CORPORATIONS

I) Introduction (pp. 1-16)

A) Subject in General: Involves the study of the means and devices by which business is
conducted either by a single person or cooperatively by a few or many people.
Business means all kinds of profit making activity.
B) The Statutes
C) The Basic Business Form
The Subject of business forms can be broken down into:
1) Unincorporated Associations: i.e. agency, partnership, etc.
2) Closely Held Businesses: (Ones with a few owners)
3) Publicly Held Businesses: (with 100s or 1000s of owners)

Restatement (Second) of Agency

D) Role of the Law of Agency in Business Associations
1) Example: A and B go into a small business together, with A putting up the money and B providing the
management. A wants to avoid being asked to invest more money and wants veto power over the important
decisions affecting the business. Profits are to be divided equally after B is paid a salary. If A and B enter an
oral agreement and B starts in, what form of business organization has been formed?
(a) This is not a good partnership, because A does not want to be liable for the organization
being formed. Unlimited liability. B was getting $1,500 a month for being in the
business, w/o a writing that modifies the UPA, then B cannot be a partner.
(b) Limited Partnership? A LLC must be filed, but it wasn’t. If it were filed then the veto
right may constitute too much control by the limited partner. (Participating in the control
includes proposing, approving, voting any of the following: dissolution, sale of the assets,
adding a partner, etc. These aren’t a veto – voting on things not enumerated but says that
an agreement is subject to the approval or disapproval of the limited partners.) You could
maybe make this an LLC if it is done properly
(c) Corporation: Nothing has been filed. We could be a corporation. We have the basis for
the corporations.
Owners (A and B Shareholders)

Board of Directors (A is President)

Officers (B is an officer)

Employees (B is an employee)
Could be setup as an S corporation, (type that is not taxed twice).
(d) Limited Liability Company? Isn’t because you have to file. But if you set it up properly,
then this has the most flexibility than any other (look and act like a partnership, but have
benefits of corporation)
(e) Partnership: If a driver is added to this hypo, then an employee is added and he is a
servant to the partnership. The employee can be held liable for what the servant does,
within the scope of his duties. (i.e. driving a truck and causing an accident – partnership
would be liable for negligence). Apparent or actual authority is the question. The share of
profit and loss are 50-50 (no matter what you contribute) unless you agree otherwise.
What is a fair split? Losses, the business loses money, then the partners are all jointly
 and severally liable for obligations of the partnership. If one partner pays for all liability,
the partnership is still liable, so the partnership must indemnify partners, for costs and
losses incurred during the business. The problem is the partnership is broke. The assets
of the partnership include contributions that the partners must make to pay off the
partnership debts. Therefore, the partnership owes one of the partners for the losses paid
for by the partner minus his % of that debt.
Class Example: A owns 20% of the profits and losses in a partnership, B is 20% and C is 60%.
The partnership owes $8,000. A is bankrupt. You must split ¼ (B) and ¾ (C) of the $8,000.
The whole amount must be covered.
A contract that agrees to cover liability between partners, this only
includes the partners. Partners are still servally and jointly liable,
therefore, 3rd persons can sue no matter what the partner’s agreement is.
(f) Limited Liability Partnership: Many states don’t allow professionals to be in partnerships. Most law firms
are partnerships. Therefore law partners up to this point each partner was severally and jointly liable. To
avoid this Texas set up partnerships with the difference that says: Partners are not liable for tort claims
against the partnership. Everyone is liable for their own torts (malpractice). Partners therefore are not
jointly and severally liable. 30 states have allowed this. Some states have added contractual claims as
well. People are liable for their own wrong doings. A partnership is liable for its own assets, then the
wrong doing partner comes next.

2) Agency Law
(a) Principal-agent: An agency is a fiduciary relationship that results from consent between the principal and
agent that the agent shall act on the principal’s behalf and subject to her control (Rest. 2nd of Agency §§1,
2)
(b) Master-servant: A master is a principal who employs an agent to perform service in her affairs and who
controls or has the right to control the physical conduct of the other in the performance of the service
(c) Independent contractor: is a person who contracts with another to do something for her, but who is not
controlled by the other’s right to control with respect to his physical conduct in the performance of the
undertaking. The independent contractor may or may not be an agent.
(d) Questions: In the above situation, has a principal-agent relationship been established? An employer-
employee relationship? An independent contractor relationship? Alternatively, are A and B partners? Is A a
limited partner? Can A get what she wants if she organizes as a corporation?

E) The Corporation as a “Person”

F) Other Theories of Corporateness: the “Nexus of Contracts” Theory

II) The Partnership (pp. 17-19; pp. 29-118): A partnership is an association of 2 or more persons to carry on
a business as co-owners for profit. Uniform Partnership Act (UPA) §6]. A lawful partnership cannot be
formed for nonprofit purposes.

Comparison w/ other forms of doing business:

(a) Agency: A partnership is a more complex form of organization than a sole proprietorship –it is really an
extension of the sole proprietorship, which incorporates many of the principles of agency law in structuring how
the partnership will function.
(1) Each partner is the agent of her copartners, and when any partner acts w/I the scope of the partnership, her
acts will bind the other partners.
(b) Joint Venture: A joint venture is an association of 2 or ore members, agreeing to share profits. However, a joint
venture is usually more limited than a partnership; i.e. it is formed for a single transaction and usually is not the
complete business of it’s individual associated members. However, the rights and liabilities of partners and
joint venturers are usually the same, and the courts usually apply the provisions of the UPA to joint ventures.
(c) Other unincorporated associations: There are other types of unincorporated associations (such as the business
trust) that are not partnerships.
(d) Uniform Partnership Act: The UPA has been adopted by most states, so that the provisions governing
partnerships are usually a part of state statutory law, rather than the common law.
A) The Need for a Written Agreement: Since a partnership is a voluntary association, there
must be an express or implied agreement in order to form a partnership.
(1) Formalities: If the partnership is to continue beyond one year, the agreement must be in writing since it
comes w/I the Statute of Frauds.
(2) Duration: If no term is specified, then the partnership is terminable at the will of any partner.
(3) Capacity to become a partner: Persons must have the capacity to contract. Some states hold that
corporations cannot be partners.
(4) Intent of the parties: Where there is any question, the intent of the parties involved is determined from all
of the circumstances.
(5) Writing are best: help to overcome disputes later; spells out the rules of he partnership.

B) Sharing of Profits and Losses: UPA Section 7 lists the factors to determine intent,
including the sharing of profits of the business.
Richert v. Handly (1957) (p. 30)
Issue: May a court determine the respective rights and duties of partners or joint venturers without 1st ascertaining
the terms upon which the parties have agreed to cooperate with one another?
Rule: The respective rights and duties of partners or joint venturers cannot be determined until the terms of all
agreements between them have been ascertained.

Richert v. Handly (1958) (p. 33)

Issue: Is the court precluded from determining the respective rights of partners who have made no agreement
concerning the proportion in which partnership losses are to be borne?
Rule: In the absence of a n express agreement to the contrary, each partner is liable for a partnership’s losses in an
amount proportionate to his share of the profits.
Comment:: Richert v. Handly illustrates the need for parties to a partnership agreement to included a provision for
allocation of losses. At the inception of a partnership, its members (particularly if they are superstitious) may be
reluctant to acknowledge the possibility that their venture will produce a net loss. Experience has shown that
partnerships, like other business arrangements, occasionally prove unprofitable. It is in recognition of this fat that
§18 of the Uniform Partnership Act has provided a standard to be used in allocating losses when partners have made
no agreement concerning loss sharing.

C) Limited Liability Partnerships (LLPs): Creates one general partners who is liable, but this partner gets to
make decisions. The limited partner, only has the money on the line, and didn’t have any decision making
capacity.
D) General Partnership Liability:
(1) Liability of alleged partners: One who holds herself out to be a partner, or who expressly or impliedly
consents to representations that she is such a partner, is liable to any 3rd person who extends credit in good-
faith reliance on such representations (UPA §16)
(2) Liability of partners who represent others to be partners : (i.e. A represents to C that she has a wealthy
partner, B, in order to obtain credit. B knows of the representation and does nothing to inform C that he s
not a partner. ) In this example, if A were part of an actual partnership, then she would make B an agent of
the partnership by her representation that B was also a partner. As such B could bind A as though they
were in fact partners (but only those other partners of A who made or consented to A’s representation
would be bound).
 Continuum of Business
Sole Proprietorship/Partnership Corporations
Joint & Several Liability Limited Liability
No Tax (except personal) (Corp. and personal tax)

Four Characteristics of Companies:

When these are mixed , depending on the mix the entitity will be a partnership or corporation
1) Limited liability
2) No tax
3)
4)
Rules for Partnership
Look to the Rules of Agency
E) Management: All partners have equal rights in management (even if sharing
of profits is unequal)
(a) Partner is an agent of the partnership: Gives them the power to act on the behalf of another (this is a
limited authority)
(b) Determination of agency
(1) Actual authority: Explicitly given
(2) Apparent authority: When you are acting outside the authority given. (create impression that
authority is there). This is done through
(i) Custom (even no actual authority the impression is you have it) Was this reliance
unreasonable? If no, can the 3rd party go after the partnership.
(ii) Course of dealings: This creates the impression of authority
To avoid apparent authority problems, then put the suppliers on notice, that there is no authority.
NOTE: PARTNERSHIP VOTE IS A HEAD COUNT, NOT INTEREST OWNED, UNLESS THE
PARTNERSHIP AGREES OTHERWISE. THEREFORE: IF 3 PAR

National Biscuit Co. v. Stroud (1959) (p. 41)

Issue: May a partner escape liability for debts incurred by a copartner merely by advising the creditor, in advance,
that he will not be responsible for those debts?
Rule: The acts of a partner, if performed on behalf of the partnership and within the scope of its business, are
binding upon all copartners.
Comment:: The rule adopted by the Uniform Partnership Act is consistent with traditional principles of agency
law. In the absence of a contrary provision in the parties’ partnership agreement, each partner acts as the agent of
the partnership and of each other partner. Only acts which are performed on behalf of the partnership and are
consistent with its purpose are binding on other partners. Even an act which was outside the scope of a partner’s
duties may bind his copartners if they ratify it.

Smith v. Dixon (1965) (p. 42)

Issue: Is a partnership bound by acts performed by one of the partners who acts with apparent authority?
Rule: The acts of a partner are binding upon the partnership if he acted within the scope, or apparent scope, of his
authority.
Comment: A partner’s acts are binding on the partnership if he acts within his actual or apparent authority. The
concept of apparent authority is from Agency law. The Restatement of Agency 2nd, §8 defines the term as:
“Apparent Authority: is the power to affect, the legal relations
of another person by transactions with 3rd persons, professedly as
agent for the other, arising from and In accordance with the other’s
manifestations to such 3rd persons.”
The existence of apparent authority is ordinarily established according to an objective test; i.e. the 3rd party’s belief
that the agent has authority to act must be a reasonable one if the principal is to be bound.
 Industry Practice should also be reviewed.
 What is the 3rd party’s reasonable expectations (Does it look like you are doing it in the ordinary course of
business – there would probably be apparent authority)

Rouse v. Pollard (1941) (p. 46)

Issue: May members of a partnership always be held liable for one another’s’ acts?
Rule: Partners are liable for the acts of their copartners only if those acts are within the scope of the partnership’s
business.
Comment:: The rule of Rouse v. Pollard is consistent with the weight of authority. A partner is, in effect, the agent
of the partnership and of the other partners. The rule of this case is a logical corollary to the proposition that a
principal is liable for all acts of his agent if performed within the scope of his agency. Note that a partner may even
be liable for a transaction in which a copartner committed fraud. This does not mean, of course, that each partner is
himself guilty of fraud. He is not excused from financial liability to the aggrieved 3rd party merely by reason of the
fact that his copartner’s conduct was fraudulent.
An agent cannot create their own apparent authority. This is created by the partnership.
DURBIN
Roach v. Mead (1986) (p. 49) CREATIVE LAWYERING
Issue: Is one partner responsible to 3rd parties for the acts of the other partner where the 3rd party reasonably believes
that those acts were within the partnership business?
Rule: Each partner is responsible to 3rd parties for the acts of the other partner where the 3rd party could reasonably
believes that those acts were within the purpose of the partnership. Court ignores the agency principle and looks to
the partner giving legal advice (you should seek independent counsel before entering into a deal with a lawyer). The
partnership was therefore liable for malpractice, and not for embezzlement.
Comment:: The case rests on the fact determination as to whether or not particular acts fall within the business
purpose of a partnership. Each case should be determined on its individual merits, and each factual situation may
change the result. The court found as a matter of fact that Roach (P) acted reasonably in believing that Mead (D)
was acting as his attorney when he borrowed the money. Because the stated purpose of the partnership was a law
partnership, when Mead (P) acted as an attorney, Berentson (D) was fully responsible for such actions.

THERE IS A TENDENCY OF CORPORATIONS LAW AS LOOKING TO WHAT IS FAIR.

REVIEW
FANARAS ENTERPRISES, INC. v. DOANE (423 Mass. 121)(1996)( (p. 52)

F) Duties of Partners to Each Other: The duty of one partner to all others is based on a
fiduciary relationship.
Meinhard v. Salmon (1928) (p. 54) FIDUCIARY DUTY
Issue: Do joint adventurers owe to one another, while their enterprise continues, the duty of loyalty?
Rule: Joint adventurers owe to one another, while their enterprise continues, the duty of finest loyalty, a standard of
behavior most sensitive. Joint venture will affect the scope of fiduciary duties (which can be modified by K); and
the amount of authority.
Dissent:: This was not a general partnership. Rather, Meinhard (P) and Salmon (D) entered into a venture for a
limited purpose. The interest terminated when the joint adventure expired. There was no intent to renew the joint
adventure after its expiration.
Comment:: One of the most important aspects of the partnership relation is the broad fiduciary duty between
partners. “The unique feature is their symmetry; each partner is, roughly speaking, both a principal and an agent,
both a trustee and a beneficiary for he has the property, authority and confidence of his co-partners, as they do of
him. He shares their profits and losses, and is bound by their actions. Without this protection of fiduciary duties,
each is at the others’ mercy.” J. Crane

Entity and Aggregate Characteristics of a Partnership

(a) Both characteristics: A partnership is treated both as a separate entity form its partners (for some purposes) and
as though there is no separate entity but merely an aggregate of separate, individual partners.
(b) Aggregate theory: The partners are jointly and severally liable for the obligations of the partnership (UPA §15).
For federal income taxes, the income or losses of the partnership are attributed to the individual partners; the
partnership itself does not pay taxes (although it does file an information return)
(c) Entity characteristics: For other purposes, a partnership is treated as a separate entity apart from its individual
partners.
(1) Capacity to sue or be sued: The jurisdictions vary as to whether a partnership can be sued and/or sue in its
own name. For example, if a “federal question” is involved, then a partnership can sue or be sued in its
own name in the federal courts (FRCP 17(b)).
Ownership of property: A partnership can own and convey title to real or personal property in its own name, w/o ll
of the partners joining in the conveyance (UPA §18)
G) Partnership Property: A frequent issue involves whether property is partnership property
or the individual property of a partner.
(a) Definition: All property originally brought into the partnership or subsequently acquired by purchase or
otherwise, for the partnership, is partnership property. (UPA §8(1))
(b) Individual partner’s interest in the partnership: The property rights of an individual partner in the
partnership property are:
(i) his rights in specific partnership property,
(ii) his interest in the partnership, and
(iii) his right to participate in the management of the partnership. (UPA §24)
(1) Rights in specific partnership property: Each partner is a tenant-in-partnership w/ his copartners
as to each asset of the partnership (UPA §25(1)). The incidents of this tenancy are as follows:
(i) each partner has an equal right to possession for partnership purposes;
(ii) the right to possession is not assignable, except when done by all of the partners
individually or by the partnership as an entity;
(iii) the right is not subject to attachment or execution except on a claim against the
partnership (the entity theory);
(iv) the right is not community property, hence it is not subject to family allowances, dower,
etc.
(v) on the death of a partner, the right vests in the surviving partners (or in the executor or
administrator of the last surviving partner). The partnship property is not part of the
estate of a deceased partner but vests in the surviving partner, who is under a duty to
account to the deceased partner’s estate for the value of the decedent’s interest in the
partnership.
(2) Partner’s interest in the partnership: A partner’s interest in the partnership is his share of the
profits and surplus, which is personal property (UPA §26)
(i) Consequences of classification as personal property: A partner’s interest is personal
property, even where the firm owns real property. The partner’s rights to any
individual property held by the partnership are equitable (the partnership holds title),
and this equitable interest is “converted” into personal property interest. This can be
important in inheritance situations where real property may be given to one heir and
personal property to another.
(ii) Assignments: A partner may assign his interest in the partnership (unless there is a
provision in the partnership agreement to the contrary), and unless the agreement
provides otherwise, such an assignment will not dissolve the partnership. (UPA §27(1)).
 The assignee has no rights to participate in the management of the partnership ( he
is not a partner – he only has rights to the assigning partner’s share of profits and
capital)
 The assignee is liable for all partnership obligations.
(iii) Rights of partner’s creditor: A creditor of an individual partner may not attach
partnership assets. He must get a judgement against the partner and then proceed
against the individual partner’s interest (by an assignment of future distributions, a sale
of the interest for proceeds, etc.)
(3) Liability to partnership creditors:
(i) On contracts: All partners, including silent ones, are jointly liable on all partnerhip debts and
contracts (UPA §15(b))
 (ii) Tort Liability: Each partner is liable for any tortious act committed by a copartner w/I the
scope of the partnership business or w/I his authority as a copartner. Liability is both joint
and several. Where the tort involves a showing of malice or intentional conduct, then it must
appear that each partner sought to be held liable possessed such intent.
H) Partnership Accounting: a partner may obtain an accounting from his partners as to affairs
of the partnership whenever the circumstances render it just and reasonable.
********************************************************************************************
Formula for Partners Accounts
PARTNERS ACCOUNT = (CONTRIBUTIONS-DISTRIBUTIONS) + (PROFITS – LOSSES)
When a partnership is dissolved, all partner accounts must equal zero

Balance Sheets: Assets Liab. & Equity

Equity = Assets-Liabilities Cash = 8K Equity = 10K
Assets = Equity + Liabilities Truck =3K Liab. = 1K

P&L Statement
Income = Revenues - Expenses

Income Statement

Default settings of Partnerships

2 or more people in business for profit, voluntary, dissolves when you choose not to be in it, or one partner is no
longer in for technical reasons (death, bankruptcy, insanity, etc.)

I) Partnership Dissolution: does not immediately terminate the partnership. The partnership
continues until all of its affairs are wound up (UPA §30). Unless otherwise provided for in
the partnership agreement, the following may result in a dissolution:
Expiration of the partnership term:
(i) Fixed term: Even where the partnership is to last for a fixed term, partners can still terminate at
will (but it will be a breach of the agreement by the terminating partner)
(ii) Extension of term: Partners can extend the partnership by creating a partnership at will on the
same terms.
Express Choice of partner: Any partner can terminate the partnership at will (since a partnership is a personal
relationship that no one can be forced to continue in). Even where it is a partnership at will, if dissolution is
motivated by bad faith, then dissolution may be a breach of the agreement.

Collins v. Lewis (1955) (p. 75)

Facts: After entering into a long-term lease of space in a building then under construction, Collins (P) and Lewis
(D) established a partnership. Collins (P) agreed to advance money to equip a cafeteria which Lewis (D) agree to
manage Collins’ (P) investment to be repaid out of the profits of the business. Delays and rising costs required a
larger initial investment than the parties had anticipated, and Collins (P) eventually threatened to discontinue his
funding of the venture unless it began to generate a profit. Eventually Collins (P) sued Lewis (D), seeking
dissolution of the partnership, the appointment of a receiver, and foreclosure of a mortgage upon Lewis’ (D) interest
in the partnership’s assets. Lewis (D) filed a cross-action in which he alleged that Collins (P) had breached his
contractual obligation to provide funding for the enterprise. The trial court denied Collins’ (P) petition for
appointment of a receiver, and a jury, after finding that the partnership’s lack of success was attributable to Collins’
(P) conduct, returned a verdict denying the other relief sought by Collins (P). From the judgment entered pursuant
to that verdict, Collins (P) appealed.
Issue: Does a partner always have the right to obtain dissolution of the partnership?
Rule: A partner who has not fully performed the obligations imposed on him by the partnership agreement may not
obtain an order dissolving the partnership.
Analysis: In this case, the jury specifically found that Collins’ (P) conduct prevented the cafeteria venture from
succeeding. It was because Collins (P) withheld the funds which were needed to cover the expenses incurred by the
business, thus requiring Lewis (D) to expend the cafeteria’s receipts in order to meet those expenses, that the
business showed no profit. In refusing to pay these costs, Collins (P) breached his contractual obligations, and he is
therefore precluded from obtaining either dissolution or foreclosure. If Collins (P) is adamant in his desire to be
released from the partnership, his only recourse is to take unilateral action to end the relationship, thus subjecting
himself to a suit for the recovery of whatever damages Lewis (D) may sustain.
Comment:: Sometimes partnerships are created for a specific period of time; e.g. 15 years. Or, they maybe
established for an indefinite but determinable period of time, as is the case with partnerships that are to continue
until the death of one of the partners. For good cause, partnerships may also be dissolved by judicial decree. This
last method of termination is comparatively rare, however. Even partners who are locked in an irreconcilable
dispute usually manage to agree to some plan which enables one or all of them to exit gracefully, because whatever
settlement the feuding individuals can work out is likely to prove more economical than court ordered dissolution, a
procedure which typically results in the partnership property being disposed of for considerably less than it actual
value.

Assignment: Not that an assignment is not an automatic dissolution, nor is the levy of a creditor’s charging order
against a partner’s interest. But the assignee or the creditor can get a dissolution decree on expiration of the
partnership term or at any time in a partnership at will (UPA §30-32)

Death of a partner: On the death of a partner, the surviving partners are entitled to possession of the partnership
assets and are charged with winding up the partnership affairs w/o delay. (UPA §37). The surviving partners are
charged with a fiduciary duty in liquidating the partnership and must account to the estate of the deceased partner for
the value of the decedent’s interest.
Cauble v. Handler (1973) (p. 78)
Facts: Cauble and Handler (D) were equal partners in a retail furniture and appliance business. Cauble eventually
died, and the administratrix (P) of his estate sued Handler (D) for an accounting of the partnership’s assets. After
receiving the report of a court appointed auditor, the trial judge awarded Cauble’s administratrix (P) $20.95 and
some interest. He then taxed the entire $1800 in auditor’s fees to the administratrix (P). She appealed, claiming that
the court should have used market value rather than cost in appraising the existing partnership assets and that the
court should have awarded her half of the more than $40,000 that Handler (D) had earned in profits by continuing to
operate the partnership’s business after Cauble’s death.
Issue: Does the non-continuing partner have a right to share in the profits earned by a partnership after the date of
its formal dissolution?
Rule: If a partnership continues to do business after it has been formally dissolved, the non-continuing partner or his
representative may elect to receive his share of the profits earned by the firm after the date of its dissolution.
Analysis: The trial court did err in computing the worth o the partnership assets by their book value rather than their
market value. But, of far greater moment was the court’s erroneous refusal to award ½ of the profits which Handler
(D) earned after the partnership was dissolved by Cauble’s death. When Handler (D) continued to operate the
business after Cauble died, the administratrix (P) had several choices. She could have insisted on liquidation, which
would have entitled her to 50% of the proceeds of the sale of all partnership property. Instead, she permitted the
business to continue. She thus became eligible to receive the value of Cauble’s interest as of the date of dissolution.
And according to § 42 of the Uniform Partnership Act, she also had the right to elect to receive a share of the profits
from the continuing business. There is no question but that she exercised that right at or before trial. The judgment
must be reversed and a new trial held, at which the court might also reconsider the decision to charge the entire
auditor’s fee to the administratrix (P).
Comment:: Cauble v. Handler describes in detail the options which are available to a non-continuing partner or his
personal representative upon the dissolution of partnership. The various rights which may be exercised if the
partnership continues in operation after the dissolution are of increasing importance. This is because dissolutions
today only rarely result in the cessation of business.
Withdrawal or admissions of a partner: Most partnership agreements provide that admitting or losing a partner will
not result in dissolution. New partners may become parties to the preexisting agreement by signing it at the time of
admission to the partnership.
Adams v. Jarvis (1964) (p. 82)
Facts: Adams (P), Jarvis (D), and a 3rd Dr. (D) entered into a medical partnership. They executed a partnership
agreement which provided, among other things, that the firm would continue to operate as a partnership eve if one of
the Drs. withdrew. The agreement also provided that a withdrawing partner was entitled to share in the profits
earned for any partial year that he remained a member of the partnership but that all accounts receivable were to
remain the property of the continuing partners. On 6/1/61, Adams (P) withdrew from the partnership. Adams (P)
later sued for a declaration that he was entitled to share in the assets of the partnership, including its accounts
receivable. The trial court concluded that Adams’ (P) withdrawal had worked a dissolution of the partnership, that
the provisions of the partnership agreement were not controlling since a statutory dissolution had been ordered, and
that Adams (P) was entitled to recover 1/3 of the value of the partnership’s assets, including the accounts receivable.
From this judgement, the surviving partners (D) appealed, contending that the trial court should have given effect to
the provisions of the partnership agreement.
Issue: Should a court enforce the provisions of a duly executed partnership agreement?
Rule: A partnership agreement which provides for the continuation of the firm’s business despite the withdrawal of
one partner and which specifies the formula according to which partnership assets are to be distributed to the retiring
partner is valid and enforceable.
Analysis: In this case, the parties unambiguously agreed that their partnership would not terminate when one of the
Drs. withdrew from the firm. There are obvious reasons why they would have made provision for the continuance
of the partnership, and where an express agreement has been reached, to that effect, there is no reason why statutory
rules relating to withdrawal should operate to effect a dissolution. The Drs. also agreed that a withdrawing partner
would have no right to share in the firm’s accounts receivable, and this provision is also enforceable, despite
Adam’s (P) contention that it is contrary to public policy. It is altogether reasonable that the remaining partners
should be able to reserve exclusive control over the accounts of an ongoing firm’s active customers. Of course,
some of the accounts receivable were ultimately collected during the year of Adam’s (P) withdrawal and thus
constitute profits in which he is entitled to share. Since the court below failed to give effect to the provisions of the
parties’ partnership agreement, it is necessary that its judgment be reversed, with directions to conduct
supplementary proceedings at which Adams’ (P) proper distributive share of the partnership assets may be
ascertained.
Comment:: In most jurisdictions, matters pertaining to the distribution of partnership assets and continuation of the
firm following one partner’s withdrawal are regulated by statute. Partners usually prefer to reach agreement among
themselves concerning these matters since a statute designed to apply to an infinite variety of situations will rarely
achieve a problem-free result when applied to a particular firm. If such an agreement is struck at the beginning
stages of the partnership, both withdrawing and continuing partners are likely to be dealt with fairly, because no
individual is apt to know at the outset whether he is destined to be a surviving partner or a withdrawing one.

Meehan v. Shaughnessy (1989) (p. 88)

Facts: Meehan (D) and Shaughnessy (P), and others were partners in the law firm of Parker, Coulter Daily & white.
Meehan (D), Boyle (D), and Cohen (D) decided to from their own law firm and take certain clients with them. In the
planning process for the new firm, they contacted such clients by letter on Parker, Coulter letterhead and asked
whether or not they would come with them to the new firm. On at least 3 occasions, they failed to honestly respond
to their partners’ inquiries as to whether or not they were leaving the firm. They met with certain clients to
determine whether or not such clients would continue to request their particular legal services when the new firm
was chosen. Some clients signed authorizations forms allowing for the case files to be transferred to the new firm.
When Meehan (D) and the other eventually left the firm, Shaughnessy (P), on behalf of the old firm, sued,
contending that this solicitation of current Parker, Coulter clients in anticipation of forming a new firm was a breach
of fiduciary duty. The trial judge found that Meehan (D), Boyle (D), and Cohen (D) did not continuously interfere
with Parker, Coulter’s relations with clients. Shaughnessy (P), on behalf of Parker, Coulter, appealed, contending
the trial court had erred in this regard.
Issue: Do partners owe a partnership a fiduciary duty not to act for their personal gain?
Rule: Partners owe the partnership a fiduciary duty of utmost good faith and loyalty and may not act or fail to act for
purely private gain.
Analysis: The secrecy and dishonesty displayed by Meehan (D) clearly breached the fiduciary duty to the existing
partnership, rendering the solicitation of clients actionable. As a result, Parker, Coulter is entitled to recover
damages directly stemming from this interference with client relations. Even though the partnership agreement was
breached by Meehan (D), by such conduct he does not forfeit his rights to his capital contributions to the
partnership. Only those client’s fees which were directly related to this interference may be recovered by Parker,
Coulter. Reversed; case remanded.
Comment:: The court rejected 2 of Parker, Coulter’s allegations against the new firm while accepting the claim of
interference with client relations. The other 2 allegations were that Meehan and others breached fiduciary duties by
improperly handling cases for their own and not the partnership’s benefit, and by secretly competing with the
partnership. The trial court found as a matter of fact that the departing partners did not mismanage their cases while
still at Parker, Coulter and in fact handled their files consistently with their partnership duties. As a result, no
recovery was granted on this basis

Illegality: Dissolution results from any event making it unlawful for the partnership to continue in business.

Death or bankruptcy: W/o an agreement to the contrary, the partnership is dissolved on the death or bankruptcy of
any partner. (UPA §31(4), (5))

Dissolution by court decree: courts, in its discretion, may in certain circumstance, dissolve a partnership. These
circumstances include insanity or a partner, incapacity, improper conduct, inevitable loss, and/or wherever it is
equitable (UPA §32)
Gelder Medical Group v. Webber (1977)(p. 103)
Facts: Webber (D) joined an existing medical partnership, agreeing to the partnership agreement which provided for
expulsion without cause and, upon expulsion or resignation, a covenant not to compete. He other partners expelled
him for alienating the patients, and he was paid off according to the terms of the partnership agreement. He
thereafter engaged in practice, and the partnership, Gelder Medical Group (P), sued to enjoin his practice through
enforcement of the covenant not to compete. Webber (D) cross-complained for declaratory relief and breach of
contract, contending he could not be expelled without cause and that the covenant not to compete was
unenforceable. The trial court granted Gelder’s (P) motion for summary judgment and denied recovery on the cross-
claim. Webber (D) appealed, yet the appellate court affirmed. The court of appeals granted certiorari.
Issue: May a partner who has been forced out of a partnership be held to a covenant not to compete?
Rule: A partner who has been forced out of a partnership as permitted by the partnership as permitted by the
partnership agreement may be held to his covenant not to compete.
Analysis: Partnership agreements may validly allow expulsion with or without cause. A partner agreeing to such
must abide by the agreement. As the restrictive covenant was reasonable in its scope, it was enforceable. Affirmed.
Comment:: The court rejected the argument that a partner could only be expelled when the remaining partners felt
in good faith there was cause for such exclusion. The court further rejected the suggestion that even if such good
faith were required, the ousted partner was not relieved of his burden to establish a lack of good faith.
Distribution of Assets:
(1) Partnership Debts: must be paid first.
(2) Captial Accounts: Then amounts are applied to pay the partners their capital accounts (capital
contribution + accumulated earnings – accumulated losses)
(3) Current Earnings: If there is anything left over, the partners receive their agreed share of current
partnership earnings. (UPA §40)
(4) Distributions in kind: Where there are no partnership debts, or where the debts can be handled from the
cash account, partnership assets may not be sold, but they may be distributed in kind to the partners.
(5) Partnership Losses: Where liabilities exceed assets, the partners must contribute their agreed shares to
make up the difference. (UPA §18(a))
Rights of Partners:
(1) No violation of agreement: If the dissolution does not violate the partnership agreement, the
partnership assets are distributed as set forth above, and no partner has any cause of action against any
other partner.
(2) Dissolution violates agreement : Where dissolution violates the partnership agreement, the innocent
partners have rights to those listed above.
(a) Rights to Damages: Innocent partners have a right to damages (i.e. lost profits due to dissolution,
etc.) against the offending partner. (UPA §38(2))
(b) Right to continue the business: The innocent partners also have the right to continue the
partnership business (i.e. not sell off and distribute the assets) by purchasing the offending
 partner’s interest in the partnership. (UPA §38(2)(b) – provision for posting bond and beginning
court proceedings). Alternatively, the innocent partners may simply dissolve and wind up the
business, paying the offending partner his share (less damages).
Effects of Dissolution:
(1) Liability of partners for existing partnership debts remains until they are discharged .
(2) New partnership remains liable for old debts:
(3) Retiring partner’s liability for debt incurred by partners continuing in the business :
 A retiring partner must make sure that prescribed procedures are followed
to terminate any possible liability for partnership obligations. The UPA
provides that notice of withdrawal or dissolution may be published in a
newspaper of general circulation (UPA §35(1).

