership prior to 1976 – most states had (ULPA Uniform Limited Partnership Act) 1976—RULPA (revised. . .) California Corporations Code §15611 et seq

II. Definitions

Definition: A limited partnership is a partnership formed by two or more persons and having as it members one or more general partners and one or more limited partners. General Partner -- assumes management responsibility & full personal personal liability for debts of the p-ship. Limited Partner—makes a contribution of cash, other property, or services & obtains an interest in the p-ship in return, but is not active in mgmt & has limited liability for p-ship debts. (RULPA 303(b). . .) Limited Liability – a limited partner’s liability is limited to the amount they put in. Max loss= loss of investment. If a limited partner takes part in management, he becomes liable as a general partner.

III. Formation

 Formalities are required. (1) must execute a certificate that states name of p-ship, character of bus., location of principle office, name, address & capital contrib. of each partner, designation of which are limited & which are gen’l., etc. (2) copy of cert. must be recorded in the county of the principle place of business

IV. Statutory

§15611. Definitions (n) “General partner” means a person who has been admitted to a limited partnership as a general partner in accordance with the partnership agreement or pursuant to §15641. (t) “Majority in interest of all partners” means more than 50 percent of the interests of all partners. etc. see page 421-422

§15621. Partnership agreement; certificate etc. (a) in order to form a limited partnership the general partners shall execute, acknowledge & file a certificate of limited partnership. . . etc. see page 424

§15632. Liability. (a) a limited partner is not liable for any obligation of a limited p-ship etc. . . see page 429.


I. General

LLC = a non corporate business that provides its owners (members) with limited liability and allows them to participate actively in the entity’s management (Keatinge)  part corp/ part partnership Started in Wyoming – 1977 California Corps Code §17000 et seq

II. Definitions member – owner of an interest in an LLC and a party to the contract known as the operating agreement  operating agreement – agreement among members as to the rights and duties  articles of organization—a filed document that create the LLC member-managed – members have statutorily granted agency and the authority to make management decisons manager-managed – members are not agents of the LLC, and only have the authority to make major decision, and managers (which are not necessarily members) have the authority to make most ordinary managment decisions.

III. Formation IV. Statutory

§17000. -§17700. See page 485.


I. General

Accountants & Lawyers

II. Definitions III. Formation IV. Statutory


I. General

Calif. Corps Code §100 et seq II. Deciding Whether to Incorporate

Corporations have five substantive advantages and a tax attribute: 1) limited liability (shareholders are not liable—managers also are treated as agents of the corp, not as principles) 2) free transferability of ownership interests (vs. p-ship interest which cannot be transferred without consent of all partners, equity ownership of company can be freely bought & sold.) 3) continuity of existence (perpetual unless they state otherwise in cert. of incorp.) 4) centralized management (all partners have right to participate in mgmt, but in a corp. B/D manages, and s/h has no right to participate in mgmt.—s/h has no power to bind corp.) 5) entity status (under RUPA partnerships are also treated as entities). 6) taxation of the enterprise at the entity level.

Corps tend to be more costly to form & maintain than other forms Subchapter s corps

1. Compare To PARTNERSHIP A partnership is in some ways treated as a sep. entity (sue & be sued & own property) Normally NOT treated this way however—treated as an aggregate of separate partners joint venture is like a partnership for a short term project or investment

2. Compare to JOINT STOCK COMPANY joint stock companies were used to avoid state restrictive regulation of corps. Large #’s of partners who were issued shares – and subject to personal liability for debts of company (unlimited) Most states now treat any bus. assoc. that operates like a corp. as a corp.

3. Compare to BUSINESS TRUSTS business trust—run like any other trust

4. Compare LLC 5. Compare to LLP 6. etc. . .

III. Formation

A legal entity that comes into existence by compliance with statutory requirements of the state where it is incorporated.  Articles of Incorporation (or certificate of Inc.) usually contains: (1) corporate name (2) Corporate purpose (any “lawful purpose”) (3) Specific business (4) Principle office & agent for service of process (5) Number of directors (original directors must be named) (6) Capital structure. --types of shares (voting/nonvoting, preferred/common), par or no par value for each, number of shares authorized for each class, a statement of the preferences, privileges and restrictions of each class. (some states require that corps begin with a minimum amount of capital). (7) preemptive rights (8) power of assessment (9) other provisions Original directors (called incorporators) must sign & acknowledge the articles

Filing. Copy of articles must be filed with the secretary of state.

Corporate existence—begins when the articles are stamped as filed in the secretary of state office. The Organizational Meeting. As soon as articles are filed the B/D must meet to: (1) resignation of incorporators & election of directors (2) election of officers (3) adoption of bylaws (duties of officers, meetings to be held by directors and s/h’s, where corp. records will be kept, regulate issuing shares. (4) authorization to issue shares and other matters—bank account, leases of property, etc.

Operating outside state of incorporation. States usually require foreign corps doing business in the state to register, pay a fee, and name an agent for service of process. Can include criminal penalties etc.

IV. Pre-incorporation Transactions by Promoters

In the course of forming the corporation, promoters often contract for products or services on behalf of the corporation (not yet formed).

General Rule on Promoter Liability: If the promoter contracts in the name of and solely on behalf of the corporation to be, the promoter cannot be held liable if the corporation is never formed. If the promoter contracts in his own name, then the promoter may be held liable and may enforce the contract. The tough cases are the ones where both the promotor’s name and th name of the corporation appear. Here court attempts to determine “intent” of the parties.

strong presumption that parties intend to deal with existing persons however, if other party intended to look solely to corporation for satisfaction, then there is no promoter liability

Goodman v. DDS (Darden Doman & Stafford Associates) Supreme Ct. of WA en banc, 1983 Goodman sold property to DDS (gen’l partnership), made contract for renovation. Contract was between DDS and corp “in formation”. The promoter is personally liable even if the contract is to benefit future corp that isn't formed yet. EXCEPTION: if other party agreed to look solely to corp. for satisfaction. Burden of proving that parties intention is solely on the promoter.

V. Defective Incorporation

General: becomes an issue when one or more of the formalities of incorporation are omitted or performed improperly & creditor wants to hold shareholders liable by disregarding the corp. entity.

1) de jure corporation – a corporation which has complied with all the mandatory provisions of inc. cannot be attacked by any party (even the state) 2) de facto corporation – there is a body of common law which indicates that even in where a corp. has not complied with all the mandatory requirements, it may have complied sufficiently to be given corporate status vis-à-vis 3rd parties (although not via the state). Good faith attempt to comply good faith actual use of business as though a corp. existed. 3) states have eliminated the question by statute – if the articles are stamped by the secty of state there is a corp. 4) corporation by estoppel – Where a corp. is not de jure or de facto, its existence as a corp. can be attacked by any third party. However in some cases the attacking party is estopped.

Cantor v. Sunshine Greenery, Inc. (Superior Ct. of NJ, 1979) De facto corp. status. Cantor brought action for breach of a lease against Sunshine Greenery & Brunetti (had signed lease as pres of Sunshine). Ct. held there was a de facto corp. at the time of making of lease so that Brunetti could not be held personally liable. (not a de jure corp. b/c articles were filed 2 days after lease, but act of executing were enouh to find a de facto corp.)

Timberline Equipment Co. v. Davenport (Oregon, 1973) De facto corp. does not exist in Oregon. Orgeon Business Corps Act precludes the existence of de facto corp.—corps only exist when articles are issued. Ct. does not decide whether corp. by estoppel still exists b/c the p dealt with D as a partnership not as a corp.


I. General 1) Limited Liability Rule: Corporation is a separate entity from shareholders. Corp. incurs debts & obligations of its own which are not the responsibility of the owner/shareholders (and s/h’s debts are not corps responsibility) 2) Exceptions: in exceptions the court is said to “pierce the corporate veil” and to dissolve the distinction between corporate entity and shareholders so that s/h’s can be held liable as individuals (a) Fraud of Injustice – if maintenance of corp. as a separate entity results in fraud or injustice to third parties (creditors etc.) (b) Disregard of corporate requirements – if shareholders have disregarded the corporate form then it is really the alter ego of the individuals and it is for their benefit not the corps. (examples – so-mingling of money, corp. meetings not held, records not kept, etc.) (c) Undercapitalization – If corporation is undercapitalized given the liabilities, debts & risk it reasonably could be expected to incur. (Walkovsky v. Calton) (d) requirement of fairness. – the veil may also be pierced in any other situation where it is only “fair” that the corp. form be disregarded. Two ways to characterize after veil is pierced: 1) individual shareholder 2) “entity enterprise” theory (companies must be instrumentalities for carrying on business without imposing burden of financial or other liabilities). When considering this type of piercing, remember the entity you are imposing liability on consists of BOTH investors investments and creditors claims.

