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BUSINESS ASSOCIATIONS OUTLINE SPRING 2006 THE LIMITED LIABILITY COMPANY

I. INTRODUCTION
A. Allows for the exercise of managerial powers without the risk of personal liability for the debts of

the business. 1. No Double Taxation (like a corporation) 2. Management allowed by everyone 3. Organization and operation are less restricted: better than an S corporation a. S Corps: A purely tax term, but you have to limit the corp to no foreign shareholders, 1 class of stock, and 75 or fewer shareholders 4. Full shield against tort and K liability (an LLP is just a shield against tort creditors)

II. TAX MATTERS

A. Kitner Regulations: were used to determine whether something was a partnership or a corporation:

Characteristics 1. Continuity of Life: a. Partnership: die routinely b. Corporation: takes a lot to kill 2. Centralized Management: a. Partnership: not present in a general partnership because each has right to manage b. Corporation: Usually centralized management c. LLC: can be member-managed OR manager-managed (1) ULLCA 101(11): manager managed company- where agency authority is vested exclusively in the managers and not the members. 3. Transferability of Interest: a. Partnership: dies when this happens b. Corporation: Can be freely traded c. LLC: Can put restrictions on the ability to trade- creates an overlap 4. Limited Liability B. Check the Box Regulations: Can choose on a tax return whether to be taxed as a partnership OR a corporation just by checking the box III. SECURITIES LAWS ISSUES A. Definition: when a membership interest in an LLC depends largely on whether members rely upon the efforts of others to generate profits (i.e. if assets are put into something that is controlled by another entity, it will be a security) 1. Manager Managed = security 2. Member Managed= NOT a security IV. CREATION OF A LLC: A. FIRST: file a document, generally called the articles of organization, with the state in order to create an LLC. 1. CONTAIN: provisions describing the name and identification as a LLC, the address of the principal place of business or registered officer, and the name and address of the registered agent for service of process. B. NEXT: enter into an operating agreement- details the relationship among the members 1. LLC does not have to be a signatory to its operating agreement and you can chose another jx to be the place where suit or arbitration takes place C. BUT: lack of an operating agreement is NOT fatal to the existence of an LLC 1. 103 ULLCA: all members of an LLC may enter into an operating agreement.

2 2. 401 ULLCA: the LLC is funded by contributions from members which may include tangible or intangible property or other benefit to the company including contracts for services to be performed. D. Transitions from another entity to an LLC: courts want to facilitate a seamless transaction from one entity into another where a sole proprietorship converts to an LLC, all of the interests and obligations incurred by the sole proprietorship or its assets are transferred to the LLC by operation of law. E. Notice to Third Parties Who Are Dealing with the LLC: if someone is notified that they are dealing with an LLC, then the LLCs participants cannot incur personal liability 1. BUT, where an agent fails to disclose either the fact that he is acting on behalf of the principal or the identity of the principal, then the notice provision of the LLC Act cannot relieve the agent of liability to a 3rd party. V. CHARACTERISTICS OF AN LLC A. Generally, LLCs are treated like corporations in all areas except tax, where they are treated like partnerships B. Concerning lawyers, LLCs will be treated like a corporate entity and representation is required C. Partnerships are different because they dont need attonerys 1. They all agree to bind each other as agents and can perceive a partner acting on behalf of a corporation

LAW FIRMS
I. TYPES OF PARTNERS
A. Income Partner all they get is income B. Equity Partner share in the profits, but you have to determine who does what and factor that

into pay (usually start with billable hours and go from there) II. Limited Liability A. LLP UPA 1775.61 (limited only with respect to torts) B. LLC 1705.01 (limited with respect to both tort and contract) C. Professional Associations 1785.08 (treated as corps) limited to a list of professions (limited with respect to both tort and contract) D. You cannot limit you individual liability for professional malpractice that YOU commit. You can limit it with respect to your colleagues, but not yourself. The professional organizational tools only protect indirect liability, not direct.

FORMATION OF A CORPORATION
Note: Corporations are creatures of statute, so if you think youre creating a corporation and you FAILED, then you have a partnership I. THE FORMATION OF A CORPORATION A. TWO TYPES OF CORPORATIONS 1. Closely Held Corporation: shareholders do most of the running of the business, stocks that are NOT publicly traded, possibility of elimination of the board of directors a. controlled by 7.32 of the Model Business Corporation Act b. 7.32(a)(1) you can ELIMINATE the board of directors as long as you comply with this section 2. The General Rule for Corporations: the publicly traded corporation a. MBCA 7.32 is an EXCEPTION if you qualify for it

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B. WHERE TO INCORPORATE 1. Take into account whether you want to be sued in other places 2. DE is often chosen b/c it is particularly generous to managers of corporations, low risk of

breach of fiduciary duties and gives managers more power than in other jurisdictions, and a lot of case law interpreting their statutes 3. Take into account the costs associated with incorporating in a state more jurisdictions, more taxing possibilities there are 4. For most corporations, the state in which they originate is usually the best place to incorporate C. HOW TO INCORPORATE 1. Must have the resources to operate as a corporation. Obtained two ways: a. Money/property are transferred to the corp in exchange for its stock b. Lending 2. 2.01 Incorporation who incorporates a. one or more persons may act as the incorporator or incorporators of a corporation by delivering articles of incorporation to the secretary of state for filing (1) may be personally liable on the contracts b/c the corporation may not yet be in existence (as an agent is) 3. 2.02 Articles of Incorporation a. MUST include these (but there are others this is a list of some that would be included) (1) Name of corporation that satisfies requirements of 4.01 (2) Number of shares corporation is authorized to issue (protects shareholders) (3) Street address and name of initial registered agent (4) Name and address of each incorporator b. MAY set forth (1) Names of individual directors (2) Purpose or purposes for which the corporation is organized see 3.01 (3) Managing the business and regulating the affairs of the corporation (4) Defining, limiting and regulating the powers of the corporation, its board of directors and its shareholders c. (b)(4) may eliminate or limit the liability of a director to the corporation 4. 4.01 Corporate Name a. Corporate names must contain the word corporation to put people on notice that there is limited liability. So if you engage in business with this corp, then you might want to get more info before you extend credit to this business. b. Sec (b) as long as the names are not identical, then the sec of state must allow the corp to use the name c. If the name is confusing to the public, then unfair competition (antitrust) should be used in suit 5. 3.01 Purposes a. every corporation incorporated has the purpose of engaging in any lawful business unless a more limited purpose is set forth in the articles of incorporation b. corp engaging in a business that is subject to registration under another statute of this state may incorporate under this act only if permitted by, and subject to all limitations of, the other statute 6. 3.01 Powers of the Corporation 7. 7.32 Shareholder Agreements a. agreements authorized by this are no longer effective when the shares of the corporation are listed on a national securities exchange

4 b. if all of the provisions in this are met, it is possible to create a corporation that doesnt have a board of directors (1) want to protect shareholders, have to have unanimous agreement to create a corporation without a board c. articles of incorporation or bylaws every buyer will have notice that this is a corporation without a board of directors (1) must be a conspicuous notice on the back of every stock certificate 8. 8.03 Number of Directors a. only need one director b. in OH, minimum of 3 unless you have fewer shareholders than 3 9. 6.21 Issuance of Shares a. shares must be in exchange for value (1) garden variety sale and in no other way (2) it would be wrong for the corporation just to pass out shares (3) must accept the stock for value b. if not, then the board of directors will be held personally liable for distributing stock for insufficient value

II. THE DECLINE OF THE DOCTRINE OF ULTRA VIRES

A. 3.04 Ultra Vires without authority 1. validity of corporate action cannot be challenged on the ground that the corporation lacked

the power to act

2. corporations power to act may be challenged a. in a proceeding by a shareholder against the corporation to enjoin the act b. in a proceeding by the corporation directly, derivatively, or through a receiver,

trustee, or other legal representative, against an incumbent or former director, officer, or agent of the corporation OR c. in a proceeding by the AG under 14.30 3. in a shareholders proceeding to enjoin an unauthorized corporate act, the court may enjoin or set aside the act, if equitable and if all affected persons are parties to the proceeding and may award damages for loss suffered by the corp or another party b/c of enjoining the authorized act B. Ashbury Ry. Carriage & Iron Co v. Riche: law of ultra vires became a judicial attempt to avoid the harsh and undesirable but apparently logically compelled consequences of a judicially created doctrine (demonstration of old rule) 1. there can NEVER be authority to act beyond the authority of the corporation 2. Its possible today to amend the articles of incorporation to provide the authority necessary to enter into the transaction C. 711 Kings Highway Corp v. FIMs Marine Repair Service, Inc: ultra vires cannot be invoked as a sword in support of a cause of action any more than it can be utilized as a defense D. Theodora Holding Corp v. Henderson: amount of charitable contribution outweighs the overall benefits flowing from placing of such gift where it serves to benefit those in need a. 3.02 General Powers (1) to make donations for the public welfare or for charitable, scientific or educational purposes Sullivan v. Hammer o As long as a charitable contribution is less than 10% of AGI, it is reasonable The Business Judgment Rule a presumption that in making a business decision they directors of a corporation (1) acted on an informed basis, (2) in good faith and (3) in the honest belief that the action taken was in the best interest of the company

III.

PREMATURE COMMENCEMENT OF BUSINESS A. PROMOTERS includes a person who, acting alone or in conjunction with one or more other persons, directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer 1. 2.01 Incorporators a. one or more persons may act as the incorporator of a corporation by delivering articles of incorporation to the secretary of state 2. 2.03 Incorporation a. corporate existence begins when the articles of incorporation are filed 3. 2.04 Liability for Preincorporation Transactions a. all persons purporting to act as or on behalf of a corporation b. knowing there was no incorporation under this Act c. are jointly and severally liable for all liabilities created while so acting 2.04 is the concrete statement of the law that we can work with, but some jx dont have 2.04 and some other jx have 2.04, but have additional law 2.04 provides either THE way or A way to find liability. o jx that said it was A way If youre within a 2.04 jx, then you might still be able to raise de facto or estoppel o jx that said it was THE way If youre not within 2.04, then there arent any other options 4. Stanley J. How v. Boss: promoter liability using an agency analysis a. If there is any doubt as to liability, then have the person dealing with the promoter say specifically that he agrees to deal with the promoter knowing that the incorporation has not yet been formed. b. General rule promoter will be personally liable unless the other party knows the corporation does not exist c. Restatement of Agency 326 When a promoter makes an agreement with another on behalf of a corporation to be formed, the following alternatives may represent the intent of the parties: (1) They may understand that the other party is making a revocable offer to the nonexistent corporation which will result in a contract if the corporation is formed and accepts the offer prior to withdrawal. (2) They may understand that the other party is making an irrevocable offer for a limited time. Consideration to support the promise to keep the offer open can be found in an express or limited promise by the promoter to organize the corporation and use his best efforts to cause it to accept the offer. (3) They may agree to a present contract by which the promoter is bound, but his liability terminates if the corporation is formed and becomes a party there can be no ratification by the corporation since it was not formed at the time the contract was made (4) They may agree to a present contract on which even though the corporation becomes a party the promoter remains liable either primarily or as a surety 5. Novation where the corporation knew of the existence of a K at the time of formation of the corporation and didnt object to it and continued acting under it, it is not considered

6 ratification b/c the corporation cant ratify an act that the corporation didnt have authority to make originally a. This will simply substitute a new party for the old party in all respects B. DEFECTIVE INCORPORATION 1. Robertson v. Levy: The corporation comes into existence only when the certificate has been issued a. De jure corporation: results when there has been conformity with the mandatory conditions precedent established by the statute. A de jure corporation isnt subject to direct or collateral attack either by the state in a qui warranto proceeding or by any other person b. De facto corporation: corporation which was defectively incorporated requires the following: (1) Valid law under which such a corporation can be lawfully organized (2) An attempt to organize thereunder (must be some type of good faith attempt to comply with the statute) (3) Actual user of the corporate franchise (4) good faith in claiming to be and in doing business as a corporation is often added as a further condition (this element can be put in each of 1, 2, and 3 OR you can make it a separate element altogether) De facto is used in jx that dont have 2.04. So, if a jx does not use 2.04, then apply de facto c. Corporation by estoppel: no corporation, the acts of the associates having failed even to colorably fulfill the statutory requirements, there was no estoppel in the pure sense of the word b/c generally there was no holding out followed by reliance on the part of the other party (1) Estoppel versus de facto practical difference estoppel works just this , de facto works with all s 2. today the certificate of incorporation provides the cut off point 3. Comment to 2.04 a. Incorporation under modern statutes is so simple and in expensive that a strong argument may be made that nothing short of filing articles of incorporation should create the privilege of limited liability (1) Other arguable exceptions (a) Where a corporate organizer enters into a transaction in the name of the corporation when he reasonably and honestly believes that articles have been filed but they have not been due to attorney negligence or other cause (b) Where a transaction is entered into after the articles have been mailed or delivered to the filing office but havent been received in the filing office thru no fault of the filer (c) Where a person knows that no corporation has been formed but insists that his contract be immediately entered into in the name of the corporation (d) Where has represented that a corporation is in existence and third person enters into a K with the corporation agreeing to look only to the corporation (e) Where a person provides funds to a promoter with the instruction dont start doing business until you incorporate and the promoter fails to follow the directions

7 4. Three approaches to liability with respect to corporations that are defective in some way a. Contract looking to parties intent b. Agency looking to find if there was principal in existence, if not then agent would be liable c. Partnership determine whether it satisfies the common law and statutory definitions of a partnership
HOW IT WORKS: Ks entered into when there is no corporation a. Who is liable? i. Does jx have 2.04? go there first (using comments to help with the possibility that there is an estoppel argument). De Jure corporation ii. Jx does not have 2.04? (Ohio) use de facto corporation with its three elements b. START with the point of view that there is no incorporation at the time of K- all flows from a lack of principal when the agent is purporting to act for the principal i. if that is the situation = the agent is liable ii. 2.04, defacto, estoppel, de jure are all DEFENSES for the agent to avoid liability

DISREGARD OF THE CORPORATE ENTITY

I. THE COMMON LAW DOCTRINE OF PIERCING THE CORPORATE VEIL
A. The attempt to avoid personal liability is not WRONG it is what we want people to be able to do. It is not unjust. Therefore, the deliberate attempt to avoid personal liability is not an unjustice. a. What is the wrongful conduct that courts are going to look for? i. The undercapitalization of the corporation. This is not enough, but it is an element. ii. Consider: Why is undercapitalization unjust in this circumstance? 1. What do we mean by unjustice? a. Undercapitalization b. Creditors who could possibly not be paid c. You knew that there were reasonably expected debts that wont be paid. B. Should we distinguish between tort and contract creditors? As a contract creditor you should be asking the appropriate questions to find out about corporation you are dealing with. Dont have that option as a tort creditor. C. Types of Piercing a. Vertical piercing going up the chain to the shareholders b. Horizontal piercing one enterprise split into individual corporations. So when one of the corps is found liable, then the rest of the corps will be required to support the finding in the suit. Note: Federal government can use common law or cite particular statutes A. MBA 6.22 Liability of Shareholders 1. purchaser from a corporation of its own shares is not liable to the corporation or its creditors with respect to the shares except to pay the consideration for which the shares were authorized to be issued or specified in the subscription agreement 2. unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not personally liable for the acts or debts of the corporation except that he may become personally liable by reason of his own acts or conduct 3. General rule that corporate entity should be recognized and upheld unless specific, unusual circumstances call for an exception B. Bartle v. Home Owners Corp: law permits the incorporation of a business for the very purpose of escaping personal liability

