Corporations

I. Introduction

The Most Common Forms of Business Organization1. Sole proprietorships2. Corporations3. General and Limited Partnerships4. Limited Liability Companies

Sole Proprietorship: A business organization that is owned by a single individualA sole proprietorship is a “business organization” for 2 reasons:

1. A business enterprise owned by an individual is likely to have a psychological and sociological identity separate from that of the individual. As a matter of law, however, a sole proprietorship has no separate identify from its owner.

2. A sole proprietor typically will not conduct the business by himself, but will engage various people - salespersons, mechanics, managers, etc. to act on his behalf and subject to his control in conducting the business

Agent: An agent is a person who by mutual assent acts on behalf of another and subject to the other’s control. The person for whom the agent acts is a principal. Acting for other can include two broad areas of action:

1. Contracts: When determining liability, the primary factor is whether it was within the agent’s scope of authority. Must

determine whether the agent was authorized to bind the principal in contract. When ask your friend to fill in for you at your cart in Boston while you do jury duty. He is filling in, he is

contracting. He is making a K for me. By selling a belt and taking the money. When someone asks for a belt and he has to get it in storage he is doing something physically for me, he is going to retrieve a supply of belts. Delivering goods and receiving payment: components of a sale. The friend is acting on behalf in a physical and contractual context. There is an agency overview here. There is no formal employment K here that underlies our relationship, what underlies it is friendship and no expectation of reward. Yet there is an agency K.

Friend is acting as an agent because he is contracting with a third party.2. Physical labor: Master-servant relationship: This type of agency involves physical services and is important in

tort law. When determining liability, the primary factor is the scope of employment. If the agent is working within the

scope of employment then they are not liable, the master is. To determine whether within scope of employment, look at foreseeability. Was the action causing the injury reasonably foreseeable? An employee going to the bathroom

and accidentally hitting the bathroom door into someone would be considered reasonably foreseeable and therefore the employer would be responsible.

This includes using the bathroom, includes cooking raw meat when you give them food and frying pan.

When you hire someone who is a smoker and you have a smoke free environment, you know that person will go somewhere around that building to smoke.

A reasonable expectation that they will engage in certain behavior. Hiring human beings that sometimes have to use the restrooms or hiring a smoker.

An example of agency by physical services: A house painter paints your house. He is working for you by performing physical services for you.

The terminology used here, for agencies dealing with physical labor, is different than the terminology for agencies dealing with contracts. Here, the agent is called a servant and the principal is called the master.

So this type of agency has a sub name called a master-servant relationship. Respondeat Superior: The liability of a master for the tort of a servant is referred to as liability in respondeat

superior or vicarious liability. Once an activity is within the scope of employment, vicarious liability is set.

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There are people who perform physical services for others but do not cause vicarious liabilities to attach: independent contractors. An attorney is an independent contractor. Masons, bricklayers, asphalt pavers. I have no control over the way the job is being done when I hire an independent contractor.

Exception: Inherently dangerous activities. When I hire an independent contractor to blow up a boulder on my neighbor's property. And the boulder goes flying everywhere, I am liable b/c it was an inherently dangerous activity.

One person can act as an agent, yet have two separate actions. For example: A clerk acts in physical sense (i.e. as a servant) by advertising perfumes (master-servant) but then also becomes an agent in contract by selling the perfume which is a contract relationship (principal-agent). We call her an agent, but there are two separate capacities happening here, contract and physical services which have different names.

An agent does not need to get compensation to be considered an agent. If Harry was helping Pizzano out for the day by advertising and selling those ties, he is still an agent even though he is not getting compensation from Pizzano.

HYPO: A corporation that is after World Peace opens up an ice cream shop. At this shop there is a drunk person who asks for a cup of water and creates a big commotion in the shop. The GM asks a bus boy (who is very muscular) to kindly remove the gentleman from the shop. The bus boy grabbed him and threw him out the front door. As he threw him out the door the drunk man hit a pedestrian walking by. The acting party is always responsible to his actions. The GM probably isn't responsible. Can the corporation be held liable for the tortious actions of the bus person? The master is the corporation; the servant is the bus person. How did the corporation empower the servant? The chain of command, the board of directors has the ultimate authority

but they delegate the authority. The B of D delegates the hiring authority to local managers. So the board has 2 potential servants.

Servant 1 who also happens to be an agent is the manager. The person is an agent b/c he can hire and is a servant b/c he does things for corp.

Servant 2 is bus person. Is there proper delegation of authority? When Servant 2 is acting is he acting as a servant of the first servant? Or is he a servant of the corporation? Look

at whose interest he is serving and whether or not there is the proper delegation of authority from Servant 1 to Servant 2. Take the relationships and isolate them.

TP will sue acting party, the person who directed and the corp as master but has to est the delegation of authority and the servant did not exceed his scope of authority.

Example: Cook your meat on pan A, not on pan B, they cooked on pan B. They didn't follow directions. The bus boy was asked to kindly remove. What does kindly remove mean? If the instruction was "without

force", remove this person, then his force was out of his scope of employment.

Agency Law Governs:1. The relationship between agents and principals

a. Rights of assurety : Agent's right to be made whole for any out of pocket expenses.2. The relationship between agents and third persons with whom an agent deals, or purports to deal, on a principal’s

behalf3. The relationship between principals and third person when an agent deals, or purports to deal, with a third person

on the principals’ behalf

Elements of an Agency: Is a legal concept which depends upon the existence of required factual elements: Must be an agreement between the parties

NO NEED for a contract, employment relationship, or intent by the parties. These things may exist, but are not necessary for the agency relationship.

The manifestation by the principal that the agent shall act for him The agent’s acceptance/consent of the undertaking, and The understanding of the parties that the principal is to be in control of the undertaking/relationship and the agent’s

actions. EXCEPTION: Agency by operation of law. This applies in instances where one party supplies “necessaries” to

another-the law imposes an obligation where none would otherwise exist. The parties may be completely oblivious to the existence of the relationship. Analysis and review will be very fact specific. The burden is on the principal to prove or disprove the existence of the relationship.

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Types of Agents : is a person who acts on behalf and subject to the control of anothero General agent : is an agent who is authorized to conduct a series of transactions involving continuity of

serviceo Special agent : is an agent who is authorized to conduct ONE single transaction, or a SERIES of transactions

not involving continuity of service

Agent/Principal in Torts Master : is a principal who controls or has the right to control the physical conduct of an agent in the performance of

the agent’s services Servant : is an agent whose physical conduct in the performance of services for the principal is subject to the control

of the principalo Respondeat Superior : The liability of a master for the tort of a servant is referred to as liability in respondeat

superior

Authority and Control:

1. Actual Authority: Principal’s words and conduct would lead a reasonable person in the agent’s position to believe that the principal had authorized the action.

(a) Express : Actual words or deeds (contract) authorize the agent to act on behalf of the principal. This is usually in writing and may be by parol evidence but there is no particular requirement that it be so. It is the actual words that express authority so to determine the scope of authority; you must look to the

source, the exact words. Hypo. Creating a power of attorney: expressly conferring authority on an agent the power to do any and all

acts for him as if he were personally present. This is a really broad statement. (b) Implied : The course of conduct, the systematic and continuous set of activities between the principal and agent

that would reasonably lead the agent to believe that he had authority to act. Where agent has done similar things in the past on the behalf of the principal and the principal has

been fine with it. Example: X has been permitted to charge other items on the company’s account, so therefore he

believes he can charge this item to the company’s account.(c) Incidental : A type of implied actual authority to do incidental acts that are reasonably necessary to accomplish an

actually authorized transaction, or that usually accompany it. A classic example of incidental authority is when an agent has actual authority to sell something and the

agent makes warranties to the third party in order to sell the something. This is incidental to selling the item which was actually authorized.

The test is whether other people similarly situated have incidental authority. The custom and usage in the industry or area establishes whether an agent has incidental authority. If other store clerks are authorized to warrantee the product, then this store clerk is.

Incidental authority may be limited by the expressed statement of the relationship. For example, the contract specifically states that other clerks may have incidental authority to warrantee a product but this clerk does not.

HYPO: John (principal) asks Pizzano (agent): Will you sell my car for me? I want $500 for it and I will give you a commission on the sale. Pizzano says I will do it for free b/c you are a friend. Note: this is still an agency even though Pizzano is not getting paid for this transaction on the principal’s behalf. The two important words are “sell” and “$500.” You must first determine what “sell” means. Pizzano makes a warranty to the person that the car has another 100,000 miles in it. He then sells it for $450. Pizzano then calls John to tell him the good news and John is pissed b/c he sold it for less than he should have. Who is liable?

Pizzano is liable to John for the $50 b/c he did not have actual expressed authority to sell below $500 and there is no reason to imply authority to do so under these facts. Incidental authority does not come into play. Although the warranty he made could be considered incidental to selling the car if other car salesman make warranties to sell their cars in the area.

Had Pizzano sold the car for $500 and the principal refused to turn over the car after getting the money, who would be liable to the third party? If the principal-agency relationship and the principal’s identity had been told to the third party before buying the car, then the principal would be liable b/c the agent would not be a part of the contract as long as the agent was acting within his scope of authority. And the contract must expressly state that the agent is not bound. The agent may even sign the contract without incurring liability as long as he is signing on the principal’s

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behalf and it has wording to that effect. If it is an undisclosed principal, then the action is unequivocally between the agent and the third party. However, the agent may recover from the principal and in most cases, the principal can become a party to the present action. In addition, an undisclosed principal may enforce a contract against a third party and therefore a third party may do the same.

2. Apparent Authority: Principal’s words or conduct would lead a reasonable person in a third party’s position to believe that the principal had authorized the agent to act on his own behalf. Apparent authority has nothing to do with what happens between principal and agent like actual authority does, it deals with what the third party perceives.

(a) HYPO: Father asks son to pick up shirts at the dry cleaners and charge it to his tab. Happens over the course of several months/years. Father forbids son to use seamstress at the dry cleaners, but this is unknown to the store. There is a manifestation of apparent authority by the father (the principal) to the seamstress (the third party) that the son (the agent) was authorized to engage in such a transaction.

(b) This essentially rests on an estoppel theory. The principal cannot deny the agency when his manifestation to a third party is reasonably interpreted to authorize the action or transaction.

(c) Apparent authority is a balancing test. Who was in the best position to prevent the injury? Who should be held responsible for the results?

The principal is generally held to be the party in the best position to prevent the injury because the principal puts the transaction in motion.

(d) HYPO: You take your $5,000 gold watch to get repaired by a watch merchant. You, as principal, have turned the goods over to the merchant – one who deals in goods of that kind. If the merchant turns around and sells the watch, the BFP can walk away with the $5,000 because the merchant has the apparent authority to sell.

This is based on the concept of entrustment. The holding out by the principal or agent with the knowledge or acquiescence of the principal, and reasonable reliance on the part of the third party. Let he who can prevent the loss bear the risk.

This is a fiduciary relationship between the principal and the agent. Each owes a duty to the other and will be liable for any breach of fiduciary duty. Watch merchant would be liable for damages for loss, but not replevin of the goods itself.

Note: The burden of proof is on the person who asserts the fact. So if the third party wants to prevail and assert title, he has the burden of proof. If the owner is trying to assert title, then he has the burden of proof.

3. Agency by Estoppel: Restatement (Second) of Agency §8B: A person who is not otherwise liable as a party to a transaction purported to be done on his account, is nevertheless

subject to liability to persons who have changed their positions b/c of their belief that the transaction was entered into by or for him, if:

o he intentionally or carelessly caused such belief, oro knowing of such belief and that others might change their positions b/c of it, he did not take reasonable steps

to notify them of the facts. *The concept of agency by estoppel is so close to the concept of apparent authority that for the most part, the former

concept can be subsumed in the latter. This type of authority creates NO enforcement rights in the principle against the third party. The question to ask is whether another party changed their position based on the belief that the transaction was entered

into by the principal? Elements:

o Principal’s act or conducto Causing third party to believe agency relationship existso Reliance on such relationship by the third party, ando Damages.

4. Inherent Authority: The power is derived from the agency relationship itself and is intended to protect those dealing with the agent. (Pizzano thinks this is crazy.)

The power to act is FAR different from the authority to act. The Restatement (Second) of Agency provides that “power is the ability to affect the legal relations of another.”

Inherent authority is generally your last hope -- when actual, apparent, and estoppel do not work, you try inherent.

5. Ratification: The principal will be bound to the third party if the principal, with full knowledge of the material facts 1) affirms the agent’s conduct by manifesting an intention to treat the agent’s conduct as authorized (sometimes referred to as

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expressed ratification), or 2) engages in conduct that appears to affirm the agent’s conduct (i.e. conduct that is justifiable only if he has such an intention)(sometimes referred to as implied ratification). Ratification is an agency concept which allows you to supply an authority that was otherwise lacking (this takes the

relationship back “ab initio” so that the authority existed from the beginning although the authority was not ratified until later).

All agency principals thereby apply to the transaction such as contract, tort, and misrepresentation. The ratification need not be communicated to the third person to be effective, although it must be objectively

manifested. To be effective, a ratification must occur before either (1) the third person has withdrawn, (2) the agreement has

otherwise terminated, or (3) the situation has so materially changed that it would be inequitable to bind the third person, and the third person elects not to be bound.

Example: The purported agent goes out and interacts with a third party in an unauthorized way and the principal or master approves the transaction.

o Sick brother of owner stays at coal yard because he can’t work. A customer calls and says they need coal immediately. So brother loads up truck and makes coal delivery but in process, breaks something, pane of glass. The owner sends a bill for the coal. That is ratification. Brother is acting as servant of owner/master b/c providing physical services and may also mean the brother is authorized to act in a contract context, principal-agent context. But when brother in law breaks something or commits a tort in this new agency relationship b/c ratified, then the owner is responsible for it. If the owner says they don’t want to have him as agent so they don’t have to be responsible for the broken pane, then the owner can’t send bill which suggests the brother was acting as agent. Can’t have it both ways.

6. Acquiescence: If the agent performs a series of acts of similar nature, the failure of the principal to object to them is an indication that he consents to the performance of similar acts in the future under similar conditions. Acquiescence equals implied actual authority.

7. Termination of agent’s authority: As a general rule, a principal has the power to terminate an agent’s authority at any time, even if doing so violates a contract between the principal and the agent, and even if it had been agreed that the agent’s authority was irrevocable.

Liability

Liability of Principal to Third PersonUnder the law of agency, a principal becomes liable to a third person as a result of an act or transaction by another, A, on the principal’s behalf, if A had actual, apparent, or inherent authority, or was an agent by estoppel, or if the principal ratified the act or transaction.

Liability of Third Person to PrincipalThe general rule is that if an agent and a third person enter into a contract under which the agent’s principal is liable to the third person, then the third person is liable to the principle. There are exceptions when dealing with undisclosed principals discussed above.

Liability of Agent to Third PersonWhere the agent has actual, apparent, or inherent authority, so that the principal is bound to the third person, the agent’s liability to the third person depends in part on whether the principal was disclosed, partially disclosed, or undisclosed.

If the principal is not bound by the agent’s act, because the agent did not have actual, apparent, or inherent authority, the general rule is that the agent is liable to the third person.

Liability of Agent to PrincipalIf an agent takes action that she has no actual authority to perform, but the principal is nevertheless bound because the agent had apparent authority, the agent is liable to the principal for any resulting damages.

Liability of Principal to AgentIf an agent has acted within her actual authority, the principal is under a duty to indemnify, exonerate, or reimburse the agent for payments authorized or made necessary in executing the principal’s affairs.

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Indemnification: the agent can recover monies from the principal that he had to pay out to third party. This is also true in reverse if principal must pay to third party based on wrong by agent, then principal can recover monies from agent.

Exoneration: if an agent is being targeted as the responsible party for the transaction and agent doesn’t benefit in any way from the transaction and principal is real party interest, the principal can be brought into the process and agent is released from it

Reimbursement: reimbursement from the principal for any out of pocket expenses incurred while acting as an agent

Liability attaches as to the principal/master if the agent/servant is acting within the scope of his authority/employment.Master-servant agency: the standard for this agency is one of foreseeability. What risks are reasonably foreseeable during the

servant’s employment?Principal-agent: The type of principal may be the determining factor as to the liabilities of the party. Note: In each of these

scenarios, the principal may be liable to the third party, BUT the agent is liable to the principal. Therefore the principal may in turn sue the agent for breach. Disclosed Principal :

o Definition: A principal is disclosed if at the time of the transaction between the agent and a third person, the third person knows that the agent is acting on behalf of a principal and knows the principal’s identity

o Liability: The principal is fully liable on the transaction and the agent may be liable if expressly included. o By expressly, that means that the document/contract should expressly state that the agent is signing on behalf

of X as a duly authorized agent and not on his own behalf OR have a statement within the contract stating “the agent described herein, named A, is not a party to this contract.” Make sure there are no ambiguities as to who will be held liable.

o Parol evidence rule : does not allow introduction of evidence that is outside the 4 corners of the document. (He also gives dictionary defn). If the document is unclear and the parol evidence is being introduced to clarify it. The biggest exception to the PE rule is ambiguity. Outside evidence may be introduced to clarify the writing if it is unclear who the parties are to the agreement

Partially Disclosed Principal : o Definition: A principal is partially disclosed if at the time of the transaction the third person knows that the

agent is acting on behalf of the principal, but does not know the principal’s identityo Liability: The general rule is that the agent as well as the principal is bound to the third person. The theory

is that if the third person did not know the identity of the principal and therefore, could not investigate the principles credit or reliability, he probably expected that the agent would be liable, either solely or as a co-promisor or surety. As a result the third party normally contracts with both the agent and the principle.

Undisclosed Principal : (defined previously). o Definition: A principal is undisclosed if the agent, in dealing with the third person, purports to be acting on

his own behalfo Liability: It is not unfair to the principle to make him liable on an authorized K, since it was his business

which was being done, and there is no reason why the ordinary rules that the principal is responsible for authorized acts should not be followed. The third party is given, not more than, but something different from, his expectation that he would get a claim against one doing his own business. What he gets is a claim against one who is an agent, with a choice of holding the principal whose business was being done.

o Exceptions: The courts protect the third party where suit by the undisclosed principal would be unfair to him. Situations where the third party can get out of the transaction, especially where there is some element of reliance by the third party.

o Enforcement of contract will cause harm or prejudice to third party. Personal distaste of the undisclosed principal is not considered harm or prejudice. However, if you have personal distaste plus something else, then it must be the something else that allows the avoidance of the contract.

Personal services: If the third party asked for a specific person and did not get or could not get that person. “I don’t want anybody, I want that specific person so it must be that specific person”

Criminal acts: For example: Kids outside the liquor store ask X to get them a case of beer. X instructs the liquor store to deliver to a certain spot and the kids show up to enforce the sale. The kids are undisclosed principals and X was their agent. The third party/liquor store may avoid the contract b/c of criminal liability on the part of the liquor store if they give the kids the beer.

Fraud: P says I don't like that person, I would never K with that person if I knew that person was the real party in interest. I want out of that deal. A man owned a private residence and they were developing the area across the street and he didn't like that. So he didn't want to give in to business movement and he refused to sell to any businesses especially restaurants. The Rest. Sent out an agent, an agent of an undisclosed principle so the TP thought the agent was buying. The TP says to agent "you don't represent restaurant ppl do you?" Agent says no. So they signed the K for sale.

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When the truth was disclosed the TP said the deal was off b/c he would never have dealt with those ppl if he knew they were in rest business. This is harm or prejudice. This allows TP to disclaim K. The harm or prejudice derives from the fact that there was fraud. Rescission of K when there is fraud.

Rules of Construction for a Writing (when something is ambiguous)If an agent does not want to be made part of the contractSignature

Questions to ask when analyzing agency:1. Is it an agency: make sure all elements of agency present2. What type of agency: principal-agent or master-servant3. If the latter, was the action within the servant’s scope of employment? If the former, was the action within the agent’s

authority?4. If within scope of employment, was it foreseeable? If within the agent’s authority, what type of authority (i.e. actual,

apparent, etc…)?5. After determining what type of authority, must determine what type of principal (i.e. disclosed, partially disclosed,

undisclosed).6. Then determine the liability based on those factors.

II. The Corporate Form

Concept (a): [The Characteristics of a Corporation]

Publicly Held EnterprisesThe corporation has traditionally been the preferred choice of form for business enterprises that are to be publicly held (that is, whose ownership interests are to be held by members of the public, as opposed to owner-managers). This preference results from 5 attributes of the corporate form.

5 Attributes of the Corporate Forma) Limited Liability

Shareholders are not personally liable for corporate obligations (i.e. shareholders have limited liability).Managers of a corporation are also normally not personally liable for corporate obligations: As long as corporate

managers act on the corporation’s behalf and within their authority, they are treated like agents, not like principals, for liability purposes

b) Free Transferability of Ownership InterestsOwnership (“equity”) interests in corporations - represented by shares of stock - are freely transferable

c) Continuity of ExistenceThe legal existence of a corporation is perpetual, unless a shorter term is stated in the certificate of incorporationThus, a corporation is relatively secure against early termination (This may have a beneficial impact on long-term

planning)d) Centralized Management

Under the corporate statutes, a corporation is normally managed by or under the direction of a board of directors, and a shareholder as such has no right to participate in management

The board is subject to fiduciary duties. Shareholders have a limited governing role that includes voting power to elect directors and approving fundamental corporate changes.

e) Entity StatusA corporation is a “legal person” or “legal entity”Thus, a corporation can exercise power and have rights in its own nameExample: A corporation can sue or be sued, and can hold property

Privately Held EnterprisesIf an enterprise is not to be publicly held, then the firm might either be a close corporation, a general partnership, a limited liability partnership, a limited partnership, or a limited liability company.

Concept (b): [Selecting a State of Incorporation]Page 7 of 72

Note on Competition Among the States for Incorporations A firm can incorporate wherever it chooses, and a corporation’s internal affairs are governed by the law of its state of

incorporation - even if the corporation has no business contacts with that state “Close Corporation” : is a corporation with only a few owners

o A close corporation will almost invariably incorporate locally, in the state where it has its principal place of business

o If a corporation does business in a state, the state will impose a doing-business tax on the corporation on a basis that reflects the amount of business

o If a corporation is incorporated in a state, the state will impose a franchise tax for the privilege of incorporation, even if the corporation does not do business in that state

Publicly Held Corporation :o Publicly held corporations usually do business in a great number of states and the cost of incorporation in any

state are likely to be inconsequential in comparison with the corporation’s total revenueso Delaware is the most successful state in attracting publicly held corporations

Factors taken into consideration whenever choosing form of business:1. Formality of Organization: What kind of formalities required organizing business?

o Easy with sole proprietorship b/c there are none. Only one mentioned is assumed name statute. o General incorporation statutes: Some other businesses have strict rigid formalities which must be followed to

create that business such as a corporation. Same with limited liability partnerships or limited liability corps. o There are formalities involved in the organization of the business

i. You fill out formsii. The expense and cost, and the more time we put in, the more it costs: lawyers fees

iii. Once the state gets involved with the business, it stays involved, you have to do certain things in order to keep the status as a corp

1. You have to have an annual shareholders meeting2. You have to have a board of directors3. Have to file annual certificates, financial information4. If you want to sell stock you have to get permission from state or federal gvmt (depending on

stock)iv. DE is very user friendly and tax friendly, they are very friendly to corps. No matter where business is

operating if problems arise, it’s the law of state of incorporation that governsv. Domestication :

1. The state of incorporation is considered the domicile. Can incorporate in DE and do business somewhere else.

2. If you are a business incorporated in another state you first have to qualify to do business in states other that incorporation.

3. In MA if someone incorporated in DE wants to do business in MA, MA sees it as a foreign corporation. In order to do business in MA, you have to go through a certain registration procedure,

2. Capital and Credit: Capital is financial foundation upon which the business rests and credit is needed to get the business started.

o Is there a capital requirement? Capital is necessary with a corp b/c you have to have funds. There are ways that a corp raises funds. There is no capital requirement anymore. It must be enough to form the business but no specific number. However, sometimes courts look at corps that don’t have solid financial foundations and they disregard them, therefore making the owners liable personally.

o Credit is extended to businesses. When a business is new, this is tough. No bank will give a loan to a new business. Despite the fact that the business can be loaned funds, with new businesses, the person still acts as guarantor. If the new business defaults on the loan, the guarantor is personally liable.

3. Management and Control: o The sole prop manages and controls the business, they are the bosses. That is not true with the crop. By statute

there is a hierarchical structure. o The corp consists of 3 different parts

i. Shareholders: investors, the risk takers, these are the ppl who seen an opportunity and take a risk with it.1. The building block of corp2. The owners of the business

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ii. Directors: by statute it’s the director that manage and control business for benefit of shareholders.1. As a group they are agents, they are acting on behalf of shareholders2. All agents are fiduciaries: ppl who act on behalf of other people, people representing other

people, They are putting aside self interest and taking up the cause of those that they represent3. The equitable interest: the use and enjoyment of something, shareholding is referred to as

equitable interest, it lies here.iii. Officers: chief executive officer, chief financial officer, the business is being conducted on behalf of the

shareholders.1. Officers are agents and fiduciaries

o Management and control is centralized in a corp in the board of directors. There has to be a board of directors, if you have a one person corp, you have to have one director. You always want to have an odd number on the board, to avoid deadlocks.

o There's a formality required in meetings and notices. Adherence to the statute is a formality, its part of the price. o The consequences of blowing off statute: full personal responsibility for all active participants.

4. Profits and Losses: In the Corp context, the corp makes the profits and bears the losses. It is an entity, a separate artificial being.

o Any losses are business losses and the entity earns the profit. How shareholders benefit is through the distribution of profit and through the distribution of dividends.

5. Liability: In corps, corp is liable not board of directors, but in SP, the sole person is personally fully liable.o they provide a shield that protects ppl in the business from personal liability: the liability shield: its common to all

businesses.o You have to really mess up to have that liability shield pierced.

6. Transferability of Interest: In a SP, there is little transferability b/c not much value while in a corp, you can freely transfer the stock. Restrictions on the transferability of stock is possible, this occurs often in small business.

7. Continuity of Existence: Whether or not the business continues after a profound event such as in SP, when owner dies, the SP is over. In Corp, whole board of directors could die along with shareholders and corp would still run. The state creates the corporation and only the state can uncreate it.

8. Tax: Individual and corp. tax consequences on both a state and personal level.o The corp is a tax paying entity. The same dollar gets taxed at the entity level and at the dividend or distribution

level.o In order to foster small businesses the federal gvmt has eased the taxes. They can ask not to be taxed as a

corporate entity and instead as is unincorporated entity.i. On certain circumstances, the taxes are allowed to flow through to those that are actively engaged in the

business, so profits and losses are treated individually at the tax payer level, and not through the entity. Subchapter S. IRC

ii. There are limitations. They must consist of certain shareholdersiii. But if you qualify then subchapter S is a desirable place to be

o Business corps are taxed at the federal level: Subchapter C Internal Revenue Code

Organizational Form: As you move down this line, you come closer to entity/corp status. This means protection from personal liability which SP does not have. Also means greater government involvement. Closer you come to insulating parties from personal liability, the more the govt wants to make sure they are protecting society. So the choice of organization impacts liability, losses, formality issues, government issues, and tax issues.

A. Sole Proprietorship. A single individual owns the business assets and is liable for any business debts. Usually very small with modest capital needs that can be met from the owner’s resources and from lenders. Least complex form of organization. The owner is liable for their own taxes and lends money in their own name.

Liability: Another drawback to having a sole prop is that since I am the business, I become personally liable to all obligations that happen in this business: the person who slips and falls in my store, etc. The sole prop enjoys full personal liability. The person who suffers a tortious act can go after the business but can also go after my home, it's all on the line, there is no shield.

o If you do business under an assumed name, you must make that fact known by registering the name of the business in the name of the owner at some public place (such as town hall). There are usually sanctions in form of penalties. Some time assumed name statutes are observed and sometimes not. When not, get $100 penalties, slap on the wrist.

o Sole proprietors can’t take care of everything themselves so they usually have employees (this is where agency comes into place). Agents act on your behalf, they are extensions of you.

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For example: When the employee (Harry) sells my items for me, then they make a contract with the customer on the sole proprietor’s behalf. Then customer says he wants five more and employee says he will get them for him, is the proprietor bound by this promise? Sole proprietor is not protected, he is fully liable.

What if Harry ties the tie on the customer after being asked by customer if he could do so and Harry accidentally chokes him, a tort is committed, who is responsible for this? Harry would be the logical answer but not necessarily the case. The sole proprietor is responsible.

o Selling SP: Sole proprietors don’t usually have anything to sell. Their value is very low b/c people will be willing to pay for things that are ongoing but once you don’t have the sole proprietor there, there is no guarantee of continued business from previous customers/clients. So they are not as freely transferable as other types of businesses.

o Continuity: There is also not as much continuity as other business types b/c if the sole proprietor dies, then the business has ended.

o Transactions with the bank: One paper I need to sign when I get a loan form the business is a promissory note: a promise to pay a sum certain together with interest according to the terms and conditions agreed to in the note. I became a promisor, and the bank becomes the promisee, or I become the debtor and they become the creditor.

Banks will often negotiate those notes, and I will get notice that I will have to pay someone else. I'm the one promising to pay even though it was a business loan. A sole prop is not recognized

separately from the sole prop. I am the business and I becomes personally obligated by signing that note. The sole prop is personally liable on these obligations.

Another document is a security agreement or mortgage agreement: provides bank with insurance in case I don't pay the promissory note and default on it, the insurance is in the form of collateral or security or security interest, I give to the bank an interest to some property either tangible personal property or real property mortgage. That interest allows the bank to act with respect to the collateral in case there is a default. This is covered by Article 9 of the UCC.

o Taxes: Another bad thing is the taxes, the tax obligations are the sole prop's. The tax authorities are taxing me on my personal income, there is no business paying taxes. The income from my business might make me pay more taxes.

B. General Partnership. A general partnership is an association of two or more persons to carry on as co-owners a business for profit. Each partner is individually liable for partnership debts. Partnerships are prevalent in the service industry – such as law, accounting, or medicine. ALL STATES have adopted a version of the Uniform Partnership Act which are laws that govern general partnerships and act as defaults if the partnership has not agreed on specific parts of the partnership.

Life Span: Requires NO DOCUMENTATION and is created whenever two or more persons associate to carry on a business as co-owners to share profits and control. A profit sharing arrangement creates the presumption of partnership even if the parties DO NOT INTEND to be partners. A general partnership DISSOLVES upon death, bankruptcy, insanity, or the withdrawal of any partner. Any partner may withdraw and demand that the business be liquidated.

Partnership agreements: spells out partner’s names, place of business, nature of business, and rights, duties and obligations of general partners. If they did not provide in advance some of these things, the act will kick in as default measure and provide these rights, duties and obligation. So if want to alter them, must do so in advance. However, this agreement is not necessary. A partnership may occur informally where they act as a partnership but never realize they are doing so. In this case, the state would not have anything to do with the partnership unless if assume a name which must be registered.

o Example: a plumber works in a large co. and he has talked about starting his own business and they do. He quits his job and starts his own business. Wife keeps books and records and keeps track of everything. The husband doesn't, he works. They formed a partnership but they didn't know about it, they didn't talk about it. But they formed a partnership just like someone who had a lawyer and pounds out a partnership agreement. These are de facto partnerships, but it is still as much as a partnership as a formal one.