Voluntary vs. Involuntary creditor: Contract vs. Tort. major difference is that in contract cases the plaintiff has an opportunity in advance to investigate the financial resources of the corporation and has then chosen to do business with it. Therefore the intent & knowledge of the risks assumed are factors to considered in deciding whether corp. veil should be pierced. Can argue that courts are more inclined to pierce w/ involuntary creditors. But also argue the “social costs” of piercing—if you allow piercing here the K creditors will be screwed & then they won’t lend.

Piercing (regular) 1) allege that businesses were being run in the individual capacity or that they were commingling funds or acting in disregard of corp. entity

Piercing (Alter ego): 1) unity of interest and ownership 2) inequitable result will follow if not pierced

(3) OPTIONAL prong on Kinney – can they be charged with knowledge—did they assume the risk and should have known better? (Laya holding – this is optional except in cases of institutional lenders . . .)

II. Subordination of s/h claims

an alternative to the piercing doctrine in contract situations when corp. becomes insolvent & s/h are debtors of corp. subordinate claims of shareholders to the claims of other creditors less drastic than piercing corp. veil usually arises in the event of reorganization or liquidation pursuant to receivership or bankruptcy proceedings an equitable remedy awarded where there has been bad faith by the s/h-creditor, mismanagement of assets, or under capitalization

III. Statutory

Uniform Fraudulent Transfer Act (page 952, white book)

California Corps. Code §500: California Corps. Code §501:

CCC §208: Legislative overruling of Ultra Vires Doctrine


Walkovszky v. Carlton (Ct. of Appeals NY, 1966) Undercapitalization/ taxis/ tort liability. Pleading case. Walk was injured in an accident with a cab. P sued the cab driver, the corp. owning the cab, and Carlton who owned the corp and nine others (each corp. had two cabs with the minimum liability insurance). Compliant alleged that the corps operated as a single entity & constituted a fraud on the public. Court held that P has no cause of action – there is nothing wrong with running a corp as part of another corp, what you have to allege is that there has been a disregard of corp. formalities & business is being carried on for personal purposes rather than corp. Says having min. insurance is not undercap. b/c state legislature should make min. higher if that is the case. YOU HAVE TO PLEAD SOMETHING MORE THAN THAT THE CORP. IS OPERATING AS ONE ENTERPRISE IN ORDR TO GET AT A SHAREHOLDER. FRAUD OR PERSONAL INVOLVEMENT. DISSENT: says it is undercapitalized.

Minton v. Cavaney (Supreme Ct. of Calif en banc, 1961) Active participation by the shareholder-attorney for Seminold co. (which leased a swimming pool). Minton’s daughter drowned in the pool & got a $10,000 judgment against Seminole which could not be paid (lack of assets). P sued D’s estate. D was a director/officer of Seminole but was not active in its affairs. Seminole never had any assets and though organized as a corp. never functioned as one. Question is whether the attorney who participates in affairs of corp, serves as officer/director/shareholder, be personally liable if the veil is pierced? Ct. says yes. Dissent says no—he was merely practicing law in helping them to form the corp. Requires: 1) unity of interest & ownership 2) inequitable result will follow if not pierced Unity = has to be inconsistent with treating corp. as a separate entity. (personal bills with corp account,add/w/d capital at will, holding self out as personally liable, inadequate capitalization)

Kinney Shoe Co. v. Polan (4th Circuit, 1991) Kinney leased its property to Industrial Realty Co. whose sole shareholder is Polan. Industrial subleased a portion to Polan Industries also held by Polan, for 50% of lease price. Industrial’s only income was rent payment from Polan. Industrila breached, Kinney obtained j-ment. Polan Indust. has filed for bankruptcy. Pierce veil to get atPOlan’s assets? Held yes. Test used— 1. unity of interest & ownership? 2. inequitable result if piercing not allowed? 3. optional prong. can Kinney be charged with knowlegde? Did Kinney assume the risk if Industrial’s default? (he should know!)

Sea-Land Services Inc. v. Pepper Source (7th Circ. 1991) Marchese (Pepper Source) owned 5 businesses, all inadequately capitalized, took money from all of them whenever he wanted, didn’t pay taxes, didn’t pay Se-Land. One company was co-owned by someone else. “Marchese’s playthings”. Sum, j-ment granted by trial court, holding all entities and Marchese liable. Reversed by 7th Cir. “reverse piercing” – you get to Marchese in order to get tp other corps. But you cant get anything from other corps until their own creditors are paid. – he is a s/h in them, so if you get his assets you get his shares, and it is your responsibility to get the other creditors paid. . .

Part 1 of test satisfied. (four subparts to determine unity of ownership & interest): 1. adequate records kept 2. commingling of funds 3. undercapitalization 4. one corp. treats assets of another as its own Part 2 is still a question of fact (must show that failure to pierce would sanction a fraud or promote injutice). Insufficinet factual showing of fraud or injustice. Must be some “additional wrong” beyond creditor’s inability to collect.

After remand ct. finds additional wrongs: 1) unjust enrichment 2) illegality of certain transactions, abuse of corp. entities, use as “playthings” CORPORATE STRUCTURE/ ALLOCATION OF POWER

I. Rights of Shareholders in Mgmt

1. shareholders have no direct power over the management of the corp. 2. they do have indirect control by: ownership allows them to remove/replace directors some recent decisions have said that transactions entered into by all shareholders are valid even without director ratification

Major issues w/ respect to shareholders: 1. when must s/h approval of corporate actions be secured? 2. when might the directors ask for such approval as a matter of policy 3. When may shareholders initiate corporate action?

* transactions “not in the ordinary course of business” require s/h approval: 1. election & removal of directors – “for cause” (otherwise vacancies on the board are filled by other members of the board) 2. bylaws – adopted by directors in the organizational meeting but can be changed by s/h or directors 3. organic changes – merging or consolidating, selling corps. assets or dissolving it, or by reducing capital or amending cert. of inc. 4. amendments to charter -- 5. other matters 6. initiation

***Management of the corp. is the duty of the directors. (Charlestown Boot & Shoe)

The Role of Officers & directors: 1. Management function – business concept & legal concept—does not man what you think it means – directors are responsible for management in the sense that they are an overall supervisory body. 2. Routine day to day management = officers 3. inside vs. outside directors

Formalities required by shareholder action The law regards shareholders as the owners of the corporation, the object of management’s fiduciary duty and the ultimate source of corporate power. Two ways to exercise this power: 1. the vote 2. the derivative suit

II. Analysis

When you want to attack board action: 1. is it something that requires shareholder approval? 2. is there a full and fair disclosure of all material facts? 3.

III. Statutory

CCC §300: Powers of the Board; delegation; close corporations; shareholders agreements; validity; liability; failure to observe formalities (page 25) Subject to the provisions of this division and any limitations in the articles relating to action required to be approved by the shareholders (section 153) or by the outsnading shares (section 152), or by a less than majority vote of a class or series of preferred shares (section 402.5) the business and affairs of the corporation shall be managed and all corporate powers shall be exercised by or under the direction of the board. The board may delegate the management of the day-to-day operation of the business. . . to a management company or other person. ..

Del Corp Code §141

CCC §152: Approved by (or approval of) the outstanding shares . . . means the affirmative vote of a majority of the outstanding shares entitled to vote.

CCC §153: Approved by (or approval of) the shareholders means the affirmative vote of a majority of the shares represented and voting at a duly held meeting which a quorum is present. . .

CCC §212: Bylaws, contents CCC §303: Directors, removal without cause CCC §304: Removal for cause; shareholders suit CCC §305: Filling of vacancies; resignation CCC §309: Performance of duties by director (see section below) CCC §708: Cumulative Voting

IV. Cases

Charlestown Boot & Shoe Co. v. Dunsmore (New Hamp. SC 1880) Charlestown sued two of its directors for refusing to work with Osgood (who they appointed to liquidate company). they sue for losses allegedly cause d by their failure to act & by not insuring buildings that burned down. Holding: that state law appoints the directors to manage the corp. Unless articles, bylaws, or state law says otherwise directors are responsible for management, officers work under their direction. Shareholders action was outside the legal structure of corp. management. The duties of a director are LOYALTY and DUE CARE (that’s all). Auer v. Dressel (Ct. of Appeals, NY, 1954) A stockholder sued to compel the president to call a special meeting of the Class A shareholders. The bylaws provided that the pres. must call a meeting when requested by a maj. of the voting stock. 55% asked for the meeting. Members of this class were entitled to elect 9 of 11 directors. 4 had changed sized & voted Auer out of president. Purpose of meeting is to pass resolution asking that fired pres. be rehired , amend articles & bylaws so that vacancies on the board would be filled by stockholders of the class which the removed dierctor represented, hear charges against the four disloyal directors in order to remove them, & amend the bylaws so that a quorum is 50% of all directors. Rule: president may not refuse to call a meeting for tshe purposes above. Purposes= proper. Stockholders who elect directors have an inherent right to remove them for cause.

