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Liability to third parties in CONTRACT

o What authority does the agent have?

Actual authority (R7): the power of the agent to affect the legal relations of
the principal by acts done in accordance with the principals manifestations of
consent to him
Occurs when the principal talks to the agent.
Express actual authority (R26): authority to do an act can be created by
written or spoken words or other conduct of the principal which,
reasonably interpreted, causes the agent to believe that the principal
desires him so to act on the principals account
Implied actual authority (R35): unless otherwise agreed, authority to
conduct a transaction includes authority to do acts which are incidental
to it, usually accompany it, or are reasonably necessary to accomplish
o What was it reasonable for the agent to believe? Consider:
The agents understanding of his authority
Past and present conduct of the principal toward the
The nature of the task or job
Prior similar practices
Specific conduct by the principal in the past permitting
the agent to exercise similar powers
Apparent authority (R8): the power to affect the legal relations of another
person by transactions with third persons, professedly as agent for the other,
arising from and in accordance with the others manifestations to such third
Occurs when the principal talks to the third party. Was it reasonable for
the third party to believe that an agency existed?
Can exceed actual authority
Some disagreement between Second and Third restatement regarding
how direct the holding out by the principal has to be.
o Second Restatement: if there is no statement made by the
principal to the third party, there is no authority.
o Third Restatement: broader view. If the principal puts an agent
out there, he holds out to the world that the agent is capable of
doing things.
Inherent authority (R8A): indicates the power of an agent which is derived not
from authority, apparent authority or estoppel, but solely from the agency
relation and exists for the protection of persons harmed by or dealing with a
servant or other agent.
Sometimes the law protects third parties in situations where it seems
unfair to allow the principal to escape liability.
The dumping ground if there is a perceived injustice

Was it reasonable for the third party to believe that they are dealing
with an appropriate person?
o Ex that would not be reasonable: A car vendor comes into a bar
and thinks that the bartender has the authority to buy $1 million
worth of cars.
o If actual, apparent, and inherent authority do not exist, two other concepts may help
create liability:
Ratification (R82): the affirmance by a person of a prior act which did not
bind him but which was done or professedly done on his account.
Elements to ratification:
o Intent to ratify
o Knowledge of the facts
o After these elements have been met, CONSIDER acceptance of
the benefits
The person must have the ability and time to reject the
benefits. There must be a fair opportunity to decide
whether to accept them.
If ratification is found to occur, it acts to signify that its as if agency
had been established from the outset/from the transaction itself.
Estoppel (R8B): If a proprietor, through dereliction of duty, allows someone to
act as if he were an agent, the proprietor is liable.
Elements to estoppel:
o Act or omission of the principal that creates the appearance of
authority in another
o The third party must reasonably and in good faith have acted in
reliance on the appearance of authority.
o The third party must change position in reliance, to her
Liability to third parties in TORT
o Does the principal have sufficient ability to control how the task is performed?
o Policy behind making masters liable for their servants
If the ER has the right to tell the EE what to do in his job and the EE does
something wrong that injures someone, the ER himself should take the
Innocent victims should be compensated from the deep pockets of principals,
who should know that they take on liability and that accidents happen.
Principals should know to get insurance.
Counterargument: If the principal cant assert a defense that he was
overly careful in hiring, training, etc., there will be no incentives for
principals to exert this care.
o Rules
R2: Master, servant, independent contractor:

A master is a principal who employs an agent to perform service in

his affairs and who controls or has the right to control the physical
conduct of the other in the performance of the service.
A servant is an agent employed by a master to perform service in his
affairs whose physical conduct in the performance of the service is
controlled or is subject to the right to control by the master.
An independent contractor is a person who contracts with another to
do something for him but who is not controlled by the other nor
subject to the others right to control with respect to his physical
conduct in the performance of the undertaking. He may or may not be
an agent.
R220: Definition of servant: In determining whether one acting for another is
a servant or an independent contractor, the following matters of fact are
The extent of control which, by the agreement, the master may
exercise over the details of the work
Whether or not the one employed is engaged in a distinct occupation
or business
The kind of occupation
The skill required in the particular occupation
Who the ultimate financial risk of loss falls on
Whether the employer or workman supplies the tools
The length of time for which the person is employed
The method of payment
Whether or not the work is part of the regular business
Whether or not the parties believe they are creating the master/servant
Whether or not the principal is or is not in the business
See R5(2): A subservant is a person appointed by a servant empowered to do
so, to perform functions undertaken by the servant for the master and subject
to the control as to his physical conduct both by the master and by the servant,
but for whose conduct the servant agrees with the principal to be primarily
o If there is a master/servant relationship, the master is liable. Consider the ultimate
financial risk. Humble Oil v. Martin
o If there is an independent contractor relationship, the master is not liable. Consider
the control of the day to day operations. Hoover v. Sun Oil
Apparent agency
o Apparent authority (in the contract situation): the principal says something to the
third party that invests the agent with authority.
o Apparent agency is more of an estoppel theory. Ask whether someone detrimentally
relied and got hurt as a result.
Policy reasons in favor of this concept: We do not want large corporations
creating apparent agency and then taking no steps to ensure against accidents.

Policy reasons against this concept: If we look at it too broadly such that a
franchisor is liable for every tort of his franchisee, this reduces the incentive to
use franchise agreements in general. Therefore, large corporations will
tentacle-like plant its own branches.
R267: apparent agency: one who represents that another is his servant
or other agent and thereby causes a third person to justifiably rely upon
the care or skill of such apparent agent is subject to liability to the third
person for harm caused by the lack of care or skill of the one appearing
to be a servant or other agent as if he were such
Crucial test:
o Whether the putative principal held out the third party as an
agent; and
o Whether the plaintiff relied on that holding out
Scope of employment
o R228: General statement for scope of employment doctrine:
Conduct of a servant is within the scope of employment if, but only if:
It is of the kind he is employed to perform
It occurs substantially within the authorized time and space limits
It is actuated, at least in part, by a purpose to serve the master (the
most important factor; aka Motive Test)
If force is intentionally used by the servant against another, the use of
force is not unexpectable by the master
Conduct of a servant is not within the scope of employment if it is different in
kind from that authorized, far beyond the authorized time or space limits, or
too little actuated by a purpose to serve the master
o Other factors to consider: similarity to acts which the servant is authorized to
perform; whether the act is commonly performed by the servants; the extent of
departure from normal methods; whether the master would reasonably expect that
such an act would be performed
o Minority test: Foreseeability/Judge Friendlys approach
o Presently interfering test: If the P was presently interfering with the servants ability
to do his job for the master, the master is liable.
o Agruello v. Conoco: even with violations of statutory law, you can still create agency
such that the servant is liable
Independent contractors
o R213: If you hire an independent contractor, you can also be liable for what that
person does.
o Where there is an independent contractor, the law will still hold the principal liable
for the torts even if the standard analysis is that the servant has to have control over
the daily operations IF:
(1) There is an inherently dangerous activity
Ex: swinging a wrecking ball in a crowded city
R416: Inherently dangerous activity

(2) The independent contractor maintains control over one particular aspect to
a great degree
(3) The principal has hired an incompetent independent contractor.
You must negligently hire an independent contractor to be liable for
Fiduciary obligations of agents
o Why have fiduciary duties?
Economic efficiency: create a generalized duty of obligation so that the agent
may fill in for any issue that arises
o Three main duties
Duty of care and skill (R379)
Duty of obedience (R385)
Duty of loyalty (R287)
Keep the businesss actions confidential
Do not profit using the principals materials
o What if the parties dont put a loyalty clause in their contract?
It may not matter. If a duty of loyalty is breached in such an egregious
manner, a duty of loyalty may still be found to have been breached.
Ex: If Tom Clancy enters into a contract with a publisher under the
agreement that there wont be a duty of loyalty to that publisher, and
then goes out the next day and partners with a competitor publisher,
the duty of loyalty may still be breached: no duty of loyalty may not
mean that Tom could go out and do what he did.
Be specific in your contracts!
The Restatement 2d is overly broad for its use of unless otherwise agreed:
this gives the parties much flexibility to tailor their relationship.
The Restatement 3d is more specific and gives better guidance: Conduct that
would otherwise constitute a breach of duty does not constitute a breach of
duty if the principal consents to the conduct, provided that the principals
consent concerns either a specific type/act/transaction, or acts of a specified
type that would ordinarily be expected to occur.
Reinforces the idea that fiduciary duty = duty of loyalty
o Duties DURING agency
The duty of loyalty is one-way: the master does not owe any duty of loyalty to
the servant.
Money earned using principals clothing belongs to principal: Reading v.
Where a persons employment is the sole cause of his personal profit
and he obtains it dishonestly, this is an advantage that he is not allowed
to keep. Here, the soldier breached his duty of honesty and good faith.
Where the employment is NOT the sole cause of the personal profit,
the profit does not necessarily belong to the principal. (i.e., Means
grows MJ in his office in the law school; his position as professor
probably is not the sole reason he profits from this side business)