J) Inadvertent Partnerships: A partnership may be formed inadvertently (i.e. not by express

mutual consent, but by implication)
Martin v. Peyton (1927) (p. 110)
PROCEDURAL POSTURE:  challenged a judgment of the Appellate Division of the Supreme Court in the First
Judicial Department (New York) in favor of ∆. The judgment was affirmed.
Facts: The partnership of Knauth (D), Nachod (D), and Kuhne (D) was in financial difficulty. Hall (D), one of the
partners, arranged a loan from Peyton (D) and other friends (D). In exchange for the loan of $2,500,000 in liquid
securities, Peyton (D) and the others (D) were to receive a percentage of the profits until the loan was repaid. The
relevant loan provisions and conditions were:
1) Peyton (D) was to have a veto over speculative investments;
2) An insurance policy was to be taken out on Hall’s (D) life;
3) The securities could be pledged as a loan;
4) And Peyton (D) and the others 9d0 were to receive dividends from the securities.
Peyton (D) could not bind the partnership, nor could he initiate any action on his own. The agreement specifically
stated that it was a load and not a partnership arrangement. It stated that no liability was to accrue to Peyton (D) and
the others (D) for the partnership debts. Martin (P), a creditor of the partnership, brought suit against it plus Peyton
(D) and the others (D). Martin (P) alleged that a partnership interest had been formed by the agreement. The court
found for Peyton (D).
Issue: Where the only control exerted or sharing of profits occurs to protect and pay off a loan, will a partnership
arrangement by found?
Rule: While words are not determinative, where a transaction bears all of the aspects of a loan, no partnership
arrangement will be found.
Analysis: If the words, cats, and agreements establish the existence of a partnership arrangement; the parties will be
liable as partners. Nothing in Peyton’s (D) words or actions establishes a partnership. Therefore, the court must
look to the contract alone. Nothing in it is other than what were necessary precautions to protect the loan. Any
control was negative in nature and was to prevent any misuse of the funds. Peyton (D) had no right to control or
initiate policy or to bind the contract. This was a loan, and Peyton (D) and the others (D) are not liable. Judgement
affirmed.
Comment:: A partnership results from either express or implied contracts. An arrangement for the sharing of
profits is often an important factor in determining the existence of a partnership. Of equal importance is the right to
share n the decision making function of the partnership and/or to bind the partnership to contractual obligations.

Smith v. Kelley (1971) (p.114)

PROCEDURAL POSTURE:  employee sought review of a judgment of the trial court (Kentucky), in favor of ∆
partners in an action seeking a partnership accounting. The court affirmed the trial court's judgment in favor of the
partners.
Facts: Kelley (D) and Galloway (D) were partners in an accounting firm for which Smith (P) went to work aas a
salaried employee. Smith (P) contributed no assets to the firm, had no authority to hire or fire personnel or to make
purchases, had no managerial authority, executed no promissory notes on behalf of the firm, and was not obligated
to bear any losses of the firm. Kelly (D), Galloway (D), and another employee all concurred in the fact that there
had never been any agreement that Smith (P) would be a partner or would share in the firm’s profits. Smith (P) was
held out to members of the public as a partner and was designated as a partner on the firm’s tax returns and a
statement filed with a state agency. Smith (P) was also listed as a partner in connection with a contract entered into
by the firm and in connection with a lawsuit the firm filed. After resigning from the firm after 3 ½ years tenure,
Smith (P) claimed to have been a partner and argued that he was entitled to 20% of the firm’s profits. When Kelley
(D) and Galloway (D) disputed his right to share in the firm’s profits, Smith (P) sued for an accounting. The
Chancellor concluded that no partnership had existed and therefore dismissed the action. Smith (P) appealed.
Issue: May the existence of a partnership arrangement be established despite proof that there was never any
intention to create one?
Rule: Unless the rights of 3rd parties are involved, a partnership cannot exist in the absence of an intention to create
it.
Analysis: A partnership is a contractual relationship, and the Chancellor, after evaluating the testimony of all the
witnesses, found that there was never any agreement that Smith (P) would be a party or would share in the firm’s
profits. In an action by an outsider, the parties’ conduct might estop them from denying that Smith (P) was a partner
in the firm. But, for purposes of an action for an accounting, actual intent that a party be accorded the status of a
partner must be established. Since the evidence presented justified the conclusion that Smith (P) was not intended to
enjoy the status of a partner, the Chancellor properly dismissed his action.
Comment:: The rule announced by Smith v. Kelley court is not applied uncompromising. In fact, certain factors are
frequently deemed sufficient to establish a partnership even where no such arrangement was intended. For example,
an agreement to share profits was, at common law, often considered sufficient to prove a partnership. Under the
Uniform Partnership Act, such an agreement is deemed prima facie evidence of the existence of a partnership
arrangement. Of course, as was acknowledged by the Smith v. Kelley court, 3rd parties may find it easier to
establish a partnership than might a would-be partner.

Young v. Jones (1992) (p.115) PARTNERSHIP BY ESTOPPEL

Facts: On the basis of an audit letter issued by the Bahamian general partnership of Price Waterhouse (D) (PW-
Bahamas) regarding the financial statement of Swiss American Fidelity and Insurance Guaranty (SAFIG), Young
(P) deposited more than ½ million dollars in a South Carolina bank, which was then sent by others from the bank to
SAFIG. SAFIG’s financial statement had been falsified. When young’s (P) funds disappeared, he filed suit against
both PW-Bahamas (D) and PW-United States (D). Young (P) asserted that PW-Bahamas (D) and PW-US (D)
operated as a partnership for profit. Young (P) alternatively contended that if the 2 were not actually operating as
partners, they were operating as partners by estoppel. PW-US (D), denying that a partnership existed between itself
and PW-Bahamas (D), moved to dismiss the action.
Issue: Is a person who represents himself to anyone as a partner in an existing partnership liable to any such person
who has, on the faith of the representation, given credit to the actual or apparent partnership?
Rule: A person who represents himself to anyone as a partner in an existing partnership is liable to any such person
who has, on the faith of the representation, given credit to the actual or apparent partnership.
Analysis: In this case, Young (P) asserted that a PW (D) brochure cast PW (D) as an established international
accounting firm and that the image was designed to gain public confidence in the firm’s stability and expertise.
However, Young (P) did not contend that the brochure was seen by him or relied on by him in making the decision
to invest. In fact, there was no evidence that Young (P) relied on any act or statement by any PW-US (D) partner
that indicated the existence of a partnership with PW-Bahamas (D). The motion to dismiss is granted.
Comment:: Under §7 of the Uniform Partnership Act (UPA) persons who are not partners as to each other are not
partners as to 3rd persons. However, §16 of the UPA, the rules applied by the court in this case, constitutes an
exception to the general rule. However, since there was no evidence that credit was given by Young (P) to any
actual or apparent partnership, the requirements of the exception were not satisfied.

June 1 Assignment
4 things that the IRS looked at
Corporation: If you have 3 or 4 you are seen as a corporation
Partnership: 2 or less

(a) Limited liability (YES – you look like a corporation)

(b) Continuity of life (YES – you look like a corporation, even with stated ending date)
(c) Centralized management?: (YES – Corporation, shareholders can’t enter into Ks for the company, only
authorized management can – power is limited to a handful of people)
(d) Transferability: (YES – Corporation anyone can sell their shares of stock)
III) Other Unincorporated Business Forms (pp. 119-165)
A) In General
(a) Proprietorship: Liability, Single tax paid by individual
(b) General Partnership: Liability, fill out tax form, tax paid by individuals:
(c) Limited Partnership : One person has unlimited liability,
 LLP w/ one or more individuals as general partners:
(GREAT FOR LAW FIRM)
 LLP w/ corporation or other limited liability entity as general partner:
Corporation has unlimited liability)
 LLP which elects to be a limited liability partnership:
 LLP Member managed limited liability company:
(d) Limited Liability Company:
 Member managed:
 Manager managed:
(e) Corporation (Incorporated Business Forms)
 S Corporation: Files for under subchapter S tax code
 C Corporation: Normal taxing (2 levels of tax, limited liability shield)

B) The Limited Partnership: Limited partnerships are entities created by modern statutes. They were developed
to facilitate commercial investments by those who want a financial interest in a business but do not want all the
responsibilities and liabilities of partners.
(1) Definition: A limited partnership is a partnership formed by 2 or more persons and having as its members
one or more general partners and one or more limited partners.
(a) General Partner: Assumes management responsibilities and full personal liability for the debts of the
partnership
(b) Limited Partner: makes a contribution of case, other property, or services rendered to the partnership
and obtains an interest in the partnership in return – but is not active in management and has limited
liability for partnership debts.
(c) A person may be both a general and a limited partner in the same partnership at the same time. In such
a case, the partner has, in respect to his contribution as a limited partner, all the rights which she would
have if she were not also a general partner.
(2) Purpose: A limited partnership may carry on any business that a partnership could carry on.
(3) Liability: The general partner is personally liable for all obligations of the partnership. A limited partner,
has no personal liability for partnership debts, and his maximum loss is the amount of his investment in the
limited partnership.
(a) Exception: Where a limited partner takes part in the management and control of the business, he
becomes liable as a general partner.
(4) Rights of Limited Partners: The rights of a limited partner are substantially the same as those or a partner in
an ordinary partnership, except that he has no rights in regard to management. He has rights of access to
the partnership books, to an accounting as to the partnership business, and to a dissolution and winding up
by decree of court.
(a) Limited partner may lend money to, or transact business with the partnership.
(b) A limited partner’s interest is assignable, unless the agreement provides otherwise. The assignment
vests in the assignee all rights to income or distribution or assets of the partnership, but unless and until
the certificate of limited partnership is amended with the consent of all other partners, the assignee is
not entitled to inspect partnership books, obtain an accounting, etc.

Formation of limited partnership: While formalities are usually not required to create a partnership, there are
certain requirements for the formation of limited partnership
(1) The partners must execute a certificate setting forth the name of the partnership, the character of the business
and the location of the principal office, the name and address of each of the partners and their capital
contributions, a designation of which partners are “general” and which are “limited”, and the respective right
and priorities (if any) of the partners.
(2) A copy of the certificate must be recorded in the county of principal place of business. The certificate may be
amended or cancelled by following similar formalities.
(a) If the certificate contains false statements, anyone who suffers a loss by reliance thereon can hold all of the
partners (general and limited) liable.
(b) The purpose of the certificate is to give all potential creditors notice of the limited liability of the limited
partners.
(3) The ULPA requires at least “substantial compliance in good faith” with these requirements. Where there has
been no substantial compliance, the purported limited partner may be held liable as a general partner.
(a) A purported limited partner can escape liability as a general partner if – upon ascertaining the mistake – he
“promptly renounces his interest in the profits of the business or other compensation by way of income.

Continental Waste System, Inc. v. Zoso Partners (1989)(p. 121)

Issue: If a limited partnerships filings were defective according to statute, does this preclude the formation of a
limited partnership?
Rule:
(1) Any contract entered into prior to the date on which the limited partnership certificate was filed and made of
record, would be contracts entered into by a general partnership and all partners involved would be liable as
general partners.
(2) If one of the limited partners participated in the management of the enterprise the partnership is a general
partnership and that general partner is personally liable.
Comment:: A purported limited partner can escape liability as a general partner if – upon ascertaining the mistake –
he “promptly renounces his interest in the profits of the business or other compensation by way of income. The
modern act requires reliance (majority) . Courts balance on whether the creditor was relying on the limited
partnership (majority), versus what is fair. The people in control should be liable (majority). If there is no actual
notice and creditors think you are a general partner and rely on this, the limited partner is liable.

Hypo #1: Corporation is General Partner of limited partnerships. Who does the Board of Directors have a fiduciary
responsibility to? The Shareholders of the Corporation or the Limited Partners of the Partnership?

In re: USACafes, L.P. Litigation (1991)(p. 130)

Issue: Whether the board of directors of a corporate general partner owes fiduciary duties to the partnership and its
limited partners?
Rule: The principle of fiduciary duty, is that one who controls property of another may not, w/o implied or express
agreement, intentionally use that property in a way that benefits the holder of the control to the detriment of the
property or its beneficial owner. A fiduciary cannot use his/her position to help yourself at the expense of another.
Comment:: Any officer who knowingly causes the corporation to commit a breach of trust causing loss is
personally liable to the beneficiary of the trust. The corporate duty is there, but so is the duty to the limited
partnership. There is no liability shield for personal acts.

C) The Limited Liability Company: Between 1988 and 1997, every state adopted LLC
statutes that authorizes the creation of a new business form, the “limited liability company”
LLC.
(1) LLC is an unincorporated business organization that contains dissolution, management
and transferability provisions similar to those of a general partnership but that can easily
be altered to resemble the limited partnership or to approach the corporate model.
(2) By combining the best of both worlds the tax advantages of a partnership with limited liability protection
for all members (usually associated with corporations) the LLC can be seen as tax driven.
(3) LLC members unlike general partners, can adopt a management structure resembling those of corporations
or LLPs by appointing managers. LLC managers, hold the power to make important policy decisions and
to bind the LLC in day to day business transactions This takes on the role of general partners and corporate
directors and officers)
(a) Scope of liability:
(b) 2 member requirement:
(c) Piercing the veil:
Poore v. Fox Hollow Enterprises (1994) (p. 140)
Issue: LLC is not a corporation, does a licensed attorney have to represent the LLC in court?
Rule: The underlying purpose of the rule prohibiting the appearance of a corporation by anyone other than a
member of the Delaware Bar also apples to the representation of LLCs.
Comment:: LLC is an artificial entity, like a corporation, and therefore an agent must represent it. With this in
mind the statute states that a member of the Delaware Bar must represent the LLC

Meyer v. Oklahoma Alcoholic Beverage Laws Enforcement Commission (1995) (p. 141)
Issue: Can an LLC hold a liquor license?
Rule: Statute says that corporations cannot hold a liquor license, the court said that the LLC is more like a
corporation, therefore LLC cannot be licensed.
Comment:: The only entities that can hold the liquor license are partnerships and individuals. The Uniform
partnership act defines a partnership and the LLC does not fall in this class. The difference is that a partnership ahs
liability, and an LLC does not. The Court reasoned that to have a liquor license there has to be some personal
responsibility and if the form of the business does not give you that then it is excluded from holding a liquor license.

D) Federal Income Taxation of Business Forms: Herein of “Check-the-box”

Income = Receipts – Expenses _
Effective Tax Rate: What are you paying net in taxes? Average Tax Rate = X rate
Marginal Tax Rate: Last $$ rate

Types of Taxation
(a) Corporate Tax Rates (p. 145) (Top effective rate is 35%)
(1) C Corporation: Taxed once, and if they keep the money no more tax. However if dividends are paid,
individuals must pay tax on the dividend only on the amount that is distributed.
(2) S Corporation:
(3) Personal Services Corporations: Taxed at a flat 35%.
(b) Individual Tax Rates (p. 146) (Top effective rate is 39%) Tax on what you earn. (Proprietorship,
Partnership (problem is that the partnership can keep the money, but income tax must be paid no matter
what was distributed to you)

Progressive Tax System: Higher taxes with higher income.

Regressive Tax System: (Sales taxes are naturally regressive) Tax affects those with a lower income more. (Flat tax
on all types of income is not that way)

June 3 Class Discussion

Taxation of Capital Gains or Losses (p. 147)
(1) Who pays taxes
(2) Are they paid 2x (is corporation taxed as a separate entity)
Mexico: If a corporation pays taxes, then dividends are not paid by you again (Integrated tax system): US
Investors would still pay tax on the distribution
(3) What are capital asset taxes
 Capital Asset: Definition
 Basis: What the stock was worth when you purchased
Exception: If stock is inherited the basis is the FMV at time of death
Adjustments: Non on stock
Home improvements, legal fees for transaction, depreciation of value of capital
asset (MACRS)
 Amount Realized - Basis = Income
 Tax Treatment on Capital Gains: v. Partnerships, Sole proprietorships, personal income tax: Only pay the tax
on the Capital Asset when the gain is realized (paid out)
 Dividends: tax must be paid the year the dividend is paid out.
 Current Approach:
 If held less than 12 months taxed at normal income rate
If held for more than 12 months and less than 18 months: tax is
If Capital Asset is owned over 18 months, the maximum tax is 20%.

Flat Tax: All income taxed the same instead of by tables.

What is income to this?

Taxation of Partnerships and Corporations (p. 149)

Tax planning strategies (p. 153) Tax is the biggest areas to determine a business form
(1) Don’t pay dividends if you are a C-Corporation: This way the corporation only pays taxes, not double taxation
on the dividends. When company reaches a certain size, sell the stock; get capital gain and pay capital gain tax
1x. Downside is more shareholders come in. instead:
(2) Corporation can buy stock back from you (Corporation redeems stock), and the same takes place.
(3) Avoid corporation: Form an LLC
(4) Zero out: Make the corporation not have any income. Revenues – Expense = Zero. Increase expenses to do
this. Most popular expense to increase is salaries (Big Bonus). Eat up a lot of profits. Individual taxes are
paid, and avoid corporate taxes. (e.g. rent to corp. land, take a loan from corp.) This is OK as long as it is
reasonable for that type of business. This is OK if reasonable.
(5) Losses: If they are expected, it is common to start out with an entity which is not taxed immediately, then
convert to a corporation, which has the tax barrier. There are now more restrictions on losses taken.
Sub Chapter S Corporation: Just like a normal corporation, but the exceptions are:
(1) Make a special filing to the IRS that you want to be treated like an S Corp
(2) Essential the individual is taxed, not the corporation
(3) Technically taxed slightly different
(4) Everyone does not choose this because
(a) You are limited to 75 shareholders
(b) Can’t have any non resident aliens as shareholders
(c) Couldn’t have a corporation or other entities as a shareholder (until 1997).
(d) Can only have one class of stock..
(e) Cannot own a controlling interest in another corporation and most other types of entities.
S-Corp v. LLC: LLC gives pass through tax treatment and limited liability.
(1) Continuity of life
(2) Centralized management*
(3) Limited liability*
(4) Flow through treatment of a partnership (tax treatment)*
 Create an entity with limited liability, with 2 other of the 4 criteria the IRS came up, and create a new entity
taxed as a partnership. This gives the best of both worlds. There is uncertainty with LLC’s.
 Some people take S-Corp because creating it is very simple, formal, well defined, and there is plenty of case
law.
 LLC will probably grow to be the entity of choice.
 LLC kills the 4 criteria test of whether you are a partnership v. a corporation.
 1/1/97 new regulations

Publicly held Limited Partnerships (p. 156)

Duties of partners v. shareholders
 Higher standard for partners
 LPs have become publicly traded entities. So the IRS and Congress said that they are no longer looking at the 4
prong test

Check-the-Box: The End of the Kintner Regulations (p. 158)

Rules for how do you want to be taxed are: (Check the box as how you want to be treated for tax treatment)
 If you call yourself a corporation, body politic, etc. you are a corporation by the IRS
 You still have the choice of C Corp or S Corp.
 If you don’t you any o the above words in your name, and have 2 or more members, you can be either a
corporation or partnership as far as the IRS is concerned. The IRS does not care about limited liability.
 If you don’t choose, by default you are treated as a partnership.
 If one person is involved you can elect to be a corporation or you are by default a sole proprietorship
 If you make an election and decide to change it, you have to stick with the change for 5 years.
 If you are a publicly traded entity you are taxed as a corporation.

Concluding Thoughts on Limited Liability (p. 162)

Professional Corporation: Created because historically you were prohibited from forming a corporation. The
advantages of a professional corporation were
(1) you are not liable for everyone else liability, only your own;
(2) Profits cannot be shared with non-professionals in the professional corporation (Lawyer cannot profit share w/ a
non-lawyer
(3) Tax benefits: Life insurance could be paid with pretax money (but this has all disappeared.
Most Professional organizations now have gone to LLCs

Limited Liability Company: These entities existed before check the box. Each state handled this
a little different. Model either on corporate or partnership statutes. LLCs can be any where in
between. Tremendous flexibility. Terminology used
 Members: These are the same as shareholders in Corporations and partners in partnerships.
 Agency type authority is given to members (any member can bind the entity). This can be changed according to
statutes, or if modified in the agreement.
 Governing structure is more like a partnership (do a head count vote) You don’t vote as % of ownership or
number of shares unless you modifiy you articles of association. (Some states look at profit pd to each member)
 Manager managed: Usually authority comes from a hierarchy of manager managed v. member managed. This
is a hierarchy similar to t Board of Directors.
 Members are not liable for the wrongful acts of other members, only your own acts. Limited liability for
business debts, but excessive distribution must be paid back by individual members.
 Most states require 2 members
 Default is that unanimous vote by all members to bring in a new member, unless the power is delegated to the
managers.
 Must say in the name of the LLC that they are an LLC (Notice concept)
 Ultimate governing document in a corporation is the articles of corporation and then the By-laws. If there is a
conflict the Articles are controlling.
 LLCs have Articles of organization. Operating agreement (like the By-laws) The operating agreement is
controlling in an LLC.
 Some states discourage LLCs by charging higher fees for formation and having franchise taxes imposed on
them.

EXAM PREPARATION
2 questions on corporate law
1 question on think piece (Business Planning) MOST OF THIS HAS BEEN DISCUSSED
Show the understanding of pros and cons of business planning

IV) Formation of a Closely Held Corporation (pp. 194-249)

A) Where to Incorporate
(1) What does it cost to incorporate
 How much does it cost to keep the corporation in that state?
 Where will you be doing business? You have to be registered in that state that you do business regularly.
You pay a fee for this as well.
  Looking at costs, Delaware has been a major choice, and look at your home state.
 If you incorporate in Delaware and do business in Ohio you will probably have to pay fees in both states
(2) Where are the state laws favorable for the corporation?
 Belief is that the advantage is in Delaware
 Look at the practical considerations to compare
 Publicly traded v. closely held: Most closely held are incorporated in the state they operate
(3) Delaware
 More expensive, hire attorneys
 Taxes in Delaware and where you do business
B) How to Incorporate
(1) What do you need to do?
 Reserve your name (before you setup the corporation)
 File Articles of Incorporation (some states have an actual form to use. This basically says
(a) Name of corporation
(b) # of authorized shares (if you change this you must amend the articles)
(c) Appointment of agent (so process can be served) & a registered office (this is usually done by a special
organization or attorney)
(d) Name and address of the incorporators (not necessarily the Board of Directors)
(e) Must be signed by the incorporator and the initial directors (indicate your capacity)

Learn the rules

Apply the rules
Examination: Don’t list a rule, point out the problematic areas of the rule and the hypo.
Partnership is a default setting, at the same time, if the plan is to set up a corporation, you aren’t anything until you
do business
Leave messages to regarding suggestions

Setting up a Corporation
1) Reserving a name (not necessary, but if you don’t someone else may take the name from you.
(a) Registering a name: This is different. When you are a company in another state and using it, you then
register that name in a new state
2) Articles of Incorporation: Must file these w/ state before you are considered a corporation. This is a Public
Document and must look at the state statute where you are incorporating in to see what is required. (Don’t put
any more than you have to on it) What is required in Articles of Incorporation:
(a) Needs a name: Can’t be deceptively similar to another company and must have either, Corp, Incorp. or
corporation)
(b) # of authorized shares (how many shares of ownership interest the company can sell) This can be changed
(but is done by amending the articles with more than a majority vote) ( a quorum is needed for a vote: A
quorum is usually a majority of the outstanding # of shares outstanding) Need a majority of those shares
actually attending the meeting)
(c) Street Address of the Corporation’s registered office: What is the address for the service of process?
(1) and the registered agent: Who should service to given to?
(d) Name and address of the incorporator: The incorporator is not responsible for actions of the corporations
(e) Signed by the orignal incorporator or the the
(f) Optional:
(1) Duration of the corporation (if this is not stipulated it is set up in perpetuity
(2) How the by-law can be altered: This affects how you will conduct business (Most states allow this in
the b-laws now)
 (3) List of initial directors of the Company: Usually need 3 directors , but if fewer than 3 shareholders then
you can have as many directors as shareholders (if there is only one person as a shareholder then only
one director is needed)
(4) Purposes of the Company: People don’t use this any more. People usually say “to conduct all legal
businesses.” That way they are not limited.
 May do this because the corporation was setup for a specific purpose (i.e. 2 competitors, jointly agree
to undertake a special project; also investors get a higher comfort level as to what they are all about)
 Usually non-profits list what their limited purpose is to be a non-profit organization re: to IRS
(5) Power: This is what can be done to pursue the business (buy/sell property; borrow/lend money; etc. )
Usually not listed, because you can be excluded. If you list make sure that you put a caveat in the list
“this list is not exhaustive.”
(6) Par Value: This is for initial capitalization. (Not usually listed) Listing this is saying that this is the
minimum amount that stock is sold for.
(7) Anything in By laws can be included (not common)
(8) Anything that investors would be liable for
(9) Limit or eliminate the liability of the Board of Directors (The Officers are not necessarily a member of
the Board.) Shareholders appoint Board, Board appoints the Officers. (this is fairly new – and the
liability cannot be totally eliminated)
3) By Laws: These are the detailed rules of how the company is run. How is the board appointed, how much they
make. Typically in the by laws
(1) Where the offices are
(2) What type of voted is needed
(3) What is a quorum
(4) Can you have a meeting by telephone
(5) Provisions that allow you to avoid having a meeting (p. 212) Allows to do business w/o having a
meeting. This must be unanimous written consent because all the shareholders must agree. (This is
allowed because of the shareholders don’t have the opportunity for discussion). A written consent is
used in lieu of an organizational meeting.
(6) Powers, size, removal, vacancies, pay, committees, how many, qualifications, of the Board
(7) Powers, size, removal, vacancies, pay, committees, how many, qualifications, of the officers, what is
the officers authorized authority
(8) Shares, types (what classes)
(9) Indemnity provisions of officers and directors
(10) Record keeping
(11) Fiscal year of the corporation (business year for reporting income to the IRS
4) Organizational Meeting or Organizational Consent (p. 206)
(1) Adopt a minute book (how will records be kept)
(2) Show the by laws
(3) Adopt the form of the stock certificate
(4) Corporate seal (This is an evidentiary issue, but not required in US)
(5) Election of the officers
(6) Salaries
(7) Accept subscriptions of the shareholders (agreement to buy shares of stock) Subscription agreement is
a contract.
(8) List expenses (of business before set up) Vote on reimbursing
(9) Choose a bank
5) Register a trademark (this is not necessary but suggested)
6) Doing business in more than one state, register to do business in foreign jurisdiction
7) Need a minute book (3 ring binder OK, share certificate, stock and transfer book; and seal (optional), Federal
Tax ID #; Bank account (when opening one the signature card must have the person authorized by at the
organizational meeting and subsequent meetings who can do this); shareholders agreement (how and who you
can sell stock shares to. (p. 732); employment contract; special permits needed to do business;

Where to File
1) Secretary of State gets this (administrative) They only look to see if you comply with the technical aspects
2) 2 copies are files with a fee
3) Filing may need to be acknowledged (Notarized – This acknowledges that this is your signature and that they
watched the signature and you presented yourself as the identity of the persons signature you signed
4) Some states require a filing in the county.
5) Publish notice in the paper

Who does this?

1) The attorney
2) CT corporation or like service can do this for you.
3) Shelf corporation is a company that already exists and does no business (you can buy this corporation that is
already set up)

NOW YOU ARE A CORPORATION

C) The Decline of the Doctrine of Ultra Vires

Ultra Vires Acts: literally means “beyond the powers.” When a corporation does an act or enters into a contract
beyond the scope of its charter, it is not necessarily illegal and it is not necessarily void. Rather, it is voidable. The
doctrine of ultra vires is declining in importance and should not be applied to purposes clauses of articles of
incorporation. When you limit your purposes or powers this act comes in to play.
English case: Ashbury Railway Cartage & Iron Co. v. Riche (1875), the discussion surrounded the question of a
contract’s being void from the beginning because the object of the contract was beyond the powers of the
corporation. The corporation was allowed to repudiate a contract on the ground of ultra vires after it had partially
performed
Arguments for Ultra Vires: The limits of power are public record, caveat emptor.

Arguments against Ultra Vires: A corporation can injure others without any repercussions. 20th Century courts did
not like this so they made arguments of estoppel, unjust enrichment, waiver, etc.

711 Kings Highway Corp. v. F.I.M.’s Marine Repair Serv., Inc. (1966)(p. 215)
Facts: 711 (P) leased premises to F.I.M. (D) for use as a move theater for 15 years. F.I.M. (D) paid a $5,000
security deposit. 711 (P) then tried to get a declaratory judgment declaring the lease to be invalid or, in the
alternative, rescission on the grounds that the intended use was outside the scope of permissible business activities
under F.I.M.’s (D) charter. F.I.M. (D) moved to dismiss arguing that only a shareholder could assert the claim
brought by 711 (P).
Issue: Should a no act of a corporation and no transfer of property to or by a corporation, otherwise lawful, be held
by reason that the corporation was w/o capacity or power to do such act or engage in such transfer except in an
action brought by a shareholder?
Rule: Yes. No act of a corporation and no transfer of property to or by a corporation, otherwise lawful, shall be held
invalid by reason that the corporation was w/o capacity or power to do such act or engage in such transfer except in
an action brought by a shareholder.
Analysis: This also includes actions taken by or in the right of a corporation against an incumbent or former officer
or director. Clearly, under this rule, there was no substance to 711’s (P) argument as 711 (P) did not fall under
either exception. Nor could 711 (P) escape application of the rule by claiming that it did not apply to executory
contracts. Complaint dismissed.
Comment:: Ultra Vires literally means “beyond the powers.” When a corporation does an act or enters into a
contract beyond the scope of its charter, it is not necessarily illegal and it is not necessarily void. Rather, it is
voidable. However, under the English case: Ashbury Railway Cartage & Iron Co. v. Riche (1875), the discussion
surrounded the question of a contract’s being void from the beginning because the object of the contract was
beyond the powers of the corporation. The corporation was allowed to repudiate a contract on the ground of ultra
vires after it had partially performed. However, the doctrine of ultra vires is declining in importance and should not
be applied to purposes clauses of articles of incorporation.

Derivative Suits: Shareholders suing on behalf of the company. Someone did something to harm the company, and
it has a cause of action. The corporation decided not to pursue a cause of action, but a shareholder decides to sue.
(1) Shareholder can sue an company (injunction, etc.) Are you an innocent shareholder?
(2) A shareholder suing derivatively (in the name of the company)can sue an officer, or director.
(3) Attorney General can sue if the corporation is acting outside the power or purpose. (depending on the state law
applied, and what state is being claimed in, then this will help decide which Attorney General sues – state of
incorporation or state of action)

Theodora Holding Corp. v. Henderson (1969) (p. 217)

Facts: In 1955 Girard Henderson (D) and his wife, Theodora entered into a separation agreement whereby Girard
(D) gave her 11,000 shares of common stock of ADI (D) and a number of shares of preferred. However, Girard (D)
retained voting control of ADI (D) through majority holdings amounting to $150,000. Theodora continued
thereafter to earn large dividends from this stock. In 5/67, Theodora form Theodora Holding Co. (P) and transferred
her 11,000 shares of ADI (D) common to Theodora Holding (P). ADI (D) common had a fair market value at the
time of $15,675,000. On 12/8/67, Girard (D) through his voting control of ADI (D), reduced the board of directors
from 8 members to 3 – himself, Ljunggren, and Mrs. Ives, his daughter. Girard (D) then caused the board to
contribute ADI (D) stock valued at $550,000 to the Alexander Dawson Foundation. Among other contributions was
a tract of Colorado land worth $467,750. The Dawson Foundation was a charitable trust controlled by Girard
Henderson (D), and he caused contributions to it to be made from 1957 to 1967. These contributions received
stockholders approval, including that of Theodora Henderson while she was still a member of the board of ADI (D).
This suit was brought by the Theodora Holding Co. (P), attacking one contribution to the Dawson Foundation of an
ADI (D) share worth $528,000, asking for an accounting by the individual defendants and Girard (D) and
appointment of a liquidating receiver for ADI (D).
Issue: May a majority shareholder cause a charitable contribution to be made out of corporate funds over the
protests of minority shareholders where such contributions diminished the equity and dividends of those minority
shareholders’ stock interest?
Rule: A majority shareholder may cause a charitable contribution to be made out of corporate funds if such
charitable gift is within reasonable limits as to amount and purpose.
Analysis: The test applied in passing on the validity of any corporate gift is that of reasonableness. Such test is
based on the provisions of the IRS Code permitting charitable gifts by corporations within 5% or annual income to
be deductible. Here, the $528,000 gift was made during a year (1967) in which ADI’s (D) total income was
$19,144,229, well within the allowable 5% figure. Delaware statutes (Del. C. §122) provide that every corporation
has the power to make donations for the public welfare or for charitable, scientific, or educational purposes. Indeed,
courts encourage such philanthropic activity as an obligation of corporations. In the present case, the $528,000 gift
to the Dawson Foundation was for consummating the purpose behind the 1966 purchase of the Colorado land tract,
namely to convert it into a western camp for underprivileged children. The relatively small loss of immediate
income to the Theodora Holding Co. (P) is far outweighed by the benefits from the gift in supporting philanthropic
or educational activities via the children’s camp. Besides it is admitted by Theodora Holding (P) that any loss in
equity or dividends from the gift is softened by the favorable tax consequences.
Comment:: Where a corporation makes a gift of corporate property or funds, such transaction raises an Ultra Vires
issue. Some courts do not allow gifts to a director’s or majority shareholder’s pet charity. The question is whether
the gift is ‘reasonably necessary’ to furthering a valid corporate objective. In California, corporations are allowed to
have the power to make unlimited gifts to charity. However, for federal tax reasons corporations generally limit such
charitable gifts to within 5% of current annual profits.

