 BASIC CONCEPTS

o Who are the participants (constituencies) in business associations?

 OWNERS
 Can be different names (corporations = shareholders) (partnerships = partners) (LLC = members).
 They have all made an investment and seek a return in such investment. We will be looking at for-
profit businesses
 MANAGERS
 May or may not be the same as the owner.
 They make important business decisions on behalf of the agency.
 Can be different names (corporations = board members/officers)
 EMPLOYEES
 CUSTOMERS
 CREDITORS
 Individuals/institutions that loan money to businesses such as banks or other financing institutions.
 This can also be suppliers
 SUPPLIERS
 Companies that do business with another company and provide the inputs that are needed for the
business to go forward and succeed.
 They can sometimes deliver goods and services based on credit rather than immediate payment
 GOVERNMENT
 Businesses are taxed and regulated by the government
 GENERAL PUBLIC
 If you don’t fall into another category, you still may be impacted by the operations of business
associations either voluntarily or not.
 Example is a business polluting the environment and as a member of the general public you may be
affected by this.
o Focus of Business Associations law is on FORMATION, OPERATION AND DISSOLUTION of businesses
o What business issues must be resolved in business enterprises?
 RETURN ON INVESTMENT
 Who is entitled to receive a return on the investment if the company is profitable and in what
amount.
 RISK OF LOSS
 If the company is not profitable, who bears the risk of loss
 CONTROL
 Who is entitled to make decisions about the business and who has control rights
 DURATION
 How long will the business association continue to exist and how will it come to an end.
o Legal rules used to achieve business objectives
 Agency
 Partnership
 Limited Liability Company
 Corporations
 GOALS
o Study law & policy of agency, partnerships, limited liability companies & corporations
o Read & interpret cases, statutes, regulations, business organizational documents
o Spot issues in planning & litigation context
o Solve hypothetical problems
 Types of Legal Materials
o Cases
 Agency – Restatement of Agency 2nd & 3rd
o Statutes and regulations
 Uniform Partnership Act
 Uniform Limited Liability Company Act
 Delaware Corporation Code
 Securities Act of 1933, Securities Exchange Act of 1934, and related regulations
o Note:
 Agency is important for all types of businesses.
 Businesses in the US are organized as a sole proprietorship
  Sole proprietorship = an individual or group of individuals doing business, but they have not formed a
specific type of business association to conduct the business
o Organizational documents (Organizational documents spell out the specifics of businesses and how they will be
operated)
 Partnership
 Partnership Agreement
o There is an agreement that is entered into
 Certificate of Limited Partnership
o Government filing that is required which is filed with the secretary of state in the jurisdiction
where the partnership is setting up
 Limited Liability Companies
 Operating Agreement
o Agreement entered into
 Certificate of Formation
o Government filing
 Corporations
 Certificate of Incorporation
o Government filing
 By-Laws
o Government filing
 Case Analysis
o Facts
 Parties & their course of dealing
 Cause of action
 Relief sought
o Legal issue on appeal
 May be multiple but focus on the main issue focused on in the book
o Arguments of the parties on appeal
o Holding: Who wins and why?
 What is the rationale of the decision and why did they decide as they did?
 What does the majority decide and why?
 If there is a concurrence or dissent, what is the main point of disagreement?
o Lawyer as planner
 Can this case help us practice better preventive lawyering?
o Test your own reaction
 Was the case correctly decided by the majority?
 If you disagree with the opinion, what is the basis for your objection?
 Can you suggest a better approach?
 MODULE 1 AGENCY
o Issues that we will discuss within agency
 How does the agency relationship arise?
 Under what circumstances can an agent bind a principal in contract and in tort?
 Liability to third parties in contract
 Estoppel and ratification
 What duties does the agent owe the principal?
o Examples:
 Susie is accepted to law school and applies to rent an apartment in a nearby building. Sam, the building
manager reviews Susie’s application, checks her references, verifies her bank information and finding
everything in order, signs the lease on behalf of Sally, the owner.
 Sally is the principal
 Sam is the agent
 Susie is the third party
 Sally decides to install a security system in the building and hires Samantha, a security system specialist, to
select the best system for her building and then arrange for the purchase and installation.
 Sally is the principal and Samantha is the agent
 Sally decides to move to another city and lists the building with Sylvester, a licensed realtor. He has her
power of attorney to sign documents and conclude a sale.
 Sally is the principal and Sylvester is the agent
o Gorton v. Doty
 This talks about the creation of the agency relationship
 Facts:
 Doty was a teacher at Soda Springs High School
 The football team was going to another city to play a game. They were being transported in private
cars.
 Doty asked Garst if there was enough cars and he said they needed one more.
 Doty said Garst could use her car if he drove it. No compensation was given. The school paid for
gas.
 Gorton was a team member who was riding in Doty’s car.
 There was a car crash. The coach was killed and Gorton was injured.
 Who were plaintiffs in original action?
 Plaintiffs were injured player and his father Gorton
 Who were defendants?
 Defendants were the teacher who lent her car (Doty) and the coach who was driving and died (Garst)
 Who won at trial?
 Plaintiffs were awarded $5K for damages for bills
 What is the issue on appeal?
 The issue is whether there was an agency relationship between Garst as the agent and Doty as the
principal
 Why is a finding of agency necessary for plaintiff to win the case?
 Doty wasn’t driving and was not negligent. Garst, driver, was the negligent party. To find Doty
liable, the plaintiffs needed to tie her in using a legal theory, being the respondents superior principle
of vicarious liability. Under this, a master/employer is liable for torts committed by a
servant/employee. In this case, the court uses principal/agent terminology instead of master/servant
employer/employee
 What are plaintiffs’ arguments?
 Plaintiffs argue that Garst was an agent of Doty, who was the principal. Under Respondent superior,
this can lead to liability of the principal if the agent is negligent.
 What are defendants’ arguments?
 Defendant argued that there was no principal agency relationship. Instead, defendant argued the
legal relationship being a loan of the car from Doty to Garst. This loan would not give rise to
liability on Doty.
 Who wins and why?
 Gorton wins
 What test does the court use to determine whether an agency relationship existed?
 Restatement 2nd §1 test.
o 1. Manifestation of consent by principal
o 2. That the agent shall act on principal’s behalf and subject to principal’s control
o 3. Consent by the agent so to act for the principal
 How does the court apply the test to the facts of the case?
 1. Manifestation of consent because she volunteered the use of her car rather than driving it herself
and made it subject on the fact that Garst drove the car.
 2. Coach was to be subject to Doty’s control because she set a condition on the use of the car, being
that Garst is the driver rather than one of the players.
 3. Coach agreed to act on Doty’s behalf because he used the car to get back and forth to the game
and he was the one driving it.
 How does the court address the defendant’s gratuitous bailment argument?
 The court rejected defendant’s loan argument because there was no evidence of a loan. The only
evidence was a conversation when asking if they had all the cars necessary and they didn’t.
 What are the main points of the dissent?
 There was not strong evidence of control. In order for there to be an agency relationship, there must
be stronger evidence that the agent was acting at the request of, at the direction of, and was
commanded so to act by the principal. The coach was acting on behalf of the school, not on behalf of
Doty. Finally, because Doty had insurance on the car, she likely didn’t have to pay and this probably
influenced the jury.
 Analysis Questions
  1. Did the dissent disagree about what test should be used or about the way the test should be
applied?
o The dissent disagreed with the way the test should be applied
 2. Majority stated: Not essential that there be a contract between principal and agent. What is the
relevance of this statement?
o The court meant that there need not be a formal written agreement. All agency relationships
imply some agreement between the parties because the relationship cannot come into
existence unless both parties agree that the agent is to act on behalf of the principal and
subject to the principal’s control. The relationship must have consent but it doesn’t need to
be contractual, so contract law requirements doesn’t need to be met.
 3. After the case is decided, Mrs. Doty asks you for advice. She wants to lend her car to the new
football coach to transport students to the game but wants to avoid personal liability? What advice
do you give her?
o You could have a disclaimer clause which states that there is no principal agency
relationship between the parties. These are not always enforced by courts but if the court
decides to, they are effective. They could also try and eliminate the aspect of control because
it was this control of coach being the driver that satisfied the test for the agency relationship.
Finally, Doty could have obtained insurance to reduce liability.
 4. Did the court have a policy agenda in using agency law to impose liability on Mrs. Doty, the
owner of the car? If so, what policy was it trying to implement?
o The court was possibly interested in telling people to take out insurance in these situations
so the court was trying to enforce this policy. Know this was not the main reason for the
court’s decision.
o FORMATION OF AGENCY RELATIONSHIP
 Restatement 2nd of Agency, §1 [Restatement 3rd of Agency, §1.01]
 1. Manifestation of consent [assent] by principal
 2. That the agent shall act on principal’s behalf and subject to principal’s control
 3. Consent [assent] by the agent so to act for the principal
o Hypothetical #A1
 Tabitha and Thomas exchange the following emails:
 Tabitha: I would like to hire you as my chauffeur when I visit Paris next week. My friend Teresa
recommended you.
 Thomas: Yeah, I remember Teresa. But I am already booked for next week.
 Tabitha: I need someone to drive me to my business meetings and to show me the sights. Will you
find me another licensed and insured limousine driver who will charge the same as you?
 Thomas: Sure.
o Has an agency relationship been created?
 Yes
 There is a manifestation of consent by the principal
 Tabitha asks Thomas to find a driver
 It is subject to the principal’s control
 Tabitha sets a perimeter of price and qualification that he has to pick from
 There is consent by the agent
 Thomas says sure
 Third party would be the new driver that Thomas finds
o Who is the principal?
 Tabitha
o Who is the agent?
 Thomas
o What are the terms?
 Licensed and insured limousine driver
 Charge the same as Thomas
 Drive Tabitha to business meetings and show her the sights
o Jenson Farms v. Cargill
 Involves business dealings
 Who were plaintiffs in original action?
 Farmers who grew and sold grain to Warren. They had a contract with Warren that involved delayed
payment and they were never paid.
 Who were defendants?
 Cargill and Warren (at time of suit, Warren declared bankruptcy and was unable to pay farmers)
 What was the course of dealing between the parties?
 Cargill was in need of supply and was doing business with Warren, who had contacts with farmers
and could purchase the grain and sell it to Cargill who could then distribute the grain. One dealing
was the purchase of grain by Cargill from Warren. Another was that Cargill made loans to Warren
for working capital purposes for business in day to day relations.
o Buyer/supplier relationship = strong connection & Cargill was buying 90% of Warren’s
grain
o Debtor/creditor relationship
 What contracts were entered into?
 They entered into a security agreement. The amount of money was increased over the years of what
could be borrowed by Warren. Warren also entered into contracts with the Farmers where the
farmers delivered the grain but didn’t receive immediate payment.
 What is the issue on appeal?
 Whether Cargill became liable as a principal on the contracts that were made by Warren and the
Farmers through its course of dealing.
 Why is a finding of agency necessary for plaintiffs to win?
 Cargill was not a party of contracts with the farmers, only Warren was. The farmers need to find a
link of Cargill on liability of the contracts.
 What are plaintiffs’ arguments?
 Plaintiff uses principal agency theory to make Cargill liable. They say Cargill was a principal
because of its control of Warren.
 What are defendants’ arguments?
 Defendant argues that there was no principal agency relationship between Warren and Cargill. They
say there was 2 parts to the relationship, the buyer/supplier and the debtor/creditor, no agency was
involved and they shouldn’t be liable.
 Who wins and why?
 The court says there was a principal agency relationship with Cargill as the principal and Warren as
the agent. Therefore, Cargill was responsible for the unpaid debt.
 What legal tests does the court refer to?
 The test for creation of an agency relationship and focuses on control
 How does it apply those tests?
 It focused on the control aspect.
 1. It said Cargill manifested its consent by directing Warren to implement recommendations which
Cargill made to Warren.
 2. Warren acted on Cargill’s behalf by getting grain for Cargill which were financed by Cargill.
 3. Cargill exercised control by interfering with the internal affairs of Warren.
 The court gave 9 factors which were actions taken by Cargill as evidence of control of business.
Many of these factors were consistent with a creditor/debtor relationship, not necessarily a principal
agent relationship.
o (1) Cargill’s constant recommendations to Warren by telephone
o (2) Cargill’s right of first refusal on grain
o (3) Warren’s inability to enter into mortgages, to purchase stock or to pay dividends without
Cargill’s approval
o (4) Cargill’s right of entry onto Warren’s premises to carry on periodic checks and audits
o (5) Cargill’s correspondence and criticism regarding Warren’s finances, officers’ salaries
and inventory
o (6) Cargill’s determination that Warren needed strong paternal guidance
o (7) Provision of drafts and forms to Warren upon which Cargill’s name was imprinted
o (8) Financing of all Warren’s purchases of grain and operating expenses and
o (9) Cargill’s power to discontinue the financing of Warren’s operations
 How does it assess the arguments of the parties?
 The court ignored Cargill’s argument.
 Analysis Questions
 1. What could the farmers have done to protect themselves from the risk of nonpayment?
o They could have insisted on cash payment instead of delayed payment, especially because it
was known that Warren was having financial issues.
  2. What could Cargill have done to ensure grain bought from Warren was paid for?
o They should have demanded evidence of payment as a condition for further financing.
However, this would have shown more control on Cargill’s part.
o AGENCY VERSUS DEBTOR-CREDITOR
 Restatement 2nd of Agency, §14O
 Creditor who assumes control of his debtor’s business may become a principal with liability for acts
and transactions of debtor in connection with his business
o Notes:
 The court, in rejecting Cargill’s argument, discussed 2 other sections of the
restatement. This is one of them
 This recognizes that under some circumstances, the creditor can become responsible
for the debtor’s actions.
 Comment: merely exercising veto power by preventing purchases or sales above specified amounts
does not thereby become a principal
 Comment: Creditor becomes a principal when it exercises de facto control over conduct of debtor
o Notes:
 These are the circumstances that can make a creditor responsible as a principal.
 Veto power = power to say yes or no
 The court relied on the de facto control
o AGENCY VS. BUYER-SUPPLIER
 Restatement 2nd of Agency, §14K
 One who contracts to acquire property from a third person and convey it to another is the agent of
the other only if agreed that he is to act primarily for the benefit of the other and not for himself.
 Comment: Factors indicating that one is a supplier and not an agent are:
o 1. Receives fixed price for property no matter what price paid by him
o 2. Acts in own name and receives title to property later transferred
o 3. Has an independent business in buying and selling similar property
 Notes:
 This case issue was that Warren was not an independent business and
instead the relationship that was formed was a principal agency relationship
o Attribution Rules
 Issue: Does the agent have the authority to bind the principal to third party and third party to principal?
 This is in a contract situation
 Qui facit per alium facit per se
 We are looking at the ability of an agent to bind a principal in a contract scenario
 He who acts through another does the act himself (translation)
 If you appoint an agent to act on your behalf, you might be liable for the acts of the agent
 If there is an agency relationship found
 Actual authority
o Express
o Implied
 Apparent authority
 Inherent authority
 If there is NOT an agency relationship found
 Estoppel
 Ratification
 When talking about authority for an agent to bind a principal we will look at 2 things:
 1. has an agency relationship been created?