Even where the master is not harmed by the conduct (the court uses
the example of the servant who exercises the governments horses and
profits from it as well by giving rides), it is still a violation of the
agents duty.
Money gained from secret side service belongs to principal: General
Automotive v. Singer
o Duties AFTER agency
Ways to terminate agency
R118: Communication from P to A or A to P saying that the
relationship is over terminates the agency. Without consent, agency
o Such a communication may take away actual and implied
authority, but apparent authority may still exist. Take
affirmative steps to notify third parties.
The purpose of the agency has been accomplished
The passage of time can end agency if that has been provided for
Agent may not solicit the clients of his former boss: Town and Country House
v. Newberry
R396: Using confidential information after termination of agency
As long as the former employee contacts people that he knew, that is
fine. However, if he takes a printed/written list and contacts everyone
whether he knew them or not, that is wrongful.
o R396(b) draws the distinction here
Look to the circumstances of the departure and see what it would have
been reasonable for the agent to take with him when he left


Partnerships are controlled by the Uniform Partnership Act (UPA), which contains the
default rules of partnership.
Partnership (defined) UPA 6(A): An association of two or more persons to carry on as coowners a business for profit
o Persons may be corporations
o A general partnership does not require written documentation: it can be formed by
o UPA 7: Rules for determining the existence of a partnership
The sharing of profits is prima facie evidence, but not if the profits were
received in payment as:
Debt installment
Salary or rent
Widows annuity
Loan interest (even if variable)

Consideration for sale of property

The person attempting to establish partnership will have the burden of
evidence proving it.
o Factors taken into consideration in determining the existence of a partnership:
The intent of the parties
A right to share in profits
An obligation to share in losses
The ownership and control of the partnership property and business
Community power in administration
The language of the agreement
Conduct of the parties to third persons
Partnership by estoppel
o Young v. Jones
UPA 16: When a person who represents himself, or permits another to
represent him, to anyone as a partner in an existing partnership or with others
not actual partners, is liable to any such person to whom such representation is
made who has, on the faith of the representation, given credit to the actual or
apparent partnership. Elements:
Representation or holding out by person (or with consent) and
Third party reliance that causes damage (giving credit to the actual or
apparent partnership)
Fiduciary obligations of partners
o UPA 21: Partner accountable as a fiduciary
No secret profits
Anti-theft provision
If youre a partner, you cant steal something that belongs to the partnership.
o Waiver of fiduciary obligations
As a blanket matter, you cannot waive fiduciary duties. However, you may
specify that certain actions will not violate those duties. (ex: Competing
ventures do not violate fiduciary obligations.)
Policy: its better to have gap-filling norms that insert fiduciary obligations
A limited partnership must be formally created: the general partner
has all the liability, while the limited partners look like shareholders in
that they are passive and protected. The limited partners must not
control the business; their role is only to put in money. The GP will
actively manage the business.
Ratification is a potential solution to the problem of fiduciary duty:
the GP owes fiduciary duties and cannot benefit at the expense of the
partnership without violating that duty UNLESS the disinterested
partners ratify the action.
A partner who seeks a business advantage over another partner bears
the burden of showing complete good faith and fairness to the other.
Accountability of partners
o UPA 13: Partnership bound by partners wrongful act

Where, by any wrongful act or omission of any partner acting in the ordinary
course of the business of the partnership or with the authority of his copartners, loss or injury is caused to any person, the partnership is liable
therefore to the same extent as the partner so acting or omitting to act.
Some firms are LLCs such that not all partners are liable for everyone else in
the firm.
o UPA 18(b): Rules determining rights and duties of partners
The partnership must indemnify every partner in respect of payments made,
and personal liabilities reasonably incurred by him in the ordinary and proper
conduct of its business or for the preservation of its business or property
Fiduciary obligations when partnerships end
o UPA 29: Partnerships are not permanent and can be dissolved, unlike corporations.
Partnership dissolves if any partner leaves.
o UPA 20: Duty of partners to reveal information: Partners shall render on demand true
and full information of all things affecting the partnership to any partner or the legal
representative of any deceased partner or partner under legal disability.
Once you plan to move, you need to move quickly.
Preparation to compete is permissible.
Contacting clients is not ok. Although lawyers should not be
prohibited from taking clients with them, clients have a right to their
choice of representation.
o If you are the leaving lawyer, you must make it clear to your
clients that they may stay with the firm or go with you. You
may not disparage another lawyer or the firm.
o The UPA does not tell us what to do when a client approaches us and indicates that
our partner is not allowed to work on their case.
We at least have a duty to disclose.
Two main approaches:
Where theres a corporate opportunity, its fine if the opportunity will
only work with one partner.
You still owe a duty of loyalty to your partners that is not defeated by
the business opportunity.
o UPA 27(1): Assignment of partners interest explains how to unilaterally get rid of a
partnership interest. The partner may convey it to an assignee.

Partnership property
o When you contribute to a partnership, that contribution becomes property of the
partnership and your interest is just an interest. You have no personal property.
Management rights
o One partner said dont buy bread; the other said buy bread: the company was liable
for the cost of the bread: National Biscuit Company v. Stroud
o UPA 9: Partner agent of partnership as to partnership business:
Every partner is an agent of the partnership...
If its a business purpose and USUAL, binds partnership.

UNLESS no authority in particular matter and third party knows.

o UPA 18(e): In the absence of an agreement to the contrary, all partners have equal
rights in the management and conduct of the partnership business, regardless of the
percentage of control/capital they have put in.
o UPA 18(h): Any difference arising as to ORDINARY MATTERS connected with the
partnership may be decided by a MAJORITY of the partners. Any difference
affecting a major issue must be decided by a UNANIMOUS vote.
Non-ordinary course of business decisions are those that all the partners
make together.
Note that you can contract around this for greater protection if you own, for
example, 90% of the business.
The case of Day v. Sidley & Austin shows the extent to which courts allow
partnerships to change these ordinary default rules
o It is important to know the status quo. D wanted to change matters and he couldnt
because he couldnt get to a majority vote, but rather to just a headlock.
Is it standard practice that one person does the bread purchasing?
Whats the standard in the industry?
What does the partnership agreement say?
o One partner said we need another EE; the other said no we dont; the non-consenting
EE was not liable for the costs used to hire and employ the EE: Summers v. Dooley
Acceptance of benefits is not enough. The rules require that you have
knowledge and that you accept. Here, D explicitly objected to the new EE
and continually voiced his objection to the hiring of the third man.
Silent acceptance can occur via ratification sometimes.
The status quo matters: the hiring of the third man is inconsistent with the
previous standard of practice.
In Nabisco, Freeman had been buying bread for a long time. However,
here, hiring an EE is not something that the partners have previously
agreed to do.
o In a deadlock situation, if the partners have not bargained for a mechanism that
would break the deadlock, the only thing they can do is dissolve the partnership.
o Fiduciary duty claim
Partners have a duty to make a full and fair disclosure to other partners of all
information which may be of value to the partnership.
Three basic duties make up a duty of loyalty:
A partner must account for any profit acquired in a manner injurious to
the interests of the partnership
A partner cannot without the consent of the other partners acquire for
himself a partnership asset, nor may he divert to his own use a
partnership opportunity
A partner must not compete with the partnership within the scope of
the business
Dissolution of partnerships
o Generally

