BA-Corp. Prof. Matheson

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Business Associations
1) Introduction
a) Epstein-Freer View and Roberts-Shepard View
i) Most people who start businesses do it to make money.
(1) The defining characteristic of a business is that economic activity is organized for
the purpose of earning a profit.
b) Roberts-Shepard View
i) A business is some form of activity that is organized to "create value" for its owners.
(1) A business must create a profit in some sense, but not necessarily in the
conventional sense.
ii) Shepard's View
(1) Believes that the goals of businesses can be broader than just earning profit.
(a) Businesses are not formed just to make money, but to help people.
c) Business Structures
i) Law makes careful distinctions between business structures
(1) Who the owners are (i.e. shareholders, partners, sole proprietor)
(2) What rights and obligations the owners have
(3) Whether the business itself is a legal entity separate from the owners.
d) Businesses are the forum for economic activity, the objective of which is often to
earn an economic return, profit, or other increased value to the proprietor.
2) Views of Other Gonster Machers

a) Friedman's View
i) In a free-enterprise, private-property system, a corporate executive is an employee of
the owners of the business.
(1) His responsibility is to conduct business in accordance with the owners' desires.
(a) Thus, the executive is the agent of the individuals who own the corporation.
(i) He is, however, a person in his own right and has duties or other social
responsibilities that he assumes on his own.
1. In this capacity, he is acting as a principal, not an agent.
a. He is spending his own money or time or energy, not the money of
his employers or the time or energy he has contracted to devote to
their purposes.
(ii) Only one social responsibility of a business
1. To use its resources and engage in activities designed to increase its
profits so long as it stays within the rules of the game.
a. Friedman says that any action taken should benefit the company in
some manner. There must be a nexus between the action and the
benefit.
ii) Agency: The fiduciary relation which results from the manifestation of consent by
one person to another that the other shall act on his behalf and subject to his control,
and consent by the other so to act. RESTATEMENT (SECOND) OF AGENCY §1
iii) Principal: The one for whom action is to be taken. Id.
iv) Agent: The one who is to act. Id.
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A.P. SMITH MFG. CO. V. BARLOW - (1953)

Facts
AP Smith manufactures valves, fire hydrants and special equipment for the water and gas
industries. Its board of directors adopted a resolution which set forth that it was in the
corporation's best interest to join with others in donating $1500 to Princeton University. The
stockholders questioned this action, and the corporation issued a declaratory judgment action in
the Chancery Division and trial was had.
The President of the company testified that such donations were expected by the community, and
that the donations create a favorable environment for their business operations.
Stockholders Argument
b) Plaintiff's certificate of incorporation does not expressly authorize the contribution and
under common law principles the company does not possess any implied or incidental
power to make it.
c) NJ statutes which expressly authorize the contribution may not constitutionally be
applied to plaintiff, a corporation created long before their enactment.
Holding
d) A donation by AP Smith was intra vires, or within the authority of the board of directors.
i) At Common Law, a manager could not disburse any corporate funds for philanthropic
or other worthy public cause unless the expenditure would benefit the corporation.
(1) However, control of economic wealth has passed from individual entrepreneurs to
dominating corporations, and thus public support has developed for corporations
to make reasonable philanthropic donations.
(a) Such contributions have been sustained upon liberal findings that the
donations tended reasonably to promote the corporate objectives.
(i) Modern conditions require that corporations acknowledge and
discharge social as well as private responsibilities as members of the
communities within which they operate.
(2) Further, state legislation adopted in the public interest and applied to pre-existing
corporations under the reserved power has repeatedly been sustained the US
Supreme Court.
ii) The donation is valid. There is no suggestion that it was made indiscriminately or to
a pet charity of the corporate directors in furtherance of personal rather than corporate
ends. It was a lawful exercise of the corporation's implied and incidental powers
under common-law principles and that it came within the express authority of the
pertinent state legislation.
NOTES and Rules

e) The MBCA and other corporate codes now expressly authorize corporations to
make charitable contributions.
i) However, there are scholars who still contend that corporate giving, if it is permitted
at all, should be strictly limited to those situations where the benefit to the firm in the
form of higher expected profits is clear and compelling.
(1) Friedman: If managers to do anything with property other than what the
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shareholders want them to do would be to expropriate resources that do not

belong to them.
f) The law views a business as a separate entity, a separate legal person
g) A body of law has developed to control the actions that separate entity or person
h) Real persons act for that corporation as agents
i) A business with more than one owner can distribute and use its funds in ways that
are opposed by at least some of its owners.
How does the owner of a business make $$ from the Business?

j) She can receive distributions of all or part of the money the business has earned.
k) She can sell all or part of her ownership interest in the business for more than she paid for
it.
How does the Owner know how much money the Business has made and how much the
business is Worth?
l) Business entities are required to keep “appropriate accounting records,” and to make
these records available to the owners. MBCA §§16.01(b) and §16.02(b)(2).
i) Businesses typically maintain several financial statements, which are provided to
investors, the company’s managers, and to the public and public enforcement
authorities.
(1) Without these accurate reports, the company can go under without the
managers or public knowing before it is too late.
ii) Types of Financial Statements
(1) Income Statement: Computes profit during a given period, usually a year.
(a) Ex: Sales – Cost of Goods Sold (COGS) - salaries = Profit Before Taxes
(PBT).
(i) Depreciation changes this analysis
1. A company which purchases a machine for 5K, which is expected to
last for more than 5 years, it would be misleading to add the entire 5K
into the expenses in year 1.
a. The profits from the machine would be understated in year 1, and
overstated in subsequent years.
(b) An income statement does not show how much cash a business may be
generating or using up in a given year.
(i) This is because some entries in the income statement, such as
depreciation, do not represent any actual movement of cash.
(2) Cash Flow Statement: Measures the cash made available to a business from its
operations during a given period.
(a) It is a measure of how much more cash a business has at the end of the
year than it had at the beginning of that year.
(i) Generally, an income statement is converted into a cash flow statement by
the following formula
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1. Cash flow = profits from income statement + depreciation – net

change in balance sheet asset accounts other than cash + net change in
liabilities and funds from new issues of stock.
(b) An increase in a balance sheet asset account other than cash results in a
decrease in cash flow.
(c) An increase in a balance sheet liability account can result in an increase in the
cash account on the balance sheet and an increase in cash flow.
(d) NOTE
(i) When a business buys something that will be used for more than one year,
then is an investment and only the depreciation appears on the income
statement.
(ii) When company buys something that it will use up in a year, it is called an
expense, and the total amount appears on the income statement.
(3) Balance Sheet: Shows the company’s assets, liabilities and the owners’ “equity”
in the business.
(a) It is a snapshot of a particular moment in a business’ history.
(i) 3 Main Sections
1. Assets
a. The things that the company owns that have value.
i. Ex: Cash, Land, Buildings, Accounts Receivable (money
owed to the company) and machinery.
ii. Assets, like cash are NOT depreciated b/c they don’t get
used up.
iii. Accounts Receivable are not depreciated but may be
written off.
2. Liabilities
a. What the company owes.
i. Ex: Wages payable, any debts.
3. Owner’s Equity
a. What is left over after a business subtracts the liabilities from the
assets.
(ii) If the assets are all of the company’s things that have value, and the
liabilities are all the “claims” on that value, then the difference
between the two is the value of the business to the owners – The
owners equity.
NOTES
- Matching: Costs or expenses should be “booked” in the same period as the revenues
those expenditures helped generate.
- Conservatism: Data should be conservative – they should present the firm’s financial
data in an accurate way, but err on the side of understating its revenues and the value of
its assets, and on overestimating its costs and liabilities.
(b) Time Value of Money: The principle that money currently possessed will
not be worth as much in the future.
(i) 100K now, will not be worth 100K later.
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3) Sarbanes-Oxley Act and Corporate Governance

a) Congress passed this in reaction to the perceived breakdown of financial accounting and
corporate accountability in the wake of the financial scandals in the 2000 time frame.
i) It seeks to protect the owners of public companies.
(1) In well-functioning governance systems, the public shareholders rely upon the
board of directors, who in turn delegate a fair amount of responsibility for the
oversight of the company’s accounting to its audit committee.
ii) Motivation for Fraud
(1) If the numbers are good, then fundamental performance is good, then the price of
the stock should go up.
4) What are the Legal Structures for Businesses?

a) Decision regarding a business structure is driven chiefly by the objectives of the
business’ founder and firms’ investors, in terms of tax status, exposure to legal liabilities,
and flexibility in the operation and financing of the business.
i) 2 Important Differences in Business Structures
(1) Tax Treatment of Business’ profits
(2) Liability exposure of the owners for the business’ debts and other potential
liabilities.
b) Sole Proprietorship
i) A person undertakes a business without any of the formalities associated with other
forms of organization.
(1) Individual and business are one and the same for tax and liability purposes.
ii) Does not pay taxes as a separate entity.
(1) The individual reports all income and deductible expenses for the business on her
personal income tax return.
iii) For liability purposes, the individual and the business are also one and the same.
c) Corporation
i) Most common legal structure for large businesses.
(1) Corporation’s owners are generally protected from personal liability.
(a) In exchange for this protection, the corporation must also pay tax on its
income just like a real person.
(i) Corporation pays a tax, then the owners of the corporation pay a tax on the
part of its earnings that are distributed to them as dividends.
(b) This double taxation creates powerful incentives for those enterprises that
anticipate distributing earnings to use a tax-advantaged, “pass-through” form,
such as a partnership or a limited liability company.
(2) Maximum tax rate on corporate income is 35%.
d) Partnership
i) Business entities that consist of 2 or more owners.
ii) Treated like a proprietorship for tax and liability purposes.
iii) Taxes are paid only at the personal level on the partner’s share of the income
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(1) This is called “pass through” taxation.

iv) Each partner is jointly and severally liable.
e) Limited Partnership
i) Like a partnership or proprietorship for tax purposes.
ii) Somewhat like a corporation for tax purposes.
(1) A partnership that has both limited and general partners.
(a) General: Assumes management responsibility and unlimited liability for
business.
(b) Limited: Similar to a shareholder.
f) Limited Liability Company (LLC)

i) A business structure to provide both the protection from liability of a corporation and
the protection from double taxation of a partnership.
(1) Owners are not individually liable for the company’s debts.
ii) The LLC is not a tax paying entity.
(1) Income taxes are only paid once – by the owners of the LLC when a part of the
company’s earnings is distributed to them.
g) How do you Choose?

i) Who will the owners be?
(1) If the investors and owners will be a small group of individuals, a partnership of
some form is clearly a possibility, as is an LLC.
(a) If the business will require Venture Capitalists, then they typically won’t
invest in LLCs, but only corporations b/c they don’t want to be held
personally liable.
ii) What are the Capital Requirements and cash flow characteristics of the business
likely to be?
Sole Proprietorship: Chapter 2

h) Most common form of business
i) The business and its owner are the same actual person and the same legal person.
(1) There is no legal separation of the business, the people who manage the business,
and the people who own the business.
(a) Therefore, the owner is responsible for the debts and obligations of the
business.
(2) No need to draft any legal document and no need to file anything.
(a) It is the “default” structure for a business with one owner; unless the owner
files papers to create some other structure, such as a corporation, his business
is automatically a sole proprietorship.
(i) The owner reports the business’ income on a personal tax return and pays
the taxes on that income (at his personal rate).
i) Problems with a Sole Proprietorship
i) Employees and Agency Principles
(1) In a sole proprietorship, the relationship between employees and owner is largely
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a matter of contract law.

(a) Agency
(i) Involves a delegation of a duty or goal of one person (principal) to another
person. (agent)
1. Restatement (Second) of Agency (RSA)
a. §1
i. Agency is a “fiduciary relation”
ii. There must be some “manifestation of consent by a principal to
an agent that the agent shall act on the principal’s behalf and
subject to the principal’s control.
iii. Consent by the agent so to act.
b. Agency is the result of conduct, and not of the words used. The
Conduct manifests that one will do something for another, who
is in charge.
(b) Third Parties and Agency
(i) Authority: Power of the agent to affect the legal relations of the principal
by acts done in accordance with the principal’s manifestations of consent
to him. RSA §7.
1. A deal by your agent with a 3rd party binds you if the agent had
“authority to bind the principal.
(ii) Actual Authority: Created by manifestations from the principal to the
agent that the agent reasonably believes create authority.
1. Express: P tells A that A is empowered to act on P’s behalf in
accomplishing some task.
2. Implied: Agent has the authority to do what is reasonably necessary to
get the assigned job done, even if P did not spell it out in detail.
(iii) Apparent Authority: Created by manifestations by Principal to a 3rd party.
1. Manifestations must be attributable to the Principle. §8 & §27.
2. Must get to the 3rd party
3. Must lead the 3rd party reasonably to conclude that the agent is an
agent for principal.
ANALYSIS: 1) is there an agency relationship, 2) Is there express or apparent authority to

act (cite the elements of express and apparent - §§26, 27. Finally, apply §140 to determine
if the principal will be liable to the 3rd party for the agent’s actions.
(iv) Respondeat Superior: A principal may be liable even though he is not

personally negligent.
1. Does not apply in all cases of agency.
a. Applies only to a subset of principal and agent relationships
called “master/servant.” RSA §220.
i. Master has the right to control the details of how the servant
does the job.
ii. Master has control over the day to day performance of the
agent’s task.
iii. Master is liable for the torts of a servant only if the tort was
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committed within the scope of employment. RSA §219

b. Servant must be distinguished from an independent contractor,
who is hired to do a job, but is not told specifically how to do it.
i. Servant: §2 states that a servant is employed by a master to
perform a service in his affairs whose physical conduct in the
performance of the service is controlled or is subject to the
right of control.
ii. Torts of ICs are generally NOT attributable to the person
who hires him.
iii. Vicarious tort liability comes from the fact that the person
engaging someone controls the details of how the job is to
be done.
HAYES V. NATIONAL SERVICE INDUSTRIES, INC – (1999)

Facts
Hayes sued NLS and its parent company alleging wrongful discharge from her employment as a
sales representative. The attorney for the 2 parties settled the case. Hayes rejected the
settlement, and National filed a motion to enforce the settlement agreement.
Lower court found that there was at least apparent authority despite the fact that the attorney
believed he had actual authority to settle the case.
Holding
The attorney’s authority is determined by the representation agreement between the client and
the attorney and any instructions given by the client.
The client is therefore “bound by his attorney’s agreement to settle a lawsuit, even though the
attorney may not have had express authority to settle, if the opposing party was unaware of any
limitation on the attorney’s apparent authority.
NOTES
- The law of agency provides the foundational structure for many of the legal
consequences that follow from the relationship between a lawyer and a client, as well as
the relationship between an individual and a law firm.
Franchises and other Business Relationships