Ultra Vires is dead, Charitable giving is OK. Charitable giving was raised to 10% by Reagan.
Most corporations give 1%.

June 10, 1998 Class Starts Here

D) Premature Commencement of Business

1) Promoters: includes a person who, acting alone or in conjunction with one or more other persons, directly or
indirectly takes initiative in founding and organizing the business or enterprise of an issuer. A promoter is also
know as a founder or organizer under the SEC. Promoter owes fiduciary duties to the participants in the venture
 as well as corporation itself. (i.e. the promoter buys property for the corporation – he is not allowed to make a
large undisclosed profit on the sale.) (EXAM NOTE: PRICES ARE WAY OUT OF WACK AND THE
COMPANY IS NOT AWARE, AND THE PROFIT MADE BY THE PROMOTER IS TOO HIGH.
Securities Exchange Act of 1933: Deals w/ formation and issue of shares. Requires filing with the SEC of the
names and any interaction between the company and promoters
Securities Exchange Act of 1934: Deals with trading and ongoing business

Novation: Specific agreement between corporation, promoter, and 3rd party to release the promoter from personal
liability.

1. Pre-incorporation Promotion
a) General rule: a person signing for a nonexistent corporation is personally liable unless there is
clear intent expressed to the contrary: (Do the parties know it’s pre-incorporation or think the
corporation is already set up)
(1) Thus, when person signs contract for architectural services as “agent for a corporation to
be formed who will be the obligor,” that person is liable if the corporation is never
formed. (Stanley J. How & Assoc. v. Boss)
Promoters are personally liable, unless one of the following are agreed to by the other party:
(a) Contract w/ promoter and other company if corporation accepts promoter and
corporation on the hook.
(b) Revocable offer  Future Corporation (if corporation formed and accepts K)
(c) Irrevocable offer  consideration is that promoter formed the K corporation
accepts with liability being released to corporation (when formed)
(2) The upshot is that you must make it expressly clear that the individual isn’t to be liable
b) Cover Your Ass (CYA)! – get copies of the stamped, filed incorporation document before
closing anything!
c) Restatement (2d) of Agency §326, comment b: Intent can be shown by a revocable offer,
offer made irrevocable for a limited time with promoter’s implied promise to use best efforts to
incorporate, etc.
d) At the end of the day, though, any ambiguity is held against the agent
e) Clarity in signature of contract: Who are you, President of the Corporation or an individual
Correct Signature: ABC Corp, by DBMcDonagh, President
Incorrect Signature:
ABC Corp.,
signature and corporate seal (you’ll be liable) or
or
ABC Corp,
By DBMcDonagh, President,
DBMcdonagh (w or w/o President) This shows that you intended to be liable personally.)
pr
ABC Corp,
signature, Authorized
signature. (corp probably not bound and personally bound)

Stanley J. How & Assoc., Inc. v. Boss (1963) (p. 225)

Facts: Boss (D), a corporate promoter entered into a contract w/ How & Assoc. (P) for architectural services. How
& Assoc. (P) were to design a building for a corporation Boss (D) was forming. Boss (D) signed the contract as
agent for the corporation to be formed which was to be the obligor. The corporation was never formed, and the
building designed by how & Assoc. (P) was never constructed. How & Assoc. (P) sued for the contract price,
alleging that Boss (D) was liable as the corporate promoter.
Issue: Is a corporate promoter liable for contracts signed by him as an agent for a corporation yet to be formed?
Rule: A promoter will be liable on a contract he entered into on behalf of a corporation yet to be formed unless the
other party agreed to look to some other person or fund for payment.
Analysis: There are 3 exceptions to this rule:
(1) the contract is treated as an option which can be accepted by the corporation when it is formed, and the
promoter agrees to form the corporation, give it the opportunity to pay;
(2) a novation with the corporation assuming the promoter’s liability and replacing him in the contract;
(3) the promoter remains liable even after formation but only as a surety.
Boss (D) argued that his signature “as agent for the corporation to be formed which is to be obligor” makes the
corporation, only, liable for the debt. In deciding on the meaning of ambiguous phrases, it is necessary to look at
them in light of the entire contract. Much of the performance due would have been completed prior to the formation
of the new contract. As a general rule, where work is to be performed prior to incorporation, the promoter will be
personally liable unless another person or fund is made so under the contract. Since this was not the case, no
novation clause was contained in the contract and How & Assoc. (P) stated that they thought Boss (D) was to be
liable, we must follow the general presumption that the promoter will be liable. Since Boss (D) did not plead
novation, his only defense is that the contract was really a continuing offer and was not valid until accepted by he
new corporation. There is no showing of this. Judgement for How & Assoc. (P).
Comment: Statutory authority aside, this decision is a matter of policy. The law normally excuses an agent from
liability for contracts he entered into in an agency capacity. The principal’s reputation and resources are the ones
which induced the other party to enter into an agreement. When the principal is not yet in existence. The agent’s
reputation and assets must be assumed to have induced the other party to enter the contract.

Fact based inquiry, based on intent, be very clear if the entity is not formed (that they will not go
after the promoter if the corporation is not formed)
Quaker Hill v. Parr (1961) (p. 231)
Facts: In May 1958, Parr (D) and others formed and incorporated Denver Memorial Gardens, a cemetery
corporation not a party to this action. Subsequently, and (as was found by the trial court) at the insistence of Quaker
Hill Inc. (P), Parr (D) and others agreed to form a corporation to be called Denver Memorial Nurseries, for the
purpose of executing a contract between that corporation and Quaker Hill (P) for the purchase of certain nursery
stock. On May 16, the contract was executed by Quaker Hill (P) and “Denver Memorial Nursery Inc., E.D. Parr,
President; James P. Presba, Secretary-Treasurer,” with Parr (D) paying $1,000 down, the balance due under a
promissory note. The shipment of stock arrived on May 26. On May 27, Parr (D) incorporated “Mountain View
Nurseries,” with Quaker Hill P) accepting that name and executing a new promissory note. Prior to the due date of
the note, however, all the purchased stock died. Quaker Hill (P) now sued Parr (D) to hold him personally liable for
the promissory note he executed for the Nurseries. From a judgment for Parr (D) Quaker Hill (P) appeals,
contending that promoters should be held liable for contracts which they enter into on behalf of corporations “to be
formed.”
Issue: Will a party acting as a promoter for a proposed corporation always be held personally liable for agreements
entered into in that capacity?
Rule: No. While promoters are personally liable on contracts made on behalf of a corporation “to be formed,” if (1)
a contract is made on behalf of such a corporation, and (2) the other party agrees to look to the corporation and not
the promoters for payment, the promoters incur no personal liability.
Analysis: This is a well recognized exception to the general rule asserted by Quaker Hill (P). Here, Quaker Hill (P)
was well aware that the corporation had not been formed and nevertheless urged it be made in its name. There is
little evidence that they ever intended to look to Parr (D) for payment. Rather, it was clear from the start that they
contemplated that the corporation be the other contacting party. Personal liability does not arise under such
circumstances. The judgment was affirmed.
Comment:: This case points out the primary exception to the general rule that promoters are to be held personally
liable on contracts made on behalf of a corporation “to be formed.” Similar to the doctrine of estoppel involved in
Cranston, a party will not be permitted to reach the individual contracting for the corporation where that party has
somehow evinced an intention to look to the corporation, not the promoter for payment. Many things may be
evidenced of intending to treat the proposed corporation as an actual corporation. The most common is evidence of
reliance on the credit of the proposed corporation as opposed to the credit of the individual promoter. Where the
promoter is held to be personally liable under a contract, the general rule Is that he may also be permitted to
personally enforce the contract against the other party.

CORPORATE ADOPTION OF CONTRACTS MADE BY PROMOTER

Corporation has no liabilities that it does not agree to. The new corporation must accept all contracts.
Corporation will almost always be found to have accepted the contract made by a promoter before the new
corporation became an entity. (Ascent of agreeing to shift the contract from promoter to corporation is usually built
into the K. The corporation must agree)
McArthur v. Times Printing Co. (1892) (p. 235)
Facts: In Sept. 1889, promoters were active in procuring the organization of Times Printing Co. (D) to publish a
newspaper. On or about Sept. 12, one of these promoters (Nimocks) made a contract with McArthur (P) on behalf
of the contemplated company for his services as advertising solicitor for period of 1 year from and after Oct. 1, the
date at which it was expected the company would be organized. The company was not organized until Oct. 16, but
the publication of the newspaper began. McArthur (P) began the discharge of his duties and after the organization
of the company, continued in his duties until discharged in April. No formal action was ever taken regarding the
contract, but all of the stockholders, directors, and officers of the corporation knew of it and none rejected it. The
lower court ruled for McArthur.
Issue: Can a corporation be held liable for contracts made on its behalf by promoters before incorporation?
Rule: Yes. Formal adoption or acceptance of a contract by a corporation is not a part of the corporation or its
authorized agents.
Analysis: A corporation may not be bound by engagements made on its behalf by its promoters before its
organization, but it may, after its organization, make such engagements its own contracts. Formal action of the
board would be necessary only where it would be required in the case of an original contract.. Adoption or
acceptance may be inferred from acts or acquiescence on part of the corporation or its authorized agents, as any
similar contract might be shown. The agreement must be one which the corporation itself could make and one
which the usual agents of the company have express or implied authority to make. The contract in this case is of
that very kind, and the acts and acquiescence of the corporate officers, after the organization of the company, fully
justified the jury in finding that it had adopted it as its own.
Comment:: The corporation must accept the benefits of the contract with the knowledge of the contract.
Knowledge is usually the issue when the contract is breached or repudiated. Traditional agency theory inputting the
knowledge of the promoters and/or officers to the corporation is usually applied. However, this requires a showing
that the promoters were acting on behalf of the corporation and not for themselves. Where the corporation is found
to have knowledge of only part of the contract, it is held to that part only.

Accepting the product or service that was contracted for by the promoter, is acquiescence to the contract.

2) Defective Incorporations
De Jure corporations is one which as been created and recognized in compliance with the general incorporation
law of the particular state (few corporations are chartered by Congress and only in extraordinary circumstances such
as the Red Cross). This usually means literal compliance with all mandatory incorporation requirements and
substantial compliance with all directory (where court has discretion) requirements.
De Facto corporation (Good Faith attempt to incorporate) is one where sufficient steps have been taken toward
incorporation for a court to be justified in finding that the association involved was “in fact” operating as a
corporation. Such a finding raises the association’s status to that of a de jure corporation against all persons except
the state (who may have the corporation declared invalid in a so-called quo warranto proceeding).
(A) Thus, where a corporation has filed, paid taxes, but had a few errors in its incorporation process, it is a
corporation for purposes of determining the order of payment to creditors. (Matter of Whatley) Court sets
out three factors for a de facto corporation:
(a) Existence of a valid law under which it could incorporate
(b) Bona fide attempt to incorporate
(c) Actual use of corporate powers
Incorporation by Estoppel is an equitable theory invoked by courts to avoid injury due to detrimental reliance
upon someone’s representations, etc.
(A) Sometimes, a court will treat a corporation as formed even though there are technical defects.

Robertson v. Levy (1964) (p. 236)

Facts: Levy (D) attempted to form a corporation. Its Articles were rejected by the Corporations Commissioner.
Prior to the acceptance of the corrected Articles, Levy (D) entered into a contract with Robertson (P) to purchase his
business for the corporation. Levy signed as corporate president. The Articles were later accepted and the
corporation was validly formed. One payment was made on the note to Robertson (P), and the corporation later
became insolvent. Robertson (P) sued Levy (D) on the note, claiming he was personally liable since the contract
had been signed before incorporation. The Trial Court found that Robertson (P) was estopped from asserting proper
formation because he knew that the corporation had not been validly formed at the time of the contract and he also
had accepted a payment on the note from the corporation.
Issue: Will knowledge of the lack of corporate status plus receipt of payments from the corporation estop a creditor
from denying corporate form?
Rule: No. Officers and directors who attempt to act for a defectively formed corporation, or prior to its formation
are jointly and severally liable for those acts.
Analysis: The pertinent statute states the corporation’s existence does not begin until the certificate of incorporation
has been issued. It further states that all persons attempting to act as a corporation w/o authority to do so shall be
jointly and severally liable for debts and liabilities resulting from these acts. The thrust of this legislation is to
destroy the common-law concepts of de factor corporations by estoppel. Equity can no longer provide relief for lack
of or defective formation. A creditor, even with knowledge of the defective formation, is not estopped from looking
to those who incurred the liability for payment. Part payment or part performance is immaterial. Levy (D) is liable
on the contract between the corporation and Robertson (P). The decision of the trial court is reversed.
Comment:: Corporate form and protection is a matter of legislative grace. To qualify, certain formalities must be
met. Failure to comply subjects the incorporators to personal liability. It is not a matter of protecting innocent
creditors. Since the corporation was not in existence, Levy (D) was acting in his individual capacity. It is the same
situation as where the promoter enters into a contract as agent for a corporation to be formed. Unless the creditor
agrees to a novation when the corporation is formed or specifically agrees that the promoter shall not be liable, he
cannot escape contractual liability (i.e. Stanley J. How & Assoc. v. Boss)

Cantor v. Sunshine Greenery, Inc. (1979) (p. 241)

Facts: When Cantor (P) leased his building to Sunshine Greenery (D), William Brunetti (D) signed the document as
president of Sunshine (D). At the time Sunshine Greenery (D) was not a de jure corporation inasmuch as the
certificate of incorporation that had been forwarded to the Secretary of State was not officially filed until 2 days
after the lease was executed. Counsel for Sunshine Greenery (D) thereafter repudiated the lease agreement, and
Brunetti (D) put a stop payment on the check supposedly covering the 1st month’s rent and security deposit. Cantor
(P sued both Sunshine Greenery (D) and Brunetti (D). In appealing the personal judgment rendered against him,
Brunetti (D) argued that a de facto corporation was in existence when the lease was signed, that Cantor (P) dealt
with the corporation as such, and that he was thus estopped to deny its corporate existence so as to hold Brunetti (D)
personally liable.
Issue: If one contracts with a de facto corporation as such, can he thereafter deny its corporate existence so as to
hold those with whom he dealt personally liable on the contract?
Rule: No. One who deals with a de facto corporation as a corporation is estopped to deny its existence in an
attempt to hold those with whom he dealt personally liable on the contract.
Analysis: In this case, a de facto corporation clearly existed because the 3 necessary elements were present:
(1) the existence of a law authorizing incorporation;
(2) actual exercise of corporate powers; and
(3) a bona fide (good faith) effort to satisfy all conditions precedent to incorporation under the existing law.
Since Cantor (P) dealt with Sunshine Greenery (D) as if it were in fact a corporation, he is now estopped from
denying its corporate existence so that he might hold Brunetti (D) personally liable on the lease contract. Reversed.
Comment:: Although “corporate” officers can escape personal liability by use of both theories, there is a difference
between corporation by estoppel and corporation de facto.
A de facto corporation is considered a corporation as against all parties except the state (in a quo warranto
proceeding to declare the corporation invalid.)
A corporation by estoppel is given corporate status only as against the particular person in the particular proceeding
before the court.

(B) Also, where attorney botches incorporation, individual s/h still retain limited liability so long as
(1) creditor thought it was a corporation at time of contract and
(2) investor in good faith thought a corporation had been formed (i.e., reasonable reliance on
the attorney) (Cranson v. IBM)
Effect of this: so long as investor had good-faith reliance, there is no liability for transactions (but liability remains
for torts)

Cranson v. International Business Machines Corp. (1964) (p. 246)

Facts: Cranson (D) and other s met with an attorney to form the Real Estate Service Bureau as a corporation under
the laws of the state of Maryland. After being advised by the attorney that the corporation had been formed,
Cranson (D) received stock in the corporation, and was shown the corporate seal and minute book. The association
was conducted as if it were a corporation (corporate bank account, etc.) and Cranson (D) was elected president. As
president, between May 17 and Nov. 8, 1961, Cranson (D) purchased 8 typewriters for the corporation from IBM
(P). Subsequently, he discovered that the attorney had not filed a certificate of incorporation with the Secretary of
State (as is required by law) until Nov 24. IBM (P) sued Cranson (D) as personally liable for the balance due on the
typewriters. From Judgment for IBM (P), Cranson (D) appealed.
Issue: May the officers of a defectively formed corporation escape personal liability for agreements he enters into on
behalf of the association?
Rule: Yes. 2 doctrines have been used by the courts to clothe an officer of a defectively incorporated association
with the corporate attribute of limited liability:
(1) The doctrine of de facto corporations, where there is evidence showing:
(a) the existence of law authorizing incorporation,
(b) an effort in good faith to incorporate under that existing law, and
(c) actual exercise of corporate powers, and
(2) The doctrine of estoppel where the person seeking to hold the officer personally liable has contracted or
otherwise dealt with the association “as a corporation. “
Analysis: Though there is a tendency to merger these 2 theories into one, there is clearly a distinct difference
between finding a corporation to be created “de facto,” and merely estopping a party due to his conduct from
asserting defective incorporation to reach an officer personally. Where a de facto corporation is found form the 3
above elements, the association becomes a corporation de jure against all person but the state. On the other hand,
estoppel depends on and is limited to the facts of each particular case. Here, IBM (P) clearly dealt with Cranson (D)
as a corporate officer and relied on its credit, not Cranson’s (D) in selling the typewriters. This is a case where
estoppel applies. Nothing more need be found. The judgement was reversed.
Comment:: This case points out 2 general principals of corporate officer liability law: De Facto incorporation and
estoppel.
De Jure corporations is one which as been created and recognized in compliance with the general incorporation
law of the particular state (few corporations are chartered by Congress and only in extraordinary circumstances such
as the Red Cross). This usually means literal compliance with all mandatory incorporation requirements and
substantial compliance with all directory (where court has discretion) requirements.
De Facto corporation is one where sufficient steps have been taken toward incorporation for a court to be justified
in finding that the association involved was “in fact” operating as a corporation. Such a finding raises the
association’s status to that of a de jure corporation against all persons except the state (who may have the
corporation declared invalid in a so-called quo warranto proceeding).
Estoppel is an equitable theory invoked by courts to avoid injury due to detrimental reliance upon someone’s
representations, etc.
In the above case the detrimental reliance of Cranson (D) was really upon his attorney’s representations, not upon
IBM’s (P). The court finds that IBM’s (P) dealing with Cranson’s (D) association “as a corporation” is an implicitly
representation upon which Cranson (D) relied.
(IF THIS WERE A PROMOTER CASE THIS WOULD BE OK. THE ANALYSIS IS DIFFERENT BETWEEN A
PROMOTER CASE AND DEFECTIVE FORMATION)

Acts of Pre-incorporation

Everyone knows not incorporated Acting like incorporated, but not

Promoter GOOD FAITH ACTIONS
1) Has fiduciary duty to corp. and 1) Levy liable cause, no de jure
 Shareholders (liable for investment)
2) Promoter is not liable unless corp. 2) Not liable due to de facto (need good
Is formed and accepts the contract faith and attempt to form
3) Not liable based on estoppel (everyone thinks corp)

We have limited liability for 3 reasons:

1) Every other state offers it
2) Attracts investors
3)
Piercing is allowed basically because of misbehavior and fairness.

JUNE 12, 1998 CLASS STARTS HERE

June 8, 1998 Class Assignment
DISREGARD of the CORPORATE ENTITY (pp. 250-298) (“Piercing the Veil”)
B. The basic question: when will a court ignore the existence of the corporation and extend liability to the
investors personally?
1. Carson: Piercing in any situation is very rare.
C. Piercing and Contract Breaches
1. Generally, courts are very reluctant to pierce in the context of contracts; after all, if the corporation
is thinly capitalized, why doesn’t the contracting party get a personal guarantee from the s/hs?

REVIEW ENTERPRISE LIABILITY

Bartle v. Home Owners Coop. (1955)(p. 250)
Summary: Where a corporation forms a subsidiary to build housing, and subsidiary goes bankrupt, the subsidiary’s
creditor’s cannot pursue the parent corporation for the remaining debt.
Facts: Home Owners Coop. (D) a cooperative association of mostly veterans, unable to secure a contractor to build
low cost housing for its members, organized Westerlea Builders, Inc. for that purpose. When Westerlea ran into
financial difficulties, its creditors, pursuant to an extension agreement, took over the construction responsibilities. 4
years later, even though Home Owners (D) contributed some $50, 000 in original capital and additional sums,
Westerlea went bankrupt. Westerlea’s trustees in bankruptcy (P) sued Home Owners (D) for the contract debts of
Westerlea. The trial court, in deciding for Home Owners (D) found that while Home Owners (D) controlled
Westerlea’s affairs, it maintained separate outward indicia at all times that credit was extended, did not mislead or
defraud Westerlea’s creditors, and performed no act injurious to them by depletion of assets or otherwise. The trial
court also ruled that the trustees (P) were estopped by the extension agreement from denying the separate identities
of the 2 corporations.
Issue: Should the trial court have “pierced the corporate veil” of Westerlea’s corporate existence to see Home
Owners (D) lurking in the background?
Rule: No. Where there has been neither fraud, misrepresentation, nor illegality, the doctrine of “piercing the
corporate veil” will not be invoked to hold a corporation liable for the debts of a wholly owned subsidiary.
Analysis: Since the law permits the incorporation of a business for the very purpose of escaping personal liability,
the doctrine of “piercing the corporate veil” is invoked only in instances of preventing fraud, or to achieve equity.
Home Owners (D) purpose in placing its construction operation into a separate corporation was within the limits of
public policy.
Dissent::
(A) Westerlea is a wholly owned subsidiary of Home Owners (D), having the same directors and management,
(B) Business was done on such a basis that Westerlea could not make a profit (no allowance was made for profit by
Westerlea).
The benefit to the stockholders of Home Owners (D) from this arrangement is analogous to dividends. Westerlea,
consequently, was no more than an agent of Home Owners (D).
Comment:: “Piercing the corporate veil” can take one of 2 routes:
(A) The corporation is the “alter ego” of its shareholders – it is so dominated and used by them, that, in reality, no
separate entity is in existence. This is usually the case where the shareholders treat the corporation’s assets as
their own, drawing on company funds for their personal use at will.
(B) Recognizing the corporation, as a legal entity would be to sanction a fraud or injustice. In these instances,
where this approach is used, the purpose of incorporating was to prevent creditors from reaching personal debts,
to run up debts in excess of assets, or, as charged in this case, to minimized expected tort liabilities.
(C) Possibly different result if fraud had been involved
1) Ex.: Where construction corporation (WCC) purchases bowling lanes and equipment from Brunswick and then
breaches, Brunswick cannot hold the construction corporation’s officers liable (Brunswick Corp. v. Waxman)
(A) Plaintiff here advances several arguments, including instrumentality rule (complete domination by s/h,
use of that domination to commit a fraud or other wrong, and injury caused by that act) and the
straw corporation theory (pierce if corporation is a dummy for purely personal ends)
(B) Court rejects both in this case – since Brunswick knew that WCC was undercapitalized, it shouldn’t be
allowed to avoid the consequences now. Caveat emptor.
(C) Compare Dewitt Truck Brokers v. W. Ray Fleming Fruit Co., where corporation was run with complete
disregard for corporate formalities, it was undercapitalized, president had withdrawn funds due to
plaintiff, president made statements to effect that he would be liable (statute of frauds prevents
enforcement). Here, court pierces veil via application of the instrumentality rule (see above)
 Why the different result? There’s still no fraud, but here there is a fundamental
unfairness: here the breach of the contract goes against the good-faith assumptions of
the contracting party.
 Instrumentality doctrine used to pierce when corporation is used as an instrument to
cause a wrong – not just because it’s an instrument

EXAM KEYS
Reviewing piercing the corporate veil, the factors to look at in determining this are:
1) Corporation Formalities (Were meetings, etc setup)
2) Control / Domination of the Company (Was there control of the company by the shareholders?)
3) Under-capitalization (was there enough money in the corporation to operate?) This should be the
philosophical reason to pierce, however most courts look at lack of corporate formalities)
4) Alter Ego/Instrumentality: Was this an alter ego of the shareholders or an instrumentality of some other
entity to completely avoid liability.

More likely to pierce in a Tort v. Contract

FORMALITY MOST DECISIVE
(A) Parents (in a publicly traded company) has probably never been pierced
(B) Parents should be pierced because the parent is more likely to dominate the subsidiary. (Parent appoints the
board)
(C) Having the same people on the board is the interlocutory board. This is pretty dominated.

Dewitt Truck Brokers v. W. Ray Flemming Fruit Co. (1976)(p. 252)

Summary: Corporation was run with complete disregard for corporate formalities, it was undercapitalized, president
had withdrawn funds due to plaintiff, president made statements to effect that he would be liable (statute of frauds
prevents enforcement). Here, court pierces veil via application of the instrumentality rule. There’s no fraud, but here
there is a fundamental unfairness. Here the breach of the contract goes against the good-faith assumptions of the
contracting party.
Instrumentality doctrine used to pierce when corporation is used as an instrument to cause a wrong – not just
because it’s an instrument
Alter ego doctrine: of its shareholders – it is so dominated and used by them, that, in reality, no separate entity is
in existence. This is usually the case where the shareholders treat the corporation’s assets as their own, drawing on
company funds for their personal use at will.
Facts: Flemming (D) was president of and ran a close, one-man corporation, Ray Flemming Fruit (D), which acted
as a commission-paid agent selling produce for growers. Corporate formalities were not observed, the corporation
was undercapitalized, and no other stockholder or officer other than Flemming (D) ever received a salary or
dividend. DeWitt (P) brought an action to collect moneys due it for providing transportation. It sought to hold
Flemming (D) personally liable on the debt, noting he had withdrawn funds from the corporation that could have
been used to pay the debt. The lower court pierced the corporate veil and imposed persona liability on Flemming
(D) who appealed.
Issue: Will the corporate veil be pierced where recognition of the corporate form would extend the principle of
incorporation beyond its legitimate purposes and produce injustice or inequality?
Rule: Yes. A court will pierce the corporate veil when recognition of the corporate form would extend the principle
of incorporation beyond its legitimate purposes and would produce injustices or inequitable consequences.
Analysis: The concept that a corporation is an entity, separate and distinct from its officers and stockholders, is
merely a legal theory introduced to serve the ends of justice and for convenience. As such, the courts will refuse to
recognized it and will pierce the corporate veil, where, as in this case, recognition of the corporate form would
extend the principle of incorporation beyond its legitimate purposes and would produce injustices or inequitable
consequences. One fact significant to such an inquiry, particularly so in the case of a one-man or closely held
corporation, is whether the corporation was grossly undercapitalized for the purposes of the corporate undertaking.
Here, undercapitalization of this one-man corporation and the presence of other factors, such as lack of corporate
formalities, lead to the conclusion that the finding below that the corporate entity should be disregarded was not
clearly erroneous. Affirmed.
Comment:: Although courts are willing to pierce the corporate veil to hold an individual responsible for corporate
debt, they are even more willing to pierce the corporate veil to hold a parent corporation responsible for the debt of a
subsidiary whose stock it holds. Intermingling of the business affairs of parent and subsidiary, i.e., not delineating
between their operations, has proven to be an almost certain way to ensure the veil will be pierced.

2. Other policy reasons may also trump piercing (Cargill v. Hedge, denying “reverse piercing” in order
to protect homestead policy – creditors should have secured the loan)

Piercing and Tort Claims

Baatz v. Arrow Bar (1990)(p. 260)
Facts: Kenny and Peggy Baatz (P) were seriously injured when McBride who had been drinking at the Arrow Bar
(D) struck them while they were riding their motorcycle. McBride was uninsured and is judgement proof. The Tort
action in 1984 claimed that The Arrow Bar was negligent in serving alcoholic beverages to McBride and this
contributed to the injuries of the Baatz (P). The Neuroth’s formed the Arrow Bar, Inc. in 1980 with substantial
money contributions. On advice of their attorney, because of South Dakota legislation they did not maintain dram
shop liability insurance at the time of the accident. The 1987 trial entered a summary judgement in favor of Arrow
Bar and the Neuroths as individual defendants.
Issue: In a tort action, should the corporate veil be pierced leaving the shareholders of the corporation individually
liable?
Rule:
A) A trial court may grant summary judgement only when there are no genuine issues of material fact.
B) When continue recognition of a corporation as a separate legal entity would “produce injustice and inequitable
consequences ”then a court has sufficient reason to pierce the corporate veil.
Analysis:
A) Baatz claims the Arrow Bar owners personally guaranteed corporate loans, and they should also be liable for
other corporate liabilities, because the company is undercapitalized. The court said they are capitalized for their
normal operations
B) Baatz says the Arrow Bar is an alter ego of the owners. The court says that there is no evidence presented
showing this or that the owners used the Arrow Bar as an instrumentality for which they conducted personal
business through
C) Baatz said that corporate formalities were not followed, because it did not say Arrow Bar, Inc. on the sign. The
mere failure on certain occasions to use these formalities like this as well as meetings and records followed are
OK. A little informality does not kill corporate formality.
Did not find the owners personally liable.
Dissent:: The dissent said that the corporation was an instrumentality, and the shareholders set themselves up to be
liability proof. This is considered a fraud on the public.

Key difference between this and contracts: the injured party here is not a willing party
1. The veil will not be pierced just because the plaintiff cannot recover solely from the corporation –
must prove control and bad conduct
 a) Thus, in Walkovszky v. Carlton, 2-cab corporation will not be pierced even where sole s/h
owns 9 other 2-cab corporations just like it. Why? Because the corporation was incorporated
in perfectly legal fashion, and the fact that there are multiple entities does not constitute a
fraud.
(1) Also note dicta saying that undercapitalization argument fails as well – the cabs carried
the requisite amount of insurance mandated by law ($10,000); since the legislature says
that amount is sufficient, the courts presume it is not undercapitalized.
(2) To even state a cause of action that can be heard, plaintiff must allege the business was
run in a “personal capacity”
b) Also see Radaszewski v. Telecom Corp., where piercing was denied where corporation was
thinly capitalized and went bankrupt but nonetheless carried adequate liability insurance
coverage. The court says no socially irresponsible behavior here.
(1) Court sets following test for piercing:
(a) Complete shareholder control of corporate policy with respect to the issue at hand
(b) Used to commit a fraud or wrong (i.e., breach of duty – no such breach here because
of adequate insurance)
(c) Injury to plaintiff
(2) Dissent: insurance isn’t per se adequate capitalization; question should be submitted to a
jury

Radaszewski v. Telecom Corp. (1992)(p. 266)

Summary: piercing was denied where corporation was thinly capitalized and went bankrupt but nonetheless carried
adequate liability insurance coverage. The court says no socially irresponsible behavior here. Court sets following
test for piercing:
 Complete shareholder control of corporate policy with respect to the issue at hand
 Used to commit a fraud or wrong (i.e., breach of duty – no such breach here because of adequate insurance)
 Injury to plaintiff
Dissent: insurance isn’t per se adequate capitalization; question should be submitted to a jury
Facts: After Radaszewski (P) was seriously injured when the motorcycle he was riding was struck by a truck driven
by an employee of Contrux, Inc., a wholly owned subsidiary of Telecom (D), Radaszewski (P) filed this suit to
recover damages for his injuries. He sought to hold Telecom (D) liable for his injuries by piercing the corporate veil
to reach its assets since Contrux was undercapitalized. Contrux initially had had basic and excess liability coverage,
which would have covered Radaszewski (P) damages. Unfortunately, 2 years after the accident, the excess liability
insurance carrier became insolvent and went into receivership. The district court dismissed the complaint against
Telecom (D), holding that the court lacked jurisdiction. Radaszewski (P) appealed.
Issue: To pierce the corporate veil, must one show control amounting to complete domination, use of that control for
an improper motive which breaches a duty owed, and injury proximately caused by that breach?
Rule: Yes. To pierce the corporate veil, one must show control amounting to complete domination, use of that
control for an improper motive which breaches a duty owed, and injury proximately caused by that breach.
Analysis: Undercapitalizing a subsidiary is a sort of proxy for the second. Operating a corporation without
sufficient funds to meet its obligations shows either an improper purpose or reckless disregard of the rights of others.
Here Contrux was undercapitalized in the accounting sense. However, it did carry $11 Million worth or liability
insurance. Insurance meets the policy behind the proper capitalization requirement just as well as a healthy balance
sheet. There is no evidence that Telecom (D) or Contrux knew that the insurance company was going to become
insolvent. The doctrine of limited liability would largely be destroyed if a parent corporation could be held liable
simply on the basis of errors in business judgement. Affirmed.
Dissent: The record is more than sufficient to support a prima facie showing that personal jurisdiction over Telecom
(D) exists. Contrux had neither the working capital nor the unencumbered assets to permit it to make decisions on
its own. On the basis of the record, Contrux was nothing but a shell corporation established to permit Telecom (D)
to operate as a nonunion carrier without regard to the consequences that might occur to those who might be affected
by its actions.
Comment:: State courts have developed a variety of tests designed to guide courts in determining when the
corporate veil should be pierced. All, however, tend to embody some sort of domination or abuse requirement and
require proof of injustice that, over the past forty years, courts have chosen to pierce the corporate veil in 40% of
reported cases.
A) However, can’t defend yourself on the grounds that you were a ‘temporary’ director (Minton v. Cavaney)
B) Mere opportunity to control isn’t enough – must be actual utilization of control (American Trading and
Production Corp. v. Fishbach & Moore)
C) However, a family-owned corporation with subsidiaries where the parent corporation totally dominates the
subsidiaries to the extent that it’s unclear to a neutral observer that they are separate entities can result in
piercing. (My Bread Baking Co. v. Cumberland Farms, where it was shown that president directly ordered
subsidiary to not return bread racks)
 In other words, a jury could reasonably find the subsidiary was a mere instrumentality of the parent – so the
issue of control should reach a jury.