The basic rule is that partnership dissolves if any partner leaves. (UPA 29)
Dissolution is different from termination. The partnership can continue even if
its dissolved. If the other partners decide that the partnership should no longer
exist, creditors will be paid off, etc. before the partnership is terminated.
Termination is more finite. This makes sense, because you wouldnt want an
entire law firm ending with one partners exit.
o Causes of Dissolution (UPA 31)
Express will of a partner
o Without violation (no definite term or undertaking
accomplished) OR
o In contravention of an agreement (for the consequences of this,
see UPA 38(2))
In this circumstance, the partner has the power to
dissolve but not the right.
As a matter of law:
Termination of definite term
Business is unlawful
Death or bankruptcy
Court order
The rules have two goals in mind:
Preventing the individual partners from being trapped when they want
to exit the investment
Limiting the ability of individual partners to use their power to exit to
damage the partnership (or to threaten to do so in order to demand
extra benefits)
o The right to dissolve
UPA 32: Dissolution by decree of court: The court shall decree a dissolution
A partner has been declared a lunatic or is shown to be of unsound
A partner becomes incapable of performing his part of the contract
A partner has been guilty of such conduct that affects prejudicially the
carrying on of the business
o This is a fact-based inquiry whether or not the business has
been affected prejudicially
A partner willfully or persistently commits a breach of the partnership
agreement or otherwise conducts the business such that it is not
reasonable to carry on the business in partnership with him
The business can only be carried on at a loss
Other circumstances which render a dissolution equitable
Its not enough that the partners dont like each other; their behavior must
affect the operation of the business.

A partner is always free to breach the contract and demand a winding up if he

wants it, but he will be liable for damages. A partner can terminate, but he is
not always entitled to a legal dissolution. The legal right to dissolution is
conferred by the court.
The UPA provides that a partnership may be dissolved by the express
will of any partner when no definite term or particular undertaking is
If the court were to accept the trial courts reasoning that the
partnership was for a specific term, it would be going against the
UPAs default rules.
If D can prove that P acted in bad faith and breached his fiduciary
duties, the dissolution would be wrongful and P would be liable.
P has the POWER to dissolve the business because its at will, but he
would also have to show that he had the RIGHT to do so.
o The consequences of dissolution
If D thinks he was wronged, UPA 38(2) allows him to get damages:
When dissolution is caused in contravention of the partnership
agreement, the right of the partners shall be as follows: The partners
who have not caused the dissolution wrongfully, if they desire to
continue the business in the same name, may do so: the other partners
will have to pay damages.
Practice pointer: Implement a buy/sell agreement at the initiation of
the partnership that includes specifications for a future valuation, etc.
Practice pointer: When considering a possible dissolution of your
partnership agreement, think through all the hypotheticals of what
could happen and what you would want as a result. Its a good idea to
bargain in detail for what you want because, if you leave gaps, the
court will supply terms/apply fiduciary duties.


o Model Code of 1984 provides the governing statutes for corporations.
o Corporation: an artificial person under the law that has certain constitutional rights.
Unlike a partnership which dissolves when a person leaves/dies, a corporation can
last forever at least until it goes bankrupt or is merged out. Ownership is freely
transferable; you can sell your shares.
o Corporations v. partnerships
Formality: Formal creation is required by state law. A corporation does not get
formed by accident. The corporation has a legal personality that gives it rights
under the law. Articles of incorporation must be filed with the Secretary of
State. (you can form a partnership by accident; no written agreement

Limited liability: As a corporation, an investor is protected. Even if the

corporation goes bankrupt, the shareholders behind it are protected. (The
general partnership does not protect partners and they are fully exposed for
debts and liabilities of the partnership. They can protect themselves through
Transferability of ownership: You can sell your shares in a corporation.
Continuity: The only thing a shareholder can do is leave. (In a partnership,
you always have the ability to dissolve it, even though you may have to pay
Centralized management: Separation of ownership and control. The corporate
forum is ready-made with an executive board already set out in law. (In a
partnership, everyone controls.)
Cost: Somewhat more expensive with annual filing fees, notification of the
annual shareholders meeting, etc. (For the partnership, the cost is 0.)
Flexibility: Less flexibility in a corporation because it has indefinite duration.
(With the possible exception of fiduciary duty, you can change the partnership
in any way you want.)
Tax: Double taxation in a corporation. Small corporations (S corporations)
have flow through tax benefits; larger ones (C corporations) do not enjoy
this. (Partnerships enjoy flow through taxation in which taxes are only paid
once, by the partners.)
o Structure of a corporation
Shareholders: hold share units that entitle them to some percentage of the
corporations profits; they put their money in and hope that the value of the
business increases
Elect the Board of Directors
Vote on issues like mergers and whether the company should go out of
Directors: are elected by shareholders unless theres an outside challenge;
provide the locus of power; have the ultimate responsibility for making
business decisions; determine basic policies; appoint and monitor officers
They have a fiduciary obligation to protect the shareholders obligation
Officers: day-to-day senior employees
Member managed LLC: this is like a partnership; each of the members
call the shots
Manager managed LLC: these default rules look more like a
o Creation of the partnership
Where to incorporate
If youre small, you will probably incorporate wherever you find

If youre large, you may find which state law works best for your
business. Consider:
o Which courts have the most experience with businesses of your
o Where is the corporate law bar the most sophisticated?
o Where are the filing fees the most reasonable?
Internal affairs doctrine: if you want to know what duties the
directors owe to the shareholders, you need to look to the law under
which the company is incorporated
o In corporate law, questions arise about the duty of loyalty because people can take
various roles within the corporation, but the courts are less strict than they are with
agency law.
Therefore, if the Board of Directors agreed to enter a transaction with people
they are connected to, they may have breached the duty of loyalty by failing to
disclose to shareholders, but the court will require the board to show that the
relationship was fair.
Promoters and the corporate entity
o MBCA 2.04: Liability for Preincorporation transactions
All persons purporting to act as or on behalf of a corporation, knowing that
there was no corporation under this Act, are JOINTLY AND SEVERALLY
LIABLE for all liabilities created while so acting.
Once the corporation is in fact born, it must agree to be bound to the contract
entered into on its behalf by the promoter. It must adopt the contract in order
for it to be bound to it.
As a promoter, if you sign in your individual capacity, you are liable. If you
want to disclaim this liability once the corporation has formed and adopted the
contract, specify in the contract that you will not be personally liable after the
adoption by the corporation.
o One who contracts with what he acknowledges to be and treats as a corporation,
incurring obligations in its favor, is estopped from denying its corporate existence.
Southern Gulf Marine v. Camcraft, Inc.
Where a party has contracted with a corporation and is sued upon the K,
neither is permitted to deny the existence or the legal validity of such
o If something goes wrong in the formation of the corporation, the corporation may still
be deemed to exist. The following doctrines offer protection to individuals who act in
good faith, believing that they have formed the corporation:
If youve done everything right, you have a de jure corporation: a
corporation as a matter of law that gives you all of the rights
If youve done something wrong, there are two doctrines that can help you:
De facto corporation
o (1) attempt to be incorporated under a valid statute
o (2) good faith
o (3) carried on as if there were a corporation

o Ex: Youre a promoter and you hire a lawyer to complete the

articles of incorporation for you. The lawyer tells you they
have been filed, when in reality they have not. If youve acted
in good faith and have no reason to think that you are not a
corporation, you will be treated as one.
o Under de facto status, the shareholders are not personally liable
Corporation by estoppel
o Designed to avoid windfall to a third party; if the third party
deals with the corporation as though its a corporation and yet
it isnt, the third party cannot get an additional right that wasnt
bargained for.