- An agency relationship involves consent and control, but an agency will arise if a
franchisor/principal has the requisite degree of control over the franchisee/agent,
notwithstanding the customary boilerplate provision in the franchising agreement
that the parties do not intend an agency relationship.
MILLER V. MCDONALD’S CORPORATION – (1997); FRANCHISORS AND VICARIOUS LIABILITY

Facts
Miller bit into a Bic Mac and suffered an injury when she bit into a heart-shaped sapphire stone
embedded into the sandwich. The trial court granted summary judgment to McDonald’s on the
ground that it did not own or operate the restaurant, but was a mere franchisor and 3K was the
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proper party to sue.
3K owned the restaurant under a license agreement with McDonald’s that required it to operate
in a manner consistent with the McDonald’s System. This agreement specified numerous
different things that had to be strictly complied with.
Despite the numerous specifications that 3K was bound to uphold, there was a provision that
stated that 3K was not an agent of McDonalds, but an IC, and any claims by a 3rd party would be
solely against 3K.
Issue
Whether there is evidence that would permit a jury to find McDonalds vicariously liable for
those injuries because of its relationship with 3K.
Holding
Reversed. There is sufficient evidence to raise a jury issue under both actual agency and
apparent agency principles.
- Miller went to the restaurant under the assumption that McDonald’s owned, controlled,
and managed it.
o Therefore, Miller was justifiably relying on McDonalds.
 If the franchise agreement goes beyond the stage of setting standards,
and allocates to the franchisor the right to exercise control over the
daily operations of the franchise, an actual agency relationship exists.
• The court believes that a jury could find that McDonald’s retained
sufficient control over 3K’s daily operations that an actual agency
relationship existed.
 McDonald’s required precise methods that 3K must fulfill
 McDonald’s regularly sent inspectors
 McDonald’s uniforms, menus, recipes, etc. were to be used.
- RSA §267 – Apparent Agency

o “One who represents that another is his servant or other agent and thereby causes
a 3rd person justifiably to rely upon the care or skill of such apparent agent is
subject to liability to the 3rd person for harm caused by the lack of care or skill of
the one appearing to be a servant or other agent as if he were such.”
 The crucial issues are whether the principal held the 3rd party out as
an agent and whether the plaintiff relied on that holding out.
• It seems clear from the requirement of uniformity with other
McDonald’s restaurants that 3K was an apparent authority of
McDonald’s and that Miller was justifiably reasonable to believe
that she was eating at a McDonald’s restaurant.
How does a Sole Proprietorship Grow?
Funding by the Owner

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j) A business is often at greatest risk when it is just starting.

i) 1st investment into a business almost always comes from the owner.
ii) When money goes into the business, it goes in as an investment (“equity”), not as a
loan to be repaid to the entrepreneur.
k) Overview of Debt and Equity

i) All financing for a business is either 1) debt or 2) equity or 3) some combination of 1
and 2.
(1) Debt Funding: A loan that the business is legally obligated to repay – generally
with interest.
(2) Equity Funding: An investment that the business receives for selling part
ownership in the business.
(3) Differences
(a) When a business borrows money, the creditor is entitled to receive both
repayment of the amount borrowed (“principal”) and interest on that principal,
according to a set schedule.
(b) If someone provides equity funds the business is NOT legally obligated to pay
anything, although the business may choose to distribute some cash as
dividends.
1. Main Benefit of equity holders is ownership interest in the firm.
a. However, the equity owner has no right to repayment if the
business fails.
(c) Debt has a fixed cost: the interest rate the business pays to borrow the money
is the cost of those funds.
(d) If equity is sold to investors, then those investors share in the success of the
company.
(i) Owners give up a certain measure of control when they give up
equity.
1. The investors have a right to have a voice in how we run the business.
l) Borrowing Money
i) People can do several things to structure a loan so it will be perceived as low risk
(1) Pledge personal or corporate assets against the loan, as a form of collateral
(2) Promise to pay the $$ back in a short time
(3) Give the creditor some measure of control over the business
(a) Seat on the board of directors of a corporation, for example.
m) Sharing Profits with a Lender

i) The ultimate issue concerning whether a payment is a loan or an equity investment
has significant legal meaning.
IN RE ESTATE OF FENIMORE – (1999); SHARING PROFITS IS A PARTNERSHIP!!!

Facts
Mrs. Serge’s brother had borrowed an excess of 12.5K over the course of a few years.
Subsequent to Serge giving the money to her brother, they entered into an agreement by which
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the brother and Serge would “divide the profits from each vehicle bought and sold.” The
agreement does not specify the giving of the money as a loan, but as an “advance.”
Upon the brother’s death, Villabona came to collect on the brother’s debts to them. Serge did
likewise.
Serge argues that she gave a loan to her brother, and therefore the money remaining should first
go to her. She doesn’t want the court to consider her a partner with her brother because
then the creditor (which she would be if she is considered to have given a loan) gets paid
first.
Holding
The Court found that a partnership existed because she was to receive a share of the profits and
the allocation of expenses.
It is not essential to the existence of a partnership that all partners have the right to make
decisions and a duty to share liabilities on dissolution, but at least one of these factors must be
present.
Partnerships – Chapter 3
Partnership: A business with more than one owner.
- All statutory and common law definitions of a partnership refer to owners, plural.
UPA §6(1)
- Partnership: “An association of two or more persons to carry on as co-owners a
business for profit.”
o Obligations of a business operated as a partnership are also the obligations of its
owners.
- A partnership, however, in some other respects, is treated legally as an entity separate
from its owners.
o RUPA §201
 Partnership: “An entity distinct from its partners.”
UPA
- Embraces an “aggregate theory”
o It considers a partnership not as a separate legal person but rather is merely the
aggregate of its partners.
 Distinction without significance.
- Partnership itself DOES NOT pay tax on its profits
o Partners pay tax on any distribution made to them.
- What is Partnership Law?

o Deals with the rights and obligations of partnerships and the rights and obligations
of the partners.
 Case law remains an important part of partnership law.
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• Interprets the provisions in partnership statutes, as well as gaps in

these statutes.
- UPA §5 and RUPA §104

o “the principles of law and equity” govern to the extent not provided by statute.
- Primary Source
(1) The partnership agreement
(a) Relations among the partners and between the partners and the
partnership are governed by the partnership agreement.
(i) If the partners fail to agree upon a contrary rule, RUPA or the UPA will
provide the default rule.
(b) Therefore, the UPA and RUPA are fallback provisions
(i) Apply only if the partners have not agreed to the contrary.
1. Businesspeople should be left to structure their relationship as best
suits them.
- Legal Problems in Starting a Partnership

o Both sole proprietorships and partnerships do NOT require paperwork to establish
them.
 A partnership is assumed if more than one person shares in a
business’ profits regardless of the persons’ intentions.
o Although partnership agreements are not legally required, in the real world these
documents are extremely important.
 Partnership agreements are CONTRACTS
 Partnership agreements can change much of the statutory law that
otherwise would govern.
o For those people who do not form agreements, UPA and RUPA provide
reasonable rules that most people would put in a partnership agreement if they
had created one.
Problems in Operating a Business as a Partnership

- Under both UPA and RUPA, partnerships can and do own property.
o The individual partners do NOT own partnership property.
Who decides what the Partnership will do?

- Questions regarding who makes decisions for a partnership arise in two ways:
o Disputes between the partnership and some “outside” 3rd party.
o Disputes among the partners.
 Look to the partnership agreement first, then to provisions of relevant
partnership statute, and then common law agency principles.
MEINHARD V. SALMON – (1928)
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Facts
Salmon and Meinhard entered into an agreement whereby Meinhard would provide $$ for
renovations to a building in exchange for a share of the profits from the building over the course
of a 20 year lease. The agreement also provided that Salmon and Meinhard were to share any
losses equally but that Salmon had the sole power to manage the building.
Right before the 20 year lease expired, Gerry approached Salmon with a proposal. Gerry wanted
someone to lease all of these properties, to destroy the existing buildings, and to put up a new,
single, larger building.
Salmon accepted Gerry’s proposal and entered into a lease and development agreement with
Gerry. Meinhard was not a party not a party to this agreement, but when he learned of the deal,
he sued.
Holding
Meinhard and Salmon were co-adventurers, subject to fiduciary duties akin to those of partners.
Joint adventurers, like copartners, owe to one another, while the enterprise continues the
duty of finest loyalty.
- To the eye of an observer, Salmon held the lease as owner in his own right, for
himself and no one else. He held it for himself and another, sharers in a common
venture.
o If this fact had been known to Mr. Gerry, he have laid before both Salmon and
Meinhard his proposal.
- The very fact that Salmon was in control with exclusive powers of direction charged
him the more obviously with the duty of disclosure, since only through disclosure
could opportunity be equalized.
o Authority is abundant that one partner may not appropriate to his own use a
renewal of a lease, though its term is to begin at the expiration of the partnership.
- A managing co-adventurer appropriating the benefit of such a lease without warning to

his partner might fairly expect to be reproached with conduct that was underhand, or
lacking in reasonable candor.
Dissent
There was no general partnership, merely a joint venture for a limited object, to end at a fixed
time.
The new lease, covering additional property, containing many new and unusual terms and
conditions, with a possible duration of 80 years, was more nearly the purchase of the reversion
than the ordinary renewal with which the authorities are concerned.
NOTES
When there is a fiduciary relationship, there is, at a minimum, a duty to disclose business
matters.
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- §404: General Standards of Partner’s Conduct

o §404(a)
 Loyalty and care owed to the partners and partnership
o §404(d)
(ii) Good faith and fair dealing
o These obligations cannot be eliminated, but can be modified to a degree.
 §103
1. If the modification is reasonable, then it is not violative.
a. In many cases, however, an elimination of a certain duty will be
violative.
Who is Liable for What to Whom?

- Liability of the Partnership
o A partnership is a legal person or entity.
 Thus, a partnership can be held liable and can sue or be sued.
• A third party can sue the partnership for the contracts entered
by its agents and for the torts committed by its agent.
- A partner can sue the partnership to enforce her rights under RUPA or the
partnership agreement.
Liability of the Partners
- Under RUPA, partners are jointly and severally liable for all obligations of the
partnership. §305, 306, and 307.
o UPA §15
 Partners are jointly, but NOT severally liable in contract but jointly and
severally liable in tort.
o With joint liability, the plaintiff must sue all of the partners together in a
single suit.
 With joint and several liability, however, the plaintiff is free to sue one
or more of the partners.
- §306
o All partners are liable jointly and severally for all obligations of the partnership
unless otherwise agreed, and in those situations in (b) and (c)
 Person admitted as partner is not liable for any partnership obligation
incurred before he becomes partner.
 Applies to LLPs only – See page 30.
§307 – Actions by and Against Partnership and Partners
- A partnership may sue and be sued
o An action may be brought against the partnership and, to any extent not
inconsistent with §306, any or all partners in the same action.
 A judgment against partnership is not itself a judgment against a partner.
• A judgment against a partnership can’t be satisfied from a partner’s
assets unless there is also a judgment against that partner.
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- A person trying to secure $$ of a partner may not get the assets of the partner to satisfy a
judgment based on a claim against the partnership unless the partner is personally liable
for the claim under §306 AND:
o A judgment based on the same claim has been obtained against the partnership
and a writ of execution on the judgment has been returned unsatisfied in whole or
part.
 Huh?
• You cannot go after a single partner’s assets unless you first
exhaust the partnership’s assets first AND the partner is
personally liable.
How Does a Partnership Business Grow?

- Requires $$$ which usually comes from one of four sources:
o Existing Owners
o “Outside” Lenders
- New Investors
- Earnings from the Business Operations
Existing Owners
- There is no statutory requirement that partners make initial or additional capital
contributions.
o Partners themselves agree on capital contributions
- Look to the partnership agreement.

o Properly drafted, such provisions will state:
 Vote or events that trigger the obligation to contribute
 Amount of each partner’s contribution obligation
 Time in which to make the additional contribution
 Consequences of a failure to contribute.
Outside Lenders
- Banks
o See Chapter 2’s discussion concerning what a business can do in order to make a
business venture appear less risky to a bank.
Additional Owners (i.e. Investors)
Financial Issues
- Again, investors are going to be balancing risk and return.
o If risk is high, then the short or long-term return to the investor has to be high to
induce the investment.
- Common Method of Measuring Return on Investment

o Compare the amount of cash flow (i.e. the cash from business operations that
15
could be paid to the business’ owners) with the amount of the owner’s investment
in a business.
 An owner’s risk ad his “return on equity” are affected not only by the
business’s cash flow but also by the business’s financial structure.
 The higher the amount of debt a business has, the higher the risk to
the owner, and the higher the rate of “return on equity” that the
investor will look for.
Legal Issues
Approval of New Partners

- RUPA §401(i)
o Requires consent of all existing partners unless the partnership agreement
provides otherwise.
Liability of New Partner

- §306(b)
o A new partner is not personally liable for partnership obligations “incurred before
the person’s admission as a partner.”
Earnings from Business Operations

- Partnerships should evaluate whether he partnership can earn a higher return than the
partners could earn individually if the money were distributed to them.
o Earnings should be distributed unless the partnership has some lucrative use
for the funds.
How do the Owners of a Partnership Make Money?

