1. Agency/Sole Proprietorships a. Statutes i. RESTATMENT (SECOND) OF AGENCY 1. l. Agency; Principal; Agent a.

. (1) Agency is the fiduciary relation which results from the manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act. b. (2) The one for whom action is to be taken is the principal. c. (3) The one who is to act is the agent. 2. 2. Master; Servant; Independent Contractor a. (1) A master is a principal who employs an agent to perform service in his affairs and who controls or has the right to control the physical conduct of the other in the performance of the service. b. (2) A servant is an agent employed by a master to perform service in his affairs whose physical conduct in the performance of the service is controlled or is subject to the right to control by the master. c. (3) An independent contractor is a person who contracts with another to do something for him but who is not controlled by the other nor subject to the others right to control with respect to his physical conduct in the performance of the undertaking. He may or may not be an agent. 3. 3. General Agent; Special Agent a. (l) A general agent is an agent authorized to conduct a series of transactions involving a continuity of service. 4. 4. Disclosed Principal; Partially Disclosed Principal; Undisclosed Principal a. (1) If, at the time of a transaction conducted by an agent, the other party thereto has notice that the agent is acting for a principal and of the principals identity, the principal is a disclosed principal. b. (2) lf the other party has notice that the agent is or may be acting for a principal but has no notice of the principals identity, the principal for whom the agent is acting is a partially disclosed principal. c. (3) lf the other party has no notice that the agent is acting for a principal, the one for whom he acts is an undisclosed principal 5. 6. Power

a. A power is an ability on the part of a person to produce a change in a given legal relation by doing or not doing a given act. 6. 7. Authority a. Authority is the power of the agent to affect the legal relations of the principal by acts done in accordance with the principals manifestations of consent to him. 7. 8. Apparent Authority a. Apparent authority is the power to affect the legal relations of another person by transactions with third persons, professedly as agent for the other, arising from and in accordance with the others manifestations to such third persons. 8. 8A. Inherent Agency Power a. Inherent agency power is a term used in the restatement of this subject to indicate the power of an agent which is derived not from authority, apparent authority or estoppel, but solely from the agency relation and exists for the protection of persons harmed by or dealing with a servant or other agent. 9. 8B. EstoppelChange of Position a. (1) 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 because of their belief that the transaction was entered into by or for him, if i. (a) he intentionally or carelessly caused such belief, or ii. (b) knowing of such belief and that others might change their positions because of it, he did not take reasonable Steps to notify them of the facts. b. (2) An owner of property who represents to third persons that another is the owner of the property or who permits the other so to represent, or who realizes that third persons believe that another is the owner of the property, and that he could easily inform the third persons of the facts, is subject to the loss of the property if the other disposes of it to third persons who, in ignorance of the facts, purchase the property or otherwise change their position with reference to it. c. (3) Change of position, as the phrase is used in the restatement of this subject, indicates payment of money,

expenditure of labor, suffering a loss or subjection to legal liability. 10. 13. Agent as a Fiduciary a. An agent is a fiduciary with respect to matters within the scope of his agency. 11. 26. Creation of Authority; General Rule a. Except for the execution of instruments under sea] or for the performance of transactions required by statute to be authorized in a particular way, authority to do an act can be created by written or spoken words or other conduct of the principal which, reasonably interpreted, causes the agent to believe that the principal desires him so to act on the principals account. 12. 27. Creation of Apparent Authority: General Rule a. Except for the execution of instruments under seal or for the conduct of transactions required by statute to be authorized in a particular way, apparent authority to do an act is created as to a third person by written or spoken words or any other conduct of the principal which, reasonably interpreted, causes the third person to believe that the principal consents to have the act done on his behalf by the person purporting to act for him. 13. 33. General Principle of Interpretation a. An agent is authorized to do, and to do only, what is reasonable for him to infer that the principal desires him to do in light of the principals manifestations and the facts as he knows or should know them at the time he acts. 14. 34. Circumstances Considered in Interpreting Authority a. An authorization is interpreted in light of all accompanying circumstances, including among other matters: i. (a) the situation of the parties, their relations to one another, and the business in which they are engaged; ii. (b) the general usages of business, the usages of trades or employments of the kind to which the authorization relates, and the business methods of the principal; iii. (c) facts of which the agent has notice respecting the objects which the principal desires to accomplish; iv. (d) the nature of the subject matter, the circumstances under which the act is to be performed and the legality or illegality of the act; and 3

v. (e) the formality or informality, and the care, or lack of it, with which an instrument evidencing the authority is drawn. 15. 82. Ratification a. Ratification is the affirmance by a person of a prior act which did not bind him but which was done or professedly done on his account, whereby the act, as to some or all persons, is given effect as if originally authorized by him. 16. 83. Affirmance a. Affirmance is either i. (a) a manifestation of an election by one on whose account an unauthorized act has been done to treat the act as authorized, or ii. (b) conduct by him justifiable only if there were such an election. 17. 144. General Rule [Disclosed and Partially Disclosed Principals] a. A disclosed or partially disclosed principal is subject to liability upon contracts made by an agent acting within his authority if made in proper form and with the understanding that the principal is a party. 18. 145. Authorized Representations a. In actions brought upon a contract or to rescind a contract or conveyance to which he is a party, a disclosed or partially disclosed principal is responsible for authorized representations of an agent made in connection with it as if made by himself, subject to the rules as to the effect of knowledge of, and notifications given to, the agent. 19. 159. Apparent Authority a. A disclosed or partially disclosed principal is subject to liability upon contracts made by an agent acting within his apparent authority if made in proper form and with the understanding that the apparent principal is a party. The rules as to the liability of a principal for authorized acts, are applicable to unauthorized acts which are apparently authorized. 20. 160. Violation of Secret Instructions a. A disclosed or partially disclosed principal authorizing an agent to make a contract, but imposing on him limitations as to incidental terms intended not to be revealed, is subject to liability upon a contract made in violation of such limitations with a third person who has no notice of them. 21. 161. Unauthorized Acts of General Agent a. A general agent for a disclosed or partially disclosed principal subjects his principal to liability for acts done on 4

his account which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized. 22. 186. General Rule [Undisclosed Principals] a. An undisclosed principal is bound by contracts and conveyances made on his account by an agent acting within his authority, except that the principal is not bound by a contract which is under seal or which is negotiable, or upon a contract which excludes him. 23. 194. Acts of General Agents a. A general agent for an undisclosed principal authorized to conduct transactions subjects his principal to liability for acts done on his account, if usual or necessary in such transactions, although forbidden by the principal to do them. 24. 195. Acts of Manager Appearing to be Owner a. An undisclosed principal who entrusts an agent with the management of his business is subject to liability to third persons with whom the agent enters into transactions usual in such businesses and on the principals account, although contrary to the directions of his principal. 25. 219. When a Master Is Liable for Torts of his Servants a. (1) A master is subject to liability for the torts of his servants committed while acting in the scope of their employment. b. (2) A master is not subject to liability for the torts of his servants acting outside the scope of their employment, unless: i. (a) the master intended the conduct or the consequence, ii. (b) the master was negligent or reckless, iii. (c) the conduct violated a non-delegatable duty of the master, or iv. (d) the servant purported to act or to speak on behalf of the principal and there was reliance upon apparent authority, or he was aided in accomplishing the tort by the existence of the agency relation. 26. 220. Definition of Servant a. (1) A servant is a person employed to perform services in the affairs of another and who with respect to the physical

b.

27. 228. a.

28. 230. a. 29. 231. a.

conduct in the performance of the services is subject to the others control or right to control. (2) In determining whether one acting for another is a servant or an independent contractor, the following matters of fact, among others, are considered: i. (a) the extent of control which, by the agreement, the master may exercise over the details of the work; ii. (b) whether or not the one employed is engaged in a distinct occupation or business; iii. (c) the kind of occupation, with reference to whether, in the locality, the work is usually done under the direction of the employer or by a specialist without supervision; iv. (d) the skill required in the particular occupation; v. (e) whether the employer or the workman supplies the instrumentalities, tools, and the place of work for the person doing the work; vi. (f) the length of time for which the person is employed; vii. (g) the method of payment, whether by the time or by the job; viii. (h) whether or not the work is a part of the regular business of the employer; ix. (i) whether or not the parties believe they are creating the relation of master and servant; and x. (j) whether the principal is or is not in business. General Statement [of Scope of Employment Doctrine] (1) Conduct of a servant is within the scope of employment if, but only if, i. (a) it is of the kind he is employed to perform; ii. (b) it occurs substantially within the authorized time and space limits; iii. (c) it is actuated, at least in part, by a purpose to serve the master; and iv. (d) if force is intentionally used by the servant against another, the use of force is not unexpectable by the master. Forbidden Acts An act, although forbidden, or done in a forbidden manner, may be within the scope of employment. Criminal or Tortious Acts An act may be within the scope of employment although consciously criminal or tortious. 6

30. 376. General Rule [Duties of Agent to Principal] a. The existence and extent of the duties of the agent to the principal are determined by the terms of the agreement between the parties, interpreted in light of the circumstances under which it is made . . . . 31. 377. Contractual Duties a. A person who makes a contract with another to perform services as an agent for him is subject to a duty to act in accordance with his promise. 32. 379. Duty Of Care And Skill a. (1) Unless otherwise agreed, a paid agent is subject to a duty to the principal to act with standard care and with the skill which is Standard in the locality for the kind of work which he is employed to perform and, in addition, to exercise any special skill that he has. b. (2) Unless otherwise agreed, a gratuitous agent is under a duty to the principal to act with the care and skill which is required of persons not agents performing similar gratuitous undertakings for others. 33. 381. Duty to Give Information a. Unless otherwise agreed, an agent is subject to a duty to use reasonable efforts to give his principal information which is relevant to affairs entrusted to him and which, as the agent has notice, the principal would desire to have and which can be communicated without violating a superior duty to a third person. 34. 385. Duty to Obey a. (1) Unless otherwise agreed, an agent is subject to a duty to obey all reasonable directions in regard to the manner of performing a service that he has contracted to perform. 35. 386. Duties After Termination of Authority a. Unless otherwise agreed, an agent is subject to a duty not to act as such [i.e., authorized] after the termination of his authority. 36. 387. General Principle [Duty of Loyalty] a. Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his agency. 37. 393. Competition as to Subject Matter of Agency a. Unless otherwise agreed, an agent is subject to a duty not to compete with the principal concerning the subject matter of the agency. 38. 394. Acting for One with Conflicting Interests

a. Unless otherwise agreed, an agent is subject to a duty not to act or to agree to act during the period of his agency for persons whose interests conflict with those of the principal in matter in which the agent is employed. 39. 395. Using Or Disclosing Confidential Information a. Unless otherwise agreed, an agent is subject to a duty to the principal not to use or to communicate information confidentially given him by the principal or acquired by him during the course of or on account of his agency or in violation of his duties as agent, in competition with or to the injury of the principal, on his own account or on behalf of another, although such information does not relate to the transaction in which he is then employed, unless the information is a matter of general knowledge. 40. 396. Using Confidential Information After Termination of Agency a. Unless otherwise agreed, after the termination of the agency, the agent: i. (a) has no duty not to compete with the principal; ii. (b) has a duty to the principal not to use or to disclose to third persons, on his own account or on account of others, in competition with the principal or to his injury, trade secrets, written lists of names, or similar confidential matters given to him only for the principals use or acquired by the agent in violation of [a] duty. The agent is entitled to use general information concerning the method of business of the principal and the names of the customers retained in his memory, if not acquired in violation of his duty as agent; . . . iii. (d) has a duty to the principal not to take advantage of a still subsisting confidential relation created during the prior agency relation. 41. 399. Remedies of Principal a. A principal whose agent has violated or threatens to violate his duties has an appropriate remedy for such violation. Such remedy may be: i. (a) an action on the contract of service; ii. (b) an action for losses and for the misuse of property; iii. (c) an action in equity to enforce the provisions of an express trust undertaken by the agent; iv. (d) an action for restitution, either at law or in equity; . . . v. (f) an action for an injunction; 8

vi. (g) set-off or counterclaim; . . . vii. (j) discharge; . . . . ii. RESTATMENT (THIRD) OF AGENCY 1. 1.01. Agency Defined a. Agency is the fiduciary relationship that arises when one person (a principal) manifests assent to another person (an agent) that the agent shall act on the principals behalf and subject to the principals control, and the agent manifests assent or otherwise consents so to act. 2. 1.02. Parties Labeling and Popular Usage Not Controlling a. An agency relationship arises only when the elements stated in 1.01 are present. Whether a relationship is characterized as agency in an agreement between parties or in the context of industry or popular usage is not controlling. 3. 1.03. Manifestation a. A person manifests assent or intention through written or spoken words or other conduct. 4. 1.04. Terminology a. (2)(a) Disclosed principal. A principal is disclosed if, when an agent and a third party interact, the third party has notice that the agent is acting for a principal and has notice of the principals identity. b. (b) Undisclosed principal. A principal is undisclosed if, when an agent and a third party interact, the third party has no notice that the agent is acting for a principal. c. (c) Unidentified principal. A principal is unidentified if, when an agent and a third party interact, the third party has notice that the agent is acting for a principal but does not have notice of the principals identity. 5. 2.01. Actual Authority a. An agent acts with actual authority when, at the time of taking action that has legal consequences for the principal, the agent reasonably believes, in accordance with the principals manifestations to the agent, that the principal wishes the agent so to act. 6. 2.02. Scope of Actual Authority a. (1) An agent has actual authority to take action designated or implied in the principals manifestations to the agent and acts necessary or incidental to achieving the principals objectives, as the agent reasonably understands the principals manifestations and objectives when the agent determines how to act.

b. (2) An agents interpretation of the principals manifestations is reasonable if it reflects any meaning known by the agent to be ascribed by the principal and, in the absence of any meaning known to the agent, as a reasonable person in the agents position would interpret the manifestations in light of the context, including circumstances of which the agent has notice and the agents fiduciary duty to the principal. c. (3) An agents understanding of the principals objectives is reasonable if it accords with the principals manifestations and the inferences that a reasonable person in the agents position would draw from the circumstances creating the agency. 7. 2.03. Apparent Authority a. Apparent authority is the power held by an agent or other actor to affect a principals legal relations with third parties when a third party reasonably believes the actor has authority to act on behalf of the principal and that belief is traceable to the principals manifestations. 8. 2.04. Respondeat Superior a. An employer is subject to liability for torts committed by employees while acting within the scope of their employment. 9. 2.05. Estoppel to Deny Existence of Agency Relationship a. A person who has not made a manifestation that an actor has authority as an agent and who is not otherwise liable as a party to a transaction purportedly done by the actor on that persons account is subject to liability to a third party who justifiably is induced to make a detrimental change in position because the transaction is believed to be on the persons account, if i. (1) the person intentionally or carelessly caused such belief, or ii. (2) having notice of such belief and that it might induce others to change their positions, the person did not take reasonable steps to notify them of the facts. 10. 2.06. Liability of Undisclosed Principal a. (1) An undisclosed principal is subject to liability to a third party who is justifiably induced to make a detrimental change in position by an agent acting on the principal's behalf and without actual authority if the principal, having notice of the agents conduct and that it might induce

10

others to change their positions, did not take reasonable steps to notify them of the facts. b. (2) An undisclosed principal may not rely on instructions given an agent that qualify or reduce the agents authority to less than the authority a third party would reasonably believe the agent to have under the same circumstances if the principal had been disclosed. 11. 3.01. Creation of Actual Authority a. Actual authority, as defined in 2.01, is created by a principals manifestation to an agent that, as reasonably understood by the agent, expresses the principals assent that the agent take action on the principals behalf. 12. 3.03. Creation of Apparent Authority a. Apparent authority, as defined in 2.03, is created by a persons manifestation that another has authority to act with legal consequences for the person who makes the manifestation, when a third party reasonably believes the actor to be authorized and the belief is traceable to the manifestation. 13. 3.06. Termination of Actual AuthorityIn General a. An agents actual authority may be terminated by: b. (1) the agents death, cessation of existence, or suspension of powers as stated in 3.07(1) and (3); or c. (2) the principals death, cessation of existence, or suspension of powers as stated in 3.07(2) and (4); or d. (3) the principals loss of capacity, as stated in 3.08(1) and (3); or e. (4) an agreement between the agent and the principal or the occurrence of circumstances on the basis of which the agent should reasonably conclude that the principal no longer would assent to the agents taking action on the principals behalf, as stated in 3.09; or f. (5) a manifestation of revocation by the principal to the agent, or of renunciation by the agent to the principal, as stated in 3.10(1); or g. (6) the occurrence of circumstances specified by statute. 14. 3.11. Termination of Apparent Authority a. (1) The termination of actual authority does not by itself end any apparent authority held by an agent. b. (2) Apparent authority ends when it is no longer reasonable for the third party with whom an agent deals to believe that the agent continues to act with actual authority. 15. 4.01. Ratification Defined 11

a. (1) Ratification is the affirmance of a prior act done by another, whereby the act is given effect as if done by an agent acting with actual authority. b. (2) A person ratifies an act by i. (a) manifesting assent that the act shall affect the persons legal relations, or ii. (b) conduct that justifies a reasonable assumption that the person so consents. . . . 16. 4.06. Knowledge Requisite to Ratification a. A person is not bound by a ratification made without knowledge of material facts involved in the original act when the person was unaware of such lack of knowledge. 17. 6.01. Agent for Disclosed Principal a. When an agent acting with actual or apparent authority makes a contract on behalf of a disclosed principal, b. (1) the principal and the third party are parties to the contract; and c. 2) the agent is not a party to the contract unless the agent and third party agree otherwise. 18. 6.02. Agent for Unidentified Principal a. When an agent acting with actual or apparent authority makes a contract on behalf of an unidentified principal, b. (1) the principal and the third party are parties to the contract; and c. (2) the agent is a party to the contract unless the agent and the third party agree otherwise. 19. 6.03. Agent for Undisclosed Principal a. When an agent acting with actual authority makes a contract on behalf of an undisclosed principal, b. (1) unless excluded by the contract, the principal is a party to the contract; c. (2) the agent and the third party are parties to the contract; and d. (3) the principal, if a party to the contract, and the third party have the same rights, liabilities, and defenses against each other as if the principal made the contract personally, subject to 6.05-6.09. 20. 6.04. Principal Does Not Exist or Lacks Capacity a. Unless the third party agrees otherwise, a person who makes a contract with a third party purportedly as an agent on behalf of a principal becomes a party to the contract if the purported agent knows or has reason to know that the purported principal does not exist or lacks capacity to be a party to a contract. 12

21. 6.10. Agents Implied Warranty of Authority a. A person who purports to make a contract, representation, or conveyance to or with a third party on behalf of another person, lacking power to bind that person, gives an implied warranty of authority to the third party and is subject to liability to the third party for damages for loss caused by breach of that warranty, including loss of the benefit expected from performance by the principal, unless b. (1) the principal or purported principal ratifies the act as stated in 4.01; or c. (2) the person who purports to make the contract, representation, or conveyance gives notice to the third party that no warranty of authority is given; or d. (3) the third party knows that the person who purports to make the contract, representation, or conveyance acts without actual authority. 22. 7.03. Principals LiabilityIn General a. . . . (2) A principal is subject to vicarious liability to a third party harmed by an agents conduct when i. (a) as stated in 7.07, the agent is an employee who commits a tort while acting within the scope of employment; or ii. (b) as stated in 7.08, the agent commits a tort when acting with apparent authority in dealing with a third party on or purportedly on behalf of the principal. 23. 7.07. Employee Acting Within Scope of Employment a. (1)An employer is subject to vicarious liability for a tort committed by its employee acting within the scope of employment. b. (2) An employee acts within the scope of employment when performing work assigned by the employer or engaging in a course of conduct subject to the employers control. An employees act is not within the scope of employment when it occurs within an independent course of conduct not intended by the employee to serve any purpose of the employer. c. (3) For purposes of this section, i. (a) an employee is an agent whose principal controls or has the right to control the manner and means of the agents performance of work, and ii. (b) the fact that work is performed gratuitously does not relieve a principal of liability. 24. 7.08. Agent Acts with Apparent Authority 13

a. A principal is subject to vicarious liability for a tort committed by an agent in dealing or communicating with a third party on or purportedly on behalf of the principal when actions taken by the agent with apparent authority constitute the tort or enable the agent to conceal its commission. 25. 8.01. General Fiduciary Principal a. An agent has a fiduciary duty to act loyally for the principals benefit in all matters connected with the agency relationship. 26. 8.02. Material Benefit Arising out of Position a. An agent has a duty not to acquire a material benefit from a third party in connection with transactions conducted or other actions taken on behalf of the principal or otherwise through the agents use of the agents position. 27. 8.03. Acting as or on Behalf of an Adverse Party a. An agent has a duty not to deal with the principal as or on behalf of an adverse party in a transaction connected with the agency relationship. 28. 8.04. Competition a. Throughout the duration of an agency relationship, an agent has a duty to refrain from competing with the principal and from taking action on behalf of or otherwise assisting the principals competitors. During that time, an agent may take action, not otherwise wrongful, to prepare for competition following termination of the agency relationship. 29. 8.05. Use of Principals Property; Use of Confidential Information a. An agent has a duty b. (1) not to use property of the principal for the agents own purposes or those of a third party; and c. (2) not to use or communicate confidential information of the principal for the agents own purposes or those of a third party. 30. 8.07. Duty Created by Contract a. An agent has a duty to act in accordance with the express and implied terms of any contract between the agent and the principal. 31. 8.08. Duties of Care, Competence, and Diligence a. Subject to any agreement with the principal, an agent has a duty to the principal to act with the care, competence, and diligence normally exercised by agents in similar circumstances. Special skills or knowledge possessed by 14

an agent are circumstances to be taken into account in determining whether the agent acted with due care and diligence. If an agent claims to possess special skills or knowledge, the agent has a duty to the principal to act with the care, competence, and diligence normally exercised by agents with such skills or knowledge. 32. 8.09. Duty to Act Only Within Scope of Actual Authority and to Comply with Principals Lawful Instructions a. (1) An agent has a duty to take action only within the scope of the agents actual authority. b. (2) An agent has a duty to comply with all lawful instructions received from the principal and persons designated by the principal concerning the agents actions on behalf of the principal. 33. 8.10. Duty of Good Conduct a. An agent has a duty, within the scope of the agency relationship, to act reasonably and to refrain from conduct that is likely to damage the principals enterprise. 34. 8.11. Duty to Provide Information a. An agent has a duty to use reasonable effort to provide the principal with facts that the agent knows, has reason to know, or should know when i. (1) subject to any manifestation by the principal, the agent knows or has reason to know that the principal would wish to have the facts or the facts are material to the agents duties to the principal; and ii. (2) the facts can be provided to the principal without violating a superior duty owed by the agent to another person. 35. 8.14. Duty to Indemnify a. A principal has a duty to indemnify an agent b. (1) in accordance with the terms of any contract between them; and c. (2) unless otherwise agreed, i. (a) when the agent makes a payment 1. (i) within the scope of the agents actual authority, or 2. (ii) that is beneficial to the principal, unless the agent acts officiously in making the payment; or ii. (b) when the agent suffers a loss that fairly should be borne by the principal in light of their relationship. 15

36. 8.15. Principals Duty to Deal Fairly and in Good Faith a. A principal has a duty to deal with the agent fairly and in good faith . . . . b. Cases i. Mill Street Church of Christ v. Hogan, (1990). 1. Facts: Hogan was injured after he was hired by a church employee (his brother) to paint the inside of the church. The church agreed employee needed help but disagreed as to who the help was. 2. Rule: Implied authority is actual authority that the principal intended the agent to possess and includes such powers as are practically necessary to carry out the delegated duties. The past acts were sufficient to imply authority. (Did not have actual express, but had actual implied). 3. Analysis: If the agent knows he has a principals authority, actual authority exists. If actual authority does not exist but a third party reasonably believes from the principals actions that authority exists, apparent authority is created. Implied authority is actual authority that the principal never formally conferred but that can be inferred based on the authority granted and past conduct. If the 3rd party knows that the authority does not in fact exist authority is destroyed. ii. Humble Oil & Refining Co. v. Martin 1. Martin suffered a personal injury at a gas station run by Schneider, but owned by Humble Oil. The question is whether Schneider is an independent contractor, or just a servant/employee. Most of the important business decisions are made by Humble. The risk of profit and loss lies with Humble; therefore it would naturally be interested in controlling the operations of the gas station: which is consistent with an employer/employee relationship. Thus, vicarious liability is present. iii. Hoover v. Sun Oil Co. 1. Same situation but in this case the guy who ran the station was really an independent contractor. Barone, alone, assumed the overall risk of profit and loss. (the big barometer). Sunoco offered advice, but Barone was not obligated to take it. Barone made no written reports to Sunoco. Thus, vicarious liability is NOT present. The difference between the two is who has the greater risk of profit and loss. iv. Shlensky v Wrigley (1968) 95 Ill.App.2d 173 1. P: Minority shareholder, suing saying that the company isnt being managed right (negligent, acting arbitrary and capriciously, and mismanagement) D: Wrigley Field, P says that D is mismanaging the organization because they do not have lights in the stadium and due to this are unable to have night games which is bad for revenue.The judgment: Unless there is a red flag such as D acting illegally, fraud, negligence, or competing interest then the court will not step in and will allow them to manage the company 16

the way that they would like to. P could do something about it such as sell or vote differently so they vote the people out. v. Murphy v Holiday INN Inc (1975) 1. Facts: Plaintiff slipped and fell on a puddle of water that was dripping from an air conditioning unit at the hotel. Plaintiff wanted to hold Defendant accountable for her injuries. A third party owned the hotel, but they agreed to a franchise agreement with Defendant that dictated the name and look of the building and fixtures. The agreement also required the third party to submit reports and pay Defendant a certain amount per room per day. 2. Issue: Did the franchise contract established a master-servant relationship? 3. Holding: No. When establishing an agency relationship through a contract, the nature and extent of the control agreed upon will determine whether the agency exists. The court allowed a summary judgment because the issue before the court was a question of law since it was interpreting terms of a contract. 4. The court noted that franchise agreements can still establish a master-servant relationship, but the agreement here did not meet the burden. However, the court seems to raise the bar for proving an agency relationship when the master-principal is obligated to exert further control to protect a trademark. vi. Parker v Dominos Pizza (1993) 1. Facts: A delivery driver for J & B Enterprise (DBA Dominos) got into a car accident with someone because he was driving recklessly. When Parker (who were pedestrians) was helping the people out of the car got injured by a third car. 2. Issue: Was Dominos an agent for J &B and the delivery driver? 3. Holding: Yes. Whether one party is a mere agent rather than an independent contractor as to the other party is to be determined by measuring the right to control and not by considering only the actual control exercised by the latter over the former. If the employers right to control the activities of an employee extends to the manner in which a task is to be performed then the employee is not an independent contractor. The preamble of the franchise agreement has many details of the operation that Dominos is in control of. Also, Dominos gave the workers for J &B Enterprise ridiculously big manuals The manual contained so much details that it left no room for chance for anything happening. The manual shows that Dominos hold control of the operations of J& B vii. General Automotive Manufacturing Co. v Singer (1963) 1. Facts: Defendant was well-respected in the field of work that he was engaged. Plaintiff hired Defendant, offering salary plus a 3% commission. Defendant helped Plaintiffs business grow, but 17

Defendant reasoned that Plaintiffs shop was unable to fill some orders that required different machinery or larger capacity. Defendant did not notify Plaintiff of these orders and instead filled these orders himself through other machine shops, keeping all the profits from this sideline business. 2. Issue: The issue is whether Defendants sideline business violated his fiduciary duty to automotive. 3. Law: An employee will be held to his or her contractual duty of loyalty, and their fiduciary duty would forbid them from engaging in activities that are competitive with their employer. 4. Held: Defendant did violate his fiduciary duty. Although Plaintiff may not have been able to fill the orders under the shops current capacity, Defendant owed a duty to Plaintiff to make Plaintiff aware of the orders. The Plaintiff could then decide whether they wanted to modify their shop to fill those orders. Defendant agreed to act solely for Plaintiff when he contracted with Plaintiff. 5. Discussion: There was a contract that specifically stated Defendants obligations, but there also is a general fiduciary duty that Defendant owed to Plaintiff by being a manager at the shop. viii. Morris Oil Co. v Rainbow Oilfield Trucking Inc. (1987) 1. Facts: Rainbow got into contracts with Dawn where Rainbow was allowed to use Dawns certificate of public convenience and necessity in operating a trucking enterprise in Hobbs. Dawn had the right to full and complete control over Rainbow in New Mexico. Morris supplied Rainbow with fuel. Rainbow went bankrupt and owed Morris $25,000. 2. Issue: Was Rainbow an agent of Dawn though the language of the contract btw the two state it cant be? 3. Holding: 1) The agreement states that Rainbow can create liabilities of Dawn in the ordinary course of business of operating the terminal. The liability was incurred in the ordinary course of business. 2) b/c the two parties made this agreement does not mean that third parties are bound to deal with one of them.

c. Notes i. Agency Costs: in all business organizations, you have investors and people in control of the investments (a professional class of people who manage the operations[agents]). 1. -Also happens with sole proprietors; the owner cant be at the shop all the time so he hires employees (agents).

18

2. Agency: the fiduciary relationship that arises when one person (the principal) manifests assent to another person (the agent) that the agent shall act on the principals behalf and subject to the principals control, and the agent manifests assent or otherwise consents to so act. 3. -There is a problem to the extent that the interests of the agent differ from the interests of the investor/owner. Employees maximize their interests, sometimes not to the benefit of the owner(s). (The potential problem of agency costs). ii. Types of agency costs: 1. Monitoring costs =Making sure employee isnt going on face book when should be working 2. Bonding costs: costs agents expend to ensure owners of reliability 3. Residual costs (whenever an employee does something that benefits himself as opposed to his employer [giving an unauthorized discount to a friend; or even Lord Black with the $8 million FDR papers, p.12]). iii. Agency Cost Theory 1. -focuses on how the actions of one actor (the agent) affect the interest of another (the principal) with whom she is tied by contract or otherwise. 2. -Assumes that agents will generally act to maximize their own interest rather than the interests of their principals. a. -Agency Cost: any cost associated with the exercise of discretion over the principals property by an agent. 3. The corporate form succeeds because it reduces the transactions costs of complex economic contracting. But it does so at the risk of creating agency problems that must be constrained if it is to succeed. 4. General rule: reduce agency costs! 5. Think of the successful sole proprietor hiring her first employee. Such a relationship is called an agency. a. In a huge public corporation, the principal is the class of dispersed shareholders and the agent is the corporations management. b. However, the principal is often capable of more closely monitoring the agent. iv. 3 types of principals RS 3d 1.04 1. 2(a)Disclosed Principal: disclosed if when an agent and a third party interact the third party has a notice that the agent is acting for a principal knowing his identity. a. Agent for a Disclosed Principal 6.01: When agent acting with actual or apparent authority makes a contract for disclosed principal: 19

i. The principal and third parties are parties to the contract ii. The agent is not unless the other parties agree 2. Undisclosed Principle 2(b) -undisclosed if when an agent and a third party interact the third party has no notice that the agent is acting for a principal. a. Agent for an Undisclosed Principal RS 6.03: When agent acting with actual or apparent authority makes a contract for undisclosed principal: i. Unless excluded the principal is a party ii. Agent and 3rd party are parties to the contract 3. Unidentified Principal (Partially Disclosed) 2(c): Agent and 3rd party are parties to the contract a. Agent for an Unidentified Principal RS 6.02: Agent and 3rd party are parties to the contract i. The principal and third party are parties to the contract ii. The agent is a party unless the agent and the third party agree otherwise. v. Types of agents 1. General agent: agent with a broadly defined scope of agent a. -Some agents are independent contractors instead of employee. Employees are under more control of the principal. An independent contractor is under the control of a principal but not to the extent that an employee is. Employee is under the control of the principal in the respect of not just what they have to do but how they do it. Independent contractor are told what to do but not how to do it (ex. roofing guy). 2. 3. Special: where the agency is limited to a single act or transaction - Special agent: agent with a narrowly defined scope of agent 4. 5. General: where the agency contemplates a series of transactions and also: 6. Independent contractors 7. Employees (can create vicarious liability on employers) vi. Termination & Formation 1. How agency relationships end death, duration of time, quitting, getting fired 2. Agency relations can be implied (think master/servant liability) even when parties have explicitly agreed to a non agency relationship. a. Creditor assumed too much control over their debtor

20

3. The relationship of the parties doesnt depend upon what they call it, but rather in law what it actually is. vii. Types of Authority: 1. Actual Authority when the principals words or conduct lead the agent to believe that the agent has authority to act. (P tells A, would you buy some stuff for me at the store?) -Actual Authority requires a manifestation of consent from the principal to the agent. RS 3.01: created by a principals manifestation to an agent that, as reasonably understood by the agent, expresses the principals assent that the agent take action on the principals behalf. Principal is bound by contract. Exists when the principals words and conducts leads a reasonable agent to act and believe that they have the authority to do X. ex. When Agent does X (buy timber from T) P is bound by this a. Expressed: P says the A go and buy this for me the agent has the actual authority to charge the Ps credit card to but the thing for P b. incidental authority: impliedly authorized action necessary to complete the explicit request of the principal. (included in this is the power of position). Cannot always think about all possibilities sometimes the agent must do things necessary. (incentive to draft good instructions). Implied: P not saying it in so many words but implying that the agent has the authority to do something. Ex. P says I need copies and A says okay Ill go do it. P never said for A to do the copies but didnt say dont do it c. Limitations on actual authority are only binding on 3rd parties with notice d. Restatement 2d 7, 26, 35 and Restatement 3d 2.012.02 2. Apparent Authority a. When the principals words or actions lead a 3rd party to reasonably believe that the agent has authority. There might be some limitation on the agents actual authority which the 3rd party doesnt know about (i.e. dont buy anything over $50). But when the agent buys $60 on the principals credit, the apparent authority binds the principal to the 3rd party. (then the agent might be liable to the principal). Is the power held by an agent or other actor to affect a principals legal relations with third parties when a third party reasonably believes the actor has authority to act on behalf of the principal and that belief is traceable to the principals manifestations.