The corporate entity and limited liability

o MBCA 6.22: Liability of shareholders
Unless otherwise provided in the articles of incorporation, a shareholder is not
personally liable for the acts or debts of the corporation except that he may
become personally liable by reason of his own acts or conduct.
This language is strong. Piercing the corporate veil and holding individual
shareholders liable is VERY RARE.
Policy: allowing corporations to shield their investors is a good thing
because it encourages growth of capital and allows us to put our
money in investments even if were not there to monitor it all the time
Just because the assets of one company may not cover the liability
does not mean that all of the corporations will be liable. There must be
something more like fraud or inequitable manipulation of the corporate
Where the parent so dominates the affairs of the subsidiary that it is
essentially a dummy, there may be liability because this is
manipulation of the corporate form. That did not happen here.
A piercing of the corporate veil is much more likely where there is a
co-mingling of assets.
Although grossly inadequate capitalization is a factor in determining whether
to pierce the veil, it is not dispositive. Most courts require that there be either
some affirmative fraud or wrongdoing by the shareholder, or a gross failure to
follow the formalities of corporate existence, before the veil will be pierced.
Piercing the corporate veil
o A properly-formed corporation will normally shield the stockholders from being
personally liable for the corporations debts. Therefore, veil piercing is rare.
However, in a few extreme cases, courts pierce the veil and hold some or all of the
shareholders personally liable for the corporations debts.
o Veil piercing is equitable and fact-based.
Factors that are important to a courts decision to pierce include:
Whether the case involves a tort or contract
o Much more typical to pierce in tort cases

Whether the D stockholder had engaged in fraud or wrongdoing

Whether the corporation was adequately capitalized
o Courts want to see that the corporation was initially
inadequately capitalized before piercing
Whether corporate formalities were followed (i.e., keeping of minutes
at meetings, issuing stock certificates, having a separate bank account)
o Test for corporate veil piercing:
Show unity of interest
Is there a separate bank account?
Do we treat the corporate form in their respective form?
Show fraud or injustice
Show that theres a reason why the shareholder shouldnt be able to
benefit from limited liability
Reverse piercing: occurs when you can show that the shareholder is
not respecting the corporate formality by treating his other
corporations as his personal piggy banks; you can go from the
shareholder to the separate businesses, even if the separate businesses
had nothing to do with your injury.
Test for corporate veil piercing: A corporate entity will be disregarded when
two requirements are met:
There must be such unity of interest and ownership that the separate
personalities of the corporation and individual no longer exist.
(satisfied here; Marchese used corporate funds to pay alimony;
corporate formalities had not been maintained; assets had been
comingled, etc.)
Circumstances must be such that adherence to the fiction of separate
corporate existence would sanction a fraud or promote injustice (not
satisfied here)
The court considers highly relevant the fact that D set up a corporation
without giving it the capital that it would almost certainly need.
o Direct liability
If Bristol has no legal duty to assure the safety of these products but
undertakes to do so and does a bad job, Bristol will be responsible. When
Bristol put its name on the label, it represented to the world that it had verified
the safety of the products.
o Veil piercing
A finding of fraud/misconduct is sometimes necessary to pierce the veil. But,
when a corporation so controlled as to be the alter ego of its stockholder, the
corporate form may be disregarded in the interests of justice. Factors that
show that a subsidiary may be the alter ego of the parent corporation:
Common directors or officers
Common business departments
Consolidated financial statements and tax returns
The parent finances the subsidiary

The parent caused the incorporation of the subsidiary

The subsidiary operates with grossly inadequate capital
The parent pays the salaries and other expenses of subsidiary
No business except that given to the subsidiary by the parent
The parent uses the subsidiarys property as its own
The daily operations are not kept separate
Subsidiary does not observe the basic corporate formalities like
keeping separate books
o Advice to give to clients to avoid veil piercing
Observe the formalities (i.e., dont comingle funds)
Dont act in bad faith (i.e., observe the minimum insurance requirements)
Limited partners do not incur general liability for the limited partnerships obligations simply
because they are officers, directors, or shareholders of the corporate general partner:
Frigidaire Sales Corp. v. Union Partners
o The law creates this mechanism whereby you can protect yourself as long as you
dont take an active roll. Here, Ds did not take an active roll.
o Practice pointer: Ps could have ensured that Ds personally guaranteed the contract in
order to make them liable.
Limited Liability Corporations
o Generally
LLCs are neither corporations nor partnerships, but have aspects of both
Select your own governance rules:
Member managed (proportional to membership interest)
Manager managed
Cant form one by accident; Articles of Organization are required
Operating agreement
Maximum flexibility v. cost of contracting
Default rules:
o New members need unanimous consent
o Partnership, flow-through tax
o Limited liability
o The main reason people choose LLC is to get the benefit of limited liability while
being able to choose the form of tax and the governance rules
o Veil piercing of LLCs
Courts have equitable power to pierce the veil of an LLC but the various
factors that would justify piercing an LLC veil would not be identical to the
corporate situation for the obvious reason that many of the organizational
formalities applicable to corporations do not apply to LLCs.
o Practice pointers: Observe the formalities and dont act in bad faith (i.e., observe the
minimum insurance requirements).

Shareholder Derivative Actions

Defined: a suit in which the shareholder sues on behalf of the corporation, on the theory
that the corporation has been injured by the wrongdoing of a third person, typically an
insider. It may in theory be against anyone who has wronged the corporation, whether that
person is an insider or an outsider.
o MBCA 7.4 defines derivative proceeding as a civil suit in the right of a domestic or
foreign corporation; shareholder includes a beneficial owner whose shares are held
in voting trust or held by a nominee on the beneficial owners behalf
Business judgment rule: a strong presumption that the Board of Directors (BOD) acts in
good faith on behalf of the corporation and its business decisions are entitled to
substantial/total deference by the court. For the court to counter this presumption, the P will
have to show:
o Breach of fiduciary duty OR
o That the decision was so egregious that it led to a waste of corporate assets
How does a plaintiff shareholder get into court?
o MBCA 8.01: The corporation is managed under the power of its board of directors,
which must follow the standard of conduct for officers set out in MBCA 8.42
o Direct action: if the shareholders own complaint comes from her capacity as a
Suits by a minority holder contending that the BOD behaved unjustly
toward him (i.e., by failing to pay dividends)
actions to compel the inspection of the corporations books and
actions to enforce the holders voting rights
anti-takeover defenses
corporation fails to hold shareholder meetings
o Test for whether a suit is direct or derivative: if P is harmed on his own, he can sue
individually. Here, P claims that his voting interest has been impaired. The right to
vote is a right that the stockholder has he holds those rights. Look to see whether
the corporation or the individual was harmed.
Ex: ABC board votes to eliminate all preferred stock. You, as a holder of
preferred stock, can sue directly because you have been directly injured.
o Derivative action: if the shareholder steps into the shoes of the corporation and sues
in the corporations own name
Suits for breach of duty of care or duty of loyalty
Suits against an officer alleging that he has usurped a corporate
Excessive compensation
Ex: If something happens to damage the value of the business itself, which in
turn lowers the value of your stock, you can sue derivatively. So, if ABCs

treasurer embezzles money and ABCs BOD has not voted to authorize a
lawsuit against her to recover the money, you may sue derivatively.
Derivative actions call for more stringent procedural rules
Policy: if the BOD is doing something wrong, it needs to be corrected.
Counter: if shareholders can sue at their whim, this would undermine
the core principle of preserving the Directors discretion to manage the
Requirements for bringing a derivative suit
o Contemporary ownership rule (MBCA 7.41)
o Demand on the BOD (MBCA 7.42)
The P must make a demand on the BOD that it bring suit.
o Posting bond
Policy: posting bond discourages strike suits: because of the large waste of
senior management time when a suit continues through trial, management will
often be tempted to settle even suits that have little merit. This incentive gives
Ps lawyers an incentive to bring strike suits those that have little probability
of succeeding on the merits but are troublesome enough to induce the
corporation to make a settlement.
o Demand made
Not wrongful
o Demand not made
Not excused
The demand requirement
o Under the MBCA, you ALWAYS have to make a demand.
o Under the NY and DE approaches, demand is a requirement unless it would make no
sense because it would be futile. If you can show that the board has violated its
business judgment rule, you can pursue your claim without making a demand.
The business judgment rule applies unless the error is egregious; here,
the merely high salary is not enough.
If D has made a demand to the board, which is not excused, he has conceded
that the board is independent enough to make an appropriate business
To make a claim for wrongful refusal, have to show with particularity that the
board acted without due diligence in making its decision to refuse the Ps
o The standard in DE for when demand is excused is REASONABLE DOUBT that the
BOD is capable of making an independent decision to assert the claim if demand
were made.
o Three main reasons for requiring Ps to make demands:
To relieve courts from deciding matters of internal corporate governance

