Business Organizations Bauman 9th ed.

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Business Organizations
Authors Jeffrey Bauman
Russell Stevenson
Robert Rhee
Text Image of Business Organizations Law and Policy: Materials and Problems (American Casebook Series)
Business Organizations Law and Policy: Materials and Problems (American Casebook Series)
Taught by
Taught at
Related course(s)

Things to Consider:

  • Forming Entity
    • o Who are the principal actors?
    • o What is their risk allocation?
    • o What business entity is best?
      • Partnership
      • LLC
      • Corporation
      • B-Corp
    • o If choosing a Corp
      • What State to incorporate in?
      • How will you raise capital?
        • Debt versus equity
      • How structure Board?
        • Staggered, class vote
      • o What to call yourself?
    • Duties of officers/directors
      • o Duty of Loyalty
      • o Duty of Care
      • o Business Judgment Rule defense
      • o Equitable Limitations
    • Agency – Implied, Express, __
    • Piercing Corporate Veil (limited liability fails)
    • Corporation in Society
      • o Personhood – two theories
        • Entity Theory = corp is distinct entity
        • Aggregate Theory = corp is vehicle for people to act through
          • Bad law (Hobby Lobby)
        • o Charitable Contributions
          • Reasonable if econ benefit, minor, w/in IRS (Theodora)
          • Boards have leeway under BJR
        • o Who are the stakeholders?
          • Corporate Social Responsibility (Business Roundtable)
          • Shareholder Primacy (Milton Friedman)
        • Role of Lawyer
          • o Corp is client, NOT the individual
          • o ABA MRPC 2.1
          • o Aggregate Theory vs. Entity Theory
          • o Reasonable Expectations Test

Contents

General Considerations[edit]

FORMING ENTITY TEST:

  1. Who are the principal actors?
  2. What is their risk allocation?
  3. What business entity is best?
    1. Partnership – more liability (for general partner), limited action for limited partner
    2. LLC – passthrough tax treatment (tax subsidies), not perpetual, limited transfer of ownership, more involvement by partner,
    3. Corporation
  4. If choosing a Corp
    1. What State to incorporate in?
      1. Benefits of Delaware law: (a) Favorable to management, (b) Familiar and comfortable for corporate lawyers, (c) Familiar and comfortable for investment bankers in VC or IPO
      2. Choice of Law
        1. Determines mandatory/default rules of incorporation
        2. Internal affairs are controlled by incorporation state law (eg raising capital, BoD decisions)
      3. How will you raise capital?
        1. Debt
          1. Bank may want security interest OR a personal guarantee. Banks are very conservative investors.
          2. Debt securities rarely issued to small companies.
          3. Process for a corporation to borrow
            1. For small dollar transactions, BoD approval not required
            2. For large transactions, BoD required
              1. No DGCL provision on point, but bank would require it
              2. DGCL default -- majority BoD in quorum attendance
            3. Equity -- # of shares authorized (look at cert of inc), # of shares outstanding, who are stockholders
              1. Difference between authorized stock and issued stock
              2. Note: DGCL 242(2) says stock authorization is majority shareholder issue, but COI raises it to 2/3 shareholder vote. Per DGCL 102, shareholder powers is merely a default provision, so can be overruled by COI terms.
            4. Post selection
              1. What to name corp

A. Allocating Risk[edit]

  • Core idea = business exists to allocate and manage risks
    • o GOAL: minimize agency cost, maximize return, minimize unnecessary risks
    • o People are more risk averse when odds involve losing money, than getting money
  • Expected Return ("R") = Sum of (each possible outcome X probability of that outcome)
    • Ex: (25% x $4) + (25% x $8) + (50% x $10) = $8.00, moderate risk, spread of $6
    • Ex: (25% x -$8) + (25% x $8) + (50% x $16) = $8.00, high risk, spread of $24
  • Two Types of Risks
    • o A) Controllable Risks
    • o B) Non-Controllable Risks
      • Ex: Weather, consumer sentiment
    • Agency Costs = costs of employing human beings in biz ops
      • o Controllable risk
      • o Shirking costs, monitoring/sanction costs
    • Shirking -- when employees give lower effort than others due to their personal CBA
      • o Can be hard to align the Principal and Agent's incentives
      • o Ways to Reduce Shirking
        • Profit Sharing
        • Flip the risk assumption
          • Incentivize employee performance (better than revenue sharing, employee will care about revenue AND cost)
        • Set performance targets -- hitting means bonus, missing means sanctions
        • Contract for responsibilities
          • Con: its complex, costly to monitor, costly to litigate violation
          • Note: BoD has duty to monitor performance
        • Make employee a stockholder
          • Restricted stock = if you leave before you earn your full stock, it goes back to company)
          • Note = loan the stock
        • Ways to manage risk
    • Insurance
    • Management practices
    • Financial methods -- forward contract (e.g. locks in sale price)
    • Diversification -- why the stock market is a social benefit
      • Corporations can diversity risk by doing many projects
  • Benefit of the firm
    • General idea: reduce contracting, information, and agency costs.
    • Coase''' = Contracting Efficiency Model.
      • Purpose of the firm is to reduce contract (transaction) costs of management, specialized labor, etc. No need for a web of contracts.
        • Also enables long-term employer/employee relationships + closer management at lower cost
      • Counter (Demsetz): Neither employer or employer is bound to continue relationship. So doesn't actually reduce contract costs, firm is just "centralized contractual agent."
    • Demsetz''' = Team Production Model
      • Firm is more efficient way to manage incentives, monitor performance, and allocate rewards than the free market.
        • Can see who put in what amount of work, and reward them via total firm returns.

B. Attributes of a Firm[edit]

  1. Legal Personhood
    • o Enables firm to sign contracts, own and sell property, sue and be sued, etc.
    • o Also has some constitutional rights, like DP and first amendment.
  2. Limited liability
    • o Equityholder is not vicariously liable for the firm’s D&O
      • Still directly liable for their actions
    • o Does NOT apply to general partners
    • o Creditors can still demand equityholders to personally contract and guarantee before issuing credit (usually to smaller corporations)
    • o Corporation:
      • Exceptions: (personally liable)
        • 1. Where the corporation is not properly formed
        • 2. For unpaid capital contributions that they have agreed to make
        • 3. Where the veil of limited liability is pierced for equitable reasons
  3. Perpetual Existence
    • o Corporation: perpetuity unless otherwise agreed
    • o Partnership: at will or a definite period; at will generally dissolved on death, bankruptcy or withdrawal of a partner; but in general, the partner’s share is calculated and paid to the partner (DISASSOCIATION) and then the partnership continues. Some partnerships can continue to exist for over 100 years.
    • o LLC: current LLC statutes provide that an LLC exists in perpetuity, unless its operating agreement or articles of organization provide otherwise
    • o
  4. Equityholders
    • o Being last in line to profits/net assets = high risk + high reward. Because you are entitled to everything left over after all else has been paid off.
  5. Managers
    • o Partnership
      • General Partnerships -- Default rule is that partners have equal business management rights (e.g. agency authorization). But can customize partnership to give some partners (even non-partners) more control.
      • Limited Partnerships -- MANDATORY rule of at least 1 general partner + 1 limited partner. Rigid form good for investment funds.
        • Limited partner = passive investor. Does not have right to act for/bind partnership.
        • General partner = manager.
      • o Corporation
        • Must have BoD -- has power to manage business and affairs
        • BoD selects officers (CEO/CFO/VPs/secretary). Doesn't run operations, officers do.
        • Shareholders can have controlling stake , but usually do not manage the corp. Typically passive investors. Normal shareholder role is to (1) vote for BoD, (2) vote on amendments to charter docs, (3) vote on certain transactions like M&A.
      • o LLC
        • Member-managed or manager-managed
  6. Separation of Ownership and Control
    • o Shareholders don't direct the operations of a company, manager does, in many cases.
      • BoD votes on major acquisitions, hiring/firing execs -- but not management
  7. Internal Affairs Doctrine
  8. Fiduciary Duty
  9. Transfer of Ownership
    • o Limited for LLC
  • ISSUE: Debate over purpose of corporation law.
    • Theory #1 = Be Liberal. It should be liberal to make incorporation as easy as possible. Just avenue to create contract between stakeholders similar to what they would do on their own.
      • Milton Friedman - Corporation should be run just to maximize profits. Solely in interest of shareholder.
      • Counter: Race to the bottom -- adopting most liberal incorporation laws gives too much to corporations.
    • Theory #2 = Be Strict. Corporations have such big social and econ impact. They should be strictly regulated.
      • Business Roundtable -- Corporations have duty to interests of all stakeholders, including employees and communities where they work.

C. Business Entities[edit]

Partnership[edit]

  • General Partnership
  • Limited Partnership
  • Limited liability partnership
  • Limited Liability Limited Partnership

Limited Liability Company[edit]

  • Allows for passthrough tax treatment (corp not taxed separately) -- maybe desirable for tax subsidies for owners.
  • IRS has "Check the Box" form -- merely check if you want to be Corporation or LLC
  • Qualities
    • No partner # requirement -- can have single owner (aka "Member")
    • All members enjoy limited liability benefit.
    • Flexibility in how to structure governance/management
      • Can be member-managed (like general partnerships)
      • Can be manager-managed (like corporations, limited partnership)
    • Not perpetual -- Only for a limited time
    • Limits of ownership transfer

Corporation[edit]

  • Tax Status -- can be classified either as C corporation or S corporation
    • o C Corporation
      • All publicly traded corporations are this.
      • Corporation is an independent entity and thus a taxpayer. Taxed on its income.
      • Shareholders are separate taxpayers, taxed on their earnings via ownership of shares (e.g. dividends, capital gains from sale of stocks).
        • Known as "two layers of taxation"
      • All shareholders enjoy benefit of limited liability.
    • o S Corporation
      • Generally smaller corporations b/c of restrictions on how it raises equity capital.
        • Must be domestic, only allowable shareholders, max 100 shareholders, only one class of stock, not ineligible corp (eg insurance co)
      • Treated like an aggregate of individuals. Thus, via passthrough treatment, tax applied at single level of shareholder.
    • Close Corporation -- Shareholder base closely held by small number of shareholders
      • o Cannot be public corp (ie no large shareholder base, no public trading).
      • o Often has shareholders involved in management.
      • o DGCL 342: (1) No more than 30 shareholders, (2) restricted transfer of shares, (3) no public offering of stock.
      • o DGCL 351: Business can be managed by stockholders instead of BoD.
    • Public Corporation -- publicly traded stock company. Anyone can buy.
      • o Must register under federal securities law.

D. Fiduciary Duties[edit]

  • Overall
    • Only applies to directors/execs. Shareholders can vote in their own interests ALWAYS.
  • o Remedy for breach is Derivative Suit.

Duty of Care[edit]

For manager making a decision
  • Business Judgment Rule (BJR) -- Limits manager exposure. Director only liable if you can overcome presumption that they acted on (a) informed basis, (b) in good faith, and (c) honest belief that action was in best interest of the enterprise.

Duty of Loyalty[edit]

For manager to put firm’s interest above their own

  • Standard for loyalty decision = inherently fair
  • Conflicts of Interest are not necessarily a problem (Bayer)
    • Must disclose conflict.
    • Transaction must be inherently fair standard
      • Burden of proof on party trying to defend the action
  • Bayer v. Beran (NY 1944)
    • Facts: $1Mil radio advertising campaign is claimed to be against duty of loyalty. That the campaign was misguided (wrong advertising audience), in order to boost the career of one of the singers, who is wife of the president/director. Was misadvertised to a classical station, rather than a variety station.
    • Holding: This was fine.
    • RULE: Manager/director has authority to appoint relative to position if she’s not disproportionately advantaged by it and qualified for the task.
    • Analysis
      • Director, like any other employee of corp, is an agent. Has fiduciary duty like a trustee.
      • Loyalty = "man cannot serve two masters"
      • Not required to use extraordinary care (like insurer), but cannot be simple dummy or figurehead.
      • Capitalist Concept: govt should penalize internal affairs of corp as long as they are good faith

Equitable Limitations[edit]

  • ISSUE: Inequitable Purpose versus Independent Legal Significance
    • o Inequitable Purpose (Delaware): Court can stop a corporate action because it has inequitable purpose.
      • Schnell: Inequitable purpose to move SH meeting just for directors to keep themselves perpetually in office and avoid contest for control by way of proxy contest (from shareholders seeking new BoD). Delaware Court can force corp to hold its meeting on the originally scheduled date.
      • Use: Delaware courts will get involved if the Directors are interfering with core business practice.
        • *Something special about the SH ability to vote not being infringed (Schnell)
      • o Independent Legal Significance (Rhode Island): Several sections law or charter might have independent legal significance.
        • Bove: RI court will allow directors to create subsidiary and do freeze out merger (avoiding unanimous SH approval from charter) if its technically allowed by one section. Not necessarily invalid simply because not allowable by another section
        • Use: This action is fine if statutory allowed and furthering some business agenda.

E. Agency Authority[edit]

  • RULE: Agent has power to act on behalf of AND bind principal to relationships with third party (thus creating liabilities for principal)
    • o Fiduciary duties between agent and principal – goes both ways
    • o 3rd Restatement of Agency: Mutual agreement creating fiduciary responsibilities
      • Assent can be manifested through words or actions
    • Ways to bind Principal to Agent’s actions
      • o Actual Authority -- Agent reasonably believes he is acting according to principal's assent, traceable to principal’s manifestation of assent to agent
        • Can be stated or implied, and not limited to specific task necessarily
      • o Apparent Authority -- Third party reasonably believes that agent is authorized, traceable to principal's manifestation of assent to third party
      • o Inherent Authority – OLD rule of 2nd Restatement of Agency, largely abandoned
        • Looks to how the principal ordinarily would conduct her business
        • Is the power of an agent which is derived not from actual 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.
          • e.g.: the power of an employee to subject his employer to liability for torts
        • o Estoppel -- If the third party assumes a detrimental change in position under belief of other person's account if (a) other person intentionally or carelessly caused such belief, or (b) person was aware that it might induce others to a detriment and didn't take reasonable efforts to notify them of the fact.
          • Essentially, would it be inequitable for the principal to deny agency
        • o Ratification -- Binds a person to a prior act by another
          • Ex: "Oh yeah, $500 is actually a fine price for selling my TV, even though I didn't ask him to do that."
        • o Respondeat Superior
      • When to bind the principals?
        • o Intervenes in the business affairs of the debtor (Cargill Inc, wheat case)
        • o Ratification (Summit Properties)
        • o Inherent authority not refuted by Board (Dage-MIT)
      • Jenson Farms v. Cargill (Minn 1981) – apparent authority via course of dealing
        • o Cargill determined to become liable for Warren’s debts as principal via course of dealing – getting too involved in debtor actions (issuing credit, opening bank, sending operational manager, keeping books/audit, etc.
          • Agency can be created w/o contract or explicit language
          • Cargill consented to agency by directing Warren to implement recommendations + Warren acted on Cargill's behalf in procuring grains + Cargill exercised control by interfering in internal affairs
          • Rest (2nd) of Agency § 14(O)): creditor assuming control of debtor’s business makes them liable
            • Prof: Court should have relied more on apparent authority.
          • o To avoid apparent authority: Inform farmers that Cargill isn't principal; don't let Cargill get too involved in Warren's operations
          • o *Note: typical loan requirements don't create principal, so as to protect banks from worrying.
        • For Non-Corporate Entities
    • General Partnership (RUPA 301)
      • Partners have actual authority to do ordinary course of business
      • No apparent authority to bind partnership outside of ordinary course of business, unless given actual authority to do so.
        • To ensure that something is authorized which may be outside ordinary course of dealing (eg purchasing property), you can get them to sign an authorization contract.
    • Limited Partnership
      • Limited partner(s) do not have power to bind partnership (ULPA 302)
      • General partner has the same authority as in general partnership (ULPA 402)
    • LLC
      • OLD RULE (ULLCA 301): Agency power lies with whoever has management authority, either in member-managed or manager-managed firm
  • Manager of manager-managed LLC can be anyone (eg BoD, exec board member, etc.)
        • Delaware -- You are an agent just by being a member
        • New York – every member is agent in member-managed / every manager is agent in manager-manged
      • NEW RULE (RULLCA): cannot be assumed to have the authority because the status of being a member. “A member is not an agent of a LLC solely by reason of being a member.”
        • In limited partnership, limited partners become general partners if they get involved with control
          • LLC need not disclose if its member or manager managed (unlike ULLCA)
          • Members and managers have no statutory default agency power to bind LLC under RULLCA
            • Rationale: 3rd party never knew if they were dealing with member or manager-managed
  • When working with an LLC, it is important to check each jurisdiction’s statute as the rules of agency may vary considerably.
  • For Corporation
    • o Creating Authority
      • 3rd party dealing with corp’s subordinate officer usually bears burden to show that act was within officer’s authority.
      • If 3rd party knows that given transaction will personally benefit some officer, courts usually require 3rd party to investigate further whether officer has valid authority to enter into the transaction.
      • Even absent authority, if corp doesn't act following transaction they can still be bound.
    • o Who has authority?
      • Board = power and authority to manage the business and affairs of the corporation (DGCL §141(a))
      • CEO = presumed authority to bind company for acts arising in the “ordinary course of business”
        • Unless action requires additional authority per bylaws or statute
        • Often want additional assurance of authority before transacting with companies – Authority Resolution
        • Officers can delegate authority
      • Subordinate officers = dangerous. Can have delegated authority, but burden on 3rd party to show it.
      • Shareholders = NOT agents. They are the principals.
    • o No statute directly on point. Authority levels are determined by organization, practice, and common law.
      • Ex: Banks have thousands of VPs and probably no agency.
    • o In transaction, it is standard practice for BoD of each party to confirm authority levels:
      • If you are the buyer, get a memo confirming authority by the BoD.
      • If you are BoD, prevent the sale by sending memo denying authority.
    • o Summit Properties Inc v. New Tech (Oregon 2004) – ratification, apparent authority, leasing case
      • HOLDING: IES ratified the lease when it inspected the building and did not object in first instance. If it wanted to object, it should have done that on original lease.
      • RULE: Ratification -- A principal can be bound to a 3rd party through its agent (subsidiary CFO) when the principal knew about the transaction, did not act against it, and reaped the benefits. Even if there was no actual authority and principal later disavows the act.
      • *This case could also be decided on apparent authority -- A contracting party may rely on the apparent authority of an agent to bind the principal, so long as the contracting party does not know or have reason to know that the agent has no actual authority.
    • o Menard v. Dage-MTI (Indiana 2000)
      • Facts: President/CEO ignored Board’s rejection and went ahead in approving land sale to Menard.
      • RULE: Inherent Agency – president of a corporation has inherent agency power to bind the corporation to a contract if the (a) contract was within the “ordinary scope of his duties” and (b) 3rd party had no notice that he lacked authority.
        • Rationale: 3rd party transacting with company has reasonable expectation that the CEO has a certain amount of power in ordinary business activities.
        • Policy: If one party is to suffer, it should be one most at fault. Principals must be responsible for losses caused by their agent’s mistakes.
      • If Board wanted to be clear that they objected, they should have notified the buyer.

F. Piercing the Corporate Veil[edit]

  • Limited liability incentivizes investment of capital, which is necessary for business function
  • REALLY LIMITED TO CLOSE CORP
  • ISSUE: Debate over giving limited liability to Public Corp versus Close Corp (little trading of stocks)
    • Public company -- need many investors for capital, so must incentivize investment by minimizing liability risk
    • Private company
      • There's no efficiency concern because it’s a private market with few players so limited liability might not make sense (Easterbrook)
      • But maybe need it to incentivize risk-taking actions that are beneficial to the business (Presser)
  • Corporate Shareholders (eg holding companies) generally enjoy limited liability
    • Corporations used to be not be allowed to own stock in another corp, but they can now.
    • Parent corps not liable for subsidiaries
  • Other ways to pierce the corporate veil
    • o Fraudulent Transfers -- Uniform Fraudulent Transfer Act (UFTA)
      • RULE: A transfer is fraudulent (whether the creditor's claim arose before or after the transfer was made) if the debtor made the transfer with actual intent to hinder, delay, or defraud any creditor.
      • SHs liable for debts if they pull money out at a time that it owes money, thereby causing corp to not pay back
    • o Equitable Subordination = same principle for bankruptcy. The claims of SHs are subordinated to creditors
    • o SHs can be liable if they actively participate in wrong committed by corporation
  • Things to know:
    • Pierce the Corporate Veil = SH is found personally liable (even though general rule that SHs not personally liable)
      • Judicial doctrine. Not itself found in 6.22(b).
      • Rare practice bc limited liability is an essential legal attribute of corporation.
    • Corporation does not itself incur debts. Its Agents enter contracts/perform torts, thus making the corp liable.
    • Will almost always be for a close corporation.

MBCA § 6.22(b): “Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct.”

Tort Creditor[edit]

  • Courts actually pierce the corporate veil LESS for torts than contact issues. Even though in contract case, there is argument that the contracting parties had opportunity to protect themselves at outset, and not in tort case.
  • ISSUE: Is the company being run as dummy to advance personal interests or no? Factors:
    • o Undercapitalized
      • Undercapitalization = we don't have enough assets or insurance to help others when company liquifies
      • Fuld/Arnold majorities: Capitalization might be minimal and valid if purpose is to run a lean/efficienct company
      • Keating/Heaney dissents: Intent matters! If it’s undercapitalized just to shield from liability, improper.
        • Industry-Specific -- You should match the necessary capitalization requirements of your industry.
        • Counter: Shielding from liability is the essential purpose of corporate law.
      • o Failure to Follow Corporate Formalities
        • Corp Formalities = BoD, annual SH meetings, buy stocks/loans, etc.
        • Counter: Why should corporate formalities matter to subsidiary legitimacy? Doesn’t have anything to do with the actual business of the corp and its purpose.
      • o SH Treating Funds and other Corp Assets as their own
        • Corporate Interests Distinct from Individual/Parent Interest?
        • Ex: shuttling funds back and forth)
        • Counter: In small company, SH is almost always involved in the management so will have same interest. Same goes for subsidiary-parent interests, bc subsidiary director is usually just employee of parent.
      • o Insurance
        • Should not matter for capitalization. This is a legislative issue (Walkovszky)
        • Inadequate insurance is governed by BJR. High bar to show picking underfunded insurance was wrongful. (Radaszewski)
      • Walkovszky v. Carlton (NY 1966) -- Closely held corp by one owner who splits into 10, this is OKAY
        • o Facts: P is injured by cab driver. Cab business is operated by 10 corporations, each of which owns only 2 cabs in its name. Driver is a SH of those 10 corps, and the parent company has the statutory minimum insurance of $10k. P claims this is way too low.
        • o Holding (Fuld): Neither cab driver nor company (D) are personally liable.
          • This was not sufficiently undercapitalized.
          • 10 companies were observing corporate formalities.
          • Insurance is NOT capitalization. If the insurance payout was too low, that is an issue for Legislature.
        • o RULE: If person uses the business as a mere agent or dummy for personal interest, then it can be pierced:
          • If parent company uses subsidiary as agent, then pierce and hold parent liable
          • Alterego -- If individual SH uses subsidiary as agent (so conducting business in his individual capacity), then pierce and hold individual liable
        • o DISSENT (Keating): Taxi corps were intentionally undercapitalized to avoid pay-outs for inevitable car accidents Just skirting legislative intent and shielding self from liability. Financial responsibility (eg sufficient capital) is essential to legitimate business.
      • Radaszewski v. Telecom Corp. (8th Cir 1992) -- Parent corp as sole investor
        • o Facts: P was hit by truck driver working for Contrux. Issue is whether you can hold owning company Telecom (D) liable.
        • o HOLDING (Arnold): Cannot pierce the corporate veil to reach a corporation’s parent simply because of errors in business judgment. Something more should be shown to indicate fraud.
          • “Financial responsibility” is nebulous and shouldn’t matter for deciding undercapitalization.
          • ISSUE: Is choosing an underfunded insurer wrongful? In this case, considered bad business judgment.
        • o DISSENT (Heaney): This incentivizes companies to buy low-premium insurance from insolvent companies. Screws out the claimant b/c parent wanted low insurance rates.