21

b. The reasonable belief of the 3rd party, based on all the circumstances, determines whether apparent authority exists. c. Just because actual authority has been removed doe not mean the third party knows. So long as it is reasonable to believe the agent still has authority without notice they have apparent authority. d. If a principal creates the impression that an agent is authorized but there is no actual authority, third parties are protected so long as they have acted reasonably. e. Also, the agent can create his own apparent authority via his representations to the 3rd party f. Restatement 2d 8, 27, 159 and Restatement 3d 2.03 3. Inherent Agency: 3rd category which is sometimes recognized when actual and apparent agency power are not. Derived from the nature of the agency relationship itself, whereas estoppel is different a. a principal allows an agent to manage property and hold herself out as its owner but that the principal privately restricts the agents actual authority to deal with the property in some particular say, she is not authorized to contract for improvements in excess of $3,000. If the agent makes a contract to clear some of the land for a price of $7,000, the principal is bound to pay the 3rd party because of the agents inherent agency power. There was no actual authority for the agent to spend that much, and there was no apparent authority since the 3rd party didnt know of the existence of the principal. b. The inherent authority theory exists for the protection of persons harmed by dealing with a principals agent. viii. Liability in Tort 1. What is the degree of control of the principal over the business affairs of the agent? a. If enough control exists, courts will recognize an employer/employee (master/servant) relationship, where the principal is vicariously liable for negligence of the agent. b. ble if the agent is an independent contractor. c. Humble Oil & Refining Co. v. Martin i. Martin suffered a personal injury at a gas station run by Schneider, but owned by Humble Oil. The question is whether Schneider is an independent contractor, or just a servant/employee. Most of the 22

important business decisions are made by Humble. The risk of profit and loss lies with Humble; therefore it would naturally be interested in controlling the operations of the gas station: which is consistent with an employer/employee relationship. Thus, vicarious liability is present. d. Hoover v. Sun Oil Co. i. Same situation but in this case the guy who ran the station was really an independent contractor. Barone, alone, assumed the overall risk of profit and loss. (the big barometer). Sunoco offered advice, but Barone was not obligated to take it. Barone made no written reports to Sunoco. Thus, vicarious liability is NOT present. The difference between the two is who has the greater risk of profit and loss. ix. Franchises 1. -The idea is uniformity of products, appearance, etc. 2. The risk of profit/loss is here, again, very determinative. a. If the franchisor exerts too much control over the franchisee, a master/servant relationship can be inferred. 3. system: a scheme including trade names, trade marks, architectural designs, insignia, patters, color schemes, styles, furnishings, equipment, advertising services, and methods of operation. x. The Governance of Agency (The Agents Duties) 1. An agent is a fiduciary to her principal a. Her purpose is to advance the purposes of the principal. b. In as much, the fiduciary is bound to exercise her goodfaith judgment in an effort to pursue, under future circumstances, the purposes established at the time of creation of the relationship. 2. Fiduciaries specific duties a. Duty of Obedience to the documents creating the relationship. b. .Duty of Loyalty (the obligation always to exercise legal power over the subject of the relationship in a manner that the holder of the power believes in good faith is bUPest to advance the interest or purposes of the principal or beneficiary and not to exercise such power for a personal benefit) c. Duty of Care (the obligation to act in good faith) Partnerships a. Statutes 23

2.

i. UPA 1. 6. Partnership defined a. A partnership means an association of 2 or more persons to carry on as co-owners a business for profit. . . . 2. 7. Rules for determining the existence of a partnership a. In determining whether a partnership exists, the following rules shall apply: i. Except as provided by section 16, persons who are not partners as to each other are not partners as to 3rd persons. ii. Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property or part ownership does not of itself establish a partnership, whether such co-owners do or do not share any profits made by the use of the property. iii. The sharing of gross returns does not of itself establish a partnership, whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived. iv. The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business, but no such inference shall be drawn if such profits were received in payment: v. As a debt by installments or otherwise; 1. As wages of an employee or rent to a landlord; 2. As an annuity to a widow or representative of a deceased partner; 3. As interest on a loan, though the amount of payment vary with the profits of the business; 4. As the consideration for the sale of a goodwill of a business or other property by installments or otherwise. 3. 9. Partner agent of partnership as to partnership business a. Every partner is an agent of the partnership for the purpose of its business, and the act of every partner, including the execution in the partnership name of any instrument, for apparently carrying on in the usual way the business of the partnership of which he is a member binds the partnership, unless the partner so acting has in fact no authority to act for the partnership in the particular matter,

24

and the person with whom he is dealing has knowledge of the fact that he has no such authority. b. An act of a partner which is not apparently for the carrying on of the business of the partnership in the usual way does not bind the partnership unless authorized by the other partners. c. Unless authorized by the other partners or unless they have abandoned the business, one or more but less than all the partners have no authority to: i. Assign the partnership property in trust for creditors or on the assignees promise to pay the debts of the partnership; ii. Dispose of the goodwill of the business; iii. Do any other act which would make it impossible to carry on the ordinary business of a partnership; iv. Confess a judgment; v. Submit a partnership claim or liability to arbitration or reference. d. No act of a partner in contravention of a restriction on authority shall bind the partnership to persons having knowledge of the restriction. 4. 11. Partnership bound by admission of partner a. An admission or representation made by any partner concerning partnership affairs within the scope of his authority as conferred by this Act is evidence against the partnership. 5. 12. Partnership charged with knowledge of or notice to partner a. Notice to any partner of any matter relating to partnership affairs, and the knowledge of the partner acting in the particular matter, acquired while a partner or then present to his mind, and the knowledge of any other partner who reasonably could and should have communicated it to the acting partner, operate as notice to or knowledge of the partnership, except in the case of a fraud on the partnership committed by or with the consent of that partner. 6. 13. Partnership bound by partners wrongful act a. Where, by any wrongful act or omission of any partner acting in the ordinary course of the business of the partnership or with the authority of his copartners, loss or injury is caused to any person, not being a partner in the partnership, or any penalty is incurred, the partnership is liable therefor to the same extent as the partner so acting or omitting to act. 25

7. 14. Partnership bound by partners breach of trust a. The partnership is bound to make good the loss: i. Where one partner acting within the scope of his apparent authority receives money or property of a 3rd person and misapplies it; and ii. Where the partnership in the course of its business receives money or property of a 3rd person and the money or property so received is misapplied by any partner while it is in the custody of the partnership. 8. 15. Nature of partners liability a. All partners are liable i. Jointly and severally for everything chargeable to the partnership under sections 13 and 14. ii. Jointly for all other debts and obligations of the partnership; but any partner may enter into a separate obligation to perform a partnership contract. 9. 16. Partner by estoppel a. When a person, by words spoken or written or by conduct, represents himself, or consents to another representing him to any one, as a partner in an existing partnership or with one or more persons not actual partners, he is liable to any such person to whom such representation has been made, who has, on the faith of such representation, given credit to the actual or apparent partnership, and if he has made such representation or consented to its being made in a public manner he is liable to such person, whether the representation has or has not been made or communicated to such person so giving credit by or with the knowledge of the apparent partner making the representation or consenting to its being made. i. When a partnership liability results, he is liable as though he were an actual member of the partnership. ii. When no partnership liability results, he is liable jointly with the other persons, if any, so consenting to the contract or representation as to incur liability, otherwise separately. iii. When a person has been thus represented to be a partner in an existing partnership, or with one or more persons not actual partners, he is an agent of the persons consenting to such representation to bind them to the same extent and in the same manner as though he were a partner in fact, with 26

respect to persons who rely upon the representation. Where all the members of the existing partnership consent to the representation, a partnership act or obligation results; but in all other cases it is the joint act or obligation of the person acting and the persons consenting to the representation. 10. 18. Rules determining rights and duties of partners a. The rights and duties of the partners in relation to the partnership shall be determined, subject to any agreement between them, by the following rules: i. (a)Each partner must be repaid that partners contributions, whether by way of capital or advances to the partnership property and share equally in the profits and surplus remaining after all liabilities, including those to partners, are satisfied; and must contribute toward the losses, whether of capital or otherwise, sustained by the partnership according to that partners share in the profits. ii. (b) The partnership must indemnify every partner in respect of payments made and personal liabilities reasonably incurred by him in the ordinary and proper conduct of its business, or for the preservation of its business or property. iii. (c) A partner, who in aid of the partnership makes any payment or advance beyond the amount of capital which he agreed to contribute, shall be paid interest from the date of the payment or advance. iv. (d) A partner shall receive interest on the capital contributed by him only from the date when repayment should be made. v. All partners have equal rights in the management and conduct of the partnership business. vi. No partner is entitled to remuneration for acting in the partnership business, except that a surviving partner is entitled to reasonable compensation for his services in winding up the partnership affairs. vii. No person can become a member of a partnership without the consent of all the partners. viii. Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners; but no act in contravention of any agreement between the

27

partners may be done rightfully without the consent of all the partners. 11. 20. Duty of partners to render information a. Partners shall render on demand true and full information of all things affecting the partnership to any partner or the legal representative of any deceased partner or partner under legal disability. 12. 21. Partner accountable as a fiduciary a. Every partner must account to the partnership for any benefit and hold as trustee for it any profits derived by him without the consent of the other partners from any transaction connected with the formation, conduct or liquidation of the partnership or from any use by him of its property. b. This section applies also to the representatives of a deceased partner engaged in the liquidation of the affairs of the partnership as the personal representatives of the last surviving partner. 13. 24. Extent of property rights of a partner a. The property rights of a partner are his rights in specific partnership property, his interest in the partnership and his right to participate in the management. 14. 25. Nature of a partners right in specific partnership property a. A partner is co-owner with his partners of specific partnership property holding as a tenant in partnership. b. The incidents of this tenancy are such that i. A partner, subject to this Act and to any agreement between the partners, has an equal right with his partners to possess specific partnership property for partnership purposes; but he has no right to possess such property for any other purpose without the consent of his partners; ii. A partners right in specific partnership property is not assignable except in connection with the assignment of rights of all the partners in the same property; iii. A partners right in specific partnership property is not subject to attachment or execution, except on a claim against the partnership. When partnership property is attached for a partnership debt the partners, or any of them, or the representatives of a deceased partner, cannot claim any right under the homestead or exemption laws;

28

iv. On the death of a partner his right in specific partnership property vests in the surviving partner or partners, except where the deceased was the last surviving partner, when his right in such property vests in his legal representative. Such surviving partner or partners, or the legal representative of the last surviving partner, has no right to possess the partnership property for any but a partnership purpose; v. A partners right in specific partnership property is not subject to a spouses right and interest by descent or vi. allowances to widows, widowers, heirs or next of kin. 15. 26. Nature of partners interest in the partnership a. A partners interest in the partnership is his share of the profits and surplus, and the same is personal property. 16. 29. Dissolution defined a. The dissolution of a partnership shall mean the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business. 17. 30. Partnership not terminated by dissolution a. On dissolution, the partnership is not terminated, but continues until the winding up of partnership affairs is completed. 18. 31. Causes of dissolution a. Dissolution is caused: i. Without violation of the agreement between the partners, 1. By the termination of the definite term or particular undertaking specified in the agreement; 2. By the express will of any partner when no definite term or particular undertaking is specified; 3. By the express will of all the partners who have not assigned their interests or suffered them to be charged for their separate debts, either before or after the termination of any specified term or particular undertaking; 4. By the expulsion of any partner from the business bona fide in accordance with such

29

a power conferred by the agreement between the partners; 5. In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time; 6. By any event which makes it unlawful for the business of the partnership to be carried on or for the members to carry it on in partnership; 7. By the death of any partner; 8. By the bankruptcy of any partner or the partnership; 9. By decree of court under section 32. 19. 32. Dissolution by decree of court a. On application by or for a partner, the court shall decree a dissolution whenever: i. A partner has been declared a lunatic in any judicial proceeding or is shown to be of unsound mind; ii. A partner becomes in any other way incapable of performing his part of the partnership contract; iii. A partner has been guilty of such conduct as tends to affect prejudicially the carrying on of the business; iv. A partner wilfully or persistently commits a breach of the partnership agreement, or otherwise so conducts himself in matters relating to the partnership business that it is not reasonably practicable to carry on the business in partnership with him; v. The business of the partnership can only be carried on at a loss; or 1. Other circumstances render a dissolution equitable. 2. On the application of the purchaser of a partners interest under sections 27 or 28, the court shall decree a dissolution: 3. After the termination of the specified term of particular undertaking; or 4. At any time if the partnership was a partnership at will when the interest was assigned or when the charging order was issued. 30

20. 38. Rights of partners to application of partnership property a. When dissolution is caused in any way, except in contravention of the partnership agreement, each partner, as against his copartners and all persons claiming through them in respect of their interests in the partnership, unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners. But if dissolution is caused by expulsion of a partner, bona fide under the partnership agreement and if the expelled partner is discharged from all partnership liabilities, either by payment or agreement under section 36(2), he shall receive in cash only the net amount due him from the partnership. b. When dissolution is caused in contravention of the partnership agreement the rights of the partners shall be as follows: i. Each partner who has not caused dissolution wrongfully shall have: 1. All the rights specified in the first paragraph of this section; and 2. The right, as against each partner who has caused the dissolution wrongfully, to damages for breach of the agreement. ii. The partners who have not caused the dissolution wrongfully, if they all desire to continue the business in the same name, either by themselves or jointly with others, may do so, during the agreed term for the partnership and for that purpose may possess the partnership property, provided they secure the payment by bond approved by the court, or pay to any partner who has caused the dissolution wrongfully, the value of his interest in the partnership at the dissolution, less any damages recoverable under this section, and in like manner indemnify him against all present or future partnership liabilities. iii. A partner who has caused the dissolution wrongfully shall have: 1. If the business is not continued under paragraph (2)(b), all the rights of a partner under paragraph (1), subject to clause (2)(a)(II) of this section,

31

2. If the business is continued under paragraph (2)(b) of this section the right as against his copartners and all claiming through them in respect of their interests in the partnership, to have the value of his interest in the partnership, less any damages caused to his copartners by the dissolution, ascertained and paid to him in cash, or the payment secured by bond approved by the court, and to be released from all existing liabilities of the partnership; but in ascertaining the value of the partners interest the value of the goodwill of the business shall not be considered. iv. 40. Rules for distribution 1. In settling accounts between the partners after dissolution, the following rules shall be observed, subject to any agreement to the contrary: 2. The assets of the partnership are: a. The partnership property, b. The contributions of the partners specified in clause b of this paragraph. 3. The liabilities of the partnership shall rank in order of payment, as follows: a. Those owing to creditors other than partners; b. Those owing to partners other than for capital and profits; c. Those owing to partners in respect of capital; d. Those owing to partners in respect of profits. 4. The assets shall be applied in the order of their declaration in clause a to the satisfaction of the liabilities. 5. The partners shall contribute, as provided by section 18(a), the amount necessary to satisfy the liabilities; but if any, but not all, of the partners are insolvent or, not being subject to process, refuse to contribute, the other partners shall contribute their share of the liabilities and, in the relative proportions 32

in which the partners share the profits, the additional amount necessary to pay the liabilities. . . . ii. RUPA 1. 101. Definitions. a. In this [Act]: i. Business includes every trade, occupation and profession. ii. Distribution means a transfer of money or other property from a partnership to a partner in the partners capacity as a partner or to the partners transferee. iii. (6) Partnership means an association of two or more persons to carry on as co-owners business for profit formed under Section 202,. predecessor law, or comparable law of another jurisdiction. iv. (7) Partnership agreement means the agreement, whether written, oral or implied, among the partners concerning the partnership, including amendments to the partnership agreement. v. (8) Partnership at will means a partnership in which the partners have not agreed to remain partners until the expiration of a definite term or particular undertaking. vi. (9) Partnership interest or partners interest in the partnership means all of a partners interests in the partnership, including the partners transferable interest and all management and other rights. vii. (10) Person means an individual, corporation, business trust, estate, trust, partnership, association, joint venture, government, governmental subdivision, agency, instrumentality, or any other legal or commercial entity. 2. 103. Effect of Partnership Agreement; Nonwaivable Provisions. a. Except as otherwise provided in subsection (b), relations among the partners and between the partners and the partnership are governed by the partnership agreement. To the extent the partnership agreement does not otherwise provide, this [Act] governs relations among the partners and between the partners and the partnership. b. The partnership agreement may not: i. Vary the rights and duties under Section 105 except to eliminate the duty to provide copies of statements to all of the partners; 33

ii. Unreasonably restrict a partners rights of access to books and records under Section 403(b); c. Eliminate the duty of loyalty under Section 404(b) or 603(b)(3), but: i. the partnership agreement may identify specific types or categories of activities that do not violate the duty of loyalty; or ii. all of the partners or a number or percentage specified in the partnership agreement may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty; d. Unreasonably reduce the duty of care under Section 404(c) or 603(b)(3); e. Eliminate the obligation of good faith and fair dealing under Section 404(d), but the partnership agreement may prescribe the standards by which the performance of the obligation is to be measured, if the standards are not manifestly unreasonable; f. Vary the power to dissociate as a partner under Section 602(a), except to require the notice under Section 601(1) to be in writing; g. Vary the right of a court to expel a partner in the events specified in Section 601(5); h. Vary the requirement to wind up the partnership business in cases specified in Section 801(4), (5) or (6); . . . or i. Restrict the rights of third parties under this [Act]. 3. Article 2. Nature of the Partnership. 4. 201. Partnership as Entity a. A partnership is an entity distinct from its partners. 5. 202. Formation of Partnership. a. Except as otherwise provided in subsection (b), the association of two or more persons to carry on as coowners a business for profit forms a partnership, whether or not the persons intend to form a partnership. b. Am association formed under a statute other than this [Act], a predecessor statute, or a comparable statute of another jurisdiction, is not a partnership under this [Act]. c. In determining whether a partnership is formed, the following rules apply: i. Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property or part ownership does not by itself establish a

34

partnership, even if the co-owners share profits made by the use of the property. ii. The sharing of gross returns does not by itself establish a partnership, even if the persons sharing them have a joint or common right or interest in property from which the returns are derived. iii. A person who receives a share of the profits of a business is presumed to be a partner in the business, unless the profits were received in payment: 1. of a debt by installments or otherwise; 2. for services as an independent contractor or of wages or other compensation to an employee; 3. of rent; 4. of an annuity or other retirement or health benefit to a beneficiary, representative or designee of a deceased or retired partner; 5. of interest or other charge on a loan, even if the amount of payment varies with the profits of the business, including a direct or indirect present or future ownership of the collateral, or rights to income, proceeds or increase in value derived from the collateral; or 6. for the sale of the goodwill of a business or other property by installments or otherwise. 6. 203. Partnership Property. a. Property acquired by a partnership is property of the partnership and not of the partners individually. 7. Article 3. Relations of Partners to Persons Dealing with Partnership. 8. 301. Partner Agent of Partnership. a. Subject to the effect of a statement of partnership authority under Section 303: i. Each partner is an agent of the partnership for the purpose of its business. An act of a partner, including the execution of an instrument in the partnership name, for apparently carrying on in the ordinary course the partnerships business or business of the kind carried on by the partnership binds the partnership, unless the partner had no authority to act for the partnership in the particular matter and the person with whom the partner was 35

dealing knew or had received a notification that the partner lacked authority. ii. An act of a partner which is not apparently for carrying on in the ordinary course the partnerships business or business of the kind carried on by the partnership binds the partnership only if the act was authorized by the other partners. 9. 305. Partnership Liable for Partners Actionable Conduct. a. A partnership is liable for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of business of the partnership or with authority of the partnership. b. If, in the course of the partnerships business or while acting with authority of the partnership, a partner receives or causes the partnership to receive money or property of a person not a partner, and the money or property is misapplied by a partner, the partnership is liable for the loss. 10. 306. Partners liability. a. Except as otherwise provided in subsections (b) and (c), all partners are liable jointly and severally for all obligations of the partnership unless otherwise agreed by the claimant or provided by law. b. A person admitted as a partner into an existing partnership is not personally liable for any obligation of the partnership incurred before the persons admission as a partner. 11. 307. Actions by and against partnership and partners. a. A partnership may sue and be sued in the name of the partnership. b. An action may be brought against the partnership and, to the extent not inconsistent with Section 306, any or all of the partners in the same action or in separate actions. c. A judgment against a partnership is not by itself a judgment against a partner. A judgment against a partnership may not be satisfied from a partners assets unless there is also a judgment against the partner for such obligation. d. A judgment creditor of a partner may not levy execution against the assets of the partner to satisfy a judgment based on a claim against the partnership unless the partner is personally liable for the claim under Section 307 and:

36

i. a judgment based on the same claim has been obtained against the partnership and a writ of execution on the judgment has been returned unsatisfied in whole or in part; ii. the partnership is a debtor in bankruptcy; iii. the partner has agreed that the creditor need not exhaust partnership assets; or 1. a court grants permission to the judgment creditor to levy execution against the assets of a partner based on a finding that partnership assets subject to execution are clearly insufficient to satisfy the judgment, that exhaustion of partnership assets is excessively burdensome, or that the grant of permission is an appropriate exercise of the courts equitable powers; or 2. liability is imposed on the partner by law or contract independent of the existence of the partnership. iv. This section applies to any obligation of the partnership resulting from a representation by a partner or purported partner under Section 308. 12. Article 4. Relations of Partners to Each Other and to Partnership. a. 401. Partners Rights and Duties. i. Each partner is deemed to have an account that is: 1. credited with an amount equal to the money plus the value of any other property, net of the amount of any liabilities, the partner contributes to the partnership and the partners share of the partnership profits; and charged with an amount equal to the money plus the value of any other property, net of the amount of any liabilities, distributed by the partnership to the partner and the partners share of the partnership losses. 2. Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partners share of the profits. 3. A partnership shall reimburse a partner for payments made and indemnify a partner for liabilities incurred by the partner in the 37

ordinary course of the business of the partnership or for the preservation of its business or property. 4. A partnership shall reimburse a partner for an advance to the partnership beyond the amount of capital the partner agreed to contribute. 5. A payment or advance made by a partner which gives rise to a partnership obligation under subsection (c) or (d) constitutes a loan to the partnership which accrues interest from the date of the payment or advance. 6. Each partner has equal rights in the management and conduct of the partnership business. 7. A partner may use or possess partnership property only on behalf of the partnership. 8. A partner is not entitled to remuneration for services performed for the partnership, except for reasonable compensation for services rendered in winding up the business of the partnership. 9. A person may become a partner only with the consent of all of the partners. 10. A difference arising as to a matter in the ordinary course of business of a partnership may be decided by a majority of the partners. An act outside the ordinary course of business of a partnership and an amendment to the partnership agreement may be undertaken only with the consent of all of the partners. 11. This section does not affect the obligations of a partnership to other persons under Section 301. 13. 403. Partners Rights and Duties with Respect to Information. a. (c) Each partner and the partnership shall furnish to a partner, and to the legal representative of a deceased partner or partner under legal disability: i. without demand, any information concerning the partnerships business and affairs reasonably required for the proper exercise of the partners

38

rights and duties under the partnership agreement or this [Act]; and ii. on demand, any other information concerning the partnerships business and affairs, except to the extent the demand or the information demanded is unreasonable or otherwise improper under the circumstances. 14. 404. General Standards of Partners Conduct. a. The only fiduciary duties a partner owes to the partnership and the other partners are the duty of loyalty and the duty of care set forth in subsections (b) and (c). b. A partners duty of loyalty to the partnership and the other partners is limited to the following: i. to account to the partnership and hold as trustee for it any property, profit or benefit derived by the partner in the conduct or winding up of the partnership business or affairs or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity; ii. to refrain from dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest adverse to the partnership; and iii. to refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership. c. A partners duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law. i. A partner shall discharge the duties to the partnership and the other partners under this [Act] or under the partnership agreement and exercise any rights consistently with the obligation of good faith and fair dealing. ii. A partner does not violate a duty or obligation under this [Act] or under the partnership agreement solely because the partners conduct furthers the partners own interest. iii. A partner may lend money to and transact other business with the partnership, and as to each loan or transaction the rights and obligations of the

39

partner are the same as those of a person who is not a partner, subject to other applicable law. iv. This section applies to a person winding up the partnership business as the personal or legal representative of the last surviving partner as if the person were a partner. 15. Article 5. Transferees and Creditors of Partners. 16. 502. Partners Transferable Interest in Partnership. a. The only transferable interest of a partner in the partnership is the partners share of the profits and losses of the partnership and the partners right to receive distributions. The interest is personal property. 17. Article 6. Partners Dissociation. 18. 601. Events Causing Partners Dissociation. a. A partner is dissociated from a partnership upon the occurrence of any of the following events: b. the partnerships having notice of the partners express will to withdraw as a partner or on a later date specified by the partner; c. an event agreed to in the partnership agreement as causing the partners dissociation; d. the partners expulsion pursuant to the partnership agreement; e. the partners expulsion by the unanimous vote of the other partners if: f. it is unlawful to carry on the partnership business with that partner; or g. there has been a transfer of all or substantially all of that partners transferable interest, other than a transfer for security purposes, or a court order charging the partners interest which has not been foreclosed; . . . h. on application by or for the partnership or another partner, the partners expulsion by determination because: i. the partner engaged in wrongful conduct that adversely and materially affected the partnership business; ii. the partner willfully or persistently committed a material breach of either the partnership agreement or of a duty owed to the partnership or the other partners under Section 404; or iii. the partner engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with the partner; 40

The partners: i. becoming a debtor in bankruptcy; ii. executing an assignment for the benefit of creditors; iii. seeking, consenting to or acquiescing in the appointment of a trustee, receiver or liquidator of that partner or of all or substantially all of that partners property; or iv. failing, within 90 days after the appointment, to have vacated or stayed the appointment of a trustee, receiver or liquidator of the partner or of all or substantially all of that partners property obtained without the partners consent, acquiescence, or failing within 90 days after the expiration of a stay to have the appointment vacated; j. in the case of a partner who is an individual: i. the partners death; ii. the appointment of a guardian or general conservator for the partner; or iii. a judicial determination that the partner has otherwise become incapable of performing the partners duties under the partnership agreement; k. in the case of a partner that is a trust or is acting as a partner by virtue of being a trustee of a trust, distribution of the trusts entire transferable interest in the partnership, but not merely by reason of the substitution of a successor trustee; l. in the case of a partner that is an estate or is acting as a partner by virtue of being a personal representative of an estate, distribution of the estates entire transferable interest, but not merely by reason of the substitution of a successor personal representative; or m. termination of a partner who is not an individual, partnership, corporation, trust, or estate. 19. 602. Partners Power to Dissociate; Wrongful Dissociation. a. A partner has the power to dissociate at any time, rightfully or wrongfully, by express will pursuant to Section 601(1). b. A partners dissociation is wrongful only if: i. it is in breach of an express provision of the partnership agreement; or ii. in the case of a partnership for a definite term or particular undertaking, before the expiration of the term or the completion of the undertaking: i. 41

1. the partner withdraws by express will, unless the withdrawal follows within 90 days after another partners dissociation by death or otherwise under Section 601(6) through (10) or wrongful dissociation under this subsection; 2. the partner is expelled by judicial determination under Section 601(5); 3. the partner is dissociated by becoming a debtor in bankruptcy; or 4. in the case of a partner who is not an individual, trust other than a business trust, or estate, the partner is expelled or otherwise dissociated because it willfully dissolved or terminated. iii. A partner who wrongfully dissociates is liable to the partnership and to the other partners for damages caused by the dissociation. Such liability is in addition to any other obligation of the partner to the partnership or to the other partners. 20. 603. Effect of Partners Dissociation. a. If a partners dissociation results in a dissolution and winding up of the partnership business, [Article 8] applies; otherwise, [Article 7] applies. b. Upon a partners dissociation: i. the partners right to participate in the management and conduct of the partnership business terminates, except as otherwise provided in Section 803; ii. the partners duty of loyalty under Section 404(b)(3) terminates; and iii. the partners duty of loyalty under Section 404(b)(1) and (2) and duty of care under Section 404(c) continue only with regard to matters arising and events occurring before the partners dissociation, unless the partner participates in winding up the partnerships business pursuant to Section 803. 21. Article 7. Partners Dissociation When Business Not Wound Up. 22. 701. Purchase of dissociated partners partnership interest a. If a partner is dissociated from a partnership without resulting in a dissolution and winding up of the partnership business under Section 801, the partnership shall cause the dissociated partners interest in the partnership to be

42

purchased for a buyout price determined pursuant to subsection (b). b. The buyout price of a dissociated partners partnership interest is the amount that would been distributable to the dissociating partner under Section 807(b) if, on the date of dissociation, the assets of the partnership were sold a price equal to the greater of the liquidation value of the value based on a sale of the entire business as a going concern without the dissociated partner and the partnership were wound up as of that date. Interest must be paid from the date of dissolution to the date of payment. c. Damages for wrongful dissociation under Section 602(b), and all other amounts owing, whether or not presently due, from the dissociated partner to the partnership, must be offset against the buyout price. Interest must be paid from the date the amount owed becomes due to the date of payment. d. A partnership shall indemnify a dissociated partner whose partnership interest is being purchased against all partnership obligations, whether incurred before or after the dissociation, except partnership obligations incurred by an act of the dissociated partner under Section 702. e. (h) A partner who wrongfully dissociates before the expiration of a definite term or the completion of a particular undertaking is not entitled to payment of any portion of the buyout price until the expiration of the term or completion of the undertaking, unless the partner establishes to the satisfaction of the court that earlier payment will not cause undue hardship to the business of the partnership. A deferred payment must be adequately secured and bear interest. f. A dissociated partner may maintain an action against the partnership, pursuant to Section 405(b)(2)(ii), to determine the buyout price of that partners partnership interest, any offsets under subsection (c), or other terms of the obligation to purchase. . . . 23. 702. Dissociated Partners Power to Bind and Liability to Partnership. a. For two years after a partner dissociates without resulting in a dissolution and winding up of the partnership business, the partnership, including a surviving partnership under [Article 9], is bound by an act of the dissociated partner which would have bound the partnership under