Provide corporate boards with reasonable protection from harassment by

litigation on matters within the board of directors
Discourage strike suits
o Demand futility exception: demand is excused if it would be futile; in permitting a
shareholder derivative action to proceed because a demand on the corporations
directors would be FUTILE, the court substitutes its judgment ad hoc for that of the
o DE approach: Once director interest has been established, the business judgment rule
becomes inapplicable and the demand is excused without further inquiry.
o NY approach: A demand would be futile if a complaint alleges with particularity that
1) a majority of the directors are interested in the challenged transaction; 2) the board
did not fully inform themselves about the challenged transaction to the extent
reasonably appropriate under the circumstances, or 3) that the transaction was so
egregious on its face that it could not have been the product of sound business
judgment of the directors
Special litigation committees
o MBCA 8.25: Committees
A BOD may create one or more committees and appoint one or more
members of the BOD to serve on any such committee
(d) each committee may exercise the powers of the BOD
(e) a committee may not:
(2) approve or propose to shareholders action that this Act requires to
be approved by shareholders
(4) adopt, amend, or repeal bylaws
o MBCA approach:
If the majority of the BOD were independent, P had the burden of showing
bad faith and that a reasonable investigation was not made.
If a majority of the board were not independent, the corporation has the
burden of proving that a reasonable investigation was made and was done in
good faith.
o First, the person bringing the motion (here, the corporation) must make an initial
showing. Under the NY standard, this showing is that this is a disinterested and
independent board. After this has been shown, everything is the Ps burden.
o The business judgment rule comes into play, and so the P must rebut this presumption
by showing that what the committee did was improper.
Zapata Two-Step (which only applies where the demand has been excused):
o First, the court should inquire into the independence and good faith of the committee
and the bases supporting its conclusions.
o Second, the court should determine, applying its own business judgment, whether the
motion should be granted.
Note that this is a change. The court applies its OWN independent business
judgment. Courts rarely step in and assert their own judgment, but this is one
of those cases where they do.

The role and purpose of corporations

Ultra vires doctrine: corporate actions that are beyond the corporations authorized powers
are void. The doctrine is of much less significance today than formerly.

Charitable donations
o MBCA 3.02(13) allows every corporation (unless its articles of incorporation provide
otherwise) to make donations for the public welfare or for charitable, scientific, or
educational purposes
o MBCA 3.01 says that every corporation may engage in any lawful business, unless a
more restricted purpose is set out in the articles of incorporation.
o Therefore, shareholders cant change the purpose of the corporation.
o General limitations on gifts, all satisfied here
There must be some arguable benefit to the corporation. Note that the benefit
may be incalculable.
D will increase its corporate image by contributing to society.
D may bring in a new customer base by interactions with Princeton.
D will get a tax break.
There must not be anything personal. (i.e., no contributions to pet charities)
The amount must be modest.
o Policy behind allowing the corporations to spend shareholders money in making
contributions to charities: modern conditions require that corporations acknowledge
and discharge social as well as private responsibilities as members of their
Establishes goodwill for the corporation
If the corporation is treated as a person in every other respect (i.e., it has the
ability to be sued), why should it not be permitted to make charitable
Counters the collective action problem: if its the social norm for corporations
to give, more will give
o The court deferred to the business ideas, but required D to give dividends to the
stockholders: Dodge v. Ford Motor Co.
The standard is whether it is an abuse of discretion not to declare dividends.
Here, it was. A business corporation is organized and carried on primarily for
the benefit of shareholders. The power of the directors is to be employed to
that end...
o The BOD manages the business. Even if a decision they make is the wrong one, that
does not give the shareholders the right to dictate decisions.
There must be a finding of fraud, illegality, or conflict of interest as a basis for
a stockholders derivative action against a BOD.
The BOD is typically entitled to broad discretion in how to run its
business. Only where a BOD says I dont care about shareholder
profits because I want to accomplish my own X objective will the
court be suspicious.

Duties of officers, directors, and other insiders

Three basic fiduciary duties:
o Loyalty
A breach of this duty is almost impossible to show unless you can prove self
dealing, etc.
o Good faith
Sometimes considered to be a subset of the duty of loyalty
To show that there has been a breach, you must show CONSCIOUS
DISREGARD of evidence of wrongdoing
Oversight falls under this duty
o Duty of care
The directors and officers are supposed to use the care, skill, and diligence of
a prudent person in like circumstances
To get past the business judgment rule and to allege that there has been a
violation of the duty of care, you must show GROSS NEGLIGENCE.
MBCA 8.30: Standards of Conduct for Directors
o (b): the members of the board, when becoming informed in connection with their
decision making function, shall discharge their duties with the care that a person in
like position would reasonably believe appropriate under similar circumstances
MBCA 8.31: Standards of Liability for Directors
o A director shall not be liable unless the party asserting liability establishes that:
No defense interposed by the director based on 2.02(b)(4) [exculpation
provision that narrows it down to intentional harm], 8.61 [judicial action],
8.62 [ratification; with directors it must be by affirmative vote of the majority
but no fewer than two], 8.63 [ratification by the shareholders], or 8.7
precludes liability AND
The challenged conduct was the result of:
Action not in good faith
A decision that the director did not reasonably believe to be in the best
interests of the corporation, or as to which the director was not
informed to an extent he believed reasonably appropriate in the
A lack of objectivity to the directors financial relationship with
another person having a material interest in the conduct
Sustained failure of the director to devote attention to ongoing
oversight of the business/respond to red flags
Receipt of financial benefit to the director which he was not entitled to
o The party seeking to hold the director liable for money damages will also have to
show that:
Harm to the corporation or its shareholders has been suffered
The harm suffered was proximately caused by directors conduct

Duty of care
o The business judgment rule is a bar to a court second-guessing a business decision. If
P can establish a breach of any one of the triads of the BODs fiduciary duty (good
faith, loyalty, or due care), the business judgment protection goes away. But, if the
BOD can show the entire fairness of the transaction, the board can still win.
o Due care is a type of procedural due care (the court avoids getting into the substance
(i.e., by asking whether the board settled on the right number))
Did you look in the right places/talk to the right people to inform yourself?
How did you get to your end result: did you negotiate/shop the offer around,
A potential downside of overemphasis on procedural due care is that its easy
to spend money on process.
MBCA 8.30(e) and (f) allows the BOD to rely on certain people in presenting
o Note that, due to MBCA 11.04, all shareholders have to vote on a merger. 12.01 does
not require shareholder approval for disposition of assets.
o If a business has more cash than it can use, it can:
Pay its money out as dividends to shareholders
Offer to repurchase some of the shares for the shareholders, in turn boosting
the value of the shares for everyone
Buy other companies
Invest in redevelopment
Be acquired by another company that can make better use of its resources
o MBCA 2.02(b)(4) overrules Van Gorkom
If an action is brought against a BOD for breach of care, the individuals will
not be personally liable.
Duty of good faith
o The BOD is entitled to rely on expert presentations/reports, which were created here.
o Breach of duty of good faith claim
The court wants at least conscious disregard of evidence of wrongdoing by
the BOD before finding a breach
Ex: If someone says to you at the branch office that managers are
stealing money, and the director ignores that and does nothing to
follow up, even absent a subjective intent to harm, this is more than
gross negligence and more of a conscious disregard in the face of a
clear duty to act.
We trust the market to set the price of compensation.
o Generally
Directors must have a rudimentary understanding of the firms business and
how it works. They must keep informed about the firms activities, engage in a
general monitoring of corporate affairs, attend board meetings regularly, and
routinely review financial statements.
The standard for oversight is conscious disregard of responsibilities