Anyone can fall prey to "let's just do it"o If one partner walks away from partnership arrangement, the other partners cannot get specific

performance for breach of contract. They can get damages, but can't make him perform as partner.o Typical things partners provide for in agreements

Status of participant: what is their contribution? 80% or 10%? Who is liable? Are there side agreements? Who signs the mortgage note? Who buys the insurance? Who pays for the taxes or insurance?

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Who manages this partnership? If this detail is not talked about then they are all equal in management and control b/c the PA kicks in if they haven't decided this and the Act says that its equal control.

UPA has equal sharing of profits and losses, so those who have 10% have to share in the losses equally. These details should be talked about.

Liability: no matter what they agree to in advance, it does not effect the fact that each partner is fully and personally liable to all debts and obligations of the partnerships. Their liability whether it be in tort K or otherwise, their liability is joint and several. P can sue one partner or all partners.

The right of contribution exists. Inter -se agreements: agreements with disparate liabilities, you can't sue third

parties. Claims: Partners SHARE EQUALLY in profits and losses, and profits and losses are divided upon

dissolution. The partners may redistribute the ownership interest so that one has a greater interest than the other but it must be provided for. If it is no so provided, the default statutory law will apply and the partners will share equally. Partners have NO statutory right to distribution of the firm’s profits though this may be provided by agreement, and there is NO right to compensation for services unless provided by agreement.

Governance: Each agent is a partner of all other partners and can bind the partnership, either by transacting business as agreed (actual authority) or by appearing in the eyes of third parties to carry a partnership business (apparent authority). A majority vote of the partners decides ordinary partnership matters, but anything that is extraordinary or contravenes the agreement requires unanimity.

Transferability: A partner CANNOT transfer his or her interest in the partnership unless all the remaining partners agree or the partnership agreement permits it. A partner may transfer his financial interest in profits and distributions.

Liability to Outsiders: Partners are jointly and severally liable in K and torts for all obligations. Partners have unlimited liability and their personal assets are at risk for all partnership obligations, whether contractual or tort.

o In most cases, the liability on partnership contracts is joint and therefore the partnership assets must be first exhausted. Then the complaining party may go after the individual partners personal assets.

o If the complaining party goes after a single partner, that partner has a right of action against the other partners. It is an agency relationship and he has rights of an agent, for reimbursement, exoneration, etc…he can seek other partner’s contribution share that he had to pay out to the injured party.

o Parties can reapportion the loss and liability themselves. But third parties can still proceed against the partners jointly and severally, then it is the partners responsibility to go after other partners if liability has been reapportioned.

Taxes: It is not a tax paying business; it is a tax reporting business. They don't pay taxes b/c its not considered to be an entity. Entities tend to be faxed at federal and state levels. A partnership is considered an association of 2 or more ppl.

Partnerships and agencies: Partnerships are agencies; each general partner is an agent of the partner.o Mutual agency relationship: each general partner is an agent of the partnership, its not an entity, it is

an association of people, each general partner is the agent of each general partner. Binds not just general partner but himself as well.

o Mutual agency aspect: Liability is usually borne by the partnership itself by assets and if there is not enough assets then through the general partners

How come it’s not an entity: b/c by tax defn it lacks the essential elements of an entity. o Elements that have to do with limited liability. No LL in partnership.o It does not have centralized management. Partners are equal in management unless provided

otherwise. o No continuity of existence with a partnership. Every time a partner leaves voluntarily or

involuntarily, the partnership dissolves. Death, insanity, legal disability, bankrupt (same factors that cause agencies to end) Tax lacks continuity

o Lacks transferability of interest. Cannot transfer your status as a partnership. There is 3 kinds of interests that a partner has:

Right or interest in specific partnership property: hold partnership assets as tenants of assets.

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Can't transfer it Right to participate in management Right to participate in the profits:

This is transferable but even though you can transfer the rights to participate in profits, the transferee only has those rights, the transferee, not being a partner doesn't get the information like the books and bank accounts. Transferee gets no rights to access information

Procedures/Phases for Ending a Partnership (or any business):o Dissolution : when a partner ceases to be a part of the partnership.

Not every dissolution is followed by a winding up and termination. Only those partnerships that are truly ending.

o Reorganization : If the remaining partners want to continue, then they can as a new partnership (new b/c change in # of partners, can keep same name and contacts, and office so outside world sees it as the same, but partners know the difference).

If the remaining partners do choose to reorganize and continue, they should notify people of the change in order to take away apparent authority of the previous partner. Actual authority ends when dissolution occurs.

o Winding up : Liquidating assets. Take all the stuff the partnership owns and liquidate it through an auction, yard sale, whatever. Then assess liability and obligations and pay them off (accounting). Whatever is left is split between the partners.

All remaining general partners have the actual authority of winding up the affairs. Actual authority is limited to the actual winding up, not other things although may still have apparent authority to do other things.

Creditors come first. When all the credit obligations are satisfied then the partners will get back what they put in. This is where the partnership agreement comes in handy. After that you get any profits you are entitled to. You can change these priorities but the partnership agreement would have to say it.

o Termination : when assets liquidated and claims satisfied, and take whatever is left over, then the business is terminated. It is over, gone, final step of ending business.

Note: Joint venture is a general partnership but a shorter form of partnership. The expectation is not a long term ongoing business relationship. Difference between joint venture and partnership is length of time and expectation and agency aspects. Joint ventures have limited power of agency.

C. Limited Partnership. Limited partners provide capital and are only liable to the extent of their investment. General partners run the business and are fully liable for all debts – can have a situation where there is one general partner and two limited partners. Limited partners combine tax advantages with limited liability.

1. Life Span : Requires FILING certificate with a state official. A limited partnership lasts as long as the parties agree, or absent agreement, until a general partner withdraws. The death, insanity, etc…of a limited partner does not effect the life span of the limited partnership.

2. Claims : Limited and general partners SHARE profits, losses, and distributions according to their capital contributions, absent a contrary agreement. Pre-dissolution distributions are by agreement, as is compensation of the general partner.

3. Governance : There are rules and some are mandatory, they must be observed.4. Transferability : A general partner cannot transfer his interest unless all the other general and limited partners

agree or the partnership agreement permits it. Limited partner’s interests are freely assignable. Limited and general partners can assign their rights or profits and distributions.

5. Liability to Outsiders : At least one partner must be a general partner with unlimited liability. Limited partners are liable only to the extent of their investment so long as they DO NOT participate in the control of the business. Limited partners were said to share in the control if they shared in operational decisions, retained control of financial matters, and decided the general partner’s tenure. Modern statutes clarify the activities that do not constitute participation. Limited partners DO NOT lose their limited liability merely being officers, directors, or shareholders of a corporate general partner, voting on major business matters or advising the general partner.

Joint Stock Association: This is another type of organization form which basically has all of the structure of the corp. (i.e. centralized management, investors, etc…) but everyone has full liability. This is not used very often anymore b/c of the liability status.

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Mass. Business trust: Mass. Business trust is placing a corp like structure into a trust structure. The trustees are chosen like the board of directors. The benes of the trust are like shareholders. The people forming the trust are the settlors just like incorporators or promoters. There is a limitation on existence of 50 years instead of perpetual existence. Legal title is in the trustee. It is run for the benefit of the benes. Equitable title with benes. No particular formality required in formation of a trust. If structure them correctly, no personal liability on benes. Must keep separation between benes and running of business, they can’t be in charge. May be taxed as separate unit or may not, depends on your choice. Not used by many people anymore.

D. Limited Liability Company. Similar to a limited partnership, the members of the limited liability company provide capital and manage the business according to their agreement. Their interests are generally freely transferable unless otherwise provided in the articles of associations and members are NOT personally liable for debts of the entity. You're not taxed as corp as long as you avoided there complete defn of association.

1. Life Span : Requires FILING of certificate or operation agreement (i.e. articles of association) with a state official. Statutes also require basic provisions be included in the art of ass. and on-going compliance with the statutes. Many statutes require at least two members for an LLC, though one member is becoming increasingly possible. Most statutes do not limit the duration of LLC’s.

2. Claims : Financial rights are allocated as according to member contributions, but some statutes provide for equal shares. Members can take share certificates to reflect their relative financial interests and distributions must be approved by all members. Member have no general right to remuneration.

3. Governance : Can be member-managed or manager-managed. If member managed, members have broad authority to bind the LLC in much the same way as partners. Members have NO authority to bind in a manager managed LLC. Generally, voting in member managed LLC is proportionate to member’s capital contributions.

4. Transferability : Members cannot transfer their interest unless all the members consent. Some statutes permit articles of association to provide standing consent for new members. Many statutes also permit transfer of financial rights to creditors.

5. Liability to Outsiders : LLC members, both as capital contributors and managers, are NOT liable for LLC obligations. Some statutes do suggest that members can become individually liable if equity or justice so requires.

E. Limited Liability Partnership. It is a partnership in every shape and form except there is no general liability. Essentially LLPs are general partnerships with one core difference and several ancillary differences. The core difference is that the liability of the general partners of a LLP is less extensive than the liability of a general partner. Although this can vary, an LLP is not personally liable for ALL partnership obligations, but only for obligations arising from her own activities --- with the exception, under some LLP statutes, that she is also liable for activities closely related to her, for contractual obligations, or both. As to the obligations a general partner is liable for, the liability is unlimited and can extend to her entire wealth. One ancillary difference is that there is a trade off for limited liability in the form of a requirement of a minimum amount of liability insurance or segregated funds. In addition, LLPs must be registered with the appropriate state offices while general partnerships do not.

1. There are 2 kinds of shields(a) The partial shield: "arising from" negligence, wrongful acts or misconduct. They cover malpractice claims. (b) The full shield (MA) - most states are adopting full shield provisions

(a) Provides the general partners in LLP are not personally liable for the debts, obligations, or liabilities of a partnership whether tort, K, or otherwise "arising while" the partnership is registered as a LLP.

2. With LLPs the partners are not liable except the partner who has acted as is the partnership under respondeat superior. When a group ops for the LLP status it has got to be carefully thought out b/c once that status is achieved, other than the acting partner, the general partners are not liable. That partners in LLPs forfeit their rights of contribution against the other partners

Tax Implications: Under federal income tax law, a corporation is a separate tax paying entity, but a partnership is not. Therefore, partnerships often have distinct advantages when it comes to taxation.

1. Taxes often make the corporate form more expensive by double taxing. Double taxing occurs when the corporation is taxed for income/earnings and then the dividends paid out to shareholders are taxed to their personal income so the same dollar is taxed twice.

2. SPs, General Partnerships, Limited Partnerships are not taxed as a separate entity b/c they are not a separate entity, therefore they do not get taxed double. Mass. Business Trust, Limited Liability Companies, and small Corporations can choose how they want to be taxed, whether as a separate entity or a partnership. Large corporations are taxed as a separate entity.

3. Characterizing of Firm and Check the Box . The IRS used to look at whether the firm exhibited three out of four characteristics for classic corporate behavior: 1) continuity of life, 2) centralized management, 3) liability for

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business debts limited to corporate assets, and 4) free transferability of interests. If the IRA took the view that the entity had enough characteristics of a corporation, it was taxed at that level. This characterization changed in 1996 when the IRS promulgated a “check the box” rule that allows domestic unincorporated forms to elect to be taxed as a partnership. Unincorporated firms can be structured with whatever organizational attributes best suit the participants needs and flow through tax status is assured.

4. S Corporations: the IRS allows certain corporations to elect flow-through tax treatment. An S corporation is incorporated under state law and retains all of its attributes – including limited liability – but it is not subject to an entity tax and all corporate income, losses, deductions, and credits flow through to shareholders. To be eligible, the corporation must:

(a) Be a domestic corporation,(b) Have no more than 75 shareholders,(c) Shareholders that are not trusts or one class of shareholders(d) All shareholders must be citizens, and(e) There can only be one class of stock.

Concept (c): [Organizing a Corporation]

How to Organize a Corporation: Once a decision has been made to incorporate, and the state of incorporation has been selected, the next step is to create or organize the corporation → To begin this process, an incorporator files articles of incorporation which is a petition asking the state to grant them preferred status as a corporation. So you give the art. of org. to the Secretary of State’s agent. They examine the art. of org. If everything is satisfactory, all of the requirements are met under the general corp state statutes, then the Secretary of State endorses his approval on the corporate charter and at that time, it is considered filed. Filed is a precise moment in time and is NOT when you hand the art. of org. to the Secretary of State’s agent. It is when the Secretary of State endorses the art. of org., that is when it is considered filed. Once it is filed, the corporate existence begins. This means it is a de jure (by law) corporation. It is now possible to have one person corporations, they look like S/P. That person does not have to be a natural

person, it could be a partnership or joint venture or a limited liability company. You can layer a business which opens these statutes even further.

Now the incorporators have to hold an annual shareholders meeting even if you only have one incorporator (although you can probably get away with not having it although it could have liability ramifications if you are caught). The incorporators have to give notice of that meeting and have to have a quorum present at the meeting. Must vote on basic things at that meeting such as who will sit on board of directors and who will be officers.

Then board of directors have to have regular meetings, have quorum present, etc…give notice to meetings. Note : Victims of torts, contractors, and third party people who are injured in some way and come forward and say the

corp never had any meetings or formality like a corporation should, never held himself out as a corporation, didn’t keep separate bank accounts, etc…despite fact that there are articles of organization, duly filed, that third party may be able to hold individual person liable.

Capital and Credit : no minimum capital requirement but need enough to form the corporation. There are cases where courts said undercapitalization was one of the chief factors that would cause the court to disregard the corporate entity, so would not be considered a corporation and therefore no personal liability protection. Credit may be hard to obtain for a corporation, similar to any new business and therefore the bank may require that you sign personally rather than as an agent of the corporation before they lend you money.

Management and control : centralized management is an essential feature for a corporation. There will be a board of directors do deal with managing the corporation.

Profits and Losses : Losses are born by the corporation, they are never passed through beyond the entity. The officers, shareholders, and board of directors are not liable UNLESS they breach their duty of fiduciary duties. But as long as they do what they are supposed to do, they will not be held liable. The profits also stop with the entity however, if you are a director or officer you are being compensated. If you are a shareholder, you have the right to share in the profits through distributions based upon the shares of stock that you own. Profits are distributed to shareholders in large corporations. In smaller corps, this does not usually happen.

Transferability of Interests : interests are freely transferable. It doesn’t matter who the shareholders are. At smaller corporate level, may restrict free transferability of stock b/c it is a concern to them.

Continuity of Existence : Corporations have perpetual existence b/c they are an artificial entity. The whole board, shareholders, and officers could go and it would still keep going.

Termination : You would have to go through dissolution. Have to file articles of dissolution with the state. Requires a special vote, extraordinary vote (2/3 vote) or petition by court to dissolve.

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Tax Consequences : entities that are corps are taxed separately. If you fit under a subchapter S status as discussed previously, then the corp will not to be taxed as a corporation at the federal level. With a large corporation, they are taxed double.

Articles of Organization:

ARTICLE I. The exact name of the corporation. The name must designate the corporate status, i.e. Inc. The only limitation is that the name cannot already be in existence and used by another entity. And can’t use legally

protected names (such as Superbowl-it is a copyrighted name). Can’t use names that are likely to be confused with another entity. Must choose an original name. Once you pick it, you can call up secretary of state’s office and reserve the name for thirty day period for a fee.

ARTICLE II. The purpose of the corporation. State the reasons for the corporation’s existence. This lays out the authorities of the corporation to act and can range

from very general to very specific. o Example: “To engage in any lawful activity.”

Ultra vires: corporation acts outside the scope of its authority. Ultra vires acts are void. The corp must act within its authority and its authority is specified by this article along with statutes that provide general powers to all corporations. When the corporation acts beyond its authority, it is an ultra vires action and void.

There used to be a requirement that this article be very specific when describing the authority of the corporation. Today, that is no longer needed, however, it is still in the best interest to get somewhat specific so that investors are aware of what the company is involved in instead of being nervous about investing in a corp who has broad unspecified authority.

The state may contest the authority of the corporation when the corporation has acted ultra vires through an action called a quo warranto. This is the state asking the corp where there authority is to carry out a specific action.

Corporate statute are also a source of corporate powers. The statute gives corp powers upon existence. They are basic kinds of powers such as the power to have corp seal, to hold and have real estate, etc… that are automatically applied with every filing of corp.

ARTICLE III. Total number of shares and par value, if any, of each class of stock authorized. Capitalization is the means for providing capital, the financial foundation on which this corp. rests. There are

different ways in bringing funds into the business but they don’t all result in capitalization. This is where the financial aspects begin to factor in. Funding is necessary to fulfill the corporate purpose – to rent space, equipment, hire contractors and employees, buy inventory, etc…

There are two methods to finance the corporation: debt and stock.Debt: Debt is a fixed claim against the corporation for principal and interest. This includes trade debt, bank debt, and

bonds and debentures. However, with debt, there is always a corresponding obligation so although there may be that much in assets, there is now also that much in liability which means the Net Worth of the company is still zero.

1. Trade debt. This is accounts payable – what the corporation owes on its books for goods and services. This is typically for inventory and supplies. For example: a baker supplies your company with bread in order to make these instant sandwiches your corporation sells. Instead of paying cash on delivery, you pay them back in periodic payments (such as within 30, 60, or 90 days from purchase).

2. Bank debt. This is loans payable – commercial bank loans. The corp goes to the bank and gets a business loan, which will generally require a personal guarantor, collateral, and security. Can borrow money from the bank, but it has to be paid back, it’s a liability. I get money in but I have a corresponding obligation to pay money back. Assets=$50,000, Liabilities=$50,000. It's not much adding to my foundation b/c at the same time I'm brining money in, I have to pay it back.

3. Bonds and Debentures. Another method of financing a corporation is to issue bonds or debentures. Essentially, bonds and debentures are promises, embodied in an instrument, to repay amounts that the firm has borrowed on a long-term basis, typically by selling the bonds on the general market or on some special market.

Bonds : These fixed obligations, when secured, are called bonds. Bonds are debt obligations that promise to repay a specific amount of money together with interest.

o Bonds are secured instruments meaning that there is some collateral, something that attaches to the bond that assures repayment (i.e. mortgage, security interest in secured goods such as an automobile).

o Bond agreement will be in writing=promissory note=promise to pay under these conditions. That gives the holder of that note a right to collect according to the

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terms and conditions contained in the note and gives them right to proceed against me legally in the event I failed to follow the terms of the agreement.

o Bonds are secured instruments. The bond holders are given priority over all other creditors. All secured creditors have priority over general creditors.

Debentures : Fixed corporate obligations which are not secured. o Same as bonds but unsecured so no safety net that bonds have.

Rights of bonds and debenture holders are administered centrally by someone like trustee. Indenture of trust is the name of the instrument for which the trustee uses to deal with bonds and debentures.

Assets - Liabilities = Net worth. If there is $100,000 worth of issuing bonds, then its $100,000 of net worth. It's carried on the liability side, its there b/c in theory the shareholders are entitled to get their money back if the business dissolves. If a corporate business's assets liquidates, then the line up is secured creditors, general creditors, and shareholders are supposed to get back what they gave.

Courts are going to look at ppl with corps, and will say that the liability shield doesn't protect you in this instance, and one of the greatest reasons for piercing the corporate shield is under capitalization of businesses. That means that the assets and liabilities are out of whack, the relationship btw the debt and equity shares is out of line. This business was heavily debt burdened from the start. They look at debt and stock equity and make the comparison btw the 2: comparison called the debt equity ratio. If for every $2 of debt you $1 of equity, you're ok.

Stock: Stock is essentially the owner selling off an ownership interest in the corporation which carries with it the right to ask questions, inspect books and records, vote (if a voting share), be consulted on fundamental changes to the business (merger, sale of substantial assets, etc…) and participate in the profits of the corporation. The issuance of capital stock may be contracted for before the business is formed. Subscribing to

Newsweek before the next issue has come out. Stock subscription agreement: like subscribing to a newspaper. A preincorporation stock subscription agreement - done before incorporation. Postcorporation stock subscription agreement - done after the incorporation.

The initial offering of “new stock” is governed by this article. The stock does not actually exist yet. Authorized Capital Stock: the total amount and type of stock that can be issued by the corporation. If issue more, that it is called an over issuance and it is VOID b/c it is beyond the authority of the corp. This can later be amended by filing an amendment to the articles of organization. Note that secondary transfers, such as stock trading, is NOT governed by article III.

The issuance of stock in a corp is necessary so that ppl are given ownership interests and so the corp is given a financial foundation. Anyone who interacts with this corp is faced with the liability shield. For example creditors want to make sure that the corp can pay back credit obligations. This is done by the corp issuing stock: this is telling you that this is new stock, stock that has never existed. The corp is creating this stock and transferring to you, and that's how you become a shareholder.

New stock must be acquired for good consideration – cash, service, promissory notes, property, or installment plans. New stock may not be given as a gift.

Offering of stock results in capitalization of the corporation. It is called equity: beneficial interests, business is conducted for the benefit of the shareholders. The capital generated by the sale of new stock constitutes a liability on the corporation – although it is a long, long, long, long term liability because when all is said and done and the corporation dissolves, the shareholders theoretically get back their investment.

There is another way of becoming a shareholder that doesn’t involve the issuance of stock, secondary transfers of stock: existing stock done through a transferee, they in no way impact the financial foundation of this corp. The transferor can transfer that stock for cash or can make a gift for it. This article does not deal with already existing stock.

Two types of stock: common stock and preferred stock. a. Common stock is your basic form of equity interest in the corporation. It affords the owner no fixed claim

on the corporation and is generally subordinate to all other claims on the corporation. Various classes of common stock may convey certain rights upon the owner.

Common stock can be voting stock or non-voting stock. If they are voting shares, then the shareholder can vote on corporate issues such as who sits on the board of directors, proposals, specific issues presented to them, fundamental changes in the corporation like amendments to the art. of org., mergers (when two corps join together to become one-one disappears and the other one remains). Voting power is significant. With non-voting shares, the corp has successfully brought in new shareholders without cutting up the pie again. Voting stock is more typical b/c it is more marketable.

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Return on the investment: when there are profits made, the profits may be distributed to the shareholders in the form of cash or other forms of consideration (property such as additional shares of stock), turkeys. With a mom and pop operation, people don’t usually get dividend checks but with large corp, it may be used as a lure to bring in purchasers of stock.

o Declaring dividends is in the discretion of the directors. There doesn’t have to be profits. The directors could spend it through company. So it is only a PROMISE of a return on your investment.

b. Preferred stocks/hybridized stocks are shares that have perks. No specific definition of the perks b/c that is up to the directors, can mix and mingle perks so not one specific type. The owner enjoys certain preferences not available to the common shareholder. The preferred share may include:

Guaranteed rate of return : If you make this investment and acquire these shares of stock, we will guarantee you a specific rate of return on your investment. This is driven on having profits to draw this from. But to the extent there are profits available, we will give you a guaranteed rate of return.

Cumulative guaranteed rate of return : If no funds available when distribution is supposed to be made to you, the next time there are funds available, we will count up all the times we were supposed to pay you, add them up and give you a lump sum before any other creditors.

Liquidation preferences : Preferences over distribution (i.e. preferences over common shareholders if business ends). Preferred shareholders would get paid before common shareholders when business is dissolved.

Preferred stocks are known as hybridized stocks b/c they have some characteristics of common stock (equity) and some of debt:

ownership interest, redistribution of pie (resembles common stock) return on investment (resembles common stock) usually non voting stock although it can be voting (which resembles debt) guaranteed rate of return (resembles debt)

Par value once played a role. Par value=face value. You have the stock certificate and on it, it says $5. The clients and owners decide the face value/par value of the stock. In the past, before any corp charter could be granted, had to show that so many funds had been transferred into corp as

sort of a guarantee to creditors. Creditors know how much money is in the bag (how much was transferred debt free into corp to get it started) by the amount of capital stock. So you issue capital stock and it goes into the theoretical bag of capital. Every stock that is sold has a fixed value on it so you multiply the amount of shares of stock that have been issued times the fixed value, and that will give you what is available in that theoretical sack (capital). This is the purpose of having par value, it is a representation that when stock was issued, at least that face value or par value was in the bag.

People authorizing the issues or the owners would be liable if you misrepresented the par value of the capital stock. Today, we don’t use par value too much anymore. It can be used and some people do but now there is no minimum

capital requirement nor a requirement that the stock must have a face value/par value. Need to specify in article whether the stock is common stock or preferred stock and whether either has a par value or no par value.Note: Secured creditors, general creditors, preferred shareholders, common shareholders is the list in order of who gets paid when business ends.ARTICLE IV. If more than one class of stock is authorized, state a distinguishing designation for each class. Also provide description for preferences, voting power, qualifications, and special or relative rights or privileges of that class.

This article defines the classes of stock that are issued. Classes are generally used for some business planning purpose, e.g. representation on the board, voting issues, etc… For example, a three person board with three people who are responsible for incorporating the business are going to issue three separate classes of stock to ensure that two members do not gang up on the third.

a. Class A – position one.b. Class B – position two.c. Class C – position three.

ARTICLE V. Restrictions, if any, imposed by the Articles of Organization upon transfer of shares of any stock. A basic feature of stock ownership is the free transferability of ownership, so that state wants to know from the start if

there are any limitations on that right. Generally, larger corporations don’t care who owns shares in the corporation. However, this does often matter to

smaller, closely held corporations as shares give access to information.

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o Thus, any restriction must be reasonable to be valid. This standard is derived from the common law doctrine of alienability. In large corporations, the corp cannot put an absolute restriction on transfer while in a closed corp, there may be situations where the corp can.

o Reasonableness does NOT affect private transactions involving the shares.o Note also that the UCC kicks in with stock transfers. In order for restrictions to be binding on innocent

transferees (BFP’s) the “holder in due course” must be noted on the stock certificate per UCC 8-204. The restriction must be conspicuously stated on the stock certificate along with being stated in this article.

ARTICLE VI. Other lawful provision, if any, for the conduct and regulation of the business and affairs of the corporation, its voluntary dissolution, or for limiting, defining, or regulating the powers of the corporation, its directors or stockholders, or any class of stockholder.

Really, you can throw just about anything in here. This is where you would typically find preemptive rights, etc… Preemptive rights allow others (such as other shareholders) to have an opportunity for first purchase when new stocks or shares are issued.

The preemptive right generally allows a shareholder the right to maintain his relative and proportional interest in the corporation by allowing the purchaser amounts of the new issuances equal to the percentage he presently holds.

o If an existing SH holds 10 percent of stock, the preemptive right gives SH to buy 10% of present issuances, allows them to maintain their same power

The past articles are a permanent part of the articles of organization. They can be changed but you must formally amend the articles of organization to change them. This is a big deal, shareholders must be convened, requirements fulfilled, filed, etc…Everything from this point on is not considered a permanent part, can change it whenever you want. Such as street address, names of officer and directors, by-laws, etc…

ARTICLE VII. Effective date of organization or the corporation shall be the date approved and filed by the Secretary of State, or otherwise specified which shall not be more than 30 days after filing date.

ARTICLE VIII. Street address of corporation, name and address of President, Treasurer, Clerk, and Directors. This section generally includes basic contact information, which is interesting because you naming individuals of

an entity that does not exist. Not a permanent part, may be changed at will with no formal amendment or formal state involvement

ARTICLE IX. Certification. Bylaws have been duly adopted and President, Treasurer, Clerk, and Directors have been duly elected.

By-laws: internal rules and regulations that govern the corporation. They are self-imposed and decided at time of incorporation. The state statutes govern the external rules, while the by-laws govern the internal rules.

Then you need the signatures of people who are the incorporators (who become the directors), signed under the pains and penalty of law. Affix signature of secretary of state if everything is in order after they have endorsed the articles. Once done, it is a de jure corporation.

Rejection of Articles of Organization: If rejected, the corp can revise the terms or can resort to the court process. Mandamus is the court process you resort to: writ that seeks to compel the performance of an official duty. Not

limited only to officials but also can include those acting in an official capacity. Not limited to elected or public officials. Mandamus would be seeking to compel the state of secretary’s acceptance of the articles of organization. Obviously this would be a civil case. However, talking and negotiating should occur before this.

Note on Initial Directors Once a corporation is under way, its board of directors is elected by the shareholders, however, a corporation has no

shareholders until stock is issued and the function of issuing stock is normally vested in the board Thus, there must be a mechanism either for naming initial directors before stock is issued or for issuing stock before

directors are elected by shareholders 2 Basic Mechanisms for Establishing Initial Directors

o Under the law of some states, the corporation’s incorporators have the powers of shareholders until stock is issued and the powers of directors until directors are elected

Under such statute, the incorporators will typically adopt by-laws, fix the number of directors, and elect initial directors to serve until the first annual meeting of shareholders

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o Under the law of other states, the initial directors can be named in the corporation’s certificate of incorporation

If the initial directors are named in the certificate of incorporation, the functions of the incorporators pass to the directors when the certificate is filed and recorded

Once initial directors are named, they will hold an organizational meeting

1st Order of Business: approval of all pre-incorporation contracts (i.e. promotion agreements, the lawyers contracts, pre-subscription contracts (see below). Then they cause stock to be issued and upon issuance and transfer, the corporation has shareholders. Directors can engage in any other management business (minutes are kept).

2nd Order of Business: shareholder’s meeting. Notice of shareholders meeting is sent out or waivers of notice are accepted. They get together and approve the pre-incorporation contracts and lawyers services.

3rd Order of Business: elect new directors. Usually the same as named in the articles of organization but not necessarily. Shareholders then do any other business and then they adjourn.

Changes of officers and directors do not have to be amended in the articles of organization when changed.

Note on Subscriptions for Shares Subscription Agreement : a would-be shareholder enters a subscription agreement under which he agrees to purchase

a corporation’s stock when it is issued to him at some future date Pre-Incorporation Subscription Agreements : In such cases, where the corporation has not yet been formed - the

agreement is then made on the would-be corporation’s behalf by incorporators, agents or trusteeso General Rule : was that pre-incorporation subscription was only a continuing offer by the subscriber and that

subscriber therefore was not bound if he made a timely revocation Under this rule, a subscriber could revoke his agreement until the moment of incorporation, or, in

the alternative, until the corporation, once formed, issued stock to the subscribero In addition, subscription agreements entered into after the corporation was formed were treated as ordinary

contracts and raised no special problems of enforceability o Modern Rule : Most statutes now provide that pre-incorporation subscriptions are irrevocable for a specified

period of time unless all the subscribers consent to a revocation or the agreement otherwise provides

Domestication of Foreign Corporation:Domestication is the filing procedure and the following of local state rules that a corporation must go through before being able to conduct business in a state other than the state they are incorporated in. For example: A company that is incorporated in mass but wants to do business in Conn. Foreign state may have preconditions which must be met before a foreign corporation can do business in that state. If you fail to domesticate, principals engaged in the business may be held personally liable for problems occurring out of that state (i.e. Conn.) or a penalty, monetary amount may be assessed.