43

Section 301 before dissociation only if at the time of entering into the transaction the other party: b. reasonably believed that the dissociated partner was then a partner and reasonably relied on such belief in entering into the transaction; c. did not have notice of the partners dissociation; andis not deemed to have had knowledge under Section 303(c) or notice under Section 704(c). d. A dissociated partner is liable to the partnership for any damage caused to the partnership arising from an obligation incurred by the dissociated partner after dissociation for which the partnership is liable under subsection (a). 24. Article 8. Winding Up Partnership Business. 25. 801. Events Causing Dissolution and Winding Up of Partnership Business. a. A partnership is dissolved, and its business must be wound up, only upon the occurrence of any of the following events: b. In a partnership at will, the partnerships having notice from a partner, other than a partner who is dissociated under Section 601(2) through (10), of that partners express will to withdraw as a partner, or on a later date specified by the partner; c. In a partnership for a definite term or particular undertaking: d. Within 90 days after a partners dissociation by death or otherwise under Section 601(6) through (10) or wrongful dissociation under Section 602(b), unless before that time a majority in interest of the remaining partners, including partners who have rightfully dissociated pursuant to Section 602(b)(2)(i), agree to continue the partnership. e. The express will of all of the partners to wind up the partnership business; or i. The expiration of the term or the completion of the undertaking; ii. An event agreed to in the partnership agreement resulting in the winding up of the partnership business; iii. An event that makes it unlawful for all or substantially all of the business of the partnership to be continued, but a cure of illegality within 90 days after notice to the partnership of the event is

44

effective retroactively to the date of the event for purposes of this section; f. On application by or for a partner, a judicial determination that: i. the economic purpose of the partnership is likely to be unreasonably frustrated; ii. another partner has engaged in conduct relating to the partnership business which makes it not reasonable practicable to carry on the business in partnership with that partner; or iii. it is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement; or iv. On application by a transferee of a partners transferable interest, a judicial determination that it is equitable to wind up the partnership business: g. after the expiration of the term or completion of the undertaking, if the partnership was for a definite term or particular undertaking at the time of the transfer or entry of the charging order that gave rise to the transfer; or h. at any time, if the partnership was a partnership at will at the time of the transfer or entry of the charging order that gave rise to the transfer. 26. 802. Partnership Continues after Dissolution. a. Subject to subsection (b), a partnership continues after dissolution only for the purpose of winding up its business. The partnership is terminated when the winding up of its business is completed. b. At any time after the dissolution of a partnership and before the winding up of its business is completed, all of the partners, including any dissociating partner other than a wrongfully dissociating partner, may waive the right to have the partnerships business wound up and the partnership terminated. In that event: i. the partnership resumes carrying on its business as if dissolution had never occurred, and any liability incurred by the partnership or a partner after the dissolution and before the waiver is determined as if dissolution had never occurred; and ii. the rights of a third party accruing under Section 804(1) or arising out of conduct in reliance on the dissolution before the third party knew or received a notification of the waiver may not be adversely affected. 45

27. 803. Right to Wind Up Partnership Business. a. After dissolution, a partner who has not wrongfully dissociated may participate in winding up the partnerships business, but on application of any partner or a partners legal representative or transferee, the [designate the appropriate court], for good cause shown, may order judicial supervision of the winding up. i. The legal representative of the last surviving partner may wind up a partnerships business. ii. The persons winding up the partnerships business may preserve the partnership business or property as a going concern for a reasonable time, prosecute and defend actions and proceedings, whether civil, criminal or administrative, settle and close the partnerships business, dispose of and transfer the partnerships property, discharge the partnerships liabilities, distribute the assets of the partnership pursuant to Section 807, settle disputes by mediation or arbitration, and perform other necessary tasks. 28. 804. Partners Power to Bind Partnership after Dissolution. a. Subject to Section 805, a partnership is bound by a partners act after dissolution that: i. is appropriate for winding up the partnership business; or ii. would have bound the partnership under Section 301 before dissolution, if the other party to the transaction did not have notice of the dissolution. 29. 807. Settlement of Accounts and Contributions Among Partners. a. In winding up a partnerships business, the assets of the partnership, including the contributions of the partners required by this section, must be applied to discharge its to creditors, including, to the extent permitted by law, partners who are creditors. Any surplus must be applied to pay in cash the net amount distributable to partners in accordance with their right to distributions under subsection (b). b. Each partner is entitled to a settlement of all partnership accounts upon winding up the partnership business. In settling accounts among the partners, profits and losses that result from the liquidation of the partnership assets must be credited and charged to the partners accounts. The partnership shall make a distribution to a partner in an amount equal to any excess of the credits over the charges 46

in the partners account. A partner shall contribute to the partnership an amount equal to any excess of the charges over the credits in the partners account but excluding from the calculation charges attributable to an obligation for which the partner is not personally liable under Section 306(c). . . After the settlement of accounts, each partner shall contribute, in the proportion in which the partner shares partnership losses, the amount necessary to pay or make reasonable provision to pay partnership obligations that were not known at the time of the settlement and for which the partner is personally liable under Section 306. c. (e) The estate of a deceased partner is liable for the partners obligation to contribute to the partnership. d. (f) An assignee for the benefit of creditors of a partnership or a partner, or a person appointed by a court to represent creditors of a partnership or a partner, may enforce a partners obligation to contribute to the partnership. b. Cases i. Martin v Peyton (1927) 1. Facts: Respondents, William Peyton et al., entered an agreement with a broker, John Hall, to loan Hall collateral to keep his business afloat. Appellant, Charles Martin, interpreted the agreement as forming a partnership. Hall was a friend of Respondents, and Halls brokerage business was suffering. Respondents discussed helping Hall and his business, but they needed to ensure that Halls business would discontinue their speculative, unwise investments. Respondents agreed to loan Hall $2.5 million in securities for Hall to secure $2 million in loans. In return, Respondents received Halls more speculative collateral and would receive a percentage of Halls profits. Respondents acquired the ability to review Halls books and veto certain investments. 2. Issue: Was there a partnership created? 3. Law: An agreement that offers a degree of control by a first party to protect first partys assets should not be considered a partnership if factors as a whole indicate that the other party still maintains day-to-day control of the business. 4. Holding: The agreements did not establish a partnership. Although Respondents ensured that they had some control over the operations of Halls business, the controls they bargained for were to ensure that their investment was secure. Immediately prior to Respondents investment, Halls business was doing poorly due to bad decision-making and Respondents needed to prevent further

47

bad decisions. Hall still was able to control the day-to-day affairs, and Respondents never had control to initiate their own ideas ii. Fenwick v Unemployment Compensation Commission (1945) 1. Facts: Chesire works for Fenwick & asks for a raise. Fenwick agrees only if hes making enough money, so he gets a lawyer to write an agreement, which said Chesire is a partner (so Chesire gets share of profits). Chesire leaves employment, & Fenwick refuses to pay into the unemployment fund b/c she wasnt an employee within the meaning of the statute. said the agreement was not a partnership agreement, but just an agreement fixing the compensation of the employee. Court held that no partnership created, the contract was nothing more than a method to provide for compensation. Just b/c the agreement says they are a partnership, doesnt make it so. 2. Reasoning: 3. i. Court looks at the characteristics of a partnership: 4. a. The intention of the parties just b/c contract said partnership, doesnt make it so. The real reason for the contract was to provide calculation for an increase in compensation, but to protect Fenwick in case he couldnt afford it. 5. b. The right to share profits not every agreement that gives a right to shares profits is a partnership, so not conclusive. 6. c. The obligation to share losses only Fenwick liable for debts of partnership. 7. d. The ownership and control of the partnership property & business - Fenwick contributed all the capital & Chesire had no right to share capital upon dissolution. Fenwick also retained all control. 8. e. Community of power in administration - Fenwick had exclusive control of mgmt of the business. 9. f. Language in the agreement Contract called it a partnership, but also excluded Chesire from most of the ordinary rights of a partner. 10. g. Conduct of the parties towards third persons didnt hold themselves out as partners, she was still working as the receptionist. 11. h. The rights of the parties on dissolution- No diff for Chesire than if she quit 12. i. Co-ownership agreement only to share profits, Fenwick had ownership. iii. Northmon Investment company v milford plaza associates (2001) 1. A partner is not bound to a 99year lease that his partner agreed to with a 3rd party. The partner has an equal say as the other partners as to the decisions that are made. 48

iv. National Biscuit Company v Stroud (1959) 1. Facts: Stroud and Freeman decided to dissolve their business February 25, 1956. Several months prior to February 25, Stroud informed Plaintiff that he was not going to be held liable for any deliveries made by Plaintiff. Plaintiff still made deliveries to the business through Freemans consent. After the business dissolved, Stroud agreed to liquidate the business assets and discharge the debts, and Stroud ended up losing his own personal money in the process. Stroud disputed the money owed to Plaintiff because he specifically requested that Plaintiff not make any deliveries or else he would not be liable. 2. Issue: Can Stroud be held liable for the deliveries that Freeman consented to but Stroud declined? 3. Law: Each partner has an equal right to the management of the business and any business performed under the scope of the partnership can only be contravened by a majority of the partners. 4. Held: Stroud can be held liable for the deliveries. Partners are jointly and severally liable for the actions of the partnership. Freemans conduct in allowing the deliveries was within the scope of the business and he has a right to make these decisions unless a majority of the partners vote to deny him of these rights. Since Stroud is only one half of the partnership, and not a majority, he is unable to prevent Freeman from exercising his rights. 5. Reasoning: -Does Freeman have actual authority? Buying bread is an ordinary course of business. There was no majority to either buy the bread or not to buy the bread. There is no actual authority either way. Freeman didnt have apparent authority because Biscuit was told that Stroud did not want to be bound. The court breaks the tie in the decision to act. You need the majority in order to overcome action not to act. The only thing that he could have done to get out of having to buy the bread is to dissolve the partnership. Yes they can fire Don. Is there a partnership agreement on point that says that he is the head of the meat issue? Don is an employee of the meat department. That would give Charles the right to hire or fire Don. Though, it could be more than just a meat issue, since Don may be driving customers away. Under the default rule they can have a majority vote if it is in the ordinary course of business. If they have a majority vote they can then fire him. Though if it is extraordinary then they need Charles vote too (there is just one employee so it may be extraordinary). v. Bane v Ferguson (1989) 1. History: Plaintiff (Bane) partner appealed the order of the United States District Court for the Northern District of Illinois, Eastern Division, which dismissed his negligent mismanagement claim 49

against defendant firm managers based on their decision to merge with another law firm. The merger caused the dissolution of the firm managers' law firm and loss of the partners' pension. 2. Facts: The partner's law firm adopted a retirement pension plan that provided that plan payments would end if the firm dissolved. The partner retired and began drawing his pension. The firm merged with another law firm but dissolved with no successor, and the partner's pension terminated. He brought an action against the firm members, alleging that they had committed negligent mismanagement in merging. The district court dismissed the claim. On appeal, the court held that Ill. Rev. Stat. ch. 106 1/2, para. 9(3)(c) prohibited less than all partners from doing an act that made it impossible for the partnership to carry out its business and that the statute was inapplicable because it only applied to protect partners, which the partner ceased to be when he left the firm. Moreover, the firm members had no fiduciary duty to the partner because he was no longer a partner and the businessjudgment rule shielded the firm members from their alleged negligence. In affirming the judgment, the court concluded that no tort cause of action existed for the mere negligence of the firm members in their management decisions where there was no allegation that they had acted in bad faith. 3. Conclusion: The court affirmed the district court's judgment. -Bane claimed violation of UPA section 9. unless authorized by the other partners one or more but less than all the partners have no authority to: Do anyact which would make it impossible to carry on the ordinary business of the partnership. This doesnt work because it was emplaced to protect partners but Bane stopped being a partner when he retired. Bane cant claim that they violated a fiduciary duty to him because they had none. Partners have a fiduciary duty to one another, they dont have a fiduciary duty to former partners. Bane cannot claim that they violated the contract because in the contract it explicitly states that retirement plan dies when there is dissolution of the firm. vi. Lupien v. Malsbenden 1. -Defendant contributed capital in the form of money to York Motor Mart. He claims he was only acting as a banker/financier. However, the loans he made to York carried no interest (his loans were really investments). The loan was to be repaid only upon the sale of Bradley automobiles (the venture of York). Thus, defendant was going to share in Yorks profits. Defendant also participated in day-to-day business operations. Court finds that the Bradley car operation represented a pooling of defendants capital and Cragins automotive skills, with joint control over the 50

business and intent to share in the fruits of the enterprise. Thus, they were partners. vii. Young v. Jones 1. PW-Bahamas issued an audit letter regarding the financial statement of SAFIG. On the basis of this letter, plaintiffs deposited million dollars into a South Carolina bank; from there the funds went to SAFIG. It later turned out that the letter issued by PW-Bahamas relied on the falsified financial statement of SAFIG. Plaintiff claims that the letter issued by PW-Bahamas regarding SAFIGs financial statement lent credence to the defrauders claims so that plaintiffs were induced to invest to their detriment. In suing for accounting malpractice, plaintiffs try to recover from PW-US, alleging that they were partners with PWBahamas, and thus joint and severally liable for the negligence of the latter. Court finds that no partnership existed in fact; the two entities are separately organized. The plaintiffs estoppel theory fails because there is no evidence that they relied on PW-USs partnership representations with PW-Bahamas in making their investment. no money was given to the apparent partnership; PW-US gave no money to PW-Bahamas. viii. McCormick v Brevig (2004) 1. Facts: A brother and sister owned equal shares of a ranch. They were listed 50/50 on tax returns. They started to argue about management of the ranch especially how they were going to manage the debt. They decided to dissolve the partnership. The sister sued the brother and partnership because he allegedly converted partnership assets to his own personal use and she wanted to get an accounting of partnership affairs. She also wanted a determination that Clark engaged in conduct warranting a decree of expulsion. She wanted an order to dissolve the partnership. The district court allowed the partnership to dissolve and appointed special masters to disburse the assets. The special master found that Joan should get $795,629 from the partnership which she objected to. The DC agreed with the masters findings and awarded Joan $1,107,672. Clark tried to give Joan that amount for the purchase of her interest which she rejected. 2. Issue: Is it legit that Clark decided to buy out Joan or did he have to liquidate the entire business? 3. Conclusion: RUPA requires that liquidation of partnership assets and distribution of the net surplus in cash to the partners upon dissolution entered by judicial decree when it is no longer reasonable practicable to carry on the business of the partnership. RUPA allows the partnership to end buy either one partner buying 51

out the other partner or dissolution the partnership and disperse the assets between the partners. Though the district court said liquidate the word has a lot of possible meanings and one of them could mean that Clark was able to buy out Joan. The court reversed the order that had required the sister to sell her interest to her brother, reversed the ruling that the brother's cattle were partnership assets, affirmed the trial court's determinations in other respects, and remanded for an accounting and liquidation. ix. Creel v. Lilly 1. History: The court held that the partnership should continue and not dissolve. 2. Facts:June 1, 1993, Mr. Creel began a NASCAR memorabilia company. September 20, 1994, Mr. Creel expanded his business by incorporating partners and moving out of his wifes floral shop and into his own space.Mr. Creel passed away and his wife is asking for the surviving partners to liquidate all partnership assets because there is no provision in the partnership agreement providing for the continuation of the partnership upon a partners death and the estate has not consented to the continuation of the business.Cash: 13,332, Inventory: 15,000, Good will: 6,666 Total: 34,998 3. Issue:Does the partnership have to dissolve and cease? 4. Holding: No. 5. Reasoning: UPA was enacted in Maryland in 1916 and is the default if there is a gap in the partnership agreement. Under UPA, upon the death of a partner, automatic dissolution with the possible result of a forced sale of all partnership assets. Over time however this was viewed as outmoded and resulted in the development of RUPA. RUPA implemented the entity theory as opposed to the aggregate theory under UPA. Entity Theory: Allows for the partnership to continue even with the departure of a member because it views the partnership as an entity distinct from its partners.Under RUPA, the estate no longer has to consent in order for the business to be continued nor does the estate have the right to compel liquidation. Maryland adopted RUPA as of July 1, 1998 with a phase-in period.As of January 1, 2003 RUPA will govern.The court looks to the partnership agreement first as that is controlling. Under the partnership agreement, the court finds that it in no way mandates that the assets, liabilities, and income be ascertained by means of forced sale. The partners followed the winding up instructions from the partnership agreement exactly how they were stated to be followed.Ms. Creel argues that the partnership agreement does not address the winding up process and that we should look to UPA for default rules The court says 52

this is incorrect. The court thinks the partnership agreement clearly states the intentions of the parties. The court notes that the partnership agreement shows a clear intention that the partners did not intend for there to be a liquidation of all partnership assets upon the death of a partner. The court even analyzes the document under UPA and RUPA. The court finds that a sale of all partnership assets is not required under with UPA or RUPA in order to ascertain the true value of the company. The Court explores the True Value of the Partnership issue raised by Creel. Mrs. Creel would like the valuation of the property to include market value such as goodwill which is the value of the business as an ongoing concern. The court however finds that because of the young age of the company, it is reasonable to conclude that the company did not possess any goodwill value and thus the book value used by the partners was correct. x. Walkovszky v Carlton (1966) 1. Fact. Plaintiff, John Walkovszky, was injured by a taxi owned by a corporation owned by Defendant, William Carlton. Plaintiff sought to hold Defendant personally liable for his injuries. 2. Law. An individual can be held liable for the acts of a corporation through the doctrine of respondeat superior if it can be shown that the individual used his control of the corporation for personal gain. 3. Facts. Defendant was a shareholder in ten separate corporations wherein each corporation has two cabs registered in its name. A single shareholder for multiple corporations is a common practice for the cab industry. A cab from one of Defendants corporations hit Plaintiff, and Plaintiff brought this cause of action to recover. Each cab has only $10,000 worth of insurance coverage, which is the statutory minimum. Plaintiff contends that Defendant was fraudulently holding out the corporations as separate entities when they actually work as one large corporation. 4. Issue. The issue is whether Defendant can be held personally liable for the injuries suffered by Plaintiff. 5. Held. The Plaintiff did not state a correct cause of action to recover from Defendant. Defendant would be held liable under the respondeat superior doctrine if he controlled the corporation for his personal benefit at the expense of the corporations benefit. Plaintiff did not offer proof to make that claim, and instead offered proof that the ten corporations operated as one large corporation. The fact that the corporations may have been one large corporation, however, does not prove that Defendant was controlling the corporations for his own behalf. 6. Dissent. The dissent argued that the corporations were undercapitalized and the corporate entity was clearly used to 53

simply escape liability. Although Defendant carried the statutory minimum amount of insurance, the intent of the legislature was not to use the insurance coverage as a means for justifying Defendants use of corporate entities. 7. Discussion. The dissent wanted to pierce the corporate veil to achieve a more equitable result, but the majority believed that it was the legislatures responsibility to raise the mandatory insurance coverage. The majority and the dissent both regard the series of corporate entities set up by Defendant as a method of limiting Defendants liability, but the majority reasons that the legislature should be the one to correct the abuse. xi. National Biscuit Co. v. Stroud 1. Under the R.U.P.A., the default is that all partners have equal right in the management of the business. Rule 18(h): if something is a matter of ordinary business operations, majority rules. But what about when you have a tie? (50/50) Every partner is an agent for the business, and each has the apparent authority to do apparently authorized things, unless the partner has no actual authority and the person with whom he is dealing knows that he has no such authority.In this case, the default rules dont help us. Here, there were two partners operating a grocery store; one of the partners decides not to buy any more bread from Nabisco, while the other goes ahead and buys it and sues the first partner for contribution.Court decides to break the tie in favor of action; that you need a majority to restrict action, rather than to go forward with it. Activities within the scope of the business should not be limited, save by the expressed will of the majority deciding a disputed question; half of the members are not a majority. xii. Fletcher v Atex Inc. (1995) pg 171 1. Facts: Eastman Kodak and Atex were sued by Fletcher for repetitive stress injuries from the negligent construction of keyboards. The action of plaintiffs, computer keyboard users, for damages from repetitive stress injuries from computer keyboards made by manufacturer, who was owned by defendant, manufacturer's parent company, was dismissed on summary judgment. The court affirmed because there were no material issues of genuine fact and defendant was entitled to judgment as a matter of law. The alter ego theory had insufficient evidence. Where the factual findings from another action were not essential to that judgment and defendant was unable to fully and fairly litigate the issue because it succeeded on other grounds, collateral estoppel did not apply against defendant. The agency theory failed because plaintiffs offered no evidence that defendant authorized or appeared to authorize the manufacturer to act on its 54

behalf. The apparent manufacturer theory failed because defendant could not have been liable where it was not the seller or distributor. The concerted tortious theory failed because there was no evidence that defendant and manufacturer xiii. Sea-land services inc v pepper source (1991) 1. Fact. Plaintiff corporation, Sea-Land Services, Inc., delivered a shipment of peppers for Defendant, Pepper Source, but was never paid. Plaintiff wanted to hold Pepper Source and the other Defendants, Gerald Marchese and other corporations he controlled, liable. 2. Rule of Law. The veil of limited corporate liability will be pierced when the plaintiff proves that 1) there is a unity of interest between the individual and the corporation, and 2) to allow the limited liability would promote an injustice or sanction a fraud. 3. Facts. Plaintiff delivered a shipment of peppers for Pepper Source, but they were not paid. Marchese was the sole shareholder of Pepper Source. Marchese was also the sole shareholder of several other corporations, and he was a co-owner of an additional corporation. Plaintiff asserted that the corporations were shells wherein Marchese shifted money around the different entities to avoid creditors collecting from the corporations. Evidence was presented that showed Marchese treated the corporate accounts as his own personal account, and he frequently shifted money around. 4. Issue. The issue is whether Plaintiff can hold Marchese and each of his corporations liable for the uncollected debt. 5. Held. Plaintiff may be able to hold Marchese and his corporations jointly liable for the uncollected debt, but Plaintiff has yet to offer evidence to completely demonstrate that the corporate veil should be pierced. The court applied the two-part Van Dorn test (from Van Dorn v. Future Chemical and Oil Corp., 753 F.2d 565 (7th Cir. 1985)) which required a plaintiff to not only prove that there is a unity of interest between the individual and the corporation, but the plaintiff must also establish that the allowance of a limited liability would sanction a fraud or promote an injustice. In this case Plaintiff did not adequately offer evidence on the second point to be awarded a motion for summary judgment. 6. Discussion. The court sympathized with Plaintiff, and they questioned Marcheses corporate doings, but the court stressed that Plaintiff needed to prove more than an injustice of an uncollected debt xiv. Sea-land services inc v pepper source (1993) pg 186

55

1. Facts: Appellee obtained default judgment against appellant corporation, but could not collect judgment because appellant had dissolved without assets. Appellee sought to pierce corporate veil to hold appellant owner personally liable and to impose liability on appellant's five other corporations under "reverse piercing" theory. Court granted appellee's motion for summary judgment. Appellants' sought review. Although appellee met first prong of piercing test by demonstrating such unity of interest and ownership that separate personalities of corporations and appellant corporation no longer existed, court reversed and remanded because appellee failed to show appellants' adherence to separate corporate existence promoted fraud or injustice. On remand, district court again pierced appellants' corporate veil because appellee established wrongs beyond inability to collect judgment. On appellants' second appeal, court affirmed because appellee showed "wrongs" necessary to pierce by demonstrating either appellant used corporate facades to avoid responsibilities to creditors or that any appellant would be "unjustly enriched." 2. OUTCOME: Court affirmed district court's judgment awarding appellee damages because appellee showed "wrongs" necessary to pierce appellant's corporate veil by demonstrating that either appellant used corporate facades to avoid responsibilities to creditors or any appellant would be "unjustly enriched" where appellant's adherence to separate corporate existence promoted fraud or injustice. xv. Summer v. Dooley 1. Same circumstances, roughly, except that the court comes out the other way. This issue was whether an equal partner in a two man partnership has the authority to hire a new employee in disregard of the objection of the other partner and then attempt to charge the dissenting partner with the costs incurred as a result of his unilateral decision. Court says that plaintiff cannot collect because a majority of the partners did not consent to the hiring of the third man. Business differences must be decided by a majority of the partners provided no other agreement between partners speaks to the issues. xvi. Day v. Sidley & Austin 1. A former senior partner of a law firm sued his former firm for damages claiming substantial loss of income, damage to his professional reputation, and personal embarrassment. -He voiced approval of a plan to merge the firm with another firm. He alleged fraud because one of the terms of the proposal was that no Sidley partner would be worse off in any way as a result of the merger. As a result of the merger the Washington Offices were 56

consolidated and plaintiff was no longer the sole chairman of the Washington office; Subsequently it was decided to move offices, which plaintiff found intolerable and resigned. Plaintiff claimed he had a contractual right to remain sole chairman of the Washington office; however no such right ever existed. Court also finds that defendants did not breach any fiduciary duty, because there is no duty to reveal information about the internal restructuring of a firm, the concealment of which does not produce any profit for the offending partners nor any financial loss for the partnership as a whole; Specific authority was originally granted to the executive committee to make such decisions. xvii. Meinhard v. Salmon 1. Salmon gets a 20 year lease from Gerry; Salmon gets Meinhard in on the deal to contribute money capital. Salmon was in charge of all management of the hotel. The venture eventually pays big dividends for both co-adventurers. Gerry approaches Salmon for a renewal lease that included a bigger plan (the leveling and rebuilding of a huge tract of land). Salmon took the lease for himself and never told Meinhard until it was a done deal. This opportunity belonged to the joint venture, rather than just something that he could do for himself. It is important that Gerry approached Salmon as the co-adventurer in the Meinhard/Salmon partnership. It might have been different if Salmon had read about the deal in a newspaper and approached Gerry as an independent adventurer. One partner may not appropriate to his own use, a renewal of a lease, though its terms is to being at the expiration of the partnership. He was much more than a co-adventurer. He was a managing co-adventurer. For him and those like him the rule of undivided loyalty is relentless and supreme. When faced with this co-adventurer opportunity, Salmon was obligated to tell Meinhard about it. He cant do it because the opportunity belongs to the partnership/joint-venture, and he cant compete with his partner. (The Strong View). Alternatively, all Salmon had to do is tip off Meinhard that there is this renewal lease out there to begin after the joint-venture is up. In other words, disclosure is enough. (The Weak View). xviii. Gibbs v. Breed, Abbott & Morgan 1. Departing partners get in trouble for raiding associates/staff, taking files, and taking clients. Everything was technically no breach of fiduciary duty except the raiding. 2. Gibbs and Sheehan are leaving BAM and going to another firm. However, in doing so, they recruit BAMs entire trusts and estates department and brought them to the new firm. The boo-boo they make is when they send a memo to the new firm, while still 57

partners at BAM and before giving notice that they were leaving, containing confidential information regarding the desired associates/staff. Pre-withdrawal recruitment is generally allowed only after the firm had been given notice of the lawyers intention to withdraw. Gibbs and Sheehan prepared the memo well in advance of even deciding, much less in informing their partners, of their intention to withdraw. This constituted a breach of fiduciary duty, and made them liable for damages to BAM. xix. Bohatch v. Butler & Binion 1. McDonald and Powers were the managing partners of the DC branch of Butler & Binion. 2. Bohatch is made a 3rd partner. She then begins to suspect that McDonald is overbilling the firms client, Penzoil. So, she goes to the managing partner of Butler & Binion. An investigation is conducted which eventually finds that no overbilling occurred. Bohatch is retaliated against and removed as a partner. She leaves the firm. Does the fiduciary relationship between partners give rise to a duty not to expel a partner who reports suspected overbilling by another partner? Court says no. A partnership exists solely because the partners choose to place personal confidence and trust in one another. . . A partner can be expelled for accusing another partner of overbilling without subjecting the partnership to tort damages. Such charges, whether true or not, may have a profound effect on the personal confidence and trust essential to the partner relationship. The threat of tort liability for expulsion would tend to force partners to remain in untenable circumstances suspicious and angry with each other to their own detriment and that of the their clients whose matters are neglected by lawyers distracted with intra-firm frictions.Thus, no duty to not expel in a partnership. Should we allow partners to retaliate against whistleblowers? xx. Gateway Potato Sales v. G.B. Investment Co. 1. Gateway sold potato seeds to Sunworth Packing; now brings suit to recover payment from Sunworth (the general partner), Sunworth Corporation (the partnership), and G.B. (the limited partner). The partnership agreement stated that G.B. was a limited partner and would not participate in the control of the business. However, Gateway only agreed to finance Sunworth because he was told by Gateway that G.B. was actively involved with the business of the partnership. 2. RULPA states that if the limited partner participates in the control of the business, he is liable only to persons who transact business with the limited partnership reasonably believing, based upon the

58

3. 4. 5.

6. 7.

8.

9.

limited partners conduct, that the limited partner is a general partner. If RULPA had been the law of the state, then G.B. would probably be off the hook. However, the governing law provided that no contact between the creditor and the limited partner is required to impose liability. To the extent that the partnership doesnt have enough money, the creditor can look to the general partner. But what if neither of those have any money? Can the creditor look to the limited partner? Gateway wasnt aware it was contracting with a limited partnership. G.B.s only exposure is the amount they invest in the partnership. If a limited partner exerts too much control, it risks being held by a court to be a de facto general partner, and thus, incur unlimited liability. (not necessarily, under RULPA) -You can work for the general partner, consult, guarantee, sue on behalf of the GP, propose, basically anything short of making actual decisions is safe ground for limited partners who dont wish to be held out to be GPs; the safe actions. RULPA: A limited partner can exert too much control, but in order to be liable, the creditor has to rely upon it.

c. Notes i. Partnership: Two or more people carrying on a business for profit as coowners. ii. Property held by the partnership is entitled in a special form called tenancy in partnership 1. This form of title gives creditors of the partnership first priority over the claims of the creditors of individual partners. 2. The most important single fact about general partnerships is that each partner is liable for all the debts of the partnership. iii. Why Make a Partnership 1. There is only so much that can be borrowed before creditors conclude that additional lending is too risky. After a certain point, selling an ownership stake may simply be a cheaper way to raise capital than attempting to borrow more money. 2. The partnership form assigns ownership rights (control and residual profits) to the parties who provide capital. iv. Factors Courts look at to see if theres a partnership 1. (1) share profits a. U.P.A. section 7(4) says that receipt by a person of a share of the profits is prima facie evidence that he is a partner in the business.

59

b. ` Also, contribution of labor and skill is the same as contribution of other capital like property and money. Labor and skill is human capital. 2. (2) share losses 3. (3) share control 4. (4) joint investment v. For a partnership to exist, two requirements must be met: 1. There must be a voluntary contract of association for sharing the profits and losses which may arise from the use of capital, labor or skill in a common enterprise. Contributing capital is another sign that a partnership exists. 2. There must be an intention on the part of the principals to form a partnership for that purpose. This intent will be implied by the actions of the parties (even if they expressly deny having such an intent). Characteristics of Partnership: 1. Shared profits/losses 2. Shared investment (contribution of capital) 3. Shared control 4. Parties intent (express or implied) 5. Shared rights to property 6. Act like partners with regard to 3rd parties 7. Rights on dissolution vi. Partnership Dissolution 1. Dissolution: event that sets off the termination of the partnership, and triggers a change in the partners legal status. Under UPA 3132, a general partnership is dissolved by the death of any general partner. In fact, even the withdrawal of a general partner will dissolve the partnership unless the partnership agreement otherwise provides. 2. Winding up: economic events that occur after a partner has withdrawn or set in motion the dissolution process. Liquidating the business (selling the inventory; resolving all pending matters if law firm, or divvying them up), cashing out. What is required by liquidation? UPA and RUPA defaults say that there must be an actual liquidation; that you cannot parcel out the assets in kind. You have to cash out, unless otherwise agreed by the partners. One reason for this is the protection of creditors. 3. Termination: the end result, after dissolution is triggered and winding up is done. 4. Dissociation: (from RUPA) partnership continues minus the departing partner a. The primary difference between UPA and RUPA.