 2. if so, does the agent have the authority to do a particular act on behalf of the principal? If so, what
type of authority?
o AGENCY-Actual Authority
 Restatement 2nd of Agency, §7 – Authority defined
 Power of an agent to affect legal relations of a principal done in accordance with the principal’s
manifestation of consent to the agent
 Restatement 2nd of Agency, §26 – test for Creation of Express Actual Authority
 1. Objective manifestation of the principal
 2. The agent’s reasonable interpretation of that manifestation
 3. The agent’s belief that she is authorized to act for the principal
 o Notes:
 The creation of express actual authority is the same as the creation of the agency
relationship
o AGENCY-Incidental (Implied) Actual Authority
 Restatement 2nd of Agency, §35 – When Incidental Authority is Inferred
 Authority for acts which are incidental, usually accompany, or are reasonably necessary to
accomplish a transaction
o Notes:
 Implied authority fills the gaps in express authority
 Express actual authority is present in some cases but principals don’t usually instruct
their agents on every detail of what is needed to carry out a task given to the agent
 Even if the agent wasn’t specifically directed by the principal to take a certain
action, the principal can still be bound under this theory by such act if the agent was
acting within the general scope of authority given to the agent and not against
authority that was granted
o Mill Street Church v. Hogan
 Actual authority
 Facts:
 There was an accident that occurred while the church was being painted and the workman was
injured
 Mill street church hired Bill Hogan to paint the church. Bill needed help and hired his brother.
 30 min in, brother was injured. Brother applied for workers comp
 His ability to collect was dependent on whether he was an employee and whether he was an
employee was dependent on whether Bill had the authority to hire his brother.
 First decision said brother wasn’t an employee
 Second decision reversed this finding and ruled brother was an employee
 Church and their insurance company are challenging this decision claiming that brother was not an
employee
 Who were the parties and what was their course of dealing?
 Mill street church hired Bill Hogan for paint job. Bill hired his brother, Sam Hogan, for help.
 How does the authority issue arise in this case and why is it important to the outcome? 
 The question of this case was whether Sam was an employee of the church. The question of
authority of an agent was important because Sam wasn’t hired by the church itself, he was hired by
his brother, who was an agent of the church. The case turns on whether Bill had the authority to act
on behalf of the church and whether that authority extended to allow him to hire his brother
 What theory of authority is discussed?
 Implied actual authority (it is not expressed because the church did not tell bill to hire Sam)
 What needs to be proved to establish such theory of authority? 
 The court states that implied authority is actual authority circumstantially proven which the principal
actually intended the agent to possess and includes such powers necessary to carry out the duties
actually delegated
 Burden of proof is on the person claiming that there was an agency and resulting authority
 What evidence was introduced in support of a finding of authority?
 One of the church elders discussed with Bill that he would need help painting the highest part of the
church and the name of someone else came up but the church did not direct Bill to hire this other
person and they even said that he can be hard to reach sometimes.
 Who wins this case and why?
 The court concluded that Bill had implied authority to hire his brother, Sam
 In the past, the church allowed Bill to hire Sam, or others, if he needed help on a project
 Bill was never expressly told to hire the other guy that was mentioned (Gary)
 The church elder told Bill he could hire anyone he wanted to
 Bill needed to hire an assistant to complete the job properly
 Ultimately, Sam was considered an employee and was therefore entitled to workman’s comp for his
injuries
o Hypothetical #A2
 Paul owns an apartment building and hires Ann to manage it.
 Paul tells Ann to hire a company to cut the grass. Ann hires ABC Landscaping and they cut the
grass. Must Paul pay the bill?
 o Yes because his instruction to Ann created express actual authority
 For express actual authority, simply look to the agreement made
 Ann decides to hire a janitor to clean the building without checking with Paul beforehand. Must Paul
pay the bill?
o Likely yes. This would be incidental or implied authority
o She had implied actual authority to use all means necessary to carry out the particular result
expressly mandated by the principal
o This is implied because the acts are necessary to the proper management of the building
 Paul tells Ann not to hire a janitor, although all apartment managers in the area customarily hire
janitors. Ann hires a janitor. Must Paul pay the bill?
o Yes even though there is no actual authority.
o An agent will not have actual authority if the principal has given the agent clear instruction
not to use some particular means to accomplish a task
o She does have apparent authority because it was customary in the area to hire janitors
o 370 Leasing Corporation v. Ampex Corporation
 Apparent authority
 Relationships among the parties?
 370 Leasing Corporation = buyer under sales contract for computer equipment with seller (plaintiff)
 Ampex Corporation = seller who was to deliver equipment purchased by 370 to Electronic Data
(defendant)
o NOTE:
 Since Ampex is a corporation and not an actual person, it can only act through
agents. In this case, Kays was the agent that the court focuses on
 Electronic Data Systems = third corporation who had an agreement with 370 to lease the computer
equipment that was being sold from Ampex to 370
 Joyce = owner of 370 (plaintiff)
 Kays = employed by Ampex as salesman
 Mueller = employed by Ampex; Kay’s boss
 Facts:
 First contract was between Ampex and 370 to buy 6 computer equipment units for $100K each.
Payment was made with $150K down payment and the rest to be paid over 5 years. This means that
this was more than just a sales contract. It was a sales contract with financing terms
 Joyce was also entering into a lease contract with Electronic Data to lease the equipment to them
 A purchase order agreement contract was delivered to Joyce by Kays but it was never signed by
Ampex and the computer equipment was never delivered
 Joyce is suing Ampex for damages for breach of contract
 How does the authority issue arise in this case and why is it important to the outcome? 
 Authority issue arises because Ampex claimed in the suit that it was not bound by the contract
entered into with 370
 They claimed that Kays didn’t have authority because he was a salesman and salesmen couldn’t
enter into contracts with financing terms as this one had
o NOTE: there was also an issue of contract law in this case.
 Whether the purchase order document that was sent by Kays to Joyce for signature
was an offer to sell that was accepted when Joyce signed the document or whether it
was an offer to purchase when signed by Joyce which required a later act of
acceptance by Ampex
 The court determined that the contract was an offer to purchase and
therefore it was necessary to find an act of acceptance by Ampex to argue
that there was a contract and Ampex was bound to deliver the equipment
 Ampex argued that Kays did not have actual authority
o NOTE: if only actual authority was recognized under the law, Ampex would have won the
case. But this is not the only type of authority that is recognized
 What theory of authority is discussed?
 Apparent authority
 The issue is whether Kays, an Ampex salesman, had apparent authority as an agent to enter into the
contract
 What needs to be proved to establish such theory of authority? 
 
An agent has apparent authority sufficient to bind the principal when the principal acts in such a
manner as would lead a reasonably prudent person to suppose that the agent had the authority he
purports to exercise
 Absent knowledge on the part of third parties to the contrary, an agent has the apparent authority to
do those things which are usual and proper to the conduct of the business which he is employed to
conduct
 What evidence was introduced in support of a finding of authority?
 Kays was employed by Ampex with the title of salesman and this was reasonable for Joyce, as a
third party, to assume that a salesman had the authority to bind his employer to sell and Ampex did
nothing to try and dismiss this reasonable inference
 Also, the actions and inactions of Ampex provided a further basis for Joyce’s belief that Kays was
authorized to act on behalf of Ampex
 Who wins this case and why?
 The court held that Kays had apparent authority to bind Ampex
 It further concluded that the letter sent to Joyce could reasonably be interpreted as a promise to ship
the 6 computer units on the dates specified in the letter and on the terms previously set out in the
document executed by Joyce and submitted to Ampex. This was an act of acceptance by Ampex
 Therefore, the appeals court upheld the district court’s finding that a contract was formed and Joyce
wins the case
 Analysis Questions
 What was Joyce’s function? Was he a sales representative of Ampex? A purchasing agent of EDS?
Neither?
o Joyce was the owner of 370 and the only employee.
 What was Kays’s position and function?
o Kays was a salesman for Ampex and he entered into the contract with 370/Joyce
 Kays did not have authority to enter into the contract. Do you find this surprising as to the agreement
to sell the core memory units or the agreement to extend credit, or both?
o Both because you would think that a company would want their salesmen to be able to act
on their behalf to sell more products
 What were the defendant’s manifestations that supported a finding of apparent authority?
o Kays was employed by Ampex with the title of salesman and this was reasonable for Joyce,
as a third party, to assume that a salesman had the authority to bind his employer to sell and
Ampex did nothing to try and dismiss this reasonable inference
o Also, the actions and inactions of Ampex provided a further basis for Joyce’s belief that
Kays was authorized to act on behalf of Ampex
 Planning Questions
 1. What should Ampex have done to protect itself?
o They could have given better training to train on limits of authority of a salesman
o They could have adopted a contract manual that all employees would get a copy of and in
this they would spell out the company policies and any limitations that existed within the
corporation
o They could have used a form contract which included language that only a contact manager
was allowed to sign a contract with financing terms
 2. What should Joyce have done to protect itself?
o He could have asked Kays for evidence of his authority to bind Ampex (this is customary for
contracts involving corporations)
o AGENCY – Apparent Authority
 Restatement 2nd of Agency, §8 & §27 – Apparent Authority; Creation of Apparent Authority
 (1) Objective manifestation from one party
o The one party we will call the apparent principal
 (2) Which reaches a third party
 (3) Causing the third party to reasonably believe that another party is authorized to act for the
apparent principal
o The another party is the apparent agent
o Applying this test to the facts of the case:
 Objective manifestation must come from Ampex
 Reaching the third party would be reaching Joyce
 Joyce had to reasonably believe that Kays was authorized to act for Ampex
  NOTE:
 With apparent authority, an agent can bind a principal even if the agent’s actions are outside the
scope of actual authority that has been granted as long as there is a manifestation that can be traced
to the principal, reaching a third party, and it is reasonable for the third party to believe that the agent
has authority, then the principal may be bound
 Restatement 3rd of Agency, §2.03
 Third party reasonably believes actor has authority to act on behalf of the principal and that belief is
traceable to the principal’s manifestations
o AGENCY – Apparent Authority – What counts as a manifestation by the principal?
 Manifestation sufficient to meet the test for creation of apparent authority can include both direct
and indirect forms of communication
 Commentary: Manifestation may consist of written or spoken words or other conduct (what constitutes a
manifestation)
 Direct communications from principal by letter/word of mouth
 Authorized statements of the agent
 Documents or other indicia of authority given by the principal to the agent
 Communications from third persons who have heard of the agent’s authority from authorized or
permitted channels of communication
 Appointing a person to a position like manager or treasurer which carries with it generally
recognized duties
 Communication to the public through signs or advertising
 Continuously employing the agent
o Hypothetical #A3 (where apparent authority applies even without actual authority)
 Octavia is an art collector and asks Oscar to bid on some original Picasso drawings at an upcoming auction
at Christel’s, a famous auction house. Octavia sends a letter to Christel’s stating as follows: Oscar will
represent me and may bid for me at your upcoming auction. In the past, Oscar had placed bids up to $1M for
Octavia. However, Octavia tells Oscar not to bid more than $750K for any item at this auction. Oscar attends
the auction and bids $1M for a drawing entitled Blue Acrobat. He wins the bid. Octavia tries to renege on the
sale. What result?
 What is Octavia’s argument likely to be claiming that she doesn’t have to pay?
o Octavia would likely claim she doesn’t have to pay because she expressly told Oscar not to
bid more than $750K and he bid more
 Is there an agency relationship?
o Yes
o Agent is Oscar
o Principal is Octavia
o Third party is the auction house
 Did Oscar have actual authority?
o Oscar probably did not have actual authority because there was no objective manifestation
from Octavia to Oscar to be able to bid $1M, she expressly stated otherwise.
o Since Oscar was expressly given directions not to do something, implied actual authority
would likely fail as well
 Did Oscar have apparent authority?
o There probably was apparent authority because Oscar was authorized to act on behalf of
Octavia, this did reach a third party (the auction house), and the third party could reasonably
believe that Oscar was authorized to act for Octavia in this manner because of his ability to
place bids this high in the past.
o The letter is the objective manifestation
o The auction house had no notice of the limit in place
 Who should win and why?
o Octavia should still have to pay because Oscar did have apparent authority based on his past
actions to bid $1M for this painting
o Watteau v. Fenwick
 Note: this is an English case, but US courts also recognize inherent authority
 Inherent Authority
 Parties:
 Humble = former owner of Victoria Hotel; manager of pub at time of supplies being ordered
 Victoria Hotel = pub/beerhouse
  Brewers = owners of Victoria Hotel; defendants
 Suppliers of Cigars, Bovril and Other Articles on credit = suppliers who were also creditors;
plaintiffs in original action
Facts:
 This was a suit for collection of an unpaid debt which was owed to the suppliers of cigars and more
 Brewers told Humble that he was to purchase everything he needed for the pub from them but he
was allowed to buy bottled ales and mineral water from other suppliers.
 Humble violated this restriction and started buying from the firm of suppliers articles that were not
approved by defendants (cigars, Bovril, and other articles)
 The cigars were such as would usually be supplied to and dealt in at such an establishment
 Plaintiffs were trying to get paid for delivery of these products and sued defendants
 How does the authority issue arise in this case and why is it important to the outcome? 
 It arises because Brewers are being sued for payment and they refuse to pay suppliers
 This is important because Humble acted on defendants behalf without their authority to do so
 Defendants argue that Humble had no authority to buy any goods for the business except bottled ales
and mineral waters and all other goods were to be supplied by defendants themselves. Since Humble
ordered prohibited items, defendants were not required to pay for such items
 What theory of authority is discussed?
 Inherent authority
 Note:
o Actual authority would not prevail in this case because Humble acted against instructions
and he did something that was prohibited by the principal (Brewers)
o Does not rely on manifestation by principal
 What were the arguments of the parties?
 Defendants arguments
o Only apparent authority could be used to hold Brewers liable. Liability of a principal for the
acts of his agent, done contrary to his secret instructions, depends upon his holding him out
as his agent—that is, upon the agent being clothed with an apparent authority to act for his
principal
 Plaintiffs arguments
o It was necessary to show that the goods supplied were ordinarily used in the business and
were within the reasonable scope of the agent’s authority
 What needs to be proved to establish such theory of authority?
 Under inherent authority, the focus is on showing that what the agent did on behalf of the principal
was customary for someone in that position
 What evidence was introduced in support of a finding of authority? 
 Humble, by ordering cigars and Bovril, was acting in a way that was customary for bar owners and
that the suppliers were unaware of any restrictions on his authority
 Who wins this case and why?
 The suppliers/creditors win the case (plaintiffs)
 The court said that once it was established that the defendant was the real principal, the ordinary
doctrine as to principal and agent applies and that the principal is liable for all the acts of the agent
which are within the authority usually confided to an agent of that character, notwithstanding
limitations, as between the principal and the agent, put upon that authority
 Secret limitations between the principal and the agent cannot be used to defeat a third party’s claim,
otherwise plaintiffs would always lose cases where there was an undisclosed principal.
 Analysis Questions:
 Is there any basis in this case for holding the defendants liable on a theory of apparent authority?
o Apparent authority would not work to hold Brewers liable because there was no holding out
and the principal was undisclosed and therefore couldn’t make a manifestation that reached
the third party (the suppliers who extended credit)
 What negative consequences would arise from a decision going the other way in this case? 
o If Brewers would have been able to avoid liability for the debt.
o The principal could avoid liability in all cases by hiding its identity. This would be unfair to
creditors and would interfere with business transactions and certainty in business dealings
and it would not facilitate commerce
o AGENCY – INHERENT AUTHORITY
 Restatement 2nd of Agency, §8A, §161, §194, §195
  A principal becomes liable for acts done on his account that usually accompany or are incidental to
transactions agent authorized to conduct
o What authority is CUSTOMARY for someone in that position/whether the authority
exercised by the agent would be considered customary or usual for someone to have in that
position
 Policy reasoning = this exists because it is necessary for the protection of persons harmed by or
dealing with a servant or other agent
 §8A = inherent agency power is a term used in the restatement of this subject to indicate the power
of an agent which is derived not from authority, apparent authority or estoppel, but solely from the
agency relation and exists for the protection of persons harmed by or dealing with a servant or other
agent
 §194 = an undisclosed principal is liable for acts of an agent done on his account, if usual or
necessary in such transactions, although forbidden by the principal
o Principal is liable for acts of an agent which are customary for someone in that position
 §195 = an undisclosed principal who entrusts an agent with the management of his business is
subject to liability to third persons with whom the agent enters into transactions usual in such
business and on the principal’s account, although contrary to the directions of the principal
o A principal is liable to third parties who an agent, who is entrusted with management of
principal’s business, enters into a transaction customary to that business even if contrary to
principal’s directions.