Schnell v. Chris-Craft Industries, Inc. (SC Del. 1971) “Inequitable conduct”. Action by dissident shareholders to enjoin the managing directors from advancing the date of the annual s/h’s meeting (by amending the bylaws—new Del law allowed them to do this) in order to gain an advantage in a proxy contest. Held: even though legally permissible, this is not an equitable exercise of the powers of the managing directors. “Inequitable action does not become permissible simply because it is legally possible. Furthermore management attempted to conceal this action as long as possible.

Unocal Corp. v. Mesa petroleum (SC Del. 1985) This case legitimized a share offer that excluded a shareholder—the concept of treating one share different than another. Pickens proposed a cash buyout of shares – ad in Wall Street Journal (tombstone) and caused a merger of target company and all common stock would be cancelled. Selective treatment of shareholders—you want to price high so that people tender stock, and high enough that you don’t attract competing bidders (if you go to broker each day—you just drive the price of stock up and make it harder for yourself to acquire it). 13%--open market purchase 37%-tender offer for cash at end of day 49% is not bought. . .SEC says that if everyone tenders you have to buy all of it on pro rata basis (if you buy 50% of company, you have to buy 50% of everyone’s stock) When Unocal is merged into Mesa, rest of people get junk bonds and get share for share stock in new company.

Blasius Industries Inc. v. Atlas Corp. (Chancery, Del., 1988) Shareholder franchise. Atlas Corp’s charter allowed a maximum of 15 directors but less sitting under current bylaws. 9% shareholder Blasius Industries (the signle largest shareholder) had submitted a consent statement that (1) adopted a precatory resolution recommending a “leveraged recapitalization” of the company, (2) amendment of the bylaws to expand the board to 15, and (3) electing 8 new directors to give Blasius control of the board. In response the board amended the bylaws to allow two new directors, and appointed two new directors. Issue is whether the board acting in good faith for the benefit of the corp may act to prevent the shareholders from electing a maj. of directors? Held that the action even though taken in good faith in response to a perceived threat interferes w/ shareholder franchise & is thus impermissible. Where the board acts deliberately to thwart a shareholder vote, it is not per se illegal or invalid, but the board must show a competing justification for doing so. (the business judgement rule wont save you) It has to be a good reason though (here they thought they were saving the corp and it wasn’t good enough). Here, no bad faith, no breach of loyalty, no breach of due care. . . just that board invaded s/h’s realm.

Stroud v. Grace (SC Del. 1992) Shareholder ratification. Milliken Industries a privately held Del Corp. was owned by the Milliken family, had 200 shareholders total. Board implemented the shareholder approved amendment to the Certificate of Incorporation (this is always required for amendments to the certificate, but bylaws can be adopted if not prohibited by the certificate. held: in the absence of fraud, waste or inequitable conduct, a fully-informed shareholder vote ratifies even a voidable transaction. Even a sloppy or disinterested board action may be ratified, and the effect of the ratification is to shift the burden to P to prove fraud, waste, or inequitable conduct. here P could not prove that the shareholder vote was not “fully informed.”

Williams v. Geier (SC, Del., 1996) Recapitalization plan changed voting rights of shareholders, included tenure voting provision which granted multiple votes to existing shares which are lost if shares are transferred. Court of Chancery held that Unocal applied and that this was a Reasonable response to a perceived threat etc. On appeal they argue that it should have been analyzed under Blasius (b/c of s/ h franchise) and also that analysis under Unocal was wrong. Held: Neither Blasius nor Unocal applies because there was no unilateral board action. (there was stockholder approval). Stroud applies here. Clarifies the holdings of previous cases: Blasius: (“compelling justification standard”) applies where a board acts for the primary purpose of preventing or impeding shareholder vote Unocal: (“Reasonableness standard”; sort of intermediary scrutiny – its less that intrinsic fairness but more than the rational basis of the BJR)—where board acts in response to a perceived threat, there is at least the appearance of conflict of interest, the burden is on P to show by a preponderance of the evidence that the board acted to perpetuate itself in office, or some other breach such as fraud, overreaching, lack of good faith, or being uninformed. If not met the court will not substitute its judgement for the board’s. Both Blasius & Unocal involved unilateral board action, Williams v. Geier does not. Here vote approving recapitalization & tenure voting was fully informed, and the boards actions are protected by the BJR, therefore s/h vote was valid & operative. No disproportionate benefit to majority shareholders, no showing that board was trying to perpetuate itself in office, no violation of fiduciary duty by the board. Only a showing of breach of fiduciary duty of the board can rebut the presumption of the business judgment rule. Burden is one the party relying on shareholder approval to prove that it was informed and without fraud, but if it is shown, the burden shifts to plaintiff to prove unfairness. (Lambert: this case is an extension of Stroud). Shareholders may vote their own economic interests so long as they don’t breach any fiduciary duty to minority shareholders in doing so. Majority of minority vote only required in interested director transactions. Compare to controlling majority shareholder cases. . .

General Datacomm Industries, Inc. v. Wisconsin Investment Board (Chancery, Del. 1999) By-law says they will never reprice a stock option. ???


I. General

One of the fundamental fiduciary duties of directors owed to the corporation – enforcement usually through a derivative suit (action on behalf of corp. by indiv. s/h)

Includes: 1) Duty of good faith 2) Duty of reasonable care (duty to make inquiry (Bates v. Dresser) 3) Business judgment (a director acting in good faith is only liable for gross negligence or worse)

Analysis: 1) is there self interest or fraud? 2) was due care exercised? 3) apply BJR when it is a business decision (no issue of s/h franchise)

II. Business Judgment Rule

The business judgment rule is a presumption that in makinga business decision the directors: 1) acted in good faith 2) in honest belief that action was in best interests of corp. (shareholders) 3) and were informed in their decision (reasonable inquiry, RPP in similar circumstances standard)

*Burden is on the party challenging the decision to rebut this presumption by showing fraud, oppression, arbitrary action, or breach of good faith. see Kamin v. American Express

III. Standard of Conduct under BJR

see page 602 Standard of Conduct – standard of conduct applicable to directors is as above (good faith, best interests, care of an OPP--informed) DUTY OF CARE & LOYALTY Standard of Review – must be grossly negligent in doing the standard of conduct (BUSINESS JUDMENT RULE)

see Van Gorkom – more like regular negilgence than gross negligence???

IV. Statutory

Calif. §309: Performance of duties by director; liability (a) A director shall perform the duties of a director. . . in good faith . . . in a manner director believes to be in best interests of corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person would use under similar circumstances (b) In performing the duties of director. . . director shall be entitled to rely on information, opinions, reports or statements, including financial statements or other financial data prepared or presented by: (1) one or more officers or employees of the corp director believes to be reliable and competent, (2) counsel, independent accountants or other persons as to matters within professional expertise, (3) a committee of the board upon which director does not serve, so long as there is good faith, reasonable inquiry (c) a person performs the duties of a director shall have no liability. . . (also see 204(a)(10) – provisions of articles may limit or eliminate liability)

Del. §141

Calif. §204(a)(10): Articles of incorporation (optional provisions) Provisions eliminating or limiting the personal liability of a director for monetary damages in an action brought by or in right of the corp. for breach of a directors duties to the corp and s/h’s as set forth in §309 provided that such a provision must not eliminate nor limit the liability for acts of omissions that involve: 1) intentional misconduct 2) knowing or culpable violation of law 3) that director believes to be contrary to best interest sof corp. or s/h’s 4) absence of good faith 5) director derived improper personal benefit 6) reckless disregard for duty 7) unexcused pattern of inattention

Del. §102 (b)(7) Certificate may contain provision limiting or eliminating personal liability of director for breach of fiduciary duty but not for: 1) breach of loyalty 2) acts/omissions in bad faith or intentional violation of law 3) unlawful payment of dividends 4) improper personal benefit. (Delaware is loser, less specific than CA – no “reckless disregard”)

V. Substance v. Process in Duty of Care

BJR gives wide latitude to substance of decision if the process is proper.