60

vii.

viii.

ix.

x.

b. UPA views the partnership as an aggregate of individuals (this drives the idea that when one partner leaves or dies, the partnership cannot continue and must terminate; the remaining partners have to start over if they want to continue; not so under RUPA). c. Under RUPA, the partnership is viewed as an entity, separate from the individuals. Thus, it can continue even if one of the partners dies or leaves. Dissolving a Partnership 1. It can be done at anytime for good faith (see page v. page) 2. They can be at-wil, or for a term. 3. Departing partners can be released from debts prior if creditor agrees, 4. Not personally liable for debts accumulated after exit or renegotiated with creditors after partner leaves. (UPA 362, 363) Third Party Claims Against Partnership Property 1. All business entities have a segregated pool of assets available to secure business debts. This partially insulates each individual partners personal assets. 2. Tenants in Partnership: UPA 25(1); affords to individual partners virtually no power to dispose of partnership property. The property belongs to the partnership as an entity (it is de facto business property) a. Each partner retains a transferable interest in the profits arising from the use of partnership property; but the property itself belongs to the partnership. i. The contributors of equity capital do not own the assets themselves but rather own the rights to the net financial returns that these assets generate. (RUPA 502, 503, UPA 26, 27) ii. Individual creditors of partners can obtain a lien on these interests, not on the partnership property (RUPA 504, UPA 28) Claims of Partnership Creditors to Partners Indivudal Property 1. What happens when a partnership creditors debts are not fully satisfied after all the assets of the partnership are used up? How far into the pockets of the individual partners can creditors reach? Limited Liability Modifications of the Partnership Form 1. Limited liability means that business creditors cannot proceed against the personal assets of some or all of a firms equity investors. 2. Limited partners share in the profits without incurring personal liability for business debts; Thus, there always must be at least one general partner (at least one person on the hook). 61

3. The trade off for limited liability is that the limited partners get no say in the management of the partnership and day-to-day operations. 4. The Control Test: general partners take part in the control of the business; limited partners who remain passive escape personal liability for partnership debts. 5. This test is abandoned by the 2001 Uniform Partnership Act: a limited partner is not personally liable for partnership liabilities even if the limited partner participates in the management and control of the enterprise. 6. Limited partners in LPs can exert all the control they want and still not be liable. a. -ReRULPA allows this as long as the GP is on the hook; but what if the GP runs out of money? 7. Most companies are set up such that the general partner is a limited liability entity, like a corporation, and the people running the corporation are limited liability partners. xi. Limited Liability Partnerships: 1. The biggest practical benefit of the LLP status is that the individual partners will not be individually liable for acts of malpractice committed by other partners. 2. RULPA: A limited partner can exert too much control, but in order to be liable, the creditor has to rely upon it. 3. RULPA states that if the limited partner participates in the control of the business, he is liable only to persons who transact business with the limited partnership reasonably believing, based upon the limited partners conduct, that the limited partner is a general partner. 4. -General Partners owe fiduciary duties to Limited Partners. xii. Tax Concerns 1. Corporations are taxed twice 2. Sole proprietorships, LLCs, LPs, and Partnerships only taxed once 3. Thus, there is a tax advantage to not being a corporation. 4. However, Corporations, LLCs, and LPs enjoy limited liability. 5. Sole Proprietorships and Partnerships do not enjoy limited liability. 6. Thus, LLCs and LPs are most desirable; only taxed once and enjoy limited liability. 3. Corporations a. Statutes i. Delaware Corp. Law 1. 101 INCORPORATORS; HOW CORPORATION FORMED; PURPOSES

62

a. (b) A corporation may be incorporated or organized under this chapter to conduct or promote any lawful business or purposes, except as may otherwise be provided by the Constitution or other law of this State. 2. 102 CONTENTS OF CERTIFICATE OF INCORPORATIONThe certificate of incorporation shall set forth: a. The name of the corporation which (I) shall contain 1 of the words association, company, corporation, club, foundation, fund, incorporated, institute, society, union, syndicate, or limited, or 1 of the abbreviations [co., corp., inc., ltd.], or words or abbreviations of like import in other languages (provided they are written in roman characters or letters) . . . ; b. The address (which shall include the street, number, city and county) of the corporations registered office in this State, and the name of its registered agent at such address; c. The nature of the business or purposes to be conducted or promoted. It shall be sufficient to state, either alone or with other businesses or purposes, that the purpose of the corporation is to engage in any lawful act or activity for which corporations may be organized under the General Corporation Law of Delaware, and by such statement all lawful acts and activities shall be within the purposes of the corporation, except for express limitations, if any; d. If the corporation is to be authorized to issue only 1 class of stock, the total number of shares of stock which the corporation shall have authority to issue and the par value of each of such shares, or a statement that all such shares are to be without par value. If the corporation is to be authorized to issue more than 1 class of stock, the certificate of incorporation shall set forth the total number of shares of all classes of stock which the corporation shall have authority to issue and the number of shares of each class and shall specify each class the shares of which are to be without par value and each class the shares of which are to have a par value and the par value of the shares of each such class. The certificate of incorporation shall also set forth a statement of the designations and the powers, preferences and rights, and the qualifications, limitations or restrictions thereof, . . . ; e. The name and mailing address of the incorporator or incorporators;

63

If the powers of the incorporator or incorporators are to terminate upon the filing of the certificate of incorporation, the names and mailing addresses of the persons who are to serve as directors until the first annual meeting of stockholders or until their successors are elected and qualify. g. In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters: h. (7) A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) for any breach of the directors duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) under section 174 of this title; or (iv) for any transaction from which the director derived an improper personal benefit. No such provision shall eliminate or limit the liability of a director for any act or omission occurring prior to the date when such provision becomes effective. 3. 109 BYLAWS i. The original or other bylaws of a corporation may be adopted, amended or repealed by the incorporators, by the initial directors if they were named in the certificate of incorporation, or, before a corporation has received any payment for any of its stock, by its board of directors. After a corporation has received any payment for any of its stock, the power to adopt, amend or repeal bylaws shall be in the stockholders entitled to vote, or in the case of a nonstock corporation, in its members entitled to vote; provided, however, any corporation may, in its certificate of incorporation, confer the power to adopt, amend or repeal bylaws upon the directors or, in the case of a nonstock corporation, upon its governing body by whatever name designated. The fact that such power has been so conferred upon the directors or governing body, as the case may be, shall not divest the stockholders or members of the power, nor limit their power to adopt, amend or repeal bylaws. 64

f.

ii. The bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors, officers or employees. 4. 122 SPECIFIC POWERS a. Every corporation created under this chapter shall have power to: i. (9) Make donations for the public welfare or for charitable, scientific or educational purposes, and in time or war or other national emergency in aid thereof . . . . 5. 141 BOARD OF DIRECTORS; POWERS; NUMBER, QUALIFICATIONS, TERMS AND QUORUM; COMMITTEES; CLASSES OF DIRECTORS; NONPROFIT CORPORATIONS; RELIANCE UPON BOOKS; ACTION WITHOUT MEETING; REMOVAL a. The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as maybe otherwise provided in this chapter or in its certificate of incorporation. . . . b. The board of directors of a corporation shall consist of 1 or more members. The number of directors shall be fixed by, or in the manner provided in, the bylaws, unless the certificate of incorporation fixes the number of directors, in which case a change in the number of directors shall be made only by amendment of the certificate. Directors need not be stockholders unless so required by the certificate of incorporation or the bylaws. The certificate of incorporation or bylaws may prescribe other qualifications for directors. Each director shall hold office until his successor is elected and qualified or until his earlier resignation or removal. Any director may resign at any time upon written notice to the corporation. A majority of the total number of directors shall constitute a quorum for the transaction of business unless the certificate of incorporation or the bylaws require a greater number. Unless the certificate of incorporation provides otherwise, the bylaws may provide that a number less than a majority shall constitute a quorum which in no case shall be less than 1/3 of the total number of directors except that when a board of 1 director is authorized under the provisions of this section, then 1 director shall 65

constitute a quorum. The vote of the majority of the directors present at a meeting at which a quorum is present shall be the act of the board of directors unless the certificate of incorporation or the bylaws shall require a vote of a greater number. c. (e) A member of the board of directors, or a member of any committee designated by the board of directors, shall, in the performance of his duties, be fully protected in relying in good faith upon the records of the corporation and upon such information, opinions, reports or statements presented to the corporation by any of the corporations officers or employees, or committees of the board of directors, or by any other person as to matters the member reasonably believes are within such other persons professional or expert competence and who has been selected with reasonable care by or on behalf of the corporation. 6. 144 INTERESTED DIRECTORS; QUORUM a. No contract or transaction between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable solely for this reason, or solely because the director or officer is present at or participates in the meeting of the board or committee which authorizes the contract or transaction, or solely because any such directors or officers votes are counted for such purpose, if: i. The material facts as to the directors or officers relationship or interest and as to the contract or transaction are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum; or ii. The material facts as to the directors or officers relationship or interest and as to the contract or transaction are disclosed or are known to the shareholders entitled to vote thereon, and the contract or transaction is specifically approved in good faith by vote of the shareholders; or

66

iii. The contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified, by the board of directors, a committee or the shareholders. iv. Common or interested directors may be counted in determining the presence of a quorum at a meeting of the board of directors or of a committee which authorizes the contract or transaction. 7. 212. VOTING RIGHTS OF STOCKHOLDERS; PROXIES; LIMITATIONS a. Unless otherwise provided in the certificate of incorporation . . . , each stockholder shall be entitled to 1 vote for each share of capital stock held by such stockholder. If the certificate of incorporation provides for more or less than 1 vote for any share, on any matter, every reference in this chapter to a majority or other proportion of stock, voting stock or shares shall refer to such majority or other proportion of the votes of such stock, voting stock or shares. . . . 8. 214 CUMULATIVE VOTING a. The certificate of incorporation of any corporation may provide that at all elections of directors of the corporation, or at elections held under specified circumstances, each holder of stock or of any class or classes or of a series or series thereof shall be entitled to as many votes as shall equal the number of votes which (except for such provision as to cumulative voting) such holder would be entitled to cast for the election of directors with respect to such holders shares of stock multiplied by the number of directors to be elected by such holder, and that such holder may cast all of such votes for a single director or may distribute them among the number to be voted for, or for any 2 or more of them as such holder may see fit. 9. 218 VOTING TRUSTS AND OTHER VOTING AGREEMENTS a. One stockholder or 2 or more stockholders may by agreement in writing deposit capital stock of an original issue with or transfer capital stock to any person or persons, or entity or entities authorized to act as trustee, for the purpose of vesting in such person or persons, entity or entities, who may be designated voting trustee, or voting trustees, the right to vote thereon for any period of time determined by such agreement, upon the terms and conditions stated in such agreement. The agreement may

67

b. c.

d.

10. 220 a.

b.

c.

contain any other lawful provisions not inconsistent with such purpose. . . . Any amendment to a voting trust agreement shall be made by a written agreement . . . . An agreement between 2 or more stockholders, if in writing and signed by the parties thereto, may provide that in exercising any voting rights, the shares held by them shall be voted as provided by the agreement, or as the parties may agree, or as determined in accordance with a procedure agreed upon by them. This section shall not be deemed to invalidate any voting or other agreement among stockholders or any irrevocable proxy which is not otherwise illegal. INSPECTION OF BOOKS AND RECORDS As used in this section, stockholder means a stockholder of record of stock in a stock corporation and also a member of a nonstock corporation as reflected on the records of the nonstock corporation. As used in this section, the term list of stockholders includes lists of members in a nonstock corporation. Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose the corporations stock ledger, a list of its stockholders, and its other books and records, and to make copies or extracts therefrom. A proper purpose shall mean a purpose reasonably related to such persons interest as a stockholder. In every instance where an attorney or other agent shall be the person who seeks the right to inspection, the demand under oath shall be accompanied by a power of attorney or such other writing which authorizes the attorney or other agent to so act on behalf of the stockholder. The demand under oath shall be directed to the corporation at its registered office in this State or at its principal place of business. If the corporation, or an officer or agent thereof, refuses to permit an inspection sought by a stockholder or attorney or other agent acting for the stockholder pursuant to subsection (b) of this section or does not reply to the demand within 5 business days after the demand has been made, the stockholder may apply to the Court of Chancery for an order to compel such inspection. The Court of Chancery is hereby vested with exclusive jurisdiction to 68

determine whether or not the person seeking inspection is entitled to the inspection sought. The Court may summarily order the corporation to permit the stockholder to inspect the corporations stock ledger, an existing list of stockholders, and its other books and records, and to make copies or extracts therefrom; or the Court may order the corporation to furnish to the stockholder a list of its stockholders as of a specific date on condition that the stockholder first pay to the corporation the reasonable cost of obtaining and furnishing such list and on such other conditions as the Court deems appropriate. Where the stockholder seeks to inspect the corporations books and records, other than its stock ledger or list of stockholders, such stockholder shall first establish (1) that such stockholder has complied with this section respecting the form and manner of making demand for inspection of such documents; and (2) that the inspection such stockholder seeks is for a proper purpose. Where the stockholder seeks to inspect the corporations stock ledger or list of stockholders and such stockholder has complied with this section respecting the form and manner of making demand for inspection of such documents, the burden of proof shall be upon the corporation to establish that the inspection such stockholder seeks is for an improper purpose. The Court may, in its discretion, prescribe any limitations or conditions with reference to the inspection, or award such other or further relief as the Court may deem just and proper. The Court may order books, documents and records, pertinent extracts therefrom, or duly authenticated copies thereof, to be brought within this State and kept in this State upon such terms and conditions as the order may prescribe. . . . 11. LLC 12. SECTION 103. EFFECT OF OPERATING AGREEMENT; NONWAIVABLE PROVISIONS. a. Except as otherwise provided in subsection (b), all members of a limited liability company may enter into an operating agreement, which need not be in writing, to regulate the affairs of the company and the conduct of its business, and to govern relations among the members, managers, and company. To the extent the operating agreement does not otherwise provide, this [Act] governs relations among the members, managers, and company. b. The operating agreement may not: 69

i. unreasonably restrict a right to information or access to records under Section 408; ii. eliminate the duty of loyalty under Section 409(b) or 603(b)(3), but the agreement may: 1. identify specific types or categories of activities that do not violate the duty of loyalty, if not manifestly unreasonable; and 2. specify the number or percentage of members or disinterested managers that may authorize or ratify, after full disclosure of all material facts, a specific act or transaction that otherwise would violate the duty of loyalty; 3. unreasonably reduce the duty of care under Section 409(c) or 603(b)(3); 4. eliminate the obligation of good faith and fair dealing under Section 409(d), but the operating agreement may determine the standards by which the performance of the obligation is to be measured, if the standards are not manifestly unreasonable; 5. vary the right to expel a member in an event specified in Section 601(6); 6. vary the requirement to wind up the limited liability companys business in a case specified in Section 801(3) or (4); or 7. restrict rights of a person, other than a manager, member, and transferee of a members distributional interest, under this [Act]. 13. SECTION 301. AGENCY OF MEMBERS AND MANAGERS Subject to subsections (b) and (c): a. Each member is an agent of the limited liability company for the purpose of its business, and an act of a member, including the signing of an instrument in the companys name, for apparently carrying on in the ordinary course the companys business or business of the kind carried on by the company binds the company, unless the member had no authority to act for the company in the particular matter and the person with whom the member was dealing knew or had notice that the member lacked authority. b. An act of a member which is not apparently for carrying on in the ordinary course the companys business or business

70

of the kind carried on by the company binds the company only if the act was authorized by the other members. c. Subject to subsection (c), in a manager-managed company: i. A member is not an agent of the company for the purpose of its business solely by reason of being a member. Each manager is an agent of the company for the purpose of its business, and an act of a manager, including the signing of an instrument in the companys name, for apparently carrying on in the ordinary course the companys business or business of the kind carried on by the company binds the company, unless the manager had no authority to act for the company in the particular matter and the person with whom the manager was dealing knew or had notice that the manager lacked authority. ii. An act of a manager which is not apparently for carrying on in the ordinary course the companys business or business of the kind carried on by the company binds the company only if the act was authorized under Section 404. . . . 14. SECTION 302. LIMITED LIABILITY COMPANY LIABLE FOR MEMBERS OR MANAGERS ACTIONABLE CONDUCT. a. A limited liability company is liable for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a member or manager acting in the ordinary course of business of the company or with authority of the company. 15. SECTION 303. LIABILITY OF MEMBERS AND MANAGERS. a. Except as otherwise provided in subsection (c), the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company. A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager. b. The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company. c. All or specified members of a limited liability company are liable in their capacity as members for all or specified 71

debts, obligations, or liabilities of the company if:a provision to that effect is contained in the articles of organization; and d. a member so liable has consented in writing to the adoption of the provision or to be bound by the provision. 16. SECTION 404. MANAGEMENT OF LIMITED LIABILITY COMPANY. a. In a member-managed company: i. each member has equal rights in the management and conduct of the companys business; and ii. except as otherwise provided in subsection (c), any matter relating to the business of the company may be decided by a majority of the members. b. In a manager-managed company: i. each manager has equal rights in the management and conduct of the companys business; ii. except as otherwise provided in subsection (c), any matter relating to the business of the company may be exclusively decided by the manager or, if there is more than one manager, by a majority of the managers; and iii. a manager: iv. must be designated, appointed, elected, removed, or replaced by a vote, approval, or consent of a majority of the members; and v. holds office until a successor has been elected and qualified, unless the manager sooner resigns or is removed. c. The only matters of a member or manager-managed companys business requiring the consent of all of the members are: i. the amendment of the operating agreement under Section 103; ii. the authorization or ratification of acts or transactions under Section 103(b)(2)(ii) which would otherwise violate the duty of loyalty; iii. an amendment to the articles of organization under Section 204; iv. the compromise of an obligation to make a contribution under Section 402(b); v. the compromise, as among members, of an obligation of a member to make a contribution or return money or other property paid or distributed in violation of this [Act]; 72

vi. the making of interim distributions under Section 405(a), including the redemption of an interest; vii. the admission of a new member; viii. the use of the companys property to redeem an interest subject to a charging order; ix. the consent to dissolve the company under Section 801(b)(2); x. a waiver of the right to have the companys business wound up and the company terminated under Section 802(b); xi. the consent of members to merge with another entity under Section 904(c)(1); and xii. the sale, lease, exchange, or other disposal of all, or substantially all, of the companys property with or without goodwill. . . . 17. SECTION 409. GENERAL STANDARDS OF MEMBERS AND MANAGERS CONDUCT. a. The only fiduciary duties a member owes to a membermanaged company and its other members are the duty of loyalty and the duty of care imposed by subsections (b) and (c). b. A members duty of loyalty to a member-managed company and its other members is limited to the following: i. to account to the company and to hold as trustee for it any property, profit, or benefit derived by the member in the conduct or winding up of the companys business or derived from a use by the member of the companys property, including the appropriation of a companys opportunity; ii. to refrain from dealing with the company in the conduct or winding up of the companys business as or on behalf of a party having an interest adverse to the company; and iii. to refrain from competing with the company in the conduct of the companys business before the dissolution of the company. c. A members duty of care to a member-managed company and its other members in the conduct of and winding up of the companys business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law. d. A member shall discharge the duties to a membermanaged company and its other members under this [Act] or under the operating agreement and exercise any rights 73

consistently with the obligation of good faith and fair dealing. e. A member of a member-managed company does not violate a duty or obligation under this [Act] or under the operating agreement merely because the members conduct furthers the members own interest. f. A member of a member-managed company may lend money to and transact other business with the company. As to each loan or transaction, the rights and obligations of the member are the same as those of a person who is not a member, subject to other applicable law. g. This section applies to a person winding up the limited liability companys business as the personal or legal representative of the last surviving member as if the person were a member. h. In a manager-managed company: i. a member who is not also a manager owes no duties to the company or to the other members solely by reason of being a member; ii. a manager is held to the same standards of conduct prescribed for members in subsections (b) through (f); iii. a member who pursuant to the operating agreement exercises some or all of the rights of a manager in the management and conduct of the companys business is held to the standards of conduct in subsections (b) through (f) to the extent that the member exercises the managerial authority vested in a manager by this [Act]; and iv. a manager is relieved of liability imposed by law for violation of the standards prescribed by subsections (b) through (f) to the extent of the managerial authority delegated to the members by the operating agreement. 18. SECTION 601. EVENTS CAUSING MEMBERS DISSOCIATION. a. A member is dissociated from a limited liability company upon the occurrence of any of the following events: i. the companys having notice of the members express will to withdraw upon the date of notice or on a later date specified by the member; ii. an event agreed to in the operating agreement as causing the members dissociation; iii. upon transfer of all of a members distributional interest, other than a transfer for security purposes 74

iv. v. vi. vii.

viii.

ix.

x.

xi. xii.

xiii.

xiv.

or a court order charging the members distributional interest which has not been foreclosed; the members expulsion pursuant to the operating agreement; the members expulsion by unanimous vote of the other members if: it is unlawful to carry on the companys business with the member; there has been a transfer of substantially all of the members distributional interest, other than a transfer for security purposes or a court order charging the members distributional interest which has not been foreclosed; within 90 days after the company notifies a corporate member that it will be expelled because it has filed a certificate of dissolution or the equivalent, its charter has been revoked, or its right to conduct business has been suspended by the jurisdiction of its incorporation, the member fails to obtain a revocation of the certificate of dissolution or a reinstatement of its charter or its right to conduct business; or a partnership or a limited liability company that is a member has been dissolved and its business is being wound up; on application by the company or another member, the members expulsion by judicial determination because the member: engaged in wrongful conduct that adversely and materially affected the companys business; willfully or persistently committed a material breach of the operating agreement or of a duty owed to the company or the other members under Section 409; or engaged in conduct relating to the companys business which makes it not reasonably practicable to carry on the business with the member; the members: 1. becoming a debtor in bankruptcy; 2. executing an assignment for the benefit of creditors;seeking, consenting to, or acquiescing in the appointment of a trustee, receiver, or liquidator of the member or of all 75

or substantially all of the members property; or 3. failing, within 90 days after the appointment, to have vacated or stayed the appointment of a trustee, receiver, or liquidator of the member or of all or substantially all of the members property obtained without the members consent or acquiescence, or failing within 90 days after the expiration of a stay to have the appointment vacated; xv. in the case of a member who is an individual: 1. the members death; 2. the appointment of a guardian or general conservator for the member; or 3. a judicial determination that the member has otherwise become incapable of performing the members duties under the operating agreement; xvi. in the case of a member that is a trust or is acting as a member by virtue of being a trustee of a trust, distribution of the trusts entire rights to receive distributions from the company, but not merely by reason of the substitution of a successor trustee; xvii. in the case of a member that is an estate or is acting as a member by virtue of being a personal representative of an estate, distribution of the estates entire rights to receive distributions from the company, but not merely the substitution of a successor personal representative; or xviii. termination of the existence of a member if the member is not an individual, estate, or trust other than a business trust. 19. SECTION 602. MEMBERS POWER TO DISSOCIATE; WRONGFUL DISSOCIATION. a. Unless otherwise provided in the operating agreement, a member has the power to dissociate from a limited liability company at any time, rightfully or wrongfully, by express will pursuant to Section 601(1). b. If the operating agreement has not eliminated a members power to dissociate, the members dissociation from a limited liability company is wrongful only if: i. it is in breach of an express provision of the agreement; or

76

ii. before the expiration of the specified term of a term company: c. the member withdraws by express will; d. the member is expelled by judicial determination under Section 601(6); e. the member is dissociated by becoming a debtor in bankruptcy; or f. in the case of a member who is not an individual, trust other than a business trust, or estate, the member is expelled or otherwise dissociated because it willfully dissolved or terminated its existence. g. A member who wrongfully dissociates from a limited liability company is liable to the company and to the other members for damages caused by the dissociation. The liability is in addition to any other obligation of the member to the company or to the other members. h. If a limited liability company does not dissolve and wind up its business as a result of a members wrongful dissociation under subsection (b), damages sustained by the company for the wrongful dissociation must be offset against distributions otherwise due the member after the dissociation. 20. SECTION 701. COMPANY PURCHASE OF DISTRIBUTIONAL INTEREST - A limited liability company shall purchase a distributional interest of a: a. member of an at-will company for its fair value determined as of the date of the members dissociation if the members dissociation does not result in a dissolution and winding up of the companys business under Section 801; or b. member of a term company for its fair value determined as of the date of the expiration of the specified term that existed on the date of the members dissociation if the expiration of the specified term does not result in a dissolution and winding up of the companys business under Section 801. c. A limited liability company must deliver a purchase offer to the dissociated member whose distributional interest is entitled to be purchased not later than 30 days after the date determined under subsection (a). The purchase offer must be accompanied by: i. a statement of the companys assets and liabilities as of the date determined under subsection (a); ii. the latest available balance sheet and income statement, if any; and 77

iii. an explanation of how the estimated amount of the payment was calculated. d. If the price and other terms of a purchase of a distributional interest are fixed or are to be determined by the operating agreement, the price and terms so fixed or determined govern the purchase unless the purchaser defaults. . . . e. If an agreement to purchase the distributional interest is not made within 120 days after the date determined under subsection (a), the dissociated member, within another 120 days, may commence a proceeding against the limited liability company to enforce the purchase. The company at its expense shall notify in writing all of the remaining members, and any other person the court directs, of the commencement of the proceeding. The jurisdiction of the court in which the proceeding is commenced under this subsection is plenary and exclusive. f. court shall determine the fair value of the distributional interest in accordance with the standards set forth in Section 702 together with the terms for the purchase. Upon making these determinations, the court shall order the limited liability company to purchase or cause the purchase of the interest. g. Damages for wrongful dissociation under Section 602(b), and all other amounts owing, whether or not currently due, from the dissociated member to a limited liability company, must be offset against the purchase price. 21. SECTION 702. COURT ACTION TO DETERMINE FAIR VALUE OF DISTRIBUTIONAL INTEREST -In an action brought to determine the fair value of a distributional interest in a limited liability company, the court shall: a. determine the fair value of the interest, considering among other relevant evidence the going concern value of the company, any agreement among some or all of the members fixing the price or specifying a formula for determining value of distributional interests for any other purpose, the recommendations of any appraiser appointed by the court, and any legal constraints on the companys ability to purchase the interest; b. specify the terms of the purchase, including, if appropriate, terms for installment payments, subordination of the purchase obligation to the rights of the companys other creditors, security for a deferred purchase price, and a covenant not to compete or other restriction on a dissociated member; and 78

c. require the dissociated member to deliver an assignment of the interest to the purchaser upon receipt of the purchase price or the first installment of the purchase price. . . . d. Interest must be paid on the amount awarded from the date determined under Section 701(a) to the date of payment. 22. SECTION 1101. RIGHT OF ACTION. a. A member of a limited liability company may maintain an action in the right of the company if the members or managers having authority to do so have refused to commence the action or an effort to cause those members or managers to commence the action is not likely to succeed. b. Cases i. Dodge v Ford motor co. (1919) pg 105 1. Summary. Plaintiff shareholders, Dodge et al., brought an action against Defendant corporation, Ford Motor Company, to force Defendant to pay a more substantial dividend, and to change questionable business decisions by Defendant. Rule of Law. The purpose of a corporation is to make a profit for the shareholders, but a court will not interfere with decisions that come under the business judgment of directors. Facts. Defendant corporation was the dominant manufacturer of cars when this case was initiated. At one point, the cars were sold for $900, but the price was slowly lowered to $440 2. Wiki facts: By 1916, the Ford Motor Company had accumulated a capital surplus of $60 million. The price of the Model T, Ford's mainstay product, had been successively cut over the years while the cost of the workers had dramatically, and quite publicly, increased. The company's president and majority stockholder, Henry Ford, sought to end special dividends for shareholders in favor of massive investments in new plants that would enable Ford to dramatically grow the output of production, and numbers of people employed at his plants, while continuing to cut the costs and prices of his cars. In public defense of this strategy, Ford declared: "My ambition is to employ still more men, to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes. To do this we are putting the greatest share of our profits back in the business."While Ford may have believed that such a strategy might be in the long-term benefit of the company, he told his fellow shareholders that the value of this strategy to them was not a primary consideration in his plans. The minority shareholders objected to this strategy, demanding that Ford stop reducing his prices when they could barely fill orders for cars and to continue to pay out special dividends from the capital surplus in lieu of his proposed plant investments. Two brothers, John Francis Dodge 79

and Horace Elgin Dodge, owned 10% of the company, among the largest shareholders next to Ford. The Court was called upon to decide whether the minority shareholders could prevent Ford from operating the company for the charitable ends that he had declared. 3. Judgment: The Court held that a business corporation is organized primarily for the profit of the stockholders, as opposed to the community or its employees. The discretion of the directors is to be exercised in the choice of means to attain that end, and does not extend to the reduction of profits or the non-distribution of profits among stockholders in order to benefit the public, making the profits of the stockholders incidental thereto. Because this company was in business for profit, Ford could not turn it into a charity. This was compared to spoliation of the company's assets. The court therefore upheld the order of the trial court requiring that directors declare an extra dividend of $19 million. ii. A.P. Smith MFG Co. Barlow(1953) pg 108 1. Summary. Defendant stockholders, Ruth Barlow et al., questioned the legality of a donation made by Plaintiff corporation, A.P. Smith Manufacturing Company. Rule of Law. Corporate gift-giving is an allowable method of increasing goodwill, but the gift should be less than 1% of capital and surplus and directed to an institution owning no more than 10% of the company stock. Facts. Plaintiff corporation, founded in 1896, had a history of donating minor sums of money to various charities and institutions. In 1956 Plaintiff voted to give $1,500 to Princeton University. Plaintiff instituted a declaratory judgment action after Defendant stockholders questioned the proposed gift. Although a state statute allows corporations to contribute to charities, Defendants assert that the corporations certificate of incorporation does not allow the gift, and the corporation was incorporated prior to the statute that authorizes the gift-giving. Issue. The issue is whether Plaintiff can donate money to a charity without authorization from stockholders or through the certificate of incorporation. 2. Held. Plaintiff can give money to charities providing that the total does not exceed the statutory maximum of 1% of capital and surplus, and the institution receiving the money does not own more than 10% of the company stock. Corporate gift-giving increases the goodwill of the corporation, and public policy should be to encourage corporations to provide to charities in the same manner as individuals are encouraged to give. Discussion. The court did not accept Defendants reasoning that the donation was not allowed because the corporation preceded the statute authorizing the gift-giving. The court explained that the potentially infinite lifespan of corporations would lead to corporations a varying ages to live under various sets of laws.