Fletcher v. Atex, Inc. (1995)(p. 273)

Facts: Fletcher (P) filed a suit against Atex (D) and its parent Kodak (D) to recover for repetitive stress injuries that
he claimed were caused by the use of a computer keyboard, mfg. By Atex (D). Summary judgement dismissed
Kodak as a D and Fletcher (P) appealed.
Issue:
Rule: Under an alter ego theory of law, there is no requirement of showing fraud (as is the rule) in a liability case.
Analysis:: The P must show (under Delaware law – because this is the state of incorporation of Atex.) (1) that the
parent and the subsidiary “operated as a single economic entity” and (2) that an “overall element of injustice or
unfairness is present. Kodak has shown that Atex followed corporate formalities, and the Ps have shown no evidence
to the contrary. The district court was correct in hold that “Atex (D) participation in Kodak’s cash management
system is consistent with sound business practice and does not show undue domination or control.” The district
court was held:
1) that Atex’s participation inn Kodak’s cash management system is consistent w/ sound business practice and
does not show domination or control.
2) District court concluded that it could find no domination based on the P’s evidence that Kodak approved Atex’s
real estate leases, capital expenditures, negotiations of sale of minority stock ownership to IBM, or that Kodak
played a significant role in the ultimate sale of Atex’s assets to a 3rd party.
Comment: Things that blur the distinction between entities are common retirement plan, common resources, etc.
(see notes on p. 277)

Other Veil-Piercing Issues: Courts try to balance common-law theories with federal laws
holding intra-corporate actors liable; where there is a statute, courts will apply it
United States v. Kayser-Roth Corporation (1989)(p. 284) STATUTES
Facts: Stamina Mills Inc. a defunct corporation, was charged with dumping hazardous waste in the waters adjacent
to the village of Forestdale, Rhode Island. The Government (P) sought to recover the costs of cleanup from Kayser-
Roth Corporation (D), the parent corporation of Stamina Mills. The Government (P) asserted that liability existed
under the Comprehensive Environmental Response Compensation and Liability Act (CERCLA). Prior to Stamina
Mills’ dissolution, Kayser-Roth (D) exerted practically total influence and control over the operations. Kayser-Roth
(D) approved all actions of Stamina Mills and was intimately involved in the selection of corporate officers and the
day-to-day operation of the company. The Government (P) contended that Kayser-Roth (D), as the operator of
Stamina Mills, was therefore liable under the Act.
Issue: May a parent corporation be responsible for the actions of a subsidiary under federal law?
Rule: Yes. A parent corporation may be held responsible for the acts of its subsidiary under federal law.
Analysis: In this case, the federal statute allows for vicarious responsibility of the parent corporation for hazardous
waste cleanup. The parent in this case was clearly an operator in that it was intimately involved in the day-to day
operations of Stamina Mills. Here, because of the very close relationship between the parent and subsidiary,
responsibility under the Act exists in 2 forms: parent-operator liability and piercing-the-corporate-veil theory. As a
result, Kayser-Roth (D) is responsible for the amount of the cleanup. Judgment for the Government (P).
Comment:: Some commentators have noted that given the rather precise definition of “operator” under the
Comprehensive Environmental Response and Liability Act, the court in this case did not need to get into the
discussion of piercing the corporate veil. It is clear from Kayser-Roth’s (D) close operating business at the time,
and therefore no need to analyze the case in terms of an alter ego theory was shown. However, in cases where such
a relationship is not as clear, such an analysis could prove beneficial.
In some situations (notably bankruptcy) courts may hold a fiduciary duty exists to creditors

Stark v. Flemming (1960)(p. 289)

Facts: Stark (P) placed her assets in a newly formed corporation. She operated her farm and duplex for it and paid
herself a $400 a month salary. This was done so as to quality her to social security. Flemming (D), the Secretary of
HEW, denied Stark (P) her claimed benefits on the theory that the corporation was a mere sham. The district court
found for Flemming on this basis. It concluded that Stark’s (P) only purpose in incorporating was to qualify for
social security benefits.
Issue: Where not provided for by statute, may the government withhold benefits because a corporation was formed
merely to qualify for them?
Rule: No. Where corporate formalities have been observed, the form cannot be disregarded unless authorized by
statute.
Analysis: If Congress has not specified that benefits are to be withheld in these cases, the Secretary of HEW (D) is
not permitted to deny them. All corporate formalities were complied with by Stark (P), and regardless of her motive
it must be related as a legitimate entity. Flemming (D) is permitted to make an independent appraisal of the salary
paid o Stark (P) in order to determine if it is excessive. He may compare salaries paid to others in similar situations
and commensurate with her responsibilities and the capital contribution to the business. The decision of the district
court is vacated and remanded for further proceedings.
Comment:: Stark stands for the principle that corporate form cannot be ignored. The motive of the incorporator is
immaterial. Therefore, incorporation cannot be attacked because the incorporator’s sole motive was to save taxes or
to avoid personal liability. No legitimate business purpose is required. A person is free to adopt whatever form he
desires, so long as he observes the formalities associated with his choice. There must be a compelling policy reason
for piercing the form if statutory authority to do so is not granted.

Roccograndi v. Unemployment Comp. Bd. Of Review (1962). 290)

Facts: Roccograndi (P) and 2 other applicants filed for unemployment compensation benefits when they were “laid
off.” All were members and shareholders of a family business which, during slow periods, laid off various family
members so as to qualify for these benefits. The Unemployment Compensation Board denied the claim based on the
fact that the applicants were really self-employed. A referee reversed. The Board of Review (D) reversed the
referee.
Issue: May corporate form be disregarded for the purpose of unemployment benefits where the applicants exert
sufficient control over the corporation to lay themselves off and/or rehire themselves?
Rule: Yes. The corporate form may be ignored where applicants for unemployment compensation benefits exert
sufficient control over the corporation to lay themselves off or rehire themselves at will and are considered self-
employed.
Analysis:: Where the applicants can exert sufficient control over a corporate entity to lay themselves off when
business is bad, they are really self-employed. The Unemployment Compensation Act provides that no benefits
shall be given the self-employed. Case law on the Act has held that in cases of close family corporations, such as
Roccograndi’s (P), the corporate form may be disregarded. The decision of the Unemployment Review Board (D) is
sustained.
Comment:: To qualify for benefits from the State, an applicant must be able to bring himself within the class sought
to be benefited. The self-employed are excluded. The courts have defined self-employed as members of a close
corporation in which they retain a substantial amount of control after being laid off. This is a public policy decision
that said parties are not within the class sought to be benefited by the legislation.

JUNE 15, 1998 CLASS STARTS HERE

KEY CASE
Cargill Inc. v. Hedge (1985)(p. 291)
Summary: policy reasons may trump piercing. In this case the court denied “reverse piercing” in order to protect
homestead policy – creditors should have secured the loan.
Facts: After purchasing a 160 acre farm, the Hedges (D) incorporated as a family farm corporation, Hedges Farm,
Inc. (D). While the Hedges (D) maintained some of the corporate formalities, they operated the farm as their own.
Annette Hedge (D) owned all the stock. All the corporate directors and officers were family members, with none of
the officers receiving any salary. Sam Hedge (D) purchased farm supplies and services on account from Cargill (P).
Cargill (P) filed suit to collect on the account, and judgement was entered in its favor. Shortly before the expiration
of the redemption period, Annette (D) was allowed to join the proceedings as an intervenor. The trial court
subsequently ruled that the Hedges (D) had a right to exempt from the execution ½ the acreage of the farm as their
homestead. The court of appeals affirmed. This appeal followed.
Issue: To apply a reverse pierce of the corporate veil, is it necessary to examine the extent to which the corporation
is an alter ego and whether creditors or other shareholders would be harmed by a pierce?
Rule: Yes. To apply a reverse pierce of the corporate veil, it is necessary to examine the extent to which the
corporation is an alter ego and whether creditors or other shareholders would be harmed by a pierce.
Analysis: Here, there is a close identity between the Hedges (D) and their corporation. Realistically, they operated
the farm as their own. They had no lease with the corporation and paid no rent. The farmhouse was their family
home. The corporation was therefore an alter ego of the Hedges (D). While a reverse pierce should be permitted in
only the most carefully limited circumstances, this is such a case. Thus, the creditors’ execution sale of the
exempted acreage is void. Affirmed.
Comment:: The court cited its prior decision in Roepke v. Western National Mutual Insurance Co. (1981) to support
its analysis here. In Roepke, the court disregarded the corporate entity to further the purposes of the No-Fault
Insurance Act; otherwise, a deceased business owner would have been deprived of no-fault coverage he would have
had if he had operated as a sole proprietorship. The policy reasons for a reverse pierce were much stronger in this
case than in Roepke – namely, furtherance of the purpose of the homestead exemption.

Pepper v. Litton (1939)( p. 294)

Summary: Dominant s/h with advance knowledge of impending bankruptcy secured a judgment for back salary
(which was paid ahead of creditors, unlike s/h claims); court denied collection in favor of creditor on basis of
fiduciary duty to creditors
Facts: Litton (P) was the sole owner of a small corporation. When the corporation became insolvent, Litton (P)
brought suit and recovered a judgement against it for “wage” claims. When bankruptcy was declared, Litton (P)
filed a priority claim for wages with Pepper (D), the trustee. Pepper (D) disallowed the claim. Litton (P) brought
suit in district court. The court found that Litton (P) had engaged in a scheme to defraud creditors and dismissed
Litton’s (P) claim under its broad equity powers. If found that Litton (P) totally controlled the corporation and had
dealt unfairly with it. Finally, allowing Litton (P) to enforce his claim would be unfair to other creditors.
Issue: May the bankruptcy court disallow a claim by a party who dominated and controlled the bankrupt
corporation?
Rule: Yes. Where a claimant in bankruptcy has dominated and controlled a corporation, is claim may be
subordinated or even disallowed upon a showing that enforcement of the claim would be unfair to other creditors.
Analysis: The parties to be protected in a bankruptcy proceeding are the corporation’s innocent creditors.
Therefore, a party owning and controlling the corporation who files a claim must be carefully scrutinized. Where he
has dealt with the corporation unfairly and has attempted to defraud creditors, or where the corporate form may be
disregarded, his claim should be subordinated or even disallowed. To hold otherwise would work an injustice upon
those who innocently bestowed credit to the bankrupt corporation. In one-man or family corporations, claims will
normally be subordinated. Here, the court found that Litton (P) had initiated a plan to defraud creditors. The fact
that his claim has been reduced to judgement is immaterial. The bankruptcy court has broad equity powers to
disallow claims which would be unfair to innocent creditors. The decision of the district court is affirmed.
Comment:: By way of explanation, wage claims take precedent over creditor claims in bankruptcy. By filing a
wage claim, Litton (P) tried to put himself ahead of the corporation’s creditors. This is known as the “Deep Rock
doctrine.” The doctrine also applies to dominant or controlling stockholder or group of stockholders. Southern
Pacific Company v. Bogert

a) Note fraud in this instance need not be shown – only inequity in a situation where a duty exists
(also note this isn’t really a piercing case, but an order-of-payment case)
3. Sophistication of the parties is often an issue, as is the voluntary nature of their participation (i.e.,
why tort victims are more likely to pierce than parties to a contract). It’s also more likely that a
parent corporation will be held liable than an individual investor – investors in parent have put
their money at risk; there’s no “nest egg” at stake.
 4. In Texas, issue of piercing the veil is a jury issue (Castle v. Newberry)
D. Summary of approach to veil-piercing problems:
1. Contract issues: show some kind of injustice. Could other party have foreseen this result? Could
they have taken steps to prevent it? Was corporation used as an instrument to commit a wrong?
2. Tort issues: look for thin capitalization. Also total domination.

June 10 -12, 1998 Class Assignment

FINANCIAL MATTERS and the CLOSELY HELD CORPORATION (pp. 299-400) Usually there are 3 sources
of assets for the beginning corporation:
1) Equity (ownership interest) STOCKS
a. Contributions in exchange for stock in the corporation
2) Debt (Interest rate, right to be repaid, no upside) BOND & DEBENTURE
a. Loans by the shareholders and loans from other sources (like banks).
b. Bonds (secured), debenture (unsecured) loans by the general public.
A) Debt and Equity Capital (p. 299) A shareholder is one who owns an “equity” security (that is, he is an owner of
the corporation as opposed to a creditor). In addition, the equity securities issued to owners, the corporation
issues debt securities to creditors.
B) Types of Equity Securities (p. 300) Typically the rights of shareholders are created (as a matter of contract) in
the articles of incorporation. In addition, state corporation law provides shareholders with certain rights (such
as the right to obtain a shareholders list, etc.), and the board (where permitted by law) may set certain terms and
conditions in issuing equity securities.
 Federal laws (Securities Act of 1933) and state laws (Blue Sky Laws) require disclosure. This is
usually done via prospectus of the company. As of 10/98 prospectuses are required to be in plain
English.
A. MBCA §§6.01-04 regulates issuance of shares; liquidation usually is face value of stock plus dividends in
arrears.
B. §6.01(b) – at least one class must have voting rights and rights to assets on dissolution
C. Par value optional in most states – but not Texas (used to be corporations had to keep assets equal to par
value)
(A) Common Shares (p. 300) – Confers voting rights, but dividends come only after preferred
shareholders; owns residual value of corporation. These have the rights to inspect the minute book of
the company, right to vote, right to sue in the name of the corporation for wrongs done to the
corporation (derivative suits), a right to the financial information of the company, and share in assets
via dividends and liquidation payments.
1. Classes of Common (p. 305) – Various classes of common stock may be issued, each with their own
unique rights (i.e. different number of votes per share, rights to different amount of dividend, etc.)
MAJOR TOOL FOR CREATING THE FLEXIBILITY OF A PARTNERSHIP. (This is because
the right is tied to the # of shares owned)
(B) Preferred Shares (p. 302)– Usually no voting rights, but get dividends first; can usually be redeemed
at corporation’s discretion at a premium; sometimes convertible into common shares; priority in
dissolution over common (but not over creditors) Payment preference is the key to this. (i.e. $4.00
preferred shares get $4.00 paid first, before the other shareholders (common) are paid anything.
1. Reasons for issuing preferred stock
(A) Contingent voting rights: (i.e. voting rights accrue only when dividends are not paid or on major
corporate transactions, such as sale of all corporate assets) This means that preferred stock does
not dilute the voting control that resides in the common shareholder.
(B) No required, fixed repayment: of principal (some do require repayments, and the corporation must
set up a sinking fund to periodically pay off part of the principal invested by preferred
shareholders) Nearly all do permit management to “call” the preferred stock (redeem it) at its
discretion.
(C) Fixed % annual dividends: these are not tax deductible to the corporation. Since the risk to the
preferred shareholders is greater (won’t receive dividends) than to the holder of debt securities
(which carry a prior right to interest payments), the rate of interest that must be paid on preferred
stock is normally higher than on most forms of debt securities.
 2. Implied preferences: At common law, the courts would sometimes imply terms in preferred stocks
(i.e. if the stock was called preferred, then the courts would imply certain preferences). Now most
state law provides that all terms and conditions of classes of stock must be specifically stated in the
articles of incorporation. However, there are also series of stocks, which are not called out in the
statutes. This allows the board of directors (if the power is given to them in the articles of
incorporation and by laws) to decide the rights and powers of each series on their own. If you want to
issue a different class, you have to amend the articles by getting a vote from the shareholders.
3. Specific preferences
Dividends: are normally paid to preferred class of stocks before other classes of stocks.
(A) Noncumulative preferred: dividends are paid only if declared by the board, and if not paid in one
year, the amount does not accumulate to future years.
(B) Cumulative: if dividends are not in one year, they are accumulated for payment in future years
Partially cumulative: the only part that is carried over is the
amount that was available at the time the dividend should
have been paid but didn’t.
(C) Participating preferred: to participate in dividends paid after the preferred and the common
shares have received a certain percentage dividend. (Both common and preferred holders
participate in remaining money available for dividends after the contracted dividends have been
paid. This depends a lot on state law.)
Liquidation rights: Normally preferred shares have priority (after corporate creditors) to the assets of the
corporation in liquidation. Typically preferred shares receive par value (plus accumulated dividends), the
common receive par, and then the preferred and common share the remainder.
Conversion Rights: are the rights to convert preferred stock into common stock with a certain ratio set. The
most common reason to convert is that companies match conversion rights with redemption rights (i.e. a
call is made on the stock and the preferred shareholder has the right to take common stock in lieu of cash.)
Not usually worth converting unless the stock goes up substantially in value.
Protective Provisions: Each share goes up in value proportionate with the issuance of new stock (i.e. if
stock split in common stock 100 to 200 shares and the value is $100 for old and new stock, the preferred
stock splits with it or there is a dividend paid, or % shares are given in dividend. Basically this prevents
dilution of the stock. There are a multitude of ways to protect. Sinking funds are used by companies to buy
out shares over time.
Treasury Share: is a redeemed share. A share bought back by the company. These are like authorized
shares, things bought back don’t get a dividend paid to them. Only outstanding shares are paid the
dividend. The differences is that authorized shares cannot be sold for less than par value, but treasury
shares can be sold for what ever can be gotten for them (less than par value).
Preferences set by board: The articles may give authority to the board to issue the preferred shares in
different series and to set certain terms with respect to each series (such as the dividend rate, redemption
rights (forces the sale of the shares back to the corporation – this is a call that is set usually by a time limit
and a price that is higher than any liquidation preference), and liquidation amounts and priorities).

A) Issuance of Shares: Herein of Subscriptions, Par Value and Watered Stock (p. 307)
1) Historically, unperformed services, promissory notes (unsecured), or intangible property (i.e. good will,
name, etc.) were not OK to buy stock
2) §6.21 – BoD has default power to issue; consideration for shares is not limited to cash (i.e., can be for
services rendered, intangibles, etc. – future services still aren’t OK, but a promissory note, may or may not
be OK)
3) Watered Stock: Property less than shares worth Other Watered stocks are
A)`Discount shares: not paying the full cash account
B) Bonus shares: not paying for the stocks at all.
To get around watered stock issues par was set very low (i.e. $1.00 or $0.01)
Issue comes up that shares must be sold for the same minimum par.
4) But only for authorized number of shares in the articles of incorporation – thus making number of
authorized shares an important s/h issue
5) Share Subscriptions and Agreements to Purchase Securities (p. 307)
6) Authorization & Issuance of Common Shares Under the Model Act (p. 308)
Hanewald v. Bryan’s Inc. (1988)(p. 312)
Facts: After the Bryans (D) incorporated Bryan’s Inc. (D) to operate a general retail clothing store, they issued
stock to themselves, lent the corporation some cash, and personally guaranteed a bank loan. However, they failed to
pay the corporation for the stock that was issued. Bryan’s Inc. (D) then purchased Hanewald’s (P) inventory and
assets in a dry good store for cash and for a corporate promissory note. It also signed a lease on Hanewald’s (P)
store. When Bryan’s Inc. (D) closed after a few months, it paid off all its creditors except Hanewald (P), sending
him a notice of rescission in an attempt to avoid the lease. Hanewald (P) sued Bryan’s Inc. (D) and Bryans (D) for
breach of the lease agreement and the promissory note, seeking to hold the Bryans (D) personally liable. The trial
court ruled against Bryan’s Inc. (D) but refused to hold the Bryans (D) personally liable. Hanewald (P) appealed.
Issue: Is a shareholder liable to corporate creditors to the extent his stock has not been paid for?
Rule: Yes. A shareholder is liable to corporate creditors to the extent his stock has not been paid for, up to the
unpaid par.
Analysis: A corporation that issues its stock as a gratuity commits a fraud upon creditors who deal with it on the
faith of its capital stock. Where, as here, a loan was repaid by the corporation to the shareholders before its
operations were abandoned, the loan cannot be considered a capital contribution. The Bryans (D) had a statutory
duty to pay for shares that were issued to them by Bryan’s Inc. (D). However, Bryan’s Inc. (D) did not receive any
payment, either in labor, services, money, or property, for the stock issued to Keith and Joan Bryan (D). The Bryans
(D) have not challenged this finding of fact on appeal. Thus, the trial court erred as a matter of law in refusing to
hold the Bryans (D) personally liable for the corporation’s debt to Hanewald (P). Affirmed in part, reversed in part
and remanded.
Comment:: The Bryan’s (D) failure to pay for their shares in the corporation made them personally liable under the
court’s application of § 25 of the Model Business Corporation Act (MBCA). The court also applied Article Xii, §9
of the state’s constitution, stating that no corporation shall issue stock or bonds except for money, labor done, or
money or property actually received. The purpose of the constitutional and statutory provisions is to protect the
public and those dealing with the corporation.

1) Eligible and Ineligible Consideration for Shares (p. 316)

2) Par Value in Modern Practice (p. 318)
Par value: This is the stated value of the equity shares when they are issued in exchange for cash or property.
The shares must be sold for at least this value unless the BoD finds in good faith that they cannot be sold for par
value.
Stated Value: Corporation shares are no par, they can be sold for a reasonable value set by the board. This
value is called the stated value. What is “reasonable” depends on the company’s worth, its earnings per share,
etc. The board’s determination is upheld as long as there is good faith.
Dillution: this is technically OK. This is where stock is sold for more or less than par. If someone buys for
more, it is acceptable to do this as long as there is no fraud.
Model Act: eliminates the idea of par value. (i.e. if stated par is $0.01 and stock is sold for 1.00 is Capital
Surplus; and Earned Surplus is what is earned from sales of products or services. ) Some states require a
minimum capitalization (20) the rest say you don’t have to. Most corporations usually choose to go with a par.
Limiting Authorized Shares: Usually protects the minority share holder from diluting their power.
If no par: No state allows dividends out of Stated Capital (i.e. par value) That is why many companies make
the par value of stock very low.Capital surplus and earned surplus are not counted for determining issuance of
dividends. If this is the case, some cases allow dividends out of earned surplus only, and not capital surplus.
In contribution of property: a question could be raised re: value of contributed value. Could open litigation later.
Creditors: With no par, they usually want security re: loans, (i.e. see the books, what property, limit on the
ability to make dividends., financial covenants, etc.)
Put: A shareholder makes someone buy their shares of stock. The problem with these are that the company
does not have the money to do this.
Calls: A company can call a share in, to buy it.
Reviewed reading the common stock information.

Accounting for Business Lawyers (p. 321)

C) Debt Financing (p. 322)
1) Terminology
(a) basically is a fixed obligation
 (b) Debenture – an unsecured obligation (usually short term)
(c) Bond – obligation secured by a lien (though commonly used to refer to both)
(usually long term)
(d) Zero-coupon bond – no interest, sold at a discount. The lower the price paid for the
bond, the higher the effective return.
(e) Junk bond – a below-investment grade debt: “High yield- debt market.” High risk,
high yield. Junk bonds are issued in connection with: Mergers; Leverage buyouts;
companies w/ heavy debts to repay; stock buyback by corporations.
2) Leverage: involves the use of debt in financing assets of a firm. The use of fixed cost financing affects the
EPS available to the stockholders, magnifying both gains and losses. Because of the risk of default, and
therefore the possibility of bankruptcy, arising form the use of debt, variability in a company’s returns
should increase with the use of financial leverage. (p. 324)
3) Concept of Leverage (p. 323) Leverage can greatly increase the return on equity, maintain control of a
corporation, and has tax advantages (i.e., interest is deductible); the downside is that it is risky and an
adversely affect financial ratios.
4) Tax Treatment of Debt (p. 325): There are usually tax advantages in C-Corp shareholders. Interest
payments on debt are deductible by the borrower whereas dividend payments on equity securities are not.
A loan by a shareholder to his corporation therefore reduces the double tax problem of a C corporation.
This offsets the benefit of the S-Corporation
5) Debt as a Planning Device (p. 327):
a) sometimes “debt” will be treated as “equity” if it looks like a sham
For example, see Slappey Drive Industrial Park v. US, where IRS
considered notes held by s/h to be equity since they didn’t require the
corporation to make timely interest payments; IRS denied deduction for
“interest.” (IRS tried to say for every $1 of equity and anything of $10
with outsiders was not considered debt, but there is no bright line rule.
But it is safe to say that 10:1 debt to equity with outsiders and 4:1 with
insiders the IRS will come after you.)
b) Also beware of under-capitalization, especially if debt is held by co-owners – ‘deep rock’ doctrine of
Pepper v. Litton (supra) could bite you (see also Obre v. Alban Tractor Co.(p. 327), saying capital
structure was permissible)
D) Planning the Capital Structure for the Closely Held Corporation (p. 328)
1) Will the structure “work” i.e. will it stand up in the event of later disagreement and possible legal attacks?
a) How to resolve disputes? (can you elect a new board?)
2) Will the structure actually provide the desired results?
a) will profits be shared the way they want
b) will it get property tax treatment
3) What will happen when unexpected liabilities arise?
4) Will the desired tax treatment be available, or more likely, is the structure created one that makes the
desired tax treatment probable if not certain?
5) Are the clients’ financial contributions reasonably protected and reasonably fairly treated in the event of
unexpected or disastrous occurrences causing the sudden and premature termination of the venture?
Issues in Capital Structure of a Closely Held Corporation
Disproportionate Stock
Watered down stock
S-Corp treatment ?
Different classes of stock for different rights. Have it setup so that overtime different classes become similar.
Mix debt and equity: Have more comparable amounts of money. $50K debt, $50K equity. To get money
needed. Mandatory conversion.

Think about possibilities of structuring deals of partners in a corporation. Corporate planning is really tough to
meet the clients needs (i.e. deal with country that only works with corporation, setup to go public, need for a
license that is only available for corporation)
E) Public Offerings (p. 331): Help to raise money for the corporation. There are a lot of securities regulations
state (Blue Sky laws) and federal.
The Law of Securities Regulations (p. 331)
1. Securities Act of 1933: Deals with initial sale of securities by the initial issuer. Covers all sales of securities
using the instrumentality of interstate commerce. The idea is that you have to register all initial offerings, and
file it with full disclosure. They don’t care about merit. This is not the same as Blue Sky laws) IPO s
a) Is it a security (Stock, bond or debenture)
b) Was an instrumentality of interstate commerce used (i.e. th phone, road, internet)?
2. Securities and Exchange Act of 1934 (created the SEC) This covers all trading
after the IPO.
3. Must comply with federal and state laws. The exceptions to this are only in closely held companies
4. 1996 National Securities Market Improvement Act: If you register for the full registration and comply with the
federal law, the blue sky laws are preempted.
5. SEC requires information re: the corporation, provide certified financial statements, prospectus, file a registration
statement under the ’33 act.

Securities Exchange Comm’n v. Ralston Purina (1953)(p. 335)

Is this offering exempt from the 1933 Act?
Issue: Does an offer of stock by a company to a limited number of its employees automatically qualify for the
exemption for transactions not involving any public offering?
Rule: No. The exemption in § 4(1) of the Securities Act of 1933, which exempt transaction by an issuer not
involving any public offering from the registration requirement, applies only when all the offerees have access to the
same kind of information that the act would make available if registration were required.
Analysis: The Securities Act does not define what is a private offering and what is a public offering. The court
looked at the intent of the Securities Act, which is to protect investors by promoting full disclosure of information
thought to be necessary for informed investment decisions. When the Act grants an exemption, the class of people
involve were not considered as needing the disclosure that the Act normally requires. When an offering is made to
people who can fend for themselves, the transaction is considered to be one not involving a public offering. Most of
the employees purchasing the stock from Ralston Purina (D) were not in a position to know or have access to the
kind of information which registration under the Act would disclose and, therefore, were in need of the protection of
the Act. Stock offers made to employees may qualify for the exemption if the employees are executive personnel
who, because of their position, have access to the same kind of information that the Act would make available in the
form of a registration statement. Absent such a showing of special circumstances, employees are just as much
members of the investing public as nay of their neighbors in the community. The burden of proof is on the issuer of
the stock, who is claiming an exemption to show that he qualifies for the exemption. Also, since the right to an
depends on the knowledge of the offerees, the issuer’s motives are irrelevant. It didn’t matter that Ralston Purina’s
(D) motives may have been good, because they didn’t show that their employees had the requisite information.
Therefore, judgement reversed.
Comment:: The exemption discussed above is now found §4(2) instead of §4(1). This case is considered to be the
leading case in this area. The test established in this case is still used in determining whether an offering qualifies
for the nonpublic offering exemption of § 4(2). Some of the factors used in determining whether the offerees have
sufficient access to information concerning the stock is 1) the number of offerees,
2) the size of the offering,
3) the relationship of the offerees,
4) the manner of the solicitation of the offerees, and
5) the amount of investment experience of the offerees.
Generally there is a 2 year rule that officers must hold (unregistered) stock for 2 years, before they can sell the stock.
Otherwise they would be considered a public offering.

June 22, 1998 Class Starts Here

July 24th is tentatively the review session date.

EXAM: 4 Questions
1) 1 Question: be a business planning question and you need to advise them as to the type of entity of what
they use and the pros and cons of all the entities that could be used) 25 Points
2) 2 Heavy fact pattern questions: will be geared around liability and anytime something wrong occurs and
what will 65 points: Not looking for a great essay, look for the issues and discuss briefly and with default
setting, problem, and what the situation really is. (i.e. Rule, violation, move on, good faith effort to
comply, what is the minority rule.
3) 1 Question: a think piece, (i.e. Should the sole duty of directors be to the shareholders?) discuss all valid
points in this area (15 points)
(a) 4 hours: can be taken anytime and can be checked out at the
registrar desk and make arrangements to turn it back in.
(b) Grading: Check for technical compliance (over time ?)
Was the exam initialed, typed or in pen?
Grade Question by Question
(c) Will grade at the end of the exam time.
4) He will administer exam the night it is scheduled for.
5) You can use word processor, do not download pages out of outline;
(a) Positive points for every problem found.
(b) Negative points for problems that are not really there.
6) Consult anything other than a person. Do not discuss the exam with anyone.
7) Double space, don’t scribble.
8) Will schedule a night during the reading period, where he will go through the exam he used previously.
9) Pre-take the exam.