Concept (d): [Pre-Incorporation Transactions by Promoters]

Promoter: promoters are the CIA of the to-be-corporation. They create, investigate, and assemble the business. A promoter is a person who transforms an idea into a business bringing together the needed persons and assets and superintending the various steps required to bring the new business into existence A promoter often makes contracts for the benefit of a corporation even before the corporation has been formed If the corporation is later formed, and benefits form such a contract, issues may arise regarding who is liable under the

contract What is the name for these business relationships that occur while assembling the business? A business relationship

for purposes of promotion that is limited in scope of duration and purpose is called a joint venture (mini general partnership). Because promoters are engaged in a joint venture, the following occur:

They are personally liable for contracts and torts: promoters are agents, accountable to each other and to the joint venture and therefore held accountable through agency theory.

o If agents, they can bind one another based on respondent superior (tort) or agency (contract). They are fiduciaries which means they are bound by fiduc duty. This means they must act in good faith and be fair in

their interactions with one another and with the business venture. They have to fully disclose any interests they have in property, disclose aspects of services they may render (such as how much money they are making). They can’t benefit personally at the expense of others.

In a comprehensive sense "promoter" includes those who undertake to form a corporation and to procure for it the rights, instrumentalities and capital by which it is to carry out the purposes set forth in its charter, and to establish it as

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fully able to do its business. Their work may begin long before the organization of the corporation, in seeking the opening for a venture and projecting a plan for its development, and may continue after the incorporation by attracting the investment of capital in its securities and providing it with the commercial breath of life. It is now established without exception that a promoter stands in a fiduciary relation to the corporation in which he is interested, and that he is charged with all the duties of good faith which attach to other trusts. In this respect he is  held to the high standards which bind directors and other persons occupying fiduciary relations.

Liability of the Promoter General Rule : When the promoter makes a contract for the benefit of a contemplated corporation, the promoter is

personally liable on the contract and remains liable even after the corporation is formed. Exception to the General Rule : If the party who contracted with promoter knew that the corporation was not in

existence at the time of contracting, and nevertheless agreed to look solely to the corporation for performance, the promoter is not deemed a party to the contract

o Such an agreement may be express or implied

Liability of the Corporation A corporation that is formed after a promoter has entered into a contract on its behalf is not bound by the contract

without more The reason is that the corporation was not in existence when the contract was made and therefore did not authorize -

and indeed could not have authorized - the promoter to enter into the contract on its behalf After the corporation has been formed, it may become bound in one of several ways:

o Ratification, adoption, novation, and that the proposition made to the promoters is a continuing offer to be accepted or rejected by the corporation when it comes into being and upon acceptance becomes an original contract on its part

o Liability has also been sustained on the ground that the corporation, by accepting the benefits of a contract, accepts the contract and is therefore estopped to deny its liability on the contract

If a promoter is liable under a contract under the law of promoter’s liability, the fact that the corporation also becomes liable on the contract, by adopting it, does not relieve the promoter of liability - instead, the promoter and the corporation are jointly and severally liable

Application (d):

1. LIABILITY OF THE PROMOTER Goodman (G) v. Darden, Dorman & Stafford Associates (DDS): G proposed to renovate an apt. building owned by DDS. During negotiations, G told DDS that he would be forming a corporation to limit his personal liability. DDS contracted with “Building Design & Development Inc” (In Formation) John A Goodman, President. Nov 1st, G filed art. of org. Between Aug. and Dec., DDS made 5 progress payments. The first check was made to “Building Design and Development, Inc-John Goodman.” G struck out his name and endorsed the check in the name of the corp. G instructed DDS to only make checks out to the corp. Court held G was personally liable on the contract. The fact that a contracting party knows the corporation is not existent does not indicate any agreement to release the promoter. To the contrary, such knowledge would show that DDS intended to make G a party to the contract b/c who else would it hold liable if default occurred. G must show not only that DDS knew that the corp was not fully formed when entering that contract but also that DDS intended to contract solely with the corp regardless of the fact it was yet to be incorporated. G could not show this.

2. LIABILITY OF THE PROMOTER Company Stores Development Corp v. Pottery Warehouse, Inc.: Company Stores leased a store to Pottery Warehouse for 5 years - PW was not incorporated at the time of the lease - the lease recited that the corporation was to be organized and was signed as: “The Pottery Warehouse, Inc. a corporation to be formed under the laws of the state of Tennessee by Jane M. Vosseller - Its President”. The court held the promoter was not liable because the lease imputes no intention on the part of Vosseller to be bound personally. This had opposite results as Goodman above. Court felt that under the facts, the contracting parties had intended to look solely to the corp for performance.

3. IN CLASS HYPO Three people come into office, A, B, and C. They want to have gourmet type ice cream shop on Newbury street. They found empty store space and can get it cheaper than its fair market value. Landlord wants them to sign lease right away. A, B, and C want it done right away even though we advise them we can’t incorporate that quickly. What do we advise?

Getting the lessor to look to the corporation for the transaction . The drawback from the lessor’s standpoint is that this looks like an illusory contract that is lacking in mutuality of obligation. This problem can be expressly avoided in the lease by holding the promoters (A, B, and C) personally liable for the obligations – while the corporation is essentially liable on an if and when basis if the corporation accepts the lease.

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1. However, this poses a risk for the lessor as the corporation might be an unproven entity with little or no assets in the event of a breach. Also, there is no guarantee that the corporation will in fact be formed.

Novation provision . Provisions for substitution for a new agreement between different parties and release of some of the present obligors is called novation. A novation provides 1) a present obligation on the parties, 2) the parties agree to a new contract, 3) the new contract extinguishes the old agreement and shifts liability from the promoters to the corporation, and 4) the new agreement must be valid. Essentially this is a mere offer to lease that runs to the corporation.

1. We bind ABC personally to the lease but we include provisions that will release them from liability at a certain point in time and substitute in their place the corp. The result would be a new K btw the crop and the lessor.

2. This is a present existing agreement binding K that provides in advance that the promoters will be released from liability at a certain time at which point in time the corp becomes the party to the K. It is a substitution of parties. The result is a new agreement prearranged, btw the lessor and the corp.

3. Problems still remain: no guarantee of acceptance of the lease by the corporation and the lessor could still revoke the offer before the corporation is able to accept. A B and C could retain liability if the business doesn’t work.

Concept (e): [Consequences of Defective Incorporation]

Defective Incorporation: This arises when the efforts to incorporate fall short. Parties truly believe that there is a duly formed corporation but some irregularity, omission, or other problem torpedoes the process. Liability issues arise, and may fall on the promoter personally to look to a partnership law for a remedy. The KEY to the analysis is to determine the association of the individuals. Possible Solutions include a de jure corporation, de facto corporation, and corporation by estoppel.1. De Jure Corporation. This is as good as it will get in such a situation.

The corporation is formed in strict compliance with the corporate statute, or in substantial conformity. What constitutes substantial compliance is determine on a case by case basis, according to the nature of the unsatisfied requirement and the extent to which compliance has been attempted.

Corporate status is not subject to challenge. It’s there and the liability shield is effective. BUT, note that the court can still go behind the corporate veil to hold the officers, directors, etc… personally liable for fraud, bad faith, and deliberate use of the corporate form to hide.

2. De Facto Corporation. By virtue of the facts – if the person made a colorable attempt to incorporate, a de-facto corporation would be found and would be enough to shelter the would-be incorporator from liability. In order to show you have a de facto you have to show 3 elements:

o A statute permitting incorporation,o A colorable attempt to comply with that statute, ando Actual good faith use of the corporate status and powers (i.e. exercise of corporate privileges). This is shown

through doing business under the corporate name. For example, the promoters write the art. of org., gave to messenger to deliver and the messenger

never delivered. They began acting as a corp. b/c they thought they were. In this situation, a court, except in Mass., will likely find that there was colorable attempt to comply with the statute and allow for a de facto corp.

The corporate status is only vulnerable to attack by the state through the quo warranto proceeding, but is good for all intents and purposes for other people. Typically, the errors occur through failure to timely deliver the corporate filing forms to the Secretary of State and mistakes within the Secretary of State’s office.

Many states have abolished this status via statute. Massachusetts defines corporate existence from the moment the secretary of state endorses the articles, and thus you know full well prior to that time that no corporate status is available.

Cantor v. Sunshine Greenery, Inc. o HELD: De facto corporation. Brunetti is not personally liable to the plaintiff’s. Evidence in this case

demonstrated that there was a bona fide intention to create the corporation before the contract and the plaintiff’s were under the impression that they were dealing with the corporation, not Brunetti individually.

o The court prohibited a collateral attack on Brunetti individually because they were admittedly contracted with Sunshine.

3. Corporation by Estoppel.

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Essentially, the corporation DOES NOT exist, it is not in strict compliance, it is not a good faith colorable attempt, it does not have existence, but because of the unique facts of a particular situation, you are estopped from denying the corporate status.

The critical distinction between estoppel and de jure or de facto is the element of reliance on the corporate status. This only applies in contract situations and will NOT occur in tort. You do not become a victim of a tort based on reliance upon corporate status. In addition, involuntary creditors cannot use this theory. The threshold is lower for this category.

The estoppel theory is used in 3 different contexts:o Third party suing a corp and would-be shareholders are denying corp status. An enterprise and its

owners, who have claimed corp status in an earlier transaction with a third party later deny that status in a suit brought by third party against the would-be corporation. This is true estoppel.

o The corporation sues another party. Defense argues that the corp cannot be a party to the suit because they are not a corporation.

o A third party suing would-be shareholders. A third party who has dealt with an enterprise on the basis that it is a corporation seeks to impose personal liability on the would-be shareholders, who turn and raise estoppel as a defense. This is most often cited situation with estoppel cases. Here the issue is whether, as a matter of equity, the claimant having dealt with enterprise as if it was a corp, should be prevented from treating it as anything else.

In this 3rd category of cases, estoppel theory is comparable in its function to de facto theory. However, the 2 theories differ in 2 important ways in their application:

o First, the nub of estoppel theory in such cases is that the third party has dealt with the business as if it were a corporation. Presumably, therefore, the theory would not apply to a tort claimant or other involuntary creditor who was a stranger to the business before his claim arose. In contrast, the de facto theory can be applied to such claimants.

o Second, the would-be shareholders need not resort to the estoppel theory if they could establish that their business had de facto corporate status. Presumably, therefore, less in the way of corporateness must be shown to establish a corporation by estoppel than to establish a de facto corporation. (In Cranson v Intl Business Mach, the court applied the estoppel theory only after observing that because the certificate of incorporation had not been filed at the time of the transaction, the de facto theory might not be applicable.) A distinction btw estoppel and de facto is that less is required to be shown for estoppel to be allowed. All you have to show is some sort of recognition of corporate status.

Under the estoppel theory, the outcome will turn heavily upon the P’s conductUnder the de facto theory, the outcome will turn heavily upon the D’s conduct in attempting to organize the corp.

Who may be held liable: If the court finds that none of the above three forms are appropriate or applicable, then older decisions generally find

that the entity is a partnership. As such, only the active participants in the partnership maybe found liable; passive investors or ‘shareholders’ are NOT liable.

The modern trend imposes personal liability only against those owners who actively participated in the business. Those owners who actively participated are held personally liable as if they were partners, but passive investors are not.

Application (e):

1. IN CLASS HYPO 3 people go to a lawyer to form a corporation but the lawyer says to go out and try it before they incorporate. The following day they call themselves ABCO corp. and they interact with a third party, and then they don't pay the vendor. When the 3 parties go out and call themselves ABCO corp do they have a de jure corporation? No de jure: no strict compliance with corporate statute No de facto: there is a general incorporation statute (there is in every state). They did not attempt to incorporate under the

statute. Was there a user of corporate powers, probably. The third party is dealing with them as a corporation but you have to have all 3 requirements.

The fact question: colorable attempt Fact question: user of corporate powers

A corporation by estoppel is the only thing that could save them. It's the third category. The only hope for the third party: they would have to show reliance, that when the third party interacted with ABCO, the 3rd party was relying on corporate existence, all the transactions were geared towards a corp.

A B and C can get off the hook. Some states like MA have tried to do away with de facto status.

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A answer: if Corps by estoppel fail, then I either have a partnership or the other way of viewing these transactions are that they are preincorporation transactions. If they're preincorporation transactions, then A B and C are promoters. Promoters are always personally liable on preincorporation transactions unless otherwise agreed. They are liable jointly and severally.

Concept (f): [The Ultra Vires Doctrine]

1. Classic Theory. Ultra Vires means beyond the authority. Transactions outside the sphere of were characterized as ultra vires (beyond the corp’s power) and unenforceable – unenforceable against the corporation b/c beyond the corporation’s powers, and unenforceable by the corporation on the ground of lack of mutuality. The powers of the corporation are defined and limited by the articles of incorporation. Classic case is someone challenges the corporations act claiming that it is beyond the powers of the corporation to engage in a particular act and thus the act is void.a. Common cases include corporate waste or corporate gifts (where the corporate elects to make payment to spouse of

deceased executive.) The challenge by ultra vires is because the gift was not bargained for and was beyond the powers of the corporation to grant. Unless the corp can establish that there was a pre-existing legal duty to the widower to give her that money (i.e. H had taken pay cut to start fund in case of death). Money donated to charities, however, is not considered ultra vires. Donations to charities are considered a responsibility of a corp.

b. Ultra vires as a Defense: The doctrine is normally applied to contractual cases, and is normally asserted as a defense. Example: P sues

corporation for breach of contract and the corporation counters with the ultra vires defense to preclude the P from recovering on the contract. P could still probably recover under quantum meruit.

The doctrine is NEVER a defense to criminal acts or tortious conduct. For example: A general manager of a delivery service corp that delivers goods using company vehicles says to his employees, “thou shall not commit torts.” Pull out articles of organization and show that they are not authorized to commit torts. So an employee goes out and accidentally hits someone. Corp is sued and corp defends saying that committing a tort is ultra vires and therefore the P is not authorized to sue corps. Court says this will not work.

Where it becomes important is in contract sense and courts will analyze situation looking at status of contract (executed, partially executed, not executed yet). Determining outcome will depend on category the contract fits into:

o Executory Contract . This is when neither party has commenced performance. If that is case, either side may plead ultra vires as complete defense in action by the other.

o Full Execution . This means that there has been full performance on both sides. If that is case, they will enforce the contract, neither side can attack the contract under ultra vires.

o Partial Performance . This means that the contract has been partially executed (i.e. part performance). Partial performance contracts includes those where there is full performance by one side. There are two separate theories under this type of contract:

Mass view: Mass courts will grant relief in quasi-contract for the fair value of goods or services (i.e. in quantum meruit or quantum valebat). The court is not granting relief on the contract (i.e. quasi-contract rather than on the contract). It is a remedy provided off the contract b/c a benefit has been conferred so give party that conferred the benefit the fair value of the goods or services. Mass approach is restitutional in nature. Person should be liable for benefit they received.

Majority view: The non-performing party is estopped from asserting ultra vires. The courts hold that ultra vires is not a defense. There is no restitution remedy since no ultra vires action and therefore the court allows proceeding on the contract. This varies by jurisdiction and some may permit an injured party to recover on the contract.

2. Modern Trend – Ultra Vires is DEAD. a. Statutes now permit incorporation for ANY purpose, general or specific. Prior laws required VERY specific

incorporation purposes stated in the articles and limited the corporate activities to those purposes only. It was a public policy decision to protect the public when dealing with limiting the powers of the players.

Problems arose with respect to stated powers and implied powers. Stated powers specifically define the powers of the corporation and implied powers are needed to carry out the stated powers.

b. The modern trend is to include the language, “the aforementioned corporation is established to engage in any lawful business.” This eliminates the NEED for ultra vires.

c. Most corporate statute have generally eliminated the ultra vires doctrine. d. Maybe used in:

(a) Gifts from corporation – not in business to make gifts. Even this is weak if its …(b) If it’s a gift to a widow, or a person (not a charity), then it may be shot down as ultra vires

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(c) Now courts are inclined not to uphold ultra vires attacks(d) Exceptions

If stockholders try to enjoin corporation Corporate action v. director A government action

(e) Very limited effect. Statutes define where it may be used.

III. The Corporate Structure

Concept (a): [The Allocation of Legal Power between Management and Shareholders]

THE SHAREHOLDERS OF A CORPORATION CANNOT ORDER THE DIRECTORS TO TAKE PARTICULAR ACTIONS IN MANAGING THE CORPORATION: (Charlestown Boot & Shoe v. Dunsmore).

1. Facts: Dunsmore (D) was the director of Charlestown (P), a manufacturing corporation. The shareholders of the corporation chose a committee to act with Dunsmore to close up the corporation’s business affairs. The shareholders chose Osgood to head the committee. Osgood offered his services, but Dunsmore and the other directors refused to act with him, and contracted new debts larger than those allowed by law. The shareholders alleged that by Dunsmore’s negligence, the corporation lost several thousand dollars in bad debts and in disposal of the corporation’s goods. The shareholders also alleged the value of the corporation’s buildings and machinery depreciated by $20,000 b/c the directors did not sell the assets when they should have, and when they were directed to do so by Osgood.

2. Issue: May the shareholders of a corporation force the directors to take certain actions on behalf of the corporation?

3. Holding: No. The provision of the statute is that the business of a dividend paying corporation shall be managed by the directors. The only limitation upon the judgment or discretion of the directors is such as the corporation by its by-laws and votes shall impose. The statute does not authorize a corporation to join another officer with the directors, nor compel the directors to act with one who is not a director. Directors are bound to use ordinary care and diligence in the care and management of the business of the corporation, and are answerable for ordinary negligence. When a statute provides that powers granted to a corporation shall be exercised by any set of officers or any particular agents, such powers can be exercised only by such officers or agents, although they are required to be chosen by the whole corporation; and if the whole corporation (the shareholders) attempts to exercise powers which by the charter are lodged elsewhere, its action upon the subject is void. There is no statute that makes it the duty of the directors of a corporation to keep its property insured. The vote choosing O as a committee to act with the directors in closing up the affairs of the plaintiff corporation was inoperative and void.

4. Basic Rule: Directors should do what they are supposed to do and if you are a shareholders, don’t get involved in management of business b/c it is none of your business. Requirements of the corporate statute are MANDATORY. This case establishes that once you use the corporate form, you have to abide by the requirements of the corporate statutes. Today, some permissiveness, particularly with small closely-held corporations.

Concept (b): [The Legal Structure of Management]

Board of directors manage the corp not the shareholders. Statutory norm or scheme: The statute answers any questions on the different positions and the power that each position

holds. These are more or less adhered to. You can move around, but it is limited movement. The court will look at the facts of the corp, whether it is personally based or driven, etc…and rules that apply to corps generally may not be as important to this corp so the court will allow some deviation.

Classic Model of Overall Structure:Typical Pyramid Structure: Bottom/base of pyramid is where the power is and therefore is where the shareholders are. They make this venture

possible through their investments, they are the risk takers. Flow of power works up to peak of pyramid so all power flows up from the shareholders since it is really their corp, they are called equity holders. It means the venture is conducted for their benefit. Shareholders elect the board of directors.

Middle of pyramid is the board of directors. They manage the corporation although the statute allows for “unless otherwise stated” so a corp can change this. Directors formulate policy and they appoint officer’s to carry out that policy.

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At the top of the pyramid are the officers. The corporation’s officers administer the day-to-day affairs of the corporation, under the supervision of the board. Board of directors elect officers (sometimes the officers will be shareholders). They are agents of the corporation. The only issue with respect to officers is did the particular officer have the authority to do what he did? That is simple agency analysis. Implied, expressed, or apparent authority.

Officers

Definition. The officer described the most important executives of the corporation, typically those appointed by the board of directors. Most states leave it up to the board or the bylaws to determine what officers there shall be.

Rights to Hire or Fire. The officers can be both hired and fired by the board. Firing can be with or without cause (this can occur even if it would cause breach of contract.)

Authority. The officer is an AGENT of the corporation and his authority is therefore analyzed under agency principles. An officer does not have the automatic right to bind the corporation. Instead, one of the four doctrines must be used to find that the officer could bind the corporation on particular facts.

For an agent to be expressly authorized, you would look to corporate statute, the articles of organization, bylaw provisions which is the typical source of the authority of an officer, any resolutions of the board.

De facto authorizations or implied authority : the board allows a person to assume an agency status and after a while he or she assumes they have this agency authority.

Inherent authority : putting someone in a particular positions carries with it all the authority that ppl in those positions ordinarily have.

Apparent authority : sometimes putting someone in a positions creates the appearance of authority there is a holding out by the corp and as long as there is reasonable reliance by a third party, the corp is bound by the actions of the agent.

Directors

Election. Members of the board of directors are always elected by the shareholders. Straight v. Cumulative . The vote for directors may either be straight or cumulative.

o Cumulative . In cumulative voting, a shareholder may aggregate his votes in favor of fewer candidates then there are slots available. Example: H owns 100 shares and there are 3 board slots. H may cast his 300 votes for 1 person.)

Removal. If cumulative voting is authorized, a director usually may not be removed if the number of votes that would have been sufficient to elect him under cumulative voting is voted against his removal.

Directors are elected for one year terms. An annual meeting is held and the purpose of this meeting is to elect directors. The only exception to this is where all director's positions are not vacant in the same year.

Exception: It is possible to stagger the board of directors: a practice that is allowed by statute to allow only certain vacancies to occur in a given year. This provides for continuity of the board. There are certain vacancies that will occur each year.

Exception: Classified boards: only certain positions are electable by certain classes of stuff. Stock A stock would elect the A position, etc. The reason why ppl would use classified stock is to ensure control of particular shareholders by guaranteeing them a certain position on the board.

Number of Directors. The number of directors is usually fixed in the articles of incorporation or in the bylaws. Most statutes usually require at least three directors. Most statutes also allow the articles or bylaws to set a variable size for the board, rather than a fixed size.

Filling Vacancies. Most statutes allow vacancies on the board to be filled by either the shareholders or the board.Removal of Directors. Most modern statutes provide that directors may be removed by a majority vote of the shareholders,

either with or without cause. A director MAY NOT be removed by his fellow directors without cause. If you’re attempting to remove a director of a class that you don’t have voting rights to vote in, then you MUST show cause to remove him/her.

Act of Board. The board may normally take action only by a vote of a majority of the directors present at the meeting. Directors are not agents of a corp, the only time they are agents are when they are duly assembled as a board. They may be agents of the corp individually if they are authorized to act in a transaction but just b/c you are a director doesn't mean that you’re an agent.Formalities Required for Action by the Board of DirectorsThe Governing Rules:1. Meetings: A single director normally has no power. Instead, directors can act only as a body. Usually, directors must act

at a duly convened meeting at which a quorum is present. Most statutes hold that a meeting an be conducted by

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conference telephone, or by any other means of communication through which all participating directors can simultaneous hear each other.

2. Notice: Formal notice is not required for a regular board meeting: if the meeting is a regular one, the directors are already on notice of its date, time and place. In the case of a special meeting, notice of date, time and place must be given to every director. The notice need not state the purpose of the meeting unless the certificate of incorporation or the bylaws otherwise provide. Most statutes provide that notice can be waived in writing before or after a meeting.

3. Quorum: A quorum of a board consists of the majority of the full board, that is, a majority of the authorized number of directors (not simply a majority of the directors then in office, which may be less than the authorized number b/c of board vacancies).

4. Voting: Assuming that a quorum is present when a vote is taken, the affirmative vote of a majority of those present (not simply a majority of those voting) is required for action.

Consequences of Noncompliance: In publicly held corporations, where bureaucratic order usually prevails, lack of quorum, lack of the requisite affirmative vote, or an uncured defect or notice, will usually render board action ineffective. However, in closely held corps, where formalities are seldom followed, the results of a failure to observe proper formalities are much less clear cut.

Shareholders: The shareholders theoretically hold the power in the corporation – it flows up from them and they are the ultimate beneficiaries of the corporation’s activities. The shareholders principally act by 1) electing and removing officers, and 2) approving or disapproving fundamental or non-organic changes to the corporation. Rights. The certificate is merely evidence of stock ownership but will often determine the rights of the holder. The

relationship is contractual in nature. Shareholders have a bundle of rights, including the right to inspection, accounting, direct standing to challenge corporate activities, and often the right to vote. There are some other functions that may be reserved to shareholders – the election of directors, making of bylaws, the authorization of shares, amendments to charters, election of officers. Say “may be” b/c you can play with these things – it is not essential that shareholders do these things. These are just typical functions that we see shareholders involved in.

Stockholders generally engage in the corporate business.o Vote . Stockholders may or may not be eligible to vote. It depends on the rights granted in the stock

certificate. Voting shareholders often vote on broad policy questions, elections, bylaws, and to authorize issuance of stock.

o Shareholders will be deemed to have approved a proposed action only if a majority of the shares actually present vote in favor of the action.

o Straight Line Method : employed in the United States. On general matters, it is one vote per share of stock. For officer/board elections, it one vote per share per officer or seat to be filled. For example, if have 100 shares, then have 100 votes on regular maters. When selecting two board members, have 100 votes for each board member seat available. So in this scenario, would have 200 votes.

o Cumulative Voting . This is a deviation from straight line voting where the shareholder will take all of their votes and accumulate them, gather them up to vote for one person. For example if have the 200 votes specific above, instead of using 100 for one director’s seat and the other 100 for the other director’s seat, can use all 200 to vote in one person for one of the two seats. This gives the minority shareholders a chance to vote in at least one director. This applies only to the electing of directors and not to regular proposals of the corp.

In MA, we do not have a statute allowing for cumulative voting and therefore the right to do so must be specified in the articles of organization. Otherwise, it is not allowed.

o Requirements for Quorum . Quorum usually constitutes a majority in interest but it can be defined by either statute of the articles of incorporation. The quorum issue is problematic for large corps. The way the get around this is through a proxy.

Proxy voting . This involves the employment of an agent to vote on my behalf, but it is different from the traditional agency because the agent is often seeking MY authorization to vote for me.

This is governed by C.F.R. 12a of the Securities Regulations. Proxy can be a general authorization to vote my shares OR a specific authorization to vote

a certain way on certain questions. Large corps will solicit proxies from the shareholders; the solicitation is done when the

notices go out. A card will say if you don't come to the meeting, let us vote for you, just check off one of these boxes and tell us who you'll vote for. If you don't have a preference, leave it to us and we'll vote.

This is a necessary evil for large corporations.

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Proxies are ‘reverse agents.’ In the typical agency relationship the principle initiates the agent. In the normal proxy solicitation, it’s the agent, the corporate insider who initiates the relationship.

o There is the formality of action (from statute): Notice Formal convocation Formal voting process by a properly organized quorum of the shareholders.

o The election of directors requires only a plurality vote, that is those candidates who receive the highest number of votes are elected, up to the maximum number to be chosen.

o Removal Actions . At common law, shareholders had little power to remove officers. Today, most statutes allow shareholders to remove directors (sometimes even with little showing of cause.) Generally however, this requires a showing of cause. You must also provide notice, present the charges and the defenses. This has nothing to do with due process, but is about corporate rights as a whole. Your showing cause b/c of the rights of the shareholders who chose that director, it has nothing to do with the rights of the director.

o Fundamental or Organic Changes to the Corporation . ALL shareholders will be entitled to vote on such matters that will change the nature of their ownership even if they do not have voting shares. In addition, an extraordinary majority is required rather than the usual majority vote which means 2/3 of the shareholders must agree to such a change. These types of changes will also require strict adherence to the formality of the vote such as notifying all shareholders of the meeting. Such matters might include mergers(Corp A and Corp B join together and one survives), consolidation (A and B creates Corp C), sale of significant portions of corporate assets, dissolution of the corporation, and terminations.

o Dissenters Rights : These are the rights of the people who do not want the fundamental change but are in the minority b/c 2/3 of the shareholders voted for the change. Dissenters usually have two choices when a fundamental change is made to the corp:

One choice is to sell their stock on the open market and get out of the corp. However, this only applies to large corps while a smaller corp has restrictions on being able to sell it b/c they don’t trade on the open market. These rights are called:

Appraisal Rights . This right gives dissenters the ability to sell stock back to the corp and receive a fair value for that stock.

Statutes provide that if you don’t think you are getting a fair deal, the dissenter can bring suit and have judge decide the value of the stock. Valuation of the stock is very important. Valuation is relatively easy with a large corp b/c fair market value is value of stock on open market. However, in small corps, it may be more difficult to determine.

Go along with the majority and accept the fundamental change. On exams when dealing with SH action, if there is no issue with formalities, at a "duly held shareholders meeting" --

don't need info about notice, quorum or proxy.

Meetings: Annual meetings are often required by statute. If management keeps postponing, shareholders can obtain a writ of mandamus to compel the meeting. Special meetings may also be held. Special meetings REQUIRE notice. Notice is not required for Annual meetings or regular meetings held by either shareholders or directors, however, notice is usually given anyway b/c it is an opportunity to advertise for the corp.o Shareholders of record are eligible to vote and must be given notice and information about the meeting. In a large

corporation, this is more fluid as shares change hands frequently. The corporation will choose a record date (typically 60 days prior to the vote) at which time the shareholders of record will be determined.

o Notice may be waived. Waivers can be signed by shareholders in advance, or on the day of the meeting. If you show up to the meeting, even though not receiving notice, it will be considered constructive notice. Some cases even allow waivers after the meeting to give up right to notice. B/c notice is a requirement; each shareholder must receive notice or have waived the right to receive notice.

o The meetings also have a requirement to have a quorum. For shareholders, a quorum means a majority in interest (i.e. at least 51% of the interest of the corp must be present). For directors, this means a majority in number. These requirements may be changed IF the corp wants to require a larger majority. Cannot change it so require a lesser amount present. Again, to reach this shareholder requirement, people may be present through proxy, an agency relationship that is described above.

o Record date does NOT suspend trading of the stock. However, the closing day will and this is usually the day before the shareholder meeting. Closing date suspends stock trading until after the shareholder meeting has concluded.

o What happens when there is a gap between record date and the closing date? Example: A holds a share at the record date but transfers that share to B prior to the closing date and prior to the shareholder meeting. A is still the holder of record and is thus entitled to notice, to vote, and participate in the meeting.

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o B becomes the agent of A in a voting arrangement. As part of the sale, A empowers B through proxy to act as an agent for A in the voting interest. B however, has a direct interest in the outcome of the vote (the agency). This is called a proxy coupled with an interest.

o Normally, the proxy arrangement is terminable at will, but this arrangement diverges from the traditional doctrine and specific performance is available.

o A, the holder of the record, seeks a loan from Fleet Bank and pledges stock as collateral. Often the bank will retain the proxy vote, notice, and information rights. The bank has a proxy coupled with an interest – the interest is the loan. They want to keep the value of the stock high because it serves as collateral on the loan.

o Election of Directors . Board of directors are generally the managers of the corporation – BUT this can be changed in the articles of incorporation. Directors must meet and manage the corporations actions and set broad policy goals (i.e. acquisitions, diversifications, products…) They are generally NOT involved in the day to day operations and must delegate authority to those who will run the corporation.

o Directors CANNOT abdicate their authority to govern . They must delegate and then supervise those hired to run the day to day operations.

o For smaller corporation, the directors are likely to be more directly involved in the day to day running of the business. Courts have carved out a special niche for the small closely held corporation.

o Constraints are imposed on the directors .o Time. Infrequent meetings.o Composition.o Information. The board is usually fed exactly what the officers of the corporation want them to see.o The board must be duly convened to act . A single member of the board cannot act unilaterally. Individual board

members can be designated to act as agents of the board or corporation in certain transactions. There are specific requirements for the duly constituted, duly convened board.

o Notice . Must be reasonably calculated to reach the intended person and provide the opportunity to attend. Notice can be waived in certain instances. The member of the board of directors represent the entire corporation even if each individual is also representing a specific constituency (e.g. the union director.) Thus, you must still think of the overall needs of the corporation in considering corporate decisions. There is a big potential for conflict here.

o Actual Presence . You must be there to participate, but technology is changing this.o Quorum . It is preferred to have an odd number of people to break deadlock votes. Dead lock is interpreted as a

vote for the status quo.o Discussion .o Vote .