8 1. Consider issues that arise when the sub corp is used as an agent of its parent corporation. Basically, the parent corp is the principal. C. Dewitt Truck Brokers v. Ray Flemming Fruit Co : when substantial ownership of all the stock of a corporation in a single individual is combined with other factors clearly supporting disregard of the corporate fiction on grounds of fundamental equity and fairness, courts have shown no hesitancy in holding individual stockholders liable 1. I: What must you show to disregard the corporate entity and find the stockholders liable 2. Factors to determine that the parent and the subsidiary operated as a single economic entity and so corporate veil may be pierced: a. Undercapitalization: Whether the corporation was grossly undercapitalized for the purposes of the corporate undertaking? Are there enough assets in the corporation to pay reasonably anticipated debts? b. Failure to observe corporate formalities this is very easy to show and shows up often (no minutes, no shares of stock issued, etc.) c. Nonpayment of dividends whether there are dividends (must be profits in order for there to be a dividend) d. Insolvency of the debtor corporation at the time are your debts grater than your assets? If the debt side is bigger, then youre insolvent (1) Equity insolvency does not look at the balance sheet, but looks at cash flow to determine if the cash coming in each month is enough to pay the bills that need to go out e. Siphoning of funds of the corporation by the dominate stockholder f. Non-function of other officers or directors g. Absence of corporate record h. Fact that the corporation is merely a faade for the operations of the dominant stockholder or stockholders i. PLUS an element of injustice or fundamental fairness 3. Promise to pay when one who is the sole beneficiary of a corporations operations and who dominates it, induces a creditor to extend credit to the corporation on such an assurance, the fact has been considered by many authorities sufficient basis for piercing corporate veil 4. Piercing issue only involves the question whether a specific shareholder is personally liable for a specific corporate obligation 5. this court says proof of plain fraud is not a necessary element and the fact that its a closelyheld corporation is also not enough 6. Notes on DEBT: a. Inside Debt: debt owed to the corp by it shareholders b. Outside debt: debt owed to people outside the corporation D. Baatz v. Arrow Bar: factors that indicate injustices and inequitable consequences and allow a court to pierce the corporate veil are 1. fraudulent representation by corporation directors 2. undercapitalization 3. failure to observe corporate formalities 4. absence of corporate records 5. payment by the corporation of individual obligations a. when the corp is making payments of the individual (i.e. car lease or mortgage), then this is a clear indication that the corporate boundary is being violated 6. OR use of corporation to promote fraud, injustice or illegalities

E.

F.

G.

H.

I.

9 7. Note: If youre going to provide capital to the corporation, then you want to finance the corporation with debt because then youll be ahead of anyone else. Example: a mortgage on the building the corp is in makes the building yours if the corp goes under. Things to look to see if there was control of subsidiary in holding parent liable 1. officers of subsidiaries are the same as the parent, it looks a lot like control 2. if the directors are the same, looks a lot like control 3. if decisions must be approved by the parent company Three theories to disregard the corporate entity 1. alter ego no difference between a corporation and shareholder therefore disregard corporate boundary (we cant tell where one entity ends and the other begins) 2. instrumentality corporation acted as agent of shareholder therefore binding shareholder to the K 3. modern radaszewski approach (used by ohio) satisfy the three part test, therefore corporate boundary should be disregarded Radaszewski v. Telecom Corp: to reach a parent company, must show three things: 1. control = complete domination of policy and business practice in respect to the transaction attacked so that the corporate entity as to this transaction had at the time no separate mind, will or existence of its own (alter ego) 2. such control must have been used by the to commit fraud or wrong (can be satisfied with undercapitalization) 3. aforesaid control and breach of duty must proximately cause the injury or unjust loss complained of (must show connection between undercapitalization and loss, show that you are the one who was injured by the failure to adequately find) Fletcher v. Atex: I: how much control the parent can exercise of the subsidiary and still avoid being held liable on a veil piercing analysis? 1. to prevail on an alter ego claim must show: a. that the parent and the subsidiary operated as a single economic entity and single economic entity: (1) whether corporation was adequately capitalized for the corporate undertaking (2) whether the corporation was solvent (3) whether dividends were paid, corporate records kept, officers and directors functioned properly, and other corporate formalities were observed (4) whether the dominant shareholder siphoned corporate funds (5) whether, in general, the corporation simply functioned as a faade for the dominant shareholder b. that an overall element of injustice or unfairness is present 2. the must show that the two corporations operated as a single economic entity such that it would be equitable to uphold a legal distinction between them 3. Division/department vs. subsidiary a. division/dept there is no legal separation between the parent and the business and the parent is personally liable for the obligations of that business b. subsidiary there is legal separation and the parent probably will not be liable on the subsidiarys obligations (1) legal services provided by parent to subsidiary (2) parent controls the borrowing (3) employee interchangeably, often employees can move between entities (4) HR dept in the parent company only Things that are NOT indicators of parent-subsidiary veil piercing: 1. Filing a single tax return (is a requirement of federal law) 2. Legal services provided by the parent to the subsidiary

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3. Subsidiary NOT permitted to borrow money 4. Employees are transferred from subsidiary to parent and vice versa 5. Cash concentration systems- permit a higher return on excess funds that would be possible if

each subsidiary maintained a separate business accounts 6. Human resources department in parent only II. REVERSE PIERCING A. either a corporate insider or a person with a claim against a corporate insider is attempting to have the insider and the corporate entity treated as a single person for some purpose B. reverse pierce should be permitted only in the most limited circumstances C. The Alter Ego Approach to reverse piercing 1. when the owners are using their own money, not the corporation to pay for things, then that shows disregard for the corporate form. 2. Consider whether they are also undercapitalizing themselves D. Pepper v. Litton: prima facie case for breach of fiduciary duty 1. case of self dealing because he was on both sides of the transaction here 2. its a prima facie case for violation of a fid duty when you enter into a transaction with your own corporation 3. unless you can prove that the transaction was in good faith and fair 4. if there is a shareholder in control of the corporation and it forces corporation to act in that shareholders interest, now were talking about breach of fiduciary duty E. deep rock doctrine The principle by which unfair or inequitable claims presented by controlling shareholders of bankrupt corporations may be subordinated to claims of general or trade creditors. 1. majority stockholder 2. involved in bankruptcy 3. fraud III. SUCCESSOR LIABILITY A. 14.02 Dissolution by Board of Directors and Shareholders 1. typically shareholders cannot dissolve their own corporation unless the board of directors recommends B. 14.05 Effect of Dissolution 1. continues corporate existence but can start winding up and dissolution, but its powers are limited to those of winding up C. 14.06-07 Claims Against Dissolved Corporation 1. provides finality (3 years after publication) after that you are out of luck 2. if assets have been distributed against a shareholdershareholder has to pay with respect to those assets but no more D. corporation dissolved wind up and liquidate known claims gathered and paid unknown guarded against by publication if claim brought within SOL maybe pursue shareholders to the extent that shareholders received assets E. Nissen Corp. V. Miller: corporation which acquires all or part of the assets of another corporation DOESNT ACQUIRE LIABILITIES AND THE DEBTS OF THE PREDECESOOR UNLESS 1. there is an express or implied agreement to assume the liabilities 2. the transaction amounts to a consolidation or merger (no real change in ownership, just a change in form) 3. the successor entity is a mere continuation or reincarnation of the predecessor entity (continuation of management/ownership v. continuation of operations; this is the most common reason) OR

11 4. the transaction was fraudulent, not made in good faith or made without sufficient corporation Note:This test is different from 14.06 and .07 because its about a corporation that modifies itself into a new corp while 14.06 and .07 are about KNOWN claims of a dissolved corporation. Claims that are not known are extinguished under .07. D. if youre not within the construct of 14.06 and .07, then the common law is the way to go to get liability

FINANCIAL MATTERS AND THE CORPORATION

I. DEBT AND EQUITY CAPITAL
A. D & E Capital are contracts between holder and the corporation (to figure out what kind of stock it

is, look at the contract between the corporation and the shareholder) B. Debt is generally thought of as a fixed claim 1. creditor is entitled to a fixed return a. interest is fixed, return is fixed 2. Examples: bonds and debt instruments a. Bonds are traded on many markets. When the corp is borrowing money without going to the bank as an intermediary, then it is selling bonds to the public (really just borrowing money from the public, selling is the misnomer) (1) Risky Bonds: when a bond is risky, then youll get a higher interest rate. Example: if GM sold a bond with a 5% interest rate, then you can purchase the bond for cheaper with a higher interest rate (yields go one way and prices go the other interest rate goes up and price goes down) b. The holder of a bond does NOT have any voting rights, but they are a FIXED claimant C. equity is thought of as a residual claim 1. residual claimants get whatever is left 2. in the event of liquidation, these claimants get whatever is left over 3. Example: stock

II. TYPES OF EQUITY SECURITIES

A. Shares Generally: MBCA 1.40(21) share means the unit into which the proprietary interest in a

corporation are divided 1. 2 types of distribution a. dividends come from earnings in profits b. liquidation B. Common and Preferred Shares 1. 6.01 Authorized Shares a. articles of incorporation must set forth any classes of shares and series of shares within a class, and the number of shares of each class and series 2. Common Shares, two fundamental rights under MBCA 6.01(b) a. (1) shareholders are entitled to vote for the election of directors and on other matters coming before the shareholders b. (2) shareholders are entitled to the net assts of the corporation (after making allowance for debts), when distributions are made in the form of dividends or liquidating distributions c. Also: (1) Have the fundamental rights of voting for directors and receiving the net assets of the corporation described above (2) Dividends upon profits (3) Negotiability

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(4) Ability to be pledged or hypothecated (5) Conferring of rights

(a) voting (b) Sue on behalf of corporation (c) Inspect book (d) Financial information (e) Residual owner (6) Capacity to increase in value 3. Preferred Shares a. Entitled to payment above the common shares b. Typically a fixed amount for distribution c. No right of preferred to force a payment d. Usually upon liquidation they have a right to be repaid their investment ahead of shareholders e. Has some of the features of a bond and some of stock f. No right to vote g. Convert preferred stock for common stock h. participating preferred after everyone in preferred gets paid they get shifted over to participate with common shareholders in the profits i. Preferred has first priority with respect to dividends might say $5 preferred or 5% preferred (of the par value so if the par value is 1,000, then its 5% of 1,000) ii. This must be distributed before there is a dividend on anyones common stock. 4. Par Value: currently useful when talking about preferred shares and bonds 5. Conversion: it is possible that at either the option of a shareholder or at the option of corporation, you could have the preferred shares convertible into common shares 6. Redemption Rights: all mutual finds are redeemable at the option of the shareholder at the fair market price 7. Dividend: 6.04 generally means out of profits C. Special Rights of Publicly Traded Preferred Shares 1. cumulative preferred dividend if a preferred dividend is not paid in any year, it accumulates and must be paid before any dividend may be paid on the common shares in a later year 2. noncumulative dividend not carried over from one year to the next, if no dividend is declared during the year, the preferred shareholder loses the right to receive the dividend for that year 3. partially cumulative dividend cumulative to the extent that there are earnings in the year, and noncumulative with respect to any excess dividend preference 4. Participating Preferred Preferred shareholders who get a specific dividend and then they are treated just like all the common shareholders (so they get their preferred dividend AND an additional dividend just like the common shareholders) 5. Convertible Preferred You can convert your Preferred stock into common stock 6. Redemption the corporation can buy back its stock (same as a dividend; Apply all the same rules that you apply to dividends) D. Classes of Common Shares 1. 6.01 shares of stock which together have 100% management rights and 100% distribution rights 2. Limits on drafting stock/share contracts a. articles of incorporation have to authorize the stock (usually authorize more shares than you are going to issue) b. issuance of new, previously unissued shares of stock (mergers and acquisitions) Consider: What kind of things should one consider when deciding what type of instrument best suits the client?

13 The Continuum of a Corporate distribution (debt paid first, equity last): Debt Cumulative P.S. P.S. Convertible P.S. Equity

III.

ISSUANCE OF SHARES: HEREIN SUBSCRIPTIONS, PAR VALUE, AND WATERED STOCK A. Share subscriptions and agreements to purchase securities 1. par value provided some protection in the past for discreet group of interested parties (creditors)if a creditor knew what par value of stock was and knew how many subscribers then the creditor knew how much money had been contributed to corporation to pay debt B. Par Value and Stated Capital 1. Par lowest price at which the corporation will sell its stock to could accept for its issuance of stock to investors. Just the issuance of the share .only about the minimum price the corporation a. Par is mostly an antique common stock is NOT required to have par, but preferred usually is. b. if the market is lower than the par value price, then youre not going to be able to sell a single stock from the corporation for the par value 2. Stated Capital not on a per share basis, states now enforce stated capital a. to protect creditors this is the amount they know cannot be traded out (1) a number at the beginning they decide to set aside 3. Hanewald v. Bryans Inc: a shareholder loan is a debt of the corporation, not an asset. Where a loan was repaid by the corporation to the shareholders before its operations were abandoned, the loan cannot be considered capital contribution a. what do we do on distribution of the shares of stock in exchange for value of some kind? 6.21 Issuance of Shares a. stock has to be exchange for consideration b. if it is transferred without consideration, promoter will be held personally liable for breach of duty of care c. can authorize shares to be issued for tangibles or intangibles (including cash, promissory notes, services performed, contracts for services to be performed, or other securities) (i.e. Notes on 6.21: Issuance of Shares (a) and (b) 1. (b) is different from Ohio because ohio says no notes or services to be performed 2. (c) you cant go after the other shareholders, but you can go after the directors a. 8.30 = standards of conduct for directors; 8.31 = when must they pay 3. (d) nothing you can do 4. (e) describes a possible escrow for payments of the shares of stock 6.22 Liability of Shareholder (limited liability implied in this section) a. no shareholder liability to corporation or its creditors with respect to the shares except to pay the consideration for which the shares were authorized b. not personally liable unless agreed upon **This is just about transactions between the corp and the shareholder Surplus = total capital (all your assets minus the liabilities) minus stated capital Leverage the difference between the interest rate and the rate of return you are getting B. Eligible and Ineligible Consideration for Shares 1. 6.21 Issuance of Shares

14 a. board of directors may authorize shares to be issued for consideration consisting of any tangible or intangible property or benefits to the corporation including (1) cash (2) promissory notes (3) services performed (4) ks for services to be performed (5) other securities b. corp may place in escrow shares issued for a K for future services (1) so that both parties are secure in their K rights 2. there are 2 possibilities in requiring that stock be exchanged for actual receipt of certain kinds of property or services (1) protect creditors who may rely on capital to extend credit (2) may protect other investors 3. Preemptive rights Want to protect your voting interest and your economic interest a. can I as a shareholder preempt the issuance of new shares from the corporation to a new shareholder. Solely about shares coming out of the corporation C. Terms: 1. Par value min rate that the corporation may sell its shares of stock for 2. Book value liquidation value 3. Market value what it can be sold for on the open market a. difference between book value and fair market value = goodwill D. 6.30: Shareholders preemptive rights 1. (b)(3) list of where there are NO preemptive rights, even if you include it in your articles of incorporation as a preemptive right II. DEBT FINANCING A. advantages leverage, interest payments deductible to corporation, debt is protected against liability of the corporation B. debenture = usecured corporate obligation C. bond = secured by a lien or mortgage on corporate property D. registered bond = one that has been registered in the name of a specific individual and from which the coupons have been removed, interest is paid directly to the registered owner by check E. zero coupon bonds = pay no interest at all, they sell at a substantial discount from face value and upon maturity the holder receives face value F. junk bonds = simply below investment grade debt instruments G. debt equity ration amount of debt over the amount equity that you have.used to determine how thinly capitalized a corporation isif thinly capitalized is bad, high ratio is bad 1. outside debt ratio owed to people other than shareholders 2. inside debt ration owed to shareholders III. PLANNING THE CAPITAL STRUCTURE FOR THE CLOSELY HELD CORPORATION A. Usually the capital structure will be an integral part of broader control consideration in which individual participants attempt to ensure their continued right to participate in the venture and the attorney reviews the entire package as a single unit B. Concerns for attorneys 1. will structure produce desired result 2. unexpected liabilities? IV. ISSUANCE OF SHARES BY A GOING CONCERN: PREEMPTIVE RIGHTS, DILUTION AND RECAPITALIZATIONS A. Preemptive rights Want to protect your voting interest and your economic interest

15
1. I: can I as a shareholder preempt the issuance of new shares from the corporation to a new

B. C. D. E.

F.