Process: preparing to make a decision, general monitoring, follow up --- governed by standard of reasonability

Substance: standard of rationality/ BJR

VI. Cases

Smith v. Van Gorkom (Del, 1985) Van Gorkom, chairman & CEO of Trans Union is approaching retirement and wants to cash out. Wants to take $55 for his shares (75,000) Pritzker offers $55/share for the whole company in leveraged buyout. ($55 was friendly offer -- more than shares going for on market – but evidence that “true value” was higher—like $65) After much hurry up pressure from Van G. the deal is closed over the objections of the CFO. Nobody has read agreement – but board approves and s/h’s ratify with 69.9% in favor. Deal challenged by shareholder as violation by the board of the duty of care, esp. the duty to make an informed decision. Here directors were grossly negligent in failing to use information readily available to them-- Lambert: it is called gross neg. but isnt it really regular neg? A 20 minute oral presentation does not = a “report”—If there had been informed shareholder approval it would be okay (Stroud, Geier). Sloppiness! (contrast to Rabkin v. Hunt Chemical – ordinary negligence is standard) Lambert: one explanation for outcome in this case is that in 80’s there was a lot of takeover activity and court wanted to discourage it—try to make them be careful about decision of selling the company) Statutory Response to this case: see Cal§204(a)(10), Del§102(b)(7)

Bates v. Dresser (SC US, 1920) receiver of a small bank sues the president and directors because the bookkeeper was stealing money. President fails to catch him. Pres liable b/c he had duty to investigate and he controlled management and situation. Directors are not liable b/c they are entitled to rely on president—also twice a year a committee examined affairs of the bank and they are entitled to rely on this.

Kamin v. American Express Company (SC, 1976) American Express purchased DLJ stock and then its value fell substantially. wants to distribute the stock to s/h as a dividend. Some shareholders wanted AmEx to sell the stock, take the loss, and realize tax benefits (offset other income). Held: no fraud or self dealing and it was informed (they heard arguments to sell stock and decided against it). Only if P can rebut presumption will burden shift to the board to prove anything. . .


I. General

The 2d of the fundamental fiduciary duties of directors means that directors must place the interests of the corporation above their own personal interests/gains problems arise because B/D usually have other interests – that is often why they are on the board! 1) contracts between corp and one of directors 2) transactions by a director that result in profits that the corp. might have engaged in 3) contracts for directors compensation 4) etc.

II. Analysis/ Burden of Proof

Analysis: 1. Usually BJR protects directors decisions, but it presupposes no conflict of interest 2. to know if you have a duty of loyalty issue ask: if you have a “materially interested” director –must be material financial interest 3. once you show this the standard becomes “just and reasonable” (in Cal--§310(a)), or “entire fairness” (Del.--§144(a)) 4. Burden of proof to show fairness is on party asserting the validity of the transaction (Lewis v SLE) 5. If there is shareholder ratification the burden of proof shifts to those challenging the transaction (Wheelabrator) to show that it wasn’t fair. (otherwise BJR applies) 6. ? 7. ?

III. Duty of Majority Shareholders

Majority shareholders have a duty of loyalty and good faith/fiduciary relationship to minority shareholders

1. Always ask first: Is there control? (analyze facts)

2. If yes, then ask Was fiduciary duty breached? (is there self dealing/overreaching?)

self dealing = intrinsic fairness standard and burden is on defendant to prove. Otherwise—BJR applies.

3. Last, are there any reasons to shift burden? (full and fair disclosure shifts burden, independent committee with bargaining power (Lynch Communications/Kahn v. Tremont), ratification. Burden shifts to prove/disprove fairness, but it still is fairness not BJR.

4. Fairness -fair price -fair dealing -entire fairness of transaction

IV. Statutory

Effect of approval by disinterested directors on interested transactions. . . (page 684-688)

Calif. §310: Contracts in which director has material non-financial interest; validity an interested director contract/transaction is not void or voidable if: 1) material facts are fully disclosed and approved by vote of shareholders (not counting vote of interested director) 2) material facts are disclosed and board or committee authorizes and the transaction is JUST and REASONABLE 3) if approved by above methods the person asserting the validity of the contract bears the burden of proving it was just and reasonable

Del §144

V. Business Associations Cases 

Lewis v. S.L.&E. Inc. (2d Circuit, 1980) Burden of proof to show fairness is on the party that is asserting the validity of the transaction. 2 corps—SLE (land owner) and LGT (renter, tire shop). Some of Lewis’ children owned stock in both, Donald owned stock only of SLE. Shareholders agreement required SLE owners to sell stock to LGT owns for book value (assets minus liabilities divided by number of stock) in 1972. LGT directors were also directors of SLE, and had rented the building to LGT well below market value for many years, which resulted in a decreased "book value"of SLE stock. Held: When directors have an interest in the transaction other than as directors of the corp, the transaction is voidable unless the proponent of the transaction can show that it is “fair and reasonable” to the corp. The burden of proving fairness is on the interested directors. (Book value – if SLE did not collect rent at $6K per month for 10 years, that si cash that SLE does not have on hand for evaluating book value. If liabilities of SLE had exceeded assets, Donald would get nothing, so how you value the assets (building) is crucial. here Donald alleged “waste” – they wasted assets of SLE—no conceivable corporate benefit to SLE. Compare to gifts where at least in theory the corp. gets something. . .

In re Wheelabrator Technologies Shareholders Litigation (Chancery, Del, 1995) Challenge to the merger of WTI and Waste into a wholly owned subsidiary of Waste, on a stock for stock basis. (Short form merger – merge the target corp into a shell, then reissue stock of the new shell corp. – same effect as a reverse stock split) Shareholders had approved merger by majority vote. 3 claims: disclosure, care, loyalty. Held: (1) disclosure was adequate (fully informed), therefore, (2) due care claim extinguished (an informed shareholder vote can cure the failure of the board to reach an informed decision –Van Gorkom), and (3) for loyalty claim, shareholder ratification shifts the burden to plaintiffs – BJR standard of review (since no control issue, otherwise “entire fairness” standard)

Sinclair Oil Co. v. Levien (SC Del 1971) Sinclair was a holding company – held 97% of Sinven. Levien held 4000 of Sinvens 120000 public shares. Sinclair controlled Sinven’s Board, and caused Sinven to pay huge dividends. Sinclair also created Sinclair International to do foreign oil stuff. Sinclair caused Sinven to contract with Sinclair International for sale of oil, but Sinclair Intl. breached (made late payments, didn’t buy as much oil as was supposed to). held: 1) payment of dividends not a breach of fiduciary duty because all shareholders benefited equally, so BJR protects that decision 2) causing Sinclair Intl. to breach its contract with Sinven was overreaching and caused the burden to shift to Sinclair to prove “intrinsic fairness”—a burden it failed to meet. Once P can prove over-reaching burden shifts (Lambert: self-interest) RULE: When a parent controls a subsidiary and receives a benefit at the expense of the subsidiary’s minority shareholders, the intrinsic fairness test applies and burden is on parent.

Kahn v. Lynch Communication Systems (Del 1994) Alcatel owned 43% of Lynch Communications, had right to purchase 40% of any new stock issued by Lynch. Agreement required 80% shareholder approval of any business combination Lynch entered into (a “lock”). All this = control of Lynch by Alcatel, even though not majority ownership. Lynch decided to get into fiber optics business, Alcatel proposed that Lunch acquire Celwave (one of its subsidiaries). Lynch appointed a board to investigate and decide. Board recommended acquisition under pressure from Alcatel. Lynch approved. Held: control need not be ownership of more than 50% of stock. In an interested merger, the party on both sides of the transaction bears the burden of proving entire fairness of transaction. two components: 1) fair dealing 2) fair price Approval by an independent committee shifts the burden to the challenger of the transaction, but the standard is still entire fairness. Mere existence of a committee doesn’t shift burden, you still need: 1) majority did not dictate terms and 2) committee must have had real bargaining power Here, because of hostile tender offer, committee could not say no, so burden wasn’t shifted

Kahn v. Tremont Corp. (SC Del 1997) Simmons owns 100% Contrans, 90% Valhi, 44% Tremont and 68% NL. Kahn owns stock in Tremont—sees sale of NL shares as unfair. Valhi wants to sell its NL stock to Tremont—if Valhi benefits, so does Simmons—which mean Kahn gets screwed. Tremont would be paying too much for the NL stock. Special committee—may change burden f proving fairness from P to D. Not a BJR case b/c it is an interested transaction. (BUT, burden shifts properly to P if special committee was outside directors). Two components to fairness--- fair price & fair dealing. OR this court = entire fairness of transaction. . . as a whole not separate test

Jones v. H.F. Ahmanson & Co. (Sup. Ct. CA 1969) S&L was owned by depositors—vote in proportion to deposit. Converted into to corp – depositors given first right to buy stock (warrants) & 15% took it. President took 86% and sold it to other people. United Savings & Loan (Association) was owned by a few people & public interest in ownership of it increased dramatically. United was not publicly traded & some s/h’s wanted it to be so they formed a holding company United Financial & traded their stock. UF only book value is that of Assoc. stock, and they owned 85% of Assoc. United went public & made a ton of money. They caused Assoc. to underwrite bond debt (cash reserves required under Calif. law) needed to make a big distribution to United shareholders. Held: they owed a fiduciary duty to minority shareholders. Majority may not use its control for its own benefit to the detriment of the minority. Maj. has a duty to use control in a way that is “fair, just, and equitable” Here they used control in two ways that violated fid. duty: 1) sold control w/out allowing minority to participate 2) used assets of Assoc. to finance debt of United.