6. Preemptive Rights and Dilution (Issuance of Shares)

a) Preemptive rights basically refers to an existing s/h’s right to not have his shares diluted by a
new offering; he must have “first crack” at buying the shares.
(1) However, this right does not entitle an existing s/h the right to buy at lower than the
market price. (Stokes v. Continental Trust – holding damages limited to price increase
after issuance)
(2) This is now an opt-in provision of the MBCA (§6.30) – Preemptive rights are optional;
however, some states have it as an opt-in provision (making preemption the default rule)
b) There is also a fiduciary duty to not issue shares at a lowball price in an effort to dilute the
shares of a s/h you don’t like, even if preemptive rights are protected (i.e., must have a
business justification for the issue) (Katowitz v. Sidler)

IF YOU ARE MAKING A PUBLIC OFFERING YOU MUST REGISTER IT UNLESS IT FITS INTO ONE
OF THESE EXEMPTIONS TO REGISTRATION:
BOTH OF THE FOLLOWING MUST MEET STATE BLUE SKY LAWS
Securities Act Release No. 33-5450 (p. 339) (§ 3 (a)(11)): Allows a localized offering without registration. The
theory is that those in a close proximity of the business in the community and the reputation would be known. The
offering and the issuer has to be entirely in the state they do business. The requirements are that:
1) The company has to be incorporated in the state,
2) the buyers all have to be from the state,
3) and offer has to be in the state.
Without this exemption to avoid a public offering you’d have to avoid the instrumentalities of interstate commerce
(e-mail, phone, mail, etc.)
Downside:
1) It is hard to do expand the ability of small business to expand so the following was created
Securities Act Release No. 336389 (p. 341) (Regulation D): This allows an offering limited in scope, without a
public offering
1) There can be no general advertising
2) No resale of the shares without an exemption (limited liquidity to investors)
3) Issuer must take reasonable care to insure that the shares are not purchased for resale. (Issuer must check with
the buyer to see why he is buying. The issuer can take many ways to take reasonable care. The safe harbor
rules of the SEC are:
(a) Inquire of the purchaser
 (b) Disclose that the shares are not registered and that there is no resale without an
exemption
(c) The shares must have a legend on them that says the shares are not registered and
are not for resale w/o exemption
4) If the aggregate offer is less than $1MM in a (rolling) 12 month period (all offers in 1 year are seen as a single
offering): there is no limit on the number of investors (Must always comply with state law)
5) If the aggregate offer is less than $5MM in a (rolling) 12 month period you can have a maximum of 35
unaccredited investors.
6) If the aggregate offer is over $5MM in a (rolling) 12 month period you can have 35 unaccredited investors and
they all must have knowledge or expertise necessary to evaluate the merits and risks of the investment. (Test of
business sophistication)
EXCEPTIONS: We do not count anyone who is known as an accredited investor in the 35 person limits. The
accredited investors are defined in this Act as:
1) Banks
2) Organization or Trust (LLC, Corporation, etc.) with assets over $5MM
If formed only for this investment does not count.
3) Directors or officers of the company
4) An individual with a personal net worth over $1MM
5) An individual with a net worth less than $1MM, and their income level (as an individual) of $200K/yr. over the
last 2 years or the combined income of spouses of $300K/yr. over the last 2 years.

Regulation D – Rules Governing the Limited Offer and Sale of Securities without Registration Under the Securities
Act of 1933 (17 CFR §230.501)(1997)(p. 342)

Smith v. Gross (1979)(p. 349)

WHAT IS A SECURITY (INVESTMENT CONTRACT)
Facts: The Smith’s (P) responded to a newsletter in which Gross (D) solicited buyer-investors to raise earthworms,
promising they would double ever 60 days and he would buy back all the worms produced at $2.25 per pound. He
told the Smiths (P) that little work was required, success was guaranteed by the repurchase agreement, etc. A suit
the Smith’s (P) filed charging Gross (D) with violation of the federal securities laws was dismissed on the ground
that no “security” was involved. On appeal, the Smith’s (P)argued that there had been an investment contract type
security involved. They claimed the worms did not multiply at the promised rate and that a profit could be made
only if the promised multiplication rate were reached and if Gross (D) bought back the entire production at the
higher than market price of $2.25 he had promised. As it turned out, he could pay the price only by selling worms to
new worm farmers at inflated prices. Gross said this was a franchise, not an investment contract.
Issue: Does an investment contract exist when a scheme:
(1) involved an investment of money
(2) in a common enterprise
(3) with profits to come solely from the efforts of others?
Rule: Yes An investment contract exits when a scheme:
(1) involved an investment of money
(2) in a common enterprise
(3) with profits to come solely from the efforts of others. (meaning the efforts made by those
other than the investor are the undeniably significant ones.)
THIS IS A PYRAMID SCHEME
Analysis: Those essential managerial efforts which affect the failure or success of the enterprise are what is meant
by efforts of others. In this case, these 3 criteria were met. A security therefore was involved. Reversed.
Comment:: The definition of “security” that has been adopted in this line of cases is quite broad. The result has
been to permit investors suckered into a number of ingenious investment schemes to utilize the protection of the
securities laws. In International Brotherhood of Teamsters v. Daniel (1979), the Supreme Court refused to
characterize a noncontributory pension plan as a “security.”

TEST FOR A SECURITY: Essential managerial efforts which affect the failure or success of the enterprise are
what is meant by efforts of others. A security exists when:
(A) An investment is involved;
 (B) in a common enterprise; (in this case they said there was a symbiotic relationship between the
companies)
(C) with profits to come solely from the efforts of others. (meaning the efforts made by those other
than the investor are the undeniably significant ones.) (In the above case the profit would come
solely from the brilliant efforts of Gross).

F) Issuance of Shares by a Going Concern: Preemptive Rights and Dilution (p. 353)
Preemptive Rights: is a right of a shareholder to subscribe to a pro rata or proportionate share of any new
issuance of shares that might operate to decrease his percentage ownership in the corporation. (i.e. 1000
shares are outstanding and a shareholder owns 100 shares. The corporation plans to issue another 1000
shares, the shareholder has a preemptive right to subscribe to an additional 100 shares.
Common Law: the shareholders were deemed to have an inherent right to
preempt new stock offerings.
Statutes:
(1) Some states provide that there are no preemptive rights unless
such rights are provided for in the articles.
(2) Other states indicate that there are preemptive rights unless they are
expressly denied in the articles.
Problem w/ preemptive rights: (As far as the corporation is concerned) is that it limits the financing
opportunities of the corporation. Because of this the preemptive rights usually are only used in closed
corporations.

NOTES ON PREEMPTIVE RIGHTS

1) PREMPTIVE RIGHTS ARE A NIGHTMARE FOR LARGE CORPORATIONS (i.e 20K new shares
and 5MM existing shares)
2) PRIVATELY HELD CORPORATIONS LOVE THESE
3) ORDINARY SHAREHOLDER: Doesn’t know the articles of incorporation say, what can they do to
protect themselves (opting out helps – opting in states help shareholders know there is a protection for
smaller investors)
4) MBCA Approach: Most larger companies will have an opt out language therefore no need for them.
5) If not taken (in opt in) the shares can be sold for the same price to another for 1 year if the rights are not
exercised as long as the price is at least as high as the price that the option was for.
6) In many states the preemptive right does not include shares that are given for something other than
money (ie. Intellectual properties, land, service)
7) Compensation of shares to officers or directors (Preemptive rights do not apply)
8) Preemptive rights don’t apply for the 1st 6 months of the corporations incorporations.
9) If different class shares have been issue, and only one class of shares will be issued , only those who own
shares in that class participate in the preemptive rights.
10)

Remedies: available to protect a shareholder’s preemptive rights.

Damages: are calculated on the basis of the difference between the
offering price of the new shares and the cost of acquiring the shares in the
market (market value)
Equitable remedies: If the shares are not available in the market, the
shareholder with preemptive rights may sue for specific performance (to
compel the corporation to issue the additional shares necessary for the
shareholder to retain his proportionate interest.) Where the shares have
not been issued (but are about to be) the shareholder may get an
injunction against issuance of the shares in violation of his preemptive
rights.

Stokes v. Continental Trust Co. of City of New York (1906)(p. 353)

Facts: Continental Trust Co. (D) had 5,000 shares of outstanding stock of which Stokes (P) owned 221 shares. The
par value of the stock was $100, but the book value was $309.69. Blair and Company offered to buy 5,000 newly
issued shares of Continental Trust (D) at $450, if those shares were issued. Continental (D) held a shareholders’
meeting and the new issue was voted. Stokes (P) demanded that he be sold enough of the new shares to keep his
percentage of stock ownership the same before and after the new issue. He also demanded that he be sold these
shares at par value; however, these demands were turned down.
Issue: Is a stockholder entitled to purchase enough shares of newly issued stock to insure that his proportionate
share of ownership will remain constant?
Rule: A corporation must allow a shareholder to purchase newly issued stock at the fixed price to allow him to keep
his proportionate share of the stock if he so chooses.
Analysis:
A) The existing shareholders have an inherent right to a proportionate share of new stock issued for cash.
B) Such a right can be waived, but it was not waived here. P protested and offered to buy his proportionate interest
prior to the sale to the brokerage firm.
C) The price to exercise preemptive rights is not to par value but the price fixed for issuing the shares by the board.
Here, it was $50 per share. The damages should be measured by the difference between the market price of the
shares at the date of the sale and the price P would have had to pay for the shares at that time ($450).
Dissent:: By demanding to buy at par, there was no evidence that he would have been willing to pay the stated price.
Comment:: This case represents the common-law view of preemptive rights, or the right of first refusal of new
issues of stock. The prevailing view is that these rights apply only to common stock.

Equitable limitations on the issuance of shares

1) Fiduciary’s objective of gaining control: As a general rule, it is improper for directors or majority shareholders
to issue shares to themselves for the purpose of perpetuating their control
2) Duty to issue shares for adequate consideration: There are equitable considerations other than whether shares
have been issue for property or services equal in value of the shares (i.e. stock watering). The fiduciaries of the
corporation (i.e. directors) have th duty to issue stock for an adequate price. The factual situations must be
closely examined to see whether there is any injury involved where shares are issued for at least their par value
but for less than their going value.
B. Initial issuance: The shares must be issue for at least their par value. Beyond this
creditors cannot complain, and the shareholders do not care about the price per share (as
long as they each pay the same amount)
C. Later issue: It makes no difference to creditors if shares are issued for less than they
might be worth (since their interests are not affected), but if stock is reasonably worth
$10 / share and is issue for $5, then the percentage interest of existing shareholders is
diluted. But where all existing shareholders buy their pro rata interest in the new
shares, it makes no difference (since their interests are not diluted). However, where
new shares are to be issued to new shareholders (or to only some of the existing
shareholders), all existing shareholders have an interest in seeing that the new shares are
issued for an adequate price.

Katzowitz v. Sidler (1969)(p. 358)

Inadequate Consideration
Facts: Katzowitz (P), Sidler (D) and Lasker (D) were the sole shareholders and directors in the Sulburn Corporation.
Sidler (D) and Lasker (D) had joined forces in an attempt to oust Katzowitz (P) form his position in the corporation,
and by stipulation Katzowitz (P) agreed to withdrew from active participation. At the time of Katzowitz’s (P)
withdrawal, the corporation owned each of the directors $2,500, and Sidler (D) and Lasker (D) proposed a new
issuance of stock to ameliorate (reduce) the debt. Over Katzowitz’s (P) objections, they passed a resolution whereby
each of the three could purchase 25 shares at $100 per share when the stock was actually worth $1,800 per share
(1/18th of book value). Katzowitz (P) did not opt to purchase, and when the company was dissolved he received
$3,247.59 to Sidler’s (D) and Lasker’s(D) $18,885.52. Katzowitz (P) brought this action to set aside the
distribution, to allow Sidler (D) and Lasker (D) the return of their purchase price of the 25 shares and to compel an
equal distribution of the remaining assets.
Issue: Can a shareholder who did not purchase from a new issuance as fraudulent where the new shares are offered
in a closed corporation at a totally inadequate price causing dilution of the shareholder’s interest in the corporation?
Rule: Yes. Where new shares are offered in a closed corporation, existing shareholders who do not want to or are
unable to purchase their share of the issuance are not estopped from bringing an action based on a fraudulent
dilution of their interest where the price for the shares was inadequate.
Analysis: The concept of preemptive rights was fashioned by the courts to protect against dilution of shareholders’
interest and is particularly applicable to the situation of a closed corporation. Although the courts and the legislature
are reluctant to regulate the price at which shares can be offered, if issuing stock for less than fair value results in a
fraudulent dilution of the shareholders’ interests, it will be set aside. Here Sidler (D) and Lasker (D) issued stock at
$100 per share when the true value of the stock was over $1,800 per share, knowing that Katzowitz (P) would not
elect to purchase his proportionate share and thereby diluting his interest. The issuance was fraudulent, and after
allowing Sidler (D) and Lasker (D) the amount they paid for the additional shares of stock, the remaining assets of
the corporation will be divided among the shareholders in proportion to their interests held before the issuance.
Comment:: Although the courts are reluctant to fix prices at which corporate stock can be issued, they can find little
justification for issuing stock far below its fair value. Generally, the only time stock can be issued far below its
book value is when book value is not reflective of the actual worth of the corporation of where a publicly held
corporation experience difficulties floating a new issue. The Model Corporations Act §26, provides that preemptive
rights only exist to the extent that such rights are provided, if at all, in the articles of incorporation.

FREEZEOUT: Any attempt to push anyone out of a corporation (This is what took place
in the above case)
Generally speaking freeze-outs are OK, as long as the price is OK, and the preemptive rights have not been violated.
Trend in most states is that the majority cannot dilute the equity of the minority’s equity without a good business
reason.

June 24, 1998 Class Starts Here

Distribution by a Closely Held Corporation (p. 363)
1. Distributions: A dividend is any distribution of cash, property, or additional shares (a stock
dividend) paid to present shareholders asa result of their stock ownership.
a) No remedy for minority s/hs where majority s/hs pay themselves salaries and bonuses but issue
nothing but nominal dividends (Gottfried v. Gottfried) (note: rule changes for small
corporations – see Davis v. Sheerin, infra)
b) However, if it’s clear that management isn’t working for profit maximization for the s/hs, a
court can force a dividend payment (Dodge v. Ford Motor Co.)
(1) Note result above is probably more due to Ford’s brazenness than anything else; also note that IRS
can nail you with penalties (IRC §§ 501, 502) for holding excessive surpluses

Balance Sheet Test: dividends may only be paid when (after the payment of the dividend) the assets exceed both
the liabilities and the capital stock accounts.
Earned Surplus Test: Indicates that dividends can only be paid out of the earned surplus (including current profits)
of the corporation.
Solvency Test: The corporation cannot pay a dividend if it is insolvent or the dividend would make it insolvent.
Definition of insolvency include:
(a) Liabilities exceed assets.
(b) The company cannot meet its debts as they fall due (regardless whether the value of
the assets exceeds the liabilities)

Gottfried v. Gottfried (1947)(p. 363)

Bad Faith
Summary: No remedy for minority s/hs where majority s/hs pay themselves salaries and bonuses but issue nothing
but nominal dividends (note: rule changes for small corporations – see Davis v. Sheerin, infra)
Facts: Minority stockholders (P) brought a suit against the board of directors (D) of a closely held family
corporation to compel it to declare dividends on the common stock. No dividends were paid on the common stock
for 14 years until immediately before commencement of this action, the purpose of which was now to compel
payment in such amount as would be fair and adequate. The minority stockholders (P) contended that the directors
(D), who owned the controlling stock, had bitter animosity toward the minority (P) and sought to coerce them into
selling their stock to the directors (D) at a grossly inadequate price.
Issue: If an adequate corporate surplus is available for the purpose, may directors withhold a declaration of
dividends in bad faith?
Rule: No. If an adequate corporate surplus is available for the purpose, directors may not withhold a declaration of
dividends in bad faith.
Analysis: The essential test of bad faith is to determine whether the policy of the directors is dictated by their
personal interests rather than the corporate welfare. Facts relevant to the issue of bad faith include:
1) intense hostility of the controlling factions against the minority;
2) exclusion of the minority from employment by the corporation;
3) high salaries, or bonuses, or corporate loans made to the officers in control;
4) the fact that the majority may be subject to high personal income taxes if substantial dividends are paid;
5) and the existence of a desire by the controlling directors to acquire the minority stock interests as cheaply as
possible.
Here, it appears that the directors (D) had legitimate business reasons for not declaring dividends, and hence, no bad
faith was involved. Complaint was dismissed.
Comment:: Closely held corporations are easily subject to abuse on the part of the dominant shareholders,
particularly in the direction of action to compel minority stockholders to sell their stock at a sacrifice. Even in the
absence of bad faith, the impact of dissension and hostility among shareholders usually falls with heavier force in a
closely held corporation. In many such cases, a large part of a stockholders’ assets may be tied up in the
corporation. It is frequently contemplated by the parties, moreover, that the respective stockholders receive their
major livelihood in the form of salaries as employees of the corporation. But the fact that the corporation is closely
held will not cause the courts to give greater scrutiny to the validity of the majority’s actions.

Dodge v. Ford Motor Company (1919)(p. 367)

Accumulation of Surplus
Summary: If it’s clear that management isn’t working for profit maximization for the s/hs, a court can force a
dividend payment
Facts: In the 1916 sales year, FMC (D) looked forward to a $60 million profit, $132 million in assets, $54 million in
cash and municipal bonds, and $122 million surplus – all set against a mere $20 million in liabilities. Despite this
President and Board Chairman, Henry Ford announced that he was forthwith discontinuing the payment of
dividends to stockholders. 2 general reasons were given.
1) He anticipated an $11.3 million construction program to go into effect in order to erect a smelter for the
company
2) And, he had determined to dedicate the company to the welfare of the general public by increasing jobs and
lowering the price of cars annually.
The Dodge Brothers (P), shareholders in FMC (D) objected to the latter reason for not declaring dividends so they
filed this action to compel repayment. From decree for Dodge (P), this appeal followed.
Issue: May the courts intervene to require payment of a corporate dividend where the avowed motive of the
directors for not paying it is to benefit the interests of third parties not participating in the ownership of the
corporation?
Rule: Yes. Ordinarily, the directors of a corporation alone have the power to declare a dividend, but the courts will
intervene to require that a dividend be paid if it is discovered that the refusal of the directors to do so is based in
fraud or an intention to conduct the affairs of the corporation not for the shareholders but rather for 3rd parties who
do not participate in the ownership of the corporation.
Analysis: It is manifestly improper for the directors of a corporation to refuse to exercise their powers for the benefit
of the shareholders. In following Chairman Ford’s reasoning, here, however, the directors have done just that. As
such, FMC (D) was directed to pay a dividend to its stockholders this year in an amount consistent only with the
legitimate expansion and business interests o the corporation. Reversed.
Concurrence: The very fact here of the extraordinary accumulation of surplus should, by itself, be enough to
establish a sufficient abuse of discretion to justify the intervention of equity.
Comment:: Though many public interest groups have urged changes in it , the general rule still is that a corporation
may not legally put the public interest above the interests of its shareholders. As a general rule, there is no right to a
dividend for any shareholder (except in those cases in which dividends are made mandatory for preferred
shareholders, by the Articles of Incorporation, in cases in which proper sources are available). Note finally that
Dodge is one of the very few cases in which equity has ever considered a refusal to pay a dividend so improper
and/or in such bad faith as to justify interference with the normal corporate decisions process. Of course, since
Henry Ford dominated the process in the FMC (D), it was ineffective to protect the (soon to depart) minority interest
of the Dodges (P).

Wilderman v. Wilderman (1974)(p. 370)

Unauthorized Salaries to Officers
Facts: Eleanor Wilderman (P) and her husband Joseph (D) founded, and later incorporated, the Marble Craft
Company (D). The business was engaged in the installation of ceramic tile and marble facings. Both Eleanor (P)
and Joseph (D) had some knowledge of the craft, but from the start of the company (D), Joseph (D) performed most
of the duties of the business, while Eleanor (P), as the company’s (D) only stockholders, elected themselves as
directors and chose Joseph (D) as president, while Eleanor (P) was designated vice president, secretary, and
treasurer. Both Joseph (D) and Eleanor (P) received salaries which had been fixed by agreement, although they
elected not to pay themselves dividends because that practice would have subjected them to double taxation.
Although the company (D) became extremely successful, the Wildermans’ marital relationship ultimately proved
unsatisfactory. They separated and later divorced, and Joseph (D) increased the amount of compensation which he
paid to himself. Although Joseph (D) had been authorized to receive an annual salary of only $20,800, he paid
himself more than $90,000 in salary and bonuses in 1971, received $35,000 in 1972, and accepted a total
compensation of nearly $87,000 in 1973. Eleanor’s (P) salary from 1971 to 1973 was $7,800 per year. During this
period, the court appointed a custodian to assist in the management of the company (D), and he succeeded in having
a $20,000 dividend declared, Eleanor (P) and Joseph (D) dividing the amount equally. But when the custodian’s
intervention failed to eliminate or reduce the disparity in salaries. Eleanor (P) filed suit against both Joseph (D) and
the company (D). Suing both as an individual and in her capacity as a shareholder, Eleanor (P) sought the return of
excessive amounts paid to Joseph (D), an injunction against additional unauthorized disbursements, and an order
directing that the company’s (D) management continue to be subjected to the supervision of the custodian. Eleanor
(P) also sought an order compelling the company (D) to pay dividends and asked that the corporate pension plan be
adjusted to reflect the fact that the excessive compensation paid to Joseph (D) had bee declared improper.
Issue: May the president of a corporation arbitrarily pay himself more compensation than the company’s board of
directors has authorized?
Rule: No. In the absence of a specific authorization b the company’s board of directors, a corporate executive may
receive only that amount of compensation which is reasonably commensurate with his function and duties.
Analysis: Joseph Wilderman (D) was authorized to receive a salary of only $20,800 per year. Any agreement
pursuant to which he may have been entitled to more compensation had been rescinded prior to 1971. The excessive
amounts which he received in 1971, 1972, and 1973 may be justified, if at all, only the application of the quantum
meruit theory. On thee basis of the evidence presented, it does not appear that the compensation to which Joseph
(D) unilaterally and arbitrarily declared himself entitled was reasonable in light of the services he performed for the
company (D). An expert witness testified that $35,000 per year was the highest salary which should reasonably
have been paid to Joseph (D). Moreover, the IRS permitted Marble Craft (D) to deduct only $53,000 of the more
than $92,000 which Joseph (D) received in 1971. Since Joseph (D) has produced no evidence which would justify
his receipt of compensation as generous as that which he paid himself, it is appropriate to require the return of any
excess over $45,000 received in any of the years in question. Appropriate adjustments in the corporate pension fund
must also be made, and dividends may be declared at the instance of the company’s (D) board of directors or, in the
event of a deadlock, the custodian.
Comment:: The salaries of corporate executives are ordinarily fixed by the company’s board of directors and are
incorporated into each executive’s employment contract, whether it be oral or written. Any person who renders
services for another has some chance of recovering compensation. It he brings an action based on quantum meruit.
Only rarely would such a suit prove beneficial to a corporate executive since, in order to recover, he would have to
prove that his services were performed on behalf of the company but were in addition to the duties which were
required of him in the usual conduct of his employment.

Unincorporated Businesses & Closely held Corporations (p. 375)

Donahue v. Rodd Electrotype (1975)(p. 378) Offer to all shareholders

Facts: as a controlling stockholder of Rodd (D) a close corporation, Harry Rodd (D) caused the corporation to
reacquire 45 shares for $800 each ($36,000 total). He then divested the rest of his holding by making gifts and sales
to his children. Donahue (P) a minority stockholder who had refused to ratify this action, offered to sell her shares
on the same terms but was refused. A suit followed in which Donahue (P) sought to rescind the purchase of Harry
Rodd’s (D) stock and make him repay to Rodd (D) the $36,000 purchase price with interest. Finding the purchase
had been w/o prejudice to Donahue (P), the trial court dismissed the bill and the appellate court affirmed.
Issue: Must a controlling stockholder in a close corporation who has caused the corporation to purchase some of his
shares see to it that an equal offer is made to the other stockholders?
Rule: Yes. A controlling stockholder (or group) in a close corporation who causes the corporation to purchase his
stock breaches his fiduciary duty to the minority stockholders if he does not cause the corporation to offer each
stockholder an equal opportunity to sell a ratable number of shares to the corporation at an identical price.
Analysis: Stemming from the fiduciary duty owed by a controlling stockholder of a close corporation to the
minority stockholders, a controlling stockholder who causes such a corporation to purchase some of his shares must
cause the corporation to offer each stockholder an equal opportunity to sell a ratable number of shares to the
corporation at an identical price. Close corporations are somewhat different in that thy are very much like
partnerships and require the utmost trust, confidence, and loyalty among the members for success. This means a
partnership-type fiduciary duty arises between stockholders, it is the basis for the rule herein announced, under
which Donahue (P) must be given an equal op0portunity to sell her shares. Reversed and remanded.
Concurrence: I do not join in nay implication that this rule applies to other activities of the corporation, like salaries
and dividend policy, as they affect minority stockholders.
Comment:: A problem which exists with close corporations is that there is no ready market to which a minority
stockholder can turn when he wishes to liquidate his holdings. Knowing that fact, the controlling stockholder has a
very powerful weapon which he would not have in a regular corporate setup. This is one of the reasons he is held to
a higher degree of fiduciary duty in this case.

D) Legal Restrictions on Distributions (p. 391) IRS can reclassify a salary as a dividend if it is deemed
unreasonable
(A) See Herbert G. Hatt, where excessive salary, boat, and plane are all deemed to be dividends for tax
purposes
(B) Note: if s/h wants to sue director for taking action that increases taxes unnecessarily, the standard is
unreasonableness
1) “Earned Surplus” Dividend Statutes (p. 392)
2) “Impairment of Capital” Dividend Statutes (p. 393)
3) Distribution of Capital under “Earned Surplus” Statutes (p. 394)
4) Insolvency:
b) General Rule: No repurchase or redemption is permitted where the corporation is insolvent or
would be rendered insolvent by the purchase distribution.
c) Definition of insolvency: is different in various jurisdictions. (Financial condition such that the
corporations’ debts are greater than aggregate of such debtor’s property at a fair valuation. ( A
condition where if all of the entity’s assets and liabilities were made immediately available and
due, they would not balance each other.
d) Subsequent insolvency: There are instances where the corporation enters into a contract (at a
time when it is solvent) to purchase shares, and at the time that the contract is to be executed,
the corporation is insolvent. For example, the corporation may agree to buy a shareholder’s
stock on an installment basis, and when one of the installments falls due, not have the lawful
source for the purchase.
5) The Model Business Corporation Act (p. 395)
Official Comment to §6.40) (p. 395) MBCA §6.40 – A corporation cannot make a distribution if it meets
two tests:
(2) Equity Insolvency Test (p. 395) (§6.40(c)(1)): can’t pay its liabilities as they come due
(absence of auditor’s qualification on audit report meets this test; otherwise, a judgment
call), and
(4) Balance Sheet Test (p. 396) (§6.40(c)(2)): the distribution
would reduce assets to less than liabilities + distribution
preferences (Must use ‘reasonable’ accounting method, but
GAAP isn’t mandated – §6.40(d))
(a) GAAP (p. 397)
(b) Other principles (p. 397)
(5) Preferential Dissolution Rights & the Balance Sheet Test (p. 398)
(8) Application to Reacquisition of Shares (p. 398)
 (a) Time of measurement (p. 398)
(b) When tests are applied to redemption-related debt (p. 398)
(c) Priority of debt (p. 399)
(9) Treatment of certain indebtedness (p. 399)

JUNE 29, 1998 Class Starts Here

June 22 & 24, 1998 Class Assignments (pp. 401-524)
Management and Control of the Closely Held Corporation
A) Traditional Roles of Shareholders and Directors (p. 401)
McQuade v. Stoneham (1934)(p. 401)
SHAREHOLDER AGREEMENTS WHERE THERE ARE MINORITY SHAREHOLDERS
Facts: Stoneham (D) was the majority stockholder in the National Exhibition Company (New York Giants Baseball
Club) and held 1,306 shares. McQuade (P) and McGraw (D) were the only other stockholders. Each held 70 shares
for which each paid Stoneham (D) $50,338.10. The 3 entered into an agreement by which they promised to use their
“best endeavors” for the purpose of continuing themselves as directors and officers of the club, with Stoneham D) as
president at $45,000 per year, McGraw (D) as vice president at $7,500 per year, and McQuade (P) as treasurer at
$7,500 per year. The agreement could not be changed w/o unanimous consent of the parties. The board of directors
had 4 other members controlled by Stoneham (D). McQuade (P), who also happened to be a New York city
magistrate, served as treasurer for 7 years when Bondy was elected to succeed him. At the meeting, Stoneham (D)
and McGraw (D abstained from voting. McQuade (P) voted for himself, and the other 4 directors voted for Bondy.
Stoneham (D) and McGraw (D) acquiesced in this election and in the failure to reelect McQuade (P) as a director at
the following shareholder meeting. The trial court would not reinstate McQuade (P) in his action to compel specific
performance but gave him damages for wrongful discharge. Stoneham (D) and McGraw (D) appealed.
Issue: Is a contract illegal and void so far as it precludes the board of directors, at the risk of incurring legal liability,
from changing officers, salaries, or policies or retaining individuals in office, except by consent of the contracting
parties?
Rule: Yes. A contract is illegal and void so far as it precludes the board of directors, at the risk of incurring legal
liability, from changing officers, salaries, or policies or retaining individuals in office, except by consent of the
contracting parties.
Analysis: While McQuade (P) argued that the agreement should be enforceable so long as the officer is loyal to the
interests of the corporation, holding such agreements unenforceable is preferable to one where the courts would have
to pass on the motives of directors in the lawful exercise of their trust. The decision should also be reversed
because, by statute, no city magistrate shall engage in any business other than the duties of his office. McQuade’s
(P) employment with the club was more than an occasional business transaction or voluntary assistance. He was
receiving a substantial salary. Reversed and dismissed.
Dissent in Part: Reversal was required on grounds of the violation of the magistrate’s duties statute only. As for the
contract, it appears to be legal. A contract which merely provides that stockholders shall in combination, use their
power to achieve a legitimate purpose is not illegal. There was no evidence that the contract here was a corrupt
bargain intended to despoil the corporation.
Comments: Generally, an agreement made by a person who is director or expects to become one which requires
that he vote in a certain way or puts him under pressure to do so is illegal and void, except in some cases where all
the shareholders are parties. Also, an agreement which places restrictions on a shareholder which wholly deprive
him of any functions as a shareholder or as a director, if he were to become one, is illegal. Such an agreement
would, under Delaware law, insofar as it concerns a close corporation and stockholders holding a majority of the
outstanding voting shares, be valid. Employment agreements OK, separate class of share OK, generally
shareholders appoint directors, and directors appoint management.

REVIEW THE FOLLOWING CASE:

Clark v. Dodge: Closed Corporation: They all agree to appoint each other.

Galler v. Galler (1964)(p. 407) IMPORTANT CASE

SPECIAL RECOGNITION OF THE CLOSELY HELD CORPORATION
Facts: 2 brothers, Isadore (D) and Benjamin, incorporated their partnership in 1924 and operated as such for over 30
years. In 1955, the 2 brothers drew up a shareholders’ agreement to provide for the financial security of their
respective families in the event of either brother’s death. The agreement provided for salary continuation payments
to the surviving widow. It further allowed the surviving widow to remain on the board of directors and to name a
successor to her husband. Specific dollar amounts of dividends were mandated by the agreement. However, these
payments were qualified so as not to impair the capital of the corporation. After Benjamin’s death, his wife Emma
(P) sought enforcement of the agreement. Isadore (D) repudiated the agreement, claiming it violated the corporation
code of Illinois and the public policy of that state.
Issue: Can shareholder agreements pertaining to dividend policy and selection of directors be enforced in the case of
a close corporation when such agreements would not be permissible in a publicly held corporation?
Rule: Yes. Close corporations will not be held to the same standard of corporate conduct as publicly held
corporations in the absence of a showing of fraud or prejudice toward minority shareholders or creditors.
Analysis: The unique nature of close corporations – close relationship of shareholders; lack of marketability of
shares; and overlapping of shareholders and officers – creates a situation which should allow “slight deviations from
corporate norms.” These deviations should be permitted so long as they do not operate to defraud or prejudice the
interests of minority shareholders or creditors. Since the principals in a close corporation usually have a close
relationship, their agreements should be enforced where no clear statutory prohibitions are violated. Since the
agreement did not imperil creditors and there were no minority shareholders’ interests involved in this instance, the
agreement was valid and enforceable.
Comments: This case is representative of the growing acceptance by most jurisdictions of the basic differences
between publicly held and closely held (close) corporations. There is recognition that the parties in a close
corporation regard themselves, in fact, as partners. This view allows for a latitude in enforcing shareholders’
agreements that would be unacceptable in publicly held corporations. Many statutes regulating corporations are
intended to protect the interests of the shareholders and creditors. Where the shareholders are few in number and
operating, in essence, as partners, the need for such rigid protection is absent. As long as the rights of minority
shareholders and creditors are not infringed, the close corporation can be given a relatively free reign as regards
internal structure and operation.

Closed Corporation Statutes: In about 30 states it is allowed to carve out traditional directors powers and allow
them to act as shareholders. 2 states don’t distinguish between directors and shareholders in closed corporations,
since they are usually the same people.
17 states you can elect to be a closed corporation at the time of incorporation. (must opt in)

In some states, amending the by laws is allowed by the board. Most state statutes said this specifically, but the
modern approach lets the Board or the Shareholders amend by laws unless the Articles of Incorporation gives this
only to one group (not usual)

Zion v. Kurtz (1980)(p. 417)

AGREEMENT OF ALL SHAREHOLDERS
Facts: Kurtz (D) was the principal shareholder of a corporation in which Zion (P) was a minority shareholder. They
executed an agreement which precluded the corporation from entering into any business transactions without Zion’s
(P) consent. The corporation subsequently breached the agreement, and Zion (P) sued to enforce it. The trial court
granted summary judgement for Zion (P), and Kurtz (D) appealed, contending the agreement violated state law by
delegating the control over corporate actions from the board of directors to a minority shareholder. The appellate
court reversed, and the court of appeals granted certiorari.
Issue: Is a shareholder’s agreement requiring minority shareholder approval of corporate activities enforceable
between the original parties to it?
Rule: Yes. A shareholder’s agreement requiring minority shareholder approval of corporate activities is enforceable
between the original parties to it
Analysis: Reasonable restrictions on director discretion are not against public policy and are not precluded by
statute. Since all stockholders assented to the agreement and it is not prohibited by statute or public policy, it is
enforceable. Reversed.
Comments: Agreements of the type discussed in this case are usually found in closely held corporations. Although
the corporation in this case was not formed as a close corporation, the court found this inconsequential. It reasoned
that because the articles of incorporation granted the board power to take all steps necessary to enforce the terms
of the articles, the corporation could easily gain close status in order to render the shareholder agreement valid.