G.

H.

I.

shareholder. Solely about shares coming out of the corporation. 2. preemptive rights & fiduciary duty of the shares being sold by the corporation, original shareholders have the right to buy proportionate shares at the offering price a. original shareholders do not have to buy but they always have that option b. preemptive rights always allow shareholders to maintain their proportionate amount of stock c. IF you can show that the Board is offering shares at lower price than is actually valued, you have a cause of action against the Board for authorizing that sale Book value = reflects what is on the books and records, however, book value often refers to liquidation value as well Par value min rate that the corporation may sell its shares of stock for Market value what it can be sold for on the open market 1. difference between book value and fair market value goodwill Dilution Example 1. There are $40 in cash inside the corporation a. A and B bought 20 shares each at $1/share 2. Person C buys 20 shares at .50/share a. Therefore, there are $50 in the corporation and each A, B, C have 1/3 of the voting rights (1) This deletes A and Bs voting rights and their economic interest (a) A and B will only get $16.67 instead of $20 if the corp is liquidated Stokes v. Continental Trust: stockholder has an inherent right to a proportionate share of new stock issued for money only, while he can waive that right, he cannot be deprived of it without his consent except when the stock is issued at a fixed price not less than par and he is given the right to take at that price in proportion to his holding, or in some other equitable way that will enable him to protect his interest by acting on his own judgment and using his own resources 1. 6.30 Shareholders Preemptive Rights a. have to have authorized preemptive rights in your articles of incorporation b. b)(3) list of where there is NO preemptive rights, even if you include it in your articles of incorporation as a preemptive right: (1) shares issued as compensation to directors, officers, etc (2) shares issued to satisfy conversion or option rights created to provide compensation (3) shares authorized in articles of incorporation that were issued within 6 months from the infective date of corporation 2. OH opt. outpresumption is that there are preemptive right Katzowitz v. Sidler: freeze out must be a valid business reason for selling stock at a dramatically cheaper than its value, the price in some way must be beneficial to the corporation 1. There will be fiduciary duties for directors when they act contrary to the interests of the shareholders. Directors also always have fiduciary duties to the corporation. a. Requirement to show that there IS NOT a breach of fiduciary duty must show that there is a valid business reason for the act Another type of freeze out insider shareholders pay for their additional shares by canceling debts owed to them by the corporation while outside shareholders are put to the painful choice of investing fresh capital over which they lose effective control or see their proportionate interest decline drastically Lacos Land v. Arden Group: when a shareholder is acting in capacity as a director there is a fiduciary duty, he is more than just a shareholder and should act in the best interest of the corporation

16 1. The director wants to guarantee his ability to control the corporation by changing his class A into class B stock. So, the director was basically acting in his own interest instead of in the best interest of the company V. DISTRIBUTIONS BY A CLOSELY HELD CORPORATION A. 1.40 (6) distribution means a direct or indirect transfer of money or other property (except its own shares) or incurrence of indebtedness by a corporation to or for the benefit of its shareholders in respect of any of its shares 1. Dividends can only come out of profits or earnings of a corporation 2. may be in the form of a declaration or payment of a dividend, purchase, redemption, or other acquisition of sharesa distribution of indebtedness or otherwise 3. Note: a company transferring its own shares is NOT a distribution and these rules dont apply. If its distributing its own shares its not really distributing anything of value . . . so its not really a distribution . . . its more of a bookkeeping thing B. 6.40 = rules for distribution. There is a two part test in section 6.40(c)
No distribution may be made if, after giving it effect:

1. the corporation would not be able to pay its debts as they become due in the usual course of

business; OR
2. If after the distribution the liabilities would be larger than the corporations assets (surplus =

C. D.

E.

F.

excess of assets over liabilities plus stated capital) a. So, consider what is included in stated capital 6.40(b) rules for when a board of directors does not fix a date for distribution to shareholders (i.e. the order of who gets paid when) Gottfried v. Gottfried: if an adequate corporate surplus is available for the purpose, directors may not withhold the declaration of dividends in bad faith. The mere existence of an adequate corporate surplus is not sufficient to invoke a court action to compel such a dividend 1. This case is about proportional redemption. There is a complaint because dividends are not being issued on specific shares. 2. I: whether the court can compel the corporation to distribute shares a. Generally courts will NOT force dividends. HOWEVER, if you can show that one group of shareholders benefit more greatly than other shareholders then youre on the path. The trouble is that shareholders have different strategies for investment and are looking for different things OUT of their investment. I either want cash (dividends) or growth. 3. Claim is that directors are acting in their own interest: a. the essential test of bad faith is to determine whether policy of directors is dictated by their personal interest rather than the corporate welfare. EARMARKS OF BAD FAITH 1. intense hostility of the controlling faction against minority 2. exclusion of the minority from employment by the corporation 3. high salaries, or bonuses or corporate loans made to officers in control a. measure against similarly situated employees in the industry b. whether IRS allows deduction as a reasonable salary c. how the salary is geared towards services rendered d. how the salary compares to others paid by this employer 4. fact that the majority group may be subject to high personal income taxes if substantial dividends are paid 5. existence of a desire by the controlling directors to acquire the minority stock interests as cheaply as possible Dodge v. Ford Motor Co: in extreme cases, courts will look behind the economics of a corporation to decide whether there should be distributions

17 G. Wilderman v. Wilderman: I: has a payment been designated as salary which is in fact a disguised dividend. If its a dividend, its income is not reduced. (note: dividends are NOT deductible) 1. Fiduciary duty analysis: a. duty to act in good faith b. prima facie case for breach of fiduciary duty where one person is on both sides of the corporation. Here, acting on one had to decide what an individuals salary will be and on the other had as the person receiving the salary (1) the burden then shifts on the other party to show that the salary was fair and reasonable (2) factors to determine if a salary is reasonable: (a) whether the salary bears a reasonable relation to the success of the corporation (b) the amount previously received as salary (c) whether increases in salary are geared to increases in the value of services rendered (d) the amount of the challenged salary compared to other salaries paid by the employer (3) remedy must pay salary and pension back to corporation H. Unincorporated Businesses and Closely Held Corporations 1. Donahue v. Rodd Electrotype: We deem a close corporation to be typified by: a. small number of stockholders (max = 75) b. no ready market for the corporation stock (1) not publicly traded on any market (2) because of this, when the corporation provides a market in the sense that they allow one stockholder to have his shares purchased by the corporation, then it should provide that market to the rest of the stockholders c. substantial majority stockholder participation in the management, direction and operations of the corporation (this is about freeze ups how do we handle the disruption that occurs when we cant get along anymore. Need a mechanism that allows us to pull our cash from the venture) 2. 6.30 Treasury Shares a. subject to preemption b. authorized and issued but repurchased by corporation 3. 7.32 Shareholder Agreements a. it is possible to eliminate board of directors, BUT those who end up with the power end up with the fiduciary duty 4. PARTNERSHIP STANDARD stockholders in a close corporation must discharge their management and stockholder responsibilities in conformity with this strict good faith standard 5. If the stockholder whose shares were purchased with a member of the controlling group, the controlling stockholders must cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price. When shareholders have been substituted for directorsgo to 7.32 I. Legal Restrictions on Distributions 1. OH surplus is the stated value of the corporation vs. the fair market value 2. 6.40 Distributions to Shareholders a. equity insolvency test no distributions may be made if the corporation wouldnt be able to pay its debts as they become due 3. 8.30 Standards of Conduct for Directors

18 a. allows Board to rely on advice of accountants, attorneys, or other in making their decisions (1) duty generally requires more than passive listening, it requires some level of understanding through questioning in determining whether an equity insolvency test was satisfied (a) director should ask questions about whether the corporation will be able to pay debts as they become due (i) income sources (ii) trends (iii) funds to satisfy existing obligations (iv)can big debt be refinanced b. 6.40 (c)(2) balance sheet test add up assets and liabilities and if there are more liabilities than assets then there is no distribution

MANAGEMENT AND CONTROL OF THE CORPORATION

I. TRADITIONAL ROLES OF SHAREHOLDERS & DIRECTORS
A. The cornerstone: Rule of Corporate Management 8.01 Requirements for Duties of Board of

B. C. D.

E.

F.

G.

Directors 1. in general, each corporation must have a board of directors a. (a) 7.32 is the exception and were going to get into cases that explain that exception 2. (b) offers the key to authorization 3. all corporate powers shall be exercised by or under the authority of and the business and affairs of the corporation managed by or under the direction of the board of directors 4. vast majority of corporations, this is the model but closely held corporations get a choice 5. 7.32 a. may eliminate board b. shareholders cannot agree who can be an OFFICER of the corporation, but they can agree and vote for who they want to be DIRECTORS OH requires that you have at least 3 unless you have fewer shareholders See also comments to 8.03 McQuade v. Stoneham: generally shareholders cannot bind directors, stockholders may not, by agreement among themselves control the directors in the exercise of the judgment vested in them by the virtue of their office to elect officers and fix salaries 1. shareholders may make agreements between themselves to elect directors, but cannot make agreements to bind directors 2. directors cannot be tied to a master other than the corporation. They must act in the best interest of the corporation. 8.08 Removal of Directors by Shareholders 1. shareholders may remove one or more directors with or without cause unless the articles of incorporation provide that the directors may be removed only by cause 8.09 Removal of Directors by Judicial Proceeding 1. court may remove director if court finds director is engaged in fraudulent conduct or intentionally inflicted harm Galler v. Galler: if for some reason you dont fall within 7.32 and you cannot use it as a shield, some states have special close corporation statutes 1. You cannot exchange corporate assets for insufficient value. You cannot waste corporate assets. Must show it is an ordinary and necessary business expense! Must have a business reason for the transfer, or the transfer will fail.

19
2. Duration 10 years is the 7.32 limit. H. Zion v. Kurtz: when all of the stockholders of a corporation agree that, except as specified in their

agreement, no business or activities of the corporation shall be conducted without the consent of a minority stockholder, the agreement is, as between the original parties to it, enforceable even though all formal steps required by the statute have not been taken. 1. should sustain agreements made by all shareholders dealing with matters normally within the province of directors even though all the shareholders could have but had not provided similarly by charter or by law provision sanctioned by statute I. Matter of Auer v. Dressel: shareholders may remove director unless articles of incorporation provides otherwisestockholders cannot force a meeting if the board cannot legally do what the meeting is calling for, there must be some legal purpose for meeting 1. If its allowed in their articles of incorporation, then shareholders can remove a director without cause. If there is a director who has violated a duty of care or a duty of loyalty, then cause for removal exists. a. Standard by which directors can be removed: MBCA 8.08 (internally), 8.09 (externally) b. Shareholders meetings: 7.01; 7.02-.05 = notification requirements for mtgs c. Note: Shareholders cannot elect officers II. SHAREHOLDER VOTING AND AGREEMENTS A. 7.22 Proxies 1. proxy, n. 1. One who is authorized to act as a substitute for another; esp., in corporate law, a person who is authorized to vote another's stock shares 2. shareholder may vote his shares in person or by proxy 3. beneficial owner person who actually paid, recognized by corporation as shareholder 4. irrevocable if coupled with an interest i.e., if you paid consideration for your proxy (see next case). Basic agency principals apply here. B. Salgo v. Matthews: I: Who between these two gets to vote and who should be entitled to vote? the record owner was a person different from the beneficial owner and the court held that the corporation must determine who had been authorized to vote the shares by the record owner. 1. Beneficial owner the one with equitable title to the stock a. The one for whom the stock is held b. This is what you get the proxy under 2. Registered owner the person written on the books 3. the beneficial owner can compel the record owner to execute a proxy appointment in the name of the beneficial owner so that the owner may vote the shares as he or she desires 4. If you are the beneficial owner, then what are your protections? You can demand a transfer on the books and become the registered owner. Or you can get a proxy from the registered owner. (7.22 = proxies) C. 7.07 Record Dates come up in two important cases 1. voting whoever owns shares on a particular date will be the shareholder of record to vote 2. dividends distribute dividends to whoever owns the shares on a particular date D. trading stock ex-dividend this means that it is traded after the dividend date but before the dividend is issued E. 7.25 Quorum and Voting Requirements for Voting Groups 1. quorum typically this is the majority of shares needed to vote on a particular matter 2. shares entitled to vote as a separate voting group may take action on a matter at a meeting only if a quorum of those shares exist with respect to that matter 3. if a quorum exists, action on a matter by a voting group is approved if the votes cast within the voting group favoring the action exceed the votes cast opposing the action, unless the articles of incorporation or the Act require a greater number of affirmative vote

20
F. Cumulative v. Straight Voting 1. 7.28 provides for cumulative voting must opt in to have cumulative voting a. unless otherwise provided in the articles of incorporation, directors are elected by a

2. 3. 4.

5.

6.