 Under US law, courts tend to restrict the use of inherent authority to agents who fall within the category of
general agents or general managers
 Restatement (Second) of Agency §3(1): General Agent is an agent authorized to conduct a series of
transactions involving continuity of service.
o They may have a title of general manager or CEO
 Restatement (Second) of Agency §3(2): Special agent is an agent authorized to conduct a single
transaction or a series of transactions not involving continuity of service.
 Note:
o Under US law, courts have applied inherent authority to hold principals liable for actions of
an agent, even in situations where the principal is disclosed, as long as the actions are within
the customary range of such agent’s authority
o Special agent = someone for just a specific job
 Restatement 3rd of Agency Approach
 Declines to recognize inherent authority
 BUT it states rule for undisclosed principals that achieves the same result:
o §2.06 Liability of Undisclosed Principal:
 (1) An undisclosed principal is subject to liability to a third party who is justifiably
induced to make a detrimental change in position by an agent acting on the
principal’s behalf and without actual authority if the principal, having notice of the
agent’s conduct and that it might induce others to change their positions, did not
take reasonable steps to notify them of the facts
 (2) An undisclosed principal may not rely on instructions given an agent that qualify
or reduce the agent’s authority to less than the authority a third party would
reasonably believe the agent to have under the same circumstances if the principal
had been disclosed.
 They are trying to move away from inherent authority and try to resolve all issues under apparent
authority. Examples:
o Restatement 3rd of Agency, §1.03 Manifestation
 A person manifests assent or intention through written or spoken words or other
conduct
o Restatement 3rd of Agency, §2.03 Apparent Authority
 Third party reasonably believes actor has authority to act on behalf of the principal
and that belief is traceable to the principal’s manifestations
 Commentary: A principal’s manifestation to an agent may differ from the
principal’s manifestation to a third party and carry different legal consequences. If
the principal places a person in a position or office with specific functions or
responsibilities, from which the third party will infer that the principal assents to
acts by the person requisite to fulfilling same, the principal has manifested such
assent to the third party.
  NOTE: even though the third restatement doesn’t recognize inherent authority, we will still use it in
this course and for the exam we will need to know all three theories of authority (actual, apparent,
inherent)
o Nogales v. Arco
 This case illustrates a distinction between apparent authority and inherent authority and it indicates that there
are real consequences in terms of the type of proof and the level of proof that might be required to use such
theories of authority in a lawsuit
 Facts:
 This case was about a foreclosure suit that was for ARCO against NSC for nonpayment of a loan
made by ARCO to NSC to construct a truck stop. ARCO prevailed in that case.
 In the first case ARCO was plaintiff and NSC was defendant. Now in the case we are reading, NSC
is plaintiff and ARCO is defendant.
 When NSC was sued in the foreclosure suit, they filed a counterclaim against ARCO claiming that
ARCO’s representative (Tucker) promised it a discount on diesel fuel that was not actually given
 The trial court instructed the jury on both actual and apparent authority but refused to instruct the
jury on inherent authority
 Issue on appeal:
 Whether the trial court erred in refusing to instruct the jury on inherent authority
 Conclusion:
 The appeals court decided there was no error
 How does a modern U.S. court distinguish apparent and inherent agency?
 The jury instructions for apparent authority focused on manifestations made by the principal and the
issue was whether the principal held out the agent as having authority and whether those
representations were made by officers or agents of the principal that had authority to make them.
 The jury instruction on inherent authority focuses on the customary powers of an agent so the
question becomes are these actions, which usually accompany or are incidental to transactions,
which the agent is authorized to conduct?
 JURY INSTRUCTION ON APPARENT AUTHORITY
 An employee agent has apparent authority to make an agreement binding on his employer-principal
if, but only if, the latter through officers or other agents authorized to do so has held out that the
employee-agent has such authority.
 In this case, in order to find Tucker had apparent authority you must find that ARCO had actually or
by necessary implication represented to the officers of NSC that Tucker had such authority, and you
must find further that such representations were made by officers or other agents of Arco having
authority from the company to make them.
 REQUESTED JURY INSTRUCTION ON INHERENT AUTHORITY (but refused by the trial court)
 ARCO’s employees who dealt with Service Center in the claimed oral agreements made ARCO
responsible for any such agreements if they are acts which usually accompany or are incidental to
transactions which the agent is authorized to conduct, even if the employees were forbidden to make
such agreements, if persons from NSC reasonably believed that ARCO’s employees were authorized
to make them, and has no notice that ARCO’s employees were not so authorized.
 Analysis question #2:
 What proof/evidence might the plaintiff have offered in support of apparent authority?
o Focus is on manifestations of the principal through other agents that reaches the third party
o Proof of statements made by Tucker’s superiors at ARCO stating that he was the person who
was authorized for ARCO to deal with NSC. These statements could be viewed as a
manifestation from the principal as required for the theory of apparent authority
 What proof/evidence might the plaintiff have offered in support of inherent authority?
o Proof that agents like Tucker generally have authority to grant discounts on behalf of
ARCO. This would constitute evidence that it was customary for someone like Tucker to
have such authority as required for the theory of inherent authority
o Botticello v. Stefanovicz
 Ratification
 Parties
 Mary and Walter Stefanovicz (defendants)
o Husband and wife who owned a farm as tenants in common
o Walter leased to Anthony with an option to purchase without consulting Mary
 Anthony Botticello (plaintiff)
o He occupied the farm under the lease and paid rent and made improvements
 o At the end of the lease he sought to exercise his option to purchase, husband and wife
refused to allow him to purchase
o He sued for specific performance, possession of the premises, and damages
o He also made 2 alternative arguments:
 (1) whether there was an agency relationship such that Walter could bind Mary to
the contract
 The trial court said there was an agency relationship
 The appeals court reversed this and said there was no agency relationship
that existed
 (2) whether Mary ratified the contract
 The trial court said there was ratification
 The appeals court reversed and said there was no ratification
 How does the agency issue arise in this case and why is it important to the outcome? 
 The farm was held in joint ownership and the court says the two were tenants in common but only
Walter signed the contract. He only had an undivided half interest in the property and couldn’t
convey the property without Mary’s agreement
 This made the issue whether Walter was acting as Mary’s agent to bind her to the contract
 What needs to be proved to establish an agency relationship?
 (1) whether there was a manifestation by the principal that the agent will act for him
 (2) whether there was acceptance by the agent of the undertaking
 (3) whether there was an understanding between the parties that the principal will be in control of the
undertaking
 What evidence on agency was relied on by the trial court, which found for plaintiff?
 When the farm was purchased and when the couple transferred some property on prior occasions,
Walter had handled many of the business aspects including making payments for taxes, insurance
and the mortgage
 The couple had discussed the sale of the farm and Mary had stated that she would not sell the farm
for less than $85K
 Who wins on the agency issue on appeal? Why? 
 The appeals court found that Walter was not Mary’s agent
 The existence of an agency relationship is a question of fact with the burden of proof on the plaintiff
and it must be proven by a fair preponderance of the evidence.
 The existence of marital status cannot in and of itself prove the agency relationship. Nor does the
fact that the defendants owned the land jointly make one the agent for the other
 Mary’s statement about the price of sale is by no means the equivalent of an agreement to sell for
that amount
 Also, the fact that one of the spouses tends more to business matters than the other does not
constitute the delegation of power as to an agent
 Although Mary may have consented in Walter’s handling of many business matters ,Walter never
signed any documents as agent for Mary, Mary always did so
 Why is ratification discussed in this case and why is it important to the outcome?
 If agency failed as an argument, he must then prove his alternative argument of ratification
 This would be needed to establish that Mary had agreed to sell the farm even though she didn’t sign
the contract
 What needs to be proved to establish ratification?
 Ratification consists in the affirmance by a person of a prior act which did not bind him but which
was done or professedly done on his account
 Ratification requires:
o Acceptance of the results of the act
o With an intent to ratify and
o With full knowledge of all the material circumstances
 In order for there to be valid ratification, at the time of the alleged affirmation by the principal, the
principal must know or have reason to know all the material facts related to the transaction
 What evidence on ratification was relied on by the trial court, which found for plaintiff? 
 The trial court found that there was ratification and concluded that Mary ratified the contract by
receiving and accepting payments by plaintiff and by acquiescing in his substantial improvements to
the farm
 Who wins on the ratification issue on appeal? Why?
  Appeals court found that facts do not support the conclusion of ratification
 The finding neither indicates an intent by Mary to ratify the agreement, nor establishes her
knowledge of all the material circumstances surrounding the deal
 At most, Mary observed the plaintiff occupying and improving the land, received rental payments
from the plaintiff from time to time, knew that she had an interest in the property, and knew that the
use, occupancy, and rentals were pursuant to a written agreement that she had not signed
 Receiving benefits and not repudiating the contract does not constitute ratification. Before the receipt
of benefits may constitute ratification, the other requisites for ratification must first be present
 Is any relief available to plaintiff?
 Walter may be liable to Anthony for breach of contract in the form of damages
 What should plaintiff have done to avoid the problem that arose in this case?
 He should have conducted a title search on the property to discover who was the owner and who
should be a signatory to the contract. If he would have done this he would have discovered the joint
ownership and would have known that Walter alone couldn’t convey an interest in the property
 He also could have asked for Mary’s signature on the contract instead of assuming that Walter could
act for both parties
o RATIFICATION
 RESTATEMENT 2ND OF AGENCY, §82, §83, §91
 Retroactive approval of a previously unauthorized act
 Affirmance through words, conduct, silence indicating consent
o Note: affirmance can occur in a variety of ways
 It can be express or implied
 Express affirmation = words or conduct
 Implied affirmance = where someone accepts benefits at a time when it is
possible to decline to accept such benefits provided the other requirements
of ratification are also met.
o This can also occur through silence or inaction. It can also occur
when someone brings a lawsuit to enforce a contract
 Requirement of intent and knowledge of all material facts
 RESTATEMENT 3RD OF AGENCY, CHAPTER 4 – RATIFICATION
 Timing: Ratification cannot follow events that would cause ratification to have adverse/inequitable
effects on a third party
o Timing of ratification is important
o Hypothetical #A4 (Analysis and Problems p. 28)
 1: P’s husband A enters into a contract for P’s new book with ABC Book Publishers. P receives check from
ABC as advance on the book that A has sold and P cashes it. P tries to sell book to another publisher and
argues that A had no authority to act for her. What result?
 ABC would win
 This is implied affirmance by P through accepting benefits of the transactions in circumstances that
she cannot deny that she knew there was a contract with ABC
 2: Same facts but P thinks that the check she received was for royalties from another book and says she has
no reason to know it was an advance on her new book. What result?
 It is likely that P will win because she didn’t have knowledge of all material facts, as required by the
test for ratification
 3: A (deranged fan) poses as P’s butler and hires landscaper to cut P’s lawn. P arrives home after they have
finished. Pam thanks them. What result if she refuses to pay saying A had no authority?
 On the ratification issue, P would probably win because the affirmation must come at a time where it
is possible to decline the benefits
 You cannot be held responsible when you never had an opportunity to turn down the benefits given
by the third party
 4: Investor P instructs broker A to put her $ into U.S. treasury bonds (this is a low risk investment). A puts
her $ into high risk stocks. P receives brokerage statement but says nothing (wait and see attitude). When
stock drops in value, she complains saying A had no authority to buy stock. Can P recover?
 A will likely win
 This is implied affirmation through silence or inaction
 A principal cannot wait forever to repudiate to see if there is a favorable result
 The repudiation must come at the time that the principal becomes aware of the transaction
  5: P owns Whiteacre. A (without authorization) sells Whiteacre to Ted. Fire destroys Whiteacre. P expressly
affirms sales contract. Ted says she’s too late. Who wins?
 Ted would win because ratification would not be effective where it would negatively impact the
rights of an innocent third party due to material change and circumstances
 The principal cannot enforce the agreement entered into by A unless the third party decides that they
want to be bound by that agreement
 Material change in circumstances between the time of the transaction and the time of the ratification
o Hoddeson v. Koos Bros.
 Estoppel
 Facts/parties
 Mrs. Hoddeson decides she wants to purchase furniture and goes to Koos Bros to do so and she goes
with her family.
 She finds a bedroom set and locates someone on the floor who agrees to help her with her purchase
 She does not know who this salesman was but he accepted her order and she puts money down for
the purchase of the bedroom set
 She did not get a receipt for the purchase and never received the furniture
 She then spoke with the store who had no record of sale or payment
 She then brought this suit against the store
 How does the authority issue arise in this case and why is it important to the outcome? 
 Koos denies that the person who took her money and order was an employee of the store and they
deny that they were liable to deliver the furniture
 Mrs. H is trying to establish that the salesman was authorized to bind Koos Bros
 Mrs. H has the burden of proving the agency relationship
 What theories of authority were advanced by Mrs. Hoddeson in this case?
 They are using the theory that the man that sold the furniture was an employee of Koos and therefore
an agent
o Express actual authority
o Implied authority
o Apparent authority
 What needs to be proved to establish such theories of authority?
 Elements of creation of an agency relationship (restatement §1)
 Elements of Actual authority (whether express or implied)
o Express authority = real authority which has been definitely granted
o Implied authority = to do all that is proper, customarily incidental and reasonably
appropriate to the exercise of the authority granted
 Elements of apparent authority
o Where the principal by words, conduct, or other indicative manifestations has held out the
person to be his agent
 Was Mrs. Hoddeson successful in establishing any of the theories of authority? Explain why or why not.
 No because they were unable to positively identify the person she thought she had paid the money to
 The person she delt with was an imposter who gained access to the selling floor
 She did not meet her burden of proof since she didn’t establish the imposter was an agent
 There was no actual authority because of this
 There might have been apparent authority but there was no manifestation by the principal, only a
manifestation by the agent that he was authorized and this was insufficient
 The alternative theory of liability suggested by the court is called estoppel. What is the justification for
imposing liability under such theory? 
 The justification for estoppel is that it would be unfair to have the customer lose, due to deception,
that the proprietor allowed to exist
 What would Mrs. Hoddeson need to prove on remand to justify an estoppel-based verdict in her favor? 
 The elements of estoppel are:
o The principal creates an appearance of authority in the purported agent
o The third party reasonably in good faith acts in reliance on such appearance of authority
o The third party changes her position in reliance upon the appearance of authority
o ESTOPPEL
 Restatement 2nd of Agency, §8B
 Principal allows another (who has no authority) to create appearance of authority and does not
correct the misimpression
  Reasonable belief by third party
 Change in position of third party (reliance)
 NOTE:
o Reliance and giving cash is important because this shows she acted in reliance
 Restatement 3rd of Agency, §2.05
 Liable to a third party who has made a detrimental change in position due to belief it was for another
person’s account
 Such person intentionally or carelessly caused such belief
 With notice of such belief, such person did not take reasonable steps to notify them of facts
o Agency Review Question #1 (this is also how we should answer essays on the exam)
 Note that this review question focuses on the creation of an agency relationship and the question of the
authority of an agent to bind a principal in contract
 Cast of Characters
 CCC = contracted by gov to repair bridge
o Agents = employees (includes officers)
 Both Lucille and Jimmy could fall into the category of agents because the
corporation is not a person and can only act through agents
 The board decides to repudiate both contracts
o Lucille = chief executive; not a member of the board
 She was authorized to enter into subcontracts without approval of the board
 She was allowed to delegate part of such responsibilities to others
 She was not authorized to purchase the cement needed for the project
o Jimmy = appointed by Lucille to be on team
 Work on hiring trucking services to pick up cement and deliver it to the work site
 He could sign contracts on CCC’s behalf but any questions should be directed to
Lucille
 He needs to find reliable companies charging the lowest possible price
 He had to hire 3 separate companies and no company could be assigned more than
40% of the work
o Lucille’s secretary
 Tells ATC rep that Jimmy has authority to hire cement trucks for project
 ATC = contract given by Jimmy to supply cement trucks for project
o Offers 10% discount as long as it supplies trucks for 60% of the job
o Jimmy accepted this bid without talking first to Lucille
 Sam Sly = contract given by Lucile to supply cement for project
o Needed an immediate answer
o Lucille accepted offer without talking to chairman
o Lucille said she would tell them when they needed the delivery but they delivered it the next
morning and the security guard allowed them in
 Issue
 Is CCC liable on contract with ATC?
o Was there an agency relationship?
o Did the agent have authority to bind the principal in contract?