Concept (c): [Authority of Corporate Officers]

Delegation of Duties. This is always the first concern did the board property delegate the authority to act on a particular issue? Unless otherwise provided, the business of the corporation is to be managed by the board of directors. See Charlestown Shoe. Authority issues will always trace back to the authority conveyed/delegated by the board of directors.o KEY to the Analysis .

o What did the board instruct the officer (agent) to do?o When bringing suit against the corporation, the goal is to trace the authority all the way back to the

corporation. BUT, the corporation will always defend as an ultra vires act in contract matters, but such defense will not work with a tort.

o Officers do have ordinary powers but they do not have extraordinary powers. So selling a large corp asset without consulting the corp or investigating the sale price will result in holding the pres liable for the difference in the price unless the board subsequently ratifies the sale of the asset.

Sources of Actual Authority.Bylaws. This is generally where the authorities of the various officers will be laid out. The bylaws govern the internal

workings of the corporation.Board Resolutions. This is acts by the board specifically authorizing particular individuals to perform particular acts.Corporate Statutes. You generally won’t find much here, but is important to look. Other statutes may apply.Certificate of Incorporation. This will spell out the general purposes of the corporation, but probably has little in the way

of duties and authority of the officers.Express. What was conferred may be subject to interpretation or require rules of construction to interpret.Implied. Arises when the agent has performed a particular act in the past without comment or opposition from the board.

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Inherent. Arises by virtue of the position. Example is President of Board. This is measured by custom and usage within the particular industry.

Apparent Authority. This is a holding out as possessing the authority to engage in the transaction. It is based upon what the third party reasonably believes entering into the transaction.

o Normally arises with the corporation’s officers. It is unusual to see at lower levels of the corporate hierarchy. o Reasonable reliance upon the acts of the officer, such as the President, CEO, COO, etc… The analysis will be

context driven, often resulting in a comparison between the ordinary vs. extraordinary acts of the corporate officer.

Note on the Authority of Corporate Officers

Presidento The modern rule is that the president has apparent authority to bind his company to contracts in the usual and regular

course of business, but not to contracts of an “extraordinary” natureo Elements of an “extraordinary” action

The economic magnitude of the action in relation to corporate assets and earnings The extent of risk involved The time-span of the action’s effect The cost of reversing the action

o Generally, “extraordinary” actions are decisions that would make a significant change in the structure of the business enterprise, or in the structure of control over the enterprise, are extraordinary corporate actions and therefore normally outside the president’s apparent authority

o The president or any other officer may have actual authority that is greater than his apparent authorityo The president’s actual authority may be found in the certificate of incorporation, the by-laws, or board resolutions, or

may derive from a pattern of past acquiescence by the board, or from the board’s ratification of a specific transactionChairman of the Board

In some corporations this position is held by the CEO who has relinquished day-by-day operations to a younger man while still holding the reins of power; in others it is held by a retired CEO whose counsel and advice are still valued; in others it provides a formula for dividing between 2 relatively equal principals the control of the corporation

Vice-Presidents In early cases, VPs had little or no apparent authority Today, courts may follow a more expansive approach to the authority of a VP

Secretary The secretary of a corporation has apparent authority to certify the board’s records of the corporation, including

resolutions of the board - but no other apparent authorityTreasurer

The treasurer has virtually no apparent authorityClosely Held Corporations

In a closely held corporation, some cases have held that if the president has been exercising absolute authority over the corporation’s affairs and the board has never questioned, altered, or rejected his decisions, the president will have extremely wide actual and apparent authority

Courts frequently recognize in officers of a close corporation the same powers that are possessed by partners in a firm under the general rule of partnership law

RatificationEven if an officer lacks both actual and apparent authority, the corporation may be bound by the officer’s act in

entering into a contract or other transaction on its behalf, if the board later ratifies the officer’s actRatification may occur where a corporation, knowing all of the facts, accepts and uses the proceeds of an unauthorized

contract executed on its behalf

Application (c):

1. FORMER BAR EXAM QUESTION: Buyer offered to purchase land owned by corporation for $10,000. Charles, the president, executed deed to buyer without consultation or investigation. Charles then learned that the price offered and accepted was substantially below fair market value.o Does Charles, as the President, have the authority to negotiate and execute the sale of corporate property ?

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o What is he doing? He is negotiating the sale, binding the corporation in contract, executing a deed, and selling corporate property.

o Five general things to consider in answer this question: o Corporate waste. Selling property for less than fair market value.o Fiduciary duty. Good faith, loyalty, due diligence in discharge of officers duties.o Closely held corporation v. publicly held corporation. Close corporation more liberally treated by courts –

get more wiggle room because of nature of corporation.o Total corporate assets. If sale is of the only corporate asset, or a substantial portion thereof, then the

transaction is significant.o Actual vs. apparent authority.

o Answer hinges on actual vs. apparent authority. o Actual authority will be defined in the certificate of incorporation, the bylaws, or by statute.o Apparent authority is one holding himself out as possessing the authority to engage in the transaction. Based

upon what the third party reasonably believes in entering into the transaction. If the corporate officer is selling all or substantially all of the corporation’s assets, then the third

party is on notice that the corporate officer may be acting beyond the scope of his authority. The third party must make reasonable inquiries of the officer leading to the transaction. Such a question will often be left to the fact finder to determine.

Such items to be examined include a board resolution authorizing the sale, authority to negotiate the sale, bind the corporate in contract, and execute the deed. Anything that might define his authority.

Inherent authority may also play a role – if other presidents similarly situated have this authority. Apparent authority is wholly context driven. Ordinary course of business might allow notwithstanding breach of duty of prudence. Extraordinary transaction could eliminate apparent authority, i.e. would take away their apparent

authority – sizable asset sale, organic change to business. Acquiescence. If there has been a common course of business by the board to allow the president to

engage in such transactions.2. OLD EXAM PROBLEM: Last month, ABCO Corporation, a duly formed, closely held corporation held its annual

company picnic. All of ABCO’s directors except Jones were present. After a few beers and hotdogs, all of the directors who were present, decided to authorize Smith, ABCO’s President, who was also a shareholder and director, to sell Greenacre, a parcel of property, which ABCO owned. The sale was designed to raise needed capital and had been under discussion by the board for some time. Two weeks ago, pursuant to his mandate, Smith found a buyer, Tertius, and duly executed a purchase and sale agreement with him, on behalf of ABCO, signing it “Smith, President of ABCO.” Last week at a duly held director’s meeting, Smith notified the board of the K with Tertius. The board responded that what they had done at the picnic was a mistake, and that selling the property required more discussion and investigation. They said that they had no present plans to sell the property. The board of directors seeks your advice as to whether they are legally obligated to sell Greenacre to Tertius under the K executed by Smith. Advise the Board of Directors.

o This question is about scope of authority, not scope of employment.o We've seen it in the tort context with the ice cream parlor problem.o "duly formed": don't have to worry about de jure, de facto, or estoppelo "closely held": more flexibility, probably family and few ppl, involved with few shareholders prolly not

marketable, they're probably all managing and directingo "annual picnic": not sure what that meanso "All of ABCO's except Jones were present": not a filler, may be important for quorum, this may be an issue.o Next line: they may have impaired judgment. There may be an issue here. They've had a few drinks and now

they're taking action by authorizing someone. I don't know if this is a formally duly called meeting and I do know that Jones wasn't there. It might not go to quorum but it may be for the need of action. They didn't call this meeting specially, they're just having a good old time and then they decided to sell Greenacre.

o Votes at board level are taken at majority level so even if Jones didn't want to sell Greenacre it wouldn’t matter b/c the majority voted to sell

o They authorize Smith, president, shareholder and director, o They should have had a notice for a formal meeting- what statute says - Jones's side -- it doesn't matter whether

Jones is present or not -- so at least the minority would have a chance to vote - public policyo The statute is set up so that all voters have a chance to vote, that doesn't just mean the majority, it means

everyone.o Jones is entitled to be there b/c he represents interests in the corporation (public policy)

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o Then the "meeting" was fraud, it wasn't a duly constituted board and the only time directors represent the business corporations is when they are a duly authorized group

o This action was invalid - the action to sell a parcel of propertyo The attempt to authorize the president - express authority - this attempt to authorize the president with

power to sell is invalid. Smith did not actually have the express authority to sell this property. o Clark v Dodge , pg 274

o Can argue the other way by saying that nothing is effected, if general public's interest isn't invoked, the board members don't care, courts will say its ok to deviate a bit from the statutory form

o If you take this side then can say that Smith was expressly authorizedo We will assume there is invalid authorization to the Presidento Does that mean that Tertius action is invalid?

o No, it doesn't automatically follow b/c there are other forms of authority such as impliedo Does the president of a business corporation have the implied authority to sell assets of the business? o There is no rule that attaches to implied authority: authority that derives from the course of conduct from

the principle and agent, action where Smith has acted similarly in the past, and board has allowed it in the past. So Smith will think he has implied authority.

o Whenever actual authority is the issue the spotlight is on the principal and agent. It has nothing to do with the third party.

o Is there implied authority -- you can't answer this from this test question. o We are talking about continuous conduct - we don't know what their continuous conduct is.

o Inherent authority or incidental authority -- do other people (agents) similarly situated have this authority?o If yes, then the agent is justified in believing that he has the same authority. If the principle didn't want

the agent to have the authority wouldn't the principle have said that?o He would have been told he didn't have the authority to make contractso You need to tell the agent that he doesn't have this authority or else he is going to do that.o Check the statute or the articles of organization or the by-laws to see if what a president can do o This is the last stand if looking for actual authorityo Whether he has inherent authority to sell assets

It will depend on custom and usage in the area The amount of assets that the sale represents of the total assets b/c presidents of corps are not

authorized to sell off all or substantially all assets of the business. -- What percentage of the assets are presented by Greenacre.

o Apparent authority - what appears to be - its what the principle through his actions have led third parties to believe to the third parties detriment

o The question is viewed through the eyes of the third partyo The third party sees the president of the corporation - the president says I'm authorized to sell Greenacre. o The president could be a liar - misrepresentation - that's a tort called deceit o What if he's not a liar - what if he's doing this in good faith b/c he has the mandate of the directorso What about trying to bend the corporation on the contract - was there a holding out. Is the third party

reasonable in believing in what President is saying? It's a fact determination. o Putting someone in the position of officer, is there a holding out that that person has authority?o Was there reasonable reliance of the third party?o By statute they validate presidential transactions in real estate - b/c its so important - we have this statute

in MAo We just ran through all the possible sources of this president's authorityo He left apparent authority to the fact finder - he must make that determination. Clients need some sort of

conclusion. o Advise the Board of Directors - to point out that's the question

o Does the board have to honor the K made with Tertius.o How would you begin to answer this question?o Prof : "My advice to the board of the directors is based on an analysis of the following issues…"

All has to do with whether the president has the authority to do with what he did And his authority could be… Doesn't like conclusions in the outset. Issue of authority of the president of a corporation concerning a sale of the assets of a

corporation.Page 31 of 72

o His conclusion: probably tertius takes the property b/c of at least apparent authority, its factually based. If you want professional opinion, that what it would be. If this turned out to be not a good deal, if corp lost as result of transaction then they could be liable.

Concept (d): [Limited Liability]

Piercing the corporate veil and therefore disregarding the corporate entity. There is a corporate entity here, full blown de jure corporation. Before concerned with status of corp. However, just b/c you have a de jure corp, does not mean you are impenetrable, the active participants may still be held liable in some situations.

The following cases recognize this exception, however, in the vast majority of cases, this concept is rejected. There is a need to recognize the integrity of the corp.

Corporate Form. Courts will look at whether the shareholders are primarily individuals OR a parent/subsidiary situation before determining whether to pierce the corporate veil.

o Individual Shareholders : Here are some factors the corporation will consider: Tort v. Contract. Courts are more likely to pierce the veil in tort cases where the creditor is

involuntary. Fraud. Veil piercing is more likely when there has been grievous fraud or wrongdoing by the

shareholders. Inadequate Capitalization. Veil piercing is MOST likely to happen where the corporation has been

inadequately capitalized. Yet, inadequate capitalization alone is not enough to pierce the corporate veil.

Failure of Formalities. The court is more likely to pierce the veil if the shareholders have failed to follow corporate formalities in running the business. Some examples of formalities are:

Commingling assets: This points toward intention, whether or not the accountants of the world treat it as a corp or see it as an extension of themselves (instrumentality). These are indicators. No recognition of corp as separate being except in liability. You should have separate accounts, separate books, etc…

Meetings: whether they ever have shareholder or directors meetings Note: In nearly all cases, TWO of the above four factors must be present in order for the court to

pierce the corporate veil. The most common combination is inadequate capitalization and failure to follow the corporate formalities.

o Parent/Subsidiary . If shares are held by a parent combination, the court may pierce the corporate veil and make the parent corporation liable for the debts of the subsidiary. The GENERAL rule is that the corporate parent shareholder is NOT liable for the debts of the subsidiary.

X corp creates Y corp. The parent creates the subsidiary. The parent, once labeled, controls the subsidiary, that is a given. So have parent-subsidiary relationship. Now we have Y corp with the same officers and directors as corp X. This is allowed and is called common directors or common officers. If they are not all the same but some are, they are called intermingling officers and intermingling directors. There is a potential for problem b/c X controls Y. If X is the sole purchaser of Y’s products, isn’t there potential for abuse? Two separate businesses that should be maintained separate, supposed to be for the shareholders. They are dealing with themselves. This is a problem: whose interests are being served and what about conflict of interest b/c of self-dealings. This is called fiduciary duty-duty of loyalty. X corp is not liable for Y corp’s debts solely based on the fact that they have common officers and directors. This alone does not disregard the corporate structure, must look at capitalization and other separation. You don’t represent the businesses as the same-look to see whether they do this or not. It is a totality of the facts, not just one element.

Factors. But as in the individual-shareholder case, certain acts by the parent may cause veil piercing to take place. Such factors include:

Failure to follow separate corporate formalities for the two corporations (i.e. both have the same board, and do not hold separate director’s meetings)

The subsidiary and parent are operating pieces of the same business, and the subsidiary is undercapitalized,

The public is misled about which entity is operating which business. Assets are intermingled as between parent and subsidiary, or The subsidiary is operated in an unfair manner (i.e. forced to sell at cost to parent.)

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Disregarding the Corporate Entity. Generally, disregarding the corporate entity is NOT a common cause of action. Frequently, it is used as a bargaining chip during pre-trial negotiations, but it is seldom carried through to trial. As such, there is not a great deal of case law covering the issue.

o The action arose out of public interest in protecting themselves against corporate abuses. o Questions follow as to what you must establish vis a vis the corporate activities such that the benefits and protections

of the corporate shield will be lost.o Personal liability ensues when :

o Directors treat corporate assets like personal assets, o When directors hold themselves out as being personally liable for corporate debt, o When there is inadequate capitalization, and o Active participate in the conduct of corporate affairs.

o Burden of Proof . Generally, the plaintiff has the burden of proof to show that the corporate officers and directors are actually defrauding the public and using the corporation as an instrumentality for personal gain. Such action only relates to the active participants involved in running the business – the officers, directors, and agents.

o Always obey the formalities of corporate action . Separate interests that are personal from those that are corporate. This includes keeping separate books and records, adhering to the formalities of shareholder or director action, sharing the formalities of employees between or among more than one corporation, and raising sufficient capital to meet existing obligations.

o There are three big cases about disregarding the corporate entity.o Walkovsky v. Carlton . Distinguishes the corporation from the individual.o Minton v. Cavaney . Inadequacy of corporate capitalization.o Costello v. Fazio . Equitable subordination.

Application (d):

1. THE CORPORATE VEIL WILL BE PIERCED WHERE THE CORPORATION IS A DUMMY FOR ITS STOCKHOLDERS: (Walkovszky v. Carlton).A. Facts: Plaintiff alleges that he was injured when he was run down in NYC by a taxi cab owned by the defendant Seon

Cab Corporation. The individual defendant, Carlton, is claimed to be a stockholder of 10 corporations, including Seon Cab Corporation, each of which has but 2 cabs registered in its name and it is implied that only the minimum automobile liability insurance required by law is carried on any one cab. Although seemingly independent of one another, these corporations are alleged to be operated as a single entity with regard to financing, supplies, repairs, employees and garaging and all are named as defendants. Plaintiff argues that he is entitled to hold their stockholders personally liable for the damages sought because the multiple corporate structures constitutes an unlawful attempt to defraud members of the general public who might be injured by the cabs.

B. Issue: To pierce the corporate veil, must it be shown that the corporation was a dummy for its stockholders who were actually carrying on the business in their personal capacity for personal rather than corporate ends?

C. Holding: Yes. The law permits the incorporation of a business for the very purpose of enabling its proprietors to escape personal liability but, manifestly, the privilege is not without limits. Broadly speaking, the courts will disregard the corporate form, or, “pierce the corporate veil” whenever necessary “to prevent fraud or to achieve equity.” Court found for Carlton. Told victim he needed to reword his pleading, there wasn’t enough in it. He needed to say that Carlton and other D’s were conducting biz in their individual capacities (he is asserting instrumentality, alter ego, second self), they are conducting business themselves and there only reason for making corp was to limit liability.

D. Discussion: Dummy reality carrying on the business in their personal capacities for their own personal needs rather than corporate needs -- this is why this case is here and is what ties it to Charlestown Boot and Shoe. Gives you a total picture of what courts are looking for: using the corp privilege and abusing it. Defined by general rules of agency: whenever anyone uses control of the corp to further his own rather than the corporate business he will be liable on the principle of respondeat superior. Carlton is the principle and the principle ought to be responsible for the actions of the servant, not only to K but to negligent acts as well. The corporation is the second self -- so is Carlton the puppet master? If corps don't follow all formalities, Courts might conclude that you had intent to commit fraud, that you wanted public to know that you conducted a dummy corporation, you are the corporation, and its out of convenience that you serve the corporate shield.

2. SHAREHOLDERS MAY BE HELD LIABLE FOR THE DEBTS OF THE CORPORATION IF THEY PROVIDE INADEQUATE CAPITALIZATION AND THEY ACTIVELY PARTICIPATE IN CORPORATE AFFAIRS: (Minton v. Cavaney).

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A. Facts: Cavaney was the attorney involved in the formation of the corporation and also served as its director, secretary, and treasurer. P received a judgment of $10,000 against the corporation in a wrongful death action for the death of their child at one of D’s pools. P then went after Cavaney individually. No shares of corporate stock were issued before the child’s death – but after the death Cavaney sought to have shares issued by the Commissioner (under statutory formalities.) Cavaney kept the records of the corp at his office for a time. During litigation, Cavaney stated that the Corp did not have any assets and was duly organized but never functioned as a corp.

B. Issue: May a shareholder be held liable for the debts of a corporation where he actively participates in conduct of the corporation and the corporation is not adequately capitalized?

C. Holding: Yes. Cavaney argues he should not be held liable under the alter ego doctrine b/c the Ps failed to show that there was (1) such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist and (2) that if the acts were treated as those of the corporation alone, an inequitable result would follow. The shareholders of a corporation are personally liable when they treat the assets of the corporation as their own, when they hold themselves out as personally liable, or when they provide inadequate capitalization and actively participate in the conduct of corporate affairs. In this case, there was no attempt to provide adequate capitalization for the corporation. The corp only leased the pool, and that lease was terminated for failure to pay rent. Its capital was trifling compared to the risk of loss. The fact that he kept the corporate records at his office supports an inference that he participated in the conduct of the business.

D. Analysis: The court here carefully explains the reasons why the veil should be pierced and Cavaney should be held liable only to conclude that he cannot be held liable, b/c he was not a party to the original action against the Corp.

Concept (e): [Equitable Subordination of Shareholder Claims]

Equitable Subordination: the lowering of priority of a claim b/c the holder of the claim is found to be guilty of improper conduct

Note on Equitable Subordination of Shareholder Claims

Equitable Subordination → The “Deep Rock” Doctrine Under the doctrine of equitable subordination, when a corporation is in bankruptcy the claim of a controlling

shareholder may be subordinated to the claims of others, including the claims of preferred shareholders, on various equitable grounds

Taylor v. Standard Gas & Electric Co. - in this case, the court subordinated the parent’s claim, as a creditor of the subsidiary, to the claims of other creditors and of preferred stockholders, because of the parent’s improper management of the subsidiary for the parent’s benefit, and because the subsidiary had been inadequately capitalized

Comparison with Piercing The equitable remedy of subordination is much less drastic: it simply takes an investment already made, and

denies it the status of a creditor’s claim on a parity with outside creditors, whereas imposing liability for corporate debts undermines the essential premise of limited liability -- that a shareholder’s risk is limited to the amount of his investment

Courts hold that it is fair to subordinate a controlling person’s claim based upon a lesser evidence of misuse of the corporate form than what is required to impose affirmative personal liability for all corporate obligations

Bankruptcy Proceedings: The business determines they are insolvent, that reorganization would be useless, and therefore they would like to

file for bankruptcy. The court will appoint a trustee in bankruptcy who will oversee the termination of the business. Trustee will

respond to federal court judge. The trustee will give actual notice to all creditors of business, all actual known creditors. Sometimes have

ongoing creditors where identities not easily ascertainable and other people that might be about to interact with the corporation, in order to reach the unknown, the trustee gives constructive notice in appropriate publications such as financial newspapers, etc…the purpose of notice is to allow people who claim to be owed something by business to come in and assert their claims.

The creditors present their claims to the trustee in bankruptcy. The trustee, as part of her function, reviews the claims and either allows them or dismisses them.

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Simultaneously, the trustee will be collecting all of the assets of the business and when they have all been collected, the trustee will liquidate the assets through auctions, yard sales, sealed bids, etc…. Liquidation is the conversion of assets into cash.

Now the trustee needs to pay the creditors with the liquidated assets. When talking about insolvency, the liabilities exceed assets, so there won’t be enough in that pool of assets to pay all of the creditors,. People will have to settle for less than what they are owed. So the creditors will get a pro rata share of what is owed them. The assets are distributed, everything is done, bankruptcy is complete, that is the end of the corporation.

Deciding Who Gets Liquidated Assets First Group A : Secured creditors share first (mortgages, secured transactions, people that own bonds). Within the ranks of

these creditors, intra vires creditors get a shot first over ultra vires creditors. So these priority groups are within the secured creditors group.

Group B : Unsecured creditors (people who have debentures). Group C : Shareholders.

o Preferred shareholders go first o Common shareholders last

Application (e):

1. SUFFERING EQUITABLE SUBORDINATION (INSTEAD OF PERSONAL LIABILITY) FOR DISREGARDING THE CORPORATE ENTITY: (Costello v. Fazio). Facts: A partnership was organized in 1948. The 3 partners, Fazio, Ambrose, and Leonard, made initial capital

contributions to the business totaling, $44,806.40. The capital contributions of the 3 partners, as they were recorded on the company books in 1952, totaled $51,620.78. distributed as follows: Fazio, $43,169.61; Ambrose, $6,451.17; and Leonard, $2,000. Later than year, it was decided to incorporate the business. In contemplation of this step, Fazio and Ambrose withdrew all but $2000 apiece of ther capital contributions to the business. This was accomplished by the issuance to them of partnership promissory notes in the sum of $41,169.61 and $4,451.17, respectively. These were demand notes. The capital contribution to the partnership business then stood at $6000 -- $2000 for each partner. 200 shares were issued to each of the 3 partners in consideration of the transfer to the corporation of their interests in the partnership. Fazio and Ambrose both became directors of the new corporation. The corporation assumed all liabilities of the partnership, including the notes to Fazio and Ambrose. Creditors’ claims against the bankrupt estate of the corporation were filed by Fazio and Ambrose. The trustee in bankruptcy objected to these claims, and moved for an order subordinating them to the claims of general unsecured creditors.

Issue: Did Fazio and Ambrose misuse the corporation and the public trust? Did they act in a way that was so fraudulent that the result should be personal liability through disregarding the corporate entity?

Holding: No. Courts are hesitant in doing this. So instead of personal liabilities for all notes, the judge said that they would recognize their notes but won't allow them to share with other creditors with this company. They have to be fair and equitable in decisions. So judge pushes them to the back of the line. If the fraud was extreme, the judge would have pierced the corporate veil by disregarding the corporate entity and making them personally liable to all of the creditors. Equitable subordination is a lesser remedy available b/c less has to be shown and it is less drastic. It is an alternative to piercing the corporate veil.

o Positive spin: this is an attempt to continue a business plan, this is a maintenance of equality. They want to maintain that nice equal relationship they had as partners and this was a legit business plan to maintain their equality: they reduced their corporate accounts so they were equal, once the corp started each would have. There is some legitimacy to that, it is a good faith effort to maintain the partnership in a corporation.

o Negative spin: they started a corp at a time when they were insolvent. In order to protect the biggest contributor (Fazio), that motivates the decision to corporate. They reduced the capital accounts to the form of debts. Here's a partnership that has more liabilities than assets and they are just adding to the liabilities, b/c they have promissory notes that creates debt. That is followed by incorporation and b/c of the asset acquisition including the acquisition of debt obligations, the meager capital contributions are grossly off set by the debts. This is a case of extreme under-capitalization. They are heavily burdened by debt, the business is still not doing well and then it is bankrupt. Prof: there are more bad things than good. Had they not converted the capital amounts to debt, they would have been in the end of the distribution line. By converting part of there capital to debt they becomes general creditors.

Discussion:o When they incorporated, the partnership was insolvent which means their assets were less than their liability:

first step down the road to bankruptcy This says something about what they intended to accomplish as a result of their incorporation.

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They are allowed to incorporate to limit their liability; however, this goes a little beyond this. BUT you cannot incorporate to commit fraud (to lie or cheat).

o They wanted to incorporate to protect themselves from personal liability particularly the personal interest of Fazio, he had the biggest stake and faced the greatest loss

There was a tax angle and the tax angle had to be how the capital accounts were to be paid and whether they came out of fund for paying dividends (taxable income) or whether they would pay back account on principle on a debt obligation which are not taxable

o How do you incorporate a partnership? Fill out the articles of organization -- ABCO becomes a de jure corporation Follow through and do whatever is organizationally required under the statute Create the shareholders who are going to provide the financial base of this corp through the

capitalization process Need to issue stock if you want shareholders For issue stock there are certain acceptable forms of consideration Forms of consideration: cash, property, services (cavanney part of payment of services he

rendered he received stock) or promissory noteso Theory: flow coming in for the issuance of stock becomes a stock of capital

Capitalization is achieved through the issuance of stock, there are other ways but they create debt

So tell Fazio, Ambrose and Leonard that if they give corp money then the corp will give them stock

Sell the partnership to the corporation : this includes all services, good will, the business name, intangible and tangible assets such as inventory

Bring appraisers in to figure out the value of stuff Also part of the sale are the debts, the passing on of liabilities (not always, not essential

part of sale transaction) This transaction is called an asset acquisition agreement Who determines the sale of a partnership? All the general partners have a say on the sale --

here that is, Fazio, Ambrose and Leonard. They could have just dissolved the partnership and a termination. But they don't want to do that, they want to sell them in tact so as partners they are going to agree to a transfer of partnership assets to the corporation.

So if they're selling the partnership to the corporation, a sale is not a gift. A sale requires something be received for what is transferred. What amount of consideration, who determines sale price -- the partners. Price is determined by the market price. On the buyers part who determines the sale price - Fazio, Ambrose and Leonard. This is called self dealing or self interested transactions.

o This self dealing is an issue.o To get money from the partnership to the corp, they can:

Make a gift of the assets of the partnership to the corp; or Sell partnership to the corp which is really a transfer of assets. There must be consideration, the

corp has to pay something back so corp gives them (partnership members) stock. o Costello chose #2 by selling the partnership to the corp and in return, getting stock in the corporation. o In a normal dissolution of a partnership, the partnership dissolves; they liquidate their assets and pay off their

creditors and winding it up by settling all accounts and dividing what is left for assets. If the business was dissolved and if we would wind up the business of the partnership this is what the line up would look like: the distribution goes to creditors first (priority to secured creditors then general creditors) including partners who have loaned money to the partnership. After that all the creditors have been satisfied, now we return the capital contributions of the partners, first the share of the profits and then their capital contribution.

o In Costello, they sold the partnership to the corp so there was no liquidation of assets or winding up. Instead, they sold their assets to the corp in return for shares of stock in the corp. This is called an asset acquisition agreement. So after the settling up of accounts, Fazio will be paid $43,000. That is how much has been built up in his capital account, that is his share of the partnership. Leonard would be owed $2000 and Ambrose would be owed $6,000.

o What they did is that they tried to maneuver themselves up in the line and they did that through the promissory notes. They took their capital contributions, what was owed to them at the end of the run and converted them to promissory notes. B/c now they were not in line as partners seeking the return of their capital contribution, they as the holders of promissory notes, they become part of the pool of general

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creditors. All they did was do a paper transaction. So now they end up with capital accounts of $2000 a piece.

o Why did they leave the $2000 a piece in the capital accounts? So they could be equal owners the corporation. By issuing themselves equal shares of the stock b/c

each of them were making an equal contribution to the corporation. They placed a value of this partnership -- a value of $6000. That is the sale and the buyer. So they're share of the partnership is each $2000. They contribute equal amounts of money to the corporation so they should get equal amounts of stock -- so they become equal owners of the business.

If they hadn't done this then Fazio would have been $41,000, Ambrose $6000 and Leonard $2000, that would have been how much their partnership shares would be worth. And Fazio would control the stock and thus own the ranch.

But now they have equal management powers, equal control, equal sharing of profits and losses. When they transfer the partnership of the corp the asset acquisition agreement recognizes equal

contribution and assumes liabilities so the corp gets the assets and assumes its liabilities which include the promissory notes.

o There are other ways to deal with this issue rather than creating debt such as: You could issues shares of stock, some of which are voting stock to keep equity but then non voting

shares to make up the money. Not a perfect solution but one attempt to address this. This is one way to deal with it especially if worried about two of them ganging up on the third and running away with it.

You can use fractionalized shares. Hybridized stock. Could give them preferred stock. This way they make an investment but are not

allowed to vote. Unlike debt, there is no expectation to get investment back, you take a risk. They could give him the preference of a guaranty rate of return.

2. HYPO: X gives funds to Y corp, Y corp goes into bankruptcy. Trustee in bankruptcy gives creditors actual notice or constructive notice and now has creditors A, B, C and X corp. Trustee in bankruptcy has to decide what obligations are real and legitimate. X corp shows him a promissory note and argues theirs is legitimate. The form may be good but substantively, the trustee will have to determine whether it is a bonafide debt or an advancement of operation capital as the parent corp. Especially since the officers and directors are the same for X and Y. The parent corp can not merely take money from one pocket (X corp) and put it their other pocket (Y corp). Need to be separate corporation. If we allow the parent to stand along with other creditors of the subs, the creditors of the parent will benefit b/c the pool of assets available to the creditors of the parent will be increased by the amount of money the parent recovers in the subs bankruptcy proceedings. If we do no allow the parent to assert its claim in the subs bankruptcy proceedings, the creditors of the subsidiary will benefit b/c the pool of assets will be greater, will not have been depleted by the assertion of another creditors, the parent. How do you resolve this problem?