I. General

Involves situation where controlling shareholder sells their controlling shares (either maj. of stock or controlling minority) in a transaction that excludes other shareholders, or includes them, but they get less for their shares. Since a person purchasing “control” can dictate the affairs of the corp, “control” is a thing of value

General Rule: A s/h may sell his stock to whoever he chooses at the best price he can get. But courts often apply the principle that one share = one share, whether or not it is controlling. Majority may sell control at a premium, since control has value and rightfully belongs to them, but they may not sell something more than control (some corporate asset) because it benefits the majority at the expense of the minority.  Sale of control that is fraudulent, or sale to a foreseeable “looter” creates liability for the seller. Where something more than control is sold the seller bears the burden of proving that minority was not deprived of something it rightfully owned for the seller’s personal gain. cannot sell board positions without selling stock/control.

Types of transactions: 1. direct from s/h’s –purchase of stock. When all of outstanding stock is purchased, one price may be offered to controlling s/h’s and a lower price to minor. s/h’s 2. Purchase of assets – buyer offers to buy corps. assets. Corp itself holds a vote & a maj. is usually required to sell. If the vote is secured the buyer deposits the purchase price with the corp. & price is distributed pro rata to all s/h’s. 3. Merger or consolidation – purchaser offers to merge a company into it. A vote of the shareholders of the company to be merged is required. If it secured by a major. vote, then the company is merged into acquiring company. S/h’s receive a pro rata interest in the purchase price.

II. Cases

Zetlin v. Hanson Holdings Inc. (NY Appeals 1979) Zetlin owned 2% of Gable Industries. A group of s/h’s (D’s—including Hanson) sold their interest in Gable (44.6%--effective control) to another party for $15/share. (market price was $7.38). P wanted to be paid the same price as D’s. Held: A majority interest can control the affairs of the company. Absent fraud, looting, bad faith etc., a controlling s/h can sell the right to control the affairs of the corp. at a premium.

Perlman v. Feldmann (2d Circuit, 1955) “sale of a corporate asset” Feldman was the president, chairman of the board, and majority shareholder of Newport Steel. Newport had operated under the benefit of the “Feldman Plan”—which required purchasers of steel to advance the price of the steel before delivery (essentially an interest free loan). He sold his shares to Wilport, a syndicate of steel buyers, and procured the resignation of his own Board of Directors. Held: The ‘Feldman Plan” was a corporate asset that belonged to all shareholders. In selling control, Feldman deprived the minority shareholders of the benefit of that asset and thus improperly appropriated it to himself. Burden of proving no breach of fiduciary duty is on the defendant. Lambert: examine the facts closely, look for something more than control of the corporation (here it is the Feldman Plan and source of supply) for PERSONAL GAIN.

Caplan v. Lionel Corp. (1964) Selling board positions. Roy Cohn (infamous scoundrel NY lawyer—used to work as counsel for Senator McCarthy on the Communist witchhunt, barred from practice in 83, dies of AIDS in 89, mafia and J. Edgar Hoover) somehow managed to procure the replacement of 6 directors while he only owns 3% of Lionel (we don’t know how. . .) Held: you cannot sell the board! having properly vacated the appointment of directors the trial court should have allowed the board to fill the vacancies (unless the by-laws allow the shareholders to do it, which wasn’t the case here). Lambert: you can sell actual stock control, but you cannot sell management in the absence of selling control. TRANSFER OF DIRECTORS HAS TO BE INCIDENT TO TRANSFER OF CONTROL! (Bares v. Brown says that transfer of directors with transfer of control is proper)

Essex Universal Corp. v. Yates (2d Cir. 1962) Sale of corporate office. Yates, president & CEO of Republic Pictures agreed to sell 500,000 shares of Republic stock (28%) to Essex Corp. and to cause the resignation of 8 to 14 of Rep.’s directors, with the vacancies to be filled by Essex—he was selling control of the board with control of the company (it was a staggered board, so this is accelerated control). between the agreement date and the closing date, the value of Republic stock goes up, so he wants to get out of the deal. To do this, he alleges that the contract for transfer of control was illegal, and that the illegality “tainted” the whole contract so as to void the whole thing. Issue: does 28% of stock ownership = control? If not, is the contract illegal? Held: As a general rule, the holder of control will not, as a fiduciary, be permitted to profit from facilitating actions detrimental to the corporation or minority shareholders. here, no such threat. It is illegal to sell control without stock, but it’s a practical certainty that the 28% transfer = control, so contract per se not illegal. “Working control”.

Note (Defining Control): Sinclair v. Levien—97% Kahn v. Tremont – 44% Perman v. Feldman – 37% Essex—28%


I. General

Definition of Distribution – giving something of value for no consideration (“dividend”) can also be forgiveness of debt = a small liquidation event – changes balance sheet by reducing assets and net worth

Shareholders are passive investors with an expectation of profit & of limited liability to extent of investment  shareholders are not entitled to dividends—it is within business judgment of board  problem with distributions is that it compromises creditors when corp gives away assets without consideration  if corp has creditors—cant move assets freely in and out of corp. If it has no creditors it can do what it wants  Creditors can sue the corporation in event of an illegal distribution (not shareholders)  Old terminology: par value- original risk of investor/stated capital paid in capital or capital surplus – still today, some statutes says that dividends come from this Also, if you want to make a distribution in Cal. based on accretion in value of property, you have to sell the property—cant just write it up.

Tests for paying dividends: 1. balance sheet test- cant pay a dividend if there is a deficit in retained earnings 2. insolvency test – can pay a dividend even if there is a deficit in retained earnings

II. Dividends out of Capital Surplus

III. GAAP Accounting

IV. Fraudulent Transfers

V. Statutory

Cal. § 114: you have to use GAAP accounting

Cal. § 166: Distribution to s/h’s is a transfer of cash or property to s/h’s w/o consideration, except a dividend in shares of the corp., or purchase or redemption of its shares for cash or property.

Cal. §500: No distributions to s/h’s are allowed except as follows: (a) may be made if the amount of retained earnings immediately prior to distrib. equals or exceeds amount of distrib. (b) may be made if , immediately after distribution: (1) assets of corp (excluding goodwill, capitalized research, R&D costs and deferred charges) are at least 1 and 1/4 times the liabilities, AND (2) current assets at least equal current liabilities or etc. . . see page 49. . .

Cal. §501: Corp cant make a distribution if it is or would as a result of the distrib. not be able to meet liabilities.

Cal. §316: directors who approve a distribution contrary to §500 or §503, are jointly and severally liable to the corporation for the benefit of all creditors or shareholders entitled to institute an action (c) damages recoverable shall be the amount of illegal distribution (plus FMV of property) plus interest, plus reasonable costs of appraisal or valuation

De. §141: protects a director against liability if he has relied on the books prepared by an independent CPA

Uniform Fraudulent Transfer Act (white book page 952) §2: Insolvency (a) a debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtors assets at fair valuation (b) A debtor who is not paying debts as they become due is presumed to be insolvent (c) [partnership. . .]

§4: Transfers Fraudulent as to Present/Future Creditors A transfer is fraudulent as to creditors if it is made for no consideration or for unreasonably small consideration, or if it is made with the intention to incur debts beyond ability to pay as they come due.

§5: Transfers Fraudulent as to Present Creditors a transfer is fraudulent as to pre existing creditors if it is made for no or unreasonably small consideration, or to an insider for an antecedent debt

§7: Remedies of Creditors various remedies including injunction

§9: Extinguishment of Claim for relief/Cause of Action

Business Associations Cases

Randall v. Bailey (NY Sup. Ct, 1940) Action by a bankruptcy trustee of a corp against former directors who made distribution based on “writing up” of corporate assets to market value, which changed the equity position of the company (balance sheet valuation) but did not increase cash on hand. Court says ok—directors can take into account unrealized appreciation/accretion in determining the value of assets for distribution purposes. But they also have to take into consideration unrealized depreciation. “All assets must be taken at actual value” Known as the valuation test.

When can you make a distribution? Valuation test – you can use appreciated assets Profit test/Nimble Dividend test – You can only pay out of retained earnings/ current profits Insolvency Test – if you are solvent, you can pay out Balance Sheet Test – looks to net worth (assets-liabilities) Earned surplus test ?? – based on accumulated profits

CA seems to follow a combo of profit, modified balance sheet, and insolvency tests. Calif. always uses GAAP accounting.