- Salary
o Receiving all or part of the profits from that business
o Law is found in the partnership agreement and other contracts and laws.
 §401(b)
• “Each partner is entitled to an equal share of the partnership profits
and is chargeable with a share of the partnership losses in
proportion to the partner’s share of the profits.”
- Selling her interest in the business
o Sale of Ownership Interest to 3rd Party
 Problems
• Finding a buyer
• Gaining any necessary approval from existing partners
• Dealing with the question of “inherited” obligations
(c) RUPA §502
(i) “The only transferable interest of a partner in the partnership is the
partner’s share of profits and losses of the partnership and the partner’s
right to receive distributions.”
(2) Sale of Ownership Interest Back to Partnership
16
(a) It is common for the partnership agreement or some separate agreement

among partners to provide for sale of partnership interests back to the
partnership or to other partners.
(i) “Buy-Sell” Agreements
1. Should address the following:
a. Remaining partners obligation to buy or do they have the option to
buy?
b. The events which trigger an obligation or option
c. How the selling partner’s interest is to be valued
d. Method of funding the payment
e. ***Pay attention to tax effects!!
(3) Withdrawal of a Partner
(a) UPA §29
(i) Dissolution: Change in the relation of the partners caused by any partner
ceasing to be associated in the carrying on as distinguished from the
winding up of the business.
(b) UPA §30
(i) On dissolution the partnership is not terminated, but continues until the
winding up of partnership affairs is completed.
(c) Winding Up: A liquidation of the business, after which the partnership will
actually terminate.
(d) RUPA §602
(i) Any partner has the “power” to dissociate withdraw at any time.
1. If the withdrawal or dissociation violates the partnership
agreement, or occurs before the expiration of the partnership
term, or satisfies any other circumstance set out in §602(b), it is
“wrongful.”
a. If the dissociation is wrongful, the partner may be paid less than
otherwise for her partnership interest and, more importantly, may
be paid later. RUPA §602(c)
(e) RUPA §701: Purchase of Dissociated Partner’s Interest
(i) If partner dissociated from partnership his buyout price will be determined
by (b).
(ii) Buyout price is the amount that would have been distributable to the
dissociating partner under 807(b) if, on the date of the dissociation, the
assets of the partnership were sold at a price equal to the greater of the
liquidation value or the going concern value without the dissociated
partner.
CREEL V. LILLY – (1999)

Facts
In 1993 Mr. Creel began a retail business selling NASCAR racing memorabilia. In 1994, Creel
entered into a partnership agreement with Lilly and Altizer to form a general partnership called
“Joe’s Racing.” 9 months later, Creel died. His wife demanded that the partnership liquidated
all of its assets in order to determine the proper amount to be given to Creel’s estate. The
partners refused.
17
In their partnership agreement, there was a crudely prepared section entitled “termination.” See
page 117.
Issue
Whether Maryland’s UPA permits the estate of a deceased partner to demand liquidation of
partnership assets in order to arrive at the true value of the business.
Holding
- WHEN CONFLICTS BETWEEN PARTNERS ARISE, COURTS MUST FIRST LOOK TO THE PARTNERSHIP
AGREEMENT TO RESOLVE THE ISSUE.
o The “termination” provision is really discussing the dissolution of the partnership
and the attendant winding-up process that ultimately led to termination.
 Paragraph 7(a) was
- Maryland’s UPA does not grant the estate of a deceased partner the right to
demand liquidation of a partnership where the partnership agreement does not
expressly provide for continuation of the partnership and where the estate does not
consent to continuation.
o To hold otherwise vests excessive power and control in the estate of the deceased
partner, to the extreme disadvantage of the surviving partners.
 Paragraph 7(a) requires that the assets, liabilities, and income be
“ascertained,” but it in no way mandates that this must be accomplished
by a forced sale of the partnership assets.
o In this case, the winding up method was outlined in 7(a) was followed exactly by
the surviving partners.
 Further 7(d) makes no mention of a sale or liquidations being essential in
order to determine the deceased partner’s proportionate interest of the
partnership.
• 7(d) more appears to be a crude attempt to draft a “continuation
clause” in the form of a buy out option by providing that the
deceased partner’s share of the partnership goes to his estate, and if
the estate wishes to sell this interest it must first be offered to the
remaining partners.
o When subsections (a) and (d) of paragraph 7 are read in conjunction, it is
apparent that the partners did not intend for there to be a liquidation of all
partnership assets upon the death of a partner.
- Further, where the surviving partners have in good faith wound up the business and
the deceased partner’s estate is provided with an accurate accounting allowing for
payment of a proportionate share of the business, then a forced sale of all
partnership assets is unwarranted.
NOTES
Book Value: The cost of inventory.
G. Partnership Endgame
18
1. Dissolution, Winding Up and Termination as Endgame for the Partnership
- Under RUPA, the partnership faces 2 choices when a partner dies or otherwise withdraws
from the partnership:
o The remaining parties can purchase the departing partner’s interest and
continue the partnership business [§701(a)-(b)], or
o The partnership can dissolve, liquidate, and terminate. [§807(b)]
- Dissolution is not the end of the partnership.

o It is the beginning of the end.
 Comment 2: RUPA §801
• “Dissolution” is merely the commencement of the winding up
process.
o Partnership continues for the limited purpose of
winding up the business.
 Winding up the partnership business entails selling
its assets, paying its debts, and distributing the net
balance, if any, to the partners in cash according to
their interests.
• The partnership entity continues, and the
partners are associated in the winding up
of the business until winding up is
completed.
o When the winding up is completed,
the partnership entity is terminated.
o The problems of a dissolving partnership’s distributions to the partners
“according to their interests” can be much more complicated, if the
partnership agreement does not fully address the problems.
 RUPA provides default rules to address the problems in §§401 and 807.
• 4 basic concepts that need clarification:
o Unless the partners agree to the contrary,
 They share responsibility not only for losses from
partnership business but also for partners’ losses
from investments in the partnership. §401(b)
 Amount of each partner’s loss from her investment

in the partnership is determined from her
partnership account, a bookkeeping device which
keeps track of how much a partner puts into the
partnership, how much she has taken out of the
partnership, and her share of the partnership’s
profits and losses. §§ 401(a), 807(a)-(b).
19
 When the partnership is dissolved, the partnership is

legally obligated to pay each partner an amount
measured by the balance in her partnership account.
§807(b).
- Summarizing §401, the amount in each partner’s account will be:

o Investment in partnership (-) Distributions received (+) equal share of
anything left over after creditors are paid.
 If there are insufficient funds to cover the creditors, this loss will be
divided equally among the partners’ accounts.
• If a partner has a negative balance in his account (for whatever
reason), he will have to contribute additional funds to the
partnership in the amount of the negative balance. §807(b).
KOVACIK V. REED – (1957)

Facts
In 1952, Kovacik and Reed entered into a joint venture whereby Kovacik would invest about
10K into a venture for some remodeling work for Sears. Kovacik said he would supply the
investment if Reed would perform the labor and they would split the profits 50/50. Kovacik did
not ask Reed to agree to share any loss that might result and Reed did not offer to share any such
loss.
In 1953, Kovacik informed Reed that the venture had been unprofitable and demanded
contribution from Reed as to amounts which Kovacik claimed to have advanced in excess of the
income received from the venture.
Procedural History
Trial court concluded that the two were to share equally all their joint venture profits and losses
between them.
Issue
Whether or not a co-venturer who invests only his labor into a project can be held liable for
financial loss as a result of the venture.
Holding
- General Rule:
o In the absence of an agreement to the contrary, the law presumes that partners and
joint adventurers intended to participate equally in the profits and losses of the
common enterprise, irrespective of any inequality in the amounts each contributed
to the capital employed in the venture, with the losses being shared by them in the
same proportions as they share the profits.
- Exception
o Where one partner or joint adventurer contributes the money capital as against the
other’s skill and labor, neither party is liable to the other for contribution for any
loss sustained.
20
- Rationale
o Where one party contributes money and the other contributes services, then in the
event of a loss each would lose his own capital – the one his money and the other
his labor.
**In this case, the partnership had already paid its obligations to creditors; it had paid these 3rd
parties with partnership funds that had been invested in the partnership by Kovacik.
- The partnership had ended. It had no more debts.
o The question was not whether creditors of the partnership would recover on their
claims, but whether Kovacik would recover anything on his investment in the
partnership.
 Unless it is answered in the partnership agreement, that question will
be answered by RUPA §807.
2. Expulsion as an Endgame for a Partner
- Expulsion is not expressly dealt with by RUPA.
BOHATCH V. BUTLER & BINION – (1998)

Facts
Bohatch became an associate at the officers of Butler & Binion in 1986. She was made partner
in 1990 and began receiving internal firm reports showing the number of hours each attorney
worked, billed, and collected.
She became concerned another partner was overbilling, so she met with the managing partner
and discussed this. Shortly thereafter she was told that she should begin looking for other
employment. In 1991 the firm denied her a year end partnership distribution for 1990 and
reduced her tentative distribution share for 1991 to 0. In September, she found new employment.
She filed this suit in October 1991, and the firm voted formally to expel her from the partnership
3 days later.
Issue
Whether there should exist an exception to this rule by holding that a partnership has a duty not
to expel a partner for reporting suspected overbilling by another partner.
Holding
- General Rule:
o The relationship between partners is fiduciary in character, and imposes upon all
the participants the obligation of loyalty to the joint concern and of the utmost
good faith, fairness, and honesty in their dealings with each other with respect to
matters pertaining to the enterprise.
 A partnership exists solely because the partners choose to place
personal confidence and trust in one another.
• Charges of overbilling may have a profound effect on the
personal confidence and trust essential to the partner
relationship.
21
- The firm did not owe Bohatch a duty not to expel her for reporting suspected
overbilling by another partner.
PAGE V. PAGE – (1961)

Facts
The partners entered into an oral agreement in 1949 as partners in a linen supply business. Each
had invested about $43,000 for the purchase of land, machinery, and linen needed to begin the
business.
From 1949 to 1957 the enterprise was unprofitable, losing about $62,000. The partnership’s
major creditor was a corporation, wholly owned by the plaintiff that supplies the linen and
machinery necessary for the day to day operation of the business. This corporation held a
$47,000 demand note of the partnership.
Shortly thereafter, the business began to improve. However, dispute this, the plaintiff wished to
terminate the partnership.
Arguments
Defendant believes that plaintiff is acting in bad faith and is attempting to use his superior
financial position to appropriate the now profitable business of the partnership.
Issue
Can a partner withdraw from a partnership so he can take the partnership’s business for himself?
Holding
- There is no showing of bad faith or that the improved profit situation is more than
temporary.
o Even though the UPA provides that a partnership at will may be dissolved by the
express will of any partner, this power, like any other power held by a fiduciary
must be exercised in good faith.
 Partners may not obtain any advantage over him in the partnership
affairs by the slightest misrepresentation, concealment, threat, or
adverse pressure of any kind.
- A partner at will is not bound to remain in a partnership, regardless of whether the
business is profitable or unprofitable.
o A partner may not, however, by use of adverse pressure “freeze out” a co-
partner and appropriate the business to his own use.
 A partner may not dissolve a partnership to gain the benefits of the
business for himself, unless he fully compensates his co-partner for his
share of the prospective business opportunity.
- Plaintiff has the power to dissolve the partnership by express notice to defendant.
o If it is proved that plaintiff acted in bad faith and violated his fiduciary
duties by attempting to appropriate to his own use the new prosperity of the
partnership without adequate compensation to his co-partner, the dissolution
22
would be wrongful and the plaintiff would be liable.
Chapter 9: Limited Partnership and How Does it Work?
A. What is a Limited Partnership and what is Limited Partnership Law?
- The most obvious difference between a limited partnership and a general partnership is
that a limited partnership has limited partners.
o Limited partnership (LP) must have at least 1 general partner.
 Limited partners are not personally liable for the debts of the limited
partnership.
• The general partners have the same rights and duties as partners in
a general partnership.
- Because of the hybrid nature of LPs, they are subject not only to limited partnership
laws but also to general partnership laws.
o RULPA §1105
 In any case not provided for in this act, the provisions of the UPA govern.
B. What are the Legal Problems in Starting a Business as a LP?
- LPs to do not come into existence until there has been a public filing, usually with the
secretary of state of the state of organization.
o Certificate of Limited Partnership document.
 The more important document to clients is the LP agreement.
- LP statutes require that:

o LP must have at least 1 partner
 This general partner, unlike the limited partners, is liable for the debts of
the partnership
o The name and the address of the general partner must be set out in the
Certificate of Limited Partnership, which is filed in public records.
 LP statutes do not, however, require that the general partner be an actual
person.
• A corporation may be a general partner, for example.
C. What are the Legal Problems in Operating a Business as a LP?
1. Who decides what?
- This is answered in either 1) a LP statute or 2) a LP agreement.

o Rule of Thumb: General Partner decides.
 RULPA establishes this as a default rule.
• Unless the LP agreement specifies otherwise, the general partner
has the same rights as a partner in a general partnership. RULPA
§403.
23
NOTE
- RULPA §303(b)(6)(v) is the only provision in RULPA relating to removal of a general
partner.
- LPs are not liable for the acts or debts of the LP.
o They are more like shareholders of a corporation – they make an investment
(which is at risk), but are not liable for what the business does.
 As the law developed, it became clear that a LP who exerted “control”
over the business of the LP would become liable for the acts and debts
of the business.
• By exercising “control,” the LP had essentially become a general
partner for liability purposes.
o §303(a)
 Even if a limited partner exercises “control,” he will
nonetheless be liable only when he acted in a way
that caused a third party to reasonably believe that
he was a general partner.
o §303(b)
 Safe harbor provision which lists activities that will
NOT constitute “control” by the limited partner.
- Under ULPA, there is NO CONTROL TEST
2. Who is Liable to Whom for What?
a. To 3rd Parties
- Each general partner of a LP is personally liable for the partnership’s debts to 3rd parties
as if the partnership were a general partnership.
o RULPA 403(b)
 Except as provided in this Act, a general partner of a LP has the liabilities
of a partner in a partnership . . . to persons other than the partnership and
other partners.
ZEIGER V. WILF – (2000)

Facts
Zeiger was supposed to receive 27K/year for 16 years after he had sold certain property to
Trenton, Inc. The contract for sale stipulated that Trenton could assign its property interests to
another entity, and Trenton assigned it to a limited partnership called Trenton LP.
After 2 years, however, the payments ceased due to a failing project and Zeiger sought to hold
Wilf personally liable for the payments.
Wilf’s Argument
He maintains that in doing so, he was functioning as vice president of the Trenton, Inc. which
was the only general partner of the limited partnership.
24
Holding
- Limited Partnership Law establishes a differentiation between the broad liability of a
general partner for the obligations of a limited partnership, and the non-liability of a
limited partner for such obligations.
o Zeiger’s argument rests on Wilf’s key role in the renovation project.
 Wilf acknowledges that role, but argues that his actions were taken as a
VP of Trenton, Inc – the corporation which was the sole general partner of
Trenton, LP.
• Since Trenton is an artificial entity, it can only function
through its officers, and that is precisely what Wilf was doing
at all times when he acted concerning this enterprise.
-
o There is no claim that Zeiger was misled, or that he relied on some
impression that Wilf was a general partner of Trenton, LP, and thus there is
no basis for any for any finding of personal liability against Wilf.
 §303, therefore will not hold Wilf accountable.
b. To the Partnership and Partners
- A general partner in a LP has liability exposure not only to third parties for the
obligations of the LP but also has liability exposure to the LP and to the limited partners
for breach of fiduciary duties.
KAHN V. ICAHN – (1998)

Facts
Kahn brought this suit on behalf of AREP against AREP’s general partner API, and the general
partner’s sole shareholder and CEO ,Icahn.
Kahn alleged that Icahn breached his fiduciary duties to AREP and usurped, for himself, a
corporate opportunity of AREP by failing to make the opportunities completely available to
AREP and, instead, keeping a percentage of the profits for his other endeavors and ventures.
The agreement between AREP and API provides that the general partner, may “compete, directly
or indirectly with the business of the Partnership.”
Holding
- Delaware law permits partners to agree on their rights and obligations to each other
and to the partnership.
o They may expand or restrict duties as they wish pursuant to the Delaware
Revised Limited Partnership Act.
 The defendant’s duties to AREP are defined by the Partnership Agreement
that clearly permitted the Icahn Defendants to make the investments
without bringing them to the limited partners.
• The clause in the partnership agreement was unambiguous
that it authorized competition with the partnership.
25
o Therefore, plaintiffs can hardly be said to have a legitimate

expectancy to be informed of relevant investments made by
API.
Chapter 10: LLCs

A. What is an LLC and what is LLC Law?
- An LLC offers all of its owners, generally referred to as members, both:

o Protection from liability for business’ debts
o Same pass-through income tax characteristics of a partnership
- LLC law is primarily contract law, with state statues being default provisions if
there is no contrary provision in the operating agreement.
o Typically, members of an LLC enter an operating agreement, which sets out the
rules that govern the firm.
 Delaware LLC Statute:
• Gives great deference to the operating agreement.
B. What are the Legal Problems in Starting a Business as an LLC?
- An LLC is formed at the time of the filing of the initial certificate of formation in the
office of the Secretary of State. §DLLCA §18-201.
o The most important document is the Operating Agreement.
What are the Legal Problems in Operating a Business as an LLC?
- Who decides what?