80

iii. Sinclair Oil Corporation v Levien (1971) pg 489 1. Summary. Plaintiff, Francis Levien, brought suit as a minority shareholder of Sinclair Venezuelan Oil Company (Sinven) which was a subsidiary of Defendant, Sinclair Oil Corporation. Plaintiff alleged that Defendant caused Sinven to pay out excessive dividends, and that Defendant breached their contract with Sinven. Rule of Law. A standard of intrinsic fairness will be applied in any self-dealing transaction by a parent corporation whose majority ownership places a fiduciary duty upon the parent corporation, but the transaction only be self-dealing if the transaction is to the detriment of minority shareholders. Facts. Sinven was a subsidiary of Defendant with operations exclusively in Venezuela. Defendant, as the majority shareholder of Sinven, caused Sinven to pay dividends that were so large that the amount exceeded the earnings of Sinven. The dividends provided cash to Defendant as well as minority shareholders, but it left no resources from Sinven to expand its operations. Defendant also neglected to meet the terms of the contract between them and Sinven. The agreement required Sinven to sell all of its products to Defendant at specified prices, but Defendant was late in payments and did not fulfill their minimum purchasing obligations. Plaintiff therefore brought this action, claiming the dividends were excessive and that Defendant breached the contract with Sinven. Issue. The issue is whether Defendant was improperly engaging in self-dealing when they issued excessive dividends and breached their contract with Sinven. 2. Held. Defendant did not engage in self-dealing by issuing large dividends but it did engage in self-dealing when they breached the agreement. Defendant complied with Delaware statute 8 Del.C. Section: 170, concerning the payment of dividends, and Defendants motives are not a factor when all shareholders benefit from the transaction (not self-dealing). However, the contract breach was to the detriment of Sinven and its minority shareholders with the positive effect being exclusive to Defendant, so the breach is self-dealing. Discussion. Majority shareholders are held to a different standard than officers or directors such as in Lewis v. S.L & E, Inc. In Lewis, any conflict of interest between a director and the corporation is voidable unless the transaction is proven to be fair. In this case, a plaintiff has to prove that the majority shareholders enjoyed an exclusive benefit to the detriment of the minority shareholders before the burden is shifted to the defendants. Zetlin v Hanson Holdings Inc (1979) pg 510 3. Summary. Plaintiff, Lev Zetlin, brought this action to receive the premium price for his minority shares that Defendants, Hanson Holdings, Inc. et al., received for their controlling shares. Rule of Law. Absent bad faith such as corporate looting of assets or a conversion of a corporate opportunity, a party can purchase a 81

controlling share of a corporation at a premium price without extending a tender offer to all shareholders. Facts. Plaintiff owned 2% of Gable Industries, Inc. Defendants owned 44.4% of the outstanding shares which they sold to Flintkote Co. for $15, giving Flintkote the controlling majority. The open market value of the shares was $7.38 per share. Plaintiff brought this action, believing all of the Gable shareholders were entitled to the premium paid by Flintkote. Issue. The issue is whether Plaintiff is entitled to the premium share value that Flintkote paid to Defendants for their controlling shares. 4. Held. The Court of Appeals of New York declined to adopt Plaintiff rule which would effectively mandate that a purchaser give a tender offer to all shareholders when they are only seeking a controlling interest in a corporation. The rule change should be provided by the legislature and not the courts, but the current law has never held that such a policy should be in place. Discussion. The court realized that the rule advocated by Plaintiff would place a significant burden on parties who are simply trying to get a majority interest in a company rather than complete ownership. iv. Perlman v Feldmann (1955) pg 514 1. Summary. Plaintiffs, Jane Perlman et al., were minority shareholders in Defendant Newport Steel Corp. Plaintiffs brought this action to recover their share of the premium paid to Defendants, C. Russell Feldmann et al., by Wilport Company. Rule of Law. A majority shareholder, particularly when they also are the president and chairman of the board, who sells his shares to a third party who then obtains a controlling interest, owes the minority shareholder their share of the premium paid by the third party for the controlling interest. Facts. Plaintiffs and Defendants were shareholders in Newport Steel. Newport Steel provided steel sheets typically to regional customers because their facilities were outdated. Due to the Korean War, steel was at a premium and it turned Newport Steel into a more profitable venture. Newport began updating their facilities, but a third party, Wilport Company, bought Defendants shares in an effort to secure more steel output. The over-thecounter price for the shares was $12 and the book value was $17.03, but Wilport paid $20 per share to Defendants. Plaintiffs sued to receive the same premium (attributable to the sale of corporate power) for their shares, and the trial court denied their claims. The trial court ruled that the premium was an inherent benefit of having a controlling ownership, and alternatively, the burden was on Plaintiffs to prove the lesser value of the stock. Issue. The issue is whether Plaintiffs are entitled to a share of the premium paid by Wilport attributed to the sale of corporate power. 2. Held. Plaintiffs are entitled to a share of the premium paid to Defendant shareholders. Feldmann was the president and 82

dominant shareholder, and in both positions he owes a fiduciary duty to minority shareholders not to let a personal interest override the interests of all the shareholders. The burden is on the shareholder to prove that this is not the case. The court is not holding that the dominant shareholder is not able to sell his shares, but in this case Feldmann did not meet his duty in the sale of his shares. The court noted that there only had to be a possibility that Defendants misappropriated a corporate opportunity and not an absolute certainty. The facts demonstrate that there was a shortage of steel and Defendants took advantage of this to obtain a market premium for their shares. Dissent. The dissent does not argue that Feldmann owed Plaintiffs a fiduciary duty, but he argues that Feldmann did not violate any duty here. As a majority shareholder, Feldmann is entitled to sell his shares for the best price he can receive. There was no evidence that Wilport was going to abuse their control or not act in the best interests of the other shareholders. Discussion. The dissent takes the position provided in Zetlin v. Hanson Holdings, Inc. which allows for a majority shareholder to get the best price for their shares without having to account for any premium to the minority shareholders. v. Essex Universal Corp. v Yates (1962) pg 519 1. Summary. Plaintiff, Essex Universal Corp., brought this action to recoup damages stemming from a contract breach by Defendant, Herbert Yates. The contract provided for Defendant to sell Plaintiff shares of Republic Pictures Corp. and allow Plaintiff to replace members of the board upon purchase. Rule of Law. An agreement to sell the control of management along with the sale of a substantial percentage of shares is not against public policy. Facts. Plaintiff offered to purchase between 566,223 shares at $8 per share ($2 more per share than the market value) of Republic Pictures shares from Defendant. This represented 28.3% of the outstanding shares of Republic Pictures. Plaintiff was going to pay 37.5% of the total price up front and pay the rest over 24 monthly payments, during which time Defendant would hold on to the certificates as security. Defendant agreed that once Plaintiff closed on the transaction that Defendant would have 8 of the 14 board members resign so Plaintiff could replace them with their own members. When the parties met to close the deal, Defendant refused. Plaintiff then brought this action for $2.7 million to recover the difference between their price and what the shares were worth. Defendant argued that the agreement was invalid because it called for terminating management. Issue. The issue is whether the stock purchase agreement is invalid because it provided for the termination of prior board members and subsequent control of management for Plaintiff. 2. Held. Chief Judge Lumbard held that the agreement is valid and does not violate public policy. Plaintiff was receiving a sizable portion of the shares which would have eventually entitled them to 83

elect representatives to the board. The agreement only accelerated that process. It was also acceptable for the majority shareholder to obtain a premium for selling the control of the company in this case because, unlike Perlman v. Feldmann, there was no breach of a fiduciary duty to minority shareholders. On remand, the burden would be on Defendant to prove that a voting block greater than Plaintiffs size would have not approved of the deal. Concurrence. Circuit Judge Clark agreed with the other judges to decline to grant a summary judgment, but his reasoning was simply that not enough facts were available to determine the legality of the transaction. 3. Circuit Judge Friendly voted to remand the case as well, but he declined to accept Chief Judge Lumbards reasoning. Judge Friendly personally would void a contract that gave controlling majority of management to a company that held less than fifty percent of the shares. But he wanted the state of New York to be able to determine what policy they would follow on their own. Discussion. There was no majority consensus on whether a stock purchase agreement that gave management control to the purchaser was valid, although two of the three judges did not rule it out. vi. Zahn v Transamerica Corp. (1947) 1. Summary. Plaintiff Zahn brought this suit after Defendant Transamerica Corp., as the majority shareholder of Axton-Fisher (A-F), decided to redeem Plaintiffs Class A shares at $80.80 per share prior to the liquidation of A-F. The value of the shares would have been substantially higher at the point of liquidation. Rule of Law. Unlike a director, a shareholder, majority or otherwise, is entitled to vote in a manner that is most beneficial to their interests. Facts. A-F was a tobacco company that had as its principal asset leaf tobacco which they bought in late 1942 and early 1943 for $6,361,981. By April of 1943 the value of the tobacco was about $20 million. Defendant, a holding company, was the majority shareholder which entitled them to control nearly every aspect of A-Fs operations. Defendant converted all of their Class A stocks to class B stocks, and then called for a redemption of outstanding Class A stocks at $80.80 per share. The companys charter allowed for the redemption, but the timing of it was suspicious because right after the redemption Defendant liquidated A-F. As a result, owners of Class A shares lost out on what Plaintiff valued to be a $240 per share return. Plaintiff redeemed some Class A shares, so Plaintiff sought equitable relief to turn in outstanding shares at $240 per share and sought the difference between the $80.80 and $240 for the redeemed shares. Defendant argued that they followed the corporate c harter when they voted for the redemption. Issue. The issue is whether Plaintiff is entitled to equitable relief 84

for a decision made by the majority shareholder that was otherwise allowable under the corporate charter. 2. Held. The court differentiated between a decision made by a shareholder and a director, and determined that the Plaintiff was entitled to equitable relief if, as Plaintiff maintains, the directors were acting on Defendants behalf when they decided to redeem Class A shares. Defendant is entitled as a shareholder to vote their interests, but their capacity as director (if the directors are acting as an extension of the majority shareholders) is limited because they owe a fiduciary duty to every shareholder. Discussion. The important factor in this case was Defendants alleged control over the Board, and the fact that the decision to redeem the shares was a decision granted to the directors and not the shareholders. vii. Saito v McKesson HBOC Inc. (2002) pg 196 1. Summary. Saito, (Plaintiff), brought a stockholders derivative suit against McKesson HBOC, Inc. (Defendant). The Court of Chancery and Court of Appeals 2. Rule of Law. The source of documents and the manner in which the corporation obtains them have little or no bearing on a stockholders inspection rights. If activities that occurred before the purchase date are reasonably related to the stockholders interest as a stockholder, then the stockholder should be given access to records necessary to an understanding of those activities. 3. Facts. Plaintiff brought a stockholders derivative suit to examine the conduct of Defendant with regard to certain accounting irregularities. Plaintiff wished to investigate wrongdoing that may have occurred prior to his stock ownership. Plaintiff sought to examine documents the corporation had obtained from financial and accounting advisors and documents of its subsidiary in order to understand what the companys directors knew and why they failed to recognize the accounting irregularities. 4. Issue. Whether a stockholder may access records that predate the purchase of the stockholders interest. Whether the source of the documents in a corporations possession should control a stockholders right to inspection under Section: 220. Whether stockholders of a parent corporation are entitled to inspect a subsidiarys books and records absent a showing of fraud or establishing that the subsidiary is actually the alter ego of the parent. 5. Held. a. Yes. The date of stock purchase should not be used as an automatic cut-off date in a Section: 220 action.

85

b. No. The source of the documents in a corporations possession should control a stockholders right to inspection under Section: 220. c. No. The stockholders of a parent corporation are entitled to inspect a subsidiarys books and records only after establishing fraud or that the subsidiary is actually the alter ego of the parent. 6. Discussion.The date of stock purchase should not be used as an automatic cut-off date in a Section: 220 action. The potential claim may involve a continuing wrong or a wrong that has its roots in events that transpired earlier. Here, due diligence documents generated before the merger agreement was signed may be essential to an investigation of accounting irregularities discovered after the merger was consummated. If such activities are reasonably related to the stockholders interest as a stockholder, than the stockholder should be given access to records necessary to an understanding of those activities even though they occurred prior to the purchase date. Here, Plaintiff wants to investigate possible wrongdoing relating to McKesson and McKesson HBOCs failure to discover HBOCs accounting irregularities. Since they relied on financial and accounting advisors to evaluate HBOCs financial position, the documents generated would be critical to Plaintiffs investigation. Stockholders of a parent corporation are not entitled to inspect a subsidiarys books and records unless there is a showing of fraud or that the subsidiary is the alter ego of the parent. However, documents HBOC gave to McKesson before the merger or McKesson HBOC after the merger are relevant to understand what the companys directors knew and why they failed to identify HBOCs accounting irregularities. viii. Roosevelt v E.I. Du Pont de Nemours & Co (1992) pg 229 1. History: Appellant shareholder challenged the decision of United States District Court for District of Columbia decision recognizing Securities Exchange Act of 1934 14(a), 15 U.S.C.S. 78n(a), included implied private right of action for alleged violations of 17 C.F.R. 240.14a-8(c)(7), but held appellant's proposal was excludable under the Rule 14a-8(c)(7) ordinary business operations exception. 2. Facts: Before appellee company's annual meeting, appellant shareholder submitted two-part proposal regarding appellee's plan to phase out production of chlorofluorocarbons. Appellee notified Securities Exchange Commission (SEC) of its intention to omit such proposal and the reasons for doing so. SEC issued a "noaction letter," citing the 17 C.F.R. 240.14a-8(c)(7) exception for 86

matters relating to conduct of appellee's ordinary business operations. Although 14(a) of the Securities Exchange Act of 1934, 15 U.S.C.S. 78n(a), supported appellant shareholder's private right of action, the court upheld the district court's determination that appellant's proposal was excludable under the "ordinary business operations" exception of Rule 14a-8(c)(7). In view of the congressional intent that 14(a) have real force, relevant judicial precedent, and agency's view of the private right, court held that shareholders could seek appropriate declaratory and injunctive relief when management refused to distribute their proposals, but concluded that the target date for chlorofluorocarbons phase-out was a matter excludable under Rule 14a-8(c)(7). 3. Conclusion: The court held that appellant shareholder could seek appropriate declaratory and injunctive relief after appellee company refused to distribute the shareholder proposal, but concluded that the target date for chlorofluorocarbons phase-out was a proposal excludable under "ordinary business operations" exception. ix. Charlestown boot & shoe Co. v Dunsmore (1880) pg 127 1. POSTURE: Defendants, the officers and directors of the plaintiff corporation, motioned for demurrer on plaintiff's claim that it was permitted to vote someone who was not a director to join in closing up its affairs. OVERVIEW: Defendants, the officers and directors of the plaintiff corporation, motioned for demurrer on plaintiff's claim that plaintiff was permitted to vote someone who was not an officer or a director to join in closing up its affairs. Court granted demurrer, holding that the pertinent statute stated that the directors of a corporation should manage the business of the corporation and that only these directors could exercise such powers. Plaintiff' action, in trying to vote someone who was not a director to help in the closing of its affairs, was inoperative and void. OUTCOME: Defendant's motion for demurrer was granted. Court held that the pertinent statute stated that the directors of a corporation should manage the business of the corporation and that only these directors could exercise such powers. x. Schnell v Chris craft industries Inc (1971) pg 131 1. Facts: Plaintiffs, who were stockholders of the defendant, sought a preliminary injunction against the carrying out of a change in the date of its annual meeting of stockholders, which was accomplished by an amendment in the company bylaws. The plaintiff's sought to install new management and directors in response to poor company performance. They contended that by advancing the date of the annual meeting, the defendant "deliberately sought to handicap the efforts of plaintiffs and other stockholders." The Court denied a preliminary injunction declaring 87

the change of corporate bylaws null and void. The plaintiffs appealed. 2. Rule of Law and Holding: A corporation may not amend its bylaws to change the voting system for an inequitable purpose. In this case, the court reversed the judgment, finding that the purpose of the amendment of the by-laws was inequitable. xi. Blasius Industries Inc v Atlas Corp (1988) pg 133 1. POSTURE: In two actions consolidated and tried together to the Court of Chancery of Delaware, New Castle, the validity of votes for the board of directors of defendant corporation was challenged by defendant's largest shareholder, plaintiff corporation. OVERVIEW: Two separate cases pitting the directors of defendant corporation against its largest shareholder, plaintiff corporation, were consolidated and tried together, requiring the court to determine who could sit on defendant's board of directors. The first challenged the validity of board action taken at a telephone meeting that added two new members to defendant's board. The second required the court to determine the outcome of plaintiff 's consent solicitation. The court held as to the first case that even though defendants acted on their view of the corporation's interest, their action constituted an offense to the relationship between corporate directors and shareholders, and thus was invalid and void. As to the second case, the court held the judges of election properly confined their count to the written "ballots" before them, and that plaintiff's consent solicitation failed to garner the support of a majority of defendant shares. OUTCOME: The judgment was entered in favor of defendant corporation where the court held that any mistakes that were made in counting votes did not alter the outcome of the vote for members of the board of directors of defendant corporation. xii. Ringling Bros. Barnum & Bailey Combined Shows v Ringling (194) pg 258 1. Summary. Plaintiff, Edith Ringling, brought an action to enforce a stock pooling agreement she had with one of the Defendants, Aubrey Haley. Synopsis of Rule of Law. Shareholders can agree to pool their votes and have a third party intercede when there is any disagreement as to how to vote. Facts. Plaintiff and Haley each owned 315 out of 1000 shares of Defendant company, Ringling Brothers-Barnum & Bailey Combined Shows, with the remaining 370 shares owned by another defendant, John Ringling North. The companys board was comprised of seven members, and if each shareholder voted independently the most likely outcome would be for each shareholder electing two board members with North selecting the extra member. However, in 1941 Plaintiff and Healey contracted to pool their votes, wherein each selected two members and then used their remaining votes to select a fifth member of their 88

choosing. The contract called for an arbitrator, Karl Loos, to resolve any disputes. The contract was terminated a year later with the parties still bound by the arbitrator provision that called for Loos to help decide how to vote. In 1946, Haley could not attend the meeting and sent her husband in her place, and instead of following Loos advice he chose to move for adjournment. Plaintiff and Defendant voted their shares, and Plaintiff brought this action to force Healey to vote according to Loos decision. Healey argued that the agreement between her and Plaintiff was invalid as it took the voting power away from the shareholders and gave it to a third party (Loos). Issue. The issue is whether the agreement between Healey and Plaintiff to pool their votes was valid. 2. Held. The court held that it no other shareholders rights were violated and public policy was not violated, as the result of a pooling agreement. Shareholders should be allowed to benefit as they see fit from their voting rights, and this often means banding together to strengthen their position. However, the court decided not to invalidate the voting and held that the members that were voted in by Healey and North would remain. Discussion. The court treats shareholder voting rights as a form of property rights. xiii. McQuade v Stoneham (1934) pg 270 1. Summary. Plaintiff, Francis McQuade, brought this action against Defendants, Charles Stoneham et al., to be reinstated as the treasurer of the National Exhibition Company (NEC). Synopsis of Rule of Law. Shareholders can not form an agreement to control the decisions traditionally vested in the judgment of the directors of a company. Facts. In 1919, Plaintiff and Defendant John McGraw each purchased 70 shares of NEC stock from the majority 1,306 shares that Stoneham owned. NEC was the company that owned the New York Giants. At the time of purchase, the parties agreed to do everything in their power to keep Stoneham as president, McGraw as vice-president and Plaintiff as treasurer. Plaintiff and Stoneham had a number of conflicts concerning the operations of NEC, and in 1928, the 7-member board of directors of NEC voted in a new treasurer (McGraw and Stoneham abstained from the vote). Plaintiff was not removed for any misconduct or ineptitude, but rather for his conflicts with Stoneham. Plaintiff brought this action to be reinstated as treasurer, and he cited the agreement that he entered with McGraw and Stoneham that provided for each of them to use their best endeavors to keep each other in their respective positions. Defendant argued that the agreement was invalid because it granted authority to shareho lders for a decision that is normally left to the judgment of directors. The lower court moved to reinstate Plaintiff. Issue. The issue is whether the shareholder agreement between 89

Plaintiff and Defendants to use their best efforts to keep each of the parties in their respective positions is valid. 2. Held. The Court of Appeals of New York held that the shareholder contract to keep the parties in their positions within NEC was invalid as a matter of public policy. Shareholders should not be able to usurp the decision-making normally left to the directors, and directors should be beholden to the corporation and not the shareholders. Although the evidence indicated that Stoneham may have exercised bad faith in that Plaintiff was competent in his position and was ousted over personal disagreements, the directors intentions are irrelevant because the court does not want to put directors in a position wherein they would have to defend future decisions. Plaintiff was also ineligible for employment with NEC because he was a City Magistrate. Concurrence. The concurring opinion agreed that the reinstatement should be denied, but only because Plaintiff was a City Magistrate. The contract, however, was valid because Stoneham as a majority owner could elect the directors who elect the treasurer and was not therefore taking away any powers from the directors that he already really had. Discussion. The court affirms the validity of shareholders to agree to pool their votes, but they decline to allow them to use their voting power but not pool the directors powers. xiv. Galler v Galler (1964) pg 274 1. Summary. Plaintiff, Emma Galler, sued Defendants, Isadore Galler et al., for reinstatement as a director of the Galler Drug Company and for money owed to her pursuant to a shareholder agreement between Isadore Galler and Plaintiffs late husband. Synopsis of Rule of Law. A shareholder agreement, particularly in closed corporations, that controls the voting for board members and the members management decisions, should nevertheless be enforced as long as the agreement is not fraudulent or harmful to the public. Facts. Plaintiffs late husband and his brother, Isadore Galler, owned all but 12 shares of a close corporation, Galler Drug (each of the brothers sold six shares to a third party that was subject to a buyback provision allowing each brother to reclaim their six shares). The brothers, in an effort to provide for their families if something were to happen to either brother, entered a shareholder agreement that would guarantee that their spouses would be elected to the board and that each would have equal representation on the board. The agreement also provided an annual payout to the spouses. There was no set expiration date of the agreement provisions. After Plaintiffs spouses death, Defendants tried to destroy all copies of the agreement. Plaintiff sued to review the agreement in order to enforce the provisions therein. Defendant argued that the shareholder agreement was unenforceable because it violated state statutes that render invalid shareholder agreements that seek to control management decisions. 90

Issue. The issue is whether the shareholder agreement between the majority shareholding brothers was invalid per statute or public policy. 2. Held. The agreement was valid and Plaintiff should be entitled to specific performance and money that was owed under the agreement. Galler Drug was a closely held corporation, and therefore subject to different circumstances than a shareholder of a large corporation. The court cited a number of prior cases, including Dodge v. Clark, to support the premise that because this agreement did not harm the public and was fair to the parties of the agreement, there is no offense to any public policy concerns. Discussion. In a closely held corporation, a minority shareholder does not have the ability to easily unload their shares as someone who held publicly traded shares, and therefore will have to resort to detailed, comprehensive shareholder agreements in order to guarantee their rights. The court weighs this public policy concern against the public policy concern of independent directors and decided not to follow the statute that prohibits these agreements, reasoning that the state could not have meant for the statute to apply in these cases. xv. Donahue v Rodd Electrotype Co. (1975) pg 248 1. POSTURE: Plaintiff, a minority shareholder in a close corporation, appealed from a decree of the Superior Court (Massachusetts), which dismissed plaintiff's suit for rescission of a purchase, by defendant purchasers, of a controlling shareholder's stock. OVERVIEW: The controlling shareholder sold his stock to defendants; however, defendants refused to purchase plaintiff's stock. The trial court dismissed plaintiff's suit, because the initial transaction had been carried out in good faith. On appeal, the court held that in a close corporation, all shareholders owed one another a strict duty of utmost good faith and loyalty. Further, the court held that a controlling shareholder could not utilize its position to create an exclusive market for its shares. In this case, defendants had created a market for the controlling shareholder but refused to extend that market to plaintiff, thereby excluding her. Therefore, the court reversed and held that either the initial sale had to be rescinded or defendants had to offer to purchase plaintiff's stock at the same price agreed upon in the initial sale. OUTCOME: The decree was reversed, and the case was remanded for entry of a judgment. xvi. Rosenthal v Rosenthal (1988) pg 286 1. POSTURE: Defendant brother appealed from the judgment of the Superior Court of Kennebec County (Maine), which upheld a jury verdict in favor of plaintiff brother that found that the agreement between the parties did not constitute an accord and satisfaction and that defendant and his wife had violated their fiduciary duty and confidential relationship with plaintiff. OVERVIEW: Plaintiff brother had an agreement with defendant 91

brother whereby plaintiff sold his interest in the family businesses back to the family. Plaintiff brought an action against defendant and the jury found that the agreement did not constitute an accord and satisfaction, that defendant and his wife violated their fiduciary obligations toward plaintiff, and that defendant had abused a confidential relationship with plaintiff. The court dismissed the claim of violating a confidential relationship because there was no evidence of record that such a relationship existed. The court vacated the judgment on the remaining claim because the trial court judge so significantly misstated the business judgment rule. The court held that defendant was entitled to an instruction on the "substituted contract" theory of their affirmative defense of accord and satisfaction and remanded the matter. OUTCOME: The court vacated the lower court's judgment in favor of plaintiff brother and remanded the matter for a new trial. The court held that there was reversible error in the presiding judge's jury instructions to the detriment of defendant brother that required a new trial. xvii. Wilkes v Springside Nursing Home Inc. (1976) pg 287 1. Summary. Plaintiff, Stanley Wilkes, brought this action to recover lost wages due to his termination by Defendants, Springside Nursing Home, Inc. et al., which violated either the partnership agreement between the parties or the fiduciary duty that Defendants owed to Plaintiff. Synopsis of Rule of Law. Shareholders in a close corporation owe each other a duty of acting in good faith, and they are in breach of their duty when they terminate another shareholders salaried position, when the shareholder was competent in that position, in an attempt to gain leverage against that shareholder. Facts. Plaintiff was locally renowned for his profitable real estate dealings, and in 1951 when Defendants heard about Plaintiffs option to purchase a particular building, they agreed to partner with Plaintiff on developing a business venture around that option. The parties agreed to allow each to receive money from the corporation as long as they actively participated in running the business. The parties then agreed to open a nursing home at the location, and by 1952 the profit from the business was large enough for them to each draw a salary from the business. One of the Defendants wanted to purchase part of the property for his own business use, and Plaintiff forced a higher price for the property than what was expected. This created bad feelings between the partners until finally, in 1967, Plaintiff notified the other shareholders that he wanted to sell his share. A month later, but prior to the sale of his shares, Defendants voted to terminate Plaintiff from his position a nd took away his stipend (despite the fact that another owner at that point received a stipend while having no day-to-day 92

responsibilities). Defendants argued that they had the power, under the corporate by-laws, to set salaries and positions. Issue. The issue is whether Defendants violated a fiduciary duty when they removed Plaintiff from his position after a falling-out between the parties. 2. Held. Shareholders have a duty of loyalty to other shareholders in a close corporation, and in this case the duty owed to Plaintiff by Defendants was violated. Therefore Plaintiff is entitled to lost wages. In close corporations, a minority shareholder can be easily frozen out (depriving the minority of a position in the company) by the majority since there is not a readily available market for their shares. Although this is traditionally an issue of management, the test for close corporations, should be whether the management decision that severely frustrates a minority owner has a legitimate business purpose. In the case at issue, Defendants decision would assure that Plaintiff would never receive a return on the investment while offering no justification. Discussion. The court is reversing a prior line of thought that management decisions are not within the scope of review of the courts. The court notes at the negative effects that the prior line of reasoning had wrought, such as the freezing out or the oppression of minority shareholders. xviii. ADLER V SVINGOS (80 AD2D 764) 1. CASE SUMMARY 2. PROCEDURAL POSTURE: Defendant shareholder appealed an order of the Supreme Court, New York County (New York) that granted plaintiff shareholder's motion for partial summary judgment, denied defendant's cross motion for summary judgment that dismissed the complaint, and dismissed defendant's first counterclaim, in an action involving the unanimity provision of the certificate of incorporation. OVERVIEW: Plaintiffs and defendant each owned an equal number of shares of the corporation. The parties executed a stockholders' agreement that provided that all corporate operations, including changes in corporate structure, would require unanimous consent of the parties (paragraph 8), no corporate stock would be sold by any stockholder without express written consent of the other stockholders, and if the parties did not mutually agree on a sale, an application would be made for judicial dissolution of the corporation. Plaintiffs sought to sell the business and defendant objected. Plaintiffs brought an action seeking to strike paragraph 8 of the agreement as void under N.Y. Bus. Corp. Law 620(b). Defendant counterclaimed for reformation of the certificate of incorporation to reflect the unanimity provision of the stockholders' agreement. The appellate court concluded it was error to grant partial summary judgment to 93

plaintiffs and to dismiss defendant's first counterclaim because the record warranted granting defendant's motion for partial summary judgment reforming the certificate to reflect the unanimity of the stockholders' agreement. OUTCOME: Plaintiffs' motion for partial summary judgment was denied, judgment was entered declaring paragraph 8 of the stockholders' agreement valid and binding upon the signatories to that agreement, defendant's motion for partial summary judgment was granted on his first counterclaim, and judgment was entered reforming the certificate of incorporation to include the unanimity provision of the stockholders' agreement. xix. Clark v. Dodge 1. | N.Y. 410, 199 N.E. 641 (N.Y. 1936) Brief Fact Summary. Plaintiff, David Clark, and Defendant, John Dodge, are the lone shareholders of Defendant corporations. Plaintiff brought this action to be reinstated as a director of one of the Defendant companies pursuant to an agreement between the parties. Synopsis of Rule of Law. An agreement between shareholders, wherein the shareholders entering the agreement are the only shareholders of the company, is valid even if the agreement contemplates controlling management decisions. Facts. Defendant companies, Bell & Company, Inc. and HollingsSmith Company, Inc., were co-owned by Plaintiff (25% of shares) and Defendant (the remaining 75% of shares). The companies manufactured medicine, the formulae that were known only by Plaintiff. Plaintiff entered into an agreement with Defendant wherein Plaintiff agreed to disclose the formulae to the son of Defendant in return for a promise that Defendant would keep Plaintiff as a director and would be entitled to 25% of all net income providing that Plaintiff was competent in his position. Afterwards, Defendant did not vote Plaintiff in as director, stopped delivering 25% of the income to Plaintiff. Plaintiff sought reinstatement and money owed from the stopping of payments and money wasted by Defendant. Defendant countered, citing McQuade v. Stoneham (263 N. Y. 323), that the agreement was invalid because it required Defendant as a shareholder to usurp the directors judgment. Issue. The issue is whether the agreement between Plaintiff and Defendant was invalid as an over-reaching agreement between shareholders to control powers of the directors. 2. Held. The Court of Appeals of New York held that the agreement was not invalid. The McQuade court invalidated a similar agreement because it affected the rights of others that were not 94

part of the agreement, and therefore it fell under the public policy argument. In this case, the only shareholders were Defendant and Plaintiff, and therefore the agreement between the two did not have any, or at least negligible, consequences on the public. Discussion. The court distinguished McQuade, noting that McQuade will be controlling when there agreements are between shareholders who do not have 100% ownership of a company. In this case it would be against public policy to allow Defendant to simply cite McQuade to avoid his obligation to pay 25% of net income to Plaintiff who already disclosed a trade secret to Defendant. xx. Merola v Exergen Corp.423 Mass 461 1. PROCEDURAL POSTURE: Defendants, majority stockholder and corporation, challenged the judgment of the Appeals Court, Middlesex County (Massachusetts) that affirmed a verdict for plaintiff minority stockholder on his breach of fiduciary duty claim stemming from his termination. OVERVIEW: Plaintiff minority stockholder was terminated by defendant majority stockholder from his position with defendant corporation. The appellate court affirmed the verdict for plaintiff on his breach of fiduciary duty claim. The court reversed although it agreed that corporation was "close" and that stockholders owed one another a fiduciary duty of "utmost good faith and loyalty." The court found, however, that although plaintiff invested in the stock with the reasonable expectation of continued employment, there was no general policy to that regard, and there was no evidence that other stockholders had similar expectations. His claim that he was induced to work by a promise that he could become a major stockholder was baseless where he was not a founder of the business, his stock purchases were made after the business was established, and there was no suggestion that he had to purchase stock to keep his job. The court concluded that his termination did not constitute a breach of fiduciary duty because it was not against public policy where he was an at-will employee, terminated in accordance with his employment contract, and fairly compensated for his stock. OUTCOME: The judgment affirming the verdict for plaintiff minority stockholder on his breach of fiduciary duty claim was reversed because there was no general policy of continued employment from stock investment, and defendants, majority stockholder and corporation, terminated plaintiff, an at-will employee, in accordance with his employment contract and fairly compensated him for his stock. xxi. Smith v. Atlantic Properties, Inc 1. 12 Mass.App.Ct. 201, 422 N.E.2d 798 (Mass.App.Ct. 1981) Brief Fact Summary. Defendants, Atlantic Properties, Inc. and 95

minority shareholder Dr. Louis Wolfson, appealed a trial court ruling that prevented Wolfson from vetoing dividend payments and required him to pay the tax fees assessed against the company. Synopsis of Rule of Law. Minority shareholders owe majority shareholders a fiduciary duty in the same manner that majority owners owe minority shareholders, and therefore the majority can seek judicial intervention for decisions that are unjustifiable for the corporations interests. Facts. Wolfson offered the three Plaintiffs, Paul T. Smith et al., to go in equal shares in the purchase and development of some real estate. The partners formed Atlantic Properties with each party becoming a 25% shareholder, and Atlantic then bought the property in 1951. The corporate by-laws provided that any proposals had to be approved by at least 80% of the directors, meaning that in real terms for the group of four there would need to be a unanimous vote. The corporation was profitable every year through 1969 but dividends were only paid in 1964 and 1970. Because so much of the value of the company was in cash, the Internal Revenue Service assessed penalty taxes in seven different years for the accumulation of the money. Wolfson was the lone dissenter for the voting for dividends, and his vote was enough to defeat the proposals under the 80% plan in the by-laws. Wolfson maintained that he wanted the money for improvements to the property, and Plaintiffs asserted that he w anted to avoid his own personal tax issues. Plaintiffs then sought damages from Defendants for dividends, damages due to the tax penalties and legal expenses, and also asked to remove Wolfson as a director. The lower court agreed with Plaintiffs that dividends should be issued and that Defendants were liable for the tax penalty amounts. Issue. The issue is whether Wolfson owes Plaintiffs the same fiduciary duty a majority would owe a minority shareholder. 2. Held. The court held that the determining factor for the fiduciary duty owed is whether a party would be considered a controlling party. Because Wolfson was the controlling party in that he alone prevented the dividend payouts despite no real business justification, the court affirms that a fair dividend should be declared. Wolfson was unreasonable and did not demonstrate utmost good faith and loyalty to the business. Discussion. The court had no problem with the by-law provision that allowed for a minority to veto dividends, but rather in the manner in which he utilized his powers to unreasonably prevent the allowance dividends in the face of tax penalties. xxii. Revlon Rule (Revlon Inc. v. McAndrews & Forbes, Inc. (Del 1985)