Morris v. Standard Gas & Electric Co. (Del 1949) Example of Nimble-dividends or current profits test.

SECURITIES LAW/ 1933 Act I. General

Securities law seeks to protect passive investors who lack direct control  always ask: is it a security? (see definition below)  If it is two things happen: (1) registration requirements apply (2) anti-fraud provisions of the 34 Act apply

 Policy is disclosure of material information so investor can make a meaningful decision

II. Analysis

1. Is it a security? §2(1) 2. Is there a sale or an offer to sell? §2(3) 3. If yes to both, registration required unless §4(1) or §4(2) exemption applies. 4. Exemption §4(1)—non-issuer transactions, §4(2) not a public offering, §4(3) dealer transaction. 5. Registration. (§5 and blue sky law—regulation D) 6. Is there an anti-fraud provision (look at 34 Act)

III. Registration

extensive & expensive!  SB2 for small businesses (<25 M in revenue), and everyone else is S1

Exemptions: §3(a)(9) – security exchanged with an existing security holder where no commission is paid  §3(a)(10) – security exchanged for existing securities or property, if terms are approved by a court or official agency  §3(a) (11) – security offered and sold only to persons of a single state, where issuer is also resident of the state §4(1) – transactions by any person other than an issuer, underwriter or dealer  §4(2) – transaction not involving any public offering (private placements)  §4(3) transactions by a dealer, so long as at least 40 days after the first date of the offering. . .. ????

see Ralston Purina

IV. Definitions

“security” Under §2(1). Investment contract: 1. common enterprise 2. profits solely from the efforts of others

SEC v. WJ Howey Co. (Sup. Ct, 1946) ACCEPTED DEFINITION land sale contracts gave purchasers small parcels of a citrus grove, with a service contract for harvesting and marketing the fruit and receiving a portion of the profits. Held to be a security. Test: An investment contract for purposes of the 33 Act is a “contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party”

elements of an investment contract: 1. investment of money 2. common enterprise 3. expect profits 4. solely from efforts of others

SEC v. Glen Turner Enterprise (9th Cir) “pyramid scheme”: GTE offered to buyers the opportunity of earning commissions on the sale of other such contracts. Held: “solely” language of Howey not meant literally, rather the real test is whether the efforts of those other than the investor are significant. Common enterprise = one where the fortunes of the investor are interwoven with and dependent on the efforts of those seeking the investment or of third parties.

*LLC interests are securities unless every member is a manager (for Cal.). For FED look at HOWEY test.

“sale” and “offer to sell” §2(3) – applies to all sales of securities, not just IPO’s. Includes most mergers, stock for stock exchanges and pledges.

“prospectus” any prospectus, notice circular, advertisement, letter, or communication written or by radio, television which offers any security for sale or confirms the sale of any security. Lambert: prospectus is a selling doc, but really it is a disclosure doc. Who does it really protect? Not the buyer, but the issuer. It is unrealistic to think that buyers make decisions based on prospectuses (Yahoo’s said in bold type “ this is a shitty risk, we don’t have any capital and we are not making any promises”)

“Stock” Stock is a security, but just because you call something “sock” does not make it a security (United Housing Foundation v. Forman)

Housing Foundation v. Foreman Look at the substance of the transaction – Condos—each tenant had to buy stock that was linked to condo – no dividend, no profiy. they got it back when they left.

Landreth Timber v. Landreth (Sup. Ct. 1985) Sale of all of the stock of Landreth Timber, held by trial court to be sale of the busines, and not sale of stock. Trial ct. interpreted Howey as requiring an examination of the economic realities of the situation. Reversed by S. Ct—if it is called stock, and it is stock, there is a per se rule that it is a security. How to tell if it is really stock: 1. dividends 2. negotiability 3. ability to pledge/ hypothecate 4. voting rights 5. ability to appreciate in value.

V. 1933 Act §2(1): The term “security” means any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate. . . investment contract . . .any put, call, straddle, option, or privilege on any security . . . etc. . .

§2(2): The term “person” means an individual, corporation, partnership, association. . . etc. . .

§2(3): The term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security for value. The term “offer to sell”. . . shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security for value. . . etc. . .

§2(4): The term “issuer” means every person who issues or proposes to issue any security. . .

§2(11): The term “underwriter” means any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security. . . etc. . .

§4: Exempted Transactions The provisions of §5 of this title shall not apply to: (1) transactions by any person other than an issuer, underwriter, or dealer. (2) transactions by an issuer not involving any public offering. (3) . . . (4) brokers’ transactions executed upon customers oredrs on any exchange or in the over the counter market but not the solicitation of such orders (5) etc. . .

§5: Prohibitions Relating to Interstate Commerce and the Mails (a) unless a registration statement is in effect it is unlawful to use mails or interstate commerce to sell through the use of prospectus or otherwise.- - or to deliver after sale (b) prospectus has to meet requirements in §10 (c) sell, buy or offer any security that isn’t registered

§11: Civil Liabilities on Account of False Registration Statement

§12: Civil Liabilities in Connection with Prospectuses and Communications

§15: Liability of Controlling Persons

§17: Fraudulent Interstate Transactions

VI. California Law

**know the difference between merit (or content based statutes and disclosure based statutes Merit States — says we will have rules & regulations that will assess the qualities of the security/transaction based on merits—qualification in that state Disclosure State – says that we want you to disclose everything and let the investors make up their mind.

California Corporate Securities Law of 1968 §25008: Offer or sale of security; offer to sell or to buy §25019: Security §25110: Necessity of qualification of security or exemption of security or transaction §25120: Necessity of qualification of security or exemption of security or transaction §25130: Necessity of qualification of security or exemption of security or transaction

VII. Cases

Reves v. Ernst & Young (Sup. Ct., 1990) Note = security. Definition of note as any note w/ maturity date no more than 90 days. Family Resemblance test announced (to determine if notes are securities—must meet one factor to = note): 1. purpose/motivation (investment or other commercial purpose, such as commercial loan)? Look to motivation of buyer & seller to enter transaction--- general use of business or finance investment vs. minor asset or to correct for cash flow problem 2. Plan of distribution (publicly offered, negotiable)? 3. Expectation of public? 4. Other regulatory scheme? (if it is regulated elsewhere—reduces risk) **Whether notes with less than 90 days maturity date are a security was not decided by this opinion.

SEC v. Ralston Purina Co. (Sup. Ct. 1953) treasury stock offered to a few hundred key employees (the ones that showed initiative and asked about it) held to be a public offering and thus not exempt from registration requirements. Held: to determine whether an offering is public don’t ask how many offerees. Just because they are employees does not mean they are not public. Employees are usually public since they usually don’t have special knowledge. *** If you are looking for an exemption ask whether you are one of the classes sought to be protected (those that would not normally have the information to be disclosed. .. )

Doran v. Petroleum Mgmt (5th Cir, 1977) Interpreting Purina. .. Wen deciding whether an offer is public think about: 1. the number of offerees 2. offerees relation to issuer (sophistication of offerees, and access to issuer information)

1934 Act

I. General

The problem: someone related to the corporation in a position to have inside information about how the corp is doing & hence what the stock is or will be worth—buys or sells with an advantage over other party.  Issue: What duty does the corporate insider have to the other party???

COMMON LAW APPROACH MAJORITY RULE: Was that directors & officers owned no special duty to present or prospective shareholders and could deal with them at arm’s length—no duty of disclosure . (Goodwin v. Agassiz) MINORITY RULE: Special facts doctrine— some courts took the position that a duty of disclosure existed if there were special facts that made omitting information unfair.

FEDERAL LAW 10b/10b-5 §16

The classic triangle case misappropriation theory

II. §10b and Rule 10b-5

§10(b): Manipulative & Deceptive Devices It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange— (a) . . . (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Rule 10b-5: Employment of Manipulative & Deceptive Devices It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device scheme or artifice to defraud, (b) To make any untrue statement of material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security.