o Owners of an LLC can elect the form of management.
 Member-Managed
• Decision-making authority of the members of a member-managed
company is much like that of the partners in a general partnership.
• Operating Agreement will answer:
o How to determine how many votes each member has
o How to determine what matters require more than majority
vote
 Manager-Managed
• Decision-making authority is similar to a corporation with a board
of directors.
• Operating agreement will answer:
o How members elect and remove managers and
o What issues require a member vote.
- Who is Liable to Whom for What?
26
o Members’ Liability to 3rd Parties

 LLC is an entity, and creditors must collect from the LLC, not its
members.
• LLC statutes protect the owners from personal liability for these
claims against the company.
o There is NO general partner who is liable.
 An advantage over a limited partnership.
o Members’ and Managers’ Liability to the Company

 A member acquires her ownership interest in a LLC by making or
agreeing to make a payment or other contribution to the company.
• Look to the operating agreement for specifics!
o Fiduciary Duties
 Member Managed
• Members owe fiduciary duties
 Manager-Managed
• Managers owe fiduciary duties
o Members doe NOT.
LYNCH MULTIMEDIA CORP. V. CARSON COMMUNICATIONS, LLC – (2000)

Facts
CLR has 3 owners: Lynch, Carson, and Rainbow (hence CLR). Carson was appointed as
president of CLR, and was given “general and active management” of CLR’s business, and he
carried out order and resolutions of the Board of Managers.
There was an OA which stated that any “opportunity which comes to the attention of a Member
to purchase cable television systems . . . shall first be offered to CLR.” Another provision,
however, also said that any Member or Manager may engage independently or with others in
other business ventures of every nature and description, and would not be deemed improper.
Carson learned of an opportunity that certain cable systems might become for sale. He notified
the company, and was essentially brushed off about the prospect. He persevered on the matter,
but to no avail, and eventually he purchased the cable systems for himself about 3 years after he
first notified the Board of CLR.
Lynch sued Carson, alleging breach of OA, and breach of fiduciary duties.
Lynch’s Arguments
Carson could not fulfill the duty created by the OA unless he presented the other members with a
no-strings-attached purchase offer at a properly called special meeting of the members.
- Carson, however, argues that “offer” simply means that he must notify the members of
the opportunity.
Issue
27
Whether Carson, acting as president of CLR, breached his OA and fiduciary duties owed to
CLR.
Holding
No. The interpretation of “offer” proffered by Lynch must be rejected.
- The provisions must be read in context of the entire OA.

o Also, the OA is plainly directed at permitting the members to enter into separate
and additional business relations in the cable television industry.
 Carson informed the other members of CLR Video of certain opportunities
to purchase cable companies.
• Only after the passage of several months or years, and at one
point after the rejection of the proposal, did Carson
independently acquire the companies.
D. How do the Owners of a Business Structured as a LLC make Money?
- OA provides how and when a LLC’s earnings are to be distributed to its members.
o Statutory provisions are default rules: ULLCA §405, for example.
LIEBERMAN V. WYOMING.COM, LLC – (2000)

Facts
In 1994, Wyoming was formed by the Mossbrooks and Lieberman. The initial capital
contribution to Wyoming was about 50K. Lieberman’s contribution represented a 40%
ownership interest in the LLC. In 1995 the OA was amended to reflect an increase in
capitalization of 100K due to two new members receiving 2.5% interest. Lieberman’s interest
remained the same.
In 1998, Lieberman was terminated as VP of Wyoming and required to leave the business
premises. Lieberman then demanded a return of “his share of the current value of the company,”
valued at around 400K (which was based on a recent offer from the Mossbrooks. Wyoming
accepted his withdrawal and approved the return of his 20K contribution. Lieberman refused to
accept.
Procedural History
District court granted Wyoming’s motion for summary judgment and denied Lieberman’s
motion for partial summary judgment.
Holding
- A member’s interest in an LLC consists of economic and non-economic interests.
o One interest is a member’s capital contribution, which a member may withdraw
under certain conditions.
 A member also generally has the right to receive profits.
o A member’s interest usually grants him the ability to participate in management.
 Overall, a member’s interest is transferable, although the management
28
rights of a transferee may be limited.
- Court goes on to hold that the Wyoming statutes provide for the return of only the initial
or stated capital contribution of a member.
o Nothing in the statute indicates that the FMV of a member’s interest is to be
included in the amount to be paid to a member upon withdrawal of that
member’s capital contribution.
 The statute requires that the Articles of Organization be amended when
the amount or character of contributions changes.
• The amount of a member’s contribution is a constant not
subject to market fluctuations.
o Other state statutes allow for the FMV to be distributed, but
they contemplate dissociation, which isn’t present here.
- However, the court says that Lieberman has NOT forfeited his interest upon his
withdrawal b/c he did not have an intent to do so.
o The fact that he demanded the 400K indicates his unwillingness to forfeit his
interest unless paid the 400K.
 So the court looks to the Operating Agreement
• There is nothing in the record indicating what became of
Lieberman’s membership certificate; there is no indication it has
been canceled or forfeited.
Chapter 4: Corporations
A. What is a Corporation and what is Corporate Law?
- A corporation is whatever the relevant state law says it is.

o Every state has a general corporation statute which provides:
 Corporation is a separate legal entity and
 Owners (shareholders) are generally not personally liable for the debts of
the corporation.
• No statutory limit on how much money an owner of a corporation
can make from her investment in a corporation
o The most that she risks is the amount that she paid for
the shares of stock.
 This is the limit of her liability.
- Purpose of Corporate Law

o The facilitation of cooperative activity that produces wealth.
- Economists View of Corporations

o A way to reduce transaction costs as compared to frequent transactions in
markets.
o Economists sometimes view the corporation as a set of contractual relationships
among the suppliers of all of the corporation’s inputs.
29
o Economists are concerned about “agency costs.”

 Any employee or other agent of the corporation may have an incentive to
benefit himself rather than the corporation.
• Much of corporate law and lawyering attempts to control agency
costs.
- 4 Sources of Corporate Law

o State statutes
 More than half the states have modeled their statutes in some measure on
the MBCA.
o Articles of incorporation (AOIs), Bylaws and other agreements
o Case Law
 Serves 2 corporate law functions
• Cases interpret and apply the provisions in corporate statutes and
in a corporation’s articles and bylaws.
• Cases fill gaps in the law
o Federal statutes
 There is no general federal corporation statute.
• There are important federal statutes that govern certain corporate
activities.
B. What are the Legal Problems in Starting a Business as a Corporation?
- Preparing the Necessary Papers

o AOIs
 A corporation does NOT exist until the AOIs are properly executed and
filed with the appropriate state agent or agency.
• MBCA §2.03
o Where the articles are to be filed
• §2.02(a)
o What AOIs must contain.
o Bylaws
 MBCA requires that a corporation adopt bylaws
• §2.06(a)
 Traditionally, this is not required.
• In the real world, almost every corporation does have bylaws, so
perhaps the MBCA is simply requiring what everyone does
anyway.
o Delaware does NOT require bylaws
 §109
 Bylaws are not required to be filed with any state agent or agency
• They are internal documents.
- Contracting Before Incorporating

30
o Promoter: Someone acting on behalf of a corporation that is not yet formed.
- “Secret Profit” Rule

o After a corporation is formed, a promoter might sell property to the corporation.
 When this happens, she has a duty to disclose to the corporation any profit
she is making.
• If she fails to do so, the corporation can recover her “secret profit.”
o This recovery emanates from the fiduciary duties that the
promoter owes to the corporation.
 There is no fiduciary duty and no secret profit
liability for the promoters’ pre-incorporation
transactions.
• When the corporation comes into
existence, the fiduciary duties attach and
retroactively prohibit the promoter from
making a secret profit on her dealing with
the corporation.
o ANALYSIS
 Has the promoter made a profit?
• For property acquired while he was a promoter, the test for profit is
the price paid by the corporation minus the price paid by the
promoter.
o A promoter is liable to the corporation ONLY if the
profit was secret.
- Issuing Stock
o Shares of stock are the units of ownership in a corporation.
 MBCA §6.03
• A corporation may issue the number of shares of each class or
series authorized by the AOIs.
o Shares that are issued are outstanding shares until they are
reacquired, converted or canceled.
o Corporation sells its own stock
 Called an issuance
o AOIs determine the number of shares a corporation may issue
 Called “authorized shares”
o A corporation is not required to issue all of its authorized shares
 Shares that the corporation actually does issue are called “issued shares.”
o “Outstanding shares” consist of issued shares that the corporation has not
reacquired
 A corporation can have more than one type (“class or series”) of stock.
VOCAB
Preferred Stock: If the AOIs provide that a certain kind of stock is to be treated more favorably
than the other class of stock, then it is preferred stock.
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Common Stock: Type of stock that does not enjoy special treatment.
Outstanding Stock: The amount of shares that have been issued and are in the hands of the
public.
Par Value: The minimum price for which a corporation can issue its shares.
- Par value affects only the issuance price.
- MBCA and a majority of statutes have eliminated the requirements that AOIs provide a
par value for stock and that corporations maintain a “stated capital” account.
Stated Capital: Includes the aggregate par value of all issued shares of par value stock.
- The stated capital account cannot be distributed to shareholders.
o It is a cushion to protect creditors, to ensure that the company retains at least some
money to pay its bills.
Capital Surplus: Excess money from the stated capital which may be distributed to shareholders.
- Choosing the State of Incorporation and Qualifying as a “Foreign Corporation.”

o Business can choose to incorporate in any state, even one in which there is no
business activity.
 The laws of that state will then become the default rules that govern the
“internal affairs.”
• Internal affairs include procedures for corporate actions and the
rights and duties of directors, shareholders and officers.
o Usually, the corporation selects its home state or
Delaware.
- Costs of Incorporating in Delaware
o Extra costs to incorporate (attorney’s fees, filing, etc.)
o Fees to State of Delaware
o Making payments as a foreign corporation
 Foreign corporations transacting business in its state to “qualify to do so.
• Includes:
o Obtaining authorization from appropriate state agency
o Appointing a registered agent in the state
o Filing annual statements in the state
o Paying fees and franchise taxes to the state.
Chapter 5: How does a Corporation Operate?

A. Who is Liable to the Corporation’s Creditors?
- A corporation is an “entity” and a “person.”

o It can be sued for the actions of its agents.
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- A shareholder’s protection from personal responsibility for the corporation’s liability is

basic to the corporate structure and to corporate law. MBCA §6.22(b)
- There are contractual and judicial exceptions to the rule that shareholders are not
personally liable for the acts or debts of the corporation.
o 3rd parties often refuse to extend credit to a corporation with limited assets unless that
corporation’s shareholders agree to be personally responsible.
DEWITT TRUCK BROKERS, INC. V. W. RAY FLEMMING FRUIT CO. – (1975)

Facts
Flemming owned FFC, which contracted with Dewitt for Dewitt to transport fruit that FFC was selling for
a 3rd party on commission. Because FFC was struggling financially, Dewitt wanted assurance that
Flemming, the principal shareholder, would be personally responsible for payment. He orally agreed to
be responsible.
This oral promise was not legally enforceable b/c of the statute of frauds, and so Dewitt asks the court to
“pierce the corporate veil.”
Procedural History
District Court found that the corporate veil may be pierced and hold Flemming personally liable.
Issue
May the corporate veil be pierced in this situation in order to hold Flemming personally liable for the
debts of his corporation?
Holding
Yes. The corporate veil may be pierced.
- “Clearly Erroneous” standard applies and the District Court was not clearly erroneous.
o General Rule:
 A corporation is a separate entity and its debts are not the individual indebtedness
of its stockholders.
o Exception: “Piercing the Corporate Veil”
 The courts will decline to recognize the general rule whenever recognition of the
corporate form would extend the principle of incorporation ‘beyond its legitimate
purposes and would produce injustices or inequitable consequences.
• Power to pierce the corporate veil is to be exercised “reluctantly”
and “cautiously” and the burden is on the party asserting such a
claim
- This claim, in every case is to be decided in accordance with its own underlying facts.
o Since the issue is one of fact, its resolution is particularly within the province of the
trial court.
Factors to Determine Whether the “Corporate Veil” should be Pierced

1. Substantial Ownership of stock in a single individual
2. Undercapitalization (i.e. any situation where a business cannot acquire the funds they need).
3. Failure to observe corporate formalities (i.e. records, payment of dividends, siphoning, etc).
4. Combine #s 1-3 with other factors clearly supporting disregard of the corporate fiction on
grounds of equity and fairness.
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**When one induces a creditor to extend credit to the corporation on such an assurance (as that
made by Flemming), that fact has been considered by many authorities a sufficient basis to pierce
the corporate veil.
NOTES
- A corporation can be a shareholder of another corporation.
o Usually, a corporation is often the only shareholder of another corporation.
 A corporation whose stock is owned by another corporation is commonly
referred to as a “subsidiary.”
Subsidiary: A corporation, a majority or all of the outstanding stock of which is owned by another
corporation, called the parent corporation.
- Parent corporations are NOT liable for the contracts, torts, and other obligations of its
subsidiary corporation unless there is a contractual or judicial exception to the rule that a
shareholder is not liable for the acts or debts of the corporation.
o A corporation may not be held liable for the actions of another company merely
because it has an ownership interest in it.
 Control Test
• Liability will be attached to a parent corporation if the parent
company exerts a direct intervention in the transaction, ignoring the
subsidiary’s paraphernalia of incorporation, directors and officers.
- Sometimes veil piercing is used, not to impose liability on a corporation’s owners, but instead to
create personal jurisdiction over them.
o Personal jurisdiction exists if defendant has “minimum contacts” with the state where the
court is located.
Enterprise Liability: Piercing the walls of one corporation, not to go after the assets of a shareholder, but
to go after the assets of related companies.
- Corporations that, although technically separate, are commonly-owned and in reality engaged in
one enterprise together should be treated as a single legal entity for purposes of liability.
- As the scale of business enterprises enlarged, the process of subdivision began; subsidiary
corporations wholly-owned or partly-owned.
o Usually, a single large-scale business is conducted, not by a single corporation, but
by a constellation of corporations controlled by a central holding company, the
various sectors being separately incorporated.
 This is because the corporations were once independent and later acquired by the
larger corporation or because the large corporations want to expand into different
fields.
B. Who Gets to Make Decisions for the Corporation?
- The answer to “who decides what” varies with the corporation.