The above case shot down McQuade if you are a closed corporation.
If you don’t act unanimously at the outset or you are not a closed corporation, you can’t get rid of the powers of the
directors v. shareholders.
McQuade is good law for
1) Large Public corporation
2) In state where you have to action to be known as a closed corporation.
3) May apply where you try to cram something down a minority’s throat

Matter of Auer v. Dressel (1954)(p. 424) PUBLICLY TRADED SHARES

THE INHERENT POWER OF SHAREHOLDERS
Facts: Stockholders of Hoe & Co. Inc. (P) sought to compel Hoe’s president (D) to call a special stockholders’
meeting after stockholders of more than the required 50% of the voting class A stock requested such meeting which
the president (D) refused call. He claimed that he did not have information sufficient to confirm the adequacy of the
number of shares backing the request. He also claimed that none of the four stated purposes for the meeting was
proper. Those purposes were as follows:
(A) to recommend reinstatement of the former president (Auer) who had been ousted by the directors;
(B) to amend the bylaws so that any vacancy on the board be filled by a vote of only those stockholders whom the
director represents;
(C) to vote upon charges against for particular directors; and
(D) to amend the bylaws regarding the number of directors necessary for a quorum.
The court summarily ordered the president (D) to call the requested meeting, and he appealed.
Issue: Must corporate management call a special meeting when the necessary number of voting shares back such a
request and when no purpose for the meeting is improper?
Rule: Yes. Corporate management must call a special stockholders’ meeting when the necessary number of voting
shares back such a request and when no purpose for the meeting is improper.
Analysis: Here, there was no reason why the stockholders could not show their approval (make a recommendation)
of their former president. As for purpose “B” stockholders who are empowered to elect directors have the inherent
power to remove them for cause. Furthermore, stockholders of one class can exclude those of another from filling
vacancies when the director only represents a particular class. The important right of stockholders to have such
meetings called will be of little practical value if corporate management can ignore the requests, force the
stockholders to commence legal proceedings, and then, by purely formal denials, put the stockholders to lengthy and
extensive litigation to establish facts as to stockholdings which are peculiarly within the knowledge of the corporate
officers. Affirmed.
Dissent: The president (D) was justified in not calling a meeting no matter how many shares supported the request if
none of the proposals could be acted upon by the stockholders. It would have been an idle gesture for the
shareholders to show their support for the former president because the management of the corporation is vested in
its board of directors. As for only allowing class A stockholders to fill class A directorships, class A stockholders
could not exclude other shareholders from voting on a proposal which would prevent them from voting on certain
directorships in the future. Further, while stockholders can recall directors before their terms have expired simply to
change corporate policy.
Comments: One aspect of the case barely discussed by the majority was the alleged impracticability and unfairness
of constituting the numerous stockholders as a tribunal to hear charges made by themselves and the incongruity of
letting the stockholders hear and pass on those charges by proxy. The dissent feared that “the consequence is that
these directors are to be adjudged guilty of fraud or breach of faith in abstentia by shareholders who have neither
heard nor ever will hear the evidence against them or in their behalf.” The majority simply stated that this question
was not before the court on the appeal and that any director who believed he was illegally removed could seek his
remedy in the courts.

Shareholders vote to
1) elect and remove directors.
2) amend by-laws.
3) Approve mergers and assets sales not in the normal course of business
(i.e. mergers, dissolutions, conflict of interest transactions – member of the board is dealing with the company
and may be doing things for his personal gains; indemnification of director or officer; make recommendations
i.e. authorize dividends; and appoint the auditors.

B) Shareholder Voting and Shareholders’ Agreement (p. 431)

XIII. SHAREHOLDER RIGHTS AND VOTING

A. General Concepts: S/holdrs can only act at reg. mtg (OHIO unanimous

written consent)

-> Must have annual mtg; special s/holdrs mtgs can be called by dir.,

Pres. or usually 25% s/holdrs (ltd to items in mtg notice); quorum is

maj. of authorized & issued record s/holdrs entitled to vote

B. Voting by Proxy (designate someone vote your shares)

1. Proxy is special form of agency; must be in writing; valid 11 mo.
unless says otherwise & valid if giver dies unless corp. notified b/4
vote taken
2. Proxy is REVOCABLE unless appt coupled w/ financial interest in
the shares (shares to bank for loan security)

C. Voting Agreements: s/holdrs pool shares & K'lly bind themselves to

vote in certain way (keep physical shares)
1. Some states say if agreement for valid purpose (getting control of
corp. is valid purpose) then IRREVOCABLE by statute (NOT OHIO) and
specifically enforced
2. W/O statute, proxies w/in the agreement are REVOCABLE
-> Can't then demand specific perf., only $ damages

D. Voting Trusts: agreement in writing where s/holdrs transfer title of

shares to trustee & get cert. of benef'l ownership
1. Valid if for proper purpose; trustee owner on books & gets to vote
the shares (less chance of rebelling)
2. OHIO: requires writing, not longer 10 yrs unless voting rights are
couple w/ an interest in the shares (maj. can vote to extend); copy must
be filed with corp.
3. PROBLEMS: agreement public & don't like giving up title
(FACT SCENARIO WILL BE GROUP DIFFUSE OWNERS; CORP IN CHAOS & THEY WANT
CONTROL - TALK VOTING TRUST OR VOTING AGREEMENT)

Shareholder Meetings
A) Annual Meeting
1) Shareholders vote on various items affecting the corporation
B) Notice varies from state to state, 10 days to 50 days. If notice is not sent and any one objects the meeting cannot
proceed. If waived then meeting can proceed.
C) The more common way of a meeting to happening is that if you showed up to the meeting and didn’t complain
about getting notice then you have acquiesced to the meeting.
D) Quorum: is needed, and this is decided by the by laws. Normally it is a majority of issued shares. What
happens if at a meeting there are 500 shares in a company and 251 shares show up and I own 3 shares. If the
person with 3 shares walks out of the room, the meeting keeps going. You cannot walk out of a meeting to
break a quorum.
E) The number of votes needed to pass corporate activities are listed in the Articles of Incorporations is typically a
majority of shares at the meeting. Traditionally you count abstentia votes as a no. Under the MBCA you don’t
count abstentias. (so only those actually vote count).
F) We don’t want to have a meeting we can sign an unanimous letter (everyone must sign) so that no meeting need
to be held. (this is in some states, other states say that you need a majority to pass a resolution.)
G) The company, in the notice, states a record date in the notice that is when they are going to look in the
corporate books to see who the shareholders are. This determines who can vote.
H) Beneficial ownership (has the right to dividends and the right to vote) is the stock issued to Cede & Company
( a nominee who is the record holder on the books) This company has to notify the (beneficial owner who can
vote (in some case, if you don’t vote the record holder may be able to vote in your place.) Dividends are paid
to Cede & Co. who then pays the dividends to the beneficial owner.
I) The record owner has an obligation to notify the beneficial owners on all activity of the stock. Most public
companies contact the record holder.
J) When the meeting is held, the record holder is sent a proxy, who forwards the proxy to the beneficial owner,
with the notice of the meeting and beneficial owner sends it back to them with how they want to vote (in some
cases the record holder may have the right to vote).

Salgo v. Matthews (1973)(p. 431)

PROXY DISPUTE
Facts: Matthews (P) headed a group of stockholders who desired to wrest control of General Electrodynamics Corp.
from Salgo (D), the president of the corporation. Matthews (P) faction, intended to accomplish its objective by
waging a successful proxy fight. A special stockholders’ meeting was convened, and Salgo (D) appointed Meer (D)
to serve as election inspector. Numerous proxies were submitted to Meer (D) by Matthews (P), but Meer (D)
refused to accept certain of these, including some that had been executed in Matthews’ (P) favor by Pioneer
Casualty Company, registered owner of nearly 30,000 shares of General Electrodynamics stock. Pioneer was in
receivership, and beneficial title to its shares had been transferred to Shepherd, who was himself bankrupt. A court
order had authorized Pioneer’s receiver to give Shepherd a proxy vote executed by Shepherd. Meer (D) took the
position that only Shepherd’s bankruptcy trustee, as beneficial owner of the General Electrodynamics stock, had a
right to vote the shares. Matthews (P) filed suit against Salgo (D) and Meer (D), and the trial court issued an order
requiring Salgo (D) to reconvene the shareholders’ meeting for the purpose of declaring Matthews (P) and his slate
as winners of the company election. Salgo (D) did so but then appealed from the court’s order.
Issues: May a corporation require that shares of its stock be voted only by their beneficial owner?
Rules: No. Shares of stock may be voted only by an authorized representative of the party designated in the
corporate records as legal owner of the shares.
Analysis: General Electrodynamics’ corporate records show that nearly 30,000 shares of its stock are owned by
Pioneer, and Meer (D) had no right to insist that those shares of its stock are owned by Pioneer, was entitled to vote
the shares, and, because of Pioneer’s insolvency, its receiver was the only representative authorized to act on the
company’s behalf. The receiver did, in fact, act, and the fact that he chose to do so through Shepherd does not
change the fact that the receiver was acting on behalf of the duly registered owner of the stock. As election
inspector, Meer (D) was entitled to use his discretion in assessing the validity of disputed proxies, but he had no
right to go beyond the corporate records to determine the identities of those shareholders entitled to vote. However,
although Meer (D) exceeded his authority, the proper remedy for his abuse of discretion was a proceeding quo
warranto. Since Matthews (P) should have availed himself of that statutory remedy, the court had no right to grant
the mandatory relief which it decreed.
Comment:: The individuals listed in a corporation’s stock book are designated its “shareholders of record.” Only
those persons who were shareholder of record on a specified date may vote in corporate elections. Ordinarily, a
list of all shareholders is maintained and kept current, and interested parties are entitled to inspect the list if certain
statutory requisites are met. Shareholders of record enjoy various other privileges as well, including the right to
bring derivative suits against the corporation and the right to receive such dividends as may from time to time be
declared.

Election of Directors and Cumulative

1) Elect directors for a year
2) Staggered /Classified Board of Directors (i.e. every 3 years new directors are elected)
3) Classification of Shares to vote:
4) Cumulative Voting v. Straight voting
a) Cum voting can be eliminated by amendment to Art. 90 day after
corptn formed; must give 48 hr notice b/4 mtg; can classify dir.
in Ohio for staggered terms
b) Dir. run at large; Non-cumulative 51% elects entire bd; Cum = #
 shares x # dir. electing; Cumulative can pool votes
c) Look to see if w/ minority s/holdrs pooled altogether, maj. can
still defeat. Requires: 1/#dir be'g elected+1 + 1=shares to WIN
When cummulative voting oust a director, then
Most states allow you to have cummulative voting or not. Do you opt in or opt out. This is only
for directors.
Review pages 435-436 re: Cumulative voting
JULY 1, 1998 Class Starts Here
QUESTIONS ON EXAM
1. HOW MANY POSITIONS DO YOU GET WITH STRAIGHT VOTING
2. HOW MANY POSITIONS DO YOU GET WITH CUMMULATIVE VOTING
3. Ties don’t count
4. See note on page 436 (case Note #1)
5. Opt in or opt out (or given by statute) does not it will automatically happen at the meeting. If no
shareholder requires cummulative voting then it won’t happen. Notice must be given if a
shareholder wants cummulative voting

Review of Cummulative Voting

Minority has 75 votes and the majority stockholder has 225 votes
3 people are running
the minority will never take one director slot
73 1 1 (minority)

5 person board
125 Total Votes 121 1 1 1 1 (minority) would get one spot
375 Total Votes 75 75 75 75 75

Humphrys v. Winous Co. (1956)(p. 437)

WAYS TO AVOID CUMMULATIVE VOTING
Facts: The board of directors of Winous Co. (D) consisted of 3 members. The company (D) created separate
classifications for each of the 3 directors so that no 2 would be required to stand for reelection at the same time.
Humphrys (P) filed suit against the company (D), contending that its classification scheme nullified the
effectiveness of cumulative voting. A state statute expressly conferred the right to vote cumulatively and prohibited
the restriction or qualification of that right. The trial court rejected Humphrys’ (P) argument, but the appellate court
reversed. Winous Co. (D) then appealed.
Issues: Does a statute which prohibits interference with the exercise of cumulative voting rights ensure that minority
stockholders will be represented on a company’s board of directors (on a classified board)?
Rules: No. A statute prohibiting restrictions upon the exercise of cumulative voting rights should not be construed
as guaranteeing minority stockholders representation on a company’s board of directors.
Analysis: The value of cumulative voting as a restraint upon a potentially oppressive majority was first recognized
by the bar association of this state. And cases in other jurisdictions have held that cumulative voting may not be
negated by charter amendments, by removing minority directors without cause, or by reducing the membership of a
board of directors. But the Ohio cumulative voting statute, while it precludes interference with the right to vote
cumulatively, cannot be interpreted as ensuring minority representation. Any scheme for classifying directors
necessarily diminishes the potential effectiveness of cumulative voting. But, since the legislature has chosen to
permit the classification of directors, it seems illogical to contend that classification should not be permitted merely
because it may tend to nullify the potential success of cumulative voting. Therefore, the appellate court erred in
deciding that the Winous Co. (D) classification scheme violated the cumulative voting statute, although the scheme
would be void today because of a code revision prohibiting the creation of classes consisting of fewer than 3
directors.
Dissent:: In authorizing classification of directors, the legislature could not have intended that practice to be used to
defeat cumulative voting. This is evidenced by the fact that the same act as permitted classification of directors also
induced the provision prohibiting restriction or qualification of the right to vote cumulatively.
Comment:: Cumulative voting is designed to enable minority shareholders to secure some representation on a
corporation’s board of directors. It permits a shareholder to cast his total number of votes (the number of share he
owns x the number of slots to be filled) for one director, instead of casting one vote per share for each vacancy. A
simple formula may be used to determine the number of shares needed to elect a given number of directors. Where
S equals the total number of shares voting, D equals the number of slots to be filled, and n equals the number of
directors the minority hopes to be able to elect, the following equation will reveal the number of shares needed to
elect the desired number of directors:
D+1+1=
number of shares minority shareholders needed in order to elect a director.

SHAREHOLDER VOTING AGREEMENTS:

Voting Trust: is given the right to vote, and is given instructions on how to vote (i.e. vote as the majority wishes, or
do whatever a particular person does, etc.) This is enforceable. There is a trustee over the trust (with a limited time
usually 10 years)
Voting Agreement: This is just a standard contract between several shareholders, and this is an agreement to vote
together, and if they can’t agree on how to vote, the arbitrator will decide and we are bound by the decision.
a) If the arbitrators decision is not followed then (the arbitrator did not have the power to vote) It
is permissible to vote the same, and does not violate the rules for voting trusts. Shareholders
have flexibility on binding themselves.
b) If the contract is violated, it must be enforced. The court can sue for damages, or force an
injunction, or have a re-vote, or not count the votes of the person who did not follow it.
c) In Ringling the court did not provide for specific performance, (in a voting trust the arbitrator
would have been given the right to vote on behalf of the shareholders)
Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling (1947)(p. 444)
VOTING AGREEMENTS COMPARED TO VOTING TRUSTS
Facts: 2 of the stockholders of Ringling Bros. (D), Ringling (P) and Haley (D), entered into an agreement by which
they always would vote their shares together, but if they could not agree, they would vote in accordance with the
decision of an arbitrator, one Loos. They made this agreement because together they would have enough votes to
elect 5 of the 7 directors, while North, the 3rd stockholder, could only elect 2. In 1946, Ringling (P) and Haley (D)
agreed to elect themselves, Ringling’s (P) son, and Haley’s (D) husband, but they could not agree on a 5th director.
Ringling (P) demanded arbitration, and Loos decided that Ringling’s (P) proposed director, Dunn, should receive the
votes of Haley (D). Haley (D) refused to vote for Dunn and voted for just herself and her husband. If the vote was
figured according to Loos’ direction, Dunn was elected, but if not, one of North’s candidates, Griffin, was chosen.
Ringling (P) brought suit to enforce the arbitrator’s decision, while Haley (D) argued that their voting agreement
was illegal. The agreement was upheld and a new election directed in accordance with the agreement. Haley (D)
appealed.
Issues: May a group of shareholders lawfully contract with each other to vote in the future in such a way as they, or
a majority of their group, from time to time determine?
Rules: Yes. A group of shareholders may without impropriety lawfully contract with each other to vote in the future
in such a way as they, or a majority of their group, from time to time determine.
Analysis:
1) The agreement in question did not give Loos the power to enforce his decision. His decision could only be
enforced if one of the parties attempted to enforce it.
2) The agreement was not illegal. The law does not purport to deal with agreements whereby shareholders attempt
to bind each other as to how they shall vote their shares. Various forms of pooling agreements have been held
valid and have been distinguished from voting trusts. The provision for submission to an arbitrator was clearly
for the purpose of breaking deadlocks.
3) The agreement did not allow the parties to take unlawful advantage of each other or any other person. As for a
remedy, only the votes of Ringling (P) and North should have been counted. While that would leave one board
vacancy, because the next board meeting follows closely, the board can fill the vacancy itself. As modified,
Affirmed.
Comment:: Generally, a stockholder may exercise wide liberality of judgement in the matter of voting of his
shares. 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 owned to his fellow shareholders. The remedy in the above case was made possible by
Delaware law which permits the chancery court., when reviewing an election, to reject the votes of a registered
stockholder where his voting of them is found to be in violation of the rights of another person.

New York – McKinney’s Bus. Corp. Law (p. 451)

PROXIES: are the instrument that grants someone the right to vote in the place of the shareholder. (i.e. agency).
The beneficial holder has the right to vote and gets the proxy from the record holder. Either of these groups can give
the proxy to a stranger.
Rules of proxies are:
1) Proxy is good for 11 months unless it is stated for another term
2) Proxy is revocable (the person who gets the latest proxy is the one who has the right to vote.)
3) Don’t need to give notice to the previous proxy holder that his right has been revoked
4) Not revoked by death or insanity of the proxy holder unless the proxy holder is on notice of the
5) Cannot sell your vote (common provision, but not in all states)
6) Proxy is irrevocable if it is coupled to an interest (i.e. borrow money and as part of the loan the bank wants a
right to the shares – including voting rights – the bank has a financial interest in the proxy or purchase
agreement to buy the shares, this could have a purchase agreement)
REMEMBER: PROXY ONLY WORKS AS LONG AS THE PERSON GIVING THE PROXY IS THE
RECORD HOLDER

Schreiber v. Carney (1982)(p. 454) Note #3

Court allowed sale of vote, but since this could be abused, if the sale of vote is intrinsically fair, it is OK. If it isn’t
fair court won’t allow it.

Brown v. McLanahan (1945)(p. 457)

DUTY OF TRUSTEES
Facts: The directors and trustees (Ds) of a 10 year voting trust of all the voting shares (preferred and common stock)
passed an amendment to the articles of incorporation of the company near the end of the trust’s term. The
amendment allowed the debenture holders (which included Ds) to vote; previously, only preferred and common
stock holders had that right. When the company went bankrupt, was reorganized, and the 10 year voting trust was
created, the debentures and preferred stock were issued to the holders of the corporation’s 1st lien bonds; hence, the
debenture holders and the preferred stock had been traded during the term of the trust, so that Ds, who held a
substantial amount of debentures, were seeking to preserve their voting control over the corporation and to dilute the
power of the preferred stockholders by allowing debenture holders to vote. Brown (P) who held trust certificates
representing 500 preferred shares, sued in a class action, alleging that passing the amendment allowing debenture
holders to vote was a violation of Ds’ duties as trustees. The district court granted Ds’ motion to dismiss, and P
appeals.
Issues: Was the passage of the amendment that diluted the voting power of the preferred stock held in a voting trust
for which Ds served as trustees a violation of Ds’ duties as trustees?
Rules: Yes. Reversed.
1) A trustee may not exercise his powers in a way that is detrimental to the cestius que trustent” (in this case, the
actual owners of the preferred shares held in trust.). Since the amendment granting the debenture holders the
right to vote diluted the value of the preferred stockholders’ right to vote, it was a violation of Ds’ duties as
trustees.

Lehrman v. Cohen (1966)(p. 463)

NON-VOTING STOCK AS A TRUST
Facts: A corporation had two classes of voting stock, equally divided among two families. To break deadlocks,
they created one share of a third class of voting stock, which had no right to dividends and a value of only $10 par,
and issued it to their corporate counsel. The corporate counsel proceeded to consistently vote against the wishes of
one of the families.
Procedural Posture: The minority family brought this action to declare the deadlock-breaking class of stock invalid
as a voting trust. The lower court found that the stock was valid.
Issue: Whether the third class of voting stock created here was valid.
Holding: Yes.
Reasoning: There are three tests that must be satisfied to establish that an arrangement is a voting trust:
1) the voting rights are separated from the beneficial ownership of the stock,
2) the voting rights are irrevocable for a fixed period of time, and
3) the principle purpose is to acquire voting control of the corporation.
Here, the voting rights were not separated from the beneficial ownership.
Although the creation of the third class of stock diluted the voting power of the other two classes,
the other two classes still retained complete control of the voting power of their own stock.
Furthermore, since even non-voting stock is allowed by Del §151(a), it is not against public
policy to separate voting rights from beneficial stock ownership.
Note 3(a): Page 370: The more stock you own the less votes you have. (i.e. 1 share = 1vote; 50 shares = 25 votes)
You can maintain power in this scheme)

Ling and Co. v. Trinity Sav. and Loan Ass’n (1972)(p. 470)
RESTRAINT ON ALIENATION OF SHARES
Facts: be obtained from the New York Stock Exchange before any sale. The limitation requiring an offering to other
shareholders of the same class appeared on the stock certificate but was not in bold type or otherwise conspicuous.
The lower court entered summary judgement for P, and the state circuit court of appeals affirmed.
Issues: Were the restrictions on the transfer of the stock valid?
Rules: Yes. Reversed.
1) Although the state law of forum generally requires restriction to be conspicuously noted on the certificate, if P
is aware of the restrictions conspicuous notice on the certificate is not required. Summary judgement for P
should not be granted w/o conclusive proof that P lacked notice of the restrictions on transfer.
2) Both restrictions are reasonable since allowing shareholders of the same class to purchase before a public sale
has not been shown to be unduly burdensome, and the approval of the New York Stock Exchange was required
by the exchange while Ling was a member.
Rule of construction: relating to restraint is that they are construed narrowly so as to give maximum scope to the
ability of the shareholder to transfer the shares.

Rodney J. Waldbaum, Buy-Sell Agreements (p. 475)

C) Deadlocks (p. 480)

A. Voluntary Dissolution
1. Corp adjudged bankrupt or gen'l assignmt for credtr benefit
2. Leave of ct when receiver has been apptd in gen'l credtr suit or in any suit to
wind up affairs
3. All assets sold at judicial sale
4. Art. cancelled for no annual franchise or excise taxes
5. Period corporate existence has ended
6. 2/3 s/holdrs (or what Art. require) approve Resolutn dissolving
-> 1-5 Bd adopts resolution of dissolution & sells all assets; 6 Bd
though no resolution still sells assets; s/holdrs don't sell the assets

B. Judicial Dissolution
1. S.Ct. or Ct. App. order to wind up corporate affairs for misuse or
nonuse of corporate powers
2. Common Pleas order to dissolve after s/holdrs entitled to dissolve
voluntarily establish:
a. Art. were cancelled or corporate existence period up &
dissolution necessary to protect s/holdrs
b. corp. insolvent/unstable & necessary to dissolve to protect
creditors, or
 c. corporate objectvs have failed, been abandoned or are
impracticable to accomplish
3. By Common Pleas order if bet. MAJ & 2/3 (if 2/3 could voluntarily
dissolve) show beneficial to s/holdrs to dissolve
4. By Common Pleas order after either 1/2 Dir. or s/holdrs 1/2 of
voting power show dir. even #, hopelessly deadlocked in mgmt of corptn &
s/holdrs can't break deadlock so dissolutn only answer OR dir. uneven #
but s/holdrs hopelessly deadlocked in electg directors (DISSOLUTION HERE
CANNOT BE DENIED JUST B/C CORP. SOLVENT OR PROFITABLE)
5. By Common Pleas order after prosecutor shows corp. organized and
used to further criminal purposes
Gearing v. Kelly (1962)(p. 480)
DEADLOCK ON THE BOARD OF A CLOSE CORPORATION
Facts: The bylaws of Radium Chemical Co. provided for a board of 4 members, a majority constituting a quorum.
Gearing (P) and her mother owned 50% of the stock, but only P was no the board. The 2 defendants owned 50% of
the stock and were on the board. A board meeting was called, P refused to attend, the 4th director resigned at the
meeting, and Ds elected a new 4th director. P had refused to attend since she knew that she would be out voted in
electing a new director and that control of the corporation would pass to Ds. P sued to set aside the election.
Issues: Where a director-shareholder intentionally refuses to attend a board meeting in order to prevent a quorum,
may the court deny the director’s equitable suit to nullify a director’s election where the requisite quorum was not
present at the meeting?
Rules: Yes. New election denied.
1) Justice does not require that there be a new election in these circumstances. Control had already passed from P
and her mother when they earlier had allowed a 4th director supporting Ds to be elected.
2) If there were to be new election, Ds would outnumber P and the result would be the same as it is now.
Dissent:: The election is void since there was not a quorum. In disputes for control of a close corporation, where
both sides own equal amounts of stock, the court should not assist either side. It is proper for P not to attend the
meeting where she is outnumbered and to seek a solution of the deadlock through other means.

In re: Radom & Neidorff, Inc. (1954)(p. 483)

JUDICIAL DISCRETION
Facts: Radom and Neidorff each owned 50% of the corporate stock; Neidorff died and his wife inherited the stock.
Radom and Mrs. Neidorff (brother and sister) did not get along, and although the corporation was very successful,
Radom petitioned under § 103 of the General Corporation Law for dissolution. The petition cited that the directors,
and Mrs. Neidorff would not sign Radon’s salary checks although he was running the business. Mrs. Neidorff had
also sued Radom in a derivative action over misappropriation of corporate funds. Profits had averaged $71,000 per
year, and there was $300,000 cash on hand. Radom had offered 3 years ago to buy Mrs. Neidorff out for $75,000.
Mrs. Neidorff claimed that she did not interfere in running the business, that she would allow a 3rd director to be
appointed by an independent body, and that the refusal to sign salary checks was a result of the pending derivative
suit. The lower court dismissed w/o a hearing.
Issues: Where the court has discretion, should it allow dissolution where the 2 sole shareholders are feuding but the
corporation is successful?
Rules: No. Decision affirmed.
1) The statue grants the court discretion to dismiss where the petition is brought by 50% of the ownership and the
directors are evenly divided and deadlocked and new directors cannot be elected.
2) The court usually grants dissolution where the corporate purposes cannot be obtained, efficient management is
impossible, and the dissolution will be beneficial to the shareholders and not harm creditors or the public. Here,
the business is successful and able to operate; Mrs. Neidorff will allow an additional director to be appointed.
Dissent:: The state law provides that where certain conditions exist, a petition for dissolution may be made to the
court. The court cannot dismiss without holding a hearing. The lower court did not do this. In this situation,
dissolution should be ordered. The shareholders are feuding, there is no likelihood that this will change, the board
and shareholders are deadlocked, and there is no other alternative remedy.
Comment: Probably what the court is doing is preventing Radom, who is able to control the business because of his
expertise, from taking over the business for much less than what it is worth. In effect, what the court is saying is,
buy out Mrs. Neidorff for a fair price.

JULY 6, 1998 CLASS STARTS HERE

Last class described deadlock at a board level
In dealing with a deadlock
You can by statute
a) dissolve the company if in the best interest of the shareholders.

D) Where dissolution will be allowed: Modern Remedies for Oppression, Dissention or Deadlock (p. 489)
What constitutes oppressive conduct and what remedy can the court give?
a) order one side to buyout the other side
b) also by bringing in someone to run the company
Davis v. Sheerin (1988)(p. 489)
OPPRESSION OF THE MINORITY SHAREHOLDER
Facts: Davis (D) and Sheerin (P) formed a corporation in 1955, with D owning 55% and P owning 45%. D was an
employee (and president), responsible for managing the corporation. In 1985 D refused P’s request to inspect the
books of the corporation, claiming that P no longer owned any stock (supposedly having gifted the stock to D in the
late 1960s). P sued after a jury trial, the jury found P owned 45% and a “buyout” of 45% interest by D was ordered
for $550,000. D challenged the buyout requirement.
Issues: Is a court-enforced buyout an appropriate remedy in these circumstances?
Rules: Yes. Lower court opinion affirmed.
1) Texas law does not explicitly provide for a buyout remedy for aggrieved minority shareholders of a
corporation.
2) Texas law does provide, that in certain circumstances (including the one where those in control of a
corporation engage in illegal, oppressive, or fraudulent conduct) a receiver may be appointed to liquidate the
corporation.
3) Texas courts have not held that a buyout is an appropriate remedy but the courts of other states have, since it is
a less extreme remedy than a liquidation.
4) Even though Texas statutory law does not provide for such a remedy, we feel that the remedy is an appropriate
one.
5) The issue here is whether it is appropriate in this case. In general, it is appropriate where the majority is
attempting to squeeze out the minority (who do not have a ready market for their shares but are at the mercy
of the majority). Oppressive conduct may include many different kinds of acts; broadly speaking, it means
conduct that reasonably can be said to frustrate the legitimate expectations of the minority, particularly
when the expectations being frustrated are those that were the basic reason the minority invested in the
corporation in the first place.
6) Oppression does not have to mean fraud, illegality, nor deadlock. It is just burdensome, harsh, unfair
conduct in dealing with the affairs of the corporation.
7) Here, conspiring to deprive P of his ownership of stock in the corporation, especially when the corporate
records clearly indicate such ownership, qualifies as oppression. Oppression can occur when an officer or
director substantially is against the reasonable expectations of a minority shareholder.
8) There are no other lesser remedies that could adequately remedy the situation. Damages and certain
injunctions could remedy breach of fiduciary duties (paying excessive legal fees, etc.) that have been occurring,
but not the problem of trying to deprive P of his ownership interest.
Broadening of the deadlock and dissolution to the buyout realm. Oppression is defined in this case. The buyout
remedy has been pretty much followed. Look at note #1 (p. 493) This usually takes place in closely held
corporations. Some states you have to elect to be a closed corpororation, v. being one. (Look a the state statute)

DERIVATIVE SUIT: is a suit brought by a shareholder on behalf of the corporation, and since they aren’t pursuing
it the shareholder is.

Abreu v. Unica Indus. Sales, Inc. (1991)(p. 499)

APPOINTMENT OF A PROVISIONAL DIRECTOR
Facts: Abreu’s (P’s) husband, Manny, c o-founded Ebro Foods, Inc. and owned 50%; the other 50% was owned by
LaPreferida, Inc. (co-owned by Ralph and William Steinbarth (Ds); LaPreferida was the distributor of Ebro’s
products). Manny died, P inherited his interest in Ebro and became its president and a director. Ralph Steinbarth
formed Unica (D) to compete with Ebro; it took away Ebro’s business with Kraft Foods; Ds also tried to obtain
Ebro’ formulas so they could manufacture Ebro’s products themselves. P sued Ralph, William, and Unica in a
derivative suit under Illinois Business Corporate Act §12.55(b) which provides for alternative remedies to
dissolution in cases where there is a close corporation and hostile factions exist and create oppression of one of the
ownership interests. This section provides for a court appointed provisional director. The trial court found there
was fraudulent self-dealing by Ds, removed Ralph as an Ebro director (leaving P and one of Ds’ nominees in a
deadlock), and, to resolve the deadlock, appointed the general manager of Ebro, Silvo Vega, P’s son-in-law, as the
3rd director, indicating he could vote only if there was a deadlock between the other directors. Ds appeal on the basis
that Vega is not impartial, this, his appointment is a violation of the court’s discretion in appointment of a
provisional director, and that Vega has improperly exercised the duties of such a director.
Issues:
a) Must a provisional director be strictly impartial under the state statute?
b) Did the provisional director improperly exercise his authority?
Rules: a) No. b) Yes.
a) The state statute does not require strict impartiality in appointment of a provisional director. The trial court
must consider the best interest of the corporation; if based on the particular situation, there is no strictly
impartial 3rd party to appoint who has the skills necessary in the urgent time frame to meet the crisis involved,
the court may use its discretion to appoint in the best interests of the corporation, although he was not strictly
impartial. He knew the business, was a CPA, and was the best person for the job under the time constraints
involved.
b) Vega acts under the supervision of the court; he is to vote only if there is a deadlock. There are 2 instances
where he has acted beyond his authority – appointment of a new auditor without a vote of the board (a board
function), and to reimburse P for expenses of this appeal. This was taken to the board, Ds’ board member
asked for time to study the proposal, and Vega voted with P to pay P’s expenses. This action is reversed; it was
a reasonable request for time to study the matter, so there is not yet a deadlock here.
Comments: (Some states require a disinterested 3rd party). The court said that the duty of directors makes them
independent (this is a fiction – they are probably influenced by the person who appointed them)
Keys: Understanding the remedies: ability to appoint directors, and when these remedies can be invoked. Note on
page 504 reviews what the statutes of Georgia allows. Look at the continuing expansion of types of corporate
misconduct and the remedies for this.