7.

plurality of the votes cast by the shares entitled to vote in the election at a meeting at which quorum is present OH is an opt out when it comes to cumulative voting Straight Voting you can cast as many votes as you have shares of stock for each director SPOT Cumulative Voting you may cast for each candidate as many shares of stock times the number of directors to be elected a. Cumulative voting guarantees the minority a certain number as long as they vote correctly (1) Its about collecting all of the votes and allocating them among the candidates to achieve the results you want b. A has 51 shares, B has 495 positions open c. Number of shares needed to elect given number of directors = (total number of voting shares at the meeting x number of directors YOU want to elect) / (number of total directors to be elected + 1) + one d. (100 xs 3 / 5+1) +1 = 51 A will put 51 shares down for three directors Example of how this all plays out a. there are 100 shares, with 3 directors (1) Two factions one with 34 and one with 66 (a) Faction A puts forward a slate of 3 directors and faction B puts forward a slate with 3 directors (b) IF we have straight voting, then B will always have 66 and A will always have 34, so B will win every time (2) What changes with cumulative voting? (a) A actually has 102 votes total (34 x 3 (which is the number of directors) (b) B actually has 198 total votes (66 x 3) (c) So, if A puts all of its votes in ONE director, then A will get to elect at least one of the 3 directors (i) The TOP vote getters are the ones that prevail, so if there are 6 people up for director, A can put 102 votes in person H, and then B can divvy up his votes to pick the other two Example of how this plays out when youre trying to figure out how many shares you need to get X number of directors a. How many shares of stock of 100 do you have to have in order to guarantee at least 3 of the 5 directors (pg 450) (1) Use the formula . . . (S / (D+1)) + 1 . . . to determine the number of shares needed to elect one director (a) S = the number of VOTING shares (not outstanding) (b) D = the number of directors to be elected (2) Where S equals the total number of shares voting, and D equals the number of directors to be elected. The formula to elect n directors is: (nS / (D+1)) +1 (a) ((3x100) / (5+1)) + 1 Example: How can you maximize the number of directors your client can elect? a. Example: 10,000 shares, 9,000 outstanding, 11 directors to be elected b. Your client has 2700 shares

21
c. Use the bottom formula: (n x 9000) / (11 + 1) = 2700 (1) Answer is 3.599 so the most you can elect is 3 directors. How can you get

to 4? Plug in 4 for n and you can find out how many shares you need to get 4 directors d. Not only do you need to know how many shares you have to have, but also how youre going to vote those shares (1) Figure out how many votes of stock you have (2) Then figure out how youre going to vote it 8. Note: When there is a deadlock (usually happens when each side has 50% of the voting power), then the MBA says the person who is in office, stays in office until a new director is voted in 9. Humphrys v. Winous Co: in order to assure minority representation on a corporate board of directors by permitting cumulative voting a. In states where the right to vote cumulatively is permissive rather than mandatory, the charters of certain corporations have been amended to replace cumulative voting with straight voting b. The affect of cumulative voting can be diminished by breaking directors into classifications c. In ohio, the minimum number of directors is three unless there are less shareholders (so if there is only one shareholder, than you only have to have one director)

III.

SHAREHOLDER VOTING AGREEMENTS A. 7.30 and .31 talk about voting agreements and voting trusts 1. Voting trusts have more safeguards in it B. 7.30 Voting Trusts 1. voting trust involves a third party trustee a. transfer legal title to trustee and retain beneficial title in beneficiaries to the trust, here the beneficial owners of the stock b. more concern with respect to voting trusts than voting agreements because you are separating out interest here and you arent in agreements, voting rights are being separated (1) result is7.30 2. with voting trusts you must have: a. list of beneficial owners b. deliver copy of list and agreement to corporation c. cant last more than 10 years 3. Prima Facie case for Breach of Fiduciary DUTY: a. What is it that the trustee owns or has an interest in? b. How is this decision going to affect their ownership or interest in whatever you say in (a)? 4. Should the Transaction Stand? a. Is it fair to the interested party (those with a beneficial interest)? b. Burden of proof rests with the fiduciary duty against whom the prima facie case was established (1) Burden: to establish overall fairness of the transaction- if all the preferred shareholders knew and agreed, this is a defense to a claim for breach 5. control device C. 7.31 Voting Agreements 1. 2 or more shareholders may provide for the manner in which they vote their shares by agreement and arent subject to the provisions in 7.30

22
2. not as difficult to create and agreement under 7.31 3. not subject to a ten year agreement 4. doesnt actually transfer voting rights D. Ringling Bros v. Ringling: The votes in this case were cast contrary to the terms of the agreement 1. shareholder may exercise wide liberality of judgment in the matter of voting and it is not

E.

F.

G.

H. I.

objectionable, that his motives may be for personal profit, or determined by whims so long as he violates no duty owed to his fellow shareholders 2. ownership of voting stock imposes no legal duty to vote at all 3. may vote their respective shares so as to obtain advantages of concerted action 4. may lawfully K with each other to vote in the future in such a way as they, or a majority of their group from time to time determine 5. What is the remedy for NOT FOLLOWING a voting agreement? a. Specific performance b. These votes were wrongfully cast c. Under the MBA, the result would be different, they would be cast according to how the arbitrator said Brown v. McLanahan: cannot favor one class at the expense of another such an exercise of power is in derogation of the trust and may not be upheld, even though the thing done be within the scope of the powers granted to the trustees in general terms 1. Prima Facie Case for Breach of Fiduciary Duty a. What is it that the trustee owns or has an interest in (1) Once we know that the trustee is acting on both sides of the transaction, then the trustee must show that he was acting for the benefit of the organization b. How is this decision going to effect their ownership or interest in whatever you say in (a). In deciding whether to allow the transaction to stand 1. Is it fair to the interested party (the beneficial interest) in this trust? 2. Burden Of Proof is with the fiduciary against whom we have established a prima facie case a. Generally burden is to establish the overall fairness of the transaction b. If all of the preferred shareholders knew and agreed, this would be a defense to a claim for a breach of fiduciary duty 3. after establishment of prima facie claim for breach of loyalty a. this doesnt mean that they are automatically liable if they can show that it was fair to the trust Lehrman v. Cohen 1. criteria of a voting trust a. the voting rights of the stock are separated from the other attributes of ownership b. the voting rights granted are intended to be irrevocable for a definite period of time AND c. the principal purpose of the grant of voting rights is to acquire voting control of the corporation 2. Purpose of the voting statute: to avoid secret, uncontrolled combination of stockholders formed to acquire voting control of the corporation to the possible detriment of nonparticipating shareholders 3. Must find the evils of a voting trust in order to prevent a corp from having voting stock. Otherwise, voting stock is allowed. Tenure voting having different voting rights depending on how long you have owned the stock 6.27 Restriction on Transfer or Registration 1. may restrict transferability, must

23 a. note conspicuously on front or back of certificate or contained in notice if no certificate b. unless so noted, it isnt enforceable against person without knowledge but is enforceable against person with knowledge 2. Restriction is authorized to a. Maintain corporations status when it is dependent on number or identity of shareholders b. To preserve exemptions under federal or state securities laws c. For any other reasonable purpose J. Ling v. Trinity Savings and Loan Assn: corporation may impose restrictions on the transfer of its stock if they are expressly set forth on the articles of incorporation and copied at length or in summary form on the face of each certificate, the articles of incorporation by reference on the face or back of the certificate of the provision of the articles of incorporation which restricts the transfer of stock K. Retirement or Death of Shareholder 1. without running through the estate a. purchase stock by the corporation avoid estate tax L. Two Primary Possibilities for Getting Out of Corporation 1. cross purchase a. shareholder to shareholder 2. redemption a. from shareholder to corporation 3. determining value if you have either (1) or (2) a. appraisal (trigger which when pulled allows for an appraisal (1) possible triggers (a) owner or shareholder becomes disabled (b) married owners or shareholders divorce (c) minority owner is fired (d) owner faces personal bankruptcy or (e) an owner is convicted of a crime or involved in a scandal b. arbitrary price (1) can have this move up and down with the consumer price index or any other escalator clause

IV. DEADLOCKS
A. Gearig v. Kelly: dont want to allow a director to refuse to attend meetings, knowing that thereafter

an associated stockholder could frustrate corporate action until all their demands were met 1. One class of stock, 4 directors, and 2 factions equally divided lead to this problem. a. Straight voting was used here B. 8.10(a) Vacancy on Board 1. if a vacancy occurs on board, if the directors remaining in office constitute fewer than a quorum of the board, they may fill the vacancy by the affirmative vote of the majority of directors 2. board of directors may fill it C. 8.05 Terms of Directors Generally 1. (e) despite the expiration of a directors term, he continues to serve until his successor is elected and qualifies or until there is a decrease in the number of directors D. In re Radom & Neirdorff: there is law that allows dissolution, but it doesnt mandate that the court order dissolution 1. Courts are reluctant to dissolve and will do so only as a last resort a. What measure will be taken short of dissolution?

24
(1) 14.34 election to purchase in lieu of dissolution (see next case) E. 14.30 Grounds for Judicial Dissolution 1. irreparable injury being suffered OR 2. the business cannot be conducted to the advantage of shareholders (i.e. deadlock) OR 3. assets being misapplied or wasted assets of the corporation going out for insufficient value F. 14.01 Dissolution by Incorporators or Initial Directors 1. majority of original incorporators before any shares have bin issued may file with the sec of

state an articles of dissolution

G. 14.02 Dissolution by Board of Directors and Shareholders 1. in order for a voluntary dissolution you must have action by the board of directors a. propose dissolution for submission to the shareholders OR b. have to agree that they cant make a decision on it b/c there may be a breach of a

fiduciary duty 2. vote by shareholders approving the proposal for dissolution H. 14.20 Grounds for Administrative Dissolution 1. secretary of state can file to administratively dissolve a corporation V. MODERN REMEDIES FOR OPPRESSION, DISSENTION OR DEADLOCK A. Davis v. Sheerin: 1. oppressive conduct = a. burdensome, harsh and wrongful conduct b. lack of probity and fair dealing in the affairs of a company to the prejudice of some of its members c. visible departure from the standards of fair dealing d. violation of fair play on which every shareholder who entrusts his money to a company is entitled to rely e. word oppressive does not carry an essential inference of imminent disaster, it can contemplate a continues course of conduct 2. Buyouts: a. Buyouts are favored by courts over dissolution b. Equitable powers of the court are sufficient to extend to a buyout 3. 14.32: judicial dissolution brought by a shareholder a. if a shareholder steps up and brings an action for dissolution then maybe one or more of the remaining shareholders can elect to purchase all the shares owned by that complaining shareholder b. makes it a high risk proposition for the petitioning shareholders 4. Abreu v. Unica Indus. Sales, Inc a. Claim is that the provisional director selected by the court is not impartial b. What is the test for whether Vega can be appointed? (1) Court is to consider only the best interests of the corporation, and not the warring factions. So its not surprising when the court appoints someone who knows the corporation, who might be on one side or the other. (2) Factors in evaluating candidates for provision director include: (a) Degree and quality of past involvement in the corporation (b) An understanding of the corporations history and current situation (c) Experience and abilities in providing a cooperative and unifying element (d) Need for immediate appointment (e) Degree of impartiality (f) A true interest in the viability and advancement of the corporation as an entity and not allegiance to one of the deadlocked factions

25
c. You can have a provisional director to BREAK deadlocks and the director does not

have to be neutral (can have allegiance to one side or the other), but that doesnt matter because the director has fiduciary duties to the company. (1) This is another way to break a deadlock.

VI. ACTION BY DIRECTORS AND OFFICERS

A. In the Matter of Drive-In Development: Subsidiary guaranteeing the debt of its parent 1. statements made by an officer or agent in the course of a transaction in which the corporation

is engaged and which are within the scope of his authority are binding upon the corporation
2. apply the usual agency principals here (i.e. apparent, estoppel, etc) B. Black v. Harrison Homes: board of directors may 1. expressly authorize the president to enter into contracts OR 2. his authority to contract may arise from having assumed and exercised that power in the past

(apparent authority)
3. OR a corporation may ratify the presidents contract to enter into contracts C. 8.20 Meetings 1. BOD may hold regular or special meetings in or out of the sate 2. may permit any or all directors to participate by any means of communications unless

otherwise provided in articles of incorporation D. 8.21 Action Without Meeting 1. As a general rule, no action without meetings UNLESS there has been written consent by ALL of the members of the BOD a. Notes: If you want to take action, then you must have unanimous agreement in the absence of a meeting. In the absence of a unanimous agreement, then we still want debate. Generally, actions taken at meetings. In order to have a meeting, you must have a quorum (can use electronic transmissions). If you go without a meeting, then you must have unanimous agreement of the board of directors. E. Lee v. Jenkins Bros: Issue of whether there was actual authority to give Lee the pension he was promised in 1920, when he started working for Jenkins Bros. Generally settled that the president as a part of the regular course of business has authority to hire and discharge employees and fix their compensation, the president only has authority to bind his company by acts arising in the usual and regular course of business but not for contracts of extraordinary nature 1. Court uses an apparent authority analysis. 2. MBCA 8.01(b) directors have corporate authority 3. MBCA 8.20 talks about meetings: this is an important provisions because the system contemplates that there will be a debate about all corporate assets F. Apparent authority is a question of fact 1. First as if there is actual authority? 2. Is there apparent authority? a. what is the nature of the K involved? b. who is the officer negotiating it? c. corporations usual manner of conducting business d. the size of the corporation and the number of stockholders? (1) Scale matterswhat is the size of the obligation compared to the assets of the corporation? Small impact more likely to find apparent authority e. reasonableness of the K? f. amounts involved? 3. Estoppel argument? a. If K party has certified copy of a resolution UNLESS K party had actual knowledge that there was no authority

26
4. Did corporation ratify? a. Would normal corporation would have objected to this? 5. Looks at the reasonable expectations of a 3rd party to determine how to apply the restatement

analysis G. Transactions in Controlling Shares 1. DeBaun v. First Western Bank and Trust Co. a. General Rule: no duties with respect to shareholders as to whom youre going to sell stock to so what is the trigger when there IS a duty on the part of a shareholder? (1) In any transaction where the control of the corporation is material, the controlling majority shareholder must exercise good faith and fairness from the viewpoint of the corporation and those interested therein (a) Control is important (b) When control is material to the transaction, then the controlling shareholder must exercise good faith and fairness. (c) Damages are to get everyone back to where they were before (2) This does NOT apply to 99.9% of the cases b. Leverage Buyout (LBO) I will borrow from the seller and I will pay back from my management of the corporation. Nothing wrong with paying off the buyout from the dividends of the corporation. c. Things NOT to do in order to avoid wrongful conduct (1) Divert cash to yourself and another one of your corps (a) Divert = STOLE. Cash went one way, non-interest bearing promissory note went the other way (b) If he would have distributed a dividend, there wouldnt have been anything wrong, other than a bad business judgment (2) Cease paying creditors promptly (3) Take payments of employees health insurance 2. Petition of Caplan: Rule the management of a corporation is NOT subject to trade and cannot be bought apart from actual stock control. You cannot sell seats on the board of directors. H. Review of management and control:
Chapter 8 = directors and Chapter 7 = shareholders Starting point: 8.01. You can have an exception to 8.01, if you follow the requirements of 7.32. 1. 8of =directors directors; Chapter 7 = shareholders Chapter 8.05 terms generally 8.08: Removal of directors by shareholders and whether there needs to be cause forto removal a. Starting point: 8.01. You can have an exception 8.01, if you fol 8.09 removal of directors in a judicial proceeding 8.33: Directors Liability for Unlawful distribution, then go to 6.40, so 6.40 and 8.33 require reference to each other 8.40 officers b. 8.05 terms of 7.07 record date for shareholders 8.08 speaks about removal and whether there needs to be cause 7.22c. proxies 7.23d. nominess 8.09 removal in a judicial proceeding 7.28 cumulative voting: Difference between cumulative voting and straight voting (1) Higher Unlawful 8.33, then go toto6.40, so 6.40 and 8 7.30 voting trusts: standarddistribution under this than voting agreements, need examine the agreement carefully to determine (2) which it is 7.31 voting agreements e. 7.31 voting agreements 6.27 - Restrictions on transfer f. dissolution 6.27 - Restrictions on transfer 14.30 (grounds for) 14.34 election to purchase in lieu of dissolution