o Ownership in large corporations is widely dispersed
o No single shareholder owned sufficient stock to control the corporation’s agenda
o Larger the corporation, the smaller the proportion of stock held by management.
1. BOARD OF DIRECTORS AND OFFICERS
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- Generally, if a corporation has more than 4 or 5 shareholders, most shareholders play virtually no
role in making decisions regarding the operation of the business.
o Their important decision is when to sell their shares.
- Under the corporation codes of all states, it is the board of directors that is entitled to make
the corporation’s most important decisions.
o Shareholders select Board of Directors, who select CEOs and other corporate
officers.
 A director can also be an officer.
• “Inside” Directors: Those directors who are also officers
• “Outside” Directors: Those directors who are NOT officers.
o Board Members are NOT agents of a corporation or its shareholders.
 AGENCY LAW DOES NOT APPLY TO BOD
• AGENCY LAW DOES APPLY TO ITS OFFICERS
MCQUADE V. STONEHAM – (1934)

Facts
Stoneham was majority owner of NEC and McQuade and McGraw each purchased 70 shares of his stock,
still leaving Stoneham with a large portion of shares. McQuade had paid Stoneham over 50K for the
stock he had purchased. As a part of the transaction, an agreement was entered into whereby Stoneham,
McQuade, and McGraw would appoint McQuade and McGraw as directors of NEC.
Stoneham became president and McGraw VP. McQuade became treasurer. This continued for a short
time until Bondy was elected to succeed McQuade as treasurer. Apparently, before this had happened,
Stoneham had appointed for “outside” directors who all unanimously voted against McQuade in favor of
Bondy, with McQuade being the only person voting for himself to remain as treasurer. McQuade was
therefore dropped as a director of NEC.
At trial, the evidence was fairly clear that Stoneham got rid of McQuade merely in order to get rid of him.
Holding
- Directors are the exclusive executive representatives of the corporation, charged with
administration of its internal affairs and the management and use of its assets.
o They manage the business of the corporation.
- Stoneham and McGraw were not trustees for McQuade as an individual.
o Their duty was to the corporation and its stockholders, to be exercised according to
their unrestricted lawful judgment.
 A contract is illegal and void so far as it precludes the board of directors
from changing officers, salaries, or policies or retaining individuals in office,
except by consent of the contracting parties.
**Board of Directors (BOD) should manage the business, not the shareholders
- Courts will uphold shareholder agreements so long as they do not TOTALLY usurp
or sterilize the Board’s power to manage its affairs
SIDENOTE
- NY has adopted a statute that permits shareholders of corporations with relatively few
shareholders to enter into agreements controlling board decisions.
2. SHAREHOLDER’S DECISIONS INSTEAD OF DIRECTORS’ DECISIONS

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VILLAR V. KERNAN – (1997)

Facts
Villar and Kernan agreed to go into the brick oven pizza business. Villar operated the business and
Kernan, the finances. They incorporated, calling it “Ricetta’s,” and Kernan received 51% and Villar
receiving 49%. They had orally agreed that “there would never be salaries.”
Later on, the manager of Ricetta’s acquired 1% from both Kernan and Villar.
The relationship deteriorated between Villar and Kernan, and Villar and Stephan tried to buy Kernan out,
but he refused. Subsequently, Stephan realigned with Kernan. In 1994, Kernan entered into a “so-called
consulting agreement” with Ricetta’s, providing automatic 2K payments to him every week. This
agreement was ratified at a BOD meeting where Villar wasn’t present.
Villar’s Argument
Villar argued that the oral agreement between Villar and Kernan not to receive salaries prevented Kernan
from receiving anything.
Procedural History
The Court agreed with Villar on the breach of contract issue.
Issue
Whether Main law preclude an action for breach of an oral contract between 2 shareholders of a closely
held corporation prohibiting their receipt of salaries from the corporation.
Holding
- Because the language of subsection (1) of §618 refers to written agreements
between shareholders, stating that “no written agreement will be invalid,” it
is logical to conclude that the legislature intended to validate only written
agreements that meet the requirements of the statute.
o To conclude otherwise would nullify the word “written.”
3. SHAREHOLDERS’ DECISIONS ABOUT DIRECTORS AND CUMULATIVE VOTING
- One person can wear several hats simultaneously in the corporate setting.
o Ex: 1 person can be a director, an officer, and a shareholder.
 This person is subject to different rules depending upon whether she is acting as a
director, officer, or shareholder.
- Shareholder’s Role:
o Make decisions about directors.
 Shareholders elect and remove directors. Del. §211(b); MBCA §8.03(c).
o In large, publicly-held corporation, the role of most shareholders in electing and
removing directors is of little practical consequence.
 They own too few shares to have any impact.
• The shareholders in a position to call the shots will usually be other
corporations that own many shares.
- Straight Voting v. Cumulative Voting

o Straight Voting: When there is a separate election for each seat on the board.
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 Each shareholder gets to cast her number of shares in any way she desires for
each of these separate elections.
o Cumulative Voting: One at-large election in which the shareholders cast votes and the top
vote getters would win the position.
 To Cumulate: Take a person’s shares and multiply by the number of
directors to be elected.
• Ex: 50 shares x 5 directors = 250 votes.
o A person can allocate her votes as she sees fit.
 Calculating the Number of Shares needed for a shareholder to elect various
numbers of directors:
• [(N x S) / (D+1)] + 1
o N = Number of directors the shareholder wants to elect
o S = Total number of shares voting
o D = Total number of directors to be chosen at the election
• NOTE
o This equation gives the total number of SHARES. From
here, multiply this number by the number of directors being
voted on. This number gives you the amount of VOTES a
shareholder has.
o If one voter’s vote trumps another, then the loser retains

their votes (i.e. the votes don’t disappear if voter loses).
- Shareholders’ Voting on Directors’ Decisions on “Fundamental Corporate Changes”

o Certain fundamental corporate changes require shareholder approval
 Amendment of the AOIs
 Dissolution
 Merger
 Sale of all or substantially all of assets
o Because these things are not routine business decisions, the corporation codes do not
leave them entirely to the board of directors.
o 3 Differences b/t Voting on Fundamental Corporate Change and Electing BOD

 Shareholder vote on election or removal of directors is a shareholder action.
• A shareholder vote on a merger or other fundamental corporate change is
approval or disapproval of a BOD decision, a reaction to the BOD action.
 There may be a supermajority approval requirement
 NO cumulative voting
- Where Shareholders Vote and Who Votes
o Annual Meeting: Meeting held once a year
o Special Meeting: Any other meeting held within a year.
o Person who has the legal right to vote at an annual or special meeting of
shareholders is the “record owner.”
o Record Owners: Owners that the corporation keeps a record of.
 The corporation is required to send notice of annual meetings and special
meetings to its record shareholders. Del. §213(a); MBCA §§7.05 and 7.20(a).
• Who gets Notice/Gets to Vote
37
oThe record owner at the record date

 The record owners as of that date are entitled to
notice and a vote at the meeting.
o §213 – Delaware
 Earliest Corp. may give notice: 60 days before
meeting.
 Latest: 10 days before meeting
o §§7.07(b) & 7.05
 70 days – Earliest
 10 days – Latest
- Who Votes (and what are Proxies)?
o A shareholder does not have to be present at the annual or special meeting to vote her
shares.
 State corporation statutes provide for shareholder voting by “proxy.”
• Means that the person who is entitled to vote authorizes another person
to vote for her.
o Proxy is a form of agency, and thus a principal may
terminate an agent’s authority at any time.
 A proxy may be revoked even if it states that it is
irrevocable
- Shareholder’s Inspection Rights

o Access to the corporation’s books and records can be important to a shareholder who
wants to act in an informed and responsible way in exercising her right to vote.
 Every state provides for access by statute.
KORTUM V. WEBASTO SUNROOFS, INC. – (2000)

Issue
1. Whether the inspection rights of a director may be limited by ordering the director not to disclose those
records to the 50% stockholder that designated the director as a board member.
2. Whether the plaintiff stockholder’s stated purpose for inspection is bonafide, and if so, whether the
scope of inspection relief should be limited b/c of the possibility of conflicting interests between that 50%
stockholder and the corporation.
Holding
No to #1. Yes to #2.
- If a board member or stockholder’s purpose for inspecting a company’s documents is

genuine and substantial, then they should have unrestricted access, subject to any
reasonable restrictions.
RINGLING BROS ET AL. V. RINGLING; VOTING AGREEMENTS AMONG STOCKHOLDERS
38
- Generally speaking, a shareholder may exercise wide liberality of judgment in the matter of
voting, and it is not objectionable that his motives may be for personal profit, or determined
by whims or caprice, so long as he violates no duty owed his fellow shareholders.
o Shareholders may lawfully contract with each other to vote in the future in such
way as they from time to time determine.
 SEE DEL. §218(C) AND MBCA §7.31
• Oftentimes, specific performance will be granted in the event of a
breach.
C. What are the Responsibilities of a Corporation’s Decisionmakers and to Whom are they Responsible?
1. What are the Decisionmakers’ Business Responsibilities?
- Management’s job is to create value for the owners.
Shareholders Derivative Suit: A shareholder sues officers of a corporation on behalf of the

corporation.
2. What are the Legal Responsibilities?
A. DUTY OF CARE
(i) Breach of Duty of Care by Board Action
SHLENSKY V. WRIGLEY – (1968); BUSINESS JUDGMENT RULE

Facts
Stockholder’s derivative suit, alleging that Wrigley was not acting in the stockholder’s best
interests by failing to erect lights so the cubs could play night games b/c Wrigley believed that
baseball is a “day game.”
Issue
Whether a plaintiff may bring a stockholder’s derivative action against the board of directors of a
company without asserting fraud, illegality and conflict of interest.
Holding
- Directors are the decision-makers of a company.
o They are chosen to pass upon such questions and their judgment unless
shown to be tainted with fraud is accepted as final.
 Business Judgment Rule: Court made Rule
• Courts will respect a business’ call regardless of its stupidity,
unless fraud is involved.
JOY V. NORTH – (1982); BOARD HAS A DEGREE OF RESPONSIBILITY TO THE CORPORATION

Facts
North was Citytrust’s CEO and Schaff was its CLO during the period in question. Management
was completely dominated by North. North also exercise strong control over the activities of the
39
BOD. In fact board members were not given materials or agendas prior to meetings and requests
for long range planning documents were left unanswered.
Holding
- A corporate officer who makes a mistake as to economic conditions, consumer tastes
or production line efficiency will rarely, if ever, be found liable for damages suffered
by the corporation.
o The fact that liability is rarely imposed upon corporate directors or officers simply
for bad judgment and this reluctance to impose liability for unsuccessful business
decisions has been doctrinally labeled the business judgment rule.
 After-the-fact judgment as to whether a decision was wise cannot be
the basis for finding a board liable.
- Business Judgment Rule (BJR) does NOT apply to situations in which the corporate
decision lacks a business purpose, is tainted by a conflict of interest, or is so
egregious as to amount to a no-win situation.
o Directors who willingly allow others to make major decisions affecting the future
of the corporation wholly without supervision or oversight may not defend on
their lack of knowledge, for that ignorance itself is a breach of fiduciary duty.
SMITH V. VAN GORKOM – (1985); BOARD MUST MAKE REASONABLY INFORMED DECISION
Facts
Class action seeking a rescission of a merger of the corporation into a new corporation.
Alternate relief was sought against the BOD. Court of Chancery granted judgment for the BOD,
holding that their conduct was not reckless.
Holding
Reversed and Remanded. The record compels the conclusion that the BOD lacked valuation
information adequate to reach an informed business judgment.
- The BOD didn’t reach an informed business judgment on in voting to sell the company
for $55/share pursuant to a merger proposal.
o None of the directors had any prior knowledge that the purpose of the meeting
was to propose a cash-out merger of Trans Union.
- Members of the board were required to rely entirely upon Van Gorkum’s oral
presentation of the proposal.
Gross Negligence: Negligence + BJR
(ii) Breach of Duty of Care by Board Inaction
BARNES V. ANDREWS – (1924)

Facts
Andrews took office as a director and his only attention to the affairs of the company consisted
of talks with the president as they met from time to time. During his time as director, a force of
40
officers and employees was hired at substantial salaries. Funds of the company were steadily
depleted.
Holding
- While directors are collectively the managers of the company they are not expected
to interfere individually in the actual conduct of its affairs.
o However, they have an individual duty to keep themselves informed in some
detail, and it is this duty which Andrews failed.
 Andrews was bound to inform himself of what was going on with some
particularity, and, if he had done so, he would have learned that there were
delay in getting into production which were putting the enterprise in most
serious peril.
- If there are NO apparent damages, however, a director cannot be held accountable.
NOTES
1. Plaintiff must show that a defendant’s dereliction caused harm to the corporation.
2. A complaining shareholder must establish some linkage between the director’s bad
behavior and corporate loss
- Causation
- It must be demonstrated that the accused director’s slothfulness was a cause of the company’s
loss.
3. A board has the right to rely on subordinates IF reasonable.
IN RE CAREMARK INT’L, INC. DERIVATIVE LITIGATION – (1996)

Facts
Caremark, a health provider, settled for violation of Medicaid and Medicare violations for over
$250 million. A shareholder’s derivative suit was filed alleging that the directors violated their
duty of care by failing to supervise the conduct of Caremark employees.
Holding
- Breach of Duty of Care may arise in 2 situations:
o Board decision that results in loss b/c decision was ill advised or “negligent.”
o Unconsidered failure of the board to act in circumstances in which due attention
would have prevented loss.
- Where a director exercised a good faith judgment, he or she should be deemed to
satisfy fully the duty of attention.
o Absent grounds to suspect deception, neither corporate boards nor senior
officers can be charged with wrongdoing simply for assuming the integrity of
employees and the honesty of their dealings on the company’s behalf.
 Only a sustained or systemic failure of the board to exercise oversight
will establish the lack of good faith that is a necessary condition to
liability.
NOTE
- Criminal violations do not automatically give rise to breach of fiduciary duties.
MCCALL V. SCOTT – (2001)

41
Facts
Similar to IN RE CAREMARK. McCall sustained significant losses b/c of health care fraud. The
defendants alleged and the District court agreed that a director need to have intentionally acted to
harm the corporation.
Issue
Whether there was a substantial likelihood of liability for intentional or reckless breach of the
fiduciary duty of care.
Holding
- Intentional conduct NOT necessary to be liable and recklessness is not necessarily
intentional. Gross negligence is the standard.
o However, it is unclear whether some reckless acts or omissions may be
excluded from the protection of provisions under Del. §102(b)(7)
 Gross negligence is the standard for measuring a director’s liability for a
breach of the duty of care.
• Gross negligence does not necessarily include intentional conduct.
Intent – Subjective standard