Contract Creditors[edit]

  • Freeman fraud TEST: You can pierce the corporate veil (eg find liability for individual owner or parent), if:
    • o (1) Is D the equitable owner?
      • Equitable Ownership Theory -- D can be equitable owner of corp, even if they are not a SH, if they exercise "considerable authority" over it. (Freeman)
    • o (2) Three-prong test
      • (A) Did D exercise complete control? Factors:
        • (a) Corporate Formalities disregarded
        • (b) Undercapitalization,
        • (c) Intermingling of funds/property
        • (d) Common office space
        • (e) Overlap in ownership/officers/employees,
        • (f) degree of discretion from dominated corp,
        • (g) whether dealings are at arms length,
        • (h) whether corp treated as independent profit center,
        • (i) payment or guarantee of debts,
      • (B) Did D use control to harm P?
      • (C) Was P actually harmed?
    • Freeman v. Complex Computing Co (2nd Cir 1997)
      • o Facts: Columbia student Glazier develops software. School licenses to C3 (D), which Glazier's friend created as sole shareholder and director. D then contracts with Glazier Co. (student's company) as its contractor - contract mentions student by name at lot. Glazier acting like real owner -- signing for D, etc. Glazier Co sublicenses to Freeman (P) to sell software on commission -- contract includes arbitration clause. Eventually, Glazier Co gets big international marketer. P claims he deserves commission for it, and D fires P and sells off all its assets. P sues C3 and Glazier.
      • o Issue: Does Glazier need to be involved in the arbitration as part of C3?
      • o HOLDING (Miner): There was total control by student, but remand to see if domination of D used to wrong P.
    • Piercing most often happens for contract cases when creditors misrepresents itself to be more solvent that it was (eg Freeman).
  • Kinney Shoe Corp v. Polan (4th Cir 1991)
    • Facts: Kinney (P) subleased to Industrial Co., of which Polan (D) was sole shareholder. The contract was with D as individual and he made initial payments from his personal bank account. P sues
    • HOLDING: Pierce the veil. D is personally liable for his corp's actions.
    • Big takeaway: Polan tried to doubly insulate himself from liability.
      • Kinney did not assume the risk of dealing with agent. He couldn’t know about the undercapitalization of Industrial because Polan had shielded himself so much.
        • If Kinney had made agreement directly with Industrial Co., then maybe don’t pierce.
      • Difference from Carlton is that Polan got too cute (eg failed basic corporate formalities, pooled assets elsewhere, did not guarantee subsidiary's debts).
    • RULE: Can pierce the corporate veil if (1) SH fails to be distinct from corporation, and (2) failure to pierce would not be equitable.
  • (1) Indistinct identities: Undercapitalized business, lack of corp formalities (no stock, no minutes, no officers), pooled assets in Polan’s own accounts.
    • Besides the sublease, Industrial has no assets, income, or bank account à undercapitalized.
  • (2) Equitable to pierce: D was clearly trying to shield himself.
        • *Note: Financial institutions must always do investigation of debtors’ solvency, so they assume the risk if debtor is undercapitalized.
    • Piercing corporate veil is factual inquiry. DC finding must be clearly erroneous.

Parent-Subsidiary Piercing[edit]

  • Split up business for (a) convenience), (b) profit maximization
  • Gardemal v. Westin Hotel Co (5th Cir 1999)
    • Facts: Man drowns bc Westin Mexico concierge negligently tell him to swim in dangerous area. Wife (P) sues Westin Mexico and its parent Westin Hotel (D). Westin Mexico claim dismissed for lack of PJ. P argues that, under Texas law, Westin Hotel is liable as principal SH of Westin Mexico bc of (a) alter ego doctrine, or (b) single business enterprise operation.
    • HOLDING: Westin Hotel isn't liable under either theory.
    • Alter Ego Doctrine = Pierce the corporate veil for parent company when the subsidiary is organized or operated as "mere tool or business conduit" for parent company.
      • Evidenced by blending of identities, BOTH formal and substantive. Factors:
        • Undercapitalization – key factor
        • Is it a typical arrangement in the industry? Here, yes it is.
        • Overlap -- brand name, stock ownership, officers, financing arrangement?
        • Autonomous -- Has its own banks, accounts, staff, insurance policies, operations?
        • State of incorporation -- incorporated by Mexico law
        • No corporate formalities.
      • No lack of equitable remedy. Can just sue Westin Mexico directly.
    • Single Business Enterprise Doctrine = corps integrate their resources to achieve common business purpose.
      • Rejected bc this is typical set-up. No evidence of blending of corp identities.
  • OTR Associates v. IBC (NJ 2002) – good example of piercing for fraud
    • Facts: IBC enters into a lease in a shopping mall and then breaches/fails to pay rent. Leasing co (sophisticated victim) has no idea that IBC is a shell company/ not part of Blimpie franchise. When franchise fails, franchisee goes bankrupts, and OTR sues Blimpie. Blimpie says, no, you contracted with IBC services, a subsidiary of ours, so you cannot sue us. IBC Services had no assets aside from the lease, i.e. it is just a leaseholder
  • o HOLDING: Yes. Pierce corporate veil because there was undercapitalization (alterego) and fraud/injustice (misrep)
    • Misrepresentation – Blimpie wanted leasing co to think that it was IBC (sent tenants in Blimpie uniforms as reps to negotiations, IBC letterhead reflects “International Blimpie Corporation,” IBC and Blimpie share corporate address.
  • o RULE: For Parent-Subsidiary, to pierce the corp veil, court must find (1) domination of subsidiary, and (2) parent abused subsidiary to perpetrate a fraud or injustice, or otherwise to circumvent the law

Veil Peircing in LLC[edit]

  • LLC can be corporate veil pierced
  • But there are fewer formalities for LLC
  • RULE: A court will pierce the LLC veil if (1) there is overall injustice/unfairness and (2) the LLC is a mere instrumentality or alter ego of its owner, in that the LLC and the owner operate as a single economic unit
  • NetJets Aviations (2nd Cir 2008)
    • o RULE: No single factor can justify a decision to disregard the corporate entity… but some combination of them is required and .. an overall element of injustice or unfairness must always be present as well
    • o Factors:
      • Undercapitalized
      • Personal cash machine -- deposited funds into LHC’s account and withdrew for personal and family’s use
      • Did not put any of the deposits or withdrawals in writing and failed to consistently characterize the transactions as loans or capital contributions.
      • Zimmerman had sole control over all financial decisions of LHC
      • Legal Formalities – failing to use legal formalities in contacting each other indicates that you’re same entity
    • o

G. Internal Affairs Doctrine / Choice of Law[edit]

  • Any entities with limited liability can be created through a filing with any state.
    • Exception: General Partnerships are not be default limited liability, so subject to the laws of jurisdiction where partnership has its chief executive office (RUPA 106(a)). General partnership need not filed anywhere.
  • RULE: Law of the state of incorporation (or filing) governs the internal affairs of corp
    • Internal Affairs = any matters relating to governance of managers and equityholders
      • Ex: If suit is brought in Texas against DE corp for internal affairs, court must apply DE law.
      • Internal affairs includes
        • SH rights regarding: voting, receiving distributions, receiving info from management, limiting powers of corp to specific fields of activity, and bringing suit on behalf of corp
        • FIDUCIARY DUTIES
        • Procedures by which BoD acts, rights and extent of officers/directors to be indemnified by corp, and corp's right to issue stock and merge
    • External affairs generally handled by state where act occurs
    • Rationale: Clarity
  • Constitutional underpinnings
    • DP -- Potential violation of due process for state statute to affect out-of-state activity
    • Dormant Commerce Clause -- "negative implication" of CC that state law can't (1) treat domestic and foreign corps differently, or (2) unduly burden interstate commerce with conflicting standards.
    • Edgar v. MITE Corp. (1982) -- anti-takeover statute
      • Facts: Anti-takeover statute in Illinois bc takeovers often involve firing old management. Law protected any corps that are 10% shares owned by Illinois citizens AND (a) 10% assets in Illinois, (b) HQ in Illinois, or (c) organized under Illinois law. Required 30 days notice for takeover -- was essentially a bar.
      • HOLDING: Takeover is NOT internal affairs. Statute barred by CC because it unduly burdened interstate commerce.
    • CTS v. Dynamic Corp. (1987)
      • Facts: More limited so as exclude foreign corps. Statute barred new controlling shareholders from voting unless a majority of disinterested shareholders voted to approve takeover. Only applied to Indiana corps with 10% Indiana stockholders + Indiana PPOB + min 100 shareholders.
      • HOLDING: Internal approval for takeover/merger is internal affairs. State can require: majority approval of shareholders, appraisal.
      • Many states have adopted similar legislation.
        • Delaware Controlled Share Act -- anyone getting majority shares in Delaware Corp requires approval of other shareholders.
  • State law dilemma
    • Concern of "race to the bottom" -- will state competition for corp charters lead to harm?
      • Ex: could increase agency costs, remove safeguards for public or minority shareholders
      • Brandeis dissent in Liggett
    • Counter: State competition is "laboratory for innovation" (Judge Winter)
      • Regulation just reduces market-power bargaining -- its less efficient!
    • Reality: MBCA is groundwork for vast majority of states. Delaware is the other major player. So real question is conflict between Delaware and MBCA.
  • Why is Delaware so strong
    • (1) Dela relies on corp franchise taxes, therefore incentivized to be generous to corps
    • (2) Dela constitution requires 2/3 vote of both houses to change corporate code
    • (3) Dela has heavy "legal capital" -- large body of corp case law, admin, etc.


H. Legal Personhood[edit]

  • ISSUE: Aggregate Theory vs. Entity Theory
    • o Is corporation a distinct entity? --> Legal personhood, with its own rights and subject to limitations
    • o Is corporation just a vehicle for people to act? --> Ignore the corporation and just focus on rights of the individuals involved
  • First Amendment Rights of Corporation
    • o Dartmouth College (1819) – Entity Theory -- Corp is not an individual. Corporation is "mere creature of law." Artificial entity only with powers that state gives it.
    • o First National Bank of Bostin v. Bellotti (1978) – favors greater 1st Amend speech rights for corporation
      • HOLDING (Powell): Statute restricting corps from spending to influence votes on referendum (that don’t impact business assets) is invalid. Just trying to suppress corporate speech.
        • Majority follows the wisdom of Greenshpan (economist). If you are SH are don’t like the corp action, you have 3 options:
          • o Remain loyal
          • o Voice your opinion (including via voting)
          • o Exit company
        • DISSENT (White):
          • Policy perspective -- Corporate money will dominate the political sphere.
          • Dartmouth College -- corp doesn't get natural person rights. Only gets rights that are incidental to purpose of the corporation.
        • o Austin v. Michigan Chamber of Commerce (1990) – anti-corp speech, overturned by Citizens United
          • HOLDING (Marshall): Statute prohibiting corporate expenditure to support campaigns for legislature is valid.
            • Entity Theory – Corporations' power come from state, benefit from state, so state can limit corp powers.
              • o Counter (Scalia): That cannot go to free speech limitations, though.
            • Corrosive Effects -- Corp can use great wealth to bully politics.
          • o Citizens United (2010)
            • RULE (Kennedy): Although corporations can be limited wrt their direct contributions to political candidates, corporations cannot be limited wrt to expenditures on their own or through independent PACs for speech that support or oppose political candidates.
              • Aggregate Theory – Corp is just an aggregation extends to the corporation the rights that individuals (and groups of indiv.) have against government infringing on their speech (following Bellotti).
                • o Prohibiting corporate speech would limit the speech of majority SHs.
              • o Hobby Lobby (2014)
                • Facts: Closely-held corporations don't want to provide health insurance coverage for abortion coverage. Company challenge constitutional of the ACA on grounds that it forces corporations who have religious beliefs inconsistent with contraception - believe have a constitutional right to exception
                • RULE (Alito): For-profit closely held corporation can’t be forced to cover insurance provisions that upsets the religious beliefs of the owners.
                  • Aggregate Theory – Corporations have religious rights under RFRA.
                  • Lessened concern for closely held corp because SHs are probably all likeminded. Unlikely to have oppressed minority SHs.
                • DISSENT (Ginsburg): This is dangerous. If we let close corp do this, then public corp can as well. And it would let the owners assert their personal rights through the corporation, against the SHs.
              • o In conclusion
                • Prof: Aggregate Theory is bad. Dissent in Hobby Lobby recognized that for public company, will be letting corp make political statements that many SHs don’t agree with. The reality of corporate democracy means that they don’t have any true channel to dissent, must simply exit.
                  • Note that most corporate scholars say its bad law to let shareholders assert their rights through the corporation.

I. Corporation & Society[edit]

Charitable Donations[edit]

  • TEST
    • o Statutory Authority – almost all states allow
      • DGCL §122(9): ''Every corporation created under this chapter shall have power to:
        • 9) Make donations for the public welfare or for charitable, scientific or educational purposes, and in time of war or other national emergency in aid thereof;
      • MBCA §3.02 (13): ''Unless its articles of incorporation provide otherwise, every corporation has perpetual duration and succession in its corporate name and has the same powers as an individual to do all things necessary or convenient to carry out its business and affairs, including without limitation power:
        • (1) to make donations for the public welfare or for charitable, scientific, or educational purposes;
      • o Reasonableness (Theodora Holding DE)
      • Court decides what is reasonableness of amount and purpose
  • Factors:
    • (1) within IRS limits for tax deductions (up to 5% of the revenue)
    • (2) relative size of contribution is small compared company revenue -- eg $80k vs $19M
    • (3) lots of economic benefit – eg BS increase via capital gains
  • *For settlement, standard of review is abuse of discretion in finding BJR, not fairness of the settlement. Even meager settlement amount is fine if SH likely to lose on merit due to BJR (Kahn v. Sullivan DE)
  • o Fiduciary Duties (Kahn v. Sullivan DE)
    • Duty of Loyalty – eg conflict of interest, resolved by having outside counsel and accountant + outside special committee for approval
    • Duty of Care – BJR applies if you pass reasonableness + show long-term interest of SH
      • Long-term interest can be via community goodwill (eg building museum for corp)
      • If find BJR, can only overcome by showing Waste
      • *If you use BJR defense, you should file motion to dismiss for failure to state a claim or SJ
  • OLD RULE: Corporate charitable Contributions not allowed.
    • o Rationale: Corporation belongs to SHs, and so do revenues. Wouldn't benefit SHs to give money to charities.
      • Also, SHs might disagree on where to give charity.
    • NEW RULE: Acceptable under BJR -- if owners think it is in best long-term interest of corporation/SHs, then its fine.
      • o All states have statutes allowing charitable donations
  • Theodora Holding Corp v. Henderson (Del. 1969)
    • Facts: Henderson switches charity for donation after kicking off the dissenting board member. Old charity sued.
    • HOLDING: This was acceptable. Under Delaware law, this was reasonable amount and purpose.
      • Court decides what is reasonable. Look at: IRS limits, after-tax gift amount ($80k) relation to revenue (19Mil), benefit to corp (actually increased BS via capital gains)
    • RULE: Gift in order to be valid must merely be within reasonable limits of both (a) amount and (b) purpose.
      • (1) must be within IRS limits for tax deductions (up to 5% of the revenue);
      • (2) size of contribution relative to size of company is small;
      • (3) lots of economic benefit.
  • o Note: Court ignores the BJR. BJR would hold that charitable gifts is fine within reasonable limits
  • Kahn v. Sullivan (Del. 1991)
    • Facts: Hammer (CEO/chairman of Occidental) seeks Board approval to build museum of personal collection. Gets approval from outside law firms/accountant + outside special committee says it would benefit Occidental via recognition. Board approves, and 2 SHs sue. Issue over settlement amount.
    • HOLDING: This settlement is okay. Donation was acceptable under Theodora/BJR.
      • Although settlement was meager, any litigation by SHs was likely to lose (bc the approval was within BJR of Board based on external assessment).
        • Independent external approval is good for supporting BJR. No breach of duty.
        • Can only overcome BJR by showing that the loss from decision was so great that it is "Waste"
      • Applies Theodora: within IRS limits, reasonable for Occidental, and had tax benefits/goodwill.
    • RULE: For settlement, don't review "fairness of the settlement", but whether court abused discretion in applying the BJR in context.
  • A.P Smith Manuf. (NJ 1953) – corporate gift to Princeton Uni is valid, claiming that gift arguably advanced long-term business interests.

B-Corp[edit]

  • RULE: You can self-designate at a Benefit Corp (B Corp). In additional to fiduciary duty to shareholders, also have legal duty to other stakeholders (employees, community, etc.)
  • Some different governance requirements
    • Must have stated purpose of creating "general public benefit" -- eg improving health, enviro, etc.
      • MBCA: Specifies interests to consider
      • DGCL: Director need only consider interests of those "materially affected" by corp ops
      • What are the MBCA/DGCL B Corp statutes?
    • Must deliver annual benefit report to SHs, post on website and file
      • DGCL: benefit report need only be given to shareholders. No requirement of assessing performance against 3rd party standard.

Shareholder Primacy vs. Corporate Social Responsibility[edit]

  • ISSUE: What is purpose of the corporation?
    • o Shareholder Primacy
      • Milton Friedman: Corp’s only responsibility is to maximizie return for SHs
      • See: Theodora Holding (DE, corp donation must help returns), Dodge v. Ford (Mich, corp must enrich SHs but incidental humanitarian expenses okay under BJR), Council of Institutional Investors (CII, accountability), Judge Strine (accountability), Kraakman, 1997 Business Roundtable
      • Prof: Under Berle-Means separation of ownership from control, SHs have little control, so they rely on the BOD and management to run business. Expectation to maximize their returns?
      • Pros:
        • Clarity – no conflicts in serving
        • How do biz directors know what is best for humanitarianism?
        • Accountability – if SH return isn’t maximized, we can hold directors accountable (CII, Judge Strine)
          • o CII = "Accountability to everyone is accountability to no one"
        • Free market will correct for any bad corporate practice
      • Arguments for Shareholder Primacy:
        • Shareholder profit needs economic profit --> operational expenses can go back into US econ
        • If you don't promote shareholder value --> deter investors, might invest abroad instead
        • Milton Friedman: Shareholder primacy makes for efficient market
          • o Counter: Morningstar: There is correlation btw profitability and good social governance --> paying attention to other constituents isn't inefficient
        • Shareholder primacy has clarity. CSG is too confusing. Multiple stakeholders can lead to conflict in interests, and there is no decision making guidelines for those conflicts.
      • Arguments against
        • Morningstar: There is correlation btw profitability and good social governance --> paying attention to other constituents isn't inefficient
        • Lipton -- (1) encourages short-termism and activist investor attacks, (2) reduces R&D expenditure, wages, and long-term sustainable investments.
        • Directors don't need to maximize shareholder wealth with every decision
          • o SH can't succeed on derivative suit for breach of duty just because director failed to maximize profit, if there was plausible better judgment by the director (Kamin)
          • o BJR gives broad power to directors even if not maximizing shareholder value
          • o No statute mandates profit maximization.
            • Ex: We allow charitable contributions, which definitely don't maximize short-term interest, as long as BJR says its in long-term interests of corp.
          • o Corporate Social Responsibility
            • Business Roundtable:
            • See: Kahn v. Sullivan (DE, building museum helps long-term), Ebay (temporary free service can be okay for marketing), Dodge v. Ford (incidental humanitarian expense okay), ALI Principles, William Allen, Constituency Provisions, Lipton – Director Primacy, 2019 Business Roundtable
            • Pros:
        • Conception of corporation as social entity – help the world and community
        • SH primacy is NOT followed in Europe (cooperative model), causes issues in doing international business
  • Who are Corporate Stakeholders?
    • o Equityholders – protected by business law (ie fiduciary duties)
    • Creditors – protected by contract + bankruptcy law
      • RULE: Business law doesn't protect creditors (ie no fiduciary duties)
        • EXCEPTION: Can't make distributions to equityholders that would make entity insolvent (MBCA 6.40(c))
    • Employees – protected by employment law + contract law
    • Customers – protected by contract law + product safety law
    • Community
      • Business law protects them in TWO scenarios
        • (1) Authorized charitable contributions
        • (2) Some state corp laws permit BoD to consider the public when making a decision
  • Dodge v. Ford Motor Co. (Mich 1919)
    • Facts: Ford (D) is majority SH of his company. Decides to stop issuing quarterly dividends, reinvest into biz by increasing employee salary + build new plant (which lowers consumer prices, thus hurting SHs). D was upfront that profits were only incidental. Dodge bros (P) are minority SHs (who needed dividends for their competing biz) sue to get dividend and enjoin construction of the plant.
    • HOLDING (Ostrander): Ford must issue dividend, but allow salary increase + plant construction under BJR.
    • RULE: Corporation can make decisions that defer profit, but only if incidental to long-term interest of SH's. Under BJR, directors allowed good faith discretion to manage employee’s welfare (eg salaries, hours, conditions) as an "incidental humanitarian expenditure".
      • Misconception that this case says no expenditures beyond SH profit.
      • Corporation purpose is to enrich SHs.
        • But need not be 100% profitable in short-term.
        • Important factor: Corporation was hugely profitable, Ford was upfront about why he didn’t want to issue dividends.
        • “A business corporation is organized and carried on primarily for the profits of the stockholders."
    • Prof: Dividend should have been valid under BJR to reinvest. Court was just anti-Ford because he was so vocal about not wanting to enrich fat cat SHs.
  • Ebay Domestic Holdings v. Newmark (Dela. 2010)
    • Facts: Craigslist’s founders (D) want to keep Craigslist as a free service to the community. Ebay (P) pays Ds for stockholder agreement that gives them minority seat on BoD and allows Ebay to compete. Founders can't buy out Ebay, so implement (1) Staggered board, and (2) a stockholder rights plan ("poison pill" that dilutes other shareholder's stock if he buys any more) to prevent the investor Ebay from making Craigslist profitable and thus to maintain Cgraiglist’s culture of serving the community.
    • HOLDING (Chandler): Craigslist founders breached fiduciary duties as directors.
      • Directors owe fiduciary duties to all SHs + majority SHs owe fiduciary duty to minority SHs
        • Separate SHs treated as singular controlling power due to Voting Agreement
      • Purely supporting community is not acceptable corporate purpose. Their corporate plan must promote SH value.
        • Free service in short term that can be acceptable as marketing, but not valid if indefinite.
        • Can't have unlimited defensive technique.
    • Unocal TEST: To show that they didn’t breach fiduciary duties, Directors must (1) identify proper objectives served by their actions and (2) justify their actions as reasonable (range of reasonableness) in relation to those objectives.
      • Enhanced Scrutiny – lies between BJR and “entire fairness”
      • Pure ethics are not a proper corporate objective. Must enhance SH value.
    • RULE: For a poison pill (shareholder rights plan), must (1) properly and reasonably perceive threat to corporate policy and effectiveness, (2) determine poison pill is proportional response to threat
      • Can’t use it indiscriminately.
  • Academic perspectives
    • William Allen reading
      • Two views of corporation
        • (1) View corp as private property of SHs -- purpose is to advance their interests
        • (2) View corp as social institution -- advance interests of public
      • Long-term/Short-Term distinction used by courts -- incorporate social responsibilities under long-term view
    • Judge Strine reading -- the need for a clear-eyed understanding of the power and accountability structure established by the Delaware general corporation law
  • ALI Principles of Corporate Governance
  • 2.01 The objective and conduct of the corporation

(b) A corporation should have as its objective the conduct of business activities with a view to enhancing corporate profit and shareholder gain''(c) Even if corporate profit and shareholder gain are not thereby enhanced the corporation, in the conduct of its business:'(1) is obliged, to the same extent as a natural person, to act within the boundaries set by law;'(2) May take into account ethical considerations that are reasonably regarded as appropriate to the responsible conduct of business; and ''(3) May devote a reasonable amount of resources to public welfare, humanitarian, educational, and philanthropic purposes.