27

THE COLLAPSE OF ENRON CORPORATION AND THE DECLINE IN TRUST

I. COLLAPSE OF ENRON
A. Enron wanted to become a virtual company and created special purpose entities B. Special purpose entities werent publicly held and the returns were never consolidated into Enrons

financial statements C. These SPEs lacked sufficient outside equity and had no other shareholders other than Enron II. SARBANES-OXLEY ACT A. Corporate Disclosure and CEO/CFO Certification 1. must report financial conditions to CEO and CFO must sign and put personal liability on the line, that way we have a person who is responsible a. business of SEC to maintain the integrity of the market b. must provide FULL disclosure of the facts to make best investing decisions B. Maintenance of Internal Controls for Monitoring 1. internal control report filed annually and methods to bring information C. Creation of a New Board to Oversee Accounting Firms that Audit Public Companies 1. must comply with rules as provided with the oversight board D. Audit Committees of Corporate Boards of Directors 1. in the past there was a requirement but now there must be independent member of the BOD to sit on the auditing committee, cant be directly tied to management of the company E. Executive Compensation, Loans to Executives and Disgorgement of Incentive-based Compensation 1. CEO and CFT must reimburse company F. Professional Standards for Attorney 1. attorneys who advise now personally liable for material that they fail to disclose III. The Securities and Exchange Act (SEA) A. Major Issue = Materiality Would a shareholder think the information important in deciding whether to buy to or sell? Materiality is important in deciding whether the information must be disclosed. B. 2 categories of corporations: 1. Large Corporations Those that are required to register under section 12 of the act a. The rules that apply to a registrant are those corporations that need to be registered in order for the rules to apply 2. All other corporations, regardless of whether they are required to register a. Other rules apply to any transaction in securities C. 10-K = a quarterly report how much room do directors have in speaking the truth and also guarding against misleading 1. Sometimes its not clear how a business transaction is going to play out, so we have to determine what needs to be disclosed

PROXY REGULATION
I. SCOPE OF REGULATION
A. 14(a): 1. elements in order to establish that a person has acted unlawfully a. person b. by use of the mails or by any means or instrumentality of interstate commerce or of

any facility of a national securities exchange or otherwise

c. in contravention of such rules and regs as the commission may prescribe as necessary

or appropriate in the public interest or for the protection of investors

28 d. to solicit or to permit the use of his name to solicit any proxy or consent or authorization e. in respect of any security f. registered pursuant to section 12 of this title B. 12(g)(1) (see page 1140 of the supp) 1. registration requirement a. every issuer b. engaged in interstate commerce or in a business affecting interstate commerce or whose securities are traded by use of the mails c. must register (1) 500 or more securities holders AND $10 million (increased the exemption from 1 million to 10 million) 2. 12g-4 (which is not in our code): de-registration if your business isnt doing so well and you have less than $10 mil in assets for 3 consecutive years and less than 500, then you can de-register a. most common way is to get fewer than 300 shareholders (1) reverse stock split, every shareholder that before had 5 shares they now have 1 new share (2) redemption of fractional share (3) this will rid of small shareholders C. Studebaker Corp v. Gittlin : statute forbids any person to solicit any proxy or consent or authorization in respect of any security therein specified in contravention of such rules and regs as the commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. 1. if information is distributed for the purpose of obtaining proxies, then at minimum you must include a. what the proxy is about b. how you intend to vote 2. Rule 14(a)-1(l)(l) (Pg 1269) a. The terms solicit and solicitation of proxies the request for a proxy whether or not accompanied by or included in a form proxy b. Broad definition of solicitation c. Solicitation all communications directed to shareholders that are reasonably calculated to effect a voting decision II. PROXY FORMS, PROXY STATEMENTS AND ANNUAL REPORTS A. Form of Proxy 14a-4 contains specific requirements as to the form of proxy documents 1. Purpose of the rule is to ensure that shareholders have the option to vote to approve or disapprove issues submitted to them, and to vote for or against the directors proposed by the persons soliciting the proxy, usually management. B. Proxy Statements 1. 14a-3 requires that a proxy solicitation be accompanied by a proxy statement containing the info set forth in Schedule 14A (pg. 1345) a. the type of information required depends to some extent on the type of issue to be presented to the shareholders for their vote 2. 14a-5 the information in the proxy must be clearly presented 3. 14a-6 proxy statements must be submitted for preliminary review by the commission only if out of the ordinary matters are to be considered 4. copies of the definitive documents must be filed with the SEC when they are distributed to shareholders C. Annual Reports

29 1. 14a-3 provides that if a solicitation is by management and relates to an annual meeting at which directors are to be elected; the solicitation must be accompanied by an annual report containing the financial information and other material described in the rule D. Managements Discussion of Financial Condition and Results of Operations 1. MD&A shall provide info that the registrant believes to be necessary to an understanding of its financial condition, changes in the financial condition and results of operation E. if you decline the opportunity to provide the proxy you can go vote the shares yourself F. if you decline the opportunity, the record holder may vote as it chooses G. Independent public accountants 1. What do you need to tell voting shareholder for them to be informed when you intend to ask the shareholders to vote on a new accounting firm? a. Info on the proxy statement must be clearly presented b. Managements discussion of financial condition and results of operation (1) Statements qualifying for the safe harbor cannot give rise to private liability if either of the two tests is met: (a) No private liability may be imposed if the forward-looking statements made without actual knowledge that the statements were false or misleading (b) No private liability may be imposed if the forward-looking statement is identified as such when made and is accompanied by meaningful cautionary language identifying important factors that could prevent the statement from becoming accurate H. Arbitrage: simultaneous buying and selling of the same negotiables or commodities in different markets in order to make an immediate riskless profit III. INFORMATION CONTAINED IN THE PROXY STATEMENTS A. 8-K: Important imformation that shareholders should know, such as the detrimental impact on the CEOs health, etc. B. 10-K (1247): annual statements by the corporation required by the SEC C. 10-Q (1253): quarterly statements by the corporation required by the SEC D. Regulation S-K (1381): forecasts/forward looking statements what management believes the companys future is requires disclosure of extraordinary circumstances, particularly any significant elements of income, from continued operations which do not arise from or are not necessarily representative of registrants business. Contains Item 303. E. In the Matter of Cat: I - Was there anything misleading about the 10-K published by Caterpillar? 1. The test for when disclosure is required: S-K Item 303 (1381) a. Start with 303(a) (1) 303(a)(3) talks about results of operations issue is how much detail is necessary? 303(a)(3)(i) b. Then, where a trend, demand, commitment, event, or uncertainty is known, management must make TWO assessments: (1) Likelihood and (2) Magnitude (1) The lower the level of certainty, the higher the level of materiality in order for you to take it into account. It goes the other way, too if there is a high level of certainty, but a low level of materiality, then it needs to be disclosed. 2. Forward Looking Statement projections of financial data, discussion of management objectives and goals for future performance, and the assumptions underlying such statements a. What if there is a Trend, Uncertainty or Ambiguity in a Cos Future? ASK: (1) Is the known trend, demand, commitment or uncertainty likely to come to fruition?

30 (a) if not reasonably likely (as determined by management) = no disclosure! (2) If the management cannot make that determination, it must evaluate objectively the consequences of the known trend, demand, commitment, event, or uncertainty on the assumption that it will come to fruition (a) Material = whether a reasonable investor would consider the information important in deciding whether to buy or sell. (Caterpillar) b. SAFE HARBOR: for Forward Looking Information: projections of financial data, discussion of management objectives and goals for future performance, and the assumptions underlying such statements: statements that qualify for the safe harbor cannot give rise to private liability if either of 2 tests is met. (1) no private liability may be imposed for forward looking statements made without actual knowledge that the statements were false or misleading (2) no private liability may be imposed if the forward-looking statement is identified as such when made and is accompanied by meaningful cautionary language identifying important factors that could prevent the statement from becoming accurate.

IV.FALSE OR MISLEADING STATEMENTS IN CONNECTION WITH PROXY STATEMENTS

14a-9 (SEA): A. no solicitation may be made by means of any proxy statement, form of proxy, notice of meeting or other communication, B. written or oral, C. containing any statement which, at the time and in light of circumstances under which it is made D. that is false or misleading 1. dont have to go all the way to a lie only need to show that it is misleading (even if they just left something out) E. with respect to any material fact (or which omits to state any material fact necessary in order to make the settlement therein not false or misleading or necessary to correct any statement in any earlier communication) 1. continuing obligation to avoid false or misleading statements 2. so something that was left in OR was left out was false or misleading F. with respect to the solicitation of a proxy for the same meeting or subject matter which has become false or misleading G. JI Case v. Borak: This case allows for a private cause of action under 14(a)!! If respondents can show by a preponderance of the evidence that the merger would have received a sufficient vote (even if the merger had not been misleading), then petitioners are not entitled to relief.
INJURY CAUSATION: show how the injury was caused by the false or misleading statement (1) Materiality. show that the statement was false/misleading THEN - intentional violation is sufficient but careless or negligent is not enoughrecklessness will likely be sufficient but the Supreme Court hasnt decided - the statement against materiality: this establishes causation if there is also an essential link SO (2) show that the proxy solicitation was an essential link THEN SHOW LOSS CAUSATION: In order to get monetary relief, then the shareholder must show how he/she was monetarily damaged as a result of the transaction. fairness might be used to show this FEDERAL CAUSE OF ACTION

H. TSC Industries Inc v. Northway: Omission of a statement in order to make other statements not

misleading

31 1. Definition of MATERIALITY there is a substantial likelihood that a reasonable share holder WOULD consider it (the fact) important in deciding how to vote a. it DOES NOT require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote. Objective Standard. b. must show that the fact would have assumed actual significance c. must also show that it would have significantly offered the total mix of information d. Reasonable shareholder = objective test 2. scienter standard = disclosing/non-disclosing party KNOWS the information to be false intentionally violates is sufficient. a. careless/negligent is NOT enough 3. Rule: SEC Proxy rules require that an omitted fact becomes a material fact when there is a substantial likelihiood that a reasonable shareholder/invester would consider it to be importantant in deciding how to cast their vote. This is a question of fact. I. Virginia Bankshares: 1. 8.31 Standard of Liability for Directors: necessary in order to bring an action for liability a. director not liable for any decision to take or not to take action UNLESS the party asserting liability in the proceeding establishes that . . . b. not precluded by 8.61, .62, .63 c. 8.61 Judicial Action (1) cannot bring an action for breach of fiduciary duty if there has been an action by shareholders with respect tot that action by the directors and that shareholder action complies with 8.63 d. 8.63 Shareholders Action (1) shareholders action respecting a transaction is effective for 8.61 purposes if a majority of the votes entitled to be cast by the holders of all qualified shares were cast in favor of the transaction 2. IF 8.31, 8.61, 8.63 can avoid liability if disinterested shareholders APPROVE the transaction 3. if there is a conflict of interest and that it disclosed to the shareholders and the shareholders who dont have conflicts of interest, dont count in terms of this analysis a. Directors might have solicited the proxies in order to insulate themselves from liabilities 4. 8.60 Conflicting Interest a. the interest of a director of the corporation has respecting a transaction effected or proposed to be effected by the corporation (or by a subsidiary of the corporation or any other entity in which the corporation has controlling itself if: (1) whether or not the transaction is brought before the board of directors of the corporation for action, the director knows at the time of commitment that he or a related person is a party to the transaction or has a beneficial financial interest in or is so closely linked to the transaction and of such financial significance to the director or a related person that the interest would reasonably be expected to exert an influence on the directors judgment (2) FIRST establish whether there is a prima facie case thru 8.60 (a) cant bring an action against the director for breach of fid duty if there has been an action by shareholders (b) PRIMA FACIE CASE FOR CONFLICT OF INTEREST : would reasonably be expected to exert an influence on the directors judgment if he were called upon to vote in the transaction

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5. Sue Facts: fact which is material to a sue decision. Sue decision is a decision by a

shareholder whether or not to institute a representative or derivative suit alleging a state law cause of action 6. Shame facts: facts which, had they been disclosed, would have shamed management into abandoning a proposed transaction 7. Short Form Merger: requires NO approval from the board of directors/shareholders of the subsidiary a. 13.02 Right to Appraisal*** (1) shareholder entitled to appraisal rights and to obtain payments of fair value of that shareholders shares in the event of any of the following action (a) consummation of a merger to which the corporation is a party if the corporation is a subsidiary and the merger is goverened by 11.04 (2) 13.21 Notice of Intent to Demand Payment (a) if proposed corporate action requiring appraisal rights under 13.02 is submitted to vote at a shareholders meeting, a shareholder who wishes to assert appraisal rights with respect to any class or series of shares (i) must deliver to the corporation before the vote is taken written notice of the shareholders intent to demand payment if the proposed action is effectuated AND (ii) must not vote (b) state law remedy for dissenting shareholders for a state law merger 8. 11.01: Merger of Corporations - Plan Requirements 9. 11.02: Acquisition of a corporations Shares by another corporation 10. 11.03/.04 voting requirements (see comments to these sections) a. 2/3 vote are needed J. Review 1. Three things that are actionable as a material fact: a. False in the sense that what they said isnt believable b. Misleading c. Omission 2. Test is actually: Need a false or misleading statement OR you need an omission which renders some material fact misleading and the solicitation of proxies was an essential link. a. Essential link in the accomplishment of the transaction 3. Just a claim that you didnt believe what he said is not enough, must also show that the subject of the opinion was also false. a. So, even if the statement is FALSE, it might not be material IF the statement gave enough information so that the opinion of someone might be material enough to come to your own conclusion b. So some statements are to unimportant to render a cause of action. 14(a) says false or misleading, but it also has to be material. 4. Opinons can be actionable because they are built on facts that is the takeawy from the Virginia Banks case.

SHAREHOLDER PROPOSALS
I. REGULATION 14a-8. SOLICITATION OF PROXIES
A. Proposal shareholder proposal is your recommendation or requirement that the company and/or its

board of directors take action which you intend to present at a meeting of the companys shareholders

33
B. Submission of Proposals Who is Eligible? 1. must have continuously held at least $2k in market value or 1% of the companys securities

C. D. E. F. G.

H.

I.

J. K.

L.

for at least one year by the date you submit the proposal and must continue to hold those securities thru the date of the meeting 2. if record holder company can verify eligibility but you must provide company with a written statemtn that you intend to continue to hold the securities thru the date of the meeting of the shareholders 3. if not a record holder must prove your eligibility No more than one proposal per shareholder meeting Not to exceed 500 words If you failed to follow eligibility or procedural requirements, the company may exclude after notifying you of the problem and you have failed to correct Company has the burden of persuading the commission or its staff that a proposal can be excluded Deadlines? 1. Company can establish deadlines 2. If not then default: a. 120 days be4 proxy is sent To present proposal, must appear thru 1. either you or your representative 2. via electronic media if company holds its shareholder meeting in whole or in part via electronic media 3. fail to appear the company excludes your proposal When can a corporation exclude a proposal even if everything has been properly complied with? 1. improper under state law (i.e. would this proposal be allowed under state law?) 2. violation of law 3. violation of proxy rules 4. personal grievance; special interest 5. relevance 6. absence of power/ authority 7. management function if the proposal deals w/ matters relating to the companys ordinary business operations 8. relates to election 9. conflicts with companys proposal cannot put up contrary proposal, you can always go up against it though 10. substantially implement 11. duplication 12. resubmissions 13. specific amounts of dividends if a company intends to exclude a proposal it must file reasons with the commission no later tan 80 days before it files its definitive proxy statement and form of proxy with commission shareholder must include, along w/ proposal 1. name 2. address 3. number of companys voting securities that you hold shareholder may send letter to commission explaining the reasons that there should be a proposal

M. Rauchman v. Mobil Corp: Proposal was to keep citizens of OPEC companies from sitting on the

Mobil board

34
1. no company is required to include any form of electioneering in its proxy statements 2. This is about relates to election and the proposal cannot relate to election of directors

COMMUNICATING WITH SHAREHOLDERS

I. REGULATION 14a-7. SOLICITATION OF PROXIES
A. if the registrant intends to make a proxy solicitation it must provide those who request information 1. Generally individuals dont have the kind of money necessary to circulate a proxy though

BUT 2. there is nothing to stop you from doing this

DISCLOSURE REQUIREMENTS
I. SELECTIVE DISCLOSURE
A. Regulation FD provides that a company disclosing material, non-public information to specified

types of securities market professionals (or shareholders under circumstances which it is reasonable foreseeable that the security holder will trade on the basis of the information) must thereafter publicly disclose the material 1. If disclosure is intentional, it must be made simultaneously, if unintentional, it must be made shortly thereafter. II. SARBANES-OXLEY A. created in response to corporate scandal- requires more accountability on the part of the officers and directors of corporation AND requires new rules for accounting.