 Is CCC liable on contract with Sam Sly?
o Was there an agency relationship?
o Did the agent have authority to bind the principal in contract?
 Rules of Law
 Agency: Were Lucille and Jimmy agents?
o Restatement (Second) of Agency §1 test
 1. Manifestation of consent by principal
 2. That the agent shall act on principal’s behalf and subject to principal’s control
 3. Consent by the agent so to act for the principal
 Theories of authority: Did Lucille or Jimmy have authority to bind CCC?
o Actual authority (express or implied tests)
 Express actual authority:
 1. Objective manifestation of the principal
 2. The agent’s reasonable interpretation of that manifestation
 3. The agent’s belief that she is authorized to act for the principal
  Implied actual authority:
 Implied authority is actual authority circumstantially proven which the
principal actually intended the agent to possess and includes such powers
necessary to carry out the duties actually delegated
 Even if the agent wasn’t specifically directed by the principal to take a
certain action, the principal can still be bound under this theory by such act
if the agent was acting within the general scope of authority given to the
agent and not against authority that was granted
o Apparent authority (3 part test from restatement)
 (1) Objective manifestation from one party (the principal)
 (2) Which reaches a third party
 (3) Causing the third party to reasonably believe that another party (the agent) is
authorized to act for the apparent principal
o Inherent authority (restatement test)
 A principal becomes liable for acts done on his account that usually accompany or
are incidental to transactions agent authorized to conduct
 Analysis of Facts
 Contract with Sam Sly
o Was Lucille an agent?
 She was given consent by the board (they voted to allow her to enter into contracts
and delegate)
 The board told her to act on the corp’s behalf to enter into subcontracts and delegate
responsibilities to others
 She believed she had this power
 Yes she was an agent
o What authority did she have?
 Actual express authority?
 She was expressly told that she was NOT authorized to purchase the cement
needed for the project
 Because of this, no objective manifestation of the principal and therefore no
actual express authority
 Actual implied authority?
 The principal did not intend for Lucille to buy cement and therefore there is
no actual implied authority either
 Because she went against a restriction, she did not have any actual authority
(express or implied)
 Apparent authority?
 Lucille was CEO, which should give a third party a reasonable belief that
she can enter into contracts on the corp’s behalf
o Yes there was apparent authority likely
 Inherent authority?
 She got a call from them, which shows he knew she was CEO and she was
the point person to talk to
 Contract with ATC
o Was Jimmy an agent?
 Lucille told him to hire concrete mixing trucks to pick up cement from the CCC
storage site and deliver it
 He was acting on behalf of the corporation to sign contracts and he was told he
could do this
 He accepted by doing what he was told and entering into negotiations
 Yes he was an agent
o What authority did he have?
 Actual express authority?
 He was expressly told not to let one single company handle more than 40%
of the work so there was no actual express authority
 Actual implied authority?
 The principal did not intend for him to allow a company to have more than
40% of the work because it was expressly said otherwise so no actual
implied authority
  Apparent authority?
 Lucille’s secretary told ATC that Jimmy did have the authority to enter into
such contracts so this did lead ATC to believe that Jimmy did have the
authority
 Inherent authority?
 It is unlikely this would prevail because he was just given authority in this
one circumstance so it would probably not be customary for him to be able
to enter into such contracts
 Conclusion
 Is CCC liable on contract with Sam Sly?
o Yes she is an agent
o Yes she has apparent and likely inherent authority
 Is CCC liable on contract with ATC?
o Yes he is an agent
o Yes he has apparent authority
o Humble Oil v. Martin
 Mere employee (therefore Humble was liable under Respondeat Superior)
 Parties
 Humble Oil
o Defendant/petitioner
o Owner of filling station where vehicle had just been dropped off
 Mrs. Love
o Defendant/petitioner
o Owner of car which hit the family
 Mr. Martin & Daughters
o Plaintiffs/respondents
o Victims of the car hitting them
 W.T. Schneider
o Operator of Humble Oil
o Independent contractor
 W.V. Manis
o The only station employee present at the time of the accident
 Facts
 Love left her car at Humble Oil, which was operated by Schneider, to be worked on
 She forgot to set the breaks and no employee checked to make sure this had been done either
 Her car began rolling and injured Martin family in the process
 The accident occurred before any employee touched it
 Martin family now sues for damages
 Background
 Humble owned the station and the equipment, which it leased to Schneider
 Humble sold S gas and other products for resale
o Hoover v. Sun Oil
 Independent contractor
 Parties
 Sun Oil Company
o Owner of service station & most equipment
o Defendant
 Mr. Hoover
o Plaintiff
o Owner of car which caught fire & injured party
 James F. Barone
o Operator of service station
o Independent contractor
o Defendant
 John Smilyk
o Employee of Barone
o Allegedly caused the fire
 o Defendant
 Facts
 Sun leased property to Barone, operator
 S was on duty and dropped a cig while filling up a car owned by Hoover
 Hoover sued for damages
o Humble Oil and Sun Oil Compared
 These are companion cases. What is the issue raised in both cases?
 Relates to the fact that both plaintiffs named the large oil companies that had leased the stations to
the operators as parties
 Whether or not the large oil companies could become liable for the negligence that happened at the
gas stations?
 Whether the gas station operators were independent contractors or whether they were employees of
the oil companies
o If they are found to be employees, the oil companies will be held liable
o If they are found to be independent contractors, the oil companies will not be held liable
 What is the legal test used by the court?
 Respondeat Superior
 The courts focused on the difference between employee status and independent contractor status
 A master (employer) is liable for the torts of its servants (employees)
o A master/servant (employer/employee) relationship exists where the servant (employee) has
agreed
 (a) to work on behalf of the master (employer) and
 (b) to be subject to the mater’s (employer’s) control or right to control the physical
conduct of the servant (employee)
 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 may or may not be an agent
o Agent-type independent contractor = one who has agreed to act on behalf of another, the
principal, but not subject to the principal’s control over how the result is accomplished
o Non-agent independent contractor = one who operates independently and simply enters into
arm’s length transactions with others
 Did Schneider and Barone view themselves as independent contractors or servants?
 They saw themselves as independent contractors & owners who ran their own businesses
 The courts were not bound by their own views though and the court was able to make their own
determination
 What kind of evidence supports their belief that they were independent contractors?
 The courts in both cases looked at evidence coming from the contracts of the parties
 Humble (Schneider):
o Neither Humble, Schneider, nor the station employees considered Humble as an employer or
master
o The employees were paid and directed by Schneider individually as their boss
o A provision in the agreement expressly repudiates any authority of Humble over the
employees
o Schneider is required to pay all operation expenses
 Sun Oil (Barone):
o The service station is a one-company outlet and represents to the public that it sells not only
Sun’s products but also their services
o The contract fails to establish any other relationship other than landlord/tenant and
independent contractor
o Both parties have a mutual interest in the sale of Sun products and the success of Barone’s
business
o Sun had no control over the details of Barone’s day to day operation
 What kind of evidence undercuts their belief?
 Humble (Schneider):
o Paragraph 1 of the contract includes a provision requiring Schneider to make reports and
perform other duties in connection with the operation of said station that may be required of
him from time to time by Humble
o Humble is required to pay 3/4 of one of the most important operational expense items
 o Humble had strict supervision and financial control of the enterprise
o Schneider had little business discretion except to hire, fire, compensate, and supervise a few
employees
o Humble furnished all equipment & controlled hours of operation
o The contract was terminable at the will of Humble
o Schneider was required to do anything that Humble might tell him to do
 Sun Oil (Barone):
o Sun sales rep offered his advice on all phases of his operation but Baron was under no
obligation to follow the advice
 What was the result in each case?
 Humble:
o Humble was found to be liable for the actions of Schneider and the other employees because
the court viewed Schneider as an employee and not an independent contractor
 Sun Oil:
o Sun Oil was not liable because the court viewed Barone as an independent contractor
 What reasons were given for the holding in each case?
 Humble:
o The result turned on Humble’s legal right to control the manner in which Schneider
performed his job
o Humble closely supervised and controlled the way in which Schneider acted
o This, the court concluded, made him an employee instead of an independent contractor
 Sun Oil:
o The outcome turned on control
o Barone set the hours of operation himself & was allowed to sell competing products
 Can the cases be distinguished on their facts? If so, how?
 Note the important factor of control of the day to day operations:
o Reporting obligations
 Schneider had periodic reporting requirements (evidence of strong financial control)
 Barone did not have any reporting requirements but was subject to periodic
inspections
o Obligation to follow directions
 Schneider was required to follow company recommendations about how to operate
his business
 Barone did not have to follow company recommendations and these were just
looked at as suggestions
o Payment of operating expenses
 Humble paid a large portion of the operating expenses in the form of paying utility
bills
 This was not the case in Sun Oil
o Title to gas and oil
 The party who bears the risk of loss tends to hold more of an ownership interest and
therefore an indication of whether that person was operating independently or a
mere employee of someone else
 Humble retained title to the petroleum products being sold by Schneider meaning
Humble retained the risk of loss on these products
 Barone took title to the petroleum products so if there was a loss, he would suffer
the loss, not Sun Oil (this is more characteristic of an independent owner rather than
an employee)
o Right to sell competing products
 This would be more indictive of an independent contractor rather than an employee
 This right existed in Sun Oil but not Humble
o Station ownership
o Calculation of rent payments
o Hiring of employees
o Set hours of operation
 In Humble, Humble set the hours of operation
 Barone set the hours
o Right to terminate the contract
  There were equal termination rights in Sun Oil
 Humble had stronger termination rights
o Use of logo on signs and uniforms
 How should Humble Oil restructure its business model to lower risk of liability for negligence of station
operator?
 Humble could loosen its strict control over the station operators
o Strong financial control with reporting requirements
o Making suggestions rather than recommendations/requirements
o Letting the station operator set the hours of operation
o Respondeat Superior Liability
 Restatement 2nd of Agency, §219
 Master is subject to liability for torts of his servants committed in the scope of employment
o NOTE: today we would refer to master/servant as employer/employee
 This only applies to employer/employee relationships
o Definitions of Master & Servant
 Restatement 2nd Agency, §2
 Master = 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
 Servant = 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
 NOTE
o Right to control physical conduct = right to control day to day operations of another
individual
o This is a deeper form of control than what is required in a principal/agency relationship
o Definition of Independent Contractor
 Restatement 2nd Agency, §2
 Independent contractor = 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 may or may not be an agent
o Servant or Independent Contractor?
 Definition of Servant, Restatement 2nd of Agency,§220 (2) – Some Relevant Factors
 Extent of control over details of work (day to day operations)
o Right to terminate relationship
o I’ll make him an offer he can’t refuse
 Engaged in distinct business or occupation
o Separate from the business/occupation that is being run by the other person
 Whether occupation is usually directed by employer or independently carried out
 Level of skill
 Who supplies the tools and place of work
 Length of time of employment
 Method of payment (hourly or per job)
o Hourly = likely employee
o Per job = likely independent contractor
 Is work part of regular business of employer
o Or some special task that an independent might be called in to perform
 Do parties believe they are creating master/servant relationship
 Is the principal in business
o Hypothetical #A5
 Jack is offered the opportunity to deliver pizza for Vito’s Pizzeria. He signs a written agreement stating:
 Jack is an independent contractor. Either side may terminate their relationship at any time with no
hard feelings. Jack will drive his own car, which shall be insured, and will dress appropriately in
clean clothing at all times. Jack may choose his own delivery routes and will be paid on a per job
basis. Jack is free to engage in any other occupation he chooses. Each Friday afternoon, Vito will
give Jack a proposed schedule for the next week and Jack will notify Vito by Saturday afternoon if
he disagrees with the schedule, which he is under no obligation to accept.
 In fact, Jack has only held odd jobs in his life and was out of work for a year before he got the delivery job.
He knows that the last person who held this position was fired for failing to accept Vito’s proposed schedule.
If Jack negligently causes an accident while delivering the pizzas, can the victim successfully sue Vito?
  Apply 220 factors and divide facts into two categories of employee or independent contractor
o Employee?
 Rule:
 Master = 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
 Servant = 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
o Independent contractor?
 Rule:
 Independent contractor = 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 may or may not
be an agent
 Leading factors
 Method of payment (hourly or per job)
 Do parties believe they are creating master/servant relationship
 Who supplies the tools and place of work
o Factors:
 Extent of control over details of work (day to day operations)
 He makes his own schedule
 Engaged in distinct business or occupation
 He can engage in other occupations & it is not a distinct business
 Whether occupation is usually directed by employer or independently carried out
 Level of skill
 Not much skill needed
 Who supplies the tools and place of work
 He supplies his own car
 Length of time of employment
 Either party may terminate the relationship
 Method of payment (hourly or per job)
 Per job work
 Is work part of regular business of employer
 Delivering pizza should be part of the regular business
 Do parties believe they are creating master/servant relationship
 The contract states that their intention is an independent contractor
 Is the principal in business
o Franchises
 Franchise = licensing system used in business (a contractual arrangement)
 The two parties to the contract:
 Franchisor = party that grants franchise rights by contract
o Franchisor obligations = license use of valuable name, logo and business system that
belongs to the franchisor
 Note that title of the property is not being transferred, it is just being used under a
license agreement
 Franchisee = party that contracts for franchise rights
o Franchisee obligations = payment of royalties & advertising fees; must operate within the
franchise system (set forth in contract and/or operating manual)
 These are in exchange for receiving the license
 Legal aspects:
 State contract law
 State franchise regulation
o Requires disclosure of risks of franchise relationship
 Franchisor-franchisee relationship, because of the strong control, can give rise to liability claims against the
franchisor for franchisee negligence based on agency principles
o Murphy v. Holiday Inns, Inc.
 Facts
 Kyran Murphy = plaintiff
  Holiday Inns = defendant
 Defendant is a franchisor who provides a well-known name, quality assurance, advertising, and a
system of running a business in return for the receipt of fees from the franchisee
 The franchisees themselves own and operate various hotels/motels around the country
 Plaintiff slipped and fell while at a hotel owned by franchisee Betsy-Len Motor Hotel Corporation
 The cause of the accident was a maintenance issue that was not corrected
 There was a water leak that was not cleaned and plaintiff slipped and fell on it
 Holiday Inn didn’t own the hotel, Betsy-Len owned and operated the premises
 What events led to the lawsuit?
 A slip and fall case that was attributable to negligence of the franchisee
 Failure to correct the maintenance problem
 Holiday Inns and Betsy-Len were in a franchise contract
 What is the issue in this case?
 Whether Holiday Inn, franchisor, can be liable for damages that were caused by the negligence of
Betsy-Len, franchisee
 What theory was advanced to find liability?
 Respondeat Superior would have to apply (which requires a particular type of agency relationship)
 The court referred to the creation of an agency relationship
 What type of evidence does the court look at?
 The court talks about the license agreement which the court declared to be the franchise contract
 The contract involved granting to the franchisee the use of the Holiday Inn system under a license
arrangement
 It provided for the payment of franchise fees (royalties)
 Included control provisions under what the franchisee must do under the contract
 How does plaintiff use this evidence to support its claim?