Recklessness – Objective (May not have know, but should have known)
- Sometimes substituted by courts for intent.
Gross Negligence – Objective (Slightly less than recklessness; wanton conduct)
- Difference b/t recklessness and gross negligence is unclear
Negligence – Objective standard (duty of care and breach)
(iii) The Special Case of Executive Compensation
- Basically, CEOs and similar executives get paid a lot of money.

o Shareholders may sometimes sue derivatively, asserting that the directors’
approval of massive compensation violated their fiduciary duties.
B. DUTY OF LOYALTY
- Duty of Care cases arise when executives or board members were lazy or dumb in the
decision making process.
o Duty of Loyalty, however, asserts that the executives or board members were
greedy and put their own financial interests ahead of the interests ahead of the
interests of the corporations and its shareholders.
(i) Competing with the Corporation
JONES CO., INC. V. FRANK BURKE, JR. – (1954)

Facts
Jones, Inc. began to suffer hard times because of “behavior lapses” by its founder Duane Jones.
Several of the company’s officers, while still in its employ, began a new competing agency.
They lured to the new agency both Jones’s key employees and many of its clients. Once the new
42
agency got on its feet, the disloyal officers resigned from Jones. Eventually, 71 of Jones’s 132
employees were employed by the new agency.
Holding
- The conduct of the individual defendants as officers, directors or employees of Jones
fell below the standard required by the law of one acting as an agent or employee of
another.
o Each of these defendants was “prohibited from acting in any manner
inconsistent with his agency or trust and was at all times bound to exercise
the utmost good faith and loyalty in the performance of his duties.”
(ii) Usurping Corporate Opportunity
NORTHEAST HARBOR GOLD CLUB, INC. V. HARRIS – (1995)

Facts
Harris was president of a golf club. Over time, she began purchasing property around the golf
club, without the BODs knowledge or previous consent. She continued doing this over a period
of time. Eventually the BOD brought suit alleging breach of loyalty and usurpation of corporate
opportunity.
Issue
What is the extent of the duty of loyalty?
Whether the opportunity of the golf club “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.
Holding
- Court discussed the Line of Business test: DELAWARE USES THIS TEST
o If executive or director is aware of a business opportunity that the business is
capable of undertaking,
o it is in the line of the corporation’s business,
o is of practical advantage to it,
o they have an interest or reasonable expectancy in the opportunity, and
o by embracing the opportunity, the self-interest of the officer or director will
be brought into conflict with that of his corporation,
Then, the law will not permit him to seize the opportunity for himself.
- Disclosure of the opportunity is a MUST.

o The disclosure-oriented approach provides a clear procedure whereby a
corporate officer may insulate herself through prompt and complete
disclosure from the possibility of a legal challenge.
 The requirement of disclosure recognizes the paramount importance of the
corporate fiduciary’s duty of loyalty.
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o Corporate opportunity is defined broadly

 Includes:
• Closely related to a business in which the corporation is
engaged.
BROZ V. CELLULAR INFORMATION SYSTEMS, INC. – (1996)

Facts
Broz was a director of CIS and was the sole stockholder and President of RFBC, a competitor of
CIS. Mackinac approached Broz about the possibility of RFBC (Broz) acquiring its license.
Broz bought the license for RFBC without making formal disclosure to and obtaining the
approval of the CIS board, however he did mention it to a couple members of the board.
Also, PriCellular was attempting to acquire CIS.
Issue
Whether or not Broz ursurped CIS’s corporate opportunity?
Holding
- Although a corporate director may be shielded from liability by offering to the
corporation an opportunity which has come to the director independently and
individually, the failure of the director to present the opportunity does not
necessarily result in the improper usurpation of a corporate opportunity.
o A corporate fiduciary agrees to place the interests of the corporation before his or
her own in appropriate circumstances.
- Court cites GUTH V. LOFT’S elements of Usurpation of Corporate Opportunity

o A corporate officer or director may not take a business opportunity for his
own if:
 Corporation is financially able to exploit the opportunity;
 Opportunity is within the corporation’s line of business;
 Corporation has an interest or expectancy in the opportunity
 By taking the opportunity for his own, the corporate fiduciary will thereby
be placed in a position adverse to his duties to the corporation.
- Must look to the totality of the circumstances.

o It is a factual question not be decided by reasonable inference from objective
facts.
(iii) Being on both sides of a deal with the corporation (“interested director transactions”)
HMG/COURTLAND PROPERTIES, INC. V. GRAY – (1999)

Facts
Gray and Fieber are two of the five directors of HMG, which bought and sold real estate. HMG
was negotiating a major scale of HMG real estate to NAF, with Gray negotiating. Fieber owned
44
an interest in NAF and discloses that interest and abstains from voting on the proposed sale to
NAF at the HMG directors meeting.
Gray, in the same position as Fieber, does NOT disclose his interest to HMG and votes on the
sale. Fieber knew of Gray’s interest but fails to disclose Gray’s interest to the other directors.
Holding
Fieber and Gray breached their fiduciary duties of loyalty and care and defrauded the company.
- Where directors stand on both sides of a transaction, they have the burden of
establishing its entire fairness, sufficient to pass the test of careful scrutiny by the
courts.
o The concept of entire fairness has two components
 Fair Dealing
• When the transaction was timed, how it was initiated, structured,
negotiated, disclosed to the directors, and how the approvals of the
directors and the stockholders were obtained.
 Fair Price
• Relates to the economic and financial considerations of the
proposed merger, including all relevant factors: Assets, market
value, earnings future prospects, and any other elements that affect
the instrinsic or inherent value of a company’s stock.
- In this case, Fieber and Gray failed to persuade the court that HMG would not have
gotten a materially higher value had they disclosed Gray’s interest.
D. Who Sues and Who Recovers?
1. WHAT IS A DERIVATIVE SUIT AND WHY DO WE HAVE THEM?
- In a derivative suit, a shareholder sues to vindicate the corporation’s claim.

o The suit is “derivative” because the shareholder’s right to bring it “derives” from
the corporation’s right.
 A small shareholder should not be permitted to tie up a corporation in
expensive litigation without some assurance to the corporation that it
will not be out of pocket if the suit is a loser.
• Therefore, oftentimes a shareholder is required to send a
“demand” to the board, requesting that action be taken on
behalf of the company.
EISENBERG V. FLYING TIGER LINE, INC. – (1971)

Facts
Eisenberg owned stock in Flying Tiger, which operated a freight and charter airline. Flying
Tiger formed a wholly owned subsidiary, called FTC and FTC formed a wholly owned
subsidiary called FTL. Then Flying Tiger merged into FTL, and FTL tool over the airline.
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Shareholders, however, received stock in FTC, but not FTL (which ran the business). Eisenberg
sued.
Eisenberg’s Argument
This action deprived him of any vote or influence over the affairs of the corporation that now
runs the airline. He was pissed that he was now the minority owner of a corporation that
owned another corporation that ran an airline.
Flying Tiger’s Argument

Eisenberg’s case was a derivative suit and he was required to post a bond.
Issue
Whether Eisenberg should have been required to post security for costs as a condition to
prosecuting his action.
Holding
No. Reversed. If the crux of the complaint is injury to the corporation, the suit is derivative.
- If the injury is one to the plaintiff as a stockholder and to him individually and not to the
corporation, the suit is individual in nature.
- Test
o Whether the object of the lawsuit is to recover upon a chose in action belonging
directly to shareholders, OR whether it is to compel the performance of
corporate acts which good faith requires the directors to take in order to
perform a duty which they owe to the corporation, and through it, to its
stockholders.
 Security for costs could not be required where a plaintiff does not
challenge acts of the management on behalf of the corporation.
• Eisenberg is claiming that Flying Tiger is interfering with the
plaintiff’s rights and privileges as stockholders.
- Where a shareholder sues on behalf of himself and all others similarly situated to enjoin a
proposed merger or consolidation he is not enforcing a derivative right; he is, by an
appropriate type of class suit, enforcing a right common to all the shareholders which
runs against the corporation.
2. HOW DOES A DERIVATIVE SUIT COMPARE TO A CLASS ACTION?
- Although derivative suits and class actions share some characteristics, they are
fundamentally different procedural devices.
o Derivative Suit: Plaintiff-Shareholder steps up to assert the corporation’s claim.
o Class Action: A class representative sues on behalf of a class of claimants who
are similarly situated.
 The representative also asserts a personal claim.
 In a class action, nobody is asserting a claim on behalf of the
corporation.
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3. DEMAND ON DIRECTORS
- Statutes impose upon the derivative suit plaintiff a requirement that she make a written
demand on the directors that they assert a claim allegedly existing in favor of the
corporation.
MARX V. AKERS – (1996)

Facts
Marx alleged that during a period of declining profitability at IBM the director defendants
engaged in self-dealing by awarding excessive compensation to the 15 outside directors on the
18-member board. Marx also appears to allege that the director defendants violated their
fiduciary duties to IMB by voting for unreasonably high compensation for IBM executives.
Holding
1. Demand is excused because of futility when a complaint alleges with particularity that a
majority of the BODs is interested in the challenged transaction.
2.
AUERBACH V. BENNETT – (1979); NEW YORK LAW

Facts
A derivative suit was brought against 4 board members out of a 15 member board. 3 of the
director members of the special litigation committee joined the board after the suit was brought.
The special litigation committee dismissed the suit.
Issue
Whether the Business Judgment Rule applies in its full vigor to shield from judicial scrutiny the
decision of a 3 person minority committee of the board acting on behalf of the full board not to
prosecute shareholder’s derivative action.
Holding
- While the court may properly inquire as to the adequacy and appropriateness of the
committee’s investigative procedures and methodologies, it may not under the guise
of consideration of such factors trespass in the domain of business judgment.
o Proof that the investigation has been so restricted in scope, so shallow in
execution, or otherwise so halfhearted as to constitute a pretext or sham, would
raise questions of good faith or conceivably fraud which would never be shielded
by that doctrine.
 If there was a fair process then the BJR applies.
• If there was not a fair process, then the court will look at the
substance of the decision.
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ZAPATA CORPORATION V. MALDONADO – (1981); DELAWARE LAW

Holding
- A stockholder does not necessarily have a continuing right to control litigation if the
board dismisses an action.
- A board may delegate authority from the board to disinterested persons, and this
committee can exercise all of the authority of the board to the extent provided in the
resolution of the board.
2 Step Test applied by the court.
1. Court should inquire into the independence and good faith of the committee and the
bases supporting its conclusion.
- Corporation should have burden of proving independence, good faith and a reasonable
investigation, rather than presuming independence, good faith and reasonableness.
2. Court has discretion in granting the motion.

- The court should determine, applying its own independent business judgment, whether the
motion should be granted.
- A board may delegate authority from the board to disinterested persons, and this
committee can exercise all of the authority of the board to the extent provided in the
resolution of the board.
4. DEMAND ON SHAREHOLDERS
- Before bringing a derivative suit, the shareholder must either:

o Make a demand on the corporation’s directors OR
o Show that the demand should be excused (futility of demand).
5. RIGHT TO JURY TRIAL
- Because a right to jury trial generally attaches only at law, there may be some question
as to whether one can have a derivative suit tried to a jury.
6. COURT APPROVAL OF SETTLEMENT OR DISMISSAL
- In routine, non-representative litigation, the parties may settle at will.

o Derivative suits and class actions have more at stake; the named parties are not
the only people who can be affected.
 A judge is therefore required to police the terms of the proposed
settlement or dismissal to ensure they are fair to everyone before the
court and those who are not present but may be affected.
• Court has wide discretion to demand that notice be given to
people affected, etc.
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7. RECOVERY IN DERIVATIVE SUITS
- Recovery in successful derivative case goes to the corporation.

o Most courts will allow the successful shareholder to recover her costs from the
losing litigant and her attorneys’ fees from the corporation.
o Under some statutes, the defendants may be able to recover their attorneys’
fees from the shareholder if the court finds that she sued “without reasonable
cause.”
E. WHO REALLY PAYS?
1. INDEMNIFICATION
- Directors do NOT have a common law right to indemnification for any judgment or
settlement that they have to pay or for the litigation costs they incur in connection
with their corporate duties.
o An agent has a right to be indemnified by its principal, but a director is not an
agent of the corporation.
 The legal bases for a corporation’s indemnification of a director are
found in indemnification statutes, AOIs, bylaws and contracts
between the corporation and its directors.
• These statutes typically distinguish when the corporation is
required to indemnify and when the corporation may
indemnify a director.
2. INDEMNIFICATION
- MBCA §8.57 authorizes a corporation to buy liability insurance for its directors and
officers.
o D&O insurance typically covers “loss” arising from claims made against
directors and officers for negligent, rather than intentionally dishonest,
conduct causing economic injury.
 Most insureds want a broad definition of the term “claim” because most
D&O policies provide “claims made” coverage, which is triggered when
the claims are made, not when the alleged wrongful conduct occurred.
o Defense costs are incurred by the insureds and typically indemnified by the
corporation, which then seeks reimbursement from the carrier for the
amounts paid.
Chapter 6: How does a Business Structure as a Corporation Grow?
- Basic Choices for a Business to procure money:

o Borrow
o Sell interests in corporation
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o Use earnings if available
A. BORROWING MORE MONEY
− Who is going to make the loan?