DUTY OF CARE AND THE BUSINESS JUDGMENT RULE*** on exam

I. BUSINESS JUDGMENT RULE:
A. Not really a rule, more of a historical analysis that has led to most jurisdictions creating their own

statutes dealing with the creation of the duty of care

B. Statement of the Business Judgment Rule (pg. 120) 1. A director who makes a business judgment in good faith fulfills the duty of care standard if

the director a. Is not interested (as defined) in the subject of the business judgment (i.e., there is no pecuniary gain) b. Is informed with respect to the subject of the business judgment to the extent the director reasonably believes to be appropriate under the circumstances; and c. Rationally believes that the business judgment is in the best interest of the corporation. (1) Subjective AND objective standard director must actually believe that the business judgment is in the best interests of the corporation and that belief must be rational! 2. When do you apply BJR? a. Defense of a director b. Elements of a complaint for directorial liability c. If the can show fraud, illegality or conflict of interest then BJR wont apply, if director doesnt apply w/in safe harbor of 8.30 C. Difference b/t 8.30 and 8.31 1. 8.30 Conduct of Directors is more of a job description and doesnt deal directly with the liability of the directors [THIS IS THE MBCAs articulation of the BJR] a. it DOES play an important role in evaluating the directors conduct

35
b. compliance may have a direct bearing on the courts analysis where transaction

justification is at issue c. business decisions themselves are not to be evaluatedrather the standard of care is to be applied to the PROCESS by which the directors become informed in connection with making their decision d. provides standard to enjoin corporate action e. REASONABLE PERSON/OBJECTIVE Standard f. About when we will respect the directors decision and leave it alone as opposed to overturn it 2. 8.31 Liability for Directors is about director liability a. Used when you want a director to pay for his wrongful decision (if it is found wrongful in 8.30) b. SUBJECTIVE intentional recklessness standard c. Standard as to this rule: as to which director was not informed to the extent to which the DIRECTOR reasonably believed d. Tougher standard, higher level of culpability D. When a board decision is challenged, courts place the burden on the challenger to overcome the business judgment presumption by proving 1. Fraud, Illegality or Conflict of Interest a. Malone v. Brincat (Fraud): directors who knowingly disseminate false information that results in corporate injury or damage to an individual stockholder violate their fiduciary duty and may be held accountable in a manner appropriate in the circumstances. b. Gall v. Exxon (Illegality): in a decision of whether or not the corporation is going to bring an action (for paying illegal bribes to foreign officals) will be upheld unless it can be determined that the directors did not act (1) in good faith and (2) in a manner the director reasonably believes to be in the best interest of the corp. (1) created a Special litigation Committee: unless could show that the committees members were themselves interested or had not acted on an informed basis, the decision were entitled to full judicial deference under the BJR E. Lack of Rational Business Purpose (Waste): Litwin v. Allen: Rules to Be Applied in Determining the Liability of Directors 1. Fiduciary a. Directors are bound by those rules of conscientious fairness, morality, and honesty in purpose which the law imposes as the guides for those who are under the fiduciary obligations and responsibilities 2. Loyalty and allegiance to the company a. Duty of loyalty and allegiance to the company (1) Cannot profit at the expense of his corporation and in conflict with its rights (2) May not for personal gain divert unto himself the opportunities which in equity and fairness belong to his corporation (3) Act honestly and in good faith but that isnt enough (a) Must also exercise some degree of skill and prudence and diligence b. Should know of and give direction to the general affairs of the institution and its business policy and have a general knowledge of the manner in which the business is conducted, the character of the investments and the employment of the resources 3. Standard today mere negligence not enough. Need recklessness to have liability for directors. There are various standards here to determine what kind of liability is possible a. Directors are liable for negligence in the performance of their duties

36
(1) NOT liable for errors of judgment or for mistakes while acting with

reasonable skill and prudence (2) Same degree of fidelity and care as an ordinarily prudent man would exercise in the management of his own affairs of like magnitude and importance b. Factors to be considered (1) Facts and circumstances of particular case (2) Kind of corporation involved (3) Size and financial resources (4) Magnitude of the transaction (5) Immediacy of the problem presented 4. Directors of bank held to stricter accountability a. Director of bank shield to stricter accountability than the director of an ordinary business corporation BUT law recognizes that the most conservative director isnt infallible b. Must look at facts as they exist at the time of their occurrence not aided or enlightened by those who subsequently take place 5. reasonable belief under 8.31 a. in the rare case where a decision respecting the corporations best interest is so removed from a directors preparation to make an informed decision is so unreasonable as to fall outside the permissible bounds of sound discretion of directors judgment will not be sustained 6. DAMAGES: use 8.31 to get $ damages from the directors 7. Shlensky v. Wrigley: court wont interfere with the management of the directors unless it clearly appears that they are guilty of fraud or misappropriation of funds a. I: we want liability AND a different decision The court uses the SAME STANDARD for both claims. So liability and injunctions give rise to the same standard. b. What is the standard that the court applies: the action must at least boarder on fraud, illegality or conflict of interest. It could be something less, but it must at least border on these. c. Apply 8.30 if you want an injunction and not liability d. If Im interested in being a director, then 8.30 offers the standard of conduct (1) there are two different standards: the decisions making function (8.30(b)) and the oversight function (8.30(b)) so they make decisions and oversee others (2) how do I know what to do as a director? act in good faith (in 8.30) F. Derivative Action: suit asserted by a shareholder on the corporations behalf against a 3rd party because of the corporations failure to take action against the 3rd party. May the shareholder substitute himself for the corporation? Yes. MBC 7.42 (requires a written demand in ALL cases). G. Direct Action: brought by a shareholder alleging injury to his shares as a shareholder. H. Gross Negligence in Discharging Duties to Supervise or Becoming Informed 1. Ohio Standard intentional or reckless conduct 2. Smith v. VonGorkom: board was grossly negligent in obtaining the information necessary in order to make their decision, the board never made any attempt to figure out what the company was worth a. Grossly negligent to do this so quickly, not to read the document and not to make a valuation determination for the company b. The proper standard for determine whether a business judgment is an informed one in Delaware is predicated upon concepts of gross negligence

37
3. Generally a Board Needs to: a. Read appropriate formal documents b. Allow enough time to consider these documents c. Obtain the necessary facts in order to make a decision (1) Injunction action under 8.30 OBJECTIVE standard (2) Damages action under 8.31 SUBJECTIVE standard 4. Harm that is alleged = the price was too low. So, to prove their case, they must show what

the price should have been a. 2.02(b)(4) a provision eliminating or limiting the liability of a director to the corporation or its shareholders for money damages for any action taken, or any failure to take any action, as a director, except liability for (A) the amount of financial benefit received by a director to which he is not entitled; (B) . . . 5. First state claim that they didnt have information. Response were entitled to rely on X because he knew everything involved. Directors have to ask questions to fulfill their duty cant just take the conclusions as is, must find out how X got there. We can defeat their claim of reliance because they werent inquisitive. The directors werent even informed about the price, so they werent entitled to rely. 6. Here, complaint is that the directors were not informed 8.31(b)(2)(ii)(B) 7. Go through 8.31 line by line and find analogous facts to interpret the application of 8.31 I. In Re Caremark Intern. Inc Derivative Litigation 1. 8.30 breaks down into two requirements: (1) decision making and (2) oversight. a. Oversight is about care. Up until now we have been focusing upon decision making. Now were looking at care, which is oversight. 2. Potential Liability for Directorial Decisions a. Director liability for a breach of the duty to exercise appropriate attention, in theory, arise in two distinct contexts (1) Liability may be said to follow from a board decision that results in a loss because that decision was ill advised or negligent (2) Liability to the corporation for a loss may be said to arise from an unconsidered failure of the board to act in circumstances in which due attention would have prevented the loss 3. directors obligations includes a duty to attempt in good faith to assure that a corporate information and reporting system, which the board concludes is adequate, exists, and that failure to do so under some circumstances may, in theory at least, render a director liable for losses caused by noncompliance with applicable legal standards 4. in order to show that directors breached their duty of care, must show a. the directors knew b. or would have known c. that violations of law were occurring and d. that such failure proximately resulted in the losses complained of (affirmative defense) 5. If someone is deliberately trying to deceive you, then itd be hard to say that you must uncover the deceit that a trusted officer is offering 1. If youre a director, then you cannot hide behind your lack of sophistication. You must educate yourself on matters regarding the company. Objective standard, not subjective. Its not whether the particular director knew enough, its about whether a reasonable director would be aware of these issues. 2. MBCA version of the Business Judgment Rule = 8.30 and 8.31 J. 8.30 isnt all that different from the business judgment rule

38 1. members of the board of directors or committee on the board, when becoming informed in connection with heir decision making function or devoting attention to their oversight function, shall discharge duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances K. Malone v. Brincat: claim is that the corp overstated its earnings, so its about using accounting methods in incorrect ways 1. overstating the companys equity = to say you have more assets than liability so it looks like youre worth more than you really are 2. no requirement to disclose, except for the federal, but if there is disclosure, then it must be complete a. why no federal cause of action for this breach? Because there was no SALE OR EXCHANGE. Without a cause of action, then there is no remedy. L. Connection between the MBC and the BJR 1. Elements of BJR and Elements of 8.30 and 8.31 a. Good Faith: 8.31(a)(2)(i), 8.30(a)(1) b. Not interested in the subject of the business judgment: 8.31(a)(2)(3)(i), 8.30(a) best interests (how do you know what best interest is? 8.60(6)(1), (2), (3), (4)) c. Informed (was the director informed when making his decision?): 8.31(a)(2)(ii)(b), 8.30(b)(c)(d) and (e) all address this issue d. Rationally believes that the business judgment is in the best interests of the corporation: 8.31(a)(2)(ii)(a), 8.30(a)(2) e. Use the law of your jx in your analysis in chief! Only use MBCA when its the law in your jx. Cases are used to explain provisions and fill in gaps. M. Demand and Demand Excused 1. 7.42 no shareholder may commence a derivative proceeding until a written demand has been made upon the corporation to take suitable action and 90 days have expired from the date of the demand no demand excused is allowed 2. 7.40: definition of a derivative proceeding 3. 7.41: standing requirement: (1) Must be a shareholder at the time of the act/omission or transfer by operation of law (a) Inheritance, divorce (sale & gift = outside scope) (2) Fairly and adequately represents the interests of the corporation in enforcing the right of the corporation (a) Fairness standard- people vindicating reasonable expectations 4. 7.42: no shareholder may commence a derivative proceeding until (1) a written demand has been made (2) and 90 days has expired (1) UNIVERSAL demand requirement 5. 7.44: an action shall be dismissed IF the corporation has determined (1) in good faith (2) after conducting a reasonable inquiry upon which its conclusions are based that the maintenance of the derivative proceeding is NOT in the best interests of the corporation (1) This provision is a specific standard for the dismissal of a derivative action (2) TURNING POINT: if it is NOT dismissed go to 8.30-.31. gets you past the derivative action to evaluate the conduct of the director on the substantive claim. 6. Zapata Corp v. Moldonado: possibilities of derivative suit a. make demand and the corporation says that there is a cause of action and the corporation will take it up b. corporation doesnt think there is a cause of action and even if they thought that it was, they are not going to pursue it claim of wrongful decision not to sue

39 (1) absent a wrongful refusal, stockholder can never have an individual right to initiate an action c. BJR would come in to evaluate the decisions of the board (1) Violation of duty of loyalty or care (a) Disinterested director (b) If yes, then dont respect their decision d. If you want demand excused, you need to show particular facts on why the directors are disinterested AND a reason you might win on your claim. If you cant do that, then no demand excused. Very difficult to get demand excused. Really, no such thing as demand excused, so you need demand
TWO STEP TEST to be applied by courts in demand excused cases I. Inquire into the independence and good faith of the committee and the bases supporting its conclusions A. Is the decision to dismiss valid under the BJR, if the answer is no, then dismiss, if the answer is yes then must continue 1. If the court determines either that the committee is not independent or has not shown reasonable bases for its conclusions, or, if the court isnt satisfied for other reasons relating to the process, including but not limited to the good faith of the committee, the court shall deny the corporations motion II. The court should determine, applying its own independent business judgment, whether the motion should be granted A. Courts are extremely reluctant to substitute their own judgment for the judgment of businessmen B. Independent application by the court of its own independent judgment rule 1. Court must carefully consider and weigh how compelling the corporate interest in dismissal is when faced with a non-frivolous suit

7. Cuker v. Mikalaukas: claim is a breach of duty of the board of directors for not pursing the

bills owed. Court must examine the circumstances surrounding the decisions in order to determine if the conditions warrant application of the BJR. If they do, the court will never proceed to an examination of the merits of the challenged decisionsthis is precisely what the BJR prohibits a. Factors to Determine Whether BJR Applies (1) Whether the board or its special litigation committee was disinterested (a) Might as who the person is related to, etc. (2) Whether it was assisted by counsel (a) This matters b/c someone needs to know by which the process proceeds (3) Whether it prepared a written report (4) Whether it was dependent (5) Whether it conducted an adequate investigation and (a) This isnt really about duty of care, not just about independence (6) Whether it rationally believed its decision was in the best interest of the corporation b. loyalty requires that some benefit go to the person who breached this duty of loyalty. Show how some person has benefited to the detriment of the corporation c. what happens when demand is wrongfully refused? (ex. I bring a demand to the corp, they refuse, and I win an action that the demand was wrongfully refused): then the shareholder starts a derivative action. (1) Derivative action (a) Demand (b) Demand excused