 Plaintiff focused on the language where the licensee is directed to implement the licensor’s system:
o That licensee construct its motel according to plans, specifications, feasibility studies, and
locations approved by licensor
o That licensee employ the trade name, signs, and other symbols of the system designated by
licensor
o That licensee pay a continuing fee for use of the license and a fee for national advertising of
the system
o That licensee solicit applications for credit cards for the benefit of other licensees
o That licensee protect and promote the trade name and not engage in any competitive motel
business or associate itself with any trade association designed to establish standards for
motels
o That licensee not raise funds by sale of corporate stock or dispose of a controlling interest in
its motel without licensor’s approval
o That training for licensee’s manager, housekeeper, and restaurant manager be provided by
licensor at licensee’s expense
o That licensee not employ a person contemporaneously engaged in a competitive motel or
hotel business and
o That licensee conduct its business under the system, observe the rules of operation, make
quarterly reports to licensor concerning operations, and submit to periodic inspections of
facilities and procedures conducted by licensor’s representatives
 What is the test used by the court?
 Respondeat Superior
 The existence of a master/servant relationship, which involves a deeper form of control than does an
agency relationship
 This requires control over the physical conduct
 Control over the day to day operations
 Whether Holiday Inn exercised control or the right to control over the methods or details of doing
the work
 What is the holding in this case?
 There was no control by Holiday Inn over the methods or details of running the business
 As a result, the court found no master/servant relationship that was created under the franchise
agreement
 Because there was no master/servant relationship, there was no liability on Holiday Inn’s part
  What are the main aspects of the court’s analysis?
 Control exercised by Holiday Inn was system-wide standardization control only
 It was the type of control needed to ensure uniformity of business identity, uniformity of commercial
service, and target public good will within the Holiday Inn franchise system
 The regulatory provisions did not give defendant control over the day to day operation of Betsy-
Len’s motel
 While it was true that Holiday Inn was empowered to regulate the architectural style of the buildings
and the type and style of furnishings and equipment, defendant was given no power to control daily
maintenance of the premises nor business expenditures nor charging for accommodations nor
hiring/firing nor profit shares
 Takeaway
 Even though there was strong control under the franchise arrangement it was not the kind of control
that gives rise to Respondeat superior liability, especially because the accident was caused by an
aspect of the operation that Holiday Inns did not have control over.
 Keep in mind that the accident was caused by an aspect of the operation that Holiday Inn did not
have control over
o Miller v. McDonald’s Corp.
 What events led to the lawsuit?
 Plaintiff, Miller, bit into a heart stone that was in a burger
 The store was operated by a franchisee
 McDonald’s was franchisor
 Trial court granted summary judgment for McDonalds saying they did not own or operate the
restaurant so plaintiff appealed
 McDonalds has 2 different types of restaurants (franchises or independently owned)
 What is the issue in this case?
 Whether McDonalds, the franchisor, can be liable for damages caused by the negligence of 3K,
franchisee
 Whether summary judgment was appropriate in this case
 Whether a jury might find that the elements of actual or apparent agency are present
 What theories were advanced to find liability in this case?
 Actual agency
 Apparent agency
 If plaintiff is to win, what must be proved under each of these theories?
 Actual agency
o There must be a right to control by McDonalds
o Control must be greater than standardization or standard setting control
o McDonalds must exercise control over the day to day operations
o The relationship that would make defendant liable requires that the defendants have the right
to control the method by which 3K performed its obligations under the agreement
 Apparent agency
o One who represents another as his servant or agent
o Causing a third party to justifiably rely on care or skill of such agent
o Is liable for harm caused by lack of care or skill of such agent
 What type of evidence does the court look at?
 The court looks at license agreements and the actual practices of the parties
 What is the holding in this case?
 Actual agency
o The trial court, in granting summary judgment, gave inappropriate relief because the jury
could find that the defendant retained sufficient control over 3K’s daily operations and
therefore an actual agency relationship existed
 The agreement did not simply set standards that 3K had to meet. Rather, it required
3K to use the precise methods that defendant established
 Thus, there is evidence that defendant had the right to control 3K in the precise part
of its business that allegedly resulted in plaintiff’s injuries
 Apparent agency
o The trial court’s grant of summary judgment was inappropriate because there was an issue of
fact about whether defendant held 3K out as its agent
  Everything about the appearance and operation of the restaurant led plaintiff to
believe that it was connected with McDonalds
 Appeals court reversed the judgment of the lower court
 Footnote about apparent agency v. apparent authority
 Apparent agency is a distinct concept from apparent authority. Apparent agency creates an agency
relationship that does not otherwise exist, while apparent authority expands the authority of an actual
agent. In this case, the precise issue is whether 3K was defendant’s apparent agent, not whether 3K
had apparent authority
 What risk mitigation strategies would you recommend to McDonald’s?
 Include a disclaimer of an agency relationship in the license agreement
o A disclaimer clause would be a clause where the parties would specifically state that there is
no agency relationship
o The purpose of such clause would be to try to avoid Respondeat superior liability
o However, courts are not bound by such disclaimers
 To post a sign in the restaurant stating that the franchisee is a separate legal entity from the
franchisor
o This also will not always be viewed as sufficient to mitigate liability
 Should McDonald’s reduce the amount of control it exercises over franchisee to avoid the risk of liability?
 This could be dangerous because the franchisee could take actions that are not consistent with
upholding the name of the franchise and could degrade the franchisor
o Apparent Agency
 Restatement 2nd of Agency, §267
 One who represents another as his servant or agent
 Causing a third party to justifiably rely on care or skill of such agent
 Is liable for harm caused by lack of care or skill of such agent
 Restatement 3rd of Agency,§7.08
o AGENCY – SCOPE OF EMPLOYMENT (for vicarious liability to be imputed, the employee’s conduct must be
within the scope of employment)
 Restatement 2nd of Agency, §228
 (1) When conduct is within the scope of employment
o Of the kind the is employed to perform
o Within authorized time and space limits
o Purpose to serve the master
o If force intentionally used, use of force is not unexpectable by the master
 (2) Conduct of a servant is not within the scope of employment if it is different in kind from that
authorized, far beyond authorized time or space limits, or too little actuated by a purpose to serve the
master.
 Restatement 2nd of Agency §229
 (1) To be within the scope of employment, conduct must be of same general nature as that
authorized, or incidental to the conduct authorized.
 (2) Factors to be considered for scope of employment:
o Act commonly done by servants
o Time, place & purpose of act
o Previous dealings between principal & agent
o How business is apportioned between different servants
o Act outside of enterprise of master or not entrusted to servant
o Master expectation that act will be done
o Similarity to act authorized
o Instrumentality of harm was furnished by master
o Extent of departure from normal methods
o Is act seriously criminal
 Restatement 3rd of Agency, §7.07
 Employer vicariously liable for torts of employee acting within scope of employment
 Scope of employment = performing work assigned by employer or engaging in course of conduct
subject to employer’s control
 Scope of employment ≠ occurring within independent course of conduct not intended by employee
to serve any purpose of the employer
o Hypothetical #A6 (whether the restatement provisions about scope of employment help in determining whether
Respondeat superior should apply)
 Buddy is the baker’s assistant at Carlo’s Bake Shop. Early one morning, while kneading dough, he notices
that a stray cat has wandered into the kitchen. He picks up the cat and, without looking outside first, throws
her out the back door and into the alley. The cat lands on a crate of fine china belonging to the neighboring
housewares store, causing the crate to fall over, breaking the contents.
 Is Carlo’s Bake Shop liable for the damage?
 Is Buddy acting within the scope of his employment?
o He was on the premises of the job and he was working when he saw the cat
o Part of his job is to keep the kitchen in a professional and safe manner
 On his way home from work that same day, Buddy stops at Barnes & Noble bookstore. He wants to read up
on baking and he finds several books on that topic. On the way to the cash register, he bumps into a huge
stack of boxes filled with books because he was not watching where he was going. The stack of boxes falls
on the foot of a bookseller, breaking it in two places.
 Is Carlo’s Bake Shop liable?
 Is Buddy acting within the scope of employment?
o Majestic Realty v. Toti Contracting
 Negligence of an independent contractor & an exception to the general rule
 What events led to the lawsuit?
 Majestic owned a building that Bohen was the tenant of
 Parking Authority bought buildings on the street which Toti was supposed to demolish for them
 During the demolition, Toti made a mistake and damaged Majestic’s building
 There was testimony of the Toti employee that he messed up
 Trial court held that Toti contracting was independent and that Parking Authority couldn’t be liable
for the negligent act of its independent contractor
 What is the legal issue?
 Whether the Parking Authority can become liable for the negligence committed by Toti
 What is the well-settled rule that typically governs negligent conduct of an independent contractor?
 There is no vicarious liability because Respondeat superior liability arises where there is a
master/servant or an employer/employee relationship
 Where a person engages a contractor, who conducts an independent business by means of his own
employees, to do work not in itself a nuisance, he is not liable for the negligent acts of the contractor
in the performance of the contract
 What exceptions to that rule do courts in this jurisdiction recognize?
 (1) where the landowner retains control of the manner and means of the doing of the work which is
the subject of the contract
o If the injury occurred where there was a lot of control, the owner may be liable
 (2) where he engages an incompetent contractor
o Could be liable if incompetent
 (3) where the activity contracted for constitutes a nuisance per se (inherently dangerous activity)
o Retained to perform inherently dangerous work
o This is the grounds where the court decides the case
 What is this court’s decision?
 Taking down a building in a city neighborhood is an inherently dangerous activity
 What is its reasoning?
 Restatement 416
 When hiring an independent contractor to conduct an inherently dangerous activity, the landowner is
liable if the contractor is negligent in conducting such inherently dangerous activities
 Toti was negligent because there was a standard procedure for taking down the building safely and
this procedure was not followed
o AGENCY – Liability for Torts of Independent Contractor
 Servant vs. Independent Contractor
 Restatement 2d Agency, §2, §220
 General rule: One who hires an independent contractor is not liable for such contractor’s negligent actions
 Exceptions:
 (1) retain control of manner and means of doing work;
 (2) engages an incompetent contractor;
 (3) inherently dangerous activity
  Restatement 2nd Torts §416: One who hires an independent contractor to conduct inherently dangerous
activity requiring precautions is liable if contractor is negligent in taking precautions
 Distinguish ultra-hazardous activities
 Ultra-hazardous activities are described as one which
o (a) necessarily involves a serious risk of harm to the person, land, or chattels of others which
cannot be eliminated by the exercise of the utmost care and
o (b) is not a matter of common usage
o Agency Review Question #2
 How would you characterize the business and legal relationship between and among Route 66 Hotels, Inc.
and the hotels that formed it?
 Look at Respondeat superior and apparent agency
 Will Route 66 Hotels, Inc. be liable for the accident?
 Do this question in IRAC format
 Applicable legal theories:
 If you were representing Route 66 Hotels, Inc., what steps would you recommend to mitigate the risk of
liability?
o Reading v. Regem (Crown)
 Breach of fiduciary duty of loyalty through misuse of assets of employer
 Facts
 Reading was a British solider in Egypt during WWII
 While in full uniform, he escorted trucks through Ciro during the night
 These trucks contained smuggled contents
 Since he was in uniform, the trucks could pass the police without inspection
 In return for his services, he received around $20K for all the different times of doing this
 The military found out about this and took the money
 Sargent sued the gov to recover the money
 How did Sergeant Reading earn the money that is the subject matter of this dispute?
 He was being paid for riding on a truck while wearing his military uniform to smuggle illegal goods
through police check points
 Issue: whether or not the employee is using asset facilities for his own profit
 Why does the Crown believe it is entitled to Sergeant Reading’s money?
 Reading misused his military uniform for his own benefit in violation of a duty of honesty and good
faith that he owed to the crown, his employer
 Does the court agree with the Crown?
 Yes
 What rule underlies the court’s decision?
 If a servant takes advantage of his service and violates his duty of honesty and good faith to make a
profit for himself, in the sense that the assets of which he has control, the facilities which he enjoys,
or the position which he occupies, are the real cause of his obtaining the money as distinct from
merely affording the opportunity for getting it, that is to say if they play the predominant part in his
obtaining the money, then he is accountable for it to his master
 Why does the court believe that the sergeant must not be allowed to enrich himself?
 The agent’s duty of loyalty includes not using his position as an agent and not to use properties or
facilities of the principal for the agent’s own benefit unless the agent has received the principal’s
consent
 The agent has a duty to act solely for the principal in all matters connected to the agency including
not misusing assets, facilities, or the agent’s position
 Note that the court carves out a moonlighting exception. When does such exception apply?
 The court distinguishes cases where the situation merely gives the agent an opportunity to make
money
 If a sergeant made money by operating a gambling operation or conducting trade, he could keep
such money and may only be liable for breach of contract
 Why should the Crown recover when it has suffered no actual loss?
 This is because duty of loyalty claims are about deterrence, not compensation
o Hypothetical #A7
 Would the result under Reading be the same if U.S. law were applied?
 Look at the restatement to answer this
  388 is not applicable because it requires that the agent be conducting a transaction on behalf of the
principal, it was a side business here
 Apply 404 and the result would likely have been the same
 Would the result be the same in the following cases:
 Sergeant had been discharged before riding on the truck?
o This would not be okay because it involves misuse of the asset of the employer
 What if wearing uniform for 30 days after discharge is permitted?
o This would not be okay because it involves misuse of the asset of the
 U.S. war hero is given cash by restaurant owner for making public appearance there
o This is probably okay because the war hero is not misusing the assets
o He is just cashing in on his fame and not profiting just because of his title
 U.S. general gets royalties for writing memoir about his heroic feats during wartime and promotes
book in civilian dress
o This is the moonlighting example
o He did something extra to earn royalties
o This is unlikely to be viewed as misusing is position
o AGENCY – FIDUCIARY RELATIONSHIP
 Restatement 2nd Agency §1
 Agency is a fiduciary relationship
 A fiduciary relationship is one involving trust and confidence between the partis
 Agent must place principal’s interests over her own interest
o AGENCY –DUTY OF LOYALTY
 Restatement 2nd of Agency, §387 – Duty of Loyalty
 Agent is subject to a duty to act solely for the benefit of the Principal in all matters relating to the
agency
 Compare Restatement 3rd of Agency, §8.01
 Restatement 2nd of Agency, §388 – Duty to Account for Profits Arising out of Employment
 If Agent makes a profit in connection with transactions conducted by him on behalf of the Principal,
Agent must turn over profit to Principal
 Example: Principal authorizes Agent to sell land for a fixed price. Agent makes a contract to sell
land to a third party who makes a nonrefundable deposit. The third party does not conclude the sale
and forfeits the deposit. Agent sells the land to another person. Agent is under a duty to Principal to
turn the forfeited deposit over.
 Compare Restatement 3rd of Agency,§8.02
 Restatement 2nd of Agency, §404 – Liability for Use of Principal’s Assets
 Agent must pay over profit if uses assets of Principal in violation of a duty
 Agent is not liable for profits made by use of time to be devoted to principal unless he violates duty
not to act adversely or in competition with Principal
 Restatement 3rd of Agency, §8.02 – Material Benefit Arising out of Position
 Agent has a duty not to acquire a material benefit from a third party in connection with transactions
conducted or other actions taken on behalf of the principal or otherwise through the agent’s use of
his position
 Restatement 3rd of Agency, §8.05(1) – Use of Principal’s Property
 An agent has a duty not to use the property of the principal for the agent’s own purposes or those of
a third party
o General Automotive v. Singer (supp. case)
 Breach of fiduciary duty of loyalty by competing with the employer in the same line of business
 Facts:
 Employer is suing Singer, employee, to account for money received from outside sources while
employed for plaintiff
 What were the terms of Singer’s employment with General Automotive?