(a) Utter failure to implement reporting or other controls OR

(b) Conscious failure to monitor or oversee existing controls
o negligence is not enough;
o cannot ignore a red flag
Ex: If youre on the BOD and someone presents you
with a problem, you cannot refuse to look ino it.
o Oversight is part of good faith, which is a subset of the duty of loyalty: Stone v. Ritter
The Articles of Incorporation exculpate directors for violations of the duty of
care. Therefore, they will not be personally liable. If they were to be
personally liable, demand would be excused because the BOD would not be
able to make an independent and informed decision about whether the case
should proceed. Here, however, demand is not excused.
The exculpatory clause will protect the directors from liability for breach of
due care, but not for breach of loyalty or good faith.
Where directors fail to act in the face of a known duty to do so, thereby
demonstrating a conscious disregard for their responsibilities, they breach
their duty of loyalty by failing to discharge that obligation in good faith.
In the absence of red flags, good faith in the context of oversight must be
measured by the directors actions to assure a reasonable information and
reporting system exists and not by second guessing after the occurrence of EE
conduct that results in an unintended adverse outcome.
What sort of actions may rise to the level of being red flags?
o A single offense may not be a red flag, but it may if it is serious
o A series of offenses may be a red flag.
Duty of loyalty
o Words associated with duty of loyalty
Self dealing
Director tailoring his own salary
Corporate opportunity
If the director establishes a corporation rather than letting the business
have the chance
Unless a member of the BOD has had it specifically blessed, he is not
supposed to compete against the corporation
o Procedure for establishing a violation of a duty of loyalty: Do we have a duty of
Board or shareholder authorization (must be material disclosure and
disinterested majority)
o If so, Business judgment rule restores.
No authorization
o D demonstrates fairness

o D does not show fairness

No conflict
Business judgment rule
The DE statute that provides that no contract shall be void because the
director is present at or participates in a meeting of the BOD which authorizes
the contract if the material facts regarding the relationship or interest are
disclosed and the contract is approved in good faith
Business opportunity doctrine
o Generally
People would not be willing to serve on BODs if they always had to give
away every opportunity to the business. However,, shareholders would not
want a rule that would allow directors to decide without constraint when an
opportunity should be completely theirs.
Law/economics explanation: People want a contract that imposes a fiduciary
duty on the directors such that they cannot take for themselves what may be
an opportunity for the corporation.
If the court finds that a corporate opportunity was usurped and that the taking
was per se wrongful, the director will have to account to the corporation for
any profits made and the venture may have to be handed over to the company.
o DE test used to determine whether there was a corporate opportunity seized:
Whether the corporation has the financial ability to exploit the opportunity.
Whether the opportunity is in the line of business of the coroporation
Whether there is an interest or expectancy in the business.
Whether embracing the opportunity would create conflict between directors
self interest and the corporation.
o P must be able to make a strong showing that the director has breached his fiduciary
duty. Because Ps have alleged enough in this case, the burden is on the directors to
show that there was not a corporate opportunity.
o Safe harbor of the boards blessing : MAKE A FORMAL PRESENTATION to the
Dominant shareholders
o Generally
Shareholders dont owe fiduciary duties to the corporation or to each other
EXCEPT if they are controlling shareholders.
This especially occurs when there is a parent corporation/dominant
shareholder and a subsidiary/minority shareholder.
The dominant shareholder will have a fiduciary duty to the minority
shareholder that is essentially an anti-theft duty such that it cant just
take all for itself.
o Parent-subsidiary relations
The fact that a parent has set subsidiarys dividend policy does not necessarily
constitute fair dealing, but a breach of contract may constitute self-dealing:
Sinclair Oil Corp. v. Levin

o Where the parent dominates the board of the subsidiary, this means that unless the
minority shareholders have been given a chance to ratify the self-dealing transaction,
they can have the court strike the transaction if it is unfair to them. In fact, once the
minority has shown self-dealing, the burden shifts to the parent to show that it
was fair.
o A Director is entitled to the business judgment rule if Ps cannot show that the
dividends resulted from improper motives and amounted to waste.
o The intrinsic fairness standard applies when the parent has received a benefit
to the exclusion and at the expense of the subsidiary.
o As long as everyone receives their proportional shares, there is no self-dealing.
o Avoid being sued by:
Ensuring that they were mindful of the rule of no disproportionate benefits
and respecting the corporate identity by being cautious in appointing directors
Buying out the 3% minority shareholders
Appointing, for example, two neutral directors per year to evaluate decisions
neutrally and take a look at the special issues that arise
Duty of complete disclosure
o Par value: the articles specify that the corporation will not sell the shares for less than
the amount of money specified per share
o Types of stock
Common stock:
shareholders have a right to the residual value of the company, either
in dividends or dissolution
Holders get to vote on BOD, mergers, etc.
Preferred stock:
Shareholders have some preference over common stock holders
normally a right to special dividends that are paid before the common
stock gets paid.
Behaves more like a debt
Has a fixed rate of interest that gets paid to whomever buys the stock
The price doesnt fluctuate nearly as much as regular stock
If the company goes bankrupt and liquidates, the preferred
stockholders get paid before the common stockholders.
A less risky investment than common stock because it has less
volatility and less downside in a bankruptcy
Cumulative stock
Cumulative dividends: if the corporation is unable to make dividend
payments, the payments accrue so that youre entitled to the lump sum
payment of all dividends
Non-cumulative dividends: if the corporation is unable to make the
dividend payments, you wont get the money that year and you dont
have a right to it in the continuing year
Convertible stock
A type of preferred stock

At the election of the shareholder, it can be converted into a different

kind of stock. This allows the holder to capture the upside of common
stock if the stock really takes off, while still maintaining the less risky
structure of preferred stock if they choose not to convert.
A holder can convert his preferred shares into common at what is most
likely a lower price than it trades at currently, and then sell it at the
higher trading price.
People are often willing to pay a premium for it because it offers a lot
of flexibility and room for advantages
Redeemable stock
The BOD can exercise its option to call the stock
There must be some sort of incentive (such as discounted rate or
higher interest rates) to buy this because it carries with it the risk that
the BOD may at any time redeem/call it back
o Controlling shareholders must make full disclosure to their fellow shareholders when
they propose a transaction with those fellow holders.
o When dealing with classes of stock, the directors primary fiduciary duty is to the
common stock: if other classes of stock exist, they exist on more of a contract basis.

Securities Law

What is a security?
o Any investment contract in a common enterprise where a third party is meant to
produce profits for the investor.
Trading in corporate securities takes place in two markets:
o Primary market
Issuer of securities sells them to investors
Regulated by the Securities Act (1933)
Mandates disclosure of material information to investors and
prevention of fraud
o Secondary market
Investors trade securities among themselves without any participation by the
original issuer
Regulated by the Securities Exchange Act (1934)
Created the Securities Exchange Commission as the primary federal
agency charged with administering the various securities laws
o 5 Commissioners, confirmed by the Senate; most work done by
staff, which has three main functions:
o Practice pointer: Be sure to determine whether the investment at issue may be a
security. If it is, the client must register it/do certain things that the federal securities
laws require. If you fail to have your client do this, it could mean malpractice for you.

Rule 10b-5
o The text: It is unlawful for any person to...
Employ any device, scheme, or artifice to defraud
Make any untrue statement of material fact or omission that renders a
statement misleading
Engage in any conduct that would operate as a fraud upon any person in
connection with the purchase or sale of any security
o In 1942, SEC enacted this to prevent insiders from making explicit fraudulent
statements to investors about how badly the company was doing, so that the investors
could buy up the shares cheaply.
o There must be a misstatement or omission of a material fact in connection with the
purchase or sale of a security. If this exists, there is a private right of action.
This covers anyone who makes a misstatement in connection with a security;
its broad and covers a lot of conduct.
o Requirements for a 10b-5 private cause of action:
Intention to defraud
Requires more than negligence
Ps must be able to allege with specificity that Ds acted with the
required state of mind
Proximate cause
The fraud caused the damages
The Basic case below outlines the definition of material
Standard: if there is a substantial likelihood that a reasonable
shareholder would consider it important in deciding whether to buy,
hold, or sell the stock.
Highly dependent upon the facts
Reliance is presumed in cases where the fraud is one of OMISSION.
o An investor cannot prove that she relied on a statement that
was never made.
Where securities fraud is based on a MISSTATEMENT, the investor
ordinarily must prove that she reasonably relied on the misstatement.
Plaintiffs may be able to establish reliance through the use of the
fraud on the market theory: When I purchased/sold stock in X
corporation, I relied upon the current market price being a fair one that
reflected all known information. When D made a misstatement to the
public about Xs prospects, his wrongdoing made the price different
form what it would have been had he fulfilled his obligations.
Therefore, when I bought/sold on the market price, I paid
more/received less because of Ds wrongdoing, and my loss was
caused by that wrongdoing.