    • RULE: ALI Principles 2.01 say that main purpose of corp is SH gain, but action can still be valid if other objective is:
      • c1) Avoiding illegality,
      • c2) Ethical w/in reasonable consideration of responsible conduct,
      • c3) Reasonable devotion to public welfare, humanitarian, education, philanthropy
    • DGCL and MBCA don't have this provision. Simply say that corp can engage in any lawful activity
  • Constituency Provisions -- authorization for board to consider interests of constituents besides SHs
    • Half of states have this (e.g Pennsylvania)
    • DGCL and MBCA do NOT have constituency provision
      • Delaware corps may consider all relevant factors in making decisions around takeovers
  • Multinational corporations – increased risk (legal, social, and econ) when doing business overseas. Must consider different statutes, cultural perspectives, etc.


Advising the Entity[edit]

A. Lawyer’s Role[edit]

ABA Rules[edit]

  • Lawyer’s legal obligations
    • (1) Obligation to the corp – SHs?
    • (2) comply with the law.
  • ABA Model Rules of Professional Conduct (2.1)''''
    • RULE: Lawyer shall advise client on the law, but also moral, economic, social, and political considerations
      • Lawyer’s counsel =/= endorsement
      • Lawyer must follow the client’s decisions IN COURT.
      • Lawyer can’t assist in crime, but can advice on legal consequences.
      • FN1: Lawyer must provide honest advise, event if it is harsh.
      • FN2: Give practical advice, not just legal technicalities.
      • FN3: Consider legal sophistication of client.
      • FN5: Duty to Offer Advice, only if you know substantial adverse consequences if he doesn't speak.
  • Restatement Sec 14: client confidence, avoid conflict of interest, deal honestly, not use advantage of relationship against client
  • ABA Model Rule 1.4: Duties of Corporate Lawyer
    • Notify client when situation requires their consent,
    • Consult on client objectives,
    • Keep client informed,
    • Comply with client info requests,
    • Consult with client about relevant limitations on lawyer's conduct when client expects impermissible assistance,
    • Explain matters to client
    • *General standards = promptly, reasonably
  • ABA Model Rule 1.6: Confidentiality
    • Don't disclose client's info wo client's informed consent
    • EXCEPTIONS: Lawyer may reveal client info to extent that lawyer believes reasonably necessary to:
      • (1) prevent death/harm,
      • (2) prevent crime that will result in harm,
      • (3) prevent/mitigate substantial financial harm to others,
      • (4) get advice about lawyer's duties,
      • (5) to defend himself if client sues him,
      • (6) comply with other law/court order,
      • (7) to resolve conflicts of interest
    • *In some states, “may” has been changed to “shall” -- so revealing info is mandatory
  • Comment 31: Common representation will "almost certainly" be inadequate if one client asks lawyer not to disclose info to other clients. At the start, lawyer must tell each client that they have equal rights of representation and that lawyer sometimes must disclose info to other clients + if there is something material that they kept secret, lawyer will need to withdraw.
  • ABA Model Rule 1.7: Lawyer is allowed to represent multiple clients
    • Important in minimizing business expenses
    • But lawyer must get informed consent before representing clients who may have conflict of interest (eg partners putting in different capital amounts)
  • ABA Model Rule 1.13: Organization as Client
    • Attorney represents the organization, via its authorization by constituents
    • RULE: Lawyer should rat on officer if he believes there is (a) violation of officer's legal obligation to org or violation of law AND (b) substantial likely injury.
    • RULE: Unless lawyer reasonably believes that org's interest doesn't require it, he should refer matter to higher authority

Moral Independence Theory[edit]

  • Potter Stewart -- business lawyer must give advice for businessman. Ethics determined by the business.
  • William Allen -- Moral Independence Theory. Outside counsel is not morally responsible for their client because they have duty of independence to legal system's values. Can't let loyalty to client cause social waste (eg violating law, spirit of the law, deceiving court).
    • Lawyer shouldn't assist in project more likely than not to violate law,
    • Lawyer shouldn't associate with unduly harsh or oppressive behavior
    • Lawyer must counsel client on ways to advance interests while satisfying underlying goals of the law or seek efficient adjudication. (eg don’t impose unnecessary cost on adversary)
    • Moral independence makes a lawyer more personally happy, improves long-term relationships/rep, and leads to better legal advice.
  • Richard Painter -- Moral Interdependence Theory. Outside counsel assumes moral responsibility of client because they have equal role in real world over decision making with client.
    • Rejects Moral Independence Theory -- Underlying premise is that lawyer/client actions are distinguishable. But not always the case because they act in cooperation.
      • Stresses nonaccountability. How do you know what was advice of lawyer or not?

Counseling on Issue[edit]

  • General steps in counseling
    • (1) Who’s interest must we consider under BJR?
      • BJR states you can take employee’s welfare into account as long there is some colorable attachment to profitability.
      • Dodge v Ford, ALI Principles – BOD is entitled to take ethical considerations into account.
    • (2) Are we legally required to do something? Precedent – if legally required to do something, must do it.
    • (3) Can we ethically recommend something as lawyer? Do we need resign?
      • Lawyer has duty to give best advice including non-legal considerations, but NO DUTY to accept to represent any client based on ethical considerations
        • Must notify of ethical issues (MRPC 2.1)
        • Interdependence Theory (Painter) – reject client if you disagree
        • Judicial efficiency
      • Difference btw Outside Counsel and In-House – can always turn down representation
      • Difference in court versus out-of-court
        • In Court -- must give best case for your client no matter what due to adversarial system
        • Out-Of-Court -- lawyer doesn't have to represent client due to moral obligations
        • Judicial Efficiency? Professional responsibility of a corporate lawyer here is to not to interpose a motion for the purpose of delay.
          • J. Chandler -- distinction btw bounds of zealous advocacy in litigation and ethical advice in a counseling setting. Enhanced scrutiny does not apply.
    • (4) What risks to consider?
      • Legal Harm – liability with law? Fiduciary duties?
      • Non-legal considerations: Financial harm, ethical issues, Reputational harm, International regulatory environment
      • Model Rules 2.1 states in representing a client, a lawyer shall render independent professional judgment with moral and ethical considerations.
        • Required to use it but have ethical obligations to employees to keep them safe. We are not required to be amoral as lawyers.
        • You may end representation if your client performs unethical or immoral acts.
  • Prof: Under Berle-Means separation of ownership from control, SHs have little control, so they rely on the BOD and management to run business. Expectation to consult corporate counsel in making their decisions and to perhaps take some responsibility.

B. Who’s the Client?[edit]

Representing Multiple Clients[edit]

  • ABA Model Rule 1.6: Confidentiality
    • Don't disclose client's info wo client's informed consent
    • EXCEPTIONS: Lawyer may reveal confidential client info to extent that lawyer believes reasonably necessary to:
      • b1) prevent reasonable certain death or substantial bodily harm.
      • b2) prevent client from committing crime or fraud that is going to result in substantial financial injury
      • b3) prevent substantial injury to the financial interests of another that has resulted from a crime.
      • b4) get advice about lawyer's duties,
      • b5) to defend himself if client sues him,
      • b6) comply with other law/court order,
      • b7) to resolve conflicts of interest
    • *In some states, “may” has been changed to “shall” -- so revealing info is mandatory
    • *This privilege belongs to corp, NOT the CEO. It can be waived by the BoD.
  • Comment 31: Common representation will "almost certainly" be inadequate if one client asks lawyer not to disclose info to other clients. At the start, lawyer must tell each client that they have equal rights of representation and that lawyer sometimes must disclose info to other clients + if there is something material that they kept secret, lawyer will need to withdraw.
  • Model Rule 1.7: Lawyer is allowed to represent multiple clients
    • Rationale: Important in minimizing business expenses
  • o RULE: Before representing clients who may have different interest (eg partners putting in different capital amounts), must get from each affected party:
      • Informed consent, and
      • Written approval

'

Entity Theory of Representation[edit]

  • 'Entity Theory: 'a lawyer represents the entity, rather than its officers, directors, employees and owners (though, with informed consent, the lawyer may also represent them).
  • Model Rule 1.13: Organization as Client
    • Attorney represents the organization, via its authorization by constituents
    • RULE: Lawyer should rat on officer if he believes there is (a) violation of officer's legal obligation to org or violation of law AND (b) substantial likely injury.
    • RULE: Unless lawyer reasonably believes that org's interest doesn't require it, he should refer matter to higher authority.
  • Reinecke v. Danforth (Wisc 1992)
    • RULE: Entity Theory of confidentiality applies retroactively if the lawyer represented a person for purposes of incorporating their business (which then became incorporated), such that lawyer was really representing the corporation, not the person.
      • Retroactive rule applies to pre-incorporation communications. So corporation (not the individual) owns privilege on any communications made during course of creating corp that pertains to incorporation.
        • If communication btw lawyer and person did not directly relate to incorporation, then the person still has privilege with the attorney for that stuff.
      • Incorporation must actually be successful for retroactive application.
        • Open issue: does retroactive rule apply if the incorporation fails?
  • State Bar of Arizona Opinion (2002)
    • Lawyer may represent only entity during formation process, as long as constituents of future-entity understand and agree to entity being the true client.
    • It is duty of lawyer in initial convos to clarify who his client will be
      • Because lawyer's clients depend on "reasonable perceptions" of those who interact with him
      • Lawyer should be explicit that he only represents the corp
      • More akin to aggregate theory than the entity theory
    • Lawyer should create engagement letter which specifies who his clients will be, won't be, and how info will be decided upon to communicate depending on confidentiality
      • Lawyer also need to routinely let people know that they're not his clients or convos aren't privileged
      • Explain that if a conflict arises, he'll need to withdraw from all representation of parties
      • Helps avoid conflict of interest charge
        • Conflict of interest = anytime lawyer's independent professional judgment is materially limited

Aggregate Theory of Representation[edit]

  • Aggregate Theory: Lawyer represents all of the owners individually AND the entity
    • Lawyer can implicitly admit duty to all owners under aggregate theory if he notes that if owners have dispute he'll stop representing them all (Opdyke v. Kent Liquor Mart, Dela 1962)
  • Lawyer has no duty to keep info confidential among owners if it relates to representations
  • Attorney-client privilege doesn't apply if there is litigation btw owners
  • Rationale: economy, efficiency

Reasonable Expectations Test[edit]

  • Reasonable Expectations Test: If attorneys lead individual/entity to believe they are client + belief is reasonable, attorney-client relationship is created (Westinghouse)
    • Intent of attorney doesn't matter
    • Close corporation has higher risk of "reasonable expectations" creating attorney-client relationship
      • Rationale: close corp has fewer owners, more involved, like a partnership
        • Partnerships also have tendency for courts to find attorney-client relationship among all partners
        • Presumably same for member-managed LLC
      • Rosman: Just saying something is a corp doesn't eliminate individual clients. Substance > form.
  • Factors:
    • (a) Type of entity – Close Corp/partnership are more likely to have reasonable expectation
    • (b) Capacity in which constituent acts – asking for personal legal advice suggests reasonable expectation
      • Absence of personal capacity advice can indicate no reasonable expectation
    • (c) Who pays the attorney – gray area
  • Lawyer "to the situation"
    • Brandeis idea that you are just lawyer to achieve objective, and you just need to be sensitive to potential conflicts that are material to undermining that objective
    • Geoffrey Hazard: Ethics in the Practice of Law (1978)
      • "lawyering for the situation" (Brandeis technique) is messy.
        • Lawyer must clearly identify his role as attorney for all constituents.
        • Attorney must not specifically say what he will do or what clients should do in situation.

C. Choice of Entity[edit]

Limited Liability[edit]

  • General rule: limited liability is preferable.
  • Corp = limited liability for all
  • General Partnership = General partners are jointly and severally liable for partnership D&Os
  • Limited partnership = only limited partners have limited liability and subject to "control rule" of RULPA
  • LLC = limited liability for members and managers without limitations of limited partnership.

Continuity of Existence[edit]

  • Corp = Perpetual
    • Pro: Provides certainty of operations
    • UNLESS
      • Bankruptcy (forced liquidation),
      • Dissolution (forced or voluntary), or
      • Certificate specifies an expiration time
  • General Partnership =dissociation gives either to continue (RUPA 701-705) or wind up (RUPA 801-807).
    • If one partner dissociates in two-person partnership, it ceases to exist.
  • Limited Partnership = perpetual
  • LLC = perpetual

Allocation of Control, Management[edit]

  • Corp = centralized with BoD
    • MGMT structure through different classes of stock - MBCA 6.01
  • General Partnership = management vested in all partners, each has authority to act
    • No centralization of management
    • Partners may modify the default ownership structure in the partnership agreement
  • Limited Partnership = formal dichotemy between General Partners (managers) and Limited Partners (passive investor)
    • Partners may modify the default ownership structure in the partnership agreement

Division of Economic Interests[edit]

“gozintas and gozoutas”'

  • Consider:
    • o Capital contributions,
    • o Allocation of P/L,
    • o Allocation of distributions
    • o Allocation of residual interests on liquidation
  • How to allocate based on economic/risk interests
    • Capital Structure
    • Basic Tools
      • Common stock -- all corporations must have this. Highest risk/reward because bears residual risk (last to get paid out)
      • Preferred stock -- priority on dividends/liquidation (eg must get paid out before common stock), could give a vote
      • Debt -- less risky than preferred stock (which his less risky than common)
      • Employment compensation -- not great if you hope to be mostly passive; guaranteed via contract
        • Employment Contract = protection, if SH fired w/o cause can sue for annual salary.
          • Enforceable only one way (can't force someone to work)
          • Base listed salary will usually change due to raises
          • Operates a severance package
          • BUT: contract duty to mitigate damages (finding new job). Good employment contract will specify limited period of severance.
  • Corp = must be at least one class of stock that is entitled to receive dividends, if any, and the net assets of the corporation upon dissolution

Authority to Act (Agency)[edit]

  • Corporation
    • Board acting collectively is agent
      • Can delegate agency
      • Corporation is the principal
        • In close corp, SHs could theoretically be principal (because they owe each other FDs)
    • Board member as individual is not agent
  • General Partnership = each has authority to bind within ordinary course of business
    • Majority vote to make a decision if there’s disagreement
    • If outside the ordinary course of business, then need unanimity

Fiduciary Duties[edit]

  • Uniform laws generally provide that the partnership or operating agreement may not eliminate FD
  • Partnership or operating agreements that fail to address fiduciary duties are subject to traditional concepts of contract interpretation

Transferability of Interests (restrictions?)[edit]

  • Lawyer’s legal obligations
  • Corp = Free transferability of financial interests, no need to obtain consent of other SHs
    • Certificate of incorporation or SHs agreement often contain restrictions on the transferability of stock
    • *Close Corp has restricted transferability
  • LLC = restricted transferability of interests
  • Partnership = can only transfer financial rights, not managemet

Taxation[edit]

  • Corp = tax benefits
    • Corp profits are taxed to corp as the entity, not SHs (until dividends)
      • *Can bypass taxation by employing SHs, and then just pay all corp profits to SHs via bonuses.
        • Limit: IRS may step in and tell you to treat SH compensation as dividends.
    • There is flexibility to treat corp as S-Corp – fewer than 75 people, get passthrough treatment
  • General Partnership / Limited Partnership = passthrough entity
  • o Even if no cash distributed, still have to pay tax- encourage distribution of the cash—may be bad for the partnership
  • Corp and Multi-member LLC can “check the box” to be taxed as a parnership

Dissension, Oppression, Termination[edit]

  • Anticipating the departure of an owner

Dissolution[edit]

  • Lawyer’s legal obligations

Flexibility vs. Efficiency[edit]

  • Corp = many default rules, highly efficient to form
  • General Partnership
  • Limited Partnership
  • LLC = entirely contractual, highly flexible
  • More Default Rules
    • o Pro: Highly efficient, less risky if you fail to anticipate something at formation
    • o Con: More restrictive
  • Fewer Default Rules
    • o Pro: More flexible, Easier if management and investors overlap
    • o Con: Inefficient to form, contracts imperfect, chance of error if you fail to anticipate something

Future Plans[edit]

  • If plan is to grow company and take it public -- only Corporation can go public
  • If plan is to raise venture capital -- VC investors usually prefer Delaware Corp (bc they understand it)

D. Where to Organize[edit]

  • If a company will conduct its business primarily in a single state, organizing in that state will reduce filing, reporting and tax burdens
  • If a business is large, sophisticated, or complex, Delaware is often the preferred, jurisdiction (also if you plan on ever going public)
  • MBCA 15.01: Authority to Transact Business Required
    • (a) A foreign corporation may not transact business in this state until it obtains a certificate of authority of the sec of state
  • MBCA 15.02: Consequences of Transacting Without Authority
    • (a) You can't sue in the state
    • (d) You can be liable for civil fine.
    • (e) Can still act within the state and defend itself in suit.
  • Why is Delaware so strong
    • (1) Dela relies on corp franchise taxes, therefore incentivized to be generous to corps
    • (2) Dela constitution requires 2/3 vote of both houses to change corporate code
    • (3) Dela has heavy "legal capital" -- large body of corp case law, admin, etc

E. What to Call Your Corp[edit]

  • RULE: Corporate name must be distinguishable
  • There can be corporations with the same name, just incorporated in different states.
    • On Certificate of Incorporate, should specify "Acme, Inc., a Delaware corporation."
  • Steps
    • (1) Check to see if that name is incorporated in the desired state. Check the Sec of State's website.
    • (2) Check to see if there is a trademark of that name.
      • Check Google, specific Sec of States' websites
      • If you plan to do business internationally, check other nations' trademarks.
      • Issue: Can be sued under trademark laws. Two types:
        • Common law trademark -- matter of state law. Rationale that using same name of other corp is unfair because of confusing customers, relying on quality/ads of other company.
        • Trademark Act -- federal law.
  • MBCA Rules
    • Must contained the word "corp.," "inc." or the like (4.01a1)
    • Must be distinguishable in the sec of state's records (4.01b)
    • You can reserve the name of your corporation for nonrenewable 120 day period (4.02).
      • Used to be important when there was delay in executing incorporation, but not very important anymore.

G. Incorporation[edit]

  • Incorporation:
    • MBCA 2.02: Articles of incorporation must set forth: names, registered office, registered agent, purpose, total numbers of shares, names/addresses of incorporators
      • MBCA 2.02(b): You may set forth additional stuff like..
        • Names/addresses of directors – not necessary, but can’t issue stock without Board
        • 2.02b4 (Exculpation of director): Provision eliminating or limiting liability for director/SHs for money damages or failures to take actions. Very important in going public.
          • You may effectively eliminate the duty of care!
          • Equivalent in DGCL 102b7:
            • In private entity, unlikely to see derivative suit for breach of duty of care. But if you ever go public, HIGH likelihood of shareholder lawsuit against directors. So you should absolutely eliminate the duty of care upon incorporation.
        • 2.02b5 (Indemnification of director) – potential liability of director for public company is enormous. Definitely do this... Director isn't liable for actions done to 3rd party in course of business unless its liability for accepting undue financial benefit
        • What am I missing here
    • MBCA 2.01: One or more persons may act as incorporator. Doesn't really matter who it is.
    • MBCA 3.01: Every corporation has the purpose of engaging in any lawful purpose unless more limited purpose is set forth in articles of incorporation.
      • Change from old system where companies had authority to only do what they were incorporated to do, and anything else was ultra vires. Now, you can do whatever you want under general purpose clause.
      • EXCEPTION: Joint venture is usually for a specific purpose.
    • DGCL 102(a)(3) -- nature of business or purposed to be promoted required. Usually will be incorporated to do any lawful activity
  • After Incorporation
    • MBCA 2.05a: Must have organizational meeting
      • 2.05a1: If directors named, due to by call of majority of directors
      • 2.05a2: if directors not named, incorporator meets to (i) elect directors and complete organization or (ii) elect Board to complete organization
        • 2.05b: You can skip the organizational meeting (eg if its just one incorporator why meet?) by specifying consent in writing what you would have decided to do at meeting
    • Complete organization:
      • Elect directors, officers,
      • Specify banking terms
        • If there is bank financing, bank will require Board to adopt "Banking Resolution" (official authorization for agent to deal with bank)
      • Sell shares
        • Doctrine of Pre-Incorporation Expenses -- Not important anymore because it used to take weeks to incorporate, and agent would contract before corp officially existed. Who would be liable?