 Singer was employed as the general manager & he had a high reputation in the field
 He was qualified at estimating cost of products
 He was to serve as general manager including soliciting and managing machine shop orders
 He was required to devote his entire time, skill, labor and attention to said employment and not to
engage in any other business or vocation of a permanent nature during the term of employment
 He was to work 5 ½ days a week
 He couldn’t disclose confidential information about the employer
  What additional side business was Singer conducting while on the job?
 He was engaged in brokering jobs for other machine shops
 If work came in for general automotive, and defendant determined that such work couldn’t be done
by them due to lack of equipment or price, he would then send the work to outside shops and retain
the difference between the price quoted and the price paid
 He did this in secret and silent
 How does he justify such side business?
 He says that general automotive couldn’t do the work that he would send out
 What is the legal basis for General Automotive’s claim that it is entitled to the proceeds from such side
business?
 They said he breached a fiduciary duty of loyalty
 This breach consisted of the fact that singer was competing in the same line of business that general
motive was engaged in
 Who wins the case?
 General automotive wins because the court does find a breach of fiduciary duty
 What is the remedy?
 Disgorgement of the profits made by side business
 What is the court’s rationale for its decision?
 Singer was bound to act in a manner that was not adverse to the interests of employer by serving or
acquiring any private interests of his own
 He was bound to act for the furtherance and advancement of the interests of employer
 He did not act in this way, he acted in his own self interest
 An agent cannot do this
 What is the point of the court’s requirement that Singer was under a duty to disclose?
 If singer had disclosed what was going on, especially that there was more work coming in that could
be handled, his employer might have decided to fulfill the orders themselves by adding more
employees or getting more equipment. They also could have decided to themselves subcontract and
keep the profits of such activity
 If the parties had contemplated the issue in advance, what agreement would they have reached regarding
Singer’s side business?
 They might have allowed the work to be sent to other shops and might have agreed to split the profit
 This assumes that GA would have declined to find ways to take on the work themselves
 Could General Automotive have asserted a claim for breach of contract in this case?
 Yes
 Since he breached the employment contract
 We assume this didn’t happen because the lawyers determined that breach of fiduciary duty would
have better remedies available than breach of contract
o AGENCY – FIDUCIARY DUTY – NO COMPETITION
 Restatement 2nd of Agency, §393 – Competition as to Subject Matter of Agency
 Agent is under a duty not to compete with principal concerning the subject matter of the agency
 After termination of agency, barrier to competition ends §396(a)
 Exception: cannot use confidential information derived from agency relationship §396(b)
 Note impact of non-compete contract clauses
o This would extend the obligation of an agent not to compete even after the employment has
ended
 Compare Restatement 3d of Agency §8.04: during the agency, Agent under a duty to refrain from competing
with Principal and from taking action to assist Principal’s competitors; however, Agent may take action to
prepare for competition following termination of agency
o Town & Country v. Newbery
 Breach of fiduciary of loyalty through misuse of confidential information from employer
 Facts
 Employees cleaned houses & the company put together a list of customers in the area
 Defendants formerly worked for town and country but eventually left
 Once they left, they started their own company and started calling old customers and used that as a
base to build their own business
 Town and country found out about this and sued the former employees
 What was the basis for Town & Country’s claim against its former employees?
  They sued because the former employees set up a competing business by taking with them the
customer list from town and country
 This was more than the names and addresses of clients. It included lists of various tasks that were
performed for each customer and the price being charged to each customer
 The information was unique to each customer
 What relief was Town & Country seeking?
 They wanted to stop the former employees from competing with them and soliciting customers
 They wanted an injunction
 They also wanted damages for unfair competition
 What is the court’s decision?
 Former employees were liable because they took the customer list
 What is its rationale?
 Based on trade secrets law and implies a breach of duty of loyalty
 The former employees couldn’t engage in business at all without breach of the confidential
relationship
 What relief was Town & Country entitled to?
 The court ordered the employees to stop using the customer list (issuing an injunction) and they
ordered that plaintiffs be paid damages for lost business
o AGENCY – FIDUCIARY DUTY – CONFIDENTIAL INFORMATION
 Restatement 2nd of Agency, §395:
 During agency relationship, Agent has duty not to use or disclose confidential info given to him or
acquired by him during course of agency to compete with or harm principal
 Restatement 2nd of Agency, §396(b)
 After termination of agency relationship, Agent has duty not to use in competition with the Principal
or to his injury trade secrets, written lists of names, or other similar confidential matters given to him
for principal’s use or acquired by agent in violation of duty
 Compare Restatement 3rd of Agency, §8.05(2)
 Agent has a duty not to use or communicate confidential information of the principal for the agent’s
own purposes or those of a third party
o Agency Review Question #3
 What role does each of the following play:
 Cecil
o Agent of USA Exports
 USA Exports, Inc.
 Superior Exports, Inc.
 Does USA Exports have any basis for a complaint against Cecil? List any grounds you can think of.
 What result in this case?
 Quizzes for Module 1
o Quiz 1: Creation of Agency
 Who won the case of Gorton v. Doty?
 Gorton and his father
 According to the court in Gorton v. Doty, who was the principal and who was the agent?
 Garst was the agent and Doty was the principal
 Which of the following is not required for the creation of an agency relationship?
 Money changes hands such that agent gets paid for completing the task
 Who won the case of Jenson v. Cargill?
 Farmers
 A creditor should never try to exercise any form of control over the debtor’s business because any attempt to
do so will lead to a finding that an agency relationship has been created (T/F)
 False
o Quiz 2: Authority in Contract
 Who won the case of Mill Street Church v. Hogan?
 Sam Hogan
 In Mill Street Church v. Hogan, which party had the burden of proof on the issue of authority?
 Sam Hogan (he is the one who raised the issue of authority)
 Who won the case of 370 Leasing v. Ampex?
 370 Leasing Corporation (because apparent authority)
 Who won the case of Watteau v. Fenwick?
  Suppliers (because inherent authority)
 A principal can never be found liable for actions of an agent that are contrary to the principal’s instructions
(T/F)
 False
o Quiz 3: Authority in Contract (continued)
 In Botticello v. Stefanovicz, the court found that Walter acted as Mary’s agent in entering into the lease
agreement with the option to purchase (T/F)
 False (this was one of two issues that was raised by the plaintiff which the court rejected)
 In Botticello v. Stefanovicz, the court found that Mary was bound by the lease agreement with option to
purchase because she ratified the contract through her conduct (T/F)
 False (for ratification, you need intent to ratify and knowledgeable of all material circumstances, and
this was missing)
 Which of the following is not required for someone to be bound under the doctrine of ratification?
 Creation of an agency relationship (is NOT required)
 In Hoddeson v. Koos Bros., the appeals court affirmed the judgment in favor of Mrs. Hoddeson because she
had sufficient evidence to establish that the purported salesman was an agent and had authority to act on
behalf of the department store. (T/F)
 False (she did not establish an actual agency relationship because the salesman was an imposter)
 Which of the following is not required for agency by estoppel to apply?
 The principal had malicious intent to harm the third party (is NOT required)
o Quiz 4: Liability in Tort
 A contract clause declaring that a party is an independent contractor and disclaiming the existence of an
agency relationship will always be upheld by a court (T/F)
 False (courts are not always bound by such a contract clause)
 A principal will always be vicariously liable for the negligence of its agents under the doctrine of
Respondeat superior (T/F)
 False (Respondeat superior doesn’t apply to every principal/agent relationship)
 Which of the following factors was most important in explaining the decisions in Humble Oil v. Martin and
Hoover v. Sun Oil?
 The amount of control that the oil company exercised over the day to day business operations of the
service station
 A franchisor will be held responsible for an accident caused by a franchisee if the franchise agreement
includes a clause requiring the franchisee to adhere to system-wide standards put in place to preserve the
value of the franchise (T/F)
 False (every franchise relationship will include system-wide control to preserve the value of the
franchise, but this does not lead to liability, more control is necessary) (this is an important
distinction to keep in mind)
 Who won the case of Murphy v. Holiday Inns?
 Holiday Inns
o Quiz 5:
 If the franchise agreement goes beyond the stage of setting standards and allocates to the franchisor the right
to exercise control over the daily operations of the franchise, the franchisor may become vicariously liable
for negligence of the franchisee. (T/F)
 True
 Apparent agency is a distinct concept from apparent authority; apparent agency creates an agency
relationship that does not otherwise exist while apparent authority expands the authority of an actual agent.
(T/F)
 True 
 The appeals court in Miller v. McDonald’s Corp. affirmed the decision of the trial court granting summary
judgment to the defendant on the ground that it did not own and operate the restaurant where the accident
occurred. (T/F)
 False 
 The appeals court in Majestic Realty Associates, Inc. v. Toti Contracting Co. affirmed the decision of the
lower court that the Parking Authority could not be held liable for the negligent act of its independent
contractor. (T/F)
 False 
 The appeals court in Majestic Realty Associates, Inc. v. Toti Contracting Co. recognized that ordinarily
when a person engages a contractor, who conducts an independent business by means of his own employees,
to do work not in itself a nuisance per se, he is not liable for the negligent acts of the contractor in the
 performance of the contract. Which of the following exceptions to that general rule was the basis for the
court’s decision in that case?
 The activity involved was inherently dangerous
o Quiz 6: Fiduciary Duty 
 In the case of Reading v. Regem, which of these statements explains the court’s decision?
 Reading breached his fiduciary duty of loyalty and is liable for such breach 
 If Reading v. Regem had been decided under the legal principles set forth in Restatement Second of Agency,
what section would be considered most relevant?
 §404
 According to the court in General Automotive Manufacturing Co. v. Singer, Singer was free to engage in his
side line business of manufacturer’s agent or consultant in direct competition with his employer and without
disclosing the existence of such conflict. (T/F)
 False 
 The usual remedy for breach of the duty of loyalty is for the agent to disgorge profits illegally
received. (T/F)
 True 
 The court in Town & Country House & Home Service, Inc. v. Newbery found that former employees who
used employer’s confidential information in the form of a customer list after termination of their
employment had acted wrongfully. (T/F)
 True 

 Chapter 2: Partnerships
o INTRO TO PARTNERSHIP
 Uniform Partnership Act (1914) (UPA)
 Not legally binding unless enacted by a state
 Default rules vs. contract clauses
 There are very few mandatory rules
 Many rules can be altered by contract by the parties
 Default rules = the statutory rule that the court will automatically apply unless the partis have made
agreements otherwise in a contract
o As long as this agreement doesn’t go against a mandatory rule in the statute, isn’t illegal, or
doesn’t go against public policy, courts typically uphold such contract provisions
o Fenwick v. Unemployment Compensation Commission
 The characteristics of partnerships
 Facts
 Fenwick operated a beauty shop where Chesire was employed
 C demanded an increase in her weekly wage and employer, F, countered with an offer to make her a
partner, which she accepted
 The parties signed a partnership agreement
 Later on, she decided to quit her job and sought unemployment compensation
 What was Chesire’s position before the Partnership Agreement was signed?
 She was a receptionist and cashier
 How did her position change after the Partnership Agreement was signed?
 They did not change
 She continued to perform the same job functions
 Her compensation did change
 In addition to salary, she was entitled to receive a 20% profit bonus if the business warranted it
 What were the terms of the Partnership Agreement?
 That the parties associate themselves into a partnership to commence January 1, 1939
 That the business shall be the operation of the beauty shop
 That the name shall be United Beauty Shoppe
 That no capital investment shall be made by Mrs. Chesire
 That the control and management of the business shall be vested in Fenwick
 That Mrs. Chesire is to act as cashier and reception clerk at a salary of $15 per week and a bonus at
the end of the year of 20% of the net profits, if the business warrants it
 That as between the partners Fenwick alone is to be liable for debts of the partnership
 That both parties shall devote all their time to the shop
 That the books are to be open for inspection of each party
  That the salary of Fenwick is to be $50 per week and at the end of the year he is to receive 80% of
the profits
 That the partnership shall continue until either party gives ten days’ notice of termination
 What was the legal issue addressed by the court?
 Whether Chesire was in fact a partner or whether she continued to be an employee, even after the
date the partnership agreement was signed
 Why was the question of partnership relevant to the dispute?
 If she was an employee, she would have been the 8th employee which would make a difference in
determining whether F was an employer required to pay into the unemployment compensation fund
 Lower court’s decision
 The commission held that she was an employee
 Then the court said she was a partner because of the existence of the partnership agreement
 What is the holding?
 The appeals court said that she was an employee, not a partner
 Even though there was a partnership agreement, the court viewed it as not controlling
 Instead, it looked at the nature and substance of the relationship
 What was the court’s reasoning?
 The court looked to the definition of partnership
 They said the agreement was nothing more than one to provide a method of compensating the girl
for the work she had been performing as an employee
 She had no authority or control in operating the business, she was not subject to losses, and she was
not held out as a partner
 Existence of Partnership - Judicial Factors used in Fenwick v. Unemployment Commission
 Intention
o Here, the court states that the reason C was entitled to receive 20% share of profits was
because F wanted to retain C as an employee
 Sharing of Profits
o Big focus of courts
o She did have the right to share of profits (20%) but this was not conclusive
o The court referred to UPA 7(4) which talks about sharing profits and said that this doesn’t
apply if the profits represent the wages of the employee
o This was a type of bonus agreement, the court said
 Sharing of Losses
o C didn’t share losses, as stated in the agreement
 Contribution of Capital and Share in Capital Upon Dissolution
o C didn’t contribute capital and she was not entitled to receive any share of capital, according
to the agreement
 Control of Business
o Big focus of courts
o C played no management role
o F had all control rights
 Language in Agreement
o Although the agreement referred to both parties as partners, the actual terms of the
agreement didn’t give C the ordinary rights of a partner
 Conduct towards Third Parties
o The parties only held themselves out as partners for income tax purposes and for
unemployment payment purposes but not to other 3rd parties
 NOTE:
o These are judicially created factors
o PARTNERSHIP – DEFINITION
 UPA, §6(1)
 An association of two or more persons to carry on as co-owners a business for profit
o Equal Sharing of Profits and Losses
 UPA, §18(a)
 Partners share equally in profits and losses
o Sharing of Profits
 UPA, §7(4)
  Share of profits is prima facie evidence of partnership but not if received as wages of an employee or
as interest on a loan (see other exceptions)
o Equal Control Rights of Partners
 UPA, §18(e)
 All partners have equal rights in the management and conduct of the partnership business
 F
o LIMITED PARTNERSHIP
 DIFFERENCES FROM GENERAL PARTNERSHIP
 Formalities: Need to file certificate of limited partnership
o This is on top of the fact that a partnership agreement is needed
 Two categories of partners: General Partners and Limited Partners
o Upon formation, a limited partnership must have at least one general partner and one limited
partner and must have at least 2 partners
o Generally, general partners run the business and have unlimited liability and limited
partners’ management abilities are either non-existence or limited and limited partners
usually have little to no liability
 Personal liability: Limited liability for Limited Partners; Unlimited for General Partners
o General partners are personally liable
o Limited partners are generally not liable except in some circumstances
 Management in General Partners; Limited Partners are passive investors
o Day to day management and the power to bind a limited partnership are reserved to the
general partners
o Limited partners have governance rights only as to a few matters
 Profit and Loss Sharing: Limited Partners share in profits and losses based on their contributions
o Based on capital contributions
o This is the general rule unless otherwise stated in the partnership agreement
 Dissolution: Dissociation of Limited Partner does not dissolve the partnership
o This is true unless otherwise stated in the partnership agreement
o Dissociation of a general partner threatens the partnership of dissolution
 Name requirement: Must signify status as limited partnership.
o Some statutes require the phrase limited partnership
o Others require this or an abbreviation
 ULPA (2001, 2013) §303(a):
 (a) A debt, obligation, or other liability of a limited partnership is not the debt, obligation, or other
liability of a limited partner. A limited partner is not personally liable, directly or indirectly, by way
of contribution or otherwise, for a debt, obligation, or other liability of the partnership solely by
reason of being or acting as a limited partner, even if the limited partner participates in the
management and control of the limited partnership. This subsection applies regardless of the
dissolution of the partnership.
o Holzman v. De Escamilla
 Limited partnership and liability
 Parties
 Company = Hacienda Farms Limited Partnership
o Limited partners
 Russell
 Andrews
o General partner
 De Escamilla
 Facts
 Russell and Andrews formed a limited partnership with De Escamilla as the general partner
 The firm was a farming partnership and it went into bankruptcy
 Creditors sought to hold Russell and Andrews liable as if they were general partners
 Trial court found all defendants liable for the debts of the partnership as general partners
 What is the legal issue?