Options: Recognize the parent’s but use equitable subordination. The claims of the parent are subordinated to the secured and

unsecured creditors. Do this b/c of their relationship to the sub. o Is there always going to be a connection btwn a sub and a parent corp? Yes. Parent corp owns all or almost

all of the stock of the sub. o Does the connection per se allow for you to equitably subordinate their claim? It depends. Measured by a

standard of fairness. Look at the transaction and say “is this the same kind of a deal that would have been struck with an outside third party or does it look like a parent or individual shareholder is taking advantage of his or her position of power?” (Taylor case is right on point when they talk about abuse of control, taking advantage of) This has a consequence of giving the parent or the individual shareholder if non-sub situation, an advantage at the expense of others. So connection per se btwn parent and sub corp is not enough. Must make further inquiries, must look at whether it would be inequitable. Abuse of control is key phrase. If the creditors would suffer some prejudice by reason of an abuse of control by the parent so as to work an injustice, then the parent will not be allowed to compete.

Recognize it as a separate corp, recognize the loans, and allow them to share along with the other creditors. Disregard the corp entity on the basis of fraud.

o Discuss issues like capitalization, intent to incorporate, did the parent incorporate the sub, if so, why, does it look like its their intent, do they maintain a separation (separate records, separate meetings of shareholders, etc…).

o If there is no corp entity, then there are no loans or they will call the loans an advancement of operating costs which means you might get it back but most likely would not. Otherwise, they consider it to be just switching pockets.

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IV. Shareholder Informational Rights and Proxy Voting

Concept (a): [Shareholder Informational Rights Under State Law]

Generally, checks and balances are built into corporate law to ensure that the corporate executives are behaving properly, remain accountable to the shareholders, and ensure that the self-interest of the executives is constrained.

Securities Exchange Act of 1934: Securities Exchange Commission oversees the public offerings of stock and other interests in stock that derive from the use of interstate stock

Inside info: Oversees large corps and look for abuses such as fraud that has to do with inside informationo Martha Stewart

Proxies: a necessary evil b/c they are the means in which we attain quorums in large corporate settings. The larger the corp, the more necessary.

o A reverse agency b/c in its form the agent solicits the proxy. In the normal principle agent relationship, the principle initiates. Normally corporate management solicits the proxy.

o Very often corporate insiders have the upper hand. The federal regulatory scheme has sought to provide a level playing field. To provide that level playing field they allow other interests.

Regulation 16, Short swing profits: makes corp fiduciaries responsible to make a profit. Designed to keep ppl on a straightened arrow and not to lead them into temptation.

A bundle of rights that shareholders enjoy: Inspection rights Theory: to keep everyone honest

o Protecting the interests of shareholders to see to it that what needs to be done is getting done Shareholders are the risk takers and investors shouldn't they be allowed to come in and investigate But sometimes very bad ppl becomes shareholders and they have other things in mind: getting secret formulas or

inside info.

Shareholder’s Inspection Rights – Common Law: at common law, a shareholder “acting in good faith for the purpose of advancing the interests of the corporation and protecting his own interest as a stockholder” has a right to examine the corporate books and records at reasonable times. The general rule is that the shareholder has the burden of alleging and proving good faith and proper purpose. State statutes: a common problem of interpretation is whether the statutes:

1. preserve the common law rule that the shareholder must prove a proper purpose2. discard the proper purpose test3. preserve the proper purpose test, but place on the corporation the burden of proving that the shareholder’s purpose is

improper (generally this interpretation is followed)A second common problem is whether the statute replaces or supplements the common law. The general answer is that the statutes supplement the common law, so that a suit for inspection that dos not fall within the relevant statute can still be brought under the common law.

The Right to Access Information. Shareholders have access to certain corporate information upon request and for a legitimate purpose. Generally,

shareholders may have access to corporate books, records, data, internal memorandums, records of meetings, bylaws, stockholder lists, financial statements, and so on under the right conditions.

o Inspection can be achieved through declaratory action (ask judge to determine your shareholdership and rights therein), via the discovery process before trial, or through mandamus.

o This right is subject to LIMITATIONS and the court will NOT permit a fishing expedition. Proper Purpose Test . Shareholders MUST demonstrate a proper purpose to gain access to corporate information.

Proper purpose shall mean a purpose reasonably related to such persons interest as a stockholder. Proponent must show by a preponderance of the evidence that the information is sought in good faith and is to be used for a proper purpose. Writ of mandamus may be used to compel service.

o Examples of PROPER purposes: improper management, self-serving management, profligate spending, imprudence, ascertain the financial condition of the corporation, preventing mismanagement (breach of duty of care or loyalty), ascertain share value, getting info to help make voting decision, or gain shareholder lists to solicit votes, solicit proxies, or solicit shareholders to join in suit against corp.

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They all have to do with the shareholders interest in corporate earning and abuses that impact on money matters, value of shares, voting on proper elections, upcoming actions, soliciting proxies -- there is an economic tie that runs throughout an improper purpose arena

o Examples of IMPROPER purposes: solicit corporate information for subsequent publication, sell corporate information to competitor, sell shareholder lists, to embarrass or harass the corp, to depress the value of shares. The kinds of purposes that are clearly at odds with the interests of the corporation. These are vague standards, but that is what it means.

Procedural Safeguards: Many statutes provide safeguards in the form of minimum shares held (e.g. must have at least 5% of outstanding shares) or that the shareholder must be a shareholder of record for a specific period (such as six months) or some combination of the two.

Mass. Gen. Laws. Mass law presents a bifurcated approach to corporate information based on the type of information sought. The effect is essentially to permit absolute access to some corporate information while additional corporate information must be acquired under the proper purpose test originating under common law. Information List A. Specific information that shareholder has right to as long as follow the procedures outlined in the

statute.o The original or attested copies of articles of org, by-laws, records of all meetings of incorporators and

shareholders, and stock and transfer records shall be kept for inspection. Defense : The corporation’s affirmative defense is that the actual purpose and reason for the

inspection are to secure a list of stockholders or other information for the purpose of selling, or using for purpose other than in the interest of the applicant as a stockholder relative to the affairs of the corporation.

This is a corporation’s only defense to seeing material listed under this statute.o All other information. Any records not delineated, for example, financial records, memos, directors minutes,

then you have to go through common law procedure which is through court of equity (i.e. proper purpose test).

Determining Who the Shareholders Are: Record Ownership & the Record Date In large corporations with many shareholders, stocks are changing hands constantly and it is difficult to determine

who the shareholders are. The determination is important for two reasons: Notification of corp matters including shareholders meetings; and Determinations about who has the right to vote and inspect corp records

o To deal with this issue, a date is set at which time all persons owning shares are recorded and that is the record used to determine who to send notices to, who has right to vote, and who has rights to corp. information. This is called the Record Date.

o Record Date : The date, chosen by the corp, is usually close but prior to the meeting. It establishes, as of that date, shareholders of record-shareholders who are entitled to notice of

upcoming meeting and shareholders who are entitled to vote at that meeting. Statutes require certain limitations on record dates such as they can’t be too long before meeting,

etc… What about shares traded after record date but before meeting? For example: If have present shareholder (record shareholder) who subsequently sells his stock. When we look to the

stockholder record, we will find name of transferor not transferee b/c the transfer was after the record date. The transferor is no longer a shareholder but technically is based on the record.

Answer: To give the transferee the rights of ownership, we create an agency. Transferor is giving the transferee the right to vote and transferor agrees to confer any notice to the transferee that he receives. These agencies are called proxies.

Since the transferee has an interest in the subject matter of the agency, this is an example of an agency that is irrevocable; this agency is coupled with an interest.

Closing date: A fixed time after which no transfers make take place. This date is fixed by corp subject to certain statutory restraints. This date/time is normally immediately prior to meeting. So usually the close of business the day before the

meeting. All transfers are suspended.

Application (a):

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1. IN CLASS HYPO: a client, Helen, talks to me about stock issue. Her husband had died 10 years prior. Her husband and brothers started a business. The biz was successful and became a middle sized corp. The husband died. Nothing was ever mentioned by his 2 surviving brothers about the business and she never raised topic with them and never discussed any topic of it. Years passed and her finances have changed so she was interested in acquiring her husband's share of the business.

o Issue: How do you go about what, if anything Helen is entitled to?o What would you do?

She would have to take the stock certificate to the clerk and say I am the rightful heir of this stock, give it to me. If the clerk says no then Helen goes to court and gets a mandamus order.

Helen could also go to corp and ask them what her husband's stock interest was. She asks to see the books and records and they say no. The problem Helen has is that in order to have shareholder access rights, one has to be a shareholder. The problem is how do they show their shareholder standing without access to the shareholder list?

Answer: You have to seek declaratory relief - would have to show court that there is a justiciable controversy and whether she is stock holder?

Could also do it through mandamus procedure and convince the court that there is a triable issue in stockholder assets

o Shareholders are equity holders, they are the beneficial owners of this business, the business is run for their benefit, they own all the assets of the business including the right to inspect records and books. People are supposed to be acting out of concern for the group and the venture.

o Shareholders are fiduciaries: they should never be motivated out of a duty to benefit self out of the expense of others in the venture

o So for inspection rights, how do we recognize rights of separate shareholders and at the same time assure they are not going to be abusive.

o This section is about access rights v. abuse. 2. THE COURT DEFINED “PROPER PURPOSE” AND “REASONABLY RELATED” IN SUCH A WAY AS TO

EXCLUDE POLITICAL AND SOCIAL AIMS IN FAVOR OF ECONOMICAL AND FINANCIAL PURPOSES: (Pillsbury v. Honeywell).

o Facts: Petitioner appealed trial court's decision denying petitioner's writ of mandamus to compel respondent to produce its shareholder ledgers and all corporate records. Petitioner was opposed to respondent's participation in Vietnam war effort and eventually bought one share of respondent's stock for purpose of voicing his concerns to respondent's shareholders. Petitioner sought shareholder ledgers in order to find the identity of shareholders so he could speak to them about respondent's participation in the war.

o Holding: Court affirmed and held respondent's purpose was improper to obtain an inspection of respondent's records. Law required petitioner to have proper purpose in seeking inspection of corporate records. Mere desire to communicate with other shareholders was not proper because it gave an almost absolute right to compel inspection. Furthermore, petitioner's status as a stockholder was shaky. He had only one definitive share, purchased for the purpose of the present suit.

V. The Special Problems of Close Corporations

Concept (a): [Introduction]

Most corps are small closely held corps rather than large corps. Closely held corps are based on personal relationships. Sometimes they are called incorporated partnerships. If they involve

families, called family corporations. The relationship btw and among parties is central to business relationship. B/c of the importance of their personal relationships, they have heightened fiduc duties.

Observe two things:Deviation from the statutory norm, wavering that is allowable (i.e special planning)Price to be paid for this deviation is a heightened fiduciary duty

Features of a Closely Held Corporation: Small number of shareholder. There is usually around 30 or less. This is only a guideline although some states such

as Delaware have a 30 shareholder cut off.

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No ready market for the stock. Their stock is not traded on the open market so when they want to get rid of stock, they must turn to the corp.

Substantial majority of the shareholders participate in the management, direction, and operation of the corporation. The shareholders are usually also on the board of directors or officers of the corp.

Fiduciary Duties: Also treated a little differently in a closely held corp. Essentially looked at as an incorporated partnership. Standard of review is more heightened b/c closely held and based on personal relationships.

o Closely Held: “Utmost good faith and loyalty”o Publicly Traded: “Good faith and inherent fairness standard of conduct, and not permitted to serve two

masters whose interests are antagonistic.”

Distinguish Between a Partnership and a Closely Held Corporation. Internal Governance. Partnership.

o Facilitative rather than mandatory. The default rules govern but the partners can contract for different rules. o All partners have equal rights.o Differences among the partners within the business are determined by majority, but outside the scope or

conflict require unanimous approval. Corporate.

o Traditional corporate status is mandatory.o Shareholders have no rights to participate in corporate management.

Authority . Partnership.

o Any partner has the power to bind the partnership if in the ordinary course of business. This holds true even if the partner lacks actual authority per the agreement if the third party is unaware of the lack of authority.

Corporate.o Shareholders have NO apparent authority to bind the corporation.

Distributive Shares. Partnership.

o Generally on a per capita basis, no partner is entitled to a salary unless otherwise provided in the agreement. Corporate.

o Distributions are made in proportion to stock ownership. Transferability . Partnership.

o No person can become a member of the partnership without the agreement of all the partners, unless otherwise provided.

Corporate.o Shares and shareholder status is freely transferable.

Term . Partnership.

o Normally created for a limited term and dissolution is easy. Any partner may cause at any time a dissolution. Corporate.

o Normally created for a perpetual time and dissolution is relatively difficult. Fiduciary Duties. Partnership.

o Partners stand in a fiduciary duty to one another. Corporate.

o Traditionally, shareholders do not stand in a fiduciary relationship to one another, but this is changing. Liability . Partnership.

o Partners are individually liable for partnership obligations. Corporate.

o Shareholders are not individually liable for corporate obligations.

Shareholder Derivative Action v. Personal Action:

Derivative Action: This is a remedy that allows the shareholder the right to seek redress for wrongs that have been made against the corporation. The shareholder will seek derivative relief.

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It is essentially standing in the shoes of the corporation or acting on its behalf. The shareholder is indirectly affected rather than personally affected.

If the complaint is against directors for assets being misused, breaching of a fiduc duty, self-interest conflict, then it is a wrong to the corp and the shareholder will bring derivative action.

The recovery or relief from the derivative action goes to the corp. The shareholder must jump through certain procedures in order to bring a derivative suit to protect the corp from

abuse of this power. FRCP 23.1: safeguards to derivative actions:

o First requirement: Contemporaneous ownership requirement: you can't buy a lawsuit. You must have owned the shares of stock at the time of the alleged wrongdoing.

Only exception: devolution by operation of law: if you inherit your shares from someone who was a shareholder at the time of the wrongdoing

Some states recognize the right to bring a derivative action as the a part of the bundle of rights of every shareholder. If the jurs sees it as such then every time there is a transfer of stock, that right passes with the stock from transferor to transferee.

o 2nd requirement: demand on directors requirement: under ordinary circumstances b4 a shareholder has standing to bring a derivative action and sue on behalf of corp, the shareholder must seek that action from the board of directors.

Exception: futility exception: there are times when a demand on directors is futile and useless, this happens when they're interested (Donahue). Under these circumstances, this requirement will be excused.

If the directors are not involved and a demand is made on them their good faith decision not to bring a suit, bars the bringing of the action.

o 3rd requirement: Demand on shareholders requirement: in jurisdictions that have this, before you have standing to bring a derivative suit, you must ask the shareholders to bring the action on behalf of the corp.

Each jurisdiction has its own list of exceptions P must allege "and if necessary, that a demand on shareholders has been made" (FRCP23.1)

This brings in what law is applied in these federal actions when the rule says if necessary…

o 4th requirement: Security for expense provisions: Requirement that Ps bringing these actions derivatively have to post security in the even they lose. P has to post a bond so that if he loses then the P has to bear the cost of litigation.

This is in some states, not in federal law. Byrd v Blue Ridge case: if there is a strong federal policy then it will overrule the state law.

Personal Action: This is when a shareholder brings an action in tort for personal relief. The shareholder is not standing in for the corp, but bringing suit on her own behalf. The shareholders is directly

affected. Here, the wrong flows to the shareholder rather than the corp. The recovery or relief from the action goes to the shareholder. This difference is critical. The shareholder does not have to jump through the procedures for a derivative suit.

Valuation:Book Value: This is when you take all of the assets and subtract the liabilities. This gives you the net worth. Then you divide the net worth by the amount of outstanding shares and that gives you the per share value.

Doesn't give you the most accurate determination of value b/c it is like a photo taken, it shows you only what exists at the moment you compute, it does not take into account future earnings of that stock.

Liquidating Value: If have a winding up b/c business is dissolving, you take all assets, sell them off, take care of all liabilities, and then figure out share price. This comes out the same as book value.

Application (a):

1. A SPECIAL DUTY OF THE UTMOST GOOD FAITH AND LOYALTY EXISTS AMONG SHAREHOLDERS OF A CLOSELY-HELD CORPORATION: (Donahue v. Rodd Electrotype).

o Facts: Donahue was a minority shareholder in Rodd Electrotype Co. (D1), a small corporation. Donahue had inherited her shares from her husband, a former employee of the company. Harry Rodd (D2), the former

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president and general manager of the company was the controlling shareholder in Rodd Co. The BOD consisted of Harry’s 2 sons and a lawyer. At a special meeting, the BOD voted to purchase most of Harry’s shares at $800 a share. On hearing these terms, Donahue offered her shares to Rodd Co. for the same price. Rodd Co. refused to buy at $800 a share and offered Donahue a much lower price, $40 to $200 over a 2 year period. Donahue then sued Rodd Co. and Harry, seeking to rescind the purchase of Harry’s shares as a violation of the fiduciary duty owed to her as a minority shareholder.

o Issue: Do stockholders in a close corporation owe each other a fiduciary duty of the utmost good faith and loyalty, similar to the duty that partners in a partnership owe to each other?

o Holding: Yes. The features of a close corporation resemble a partnership where in order for the entity to succeed, the relationship among the owners must be one of trust and absolute loyalty. In general, minority shareholders are vulnerable to oppressive actions by the majority known as “freeze-outs” which can include the refusal to declare dividends, a draining of corporate earnings through exorbitant salaries and bonuses to majority shareholders, and the exclusion of the minority from the corporate offices and employment. Because of the resemblance of a close corporation to a partnership, the court holds that the stockholders of a close corp owe each other a duty of the utmost good faith and loyalty, similar to the duty that partners in a partnership owe to each other. Under this standard, if a controlling stockholder causes the corporation to purchase his shares, the controlling stockholder must also cause the corporation to offer every other stockholder the chance to sell a ratable number of shares to the corporation at an identical price. (Note: normally the controlling stockholder’s stock carries with it a premium which makes is worth more than book value or market value. But here, is it really worth that much more?) Otherwise, the controlling stockholder unfairly benefits from the creation of market for company shares and from the preferential distribution of company assets. Here Rodd Co. is a close corporation and Harry’s family constituted a “controlling group.” Since Donahue was not given an equal opportunity to sell her shares, the controlling group breached its fiduciary duty to her. On remand, the trial court is to enter an order to either rescind the purchase of Harry’s shares or compel Rodd Co. to buy all of Donahue’s shares at the same price paid for Harry’s shares.

o Discussion: The Rodds are using the business as they're own personal asset, they're abusing and exploiting the minority shareholder. They're benefiting self at the expense of others. They're not considering in their actions the community of interest. They're not considering the other's interest in this corp.

o Extra Points Made by the Court :1. The court does not limit this decision to minority shareholders, minority shareholders may do equal

harm. Minority shareholders are watched just as closely as majority shareholders. This is a very important point.

2. Limiting this opinion to the facts. Corporation is a purchaser of this stock, and they say in note that they express no opinion as to the standard of duty applicable to transactions in the shares of the close corp when the corp is not a party to the transaction. If third party is involved in buying the stock, and the minority wants the same deal, the third party can tell them to get lost. Strict fiduc duty when corp is the purchasing party.

3. If the shareholder whose shares were purchased was a member of the controlling group, the controlling shareholders must cause the corp to offer each shareholder an equal opportunity to sell a ratable number of his shares to the corp at an identical price.

o The less harmful alternative standard: when ppl are making decisions whether they be directors or any other group in control, when these groups or directors are making decisions they have to consider options, and the effect of their decisions on minority interests. They're not just allowed to make a decision in good faith and escape accountability, they have to choose the option that creates the least harm on minority interests. Minority shareholders have a right to argue that the majority had an alternative course of action that could have been taken and would have been less harmful to minority interests.

Courts will weigh the business purpose vs the harm to minorities. o Business judgment rule: protects directors accused of wrongdoing. Gives them a shield since they are

vulnerable. All is required that directors make decisions in good faith for the good of the company. 1. Only made available to directors2. In close corporations, directors can not use business judgment rule as a defense. They are not entitled to

it. The discretion available to them is reduced. 3. Caymen v American Express

2. MA APPROACH TO CLOSE CORPORATIONS unified approach. Does not have a number. It's the feeling you get, it’s the fact that it’s a small number of ppl and the fact that most of the shareholders participate in management, direction, and operation of corp. With a small number of shareholders and the fact that majority shareholders are involved in the direction of the business. It is something that could be right for abuse. The majority could easily take advantage of their position and abuse the minority.

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3. Helms v. Duckworth: emphasized the two-man close corp to a partnership: “In an intimate business venture such as this, stockholders of a close corp occupy a position similar to that of joint adventurers and partners. While courts have sometimes declared stockholders ‘do not bear toward each other that same relations of trust and confidence which prevails in partnerships,’ this view ignores the practical realities of the organization and functioning of a small ‘two-man’ corporation organized to carry on a small business enterprise in which the stockholders, directors, and managers are the same persons”

4. Meinhard v. Salmon: “joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Many forms of conduct in a work a day world for those acting at arms length are forbidden for those bound by fiduciary ties. Not honesty alone, but an honor most sensitive, is then the standard of behavior.”

Concept (b): [Special Voting Arrangements at the Shareholder Level]

Ways to Control Corp through Shareholder Voting:1. Proxy Voting2. Voting Agreements3. Voting Trusts 4. Cumulative voting: (used in Ringling Bros)

Side Notes To Be Discussed in More Detail Later: Rights of a partner: rights to specific partnership property right to manage and control right to participate in the profits

Only right that is transferable is the right to participate in profits b/c it doesn’t matter who gets the profits but if you start allowing partners to transfer their rights, then impose on partnership relationship.

One main feature of the transfer of stock in a large corporation is the inability to place absolute restrictions on the sale of stock. They may put reasonable restrictions on the stock such as an offer-back provision where the employee/shareholder must first offer the stock back to the company before selling it to a third party.

It is important to remember that although corporations may not place absolute restrictions on stock, two private persons may enter into an agreement to place an absolute restriction on each others and their own stock. This is b/c of the freedom of contracts.

Proxy Voting: Proxy voting allows shareholders to vote on certain matters prior to a meeting or assign the voting right to another person who will be present at the meeting. In our class, assigning the voting right to another is the most prevalent for of proxy voting.

Traditionally, proxy voting is treated as an agency relationship. The shareholder is the principal and the proxy is the agent. This means that the relationship may be terminated at any time by either the principal or the agent.

Proxy Coupled with an Interest/Agent Couple with an Interest : This occurs when the proxy, the person voting on behalf of the shareholder, also has their own interest in the corporation. This may occur if the proxy is another shareholder or a group of shareholders.

o This type of proxy provides the one exception to the agency termination rule. This type of proxy is irrevocable.

o Under this type, the proxy holder is executing the proxy power on behalf of the shareholder and on behalf of himself.

Where a proxy is given pursuant to a voting agreement, normally the proxy holder is either an arbitrator, who has no proprietary interest in the corporation, or a shareholder, who has a proprietary interest in the corporation but not in the shares that are the subject matter of the proxy.

Voting Agreements: (aka Shareholders Agreements/Pooling Agreements): This is when a group of shareholders (two or more) make an agreement among one another to vote as a unit on a corporate issue or on all matters. Some agreements expressly provide how votes will be cast while other agreements merely commit the parties to vote together. Generally, such agreements are designed to maintain control of the corporation and prevent others from gaining control.

Voting agreements will almost always be upheld by the court. Usually the agreement provides for an arbitrator or third party to make a decision when one cannot be made between the parties subject to the agreement. However, how they are upheld is split between two theories.

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o The court may specifically enforce the agreement by either having a proxy (the arbitrator) or a proxy coupled with an interest (the winning party) cast the votes of the dissenters in favor of the arbitrator’s decision. However, many courts do not feel comfortable having any type of proxy vote for the dissenting shareholders b/c it resembles a voting trust which requires certain formalities not present here.

o The court will recognize the agreement but negatively enforce the agreement rather than specifically enforce the agreement. Under this theory, the dissenters’ votes won’t be counted at all. The problem with this theory is that it may contradict the purpose of the voting agreement by allowing shareholders not subject to the agreement to win the corporate issue or elect more directors. The purpose of the agreement is for control which is given up when one shareholder’s votes are not counted.

The corporation may be able to restrict the use of voting agreements if the statute is permissive rather than mandatory. However, if the statute states that a corp must provide for voting agreements, then it is mandatory, and the corp cannot refuse. The corporation may also allow voting agreements by putting it in their art. of org. This is public record and therefore everyone knows they can do it. If a restriction is allowed on voting agreements, it must be in a conspicuous place such as on the certificate of stock or in the art. of org. If the restriction is in the by-laws it will not be upheld b/c the by-laws are not a public record and therefore does not put shareholders on notice of this restriction.

Voting Trusts: This is when shareholders place their shares in a trust and the trustee then votes the shares for the benefit of the beneficiary. The trustee now has legal title and voting rights and the beneficiaries, or shareholders, have equitable title so they still receive dividends and so forth. The trust is funded with the shares. Similar to voting agreements, voting trusts are designed to maintain control of the corporation and prevent others from gaining control.

A voting trust is a form of a pooling agreement. Most states have statutes which explicitly validate voting trusts and provide strict requirements for their creation and

content. This is true in Delaware. Mass. allows for voting trusts but does not require any formalities. Usually 2 or more shareholders are involved, so that the voting trust is a type of pooling agreement. Sometimes,

however, only one shareholder is involved – for example, where a sole shareholder created a voting trust to satisfy creditors, or to vest control of his business to managers.

Requirements for a Voting Trust :o Maximum Term. A maximum term must be set within the voting trust agreement. Most states require that a

voting trust last no longer than 10 years.o Disclosure. The voting trust must be filed with the corporation and be available for inspection. The main

reason for this is for other shareholders and the corporation to know who has voting power. A record is kept with all voting shareholders. If the voting trust was not filed with the corp, the shareholders names subject to the trust would still be listed as the ones holding the voting power while in truth, the trustee holds the voting power. Therefore by filing the voting trust agreement, the record will reflect the trustee as having the voting power in case a shareholder or the corp would like to contact them regarding their voting power.

o Writing. The creation of a voting trust normally requires the execution of a written trust agreement btw participating shareholders and the voting trustees.

Termination : Upon termination of the voting trust, the shareholders will receive their stock certificates back and be reinstated as complete owners by registering them as such on the corporation’s record book.

Courts are more comfortable with these types of voting powers b/c the trustees are held to a high fiduciary duty being trustees anyway so not as much room for abuse as there is in third party/arbitrators deciding a tie breaker in a voting agreement issue.

Cumulative Voting: This is when a shareholder gathers up all of their shares and put them towards whomever they want rather than having to vote for each seat available. For example: A has 60x3 shares and B has 40x3 shares to fill 3 seats. In a straight line voting, A would be able to pick all of the directors. Under cumulative voting, B, who gets 120 votes b/c there are three seats to fill could cast all his votes for one director in order to be able to elect one of the three. This topic was also discussed earlier in the outline if need further explanation.

Application (b):

1. SHAREHOLDER VOTE-POOLING AGREEMENTS ARE NOT AUTOMATICALLY UNLAWFUL: (Ringling Bros. v. Ringling).

o Facts: The stock was divided by three people, Ringling (R), Haley (H), and North (N). R and H owned 315 shares each and N owned 375 shares. Board had seven directors. R and H execute a mutual agreement to act jointly in exercising corporate voting rights in order to be able to control the election of 5 out of the 7 board members.

Provisions in agreement:

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Offer-back provision : R and H agreed to offer their stock to the other before selling the stock to a third party if they decided they wanted to sell. This will be upheld. This agreement could have provided for absolute restraints on transfer b/c this is a private agreement.

Pooling agreement : R and H agree to consult with each other and vote jointly as to the directors they agreed upon.

Third party makes decision if they don’t agree : Mr. Loose, the person who drafted the agreement, makes the decision for R and H if they don’t agree. R and H could use an arbitration panel or anybody they want. They chose Mr. Loose.

R and H couldn’t agree on a candidate to fill one of the positions on the board. One wants to adjourn meeting to give them time to agree while other says they had enough time. Mr. Loose (the arbitrator) is then dragged into it to determine whether to adjourn the meeting. They present their sides to him. R voted for one set of directors and Mr. Loose directed H to vote in a way that would elect those directors. Instead, H attempted to vote in a way that would benefit N’s slate of directors. The problem with this agreement is that neither party made contingency plans if one decides, after hearing Mr. Loose’s decision that they still don’t want to follow it so there is no direction as to what the party should do. Mr. Loose says take this action. One of the parties still disagrees. However, Mr. Loose can’t cast their votes for them or allow the person agreeing with the arbitrator to cast the votes for the two parties. There should have been a provision either allowing the arbitrator to cast votes on behalf of the disagreeing party in favor of his decision and agreeing party. In doing so, Mr. Loose would become a proxy and an agent. Consent for the agency would be in the memorandum of agreement or implied based on agreement. Mr. Loose voting in favor of his decision would be specific performance of the agreement. If agreement said to flip coin if didn’t agree rather than Mr. Loose decide, then there should be a provision providing that the winning party would cast the losing party’s votes. Now the winning party becomes a proxy and therefore an agent. However, the winning party and dissenter have an interest in the outcome and therefore is a proxy coupled with an interest or an agent coupled with an interest. Under an agency/proxy coupled with an interest, the agency would be irrevocable. This is an exception to the general rule that agencies may be terminated at any time by either the principal or the agent. The Chancery court ruled that the agreement btw R and H gave the arbitrator an implied and irrevocable proxy to vote their shares as he determined. It ordered a new election where H would be required to vote according to the direction of the arbitrator.

o Issue: Is a vote pooling agreement among shareholders automatically unlawful?o Holding: No. The Court has Three Possibilities on how to handle case:

1. Proxy : Allow outside source/arbitrator/Mr. Loose to cast votes as an agent in place of dissenter for the winning position

2. Proxy Coupled with an Interest : Allow the winning signatory (R or H), to cast the losing parties votes. 3. Do not Specifically Enforce Agreement : In this situation, the court will negatively enforce the agreement

by not counting the votes of the dissenter at all. Court chose # 3 b/c the court was uncomfortable applying proxies. The court recognized the validity of agreement but not comfortable with creating proxies either with Mr. Loose or the other party to the agreement. However, ultimately, this doesn’t help either R or H b/c now N gets to choose more people which disturbs the balance of what they tried to achieve.

o Decision and Rationale: H contends that the voting agreement in this case is really a disguised voting trust which must meet certain Delaware statutory requirements in order to be enforced, such as the actual conveyance of legal title to the shares to the voting trustee. H argues that the agreement she signed does not meet those statutory requirements and therefore cannot be enforced. The court thinks that the voting trust statute does not apply and that, in general, a vote pooling agreement among shareholders is not unlawful. Traditionally, shareholders have been permitted to exercise wide discretion in corporate voting. It is not legally objectionable if the sharheolder’s motives in casting a vote are for personal profit or based purely on whim, so long as the shareholder is not violating any duty owed to the other shareholders of the company. In fact, there is not requirement that a shareholder vote at all. A group of shareholders, then, can properly vote their shares so as to obtain the advantage of joint action. They can lawfully contract with each other vote in the future in such a way as they or a majority of their group determine is appropriate. Legal consideration for such an agreement is found in the mutual promises of the shareholders in the group. Here, the agreement to act according to the decision of the arbitrator is valid. The arbitrator’s good faith has not been challenged and the record indicates he acted in good faith. H breached the contract by not voting in accordance with the arbitrator’s direction. The court does not however, agree with the Chancery Court that the election should be held again. The agreement here did not create an implied and irrevocable proxy permitting the arbitrator to cast any votes. N was not a party to the vote pooling agreement and did not do anything wrong at the shareholder’s meeting. Instead of a new election, the court holds that H’s votes should not be counted.