96

1. When Board decided corp was for sale, the duty changes from preservation of corp as corp. entity to the maximization of the value at a sale for stockholders. xxiii. Paramount Communications Inc. v. QVC 637 A2d 34 1. Brief Fact Summary. Defendants, Paramount Communications, Inc. et al., are appealing an order enjoining the merger agreement between Paramount and Viacom Inc. Plaintiffs, QVC Network Inc. et al., sought to enjoin the agreement because the agreements defensive measures prohibited QVC from competing for a merger 2. Synopsis of Rule of Law. A merger agreement between a target company and an acquiring company that restricts the target companys directors from upholding their fiduciary duties owed to their shareholders is invalid. 3. Facts. Paramount was looking for possible merger or acquisition targets in order to remain competitive in their field. The CEO of Paramount had a meeting with the CEO of Viacom wherein they discussed Paramount merging into Viacom. The discussions hit a dead end until QVC sought to acquire Paramount. The discussions between QVC and Paramount were renewed, and the parties entered a merger agreement that had several defensive measures to prevent other companies, namely QVC, from bidding against Viacom. There was a no-shop provision that prevented Paramount from soliciting other bidders; a termination fee provision that paid Viacom $100 million if they were eventually outbid; and a stock option provision that allowed Viacom to purchase 19.9% of Paramounts shares at $69.14 per share. The stock option provision also allowed Viacom to pay for the stock in subordinated notes or Viacom could elect to get a cash payout for the difference between the option price and market price. The stock option was significant because Paramounts shares rose sharply and would have led at one point to a $500 million payout to Viacom if the merger fell through. QVC started bidding against Viacoms offer which forced Viacom to renegotiate with Paramount to raise their offer although the defensive measures were never renegotiated. QVC raised their offer even further, but the Paramount believed that the offer was too conditional (similar to Viacoms offer, it was two-tiered) and the board still felt that the merger was not in the companys best interests. Therefore, the Paramount board turned down a QVC offer that could have been about $1 billion more than Viacoms offer. In the lower court, Plaintiffs successfully enjoined Defendants from carrying out the merger agreement. Issue. The issue is whether the Paramount board violated their fiduciary duty to shareholders by not fully considering the QVC offer. 4. Held. The Delaware Supreme Court held that the merger between Defendants should be enjoined, and that the merger agreement between Paramount and Viacom was invalid. Defendants argued that they were under no obligation to seek the maximum value for shareholders under the Revlon rule because there was no breakup of the company, but the court determined that the 97

company was shifting its control to another entity and therefore the sale of Paramount reached the point to where the prime concern for the Paramount directors was to maximize shareholder value. Paramount was under no contractual obligation to avoid discussions with QVC because the merger agreement between Viacom and Paramount was invalid. Paramount could not contract to remove their fiduciary duties to shareholders, and the defensive provisions had that effect. 5. Discussion. The court looked at what the shareholders would be losing if Paramount was acquired, and with Viacom, unlike the case between Time and Warner in Paramount Communication, Inc. v. Time, Inc., the Paramount shareholders would lose complete control. Therefore there was a heightened scrutiny of the directors actions when seeking a merger. xxiv. LYONDELL CHEMICAL CO. v. RYAN - 970 A.2d 235 1. PROCEDURAL POSTURE: Appellant stockholders filed a class action suit against appellee directors alleging a breach of the fiduciary duties of care, loyalty and candor. The Court of Chancery (Delaware) denied the directors' motion for summary judgment in order to obtain a more complete record before deciding the issue of bad faith. The court accepted an interlocutory appeal to consider the claim that the directors did not act in good faith in selling the company. 2. OVERVIEW: The trial court found that the company charter included an exculpatory provision, pursuant to Del. Code tit. 8, 102(b)(7), protecting the directors from personal liability for breaches of the duty of care. Thus, the case turned on whether the alleged shortcomings also implicated the duty of loyalty, a breach of which was not exculpated. The sole issue was whether the directors were entitled to summary judgment on the failure to act in good faith claim. The court found that they were. The directors were disinterested and independent; they were aware of the company's value and its prospects; and they considered the offer, under the buyer's time constraints, with the assistance of financial and legal advisors. There was no evidence from which to infer that they knowingly ignored their responsibilities, thereby breaching their duty of loyalty. The trial court should have inquired whether the directors utterly failed to attempt to obtain the best sale price. The directors did not breach their duty of loyalty by failing to act in good faith. In concluding otherwise, the chancery court reversibly erred. 3. OUTCOME: The court reversed the decision of the chancery court and remanded the matter for entry of judgment in favor of the directors. xxv. Unocal v. Mesa Petroleum 1. Brief Fact Summary. Defendant, Unocal Corp., appealed the lower court decision that prevented Unocal from excluding Plaintiff, Mesa Petroleum Co., from participating in Defendants self-tender for its own shares.

98

2. Synopsis of Rule of Law. Directors have a duty to protect the corporation from injury by third parties and other shareholders, which grants directors the power to exclude some shareholders from a stock repurchase. 3. Facts. Plaintiff was a corporation led by a well-known corporate raider. Plaintiff offered a two-tier tender offer wherein the first tier would allow for shareholders to sell at $54 per share and the second tier would be subsidized by securities that the court equated with junk bonds. The threat therefore was that shareholders would rush to sell their shares for the first tier because they did not want to be subject to the reduced value of the back-end value of the junk securities. Defendant directors met to discuss their options and came up with an alternative that would have Defendant corporation repurchase their own shares at $72 each. The Directors decided to exclude Plaintiffs from the tender offer because it was counterintuitive to include the shareholder who initiated the conflict. The lower court held that Defendant could not exclude a shareholder from a tender offer. 4. Issue. The issue is whether Defendant can exclude Plaintiff from participating in Defendants self-tender. 5. Held. The court held that Defendant could exclude Plaintiff from its repurchase of its own shares. The directors for Defendant corporation have a duty to protect the shareholders and the corporations, and one of the harms that can befall a company is a takeover by a shareholder who is offering an inadequate offer. The directors decision to prevent an offer such as the one at issue should be subjected to an enhanced scrutiny since there is a natural conflict when the directors are excluding a party from acquiring a majority control. In this case the directors met the burden. There was evidence to support that the company was in reasonable danger: the outside directors approved of their selftender, the offer by Plaintiff included the junk bonds, the value of each share was more than the proposed $54 per share, and Plaintiff was well-known as a corporate raider. 6. Discussion. The burden of proof was on the directors to prove that there was a legitimate business interest at stake to rebut the presumption of their conflicting interest in denying the takeover. This was well-established, but the allowance by the court to allow the directors to deny the plaintiff from participating in the resulting repurchase was new ground. 7. Addl Note: 8. Using the Unocal and Unitrin standards. Directors often must protect their company against a hostile takeover. Yet by doing so, they risk being sued by a hostile bidder or the companys stockholders. Under the business judgment rule, attorneys Elizabeth McGeever and Eric Andersen indicate, the court will not substitute its judgment if a disinterested board has exercised due care and has in good faith made an informed decision it believes is in the companys interest. However, if the board is responding to an actual or potential takeover bid, the decision will be subject 99

to enhanced scrutiny under the Unocal standard. The board must show that the takeover was a threat to the company and that its response was reasonable and proportionate to the threat. When this test is satisfied, courts will apply the business judgment rule to the board's decision. The Delaware Supreme Court in Unitrin clarified the Unocal standard, holding that a defensive measure is disproportionate if it precludes an acquisition of the company or is coercive to stockholders. A later Delaware decision found deal protection provisions to be preclusive and coercive because they make it mathematically impossible for an alternative deal to succeed. Adding Blasius, Revlon, and entire fairness. If the board intentionally interferes with stockholders' voting rights, Blasius Industries v. Atlas Corp. requires a "compelling justification." The Blasius standard applies only when it is the board's primary purpose to interfere with the stockholders' right to vote, the authors note. This may occur when a stockholder vote is near and the board takes steps to put it off or to change the result. In certain situations, boards must satisfy the Revlon standard to show that they did not breach the duty of care. Enhanced scrutiny under Revlon requires directors to seek the highest value to stockholders if the company attempts to sell itself through a bidding process, the directors seek a transaction that involves breaking up the company, or the transaction will result in the sale or change of control of the company. With a sale or change in control, the court will review the boards decisionmaking process and the reasonableness of the action. Courts will not apply Revlon if a majority stockholder could have blocked the sale of control. If the board is interested or did not make an informed decision, the transaction must meet the entire-fairness standard. Directors can be considered interested, the authors remind, if they are about to be removed from office or if they have a personal financial interest through a leveraged buyout.Standards for interested stockholders. The authors point to another statute boards must consider, although the statute's waiver language is still being adjudicated. Section 203 of Delaware's business combination law, Title 8, prohibits an interested stockholderone who owns at least 15% of the voting stock of a companyfrom entering into a business combination with the company for three years after becoming an interested stockholder. The three-year prohibition may be waived if the target's board approves the deal, the stockholder acquires 85% of the company's stock, or the board and two-thirds of the stockholders subsequently approve the business combination. Delaware courts have not determined whether the exception requires 85% of the voting power or of the equity ownership. A board's decision to exempt an interested stockholder from the prohibitions of Section 203 may be reviewed under the entirefairness standard. xxvi. Notes1. Moran, shareholder rights plan OK (poison pill). 100

2. Carmody v. Toll Brothers dead hand poison pill no good. xxvii. Class 24 LLC CASES! 1. McConnell ( Blue Jackets Case) xxviii. VGS, INC. v. CASTIEL 2000 WL 1277372 (Del. Ch. 2000) 1. Brief Fact Summary. Plaintiff corporation, VGS, Inc., brought this action to validate its merger with Virtual Geosatellite LLC (LLC) after two of the three managers of the LLC, without notifying the third majority shareholder, voted for the merger. 2. Synopsis of Rule of Law. Minority shareholders owe the majority shareholders a duty of loyalty to inform them in advance of any plans for a merger or the structure of a merger. 3. Facts. Defendant, David Castiel, formed LLC to pursue an FCC license to build and operate satellites. The members of LLC included Virtual Geosatellite Holdings, Inc. (Holdings) which controlled 660 units of LLC; Ellipso, Inc. (Ellipso) which controlled 120 units; and Sahagen Satellite Technology Group LLC (Sahagen Satellite) which controlled 260 units. Castiel had controlling ownership of Holdings and Ellipso, and Peter Sahagan controlled Sahagan Satellite. Castiel was able to appoint two of the three managers (Castiel and Tom Quinn) and Sahagan was the third manager. Sahagan and others associated with LLC believed that Castiels management of LLC was subpar. Sahagan was able to convince Quinn to vote with him to merge LLC into VGS, a move which would change Castiels majority status into a minority status. Because Castiel would remove Quinn and make sure his majority standing remained if he knew of the merger vote, Quinn and Sahagan voted without Castiels knowledge. After the merger, Sahagans ownership went from 37.5% to 62.5% while Castiels ownership was 37.5% of VGS compared to 75% of LLC. Sahagan justified the vote by declaring that only a majority had to vote in favor (not unanimous). 4. Issue. The issue is whether a clandestine vote between Sahagan and Quinn to merge LLC into VGS without notifying the controlling shareholder renders the merger invalid. 5. Held. The court held that the merger is invalid. Although Plaintiff is correct that there was only a requirement of the majority of LLC managers to vote for the merger, Sahagan and Quinn violated their fiduciary duty to Castiel by not informing him of the vote. A minority interest has a duty of loyalty to the majority interest, even if it means that the majority interest will thwart the vote by removing Quinn. The fact that Castiel may have been a poor performer does not exempt the other members of their duty to inform him in advance of the meeting. 6. Discussion. The court treats the majority shareholders incompetence as a separate issue from the minority shareholders duty of loyalty regarding board meeting notifications. xxix. Bastan (CT) no absolute right to veil under LLC.- a person who ignores the intended separation between the individual and the company ought to

101

be no better off than the sole shareholder who ignores corporate obligations xxx. ELF ATOCHEM NORTH AMERICA, INC. v. JAFFARI freedom of LLC to k. xxxi. Matter of Kemp & Beatly (NY) 1. POSTURE: Appellants, corporation and its majority shareholders, sought review of Appellate Division of the Supreme Court, First Judicial Department (New York) decision affirming lower court's decision to grant petitioners' application for the judicial dissolution of appellant corporation unless the corporation or any shareholder elected to purchase petitioners' shares at fair value. 2. OVERVIEW: Appellants, corporation and majority shareholders, sought review of appellate court decision affirming the lower court's decisions to grant petitioners' application for dissolution of appellant corporation unless the corporation or any shareholder elected to purchase petitioners' shares at fair value within 45 days. The court affirmed, holding there was sufficient evidence supporting the lower court's conclusion that majority shareholders had altered a long-standing policy to distribute corporate earnings on the basis of stock ownership, as against petitioners only. Furthermore, the court reasonably determined this change in policy amounted to an attempt to exclude petitioners from gaining any return on their investment and no error occurred in determining that this conduct constituted "oppressive action." Moreover, no abuse of discretion occurred in concluding that dissolution was the only means by which petitioners could gain a fair return on their investment. The court merely modified judgment by permitting additional 30-day extension for exercising option to purchase petitioners' shares. 3. OUTCOME: Lower court's decisions granting petitioners' application for judicial dissolution of appellant corporation modified to permit an additional 30-day extension to purchase petitioners' shares. No abuse of discretion occurred in concluding dissolution was only way petitioners could gain fair returns on investments as they were subjected to oppressive conduct of majority. xxxii. Meiselman v Meiselman (1983) pg 336 1. challenged the decision of the Court of Appeals (North Carolina), which reversed the trial court's decision denying appellee minority shareholder's claim seeking to dissolve the corporation pursuant to N.C. Gen. Stat. 55-125(a). 2. OVERVIEW: Appellee was minority shareholder in a group of family-owned close corporations. The minority shareholder filed suit seeking to dissolve the corporations under the provisions of N.C. Gen. Stat. 55-125(a) or, in the alternative, any other such relief as a court could deem appropriate under 55-125.1. The trial court denied the minority shareholder's request for relief. The appellate court reversed the decision of the trial court. The shareholders and corporations appealed. The minority shareholder requested relief under 55-125.1(a)(4), a buy out at fair value of the minority shareholder's interest. The court held that 102

the trial court erred in its analysis. The court held that the trial court should have determined if the majority shareholders usurped a business opportunity that rightfully belonged to the corporation. 3. OUTCOME: The court modified, affirmed, and remanded the decision. xxxiii. McCallum v Rosens diversified inc. (1998) pg 340 1. POSTURE: Plaintiff minority shareholder appealed from the judgment of the United States District Court for the District of Minnesota, which held that the minority shareholder failed to present evidence showing that defendant closely held corporation acted unfairly prejudicial toward him. The district court dismissed the minority shareholder's request for a buy-out of his stock on a motion for summary judgment. 2. OVERVIEW: The minority shareholder alleged that the closely held corporation's controlling shareholders had acted unfairly prejudicial toward him because they: (1) undermined his authority as CEO; (2) excluded him from important company decisions; (3) engaged in conduct directed at minimizing the value of the company; (4) terminated his employment; (5) offered to redeem his shares at an artificially low price; (6) denied him access to company books, records, and financial information; (7) engaged in self-dealing, usurped company opportunities, and commingled personal ventures with the affairs of the company. The court found that the district court erred in dismissing certain of the minority shareholder's allegations as failing to observe the derivative pleading requirements for shareholder proceedings. The court determined that the minority shareholder was entitled to equitable relief based on the uncontroverted assertions that were not dismissed as derivative claims. The court found that the uncontested facts demonstrated that the minority shareholder's reasonable expectations were defeated. 3. OUTCOME: The court reversed the summary judgment, which held that the minority shareholder was not entitled to a buy-out of his stock. The court remanded with directions that the district court should determine the fair value of the minority shareholder's shares in accordance with the state statutes. xxxiv. Muellenberg v Bikon Corp. (1996) g 343 1. POSTURE: Appellant minority shareholder filed a petition for certification for review of judgment entered by the Superior Court, Appellate Division (New Jersey), which reversed a judgment by the trial court compelling respondent majority shareholders' to sell their shares in a closely held corporation to appellant. 2. OVERVIEW: Appellant minority shareholder and respondent majority shareholders owned and operated a closely held corporation. When a business dispute arose, respondents filed an action to dissolve the corporation. Appellant filed a counterclaim seeking to gain control of all the shares of the corporation. The trial court determined that respondents engaged in a course of conduct that amounted to oppression of appellant and that the only equitable remedy was to compel respondents to sell their 103

shares to appellant. The appellate court reversed, concluding that the trial court erred in finding oppression. The court reversed the judgment of the appellate court, concluding that respondents' efforts to oust appellant from the corporation, as both a shareholder and the general manager, amounted to oppression because such efforts were contrary to appellant's reasonable expectations that he would remain with, and not be frozen out of, the business after having played a critical role in its success. Further, the court found that the trial court acted within its discretion under N.J. Stat. 14A:12-7(1)(c), 14A:12-7(8) when it ordered respondents to sell their shares to appellant. 3. OUTCOME: The court granted appellant minority shareholder's petition for certification, reversed the judgment of the appellate court, and reinstated the judgment of the trial court because respondent majority shareholders engaged in a course of conduct that amounted to oppression of appellant and it was appropriate for the trial court to remedy such conduct by ordering respondents to sell their shares to appellant. xxxv. Donahue v. Rodd Electrotype 1. POSTURE: Plaintiff, a minority shareholder in a close corporation, appealed from a decree of the Superior Court (Massachusetts), which dismissed plaintiff's suit for rescission of a purchase, by defendant purchasers, of a controlling shareholder's stock. 2. OVERVIEW: The controlling shareholder sold his stock to defendants; however, defendants refused to purchase plaintiff's stock. The trial court dismissed plaintiff's suit, because the initial transaction had been carried out in good faith. On appeal, the court held that in a close corporation, all shareholders owed one another a strict duty of utmost good faith and loyalty. Further, the court held that a controlling shareholder could not utilize its position to create an exclusive market for its shares. In this case, defendants had created a market for the controlling shareholder but refused to extend that market to plaintiff, thereby excluding her. Therefore, the court reversed and held that either the initial sale had to be rescinded or defendants had to offer to purchase plaintiff's stock at the same price agreed upon in the initial sale. 3. OUTCOME: The decree was reversed, and the case was remanded for entry of a judgment. xxxvi. Rosenthal v. Rosenthanl 4 duties in a Me. case 1. Act with degree of diligence, care and skill which ordinarily prudent person would exercise under similar circumastances 2. Discharge the duties affecting their relationship in good faith with a view to furthering the interests of one another as to the matters within the scope of the relationship. 3. To disclose and not withhold from one another relevant information affecting the status and affairs of the relationship. 4. To not use their position, influence of knowledge respecting the affairs and organization that are subject to the relationship to gain any special privilege or advantage over the other person or persons involved in the relationship. 104

xxxvii. Other Corp Cases (Fid Duties and Such) 1. 2. Francis v united jersey bank (1981) pg 383 3. Summary. Plaintiffs, the trustees in bankruptcy of Pritchard & Baird Intermediaries Corporation (P&B), filed suit against Defendant, the executrix of the estate of Lillian Pritchard, for a breach of fiduciary duty as a director of P&B. Lillian Pritchard did not exercise ordinary care in monitoring the finances of P&B when her sons, other members of P&B management, misappropriated funds. 4. Rule. A director can be personally liable, even to third parties, if they neglect to provide the ordinary care of staying current with corporate affairs as one would normally do in that position, and that neglect is the proximate cause of the damages. 5. Facts. P&B was a broker between ceding insurance companies and reinsurance companies. They earned a commission on the transactions between the two entities. Typically, brokers in the reinsurance business hold funds from the ceding and reinsuring companies in a separate account and pay each party from that account. The former CEO of P&B, Charles Pritchard, Sr. (the husband of Lillian Pritchard) did not practice this method, but he still ensured that the funds deposited by third parties were never used as personal funds. Charles Pritchard, Sr., eventually stepped down and his two sons controlled the business. Once the sons had control they took out personal loans from the account but never paid back the loans or any interest. This practice of misappropriating funds continued until P&B could no longer meet their obligations, and they went into bankruptcy. During the entire period that the sons controlled P&B, Lillian was the majority shareholder and sat on the Board as a director. During her tenure as director, she never participated in any business matters of P&B. Defendant argued that Lillian was elderly and sick, and therefore should be excused for her absence. 6. Issue. The issue is whether Lillian Pritchard is personally liable for negligently failing to prevent the misappropriation of P&B funds by her sons. 7. Held. Lillian Pritchard, as a director on the Board, had a duty of care in managing the business. She did not have to know every detail of day-to-day operations, but she needed to have a baseline understanding of the finances and important activities. If she did not understand the activities, then she was obligated to consult counsel for advice. Her absence from the business did not excuse her duties. The court determined that if she did intervene in the dubious financial decisions of her sons, or at least consulted an attorney or expert, it may have prevented her sons from fleecing the company. Therefore, her lack of care was a proximate cause of the damages to the company and the third parties who relied upon the company. Because of the nature of the business (holding assets of third parties), she was liable to the third parties for any damages. 105

8. Discussion. The decision makes it impossible for directors to hide their head in the sand to avoid liability. The amount of oversight required will depend on the nature of the business, so it will be very fact-specific. 9. 10. Kamin v American express co (1976) pg 396 11. Facts. Plaintiffs, Howard Kamin et al., filed a shareholder derivative suit against Defendant corporation, American Express, and their officers after Defendants allegedly negligently decided to issue a dividend. 12. Rule of Law. A court will not interfere with the decision of a companys directors unless there is evidence of fraud or dishonest practice. 13. Facts. Defendant corporation purchased common stock for $29.9 million, and now the stock has a market value of $4 million. The directors decided to declare a special dividend, giving the shares of stock to the shareholders. Plaintiff demanded that Defendants sell the stock on the open market and use the $25.9 million capital gains loss to offset other capital gains. The offset would save Defendant corporation $8 million in taxes. Plaintiffs decided not to pursue Plaintiffs demand, reasoning that the significant loss would adversely affect the value of Defendants stock. Plaintiff then brought suit, classifying the directors decision as negligent decision-making. 14. 15. Issue. The issue is whether Plaintiffs can bring a derivative action challenging the business decision of the directors of the corporation. 16. Held. The court will not overrule a business decision of the directors of a company unless there is evidence of fraud or some other dishonest dealing. The decision to declare a dividend may be an unwise judgment, but it is a judgment that is outside the scrutiny of the court. The only accusation of dishonest dealing was a general assertion that four of the twenty directors had a financial interest in the outcome. 17. Discussion. This decision is a restatement of the business judgment rule. The courts do not want to invest significant resources into second-guessing business judgments of corporate directors. Going to court for corporate decisions is expensive and can often be avoided through other avenues. 18. 19. In re caremark international inc derivative litigation (1996) pg 420 20. Facts. The parties to this case, shareholders who brought an initial derivative suit and the Defendant Board, submitted a settlement proposal to the Delaware Court of Chancery. The settlement called for more oversight by Defendants to ensure the corporate employees abide by laws regarding relationships with outside health care professionals. 21. Rule of Law. Directors are potentially liable for a breach of duty to exercise appropriate attention if they knew or should have known 106

that employees were violating the law, declined to make a good faith effort to prevent the violation, and the lack of action was the proximate cause of damages. 22. Facts. Defendant corporation, Caremark International, Inc., provides health care services and products to patients who are often referred to them by a physician. Since the business is reliant on referrals, there is a temptation by companies such as Caremark to compensate physicians. A federal law, the AntiReferral Payments Law (ARPL) is in place to prevent such a system, and in 1991 the Department of Health and Human Services began investigating potential ARPL violations. The Department of Justice joined the investigation soon thereafter, and by 1992 Caremark instituted several new policies and procedures in attempt to find any internal wrongdoings. But in 1994, Caremark was indicted for violating the ARPL. Plaintiffs initiated this suit that year, alleging that the Board of Directors did not exercise the appropriate attention to this problem. 23. Issue. The issue is whether the Board exercised an appropriate level of attention to the possibility of ARPL violations. 24. Held. There was no evidence that the directors knew that there were ARPL violations, and there was no systemic or sustained failure to exercise oversight. However, the terms of the settlement merely required Caremark to institute policies to further assist in monitoring for violations. Therefore the settlement was approved. 25. Discussion. A breach of duty to exercise appropriate attention, as the court notes, is more difficult for Plaintiffs to prove than a breach of the duty of loyalty. Most decisions that would come under this duty will resemble many decisions shielded by the business judgment rule. 26. 27. MILLER v. AMERICAN TELEPHONE & TELEGRAPH CO. (1974) 28. Facts: P complained that the directors or the officers have not taken any steps to recover the 1.5 million owed to AT&t by DNC for communication provided during the 1968 democratic national convention. P claims by not collecting amount the directors breached their duty to exercise diligence in handling the affairs of the corporation. P alleges that AT&T made campaign contribution to DNC in violation of 18 U.S.C. 610 which prohibits corporate campaign spending. P states there is a waste of 1.5 million. 29. . That statute and its predecessor reflect congressional efforts: (1) to destroy the influence of corporations over elections through financial contributions and (2) to check the practice of using corporate funds to benefit political parties without the consent of the stockholders. . . . 30. P states an actual lose of 1.5million due to Ds actions. P has to show later on that D breached its fiduciary duty by: (1) made a contribution of money or anything of value to the DNC (2) in connection with a federal election (3) for the purpose of influencing the outcome of that election. . . . . 31. 107

32. Lewis v S.L & E Inc. (1980) pg 446 33. Summary. Plaintiff, Donald Lewis, brought a derivative suit against Defendants, the directors of S.L. & E, Inc. (SLE), for waste after Defendants did not raise the rent paid to SLE by a company, Lewis General Tires, Inc. (LGT), that Defendants also owned. 34. Rule of Law. Directors that have a conflict of interest in a corporate transaction have the burden to prove that no waste was committed. 35. Facts. Plaintiff and Defendant directors were brothers. Their father left each of his children shares of SLE but only Defendants were shareholders of LGT. The siblings that had only SLE shares agreed to sell their shares of SLE to Defendants at the June 1, 1972 book value. Prior to that date, SLE, whose only asset was property, leased property to LGT. The lease expired in 1966, but Defendants, who were directors of both LGT and SLE, never entered into a new lease nor increased the rent. During that time, property taxes increased from $7,800 to $11,000 per year while rent stayed at $14,400 per year. Defendants testified that they did not seriously think of SLE as a separate entity, but instead treated it as a shell for LGT. When the agreement for the siblings to sell Defendants the remaining shares of SLE came due, Plaintiff brought this action of waste by Defendant directors for allowing LGT to pay a low rent. Defendants countered to for the specific performance of Plaintiff 36. to sell his shares, arguing that LGT paid a fair amount for property in that location. 37. Issue. The issue is whether Defendants have the burden to prove that there was no waste in the transaction wherein there was a conflict of interest 38. Held. The burden is on a party who has a conflict of interest in a transaction to prove that there was no waste. Normally, the burden is high for the proof a complaining party has to offer to override a business judgment of a director, but when there is a conflict of interest, the burden is reduced. Because Defendants did not offer proof that there was no other tenant willing to pay more, or that the value of the rent was fair, the lower court holding was reversed. 39. Discussion. Common law will void transaction where there is a conflict of interest unless the party can affirmatively demonstrate that it was a fair transaction. 40. 41. Cookies Food Product v Lake warehouse 42. Fact Summary 43. In 1975, L.D. Cook organized Cookies Food Products, Inc. as a barbecue sauce manufacturing and distributorship. The company was not very successful until, Duane "Speed" Herrig began distributing the barbecue sauce to retail outlets. Over the years, Herrig's distributorship agreement spurred significant growth in barbecue sauce revenue. In 1981, Herrig acquired a majority 108

stake in Cookies and in 1982, Herrig even developed his own taco sauce! Herrig received royalties for the taco sauce and his distribution agreement with Cookies increased subsequent to his acquisition of a majority interest. The plaintiff alleges that Herrig was involved in self-dealing. 44. Rule of Law and Holding 45. "No contract or other transaction between a corporation and one or more of its directors or any other corporation, firm, association or entity in which one or more of its directors are directors or officers or are financially interested, shall be either void or voidable because of such relationship or interest . . . if any of the following occur: 1. The fact of such relationship or interest is disclosed or known to the board of directors or committee which authorizes, approves, or ratifies the contract or transaction . . . without counting the votes . . . of such interested director. 2. The fact of such relationship or interest is disclosed or known to the shareholders entitled to vote [on the transaction] and they authorize . . . such contract or transaction by vote or written consent. 3. The contract or transaction is fair and reasonable to the corporation." The court found that there was no disclosure issue and that the contract between Cookies and Herrig was fair and reasonable to the corporation. 46. 47. Northeast harbor gold club inc v harris 48. Plaintiff corporation challenged a judgment from the Superior Court in Hancock County (Maine), which entered judgment in favor of defendant president in the corporation's action against the president for breach of fiduciary duty. 49. 50. OVERVIEW: While she was in office, the president purchased land that adjoined the corporation and subsequently applied for a subdivision permit. She informed the corporation after she purchased the land for her benefit. The corporation brought an action against the president for breach of fiduciary duty. When the trial court found in favor of the president, the corporation sought review. The court found that corporate fiduciaries were required to discharge their duties in good faith with a view toward furthering the interests of the corporation. A fiduciary was required to disclose information concerning any potential conflict of interest. The court adopted a rule to determine whether a fiduciary had improperly taken a corporate opportunity. A corporate officer was required to offer the opportunity to the corporation and it must have been formally rejected. The court reasoned that corporate opportunity included opportunities closely related to a business in which the corporation was engaged. 51. 52. OUTCOME: The court vacated the trial court's decision, which found that the president did not breach her fiduciary duty to the corporation by purchasing land. The case was remanded to the trial court. 109

53. 54. 55. c. Notes i. Intro/Formation 1. Basics a. Corporation: a legal personality with indefinite life, limited liability for investors, free transferability of ownership interests, centralized management appointed by equity owners. b. Who is the principal? The equity owners/shareholders? Shareholders | Board of Directors | CEO / | \ Manager Manager Manager | | \ Employee Employee Employee 5 Characteristics of Corporations: 1. Legal personality with indefinite life 2. Limited liability for investors 3. Free transferability of share interests 4. Centralized management 5. Appointed by equity investors

c. These facets make it easy to raise a lot of money i. Investors are only on the hook for the amount of their investment. ii. Can invest money and give to kids. Company is presumed to last indefinitely. Having an indefinite life enhances the stability of the corporate entity. iii. If you decide you dont like you can sell your share to someone else very easily (this is good for the

110

company because the capital stays in the company). d. Investors are incentified to sit back and let managers do what they want e. Very limited role in the organization f. Agency Costs/Fiduciary Duties g. Limited Liability i. shareholders cannot lose more than the amount they invest. ii. The chief purpose of limited liability is to encourage investment in equity securities and thus to make capital more available for risky ventures. h. Passive Shareholders are normally not liable for corporate debt aside from their own liability i. Not personally responsible for corporate debts j. Mangers are not liable for corporate debts i. No overexposure for corporate debts ii. Agents authority to bind their principle 2. Corporate management binds corporation. a. Centralized management b. Free transferability of ownership 3. Buying and trading shares 4. Entity status a. Easy to be sued. b. Owns property i. 5 Characteristics ii. These characteristics make it very easy to raise money 1. LL 2. Centralized Management a. Shareholders elect the Board of Directors. The Board of Directors then appoints officers. The corporation is managed under the supervision of the Board, with dayto-day control resting with the officers. b. However, most of the time the directors dont have the time to closely monitor the managers, and usually rely exclusively on the managers representation about company affairs. (Maybe itd be better to have professional directors?) c. Also, governance power resides in

the Board of directors, not in the individual directors who constitute that Board
3. 111 Free transferability of ownership

a. equity investors legally own something distinct from any part of the corporations property: they own a share interest. This share can be transferred together with all rights that it confers. Selling partial stakes in a sole proprietorship or partnership is somewhat more complicated. 4. No Role 5. Entity Status 5. Closely Held Corporations a. a corporation with (1) a small number of stockholders, (2) a lack of any ready market for the corporations stock, and (3) substantial participation by the majority stockholder(s) in the management, direction, and operations of the corporation. b. Seem more like partnerships. Relatively small group of people incorporating for limited liability purposes rather than capital raising. i. Shareholders are actively involved, rather than being simply passive investors of a publicly held corporations. c. We have ownership and control overlapping (kind of like partnerships) d. In a close corporation the return on investment is usually in the form of salaries since most of the shareholders work there. e. There is very little market for the shares of close

corporations
f. A group of shareholders may lawfully contract to vote in any manner they determine. Voting trust = valid contract that should be upheld. (see Ringling Brothers) g. Shareholders can agree with other shareholders to act in concert (vote pooling agreements) h. However, even though these are legal, they cannot empower non-shareholders to vote the shares of actual shareholders. i. For close corporations, people tend to incorporate locally,

rather than in Delaware.

j. Donahue v. Rodd Electrotype i. The company is buying back one of the majority shareholders shares at $800/share, but does not offer (and actually refuses) to buy the shares of the minority shareholder at the same price. ii. Majority performs a freezeout; they treat the minority shareholder poorly in order to get her to cave and sell her shares at the much lower price.