− What covenants will the lender require?
− Lenders reduce risk by requiring financial and operational commitments from the
borrower until loan is paid.
− How is the corporation going to service the debt (i.e. Pay the monthly interest and then repay
the loan?
− What happens if the corporation defaults?
− Lenders oftentimes require personal guarantees.
B. Issuing More Stock
1. To whom?
a. Preemptive Rights and other Rights of Existing Shareholders
− Existing shareholders can be protected from dilution of their percentage of shares with
“preemptive rights.”
− Preemptive Rights: A shareholder with preemptive rights has the right to purchase that
number of shares of any new issuance of shares that will enable the shareholder to
maintain her percentage ownership.
− MBCA § 6.30
− Do NOT provide for automatic preemptive rights. They must be in the
AOIs.
− Preemptive rights only apply to transactions involving CASH.
BYELICK V. VIVADELLI– (1999)

Facts
Byelick owned 10% of VTIC. The Vivadellis owned the remaining 90%. In 1996, the
Vivadellis eliminated the shareholders' preemptive rights which were provided for in the by-
laws. VTIC's director’s then issued 50K additional shares to Vivadelli. This reduced Byelick's
ownership interest in the company from 10% to 1%.
Byelick alleged that the issuance constituted a breach of fiduciary duty.
Vivadellis' Claim
Say that Byelick's breach of fiduciary duty claim as an attempt to gain preemptive rights, which
were lawfully eliminated by a properly conducted board meeting.
Procedural History
Trial court denied summary judgment motion.
Issue
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Was denial of summary judgment proper when Byelick alleged a breach of a fiduciary duty
when the Vivadellis eliminated Byelick's preemptive rights, issued 50K extra stocks for
themselves thereby diminishing his ownership percentage?
Holding
Issue should be decided at trial. Stockholders in the close corporation owe one another
substantially the same fiduciary duty in the operation of the enterprise that partners owe to
one another.
- A lawful amendment of a corporation's AOIs to eliminate preemptive rights requires:
− No violation of fiduciary duties is involved
− Procedures required to effectuate such amendment are allowed.
− Even where preemptive rights are not provided to shareholders in the AOIs or the by-laws, a
director’s fiduciary duty nonetheless constrains the issuance of shares.
− Issuance of shares at favorable prices to directors or the issuance of shares on a non-
proportional basis for the purpose of affecting control rather than raising capital
may violate that duty.
b. Selling to Venture Capitalists
What and Why is Venture Capital?
− Venture capital is a substantial equity investment in a non-public enterprise that does not
involve active control of the firm.
− Most often associated with high-tech companies.
− Most companies that seek venture capital are unstable and risky.
− 1/3 of venture capital-financed companies wind up in bankruptcy.
− Venture capitalists demand high returns because the successful 1/3 must cover
the losses generated by the other 2/3, as well as the high transactions costs that
venture capitalists pay in seeking, monitoring, and evaluating their investments.
− Venture Capitalists usually obtain a significant voice in the control of the firm.
Venture Capitalists: A shareholder, but a shareholder with special rights including:

1. Downside protection: requires the venture capitalists to be paid first the company's assets
are sold off.
2. Upside Opportunities: Right to acquire additional stock at a predetermined price
3. Voting and Veto Rights
4. Exit Opportunities: Right to sell the shares back to the corporation.
c. Selling to a Person or to the Public
− A corporation can sell stock to a few people or to thousands.

− If a corporation goes “public” there are rigorous registration requirements that federal and
state laws impose on some stock sales.
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2. What are the Legal Constraints on How a Corporation Issues its Stock?
a. Registration Requirement for Public Offerings.
(i) Some of what your clients might have learned about securities registration in business
school.
Why Go Public
− Raise money
− Public markets are viewed as the largest and least expensive source of capital.
How much $$ to Raise
− Most companies tend to use a public offering to raise enough money to meet anticipated
needs for at least 2 years.
How many additional shares to sell?

− Company will first calculate what it is currently worth:
− Price/share [x] # of shares outstanding.
− The price/share is a reflection of the voting that takes place every day in the stock
market on these relative values.
− The number of shares sold must equal the number bought.
− Companies that have not started yet:

− To calculate current value:
− Look at comparables that are publicly traded and determine the market value of these
enterprises.
− Ex: If several fast food chains sell for about 20 times the past year's earnings,
then Bubba's Burritos should be worth about 20 times its expected future
earnings.
− If Bubba's Burrito's expects to earn 10 million, then it should be valued at 200
million.
− Once the company has estimated what its entire business is worth, it will then divide
that sum by the number of shares outstanding.
− This results in the value per share.
How does a Corporation make a Public Offering?

− A public offering is about a registration process filed with the SEC and the marketing of the
stock by an underwriter.
− An underwriter manages the process of drawing up the offering memorandum that is filed
with the SEC.
− It is responsible for advice on structuring the offering, pricing the securities, and
maintaining a market for the securities after the offering.
Where does the money come from?

− Underwriting activities are conducted on either a “firm commitment” or a “best efforts”
basis.
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− Firm Commitment: Underwriter buys all of the shares in the public offering from the
issuing company at the public offering price, less a negotiated discount.
− Underwriter then resells the shares to other investment bankers and the public.
− Underwriter bears the risk that the shares cannot be resold at the offering price.
− This can be reduced somewhat by ensuring that the offering price is not set until
very late in the offering process.
− Best Efforts: Money comes from the public, not the underwriter. Rather than buying the
stock itself and then reselling it, the underwriter instead uses its best efforts to help the
issuer to find buyers for the stock.
− The corporation bears the risk that shares cannot be sold at the offering price.
− Most underwriters work on a best efforts basis.
(ii) Some of what you can learn about securities regulations from the SEC website.
− Federal securities law is a product of the 1929 Market crash and the New Deal of the 1930s.
− They involve the 1933 Securities Act and the 1934 Securities Exchange Act.
− 33 Act: Governs the issuance of securities by the corporation itself.
− Requires a company issuing securities will first file a detailed and extensive
“registration statement” with the SEC and will provide a copy of the main part of
that registration statement (“the prospectus” to all people to whom the securities
are offered.
− 34 Act: Provides information to the markets for new securities and resales by
requiring many corporations continually to provide detailed public reports about their
operations.
Chapter 7: How do the Owners of a Corporation Make Money?
- An owner of a business makes money either because she receives all or part of the
money that a business earns or because she sells her ownership interest.
Close Corporation: A business entity typified by 1) a small number of stockholders, 2) the

absence of a market for the corporation’s stock, and 3) substantial shareholder participation in
the management of the corporation.
- Close corporation shareholders “usually expect employment and a meaningful role in
management, as well as a return on the money paid for their shares.”
- Both legislative and judicial efforts have been made to ease the plight of the
“oppressed” close corporation shareholder.
o Many state legislatures have amended their dissolution statutes to include
“oppression” by the controlling shareholder as a ground for involuntary
dissolution of the corporation.
 Some courts have imposed an enhanced fiduciary duty between close
corporation shareholders and have allowed an oppressed shareholder
to bring a direct cause of action for breach of duty.
53
A. RECEIVING SALARIES FROM THE CORPORATION
- MBCA §8.01: Generally authorizes the board of directors to manage “the business
and affairs of the corporation.”
1. Who Decides Which Shareholders Get Salaries?
HOLLIS V. HILL – (2000)

Facts
Hollis and Hill jointly founded FFUSA, which marketed first lien mortgage notes and other non-
security financial products. Both were 50% owners of FFUSA, with Hill as president and Hollis
as VP. Hill stopped paying Hollis’ salary and rejected all of Hollis’ proposals to resolve the
dispute.
During the dispute, Hill took FFUSA annuity business and without Hollis’ knowledge, placed it
into a sole proprietorship without first consulting Hollis. Hill stopped sending FFUSA financial
reports to Hollis, to which Hollis demanded his right to inspect the reports. They came to a
temporary agreement, but problems resurfaced. Eventually, Hill told Hollis that his position
commanded no salary.
Hollis filed suit, alleging shareholder oppression.
Procedural History
District court, applying Nevada law, concluded that Hill’s conduct was oppressive and ordered
him to buy Hollis’ shares in FFUSA. The Court ordered Hill to buyout Hollis for nearly 800K.
Issue
Was a duty of loyalty breached by Hill and, if so, whether the district court erred in granting a
retroactive buyout remedy?
Holding
Yes. A fiduciary duty existed between Hollis and Hill.
- With only 2 shareholders and management responsibilities divided between them, a
fiduciary relationship was created not unlike that in a partnership.
o Court concedes that many of the actions by Hill fall within the business judgment
rule, they nevertheless held that certain actions by a director, however, receive
much different treatment when the corporation only has a few shareholders,
including that director.
 Close corporations present unique opportunities for abuse because
the expectations of shareholders in closely held corporations are
usually different from those of shareholders in public corporations.
- Court applies Massachusetts law, and holds that the duty existing between controlling
and minority shareholders in close corporations is the same as the duty existing
between partners.
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o A controlling shareholder cannot effectively deprive a minority shareholder

of his interest as a shareholder by terminating the latter’s employment or
salary has been widely accepted.
2. What are the Legal Limitations on Salaries?
EXACTO SPRING CORP. V. COMMISSIONER OF INTERNAL REVENUE – (1999)

- Courts are not the proper authority to determine appropriate salaries for corporate
officers.
o Indirect Market Test
 The owner pays the manager a salary and in exchange the manager works
to increase the value of the assets that have been entrusted to his
management
• The higher the rate of return that a manager can generate, the
greater the salary he can command.
GIANNOTTI V. HAMWAY – (1990)

Facts
Hamway and others filed a complaint against Libbie, alleging that Libbie’s board members were
authorizing and making payments from corporate funds to themselves for directors’ fees and
officers’ salaries “grossly in excess of the value of the services they have rendered to Libbie.” In
facts in 1985, for every dollar of profit earned, the board received $2.67 in compensation.
Including other aspects, the ratio of compensation to profits was 4 to 1.
Hamway also charged that Libbie refused to declare dividends on Libbie common stock which
should have been declared.
Hamway asked the court to order the liquidation of the assets and business of Libbie.
Procedural History
Chancellor found in favor of the plaintiffs and ordered the dissolution of the corporation.
Issue
Was the BOD’s actions “oppressive,” and if so, was the order of dissolution and liquidation of
the corporate assets and business proper?
Holding
Yes.
- Oppressive means conduct by corporate managers toward stockholders which departs
from the standards of fair dealing and violates the principles of fair play on which
persons who entrust their funds to a corporation are entitled to rely.
o Does not necessarily mean fraudulent conduct and is not synonymous with
the statutory terms “illegal” or “fraudulent.”
55
- Further, the court notes that it is hesitant to question the reasonableness of a

corporate officer’s compensation when it is set by a disinterested board.
o However, where the directors elect themselves as officers and set their own
salaries, it is impossible to have a “disinterested board.”
- Court analyzed the status of the BOD’s employment and determined they were part-time
employees with little knowledge of the industry.
o The court applied various factors in its analysis:
 Time spent working
 Responsibilities
 Qualifications
 Knowledge
 Outside interests
 Who is actually running the operation
- Because the trial court’s finding of oppression in this case is not plainly wrong or without
evidence to support it, the court refused to say that the trial court abused its discretion in
decreeing dissolution.
B. RECEIVING DIVIDENDS FROM THE CORPORATION
1. What is a Dividend?
Dividend: A special type of distribution, a payment to shareholders by the corporation out of its
current or retained earnings in proportion to the number of shares owned by the shareholder.
- Most corporations do not pay dividends.
o This includes closely held corporations
- Under the MBCA §6.40(c), a distribution is proper so long as the corporation is not
insolvent and as long as the distribution does not render the corporation insolvent.
o Assets > Liabilities
- Traditional Approach: A > L + Earned Surplus

o The distribution may come from different funds or accounts.
 Earned Surplus or Retained Earnings: Value generated by the business
itself.
• Consists of all earnings minus all losses minus distributions
previously paid.
 Capital Surplus: When a corporation issues par stock, the surplus over the
par value may be used to make distributions.
o Stated Capital: The amount of money accumulated as a result of establishing a par
value for stock.
 May not use this to make distributions.
ZIDELL V. ZIDELL – (1977)
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Facts
Zidell owned 3/8 of issued and outstanding stock of 4 affiliated different corporations that
bought and sold scrap metal. The other 5/8 was owned by Zidell’s brother and his brother’s son.
In 1973, Zidell wanted a pay raise, and the board declined. Zidell resigned.
Prior to his resignation, the customary practice had been to retain all earnings in the business
rather than to pay dividends and Zidell agreed while he worked there. However, once Zidell
quit, he demanded a dividend be paid. A dividend was declared and paid on the 1973 earnings of
each corporation.
Arnold contended that these dividends were unreasonably small and not set in good faith.
Procedural History
Trial court declined to rule that defendants acted in bad faith but held that larger dividends
should have been declared in order to allow Zidell a reasonable return. The court then ordered a
much larger dividend than that set by the board.
Holding
- Those in control of corporate affairs have fiduciary duties of good faith and fair
dealing toward the minority shareholders.
o Insofar as dividend policy is concerned, however, that duty is discharged if
the decision is made in good faith and reflects legitimate business purposes
rather than the private interests of those in control.
 Factors showing bad faith
• Intense Hostility
• Exclusion of Minority from Employment
• High salaries, or bonuses or corporate loans made to the officers in
control
• The fact that the majority group may be subject to high personal
income taxes if a dividend is paid
• Existence of a desire by the controlling directors to acquire the
minority stock interests as cheaply as possible.
SINCLAIR OIL CORPORATION V. LEVIEN – (1971)

Facts
Sinclair (parent corp.) owned about 97% of Sinven’s (a subsidiary of Sinclair) stock and Levien
was a minority shareholder. Sinclair nominated all members of Sinven’s BOD, who were not
independent of Sinclair. Levien sued Sinclair, alleging that they were paying out too much in
dividends (nearly 38,000,000 in excess of its profits).
Levien attacks these dividends on the ground that they resulted from an improper motive –
Sinclair’s need for cash.
Procedural History
Chancellor held that because of Sinclair’s fiduciary duty and its control over Sinven, its
relationship with Sinven must meet the test of intrinsic fairness.
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Intrinsic Fairness Test

- Under this standard, the burden is on Sinclair to prove, subject to careful judicial
scrutiny, that its transactions with Sinven were objectively fair.
Sinclair’s Argument
The transactions between it and Sinven should be tested by the Business Judgment Rule.
Issue
Did the Chancellor err when holding that Sinclair must satisfy judicial scrutiny pursuant to the
Intrinsic Fairness Doctrine?
Holding
Yes. If a plaintiff can meet his burden of proving that a dividend cannot be grounded on
any reasonable business objective, then the courts can and will interfere with the board’s
decision to pay the dividend.
- Court does not believe that the Intrinsic Fairness Test (IFT) must be applied to a dividend
declaration by a dominated board, but at times it may apply.
o Ex: If there is a case of self-dealing, it will likely apply.
- The BJR should have applied.

o The motives for causing the declaration of dividends are immaterial unless
the plaintiff can show that the dividend payments resulted from improper
motives and amounted to waste.
2. To Whom are Dividends Paid: Preferred, Participating, Cumulative?
- Although all shares in a particular class must have identical rights, one class can have
greater rights, or “preferences,” than another.
Preferred Stock: Class of stock with a preference is generally referred to as “preferred”

o A typical preference for a class of stock is priority in the receipt of dividends.
o Preferred means “pay first.”
Common Stock: Class without such a preference is generally referred to as “common.”
Preferred Participating Stock: Stock that not only gets paid first, but also gets paid again. These
shares get paid pursuant to its preferred stock status and get paid again with the funds that will
also be paid to the common stock holders.
Cumulative Preferred Stock
NEED IN-BETWEEN NOTES
What are the Legal Duties Applicable to Buying or Selling Stock?
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A. Buying or Selling with Inside Information
DIRKS V. SEC – (1983)