40 (c) Demand refused

8. Deleware applies Zapata and other places apply cuker and some places apply only the

MBCA
1. Starting Action in a Derivative Proceeding 7.40 beginning of derivative proceedings 7.41 has a standing requirement must be shareholder at the time of the act or became holder by transfer thru operation of law (i.e., divorce, inheritance) AND must fairly and adequately represent the interests of the corporation in enforcing the rights of the corporation 7.42 must have a demand, cannot argue by anlogy to those states that allow demand excused 7.44 dismissal What SHALL be dismissed, drafters set up an independent standard for evaluating dismissal. This is a much more specific standard in a more limited context There are analogous provisions (to 8.30) looking for (1) good faith ( Cuker) and (2) after conducting a reasonable inquiry (Van Gorkam) 7.45 discontinuance or settlement 7.46 payment of expenses 2. Director Action 8.30 standard of conduct for directors objective standard How would a decision be challenged? In a derivative action Shareholder says corporation X wasted its money in doing such and such With respect to derivative action itselfsee above If we get past that and the action proceeds and we are now evaluating the conduct of directors on a substantive claim we are now at 8.30 If you want personal liability for directors, go to 8.31 8.31 standards of liability for directors subjective standard Should the directors personally pay? Mostly about process One of the assumptions is that there is no duty of loyalty problem Direct by shareholder alleging damage AS a shareholder Derivative by a shareholder damage TO the corporation Any further claim about actual liability of directors (in most jurisdictions, all will be judged under business judgment rule for both

DUTY OF LOYALTY AND CONFLICT OF INTEREST

I. SELF-DEALING
A. 8.60 creates the class of cases which are subject to review under 8.61 1. if director knows at the time of the commitment that he or a related person is a party to the

transaction or has a beneficial financial interest in or so closely linked to the transaction and of such financial significance to the director or a related person that the interest would reasonably (OBJECTIVE) be expected to exert an influence on the directors judgment if he were called upon to vote on the transaction 2. directors conflicting interest action = with respect to a corporation means a transaction effected or proposed to be effected by the corporation respecting which director of the corporation has a conflicting interest

41
3. related person a. spouse, parent or sibling of a director or a child, grandchild, sibling, parent of the

director or an individual having the same home as the director, or a trust, or estate of which an individual specified in this clause (1) is a substantial beneficiary or (2) a trust, estate, incompetent, conservatee, or minor of which the director is a fiduciary B. 8.61 Judicial Action 1. Just because there is an economic interest in the transaction is not enough. In order to get the injunction you have to go back to the definitional section and get that kind of an interest (i.e. must be one described in 8.60, which offers the requirements for the prima facie case). a. If it is, then look to 8.61 (b). If not, then (a) states that there is no cause of action. 2. directors conflicting interest specific cannot use a general notion, must use the defined term of 8.60...may not be enjoined to give rise to damages if any of the following are true a. assumption is that it may be enjoined unless one of the three following are triggered: (1) directors action respecting the transaction was at any time taken in compliance with section 8.62 (approval by disinterested directors, safe harbor) (2) Shareholders action respecting the transaction was at any time taken in compliance with 8.63 (approval by disinterested shareholders) (3) The transaction judged, according to the circumstances at that the time of the commitment, is established to have been fair to the corporation C. Marciano v. Nakash: if the court feels that the transaction is fair to the corporation upheld 1. if there is fraud, undue overreaching, waste, court will set aside 2. if there is no fraud, waste, etc., but the court is not convinced that the transaction is fair, it will be upheld only where the interested director can convincingly show that the transaction was approved (or ratified) by a truly disinterested majority of the board of directors without participation of the interested director 3. Proceeding thru this type of problem a. Establish whether there was a conflict of interest (here the directors were lending money to the corporation, definitely a conflict of interest) (1) 8.60 after I establish this prima facie case (i.e. both sides of the transaction), then the director must show that 8.61 PROTECTS him or her under the three was in 8.61 b. Ask whether transaction is in one of the safe harbors (1) 8.61 lists three ways, that point to other sections of the code to determine whether the director is protected (8.62 has a safe harbor provision) (2) UNLESS youre in DE, then you must also ask whether it is intrinsically fair (a) Do a kind of comparison: would corporation enter into this transaction at arms length with a totally unrelated D. Executive Compensation: 1. Heller v. Boylan: directors, even through democratic means, cannot vote for a wasteful transaction which would amount to giving away property 2. Brehm v. Eisner: a. WASTE TEST: an exchange that is so one sided that no business person of ordinary, sound judgment could ever conclude that the corporation had received adequate compensation b. What is the rule considering director compensation: its not the salary itself that is enough (saying the salary is too high is not enough), you need to explain WHY the compensation is not commensurate with the services being rendered. Show what

42 other executives in the same industry and at the same level are receiving. Need some analytical framework. E. Conflict of Interest: 1. Sinclair Oil Corp v. Levin: I: Whether there is a conflict of interest. If there is NOT a conflict of interest, then the test applied is the BJR. If there IS a conflict of interest, then there is a shift in the burden of proof and the intrinsic fairness test is applied a. under an intrinsic fairness standard, parent company must first prove that its causing subsidiary not to enforce a contract was intrinsically fair to the minority shareholders of the subsidiary b. this is a VERY SPECIFIC case about parent-subsidiariesestablishes an extra element needed to be shown in a breach of loyalty claim in the parent-subsidiary claimhere you have to show that parent received something to the detriment of the subsidiary F. Care and Loyalty: 1. Weinberger v. UOP, Inc: Fairness = fair dealing AND fair price must have both, it is not sufficient to only have one a. What has been done to violate the fiduciary duty? The merger, the price of it, and the process of doing it. What is the real claim? How do you violate a duty of loyalty? They didnt show the report to the company. Did they have a duty to? YES. They had to duty to disclose what they knew about the merger to the company. They needed to disclose this martial information about the action. b. The test for fairness: (1) Fair Dealing: What was misleading? The role the signal played in requiring the short time frame. The minority interest was left with the impression that there was a careful study of the price offered, when they wasnt true. (2) Fair Price: What should be considered? In this case: liquidation value, going concern value. (a) While this is the second component, its probably the primary one. Because if they are found for not dealing fairly, then you still have to prove damages under fair price. Without damages, there is no recovery G. Notes: 1. Whats an outside director someone who isnt an officer of the corporation 2. Inside director president, VP, etc II. CORPORATE OPPORTUNITY: Claim that a director is taking an opportunity that he corporation would take A. Northeast Harbor Golf Club v. Harris: Duty of loyalty must disclose and not withhold relevant information concerning any potential conflict of interest with the corporation, and they must refrain from using their position, influence, or knowledge of the affairs of the corporation to gain personal advantage 1. Line of Business Test whether the opportunity was so closely associated with the existing business activities as to bring the transaction within that class of cases where the acquisition of the property would throw the corporate officer purchasing it into competition with his company 2. Fairness Test true basis of governing doctrine rests on the unfairness in the particular circumstances of a director, whose relation to the corporation is fiduciary, taking advantage of an opportunity (for her personal profit) when the interest of the corporation justly calls for protection. This calls for application of ethical standards of what is fair and equitable in particular sets of facts

43 3. ALI Principles of Corporate Governance Taking of Corporate Opportunities by Directors or Senior Executives a. Director may not take advantage of a corporate opportunity unless (1) Director or exec first offers the corporate opportunity to the corporation and makes disclosure (2) Corporate opportunity is rejected by the corporation (3) Either (a) The rejection of the opportunity is fair (b) Opportunity is rejected in advance (c) Rejection is authorized in advance or ratified b. Corporate opportunity means (1) Any opportunity to engage in a business activity of which a director or senior executive becomes away either (a) In connection with the performance of functions as a director or senior exec (b) Through the use of corporate information or property, if the resulting opportunity is one that the director or senior exec should reasonably be expected to believe would be of interest to the corporation (2) Any opportunity to engage in a business activity of which a senior exec becomes aware and knows is closely related to business of corporation c. Burden of Proof party who challenges the taking of a corporate opportunity has the burden of proof if above requirements are met and if not, then director or senior exec has the burden of proving that the rejection and the taking of the opportunity were fair to the corporation (1) Plaintiff needs to show that there was NOT ratification by disinterested directors in order to get the burden to shift (2) What if there is a ratification by disinterested directors? There might not be adequate disclosure, so we wont respect the decision in that case. 4. Use MBCA to bring a cause of action out of the code a. 8.31(a)(2)(v) The comments to 8.31(a)(2)(v) say to look at the ALI b. Another way might also work 8.31(a)(2)(ii)(A) c. What remedy is appropriated? Give them an opportunity to purchase the land from her 5. Also consider whether the corp has the financial ability to take on another opportunity a. Corporations start with nothing, but yet they thrive but using things like debentures borrowing on security. Corporate opportunity test:
a. FIRST, show that there was a corporate opportunity i. Opportunity closely related to the business in which the corporation is engaged OR ii. Opportunities that accrue to the fiduciary as a result of her position with the corporation. b. THEN, show that either i. The fiduciary did not offer the opportunity to the corporation OR ii. That the corporation did not properly reject the opportunity c. IF the board did not reject the opportunity by a vote of disinterested directors after full disclosure, then the fiduciary must defend the actions on the basis that the taking of the opportunity was fair to the corporation (consider the cases that talked about fair dealing and fair price) . i. strict requirement of full disclosure ii. General Factors in Determining a Breach of Fiduciary duty 1. feasibility of corporate action- either financial inability OR refusal of 3rd parties to deal with the corp 2. preexisting relationship 3. opportunities of special value to the corporation 4. corporate waiver of opportunity a. Delaware has moved to the fairness test- whether or not the director had appropriated something to himself that in all fairness should belong to the corporation In some jurisdictions, including DE, in your complaint if you are a corporation, you still have to show that the corporation has the financial ability to pursue the opportunity

44

III.

DUTIES TO CORPORATE CONSTITUENCIES OTHER THAN COMMON SHAREHOLDERS A. Preferred Shareholders yes owed a fiduciary duty, look at the share itself to see what the shareholder is enttled to B. Creditors have contractual duties, this is where you would go to see where the rights and responsibilities C. Holders of Convertible Securities some fiduciary duties, duty of reasonableness and notice and not quite the lack of duty owed to creditors but something in between D. Other Constituencies (i.e., other employees, labor, community) every state allows other constituencies to be recognized E. In bankruptcy, you have an institution who is acting for creditors. Creditors first, not shareholders, in bankruptcy. So if the corp is in bankruptcy, then the court can find breach of fiduciary duty to creditors. Creditors do not have standing to bring claims about breach of fiduciary duty unless the company is in bankruptcy.

RULE 10b-5, INSIDER TRADING AND SECURITIES FRAUD

I. DEVELOPMENT OF A FEDERAL REMEDY RULE 10B-5
.A Focuses on information and the accurate telling of information rather than any particular egregious

behavior
.B Fraud a knowing misrepresentation of truth or concealment of material fact to induce another to act

to his detriment
.C Kardon v. National Gypsum: court recognizes for the first time a cause of action based on 10b-5 for

private litigants, other than the SEC. But what are the requirements? See Blue Chips.
.D Blue Chip Stamps v. Manor Drug Stores: first element of a private cause of action under 10b-5 is

that you must have STANDING. This means a private person must be a purchaser or seller. The SEC has automatic standing. .E Ernst & Ernst v. Hochfelder: second and third elements: Scienter and Misstatement or Omission .1 Scienter (guilty knowledge intention requirement) .a If either wishes to bring a cause of action under 10b5, then both would have to show that the violation was either INTENTIONAL (knowing misrepresentation) OR the misrepresentation was RECKLESS (meaning intentional disregard for the facts and circumstances so that the results are misleading. Like an intent to disregard or an intent to mislead). Negligence isnt enough. .2 MISSTATEMENT OR OMISSION. Third element: show the words that were misleading or show the fact that was omitted that made the statement misleading. If you cant do that, then no cause of action .F Santa Fe Industries v. Green: statute of limitations suits must be brought within one year after the discovery of the facts constituting the cause of action and within three years after such cause of action accrued .1 aiding and abetting (i.e. attys, bankers, etc.) no longer available .2 Just a disagreement about the price does not lead to a cause of action. Have to show a MISSTATEMENT OR OMISSION .G In Re Enron I: you cant use aiding and abetting anymore, but can you still proceed on what appears to be secondary violations with respect for attorneys, accountants, bankers ? .1 You can discuss illegal conduct, but you CANNOT participate in it. Scienter standard

45
.2 What changes have emerged after the scandals? .a Audit committees independent of the companies that cannot do anything for the

.b .c .d .e .f

company but audit. Do not offer any business advice services ()1 Board of Directors must be outside directors (directors who are not employees of the company or related entities) on the audit committee that oversee everything Must be a web posting of stock ownership CEOs and CFOs must now certify the audit reports, saying that the reports fairly represent the companys financial position Must be internal controls that are designed to bring to light any wrongdoing. No retaliatory action with respect to whistle-blowers No more credit/loans to executive officers. So company can no longer lend money to executive officers. Going private is a way to avoid this. Going private by being not publically traded.

II. INSIDER TRADING

A. Matter of Cady, Roberts and Co: 1. obligation rests on 2 elements a. the existence of a relationship giving access, directly or indirectly, to information

intended to be available only for a corporate purpose and not for the personal benefit of anyone b. inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing B. DUTY cannot find liability for someone who does not owe a duty to the corporation 1. the fraud which an insider must commit is having information about the corporation which is not publicly available, and then trading on it 2. Is the mere position of inside information enough? No. The mere possession of material non-public information is not enough. There needs to be some kind of relationship between the insider/person in possession of the information that gives rise to a duty NOT to trade. Includes not merely, the insider, but individuals that he/she tells the information to. C. SEC v. Texas Gulf Sulphur (Ore strike) 1. anyone in possession of material inside information must either disclose it to the investing public, or if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed (this is not the rule we end up with) a. This comes from 10b-5(c). According to this rule, you must disclose before you can trade anything. However, if you disclose, then you might be violating your fiduciary duty to the corporation. So, this rule basically means that you cant trade. 2. Material Inside Information an insiders duty to disclose information or his duty to abstain from dealing in his companys securities arises only in those situations which are essentially extraordinary in nature and which are reasonably certain to have a substantial effect on the market price of the security if the extraordinary situation is disclosed 3. Tipper the one who tells. Tippees ones who are told. They will be charged as if they violated that duty. Well hold the tipper responsible for all the trades of the tippees 4. USE TSC INDUSTRIES TEST a. Where a corporate purpose is served by withholding the news of a material fact, those persons who are thus quite properly true to their corporate trust must not during the period of non-disclosure deal personally in the corporations securities or give to outsiders confidential info not generally available to all the corporations stockholders (1) When this happens MUST refrain from trading

D.

E.

F.

G.