112

iii. Minority shareholder is not getting any dividends and she cant sell her shares on the market (no market for them). iv. Court decides to give her a remedy: says that a close corporation is akin to a partnership, and in partnerships, partners owe each other partner-like fiduciary duties (utmost good faith and loyalty). v. Says, the controlling shareholders must offer minority shareholders equal value for their shares or be liable to damages. vi. Easterbrook says: to the extent that they decided to bargain for the corporate form, rather than a partnership, then thats just their tough luck. There should be no partnership-like remedy for close corporations. (Delaware and Kansas standard)Controlled Corporations k. Situations in which one person or a family controls everything. l. Ex: Wrigley was majority shareholder, Chairman of the Board, and CEO of the Chicago Cubs. m. Commonly, you see family members firing and trying to harm one another but in the corporate setting. n. Controlling shareholder does things that he wants, and

sometimes that doesnt sit well with the minority shareholders. 6. Formation/Incorporation of Corporations Generally a. Originally, charters were not granted as freely as they are now. b. File a document with the Secretary of State i. Purpose: To do anything its lawfully ok to do
c. The incorporator drafts and signs the document, called either the articles of incorporation or the certificate of incorporation i. Purpose is stated herein. ii. Also, charter defines how many shares and classes of shares the corporation will be authorized to issue and what the characteristics of those shares will be. iii. Finally, it provides for the size of the governing board, and terms for board members. d. Corporate Bylaws i. These fix the operating rules for the governance of the corporation. Also establish meeting dates. e. Centralized Management i. Board of Directors consists of people who are not agents, but who are still fiduciaries. 1. Everyone below them makes up the managements; officers/employees are agents.

113

2. The board is there to monitor management, however they get most information from management and have day jobs f. Capital Structure i. Borrowing money through issuance of debt instruments ii. Selling ownership claims in the corporate equity by issuing equity securities. g. Legal Character of Debt i. Maturity Date: the issuer of debt (the corporation) has a legal obligation to repay at a stated date in the future. It must repay the principal amount, plus interest. It is common for the borrower to have to make semi-annual interest payments ii. Buying a bond of a corporation: Unlike equity holders, a creditor holding a bond is legally entitled to periodic payment and a priority claim over equity holders of the corporations assets should the corporation ever fold. iii. Debt is more secure than equity, in that, if there is a problem, the people holding debt will get their money before equity holders. The flip side is that equity holders stand to gain, potentially, more money from their investment h. Taxes Interest paid by the borrower is deductible from its taxable income. The corporation, like all tax payers, pays tax only on its texable income, which is roughly its net income after cost. i. Legal Character of Equity. i. Common Stock owners can vote to elect directors (one vote per share). This is their big thing: they get control rights. ii. You also have limited information rights. iii. Also, to the extent that the company declares a dividend, youre entitled to your pro rata share. However, shareholders cannot force the Board of Directors to declare a dividend. iv. These people are residual owners, because they get whats left over at liquidation after the creditors/holders of debt are paid off. v. There is also a kind of stock called Preferred Stock: holders of this kind are subject to less risk and have preference over holders of common stock. vi. Also, some companies have different classes of stock which carry different levels of voting power. j. Piercing the Corporate Veil i. The power of the court to set aside the entity status of the corporation to hold its shareholders liable directly on contract or tort obligations. ii. Two prong test employed: 114

iii. 1. Unity of interest/control, 2. Fraud or injustice would result if court didnt pierce the veil. iv. In re 1st prong, there are issues of separateness: 1. a. financial separateness: undercapitalization, commingling. b. formal separateness: observing corporate formalities. v. In re 2nd prong, fraud is a term of art: 1. a. there has to be some sort of equitable hook for the court to invoke this huge exception (piercing the corporate veil). The injustice cant just be its unjust that we didnt get paid. This is a big problem, using the corporate form to try and avoid paying what you owe (hiding behind the corporate entity).

vi. Piercing the corporate veil is an equitable remedy, and the burden rests with the party asserting such claim. A totality of the circumstances approach is used in determining whether to pierce the corporate veil, and each case must be decided on its own facts. vii. Two prong test: 1. 1. Is the unity of interest and ownership such that separate personalities of the corporation and the individual shareholder no longer exist? 2. 2. Would an inequitable result occur if the acts were treated as those of the corporation alone? viii. RULE: Thin capitalization alone is insufficient ground for piercing the corporate veil. 7. Normal Governance: The Voting System a. Shareholders most basic right: the right to elect the board of directors. b. The Collective Action Problem i. : Usually a problem in large public companies. ii. Assume that shares in a corporation are held by 100,000 shareholders, each with a $100 investment. In this case, informed shareholder action/voting would require that some investments in information be made by a very a large number of shareholders. This would be collectively and individually costly. Any one shareholders vote is quite unlikely to affect the outcome of the vote. Thus, a shareholder is likely to get the same proportionate share of any benefit without regard to
115

whether she invests in becoming informed and voting intelligently. Economically, her incentive is to remain passive. iii. This is also known as the Free-rider problem: shareholders assume that others are paying attention, and so they can be passive and share in the benefit c. Electing Directors i. Why does common stock carry voting rights? 1. Because, unlike bondholders, common stock owners security has no maturity date and no legal right to periodic payments. Thus, they have a greater need for the default protection of voting rights than other investors. 2. Bondholders, by contrast, are protected by a hard contractual right to interest payments and to the return of their principal, usually on stated maturity dates. ii. There must be annual elections, either in bulk or staggered. 1. There has to be notice and a quorum. iii. Shareholder Information Rights 1. The Stock List: discloses the identity, ownership interest, and address of each registered owner of company stock. 2. Inspection of Books and Records: Requests to do so are viewed with care, requiring plaintiffs to show a proper purpose and screening his/her motives and the likely consequences of granting the request.

116

8. Fiduciary Duties (in the corporate context) DECISION C.O.I ?

Y

Breach of D.O.L

- Good Faith , w/informa tion meant

D.O.C Procedures Met? Grossly

neglige nt,

B.J.R Kicks in

Fairness * Unless Analysis 102(b)(7)

clause

Not Ok a. 1. Duty of Care: i. If you are financially disinterested, act in good faith, and act with full info, then you have fulfilled the duty of care. ii. Standard by which court reviews this duty is the business judgment rule. iii. Courts are extremely deferential and lenient; they only look to see if the procedures have been followed (the director(s) acted in good faith, with full info, and was disinterested [no conflict of interest]), and to any substantive matters. Courts reason that if the procedures were followed then they presumably acted rationally. iv. If the duty of care procedures have been followed, the court will apply the business judgment rule to look for gross negligence. If none is found then no liability attaches. v. However, even if a court were to find that one of the procedures were not met (ex: the directors were under-informed), a plaintiff might still lose if the company had a 102(B)(7) provision in its charter freeing the directors from personal liability. (Duty of care can be waived in the companys charter). vi. Only applies to directors, not officers. vii. You want to discourage overly-conservative decision making: if were second guessing every decision of the management, then fewer risks will
117

b.

c.

d.

e.

be taken, and this would be a bad thing (this means less money made). viii. Waste: The theoretical exception to the business judgment rule; applies to business decisions so egregious that they result in the waste of corporate assets. ix. This has never resulted in a money award. x. The unicorn of corporate law (you hear about it all the time, but never actually see it). Director Passivity and Liability i. liability can attach if directors simply fail to do anything under circumstances in which it is later determined that a reasonably alert person would have taken action. ii. Actual liability is more likely to arise from a failure to supervise or detect fraud than from an erroneous business decision. Duty of Loyalty i. The duty of loyalty requires a corporate director, officer, or controlling shareholder to exercise her institutional power over corporate processes or property in a good-faith effort to advance the interests of the company. ii. Thus, officers, directors, and controlling shareholders may not deal with the corporation in any way that benefits themselves at its expense. Self-Dealing Transactions i. Directors and corporate officers may not benefit financially at the expense of the corporation in selfdealing transactions. ii. The Disclosure Requirement: interested director must make a full disclosure of all material facts of which she is aware at the time that the transaction is authorized (by a majority of disinterested directors or by shareholders) The Effect of Approval by a Disinterested Party i. The Safe Harbor Statutes: these statutes provide that a directors self-dealing transaction is not voidable solely because it is interested, so long as it is adequately disclosed and approved by a majority of disinterested directors or shareholders, OR it is fair. ii. If there is a conflict of interest, you have to determine whether youre in the safe harbor iii. If you are, then the duty of loyalty taint is cleansed; but you still have to make sure the duty of care procedures have been met.
118

iv. Also, if the ratification is by a majority shareholder, the analysis doesnt end (because of the suspicion that the dominant shareholder is just going along with the interested director). v. About ratification: it doesnt count unless the interested party makes a full disclosure of all material facts. f. Corporate Opportunity Doctrine i. When does an opportunity belong to the corporate entity? ii. When an opportunity does belong to the corporation, when may a director/fiduciary pursue the opportunity for himself? 1. The first question is, is there a conflict of interest? 2. If so, has there been ratification? 3. If not, was the directors action fair? 4. If no, then liability attaches. (see chart) iii. A director need not necessarily disclose the opportunity to the Board (assuming the transaction ultimately turns out to have been fair), but if he is smart he will do so in order to protect himself from future accusations of usurpation of the opportunity. iv. In 2000, the DE legislature authorized waivers in corporate charters of the corporate opportunity constraints for officers, directors, or shareholders. 1. So, directors at companies with these waivers dont have to worry about usurping corporate opportunities. v. The Line of Business Test: the opportunity is a corporate opportunity if it is in the companys line of business and the company can financially afford the venture. (The Deleware Standard. FL also uses this test) 9. Business Judgment Rules a. the judiciary will NOT interfere with a business judgment unless there is evidence of fraud, disloyalty, C.O.I., done in bad faith, and/or w/o full information b. The court does not want to discourage risk. c. Note: ** VIOLATING A LAW PREVENTS A CORP FROM TRYING TO HIDE BEHIND THE BJR i. See Miller v. AT&T 10. Disney Cases a. Facts i. Disney Employs Ovitz for a lot of $ ii. Ovitz had poor job performance
119

iii. Disney force to fire Ovitz iv. - Derivative action against: the old board for hiring Ovitz and the new board for Firing Ovitz w/o cause and therefore giving him compensation b. Decisions; i. Brehm v. Eisner 1. Ct. Rules that the hiring and firing were clearly Bus. Judgments and therefore protected. 2. Ovitz base salary was $1,000,000 plus stock options 3. If fired, Ovitz got $10,000,000 plus the vesting of his options 4. old board did not realize this and instead relied on an expert 5. ** IF A BOARD RELIES ON AN EXPERT DE CTS GIVE THE BOARD A SAFE HARBOR (DE GEN. CORP. LAW 141 (C)) 6. Ct finds complaint had conclusory statements, claim dismissed w/o prejudice ii. In Re Walt Disney Der. Lit. (2003) 1. Re-pleaded complaint; Shareholders used informational rights to get the minute books, etc. 2. Complaint changed D.O.C argument to good faith argument 3. Ct. is receptive; points out that Eisner and Ovitz are friends 4. directors made no good faith effort to check Eisners actions 5. ct. takes this lack of effort and says lack of good faith; pleading survives and is sent to trial 6. gets shareholders around BJR and around 102(b)(7) (only applies to D.O.C.) iii. In Re Walt Disney Litigation (2006) 1. Appeal from lower courts ruling for Disney 2. Less emphasis on friendship 3. ct says $ was reasonable for Ovitz 4. ct affirms, saying while Disney made a bad choice, they are protected by the BJR 5. As to no-cause termination, ct found that one must be dishonest, criminal, etc. to be fired for-cause when a no-cause clause exists; Ovitz did not qualify
120

6. As to good faith, Ct. rules that under these facts, no good faith 7. * Ct. Defines good faith/bad faith 8. Subjective Bad Faith: actual intent to do harm 9. Gross Negligence: Ct. REJECTS THIS AS BAD FAITH 10. Intentional Dereliction of Dutiesconscious disregard of Duty 11. * In 2006, Ct. says that Good Faith is a subsidiary element of D.O.L. 12. D.O.L 13. Conflicts of interest 14. Occurs when 1 director/officer of a co. enters in a K w/ a corp. in which he has a pecuniary interest 15. Originally K would be voidable @ law: would be permitted if fair AND agreed by disinterested board members 16. Now statutory provisions require one OR the other 11. Transactions in Control a. Investors can gain control over corporations in two ways: i. Purchasing a controlling block of shares from an existing control shareholder 1. -In such a sale, the incumbent controller will demand a premium over the price of the publicly traded stock for her control block. 2. The premium is the added amount an investor is willing to pay for the privilege of directly influencing the corporations affairs. Zetlin v. Hanson Holdings, Inc. ii. Purchasing the shares of numerous smaller shareholders 1. Should minority shareholders be given the opportunity to sell their stock at the same price offered to the controlling shareholder? iii. Tender Offers 1. Since large public companies generally do not have a controlling shareholder, one wishing to acquire a control stake must aggregate the shares of many smaller shareholders. 2. Tender offer: an offer of cash or securities to the shareholders of a public corporation in

121

exchange for their shares at a premium, over market price 3. An end run around the board; when someone attempts to buy control of the company by making a general offer to the shareholders 12. Shareholder Lawsuits a. Derivative suits behalf of corporation i. Either filed by a group of shareholders or by the board of directors. ii. Prosecuting a corporate claim iii. An assertion of a corporate claim against an officer or director, which charges them with a wrong to the corporation. Such an injury only indirectly (or derivatively) harms shareholders b. Direct/Class actions suits filed by shareholders on behalf of themselves i. Prosecuting a shareholder claim ii. If there is securities fraud, then thats an injury to the shareholders instead of the corporation. iii. This claim is to recover damages suffered by individuals directly. c. How do we distinguish? i. Who owns the claim? Who was injured here? ii. If the company is injured then the shareholders are also indirectly injured, but that doesnt make something subject to a direct action. iii. Who suffered the alleged harm (the corporation or the suing shareholders) iv. Who would receive the benefit of any recovery or other remedy (the corporation or the stockholders individually)
Remember: Shareholder rights include the right: 1. to vote 2. to sue 3. to sell -If any of these rights are directly infringed upon, there is a direct, rather than derivative, claim.

d. How do claimants get reimbursed for attorneys fees

122

i. Common-fund doctrine: an exception to the general rule in which claimants can be reimbursed if a common fund exists. ii. Substantial Benefit Rule: another exception in which the successful plaintiff in a stockholders derivative action may be award attorneys fees against the corporation if the corporation received substantial benefits from the litigation (benefit does not necessarily have to be pecuniary) e. Standing Requirement i. 1st, the plaintiff must be a shareholder for the duration of the action. ii. 2nd, the plaintiff must have been a shareholder at the time of the alleged wrongful act or omission. iii. 3rd, the plaintiff must be able to fairly and adequately represent the interests of shareholders (this means, essentially, that there are no obvious conflicts of interest) iv. 4th, the complaint must specify what action the plaintiff has taken to obtain satisfaction from the companys board, or state with particularity the plaintiffs reason for not doing so (The Demand Requirement). v. When the shareholder has made his demand and the Board of Directors decides to dismiss the suit, the court will review that decision to see if it was wrongful using the business judgment rule as its standard. f. Demand Requirement i. Shareholders must make their demand (for satisfaction) to the board of directors prior to filing the derivative claim, or prove that it would have been futile to do so ii. There is a heightened pleading standard when attempting to prove futility. iii. Thus, a shareholder can proceed with a derivative suit if: 1. A demand is made and the Board of Directors wrongfully refuses to prosecute the claim (courts review the boards decision under the BJR) 2. No demand is made because would be futile to do so. iv. Requires Shareholders to demand that mgmt bring suit on the corps behalf (unless the derivative action is being brought against the directors). This
123

stems from the idea that shareholders should not be given free will to sue on cos behalf all the time: v. In NY and DE, shareholders must make the demand unless such action is futile. Ps can show demand would be futile by showing facts that: 1. the dirs did not adequately inform themselves before taking and action or were derelict in duty a. C.O.I b. Dir failed to exercise Bus. Judgment vi. MARY v. AKERS 1. P sues IBM, claiming excessive comp. to IBMs directors 2. DE approach to saying demand is futile: 3. Reasonable doubt that: a. Directors are disinterested AND B.J. 4. NY approach is same, but adds lack of information 5. Court holds that the mismanagement claim would require demand, so loses on its face vii. Special Litigation Committees 1. Basically, a way that a Board who, because they were not independent and disinterested, can still get a derivative suit dismissed. 2. However, the Special litigation committees autonomy must not be compromised in order for its recommendation to be untainted. 3. New York says: if you have a totally independent SLC, then we should defer to them and apply the BJR. 4. Zapata requires more scrutiny of the SLC: a. A searching inquiry to determine whether the SLC is truly independent and disinterested. (This is where the NY standard ends) 5. An optional merits review of the motion by the judge/chancellor. Motion can be dismissed if the judge/chancellor determines, via his judicial business judgment, that the motion ought to be dismissed. 13. Limited Liability Corporations a. The quest for the hybrid entity (how can we get a form that combines limited liability with single taxation?)

124

b. LLCs enjoy the benefits of partnerships and corporations (the best of both worlds) i. Freedom to contract (even including freedom to contract out of fiduciary obligations) ii. Limited Liability iii. Flow Through taxation: profits are taxed once, at the individual level, and not at the firm level as well (unlike corporations)
Corporate taxation: Say a corporation makes $1 million -Corporate tax rate is 35% (350,000) -650,000 left -then, individual tax rate is 40% (260,000) -Total enjoyed after taxes is 390,000 -effective tax rate of 61% -This is what we mean when we say that corporations are taxed twice. -It might be said that the corporate tax is the price corporations pay in exchange for limited liability. (C corporations, at least) -Partnerships do not have limited liability and so are only taxed once. Why would you want to form a corporation over an LLC? -If venture capital is a source of your funding, venture capitalists tend to prefer the corporate form.

c. LLCs enjoy the perks of both forms: i. Limited liability: No member can be liable for anything other than the amount of his investment in the LLC, regardless of how involved that member is in the daily operations of the business. ii. Flow-through taxation (single taxation): LLC members can elect to have the entity treated, for federal tax purposes, as a partnership, therefore avoiding double-taxation a la corporations. iii. Flexible defaults (ULLCA): Can bargain around almost anything.(Freedom to contract) iv. Liquidity: ownership interests are not really freely transferrable, but LLCs usually have workable exit options. v. Member managed (like a partnership) or Manager managed (like a corporation) 1. In member-managed LLCs, members do have fiduciary duties (under the default rules) 2. In manager-managed LLCs, members do not have fiduciary duties (under the default rules)

125

vi. A limited liability company involves a fiduciary relationship, but that usually takes a back seat if the members contract around those (default) obligations. (see McConnel v. Hunt Columbus Blue Jackets Case) vii. ULLCA- Uniform Limited Liability Company Act 1. Formation- fill out form; accompanied w/articles of organization; No by laws, but operating or LLC agreement viii. Reasons NOT to be an LLC: 1. Stigma of being a corp. 2. Small lawyers may be more comfortable with corp. law 3. Some tax reasons 4. easier to do an IPO if you are already a corp. 5. Some investors want to be Shareholders in a corp. 6. Corp. law is more established; more certainty 7. Freedom of K under LLC act. (see Elf. V. Jafari. 8. Under DE laws, you can bargain out of Fid. Duties, except good faith ix. 103 (b)- ULLCA 1. Oper. Agreement may NOT a. (1) rest. right to info b. (2) Eliminate duty of loyalty c. (3) Eliminate Duty of Care d. (4) Eliminate Good Faith e. (5) Vary the right to expel f. (6) Vary the wind-up requirement g. (7) restrict the rights of a person
x. BASTAN v. RJM ASSOC.

1. D paid personal expenses w/ LLC Funds 2. Caused independence of LLC to cease 3. D argues you cannot pierce the veil (No Liability) 4. Ct is NOT persuaded that the legislature intended limitation on member liability to be absolute 5. Ct. holds that the veil piercing rules of corp. law apply xi. Reasons for piercing the Corp. Veil 1. Disregarding Separateness of entity a. Not following monetary formalities b. Under Capitalizing, etc
126

2. Injustice or fraud 14. Mergers & Acquisitions a. An acquisition, also known as a takeover or a buyout, is the buying of one company (the target) by another. b. An acquisition may be friendly or hostile. In the former case, the companies cooperate in negotiations; in the latter case, the takeover target is unwilling to be bought or the target's board has no prior knowledge of the offer. Acquisition usually refers to a purchase of a smaller firm by a larger one.
c. The Market-Out Rule i. 262 of Delaware DGCL ii. Shareholders in a privately traded firm (with fewer than 2,000 shareholders) will always have appraisal rights in a merger if they are required to vote on it. iii. But shareholders in a public company with more than 2,000 shareholders have no appraisal rights in a stock-for-stock merger.

A purchase deal will also be called a merger when both CEOs agree that joining together is in the best interest of both of their companies. But when the deal is unfriendly - that is, when the target company does not want to be purchased - it is always regarded as an acquisition. Whether a purchase is considered a merger or an acquisition really depends on whether the purchase is friendly or hostile and how it is announced. In other words, the real difference lies in how the purchase is communicated to and received by the target company's board of directors, employees and shareholders. It is quite normal though for M&A deal communications to take place in a so called 'confidentiality bubble' whereby information flows are restricted due to confidentiality agreements TAX FREE REORGANIZATIONS: -If you sell anything at a gain, you are taxed on it (capital gains tax) -Exception in M & A: if what you held before the transaction is pretty similar to what you have after the transaction, it is not taxed (tax free reorganizations) -Ex. Had ABC shares, then XYZ shares -If you get cash for stock, probably not tax free -If you get a combo of stock and cash, it depends on the ratio, etc. THE APPRAISAL REMEDY / APPRAISAL RIGHTS -Right to demand appraisal of stock -Applies when everyone else agrees to a merger or an acquisition (minority right) -Mostly an issue in two situations: traded, 1. When target is not publicly traded company (if the target is publicly you don't get appraisal rights b/c the value is the fair market valueno need for particular protection)

127

fairly1 2. Weird structural thing where we suspect that they may not be treated Mechanics: -DE law: it can take years -RMBCA: tries to make it faster- 13.01- make an offer of fair price and person can contest if they don't like it

The Market-Out Rule -262 of Delaware DGCL -Shareholders in a privately traded firm (with fewer than 2,000 shareholders) will always have appraisal rights in a merger if they are required to vote on it. -But shareholders in a public company with more than 2,000 shareholders have no appraisal rights in a stock-for-stock merger. De Facto Merger Lorel is buying all of ARCOs assets -Lorels shareholders dont get a vote or appraisal rights -ARCOs shareholders do get to vote, but dont get appraisal rights Freeze Out Mergers Ex: Controlling shareholders of parent corporation, who wholly own the parents subsidiary, force the parent to absorb the subsidiary. Even after the repudiation of the unanimity rule allowed a qualified majority of shareholders to impose a merger against the will of a disagreeing minority, all shareholders had the right to continue as shareholders of the surviving entity. -FL led the way by amending its statute to permit cash consideration in a merger. Weinberger (UPO/Signal) Court is wagging its finger at Signal for being greedy -We have an interested transaction (and apparently no ratification) -Thus, the standard of review is entire fairness (look back at chart) -Entire fairness includes both: 1. Fair dealing 2. Fair price Fair dealing embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and the stockholders were obtained. Candor is key. -One possessing superior knowledge may not mislead any stockholder by use of corporate information to which the latter is not privy Fair price relates to the economic and financial considerations of the proposed merger. Both aspects of fairness must be examined as a whole. -The study saying that $24 was a fair price was materially relevant, and not disclosing that info was a violation of the UPO directors fiduciary duties; lack of candor.
1

Ask Allison what this means

128

-When directors of a DE corporation are on both sides of a transaction, they are required to demonstrate their utmost good faith and the most scrupulous inherent fairness of the bargain. -When in doubt, disclose! Khan A controlling or dominating shareholder standing on both sides of a transaction, as in a parent-subsidiary context, bears the burden of proving its entire fairness. -The initial burden of establishing entire fairness rests upon the party who stands on both sides of the transaction. -However, an approval of the transaction by an independent committee of directors or an informed majority of minority shareholders shifts the burden of proof on the issue of fairness from the controlling or dominating shareholder to the challenging shareholder-plaintiff. -Also, however, the mere existence of an independent special committee does not itself automatically shift the burden to the plaintiff. -Two factors are required: 1. Majority shareholder must not dictate the terms of the merger 2. The special committee must have real bargaining power that it can exercise with the majority shareholder on an arms length basis. The precarious position of a Board faced with a hostile tender offer: -In a tender offer, the acquirer circumvents the board and gets the shares directly from the shareholders. -A companys shares are currently worth $10/share -A newcomer feels that the current management is underperforming, so he makes a tender offer to the shareholders to buy their shares for $15/share because he believes that with his management plan in place the companys shares could be worth $25/share. -Current management tries to fend off this hostile take over by saying, $15?! Are companys shares are worth far more than that. -Then the question presents itself, why is the current price $10/share? -Managements usual response is that they are, in actuality, really good managers, its just that the market doesnt appreciate them. Stock prices fall when companies fail to perform well, and cheap stock presents an opportunity to those who believe they could do better than incumbent managers. -Control contests are unpleasant for incumbent managers. -But, the threat of a takeover has the salutary effect of encouraging all managers to deliver shareholder value. -Thus, control contests are an important potential constraint on manager- shareholder agency costs. Green Mail: When the current management offers the potential usurper essentially a bribe to halt his hostile bid attempt. -This practice is sanctioned by Unocal v. Mesa Petroleum
129

-In the prior example, the management offers the newcomer $15/share for his when the current market price is $10/share. T. Boone Pickens was famous for getting green mailed. Corporate raiding: Buying a large interest in a corporation and then using voting rights to enact measures directed at increasing the share value. The measures might include replacing top executives, downsizing operations, or liquidating the company.

shares,

Hostile takeovers

A hostile takeover allows a suitor to bypass a target company's management unwilling to agree to a merger or takeover. A takeover is considered "hostile" if the target company's board rejects the offer, but the bidder continues to pursue it, or the bidder makes the offer without informing the target company's board beforehand. If the board of the target cooperates, the bidder can conduct extensive due diligence into the affairs of the target company. It can find out exactly what it is taking on before it makes a commitment. But a hostile bidder knows about the target by only the information that is publicly available, and so takes a greater risk. Also, banks are less willing to back hostile bids with the loans that are usually needed to finance the takeover. A hostile takeover can be conducted in several ways: 1. A tender offer can be made where the acquiring company makes a public offer at a fixed price above the current market price. Tender offers in the USA are regulated with the Williams Act (this is usually the better option because it gives you control and increases your ownership. The downside is that its usually a little more expensive) 2. An acquiring company can also engage in a proxy fight, whereby it tries to persuade enough shareholders, usually a simple majority, to replace the management with a new one which will approve the takeover. 3. Another method involves quietly purchasing enough stock on the open market, known as a creeping tender offer, to effect a change in management.

Poison pill (Shareholders rights plan)

Poison pill is a term referring to any strategy to increase the likelihood of negative results over positive ones for a party that attempts any kind of takeover. -Although academics generally believe that hostile tender offers are a useful device for disciplining corporate management, managers themselves believe that vulnerability to hostile bids is a profound weakness in the corporate governance structure because it exposes shareholders to abusive tender offer tactics. They argue that they cannot protect shareholders without the tools to defeat inadequate tender offers. Shareholders rights plan: a type of poison pill that gives shareholders the right to buy the companys stock at a discounted price. These rights are triggered become exercisable to actually buy discounted stock only if someone acquires more than a certain percentage of the companys outstanding stock without first receiving the target boards blessing. Moreover, the

130

person whose stock acquisitions triggers the exercise of the rights is excluded from buying discounted stock causing her holdings to be severely diluted If every right holder buys stock at half price, the aggregate effect will be to increase the proportionate holdings of all shareholders except the triggering person, whose rights are cancelled upon the concurrence of the triggering event and who, as a result, will only own a much smaller interest in the company than that for which he initially paid.
Effects on shareholders The goal of a shareholder rights plan is to force a bidder to negotiate with the target's board and not directly with the shareholders. The effects are twofold: It gives management time to find competing offers that maximizes selling price. Several studies have indicated that companies with poison pills (shareholder rights plans) have received higher takeover premiums than companies without them. This results in increased shareholder value. The theory behind this is that an increase in the negotiating power of the target is reflected in higher acquisition premiums.

Constraints and legal status Following the development of poison pills in the 1980s, the legality of their use was unclear in the United States for some time. However, poison pills were upheld as a valid instrument of Delaware corporate law by the Delaware Supreme Court in its 1985 decision Moran v. Household International, Inc. Flip-in vs. Flip-over p. 528 ways around a poison pill Friendly Transactions Smith v. Van Gorkum -Van Gorkum wanted to put the company, Transunion, up for sale. He starts pulling numbers out of the air ($55/share). -Van Gorkum was near retirement and wanted to use the merger to cash out. -He meets with Jay Priztker, a takeover artist, and makes him an offer for $55/share. -They had no basis for saying that that was a good price. -VG calls a special meeting with his Board of Directors, none of which were trained financial analysts (all they have was the market price [what the companys shares were selling for at the time, which is not necessarily a reflection of the companys true value.]) -They approve the merger. This was a rush job. -VG includes a market test that purported to allow other bidders to bid higher. -However, this market test was tied up with the deal with Priztker. -Did the Transunion Board satisfy its duty of care obligations? -Court says no; they did not act with full information. -Board found to have been grossly negligent in its degree of uninformedness. -For the first time, a board was found to have violated its care obligation. -Afterward, the DE legislature passes 102(b)(7) -The court is applying a higher scrutiny in cases where the company is being sold.
131

Unocal v. Mesa Petroleum -Court held that a board of directors may only try to prevent a take-over where it can be shown that: 1. There was a threat to corporate policy AND 2. The defensive measure adopted was proportional and reasonable given the nature of the threat. Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., -You have multiple bidders, one that you want, and one that you dont want. -Fending off the latter triggers the Unocoal duties (Boards defensive actions have to be proportional; not overkill). -Revlon does two defensive tactics to fend off Pearlman, the takeover artist. -Pearlman increases his offer. -Revlon gets a white knight, Forseman, to come in and bid on Revlon. Revlon Duties: -After it becomes inevitable that the company is going to be broken up, the Board of Directors is supposed to shift its role from being protectors of the corporate enterprise to effectively becoming auctioneers, attempting to get the best price possible via bidding. When the Board favors one bidder over another, to the extent that that interferes with the Boards auctioneer duties, that is a breach of the Boards Revlon duties, and justifies the court striking the lock-ups, and merger agreement between the target company and the favored bidder.2 But, when exactly is that line crossed? When is the takeover inevitable? Paramount 1 (The Time-Warner Case) -Time wanted to diversify to become a multimedia company. -They scoped out a few companies and ultimately felt Warner was a good fit. -They enter into a contract; a merger-of-equals; also, a stock-for-stock transaction (all of the Time shareholders and all of the Warner shareholders will become shareholders in the new Time-Warner entity.) -Paramount makes a tender offer of $175/share; afterward, Times stock value went up to $188/share. (The reason for the latter is a public expectation that the value of the company will increase). -In response to Paramounts bid, Time changes the merger agreement from a merger-of-equals to a friendly tender offer by Warner; in response, Paramount ups the bid to $200/share. -Revlon says that when breakup becomes inevitable, the role of the board shifts to that of an auctioneer, attempting to get the best value for the stockholders. -However, the Revlon duties dont apply since Time isnt being broken up. -Also, this is not a sale of control situation; -Unocal duties do apply to this case, since Time used defensive tactics to fend off Paramounts bid in favor of Warner (Was the Boards response reasonable and proportional to the supposed threat?)
2

Revlon duties include both duties of care and duties of loyalty. Money damages can result as a breach of the latter.