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2. OVERLAP OF VOTING TRUSTS AND SHAREHOLDERS’ VOTING AGREEMENTS: (Abercrombie v. Davies).o Facts: This is a case where they didn't use a trust. They used a lawyer device, that's used all the time: escrow:

basic property concept. Lawyer holds the funds in escrow. Escrow: a physical surrender of stock to escrow agents, they took the certificate of stock and endorsed them, they also used proxies, which ran to the escrow agents, allowing the escrow agents to vote the share of stock. The escrow agent was given the right to vote the shares and the shares were to be voted as a unit. Escrow agents could at any time transfer it to a voting trust. The message: it's not a voting trust. Someone challenged the validity of this agreement, and said it was a secret voting trust.

o Holding: Although it didn't say it was a trust and they tried to stay away from trust terminology, they are the nuts and bolts of what a trust actually is. The court said this agreement is nothing more than a voting trust, its secret and is therefore invalid.

3. NOTE ON CLASSIFIED STOCK: a voting agreement can consist of creating a new class of stock with just voting rights. That is a valid provision in a voting agreement.

Concept (c): [Agreements Controlling Matters Within the Board’s Discretion]

In a small closely held corporation, a shareholder agreement providing that the shareholders would use their best efforts for the purpose of voting themselves in as directors and keeping them as directors is valid as long as it does not go beyond this. There are limitations to shareholder agreements when the management of a corporation is at risk. In a large corporation, this type of shareholders agreement might create a problem. There must be a safety valve in the agreement in case one of the directors is causing havoc within the corporation b/c the shareholders can not re-elect or continue to allow a director who is no longer managing the corporation correctly. This is so b/c the directors and shareholders have a fiduc duty to the corporation itself.

However, a shareholders agreement which provides for the same and then continues on to provide for those shareholders now directors to also vote themselves into officer positions is taking it too far and is beyond the limitations of a shareholders agreement if it is made between majority shareholders without any acceptance from minority shareholders. See the following cases.

o This is a shareholder/directors agreement, this is one that seeks to operate not only at shareholder level but seeks also to operate at the directors level

These agreements are always suspect b/c they seek to tie the hands of the board in the performance of their management functions and the board is supposed to be acting in the best interest of the entire corporate community (including minority shareholders and creditors).

Anything that ties the hands of the directors is suspect. Agreements that go this one stop further.

Application (c):

1. NEW YORK COURT OF APPEALS HOLDS THAT A SHAREHOLDER AGREEMENT PURPORTING TO RESTRICT THE SHAREHOLDERS’ POWERS AS DIRECTORS IS UNENFORCEABLE, EVEN IN A CLOSE CORPORATION: (McQuade v. Stoneham).

o Facts: Stoneham was a majority shareholder of the close corporation. Stoneham sold a minority stake in the franchise to McGraw and McQuade. As part of the stock sale, the three men entered into an agreement that they would each use their best efforts to maintain each other as directors and officers of the corporation. For six years, all three men served on the board of directors and as paid corporate officers. (Where as Ringling decided lets combine for purposes of electing directors, they say here, lets elect ourselves as directors, and lets elect each other to fulfill officers positions.) After a disagreement btw McQuade and Stoneham, Stoneham and McGraw refused to vote for McQuade’s re-election as a corporate officer and McQuade was not elected. He was later dropped from the BOD as well. McQuade sued for breach of K, seeking reinstatement as an officer and a director. The trial and appellate court both refused the reinstatement remedy, but gave McQuade damages for wrongful discharge.

o Issue: Is an agreement among shareholders of a corporation to restrict their discretion as directors of the corporation valid and enforceable?

o Holding: No. While shareholders can unite to elect directors, they cannot unite to limit the power of elected directors to manage the business according to their best judgment. When directors are choosing officers they are supposed to not pick themselves, but the most qualified people, they owe that duty to the corporation as a whole, including minority shareholders. Here, Stoneham and McGraw were not trustees for McQuade as an individual. Their duty as directors was to exercise their lawful judgment for the benefit of the corporation and all of its

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stockholders. To the extent it attempts to restrict a BOD from changing officers, salaries, or other corporate policies, a K violates public policy and is illegal.

o Analysis: This court finds that the traditional notion that a corporate director owes a fiduciary duty of undivided loyalty to the corporation should apply in all circumstances, even in the special context of a closely held corporation, to prevent any shareholder agreement attempting to limit a shareholder’s discretion as a director.

o Note: In a close corp, if there is unanimous shareholder approval to elect a certain person as an officer then it will be upheld as long as there is no damage to anyone, including the public and creditors. "All shareholders by their universal consent can do what they want with the corp. provided that creditors are not effected." Therefore an otherwise illegal contract/agreement btw shareholders that protracts the powers of the board of directors will be upheld when there is no damage to the public or creditors. The court will consider the illegality of usurping the powers of the board negligible. Remember that this has a lot to do with fact that closely held corps are in there own class b/c considered an incorporated partnership so they are allowed to deviate from the statutory norms for corps in some situations.

2. IF THE ENFORCEMENT OF A K THAT LIMITS THE POWERS OF DIRECTORS DOES NOT DAMAGE THE PUBLIC OR THE CREDITORS THEN IT SHOULD NOT BE ILLEGAL: (Clark v. Dodge).

o Facts: Fact pattern involving the only 2 shareholders of this corporation. Agreement was that the P would be retained as director (typical Ringling Bros agreement) and as general manager. Management function, that's a function that the board oversees. By this agreement, P and D say forget about the board, P will be the manager and also agree as to the salary of manager. This is usually a function that the board controls. P brings this action saying he can't be ousted and then produces this shareholder/director agreement.

o Holding: the court holds this agreement to be valid, it discusses the public policy and says its not effected. This ruling results in the no damages test: another way of saying nobody cares, if the enforcement of a particular K damages nobody, not even the public, the K should not be illegal even if it does detract somewhat from the power of directors.

What if it detracts significantly from the powers of directors? Prof: don't know. The test is predicated factually on the proposition that all shareholders by their universal consent are in agreement.

o Clark v. Dodge does NOT stand for the proposition that any infringement on the board of directors by unanimous shareholders agreement will be upheld if no one is hurt including the public and the creditors. It only pertains to negligible infringements/slight infringements on the board. If there is a major infringement/major detraction on the powers of the board, then the no damage test DOES NOT APPLY and the agreement will NOT be upheld.

3. IF THE ENFORCEMENT OF A K SIGINIFICANTLY LIMITS THE POWERS OF DIRECTORS BUT DOES NOT DAMAGE THE PUBLIC, THE K IS STILL ILLEGAL: (Long Park v. Trenton Theatre).

o Facts: All shareholders get together and agree (shareholders/directors agreement) that as directors, they are not going to get involved with the directing of the company. They couldn’t be bothered with it. They contracted with professional managers to come in and manage the corp. The directors did not interfere with the management companies running of the company for nineteen years. There was no oversight, power of review, just told them to manage it for 19 years and don’t bother us.

o Issue: There was no damage to the public or the creditors, so is the unanimous shareholder’s agreement valid under Clark v. Dodge?

o Holding: NO. This is major detraction, no functioning of company by directors for 19 years. You can’t have a board of directors that abdicate their powers; they may delegate but not abdicate. Even when they delegate powers, they still need to be able to review actions of those the jobs were delegated to. They would still need reporting mechanisms, and some way to review work of managing company. This is clearly a violation of statutory norm that goes beyond slight infringement and therefore the agreement is invalid and unenforceable.

o POINT: In a close corp, you can treat it like an incorp partnership and tailor the corp to meet the needs of the individuals and the specifics of the business but still must pay attention to the corp statute. You may deviate from it but cannot go too far. Slight deviations are allowable particularly if no one is affected especially if everyone has agreed, all by their universal consent, BUT you have to always keep in mind cases like Long Park v. Trenton, just b/c everyone agrees does not mean you can completely turn back on corp statute.

4. IN CLASS DISCUSSION Give advice: Describe to a client the effect of shareholder agreements even those that infringe on the powers of directors.

o Describe the no damage test -- you have some wiggle room. And the wiggle room is what defines how much the public will be affected.

o Prof : You can make agreements as shareholders. This is like an onion, where you peel the layers away, that’s what happens in these agreements. One of the things you have to do is you have to ask whose acting, in close corps its impt to see what hat ppl are wearing. In a closely held corp ppl tend to be all the same, there's this stew

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pot and they're all acting in different capacities. In shareholder agreements they are acting as shareholders. Their function is to act with respect to electing and removing directors, public policy. If a few ppl want to join forces, they can. The unity can allow ppl to choose ppl on the board, even yourself (Ringling in my corner). You will run into trouble if you go beyond shareholder level and you try to effect decisions that are ordinarily made by the board level in which they make management decisions. Management - don't assume you know what that means. Management could mean choosing officers, hiring and firing, choosing authority but don't know how far that goes. In this context it means doing what corp directors are charged to do, in this setting, it is the previously listed. Impinge on the powers of directors and then under the no damages test, your agreement will be ok. That is assuming the creditors aren't involved and the shareholders and public aren't involved b/c the statute is still intact. The public is ok, b/c there is only a slight impingement, not substantial. And shareholders are ok b/c they're all aboard. In real life, ppl need some direction. The client needs closure, needs opinion. You as a lawyer will be reluctant, but prepared to give your opinion. This will probably be upheld, no guarantees.

5. ILLINOIS SUPREME COURT ADOPTS MODERN VIEW AND UPHOLDS SHAREHOLDER AGREEMENT LIMITING DIRECTOR DISCRETION: (Galler v. Galler).

o Facts: Two brothers and their wives were shareholders in this duly incorporated business. They all signed a shareholder agreement which allows for a salary continuation to either spouse if the other dies. (This allows the salary of a deceased brother to continue to be made to the surviving widow.) It also allowed for a declaration of dividends to the widow (a payout of dividends). One of the brothers died and the other refused to honor the agreement. The brother made two arguments 1) that the continuation of the salary was ultra vires b/c it is ultimately a gift to a surviving spouse which is not allowed under the corp statutes and 2) since corp gifts are the giving away of corp assets and not within the domain of business corps, the gift constitutes corporate waste and 3) the shareholder agreement was actually a shareholder/director agreement b/c it usurped the power of the board of directors by forcing the board to declare dividends when that type of decision is solely within the discretion of the board, dividends must not come out of capital and declaration of dividends must not violate provisions of art of org or any contract with creditors. Declaring dividends is strictly regulated by the corp statute.

o Issue: Are there circumstances where a shareholder agreement limiting the discretion of the BOD of a close corporation will be upheld?

o Holding: Yes. Court upholds shareholder agreement. This is a modern day application of the no damage test. The court holds that b/c it is a close corp, all of the shareholders agreed, and there was no damage to anyone, including the public or creditors, then the agreement will be valid. The court recognizes that the agreement usurps a power solely within the board’s discretion and agree that the continuation of salary is ultra vires under the corp statute, however, b/c of the circumstances, and the fact that this would be considered a slight infringement, they will uphold the agreement. The purpose of the agreement was to make sure a family was taken care of if one spouse died and that is legitimate in a closely held corp.

o Difference with a publicly held corporation: We think that special rules, not applicable to publicly held corps, should apply to shareholder agreements in a close corp context. A shareholder of a publicly held corp generally has a ready market for his shares and can sell them if he disagrees with the way management is operating the business. A minority shareholder in a close corp, however, has no ready market for his shares, and may find himself at the mercy of an oppressive and unknowledgeable majority, if he cannot rely on a shareholder agreement to protect his interest. As in this case, the shareholders of a close corp are often also the directors and officers of the company. Thus, unlike a publicly held corp, in a close corp, with the directors and officers often having a major financial interest in the company, it is often impossible to obtain a truly neutral, independent judgment of the BOD. In our view, these conceptual differences btw a close corp and a publicly held corp justify permitted the shareholders of a close corp to reach agreements concerning its management. We will uphold such agreements where no minority shareholder is prejudiced, there is no fraud or injury to a corporate creditor or the public, and no clearly prohibitory statutory language is violated by their enforcement. Here, those conditions are met. No shareholder who was not a party to the agreement has claimed injury as a result of the proposed enforcement of the agreement.

Concept (d): [Supermajority Voting and Quorum Requirements at the Shareholder and Board Levels]

Today, a closely held corp can require unanimous shareholder approval of any corporate action if the shareholders all agree to it. Before, the court would strike down a provision requiring unanimous shareholder approval of a corporate action even if it was unanimously adopted by the shareholders. This is b/c they said it was against the statutory norm and goes to far. The statute only required a majority vote and that is the maximum the corporation could require. However, once the court decided this case, NY changed its statute through the legislature to allow for unanimous shareholder approval of corporate actions when all of the shareholders have agreed to do so. Court today will recognize and uphold such agreements/requirements.

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Application (d):

1. NEW YORK COURT OF APPEALS FINDS IT TAKES SHAREHOLDER UNANIMITY TO STRIKE A UNANIMITY PROVISION FROM A CORPORATION’S CERTIFICATE OF INCORPORATION: (Sutton v. Sutton).

o Facts: P1 and P2 owned 70% of the outstanding stock of a close corporation. The other 30% of the corp was owned by David. The corp’s certificate of incorporation included a unanimity provision which provided that all of the shareholders of the corporation had to agree on any corporate business transactions, including the amendment of the certificate of the incorporation. P1 and P2 sued to compel David to sign an amendment to the corporation’s certificate of incorporation striking a provision requiring unanimous shareholder approval, including for any amendment of the certificate.

o Issue: May the unanimity provision of a corporation’s certificate of incorporation be amended by a less than unanimous vote of the shareholders of the corporation?

o Holding: No. Court said cannot compel the minority to do so. The statute now permits unanimous voting provisions and specifically that the supermajority provision in the articles of org may be amended by a 2/3 vote unless the articles “specifically provides otherwise” as it does here.

2. MA STATUTE 7.32 deal with shareholder agreements: any agreement that complies with this section is effective even though it is inconsistent with other sections of the statute, it allows deviations from the statute

o Allows you to eliminate the BOD in a corp -- significant o Agreements can determine who will be directors of officers of the corpo Term of officeo Selection and removal of officerso Can effect the voting power by shareholder agreemento Can effect the powers of shareholderso The relationship btw and among shareholders7.32 - conditions that need to be produced b4 these agreements are allowed

Agreements shall be set forth in articles of assoc and the agreements must be approved by all persons who are SH at time of agreement

This calls for a unanimous shareholder approval - they are talking about voting and non voting shareholders b/c these changes are fundamental corp changes and everyone is allowed to have a part in this change

They are valid for 10 years They have to be noted in a particular way on the back or front of stock certificate If someone takes stock that isn't noted the way its supposed to be the transferee can rescind the

transfer3. PRACTICE EXAM QUESTION FROM OTHER OUTLINE: “Small # of shareholders all involved in

management”=closed corp. Duly formed corp= no question about whether they were correctly formed as a corp. At inception of the corporation they (shareholders) all agreed in writing=shareholder agreement. Do they have to be in writing? No, the statute does not require it but they should be. Agreed in writing to “always decide as a unit on any matters to come before us.” They are shareholders, officers and directors…there is no one else, just them. Shareholder/director agreements-covers everybody. Is that benetendi or Sutton? Unanimous vote requirement? This applies to shareholder and director voting. No, doesn’t say unanimous, says they should decide as a unit. What does that mean? Two positions: 1) Unit synonymous with unanimous (purpose of agreement is control which can’t happen with disagreement) 2) all it requires is that they all come together at one time and place to make decisions but normal process of corp democracy will apply-majority approval. This will be a problem for us b/c two different positions. If unanimous at shareholder level, might be able to sneak it in with Sutton case but unanimous vote requirement at directors level could mean that nothing would get done, there would be a stalemate and no corp action would ever take place. “The ABCO art of org contain the following ‘no stock should be sold to or transferred unless first offered to abco corp, if abco corp decides to acquire the stock, should pay price at which stock was first issued, abco should notify offeror within 30 days if they want to buy it.’” This is a stock restriction.

Concept (e): [Valuation]

MERGERS:

Definition: When one company merges into the other. The ones that merges disappears and the one it is merging into survives. A+B corp=A corp.

They can assume a different name. Page 50 of 72

Consolidation: Consolidation is not a merger. Consolidation is when two companies join together but do not merge. A+B=C corp.

Acquisition: This is when one corp acquires another. How would A corp acquire B corp? A corp buys B corp’s assets. Then A can do what it wants with the business. It

could maintain it as a separate operating company, it could restructure it to become a subsidiary, or it could merger. Not all of these actions must be followed by a merger.

How does A corp pay for acquired assets? Could pay for it with cash or could pay for it in A corp stock. For example, give B shareholders A corp stock in place of their existing B corp stock. This is called a stock for stock deal.

o Buying the B corp with cash is the simplest way to acquire the corp. However, there are severe tax consequences for doing so, so it will not be the first way A corp tries to buy B corp. See discussion below.

Requirements for Acquisition:The shareholders of B must approve this transaction. In every corp statute, says if you are contemplating a sale of all or

substantially all of the assets of a corp, you have to have shareholder approval. You have to have a super majority approval, either ¾ or 2/3. Not only that, approval is of all shareholders, not just voting shareholders.

If you are a dissenter (i.e. don’t want acquisition to occur), then you have appraisal rights, rights to be bought out.

Ways to Structure Acquisition in Order to Avoid Tax Consequences:There are three types of mergers that may take place: These names are based on what subsection they are found in, in the section of the Internal Revenue Code (IRC).

C Type Merger: Selling the business, its assets and liabilities for A corp stock as payment rather than cash. In other words, when we buy B corp and transfer the assets and liabilities, instead of paying cash with taxable consequences, pay for B corp in stock. B’s assets get sold to A and A pays for it in stock and then the stock is subsequently distributed to the B corp’s shareholders. Assets for stock transfer is a non taxable transfer. The B corp is friendly in this scenario and wants to sell.Must get approval from A corp and B corp shareholders.

A Type Merger(aka Statutory Merger): This is a stock for stock exchange. In this kind of transaction, stock in B corp is exchanged for stock in A corp. B corp goes to shareholders and says, we are proposing a merger, get approval, then have them turn in stock and at end of transaction, you will be given back, in exchange, stock in A corp. Stock for stock transfer is a non taxable transfer.The B corp is friendly in this scenario and wants to exchange.Must get approval of A corp and B corp shareholders.

B Type Merger: This is when A corp bypasses the B corp directors all together and deals directly with the shareholders to buy out their shares with stock. If they buy the shares with cash, it is taxable and does not comply with subsection B and therefore would not be considered of this type.This usually occurs b/c B corp does not want to sell and is therefore not cooperating with A corp. A corp could

choose to forget about B corp OR they could try to acquire B corp by buying a majority of the shares directly through the shareholders.

Hostile Takeover: This type of merger is sometimes called a hostile takeover b/c A corp is trying to acquire B corp when they don’t have their cooperation.

Procedure: A corp goes around to shareholders of B corp and says “we are interested in buying your stock, do you want to sell?” In smaller corp, can do it face to face. In large corp, can’t do it face to face so large scale transaction involved. Approach people through actually notifying shareholders and/or notifying them constructively through newspaper advertisements. The notification extends an invitation to shareholders to offer up their shares. This is called tender offers (tend their shares). Tender offers: Offering shareholders to tender their shares to A corp through constructive or actual notice.

Tender offers are highly regulated by state and fed govts. Tender offers are very conditional. A corp doesn’t want a thousand shares out of billions, they want

enough to become a controlling shareholders (i.e. 51%). Therefore A corp will usually condition the tender on them getting a specific amount of stock by a specific date.

There is usually a price offered along with the previous condition. A corp can pay for this stock in cash (i.e. shareholder tenders these shares for cash (taxable and not

a B type merger)) or comply with subsection b of IRC and conduct a stock for stock transaction.

Delaware Block Approach: Under this approach, the value of shares of stock or value of business is determined by looking at three different things:

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1. Market value of stock if there is a market value. The market value of a closely held corp is difficult to determine b/c of the lack of trading on an open market. In some closely held corps there are small transfers of stock in a face to face transaction and these values can be used to determine the market value.

If a merger is occurring, it may affect the stock so you should only look at transaction or market value pre-merger and even pre-announcement of possible merger b/c of that effect.

2. Asset valuation . This is very subjective and largely a matter of who is doing the valuation and for what purposes it is being conducted. Must take into account depreciation. There are several ways to value both tangible and intangible assets of a corporation such as:

Tangible Assets: Things you can see, touch, and feel.o Net Asset Value: This is the assets minus the liabilityo Book Value: This is the cost of buying it in the first place minus depreciation (i.e. a car).o Liquidation Value: Value of all assets if sold on open marketo Reproduction Cost: The cost to reproduce the asset minus depreciationo Replacement Cost: Cost to obtain a replacement in the open marketo Present Usable Value: How much it is worth to people to use it.

Intangible Assets: Accounts, good will, fungible items, future worth to the shareholdero Income capitalization (aka earnings value). Deals with the present and future value of the corp to the

shareholder. The value retained by the shareholder and likely reason he purchased it in the first place.o Intangible assets are very difficult to value.

3. Earnings value of business : This is the most difficult element. The expectation of income from this business. This element is not static b/c part of the value has to do with what it will be worth in the future. The willingness of the buyer to take a risk in the future of the business.

Dewing Formula : This formula take into account factors which affect future earning capacity. The future earning capacity is based upon two things: 1) looking to the past and 2) and projecting the past performance into the future.

o So for the first part, look at earnings over the past five years or look at the earnings per share over the past five years and average them out.

o Now projecting them to future: how likely is it that those earnings will be attainable in the future and how long can we be assured that they will continue? The baseline is predicated on the preceding five years. Now look at the following factors:

How risky is this business? If something were to go wrong, how affected would the business be? Some businesses earnings represent the entire value of the business, that means, that the business per se has very little value.

For example, if you have a solo law firm and the lawyer dies, the business is likely to go under in a year b/c the lawyer was the business. This type of business has little value and the percentage of the value of the business is 100% which means the capitalization rate is 1. Therefore the capitalization rate, rate it would take to recoup capital (i.e. investment) would be one year. This rate is called the discount rate. In other words, the investor is not that reassured that the business will do well for a long period of time which means more risk.

On the other hand, a large corporation like GE has been around forever and has large capital assets, excellent good will, and solid stable fortune 500 company. Buyer would be more willing to hang on for awhile b/c in these businesses, the value and earnings are likely to continue. Earnings represent a percentage of the value of the business and it is a small percentage, the business unto itself is a valuable thing. So the percentage of the value of the business would be 10%. Which translates to the reasonably prudent buyer can hang around for at least 10 years and recoup his or her investment with some relative assurance that there are minimal risks and there will be a reflection of the earnings of the past into the future. They are older, stable, less effected by general conditions and changes in personnel and ownership.

So capitalization rate for a business easily affected and worth less is 1 while steady businesses which are not as effected by outside events is 10. These are the two extremes.

Once you take all of these into account, the court will give each of these three determiners a percentage value. In other words, what weight should they be given in determining the business’ value and thereby determining the value of each individual’s shares. Once that is determined, then you know the value of the dissenting shareholder’s stock.

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Application (e):

1. MA HIGH COURT ACCEPTS TRIAL COURT’S USE OF THE “DELAWARE BLOCK METHOD” OF STOCK APPRAISAL: (Piemonte v. New Boston Garden Corp).

o Facts: This was a closely held corp so not ready market for the shares. Shareholder dissented to an A Type merger (stock for stock swap) and sought to sell out his shares to the corp under his appraisal rights. However, he sought a court supervised valuation of the share value b/c of the threat of corporate abuse. Court viewed the business as an old established business, and thus more attractive to willing investors. They used the Delaware Block Approach and under Earnings Value of Business, determined the capitalization rate was 10% and therefore an investor could wait 10 years to recoup his investment. Under the asset valuation, a little trading had been done and the last shares were sold for $26.50 (before announcement of merger). Everything else was done according to the Delaware Block Approach and came out with a value sufficient for the court to uphold.

o Issue: Is the Delaware Block Approach an acceptable procedure for valuing corporate stock under an appraisal statute allowing shareholders to opt out of a merger approved by the majority of the shareholders of the corporation?

o Holding: Yes. MA law permits the appraisal of the stock of the shareholders who opt out of a merger approved by the majority of the shareholders of the corporation. The MA provisions were based on similar Delaware statutory law and thus MA courts are permitted to use the Delaware Block Approach as well.

2. NOTE: Today, the Delaware Block Method has fallen out of favor and the trend is to use the valuation methodologies that are in use by the financial community at the relevant time.

Concept (f): [Restrictions on the Transferability of Shares, and Mandatory-Sale Provisions]

Black Letter Law: Stock in a business corporation is freely transferable. This section says that you can alter that. There are conditions that have to be complied with in restrictions. You restrict to control.

In private agreements between shareholders, shareholders can restrict the sale of stock any way they want. Freedom of contract. The shareholders can impose restrictions at the shareholder level by a shareholder agreement.

When the corporation is imposing the restrictions, stock is viewed as property, and therefore the corporation may not impose unreasonable restrictions on the alienation (transferability) of the stock. This is where problems arise.

o What is an unreasonable restriction? (FBI Farms v. Moore) The incidence of corporations imposing stock restrictions is much more prevalent in closely held corporations than

large corporations b/c in closely held corps, they want shareholders with whom they have personal relationships with and therefore they don’t want the shares to be sold to just anyone.

These restrictions can be found in a private agreement between shareholders, in the articles of organization, the by-laws, or through a shareholders vote.

Questions to Ask to Determine whether Stock Restriction Valid: Is stock restriction valid?

o If imposed by private agreement, it is fine. o If corporate imposement, is it reasonable? Reasonable if used to accomplish a corp end such as one designed to

keep control of a corp or something dealing with the personal nature of the business then it probably will be able to stand up under reasonableness inspection.

o In Mass., they recognize distinctions between restrictions at private level and those at corp level and understand standard of reasonableness when imposed at corp level but they make standard of reasonableness slightly different than anywhere else. In Mass., the stock restriction will be held valid unless it is palpably unreasonable. So use qualified reasonableness standard by adding “palpably.” This means it must be obviously unreasonable.

Is the restriction effective against third party transferees? o UCC 8-204 says a restriction imposed by the issuer (corp), even though otherwise lawful (passes validity test) is

ineffective against a person except with ACTUAL knowledge of it. o Article 8 requires corp to note it conspicuously which means it must be either 1) referred to and reprinted in full

on face of certificate 2) referred to and reprinted in full on back of certificate or 3) referred to and copy of restriction will be furnished by corp upon request. In mass, must reprint it in its entirety somewhere on the certificate. If reprinted on back, must be referred to on front.

If invalid on first one, strike it out and don’t get to second question. If valid, then go on to second question. Whether or not the restriction is effective against the transferor depends on when the stockholder acquired the stock.

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o If the stockholder obtains the stock after the restriction has been imposed by the corp, then it depends on where the restriction is contained. If in the art of org, then stockholder is deemed to have constructive notice. If imposed through by-laws or elsewhere, there is a question of fact as to whether the shareholder ought to be charged with notice. See notice above under third party transferees.

o If restriction is imposed after the shareholder obtains the stock, the shareholder is not bound by it.

Different Forms of Restrictions:Different forms of restrictions and are all control devices. Control devices: proxies, proxies coupled with an interest,

voting trusts, pooling agreements, and restrictions. The others were discussed earlier. Three basic types of restrictions are commonly used in the context of the close corporation:

1. First refusal : Prohibits a sale of stock unless the shares have been first offered to the corp (corp imposed restriction) or other shareholders (if privately imposed restriction) or both.

It is often required to be at the same price and terms as offered to others rather than a stated formula. Note that these restrictions can be VERY broad “sell, transfer, or otherwise dispose of stock.” This is the least restrictive in its impact on a shareholder who wants to sell his stock b/c get price that others are

willing to pay and such provisions are widely upheld.2. First option : Prohibits the transfer of stock unless the shares have been offered to the corporation, the other shareholders,

or both at a price fixed under the terms of the option. Basically same thing as first refusal except there is a fixed price in this restriction. The first option restriction

stipulates a price-it is a price fixed. The restrictiveness on the relationship depends upon the difference between the option price and a fair price at the

time the option is triggered. 3. Consent restraint : Prohibits a transfer of stock without the permission of the corporation’s board of directors.

It absolutely prohibits the transfer of stock without permission. The permission may be the corp’s permission or other shareholders’ permission. If the corp or the shareholders say no, then that is it and you are stuck with it.

This is the most severe type of restriction and considered unreasonable at one time but now courts recognize its validity in closely held corporations.

Colbert v. Hennessey (Mass case): Court held a consent restraint valid. The agreements was a means of securing corporate control of the Bay State to those whose enterprise sponsored it and who contributed to the daily operation of the business. This was not a “palpably unreasonable” purpose.

However, the validity of consent restraints remains uncertain in the absence of statute or authoritative precedent.

Mandatory sale: The three basic types of restraints discussed above limit the shareholders’ power of transfer. Other types of arrangements go further and give the corporation or the remaining shareholders an option to purchase a shareholder’s stock upon the occurrence of designated contingencies, even if the shareholder wants to retain their stock.

For example: a survivor purchase agreement operating upon the death of the holder. These agreements provide that in the event of death of the shareholder, the estate must sell the shares back to the corporation, either at a fixed price or a price to be determined (depending on terms).

A common example is an arrangement under which the corporation is given an option, in the event an employee is terminated, to repurchase stock that it has issued to the employee. The courts have tended to enforce such an arrangement under even when the option price is quite lose in relation to the value of the stock at the time the buyback right is triggered.

Compare Allen v. Biltmore Tissue Corp. with Evangelista v. Holland. Allen . Corporately imposed restriction on transferability – option to repurchase upon the death of the holder.

Court looks to statutory compliance, reasonableness of the restriction, and sufficient notice to 3rd parties. Stated that the notice may be stated boldly upon the certificate to ensure ACTUAL notice.

Evangelista . Privately imposed restriction on transferability – right of first option. Restriction stated that the corp. could buy out shares from estate of deceased shareholder at a stated price of $75,000. Stock was worth $191,000 at time of death. Court said you agreed to the restriction, you have to live with it.