Types of Entities[edit]

Corporation Partnership LLC
General Pro/Con
Tax Status C Corp – two layers, shareholder doesn’t pay for corp income until dividends issued*S Corp – Single layer/passthrough. Must be domestic, max 100 shareholders, only one class of stock, other limits (no insurance co)
Ownership *Close Corp -- max 30 shareholders GP – Must have two partners.LP – Must have 1 LP + 1 GP. No partner requirement, can have single member
Limited Liability Yes, for all shareholders General Partnership – no LL.Limited Partnership -- Limited liability for passive partners; liability for GP.LLP – Limited liability for general partner (eg law firms).LLLP – No liability at all. All members have LL
Management & Control Manager-managed via BoD/Officers.Authorization levels and governance limits agents’ power*Close Corp – Biz can be managed by shareholders (DGCL 351) General Partnership – member-managed. Each partner has full rights to bind partnership.Limited Partnership – manager-managed. GP serves as manager. Flexibility; member-managed or manager-managed
Equityholders – entitled to remainder after earnings/losses paid off Stockholders (DE)/Shareholders (MBCA)Ownership interests: -Equity Securities (common/pref stock) -Debt Secs (bonds, debentures, notes) -Derivative Secs (stock options, warrants (eg equity kicker)) Partners Members
Ability for Private Ordering (enabling statutes allowing internal rules of org) Very rigid – BoD manages, formalities like shareholder meeting, fiduciary duties*Close Corp – shareholders can manage Lots of flexibility Lots of flexibility
Transfer of Interests Public – Free transfer*Close Corp – Restricted, no IPO
Continuity of Existence Perpetual
Documents Articles of Incorporation (MBCA)Certificate of Inc. (DGCL)Bylaws Partnership Agreement Operating Agreement
Fiduciary Duties Directors, officers, and controlling shareholders owe duty to corp (and through corp to other shareholders)*Close Corp -- Flexible – parties may agree to fiduciary duties Flexible – Parties may agree to fiduciary duties
Sources of Law Statutes: MBCA (not uniform, ABA owned, not in DE/NY/CA/MD), DGCLMandatory v. Default RulesCharter: Arts of Incorporation (MBCA) or Certificate of Incorporation (DGCL)BylawJudge-made law -- dealing mostly with equitable issuesSecurities law (if public)Stock-exchange listing requirements Statute:General = UPA, RUPA Limited = RULPA, ULPAPartnership AgreementJudge-made law (e.g. fiduciary duty) Statute: ULLCA (19 states), RULLCA -- less standardizedOperating Agreement (or LLC Agreement)Judge-made law
  • "Certificate" ("articles of incorporation", filing) has certain requirements
    • Indicate limited liability status / name of corporation
    • Business address and name of statutory agent (for service of process)
    • Indicate # of stocks authorized to issue (for corporation only)
  • Filing can include non-required information
    • Indicate different types of stock (eg preferred stock)
    • Exculpation clause of directors in case of fiduciary duty breach
    • Indemnification clauses
  • POLICY DISPUTE
    • o Race to the Bottom – states was companies to incorporate for filing fees + business


A. Close Corporation[edit]

Allocation of Control[edit]

  • Main Qs:
    • o (1) When do SHs vote?
      • Election of Board
      • Fundamental corporate changes (eg M&A, dissolution, sale of major assets)
    • o (2) Who votes?
      • Record owner on record date
      • Proxy
    • o (3) How do SHs vote?
      • Quorum – count number of shares, not number of voters
      • Minitest:
        • (A) Is it cumulative voting
          • o Must be expressly opted for in Articles (not a default)
        • (B) Is there a SH Voting Agreement?
          • o Is it Voting Trust or Voting Agreement?
          • o Does it comply with state statute?
          • o Is it effective?
  • Elements (Donahue)
    • Small number of stockholders
      • DGCL 342: less than 30
    • No ready market for corporate stock
    • Substantial majority SH participation in the management, direction and operations of the corporation.”
  • Special issues:
    • Fiduciary duties – SHs in close corporations owe one another strict duties of utmost good faith and loyalty. Treat Close Corp as same duties as partnership. (Donahue, Mass)
      • All SHs of close corp are owed equal opportunity to purchase new stock, or else return to prior status.
    • Special statutory treatment
      • Default: DGCL 141(a) / MBCA 8.01(b) -- BoD manages business and affairs of corp.
      • DGCL 341-356: must expressly opt-in as Close Corp
        • Gives greater management flexibility to SHs
        • In Close Corp, SHs can restrict Board.
      • DGCL 354 - permits written SH agreements in close corp to mimic that of partnership
      • DGCL 342 -- Must affirmatively designate yourself as Close Corp
        • Close Corp (DGCL 342) = (1) no more than 30 stockholders, (2) restricted stock transfer, (3) no public offerings
        • Closely-Held Corp = shares held by limited number of shareholders
      • DGCL 350 – SHs may agree to restrict or interfere with discretion of BoD
        • Passes director liability to shareholders
      • DGCL 351 – SHs can manage rather than BoD
        • No BoD necessary at all!
        • Shareholders assume liability
      • MBCA 7.32 = shareholder agreements, all SHs can agree to limit or eliminate BoD
        • ONLY for private corps
        • Must be agreed to by ALL of the existing SHs at the time the agreement is made
        • New manager SHs assume liabilities of directors
        • Can NOT eliminate duty of care/loyalty
          • Exception: MBCA 2.02b4, DGCL 102b7 -- Liability for money damages for breach of duty of care can be exculpated.
    • Special voting measures + Piercing Corporate Veil
      • Cumulative voting is restricted to close corp (in both MBCA and DGCL)
      • Voting trusts and voting agreements limited to close corps
      • Piercing the Corp Veil has only really been used for close corporations
  • Director-SH can’t commit votes in advance, unless there is MBA 7.32 Voting Agreement – p. 102, p. 105
  • Donahue v. Rodd Electrotype (Mass 1975)
    • Facts: Harry passed along most of his stocks in close corp to his kids, the directors. The corp then repurchased his remaining stocks. Donahue (P) requested that the corp buy back her stocks at the same price after husband dies, but it refused. Donahue sues D to force resale of the stocks to Harry, claiming breach of duties to minority SHs.
    • HOLDING (Tauro): This was breach of fiduciary duty.
      • Need to protect minority SHs in close corp from freeze-outs, bc there is no market to sell stocks.
      • Only diff from partnership is that close corp SH can’t easily dissolve his investment
    • RULE: SHs in close corporations owe one another strict duties of utmost good faith and loyalty. Treat Close Corp as same duties as partnership.
      • All SHs of close corp are owed equal opportunity in to purchase new stock, or else return to prior status.
  • Protections for Minority SHs
    • Options
      • Class voting – give specific # of Board seats to minority SHs
      • Cumulative Voting – must be specified in the Articles of Incorporation
      • Supermajority Voting – must be specified in Articles of Incorporation
      • Gives SHs ability to veto Board decisions
      • Dispute resolution or exit options
    • Problem: Protections are worthless if majority SHs have power to eliminate them (eg by staggering board elections, expanding Board, amending articles or bylaws)
      • Solution: MBCA 7.27(b) -- amending the quorum/voting requirement requires meeting the greater quorum/voting requirement in place already
      • Default voting rule is majority vote of quorum
        • MBCA 7.25 default
          • (a) Quorum is half of eligible voting shareholders
          • (b) If quorum exists, default voting requirement is simply majority
  • Election of board
    • Default Rule (“Straight Voting”)
      • Mechanics
        • One vote per share
        • Candidates nominated at SH meeting
        • SH can vote their shares for candidates. # equal to Board positions
          • Ex: vote for 4 candidates if 4 spots open, even though may be 8 candidates
      • Candidates with highest number of votes are elected
  • RULE: MBCA/DGCL – Only Plurality needed
      • Problem: Minority SH will lose out on Board position if there is Contested Election.
        • SH with plurality shares will always get to pick the director unless there is cumulative voting or some SH voting agreement opposing him.
        • Ex: A/B have 400 votes each, C has 200 votes.
          • A gets 800 votes (A/B),
          • B gets 800 votes (A/B),
          • C gets 200 votes (C),
          • D/E gets 1000 vote (A/B/C). So C is out.
    • Alternate Voting Schemes
      • Supermajority Voting
        • Can require supermajority (eg 80%) of Board/shareholder vote on issues
        • Problem: Some courts have struck down supermajority voting
          • More favorable toward close corporations
          • Some states by default allow high voting requirements for Articles/Bylaws (eg MBCA 2.02/7.25c/8.24c, NYBCL 616/709).
      • Cumulative voting – only for close corp
        • MBCA/DGCL – cumulative voting must be part of Articles
        • Mechanics
          • SHs get # of votes = (# shares they hold) X (number of directors to be elected)
          • Can allocate votes among candidates however they want
          • Candidates with highest votes win.
        • Formula: X = (s x d)/(D+1) + 1,
          • X (# shares needed to elect d directors)
          • s (# shares at meeting)
          • d (# directors desired to elect)
          • D (total number of directors to be elected)
          • Ex: 201 = (1000 x 1)/(4+1) + 1
        • Optional in most states
          • EXCEPTION: Mandatory in Cali for close corps.
        • Problem: Minority can lead to deadlock. Majority can respond by staggering board elections or decreasing board size – thereby increasing percentage of shares needed by minority to elect director.
          • Ex of minority deadlock: A gets 800 votes (A), B gets 800 votes (B), C gets 800 votes (C), D/E get 800 votes each (A/B). Though formula, C would need 201 votes to ensure his own election.
      • Class voting
        • Divide SHs into different classes, and each class gets a certain number of directors.
        • Problem: Minority can lead to deadlock. But hard to protect plan, because majority can amend articles/bylaw.
    • Three types of voting arrangements
      • Voting Trusts – only for close corp
        • SH transfers shares to a trust, making it the record owner and them the beneficiary. SHs designate a trustee to vote according to instructions.
        • Statutes?
        • Limitations
          • Older statutes limit life to 10 years + require notice to corporation of voting trust
          • MBCA 7.30 and DGCL 218 no longer have 10 year limit
        • Pro: More reliable than Voting Agreement bc its more formalized and gets specific enforcement
        • Con: Requires actual transfer of voting interest
      • Voting Agreement – only for close corp
        • “Vote Pooling Agreement” – contract among SHs to vote a certain way
        • Can't unduly restrict Board, rare issue
          • Ex: by deciding management things set for Board in charter (eg salaries/employees))
          • DGCL exception: Unless you opt-in to close-corp and allow SH to act as Board
        • Delaware:
          • Statute: DGCL 218(c)
          • Ringling Bros – voting agreement btw SHs recognized judicially
        • ISSUE: Specific enforcement or disregard? States split.
          • MBCA 7.31 -- specific enforcement allowed if violated
          • Delaware (Ringling Bros) – No specific enforcement. Just ignore the votes in violation.
        • NYBCL 620(a)
      • Irrevocable Proxies
        • Based on agency power
        • Proxy = SH gives someone else a proxy (agency power) to vote her shares (w instructions or w full discretion)
        • Difference from trustee -- Trustee is more complicated, and you instruct them how to vote.
        • Policy Problem: Don't want to give voting powers to agent with no economic interest in corp!
          • RULE: Irrevocable proxy must be "coupled with an interest" (MBCA 7.22(d), DGCL 213(e))
            • (1) a pledgee (eg bank that gets the stock as pledge for loan)
            • (2) a person who purchased or agreed to purchase the shares
            • (3) a creditor of the corporation who extended it credit terms requiring the appointment
            • (4) an employee of the corporation whose employment contract requires the appointment
            • (5) a party to a voting agreement created under MBCA §7.31 .
          • If no economic interest in company, we can't be assured that they will vote properly.
    • Other shareholder decisions

MBCA § 2.02 - ARTICLES OF INCORPORATION : Needed components to incorporate a business.MBCA § 6.27 - RESTRICTION ON TRANSFER OF SHARES AND OTHER SECURITIESSubchapter B. VOTINGMBCA § 7.22 - PROXIES(a) A shareholder may vote his shares in person or by proxy.(b) A shareholder or his agent or attorney-in-fact may appoint a proxy to vote or otherwise act for the shareholders by signing an appointment form or by an electronic transmission.(c) An appointment of a proxy is effective when a signed appointment form or an electronic transmission of the appointment is received by the inspector of election or the officer or agent of the corporation authorized to tabulate votes.(d) An appointment of a proxy is revocable unless the appointment form or electronic transmission states that it is irrevocable and the appointment is coupled with an interest.Subchapter C. VOTING TRUSTS AND AGREEMENTSMBCA § 7.30 - VOTING TRUSTS(a) One or more shareholders may create a voting trust, conferring on a trustee the right to vote or otherwise act for them, by signing an agreement setting out the provisions of the trust and transferring their shares to the trustee.(b) A voting trust becomes effective on the date the first shares subject to the trust are registered in the trustee's name.(c) All or some of the parties to a voting trust may extend it for additional terms of not more than 10 years each by signing an extension agreement and obtaining the voting trustee's written consent to the extension.MBCA § 7.31 - VOTING AGREEMENTS(a) Two or more shareholders may provide for the manner in which they will vote their shares by signing an agreement for that purpose.(b) A voting agreement created under this section is specifically enforceable.MBCA § 7.32 - SHAREHOLDER AGREEMENTS(a) An agreement among the shareholders of a corporation that complies with this section is effective among the shareholders and the corporation even though it is inconsistent with one or more other provisions of this Act:(b) An agreement authorized by this section shall be:(c) The existence of an agreement authorized by this section shall be noted conspicuously on the front or back of each certificate for outstanding shares or on the information statement required by section 6.26(b).(d) An agreement authorized by this section shall cease to be effective when shares of the corporation are listed on a national securities exchange or regularly traded in a market maintained by one or more members of a national or affiliated securities association.(e) An agreement authorized by this section that limits the discretion or powers of the board of directors shall relieve the directors of, and impose upon the person or persons in whom such discretion or powers are vested, liability for acts or omissions imposed by law on directors to the extent that the discretion or powers of the directors are limited by theagreement.(f) The existence or performance of an agreement authorized by this section shall not be a ground for imposing personal liability on any shareholder for the acts or debts of the corporation even if the agreement or its performance treats the corporation as if it were a partnership or results in failure to observe the corporate formalities otherwise applicable to thematters governed by the agreement.(g) Incorporators or subscribers for shares may act as shareholders with respect to an agreement authorized by this section if no shares have been issued when the agreement is made.DGCL § 202 - Restrictions on transfer and ownership of securities.

  1. a) A restriction must be noted conspicuously
  2. c) A restriction on the transfer of securities of a corp is permitted if:

1) the holder of the restricted securities must offer to the corp or any other holders a prior opp to buy the restricted securities2) the corp or holder is obligated to buy securities which are the subject of an agreement to buy3) corp or other holders are required to consent to the transfer4) transfers to designated persons or classes of persons are prohibited if designation is not unreasonableDGCL § 218 - Voting trusts and other voting agreements.(a) [voting trusts allowed] Stockholders may by written agreement vest in one or more voting trustees the right to vote the stock for the duration, and subject to the terms and conditions, stated in such agreement.(b) [stock certificates] New certificates of stock or uncertificated stock representing the stock shall be issued to the voting trustee(s), and any outstanding certificates shall be surrendered and cancelled, after the delivery of a copy of the agreement to the corporation’s registered office or principal place of business.(c) [proxy; liability limitation] T he voting trustee(s) may vote the stock either in person or by proxy, and in so doing shall incur no responsibility as stockholder, trustee or otherwise, except for their own individual malfeasance.(d) [amendments to voting trusts] “Any amendment to a voting trust agreement shall be made by a written agreement, a copy of which shall be delivered to the corporation’s registered office or principal place of business.(e) [voting agreements allowed] Stockholders may by written agreement agree to exercise any voting rights as provided by the agreement.(f) [non-exclusivity] “This section shall not be deemed to invalidate any voting or other agreement among stockholders or any irrevocable proxy which is not otherwise illegal.”DGCL § 350 - Stockholders of a close corp who own a majority of the voting stock can enter a written judgment to supplant the board in part or whole in management of the corp.DGCL § 351 - Certificate of incorp can say that corp shall be managed by stockholders rather than a board.DGCL § 354 - Close corp stockholders can make agreements to treat a close corp like a partnership.

Division of Economic Interests[edit]

“gozintas and gozoutas”'

  • Consider:
    • o Capital contributions,
    • o Allocation of P/L,
    • o Allocation of distributions
    • o Allocation of residual interests on liquidation
  • How to allocate based on economic/risk interests
    • Capital Structure
    • Basic Tools
      • Common stock -- all corporations must have this. Highest risk/reward because bears residual risk (last to get paid out)
      • Preferred stock -- priority on dividends/liquidation (eg must get paid out before common stock), could give a vote
      • Debt -- less risky than preferred stock (which his less risky than common)
      • Employment compensation -- not great if you hope to be mostly passive; guaranteed via contract
        • Employment Contract = protection, if SH fired w/o cause can sue for annual salary.
          • Enforceable only one way (can't force someone to work)
          • Base listed salary will usually change due to raises
          • Operates a severance package
          • BUT: contract duty to mitigate damages (finding new job). Good employment contract will specify limited period of severance.

Transfer of Ownership – restrictions?[edit]

  • What are the concerns?
    • o Entry of a new owner (perhaps undesirable one)
    • o Liquidity for a departing owner
  • TEST:
    • o Has there been a trigger for Stock Transfer?
      • Death or disability
      • Proposed sale of stock
      • Termination of employment
        • Voluntary -- quitting
        • Involuntary – being fired
      • o Is there a transfer provision?
        • Right of First Refusal – seller must first offer his shares to corp/other SHs and offer same terms as would sell to 3rd party
          • Problem: potential 3rd party buyer is reluctant to purchase these bc they know they have to spend a lot on due diligence without the guarantee of being able to make purchase
        • First option – Corp has first option to make an offer, price and terms fixed by agreement
        • Consent – no sale allowed without consent of corp board and other SHs.
          • Refusal by other SHs must be "reasonable" – otherwise issue of restraint on alienation of property
          • Problem: other SHs would not give the consent to a good deal.
        • (4) Sale option -- withdrawing SH can receive an option to sell her shares on specified occurrence
        • (5) Buy-sell agreement -- Corp or other SHs must buy shares of shareholder upon specific occurrence (eg death).
      • o How do you do valuation (eg in first option)? How do you determine price?
      • Book Value -- but that doesn’t always relate to the value of shares (e.g. penny stock)
      • Capitalized Earnings
      • Appraisal – need to agree in advance to do this
      • Mutually Agreement
        • Mutually agree upon formula
        • Mutually agree to periodically value stock together (unless they forget and then have a falling out -- then court decides)
      • Arbitration -- buyer and seller name value, arbitrator picks
      • Texas showdown -- each party names a price, they trade, and either can agree
    • How can purchase options be funded? Look to Articles, bylaws, or SH agreements
      • Key Person Life Insurance -- can have mandatory life insurance for SHs, where death payment goes to buy stock after death
  • Unless conspicuously noted on stock, a restriction, even though permitted, is ineffective except against a person with actual knowledge of the restriction ( DGCL 202(a) , MBCA 6.27 )
  • o For Close Corp, restrictions on liquidity rights of SHs withdrawing from Corp must be conspicuously noted
    • E.g. buy-sell agreement,

FD, Dissension, Oppression, and Termination[edit]

  • All states allow suits for oppression, but defining oppression is generally a common law issue
    • Dissolution is a common judicial remedy.
    • Emphasis should be on ANTICIPATING oppression and termination and contracting in advance. (Nixon).
  • TEST:
    • A) Does jurisdiction recognize fiduciary duties between SHs?
      • Yes = Mass (Donahue), partnership-esque FD for close corporations
      • No = Delaware (Nixon). You MUST opt-in as close corp.
    • B) Was the act oppressive in beach of duties?
      • Mass (Wilkes): To show breach of duty, can either show that (a) There was no legitimate business objective, and/or (b) There was alternate path that would have been less harmful alternative to minority.
        • Ex: Firing one co-founder and eliminating his salary just because he’s annoying isn’t valid.
        • Ex: Unreasonable use of veto is breach of duties.
          • Reasonable Expectations standard
      • Delaware (Nixon): Use entire fairness standard. BJR is a high standard.
        • Burden is really on the parties to contract for their protections.
    • C) What is remedy to protect minority SH (eg dissolution due to oppression)?
  • Wilkes v. Springside Nursing Home (Mass 1976)
    • Facts: 4 people make partnership agreement to create nursing home. After a while, they disagree. 3 decide to eliminate Wilkes' (P) salary, and then do not reelect him. P sues for breach of duty.
    • HOLDING (Hennessy): Freezing out minority for personal reasons is not a valid business objective.
      • Denying minority shareholders in close corporation of office/employment is a prohibited "freeze out"
        • This is because salary and benefits is typically how investor recoups his investment.
      • Contributing factors: No dividend (so employment was only return option) + long-standing policy that co-founders be employees.
      • Can dismiss officers for misconduct or negligence, but not for personal desire.
    • RULE: To show breach of duty, can either show that (a) There was no legitimate business objective, and/or (b) There was alternate path that would have been less harmful alternative to minority.
  • Nixon v. Blackwell (Dela 1993)
    • Facts: Ds created employee stock ownership plan and purchase "key man life insurance" which allowed them to sell their stock, but did not provide equal opportunity to Ps.
    • HOLDING (Veasey): This is valid with legitimate business objective.
    • RULE: In Delaware, use "entire fairness" standard for board actions rather than BJR.
    • Key Point: Don't want to fashion judicial protections for closely held corp investors who fail to contract for their protections at outset. They had choice to be minority stakeholder and took it.
  • Smith v. Atlantic Properties (Mass 1981
    • o RULE: Unreasonable use of veto power is breach of fiduciary duty btw shareholders, even if done by minority SH.
    • o Problem: By imposing duties btw shareholders, court is getting involved in what could be a BJR (ex: what is right price of dividend)
      • Courts moving away from recognizing fiduciary duties in close corp. Look to state law, instead.
    • Reasonable expectations standard -- very loose
      • Moll reading: Can focus either on majority's actions (look at biz justification) or minority's action (look for harm)
      • Easterbrook/Fischel: Reasonable expectations standard is too open-ended. Will allow minority to coerce shareholders by threatening bad faith law suits.
  • Majority can abuse minority by (a) making their stocks illiquid, or (b) limiting their control

B. Partnership[edit]

  • Overall
    • o Partnership Agreement – need not filed with state

General Partnership[edit]

  • Definition
    • o RUPA § 102(11) “Partnership means an association of two or more persons to carry on as co-owners a business for profit”
    • o Can be natural persons or entities
    • o No formal agreement required
    • o No filing with state required – not limited liability
    • o No intent required to form a partnership required (the “inadvertent partnership”)
      • RUPA 202: If you get a share of the profits, you're presumed to be partner.
        • (c)(3) unless the payment was for (i) debt, (ii) wages or other employee comp, (v) interest on loan
  • Formation
    • o Can create partnership just by getting partners' mutual assent. Do not need to file with state.
      • Whether written or oral
      • Presumed partnership if you receive share of profits.
    • Martin v. Peyton (NY 1927)
      • RULE: For a creditor to be a partner in a firm, the creditor must be closely enough associated with the firm so as to make it a co-owner carrying on the business for profit.
        • Court will look at substance of relationship to determine if a partnership exists (eg good faith understand of obligations). Consider written statements + profit-sharing.
          • Mere statements of intent (that no partnership intended) are not definitive.
  • o May be proved by circumstantial evidence
  • o The receipt by the defendant of a share of the profits of the business is enough
        • Even though creditors executed loan documents with debtor firm for collateral, it doesn't mean creditors have to do with business operations of firm. Just safeguarding investments.
  • Private Ordering
    • Private ordering is determined by partnership agreement -- CONTRACTUAL
  • Key Statutory Defaults
    • Equal Allocation of Financial Interests (profits + losses)
      • RUPA § 401(a) “Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner's share of the profits."
      • Profit distribution doesn't depend on individual contribution of labor/capital
        • Kovacik (Cali 1957) -- Money partner can't recover losses from labor partner in default.
    • Liability for Debts
      • General rule: Joint and severally liable for debts of partnership
        • RUPA § 306(a) “Except as otherwise provided in subsections (b) and (c), all partners are liable jointly and severally for all debts, obligations, and other liabilities of the partnership unless otherwise agreed by the claimant or provided by law.”
      • No liability for prior debts
        • RUPA § 306(b) “A person that becomes a partner is not personally liable for a debt, obligation, or other liability of the partnership incurred before the person became a partner.”
    • Management
      • RUPA 401f/j: Equal management rights + majority vote of partners
      • RUPA 301: If action is within ordinary course of business, each partner is an agent of the partnership
        • RUPA 401k: Differences about ordinary course actions resolved by majority vote of partners.
      • RUPA 401k: If action is outside ordinary course of business, must have unanimity
    • Transfer of Equity Interest
      • RUPA 502: only financial rights are transferable (ie property interest)
        • Governance rights are not transferable
        • So you can transfer financial rights and maintain your governance rights (not automatically dissociated). And just buying financial rights does not grant you governance rights.
      • RUPA 401i: Unanimous consent of all partners required to make new partner
    • Dissociation
      • RUPA 601: Exit of partner will cause their dissociation in case of
        • (1) express withdrawal,
        • (2) expulsion via partnership agreement or unanimous vote,
        • (3) expulsion by court order,
        • (4) death, incapacity, bankruptcy, or dissolution
      • Effect of dissociation on partner
        • Right to participate in management terminates
        • Partner remains liable for debts incurred while a partner
          • No duties and obligations with respect to subsequent events
  • o Wrongful Dissociation -- leaving too early or breaching partnership agreement (RUPA 602b) can make you liable for consequential damages (602c)
        • If dissociation doesn’t cause dissolution, partnership must purchase partner’s interest unless partnership agreement provides otherwise
          • RUPA 701: Default provision for buyout of dissociated partner's interest. But this can be replaced in partnership agreement.
    • Dissolution and Winding Up
      • Dissolution (end of partnership) and Winding Up (things you do in preparation for dissolution)
      • Occurs if
        • Partnership at will withdraws
        • Partner for a term or undertaking:
          • A partner dissociates and at least half of remaining partners vote to dissolve
          • All partners vote to dissolve
          • Term expires or undertaking is concluded
        • In accordance with the agreement’s terms
        • By court order
  • Partnership Agreement
    • Can be oral or written
      • Better to have written
    • Can modify most default rules
    • Mandatory Provisions – CANNOT:
      • Unreasonably restrict right to books and records,
      • Alter or eliminate duty of loyalty or duty of care, (but can identify acts that don’t violate)
      • Eliminate contractual obligation of good faith and fair dealing,
      • Relieve or exonerate someone from liability for bad faith conduct,
      • Vary the grounds for expulsion of a partner,
      • Vary the causes of dissolution.
  • Fiduciary Duties
    • RUPA 105c5: Mandatory Provisions -- partnership agreement may not… Eliminate duty of loyalty, obligation of good faith, or "unreasonably reduce" duty of care
      • LIMIT (RUPA 105d3): If not manifestly unreasonable, the partnership agreement may:
        • (A) alter or eliminate the aspects of the duty of loyalty;
        • (B) identify specific types or categories of activities that do not violate the duty of loyalty;
        • (C) alter the duty of care, but may not authorize conduct involving bad faith, willful or intentional misconduct, or knowing violation of law; and
        • (D) alter or eliminate any other fiduciary duty.
      • In other words, you can reasonably eliminate or tightly define duty of loyalty. Cannot eliminate duty of care, but can alter it.
    • Duty of Loyalty, RUPA § 409(b): “The fiduciary duty of loyalty of a partner includes the duties:
      • (1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner:
        • (A) in the conduct or winding up of the partnership’s business;
        • (B) from a use by the partner of the partnership’s property; or
        • (C) from the appropriation of a partnership opportunity;
      • (2) refrain from dealing with the partnership in an adverse manner
      • (3) refrain from competing with the partnership in the conduct of the partnership’s business before dissolution.
    • Duty of Care, RUPA § 409(c): “The duty of care of a partner in the conduct or winding up of the partnership business is to refrain from engaging in grossly negligent or reckless conduct, willful or intentional misconduct, or a knowing violation of law.”
  • o Duty of Good Faith & Fair Dealing, RUPA § 409(d): partners shall discharge duties consistent with contractual obligation of good faith.
    • RUPA allows modification of this (subject to limits) under RUPA 105 via partnership agreement.
    • Meinhard v. Salmon (NY 1928)
      • Facts: Salmon needed additional capital to enter deal converting hotel to office space, so brought Meinhard on as well. Two parties made a large amount of money, but after period landlord wanted Salmon to tear down existing building and put new larger building w/ increased future revenue. Salmon accepts deal, but doesn’t tell Meinhard about it.
      • HOLDING (Cardozo): This was breach of duties.
        • “A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”
      • RULE: Joint venturers and Partners owe each other fiduciary duties like duty of loyalty; they cannot take advantage of one another. Must disclose profitable opportunities that arise from the partnership so both have equal change to take advantage.
        • Duty Owed: If deal is in any way a continuation of same deal, cannot be secretive & silent
        • No Duty Owed: if a totally separate deal from current one
  • Limited Liability Partnership (LLP)
    • Basically general partnerships with limited liability
    • Unlike general partnerships, must file a statement of qualification with state
      • Only real reason to not do LLP is for filing expenses
      • Risky to not do it, but ok if there is good monitoring, sufficient capitalization/insurance, or partners are LLCs themselves
    • Note
      • Statutory Authorization -- RUPA 306, permitted in all 50 states
      • Common for professional industries, lawyers, accounting