Requirements to be covered by 10b and 10b-5: 1. applies to purchase & sale 2. remedies—private right of action (Kardon v. National Gypsum and actions by the SEC 3. a security must be involved 4. interstate commerce must be used 5. “any person connected with”—very broad

III. Analysis/Elements of a 10b-5 Cause of Action

FOLLOW THESE ELEMENTS: 1. Manipulative or deceptive device or contrivance/ fraud 2. Fiduciary relationship/ a duty (“insider”) 3. Materiality 4. Reliance / Causation 5. Purchase or Sale 6. Scienter

1. Manipulation/Deceptiom you have to allege material misrepresentation or material failure to disclose or you are outside 10b-5.  Mere unfairness of terms in case where full and fair disclosure is made is not good enough (Santa Fe Case) Congress did not intend to federalize fiduciary duty law

2. Who has a duty/who is insider?

CLASSICAL THEORY Two elements: 1) a relationship giving access directly or indirectly to information intended to be available only for a business purpose and not a personal purpose 2) presence of inherent unfairness where a party takes advantage of such information ***DUTY arises not from possession of information but from relationship of the person to the company and shareholders (not relationship to the buyer/seller. . .) (see Chiarella)

Quasi-insiders: Accountants, lawyers, i-bankers, -- they have the kind of access that makes them an “anyone” per 10b-5 (Cady-Roberts)

TIPPOR/TIPPEE Analysis 1. must be a breach of fiduciary duty 2. tippee must know or be expected to know of the breach 3. tippor- no personal benefit = no breach 4. tippee derives liability from tippor

Silence Cases v. Misstatement cases The silence cases are hard because because the statute doesn’t mention silence. But at some point silence becomes a 10b-5 violation. Where? Ask: 1) is there a breach of fiduciary duty? 2) is there personal benefit?

MISAPPROPRIATION/Fraud on The Source Analysis As of 1997—O’Hagan—this is the law  Brought up in Chiarella (court rejects b/c it was not put before the jury). Burger Dissent discusses.  Idea is that anyone who misappropriates material, nonpublic information in breach of ANY fiduciary duty and trades on that information to his own advantage violates 10(b)/10b-5.  Idea is that duty to disclose runs to THE PUBLIC/MARKET—creates a parity of info rule 3. Materiality

See TSC Industries—a proxy case but it comes up with the standard of materiality that is used in 10b-5--- “Substantial likelihood that a reasonable shareholder would find it important” Now it is what “would be considered important by reasonable s/h” not “what might be”.  Adopted wholesale for 10b-5 cases in Basic v. Levinson  courts must consider all of the facts in each case (Basic) an absolute rule (such as one in Basic that says preliminary agreement must be signed before it is material) is not in accord with the test

4. Reliance/Casuation from Basic v. Levinson: 1. in face to face transaction reliance is a subjective look at what the person did (burden on plaintiff to prove actual reliance) 2. in market transaction you use fraud on the market theory to create a rebutttable presumption of reliance. (SEE BASIC)

Causation is closely linked to both reliance and materiality. (If it is material, then they probably relied, it probably caused their action)

5. Purchase or Sale “any contract” to purchase or sell plaintiff must be an actual purchaser or seller can’t say – I didn’t purchase or sell b/c of this see Blue Chip Stamps case “In connection with” requirement *means that someone bought or sold (see Blue Chip)

6. Scienter  standard of care to which you hold defendant Supreme Ct= has to be scienter (actual intent to deceive manipulate or defraud) Texas Gulf Sulfur said: Scienter = negligent conduct or lack of diligence—does not require specific intent to defraud. . . hmm???

see Ernst & Ernst v. Hochfelder. Says it has to be intentional—negl. not enough for 10b-5 liability.

IV. Cases

Goodwin v. Agassiz (Mass. 1933) COMMON LAW RULE. Goodwin saw an article in the paper that said the company discontinued copper exploration. He sold his stock on the exchange. Agassiz, a director of the company knew of a geologists theory that he believed had value. Without disclosure he bought the stock. Later, theory proved to be correct & stock went up. Goodwin wants to rescind the sale. Is there a duty to disclose in arms length transaction? Court says no – purchase was impersonal, theory was only a hope.

Kardon v. National Gypsum (PA, 1946) District ct opinion but very important there is a private right of action under 10b and 10b-5. Plaintiffs owned shares of Natl. Gypsum and another company and wre induced to sell tehir stock in both to the Slavins on the basis of material misrepresentations. Alleged conspiracy to defraud by representing that corp. was not negotiating for the sale of its assets. Issue: does ct. have jx. to hear a private c of a. held: yes! The language of the statute suggests that congress intends for it. Problem here is that he did not plead with enough specificity.

In the Matter of Cady, Roberts & Co. (1961) Silence. Insiders (including officers, directors, controlling shareholders but this is NOT an exhaustive list) have a duty either to disclose or refrain from trading on inside information. Analysis: 1. relationship gives access to information for corporate purposes and not personal benefit 2. inherent unfairness – where party takes advantage of info unknwn to party with whom he is dealing Lambert: this is a silence case—stands for the fact that a fiduciary must not remain silence—has a duty to disclose. This and Texas Gulf Sulfur – makes omission a part of “misstatement”.

TSC Industries v. Northway Landmark proxy solicitation case. Prior to this case the standard of materiality was that it “might be important”. This says the standard is information that “would be important”. “Substantial likelihood that a reasonable shareholder would find it important”. Significantly altered the total mix of information they would use in making decision. Question is – does this standard apply to 10b-5 cases?

SEC v. Texas Gulf Sulfur (1968) pages 828-29 The MODERN RULE> TGS was in business of exploring for an mining minerals. Potential big find in Timmins, Ontario. Explored & found it was good—better than thought. Several employees bought stock (even those that had never bought stock before). Then, later, public disclosure. Ct. looks at whether, when they bought the stock, it was material fact. Material= “whether a reasonable person would consider the information important in forming a decision in relation to transacting in the security. If so—duty is to disclose fully or refrain from trading on it. Public disclosure means effective disclosure, not just “technically” Scienter = negligent conduct or lack of diligence—does not require specific intent to defraud. Tippers—also liable

Basic Inc. v Levinson (Sup. Ct. 1988) Lambert: this case is not a paragon of clarity in his opinion. Basic was engaged in merger negotiations and made three statements that they were not in such negotiations. Levinson & others formed a class and sued under 10b-5. Issues are what is the standard of materiality? and is it appropriate to use fraud on the market theory to create a rebuttable presumption of reliance? Yes and yes. Materiality: adopts TSC Industries standard. (an absolute rule, such as it is not material until preliminary agreement—not in accord with this standard) Reliance: this is an element of 10b-5 case. Two wasy to show—in face-to-face it is whether subjectively the buyer considered the statements/omission. In market transaction it is okay to use the “fraud on the market theory” -- that is, markets are efficient and they absorb information whether false or not & prices are reflected by that. A plaintiff can be presumed to “rely” on the integrity of that information. Rebuttable presumption – plaintiff can show that 1) the market price did not react to the misstatement or 2) this plaintiff had other reasons/did not rely. BUT IT SHIFT BURDEN TO DEF. DISSENT: fraud on market theory should not apply – economic not leagl (legilature should do it) besides, it is not clear that investors rely on “integrity” of market anyway (ie on price of stock as reflection of value)

Blue Chip Stamps v. Manor Drug Stores Blue Chip was subject to an antitrust consent decree that required it to offer shares to retailers it had dealt with. It registered and about 50% of stores purchased. Two years later one of the non-purchasing offerees (Manor Drug) sued under 10b-5 claiming that the prospectus was overly negative so that they did not purchase—allowing Blue Chip to then offer the share sto the public at a higher price. Held: Manor Drug has no standing to sue under 10b-5 b/c there was no purchase or sale. Policy reasons also relevant—frustrate business activity, have high settlement value, “I would have done x. . . “ is too easy to say. . .

Ernst & Ernst v. Hochfelder (1976) Supreme Ct. says that “manipulative & deceptive” is intentional conduct. Accountants were sued by customers of the firm because the president embezzled money and they were negligent in discovering it. 10b-5 does not apply where the defendant was negligent in performing duties or in aiding/abetting fraud. Plaintiffs have to show intentionally fraudulent conduct. DISSENT: Blackmun and Brennan—an investor can b hurt just as much by negligent conduct as by intentional. . .

Santa Fe Industries Inc. v Green (1977) Merger case and minority s/h’s thought the terms sucked. Sued in fed ct. to enjoin the merger on grounds that it violated 10b-5 b/c price was bad and there was no business purpose except to screw them over. Held: 10b-5 does not rpovide a remedy for breach of fiduciary duty when full disclosure is made and no misrepresentations have taken place. Here investors were fully informed. this is for state law.

Chiarella v. United States (SC 1980) Chiarella was a printer. He surmised the identity of target company and bought stock = $30K. Consent decree with SEC—he gave money back. Now he has criminal trial. Court held that he did not violate anti-fraud provisions because ehe did not have a duty. Silence is only a fraud when you have a fiduciary duty arising froma relationship pof trust with the parties in the transaction. He was not an insider of either company. Not every instance of unfairness= a fraud under 10b-5. There is no “general duty to disclose” under 10b. Dissent: (Burger) Misappropriation theory: When a person misappropriates nonpublic information he has an absolute duty to disclose or refrain from trading. Dissent (Blackmun & Marshall): what is wrong is use of inside information as a result of access to that information that the ordinary investor does not have and which was not meant to personally benefit defendant.