Pricing ProvisionsAnother problem concerns the pricing clause in first-option, repurchase, or mandatory sale arrangements. Where shares are closely held, price cannot realistically be set on the basis of market value. Some alternative pricing provision is therefore required.1. Book Value

o Book value may be an unreliable guide to a corp’s real worth: it reflects the historical cost of assets, rather than their present value, and usually ignores goodwill or going-concern value

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o The courts have tended to hold that a large disparity btw book value and real value is not in itself sufficient to avoid the operation of a book-value pricing provision: “Specific performance of an agreement to convey will not be refused merely because the price is inadequate or excessive. The difference must be so great as to lead to a reasonable conclusion of fraud, mistake, or concealment in the nature of fraud and to render it plainly inequitable and against conscience that the contract should be enforced.”

o Thus a book-value formula may be disastrous where goodwill represents the most valuable component of the business2. Capitalized Earnings

o A second common approach is to fix the price on the basis of a multiple of earnings.o This approach is less likely than a book-value formula to produce an unfair price, but it involves a number of drafting

or interpretation problems, such as: Defining earnings Over what period Without or without salaries paid to shareholder-officers Considering the possible impact of the transferor’s withdrawal on the value of the business

3. Periodic Revisions o A third common approach is to agree on a dollar price when the provision is adopted, subject to periodic revision at

agreed-upon intervalso This approach may lead to trouble when the parties fail to make periodic revisions through carelessness or inability to

agree4. Appraisal

o A fourth approach is to provide for appraisal by a third party at the time the option is triggered. o This approach has the advantage of flexibility

Issuance Price/Par Value This is the price at the time the stock was issued to the shareholder If the difference between the issuance price and the market value of the stock is significant, it may be a factor in

determining reasonableness.

Application (f):

1. A CORPORATION MAY ADOPT REASONABLE RESTRICTIONS ON THE TRANSFER OF STOCK TO PROTECT CORPORATE INTERESTS: (FBI Farms v. Moore).

o Facts: D was a family owned corp owned by 3 couples, including Moore and his then wife. At a 1977 meeting, the BOD adopted restrictions on the transfer of shares, requiring director approval before any stock transfer, allowing the corp a right of first refusal, and restricting any sale of stock to blood member of the family. Moore and his wife, Linda divorced and Linda was awarded all the couple’s shares in the corp. More obtained a money judgment secured by a lien on Linda’s stock. When the money judgment went unsatisfied, Moore obtained a writ of execution and purchased Linda’s shares at a sheriff’s sale. Moore thereafter filed suit against FBI for a declaratory judgment that the corp’s attempted cancellation of the shares was invalid, that he properly retained ownership of the shares, and that he owned the shares unencumbered by the transfer restrictions.

o Issue: Are restrictions on the transfer of shares requiring board approval and a right of first refusal reasonable in a family owned corporation, and are they applicable to an involuntary transfer at a sheriff’s sale?

o Holding: Yes. By statute, a corporation may impose restrictions on the transfer of shares to serve a variety of legitimate purposes, including control of the corp’s ownership and management free from outsider interference. Such restrictions, however, are valid and enforceable against the transferee only if the restrictions comply with state law and are “noted conspicuously on the front or back of the certificate or are contained in the information statement required” by state statute. Transfer restrictions, as contractual obligations btw multiple shareholders or btw a shareholder and the corporation, are given their plain and ordinary meaning to manifest the intention of the parties. Whether the restrictions are noted conspicuously on the stock certificates, they bind a person with actual notice of the restrictions. Here, Moore was a member of the BOD that approved the restrictions in 1977. Because he had notice of the restrictions before his purchase at the sheriff’s sale, he is bound by the restrictions.

The restrictions created a right of first refusal in the corporation and its shareholders to invalidate any stock transfer. While the restrictions do not apply to Moore b/c he was not an owner of the stock until after the purchase, as the purchaser with notice of the restriction, he had a right to insist that Linda first offer the sale to the corporation or its shareholders. The corp, however, also had notice of this right and failed to invoke it before the sale. The corp cannot forgo a known right, await the future consequences, and thereafter seek to enforce the right

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against a subsequent purchaser. Thus, while Moore is bound by the right of first refusal, FBI may not enforce the right b/c of its failure to do so at the time of the sale.

With respect to the requirement of board approval, the restriction is valid only if it is reasonable. “A restriction is reasonable if it is designed to serve a legitimate purpose of the aprty imposing the restraint and the restraint is not an absolute restriction on the recipient’s right of alienability.” Reasonableness is determined, in part, by considering the size of the corporation, the degree of restraint on alienation, the time the restriction was to continue in effect, the method to be used in determining the transfer price, the connection to corporate objectives, the possibility of a hostile takeover, and the best interests of the corp. When the restrictions arise out of fraud or a breach of fiduciary duty, they will not be upheld. Here, the restrictions impose substantive limitations on transfer, but do not arise to fraud or breach of fiduciary duty. The reasonableness of the restrictions, like all contract terms, must be determined as of the time of their adoption without regard to later events. Therefore, b/c the requirement of board approval was reasonable at the time it was adopted, it cannot be invalidated b/c of the parties’ later disputes.

Similarly, the restriction of transfer to blood members only is valid and enforceable. AS a family owned farming corporation, the shareholders had a legitimate interest in excluding outside ownership of the corporation. And finally, the restrictions make no distinction btw a voluntary and involuntary transfer, such as a sheriff’s sale. Restrictions normally don’t apply to involuntary transfers. The rights of third parties can not be infringed by private agreement. Here, however, Moore acquired the stock with knowledge of the restrictions. By his purchase he acquired the stock encumbered to the same extent as it was in Linda’s hands. While these restrictions may render the stock unmarketable, Moore succeeds to the shareholders interest in the corp.

o Analysis: In close family corporations such as here, stringent transfer restrictions are more likely to be considered reasonable, given the important interest in limiting the shareholder to a chosen few. This corporate interest is stronger in small, family owned corps then it is in large, publicly traded corps.

1. The Duty of Care and the Duty to Act in Good Faith

Concept (a): [The Duty of Care]

Fiduciaries & their Duties: A fiduciary is a person possessing a duty to work primarily for another. They must at all times act in good faith,

loyalty, and provide full disclosure of all material facts to their principal. The fiduciary relationship arises in the following instances:

o Agency relationship, including officers of the corporationo Director’s relationship to the shareholders and possibly with the corporation. Directors are not agents of corp

unless they are acting as a duly constituted board unless they have been specifically identified as an agent for particular purposes.

o Corporation’s/Director’s relationship to creditorso Corporation’s relationship to communityo Shareholders relationship to one anothero Depending on context, fiduciaries can include other people. Fiduc in stock regulation could include Martha

Stewart; those that acquire inside info about a stock. Might even include, depending on time and situation, the printing press man who acquires info from the paper.

o The concept of the fiduciary is being expanded as we speak, traditionally they were the directors, then included officers, then included shareholders (majority or controlling), and then minority shareholders via Donahue case, and then printing press operator

There are 4 important fiduciary duties:1. Duty of Care2. Duty to Act Lawfully3. Duty of Loyalty4. Duty to Act in Good Faith

Prof Exam Tip: anytime someone acts on behalf of another look out for a fiduciary -- that is a very broad approacho Once we determine that someone is a fid, what do we expect them to do? We expect them to act on behalf of the

ppl they serve. Implicit in that is that they shouldn’t be acting for themselves. This starts with the Lewis case.

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o We also expect them to be careful when they're acting, to take care. o We expect them to act lawfully, not to commit unlawful acts.

Duty of Care: This is the duty to do what is reasonably expected of you. It is an affirmative obligation on the fiduciary. Duty of care has to do with ppl neglecting what they are supposed to be doing Duty of care is almost unique to directors and their duties as directors. The duty of care includes the duty to:

o Monitor : This includes monitoring the operations of the corps and the carrying out of tasks by the officers, the board meetings, the particular market, and the corps position in it.

o Make Inquiries : Must make inquiries into economic decisions and new corporate opportunities along with anything you feel may be going wrong in the carrying out of anything you are responsible for monitoring.

o Prudent Decision Making : Making reasonable decisions rather than flipping a coin for the answer.o Using a Reasonable Process to Make Prudent Decisions : Look into your options in making a particular

decision, its pros and consequences and alternatives to doing so. Don’t just flip and coin or make a decision without inquiring into options and alternatives or information regarding your decision.

How do we hold someone accountable?o Establish a dutyo Establish a breach of that dutyo Establish that there were causally related injurieso The burden of proof is on the P to show that there was a breach of that duty and that there were causally

related injuries

Checklist for directors: a director is not an ornament, but an essential component of corporate governance, a director cannot protect himself behind a paper shield that says "dummy director." all directors are responsible for managing the affairs

A rudimentary understanding of the business of the corp: should become familiar with fundamentals of the corp Continuing obligation to keep informed, may not shut eyes They have a duty to look -- the sentinel asleep at his post Duty to monitor -- pay attention Attend board meetings regularly Have a general familiarity with the financial status of the corp

Standard of Care: This states how an actor should conduct a given activity or play a given role: The Reasonably Prudent Person Standard.

A director must act in good faith and they must act as ordinarily prudent persons would under similar circumstances in like positions. The standard is not how they would act in their own business affairs but what the ordinary prudent person under similar circumstances in a like position would act.

At the least, this involves the elements above such as monitoring, making inquiries, making prudent decisions based on a reasonably prudent decision making process.

Standard of Review: This states the test a court should apply when it reviews an actor’s conduct to determine whether to impose liability or grant injunctive relief. Gross Neglect or Wanton and Willful Misconduct.

Most frequently this is employed for irrational decisions or conduct, or the failure to meet affirmative obligations of the position.

These are considered grossly negligent: no plausible business reason for themo Banks hiring known embezzlerso Not getting fire insuranceo Failure to know facts: ppl who don’t go to meetings on a consistent basis, ppl like Mrs. Prichard, however

she didn't make decisions so the BJR wouldn't apply to her

Business Judgment Rule: the presumption that directors’ business decisions are deemed non-negligent if done without bad faith, self-interest, fraud, or oppression of shareholders.

If the fiduciary acted in good faith and honest belief that the decision was in the best interest of the corporation, then the business judgment rule will afford the fiduciary a defense in an action against the fiduciary at least for a breach of duty.

In most statutes, directors are permitted to rely upon reports (financial statements, reports given by others in corp, legal counsel reports) rather than requiring the directors to go out and start reinventing wheel. In Mass., the statute has opened up the corp definition to include elements not previously considered. Statute says that in determining what

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the best interest of corp is, the directors making the decisions, can take into account all kinds of things including the interests of the corp’s employees, suppliers, etc… This gives the directors more wiggle room in making their decisions These are called “corporate constituary statutes”-expanding what directors can look at.

This rule applies solely to directors in the directorial capacity. The defense may not be used by a director making an individual decision without the board. The decision must have been made by the board for it to be afforded this defense. If the decision was made by the board, and only one director is being sued in his individual capacity, he may still use this defense as long as decision was made by the board.

Necessary Elements for the BJR to Apply:1. The director must have made a decision. So a director’s failure to make due inquiry, or any other

simple failure of action, does not qualify for protection under the BJR. This rule won’t help Mrs. Prichard b/c she didn’t do anything, she wasn’t there. She was not

protected by the BJR. 2. The director must have informed himself with respect to the BJR to the extent he reasonably believes

appropriate under the circumstances.3. The decision must have been made in good faith. (Disney case)

Cases where what the directors decide on are against the law.4. The director may not have a financial interest in the subject matter of the decision.

This is Ch. 9. Telling us that if a director is making a decision as a director in his official capacity, then that

director must not have an interest in the subject matter of the transaction. If he does have an interest in the subject matter that is called self interest. These transactions

are not protected by the BJR.o If the four elements are not satisfied, the standard of review will be based on entire fairness and reasonability.o If the four elements are satisfied, the decision must be found rational, or must have a rational basis which is

difficult not to find.o In other words, if the BJR applies, then the directors will be protected from shareholders for the decisions

they have made b/c it is their job to make decisions and cannot second guess them every time a shareholder doesn’t like the decision made.

o If the judgment was made dishonestly or for self interest, the business judgment rule will not apply. In addition, if the decision was illegal, then the BJR will not apply. See Miller case below.

o Burden of Proof : The burden of proof is on the party alleging the breach of duty of care. Claimant must assert sufficient facts to prove that the effect of the decision was so grossly negligent that the director should NOT be protected under the BJR.

o Small Corporations : The closely held corp will not generally fall under the BJR, BUT rather the less harmful alternative standard set forth in Donahue. Risk of shareholder abuse, etc…warrants judicial intervention into fiduciary decisions b/c of the fact that it is a closely held corp.

Application (a):

1. CORPORATE DIRECTORS LIABLE FOR NEGLIGENTLY IGNORING OTHER DIRECTORS’ MISDEEDS: (Francis v. United Jersey Bank).

o Facts: Mrs. Prichard and her sons were officers, directors, and shareholders of the corp. The sons embezzled $12 million from the corp, misappropriating accounts commingled with clients’ funds as “loans” to themselves, and bankrupting the corp. The sons disguised their pilfering somewhat, but the corp’s financial statements still showed huge and ever-increasing loans. Mrs. P never participated in the embezzlement, but did not stop it, apparently b/c she was unaware of the corp’s finances. The corp’s trustees sued Mrs. P as director, for negligent violation of her directorial duty of care in not noticing or preventing the misappropriation. Evidence showed Mrs. P, while nominally a director of the corp, never participated in its management and knew nothing of its corporate affairs.

o Issue: Are corporate directors personally liable for violating their duty of care by failing to prevent wrongful acts by other corporate officers?

o Holding: Yes. Corporate directors are personally liable for violating their duty of care by failing to prevent wrongful acts by other corporate officers, if (i) they owed a duty to the victim, (ii) they were negligent in monitoring the other officers, and (iii) their negligence was the proximate cause of the injury. Under all states’ common law, directors must “discharge their duties in good faith and with the degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions.” Though the exact degree of care depends on circumstances, generally “a director should acquire at least a rudimentary understanding of” the corp’s business, b/c lack of knowledge is no defense to the duty of care. Also, “directors

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are under a continuing obligation to keep informed” about corporate activities, to enable them to act with care…Directorial management does not require a detailed inspection of day to day activities, but rather a general monitoring of corporate affairs. Mrs. P owed fiduciary duties to her clients, which included a duty to read the corp’s financial statements, which would have disclosed the conversion disguised as loans. She breached that duty by ignoring those financial statements. Nevertheless, a director’s negligence creates liability only if that negligence proximately caused the loss. When dealing with negligent omissions, the test of proximate causation is to determine what steps the director should reasonably have taken, and whether reasonable steps would have averted the loss. The act/failure must be a substantial factor in producing the harm. Usually, directors absolve themselves from liability if they alert the other directors of the impropriety, vote against it, and resign if outvoted. Here, Mrs. P should have actually stopped the misappropriation, b/c the corporation was nearly insolvent and had a fiduciary duty to depositor-clients. Her inaction was a “substantial factor” in permitting the misappropriation, since the sons stole freely knowing Mrs. P ignored their conduct, and the court believes she could have prevented it by threatening suit.

2. IN CLASS DISCUSSION Cases like Francis are difficult to prevail in b/c sometimes proving the breach is difficult. People usually go to duty of loyalty b/c its easier.

3. CORPORATE DIRECTORS ENTITLED TO BUSINESS JUDGMENT PRESUMPTION ON DIVIDEND DECISIONS: (Kamin v. American Express).

o Facts: The Corporation bought a stock for 29mil which is now worth only 4mil. Then they made the decision to distribute the stock in kind to the shareholders as dividends rather than take it as a loss and get an 8mil tax break for that loss. A derivative action was brought by a shareholder against the directors which means it presupposes a wrong against the corp and any recovery, will go to the corp. The shareholder alleged breach of fiduciary duty of the duty of care b/c the directors did not act as a they would in their own affairs in making the decision. The shareholder alleges that 4 out of the 20 board members were self-interested in the transaction (this is the only hint of self-interest in the case). The shareholder also contends that the directors carelessly wasted corporate assets.

o Issue: Have corporate directors violated their duty of care by ordering dividends which do not maximize tax savings?

o Holding: No. Corporate directors’ decisions on dividends are not actionable as breaches of care, absent fraud, self-dealing, bad faith or oppression. Specifically, the manner and amount of distributions is exclusively a matter of business judgment for the directors. The court held that the BJR protects the decision makers from reasonable decisions and allows the directors discretion in making decisions. The court held that it will not interfere with director’s decisions unless the powers have been illegally or unconscientiously executed or unless it be made to appear that the acts were fraudulent or collusive or destructive of the rights of the shareholders. Mere errors of judgment are not sufficient grounds for equity interference, b/c the directors are given discretion in making those decisions. The court held that the P did not sustain its burden of showing self-interest and therefore the BJR does apply. Had it not, the BJR would not have applied.

o Important Quotes from the case: “In actions by stockholders, which assail the acts of their directors or trustees, courts will not interfere

unless the powers have been illegally or unconscientiously executed; or unless it be made to appear that the acts were fraudulent or collusive, and destructive of the rights of the stockholders. Mere errors of judgment are not sufficient as grounds for equity interference, for the powers of those entrusted with corporate management are largely discretionary.”

“Courts will not interfere with such discretion unless it be first made to appear that the directors have acted or are about to act in bad faith and for a dishonest purpose. It is for the directors to say, acting in good faith of course, when and to what extent dividends shall be declared…The statute confers upon them directors this power, and the minority stockholders are not in a position to question this right, so long as the directors are acting in good faith.

“Questions of policy of management are left solely to their honest and unselfish decision, for their powers therein are without limitation and free from restraint, and he exercise of them for the common and general interests of the corporation may not be questioned, although the results show that what they did was unwise or inexpedient.”

2. PIZZANO Yes directors have a duty of care, yes it is defined by statutes, the P has the burden of showing the duty, the breach, the causally connected injuries, and P has to show that BJR should not protect these directors, the reasons why it is inappropriate.

3. DIFFERENCE BTW DUTY OF CARE AND LOYALTY: o It means the burden of proof shifts to the fiduciary; he has to establish that what he or she did was proper.

That is a MAJOR difference It’s a difference that allows the actions to proceed much easier then if they were duty of care actions

o The standards are different: very loose fitting

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o The remedies are restitutionary, we go into fiduciaries pocket and get what they received in their breach of duty of loyalty

Concept (b): [The Duty to Act in Good Faith]

Good Faith: A state of mind consisting in: 1. honesty in belief or purpose, 2. faithfulness to one’s duty or obligation, 3. observance of reasonable commercial standards of fair dealing in a given trade or business, or 4. absence of intent to defraud or seek unconscionable advantage

Application (b):

1. DIRECTORS OWE THE CORPORATION AND ITS SHAREHOLDERS A DUTY OF GOOD FAITH: (In re The Walt Disney Co. Derivative Litigation).

o Facts: Shareholders brought a derivative action against Walt Disney Co for blindly approving he hiring of a new president. The D, CEO, hired his friend. After a year when D realized that the hiring was a mistake b/c of his friend’s management style, they mutually agreed that he should seek alternative employment. They negotiated a non fault termination agreement that would preserve his friends benefits and reputation. Neither the new BOD or compensation committee had been consulted or approved the termination. Disney by-laws required board approval of the non-fault termination. Nonetheless, the board failed to question the termination, explore alternatives, or consider the terms of the severance package. Disney shareholders brought a derivative action, alleging that the directors breached fiduciary duties by blindly approving the hiring and non-fault termination.

o Issue: Must the P’s complaint for breach of fiduciary duties be dismissed based on the corporate limitation of director liability or the business judgment rule?

o Holding: No. The P’s allege that the directors failed to exercise any business judgment in good faith. On such facts, the BJR does not relieve the directors of liability for their actions. Taken as true, the allegations of the Ps’ complaint portray the directors’ conscious indifference to the consequences of the hiring and termination without regard to the best interests of the corporation or its shareholders.

VI. The Duty of Loyalty

Three Categories of Duty of Loyalty Cases:1. Conflict of Interest Cases2. Usurpation of Corporate Opportunities Cases3. Competition Cases

Concept (a): [Conflict of Interest]

Three Categories of Conflict of Interest Cases:1. Self-dealing and Self-interested transactions.2. Interlocking Directorates.3. Parent/Subsidiary Relations.

1. Self Dealing and Self Interested Transactions: This is self-dealing, standing on both sides of a transaction. The fiduciary will have a conflict of interest in any transaction where he stands directly or indirectly on both sides of the transaction. These typically involve directors, officers, and possibly shareholders. At one time, such transactions were void, however contemporary law now permits under the following circumstances: FAIR Transactions. Such transactions are NOT void provided they are approved by a disinterested majority of the

directors (i.e. ratification) AND are found to be fair.o Intrinsic Fairness Standard = arms length transaction. This means that there must be the same terms and

conditions that would have been obtained by a disinterested board in an arm’s length transaction.o The standard now is the courts will review these contracts and will subject them to rigid and careful scrutiny

and will invalidate it if it is found to be unfair. That is the intrinsic fairness standard. o In applying this standard, the burden of proof shifts to the fiduc to prove that what he did fulfills the intrinsic

fairness standard.

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FULL Disclosure. There MUST be full disclosure of all material facts. The fiduciary must provide notice of his interest in the terms of the transaction, and in some case decisions, he must disclose all profits derived therefrom, although Pizzano doesn’t agree with this.

o Making a profit on the transaction is not unfair per se, so long as the deal is fair . However, if the profit is so far in excess of the fair market value, the transaction could constitute corporate waste.

Wasteful acts are ultra vires and thus VOID. This is particularly significant in the case of close corporations where shareholders are also directors – this comes back to the control issue.

The only time Pizzano can think of that a shareholders may be able to ratify corp waste is if it is a closely held corp (Donahue) and if nobody is hurt, not even the public (Clark v. Dodge) and there was unanimous shareholder ratification.

o IMPORTANT Note: The interest on the part of the board member in the transaction PREVENTS the application of the business judgment rule to the transaction.

Burden of Proof : Burden of proof shifts from P to D once P establishes possible claim of breach of duty of loyalty. P must come forward and assert a conflict. P has to initially assert a self-interest which would be done in the pleadings and then the issue of P establishing a potential for a conflict of interest is determined in a mini bench trial held. The court will look at what the P plans to present to establish the existence of a conflict and how Ds will respond to it. If court thinks credible evidence will be produced, then the burden will shift. It does not need to be conclusive evidence that the conflict exists, just that the court feels enough evidence is produced so that burden will shift. This mini trial focuses solely on this question.

Common Fact Patterns:o Director contracting with his own corporation, for example, by selling corp his services or selling corp his property.o Director setting his compensation. Compensation at the fair market value is reasonable, but the corporate board

generally should NOT be setting its own compensation agreements.

2. Interlocking Directorates: This is where the same, or substantially similar, directors sit on two or more boards of two separate corporations and the corporations are doing business with each other. So there are interlocking directorates (aka intermingling boards or common directors). When the directors are acting on the boards of both corporations, they are on both sides of the transaction and therefore transactions between the two corporations raise questions: 1) Is there self-dealing between the corporations, and 2) On who’s behalf are the board members working for throughout the transaction? These are the same issues raised when an individual director engages in an interested transaction with the corp that he is on the board of.

o The fairness standard described above is the standard for these types of cases. o The BJR does not apply in cases where there is self-interest such as these.

3. Parent/Subsidiary Relationships: Parent corporation serves as the umbrella to the Subsidiary Corporation and questions arise regarding control of one by the other b/c the parent controls the subsidiary through stock ownership. Conflict arises when the parent acts as puppet master to the subsidiary by controlling board elections and resolutions.

When the parent dictates through the board of directors to the subsidiary the terms of a transaction, there is a conflict. Are the directors of the sub cutting deals in favor of the parent or protecting interests of the subsidiary. Both sides of

the transaction=conflict of interest. If talking about director action, directors are protected in their directorial functions through the application of the

business judgment rule. However, once a conflict of interest is presented (through bench trial) not only does the burden of proof shift, the standard of fairness becomes involved and fiduc must establish fairness of action, directors are also not protected under the business judgment rule. The self-interest precludes the operation of the business judgment rule.

Application (a):

1. SELF INTERESTED TRANSACTIONS:A. DIRECTORS HAVE A DUTY TO DISCLOSE ANY PERSONAL INTEREST THEY HAVE IN A

TRANSACTION AFFECTED BY THE CORPORATION: (Talbot v. James). Facts: D is 50% owner of business, serves as director and officer. Becomes the general contractor and is

rendering services to his own corporation. A shareholder sued D for violating his fiduciary duty when D failed to disclose his interest in a K entered into by the corporation.

Issue: Do directors and officers of a corporation have a fiduciary duty that prevents them from contracting with the corporation for their profit without first disclosing the terms of the K to the disinterested officers and directors of the corporation?

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Holding: Court held that contracting with your own corporation is OKAY provided that the deal is FAIR, shrouded in GOOD FAITH, and there is FULL DISCLOSURE of all material facts to the transaction. In this case, D did not disclose his interest and did not disclose his profits derived from the transaction. Pizzano thinks the court went too far in requiring disclosure of profits, should only have to disclose his self interest in the transaction. In this case, Fairness has to do with full disclosure of all material facts.

B. APPROVAL OF A SELF-INTERESTED TRANSACTION BY DISINTERESTED DIRECTORS OR BY SHAREHOLDERS DOES NOT MAKE THE TRANSACTION IMMUNE FROM JUDICIAL REVIEW FOR FAIRNESS: (Cookies Food Products v. Lakes Warehouse).

Facts: P (Cookies) entered into an exclusive distribution agreement with D1 (Herrig) , one of P’s shareholders. D1 owned an auto parts business (D2) and the Lake Warehouse distributing Inc (D3). The agreement provided that D1 could purchase P’s product at a discounted price and could market and distribute the products through Lake Warehouse. D1 eventually became P’s majority shareholder and P’s board extended the term of the agreement and expanded the types of services from which D1, D2, and D3 were compensated. D1 also got royalties and P’s minority claimed that all these transactions were entered into in breach of Herrig’s fiduciary duty to the corporation b/c Herrig did not fully disclose the benefit he was to receive.

Issue: May a court focus on the corporate profitability in determining the fairness of a self-dealing transaction?

Holding: Yes. Court held that self-dealing is allowed under Iowa law if the self-dealing does not violate the duty of loyalty. Iowa legislature (and MA) has established 3 circumstances under which a director may engage in self-dealing without violating the duty of loyalty: (1) The interest MUST be fully disclosed to the board before it authorizes the transaction. (2) The interest MUST be disclosed to the shareholders who must vote or provide written consent, and (3) the transaction MUST be FAIR and reasonable to the corporation – there must be good faith, honesty, and fairness. The court also agrees that establishing fairness requires showing of “fair price” and a showing of the fairness of the bargain to the interests of the corporation. The court said that all of those requirements were met in this case and therefore there was no breach of the duty of loyalty. Applying this standard the court believes that Herrig’s services were fairly priced and consistent with Cookies corporate interest. All of the agreements benefited Cookies. The record demonstrates that all of the members of the board were aware of Herrig’s interest. Herrig was under no obligation to disclose the extent of his profits. Therefore, the disclosure made was sufficient to enable the board to make an informed decision concerning the Ks.

2. INTERLOCKING DIRECTORATES:A. WHEN ANY SELF-INTERESTED TRANSACTION IS CHALLENGED, THE DIRECTORS MUST SHOW

THAT THE MERITS OF THE TRANSACTION WERE FAIR TO THE CORPORATION: (Lewis v. S.L. & E.). Facts: Businesses are related by family members – relatives sit on boards of both corporations. The

same people serve on the two boards that are transacting business with one another. Lewis, a shareholder of SLE, brought a derivative action against the corporation and its directors, all of whom were brothers of Lewis. Lewis claimed that the directors had wasted corporate assets by causing SLE to charge its tenant LGT, unreasonably low rent from 1966 to 1977. At trial the directors testified that they never thought of raising LGT’s rent. They further testified that they never treated the 2 corps as separate entities, but merely believed that SLE existed as a shell for LGT. Lewis is saying b/c of the low book value; SLE didn't realize its maximum potential in the rental property. The thrust of the complaint is that all the directors breached their fiduciary duty to SLE by not renting the property at a fair rental value. The question is whose interest was being served? The directors owned a duty to SLE to maximize profits, but yet they undervalued the rental property. Lewis is arguing that it was for LGT's interests. They're not benefiting self; they are benefiting one corporation (LGT) at the expense of another. HE asserts that the book value should take into account the fair rental value of the property rather than the sub-value rent that is now being paid.

Issue: Must a P prove the unreasonableness of a transaction btw a corporation and its directors? Holding: No. When a shareholder attacks a transaction in which the directors have a personal interest

other than as directors of the corporation, the directors must prove that the transaction is fair and reasonable to the corporation. The BJR does not apply here b/c there is a conflict of interest and thus the burden of proves moves to the directors. In the present case, the directors of SLE have failed to do so. The directors never made an effort to determine the fair rental value of SLE’s property. Rather, they merely assumed that SLE existed for the benefit of LGT, their own corporation. Recovery in these cases is restitution. In this case it’s the difference of what was paid on the rental and what was paid. So the

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corp has to ante up the difference. And then there is a re-evaluation of the value. In this case Fairness is at fair market value.

Analysis: This case provides an excellent overview of the requirements of the “merit based” fairness test. The court first notes that directors who have an interest in both sides of a corporate transaction are not entitled to the protection of the business judgment rule. Although fairness under the BJR entailed a judicial examination of the process by which a transaction was effected, the issue of fairness in a conflict of interest transaction requires an examination of the merits of the transaction. Moreover, the court here holds that, in contrast to the heavy burden a P faces under the BJR, the burden of proving fairness in a conflict of interest transaction befalls the interested directors.

Concept (b): [Usurpation of Corporate Opportunities]

Generally, an opportunity comes to the attention of the fiduciary (i.e. director, officer, etc…) and rather than passing it along to the corporation, he takes it for himself and exploits it for gain. The fiduciary is essentially taking advantage of his position. However, where do you draw the line in such a transaction? This depends on the jurisdiction in which you are asking this question. There are three jurisdictional approaches to this question:

1. Interest and Expectancy Standard : The fiduciary is held accountable to corp if the corp has an interest in or an expectancy in the particular opportunity.

a. This is a very narrow test. b. Interest in the legal sense, like an option or offer made on the property. c. Understanding Legal Interest : For example: A corporation decides to make an offer to buy Greenacre and

sends Pizzano out to make an offer for the asking price. Instead, Pizzano, as director, and now a specially authorized agent of the corp, goes out there and offers a higher price than the asking price on his own behalf. This is the kind of legal interest the test proposes.

d. Understanding Expectancy : For example: The corporation has a lease with a renewal provision. The renewal time is coming up and before the corp has a chance to express interest in the renewal, the fiduc comes in and usurps it. The corp had an interest or expectancy in the renewal of the lease and therefore the fiduc is held liable.

e. An Example not Falling Under test : Cola corp went bankrupt and their secret formula was up for grabs. So fiduc goes out and buys the secret formula on his own behalf, manufactures it, and then sells it to his corp. Under the interest and expectancy standard, he is not accountable b/c the corp had no legally protected interest in the cola corp nor did they have any expectancy interest growing out of an existing right to the cola corp. Because of this case, the courts changed standard in some jurisdictions.

2. Line of Business Standard : If the opportunity is related to the line of business of the corp being served by the fiduc, and the fiduc usurps that opportunity on his own behalf, then the fiduc is accountable.

a. For example: Same fact pattern in above example but the fiduc was working for another cola corp. This is in line with the business of the corp and therefore the fiduc should have made it available to the corp.