Limited Partnership[edit]

  • Legal Personhood
  • Used mostly for syndications, and pooled investment funds (e.g. Real estate, Oil and gas, Venture capital, Private equity, Hedge funds)
  • Requires filing with the state (because gives limited liability to some partners)
  • Requires two classes of partners: General Partner and Limited Partner
    • General Partner
      • Has rights and powers like general partnership (RULPA 403a)
      • Acts as manager
      • Liable for debts of partnership
      • Usually itself an entity with limited liability, i.e., corporation or LLC
      • Normally has fiduciary duties to partnership
    • Limited Partners
      • Passive investor
      • Does not have power to act for or bind partnerships (ULPA 302)
      • No personal liability for debts.
        • EXCEPTION: Limited partners can become liable if they participate in control in a way that leads third parties to believe they are general partners.
  • Gateway Potato – example of losing protection. A limited partner may be personally liable for partnership debts if the limited partner has performed substantially the same role as a general partner, even if the limited partner had no interaction with the creditor.
  • *ULPA (2001) essentially eliminates the rule imposing liability on limited partners that participate in control
    • No duties to partnership or partners except duty of good faith and fair dealing
        • Bc bound by partnership agreement (ULPA 305b)
  • Financial Rights
    • Default for limited partnerships is proportional to contribution
      • So more like corporation than General Partnership
    • Rights on withdrawal
      • Under RULPA default, limited partner has right to withdraw and receive unpaid distributions + fair value of partnership interest
      • Under ULPA default, there’s no right to withdraw and receive distribution
      • Default rule can always be modified in partnership agreement
  • Transferability of Interests
    • Default rule similar to general partnerships
    • Can transfer economic interests only
    • Partnership agreement can (and often does) provide for free transferability of limited partnership interests
  • Fiduciary Duties
    • Cannot eliminate duties, but can contract to limit them (ULPA 110b / RUPA 103b)
    • The partnership agreement may not:
      • Alter or eliminate the duty of loyalty or the duty of care, except that it may:
        • Specify the method by which a specific act or transaction that would otherwise violate the duty of loyalty may be authorized or ratified
        • Alter or eliminate certain aspects of the duty of loyalty if not manifestly unreasonable
        • Identify specific types or categories of activities that do not violate the duty of loyalty
        • Alter the duty of care, but may not authorize conduct involving bad faith, willful or intentional misconduct, or knowing violation of law
        • Alter or eliminate any other fiduciary duty.
      • Eliminate the contractual obligation of good faith and fair dealing, but it may prescribe the standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured
      • Relieve or exonerate a person from liability for conduct involving bad faith, willful or intentional misconduct, or knowing violation of law
    • Delaware (DRULPA 17-1101)
  • Insists on “freedom of contract”
      • Permits elimination or modification of any duty to the partnership or the partners except for the duty of good faith and fair dealing
    • Good Faith and Fair Dealing
      • Derives from contract law.
        • Contrast: fiduciary duties derived from tort or trust law
      • Looks at situation at the time of contracting; i.e., “What would the parties have agreed to when they drafted the agreement?”
        • Contrast: fiduciary duties looks at situation at time of alleged wrong; i.e., “How should the parties have acted in light of their duties?”
      • Gerber v. Enterprise Products Holdings (Dela 2013)
        • Implied covenant
          • Enforce parties' original contract by implying only the terms that they would have agreed to during original negotiations if they'd thought to address them
          • Parties must refrain from arbitrary or unreasonable conduct which would prevent other party from reaping fruits of the bargain
        • Temporal importance: for contracts (eg obligation of good faith), look at the parties during original negotiation.
        • Fair dealing is not "entire fairness." Just that party acted consistently with original agreement.
        • Good faith does not imply loyalty, just faithful adherence to original agreement.
      • Dieckman v. Regency General Partnership (Dela 2017)
        • FACTS: General partner (D) sought to merged with another LP in their MLP family (master limited partnership). Raised normal issue of conflict of interest, so D invoked two safe harbor provisions from partnership agreement: (1) Special Approval by independent committee, and (2) Unaffiliated Unitholder Approval. Limited partner (P) claims that independent committee was conflicted bc member was on BoD of affiliate company (only dropped of BoD for short, temporary time ) + approval fails bc D made misleading statements to get approval (eg didn’t disclose committee conflict)
        • HOLDING: Safe harbor provision didn't explicitly require partner to not be deceptive, but it was implied in the partnership agreement.
          • DRULPA gives "maximum effect" to principle of freedom of contract. Usually allows eliminating partnership fiduciary duties in MLP. Investors must read PA carefully for benefits/limits.
          • Look at reasonable expectations of material facts at time of contracting.
        • RULE: Implied covenant naturally implies obvious terms (eg general partner not be deceptive), such that the partnership agreement can have implied conditions.
  • Limited Liability Limited Partnerhsip
    • Created by ULPA (2001)
    • Has not been universally adopted

C. Limited Liability Company[edit]

  • Operating Agreement need not be filed with state, just the Certificate
  • Formation:
    • o (1) File Certificate with Sec of State,
      • ULLCA: Certificate of Organization (filing doc w sec of state), Operating Agreement (organic doc),
      • DE: Certificate of Formation (filing doc w sec of state), LLC Agreement (organic doc)
    • o (2) Draft and execute agreement
  • Advantages/Disadvantages
    • o Advantages
      • Flexibility -- buy/sell arrangement, management order, member-managed or manager-managed
      • Limited liability
      • Centralization of management
      • Optional tax treatment
    • o Disadvantages
      • No default structure
      • Need for extensive structuring and drafting
      • Difficult to transfer ownership interests
    • Drafting Issues to address in the operating agreement
      • o *usually handled by contract via operating agreement (RULLCA 105)
      • o Allocation of control
        • Member-Managed default (can be changed)
          • Default rules generally similar to general partnerships (RUPA 401)
            • o EXCEPTION: RULLC § 301(a) “A member is NOT an agent of a LLC solely by reason of being a member.”
          • RULLCA 407b:
            • o (2) Each member has equal rights in management/conduct in ordinary course of business,
            • o (3) differences among members decided by majority vote of members,
            • o (4) act outside of ordinary course of activities needs consent of all members
          • Manager-Managed default (can be changed)
            • Default rules (RULLC 407c) similar to member-managed LLC
              • o Managers have management rights
              • o If you are managing member and you dissociate, you stop being manager
            • Complete flexibility: Single manager, Multiple managers, Committee of managers that act similar to board of directors, or any other appropriate situation
            • Delaware is different (18402)
              • o Default rights in management/conduct is proportional to membership interest
              • o Each member and manager has authority to bind entity
            • o Allocation of economic interests
              • RULLCA
                • No default rule on allocation of P/L
                • RULLCA 404: Default rule on allocation of distributions (eg dividend) is equal shares for each member
              • Delaware
                • DLLCA 18503: Default rule is allocation of P/L in proportion to contribution
                • DLLCA 18504: Default rule for proportional allocation of distributions
              • o Authority to act (who has power to bind) -- different from carte blanch of general partnership
                • RUPA 301(1): Each partner is an agent of partnership
                • RULLCA 301(a): Each member in NOT an agent
                  • Deliberalty leaves existence of authority to act to general principles
                • DE: Each member is agent
              • o Fiduciary duties
                • RULLCA
                  • RULLCA 409: Standards of conduct
                    • o Members in member-managed LLCs and managers in manager-managed LLCs owe duties of loyalty and care
                    • o (b) Duty of loyalty
                      • Account to LLC for profits or company opportunities
                      • Refrain from dealing with LLC in an adverse capacity
                      • Refrain from competing
                    • o (c) Duty of care -- don't act recklessly, grossly negligent, or unlawful manner toward corp
                      • Implied deference to BJR
                    • o (d) Obligation of good faith and dealing
                  • RULLA 105d3: Operating agreement can change default rules on duty of loyalty (alter, eliminate, or regulate), duty of care (alter, but can’t eliminate or authorize bad faith or unlawful conduct), or any other fiduciary duties that may exist
                  • McConnell v. Hunt Sports (Ohio) -- Wrote-out fiduciary duty w/ clause in OA that allowed members to compete w/ the LLC
                    • o Facts: McConnell and Hunt LLC are members of a hockey team LLC. Hunt repeatedly rejected negotiation terms for arena lease. Building owner went to McConnell for help, and so McConnell agrees to buy the arena due to Hunt's holds out. Hunt argues for fiduciary duty not to compete with LLC, but there was provision in OA allowing interest in "any other biz of any nature".
                    • o HOLDING: Under freedom of contract of Ohio statute or RULLCA 105d3, this is allowed.
                    • o RULE: You can create Operation Agreement that expressly allows members to compete with business of the company. So you can contract round FD obligations.
                  • Delaware
                    • NO default rules
                      • o Delaware § 18-1101
                        • (b) It is the policy of this chapter to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.
                          • Maximum effect of freedom of contract -- so you put in what you want
                        • (c) To the extent that, at law or in equity, a member or manager or other person has duties (including fiduciary duties) to a limited liability company or to another member or manager or to another person that is a party to or is otherwise bound by a limited liability company agreement, the member's or manager's or other person's duties may be expanded or restricted or eliminated by provisions in the limited liability company agreement; provided, that the limited liability company agreement may not eliminate the implied contractual covenant of good faith and fair dealing.
                          • You can totally eliminate member/managers duties of loyalty and care, but CANNOT eliminate good faith/fair dealing
                        • Auriga Capital – Suggestion that there are implied FD of Loyalty and Care for LLCs
                          • o Facts: Member alleged breached fiduciary duty, but no duties in default or OA.
                          • o RULE (Strine): Courts control any implied DE common law fiduciary duty to enterprise and other members.
                            • Amendment to 18-1104: Rules of law and equity shall govern fiduciary duties.
                          • o Prof: Judge Strine is right. But still good idea to explicitly state FD in OA.
                        • o Provisions for transfer of ownership
                          • Default rules
                          • Can only transfer a "transferable interest" (ie right to receive distributions)
                            • Transfer of transferable interest does not cause dissociation of transferor or dissolution of LLC
                            • But transferor can be dissociated by unanimous vote of other members
                          • Admission of new member requires unanimous approval of other members
                        • o Dissociation and oppression
                          • Dissociation – default rules
                            • Member withdraws At Will – Member can generally withdraw and dissociate at will
                            • Occurrence of event of dissociation via OA
                            • Expulsion by other members
                            • Court order -- (A) engaged in wrongful confuct, (B) Committed material breach of OA or duty/obligation under 409, (C) engaged in conduct that would make it impracticable to continue
                            • Death, disollution, or bankruptcy
                            • RULLCA 601-602; ULPA 601-602; RUPA 601
                          • Dissolution and Dissension
                            • RULLCA § 701: Events Causing Dissolution -- The operating agreement may not curtail the court’s power to adjudicate a claim for judicial dissolution
                              • o Under operating agreement
                              • o Unanimous consent of members
                              • o By court order when
                                • (A) conduct of substantially of company's activities are unlawful,
                                • (B) Not practicable to carry on in conformity with OA,
                                • (C) managers in control of company
                                  • (i) have or will act in illegal or fraudulent manner,
                                  • (ii) have or will act oppressively toward applicant
                                • Rationale: Dissolution is a club used by oppressed member. Why would you want to destroy a business?
                                • Haley v. Talcott (DE) -- example of petition for dissolution due to dissension, deadlock, oppression
                                  • o Facts: Talcott owns restaurant, and Haley runs it. Equal members of LLC to buy building for it. Have falling out, so Haley sues for dissolution bc Talcott is being oppressive. Talcott looks to invoke exit provision of OA that would buy H's stake or sell T's sake.
                                  • o Issue: Haley had signed personal guarantee for real estate. If he sold his LLC stake, he would still be on the hook.
                                  • o HOLDING: Unfair for Haley to be personally liable, so dissolve.
                                  • o RULE: If you create remedy for deadlock that would dissociate the member, make sure it accounts for unfair situations (like personal guarantees to bank) in order to avoid dissolution.
                                • Disregarding the Entity
                                  • o Essentially the same as corporate "piercing the corporate veil"
                                  • o Cortez v. Nacco Material (Oregon 2014) --
                                    • Facts: Swanson Group is sole member of Sun Stud LCC, member-managed. Manager includes oversight of safety protocol for Sun Stud LLC. Employee Cortez (P) sues Swanson under Oregon employer liability law (ELL).
                                    • RULE: LLC member/manager only liable if corporate officer would be liable. Member-manager is personally liable if knew or participated in negligence of responsible employees (bc then duty to fix), but otherwise not liable for LLC’s negligence.
                                      • Rationale: RULLCA 304: D&O and liability of LLC are its alone. Member/manager is not personally liable solely by reason of acting as member/manager.



Accounting / Financing[edit]

A. Accounting[edit]

  • Income Statement
    • Company can lower R&D figure to fluff up financial (increasing income)
  • Balance Sheet
    • Book Value (aka shareholder's equity) = Total Assets - Total Liabilities
      • Can be misleading, because (a) financial statements don't reflect reality, (b) for liquidating purposes, will always need to sell shares for less than Book Value price
      • PP&E reflects value less depreciation. So book value of building likely does not reflect fair market value
    • PP&E -- how to reflect depreciation speed
    • Depreciation -- should we adjust bc depreciation is artificial?
    • Intangible Assets - how to we value these
  • Valuation Approaches
    • o Corp
      • Equity value = aggregate value of outstanding shares
      • For public company: Market Capitalization (market cap) = Shares Outstanding X Share Price
        • Flaw: Stock price is not absolute indicator of value
          • Corp can decrease stock price by dividing stocks in two via "Stock Split"
          • Corp can increase stock price by combining stocks via "Reverse Stock Split”
  • o Discounted cash flow = most common valuation analysis bc investors most concerned about cash
  • o Higher PE ratio indicates that investors are willing to pay more for it (perhaps because lower risk (eg preference for Walmart vs Apple)). But book value will be higher for a company like Apple (which has all kinds of value built in like stockholder's equity) rather than Walmart (book value is mostly inventory).

B. Financing[edit]

  • Three types: Equity Securities (stock), Debt Securities, Derivative Securities

Equity Securities[edit]

  • Common Stock
    • o Qualities
      • Residual interest
      • Created by charter -- must specify types and # of stocks
      • Does NOT represent "ownership" of corp -- only get indirect control via voting
      • Usually entitled to dividends (when/if declared)
      • Usually has right to vote -- need this to elect Board
      • Can be issued in classes with different rights
      • All a matter of contract
    • o Statutory requirements
      • MBCA 6.01: Art of Inc must specify one or more class of shares with voting rights
    • Preferred Stock
      • o Qualities
        • Next most senior after common stock
        • Terms defined in charter or in "certificate of designation" (ie for blank check preferred stock authorized by Board)
        • Dividend/Liquidation Priority -- preference in dividend and liquidation
          • So if its cumulative dividend, corp must pay all aggregate dividend to preferred stockholders before giving to common
        • Potential Right to Conversion (to common stock)
        • Potential Right to Require Redemption -- means that corp must buy back stock under certain circumstances
          • Usually required by Venture Capital
        • May or may not have voting rights; may be contingent voting rights
          • Ex: right to vote in new Board if they fail pay dividends owed
        • All a mater of contract
      • o Statutory authorization
        • MBCA 6.01c: Art of Inc may authorize classes with special features (listed above)
      • What is Valid Consideration for Stock?
    • Stock can be issued for cash, property
    • But can stock be issued in exchange for a note, services rendered, future services?
      • Older statutes said that notes, services rendered, or future services were NOT valid consideration
        • Rationale: Balance Sheet reflects shareholders equity to reflect company worth.
      • New statutes say you can issue stock for anything
        • MBCA 6.21: BoD may authorize shares to be issued for a whole range of things
        • DGCL 153: BoD can determine consideration of shares of stock with par value
          • Only subject to good faith determination
          • Stock without par value can be issued for anything

Debt Securities[edit]

  • Includes bonds, debentures, notes, etc.
  • Qualities
    • Pay interest
    • Obligation to repay principal
    • Rights on default
      • Note: Acceleration can be a risky move, so creditors are pretty cautious about who they lend to
  • Acceleration = failure to pay an installment of interest will make it all automatically due. If debtor can't pay, bondholder can pursue legal remedies like bankruptcy.
    • May be convertible or redeemable
    • Usually no voting rights
    • Usually have seniority system -- eg some debts get paid first
    • Usually comes with a list of covenants
      • Embodied in the body of the note or an indenture
      • Positive ("I agree to pay on x interval") or negative ("I agree not to borrow from other bank")
    • All a matter of contract (and custom)
  • Debt/Leverage
    • General rule: Shareholders are better off with more leverage (debt) AS LONG AS corp is profitable
      • Lower equity means less division of revenue for existing SHs
    • 50-50 debt-equity ratio is normal
      • EXCEPTION: For real estate developers, 90-10 debt-equity ratio is normal. But they go bankrupt often.
    • Advantages: Increases returns when company profitable, lowers cost of capital
    • Disadvantages:
      • Increases risk,
      • Increases losses when company not profitable,
      • Inhibits further borrowing (eg purchases on credit)
      • Excessive debt can lead to veil piercing -- like the undercapitalized company cases
      • "Deep Rock doctrine" = high debt may be treated as equity in bankruptcy, bc unfair for SHs to put creditors at risk
      • IRS may disallow interest deduction when debt/equity held in same proportions
        • Ex: If banks are each lending 25% of total capital structure, IRS may just view that as each owning 25% equity
  • Legal Capital
    • Outdated concept. -- Protected creditors by keeping a minimum level of equity in the corporation
    • No longer in MBCA (2.02a2 and 6.21)
    • Still exists in Delaware and some other jux
      • DGCL 102a4: Corp must state # of shares to issue AND either stated par value or no par value
    • Accounting for issuance of stock
      • MBCA -- all value that corp gets for stock goes under "Paid in Capital" within Stockholders' Equity on BS
      • DGCL 154 -- Board may determine that only a part of the consideration share be considered capital
        • Stockholders' Equity
          • Capital -- at least par value of shares issued
          • Capital Surplus -- the rest of paid-in capital
          • Retained Earnings -- later, if any
        • Ex: Sell 1000 shares $.01 par value for $1000
          • Capital = $10
          • Capital Surplus = $990
        • Ex: Sell 1000 shares of no par value for $1000
          • Capital = Whatever Board decides (if board takes no action on entire consideration)
    • Problems created by par value
      • Watered stock -- illegal to sell stock below par value
      • Limitations on distributions (dividends or stock repurchase)
        • DGCL bases limitations on distributions on "surplus"
          • Limitations on dividends
            • DGCL 170a: Directors may declare dividends (1) out of surplus
          • Limitation on repurchase of stock
            • DGCL 160: prohibition on impairment of capital
              • Impairment of Capital = you've repurchased share without surplus to do it
        • MBCA bases limitations on distribution on solvency

Limitations on Distributions, Board Discretion[edit]

  • Statutes
    • o DGCL 170: (a) The directors of every corporation . . . may declare and pay dividends upon the shares of its capital stock either:
      • (1) Out of its surplus . . .; or
      • (2) In case there shall be no such surplus, out of its net profits for the fiscal year in which the dividend is declared and/or the preceding fiscal year.
    • o DGCL 160: (a) Every corporation may purchase . . . its own shares; provided, however, that no corporation shall:
      • (1) Purchase or redeem its own shares of capital stock for cash or other property when the capital of the corporation is impaired or when such purchase or redemption would cause an impairment of the capital of the corporation
    • o DGCL 154: Revaluation of Surplus
      • The capital of the corporation may be increased from time to time by resolution of the board of directors directing that a portion of the net assets of the corporation in excess of the amount so determined to be capital be transferred to the capital account… The board of directors may direct that the portion of such net assets so transferred shall be treated as capital in respect of any shares of the corporation of any designated class or classes. The excess, if any, at any given time, of the net assets of the corporation over the amount so determined to be capital shall be surplus. Net assets means the amount by which total assets exceed total liabilities.
    • MBCA 6.40(c): No distribution may be made if, after giving it effect:
      • Equity Insolvency Test: (1) the corporation would not be able to pay its debts as they become due in the usual course of business, or
        • Plain English: look at practical effects on business for making distribution. If it makes you insolvent in practical matters, then you can't do it.
      • Balance Sheet Test: (2) the corporation's total assets would be less than the sum of its total liabilities plus (unless the Art of Inc permit otherwise) the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rigths upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution.
        • Plain English: If total assets are less than total liabilities, you can't do it.
    • MBCA 640(d) -- Board can make determination based on reasonable reevaluation
  • Cases
    • ThoughtWorks (Dela 2010) -- similar prohibition as MBCA 6.40c that prohibits corp from purchases its own shares when that would make the company unable to pay its debts.
    • Klang v. Smith's Food & Drug Centers (Dela 1997)
      • Facts: SFD agreed to be acquired by Yucaipa. Deal involved issuance of new debt and repurchase of 50% of stock of SFD. ISSUE: Could SFD repurchase its shares (distribution) without violating DGCL § 160? Because the balance sheet shows that there may be insufficient surplus.
        • Board had revalued assets pursuant to § 154 -- At any time, if we have extra assets, we can add to the capital surplus account. Then you can say actually we have more value than the balance sheet shows.
        • There was a series of mergers and share sales btw SFD and Yucaipa to ensure that SFD could get a bank loan bc SFD may not have had strong enough BS to afford bank loan to do share buyback on its own, so it needed additional BS assets of Yucaipa's subsidiary.
      • RULE: Courts will defer to the board’s measurement of surplus, absent evidence of bad faith or failure on the part of the board, to evaluate the assets on the basis of acceptable data it reasonably believed reflected current value.
  • It's fine to get a third-party appraisal and then use "Total Invested Capital" and long-term debt as bases for measuring surplus. It is unrealistic to hold that a corporation is bound by its balance sheets for purposes of determining compliance with section 160.
    • Kamin v. American Express (NY 1976) – broad Board discretion
      • RULE: Board may forego money-saving tax recognition via sale of stocks in order to keep their company’s stock price high (when sale might make their stock price lower). This is not bad faith and is valid under BJR.
        • Bad faith looks for something personal influencing business decision. Rare to find bad faith!
      • Critics: Court should have considered “efficient market theory"
        • Efificienct Market Theory -- stock price incorporates all relevant info, and free market will work itself out.
        • So stock price wouldn't have reflected full $25 mil loss bc would have understood tax savings.
    • Dodge v. Ford Motor Co (Mich 1919) -- found bad faith in refusing to declare a dividend for purposes of keep people in jobs.