This creates a presumption of reliance on Ds

misleading statements, since the efficient market
theory posits that the publicly traded stock incorporates
all available information.
This is what happens in Basic
Information is material to investors if there is a substantial likelihood
that a reasonable shareholder would consider it important in deciding
whether to buy, hold, or sell the stock.
Where its uncertain whether the merger will actually happen, apply the
probability/magnitude approach: balance both the indicated probability that
the event will occur and the anticipated magnitude of the event in light of the
totality of the company.
This is a loose, hard-to-apply standard.
There is no affirmative duty to disclose. The fact that information is
material does not mean that directors have a duty to disclose it.
Fraud on the market theory: As long as the information is out there on the
market where a sophisticated investor can find it, the market price will move
in the direction of a price that incorporates all publicly available information.
Therefore, it created a situation in which everyone relied.

Problems of Control

Proxies, generally
o A proxy is a document whereby the shareholder appoints someone (usually
management) to cast his vote for one or more specified actions. It is a kind of agency
relationship in which the owner of the shares gives someone else the right to vote it.
The proxygiver consents to the proxyholders voting on her behalf.
The person at the shareholder meeting votes by proxy for someone who isnt
at the meeting. No individual shareholder is likely to show up at every
stockholder meeting.
o Why do publicly held companies solicit proxies?
Because few individual stockholders show up.
The annual stockholder meeting is required by law to have a quorum, which
can be set by the articles of incorporation but by default has to be a certain
percentage of the stockholders.
o When do shareholders vote?
Corporations must hold annual shareholder meetings
Special meetings can be declared
For example, if a merger were on the table
Shareholders that hold at least 10% of the shares can cause a meeting
to be held
Only business that has been noticed for a meeting can be conducted at
the meeting

What can a shareholder do if she opposes a course of action?

Vote against it
Sell his shares
Dissenters rights to get shares appraised
o Difficult remedy; lots of procedural hurdles
o How are shareholder votes counted?
One vote, one share
o How is a proxy solicitation regulated?
Rule 14(a) of Federal Securities Law
Proxy fights
o Shareholder democracy is used as a tool to constrain the managements ability to do
certain things by replacing management.
o Insurgents want proxies returned for their slate of candidates. If the incumbent
directors arent doing what they think is in their best interest, one way to change it is
to elect new directors.
o Federal rules on proxy fights
Under Rule 14a-7, the firm can choose to either mail your material and bill
you for the costs or to give you the shareholder list instead. Nothing in federal
law requires the firm to give you the list, but you still have your rights under
state law.
o The reality: proxy battles are rare and expensive
The incumbent slate of directors will almost always win.
They are too expensive; the easier thing is for the shareholder to exit the
If youre a shareholder and you think the business would be worth more under
different management, even if youre right, that money will not actually
benefit YOU it will benefit other people and your value of shares will only
increase slightly.
Collective action problem
A better strategy is to make a tender offer: try to take over the business at a
premium to capture all the benefits

Strategic use of proxies and reimbursement.

Provide interpretive guidance to private parties raising
questions about the application of the securities laws to
a particular transaction
Advise the Commission as to new rules or revisions of
existing rules
Investigates and prosecutes violations of the securities
The existing BOD may use corporate funds for a proxy battle: Levin v. MGM
Incumbents have a right to be repaid whether they win or lose, as long as the proxy battle is
on a policy (and not a personality) issue: Rosenfeld v. Fairchild

o Because D secured shareholder ratification, the business judgment rule serves to

protect it. The presumption is that the BOD made a business decision in the best
interest of the corporation.
o If the insurgents win, they still dont have a right to be paid, but it may be appropriate
if they get shareholder approval on full disclosure.
o The corporation can only reimburse REASONABLE EXPENSES in a proxy contest.
Example: taking important institutional investors out to dinner is reasonable
Shareholder proposals
o Often used:
To require that all directors be elected annually
To cultivate voting to prevent the same person from being the CEO and
Chairman of the board
To remove poison pills: methods a public company uses to deter hostile
Poison pills are normally things like clauses in the charter agreement
that create some sort of overwhelming event that prevents a hostile
acquirer from achieving a majority holding. They make attempted
takeovers more expensive.
o Ex: Clause that states that, if someone buys in and owns, for
example 30% of the stock, the existing shareholders have the
right to purchase double their existing shares at a discount price
o Rule 14a-8
Costs the proposing shareholder almost nothing, and is mainly used by
persons with small stockholdings who seek to influence the corporations
policies concerning matters of great social or political interest.
Where the rule applies, the shareholders proposal must be included in
managements own proxy materials. There is NO COST of sending a letter to
management submitting the proposal.
General requirements
You must have continuously held at least $200, or 1% of the company
in order to submit a proposal
You can submit one proposal per meeting
The proposal can be no more than 500 words
The presumption is that, if you make the proposal, the corporation has
to include it. However, if the corporation thinks it can be excluded, it
must notify the SEC that it intends to exclude it. The shareholder gets
a copy of this notice. The SEC staff will make an initial decision.
o If it decides that the proposal should be excluded, it will send a
no action letter. This is not a promise or a legal ruling, but it
gives the corporation some comfort that this is the SECs
The shareholder may appeal this to the Commission or
to federal court.

Broad proposals are better than specific ones that could be attacked as
interfering with management
Reasons for excluding a proposal (EXCEPTIONS):
The company can omit any proposals that
o ...Relate to less than 5% of its total assets and sales; AND
o Is not otherwise significantly related to the business
This is not a strict economically significant test.
o ...are improper under state law
o ...would cause the company to violate any state, federal, or
foreign law to which it is subject
o ...are a violation of proxy rules
o ...are a personal grievance or special interest
o ...are irrelevant
o ...have an absence of power/authority
o ...relate to management functions
o ...relates to election (specific election for a specific seat)

Shareholder inspection rights

o There is nothing in the federal proxy rules requiring a corporation to give a
shareholder the shareholder list, but the federal rules do not impair any rights the
shareholder may have under state law. Battles for the list are fought under state laws.
o Exchange Act 14-a
Gives the shareholder two options if he wants to send out a proposal:
He can ask the corporation to mail it at his expense OR
He can ask the corporation to provide him with the list of all
o Most corporations dont want to part with the list
Does not address what records must be kept or when shareholders are entitled
to inspect
o Model Code 16.02
Shareholders have an absolute right to the bylaws, articles of incorporation,
minutes of meetings, etc. > fundamental corporate materials
Additional records are given only if the shareholder can show that he has a
proper purpose
There is no requirement that the shareholder have held the stock for a
particular time or that he have a certain number of shares.

P allowed to inspect the corporations stock register to ascertain the identity of fellow
stockholders to inform them directly of his exchange offer in Crane v. Anaconda
DE CODE RULE: Stockholder inspection is allowed for purposes reasonably
related to their interests as stockholders. It will be the shareholders burden to

prove a proper purpose to inspect records OTHER than shareholder lists. It is

the corporations burden to show that the purpose for requesting shareholder
lists is not proper.
The shareholder is presumptively entitled to receive the shareholder
o Its easy to produce.
o Other records may involve the compilation of data that arent
already in list form; other information may be sensitive or
private; shareholders could be trying to make political points
and not be focused on the value of the corporation.
P does not get the list here because his focus is on being an activist not on
the business. He would need to prove an investor purpose.
He could do this by arguing that whatever profit the company is
making in producing fragmentation bombs is outweighed by having its
name attached to the bombs.
o The internal affairs doctrine: the law of a corporations state of incorporation
governs the internal affairs (i.e., voting rights, fiduciary duties) of the corporation.
Access to shareholder lists is an EXCEPTION to the internal affairs doctrine,
because here, MD law would control not NY law. NY law only controls here
because there are NY shareholders whose interests need to be protected.

Close corporations

Control and close corporations

o Close corporation: a corporation that does not have publicly traded stock
Typically consist of only a few family members and friends
Some jurisdictions specify an actual number of shareholders (i.e., DE law
specifies 30)
Looks like a partnership in that the people intend to run the business together
o The law that applies to close corporations is corporate law.
Tension: in partnership, the default rules protect minority interests.
Model Code has some rules that apply specifically to close corporations.