132

-Time was attempting to protect its long term strategy of merging with Warner. -Also, wanted to protect the price of the company and the Time culture. The proportional response only has to be within a range of reasonableness (i.e. nondraconian). -Directors may consider, when evaluating the threat posed by a takeover bid, the inadequacy of the price offered, nature and timing of the offer, questions of illegality, the impact on constituencies other than shareholders, the risk of nonconsummation and the quality of securities being offered in exchange. -Court says Unocal standard has been satisfied. -The Moran case suggested that the board cant just sit around and tell the would- be acquirers to get lost; they have to at least talk to them (even if they dont like them). -In this case, Court says you can just say no. -If you have to talk them (engage a would-be acquirer), then that might have bad consequences for the target company. There are two circumstances which may implicate Revlon duties: 1. When a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company. 2. Where, in response to a bidders offer, a target abandons its long-term strategy and seeks an alternative transaction also involving the break-up of the company. Directors/Officers have 5 duties: 1. Care 2. Loyalty 3. Good Faith 4. Unocal 5. Revlon Paramount 2 (The QVC case) -Paramount enters into a merger agreement with Viacom and attaches a lot of strings -No Shop Agreement; Termination fee; Stock Option -Paramount is under an obligation not to talk to QVC -Does Revlon apply? -Paramount thinks no, because Paramount is not being broken up. Court says that Revlon duties also apply when control is being sold so that controlling shareholders will be in the minority in the resulting/surviving entity. -Absent effective protective provisions, minority stockholders must rely for protection solely on the fiduciary duties owed to them by the directors and the majority stockholder, since the minority stockholders have lost the power to influence corporate direction through the ballot. -In this case, the public stockholders currently own a majority of Paramounts voting stock. Control of the corporation is not vested in a single person, entity, or group, but vested in the fluid aggregation of unaffiliated stockholders. In the event the Paramount-Viacom transaction is consummated, the public stockholders will receive cash and a minority equity voting position in the surviving corporation. -Because of intended sale of control, the Paramount-Viacom transaction has economic consequences of considerable significance to the Paramount stockholders. Once control is shifted, the current Paramount stockholders will have no leverage in the future

133

to demand another control premium. As a result, the Paramount stockholders are entitled to receive a control premium and/or protective devices of significant value. -In the sale of control context, the directors must focus on one primary objective to secure the transaction offering the best value reasonably available for the stockholders and they must exercise their fiduciary duties to further that end. Barkan says that directors can fulfill this duty by conducting and auction and/or canvassing the market. -Thus, Revlon duties did apply, and Paramount failed in their obligation to perform these duties (particularly because of the No Shop Agreement). -However, a court applying enhanced judicial scrutiny should be deciding whether the directors made a reasonable decision, not a perfect decision. If a board selected one of several reasonable alternatives, a court should not second guess that choice. -Until Revlon is triggered, there is only BJR. But, when you cross the line into Revlonland, those duties are triggered and scrutiny is heightened. What courts do in fact, is to accord corporate boards degrees of deference along a continuum. Where as in Revlon itself, the merger consideration is cash, courts will not defer to the boards judgment. In such instances, any deal protection accorded to the favored merger partner will be closely reviewed to assure it represents a good-faith effort to get the best current price. -By contrast, where the consideration is stock of a company of approximately equal size, deal protections will receive the greatest deference. -In the middle range, courts will inevitably assess the deal protective terms by evaluating the good faith of the corporate directors who approve these terms. Lyondale -Deals with the interplay between Revlon duties and 102(b)(7) waivers. -A Revlon breach can be related to a breach of duty of loyalty and/or care. -If the company has a 102(b)(7) waiver, the directors cant be held to have violated Revlon due to a breach of duty of care (they are exempted); if such a provision exists then the only ways they can violate are via breach of duty of loyalty or by a good faith/fair dealing thing. -When do the Revlon duties attach (if at all)? -During the wait and see approach the break up of the company was not yet inevitable, and so BJR is applied rather than Revlon duties.

Lock-Ups
-contractual provisions agreed to in order to shore up a deal. -Termination fees and break-up fees: cash payments in the event the seller elects to terminate the merger or otherwise fails to close. No-Shop Agreements: Once youre in the deal with the acquirer, you wont actively solicit other buyers. No-Talk Agreements: You wont even listen to unsolicited offers by other potential buyers. -However, these are not absolute and directors can only comply with them to the extent that they arent violating their fiduciary duties under Revlon Omnicare
134

-Genesis entered into a merger agreement with NCS, then the NCS board withdrew its recommendation that the stockholders vote in favor of the merger. -Nevertheless, there were all these lock-up provisions that seemed to make the deal a fait accompli. -However, the NCS board failed to negotiate a fiduciary out clause in case the Genesis transaction became an inferior offer. -Dissent argues that Unocal should not have applied since the board wasnt trying to fend off anyone when they entered into the agreement. -However, the board was faced with the prospect of no deal, and so they had to agree to these lock-ups in order to get the deal with Genesis. -Their mistake, however, was in not negotiating a fiduciary out clause. -Thus, they have 2 choices: (1) face the consequences of violating the lock-up provisions, or (2) violate their fiduciary duties to the company. Anti-takeover statutes -States want to protect their local companies; they want to protect against some out of state company buying a local company and moving the jobs elsewhere (and tax revenue elsewhere) -Thus, they implement legislation in the form of anti-takeover statutes designed to limit the ability of out-of-state companies to perform hostile takeovers.
d. 15. Snierson says: Dont engage in insider trading. a. Why prohibit insider trading? i. 1. Its not fair for some people to have inside information and make money from it while the rest of us dont; the parity of information in the market. ii. -If people dont trust the market, theyre not going to invest in it. iii. Property-based rationale: insider information belongs to the company and not to the individual. Thus, the individual using the information is making a secret profit and usurping a corporate opportunity. b. Why allow insider trading? i. -Its a way to compensate managers; in addition to paying salaries, maybe we can just give them insider information. ii. -A victimless crime c. Elements of Fraud i. false statement (affirmative misrepresentation) or actionable omission ii. -that is material, and iii. there is an intent to deceive, and

135

d.

e.

f.

g.

h.

iv. there is reliance on the false statement or actionable omission v. Causation vi. Injury Regarding the false statement: there is a problem applying this to securities (unless theres a failure to disclose, you need a duty to disclose) Another problem is with the reliance part: In a face to face transaction maybe you can rely on something they say, but securities transactions are impersonal. Insider trading: the trading of a corporation's stock or other securities (e.g. bonds or stock options) by individuals with potential access to non-public information about the company. In most countries, trading by corporate insiders such as officers, key employees, directors, and large shareholders may be legal, if this trading is done in a way that does not take advantage of non-public information. However, the term is frequently used to refer to a practice in which an insider or a related party trades based on material non-public information obtained during the performance of the insider's duties at the corporation, or otherwise in breach of a fiduciary or other relationship of trust and confidence or where the non-public information was misappropriated from the company. In the United States, trading conducted by corporate officers, key employees, directors, or significant shareholders (in the U.S., defined as beneficial owners of 10% or more of the firm's equity securities) must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While "legal" insider trading cannot be based on material non-public information, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation (broadly speaking) and that their trades otherwise convey important information (e.g., about the pending retirement of an important officer selling shares, greater commitment to the corporation by officers purchasing shares, etc.) Illegal insider trading i. The United States is generally viewed as having the strictest laws against illegal insider trading, and makes the most serious efforts to enforce them. 136

ii. Definition of "insider" iii. In the United States, corporate insiders are defined as a company's officers, directors and any beneficial owners of more than ten percent of a class of the company's equity securities. Trades made by these types of insiders in the company's own stock, based on material non-public information, are considered to be fraudulent since the insiders are violating the fiduciary duty that they owe to the shareholders. The corporate insider, simply by accepting employment, has made a contract with the shareholders to put the shareholders' interests before their own, in matters related to the corporation. When the insider buys or sells based upon company owned information, he is violating his contract with the shareholders. i. For example, illegal insider trading would occur if the chief executive officer of Company A learned (prior to a public announcement) that Company A will be taken over, and bought shares in Company A knowing that the share price would likely rise. j. However, "insiders" are not just limited to corporate officials and major shareholders where illegal insider trading is concerned, but can include any individual who trades shares based on material non-public information in violation of some duty of trust. This duty may be imputed; for example, in cases of where a corporate insider "tips" a friend about non-public information likely to have an effect on the company's share price, the duty the corporate insider owes the company is now imputed to the friend and the friend violates a duty to the company if he or she trades on the basis of this information. k. Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firms shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibits fraud related to securities trading.14(e)-3 is another way to catch insider traders (deals with tender offers) l. The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high

137

as three times the profit gained or the loss avoided from the illegal trading. m. Traditional Approach to insider trading (KADY Roberts Rule) 16. Seemed, originally, to apply to anyone with access (i.e. whenever there is a confidential relationship) a. Such people have a duty to abstain or disclose i. But who really owes this duty? 1. Anyone who works with or for the issuer of the stock: investment bankers, law firms (both deemed constructive insiders by Dirks), janitors, theoretically, could be if they are entrusted with sensitive information. b. Dirks v. SEC: Tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. c. The insider has a duty of loyalty to the company not to tip d. The tippee can have a duty of care imputed to him by the tipper. e. To pass the duty of along, the tipper has to breach his duty of loyalty and tip the tippee, who either knows or should know that there has been a breach, and you can go all the way down the line along the person to who actually does the insider trading. f. But a break in the link frees everyone down the line (i.e. if one tippee couldnt have known that his tipper breached his duty) g. SEC Rule 10b-5 i. It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, ii. (a) To employ any device, scheme, or artifice to defraud, iii. (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

138

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, h. SEC Rule 10b-5, codified at 17 C.F.R. 240 i. 10b-5, is one of the most important rules promulgated by the U.S. Securities and Exchange Commission, pursuant to its authority granted under the Securities Exchange Act of 1934. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. j. person isnt liable for insider trading unless he is either (1) an insider, (2) a tippee, or (3) a misappropriator. (Chiarella v. U.S.) k. True Insider: one who learned the information either as an employee or director of the corporation whose stock is being traded. l. Constructive Insider: one who was performing services for the corporation, such as a lawyer or accountant. m. Tippee: one who learned the information from an insider 17. Alberts Insider Notesa. Section 5. Inside Information b. Class Notes: c. Insider trading d. Insider trading is simply trading on non-public information by someone with a duty not to trade e. The insider can exploit his advantage whether the information is good or bad f. Two primary forms of insider trading g. Classical insider trading: Typically, a corporate insider trades [buys or sells] shares of his corporation, using material, non public information obtained through his position as an insider h. The insider exploits his informational advantage [which is a corporate asset] at the expense of the corporations shareholders i. Classical insider trading: j. This constitutes a deceptive device for 10(b) and triggers the disclose or abstain rule which we will get to soon k. The classical theory applies to traditional insiders [directors, officers, 10% shareholders] AND to temporary fiduciaries as described in Footnote 14 to Dirks which we will also get to soon l. Misappropriation/outsider trading:

iv.

139

m. Misappropriation or outsider trading prohibitions target the trading based on non public information by someone in breach of the duty he owed to the source of his information n. An insider can also exploit an informational advantage by trading in other companies stocks when he learns that his firm [or a related firm] will do something that affects the value of another companys stock, and trades on this material non public information o. The insider misappropriates the information at the expense of his firm, through a breach of trust or confidence p. The crux of this application centers not on a fiduciary relationship between the insider and the purchaser or seller of the security, but on the fiduciary-turned- trader's deception of the folks who entrusted him with the information in the first place q. The fiduciary's undisclosed, self-serving use of a principal's information to buy or sell securities, in breach of his duty of loyalty and confidentiality r. Securities and Exchange Commission v. Texas Gulf Sulphur Co., (1969). s. Facts: Texas Gulf Sulfur (TGS) (D) began exploratory drilling in eastern Canada in the late 1950s. Mollison (D), who was TGSs (D) Vice President and a mining engineer, supervised the project. Clayton (D), an electrical engineer, also worked on the site. In November 1963, TGS had done exploratory drilling on an area that appeared to be strong in mineral content. TGS decided to buy the land, and its president, Stephens (D) ordered all employees to keep the drilling results a secret so TGS would not have competition driving up the lands price. The company resumed drilling on March 27, 1964, once it had purchased enough land to protect its interests. In the period between November 1963 and March 1964, several TGS employees and others they had tipped of purchased TGS stock and calls on the stock. BY the end of March 1964, they owned 8,235 shares and 12,300 calls. Rumors began circulating that TGS was nearing a major ore strike, and on April 11, articles in the New York Herald Tribune and the New York Times indicated that TGS was about to score a major strike. Stephens immediately contacted others and obtained a current report on the drillings progress. The following afternoon, TGS issued a press release indicating that as of April 12, the reports of a substantial copper discovery as the Canadian job site exaggerated the scale 140

and the operations and that most of the drilled areas revealed only barren pyrite or graphite without value, although a few had resulted in the discovery of small or marginal sulphide ore bodies. However, the insiders knew as of the evening of April 10 that TGS had discovered 6.2 to 8.3 million tons of proven ore worth approximately $26 to $29 per ton. On April 13, the New York Herald ran a story titled Copper Rumor Deflated, correcting its previous report of a major strike but indicating that recent mineral activity near the drilling site had provided favorable results. On April 13, a Canadian journalist interviewed several insiders in preparation of an article confirming a 10 million-ton ore strike. The article was published on April 16, and TGS gave the Ontario Minister of Mines a statement regarding the discoverys extent for release to the media. Mollison (D) and Holyk (D), another insider, thought the statement would be released over the airways at 11 p.m. on April 15, but it was not released until the next morning. An official statement announcing the discovery of at least 25 million tons of ore was released over the American airwaves, appeared on Merrill Lynchs private wire, and was announced over the Dow Jones ticker tape that morning. On April 15, Clayton (D) ordered 200 shares of TGS stock through his Canadian broker. Crawford (D) ordered 300 shares at midnight on April 15 and an additional 300 shares early the next morning. Other insiders similarly purchased stock before the discoverys announcement became common knowledge. The SEC sued, alleging violations of the insider trading laws. t. Rule: A person who is trading a corporations securities for his own benefit and who has access to information intended to be available for business use only, may not take advantage of the information, knowing it is not available to those with whom he is dealing. u. Decision/Rationale: Insiders violate Rule 10b-5 when they purchase shares before disclosure of information intended to be available only for corporate purposes is announced to the public. If anyone possesses such information, they must either disclose it to the investing public, or if disclosure is not possible, they must refrain from trading in or recommending for trade the securities involved until the secret information is disclosed. The existence of a vast amount of viable ore on TGS land is material information that a reasonable investor would like to know before 141

deciding whether or not to purchase TGS stock. Discovering that large a quantity of valuable ore would most certainly have an effect on a mining companys stock value. All of the stock purchases and calls made by individuals who knew of the ore discovery before the public announcement violated Rule 10b-5. v. Notes: The case above was an SEC enforcement action. It has previously been established that 10(b) gave rise to a private cause of action for damages, though the question of who can sue whom for what amounts has given rise to considerable litigation and is still largely unsettled. In a private action for damages the plaintiff must prove (1) defendant made a material misrepresentation or omission inc connection with the purchase or sale of security, (2) reliance, (3) scienter, and (4) causation. In 1984, Congress amended 21(d) of the 34 Act to allow the SEC to seek a civil penalty up to three times the insiders profits. In the Insider Trading and Securities Fraud Enforcement Act of 1988, Congress added 20A to the 34 Act. This provision gives an express cause of action for damages to contemporaneous traders against inside traders and tippers. Section 20(A)(d) preserves but does not clarify existing law relating to implied causes of action under 10(b) and Rule 10b-5. The Act provides expressly for derivative liability of employers for the actions of their employees (for example, the actions of employees of brokerage firms), but (contrary to the general rule for vicarious tort liability) not if the employer is able to prove of material, nonpublic information in trading the shares of a company by a corporate insider or other person who owes a fiduciary duty to the company. w. Class Notes: x. How do we know when a fact is material? This is the case that started the balancing test- this is the language that the SC picked up in crafting its balancing test for Basic y. What standard does the court use to determine materiality here? The court applies the balancing test [the indicate probability that the event will occur and the anticipated magnitude of the event, in light of the totality of the company activity] and find that the results were material. The court announced a reasonable investor standard for materiality: information is material if a reasonable investor would consider it important. Such an investor will consider 142

information important if it might affect the value of the stock. z. What is the result of this standard on insiders? Under this materiality standard, insiders will seldom be able to defend their trades by arguing that information is immaterial. According to the court, the fact that insiders trade on a piece of information itself demonstrates its materiality. This result makes intuitive sense, but also effectively eliminates the materiality requirement in insider trading cases: no one files an insider trading case unless an insider has traded, yet the fact that an insider traded will itself be evidence of the materiality of that information. aa. First question- who are insiders? The court refers to 16(b)- what is that all about? 16 of the 1934 Act restricts the conduct of officers, directors and 10% shareholders. 16(b) deals with short swing profits, a concept we will come back to bb. Are insiders always prohibited from investing in their own company, because of their access to inside information? Of course not. The court is very clear on this: insiders duty to abstain or disclose ONLY arises in those situations which are essentially extraordinary in nature and which are reasonably certain to have substantial effect on the market price of the security if [the extraordinary situation is] disclosed. cc. Does an insider have to share the benefit of her superior financial or expert analysis by disclosing her guesses or predictions? Of course not- the courts are not aiming to entirely level the playing field dd. When can an insider trade on inside information? Insiders must wait to trade until the information has been effectively disseminated, until the information is effectively disclosed in a manner sufficient to insure its availability to the investing public. Thus, those who traded before the April 16th announcement violated Rule 10b-5 ee. What was the legal rule announced in this case? Where an insider has material nonpublic information the insider must either disclose such information before trading or abstain from trading until the information has been disclosed ff. Rationale for rule? The Rule is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information.

143

gg. The essence of the Rule is that anyone who has access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone may not take advantage of such information knowing it is unavailable to those with whom he is dealing, i.e., the investing public. hh. Why do we regulate insider trading? ii. Information parity jj. Integrity of the trading markets kk. Operational concerns ll. Remedies for Insider Trading mm. SEC injunctions nn. Disgorgement oo. Civil penalties pp. Criminal sanctions qq. Note: Introductory Note on Current Law rr. Chiarella v. United States involved a criminal prosecution. Chiarella by virtue of his job (markup man) and ingenuity correctly identified a target he was hired for, and bought shares of its stock through a broker. When a tender offer was announced, the target shares rose in value and Chiarella sold his shares at a profit. The Supreme Court held that his conduct was not a violation because he was not an insider of the corporation whose shares he had traded and the basic proposition that, under 10b and Rule 10b-5, a corporate insider must abstain from trading in the shares of his corporation unless he had first disclosed all material inside information known to him, the Court concluded that the duty to abstain arises from the relationship of trust between a corporations shareholders and its employees. Since there was no relationship of trust between Chiarella and the shareholders of the corporations whose shares he traded, he had no duty to disclose or abstain. The Court stated, not every instance of financial unfairness constitutes fraudulent activity under 10b. ss. Tipping tt. So the world of folks who cant freely trade on non public information break down into: INSIDERS: These folks obtain material non public information because of their role in the corporation [officer, director, employee, controlling shareholder]; They have a 10b-5 duty not to trade [abstain or disclose] uu. Who is a constructive/temporary insider? 144

vv. Footnote 14 tells us that certain professionals can become fiduciaries of the shareholders because of the special confidential relationship, and because of their access to information ww. These folks are temporary [or constructive] insiders, and they are prohibited temporarily from trading in the company stock where they are temporary insiders xx. Temporary I they (1) obtain material nonpublic information from the issuer with (2) an expectation on the part of the corporation that the outsider will keep the disclosed information confidential and (3) the relationship at least implies such a duty yy. under OHagan have an abstain or disclose duty when they are aware of material nonpublic information that they got from a relationship of trust or confidence zz. What is tipping and why is it wrong? aaa. You cant use a tippee to do what you are not legally permitted to do yourself bbb. Folks with no other duty of confidentiality pick up a 10b-5 duty to abstain or disclose when they knowingly trade on improper tips ccc. Both inside and outside traders who have this confidentiality duty can be liable as participants in illegal trading if they knowingly make improper tips ddd. So tippees are liable for trading after obtaining material, non public information that he/she knows or has reason to know came from someone who breached a duty of confidentiality eee. In general, the tippees liability is derivative of the tippers, arising from his role as a participant after the fact in the insiders breach of a fiduciary duty. fff. The tipper is liable even though he/she didnt trade his/herself, as long as the tipee does ggg. Tipper/tippee issues: what are the possible approaches for the Supreme Court in tipper/tippee cases? hhh. Supreme Court rejects the SEC view that anyone who obtains information from an insider picks up the insiders duty iii. They divided people who receive inside information into 3 categories: jjj. Temporary FN 14 [to Dirks] insiders: lawyers and accountants who enter into confidential relationships with 145

corporations and are given access to inside information for corporate purposes kkk. Tipees who receive information from an insider/tipper in breach of the insider/tippers duty to refrain from profiting on undisclosed information and who expects that the tippee will buy/sell based on that information lll. Non-temporary insiders, non-tippees: this group can trade freely mmm. Everybody else: non tippee non temporary insiders: nnn. Strangers with no relationship to the source of the material non public information have no 10b-5 duty to abstain or disclose ooo. Doesnt matter whether they overhear the material non public information or develop it themselves ppp. qqq. Dirks v. Securities & Exchange Commission, (1983). rrr. Facts: Dirks (D) an officer of a NY brokerage firm that specialized in providing investment analysis of insurance company securities to institutional investors, received information from Secrist, a former officer of Equity Funding of America, that Equity Fundings assets were vastly overstated through the corporations fraudulent practices. Secrist told Dirks that other regulatory agencies failed to act on similar claims brought by other Equity Funding employees. Dirks decided to investigate Secrists story and interviewed several officers and employees. Their senior managers denied any wrongdoing, but some other employees verified Secrists claims. Although Dirks did not own their stock, he informed some of his clients of the claims. As a result, some of the shareholders sold their shares, including five investors whose combined liquidated holdings exceeded more than $16 million. Dirks investigated Equity Funding for two weeks. During that time, the price of their stock fell from $26 to $15 per share. This dramatic drop led the NY Stock Exchange to cease trading of their stock. California insurance authorities reviewed Equity Fundings financial records and uncovered evidence of fraud. After this discovery, the SEC filed a complaint against Equity Funding, and the Wall Street Journal published a front page story on the fraudulent activity. After a hearing concerning Dirks role in exposing the fraud, the SEC (P) found that Dirks had aided and abetted violations of antifraud provisions of the Securities 146

Exchange Act by repeated the fraud allegations to members of the investment community who later sold their stock. However, because Dirks also brought the fraud to light, the SEC only censured him. On review, the Court of Appeals entered judgment against Dirks, and Dirks appealed. sss. Rule: A tippee does not inherit a duty to disclose material non-public information merely because he knowingly received the information. (In general, the tippees liability is derivative of the tippers, arising from his role as a participant after the fact in the insiders breach of a fiduciary duty. A tippee therefore can be held liable only when: The tipper breached a fiduciary duty by disclosing information to the tippee, and the tippee knows or has reason to know of the breach of duty). ttt. Decision/Rationale: An individual who is not a fiduciary and was not in confidence with a securities seller, does not always have a duty to disclose material nonpublic information of which he has knowledge. Such an imposition could adversely impact the continued existence of market analysts. An analyst must seek out information about publicly traded corporations practices and financial status and analyze the information. The analyst usually obtains his information by interviewing corporate officers and insiders. Analysts cannot help but obtain material, nonpublic information. This does not necessarily mean they should be prevented from trading on the information or passing it on to investors. Market analysts are an important part of the stock market because they promote efficiency in pricing. However, a tippee who improperly receives insider information may assume an insiders duty to disclose if the insider breached his fiduciary duty to the shareholders by disclosing the information to the tippee, and the tippee knew or should have known of the breach. Whether a disclosure is a breach of duty depends on the disclosure's purpose. The test is whether the insider will personally benefit, directly or indirectly, from the disclosure. If there is not personal benefit or gain, there is no breach of duty. Reversed. uuu. Dissent: The majority creates a special motivational requirement on the fiduciary duty doctrine. This new requirement excuses a knowing and intentional violation of an insiders duty to shareholders if the insider does not personally benefit. Such a requirement is not justified. 147

vvv. Analysis: Tippees may not use the information they receive for their own benefit. If they do, their exception from the duty to disclose disappears, and they will be deemed to be in violation of Rule 10b-5. www. Notes: In 2000, the SEC adopted Regulation FD to create a non-insider trading-based mechanism for restricting selective disclosure. If someone acting on behalf of a public corporation discloses material nonpublic information to securities market professional or holders of the issuers securities who may well trade on the basis of the information, the issuer must also disclose that information to the public. Where the disclosure is intentional, the issuer must simultaneously disclose the information in a manner designed to convey it to the general public. xxx. Class Notes: yyy. What has to be true for a tipper to breach this duty? A fiduciary duty breach occurs only where a tipper earns a personal benefit from the tip. Absent some personal gain, there is no breach of duty. Looking at objective criteria, the courts must determine whether the insider personally will benefit, directly or indirectly, from his disclosure. Examples of personal gain: tippee pays for the tip; 2 insiders at different firms trade tips; gift; Pecuniary gain; enhanced reputation that will translate into future profits; or gifts. And absent a breach of duty by the insider, there is no derivative breach. Thus, Dirks is liable only if Secrist breached a fiduciary duty to EF shareholders in telling Dirks, and Dirks knew (or should have known) of that breach. Because Secrist was trying to stop fraud, he breached no fiduciary duty. zzz. Rule 14e-3: aaaa. Historical background: Chiarella and Dirks created significant gaps in the insider trading prohibitions coverage bbbb. Rule 14e-3 dealing with tender offers was the SECs immediate response to Chiarella, but the rules scope is very limited. It is not triggered until the offeror has taken substantial steps towards making the offer and, more important, is limited to information relating to a tender offer cccc. As a result, most types of inside information remained subject to the duty-based analysis of Chiarella and its progeny

148

dddd. The misappropriation theory filled part of the gap, although it too is limited in that it requires a breach of fiduciary duty before trading on inside information becomes unlawful eeee. It is not unlawful, for example, to trade on the basis of inadvertently overheard information ffff. United States v. OHagan, (1997). gggg. Facts: OHagan (D) was a partner in the Dorsey & Whitney law firm in Minneapolis, Minnesota. In July 1988, Grand Metropolitan PLC, a London Company, retained Dorsey & Whitney to represent them in a potential tender offer for the common stock of the Pillsbury Company. Grand Metropolitan made a public announcement of its tender offer on October 4, 1988. On August 18, 1988, OHagan purchased call options for Pillsbury stock, each of which gave OHagan the right to purchase 100 shares of Pillsbury stock before a specified date in September 1988. OHagan owned 2500 unexpired Pillsbury options by the end of September 1988, more than any other individual investor. He also purchased 5000 shares of Pillsbury common stock that September at a price of just less than $39 per share. Pillsbury stock rose to nearly $60 per share when Grand Metropolitan announced its tender offer in October. OHagan sold his call options and common stock at a profit of more than $4.3 million. hhhh. Rule: An attorney who, based on inside information he acquired as an attorney representing an offeror, purchased stock in a target corporation before the corporation was purchased in a tender offer is guilty of securities fraud in violation of Rule 10b-5 under the misappropriation theory. (The misappropriation theory is a valid basis on which to impose insider trading liability. A fiduciarys undisclosed use of information belonging to his principal, without disclosure of such use to the principal, for personal gain constitutes fraud in connection with the purchase or sale of a security and thus violates Rule 10b5. The SEC had authority to adopt Rule 14e-3 as a prophylactic measure against insider trading in connection with a tender offer.) iiii. Decision/Rationale: An attorney breaches his duty of loyalty to his law firm and its client in violation of Rule 10b5 if he uses nonpublic information to trade securities. The misappropriation theory provides that a person is guilty of fraud if he misappropriates confidential information for 149

security trading purposes, in breach of a duty owed to the informations source. The theory behind the misappropriation doctrine is that a fiduciarys self-serving use of a principals information to trade securities deprives the principal of its right to exclusive use of its private information. Misappropriation satisfied 10bs requirement that chargeable conduct must involve a deceptive device or contrivance in the purchase or sale of securities. A fiduciary who is feigning loyalty to a principal while secretly using the principals private information for his own gain defrauds the principal. Reversed and remanded. jjjj. Analysis: The misappropriation doctrine supplements the protective sweep of the insider trading protections for securities. It was designed to protect the securities market from abuse by outsiders who have access to confidential information, but who owe no obligation or fiduciary duty to the corporations shareholders. A defendant can overcome allegations of misappropriation by evidence of full disclosure of the use of nonpublic information for trading. kkkk. Class Notes llll. Tippers can be liable EVEN IF THEY DONT TRADE, as long as a tippee down the line eventually trades mmmm. Tipees: those with no confidentially duty will INHERIT an abstain or disclose duty IF they knowingly trade on improper tips. If tippee knows or should know the info came from a person who breached a duty in sharing, tippee is liable for trading. Ditto for sub tippees nnnn. Under OHagan, we see that there can be no 10b-5 insider trading liability if there is no breach of trust or confidence oooo. Notes: pppp. According to the Court, liability under 10b could not have been imposed if OHagan had disclosed to the source of the information that be planned to trade on the nonpublic information qqqq. In United States v. Chestman, Ira Waldbaum was the president and controlling shareholder of Waldbaum, Inc., a publicly traded supermarket chain. Ira decided to sell Waldbaum to A & P at $50 per share, a 100% premium over the prevailing market price. Ira informed his sister Shirley of the forthcoming transaction. Shirley told her daughter Susan Loeb, who in turn told her husband Keith Loeb. Each person in the chain told the next to keep the 150

information confidential. Keith passed an edited version of the information to his stock broker, Robert Chestman, who then bought Waldbaum stock for his own account and the accounts of other clients. Chestman was accused of violating Rule 10b-5. The Second Circuit held that a person violates Rule 10b-5 when he misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence and uses that information in a securities transaction. The Court further held that in the absence of any evidence that Keith regularly participated in confidential business discussions, the familial relationship standing alone did not create a fiduciary relationship between Keith and Susan or any members of her family. Accordingly, Loebs actions did not give rise to the requisite breach of fiduciary duty. rrrr.In 2000, the SEC addressed the Chestman problem by adopting Rule 10b5-2, which provides a non-exclusive list of three situations in which a person has a duty of trust or confidence for purposes of the misappropriation theory First, such a duty exists whenever someone agrees to maintain information in confidence. Second, such a duty exists between two people who have a pattern of practice of sharing confidences such that the recipient of the information knows or reasonably should know that the speaker expects the recipient to maintain the informations confidentiality. Third, such a duty exists when someone receives or obtains material nonpublic information from a spouse, parent, child, or sibling. ssss. In 2000, the SEC adopted Rule 10b5-1, which states that Rule 10b-5s prohibition of insider trading is violated whenever someone trades on the basis of material nonpublic information tttt.

151