Dirks v. SEC (Sup. Ct. 1983) Tippee liability is derivative liability – derived from tippor. Tippee cannot be liable unless tippor had 1) breach of fiduciary duty, 2) for personal benefit. Here, the insider was motivated by a desire to expose fraud, not personal gain. therefore, the information was not improperly disclosed. Look to the purpose of the tip. Lambert: this is not a parity of information statute or a general anti-fraud statute either. (if you are plaintiffs lawyer always allege personal benefit – if no financial benefit allege quid pro quo) Dissent (Blackmun, Brennan, Marshall)—this is just another attempt to limit protections to investors. Dirks’ clients benefited from inside information to the detriment of others who did not have that info—that is the problem.

Carpenter v. United States (Sup. Ct, 1987) Misappropriation theory. CIRCUIT COURT: Carpenter had a friend who wrote a column in WSJ. He got info from the fried and gave it to two stockbrokers. WSJ had an explicit written conflict of interest policy prohibiting its employees from disclosing to anyone information received in course of employment. Profits between all defendants = $690,000. 10b-5 applies via misapp. theory. 10b-5 prohibits any person from committing any act that amounts to any fraud. SUPREME COURT: court was evenly divided (4-4) on the securities law question and so affirmed on misapprop. theory (goes way far. . .) But it is evenly divided so it is questionable whether it is good law. ..

United States v. O’Hagan (Sup. Ct. 1997) Rejecting the Misappropriation Theory. O’Hagan is a partner at Dorsey & Whitney. Firm is employed by Grand Met in connection with acquisition of Pillsbury. O’Hagen knew about it and bought call options in Pills. After acquisition was announced he exercised options at $4M profit. Held: 8th Circuit was wrong—misappropriation is the right rule. “A fiduciarys undisclosed self-serving use of a principles information to purchase or sell securities in breach of a duty of loyalty and confidentiality, defrauds the principle (the “source”) of the use of that information.”

Issues Emerging from Misappropriation p. 197-201 in Suppl.

In re Carter-Wallace Securities Litigation (2d Cir. 1998) District court said that “as a matter of law” drug advertisements made in trade journals are not “in connection with” the sale of securities. court says these ads could be highly relevant to analysts. Therefore, false ads in trade journals may be “in connection with” a securities transaction if the proof at trial establishes that ads were used by market professionals in evaluating stock of company.

Esoteric distinction bewteen possession and use of material info. Adler & Smith cases in 9th & 11th Circuit – says poss’n is not enough, have to use info. . . . . Questionable assumptions about human psychology. If someone has info relevant to an action they take, the info must be a casue in fact of the action --- every action a person takes is based on all the then known relevant information. Trader cant know if they would or would not have traded in the absence of that info, unless they were contractually committed to trade before poss’n of the info.


I. General

only applies to securities required to be registered pursuant to §12(a) – companies with more than 500 shareholders and assets greater than $5M. Little companies this doesn’t apply (to de-register must go to less than 300) with big companies—hard to get a quorum at s/h meeting – so you do it by proxy does not apply to any security – only those registered under 12(g)

ELEMENTS: 1. statement or omission 2. false or misleading 3. material 4. fact 5. causation 6. at least negligence (Sup. Ct hasn’t addressed—this is 2d Circuit)

Materiality -follow TSC Industries -- a statement is material is there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.

Causation Causation is established if 1) materiality is established 2) proxy solicitation was an “essential link” in accomplishment of transaction

II. Statutory §14: Proxies (a) Solicitation of proxies in violation of rules and regulations you cannot solicit any proxy, consent or authorization in violation of these rules (d) Tender offer by owner of more than five per centum of class of securities; exceptions (e) Untrue statement of material fact or omission of fact with respect to tender offer

Rule 14a-9: False or Misleading Statements No solicitation shall be made by any proxy statement or other communication containing any statement which, at any time it is made, is false or misleading with respect to any material fact or which omits to state any material fact necessary in oredr to make the statements therein not false or misleading or necessary to correct any statement in earlier communication with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading.

*note: no “manipulative/deceptive” language. That means that a Rule 14a-9 case is easier to make out than a 10b-5 case.

III. Cases

JJ Case Co. v. Borak US 1964) Stockholder sued for recission or damages with respect to a consummated merger authorized by proxies solicited by a proxy statement alleged to have contained false statements. May a s/h bring a private right of action? yes. Will the court unwind a merger that has already been completed? yes. Held: A private right of action in the form of a derivative suit is implied under the act. Remedies are not limited to damages—court can grant rescission. But fairness is looked at in damages proceedings – if it was fair transaction = no damages awarded at all.

Mills v. Electric Auto-Life Co. (US 1970) Causation case—was the defendants omission of material facts in the proxy statement the cause of loss. (s/h’s approved a merger into a company that controlled 54% of the board—11 directors). Trial court ruled that omission was material—but what about causation? Held: yes. As long as the omission is material, causation is presumed. Test is: 1. material? 2. was the proxy solicitation an essential link in the accomplishment of transaction? Remedy—doesn’t have to be rescission, can also be money damages. Rescission only if “equitable” to do so.

TSC Industries v. Northway objective test for materiality: would reasonable shareholder consider the omitted fact? Would disclosure of the omitted fact have significantly altered the total mix of info available?

Virginia Bankshares v. Sandberg (US 1991) Can a statement of opinion (“high value”, “fair price”) be a statement of material fact? Proxy solicitation used these terms. . Two arguments—that it is not material, and that it is not a fact. Held: 1. conclusory terms are reasonably relied on as being based in fact 2. statements of opinion can be material – it is closely related to underlying financial facts. Disbelief can be material. Additional disclosures can neutralize the misleading effect of materially misleading statements 3. causation problem here: minority vote was not required, and minority apparently did not forgo any state law remedy. . .

Gerstle v. Gamble-Skogmo scienter not required for 14a-9 liability—negligence is sufficient. But not strict liability.


I. General

Two kinds of shareholder suits: 1) Shareholders suing on their own behalf individual suits  class actions 2) Shareholder derivative suits s/h sues on behalf of the corp. to enforce a duty or redress a wrong—usually involve officer/director/maj. s/h failure to exercise due care/loyalty procedurally complex & burdensome!

derivative suit— usually “Jones ex rel Corp. v. 3rd party”

protects creditors b/c money goes back into corp =you get paid

II. Business Associations Important Cases

Sax v. World Wide Press, Inc. (9th Cir. 1987)

Sax was hired by WWP as the genl. mgr. Oral agmt. of 75K stock options. After acquiring 5% of the stock, WWP refused to sell any more therby breaching the agmt. Sax then terminated employment. Then he sued WWP saysing that after his termination of employment “the individual defendants conspired to deplete WWP’s assets and depreciate the value of his stock”. sax is suing as an individual and seeks actual & punitive damages. District ct. dismissed his claim saying that the alleged acts did not injure him personally, but injured the corporation and that accordingly any action must be brought as a derivative action. Affirned by 9th circuit – allegation that they depleted corp. assets goes to a wrong to the corp.

Schumacher v. Schumacher (North Dak. SC 1991)

Dean & Sandra Schumacher suing Mary as executor of Roberts extate. The four of them were the board of the corp (Robert 51 shares, Dean 49 shares). Breach of contract (employment), breach of promise, faikure to pay notes due, breach of fiduciary duty, fraud, deceit, infliction of emot. distress. Trial court holds that it was correct to say that some of these had to be derivative actions – Dean & Sandra appeal. General Rule: breach of fiduciary duty by controlling s/h’s is generally a derivative action. Exception: is in closely held corporation when a minority s/h alleges harm to himself which is distinct from harm suffered by other Test for invoking exception: Would a direct action: 1. unfairly expose the corp. to a multiplicity of suits 2. materially prejudice any corporte creditors interests? 3. interfere with fair distribution of any recovery among all interested parties. Here—none of these. Direct action is okay!

Bagdon v. Bridgestone/Firestone Inc. (7th Cir. 1990) Unclear whether they are saying that Delaware does not follow this exception. . .??? Know for the course that Delaware does not follow this exception. . .

Glenn v. Hoteltron Systems, Inc. (Ct. App. NY 1989) Two guys—each own 50%. One guy misappropriates money into a corp owned only by him. Other guys sues in a derivative suit and wins—question is in a derivative suit do the damages go to the individual or back into the corp? they go back to corp—that means in any case where the wrongdoer is also a shareholder he will get part of the recovery. Here this impact is magnified b/c it is closely held. But that doesn’t change the rule!

Perlman v. Feldman (2d Cir. 1955)

Bangor Punta Operations Inc. v. Bangor &Aroostook RR (SC US 1974) Rifkin v. Steele Platt (Col. Ct. Appeals 1991)

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