Derivatives[edit]

  • Value "derives" from value of another security
  • Derivatives created by corporation -- enable derivative holder to buy stock in corp
    • Stock options
      • Usually not transferable
      • Often used for compensation -- eg if you work for 4 years, you are fully vested in X shares in our company
    • Warrants
      • Usually transferable
  • Stock options created by third parties
    • Options = right to buy common stock at specific time/price
    • Call Option = right, but not obligation, to buy specified asset at fixed price
      • No limit on potential profit that option holder can make
      • Warrant is another form of call option issued by corp
    • Put Option = right, but not obligation, to sell a specified assets at fixed price



Corporation[edit]

A. Models of Corporate Governance[edit]

Separation of Ownership from Control (Berle & Means)[edit]

  • Everyone agrees that corporation should serve shareholders at least somewhat
  • Problem = owners are being shut out.
    • o "Management Control" is self-perpetuating -- found that BoD appoints the proxy committee, by which most small shareholders will exercise their voting rights, so BoD is essentially controlling itself.
    • o Free market has failed
  • Solution = Corporate law.
    • o Fiduciary duties to shareholders, required info disclosures to shareholders
    • o Suggest even more regulation (eg antitrust, environmental law, labor laws)

Market for Corporate Control (Manne)[edit]

  • Market solution = Takeovers
    • o Promotes efficiency -- control of company depends on owning stock, so outsider takeover can occur if stock price falls too much. à management has incentive to properly run the business and maintain high stock price.
  • Flaws:
    • o Takeovers are expensive, and not every badly managed company has takeover
    • o Management developed anti-takeover devices (sometimes with shareholder consent!)
    • o States have passed anti-takeover statutes at behest of corps
    • o Free riding problem

Contractarian Model[edit]

  • Nexus of Contracts -- corp is contractually efficient vehicle for business relationships
    • Freedom of contract, reliance on market forces
    • Govt should just be there to identify and enforce voluntary contractual agreements
  • Efficiency argument made by Coase
  • Uses Aggregate Theory (eg Hobby Lobby)
    • Opposite from Berle and Means
    • Prof: Bad!
  • Flaws
    • Are there limits? Do we assume fiduciary duties will be contracted, or do we impose them?
    • What incentives exist?
    • Agency Theory -- SHs aren't true principals, they don't give commands to Board
    • Efficiency Argument is unfounded -- We don't know what an efficient contracting scheme looks like, bc true free bargaining will never happen

Political Product Model[edit]

  • Role of public SH is combination of political and econ forces
  • Having strong managers + weak owners isn't the perfect corporate model, but exists due to historical realities of politics and econs
    • Foreign countries have different models.
      • Ex: Japan, the company is a family, so Board and Investment Banks work together.
      • Ex: Germany has Dual Boards – (a) Managing Board + (b) Supervisory Board

Team Production Model[edit]

  • Flaws of Shareholder Primacy -- directors don't need to maximize shareholder wealth with every decision
    • o SH can't succeed on derivative suit for breach of duty just because director failed to maximize profit, if there was plausible better judgment by the director (Kamin)
    • o BJR gives broad power to directors even if not maximizing shareholder value
    • o No statute mandates profit maximization.
      • Ex: We allow charitable contributions, which definitely don't maximize short-term interest, as long as BJR says its in long-term interests of corp.
    • Team members (SHs, creditors, managers, employees) all give control of enterprise to the Board for efficiency
    • Mediating Hierarchy -- Board is central mechanism for goal setting and resolving disputes btw team members (eg allocation)
      • o Only when the structure itself is threatened do Courts gets involved

Director Centric Model[edit]

  • Separation of ownership and control (ie letting Board control business) has been hugely efficient for wealth increases in the U.S.
    • Don't give more power to the shareholders
    • At certain point, greater accountability makes decisionmaking less efficient
  • Lipton Reading -- big on director primacy
    • Primarily about director primacy -- leave the directors alone, they have been doing fine
      • But bleeds into corporate social governance (eg directors will consider this stuff)
      • Discusses changes in governance philosophy
    • Since 2008 recession, there is recognition that shareholder primacy (1) encourages short-termism and activist investor attacks, (2) reduces R&D expenditure, wages, and long-term sustainable investments.

Agency Capitalism Model[edit]

  • Today, most shares are owned by pension funds/mutual funds, NOT individual investors.
  • Funds should act as agent for their beneficiaries.
  • Two agency relationships:
    • Corporate managers act as agent for shareholders
    • Institutional shareholders are agents for their beneficiaries
  • Concerns:
    • (a) institutional shareholders to be more focused on improving portfolio company's business strategy rather than just getting high returns,
    • (b) Since shares are spread thinly across many portfolio companies, improved business strategy in any one doesn't matter
      • So institutional investors aren't incentivized to use their governance rights to improve underperforming company, but rather just sell shares

B. Director’s Governance Role[edit]

Duties[edit]

  • ABA Corporate Director's Guidebook
    • Board should be responsible for:
      • Monitoring corp performance,
      • Selecting and managing CEO (setting his goals, evaluating performance and compensation) -- one of the most important Board duties
      • Succession planning,
      • Overseeing risk,
      • Understanding financial statements and monitoring controls
      • Evaluating and approving major transactions
      • Establishing and monitoring compliance systems
    • To be effective, director should know the corps': business plan, KPIs, operational/financial/strategic plans, risks, competitive performance, reporting and compliance mechanisms

Formalities[edit]

  • Board Action at Meeting
  • o Each director has one vote and may not vote by proxy
  • o Unless the articles or by-law provide otherwise, the vote of a majority of the directors present at a board meeting at which there is a quorum is necessary to pass a resolution.
  • o Directors must act collectively, not individually. No individual agency.
  • MEETING RULE: Director actions are generally only enforceable if decided at physical Board meeting. Informal action by director w/o meeting is invalid.
    • o Rationale: Protect SHs from unconsidered director action
    • o EXCEPTIONS: Informal board actions may be recognized by courts, particularly in close corporations.
      • Unanimous Director Approval -- all director separately approve transaction, no meeting necessary
      • Emergency
      • Unanimous Shareholder Approval -- Meeting Rule meant to protect SHs, not needed here
      • Majority Shareholder-Director Approval -- majority of Board were involved in informal action AND own majority to outstanding shares
      • Unanimous Written Consent of Directors (MBCA 8.21a/DGCL 141f)' – can be electronic writing'
      • Conference Call (MBCA 8.20b/DGCL 141i) -- or other means, only if all can simultaneously participate and hear each other.
        • ABA MRPC 1.1: Lawyer should stay abreast of changes in law and practice wrt technology.
  • Quorum
    • o Default Quorum = majority of the directors, although the articles or bylaws may provide for either a greater or lesser number
      • DGCL 141(b) – majority directors, but absolute minimum quorum of 1/3 of the directors.
      • MBCA 8.24 (same)
    • Notice
    • Regular Meetings = no notice required, unless stated in Arts of Inc (MBCA 8.22a)
      • Rationale: directors assumed to know schedule
      • But companies normally provide notice of purpose anyway
    • Special Meetings = 2 days notice for meeting date/time/place, unless stated in Arts of Inc or bylaws (MBCA 8.22b)
  • o Rules
    • Notice must be in writing or oral (if reasonable in the circumstances)
    • Notice can be sent electronically MBCA §1.40 comment 4.
    • Waiver -- Director w/o proper notice may waive notice by:
      • Signing waiver before or after meeting (MBCA 8.23a), or
      • Participating in meeting wo complaint (MBCA 8.23b)
      • *Attending meeting just to protect lack of notice does not constitute waiver (MBCA 8.23b)
    • o Action taken at a board meeting held without the required notice is invalid.

Board Committees[edit]

  • DGCL 141a/MBCA 8.01b – Corporate powers and business affairs are managed by the Board
  • Board can delegate to committees
  • o DGCL 141(c)(2): the board may set up one or more committees consisting of one or more members.
  • o The jurisdiction and powers of the committee must be specified either in the bylaws or in the board resolution creating the committee.
    • Director can rely on committee reports/actions even if he doesn't serve on it as long as committee reasonably merits confidence (MBCA 8.30b)
  • Types of committees
    • Executive Committee
      • Has full authority of board except certain transactions (eg approving dividend, merger) (MBCA 8.25e)
    • Audit Committee
      • Required by NYSE and NASDAQ
      • SOX 301: Audit Committee must have independent directors
      • SOX 407: Audit Committee requires financial expert
      • Qualifications
        • Must have 3 independent directors
          • Each must be “financially literate” -- as interpreted by the board in its business judgment
        • One member must have accounting or related financial-management expertise
      • Limitations
        • May not serve on the audit committee of more than 3 public companies without permission from each company
        • Barred from receiving any comp (other than director's fees) for consulting to the corp
      • Responsibilities:
        • Appointing and overseeing public accounting firm
          • Accounting firm must report to Audit Committee on services, their policies, written communications with management, etc.
        • In charge of receiving and evaluation employee submissions about "questionable accounting or auditing matters"
    • Finance
    • Nominating and Governance
      • Required by NYSE and NASDAQ
      • Regulation S-K Item 407(C):
        • (1) Disclose if you have one, or why not if you don’t
        • (2)(v): Describe minimum qualifications needed by nominee
        • (2)(vi): Describe how you consider diversity, or why you don’t
      • A corporation must certify that it has adopted a formal written charter or board resolution addressing the nomination process.
      • Must consist of solely independent directors (NYSE)
    • Compensation
      • Required by NYSE and NASDAQ
      • Must consist solely of independent directors
        • NASDAQ requires 2 NYSE = at least 1
      • May receive advice from compensation directors that’s not indpendent
      • Balance: Incentivize performance and retention of senior execs but not be too generous
    • Specialized Committees (eg litigation for derivative suits)
  • Flexible options
    • Permanent or temporary
    • Active (makes decisions) or passive (research)
  • Federal Law
    • Securities Exchange Act (1934 Act)
      • Only applies to public companies
      • Requires periodic disclosures (Sec 12/13 (10K/10Q)), disclosures by Board and soliciting proxies to shareholders (Sec 14A)
        • Election of directors is question of state law, but disclosures pursuant to election are federal
    • SOX
      • 301 -- standards for audit committees
      • 402 -- prohibits loans to corporate execs
      • 406 -- issuers must decide and explain code of ethics
        • Must disclose that there is Code of Ethics for CEO, CFO, accounting officer (or explain why there isn't) and that has "reasonably necessary" ethical standards
        • Code of Ethics must be publicly available via website or public disclosure
          • Whistleblower protection
        • Amendments or waivers to Code must be disclosed on Form 8K
      • 407 -- disclose existence of audit committee financial expert
      • 404 -- Internal controls
        • CEO/CFO must certify adequate controls + maintain controls + evaluate controls w/in 90 days of report + disclose any controls changes
        • Officers must disclosure to Audit Committee any internal controls deficiencies + "any fraud" by those responsible for controls
      • CEO/CFO must certify that disclosures contain no material misstatements or omission + fairly presents financial situation in all material respects
    • Form 10-K: Provide code of ethics for CEO and other officers, or explain why you don’t have one
    • Board Composition, Nomination, etc.
      • Must disclose directors' skills, qualification, etc..
      • Must disclose Board structure
        • Explain whether and why CEO and Board Chairman are together or separate
          • If together, must disclose whether Board has Lead Independent Director and their role
      • Must explain process for identifying and evaluating nominees to committee
    • Don't need to define diversity
  • Stock Exchange Listing Standards
    • Independence required
    • Adopt Code of Business Conduct and Code of Ethics for employees (NASDAQ, NYSE)
      • NASDAQ - must have clear standards, mechanism for enforcement/reporting/judging violations
    • Must have Audit Committee, Compensation, Nominating (NASDAQ, NYSE)
    • Usually more stringent than state law
  • Best Practices
    • Can vary, but there are guidelines published by
      • Institutional Shareholders Services (ISS),
      • Council of Institutional Investors (CII),
      • Business Roundtable
    • Public corps pressured to adopt these due to institutional investors
  • o American Bar Association Corporate Governance Committee
    • Principles:
      • Separating Chairman and CEO
      • Appoint "lead director" from independnet directors
      • Regular meetings of independent directors in exec session
      • Annual reviews of Board performance
      • Term limits and mandatory retirement age polciies
      • Require directors to hold specified amount of company stock
      • Require director continuing education

Independence[edit]

  • RULE: NYSE/NASDAQ both say that Board must have majority of independent directors (NYSE 303A.01) and meet regularly in exec session without management (NYSE 303A.93)
    • Note: Outside director =/= independent
    • State laws do not define independence. Listing standards dude.
  • NYSE § 303A.02 Independence Tests
    • (a)(i) No director qualifies as "independent" unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company).
    • (b) In addition, a director is not independent if:
      • (i) The director is, or has been within the last three years, an employee of the listed company, or an immediate family member is, or has been within the last three years, an executive officer, of the listed company.
      • (ii) The director has received, or has an immediate family member who has received, during any twelve-month period within the last three years, more than $120,000 in direct compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service).
      • (iii) (A) The director is a current partner or employee of a firm that is the listed company's internal or external auditor; (B) the director has an immediate family member who is a current partner of such a firm; (C) the director has an immediate family member who is a current employee of such a firm and personally works on the listed company's audit; or (D) the director or an immediate family member was within the last three years a partner or employee of such a firm and personally worked on the listed company's audit within that time.
      • (iv) The director or an immediate family member is, or has been with the last three years, employed as an executive officer of another company where any of the listed company's present executive officers at the same time serves or served on that company's compensation committee.
      • (v) The director is a current employee, or an immediate family member is a current executive officer, of a company that has made payments to, or received payments from, the listed company for property or services in an amount which, in any of the last three fiscal years, exceeds the greater of $1 million, or 2% of such other company's consolidated gross revenues.
  • Rationale:
    • Donald Clarke Reading -- Evidence shows that Board independence doesn't guarantee corporate performance (see: Enron had fully functional audit committee). Some studies show that there is improved performance by having insiders on finance committee.
    • Bhagat & Black Reading -- There is potential policy advantage of less independence.
      • Board Independence checks insider CEO from self-dealing, but "reasonable number" of Insiders on the board can add to long-term corp performance.
      • Why Board Independence doesn't correlate with firm performance
        • Inside directors have better firm knowledge than independent directors
        • Independent directors might not be truly independent (eg feel loyal to CEO), have insufficient financial incentives, not enough time to focus on corp
        • Some independent directors are just there for "Visibility" (eg diversity), not effective
      • Gordon: Board Independence might corelate with overall social welfare
        • Improve managers adherence to stakeholder interests
        • Improve reliability of public disclosures (so more confident investors)
        • Bind firm responsiveness ot stock market signals

C. SH’s Governance Role[edit]

  • Main Qs
    • o SH voting
    • o SH right to inspect books – legit purpose
    • o Annual meetings/special meetings
    • o Quorum, majorities, pluralities
    • o Record owner on record date – p. 92
    • o Proxy – p. 93
    • o Straight and cumulative voting in electing directors
    • o Voting trusts and voting arrangements

Shareholder Meetings[edit]

  • Calling the Meeting
    • Annual Meeting = fixed date specified in bylaws
    • Special Meeting can be called by:
      • MBCA 7.02a1: BoD
      • MBCA 7.02a1: Anyone else authorized by Arts of Inc.
      • MBCA 7.02a2: SHs with 10% of corp
        • *DGCL 211d excludes SH power to call special meetings. But can use statutory power to act by written consent (DGCL 228) to exercise their powers even without a special meeting
  • Notice
    • Corp must give written notice of all meetings to voting SHs
      • BoD sets "record date" prior to meeting -- provide only shareholders who are "of record" by that date will be eligible to vote at meeting
        • This is just default for special meetings. Art of Inc or bylaws can specify if someone else besides BoD can set the record date and send notice.
        • Two record dates
          • 1 for stockholders entitled to notice (MUST be btw 10-60 days (inclusive) in advance)
          • 1 for stockholders entitle to vote (default is the same record date for notice)
    • Special meeting can only address matters "within purpose described in the meeting notice"
    • Shareholders can waive notice by (a) writing, or (b) showing up and not objective
  • Quorum
    • Default quorum
  • MBCA 7.25a: a majority of the votes entitled to be cast on the matter by the voting group
  • DGCL 216(1): a majority of the shares entitled to vote
    • Amending Quorum
      • MBCA: Need supermajority vote to alter a supermajority voting requirement in Arts of Inc or bylaws
      • DGCL: Need majority to amend quorum requirement (minimum quorum is 1/3)
  • Voting
    • 1 share = 1 vote (default)
    • SHs (but not directors) can vote by proxy
    • Decisions made by majority of present voters
  • DGCL §216 (2): affirmative vote of the majority of shares present
  • MBCA §7.25 (c): votes cast within the voting group favoring the action exceed the votes cast opposing action
      • Abstentions Wrinkle
        • MBCA 7.25c: Count all voters for quorum, but don't count ABSTENTIONS in decision vote (just count if Yes > No).
        • DGCL 216: Do count abstentions in seeing if a vote clears majority of present eligible voters!
      • Exception: Mergers -- DGCL 251c: Need majority vote of all shares outstanding (and entitled to vote) for approval of mergers! Not just the voters at meeting!
      • Exception: Electing Directors -- plurality
    • Supermajority
      • MBCA 7.27: Need a supermajority to set a supermajority threshold
      • DGCL 242: Just need a majority to set supermajority requirement. But need supermajority to modify.
  • Action by Written Consent
    • MBCA 7.04a: Actions may be taken w/o meeting only if written consent of ALL SHS entitled to vote on an action
    • DGCL 228: Allows MAJORITY of entitled shareholders to act by written consent
      • Must give prompt notice to nonconsenting SHs that action has been taken, but no advance notice required!
      • 60 day window from first consent to get consent signatures
      • This is just the default

Election and Removal of Directors[edit]

  • Election of Directors = plurality
  • o MBCA 7.28: directors are elected by a plurality of votes cast.
  • o DGCL 216 (3): Directors shall be elected by a plurality of the votes of the shares present
  • *Vacant directors' seat can be filled by shareholders OR remaining directors (unless articles say otherwise)
  • Removal and Replacement
    • Old rule that Directors could only be removed for cause
    • RULE: Shareholders can remove directors with or without cause, unless Arts specify only for cause (MBCA 8.08, DGCL 141)
      • For cause removal is mandatory power and can't be restricted
      • Campbell v. Loews (Dela 1957)
        • RULE: Shareholders have inherent power to remove directors for cause
          • Rationale: Without this, even the worst director could indefinitely remiain on board
          • Shareholders also have inherent right to elect directors to fill vacancies (so vacancy filling isn't only a director power)
        • RULE: It is not valid to remove directors bc they won't cooperate with CEO, desire to takeover the corp
          • Ex: Directors are being rude, accusing CEO of bad stuff, refusing to cooperate on CEO plan
        • RULE: It IS valid to remove directors bc they are harassing CEO to the point where it’s deliberately obstructive and burdensome on the corp
          • Ex: Sending daily mail to CEO, bunch of lawyer/accountant doc requests to CEO (going back 20 years)
          • Must give the directors detailed charges, notice, and oppt to respond before special meeting
  • Classified Boards
    • Directors elected to serve 3 year terms
    • 1/3 of Board elected each year
    • Thought to be an anti-takeover device
      • Can be overcome by soliciting proxies to remove full Board
  • SH elect directors, but usually not involved in selecting them.
    • Existing directors get to nominate the new directors
  • Collective Action Problem, Clark Reading -- "Rational Apathy"
    • Takeaway: NO shareholder (unless you are very big) will have economic incentive to put in the time/money to get a proxy collective action together.
      • "Wall Street Rule" = shareholders really have 2 options: vote with mangement or sell stock
    • High cost of informing yourself as shareholder. Easier just to free ride.

SH Right to Inspect Books/Records[edit]

  • What’s covered?
    • MBCA 16.02
      • Inspection rights to all shareholders of record + beneficial owners
      • Must have signed written notice of the shareholder’s demand at least five business days
      • Two different classes of documents
        • (1) Can readily inspect Arts, bylaws, minutes of shareholder meetings.
        • (2) Can NOT inspect board meeting minutes, accounting records, or shareholder list unless there is (a) "proper purpose," (b) "reasonable particularity," (c) records "directly connected" to purpose
    • DGCL 220
      • BROADER than MCBA -- "and other records"
      • Inspection rights to all beneficial owners + need proper purpose.
      • Dela Courts encourage 220 searches to obtain facts before initiating derivative lawsuits
  • Proper Purpose
    • Clearly Okay purposes
      • Get shareholder list to communicate with other shareholders
      • Get shareholder list to pursue a tender offer
      • To investigate alleged misconduct before a derivative suit
  • o Is economic purpose required? Or can you have social purpose?
      • Pillsbury v. Honeywell (Minn 1971) = Only SH with a bona fide econ interest in corporation get inspection powers.
        • Buying 100 shares just to inspect after you heard about some political issue is not a bona fine interest. Corp allowed to deny request.
        • But it could be okay for legit shareholder to request inspection for environmental issue if he thinks it will affect short- or long-term econ performance of corp.
      • Delaware = rejects Pillsbury. Allows broad inspection rights, unless the request is a "fishing expedition."
        • It's a case-by-case review from the courts, but not limited to just economic purpose.