3. Fairness Standard : Is it fair to allow this fiduciary to take advantage of this opportunity? a. No guidelines for that, it is a subjective determination of fairness. b. Mass. employs this test.1. Fairness analysis - factors:

1. Is the opportunity needed for the corp and for foreseeable expansion of the business?2. Did the discovery of the opportunity come to the fiduciary by reason of his or her official position?3. Was the corp negotiating for or seeking the opportunity and if it was has it abandoned its efforts in

this regard?4. Was the director or officer specifically charged with the task of acquiring these opportunities?5. Did the fiduciary use corporate funds and facilities?6. When the fiduciary takes over the opportunity does it place him or her in an adverse or hostile

position?7. Was the corporation in a favorable position to take advantage of the opportunity?

To include financial favorability. In some instances some corps are unable to take advantage of a corp opportunity.

Court will balance these. 4. ALI Approach : first requires the corporation to prove that the opportunity is a corporate opportunity by showing:

a. that the opportunity was offered to the director or officer in his official capacity under circumstances which should reasonably lead him to believe that the offeror expects the opportunity to be offered to the corporation;

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b. the director became aware of the opportunity through the use of corporate information or property, if the opportunity is one that the director should believe is of interest to the corporation; or

c. that the senior executive knows the opportunity is closely related to a business in which the corporation is engaged or expects to engage.

After showing that the opportunity is a corp opportunity, the corporation mush show that it was either not offered the opportunity by the director, or the corporation did not properly reject the offer. If the offer was not properly rejected, the director may defend on the basis that the taking of the opportunity was fair to the corp. If the director did not disclose the opportunity, the director has violated her fiduciary duty and may not defend in any case. This disclosure oriented approach provides a clear procedure whereby a corporate officer may insulate herself from a legal challenge by making a full disclosure.

Under this approach, the director of officer has an absolute duty to disclose the corp opportunity. Any failure to do so constitutes a breach of loyalty under the ALI approach. Under the other approaches disclosure is merely a factor in determining whether the director breached his duty.

*Must know all jurisdictions for the exam.

Analysis (b):

1. HYPO: we have a corp that is experiencing financial difficulties. It’s a large public corp, its unable to pull out of the financial difficulties. The BOD gets together as a duly constituted board. The BOD is brainstorming all kinds of ideas on how to put the business back on the right track. They decide the corp needs a little jolt. The jolt they need is money, capital, to try to jumpstart the business. They come up with a plan to issue bonds. A person who buys a corporate bond, loans money to the corp. The corp agree to in exchange to repay the loan together with interest. It may be payable at once or in increments. Their basic problem is the bonds may not be that marketable, whose going to loan money to a business that's on the edge? So they sweeten the deal, they discount the bonds -- they put them on sale. Which means that maybe they sell those bonds for 30% of their face value, which means you only have to give them 30% and you get 100% back with interest. They vote on it, its unanimous. They buy all the bonds themselves at discount. It doesn't work. The business goes under, it goes into bankruptcy and the creditors line up. All the directors are at the front of the line b/c bonds are secured instruments, which means that bond holders have the rights of security holders. What does the trustee in bankruptcy do with the claims of the directors on the corporate bonds?

It’s a parallel to Northeast b/c there it was a corp fiduciary that took advantage of her position In Northeast Golf: she bought 2 different properties. She never went to the club and told them that properties

were going out on the market. o She formally disclosed that she purchased the property and she told the board that she had no present

plans to develop it. Again, the board took no formal action as a result of Harris' purchase. Why did the court make that statement?

o The parallel: she purchased something (property) and now there is a claim that what she did was wrong.o The board in Hypo purchased something that they shouldn't have purchased?

Why should the board not have purchased those bonds? They're on both sides of the table, they are setting the price of the bonds and then

purchasing them. This is like Fazio. This is a self interested transaction. A conflict of interest is presented when someone or people sit on both sides of the transaction.

This is another example of conflict of interest raised by the self interest of this transaction.

o By our standards self dealing does not make the transaction void, but they have to be fair and so long as waste isn't committed.

o There may be enough disinterested directors in the HYPO to carry the transaction. So long as its fair and its not waste, it will be ok. But in this hypo, they're all buying which means they're all interested. Does that interested nature disqualify them all from purchasing? No, so long as the transaction is fair and so long as it can be justified as in the best interest of the business.

o BJR does not operate here b/c of the self interested nature of these transactions. Legitimate purpose argument: they're acting in good faith trying to bring money into the business which

benefits the business and therefore benefits everyone. Creditors are also benefited by this infusion of funds. They are trying to save the business. This is one of the few ways they had for bringing money into the business. This was a good faith attempt to jumpstart this business.

They as corp fiduciaries are obligated to get the best deal for the corporation and they haven't tried. They didn't try to discount the bonds 10% and sell them, they didn't try. They instead presented a 30% discount and bought it

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themselves. How do we know that's the best deal? How do we know there weren't buyers out there who would have bought at a lower discount.

o They didn't try to get the best opportunity for the corporation. This is an example of taking advantage of your corporate position to benefit yourself to violate their duty to the corporate venture. Were they really thinking of the corp when they issued bonds?

Could this be the usurpation of a corporate opportunity? The corp opportunity is the fact that they deprived the corp of something they might have had -- a better deal. It's very subtle but there. The same rules apply to these character as they do in Northeast Golf.

There can be an argument that at some point their officer role stops. Like in Northeast -- when do they stop being a fiduciary and start being a normal person again? Not all opportunities that come to fiduciaries are corporate opportunities. Courts are trying to arrive at whether it is a corporate opportunity or whether it’s a normal opportunity.

In this Hypo clearly it is a corporate opportunity. There is a suspicion here that they didn't do what is best for the corporation. They have to show that what they did was proper. They have the burden of proof.

2. DIRECTORS AND OFFICERS ARE PROHIBITED FROM USURPING FOR THEMSELVES A BUSINESS OPPORTUNITY THAT RIGHTFULLY BELONGS TO THE CORPORATION: (Northeast Harbor Gulf Club v. Harris).

a. Facts: Harris buys property abutting the golf course after being informed of the opportunity b/c of her president status of the Golf Club. She then informed the directors of her acquisition. Subsequently, she bought additional land that she was informed about personally and not as pres of Golf Club which also abutted the Golf Club. The corp may have been interested in either properties but never had a chance to acquire the property b/c she purchased it on her own behalf before revealing the opportunity to the Golf Club. She argues stating that the corp would have been unable to buy it anyway b/c they were not financially able to. The jurisdiction of the case is the determining factor of whether the property involved a corporate opportunity or not.

b. Issue: Does the corporate opportunity doctrine require a director or officer to disclose only those business opportunities that are in the corp’s line of business and that corp is financially able to undertake?

c. Holding: No. This case requires us to define the scope of the corporate opportunity doctrine in Maine. Various courts have embraced different versions of the corporate opportunity doctrine. If not corp opportunities by whatever standard, then there isn’t a problem, fiduc may act as long as not in direct competition with his corp. The court follows the ALI, if it is a corporate opportunity under ALI, that the fiduciary disclose her interest in the transaction and secure ratification by a majority of the disinterested directors or shareholders. The case is remanded to determine under ALI standard, whether it was a corporate opportunity.

d. ALI standard i. 5.05: attempt to define corporate opportunities

ii. Bottom line: consistent with Talbot v. James1. Tell them everything, don't sneak around. 2. If you got nothing to hide, tell them. 3. 1st paragraph of 480. If Harris failed to offer the opportunity at all then she may not defend

that the failure to offer opportunity is fair. It's full disclosure. e. This is an action by the golf club against Harris. She went to the board on 2 occasions and told them she

purchased these parcels of property. The board took no formal action. Why is this important? Is the no action a vote in favor, ratifying what she did. They said nothing, is that an affirmation?

i. Here they did nothing, is that a decision for BJR?ii. There is a potential action here against the board, they breached their fiduciary duty of care by

doing nothing. Their inaction could give rise to an action against them for them not taking action against her. That is called neglect.

3. IN CLASS DISCUSSION Stock Restrictionsa. Stock restrictions imposed by corp need to be reasonable, in MA they cannot be manifestly unreasonableb. If there is a great disparity with the issuing price and the present market price - it might make that restriction

unreasonablec. The only way A can pass the stock is to get the restriction declared invalid b/c it is invalid, but he's still not out of

the woods, b/c now he has to worry about the shareholder agreement he signed where it said they must decide as a unit -- is that a shareholder agreement, shareholder director agreement?? It just says vote as a unit not that they all have to agree.

d. Does it apply to transfer of stock when it says they all have to decide as a unit - does that require permission to transfer stock? If you construe it in that way then it is a consent restraint - the most restrictive form of restrictions.

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e. If it doesn't apply to stock transfers then it might be a shareholder director agreement, even if it does apply it may be a shareholder director agreement and be invalid b/c it requires unanimous vote at director level if you construe unit as unanimous vote.

4. If the opportunity is ultra vires to the corp, then it is not a corp opportunity.

Concept (c): [Competition]

Competition: Third Category of the Duty of Loyalty Cases.

Generally, a director may not engage in business that is in direct competition with the one he directs. They may engage in unrelated business but not in one with direct competition.

Must determine what is considered in direct competition. After resignation, the director may be involved in direct competition unless there are covenants not to compete in his

employment contract. A director may never, even after resigning, wrongfully appropriate patents, copyrights, trade secrets, or legally

protected confidences. The director may, after resigning, use skill or know how that was acquired at the former corp. The problem with the

know how test is that it is difficult to determine what is know how and what is a legally protected confidence or trade secret. For example, say the director of Thomas’s English Muffins was diligent in his directorial duties and learned how to make the nooks and crannies in those muffins. He then resigns and starts at a new corp who makes muffins. Can he use that information in the new corp? Is that know how he learned on the job or a trade secret? Don’t know, that is the difficulty with this element.

Summary of Differences Between Duty of Care and Duty of Loyalty:

Standards:o Duty of care case deals with failure, neglect, not doing something that was reasonably expected of you.o Duty of loyalty deals with misplaced loyalties, benefiting self as a director at expense of the corp, self-

dealing. Burden of proof:

o Duty of care burden is on person asserting the fact which is the same as in tort type actions. If you are challenging the director’s actions or neglect, the Ps challenging the action or inaction have the burden of proof on question of neglect.

o Duty of loyalty cases, burden is on the fiduciary to establish that what he or she did or what the whole board did was proper and right and served legitimate business purpose. The fiduciary under attack bears the burden of proving that he was right. So shift in burden of proof.

Business judgment rule:o Almost always applies in context of duty of care and MAY apply in context of duty of loyalty.

Remedies:o In duty of loyalty cases, the traditional remedy is restitutionary in nature. You put the parties back the way

they were, make them whole again. Sometimes form of restitution is carried out through a constructive trust. Courts will impose a trust

on the thing you acquired. One person to have legal title for the benefit of another, trustee and bene, so I become trustee for the benefit of my corp. I found out secret formula to my companies pepsi-cola secret formula so I become the trustee for the secret formula for the benefit of my corp.

Under restitution, the director need only return the gain to which he was not entitled to. This means that under duty of loyalty cases, the P must prove that the fiduc has benefited from the

breach Corporate Opportunities:

If fiduc has dumped or disposed of the corp opportunity by selling it to the company (self interest dealing) then the profits can go to the corp and there will be an accounting of the profits.

Sometimes, under breach of duty of loyalty cases, the directors may be subject to punitive damages depending on the level of abuse.

o In duty of care cases, the director must pay damages although he made no personal gain from his wrongful actions.

Under the duty of care, the P does not need to prove that the fiduc benefited from the breach.

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It is possible for duty of care and duty of loyalty to come out of same fact pattern -- Yeso Francis case - attention was focused on Mrs. P - analysis had to do with duty of careo If instead of focusing on Mrs. P we step back and if the client was a shareholder.

As the lawyer you would be looking not only at Mrs P violating her duty of care but you would be thinking about the boys the BOD for breaching their duty -- that’s not duty of care, they're intentionally stealing - this is duty of loyalty - interest v. duty analysis

o Northeast Golf Club Focus was pres Harris - did she do something to breach her duty of loyalty, specifically corporate

opportunity Step back and say what if shareholder of country club comes to us and she went to the board and the

board took no action. Would have to think of derivative vs. direct suits, have to think about what actions lay.

Against the board it would by duty of care. If this was not a corporate opportunity she could sell it to the corp and make a profit as long as she

discloses the profit - talbot v james and the transaction was fair Need to do disclosure and then fairness

If its corporate opportunity then it’s a different set of rules If she doesn't comply with their requests then they will say usurpation and they will have a constructive

trust imposed on her, "pretending that she is holder property for them"o One of the things to distinguish btw care and loyalty - with loyalty the remedies are restitutionary in nature

therefore, if the fiduciaries haven't benefited then we're not talking duty of loyalty but of duty of care Fiduciary means that they have gotten something that he or she should not have gotten, and we reach

into their pockets and say ante up

Concept (d): [Compensation, the Waste Doctrine and the Effect of Shareholder Ratificiation]

Compensation should be reasonable and will be held to this standard when person setting salaries is same person receiving the salary. This is to prevent corporate waste. In other words, the compensation that is tendered by the corp must be roughly commensurate with the consideration that passes to the corp from the employee.

Compensation could come through profit sharing, shared bonuses, stock options, shared purchase plans, deferred compensation plans, pension plans, annuity plans, medical plans, etc…. Employees benefit in a bargained for exchange of consideration.

If the compensation is in stock options, actual compensation is the difference between option price (price employee has right to buy it for) and the fair market value of the share at the date the option is exercised. The stock option price is usually lower than the market value. There are several approaches to valuing stock options of which we do not need to know for exam.

The option plan generally does not require shareholder ratification. However, to be a qualified plan under the federal tax code, one of the conditions is shareholder ratification.

In addition, it is considered compensation and therefore the corp must get something in return for the benefit conferred upon the holder of the option.

Corporate waste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade. Words like outrageous, egregious, substantial, etc…are tossed around in these cases.

Slight deviations above market price, provided there is no self interest, will still be protected by the BJR. Essentially, the transaction must serve the corp purpose, must be done in good faith and for sufficient

consideration. Reminder: corporate gifts constitute waste unless there is some benefit to the corporation such as in a

charitable gift.

Directors at common law did not get compensated unless they rendered extraordinary services. In order for directors to be compensated, they have to be granted compensation, they have to vote on it and the directors are the ones that vote on it. Officers likewise receive compensation but they are typically employees so they get salaries or other forms of compensation. It is the directors that vote on those things as well or delegated authorities of the board but source is from the board.

Doctrine of Corp Waste results when compensation is so excessive that no reasonably prudent person would ever consider such compensation as fair. Corp waste results in ultra vires transactions, and therefore VOID.

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Ultra vires actions in some jurisdictions may be ratified by shareholders by unanimous consent of the shareholders if it follows other requirements under Clark v. Dodge which involved a closed corp setting.

Lewis v. Vogelstein: Directors got together to determine their compensation and value to the corp and they come up with a stock option plan. A shareholder’s derivative suit was brought complaining that these grants of options constitute excessively large compensation for the directors in relation to their service at Matel. Therefore the shareholders put forth two claims: a breach of the director’s fiduc duty of loyalty by self interested dealings regarding their excessive compensation and not disclosing (material omission of) the value of these options when successfully getting shareholder ratification and the argument that these excessive compensations amounted to corporate waste. Here, directors are voting themselves compensation, shareholder looks at that and says is there something wrong b/c self interested transactions. Conflict of interest-self dealing. Directors argue that someone has to vote on their compensation and that they believed these compensations were made in good faith for the best interests of the corp, therefore they are protected under the BJR. The court holds that the directors are not protected by the BJR b/c self interested dealings prevents application of the BJR. The applicable standard when BJR is precluded is the standard of fairness. The intrinsic fairness standard means that in self interested transactions, 1) BJR does not operate to protect directors in decision making function, 2) standard to be applied is one of fairness (must be fair to corp-arms length transaction standard). Is the compensation package equivalent to what an arms length transaction would have been? And 3) burden of proof on question of fairness is on the fiduciary. The court holds that salaries this excessive don’t pass fairness standard and therefore they are wrongful. Such an exaggerated difference between what corp gave up compared to what it received that it is compared to giving away of corp assets: Corporate waste. Court in Lewis says shareholder ratification has an effect on the action of the Matel directors. Four possible effects of shareholder ratifications on director’s actions:

complete defenseshift the substantive test from fairness to that of wasteshift burden of proof from D to Pratification has no effect at all.

The unanimous ratification of the shareholders may be a complete defense to corporate waste when have fulfillment of Clark v. Dodge requirements. However, ratification that is not unanimous, although it will not be a complete defense or vindicate the fiduciaries, may effect the way the court resolves the conflict. That is where the four possible effects listed above come in to the picture.

The Lewis court adopted #2. So the directors get a pass on the intrinsic fairness analysis and go to the standard for corporate waste.

Summary: There are Two Ways the Shareholder’s May Attack the Directors’ Actions:Intrinsic Fairness Standard. Under these circumstances, the BJR does not apply b/c it deals with a self interested

transaction. The burden is on the fiduc to show that the decision was fair. HOWEVER, if there has been shareholder ratification of the directors’ actions, then the directors can argue that

the standard is one of corporate waste and court will not apply the Intrinsic Fairness Standard. Corporate Waste: Under this standard, they will have to show a reasonable relation between their services and the value of

their stock options. That is the standard. The measure of waste is whether any reasonably prudent person would have made this decision. If there is an

absence of any reasonable relationship between what has been given up by corp and what is received by the fiduciaries, then the fiduciaries have committed corporate waste.

This standard is easier on fiduciaries b/c only need reasonable relationship where as with intrinsic fairness standard, need transaction to be fair. Fairness is a higher standard.

Doctrine of waste applies even if fiduc does not benefit from action (similar to breaches of duty of care). So fiduciaries can be held accountable for committing waste even if they don’t benefit.

Concept (e): [Duties of Controlling Shareholders]

The traditional fiduciaries include directors, officers, etc…but controlling shareholders may also have fiduciary duties. In addition, in Donahue, the court, in dicta, suggests that minority shareholders may also owe fiduciary duties b/c they too have the power to screw up.

Application (e):

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1. WHEN A PARENT COMPANY ENGAGES IN SELF-DEALING WITH ITS SUBSIDIARY, THE PARENT HAS THE BURDEN OF PROVING THE INTRINSIC FAIRNESS OF THE CHALLENGED TRANSACTION: (Sinclair Oil v. Levien).

a. Facts: P, a shareholder of Sinven, brought a derivative action against Sinclair, owner of 97% of Sinven’s stock. P alleging that Sinclair caused Sinven to pay excessive dividends, denied Sinven opportunities to develop and expand, and breached a requirements K with Sinven. As a parent company, Sinclair nominated the members of Sinven’s BOD, all of whom were directors or employees of Sinclair. For a period of 6 years Sinven paid out dividends that exceeded earnings. P claimed that dividends were paid in order to infuse Sinclair with cash. P also claimed that Sinclair’s policy of pursuing development through other subsidiaries denied Sinven any opportunity to expand its operations. P’s final claim stemmed from a requirements K btw Sinven and Intl, one of Sinclair’s subsidiaries. P alleged that Intl breached the K by consistently being late on payments and by purchasing less oil then the K’s minimum.

b. Issue: Should challenged transactions btw a parent company and its subsidiary be tested by the BJR?c. Holding: No. When the transactions involves a parent and a subsidiary, with the parent controlling the

transaction and fixing the terms, the test of intrinsic fairness, with its resulting shift of the burden of proof, is applied. A parent does owe a fiduciary duty to tis subsidiary when there are parent-sub dealings. However, this alone will not invoke the intrinsic fairness standard. This standard will be applied only when the fiduc duty is accompanied by self-dealing – the situation where the parent is on both sides of the transaction. Self dealing occurs when the parent, by virtue of its dominations of the sub causes the sub to act in such a way that the patent receives something from the sub to the exclusion and detriment of the minority stockholders of the sub. Applying this rule to the facts we find that the excessive payment of dividends did not involve self-dealing b/c both, Sinclair and the minority shareholders received a proportionate share. Thus, the BJR should have applied, and Sinclair’s motives are immaterial, unless the payments amounted to waste. As to the claim of denied expansion, P has not pointed to any particular opportunities that were presented to Sinven, and usurped by Sincliar. Sinclair was under no duty to actively seek expansion opportunities for Sinven. We do find, however, the K btw Intl and Sinven was self dealing. Sinclair, through its sub, received the products byt failed to comply with the terms of the K, all to the detriment of Sinven’s minority shareholders. As a result, Sinclar was required to prove that the K was intrinsically fair. This, it failed to do.

d. Lesson from this case: once self dealing exists , the intrinsic fairness standard applies and the burden shiftsi. If it doesn't apply, then the directors are protected by the operation of the business judgment rule

(This is their defense)ii. They are protected by the BJR unless the P can establish that the BJR does not apply

1. P could assert some egregious conduct such as gross negligence2. P could assert waste - it means you gave away stuff and didn't receive just consideration

for ita. Waste is in the eyes of the beholder, what's waste to you may not me waste to me

Concept (f): [Sale of Control]

A controlling shareholder sometimes sells his stock at a premium b/c he is not only selling the stock but he is also selling the control of the corporation. Some theorists suggest that the controlling shareholder should account to the corp for the profits made based on the selling of control of the corp since the control if the corp is an asset of the corp that belongs to everyone, all shareholders. Other theorists suggest that the controlling shareholder should be able to do whatever he wants since he paid the money to control the corp.

General Rule: A shareholders is allowed to sell at a premium and therefore does need to offer the same deal to everyone (i.e. minority shareholders). BUT there are well recognized restrictions on the controlling shareholder’s power to sell. There are three exceptions to this general rule:

Selling to a Known Looter: If selling the controlling share to someone who is a known looter (a person/company who loots corp assets and then dumps the corp), then the controlling shareholder will be held accountable based on a breach of fiduc duty of care. There are corps out there that see certain weaknesses in other corps so they come in, buy out controlling

interests, and destroy corp and make money doing so. Harris v. Carter: This case stands for the proposition that the controlling shareholder does not need

actual knowledge but the standard is whether a reasonably prudent person would be alerted to the risk that the buyer is dishonest. The controlling shareholder has a duty to make an inquiry, a reasonable investigation of the buying corp. If reasonable investigation would have disclosed facts or intentions or reputation of buyer, then controlling shareholder has breached his duty of care (i.e., neglect of duty; failure to act; failure to investigate). Donald Carter and others owned 52% of Atlas Corp. The Carter

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group sold its stock in Atlas and transferred control of Atlas’s board to Frederic Mascolo and others. P, a minority shareholder in Atlas claimed that the Mascolo group had looted Atlas by engaging in self-dealing transactions on unfair terms & that the Carter group was liable for the resulting losses to Atlas b/c it had reason to suspect the integrity of the Moscolo group but failed to conduct even a cursory investigation. Court held for shareholders.

Conversion of a Corp Opportunity: This is the theory of corporate action. When a third party wants to acquire the controlling interest so he can take over the corp, he can do it in one of the following way:

(1) Buy from Controlling Shareholder . Approach a controlling shareholder and offer to purchase the shares (Zetland); or

(2) Tender Offer . If shares are spread out, make a tender offer by approaching all different shareholders in order to accumulate controlling share; or

(3) Merger or Acquisition Route . Approach board of directors of corp and try to take over corp through merger or sale of all assets.

If third party attempts the merger route or asset acquisition route, everyone involved in corp being take over will benefit (i.e. all shareholders share in that benefit).

The corp opportunity comes into play when the controlling shareholder approaches third party and says “you don’t have to buy the assets or merge with corp, all you have to do to take over corp is to buy my controlling interest, it is yours.” That is the theory of corp action. When controlling shareholder does that it is a conversion of a corp opportunity. It is a corp opportunity b/c depriving corp and all its parts the opportunity to share in the takeover which would have resulted if there was a merger or an asset acquisition.

Fraud or Other Acts of Bad Faith: This may include the sale of an asset (Perlman) such as the sale of a corp position like the position of president, officer, etc…

An agreement between the buyer and seller to buy a controlling shareholder’s shares at a premium may be coupled with an agreement to have a majority of the directors resign in order for the buying corp to place their own directors in those positions. This is a legal contract. The purpose of buying a controlling share is to CONTROL the company which you do by having a majority of your own directors on the board. Therefore if a buyer buys a controlling share, he may also require that a majority of the board resign so his new director’s can be elected.

However, if the buyer buys a NON-controlling share of the corporation at a premium b/c he will be allowed to elect a majority of directors, then the agreement will be invalid b/c he is essentially selling the director’s positions for the premium which is the sale of an asset of the corp and will be considered an act of bad faith.

Next series of cases: theory of action is that ppl who are controlling shareholders in selling controlling interests are selling something that doesn't belong to them -- control in a corp.

o Control is not something to be used for the benefit of any one particular shareholdero A logical extension is that if your selling controlling interest and ur making an extra buck b/c of the

premium, then the premium is something you got for the control feature and the control feature doesn't belong to you so the premium doesn't belong to you.

o Ramifications of this action: making a buck is wiped away Control feature is something you don't own

Application (f):

1. ABSENT LOOTING OF CORPORATE ASSETS, CONVERSION OF A CORPORATE OPPORTUNITY, FRAUD, OR OTHER ACTS OF BAD FAITH, A CONTROLLING SHAREHOLDER IS FREE TO SELL AND A PURCHASER IS FREE TO BUY, THAT CONTROLLING INTEREST AT A PREMIUM PRICE: (Zetlin v. Hanson Holdings).

a. Facts: Hanson Holdings and Sylvestri, owners of over 44% of the outstandinf shares in Gable, sold their entire controlling share to Flintoke for a premium price of $15 per share, at a time when the stock was trading at $7.38 per share. The stock acquired represented effective control of Gable.

b. Issue: Are minority shareholders entitled to an opportunity to share equally in any premium paid for a controlling interest in the corporation?

c. Holding: No. Court held that in recognizing that those who invest the capital necessary to acquire a dominant position in the ownership of the corporation have the right of controlling that corporation, it is well established law that absent looting of the corporate assets, conversion of a corporate opportunity, or fraud or other acts of bad faith, a controlling shareholder is free to sell, and a purchaser is free to buy that controlling interest at a premium

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price. The court held that they will not require the buyer to make the same offer to everyone else and won’t require seller, the controlling shareholder to share the premium.

d. Prof: In taking the benefit to themselves, they are breaching the duty of loyaltyi. In doing what they did, they are breaching their duty of loyalty b/c control is something that they do not

own for their own benefit, control is something that is held for the benefit of the venture.ii. Starting with Donahue - interests conflict with duty

2. Kaplan case: This case stands for proposition that you cant buy and sell corp positions, either officers (i.e. executives) or director’s positions. One shareholder owned 3% of shares, not a controlling interest. He sold shares and along with sale, provided 6 out of ten positions on board of directors. It was a ten person board, he could provide 6 members of board. Don’t know how someone with a 3% share was able to pick 6 out of ten directors but he did. Stock brought premium b/c of that even though not a controlling shareholder, he is selling positions on the board and held accountable for it.

3. Essex Universal Corp v. Yates: Defendant Yates was president and chairman of the board of directors of Republic Pictures Corporation. Essex Universal Corporation learned of the possibility of purchasing from Yates an interest in Republic. Yates & Harris (president of Essex) signed a contract in which Essex agreed to buy and Yates to “sell or cause to be sold” at least 500,000 and not more than 600,000 share of Republic stock - at $8 per share ($2 over market price). The contract contained a provision on “Resignations” - in which seller promised to deliver to buyer the resignations of the majority of the directors of Republic - allow for a special meeting of the board of directors and the nominees of the buyer to be elected directors. Such a procedure was in form, permissible under the charter and by-laws of Republic, which empowered the board to choose the successor of any of its members who might resign. The court held that a resignation provision does not, on its face, render the contract illegal and unenforceable. This case reinforces Zetland and adds the allowance of contracting for the resignation of a majority of director’s as long as the agreement is for the sale of a controlling share of the corporation.

4. A DOMINANT SHAREHOLDER MAY NOT RECEIVE A PREMIUM FOR THE CONTROL OVER CORPORATE ASSETS OR BUSINESS OPPORUNTITUES: (Perlman v. Feldmann).

a. Facts: Minority shareholders of Newport steel bring derivative action in fed district court under diversity of citizenship. The action was to compel an accouting for and restitution of, allegedly illegal gains accrued to Feldmann as a result of their controlling interests in the Corp. Feldmann had the controlling interests of the corp and was also the pres and chairmen of the board of directors. Feldmann selling stock at $20 per share when it has a market price of $12 and a book value of $17. The buyers, Wilport Co., consisted of end-users of steel who were interested in securing a source of supply in a market becoming ever tighter in the Korean War.

b. Holding: Ultimately, the shareholders were complaining of a breach of the duty of loyalty and wanted restitution. The court held that the consideration paid for the stock included compensation for the sale of a corporate asset (under exception #3 above), b/c he was selling a power held in trust for the corp by Feldmann as a fiduciary. This power was the ability to control the allocation of the corporate product in a time of short supply, through control of the board of directors; and it was effectively transferred in this sale by having Feldmann procure the resignation of his own board and the election of Wilport’s nominees immediately upon consummation of the sale. Both as director and as dominant stockholder, Feldmann stood in a fiduciary relationship to the corporation and to the minority stockholders as beneficiaries thereof. The court held for the shareholders and precluded the new shareholders from a piece of the recovery. The court can do this b/c it is a court of equity and they can do just about anything.

Note on Difference Between Derivative Action and a Direct Action:A wrongful action that depletes or destroys corporate assets, and affects the shareholder only by reducing the value of the

stock, gives rise only to an action on the corporation’s behalf.Wrongful actions that do not deplete or divert corporate assets, and interferes with rights that are traditionally viewed as

either incident to the ownership of stock or inhering in the shares themselves (such as voting or pre-emptive rights), gives rise only to a direct action by the injured shareholders.

Those with both actions will be considered two actions, one derivative and one direct. This occurs in proxy-rule violations where there is an interference with the individual shareholder’s voting right and involves a breach of management’s fiduciary obligations.

Under derivative actions, the recovery will go to the corp while with direct actions, the recovery will go directly to the shareholders.

Note on Who Can Bring a Derivative Action

Contemporaneous Shareholder Status

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It is generally agreed that the plaintiff in a derivative action must be a shareholder at the time the action is begun and must remain a shareholder during the pendency of the action

What constitutes shareholdership for derivative-action purpose? The NY Business Corporations Law Statute : Provides that a plaintiff in a derivative suit must be “a

holder of shares or of voting trust certificates or of a beneficial interest in such shares or certificates The Courts Define Shareholdership :

Record ownership is generally not required, an unregistered shareholder will qualifyLegal ownership is not required -- equitable ownership suffices

Parent/Subsidiary : A shareholder in a parent corporation can bring a derivative action on behalf of a subsidiary, despite the fact that he is not a shareholder in the subsidiary

Creditors An implication from the rule that the plaintiff in a derivative action must be a shareholder at the time he brings

suit is that a creditor (including a bondholder) ordinarily has no right to bring a derivative action However, if a corporation is insolvent in fact, the directors owe fiduciary duties to the creditors, whether or not

there has been a statutory filing under bankruptcy lawDirectors

Occasionally a statute gives an officer or director the right to bring a derivative action

Note on the Corporation as an Indispensable Party It is well established that the corporation is an indispensable party to a derivative action, and therefore must be joined

in the suit.

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