46 (a) If you have material inside info, you cannot trade unless you disclose (b) If you disclose and trade, there will be a state law fiduciary duty violation (i) Unless you refrain from trading altogether, you will be violating either federal or state law (2) Insider trading raises a presumption that the information is material (3) Duty (a) Establish that the tipper was an agent of the corporation OR a fiduciary (i) Law of agency says that employees owe their employers a duty of confidentiality and that they may not use confidential info for the agents owen behalf (ii) Employees owe a duty to the corporation AND the corporation owes a duty to the shareholders When may insiders act: only after the news has been publicly disclosed 1. Beat the news when you know the news is forthcoming, so you try to get ahead of it. If youre a minute early, then civil and criminal liability. Chiarella v. US (The printer) 1. Looking for what kind of relationship? Fiduciary relationship of trust somewhere. Clearly, employer/employee isnt much of a stretch, but this concept is going to get stretched very far. Would the course construction of 10b-5 reach the following persons? 1. Secretary or messenger who overhears snippets of conversations from his superiors, infers that a favorable development is about to occur, and buys shares of his employer? Need material information, scienter 2. Person sitting in a restaurant who overhears conversations at the next table from which she infers that a favorable development is about to occur with respect to XX company, and buys shares in XX company. a. Not duty, so no breach. Mere possession of non-public information is not enough, must be some kind of duty. 3. The reporter who attends a press conference at which a favorable development is announced, and then, immediately after the conference and before the news appears on the ticker services, telephones his broker and places an order to purchase a. Its material non-public information, so that part of 10b-5 is satisfied. But its not the usual kind of insider information because it doesnt come from the employer itself. b. Duty. Duty owned to the newspaper. Newspaper owns the info that the company is going to be mentioned in the column. Violated when used for the personal benefit of the newspaper guy. 4. A subtipee who believes his tippee has connections with employees of the corporation but is not himself employed by the corporation. Illustration: Corp Employee/Tiper Tippee subtippee a. Find out if there has been some kind of duty breach at the tiper lever. If the answer is yes, then the next question is whether the subtippee knew or should have known about that duty breach. If the info actually came in this way, then the subtippe will be criminally liability if this is actually what happened. However, if the tipee was someone who just walked by a window and heard the information, then the subtippee will not be liable. Test is knows or should have known Rule 14e-3(a): Establishes liability when there is a tender offer (i.e. a public offer to purchase the shares of a corporation) for shares of a corporation. 14e establishes a duty of disclosure for anyone who trades in securities while in possession of such information, the rule establishes a specific duty to disclose or abstain from trading under Section 14(e).

47
1. Removes the duty factor. So now anyone can be liable for trading with this info. This rule

would encompass the previous case even though 10b-5 would not 2. There is a judicially created 8 factor test: ()1 active and widespread solicitation of public shareholders ()2 tender offers must be for a solicitation for a substantial percentage of stock (number varies depending on size of corp) ()3 whether the offer to purchase is made at a premium ()4 whether the offer is contingent on a fixed minimum ()5 ___ ()6 whether the offer is open only for a limited period of time ()7 whether the offerees are subject to pressure to sell their stock ()8 the existence of public announcements of a purchasing program **This is found in Wellman vs. Dickenson 475 F Supp 783 H. Duty and Breach of Duty 1. US v. OHagan (atty for firm who did not work on take over, but traded on info): a. The classic theory is 10b-5, but the misappropriation theory advances it: The statute reaches any deceptive device used in connection with the purchase or sale of any security (1) Classical theory an employee, officer, or director of the corporation who owes a direct duty to the corporation. Says that 10b-5 is violated when a corporate insider trades in his company stock on the basis of material nonpublic information (2) Misappropriation theory this describes a circumstance in which a person in possession of material, nonpublic information, trades in violation of a duty to someone other than the corporation in which the securities are traded. (a) Person commits fraud in connection with a securities transaction and thereby violates 10b-5 when he misappropriates confidential info for trading purposes in a breach of duty owed to the source of that information. Elements: (i) In connection with (ii) confidential information = material info (iii) For securities trading purposes = only need a mere connection (iv)In breach of a duty owed to the source of the info = the breach is not acquiring the information, its taking the information and trading I. Dirks v. SEC: must be MORE THAN mere possession in order to have an insider trading claim 1. Test for determining whether the is a breach by an insider under the classical theory: a. Material, non-public information b. duty (must actually be a duty for there to be a breach) c. insider breached a fiduciary duty d. scienter knew or should have known that there was a breach of duty by the tipper e. must also show that insider has benefited pecuniary gain (1) or closely linked to a pecuniary gain or reputational benefit that will transfer to future earnings 2. must not only be a breach by the insider, but also the way we will know there is a breach is some pecuniary gain and in order to reach the tipee, only if tippee knew or had reason to know of the duty breach in order to satisfy the scienter requirement

III.

IIII.

48 3. tippee violates 10b-5 when the tipper/insider breaches the fiduciary his fiduciary duty to the shareholders by tipping information for his own personal benefit and the tippee knows or should know that the tip was a breach of the tipper/insiders fiduciary duty J. US v. Chestman 1. fiduciary relationships cannot be imposed unilaterially 2. marriage without more doesnt create a fiduciary relationship 3. Rule 10b5-2: a. duty of trust or confidence exists (1) whenever a person agrees to maintain information in confidence (2) whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, patter, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality (3) whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child or sibling; (provided, however, that the person receiving or obtaining the information may demonstrate that no duty of trust or confidence existed with respect to the information expected that the person would keep the information confidential b/c of the parties history, patter, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information) 4. just creates the duty, doesnt tell you about breaching, then must decide whether this duty has been breached Securities Exchange act of 1934 A. 21A. Civil Penalties for Insider Trading 1. Liability for a controlling person who, at the time of the violation, controlled directly or indirectly . . .Talking about supervisors those who control the institution 2. With money, you never want to allow a single person to handle it alone B. 20A. liability to contemporaneous traders for insider trading 1. What kind of causes of action might there be against the person who gives a false tip? State law fraud claim. Must be intent to deceive. 2. False tips might support causes of action as long as the recipient was not deeply involved in an attempt to defraud the market AND the action would not interfere with the market C. 16 Directors, officers, and principal stockholders 1. Two classes of individuals affected a. The owner of more than 10% of any class of equity security b. Directors and officers of the issuing (1) They have to file a statement with the condition describing their ownership 2. Officers is a term that can be used to apply to any employee of the corporation. But the SEC has said that officers include: the issuers president, principal financial officer, accounting officer . . . 3. Insider trading still prohibited under 10b-5, 16 provides a clear-cut mechanism in a 6 month time frame FRAUD A. Basic Inc. v. Levinson (merger agreement): In order to claim omission you must find something that is material itself which makes the misstatement misleading. 1. A cause of action requires: (1) Standing, (2) Misstatement or Omission, (3) Materiality, (4) Reliance, (5) Scienter

49 2. MATERIALITY there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available (TSC) 3. Materiality - when would you ignore something and when you would pay attention. Balancing between the probability that the event will occur and the magnitude of the event look for the facts. a. Probability is low and magnitude is low probably not material b. Probability is high and magnitude is high material 4. RELIANCE presumed when materiality is shown a. Any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price, will be sufficient to rebut the presumption of reliance (1) Is the presumption rebuttable? Yes. What could the defendant show in order to rebut this? That the information didnt distort the market price or there was no effect on the market. 5. Fraud on the Market Theory a. Reliance is an element on a 10b-5 cause of action, it provides the requisite causal connection between a defendants misrepresentation and a plaintiffs injury b. Rebuttable presumption when materiality is show, presumption is that the person relied on the integrity of the market in trading (1) May rebut by any showing that severs the link between the misrepresentation and the price paid by the Plaintiff c. Presumption of reliance employed here is consistent with the congressional policy and is supported by common sense and probability 6. Scienter piece requirement seems much lower, no pecuniary gain, instead just look to see if someone deliberately made statement and the materiality of the misrepresentation. B. SCIENTER, MATERIALITY, RELIANCE 1. Must also be an omission or misstatement may want to start with this (but can be part of materiality and part of scienter)
Is the claim a claim for insider trading, if the claim is for insider trading then scienter standard seems higher IN ALL CASES intentional violation of 10b-5, it is just established differently.always not just negligent, had to be intentional Insider Trading have to trade intending to deceive by taking advantage of material inside info, must intend to profit For Basic Industries have to intend to mislead , intend to deceive 2. Reliance - kind of a causation that is thru your reliance you acted in a way that was harmful,

IIV.

I relied on what you said and I can show that just by showing materiality. a. You can rebut by showing that market already had information or that you were trading for some other reason other than the statement that was made. LIABILITY FOR SECURITIES FRAUD: STATUTORY REGULATION A. Strike Suits: a cause of action brought by a shareholder with minimal interest after a decline in company stock B. LOSS CAUSATION 1. Must show that the decline in value or increase in value itself was caused by the statement that you claim was in violation of 10b-5 a. Intent to require an allegation of loss causation b. A general allegation of transaction (or but for) causation would appear insufficient to survive a motion to dimiss

50
c. Have to show that the values changed as a result of the violation C. How do you determine damages: 1. No damage award based on the market price of a security may exceed the difference b/t the

purchase or sale price of the security and the mean trading price at which the security traded within the 90 day period immediately following the disclosure of corrective information D. IPOs = Initial Public Offer 1. When a corp goes public/puts their stock on a public market to generate capital. Selling authorized, but unissued shares. E. All about 21D. on 1171 of supp.

51

ELEMENTS OF LIABILITY UNDER 10b-5 for INSIDER TRADING

1. STANDING: a. INDIVIDUAL: must have standing under 20A b. SEC: standing not required this does NOT apply to the SEC when it brings an action 2. SCIENTER: intent to deceive guilty knowledge with respect to disclosing the false/misleading information (Basic) a. Insider Trading- intended to deceive by taking advantage of material inside information and to profit from it. b. cannot be liable on a claim for insider trading, fraud or misrepresentation without scienter i. **NOTE: the USC has not decided whether recklessness qualifies (gross disregard, failure to inform, breach of duty of care.) ii. Securities Fraud- intend to mislead/deceive by a statement or omission 3. MATERIAL, INSIDE (non-public) INFORMATION: a. TSC industries TEST: i. Show that the fact would have assumed actual significance in the deliberations of the reasonable shareholder- a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. 1. ALSO when a person has material, inside information, he cannot trade unless he discloses. (without violating federal law) 2. BUT when a person discloses and trades, there will a violation of state law fiduciary duty a. MUST REFRAIN FROM TRADING ALTOGETHER. 3. AND insider trading raises a presumption that the information is material. ii. BUT once the information has been publicly disclosed (reasonably have been expected to appear over the media of the widest circulation), an insider can act. 4. DUTY/BREACH: a. Classical Theory: i. Rule 10(b) is violated when a corporate insider trades securities of a corporation on material, nonpublic information (when a person breaching the duty owes a duty to the corporation itself) 1. TARGET: corporate insiders breach of duty to shareholder with whom the insider transacts a. shareholder company employee b. Misappropriation Theory: i. A person commits fraud in connection with a securities transaction and therefore violates rule 10(b) when he misappropriates information for securities trading purposes, in a breach of duty owed to the source of the information. (typically the employer is the source) 1. TARGET: trading on the basis of nonpublic information by a corporate outsider in a breach of duty not owed to a trading party, but to the source of information. a. DUTY: runs to the source of the information- (newspaper, print shop) 2. on the basis of is satisfied if the person was aware of the material nonpublic information when the person made the purchase/sale. a. UNLESS the person was within one of the safe harbors (10b-5-1(c)(1)(i)before becoming aware had i. Entered into a binding K to purchase or sell the security ii. Instructed another person to purchase or sell iii. Adopted a written plan for trading securities OR iv. There was a K, plan or instruction set out ahead of time.

52 3. in connection with is construed very broadly any part of the transaction that is manipulative/deceptive will be a duty breach c. Tipper-Tippee Liability: SHOW i. The insider (tipper) breached a fiduciary duty OR a similar relationship of trust and confidence AND 1. need either a fiduciary duty OR a similar relationship of trust/confidence : 10b5-2 show a. a person agrees to maintain information in confidence b. have a history, pattern of practice of sharing confidences, such that the sharee knows that the sharer expects confidence c. when information is received from a spouse, child, parent, or sibling UNLESS it can be shown that no duty of trust/confidence existed. ii. That the outsider (tippee) knew of should have known (scienter) that the tipper was breaching a duty 1. To show a breach by the tipper, show that the tipper has benefited (some kind of pecuniary gain/linked to one) d. AND SHOW DUTY BREACH (inside each theory) 5. LOSS CAUSATION a. NOT required for the SEC b. Required for Private Causes of Action Elements for a cause of action under 10b-5 for Insider Trading: SEC Standing No Scienter Traded on material non-public, inside, information this is the heart of insider trading (Texas Sulfur) Must be a duty/breach (whats the meaning of duty? does not have to be a traditional, legal, historical duty, can be a family relationship) Loss Causation: 21D(D)(4) (1174) Yes Yes

Private Yes, 20A: contemporaneous trading Yes Yes

Yes

Yes

NO

Yes

53

ELEMENTS OF LIABILITY UNDER 10b-5 for SECURITIES FRAUD

1. STANDING: must be a purchaser/seller if the SEC is not bringing it a. SEC: no need for standing b. Individual: must be a purchaser or a seller (Blue Chip) 2. MISSTATEMENT OR OMISSION: must be either an omission which is necessary to keep the statement from being false or misleading OR a statement that is misleading 3. MATERIALITY: Show a material misstatement or omission: Refined Standard for Mergers/Securities Fraud (coupled with #2): a. TSC industries TEST: Show that the fact would have assumed actual significance in the deliberations of the reasonable shareholder- a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. i. In a merger- ASK if there is a high degree of probability that the event will come to pass OR if there is an impact on the investors future 1. if BOTH the probability and the impact are high - a reasonable investor will be interested. ii. Refined standard: how the court decides whether an investor would find the information important is defied by the fraud on the market theory. 1. NOT a separate standard- just arises in a specific context b. Use Basic as an extension of this rule 4. SCIENTER: in all cases there is an intentional violation of 10b-5. (Ernst & Basic) a. Securities Fraud- intend to mislead/deceive by a statement or omission i. An intent will likely be inferred depending on the statement (Basic) ii. NOT requiring a showing of pecuniary gain- lower standard iii. Under 21D must be plead with particularized facts. Requires INTENTIONAL misstatement or omission. Recklessness will also do. Recklessness about what? Misstatements. Show that the speakers intended to deceive. 5. RELIANCE: there is a rebuttable presumption of reliance if the fraud on the market theory is satisfied a. Individual: Fraud on the Market Theory: a rebuttable presumption when materiality is shownpresumption is that the person relied on the integrity of the market in trading. i. Rebut: any showing that severs the link between the misrepresentation and the price paid by . b. SEC: does NOT have to show reliance 6. LOSS CAUSATION: PSLRA a. Individual: must show loss causation i. Plaintiff must plead and prove loss causation 1. Show That The Decline In Value, Itself, Was Caused By The Statement. a. A general allegation of but for causation would be insufficient to dismiss (I would have something but/for what you said) ii. found in 21D.(B)(4) b. SEC: does not have to show 7. DUTY/BREACH a. Unclear if this is required for either. So if this were an element, then can you satisfy it? 8. DAMAGES: a. Individual: must show damages b. SEC: does not have to show

54 Elements for a cause of action under 10b-5: SEC Standing (Blue Chip) Not required Misstatement or Omission (Santa Fe Required Industries) Coupled with M or O, should go right Required next to M or O discussion: Materiality (TSC always discuss this case when discussing materiality. Basic might also be needed when something is uncertain and you want to use the basic test as a refinement of tsc. So, these case are not separated, they are one rule and basic is just an extension of tsc. Scienter (Ernst & Ernst). Under 21D Required must be plead with particularized facts. Requires INTENTIONAL misstatement or omission. Recklessness will also do. Recklessness about what? Misstatements. Show that the speakers intended to deceive. Reliance (Basic) materiality giving rise to the presumption (which could be rebutted) Loss Causation (found in 21D.(B)(4)) Duty (the least clear element not clear if this element is necessary). If this were an element, then could you find one? Not required Private Cause of Action Required Required Required

Required

Required

Not Required Unclear

Required Unclear