E) Action by Directors (p. 504) The general rule is that the board must act as a board, by resolution or vote at
properly called meetings, at which there is a quorum, or in some way approved by state law as an alternative
(i.e. by unanimous written consent), in order for an action by the board to be valid.
Baldwin v. Canfield (1879)(p. 504)
FORMAL BOARD ACTION REQUIRED
Facts: King owned all the stock in a corporation. He pledged the stock for a loan, partly to a bank and partly to
Baldwin (P). The corporation’s only asset was a piece of real property. King then agreed to sell Canfield (D) the
property for some bonds and a note. D knew about the corporation, but he did not know about he pledge of its stock
to P. King agreed with P to liquidate the loans with the consideration received from the sale of the corporate
property to D, but he never did. King gave D a deed from the corporation (signed by some of the directors). No
directors’ meeting was ever held to authorize the sale of the property. The pledgees (Baldwin) of the stock sued
King and D to cancel the sale.
Issues: When a board of directors acts separately and without a meeting in passing a resolution, will the board’s
actions be upheld?
Rules: No Judgement for P.
1) Title to property was in the corporation. The deed given by King was a valid conveyance to D. Directors must
act as a board; the separate action individually of members of the board does not constitute official board
action. Hence, the directors never took action with reference to the sale of the property, and the deed is
ineffective since board action is required in this transaction.
2) D has an equitable interest in the land, subject to the interest of the pledgees .
Comment:: Most states allow corporate action where all directors consent in writing to the action, even if a
meeting is not held. (some states don’t require unanimous consent)

Mickshaw v. Coca Cola Bottling Co. (1950) (p. 506)

RATIFICATION
Facts: Coca Cola Bottling Co. (D) published a public announcement in a local newspaper in 1940 stating that it
would pay any of its workers who were drafted the difference between their army wage and their former wage for
the entire length of their military service. The advertisement was authorized by Feinberg, one of the 3 directors of
the corporation, who showed it to Mickshaw (P), a former employee who, under threat of conscription, joined the
military and served for 37 months. Mick Ackerman, one of the 2 other directors, knew of the advertisement and
acquiesced in its publication. Sam Ackerman, the 3rd director, never disavowed the advertisement. P returned from
the war and worked for D for over a year. After leaving, P sued to recover the difference between his military wage
and former wage with D (he had not made a claim during his employment for fear of losing his job). Lower court
held for P. D appealed.
Issues: May a single director bind the corporation to a contract?
Rules: Yes. Affirmed.
1) Feinberg’s actions, coupled with the knowledge and acquiescence of all of the other board members, is
sufficient to bind D even though there was no explicit authorization by the directors of D.
2) Even if the 3rd director did not authorize the ad, and never knew about it, the promise is still valid since 2 of
the 3 directors (a majority) did.
Comment: In Hurley v. Ornsteen it was found that a majority of the directors of a corporation cannot bind the
corporation by entering into a transaction without the knowledge of the other directors where no formal directors
meeting was held.
1) Other opinions are contra to Hurley and hold that where a majority of the directors knew of the transaction at
the time it occurred, or knew about it afterward and took no action to disaffirm the unauthorized action by the
corporate officers, the action will be held to be ratified since it has been acquiesced in by the corporation.
2) Some opinions hold that even where the directors did not know of the transaction, such knowledge is
chargeable to the corporation if the corporation accepted the benefits thereof and if the directors reasonably
should have known of the transaction.

WHEN CAN A BOARD BE BOUND?: The simple concept is that the board can be bound by 1) formal adoption
of a resolution (before the action); 2) ratification of the resolution (after the fact) or 2) resolution by acquiescence

Cooke v. Lynn Sand & Stone Company (1994)(p. 508)

MISREPRESENTATION
Facts: Cooke (P) is a director officer and shareholder of D. He is suing to enforce his employment contract. P served
as an at will employee without a contract, he is not head of the family who owns the business. In 1979 they hire a
VP from outside, and he gets an employment contract. Corporation wrote a 5 year agreement, but did not bind the
itself from the directors. The board set up a resolution saying the Pres. and VP have the power to set up contracts
when in the best interest of the Corporation. The resolution is renewed every year and the VP gets a new 5 year
contract each year. (This done to protect his job against buy outs) Cooke has the same contract drawn up to him.
He shows a draft to the board and said this is something for you to consider. No one responded, and a year later the
VP prepares a contract for Pres, as Pres. Prepares an employment contract for the VP. They both sign each contract.
Neither contract is given to the board, and no notice is given to them. The company is in the process of the buyout.
During the purchase, the contract is disclosed and nothing was said. The company is bought out and the purchaser
wants to pay less than what the contract reads. P does not getting less pay and is fired.
Issues:
Rules:
1) The contract was executed in violatoin of the fiduciary duties of the directors, and duty of candor (duty to
disclose things when they first happen). The resolution was boiler plate and meant to deal with 3rd parties and
not insider deals. There was an acknowledgement that the board needed to look at the contract.
2) Ratification: Cooke claimed that he listed it as a liabiity and this was a ratification (or at least an adoption of
the contract) This was only a listiing of what the corporation may be liable for (i.e. if the corp. was being sued
this would be listed, but is not an admission of the corps guilt in a suit.
Key: more casual approach to holding the board more liable, There is a limit to this. You can’t use a boiler plate for
the insiders to bind the company.

F) Authority of Officers (p. 513)

Shareholders (appoint the board- act for themselves) No personal liability

Board (No day to day decisions – appoint officers, have duty to the corporation and the shareholders)

Officers (make the ongoing decisions – sign the paper work. Make day to day contracts) Have duties to
shareholders and corporation.

In many companies the same person wears all three hats.

Black v. Harrison Home Co. (1909)(p. 513)

EXPRESS AUTHORITY
Facts: C.G. Harrison, his wife Sarah, daughter Olive, son Lewis, and a brother-in-law incorporated Harrison Home
Co. (D) and elected C.G. Harrison president, Sarah vice-president, and Olive secretary. Sarah and Olive owned
most of the stock, and the officers plus 2 other family members were the directors. The bylaws authorized the
president and secretary, acting jointly, to sell land owned by the corporation. After C.G. died, Sarah became
president, and after Olive died, Sarah authorized an agent to sell certain property owned by the corporation. Black
(P) purchased the property through the agent, but D refused to convey, arguing that Sarah could not bind the
corporation acting alone. P sued D for specific performance, and the lower court held for D. P appeals.
Issues: May the president, contrary to the bylaws of the corporation, bind it in a contractual relationship?
Rules: No. reversed.
1) Absent a bylaw or resolution of the board, a president may not bind a corporation to a contract . Since D has
always required both the president and secretary to act jointly to bind the corporation to a contract, Sarah, acting
alone, could not bind it.
2) The argument that Sarah should be estopped from denying authority to make the sale since she owns all of the
stock of the corporation is not persuasive, since the estate of Olive also owns stock in the corporation.
Comment:: This case represents the old, common law notion that management rests with the directors and that the
officers must have express authority (or authority implied from express authority) in order to act for the
corporation. The modern view accords much more scope to the officers – either from inherent authority arising
from their positions, or from apparent authority – to perform actions that are acquiesced in by the board of
directors.

Authority:
Implied and Inherent authority of the officers.
MBCA 8.01
KEY: Check the scope of the authority of the person you are contracting with (what does the statute say, and what
do the (up to date) by-laws say. The secretary can certify the accuracy of the by laws)
Authority has been broadened, because the layman has a reasonable expectation that the president has more power.
Officers of a company:
President: has the authority to sign things in the “usual and ordinary course of business” and presides over meetings
VP: delegated authority of the president
Treasurer: Keeps the funds
Secretary: Keeps minutes, stock transfer book, sends out notices, and co-signs with the president when needed.
A corporation must have 2 different people as officers.

Lee v. Jenkins Bros. (1959)(p. 517)

APPARENT AUTHORITY
Facts: Lee sued Jenkins Bros. to recover pension payments allegedly due under an oral contract made on behalf of
the corporation by the president. The lower court dismissed on the grounds that there was insufficient evidence of
the oral contract to enforce it. The court of appeals affirmed, and went on to discuss the following issue:
Issue: Whether, as a matter of law, a president of a corporation does not have the authority to secure employment of
badly needed personnel by granting a “life pension”.
Rule: No.
The actual authority (granted either implicitly or explicitly by a corporation) of a corporate officer is augmented by
his apparent authority to third persons. As a general rule, the president only has the authority to bind the
corporation by acts arising from the usual and regular course of business, but not for contracts of
“extraordinary” nature. It is generally settled that a president may hire and fire employees, but it is a question of
fact as to whether the granting of a life pension is so “extraordinary” as to defeat the apparent authority of the
president.
Apparent Authority: What has been done in the past.

In the Matter of Drive-In Dev. Corp. (1966)(p. 522)

RELIANCE ON REPRESENTATION OF THE OFFICERS
Facts: The parent company of Drive-In (Tastee Freez) wanted to borrow money from the National Boulevard Bank
(P). P required that Drive-In (D) guarantee the loan, which guarantee was signed by Maranz as “Chairman” and
attested to by Dick as “Secretary.” P asked for a resolution of D’s board showing the authority of Maranz to sign the
guarantee. P received a certified copy (by Dick as secretary) of D’s board minutes, showing the authority of Maranz
to sign the guarantee. Later D went into Chapter XI proceedings under the Bankruptcy Act, and P filed its claim for
the amount of the unpaid loan. The referee disallowed P’s claim on the basis that D’s corporate minutes did not
show the authorization to make the loan guarantee. Testimony of D’s directors was unclear as to whether Maranz
had ever been authorized to enter the guarantee on behalf of D. From a judgement affirming the referee’s decision,
P appealed.
Issues: May a plaintiff who enters into a guarantee transaction with a corporation on the representation of its officers
that they had authority to enter the transaction rely upon these representations?
Rules: Yes. Lower court judgement reversed.
1) Here, the officers of D appeared to be acting within the scope of their apparent authority.
2) D’s officers had no actual, express authority. But it is the secretary’s duty in the corporation to keep the
corporate records, and once P received a copy of the certification of board resolutions, it was reasonable for P
to assume that D’s officers had the authority to enter into the guarantee agreement. P had no duty to
investigate further.
Key: Get a secretary’s certificate and this binds the corporation.

Duty of Care and the Business Judgement Rule (pp 663-752) By law, directors have the duty of management of
the corporation. This duty is normally delegated to the officers, thus, the directors must supervise the officers. The
legal duties of the directors and officers are owed to the corporation; performance of these duties is enforceable by
an action on behalf of the corporation brought by an individual shareholder (called a “derivative suit”).
1) Fiduciary relationship of directors to the corporation
a) Duty of loyalty or good faith
b) Duty of reasonable care
c) Business judgement
(1) A different standard of care would apply to directors and to officers (i..e. if there is a
more limited role for directors then negligence is failure to perform with care expected of
a director, but not necessarily failure to perform with the prudence that a director would
give his own personal business dealings).
(2) Business Judgement Rule: where a matter of business judgement is involved the
directors meet their responsibility of reasonable care and diligence if they exercise an
honest, good-faith, unbiased judgement. Where this standard is applied, a director would
only be liable (if his actions were in good faith) if he were guilty of gross negligence or
worse.
2) Damages: To form a cause of action, it must be shown that the director or officer failed to exercise reasonable
care and that as a direct and proximate res ult the corporation has suffered damages.
a) Joint and several liability: Either one director may be held liable for his own acts, or all directors may be
held liable (all those participating in the negligent act.) Where more than one director is held responsible
liability is joint and several.
Litwin v. Allen (1940)(p. 663)
DUTY OF CARE OWED BY BANK DIRECTORS
Facts: A shareholder (P) brought a derivative action against the directors of Guaranty Trust and it’s wholly owned
subsidiary (the Guaranty Company). The Trust Company purchased some bonds from Alleghany Corporation (J.P.
Morgan is the broker) and gave an option to Alleghany to repurchase them in 6 months for the same price. If
Alleghany did not repurchase, the subsidiary (Guaranty Company) was obligated to purchase the bonds at the same
price from the Trust Company. Alleghany could not get a loan, and so the subsidiary bought the bonds at $105
(market value was then in the $80’s). The bonds subsequently dropped drastically in price, and the Guaranty
Company lost substantial amounts of money.
Issue: Has there been a violation of the director’s duty of due care in entering the transaction with Allegheny
Corporation?
Rule: Yes. Judgement for P.
1) The duty of due care is higher for bank directors than for other companies since banks are affected with the
public interest. Thus, bank directors must exercise the care of “reasonably prudent bankers.”
2) The purchase by Guaranty subject to the option to buy in Alleghany at the same price is an ultra vires act
(“beyond the powers” When a corporation does an act or enters into a contract beyond the scope of its
charter) of the corporation (i.e. against public policy for the bank to give such an option).
3) Furthermore, all of the directors of both companies that voted for or ratified the purchase have violated their
duty of due care. They have not shown sufficient diligence in allowing the bank to purchase bonds with an
option to sell at the same price (all of the risk is on the bank for a drop in price; if the price rises, they get no
gain.)
4) The directors are responsible for the losses from holding the bonds up to the expiration date of the option.
Conclusion: This case indicates that the standard of care may vary according to the kind of business involved and
the precise circumstance in which the directors acted. Good faith makes the difference..
BUSINESS JUDGMENT RULE: (This protects directors from negligence). As long as a director acts with
reasonable skill and prudence the courts will not hold them liable. The directors are required to act as an ordinary
man would at the time of the act
Business Judgement Rule:
Protects: Directors (and to a lesser degree officers) from decision that don’t payoff)
Not liable when they act with reasonable skill and prudence.
Court presumes good faith on the part of the director (including that they are disinterested and they are not
beholding to a majority stock holder. They act with due care: exercise informed, independent juudgement) They
are liable if they don’t exercise due care and make grossly unsound decisions.
Wrigley:
Lttlum/VanGorkhom: Grossly unsound makes you unsound (not heavily accepted and clauses in the articles limit
this via clauses in the Ariticles or insurance)
July 8, 1998 Class Starts Here
Shlensky v. Wrigley (1968)(p. 671)
BUSINESS JUDGMENT RULE
Facts: Shlensky (P), a minority shareholder in the corporation (D) that owns Wrigley Field and the Chicago Cubs,
brought a shareholder’s derivative suit against the directors of the corporation for their refusal to install lights at
Wrigley Field and schedule night games for the Cubs as other teams in the league had done (to increase revenues).
The directors’ motivation was allegedly the result of the views of Mr. Wrigley (also a defendant), the majority
shareholder, president, and a director of the corporation, who wanted to preserve the neighborhood surrounding
Wrigley Field and who believed that baseball was a daytime sport. The lower court dismissed P’s action.
Issue: May a shareholder bring a derivative action where there are no allegations of fraud, illegality, or conflict of
interest?
Rule: No. Affirmed.
1) The court will not disturb the “business judgement” of a majority of the directors – absent fraud, illegality, or a
conflict of interest. There is no conclusive evidence that the installation of lights and the scheduling of night
games will accrue a net benefit in revenues to D, and there appear to be other valid reasons for refusing to
install lights, e.g. the detrimental effect on the surrounding neighborhood.
2) Corporations are not obliged to follow the direction taken by other similar corporations. Directors are elected
for their own business capabilities and not for their ability to follow others.
Key: Note 8 (p. 675) review. Also (p. 683) Notes 9 & 10
 Good faith and process is about the directors take care in the process of making the decision. Not that the
decision was bad.

Smith v. Van Gorkhom (1985)(p. 684)

(Thought to be a bad decision in corporate law)
INFORMED JUDGEMENT IN MERGER PROPOSALS
Facts: Shareholders (Ps) of Trans Union sued Trans Union seeking rescission of a merger into New T Company (a
wholly owned subsidiary of defendant Marmon Group, controlled by Prizker), or alternatively, damages against
members of Trans Union’s board (Ds).
1) Trans Union was a profitable, multi-million dollar leasing corporation that was not able to use all of the tax
credits it was generating. Several solutions were explored. Van Gorkom (chairman) asked for a study by
Romans (financial officer) regarding a leveraged buy-out by management. Romans reported that the company
would generate enough cash to pay $50 per share for the company’s stock, but not $60 per share. Van Gorkom
rejected the idea of this type of buy-out (conflict of interest) but indicated he would take $55 per share for his
own stock (he was 65 and about to retire). On his own, Van Gorkom approached Pritzker, a takeover specialist,
and began negotiating a sale of Trans Union. He suggested $55 per share and 5 year payout method without
consulting the board or management. The price was above the $39 per share market value, but no study was
done by anyone to determine the intrinsic value of Trans Union’s shares. In the final deal, Trans Union got 3
days to consider the offer, which included selling a million shares to Pritzker at market, so that even if Trans
Union found someone else who would pay a better price Pritzker would profit; For 90 days Trans Union could
receive but not solicit competing offers.
2) Van Gorkom hired outside legal counsel to review the deal, ignoring his company lawyer and a lawyer on the
board. He called a board meeting for 2 days later. At the meeting, Trans Union’s investment banker was not
invited, no copies of the proposed merger were given, senior management was against it, and Romans said the
price was to low. Van Gorkom presented the deal in 20 minutes, saying that the price might not be the highest
that could be received, but it was fair. The outside lawyer told the board that they might be sued if they did not
accept the offer and that they did not need to get an outside “fairness” opinion as a matter of law. Romans said
he had not done a fairness study but that he thought $55 per share was on the low end. Discussions lasted 2
hours, and the merger offer was accepted.
3) Within 10 days, management of Trans Union was in an uproar. Pritzker and Van Gorkom agreed to some
amendments, which the board approved. Trans Union retained Salomon Bros. To solicit other offers.
Kohlberg, Kravis, Roberts & Co. made an offer at $60 per share. Van Gorkom discouraged the offer and spoke
with management people who were participating in it. Hours before a board meeting to consider it, it was
canceled, and was never presented to the board. General Electric Credit Corp. made a proposal at $60 per
share, but wanted more time, which Pritzker refused to give, so it too was withdrawn.
4) On December 19, some shareholders began this suit. On February 10, 70% of the shareholders approved the
deal. The trial court held that the board’s actions from its first meeting on September 20 until January 26 were
informed. Ps appealed.
Issue: Did the directors act in accordance with the requirements of the business judgement rule?
Rule: No. Reversed.
1) The business judgement rule presumes that directors act on an informed basis, in good faith, and in an honest
belief that their actions are for the good of the company. Plaintiffs must rebut this presumption. There is no
fraud here, or bad faith. The issue is whether the directors informed themselves properly. All reasonably
material information available must be looked at prior to a decision. This is a duty of care. And the directors
are liable if they were grossly negligent in failing to inform themselves.
2) The directors were grossly negligent in the way they acted in the first board meeting that approved the merger .
They did not know about Van Gorkom’s role, and they did not gather information on the intrinsic value of the
company. Receiving a premium price over market is not enough evidence of intrinsic value.
3) An outside opinion is not always necessary, but here there was not even an opinion given by inside
management. The Van Gorkom opinion of value could be relied on had it been based on sound factors; it was
not and the board members did not check it. The post September market test of value was insufficient to
confirm the reasonableness of the board’s decision.
4) Although the 10 board members knew that company well and had outstanding business experience, this was not
enough to base a finding that they reached an informed decision.
5) There is no real evidence of what the outside lawyer said, and as he refused to testify, Ds cannot rely on the fact
that they based their acts on his opinions.
6) The actions taken by the board to review the proposal on October 9, 1980, and January 26, 1981, did not cure
the defects in the September 20 meeting.
7) All directors take a unified position, so all are being treated the same way.
8) The shareholder vote accepting the offer does not clear Ds because it was not based on full information.
Dissent:: There were 10 directors; the 5 outside ones were chief executives of successful companies. The 5 inside
directors had years of experience with Trans Union. All knew about the company in detail. No “fast shuffle” took
place over these men. Based on this experience, the directors made an informed judgement.

THE REST OF THESE CASE DISCUSS DERIVATIVE SUITS

THESE DISCUSS BUSINESS JUDGEMENT RULE, BUT IT REALLY IS A DIFFERENT APPLICATION
The approaches in these shareholders derivative suits are:
1) Misconduct/ Breach
2) COA
Del. Gen. Corp. Law (p. 703)
Gall v. Exxon Corp. (1976)(p. 706)
SPECIAL COMMITTEES OF THE BOARD REVIEWING BOARD ACTIONS
Facts: Gall (P) brought a shareholder’s derivative action alleging that directors of Exxon (D) had given $38MM
improperly as campaign contributions to secure political favors in Italy. P claimed violations of the 1934 Act for
filing false reports with the S.E.C. and soliciting proxies from shareholders without revealing the illegal
contributions, and for a breach of fiduciary duties, and waste and spoliation. D formed a special committee of the
board of directors to investigate the charges, and the committee determined that the corporation would not be aided
by bringing suit against any of the directors since most of the directors involved had little actual knowledge of the
nature or legality of the payments and since all such payments had ceased in 1972. D moved for summary
judgement arguing that the decision of the committee was within the sound business judgement rule and should not
be disturbed by the court.
Issue: Is this decision (made by a special committee of the board of directors) not to bring a cause of action held by
the corporation within the sound business judgement of the corporate management?
Rule: Yes.
1) The directors are empowered to determine by the exercise of their business judgement whether bringing the
cause of action would benefit the corporation, and absent prejudice in the decision, the court should allow the
decision to stand.
2) P will be given time for discovery to determine whether there was prejudice in the decision before summary
judgement will be granted.
Conclusion: The special committee consisted of directors who had had no knowledge of the illegal contribution at
the time they were made.

Zapata Corp. v. Maldonado (1981)(p. 713)

2 STEP APPROACH TO TERMINATION OF A SHAREHOLDER’S DERIVATIVE
SUIT
Court looks at what the committee did
1) Did it exercise due care on an informed judgement (If yes) (if no go to step 3)
2) Court makes an independent decision to whether killing the suit is in the company’s best interest.
3) Only the shareholder can kill the suit.
Facts: Maldonado (P), a shareholder in Zapata Corp. (D), instituted a derivative action on D’s behalf. The suit
alleged breaches of fiduciary duty by 10 of D’s officers and directors. P brought this suit without first demanding
that the board bring it, on the ground that the demand would be futile since all directors were named as defendants.
Several years later, the board appointed an independent investigating committee. By this time, four of the
defendants were off the board, and the remaining directors appointed 2 new outside directors. These new directors
comprised the investigating committee. After its investigation, it recommended that the action be dismissed. Its
determination was binding on D, which moved for dismissal or summary judgement. The trial court denied the
motions, holding that the business judgement rule is not a grant of authority to dismiss derivative suits, and that a
shareholder sometimes has an individual right to maintain such actions. D filed an interlocutory appeal.
Issue: Did the committee have the power to cause this action to be dismissed?
Rule: Yes. Trial court interlocutory order reversed; case remanded for proceedings consistent with this opinion.
1) A shareholder does not have an individual right, once demand is made and refused, to continue a derivative
suit. Unless it was wrongful, the board’s decision that the suit would harm the company will be respected as a
matter of business judgment. A shareholder has the right to initiate the action himself when demand may be
properly excused as futile. However, excusing demand does not strip the board of its corporate power. There
may be circumstances where the suit, although properly initiated, would not be in the corporation’s best
interests. This is the context here.
2) The court must find a balancing point where bona fide shareholder power to bring corporation causes of action
cannot be unfairly trampled on by the board, but where the corporation can rid itself of detrimental litigation.
A 2 step process is involved:
a) The court must recognize that the board, even if tainted by self-interest, can legally delegate its authority to
a committee of disinterested directors. The court, also may inquire on its own into the independence and
good faith of the committee and the bases supporting its conclusions.
b) If the court is satisfied on both counts, the second step is to apply its own business judgement as to whether
the motion to dismiss should be granted.
Thus the suit will be heard when corporate actions meet the criteria of the 1st step, but where the result would
terminate a grievance worthy of consideration.

Cuker v. Mikalauskas (1997)(p. 74)

1 STEP APPROACH TO TERMINATION OF A SHAREHOLDER’S DERIVATIVE
SUIT
Facts: A minority shareholder in an energy company brings a derivative action for not poor collections. The
members of the board not named plus 3 outside directors and had never been employed by the company found no
bad faith, and had made decisions in the best interest of the company. The 12 non-defendant board members decide
to kill the suit. The lower court says that it is not up to the board to kill the suit. The higher court overturns this.
Issue: Can the board decide to kill the suit.
Rule: The court says that the board of directors decision to kill the suit, they will not look to the merits of the claim,
as long as the process of making that decision are done by following the Business Judgement Rule (i.e. see if the 1 st
step of the Delaware test (step one of Zapata)) then their judgement is OK. The court will not substitute. If the
Board did not follow the Business Judgment Rule, then the case goes to court.
Conclusion: There are many variations on this.

Aronson v. Lewis (1984)(p. 721)

DEMAND ON THE BOARD IN DERIVATIVE SUITS
Facts: Lewis (P) was a shareholder of Meyers Parking Systems; he brought a shareholders derivative suit
challenging transactions between Meyers and one of its directors, Fink, who owns 47% of its stock. Meyers’ board
approved an employment contract for Fink, 75 years old, for $150,000 a year plus an override on profits; on
termination Fink was to receive at least $100,000 a year for life; Fink was to devote substantially all of his time to
the business. Also, Meyers made $225,000 in interest free loans to Fink. P alleged there was no business purpose
and a waste of corporate assets in these transactions. P did not make a demand on the board before bringing the
derivative suit because:
1) all directors were named as defendants and they participated in the wrongs;
2) Fink picked and controlled all directors; and
3) To bring this action, the defendant directors would have to have the corporation sue themselves.
P sought cancellation of the employment contract. The defendant directors bring an interlocutory appeal of a trial
court finding for P that no request for actions need be made on the board of directors.
Issue: Where state law requires that demand on the directors be made prior to bringing a shareholder’s derivative
suit, will such a demand be excused?
Rule: Yes. While the trial court finding for P is reversed, P is given leave to amend his complaint.
1) The demand requirement is to ensure that shareholders first pursue intra-corporate remedies and to avoid strike
suits.
2) The issue of the futility of a demand is bound up with the business judgement rule; directors apply it in
addressing a demand notice. The business judgement rule can only be claimed by disinterested directors whose
conduct meets the rule’s standards. The business judgement rule applies in a board’s determination of whether
 to pursue a derivative suit and whether to terminate one already brought by a shareholder (where demand on the
board was excused).
3) This case involves the question of when demand is futile and thus excused. The trial court test was whether the
allegations in the complaint, when taken to be true, show that there is a reasonable inference that the business
judgement rule is not applicable for purposes of a pre-suit demand. This test means that where director action
itself is challenged, demand futility is almost automatic. There must be a better test.
4) The test is: Based on the particularized facts alleged, is there a reasonable doubt that:
a) the directors were disinterested and independent; and
b) the challenged transaction was the product of a valid exercise of business judgemen t
5) A general claim that Fink controls the board and owns 47% of the stock does not support a claim that the
directors lack independence. P must allege particularized facts showing that control and showing that entering
the contract was a breach of good faith or shows control.
6) A bare claim that defendants would have to sue themselves s also not enough. Particular facts again must be
alleged showing lack of director independence or failure to adhere to standards of the business judgement rule.
REVIEW OF DERIVATIVE SUITS
1) Injury must be to corporation and not to the shareholder, the corporation can only recover
2) Shareholder’s ownership is contemporaneous. The shareholder must own the shares at the time of alleged
misconduct.
a) Exception: If you obtain the shares by devolution of law (not by choice – i.e. court forces ownership,
example inherit in a will)

3) Shareholder must continue to hold shares until the suit is settled.(unless by devolution)
4) Shareholder must make demand unless it would be futile. (Some states say even if it is futile, you still have to
make demand if irreparable damage can’t be avoided)
5) Corporation has the right to take over the suit.
6) Corporation can kill the suit (This can be done by a disinterested board, or an investigative committee who
decide it is not in the best interest of the corporation to pursue the suit – Business Judgment Rule applies)
Exceptions:
a) When self interest is potential some states will follow Zapata
b) Some states say it is still at the court’s discretion.
7) Futility requires reasonable doubt that the directors are liable

ALI PRINCIPLES OF CORPORATE GOVERNANCE (p. 738)

JULY 13, 1998 Class Starts Here

Duty of Loyalty and Conflict of Interest (pp. 753-809) The officers and directors owe a duty of loyalty to the
corporation. This means that the directors must place the interests of the corporation above their own personal gain.
Problems arise because directors have other business involvements, and it is often for this reason that they are placed
on the board. Therefore, no rule of law that prevents a corporation from dealing with its own directors is feasible,
but it is difficult to develop rules that properly circumscribe these dealings.
CONTRACTS OF INTEREST OR INTERLOCKING DIRECTORS: Over time, there has been an evolution in
the rules applied by the courts.
Early rule: Common law was that any contract between a director and his corporation, whether fair or not, was
voidable. This rule not only applied to individual contracts with directors, but also to the situation of interlocking
directorates (2 or more corporations having common directors). It was even applied to the situation where one
corporation owned the majority of the stock of another and appointed its directors (parent – subsidiary relationship).
Disinterested Majority Rule: Earlier many courts held (and some still do) that conflict of interest dealings were
voidable only where the directors had not made a full and complete disclosure of the transaction (its value, his
interest, profit, etc.) to an “independent board” (quorum of non-interested directors), or the transaction was shown to
be unfair and unreasonable to the corporation. The burden of proof as to the fairness of the transaction was on the
director.
Liberal Rule: Many courts now hold that it makes no difference whether the board is disinterested or not. The issue
is whether the transaction is fair to the corporation. Part of the “fairness” is that the director’s interest be fully
disclosed, however. Where the board is not disinterested, the contract will be given very close scrutiny.
State Statutes: Many states have adopted statutes that combine elements from all of the previous judicial positions.

Marciano v. Nakash (1987)(p. 753)

SELF DEALING
Facts: A jeans-manufacturing corporation had two principle shareholder families. When the corporation fell into
financial problems, the shareholders deadlocked on the issue of how to proceed. One of the families, without
consulting the other, loaned the corporation $2.3 million of their personal funds at an interest rate of 1% over prime.
The loan was an interested transaction, and was not approved by a disinterested majority of the directors or
shareholders. The other family brought an action to have the debt declared void.
Issue: Whether the loan, although an interested transaction not approved by a disinterested majority of the directors
or shareholders, was nonetheless fair and therefore valid.
Rule: Yes.
Del. Section 144(a) provides a basis for immunizing self-interested transactions. Its tests were not satisfied.
However, section 144(a) merely removes an "interested director" cloud, preventing invalidation "solely" because an
interested director was involved. Thus, the proper analysis is a two-tiered analysis: first apply 144(a), then apply a
fairness test. Here, the loans compared favorably with what was available from market lenders. Thus, they were
objectively fair. Furthermore, the loans were made in the good faith effort to keep the corporation alive. On the
other hand, approval by fully informed disinterested directors under section 144(a)(1) or disinterested stockholders
under section 144(a)(2) permits invocation of the business judgment rule and limits judicial review to issues of
waste with the burden of proof upon the party attacking the transaction.

Heller v. Boylan (1941)(p. 761)

MUST PROVE WASTE
Facts: In 1912 the shareholders adopted a bylaw providing for an incentive compensation system whereby the
president and the vice presidents of American Tobacco Company divided 10% of the company’s annual profits over
the earnings from comparable company properties held in 1910. This system occasioned salaries and bonuses
totaling $15,457,919 for 1929 through 1939 for the 6 officers. This is a shareholder’s derivative suit brought by 7
out of the company’s 62,000 shareholders (the 7 owning 1,000 out of a total of over 5 million shares), protesting
these payments as waste and spoliation of corporate property (in that they bore no reasonable relationship to the
value of the services for which they were given) by the majority shareholders. The bylaws had been ratified twice, in
1933 and 140, and had been held valid by the court on a prior occasion.
Issue: Did the huge bonus payments to the president and vice presidents mandated by the shareholder-adopted
bylaw amount to waste or spoliation of corporate assets to the detriment of minority shareholders?
Rule: No.
1) Although the sums are large, the shareholders adopted the bylaw and have ratified it, so the court will not
replace the shareholder’s judgement with its own.
2) If a bonus payment bears no reasonable relationship to the value of services for which it is given, then the
majority shareholders cannot give it, since to do so is waste and adversely affects minority shareholders. But
there must be proof of waste (beyond the mere amount of the payments, as here). Since the plaintiff has entered
no such proof, the court will not substitute its judgement for that of the shareholders.