 Whether Russell and Andrews, who were under the partnership agreement limited partners, are
liable to the creditors as if they were general partners
 General rule
  Limited partners do not have joint and several liability for debts and obligations of the limited
partnership that exceed the assets of the limited partnership, that are beyond the partnership’s ability
to pay
 The general partner has unlimited personal liability for such debts and obligations, but not the
limited partners under ordinary circumstances
 This case is about an exception to this general rule
 What is the trustee’s legal argument supporting its claim that Russell and Andrews should be liable to
creditors?
 The limited partners took control of the partnership through their actions and the consequence is that
they loss their limited liability
 What evidence supports this legal argument?
 The court notes that the parties consulted with the general partner about what crops should be
planted and the general partner was typically overruled by the limited partners if there was a
disagreement
 The limited partners forced the resignation of the general partner and replaced him at a point
 Any two partners were allowed to sign checks on behalf of the partnership and the limited partners
had signed many of these checks. All of the other checks were signed by the general partner and one
of the limited partners (the power to control the spending of money in a business is control over the
business)
 This indicates that the limited partners participated in management
 What is the holding?
 The court found that Russell and Andrews, although named as limited partners in the partnership
agreement, were liable to the creditors as if they were general partners
 What is the court’s rationale?
 The court relied on the CA Civil Code provision below
 If they exercised control over the business is what the court looked at
 California Civil Code §2483
 A limited partner shall not become liable as a general partner, unless in addition to the exercise of
his rights and powers as a limited partner, he takes control of the business.
 How is this provision used by the court to decide this case?
 The court looked at the unless and said that the limited partners exercised control over the business
to be found liable
o LIMITED PARTNERSHIP
 RULPA §303
 (a) Limited partner is NOT LIABLE FOR OBLIGATIONS of limited partnership unless
o Limited partner is also a general partner OR
o Limited partner takes part in the control of the business
 In this case, limited partner is liable to a third party who transacts business with the
limited partnership and who reasonably believes based on the limited partner’s
conduct, that she is a general partner
 (b) Limited partner does not participate in control solely by consulting/advising with general partner
on partnership business
 NOTE:
 There is NO uniformity among the states on this topic so you have to make sure to check the specific
state’s statute to know the rule they apply in this situation
o Hypothetical #P1
 Assume that RULPA §303(a) is in effect in the jurisdiction. A creditor of Hacienda Farms, who had
delivered fertilizer to the farm on de Escamilla’s order, saw and heard Andrews and Russell engaging in the
conversations about which de Escamilla testified.
 Would Andrews and Russell be liable to the creditor?
 What if, in addition, the creditor had in the past received payment by checks that bore the signatures
of Andrews and Russell?
o Meinhard v. Salmon
 Fiduciary duty of partners
 Parties
 Louisa Gerry
o Owned Hotel Bristol
o Leased to Salmon
  Walter J. Salmon
o Lessee
o He renovated the hotel and had a silent partner
o Manager of the building (as agreed upon by S and M)
 Mr. Meinhard
o Silent partner who provided money for renovations to the hotel
o He was a wool merchant
o He had no expertise in management or running the hotel business
 Eldridge Gerry
o Son of Louisa who became the owner of the property by the end of the term of the lease
o He decided he wanted to replace the building for a larger project involving additional land
 Facts
 S & M agreed that S would be the manager of the hotel
 They would split the profits 60-40 where S would get 60 and M would get 40, for the first 5 years of
the lease
 Then after the first 5 years, they would split 50/50 for the remainder of the lease
 E talked to S about investing in the new project
 E did not talk to M because it seems that E did not know about M since S’s name was on the lease
and he was the manager of the project
 S took the new lease and M found out and sued
 NOTE
 The case refers to the parties’ relationship as being a joint venture
 A joint venture under state law is a separate kind of business relationship than a partnership
 However, the fiduciary duty principals apply the same to general partnerships
 Why did Meinhard sue Salmon?
 Because he was cut out of the new deal that was offered from E to S at the end of the first lease
 What relief was Meinhard seeking?
 He wanted to be included in the new lease
 What were the terms of the 1902 lease?
 This covered the Hotel Bristol site only
 It was for 20 years
 Involved an equal investment between M and S for purposes of the renovation, management, and
operation of the building
 The cost was $200K to add shops and offices
 There was profit sharing of at first 60/40 and then 50/50 after 5 years
 There was equal sharing of losses and S was granted sole power of management and other rights
 Lease payments were about $55K and there were preemptive rights for each party in the contingency
of death
 What were the terms of the 1922 lease?
 This was a lease for a much larger parcel of property
 It covered the Hotel and neighboring property with considerable value
 The plan was to knock down the buildings and construct a new building in its place
 The lease was between E and Midpoint Realty, which was owned and controlled by S
 It was for a 20-year term but there was a possibility to extend for 80 years
 No change for 7 years and after this time they are to be torn down
 A new building costing $3M was to replace the old buildings
 Lease payments were between $350K and $475K
 S personally guaranteed the performance by the lease of the covenants of the new lease until such
time as the new building had been completed and fully paid for
 How did Justice Cardozo decide the case?
 He found in favor of M
 What relief did he award?
 He awarded M an equitable interest in half of the value of the entire lease
 This meant that S must hold the lease for the benefit to the tune of 50% of M
 But S was also awarded voting control if the two disagreed about the property
 What was Cardozo’s reasoning? How did Justice Cardozo view the terms of the joint venture?
 S breached a fiduciary duty of loyalty to M
  Joint ventures, like co-partners, owe to one another the duty of the finest loyalty
 This was not the morals of the marketplace but a rule of undivided loyalty
 It was a duty that involved not honesty alone but the punctilio of an honor the most sensitive
standard of behavior. It is unbending and inveterate, it is uncompromisingly rigid
 The standard here is especially high here because S was not just involved in a joint venture, he was
also serving as the manager
 He viewed the joint venture as covering this opportunity because the keystone of the project was
Hotel Bristol
 S was approached because the owner didn’t know of the existence of M
 E would have approached both parties had he known of M
 S took the lease in a breach of his duty to M
 According to Cardozo, how should Salmon have handled the 1922 lease?
 S took the opportunity for the new lease in silence so he excluded M for the chance to compete for
this opportunity
 S should have disclosed the opportunity to M and given him the chance to compete for it
 How did Justice Andrews (dissent) view the terms of the joint venture?
 He viewed it as a joint venture that had in view a limited object and was to end at a limited time
there was no intent to expand it into a far greater undertaking lasting for many years
 He believes that the joint venture ended when the first lease ended and whatever was left in value
was reverted to S. any equity which M possessed was in the particular lease itself, not in any
possibility of renewal
 Did Andrews believe that Salmon acted wrongfully?
 He believed the term of the joint venture only lasted 20 years and only extended to Hotel Bristol
 Because of this, he believes that S didn’t act wrongfully
 However, if this had been a general partnership, the majority decision would have been correct!!
o This is because a general partnership is viewed as having a broad arrange of activities that
are associated with it whereas a joint venture typically focuses on a particular project
o Partnership – Fiduciary Duty of Loyalty
 UPA, §21
 A partner must account/hold as trustee (disgorgement)
 Profits or benefits derived from any transaction connected with partnership or use of its property
 NOTE:
o The language about accounting and holding as trustee means that the remedy for breaching
the fiduciary duty of loyalty is disgorgement of those profits
 RUPA, §409(b) – Duty of Loyalty
 Duty of loyalty is to account and hold as trustee profits/benefits derived from a use of partnership
property including partnership opportunity
 The duty of loyalty includes
o Refraining from conflict of interest transactions and
o Refraining from competing before dissolution of the partnership
o Hypothetical #P2
 If you were Salmon’s lawyer at the time he entered into the initial lease, what type of deal with Meinhard
would you have recommended?
 If you were representing Meinhard, what would you have recommended?
o Hypothetical #P3 – Duty of Loyalty
 (A) Michael is a partner in a business consulting firm with a national clientele. While on a skiing vacation in
Colorado, Michael meets Dorothy, who seeks some business advice. Michael at first declines, explaining,
I’m on vacation. He suggests that Dorothy use the services of another partner and offers to call his office and
arrange matters. Dorothy, however, insists on Michael’s services and offers to pay double his usual charges.
Michael finally agrees. He takes a day out of his vacation, provides Dorothy the advice she needs and
pockets a large fee.
 May Michael keep the fee?
o Likely no
o Because by doing so, he would be acting in competition with the firm for which he serves as
a partner
o This is an example of competing with the business in the same line of business
 (B) Alice, a partner in a biotechnology partnership, knows that the partnership is looking to rent new office
and laboratory space. She happens to know of a building, in the ideal location, suitable to house the firm’s
 special equipment. She learns that the owner is willing either to lease or to sell. Alice decides that the
building would make a fine personal investment, so she buys it for herself. She leases the building to a
company that does not compete with the partnership, and later she resells the building at a profit.
 May Alice keep the profit?
o Likely no
o This is taking profit from a business opportunity that should have been offered to the
partnership
 (C) Alex is a partner in a landscaping company that works exclusively on commercial projects. On
weekends, without the permission of his copartners, Alex uses company equipment to do landscaping at
private homes.
 May Alex keep the money earned from these jobs?
o Likely no
o This is using partnership property for personal gain
 (D) Alice is a partner in a biotechnology partnership that is looking to rent new laboratory space. Alice
happens to own a building, in the ideal location, suitable to house the firm’s special equipment. Alice
contracts with the partnership to sells the building to it at a good price.
 May Alice close on the deal?
o This depends on factors such as whether other partners would approve the transaction
o This involves a conflict of interest
o She is on both sides of the transaction
o She is acting on her own behalf as owner of the building and acting as a partner in the
partnership and having a fiduciary duty
o Hypothetical #P4
 If RUPA §409(b) had been the law when Meinhard v. Salmon was decided, would the result have been the
same or different?
 Likely that the result would have been the same
 Why?
 Partnership would apply in that situation
o Partnership – Fiduciary Duty of Care
 RUPA, §409(c) – Duty of Care
 Partner must not act in a manner that is grossly negligent or reckless or engage in intentional
misconduct or knowing violation of the law
 NOTE
o The duty of care is a responsibility that partners have to act in a diligent and careful way
when conducting business on behalf of the partnership
o Hypothetical #P5
 What would Judge Cardozo think about RUPA §409(c)? Is it in line with his idea of fiduciary duty as
expressed in Meinhard v. Salmon?
 He would have required liability for simple negligence, not the conduct described in 409(c)
 There is a distinction between these two forms of fiduciary duty
o Partnership – Information
 UPA, §20
 Partners shall provide on demand true and full information of all things affecting the partnership to
any partner
 NOTE:
o This duty is often referred to as the duty of candor or the duty of disclosure
 UPA, §19
 Partners may inspect and copy partnership’s books
 NOTE:
o This means books and records about the partnership and other information about the
partnership
o This can also include financial and other information
 RUPA, §403
 Partners may inspect and copy books and records of the partnership
 Partner entitled to information from other partners and partnership that is needed for exercise of
partner’s rights and duties without making demand
 Partner entitled to other information upon demand
 o Example (offer information without demand needed): Rachel and Sam are partners and
Rachel is considering selling her transferable interest to Sam. Sam learns of some
information suggesting the partnership is entering a boom period (make high profit and do
very well). Rachel is unaware of that information. He must disclose that information to
Rachel even though she has not made demand.
o Partnership – Fiduciary Duty of Good Faith in Expelling Partner
 UPA, §31(d)
 Dissolution is caused without violation of the partnership agreement by expulsion of any partner
from the business bona fide in accordance with such a power conferred by the agreement between
the partners.
 NOTE:
o There is a duty to use good faith when partners try to expel another partner from the
partnership
o Partnership – Financial Investment and Return
 Partners contribute capital and/or labor
 Financial return (UPA §18(a))
 Partner has a right to repayment of contribution
 Right to share equally in profits and surplus after payment of liabilities
 Obligation to contribute to losses sustained by partnership according to such partner’s share in
profits
 Right to indemnity against expenses and liabilities incurred in partnership business
 UPA §18(b)
 Indemnity = right to be made whole
o Hypothetical #P6
 Huey, Dewey and Louie form a partnership to conduct a swimming pool maintenance business. Huey and
Dewey each contribute $10K and Louie contributes $5K. They do not discuss sharing of profits and losses.
At the end of the first year, the partnership has profits of $10K.
 What is each one’s share of the profits?
o No partnership agreement on profit or loss sharing so this means the court will apply default
rule saying each is entitled to 1/3 of profits
o Hypothetical #P7
 Huey, Dewey and Louie form a partnership to conduct a swimming pool maintenance business. Huey and
Dewey each contribute $10K and Louie contributes $5K. They agree to share any profits 40% for each of
Huey and Dewey and 20% for Louie. They do not discuss losses. At the end of the first year, the partnership
has a loss of $10K.
 Who is responsible?
o Court will apply default rule because no agreement about losses
o Default rule says to apply as agreement of profits
o Partners are responsible for the losses as they would profits
o Putnam v. Shoaf
 Property rights of partners in a partnership
 What is the relationship among these parties?
 Frog Jump Gin Company
o Company which partnership existed under
o Operating at a loss
 Mrs. Putnam
o Original equal partner until her husband died and she inherited his share
o After his death she owned 50%
o Decided to sever and sold her partnership share
 Mr. and Mrs. Charlton
o Original equal partner
o 50% share
 Mr. and Mrs. Shoaf
o Took over Mrs. Putnam’s ½ partnership share
 How was the partnership interest transferred?
 Quit claim deed between P and S
 Referred to all real and personal property
 Released P from any liability
  How did the dispute arise?
 Original bookkeeper was embezzling funds so they sued and obtained a judgment which C was
entitled to half and the dispute is about the other half and who is entitled to it, P or S
 P claimed she was entitled to half of the total recovery
 What is Putnam’s claim based on?
 She only transferred the items because the quit claim deed didn’t mention this specific situation so
she was entitled to the money since she didn’t convey this specific money
 What does the court decide?
 Finds against P
 What is the court’s rationale?
 Partners property interest in the partnership
 UPA 24 (3 things that property rights of a partner consist of)
 UPA 25 (nature of a partner’s right)
 UPA 26 (nature of partner’s interest)
 P can only have transferred her economic rights she had no rights in specific pieces of partnership
property
 The partnership itself owned the assets
 Because UPA says each partner are owners of specific partnership property, it doesn’t matter that the
claim against the bookkeeper wasn’t named as specific property when transferring
o PARTNERSHIP – Property Rights
 UPA §24 EXTENT OF PROPERTY RIGHTS OF A PARTNER
 Property rights of a partner are
o (1) his rights in specific partnership property,
o (2) his interest in the partnership, and
o (3) his right to participate in the management.
 UPA §25 NATURE OF PARTNER’S RIGHT IN SPECIFIC PARTNERSHIP PROPERTY
 UPA §25(1) Partner is co-owner with partners of specific partnership property holding as a tenant in
partnership.