Proxy Voting[edit]

  • SHs can vote by proxy
    • Authorization for proxy voting is generally limited (by state statutes) to 11 months from date of execution at meeting
      • EXCEPTION: DGCL 212 has NO time limit on authorization.
    • Proxy is only irrevocable if expressly stated + "coupled with an interest" (MBCA 7.22(d), DGCL 213(e))
      • (1) a pledgee (eg bank that gets the stock as pledge for loan)
      • (2) a person who purchased or agreed to purchase the shares
      • (3) a creditor of the corporation who extended it credit terms requiring the appointment
      • (4) an employee of the corporation whose employment contract requires the appointment
      • (5) a party to a voting agreement created under MBCA §7.31 .
      • *If no economic interest in company, we can't be assured that they will vote properly.
  • Collective Action Problem, Clark Reading -- "Rational Apathy"
    • Takeaway: NO shareholder (unless you are very big) will have economic incentive to put in the time/money to get a proxy collective action together.
    • High cost of informing yourself as shareholder. Easier just to free ride.
    • "Wall Street Rule" = shareholders really have 2 options: vote with mangement or sell stock
  • Traditional Institutional Investor
    • o ERISA (pension fund)/Investment Advisor Act (mutual fund) = legal duty on behalf of beneficiaries to exercise proxy rights in best interest of beneficiaries
      • These managers can't follow Wall Street Rule anymore – MUST hold the share and do something in best interest of beneficiaries
      • So managers have legal duty to be active proxy
    • o Hire Proxy Advisory Firms do all the research and recommend that they vote a certain way
  • Activist Investors
    • o (agency capital model)
    • o Usually institutions which making living on the business model: acquire a company which is not running well. Then go to the company and give advices to increase the stock price.
    • o Cons: short-time solution, may make the company overleveraged.
    • o Pros: increase the stock price, make the company run well

Proxy Regulation / Solicitation[edit]

  • Proxy Process
    • Annual Meeting
      • Why have it: Tradition, statutory requirements (MBCA 7.01, DGCL 211b), stock exchange rules, investor relations
    • When Do You Need SH Vote?
      • Election of directors,
      • Appointing auditor,
      • Other matters proposed by management:
        • Approving a merger,
        • Approving stock option plan change
  • o Stock option employee plan helps incentivize hard work in employees (ie they have vested interest in improving corp performance).
  • o RULE: Stock option plan for public company needs shareholder approval (SEC rule)
        • Amending Articles
      • Shareholder proposals
        • Any shareholder has right to show up at meeting and make proposal -- will usual fail
        • RULE: If management knows in advance that shareholder will introduce proposal at meeting, management must include it in proxy solicitation materials + indicate how management will vote.
    • Schedule
      • Board sets date of meeting
      • Board sets record date -- date at which any shareholder "of record" has right to appear at annual meeting and vote.
        • Always well in advance of meeting. Lets corp know in advance of meeting who to send proxy solicitation materials to.
        • So if you buy shares btw record date and meeting, you can theoretically get the record holder to send you proxy solicitation. But in practice, you're disenfranchised.
      • File and prepare proxy statement -- info given to ppl from who you solicit proxies.
      • Send out notice of meeting, proxy statement, and form of proxy (by mail or email)
    • Problem of "street name" holdings
      • Rule: You need to identify “Record owners on record date”
      • But how do you get proxy materials to actual beneficial owners (rather than the proxy firm who’s name it is under (hence the “record owner” with that street name))
      • Two ways:
        • (1) Brokerage firms holding stock on behalf of customers must forward materials to the customers (per SEC rules)
        • Company can send some proxy materials to brokerage firms + some to NOBO list
          • Non-Objecting Beneficial Owners (NOBO) List -- list of customers maintained by brokerage firm who don't object to having their contact info provided to company whose stock they own.
  • o DGCL 231 = public corporations must appoint one or more inspectors in advance of any SH meeting to count proxies
    • Under current SEC rules, the definitive proxy statement must always be filed with the SEC although a preliminary proxy statement usually need not be filed
  • Securities and Exchange Act 14A
    • RULE: Anyone who solicits proxies must file a proxy statement with the SEC, including info specified by SEC rules
      • Primarily management solicitations, but also solicitations by other shareholders in proxy contest or tender offer
        • Proxy Contest -- when shareholders want to boot the Board
      • Proxy statement must explain: What will be voted on, How proxy will vote, Explanation for vote
    • Disclosure of Info useful to SHs
      • Proxy Statement must accompany or be preceded by annual report (10K)
      • Info about BoD and candidates for election
      • Security ownership of management and large shareholders
      • Info on exec and director comp
      • Info on Board structure and committees
      • Info on proposals to be voted on
    • 14c: You must provide this info EVEN IF proxies aren't solicited
      • Ex: If management will be voting at meeting and have controlling stake
  • Definition of Proxy
  • o Rule 14a–1(f). ''The term “proxy” includes every proxy, consent or authorization within the meaning of section 14(a) of the Act.
    • The consent or authorization may take the form of failure to object or to dissent. (ie "If you don't object, we will vote for you on X")
  • Definition of Solicitation
    • o Rule 14a-1(l). ''(1) The terms “solicit” and “solicitation” include
      • (i) Any request for a proxy whether or not accompanied by or included in a form of proxy:
      • (ii) Any request to execute or not to execute, or to revoke, a proxy; or
      • (iii) The furnishing of a form of proxy or other communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.
        • Very broad standard
    • Studebaker Corp v. Gitlin
      • RULE: Requests for consent to seek SH list which are part of a "continuous plan" (ie to do proxy contest) leading to a request for proxies will therefore be considered a solicitation.
      • Holding: Any such solicitation is subject to the Proxy Rules, so Gitlin should have said who he was and what he was looking to vote on.
    • Union Pacific RR v. Chicago & NW Ry Co
      • -Facts: Brokerage firm prepares report favoring NW over Union in offer to acquire RI. NW distributes report to RI SHs.
      • Holding: This was a proxy solicitation bc "reasonably calculated" to encourage vote in NW's favor.
    • Smallwood v. Pearl Brewing Company (5th Cir 1974)
      • Facts: Company sends advisory letter on new merger 2 months before proxy statement. Says they believe it is a good idea, but mostly neutral.
      • Holding: This is not a solicitation. Important to balance Prompt Disclosure of transactions versus Proxy Rule timing requirements.
    • Long Island Lighting Co v. Barbash (2nd Cir 1985)
      • Facts: SH calls special meeting to elect new directors favoring conversion to municipally-owned utility. Another SH group publishes ad in Newsday criticizing management supporting conversion. Long Island sues on grounds ad was a proxy solicitation
      • HOLDING: "Indirect” communication can constitute proxy solicitation -- this was intended to encourage readers of Newsday to vote in favor for new directors.
      • DISSENT (Winter): This was not a solicitation, but just a mere ad in newspaper. Not directed at SH + no proxy actually requested.
        • SEC has since effectively adopted Winter’s view.
    • Rule 14a-2(b)(6): Exempt from proxy rules if doesn't seek or request power to act + made more than 60 days prior to date of shareholder meeting
      • Exempts most communications as long as you’re not expressly seeking proxy
      • If you say "we plan to seek solicitation," can't then talk about all of the advantages of the vote unless you follow the rules.

SH Proposal[edit]

  • Shareholder Proposal Rule (Rule 14a-8): Any SHs can have proposal included in company's proxy materials for vote at annual meeting if
    • (1) SH meets ownership requirements,
      • Proponent has continuously held at least 1% or $2k worth of company voting share for 1 year by date of submission
    • (2) Submits proposal in timely fashion/proper form,
      • Proponent may submit no more than one proposal per company for particular meeting
      • Proposal + supporting material may not exceed 500 words
      • Proposal must be submitted at least 120 days before proxy statement
    • (3) Proposal has proper subject matter.
  • Company response to SH Proposal
    • o Exclude
    • o Accept
      • Company can recommend SHs vote against the proposal if it ultimately includes it in proxy statement
        • Must not be materially false or misleading opposition
  • o Submit to SEC for interpretation – MOST COMMON
    • SEC is arbiter. Can give No Action Letter.
      • Not binding law, so SH can’t sue for aggrievement
    • Technical Exclusion, 14a-8(i): You can exclude the SH Proposal if…
      • o (9) Conflicts with company's proposal: If the proposal directly conflicts with one of the company's own proposals to be submitted to shareholders at the same meeting;
      • o (10) Substantially implemented: If the company has already substantially implemented the proposal;
      • o (11) Duplication: If the proposal substantially duplicates another proposal previously submitted to the company by another proponent that will be included in the company's proxy materials for the same meeting;
      • o (12) Resubmissions: If the proposal deals with substantially the same subject matter as another proposal or proposals that has or have been previously included in the company's proxy materials within the preceding 5 calendar years, a company may exclude it from its proxy materials for any meeting held within 3 calendar years of the last time it was included if the proposal received:
        • (i) Less than 3% of the vote if proposed once within the preceding 5 calendar years;
        • (ii) Less than 6% of the vote on its last submission to shareholders if proposed twice previously within the preceding 5 calendar years; or
        • (iii) Less than 10% of the vote on its last submission to shareholders if proposed three times or more previously within the preceding 5 calendar years
      • Substantive Exclusions, 14a-8(i): You can exclude the SH Proposal if…
        • o (1) Improper under state law: If the proposal is not a proper subject for action by shareholders under the laws of the jurisdiction of the company's organization;
        • o (2) Violation of law: If the proposal would, if implemented, cause the company to violate any state, federal, or foreign law to which it is subject;
        • o (3) Violation of proxy rules: If the proposal or supporting statement is contrary to any of the Commission's proxy rules, including Rule 14a-9, which prohibits materially false or misleading statements in proxy soliciting materials;
        • o (5) Relevance: If the proposal relates to operations which account for less than 5 percent of the company's total assets at the end of its most recent fiscal year, and for less than 5 percent of its net earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related to the company's business.
        • o (7) Management functions: If the proposal deals with a matter relating to the company's ordinary business operations; (ordinary business decisions and question of public policy usually excluded)
        • o Line of cases….
      • SH Nominations
  • Main Qs:
    • o (1) When do SHs vote?
      • Election of Board
      • Fundamental corporate changes (eg M&A, dissolution, sale of major assets)
    • o (2) Who votes?
      • Record owner on record date
      • Proxy
    • o (3) How do SHs vote?
      • Quorum – count number of shares, not number of voters
      • Minitest:
        • (A) Is it cumulative voting
          • o Must be expressly opted for in Articles (not a default)
        • (B) Is there a SH Voting Agreement?
          • o Is it Voting Trust or Voting Agreement?
          • o Does it comply with state statute?
          • o Is it effective?
  • Election of board
    • Default Rule (“Straight Voting”)
      • Mechanics
        • One vote per share
        • Candidates nominated at SH meeting
        • SH can vote their shares for candidates. # equal to Board positions
          • Ex: vote for 4 candidates if 4 spots open, even though may be 8 candidates
      • Candidates with highest number of votes are elected
  • RULE: MBCA/DGCL – Only Plurality needed
      • Problem: Minority SH will lose out on Board position if there is Contested Election.
        • SH with plurality shares will always get to pick the director unless there is cumulative voting or some SH voting agreement opposing him.
        • Ex: A/B have 400 votes each, C has 200 votes.
          • A gets 800 votes (A/B),
          • B gets 800 votes (A/B),
          • C gets 200 votes (C),
          • D/E gets 1000 vote (A/B/C). So C is out.
    • Alternate Voting Schemes
      • Supermajority Voting
        • Can require supermajority (eg 80%) of Board/shareholder vote on issues
        • Problem: Some courts have struck down supermajority voting
          • More favorable toward close corporations
          • Some states by default allow high voting requirements for Articles/Bylaws (eg MBCA 2.02/7.25c/8.24c, NYBCL 616/709).
      • Class voting
        • Divide SHs into different classes, and each class gets a certain number of directors.
        • Problem: Minority can lead to deadlock. But hard to protect plan, because majority can amend articles/bylaw.
    • Three types of voting arrangements
      • Irrevocable Proxies
        • Based on agency power
        • Proxy = SH gives someone else a proxy (agency power) to vote her shares (w instructions or w full discretion)
        • Difference from trustee -- Trustee is more complicated, and you instruct them how to vote.
        • Policy Problem: Don't want to give voting powers to agent with no economic interest in corp!
          • RULE: Irrevocable proxy must be "coupled with an interest" (MBCA 7.22(d), DGCL 213(e))
            • (1) a pledgee (eg bank that gets the stock as pledge for loan)
            • (2) a person who purchased or agreed to purchase the shares
            • (3) a creditor of the corporation who extended it credit terms requiring the appointment
            • (4) an employee of the corporation whose employment contract requires the appointment
            • (5) a party to a voting agreement created under MBCA §7.31 .
          • If no economic interest in company, we can't be assured that they will vote properly.


B. Shareholder Litigation[edit]

  • TEST, Tooley (Dela 2004): To determine if it’s a derivative suit, look solely at:
    • o (1) Who suffered the alleged harm (the corp or the suing stockholders individually)?
      • These shareholders saying that they suffered harm - not the corp.
      • In direct suit, helpful to show that plaintiff can prevail without showing injury to the cop
    • o (2) Who would receive benefit of recovery (corp or the stockholders individually)?
  • Exceptions to General Rule finding Derivative:
    • o Close Corporations
      • Rationale: Director is also shareholder. If they lose derivative suit, they're just repaying to corp and getting payment back.
      • Sometimes, court will just allow the derivative suit to have direct suit payout (ie just to the suing shareholder).
        • ALI 7.01d: Court has discretion to treat derivative action in close corporation as a direct action and allow individual recovery. Only if doing so doesn't (i) unfairly expose corp to multiplicity of actions, (ii) materially prejudice interests of credits, or (iii) interfere with fair distribution of the recovery among all interested persons
      • o Merger
        • Facts: P acquires T in merger, with P surviving. T SHs allege T directors breach of duty of care in approving, but T is not gone.
        • If it were derivative suit, recovery/benefit would go to P corp. So suit by T SHs considered as class action direct suit against T directors.
  • ALI Principles 7.01: The key distinction is whether you can only prevail by showing breach of duty to corp (derivative) or not (direct action).
  • In a derivative suit, the corp pays the lawyer’s fees. However, in a direct action, the shareholders pay the fees.

Direct Suit[edit]

  • Direct actions is benefited by not having procedural burdens of derivative suit (eg pre-suit demand on board, BoD power to seek dismissal of derivative suit)
  • Close Corp (ALI 7.01d): Court has discretion to treat derivative action in close corporation as a direct action and allow individual recovery. Only if doing so doesn't (i) unfairly expose corp to multiplicity of actions, (ii) materially prejudice interests of credits, or (iii) interfere with fair distribution of the recovery among all interested persons
  • Examples
    • o Inadequate Disclosure
    • o oppression of minority shareholders
    • o Appraisal rights…
    • o proposed reorganization favoring one class of shares over another
    • o compelling declaration of a dividend
    • o inspection of corporate books and records
    • o shareholder voting rights
    • o preemptive rights
    • o injunctive relief where the board of directors improperly abdicated its authority to corporate officers

Derivative Suit[edit]

  • Basic idea = You are suing to ensure corp "fairly and adequately represent" interests of all similarly situated SHs
  • Examples:
    • o Breach of duty
      • Loyalty
      • Care
    • o Corporate rights arising out of tort or contract
    • o Corporate mismanagement
    • o Executive compensation
    • o Waste of corporate assets
    • o Self-dealing by officers/directors
    • o Adequacy of consideration for issuance of corporate stocks
    • o Asset sales or purchases
    • o Payment of special dividends
  • Consequences if derivative
    • o Recovery goes to corporation
    • o All SHs benefit
    • o Creditors and other benefit, as well
    • o Preclusive wrt subject matter
    • o Successful plaintiff’s attorneys’ fees paid by corporation
    • o Requires showing that demand futile, thus can be outcome-determinative
  • Delaware Rule 23.1: If its derivative suit, plaintiffs must show that:
    • (b)(1) They retain ownership of shares throughout litigation
    • (b)(3) Make pre-suit demand of Board, or state with particularity why demand was not necessary
    • (c) obtain court approval of any settlement1
  • Role of the Lawyer
    • Option 1: Lawyer may never jointly represent both Corp and Individuals Ds in derivative action
      • Rationale 1: Corp interests might not get adequate consideration. Lawyer is used to working with directors as reps of the corp.
      • Rationale 2: Lawyer might have received confidential info from Individual Client in course of representing Corp. Lawyer has duty to keep it confidential from others who might use it to clients' disadvantage, and Corp might want to use that info to Individual Clients' disadvantage. Conflict!
    • Option 2: Prohibit dual representation when P alleges fraud, intentional misconduct, or self-dealing (Bell Atlantic)
      • Rationale: Breach of duty of loyalty is more serious than breach of duty of care.
      • Preferred by MRPC -- focus on the nature of P's allegations
        • Model Rule 1.13, Comment 14: Most cases should allow lawyer to rep the Corp as he normally would. Only when "serious charge of wrongdoing" by corp leaders is when conflict on interest might arise.
    • Option 3: Dual rep is allowed when disinterested directors conclude there is no basis for the claim (ALI 3rd Restatement)
      • Lawyer must get consent of all clients
        • For corp D, lawyer must get consent of "responsible agents not names and not likely to be named in the case"
  • To qualify as Plaintiff, must have
    • o (1) Adequacy
      • Very liberal requirement
      • Plaintiffs must be capable of adequately and fairly representing the interests of the SHs on whose behalf the suit is brought
      • In re Fuqua (Dela 1999)
        • RULE: A plaintiff who understands the basic nature of a SH derivative action brought in her name, but is unfamiliar w/ the facts and exercises little control over the cases, is nevertheless an adequate rep. of the shareholder class
          • o Illness and memory suffer doesn’t bar a P
          • o Lack of proficiency in matters of law doesn’t bar a P
        • Just need competent support from advisor and attorney and have no disabling conflicts
      • o (2) Standing
        • (a) Contemporaneous ownership -- Owned stock @ time of wrong and must retain the stock throughout the litigation
        • (b) Continuing interest
          • Have to remain a shareholder.
          • SH of a corp that does not survive a merger lacks standing to sue derivatively for misconduct that occurred before the merger because the claim now is an asset of the surviving corporation
            • o Note: If the merger is the subject of the derivative claim (ie former SHs sued to block the merger but it went through), Court might allow it as direct suit of former shareholders against former directors.
          • (c) Security ownership -- Have to be the owner of record or beneficial owner of the stock (MBCA 7.40(e))

Demand Requirement[edit]

  • Statutes
    • Delaware Rule 23.1: If its derivative suit, plaintiffs must show that they made pre-suit demand of Board, or state with particularity why demand was not necessary
    • MBCA 7.42: No shareholder can commence derivative suit until:
      • (1) Written demand made to corp to take suitable action
      • (2) 90 days have expired since demand -- unless you got express rejection or will suffer irreperable harm
  • MBCA 7.40-7.47
    • No excusal of demand for futility
    • Always have to make a demand on the board, then if demand is rejected, you attack the decision to reject demand on same basis that you attack the yet-to-occur decision under the traditional approach
    • Can demand be excused, or must you be explicitly refused?
    • MBCA 7.44: Excusing Demand
      • (a) Court can excuse demand if one of the groups below has determined in good faith, after conducting a reasonable inquiry upon which its conclusions are based, that the maintenance of the derivative proceeding is not in the best interests of the corporation.
      • (b) If not court-appointed panel, then either of these two groups can make determination in good faith to excuse demand
        • (1) Majority vote of qualified directors present at meeting of BoD (as long as qualified directors constitute quorum)
          • MBCA 1.43(a): qualified director means they…
            • (1)(i) don’t have material interest in outcome of proceeding
              • (b)(2) "material interest" means an actual or potential benefit or detriment (other than one which would devolve on the corporation or the shareholders generally) that would reasonably be expected to impair the objectivity of the director's judgment when participating in the action to be taken.
              • (3) Being named defendant makes you interested
            • (1)(ii) don’t have material relationship with person who has such interest
              • This means financial, professional, employment, "or other" relationship
              • (b)(1) "material relationship" means a familial, financial, professional, employment or other relationship that would reasonably be expected to impair the objectivity of the director's judgment when participating in the action to be taken
          • Prof: Up to factfinder to decide whether material interest/relationship exists.
  • (c) The presence of one or more of the following circumstances shall not automatically prevent a director from being a qualified director:
  • '(2) a majority vote of a committee consisting of 2 or more qualified directors appointed by majority vote of qualified directors present at a meeting of the board of directors, regardless of whether such qualified directors constitute a quorum.'
  • Purpose
    • DGCL 141
    • Business and affairs managed by or under direction of the Board (includes decisions to sue)
    • Boards usually don't respond favorable to demand
      • Exception: Ford Motors -- Goldman Sachs IPO has "friends and family list" (really nice, lets you buy stock at offer price -- offer price usually lower and expect to sell at end of day for profit). Bill Ford makes huge profit based on "Friends and Family List". Shareholders of Ford make demand, claim Ford usurped a corporate oppt by using F&F List for himself. Board formed special committee, Ford agreed to sell stock at profit.
  • Demand Futility
    • Aronson v. Lewis (Dela 1984) (when current board made challenged decision)
      • RULE: Demand not necessary if alleged particularized facts creating reasonable doubt that:
        • (A) Majority Board not disinterested and independent, or
          • Interested = benefit or detriment wrt transaction that others in your class don’t receive
          • Independence = exists whenever you are NOT dominated, controlled, beholden to by another or dependent on another
        • (B) Challenged decision was not product of valid exercise of BJR.
          • Can show invalid exercise of business judgement by showing (a) uninformed basis, or (b) inadequate deliberation
          • **says “and” but other cases have said its really “or” see Brehm v Eisner p.691
          • Lack of BJR shows violation of duty of care.
      • Circumstances when the business judgment rule does not apply:
        • Has to be “grossly negligent”
        • When judgment does not exist, breach of duty of care
        • Conflicts of interests (connected with the first prong)
        • NOTE: Being a potential defendant does not prove that the directors are not independent or disinterested. But need to show that the directors would be liable to prove that they are not independent.
    • Rales v. Blasband' (Dela 1993) (when no decision made or its new board)'
      • RULE: Does complaint raise reasonable doubt that majority of New Board directors can exercise independent judgment on whether to sue?
      • Applicable when current board did not make challenged decision because:
      • When this might be true?
        • Majority of board that made decision has been replaced
        • Subject of suit not a business decision (e.g. alleged failure to act in good faith)
        • Different board made challenged decision (as in merger situation) (Rales case)
      • plaintiff must allege facts “that allow a reasonable inference that the directors acted with scienter which, in turn, requires not only proof that a director acted inconsistently with his fiduciary duties, but also more importantly, that the director knew he was so acting.”
  • Decision case (not Caremark), so test for demand futility is… Aronson rule: particularized facts either that (i) decision was not under reasonable business judgement, or (ii) board lacked independence.
  • Caremark failure to act case is Rales test.
  • Interested v. Independence
    • Interest versus Independence
      • Interested director can't be independent
      • Independence is broader than interest -- goes to even relationship with interested person
    • Einhorn v. Culea
      • MBCA: No statutory independence definition.
      • Factors to consider in independence
        • Status as a defendant
        • Participation in or approval of alleged wrongdoing
        • Past or present business dealings with Ds
        • Personal, family, or social relationship with Ds
        • Business relations with corp
        • Number of members on committee
        • Role of courporate and independent counsel
    • For interest, see MBCA 1.43
  • o Factors for independence (in independence context)
      • Even saying your friends is fine (Martha Stewart).
      • Probably okay to just be professor (Raval in INfoUSA).
        • But professor + closer relationship can ruin independence (Oracle)
      • Donation to your university is fine (Walt Disney to dean of Georgetown)
        • But donation to your department is not okay (Raval in InfoUSA)
      • Legal fees from business can lead to lacking independence ($500k/year, Kaplan in InfoUSA)
      • Board earnings is not enough alone to establish “reasonable doubt” or dependence (In re Walt Disney).
        • Even if you’re otherwise poor (elementary school teacher in Disney)
      • Free office space (Anderson, Haddix, Walker in InfoUSA)
      • But good idea to bring in two independent directors specifically for SLC.
        • Will always have structural bias. But not enough on its own to overcome independence (Martha Stewart).
        • But still will feel bound (Oracle).
  • Directors of a corporation are not permitted to personally accept private stock allocations in an initial public offering of the corporation’s stock when the corporation itself could have purchased said stock. (Ebay)

Inspect Books and Records, DGCL 220[edit]

  • Preference of Delaware court to inspect books and records before suit
  • DGCL 220: Can inspect books and records
    • Proper Purpose +
      • Trying to satisfy demand futility is a proper purpose
    • Necessary and Relevant +
    • Credible Basis for Wrongdoing
    • Limits to scope
      • Saito v. McKesson HBOC (Dela 2002)
        • Facts: McKesson announces agreement to acquire HBOC in stock merger. 3 days later, Saito (P) acquires McKesson stock. Merger closes, and then McKesson announces restatements due to HBOC accounting errors. Satio seeks access to books and records to support claims against both Boards and outside advisors.
          • Lower court says can that P can only sue for wrong done after they acquired stock (DGCL 327). So can only look at records from after they acquired stock. Also says no fiduciary claim against 3rd party advisors or former HBOC directors, so can't review their docs.
  • HOLDING: You can examine any document that is Necessary and relevant Standard
          • Shareholders can use records for purposes other than lawsuits.
          • Many docs may be relevant
            • Pre-acquisition docs of McKesson
            • Third Party docs, and
            • HBOC docs given to McKesson
      • Seinfeld v. Verizon (Dela 2006)
        • Facts: P asks to examine record in support of claim that Board has overpaid senior execs.
        • HOLDING: You must show some "credible basis for wrongdoing" before you can inspect records.
          • 220 cannot be used in support of "fisihing expedition"
          • Preponderance of evidence to show credible basis for court inference that there was possible mismanagement.
  • Role of Counsel
  • Can one firm represent the corporation and the individual defendants?
    • o If there is fraud, misconduct—no
    • o If M&A, routine - probably can
  • Can the corporation’s regular counsel represent the individual defendants?
    • o If the counsel handled the challenged decision, may need to use another firm