Obligation of Majority Shareholders to Minority

a) Duty of loyalty and good faith: The majority shareholder(s) have a fiduciary relationship to the corporation
(such as in a contractual relationship), the transaction will be closely scrutinized to see that minority
shareholders are treated fairly. An example would be the situation where a corporation loans a majority
shareholder money.

Sinclair Oil Corp. v. Levien (1971)(p. 773)

SUBSIDIARY RELATIONSHIP
Facts: Sinclair Oil Co. (D) owned 97% of stock of a subsidiary involved in the crude oil business in South America;
D appointed all of the subsidiary’s board members and officers. Then over 6 years D drained off dividends from the
subsidiary to meet its own needs for cash. The dividends paid met the limitations of state law, but exceeded the
current earnings of the same period. Levien (P), a shareholder of the subsidiary, filed a derivative suit, charging that
the dividend payments limited the subsidiary’s ability to grow; also, that in a contract between D and the subsidiary
for the purchase of crude oil, D had failed to pay on time and had not purchased the minimum amounts as required
by the contract.
Issue:
Rule: Yes. Judgement for D on the dividend
Comment::

Weinberger v. UOP, Inc. (1983)(p. 778)

BURDENT OF SHOWING UNFAIRNESS
Facts: Signal Co. owned a majority of UOP stock, and wished to acquire the rest of the stock by a tender offer, and
then merge with UOP. Using UOP resources, two of the UOP directors, who were also Signal directors, completed
a valuation study that indicated that a fair price for the tender offer would be up to $24 per share. Signal then made
a $21 per share offer, and obtained a fairness opinion from their banker, Lehman Brothers. However, the $24 per
share study was never disclosed to UOP’s shareholders when they voted to approve the merger at $21 per share. A
class action by the minority shareholders challenging the fairness of the merger. The lower court found for the
defendants.
Issue: Whether the burden of proof shifts to the plaintiff to prove the unfairness of an action when it has been
approved by a majority of disinterested but not adequately informed shareholders.
Rule: No.
The burden always remains on the interested shareholders to show that they made a full disclosure to the
disinterested shareholders. The proxy statement to the disinterested shareholders did not reveal the study assessing a
fair price at $24 per share. This was a matter of material significance, and the interested shareholder’s (Signal’s)
failure to disclose it prevented the minority shareholders’ vote from being a valid ratification of the transaction, thus
requiring that it be subject to the intrinsic fairness standard. Fairness has two aspects: 1) fair dealing, and 2) fair
price. Here it was not fair dealing to use UOP’s resources to generate a report, and then fail to disclose that
favorable report. It was a breach of fiduciary duty for the dual directors to withhold this information from the
minority shareholders. Also, the price was not fair because it was less than the amount indicated by the report, and
the fairness opinion was too hastily prepared to be relied on.

Corporate Opportunity (p. 794) The duty of loyalty of directors and officers to the corporation prevents them
from taking opportunities for themselves that should belong to the corporation.
1) Use of corporate property: Clearly a director may not use corporate property or assets to develop his own
business or for other personal use.

2) Corporate expectancies: A director or officer may not assume for himself properties or interests in which the
corporation is “interested,” or in which the corporation can be said to have a tangible “expectancy,” or which
are important to the corporation’s business or purposes.
a) i.e. If a corporation has leased a piece of property, a director cannot buy the property for himself. And if it
is “reasonably foreseeable” that the corporation would be interested in the property, then there is the
necessary expectancy. Where opportunities relate very closely to the business of the corporation, there is
also the necessary expectancy.

Northeast Harbor Golf Club, Inc. v. Harris (1995)(p. 794)

Facts: Harris was the president of the Golf Club corporation. Harris, in her capacity as president, was approached
by a real estate agent with an opportunity to purchase surrounding land. Without disclosing the offer to the
corporation, Harris purchased the land with her own funds. Later, Harris informed the board, but they took no
action, apparently in reliance on her statement that she would not develop the land. Later, Harris began to develop
the land. The corporation brought an action to enjoin the development, and to put a constructive trust on the
property in favor of the corporation. The trial court found that Harris had not taken a corporate opportunity because
the real estate investment was not in the line of business of the corporation, and also that it did not have the financial
ability to purchase the land.
Issue: What is the proper test for determining whether a corporate opportunity existed.
Rule: According to the ALI Principle of Corporate Governance Section 5.05, a corporate opportunity is one which a
director
1) becomes aware of in his corporate capacity, or
2) uses corporate information or property to acquire, or
3) is closely related to a business in which the corporation is engaged or expects to engage.
The ALI defines corporate opportunity broadly. There is evidence that the property was offered to her in her
capacity as president - making it a corporate opportunity. If it is a corporate opportunity, then Harris must offer it to
the corporation first and have the board reject it after full disclosure, AND either
1) have the rejection ratified by a disinterested majority of the directors, or
2) a disinterested majority of the shareholders. If these tests are met, then the burden of proof is on the
challenger to show that the transaction was unfair to the corporation.
However, if Harris failed to offer the opportunity, then she loses outright. Also, if Harris offered the opportunity,
but it was not ratified by a majority of disinterested directors or shareholders, then the burden of proof is on her to
prove that it was fair to the corporation. The case must be remanded for application of these standards of law.

Duties to other Constituencies (p. 805)

TRANSACTIONS IN SHARES (pp. 810-958)

A) The Development of the Federal Remedy: Rule 10B-5 (p. 810)
1) Securities Exchange Act of 1934 (p. 810)
2) RULE 10B-5: Employment of Manipulative & Deceptive Devices (p. 810)
B) Insider Trading (p. 833)
The Regulation of Insider Trading (p. 834) Rule 10b-5 has very broad application to securities transactions.
Even though it does not mention “insiders” specifically, not specifically require that one person having
information not had by another disclose this in a securities transaction, nevertheless the S.E.C. and the court
have used Rule 10b-5 to cover such transactions.
1) Fiduciary relationship: The origin of the concept of an “insider” is the idea that where one person occupies
a “fiduciary relationship” with another, this fiduciary must disclose relevant, material information to the
person for whom she has the responsibility.
2) Insider Defined: There are 2 elements that must be shown in order to designate someone an “insider”:
a) The person must have a relationship giving access, directly or indirectly, to information intended to be
available only for a business purpose and not for the personal benefit of anyone; and
b) An inherent unfairness must be present where a party takes advantage of such information, knowing it
is unavailable to those with whom she is dealing.

SEC v. Texas Gulf Sulphur Co. (1968)(p. 837)

Facts: Texas Gulf Sulphur (TGS)(D) was engaged in exploration mining of minerals. In November 1963, it drilled a
test hole on property near Timmins, Ontario, Canada, and the sample revealed significant deposits of copper, zinc,
and silver. Present at the site, were employees Clayton (D) and Holyk (D). TGS then began to acquire rights to the
surrounding property (which was completed by March 27, 1964). The assay report of the drilling indicated that the
oee discovery could be very significant, and the president (Stephens, also a defendant)instructed those employees
who knew of the discovery to keep it quiet. Additional holes were drilled to track the extent of the ore deposit, and
all indicated that the discovery was significant. By April 10, 1964, rumors of the find had reached the New York
newspapers. Stephens therefore had 2 TGS executives (Ds) prepare a news release that was issued on April 12. The
release discounted the rumors, indicated that insufficient information was available upon which to evaluate a
possible ore discovery, and stated that additional drilling would be required before definite conclusions could be
arrived at. In the meantime, more holes were drilled, and the company’s analysis of the results was completed by
April 16. Between April 12 and April 16 TGS (through company employees, including 2 additional defendants,
Mollison and Darke) gave out 2 reports that indicated that a discovery had been made, and on April 16 a disclosure
was made to representatives of the press that a discovery had been made. A written release concerning the
discovery went over a brokerage firm wire service that morning. TGS stock on the New York Stock Exchange went
from $17.50 per share on the date of the first test hole, to $32 on April 12 to $37 on April 16, and finally to $58 per
share in the middle of May 1964. The S.E.C. (P) brought an action under Rule 10b-5 against employees of TGS that
bought stock or calls to buy TGS stock prior to the full disclosure to the public concerning the ore discovery. , P also
sued TGS for the misleading press release of April 12 and the employees who received options to purchase TGS
stock prior to public disclosure (or disclosure to the TGS directors granting the options for that matter). And finally,
tippees (of the insiders) who bought TGS stock were also joined as defendants.
Issue:
1) Is it a violation of Rule 10b-5 for officers, directors, and employees of a corporation, having inside information
concerning the probability of a major ore discovery by the corporation, which information has not been
disclosed to the public and which if it were disclosed would affect the price of the corporation’s securities, to
 purchase the corporation’s securities or to receive options to purchase such securities without public disclosure
of the material information?
2) May those communicating the inside information to others (who purhcase securities based on this information)
also be held liable under Fule 10b-5?
3) Is it a violation of Rule 10b-5 for TGS to have issued a misleading press release concerning information that
could have a material effect on the price of its securities?
Rule: Yes to all three issues.
1) Inside Information: Rule 10b-5 says that anyone trading for his own account in securities of the corporation
who has access, directly or indirectly, to information intended only for corporate purposes and not or personal
benefit, may not take advantage of such information knowing that it is unavailable to those with whom he is
dealing. Either the information must be disclosed to the investing public or trading in or recommending the
securities must be discontinued until after such disclosure. This includes “tippees” (those who are told of the
material information by corporate insiders).
2) Materiality: Only information that is essentially extraordinary in nature and which is reasonably certain to
have a substantial effect on the market price of the security if disclosed need be disclosed. The test is whether a
reasonable investor would attach importance to the information in determining his course of action. To make
the determination, the probability that the event will occur and the magnitude of the event if it does occur must
be balanced. Here, the first public disclosure may have been misleading – the case is remanded to determine if
it was such that a “reasonable investor” would have relied on it.
3) Press release: If corporate management can show that it was diligent in ascertaining that the information that it
published in the press release was the whole truth, and that such information was disseminated in good faith,
Rule 10b-5 is not violated. The court remands to the trial court for a determination of whether the press release
was misleading and, if it was, whether the corporation violated the required standard of care in issuing it so that
an S.E.C. injunction will issue against further violations.
4) When may insiders act?: Before insiders may act, the information must have been effectively disclosed in a
manner sufficient to ensure its availability to the investing public. So the director who left the news conference
on April 16 to call his broker to purchase securities is liable.
5) Good faith as defense: Specific intent to defraud need not be shown. Negligent insider conduct is sufficient for
liability. Hence, the claim that the news was pubic when the officer [honed his order the night before the
company news conference is not a reasonable belief, and the officer is liable for negligent violation of the Act.
6) Stock options: Accepting stock options in February 1964 from a company committee and the board, neither of
which knew of the information, is a violation by officers who did know.
7) The “in connection with” requirement: The 1934 Act was meant to promote a free market and protect the
investing pubic. Section 10(b) protects against fraudulent or misleading statements or acts “in connection with”
the purchase or sale of securities. This means that any device is proscribed, whatever it might be, that would
cause reasonable investors to rely thereon in connection with buying or selling corporate securities. It need not
be shown that the party using the device was involved in the purchase or sale

Charella v. United States (1980)(p. 850)

Facts: A printer, in the course of his job, prints press releases from different corporations. Several press releases
from acquiring companies which announced mergers passed through his hands, and from their information, he was
able to deduce the parties, and purchased the stock of the target company before the information became public. The
printer was convicted of insider trading under SEC Rule 10(b) for failing to disclose this non-public information,
and trading on it. The court of appeals affirmed stating that no person, whether or not a corporate insider may trade
on any illegally obtained non-public information.
Issue: Whether a person who learns from the confidential documents of one corporation that it is planning to
attempt to secure control of a second corporation violates SEC rule 10(b) if he fails to disclose the impending
takeover before trading the in the target company stock.
Holding: No.
A corporate insider must refrain from insider trading without disclosure because the insider owes a duty to the
corporation based on his position. Specifically, the insider should not be allowed to profit personally from his
access to confidential information by virtue of his position. However, a purchaser of stock who is neither an insider
or a fiduciary has no duty to the prospective seller to disclose non-public information because he does not stand in a
position of trust and confidence to the seller which would make the transaction unfair. The jury instructions here
were too broad, and thus the conviction must be reversed. The court makes no opinion as to whether the printer
breached a duty to the acquiring corporation who hired him.

Synopsis of Rule (p. 860)

United States v. O’Hagan (1997)(p. 861)
Facts:
Issue:
Rule:
Comment::

Dirk v. SEC (1983)(p. 873)

BROKER
Facts: Dirks (D) was an employee of a broker-dealer firm that specialized in providing investment analysis of
insurance companies for institutional investors. He received information from Ronald Secrist, a former officer of
Equity Funding (a New York Stock Exchange Company), that its assets were vastly overstated since the company
was creating false insurance policies. D investigated by interviewing company officers and employees. Some of the
employees verified the charge. D discussed this information with some of his clients, who sold the stock, driving
the market price down. Finally, the S.E.C. halted trading in the stock. Then the California insurance commissioner
investigated and discovered the fraud. Equity Funding entered receivership. The S.E.C. sued D under section 17(a)
of the 1933 Act for aiding and abetting his clients that sold their stock based on the inside information. The circuit
court affirmed the S.E.C.’s decision against D. The Supreme Court granted certiorari.
Issue: Where the insider is not motivated by personal gain, is a person who got the inside information from an
insider and who gave it to tippees that traded on the information in violation of Rule 10b-5?
Rule: No. Judgement of the circuit court was reversed.
1) To be an insider, a person must have a fiduciary relationship with the shareholders of the company whose stock
is traded.
2) The S.E.C.’s position is that a tippee from such an insider inherits the fiduciary duty of the insider if he knows
the information is material and non-public and if he knows that the insider has a fiduciary duty not to disclose it.
3) But a rule such as that suggested by the S.E.C. might inhibit market analysis form doing their work, which is to
question corporate insiders and discuss this information with their clients.
4) The motivation of the insider is critical. The test is whether the insider will personally benefit, directly or
indirectly, from his disclosure. Absent some such personal gain, there is no breach, and the tippee who takes
such information and gives it to those who might trade on it has not breached any duty, since his duty is
derivative from the insider’s duty. Gain might be monetary, reputational , etc.
Dissent:: Secrist could not trade on his information. He could not get someone to do the trading for him. But he
used D to disseminate information to D’s clients, who traded with unknowing purchasers. It makes no difference to
these unknowing shareholders whether Secrist had a good or bad purpose in disclosing the inside information. The
breach is to take action disadvantageous to one to whom a duty is owed.
Comment:: The Court noted that in certain circumstances, such as where corporate information is revealed
legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may
become fiduciaries of the shareholders because they have entered into a confidential relationship in the conduct of
the business of the corporation and are given access to information solely for corporate purposes.

United States v. Chestman (1991)(p. 881)

FIDUCIARY OR “SIMILAR RELATIONSHIP OF TRUST AND CONFIDENCE”
Facts: Ira Waldbaum was the controlling shareholder of Waldbaum, Inc. In 1986, Waldbaum agreed to sell the
corporation. He told his sister and his children about the pending sale, and admonished them to keep the news
confidential until after the public announcement of the sale. However, Waldbaum’s sister told her daughter, Susan,
who then told her husband, Keith, about the pending tender offer. Keith told Chestman (D), a stockbroker, that
Waldbaum, Inc. was going to be sold for a substantially higher price than market price. D then traded on behalf of
himself, several clients, and Keith based on this information. Keith agreed to cooperate with the S.E.C. in their
investigation. D was convicted under Rule 10b-5 as an aider and abettor of the misappropriation and as a tippee of
the misappropriated information and for mail fraud. D appeals.
Issue: If a wife tells her husband about a pending tender offer for stock in her family’s business, and the husband
tells his stockbroker who then trades based on the information, has the husband breached a fiduciary or “similar
relationship of trust and confidence” sufficient to impose liability for violation of 10b-5 and mail fraud?
Rule: No. Conviction reversed.
1) The relationship between Keith and Susan Loeb does not fall within any of the traditional fiduciary
relationships, this, we must determine whether their relationship constitutes a “similar relationship of trust and
confidence” sufficient to impose Rule 10b-5 liability.
2) A “similar relationship of trust and confidence” must share the same qualities as a fiduciary relationship. A
fiduciary relationship depends on reliance, control, and dominance and exists when confidence is reposed on
one side and there is a resulting superiority and influence on the other. A fiduciary relationship involves
discretionary authority and dependency: one person depends on the other to serve his interests. Because the
fiduciary obtains access to the other person’s property to serve the ends of the fiduciary relationship, he
becomes duty bound not to appropriate the property for his own use.
3) The court found that the government presented insufficient evidence to establish a fiduciary relationship or its
functional equivalent between Keith Loeb and the Waldbaum company. Keith had not been brought into the
family’s inner circle whose members discussed confidential business information. Keith was not an employee
of Waldbaum and he did not participate in confidential communications regarding the business. The
confidential information was gratuitously communicated to him and did not serve the interests of the Waldbaum
company. Nor was the relationship characterized by influence and reliance of any sort. A fiduciary duty cannot
be imposed unilaterally by entrusting a person with confidential information.
4) Nor was there sufficient evidence to establish a fiduciary relationship or its functional equivalent between Keith
Loeb and his wife. Kinship alone does not create a fiduciary relationship. Susan admonished Keith not to
disclose that Waldbaum was the target of a tender offer. Although they had maintained confidences in the past,
there was no evidence of the nature of the confidences, therefore, the jury could not reasonably find that there
existed a fiduciary relationship. In the absence of explicit acceptance by Keith of the duty of confidentiality,
there is no fiduciary relationship. While acceptance can be implied, it must be implied from a preexisting
fiduciary-like relationship between the parties, Susan’s disclosure of the information served no business purpose
and was unprompted; Keith did not induce her to convey the information. The government did not prove a
pattern of sharing business confidences between Keith and Susan.
5) Keith did not owe a fiduciary duty to either Susan or the Waldbaum company, and he did not defraud them by
disclosing the news of the tender offer to D. Since Keith is not guilty of fraud, D cannot be held derivatively
liable as Keith’s tippee or as an aider and abettor. A mail fraud conviction requires a breach of the same
fiduciary like duty, which we have found does not exist here. D’s convictions must be reversed.
Concurrence: A family member who has received or expects benefits from family control of a corporation, who is
no a position to learn confidential corporate information through ordinary family interactions, and who knows that
under the circumstances both the corporation and the family desire confidentiality, has a duty not to use such
information for personal profit where the use risks disclosure. To hold otherwise would discourage open family
communication and would mean that a family-controlled corporation is subject to greater risk of disclosure of
confidential information than a publicly-owned corporation. Thus, I would affirm D’s conviction.
Concurrence: Judge Winder’s proposed familial rule adds an element of uncertainty to this area of the law; it is
unclear who would be subject to the duty of confidentiality.

Securities Exchange Act of 1934 15 USCA §78u-1 (1997)(p. 893)

Securities Exchange Act of 1934 15 USCA §78t-1 (1997)(p. 897)
Securities Exchange Act of 1934 15 USCA §78p-1 (1997)(p. 899)

C) SECURITIES FRAUD (p. 906)

Materiality: The misrepresented or undisclosed fact must be a “material” one. A number of tests of “materiality”
have been suggested by the courts.
1) Reasonable person standard: In List (1965) the court stated that the “basic test of materiality…is whether a
reasonable man would attach importance to the misrepresented fact) in determining his choice of action in the
(securities) transaction in question.”
a) in a situation where the impact of a fact is uncertain, it has also been suggested that in
applying this materiality test, the probability that the event will occur must be balanced
 against the magnitude of the event if it occurs. (i.e. a high probability, high magnitude
event is clearly material.)
b) IN SEC v. Texas Gulf Sulphur Co, the issue was whether the corporation had met its disclosure
responsibility concerning a huge potential ore discovery. It had issued a press release that acknowledged
drilling operations but hedged as to the possible results (even though the know information was favorable
and the magnitude of the potential effect on the company was huge).
2) Value of Corporation’s Securities: Another test used to determine the materiality is whether the fact in
“reasonable contemplation” would affect the value of the corporation’s securities Kohler v. Kohler (1963)
3) Consider all of the Facts: Under whatever test is used, it is clear that the courts consider all of the facts to
determine whether the undisclosed information might reasonably have influenced the plaintiff’s conduct.
4) Examples of material Facts: include the intention of company management to pay a dividend, or a significant
drop in the profit level of the company.

Basic Inc. v. Levinson (1988)(p. 906)

PRELIMINARY MERGER NEGOTIATIONS
Facts: Officers and directors of Basic, Inc., including Ds, opened merger discussions with Combustion
Engineering in September 1976. During 1977 and 1978, Basic denied 3 times that it was conducting merger
negotiations. On December 18, 1978, it halted trading on the NYSE, saying it had been approached. On December
19, 1978, it announced that the board had approved Combustion’s $46 per share tender offer. Levinson and others
(Ps) are a class of shareholders who sold their stock after Basic’s 1977 statement and before the trading halt on
December 18, 1978. They sued under Rule 10b-5. The district court, on the basis of a “fraud-on-the-market
theory,” adopted a rebuttable presumption of reliance by members of the class. On a motion for summary
judgement, the district court ruled for Ds, holding that at the time of the 1st announcement in 1977, no negotiations
were actually going on, and that the negotiations conducted at the time of the 2nd and 3rd announcements were not
destined with reasonable certainty to become a merger agreement. The court of appeals affirmed the holding about
reliance, but reversed the summary judgement. It held that preliminary merger discussions could be material.
Further, it held that once a statement is made denying the existence of discussions, then even discussions that might
otherwise have been immaterial can be material. The Supreme Court granted certiorari.
Issue:
1) Is the standard used to determine whether preliminary merger negotiations must be disclosed a materiality
standard under Rule 10b-5?
2) Is it appropriate to use rebuttable presumption of reliance for all members of a class on the basis that there has
been a fraud on the market?
Rule: 1) Yes. 2) Yes.
1) The TSC Industries test is the test of materiality for Rule 10b-5 cases; that is, a fact is material if there is a
substantial likelihood that a reasonable shareholder would consider it important.
2) With contingent events like mergers (that may or may not happen), the probability that the merger will occur
and the magnitude of the possible event are looked at. All relevant facts bearing on these 2 issues should be
considered.
3) An absolute rule (such as the one requiring that a preliminary agreement be arrived at before negotiations are
material), while convenient, is not in accord with the TSC Industries test. The circuit court was wrong. If a fact
is immaterial, it makes no difference that Ds made misrepresentations about it.
4) The case must be remanded to consider whether the lower court’s grant of summary judgement for Ds was
appropriate.
5) Reliance, is an element of a Rule 10b-5 cause of action. It provides a causal connection between a defendant’s
misrepresentation and a plaintiff’s injury. But this causal connection can be proved in a number of ways. In the
case of face to face negotiations, the issue is whether the buyer subjectively considered the seller’s
representations. In the case of a securities market, the dissemination or withholding of information by the issuer
affects the price of the stock in the market, and investors rely on the market price as a reflection of the stock’s
value.
6) The presumption of reliance in this situation assists courts to manage a situation where direct proof of reliance
would be unwieldy. The presumption serves to allocate the burden of proof to defendants in situations where
the plaintiffs have relied on the integrity of the markets, which Rule 10b-5 was enacted to protect. The
presumption is supported by common sense. Most investors rely on market integrity in buying and selling
securities.
7) Ds can rebut the presumption.
a) Ds could show that misrepresentation or omission did not distort the market price (i.e., Ds could show that
market makers knew the real facts and set prices based on these facts despite any misrepresentation that
might have been made.)
b) Or Ds could show that an individual plaintiff sold his shares for reasons other than the market price,
knowing that Ds had probably misrepresented the status of merger negotiations.
Dissent (as to the fraud on the market theory::
1) The fraud-on-the-market theory should not be applied in this case.
2) The fraud-on –the-market theory is an economic doctrine, not a doctrine based on traditional legal fraud
principles. If Rule 10b-5 is to be changed, Congress should do it.
3) It is not clear that investors rely on the “integrity” of the markets (i.e. on the price of a stock reflecting its
value).
4) In rejecting the original version of section 18 of the Securities Exchange Act, Congress rejected a liability
provision that allowed an investor recovery based solely on the fact that the price of the security bought or sold
was affected by a misrepresentation. Congress altered section 18 to include a specific reliance requirement.
5) The fraud-on-the-market theory is in opposition to the fundamental policy of disclosure, which is based on the
idea of investors looking out for themselves by reading and relying on publicly disclosed information.
6) This is a bad case in which to apply the fraud-on-the-market theory. Ps’ sales occurred over a 14 month period.
At the time the period began, Basic’s tock sold for $20 per share; when it ended, the stock sold for $30 per
share, so all Ps made money. Also, Basic did not withhold information to defraud anyone. And no one
connected with Basic was trading in its securities. Finally, some Ps bought stock after Ds’ first false statement
in 1977, disbelieving the statement. They then made a profit, and can still recover under the fraud-on-market
theory. These Ps are speculators. Their judgement comes from other, innocent shareholders who held the
stock.

§10(B) AND THE VAGARIES OF FEDERAL COMMON LAW: THE MERITS OF CODIFYING THE
PRIVATE CAUSE OF ACTION UNDER A STRUCTURALIST APPROACH (p. 930)

E) TRANSACTIONS IN CONTROLLING SHARES (p. 937)

Sales Controls: The most complex problem involving the sale of corporate stock is the situation where a
shareholder owning a majority interest (or a controlling minority interest) of the shares sells that control in a
transaction from which the other shareholders are excluded (the controlling shareholder receiving a premium price
per share on the stock over book or market value), or where all sell, but the owner of the control shares receives
more per share than the other shareholders. Since a person purchasing “control” can dictate the affairs of the
corporation, “control” is something of value.
General Rule: Is that a shareholder may sell his stock to whomever he wants to at the best price he can get.
1) Majority shareholder: Most courts would say that a majority shareholder has the same right. Where the
majority shareholder agrees to have a majority of the board of directors resign and the purchaser’s appointees
elected (where this would naturally occur anyway), this is also not illegal per se.
Zetlin v. Hanson Holding Inc. (1979)(p. 937)
SPECIAL PRICE FOR CONTROL
Facts: Zetlin (P) owned 2% o Gable Industries. A group of shareholders including Hanson (Ds) sold their interest in
Gable (44.6%), which was effective control, to another party for $15 per share when the market price was $7.38 per
share. P wanted to be paid the same price as Ds and to share a proportionate amount of his stock. The trial court
found for Ds; P appeals.
Issue: Absent fraud, can a controlling shareholder sell control for a premium price?
Rule: Yes Affirmed.
1) A majority interest can control the affairs of the company. Absent looting, conversion of a corporate
opportunity, or other acts of bad faith, a controlling shareholder can sell the right to control the affairs of the
corporation for a premium price.

Looting Theory: In a situation where the purchaser buys only the controlling stock, the controlling shareholders
may be liable to the minority when the purchaser later “loots” the corporation (if the majority shareholders knew or
had reason to know that the purchaser intended to loot the corporation). Paying a “premium” is one indication or
notice of possibly intended “looting.”
Debaun v. First W. Bank and Trust Co. (1975)(p. 938)
LOOTING
Facts: DeBaun and Stephens (Ps) held 30 of the 100 shares of stock in a photo finishing business where they
worked. They were also directors. After the death of the founder, who held the balance of the stock in 1964, the 70
shares passed to a testamentary trust administered by First Western (D). Ps and another managed the business very
successfully until 1968. In 1966, D decided to sell the 70 shares (on the basis that it was not an appropriate trust
investment) without informing Ps. After an appraisal and aid from a broker, D located a tentative buyer, Mattison.
About the same time, DeBaun learned of the proposed sale and submitted an offer, which was refused. D, after
receiving a sketchy balance sheet of the trust through which Mattison was seeking to purchase the shares, ordered a
Dunn & Bradstreet report on Mattison (which report noted pending litigation, past bankruptcies, and existing tax
liens against corporate entities in which Mattison had been a principal).
Also one of the officers of D had knowledge that there was an unsatisfied judgement that had been rendered against
Mattison in favor of D'’ predecessor. Mattison explained these problems on the basis that he usually acquired
failing companies and tried to turn them around. The public records of Los Angeles County, which were not
checked by D, revealed $330,886 in unsatisfied judgements against Mattison and his entities and 54 pending actions
totaling $373,588, as well as 22 recorded abstracts of judgements against him for $385,700 and 18 tax liens
aggregating $20,327. Notwithstanding the information available to D, on the basis of the fact that one of D’s
officers knew Mattison and that Mattison was warmly received at an exclusive club, D accepted Mattison’s offer of
$50,000 in securities with the balance of the purchase price to be paid out of the revenues of the corporation (even
though D knew Mattison would be forced to make some of these payments out of the capital assets of the
corporation). D sold Mattison the shares in July, and in less than one year the corporation’s net worth of $220,000
was reduced to a net deficit of over $200,000 by Mattison’s diversion of corporate assets to himself through various
schemes. Ps sued D to recover for its breach of duty to minority shareholders in selling to Mattison. The trial court
found for Ps an awarded damages of $438,000 ($220,000, or the net asset value at the time of sale by Mattison, plus
$218,000 as the discounted value of the anticipated corporate profits for the next 10 years). D appealed.
Issue: Does a controlling shareholder owe the other shareholders a duty not to sell its controlling interest to an
individual who was likely to loot the corporation?
Rule: Yes. D breached its duty to P by selling to Mattison.
1) D knew of Mattison’s numerous financial failures and that Mattison could not meet his obligations to pay for
the corporation without using its assets.
2) A majority shareholder owes a duty to the minority shareholders to investigate an individual and not to sell to
him if they reasonably should know he will loot the corporation.

Sale of corporate assets: Where the purchaser buys only the majority stock, the majority may be liable for any
premium received if the corporation has some particular “corporate asset” that creates this premium, since this asset
belongs to all shareholders equally. But what constitutes a “corporate asset”? Isn’t this involved in every corporate
sale, so that whenever a purchaser offers to buy control he must give this same offer to minority shareholders?

Perlman v. Feldman (1955)(p. 947)

FIDUCIARY RELATIONSHIP
Facts: Newport Steel is a mid-sized steel company trying to expand its market during the steel shortages of the
Korean war. Feldmann is the chairman and controlling stockholder of Newport. Feldman sold his controlling
interest in Newport for $20 per share to a customer company, Wilport, who needed to secure a stable source of steel
during the shortage. This enabled Wilport to allocate more steel to itself by placing several people on Newport’s
board. The book value of the stock was $17 per share and the market value was $12 per share. A derivative action
brought by minority shareholders against Feldmann for an accounting and restitution of the profits that Feldmann
personally realized from the sale of his controlling interest. The trial judge found that the $20 per share price was
fair and was not the sale of a corporate asset.
Issue: Whether the sale of control under these facts was the sale of a corporate asset which would entitle the
corporation to the profit realized by Feldmann.
Holding: Yes.
A fiduciary has the responsibility to dedicate his uncorrupted business judgment for the sole benefit of the
corporation in any dealings which may adversely affect it. The possibility that the corporation would have benefited
is all that is required, not a showing of absolute certainty. Feldmann’s actions prevented the corporation from
obtaining interest-free advances from prospective purchasers to expand production. It also prevented the
corporation from building up its customer base. The defendant must show that there was no possibility of any gain
by the corporation and he has not met that burden of proof. In a time of a market shortage, where the power to
allocate a corporation’s product commands an unusually large premium, a fiduciary may not appropriate to himself
the value of that premium.

Sale of a corporate office: In a purchase transaction, the majority also agrees to assist the purchaser in the
accomplishment of some corporate action requiring the exercise of their corporate office. Some courts have held
that any premium paid to majority shareholders must be distributed pro rata to all shareholders where a premium
price has been paid based on the majority’s exercise of its “corporate office” (on the basis that this belongs to the
corporation as a whole, not to the majority shareholder exclusively).

Petition of Caplan (1964)(p. 956)

STOCK MUST CHANGE HANDS
Facts: Cohn owned 3% of Lionel Corporation stock but controlled 7 of the 10 directors of the corporation. He
agreed to sell his shares to Defiance Industries, Inc. and the have the directors he had nominated resign to allow
Defiance nominee to take their positions. Defiance then sold its interest in the contract to Sonnabend and agreed to
have its nominees resign to be replaced by Sonnabend nominees. A shareholder of Lionel challenged the elections
of the 7 Sonnabend nominees.
Issue: May control of a corporation, apart from stock control, be traded?
Rule: No. Control may only be traded as part of the trade of actual stock control.

(The Following will not be covered)

PROXY REGULATION (pp. 593-606, 615-631, 647-662)

FOREIGN ISSUES (Handout A)