Facts
Dirks received material nonpublic information from “insiders” of a corporation with which he
had no connection. He openly discussed the information he had obtained with a number of
clients and investors. Some of these persons sold their holdings of Equity Funding securities.
SEC’s argument
When tipees come into possession of material ‘corporate information that they know is
confidential and know or should know came from a corporate insider,’ they must either publicly
disclose that information or refrain from trading.
Issue
Did Dirks violate the antifraud provisions of the federal securities laws by disclosing the
nonpublic material information?
Holding
No. Court reiterates the CADY/ROBERTS standard announced in CHIARELLA:
- Two elements for establishing a Rule 10b-5 violation:
o Existence of a relationship affording access to inside information intended to
be available only for a corporate purpose
o Unfairness of allowing a corporate insider to take advantage of that
information by trading without disclosure.
- A duty to disclose under §10(b) does not arise from the mere possession of
nonpublic market information, but only from the existence of a fiduciary
relationship.
o There must also be “manipulation or deception.”
 There must be an inherent unfairness involved where one takes advantage
of information intended to be available only for a corporate purpose and
not for the personal benefit to anyone.
• An insider will be liable under Rule 10b-5 for inside trading
only where he fails to disclose material nonpublic information
before trading on it and thus makes “secret profits.”
- There can be no duty to disclose where the person who has traded on inside
information was not 1) the corporation’s agent, 2) was not a fiduciary, or 3) was not
a person in whom the sellers had placed their trust and confidence.
Court then addressed when a person may inherit a fiduciary duty:

- CHIARELLA COURT
o Anyone who regularly receives material nonpublic information may not use
that information to trade in securities without incurring an affirmative duty
to disclose.
- Court goes on to hold that a fiduciary duty attaches only when a party has legal
obligations other than a mere duty to comply with the general antifraud
proscriptions in the federal securities laws.
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o A duty to disclose arise from the relationship between parties and not merely
from one’s ability to acquire information because of his position in the
market.
 This should not be interpreted to mean that tippees always are free to trade
on the information.
• Some tippees must assume fiduciary duties because the
information given to them has been provided improperly.
o A tippee assumes a fiduciary duty to the shareholders
only when 1) the insider has breached his fiduciary duty
to the shareholders by disclosing the information to the
tippee and 2) the tippee knows or should know that
there has been a breach.
***Remember the elements for a tippee are derivative. There is no tippee without a tipper who
violated a fiduciary duty to the source.
ANALYSIS
DIRKS RULE: a tippee can be liable but must be derivative from tipper:
1) Tipper liability exists when:

a) insider (tipper) breached a fiduciary duty AND
b) tippee knew or should have known that breach occurred AND
c) Insider (tipper) received some personal benefit (not necessarily
financial)
2) Classical theory also applies to others who become temporary
fiduciaries of corporation
UNITED STATES V. O’HAGAN – (1997); CLASSICAL AND MISAPPROPRIATION THEORIES APPLY

Facts
O’Hagen was a partner in a law firm. The law firm represented Grand Met to help them tender
an offer to acquire Pillsbury. The offer was announced on October 4, 1988. Although O’Hagen
was not working on this transaction, he learned of it. About 2 months before the offer was
announced O’Hagen bought Pillsbury stock and options to acquire Pillsbury stock. The stock
rose in price after the sale, and O’Hagen sold the stock for a profit of $4.3 million. He was
indicted on federal charges.
Procedural History
O’Hagen was convicted and the 8th Circuit reversed.
Issue
Should O’Hagen be convicted under Rule 10b-5?
Holding
Yes. Court discusses the “Classical” Theory and adopts a second “misappropriation theory” of
Rule 10b-5.
- Classical Theory
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o Rule 10b-5 is violated when a corporate insider trades in the securities of his
corporation on the basis of material, nonpublic information.
- Misappropriation Theory
o Purpose: To protect the integrity of the securities markets against abuses by
‘outsiders’ to a corporation who have access to confidential information that
will affect the corporation’s security price when revealed, but who owe no
fiduciary or other duty to that corporation’s shareholders.
o Holds that a person commits fraud in connection with a securities transaction, and
thereby violates §10(b) and Rule 10b-5, when he misappropriates confidential
information for securities trading purposes, in breach of a duty owed to the source
of the information.
 A fiduciary’s undisclosed self-serving use of a principal’s information to
purchase or sell securities, in breach of a duty of loyalty and
confidentiality, defrauds the principal of the exclusive use of that
information.
• A fiduciary who feigns loyalty to the principal while secretly
converting the principal’s information for personal gain, defrauds
the principal.
ANALYSIS
RULE: A person who trades in securities for personal profit, using confidential information
misappropriated in breach of a fiduciary duty to source of information is guilty of violating rule
10b-5.
- RULE 10b-5 can be based on misappropriation of confidential information
o Supreme Court adopts misappropriation theory
 2 forms of misappropriation theory:
• Rule 10b-5: deceptive conduct in connection w/ a securities
transaction
• knows or has reason to know
RELIANCE ELECTRIC CO. V. EMERSON ELECTRIC CO. – 1972

- This case discusses Section 16(b) of the Securities Exchange Act of 1934.
o §16(b) says that a corporation may recover the profits realized by an owner
of more than 10% of its shares from a purchase and sale of its stock within
any 6 month period, provided the owner held more than 10% both at the
time of purchase and sale.

- Ex: R owns no stock in A. He then purchases 15% of A’s stock. That purchase is not
covered under §16(b), because immediately before the purchase, his ownership was zero.
Now R buys an additional 5% of A’s stock. That purchase is covered, because he was
about 10% when he made this purchase. Now R sells all 20% of A’s stock. That sale is
covered because he was above 10% when he made the sale.
o §16(b) applies only to large corporations – those required to register under
§12 of the ’34 Act.
61
- If the person is an officer or director when he bought or sold, he would be covered

by the statute, regardless of how much Bubba’s stock he owned.
- §16(b) ONLY APPLIES WHEN THERE IS A PROFIT FROM PURCHASES OR

SALES MADE WITHIN 6 MONTHS OF EACH OTHER.
Common Law Duty of Selling Shareholder
DEBAUN V. FIRST WESTERN BANK & TRUST CO. – (1975)

Facts
Mattison ran a color photography business into the ground after acquiring the majority of shares
from First Western Bank (who acquired them as executor of the majority stockholder’s estate.).
First Western had knowledge that Mattison had judgments against him for a lot of money, but
did not pursue an investigation into the public records where a mass of derogatory information
lay.
Two minority stockholders sued First Western, asserting their right to recover for damage caused
by First Western.
Issue
May a majority stockholder be held liable to minority stockholders when selling the majority of
stock in a company without reasonable investigation?
Holding
Yes. First Western owed a duty to the corporation and its minority shareholders to act
reasonably with respect to its dealings in the controlling shares with Mattison.
- 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.”
o That duty of good faith and fairness encompasses an obligation of the controlling
shareholder in possession of facts such as to awaken suspicion and put a prudent
man on his guard that a potential buyer of his shares may loot the corporation of
its assets.
 A reasonable and adequate investigation of the buyer is necessary.
- Measure of Damages
o Value of Corporation as a going concern at the time of breach = Corp.’s Assets at
time of breach + Goodwill factor (computed on basis of future net income
reasonably to be anticipated from Corp.’s past record.).
PERLMAN V. FELDMANN – (1954)

62
Facts
Feldmann was the dominant stockholder of a corporation which operated mills for steel sheet
production. He sold all his shares to Wilport, end-users of steel, interested in securing a source
of supply in a market becoming tight due to the Korean War.
Plaintiff’s Claim
The consideration paid for the stock included compensation for the sale of a corporate asset, a
power held in trust for the corporation by Feldmann as its fiduciary. Thus, Feldmann must
account to the non-participating minority stockholders for that share of their profit which is
attributable to the sale of the corporate power.
Procedural History
Court below held that the rights involved in the sale were only those normally incident to the
possession of a controlling block of shares, which in the absence of fraud or foreseeable looting,
was entitled to deal according to his own best interests.
Issue
Must Felmann, as a majority stockholder, pay the profit received from his sale of shares to the
minority stockholders?
Holding
- Both as director and as dominant stockholder, a person stands in a fiduciary relationship
to the corporation and to the minority stockholders as beneficiaries.
o The same rule should apply to his fiduciary duties as majority stockholder,
for in that capacity he chooses and controls the directors, and thus is held to
have assumed their liability.
 Fiduciaries always have the burden of proof in establishing the
fairness of their dealings with trust property.
• The actions of defendants in siphoning off for personal gain
corporate advantages to be derived from a favorable market
situation do not betoken the necessary undivided loyalty owed by
the fiduciary to his principal.
- The corporate opportunities of whose misappropriation the minority stockholders
complain need not have been an absolute certainty in order to support this action against
Feldmann.
o When the sale necessarily results in a sacrifice of this element of corporate
good will and consequent unusual profit to the fiduciary who has cause the
sacrifice, he should account for his gains.
To Whom May a Shareholder Sell Her Shares?
DONAHUE V. RODD ELECTROTYPE COMPANY OF NEW ENGLAND, INC. – (1975)

Facts
Donahue, a minority stockholder in a close corporation, was angry that Rodd had purchased Mr.
Rodd’s shares without first offering to purchase hers. She sued to rescind Rodd’s purchase of
Mr. Rodd’s shares.
63
Plaintiff’s Claim
Donahue urged that the distribution constituted a breach of fiduciary duty owed by the Rodds to
her because the Rodds failed to accord her an equal opportunity to sell her shares to the
corporation.
Holding
- The close corporation bears striking resemblance to a partnership.
o Just as in a partnership, the relationship among the stockholders must be one of
trust, confidence and absolute loyalty if the enterprise is to succeed.
 Stockholders in the close corporation owe one another substantially
the same fiduciary duty in the operation of the enterprise that
partners owe to one another.
• Stockholders in close corporations must discharge their
management and stockholder responsibilities in conformity with
this strict good faith standard.
o In a close corporation, the corporation cannot
discriminate among shareholders when repurchasing
shares.
 The controlling group may not, consistent with its
strict duty to the minority, utilize its control of the
corporation to obtain special advantages and
disproportionate benefit from its share ownership.
JORDAN V. DUFF & PHELPS, INC. – (1987)

Facts
D&P was a closely held corporation where Jordan had acquired 188 shares of the company’s
outstanding stock. Under his employment agreement, he was obligated to resell his shares back
at book value to the corporation upon his leaving the company. He resigned on November 16,
1983, Jordan resigned and Hansen did not volunteer any information about an upcoming merger.
As a result, he lost out on about 430K because shortly after his resignation D&P announced a
merger.
Issue
Was B&P’s failure to disclose the merger to Jordan required, and if so, was the information
material?
Holding
- Close corporations buying their own stock, like knowledgeable insiders of closely
held firms buying from outsiders, have a fiduciary duty to disclose material facts.
o In this case, whether or not Jordan was defrauded is a question for the jury.
BERREMAN V. WEST PUBLISHING CO. – (2000)

Facts
Plaintiff former employee alleged breach of fiduciary duty, unfairly prejudicial conduct in
violation of a Minn. Stat., and fraud. Plaintiff asserted that West had a duty to disclose to him,
64
before he retired and sold his stock back to the company, that West directors had begun to
consider the sale of the company. West merged with (Thomson) ended up paying much more for
stocks than Berreman received when he retired.
Issue
Was the failure to disclose discussions among West’s own officers about the future of West, and
if so, did they violate a fiduciary duty to Berreman by a failure to disclose the fact that they were
considering selling?
Holding
In this case, the court assumed for purposes of the case West was a close-corporation, although
they were not sure b/c West had far more shareholders than typical close corporations. The court
then held preliminary discussions about merger are not material.
- Information is material if there is a substantial likelihood that a reasonable
shareholder would consider it important in deciding how to vote.
- Court then discussed the Probability-Magnitude Test:

o Materiality will depend at any time upon a balancing of both the indicated
probability that the event will occur and the anticipated magnitude of the event in
light of the totality of the company activity.
 Probability: Measured by evaluating the indicia of interest in the
transaction at the highest corporate levels
 Magnitude: Should be assessed by considering such facts as the size of the
two corporate entities and of the potential premiums over market value.
65

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2) Views of Other Gonster Machers

A.P. SMITH MFG. CO. V. BARLOW - (1953)

NOTES and Rules

shareholders want them to do would be to expropriate resources that do not

How does the owner of a business make $$ from the Business?

ii) Types of Financial Statements

1. Cash flow = profits from income statement + depreciation – net

3) Sarbanes-Oxley Act and Corporate Governance

4) What are the Legal Structures for Businesses?

(1) This is called “pass through” taxation.

f) Limited Liability Company (LLC)

g) How do you Choose?

Sole Proprietorship: Chapter 2

a matter of contract law.

ANALYSIS: 1) is there an agency relationship, 2) Is there express or apparent authority to

(iv) Respondeat Superior: A principal may be liable even though he is not

committed within the scope of employment. RSA §219

HAYES V. NATIONAL SERVICE INDUSTRIES, INC – (1999)

Franchises and other Business Relationships

MILLER V. MCDONALD’S CORPORATION – (1997); FRANCHISORS AND VICARIOUS LIABILITY

proper party to sue.

- RSA §267 – Apparent Agency

How does a Sole Proprietorship Grow?

Funding by the Owner

j) A business is often at greatest risk when it is just starting.

k) Overview of Debt and Equity

m) Sharing Profits with a Lender

IN RE ESTATE OF FENIMORE – (1999); SHARING PROFITS IS A PARTNERSHIP!!!

- What is Partnership Law?

• Interprets the provisions in partnership statutes, as well as gaps in

- UPA §5 and RUPA §104

- Legal Problems in Starting a Partnership

Problems in Operating a Business as a Partnership

Who decides what the Partnership will do?

MEINHARD V. SALMON – (1928)

- A managing co-adventurer appropriating the benefit of such a lease without warning to

- §404: General Standards of Partner’s Conduct

Who is Liable for What to Whom?

Liability of the Partners

How Does a Partnership Business Grow?

- Look to the partnership agreement.

Additional Owners (i.e. Investors)

- Common Method of Measuring Return on Investment

Approval of New Partners

Liability of New Partner

Earnings from Business Operations

How do the Owners of a Partnership Make Money?

(a) It is common for the partnership agreement or some separate agreement

CREEL V. LILLY – (1999)

1. Dissolution, Winding Up and Termination as Endgame for the Partnership

- Dissolution is not the end of the partnership.

 Amount of each partner’s loss from her investment

 When the partnership is dissolved, the partnership is

- Summarizing §401, the amount in each partner’s account will be:

KOVACIK V. REED – (1957)

2. Expulsion as an Endgame for a Partner

- Expulsion is not expressly dealt with by RUPA.

BOHATCH V. BUTLER & BINION – (1998)

PAGE V. PAGE – (1961)

would be wrongful and the plaintiff would be liable.

Chapter 9: Limited Partnership and How Does it Work?

A. What is a Limited Partnership and what is Limited Partnership Law?

B. What are the Legal Problems in Starting a Business as a LP?