Special Committee[edit]

  • NY RULE: If SLC is independent and acted reasonably, court will not review. BJR applies, dismiss suit (Auerbach, NY 1979)
  • DELA RULE: SLC decision to dismiss suit can always be reviewed by court. BJR does not apply (Zapata, Dela 1981)
    • Two-Part test to determine whether motion to reject is in best interest of the corp.
      • (1) SLC made recommendation with independence, good faith, and reasonableness (adequate bases of info)
        • Burden of proof on corp / SLC
      • (2) If SLC is independent + reasonable, Court applies ITS OWN independent judgment on whether suit should proceed
  • MBCA 7.44: majority vote of SLC consisting of 2 or more "qualified directors" allows dismissal
    • Technically can have 2-person SLC.
    • Qualified = someone who doesn't have material interest in outcome of the proceeding OR material relationship with interested party.
      • Material interest = "substantial likelihood of liability" from result of suit. Simply naming the director isn't sufficient to eliminate them as qualified.
      • Relationship = Einhorn factors
        • Committee member is def with liability
        • Committee member participation in or approval of the alleged wrongdoing
        • Past or present business relations with def
        • Person/family/social relations with def
        • Economic relations with the corp
        • Number of members on SLC
        • Rules of corporate counsel and independent counsel
  • Factors for independence
    • Even saying your friends is fine (Martha Stewart).
    • Probably okay to just be professor (Raval in INfoUSA).
      • But professor + closer relationship can ruin independence (Oracle)
    • Donation to your university is fine (Walt Disney to dean of Georgetown)
      • But donation to your department is not okay (Raval in InfoUSA)
    • Legal fees from business can lead to lacking independence ($500k/year, Kaplan in InfoUSA)
    • Board earnings is not enough alone to establish “reasonable doubt” or dependence (In re Walt Disney).
      • Even if you’re otherwise poor (elementary school teacher in Disney)
    • Free office space (Anderson, Haddix, Walker in InfoUSA)
    • But good idea to bring in two independent directors specifically for SLC.
      • Will always have structural bias. But not enough on its own to overcome independence (Martha Stewart).
      • But still will feel bound (Oracle).
  • o Directors of a corporation are not permitted to personally accept private stock allocations in an initial public offering of the corporation’s stock when the corporation itself could have purchased said stock. (Ebay)
  • Settlement
    • Settlement in derivative suit must be approved by court analyzing fairness.
    • If the payment is high, the lawyers usually won't contest it. So court is judging this in absence of adversaries!
    • Judge needs to evaluate:
      • Does payment fairly represent loss to shareholders?
      • What is value of governance mechanism?
        • Trulia -- Court is skeptical of value of governance-only settlement to shareholders
      • Attorney's fees not overly incentivizing settlement?
  • o Factors for court review of fairness (Polk v. Good, Dela 1986): (1) probable validity of the claims, (2) apparent difficulties in enforcing the claims through court, (3) collectibility of any judgment recovered, (4) delay, expense, and trouble of litigation, (5) amount of compromise as compared with amount/collectability of judgment, (6) views of the parties involved

C. Duty of Care[edit]

  • The statutes
    • o DGCL- No mention of “duty of care”
      • Law entirely judge made
      • Gross negligence: reckless indifference or actions that are without the bounds of reasons.
    • o MBCA- attempt to codify
      • MBCA 8.30: Standard of conduct for Directors – aspirational
        • (a) Each member of the board of directors, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interests of the corporation.
        • (b) The members of the board of directors or a committee of the board, when becoming informed in connection with their decision-making function or devoting attention to their oversight function, shall discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.
      • Reliance on others (MBCA 8.30e)
        • (e) In discharging board or committee duties a director who does not have knowledge that makes reliance unwarranted is entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, prepared or presented by any of the persons specified in subsection (f).
        • (f) A director is entitled to rely . . . on:
          • o (1) one or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the functions performed or the information, opinions, reports or statements provided;
          • o (2) legal counsel, public accountants, or other persons retained by the corporation as to matters involving skills or expertise the director reasonably believes are matters (i) within the particular person's professional or expert competence or (ii) as to which the particular person merits confidence; or
          • o (3) a committee of the board of directors of which the director is not a member if the director reasonably believes the committee merits confidence.
        • MBCA 8.31: Standard of Liability for Directors' -- mandatory'
          • (a) A director shall not be liable to the corporation or its shareholders for any decision to take or not to take action, or any failure to take any action, as a director, unless the party asserting liability in a proceeding establishes that:
            • o (2) the challenged conduct consisted or was the result of:
              • (i) action not in good faith; or
              • (ii) a decision
                • (A) which the director did not reasonably believe to be in the best interests of the corporation, or
                • (B) as to which the director was not informed to an extent the director reasonably believed appropriate in the circumstances; or
              • (iv) a sustained failure of the director to devote attention to ongoing oversight of the business and affairs of the corporation, or a failure to devote timely attention, by making (or causing to be made) appropriate inquiry, when particular facts and circumstances of significant concern materialize that would alert a reasonably attentive director to the need therefore;

Oversight Duty[edit]

  • Cases will touch on focus on nonfeasance (failure to act)
    • o As opposed to making bad decision (misfeasance) or intentional wrongdoing (Malfeasance)
  • Showed bad faith is a necessary condition (Citigroup)
    • o But good faith is now a duty of loyalty issue (Stone v. Ritter)
  • Can be:
    • o Failure to implement controls systems or
    • o Failure to monitor controls system
  • Consists of two aspects
    • o Supervision of ongoing business
      • Performance/compensation of senior officers
    • o Monitoring legal compliance
      • Oversight plans
      • Policies/practices to foster compliance with law/ethical conduct
      • Preparation of financial statements
      • Corporation's internal controls
      • Arrangements for providing adequate/timely info to directors/shareholders
    • Francis v. United Jersey Bank (NJ 1981) -- failure to exercise care, baseline for what is reasonable
      • o Reasonable person would have looked at financial statement and known something was fishy. Just asking sons "Is everything okay?" isn't reasonable.
        • Even a "simple housewife" could have met the standard of conduct by paying adequate attention.
      • o Directors should:
        • Acquire at least a rudimentary understanding of the business
        • Have a continuing obligation to keep informed about the activities of the corp
        • Attend board meetings
        • Remain familiarity w/ financial statements
        • Inquire into issues that arise
      • o RULE: Director's duties are subjective standard. Consider in relation to the specific situation (i.e. company, industry, director’s experience, etc.). But, there is an objective floor of ordinary prudent person's judgment, even absent business expertise (MBCA 8.30b).
        • Official Comment for MBCA 8.30(b): If a director has special background in an area, and fails to oversight the problem, he or she violates the aspirational standard.
      • Graham v. Allis-Chalmers (Delaware)
        • o Imposes duty of inquiry only when there are “obvious signs” of employee wrongdoings. (red flag test)
          • Reasonable person standard
        • o No inherent duty to establish corporate controls. Directors can rely on good faith of employees.
          • “absent cause for suspicion there is no duty upon the directors to install and operate a corporate system of espionage to ferret out wrongdoing which they have no reason to suspect exists.”
        • o HOWEVER
          • SOX requires controls
          • Caremark seems to require some sort of monitoring system even absent a red flag
          • MBCA 8.30 urges directors to implement information systems, the MBCA minimizes the need to inquire into every possible future problem
        • In re Caremark International Inc. Derivative litigation' (Delaware)'
          • o TEST: only a sustained or systematic failure of the board to exercise oversight – such as an utter failure to attempt to assure a reasonable information and reporting system exits- will establish the lack of good faith that is a necessary condition to liability.
            • Must make good faith effort to be informed.
            • Directors have affirmative duty to establish an effective legal compliance program that covers, at the very least, the most important laws to which the corporation is subject.
              • As long as the process is rational, BJR protect the directors from liability.
            • o Caremark duty: a director’s obligation includes a duty to attempt in good faith to assume that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for loses caused by non-compliance with applicable legal standards.
            • o Summary
              • Caremark claims often involve the following two situations:
                • (1) When directors fail to install a system whereby they may be made aware of and oversee corporate compliance with law; or
                • (2) Where the board has an oversight system in place, but nonetheless fails to act to promote compliance.
                  • o In the latter situation, the directors may be liable only where their failure to act represents a non-exculpated breach of duty.
                • Where the directors are on notice of systemic wrongdoing but nonetheless act in a manner that demonstrates a reckless indifference towards the interests of the company, they may be liable for a breach of duty of care,
                  • but in order to be liable when an exculpation clause applies, the inaction of directors in the face of “red flags” putting them on notice of systemic wrongdoing must implicate the duty of loyalty.
                  • To imply director liability, the response of the directors must have been in bad faith. That is, the inaction must suggest not merely inattention, but actual scienter. In other words, the conduct must imply that the directors are knowingly acting for reasons other than the best interests of the corporation
                • Stone v. Ritter
                • P would have to show:
                  • o (1) that the directors knew or should have known that violations of law were occurring,
                  • o (2) that the directors took no steps in a good faith effort to prevent or remedy that situation,
                  • o (3) that such failure proximately resulted in the losses complained of.
                • In re Citigroup Inc. (business risk; have reporting system) (Delaware)
                  • o Beach of good faith case by failure to monitor the business risk
                    • Citi’s Charter exculpate the duty of care
                  • o Rule: To establish oversight liability a plaintiff must show that the directors knew they were not discharging their fiduciary obligations or the directors demonstrated a conscious disregard for their responsibilities such as by failing to act in the face of a known duty to act.
                    • Declines to extend duty of oversight to Business Risks
                      • Very hard for court to find conscious disregard to monitor for business rsiks
                      • Business risk and legal risk is fundamentally different
                      • So seeing signs of deterioration in subprime mortgage and not doing anything about it is OKAY under BJR. Not bad faith failure to monitor.
                    • It is hard to draw a line how much resources should be put into monitoring the business risk
                  • o FN 63 expertise are not held to a higher standard of care in the mere oversight context simply because of their status as an expert. The test is still whether there is bad faith.
                • In re Puda Coal, Inc. (Delaware)
                  • o RULE: Independent directors that they must be capable of fulfilling their fiduciary duty of oversight, no matter where the company’s assets or operations are located.
                  • o If you have branches overseas, you should:
                    • Physical body in this country
                    • Language skills
                    • Retain accountants and lawyers who are fit to the task of public company maintaining controls.
                  • o Delaware does not allow dummy directors.

Decisionmaking Duty to be Informed[edit]

  • Smith v. Van Gorkem
    • o HOLDING: Gross Negligence established by Board bc failed to make informed business decision
      • Board didn't inquire about how the sale/price was established -- didn't inform themselves of VG's role in reaching these things by himself.
      • Uninformed about intrinsic value of company.
        • Board can rely on VG's representations, but not okay that they didn't get docs from him
        • Board didn't have any real info
          • o VG didn't do DCF analysis
          • o Didn't get inside or outside banker valuation
          • o Didn't get management's advice on valuation. Uninformed that CFO said that $55 was bottom range of fairness price
        • Were grossly negligent in approving the sale of the company upon 2 hours consideration w/o prior notice and w/o exigency
          • Board approved the final definitive agreement w/o fully reading it
        • o You do not NEED fairness opinion from outside bankers, but HIGHLY RECOMMENDED
        • o RULE: Board normally has duty of care to corporation. Once they agree to sell, the duty shifts and Board now owes duty to SHs to
          • (1) inform themselves of all info reasonably available and relevant, and
          • (2) disclose all material info to shareholders in approving decision
        • o TEST: There is a rebuttable presumption that Board is adequately informed and with good faith in making business determination.
          • Presumption is rebuttable if P can show that Board did not adequately inform themselves
          • If presumption is rebutted, then question becomes "Entire Fairness" and burden shifts.
            • Board has burden to show that transaction was entirely fair (ie price was adequate, no harm to P) or settle. (Cede IV)
            • Alternatively, merger can be sustained if approved by an informed electorate of shareholders (requires proper disclosure)
  • RULE: Applicable standard for duty of care is gross negligence. You must show gross negligence to establish breach of duty of care.
    • If you can show more than gross negligence, you move to breach of duty of good faith (ie intent to do harm), which is an aspect of duty of loyalty (Stone v. Ritter).
  • Other elements of liability
    • o Lack of objectivity -- Kind of like independence, but the proof required is less than independence (MBCA 8.31a2iii)
      • Independence is about dominated, objectivity just means some familiar relationship
    • o Causation -- Need to show causation and loss, but causation can be inferred (Barnes)
    • o Reliance is usually okay, imposes certain code of conduct on disclosure (MBCA 8.30d)
    • o Rebutting the Presumption of the Business Judgment Rule
      • BJR is often stated as a rebuttable presumption
      • Where BJR rebutted, examined under the entire fairness standard
        • Two basic aspects
          • o (1) fair dealing
          • o (2) fair price
        • Or cleanse the action

Liability + Protections[edit]

  • Standard of liability
    • o MBCA 8.31: Standard of Liability for Directors' -- mandatory'
      • (a) A director shall not be liable to the corporation or its shareholders for any decision to take or not to take action, or any failure to take any action, as a director, unless the party asserting liability in a proceeding establishes that:
        • (2) the challenged conduct consisted or was the result of:
          • o (i) action not in good faith; or
          • o (ii) a decision
            • (A) which the director did not reasonably believe to be in the best interests of the corporation, or
            • (B) as to which the director was not informed to an extent the director reasonably believed appropriate in the circumstances; or
          • (iii) a lack of objectivity due to the director’s familial, financial or business relationship with, or a lack of independence due to the director’s domination or control by, another person having a material interest in the challenged conduct
            • (A) which relationship or which domination or control could reasonably be expected to have affected the director’s judgment respecting the challenged conduct in a manner adverse to the corporation, and
            • (B) after a reasonable expectation to such effect has been established, the director shall not have established that the challenged conduct was reasonably believed by the director to be in the best interests of the corporation; or
  • o (iv) a sustained failure of the director to devote attention to ongoing oversight of the business and affairs of the corporation, or a failure to devote timely attention, by making (or causing to be made) appropriate inquiry, when particular facts and circumstances of significant concern materialize that would alert a reasonably attentive director to the need therefore;
  • Protection #1: BJR
    • o Key defn by Aronson = rebuttable PRESUMPTION that directors are (i) informed, (ii) in good faith, (iii) in best interest of corporation. Absent abuse of discretion, court respects BJ.
    • o Burden shifting
      • P has initial burden to show evidence that decision not within duty of care, loyalty, or good faith.
      • If P meets this burden --> burden shifts to D to challenge the evidence or to show TOTAL FAIRNESS, which is fairness of process and substantive fairness (price)
      • If board meets their burden --> burden of persuasion shifts back to P to claim there was waste
    • Shlensky v. Wrigley
  • Unless Plaintiffs can show fraud, self-dealing, or lack of good faith, BJR protects the directors from direct liability via veil piercing (like in Ford).
      • Not sufficient to just show that no other companies are doing the same thing.
        • Improving surrounding neighborhood can improve attendance at games and thus profitability, so BJR.
      • Wheeler -- every SH implies consent to be bound to exercise of BJ by agents of the corp. That is the trade-off of being SH!
    • Brehm v. Erisner -- “Due care in the decisionmaking context is process due care only.”
      • Look at process being reasonable, not the outcome
  • o Waste
    • Very rare – like Nessie
    • Overcomes BJR
      • TEST: Corporation expends assets without any benefit
        • Dela: there is waste only if “what the corporation has received is so inadequate in value that no person of ordinary, sound business judgment would deem it worth that which the corporation has paid.
        • Grobow v. Perot: “No Benefit Rule”
          • Look at where the benefit of the decision has gone
      • In re Disney -- close call for BJR
        • Facts: Eisner and Disney Board gave president employment contract w/ really nice severance package if fired without cause. Then did so because of clashing.
        • RULE: Nice severance package is protected by BJR – incentivize getting good Board members
          • Can protect severance package by making it performance-based
        • RULE: Actions in bad faith are not exculpable
          • 3 types of bad faith: (a) Objective Bad Faith -- Intent to do harm, (b) Lack of Due Care -- gross negligence but no intent to do harm, (c) Conscious disregard for one's responsibilities" -- Intermediate category
        • Close call:
          • i) BoD was warned of adverse publicity,
          • ii) Comp committee spent very little time reviewing contract,
          • iii) Board received only summary of terms,
          • iv) Did not review any docs,
          • v) Did not ask any Qs.
  • Protection #2: Exculpation Clause
    • o *Standard of liability is lower than standard of conduct – don’t want to deter people
    • o DGCL 102b7 / MBCA 2.02b4 – articles of incorporation can exculpate directors from duty of care
      • EXCEPT if:
        • (1) action led to financial benefit for director or
        • (2) intentionally resulted in harm to shareholders
      • Disney – 3 types of bad faith acts can’t be exculpable
        • Objective Bad Faith -- Intent to do harm
        • Lack of Due Care -- gross negligence but no intent to do harm
        • Conscious disregard for one's responsibilities" -- Intermediate category
  • o DGCL 141e / MBCA 8.31e – reasonable reliance on outside source
  • Protection #3: Indemnification Clause
    • Mandatory Indemnification = if director is successful in defending themselves, must indemnify them
      • MBCA 8.52: A corporation shall indemnify a director who was wholly successful, on the merits or otherwise, in the defense of any proceeding to which he was a party because he was a director of the corporation against reasonable expenses incurred by him in connection with the proceeding.
      • DGCL 1.52 -- same thing
    • Permissible Indemnification = may indemnify director if he acted in good faith + reasonably believed they were acting in best interest of corp
      • Can NOT indemnify them for payments to corp during derivative suit for which he is liable (ie the advancement)
        • But CAN indemnify for reasonable expenses (ie lawyer fees)
      • MBCA 8.51
      • Determination/authorization
        • MBCA 8.55a-b:
          • Two or more qualified directors or majority vote of all qualified directors
          • Special legal counsel selected by majority vote of directors (either including or excluding interested ones!)
      • Same in DGCL 145 -- can indemnify as long as in good faith conduct of corporation OTHER THAN IN DAMAGES IN DERIVATIVE SUIT
  • Protection #4: Director & Officers’ (D&O) Insurance
    • MBCA 8.57
      • Against liability asserted against or incurred by individual… whether or not the corp would have the power to indemnify or advance expenses
        • SO, can get D&O insurance even
      • Who
        • “Duly elected” or “duly appointed” directors and officers
        • Titles are irrelevant, applies only to senior officers appointed by the board
        • Employees not covered
      • Types of coverage
        • “Side A” coverage: Claims against officers and directors not indemnified by corporation
        • “Side B” coverage: Reimbursement of corporation for indemnification expenses
        • “Side C” coverage: Covers entity against certain liabilities, including securities liabilities for public companies
        • Sometimes additional “sides”
      • Actions covered
        • Varies with policy
        • Broadest coverage is “wrongful acts” in capacity as officer or director
        • Excludes intentional misconduct
        • There may be other exclusions
      • When
        • Usually “claims made,” i.e., all claims arising during policy period regardless of when asserted
    • Two kinds of D&O Insurance
      • (1) Insurance for the corporation to indemnify against expenses it incurs (eg advanced legal fees)
      • (2) Protect directors for expenses they incur, including legal fees AND damages incurred in suit or settlement
        • This is why most of these cases will result in settlement. Insurance company will pay the settlement cost, so you settle despite thinking you can win (bc youll incur more attorney fees)
  • Protection #5: Advancement for Expenses
    • MBCA 8.53:
      • a1: Must sign writing affirming that you met conduct of 8.51, AND
      • a2: Must sign writing undertaking repayment of funds if they fail to meet standard of 8.51
        • But need not front that money
      • Authorization enabled by
        • e1: 2 or more qualified directors (i) or a vote by the entire board (ii)
          • Not qualified if you're party to the proceeding (MBCA 1.43), so rare
            • MBCA 1.43: (a) A “qualified director” is a director who, at the time action is to be taken under”
            • (2) section 8.53 or 8.55, (i) is not a party to the proceeding, (ii) is not a director as to whom a transaction is a director’s conflicting interest transaction or who sought a disclaimer of the corporation’s interest in a business opportunity under section 8.70, which transaction or disclaimer is challenged in the proceeding, and (iii) does not have a material relationship with a director described in either clause (i) or clause (ii) of this subsection (a)(2);
        • e2: majority Shareholders -- but rare

D. Duty of Loyalty[edit]

Need to show Burden of proof Cases
No independent approval Entire Fairness Proponent Marciano v. Nakash
Approval by independent/disinterested board or committee Overcome BJR Opponent Benihana of Tokyo v. Benihana
Approval by shareholders Overcome BJR Opponent

*Not applicable if shareholder approval of transaction required by statute. Gantler v. Stephens

  • Duty of loyalty CANNOT be exculpated.
  • Duty of good faith is part of duty of loyalty (Ritter) --> can't be exculpated
  • ATR-Kim Eng Financial Corp v. Araneta (Dela 2006)
    • Facts: Ps are minority shareholders in PMHI. Araneta (D) controlled 90% of PMHI shares and served as chairman of BOD. Araneta transferred key asset to family members, leaving P’s minority stock ownership worthless (D drained corp. for his own benefit). 3 directors: 1 conflicted (Araneta) + 2 employee managers. Directors did not have regular Board meetings, Araneta’s word authoritative, never questioned him or even knew about corp activities. No reporting system in place. Didn’t even know about transfer.
      • Demand excused – don’t have a board w/ the majority being independent
    • RULE: Directors breach fiduciary duties when they fail to monitor self-dealing by other directors even though they did not participate in, approve of, or directly profit from the transactions.
      • Like Pritchard, literally doing nothing in oversight is bad faith and will lead to breach of duty of loyalty. 102b7 does not exculpate for duty of loyalty breach, so liable.
  • McPadden (Dela 2008)
    • o For a failure to be informed from the systems (ie part 2 of Caremark), it is very difficult to win. Showing gross negligence is sufficient to get demand excused under Aronson, but not sufficient to show liability unless there is bad faith (ie conscious disregard of duties).
    • o Usually, having a minimal reporting system is enough to survive bad faith allegation and get yourself under 102b7 exculpation clause.

E. Duties of Controlling SHs[edit]

F. Corporate Actions[edit]

  • Raising Capital
    • Borrow -- get a loan or issue debt securities
      • Bank may want security interest OR a personal guarantee. Banks are very conservative investors.
      • Debt securities rarely issued to small companies.
      • Process for a corporation to borrow
        • For small dollar transactions, BoD approval not required
        • For large transactions, BoD required
          • No DGCL provision on point, but bank would require it
          • DGCL default -- majority BoD in quorum attendance
    • Sell stock -- Raise equity capital
      • Difference between authorized stock and issued stock
      • Note: DGCL 242(2) says stock authorization is majority shareholder issue, but COI raises it to 2/3 shareholder vote. Per DGCL 102, shareholder powers is merely a default provision, so can be overruled by COI terms.
  • o Alternate solution
      • Create subsidiary --> transfer assets to subsidiary --> subsidiary sell shares to raise additional capital --> subsidiary uses some new capital in its operations and loans rest to parent
        • Creating subsidiary just requires filing with state -- no BoD or S/H vote!
        • Transfer of assets to sub -- probably BOD vote, no S/H vote (unless transferring all or substantially all portion of assets)
        • Subsidiary sells stock -- It's a majority vote for the BoD of subsidiary corporation (DGCL 216(2)), no S/H vote
        • Loan from parent to sub -- BOD vote from both parent and sub; no S/H vote
  • How to block Corporate actions
    • Claim breach of fiduciary duty
    • Other equitable claim

Poison Pill = enhanced scrutiny, see Ebay