Voting agreements occur where two or more shareholders agree to vote together as a unity
on certain or all matters
o Courts dont have a problem with voting agreements that merely duplicate/combine
things that the shareholders can do anyway (i.e., voting for the BOD).
o Corporate law vests control in the BOD. So, if an agreement takes away the BODs
discretion, the court may throw it out.
o Model Code
7.30: Voting trust
the shareholders who are parties to the voting trust transfer their stock
to the trust, which is controlled by the trustee. The trustee has the
power to vote for the shareholders.
Takes away a lot of control from stockholders.

7.31: Voting agreement

Alternative to the voting trust
Two or more shareholders may provide for the manner in which they
will vote their shares by signing an agreement for that purpose. A
voting agreement is not subject to 7.30. A voting agreement created
under this section is SPECIFICALLY ENFORCEABLE.
o This solves Ringling Brothers, but still put terms in a voting
agreement that specifies that specific performance will occur.
7.32: Shareholder agreements
intended to apply ONLY to closely held corporations (see (d))
o this reflects the modern view that close corporations are
different: the rules of corporate law are problematic when
applied to close corporations. This rule allows close
corporation shareholders to change the rules of the games as
they see fit.
(a) allows shareholders to eliminate the board or restrict its authority
o almost anything goes if you have a proper shareholder
(b) unanimous written agreement required
o valid for 10 years unless otherwise agreed
(c) stock certificates must be marked conspicuously
(e) fiduciary liability attaches to those who control the corporation
o you cannot eliminate the duties to the corporation, to each
other, or ot the company via a contract
(f) limited liability still available
o the investors could have formed a partnership
(g) incorporators can act as shareholders
o you dont have to wait until your corporation is up and running
to have a shareholder meeting to change it to suit your
purposes. You should negotiate what you want before investing
and then draft the bylaws accordingly.
o Shareholder agreements to vote for directors are always ok. Agreement valid in
Ringling Bros v. Ringling.
o In cumulative voting, you multiply your number of shares by the number seats to be
elected. Then you can collude with another shareholder to pile your votes together
and ensure control at least over one group.
Cumulative voting was invented to remedy the inadequate representation of
minority shareholders. It entitles a shareholder to aggregate his votes in favor
of fewer candidates than there are slots available. The result is that a minority
shareholder is far more likely to be able to obtain at least one seat on the
Example: A has 72 votes, B has 28 votes. There are 3 directors to be elected. B
can take his entire package of 84 votes (28 shares x 3 seats) and put it all on
his single favorite candidate, B1. B1 therefore has 84 votes. Now, no matter

how A divides up his 216 votes (72 shares x 3 seats), he cannot come up with
three candidates all of whom beat B1.
o How to avoid the problem to make the vote that was supposed to happen binding and
P and Mrs. Haley could have made this enforceable by a voting trust: under
this, a trustee has the power to vote the shares, which eliminates the problem
of people who decide to breach the agreement.
Downside: as a shareholder, you lose control.
P and D could have given an irrevocable proxy to Loos so that if there were a
disagreement and he had to arbitrate, hed have the power to vote everyones
shares in accordance with his decision.
Practice pointer: If youre Ps counsel, tell her that she should have walked
away from the meeting as she was supposed to once Loos said that it was
Shareholder agreements limiting what directors can do
are not ok in public corporations. Agreement not valid in
McQuade v. Stoneham Practice pointer: What could P have
done to protect himself here?
Put himself into an employment contract that would give him a
generous severance package if he was fired without cause
Create a class of stock that has certain rights associated with it
o Have a redemption right defined that will guarantee P
Make P a venture capitalist
Create a class of stock that can only be held by Ps position.
This is no longer good law: shareholder agreements of this type CAN be
o Shareholder agreements limiting what directors can do are not ok in public
corporations. BUT, this is not the case in closely held corporations, as long as there
are no objecting minority shareholders.
This is the leading non-NY case showing the trend to approve
agreements that interfere to some extent with the discretion of the
BOD, even where no statute expressly authorizes such an agreement.
Agreements that have no termination provisions are problematic, so
the court implies a term based on the wifes life expectancy.
There are no complaining minority shareholders.
In a close corporation, a shareholder agreement that goes beyond what
the shareholders normally do may be enforced, as long as there is no
complaining shareholder who is not a party to the agreement.
Abuse of control
o MA position
Particularly concerned about the minority shareholder
Starts from the view that close corporation people are basically partners
o DE position

You made your bed, now you must lie in it

If you wanted protection, you and your lawyer should have instituted a
buy/sell agreement, an employment agreement, etc.
The courts do not want to give special protection to shareholders who refuse
to protect themselves
Rejects fiduciary duties the relationship is fundamentally contractual
o Balancing test: When a minority challenges a majority action, the MAJORITY must
show a legitimate business purpose for the action. The burden then switches to P to
show that the same purpose could have been achieved in a less harmful way.
Here, therefore the majority shareholder must demonstrate a legitimate
business purpose. (If P was an original investor there is obviously a
component of bad faith in pushing him out of the business.)
What could P have done?
o Brought a derivative suit on behalf of Springside Nursing
Home to argue that the salaries being paid are disguised as
dividends. But, if he wins, the money merely gets paid back
into Springside.
o Had this been a partnership, P would have an equal right of
participation in management and profits, so he 1) couldnt have
been excluded and 2) could have dissolve the business and
forced Ds to buy him out.
Practice pointer: If you represent D, draft the language of the contract
so that there is NO question about its meaning: write, If the EE ceases
to be an EE, either with or without cause, D shall have the option to
repurchase his stock.
o Use the reasonable expectations of the minority test to determine whether there was a
breach of fiduciary duty: Brodie v. Jordan (MA)
The proper remedy for a freeze out is to restore the minority shareholder as
nearly as possible to the position she would have been in had there been no
Analyze the proper remedy for a freeze out in terms of shareholders
reasonable expectations.
What were P and Ds reasonable expectations?
Con of this approach: doesnt tell us whose expectations matter when,
or what makes them reasonable
Obligations of MINORITY stockholders
o A minority shareholder owes a fiduciary obligation to his co-stockholders if he holds
a veto power over corporate actions: Smith v. Atlantic Properties
o If the shareholder has CONTROL, he can exercise it over the corporation and
therefore owes fiduciary duties.
o Practice pointer: always have a buy/sell agreement and do not set up your corporation
in a way that invites deadlock.
Shareholder oppression: summary
o #1: Understand the problem

Majority control of BOD, lack of exit, etc.

In a close corporation, theres no separation of control. The formality of
corporate law can be useful when all the players get along.
o #2: Judicial approaches
Strong fiduciary duty among shareholders in closely held corporations (MA)
Wilkes two-part test
o Balance
The duty is akin to those owed by partners
Reasonable expectations of shareholders (NY, MA?)
What did the shareholders understand at the time of investment?
You made your bed, now lie in it. (DE)
If you want it, bargain for it.
o #3: Statutes
MBCA 14.30(ii): you can petition for dissolution if you can show that the
majority has engaged in acts that are ILLEGAL, OPPRESSIVE, or
MBCA 14.34: Election to purchase: gives the majority an absolute ability to
purchase the complaining stockholders stock at face value
As the D, you can elect to purchase or you can actually litigate
In lieu of dissolution, a corporation or any shareholder may elect to
purchase all shares owned by the exiting shareholder at the fair value
of the shares (usually applies to noncomplaining shareholders if the
parties are unable to agree on a price, the court will determine the fair
value of the shares)

o In most orders of dissolution, the result is a buyout.
o The court can order dissolution if the exit mechanism would produce an unjust result.
o CAs statute: where liquidation is REASONABLY NECESSARY for the protection of
the rights of complaining shareholders, involuntary dissolution is the remedy.
o If all P can show is a personality conflict/family feud, dissolution is not the
appropriate remedy.
o SCs statute: dissolution is appropriate where the directors have acted in a manner
that is illegal, fraudulent, or oppressive.
o The SC statute requires judicial discretion; courts should intervene to prevent
GENUINE DISPUTES rather than get in the middle of POWER STRUGGLES.
o The statute is elastic and must be applied flexibly.
Look at the parties reasonable expectations
Look for classic freeze out patterns