 UPA §25(2)(a) Partner has equal rights with his partners to possess specific partnership property for
partnership purposes (but not for other purposes unless other partners consent).
 UPA §26 NATURE OF PARTNER’S INTEREST IN THE PARTNERSHIP
 Partner’s interest in the partnership is his share of the profits and surplus and is personal property.
 UPA §27 ASSIGNMENT OF PARTNER’S INTEREST
 Assignee may only receive profits of assignor, but may not participate in management of
partnership, or require information or account of partnership transactions, or inspect partnership
books unless there is an agreement with the other partners
o Partners may only assign their economic interests in the partnership
o Consistent with UPA §18(g): No person may become member of partnership without the
consent of all the partners.
o Hypothetical #P8
 Suppose that after Mrs. Putnam conveyed her one-half interest to Shoaf, it was discovered to everyone’s
surprise that an underground stream had undercut the land on which the gin was located and it was necessary
to abandon the property.
 Could the Shoafs recover their loss from Mrs. Putnam?
o No
o Because no specific interest in specific assets of the partnership
o Hypothetical #P9
 Laura is a partner in XYZ Consultants. She applies for a personal loan to buy a sailboat from Second Street
Bank. The Bank asks her to assign her XYZ partnership interest as security for the loan. The security
agreement provides that if Laura defaults on repayment of the loan, Second Street Bank will exercise Laura’s
management rights in, and have the right to receive any income due to Laura from, XYZ. There is no
provision in the XYZ Partnership Agreement on assignment.
 Can Laura enter into such an assignment?
o UPA 27
o No
o She cannot transfer her management rights, only her economic interest
o This could be changed by contract though
o Partnership – Default Voting Rules
  Disagreements among partners are decided by a partnership vote
 One partner = one vote, even if contributions are not equal (unless changed by contract)
 Some matters are decided by majority vote (UPA §18h)
 Ordinary business decisions
 Other matters require unanimous consent (UPA §9(3), §18g, §18h)
 Assign partnership property in trust to creditors/secure payment of debt
 Dispose of good will of partnership
 Do an act making it impossible to carry on partnership’s ordinary business
 Confess a judgment against partnership
 Submit a claim involving the partnership to arbitration
 Admit new partners
 Contravene any agreement of the partners
o This may include extraordinary matters that substantially change past practice e.g. entering
new lines of business
o National Biscuit Company v. Stroud
 Parties
 Stroud’s Food Center (general partnership)
o C.N. Stroud
 Told plaintiff (bread co) that he would no longer be responsible for any additional
bread sold to the general partnership company
o Earl Freeman
 National Biscuit Company
o Seller of bread
 How did the dispute arise?
 Disagreed about ordinary business manner
 F wanted to order bread from N and S objected
 How did Stroud try to resolve the dispute?
 He went to N and said he would no longer be personally liable for any bread sold and delivered to
the general partnership
 F ordered more bread and N delivered it
 Now N is suing for payment trying to hold both the partnership and S liable
 S objected
 Was Stroud successful in his attempt to resolve the dispute? Explain why or why not.
 No
 Notice was not effective
 UPA 18(e)
 Equal rights
 UPA 18(h)
 Ordering bread is an ordinary business decision so majority vote was not enough and partnership
was not bound
 UPA 9(1)
 Each partner is viewed as a legit agent
 UPA 15
 Partnership is liable so S is liable
 What should Stroud have done?
 He could have only dissolved the partnership and then notified
 This was the only way
o Partners – Management & Voting
 All partners have equal rights in management
 UPA §18(e)
 Any difference arising as to ordinary business matters connected with the partnership business may be
decided by a majority of the partners
 UPA §18(h)
o Partnership – Partners as Agents
 Each partner is an agent for partnership and binds the partnership when apparently carrying on in the usual
way the business of the partnership
 UPA §9(1)
 o Exception = Partner has no authority to act for partnership in the matter and third party
knows that
 Partners are jointly and severally liable for debts and obligations of partnership
 UPA §15
o Hypothetical #P10
 Suppose that Stroud and Freeman consulted you for legal advice before forming the partnership known as
Stroud’s Food Center. How would you have drafted the partnership agreement to avoid the problem that
arose in this case? (problem of deadline)
o Partnership – Changing Management Rights by Contract
 Default rules are often changed in the following areas:
 Delegating decision making to a managing partner or executive committee
o Common in larger partnerships
 Weighting partnership voting to reflect pro rata contributions to capital
o Default rule is equal rights in management regardless of capital
 Changing requirement of unanimous consent for certain important events
o Can slow down business decision making because it operates like a veto power
 Requiring supermajority voting for important decisions where partners feel majority may not be
sufficient
 Right to expel partners of a partnership
o Partnership – Dissolution
 Definition of Dissolution = Dissolution of a partnership is the change in the relation of the partners caused
by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the
business.
 UPA, §29
 Dissolution versus Winding Up = Partnership is not terminated upon dissolution but continues until winding
up of business is completed.
 UPA, §30
 Dissolution is not the end of the partnership but it is the beginning of the process of winding off
which will eventually end the partnership
 Causes of Dissolution (UPA §31) (without judicial stuff)
 Without violation of partnership agreement: (note that there are negative consequences if a
dissolution occurs in violation of the partnership agreement) (AKA RIGHTFUL DISSOLUTION)
o At the end of a fixed term or with consent of all partners if partnership for a term
o By express will of any partner if partnership at will
o Upon expulsion of a partner under a clause in the partnership agreement
 With violation of the partnership agreement, if dissolution not permitted by any other section, by
express will of any partner at any time (AKA WRONGFUL DISSOLUTION)
o Business becomes unlawful
o Death or bankruptcy of partner or bankruptcy of partnership
o Court decree under §32
 Dissolution by Court Decree (UPA §32) (a partner may apply to a court for judicially decreed dissolution of
the partnership)
 Upon application, court shall decree a dissolution whenever: (grounds for court’s discretion)
o If partner is insane or unable to meet requirements of partnership agreement
o If partner guilty of such conduct as prejudices carrying on the business
o Partner willfully or persistently breaches the agreement or makes it not reasonably
practicably to carry on business with him
o Business can only be carried on at a loss
 Compare RUPA §801(5) (recent version)
 Partnership is dissolved on application by a partner through judicial determination that
o Economic purpose of partnership is likely to be reasonably frustrated
o Another partner has engaged in conduct relating to the partnership business that makes it not
reasonably practicable to carry on the business in partnership with that partner OR
o It is not otherwise reasonably practicable to carry on the partnership business in conformity
with the partnership agreement
 How does this differ from the comparable rule under the UPA?
o Objective factors is more of a focus
 Do you think the change is a good one?
 o Less emotional language and more objective
 Right to Require Liquidation, UPA §38(1) (in rightful dissolution of partnership)
 If dissolution caused in any way except in breach of agreement, each partner may request liquidation
o Liquidation = the assets of the partnership would be gathered and sold and the proceeds
would be applied to pay off partnership liabilities. Any money left over is paid to the
partners in liquidation
 Right to Damages and to Continue the Business UPA §38(2) (negative consequences resulting from
dissolution in violation of a partnership agreement mentioned above)
 If dissolution in violation of partnership agreement occurs:
o Non-breaching partner may claim for damages against breaching partners and may continue
the business and possess the partnership property for that purpose
 If business continued (meaning the non-breaching party decides to continue the business), breaching
partner entitled to receive value of her interest less damages but not including good will of the
partnership
 Rules for Distribution – Payment of Liabilities, UPA §40(b) (how partners are to settle accounts after
dissolution) (in order from first to get paid to last)
 Payment to creditors other than partners
 Payment to partners other than for capital or profits
 Payment to partners for capital
 Payment to partners for profits
 Rules for Distribution – UPA, §40(d)
 Partners must contribute the amount necessary to satisfy the liabilities in §40(b)
o As provided in §18(a)
o Duration of Partnership (whether the dissolution is rightful or wrongful depends on what the parties have agreed to
be the duration of the partnership)
 At will = no limitation on duration or length of the partnership;
 This is the default rule
 If the parties do not limit duration, it will be interpreted to be at will
 Fixed term
 Express term = Together for 5, 10, 15, etc. years; if parties agreed to stay together for a stated
number of years
 Implied term (the court would need to see that there is strong evidence showing the following)
o Until certain sum of money earned
o One or more partners recoup investment
o Certain debts are paid
o Certain property disposed of on favorable terms
o Owen v. Cohen
 Judicial dissolution
 What was the relationship between Owen and Cohen?
 Orally agreed to be partners in the operation of a bowling ally
 O lent money to the partnership with the agreement that it was to be repaid out of business profits
 How did the dispute arise?
 C felt he was entitled to more and was rude to O
 The parties disagreed about how much to charge for bowling and how much money C was taking out
of the business
 O decided he didn’t want to do it anymore and filed an action seeking dissolution of partnership and
sale of partnership assets
 Owen sues for judicial decree of dissolution
 What are the business reasons for seeking dissolution?
o Not getting along with C because he was rude and they were fighting
o Whether gambling should be allowed and whether compensation should be at a certain level
 What are the legal grounds for dissolution?
o UPA 32
o Court shall decree a dissolution whenever
 A partner has been guilty of such conduct as tends to affect the carrying on of the
business
  A partner willfully or persistency commits a breach of the partnership agreement, or
otherwise so conducts himself in matters relating to the partnership business that it
is not reasonably practicable to carry on the business in partnership with him
 Other circumstances render a dissolution equitable
 Was such a suit needed for dissolution? Note: Opinion states partners did not expressly fix duration
of partnership.
o It depends on what type of partnership this was considered to be
o In another part of the opinion the court discusses whether this was a partnership for an
implied term
o UPA 31
o If this was considered to be a partnership at will then it would not have been necessary to
file suit for dissolution. One partner could have simply given notice to the other partner and
that would be sufficient
o If there were an implied term, that would be a type of fixed term partnership agreement so
you would have to have dissolved at the end of the fixed term or if both parties agreed to
dissolve the partnership
 It seems that it was in the middle of a term partnership and the parties would not
have agreed to the dissolution
o Without finding that the dissolution occurred not in violation of the partnership agreement, it
could fall under a violation, but with that it would carry additional negative consequences
 What are the advantages of seeking judicial dissolution?
o If the court determined that there was an implied term and he wanted to avoid a decision of
wrongful dissolution, he could use an alternative route, which is what he did in bringing in
UPA 32
o There are benefits to judicial dissolution especially when there is fighting. In the event of a
judicial dissolution, the parties do not have to deal with one another directly, the court does
all the dirty work
 What is the result?
o The court says that judicial dissolution was an appropriate remedy because of C’s
misconduct and disagreements which affected the carryon of the business
 Owen seeks return of $6986.63 loan.
 Why did he do so?
o He wanted his loan to be repaid in full before any distribution was made to him or the
partner on account of profits or return of capital
 Why did Cohen object?
o He objected on the grounds that the parties agreed when making the partnership that the loan
was to be repaid out of profits of the business
o As the bowling alley brought in profits, that was the money that was to be used to repay the
loan
 What is the result?
o C’s conduct is what caused the dissolution because he made it impossible to continue the
partnership which thereby made it impossible to repay the loan through the profits of the
partnership
o The court ordered that the loan be repaid first since C was at fault
o Page v. Page
 Partnership dissolution; duration of a partnership; and the ability of one of the parties to dissolve the
partnership at will
 Who are the parties?
 Plaintiff (HB) and defendant (George) are partners in a linen supply business
 Parties are brothers
 Each invested the same amount of money ($43K)
 Partnership’s main creditor is a corporation owned by plaintiff
 How did the dispute arise?
 The partnership was unprofitable for 8 years but then for 2 years there were small profits
 Despite the small profit, plaintiff, who’s corporation was the partnership’s main creditor, wanted to
dissolve the partnership
 What is the issue?
 Whether HB (plaintiff) is entitled to dissolve the partnership by giving notice at this time
  HB did not want to be found in violation of the partnership agreement
 What needs to be answered is whether the partnership was at will or for fixed term
 Which partner argues for term partnership?
 Defendant (George) because he doesn’t want the partnership to dissolve
 At will?
 Plaintiff (HB) so he can freely terminate
 What was the decision of trial court?
 The trial court found for defendant stating this was a partnership for an implied term namely such
reasonable time as is necessary to enable said partnership to repay from partnership profits,
indebtedness incurred for the purchase of land, buildings, laundry and delivery equipment and linen
for the operation of such business
 What evidence was introduced to show there was a term?
 Related to earlier partnerships entered into by the brothers showing an implied term to remain in
partnership until the partnership pays for itself
 Former partnership agreement in writing stated that profits were to be retained until all obligations
were paid
 What does appeals court decide on this issue?
 They reversed lower court decision and found this was an at will partnership
 The evidence was not strong enough to imply the term
 This showed only that the parties hoped to make a profit and be able to pay for expenses but the
testimony did not show that this was a partnership for a term
 Why is bad faith raised as an issue in this case?
 Defendant raised the issue saying plaintiff was dissolving the partnership in order to keep all future
gains for himself at the expense of defendant
 Defendant felt he would get very little out of the dissolution of the partnership assets and he felt his
brother (plaintiff) wanted to take advantage of a new business opportunity of the opening of a new
air force base in the area
 What result if bad faith were established?
 The court said that there was nothing on the trial court record showing evidence of bad faith nor was
there evidence of any future profit or gain
 However, the court did note that this was an action for declaratory judgment which will be the basis
for future action by the parties so defendant is protected by the fiduciary duties of good faith of co-
partners
 Plaintiff must exercise this dissolution in good faith and if not, he must fully compensate brother for
his share in the lost opportunity
 Takeaways:
 How and when it is possible to imply a term from the agreements of the parties
 Not every argument that a term should be implied will be found in court
 There has to be strong evidence that the parties agreed to be together until a certain future point
 Even though under UPA 31, it is possible to terminate an at will partnership by one partner giving
notice to the other, that right must be exercised in good faith and not with the intent to get rid of the
other partner for that partner’s gain
o Liquidation or Continuation?
 Default rule is that upon dissolution caused in any way (except in breach of partnership agreement) any
partner may request liquidation.
 In practice, partners often agree to continue the business because liquidation will not produce maximum
value to partners.
 Partners may agree to continue the partnership rather than liquidate and pay out the partners in cash.
 Example:
 Andrew, Barry and Chris formed a partnership (ABC) to sell used casebooks to law students. They
have no written partnership agreement and no agreed term.
o Andrew decides to accept full time employment as a casebook editor and talks to the others
about resigning.
o David expresses an interest in joining the business. After discussions among the four of
them, A, B, C & D agree that David will buy out Andrew’s interest.
o Andrew starts his new job and David joins the business.
o B, C & D continue to sell used casebooks through a successor partnership (BCD).
 o Andrew’s withdrawal has dissolved the old ABC partnership, but A, B & C have each
agreed not to compel liquidation.
o Parties negotiated the terms of the exit and entrance of parties
o Hypothetical #P11
 Returning to the facts of Page v. Page: (based on court’s discussion, what is required of plaintiff)
 Suppose plaintiff wishes to buy out his brother and continue with a new partner (who will take over
as manager and have a 25% interest) CONTINUATION
o How should plaintiff proceed?
 Suppose plaintiff wants to force liquidation (shut down business and sell off physical assets).
LIQUIDATION He wants to bid for the better accounts of the business.
o How should plaintiff proceed?
o BUY-SELL AGREEMENT (negotiated and contracted for at the beginning of the partnership)
 Purpose: Allows partners to part ways based on negotiated terms agreed to upon formation of partnership
 What are common terms in such agreements?
 Trigger events = under what circumstances is there an opportunity for someone to sell their
partnership interest
 Obligation versus option to buy
 Price
 Method of Payment (whether it is immediate cash or over a term)
 Protection against partnership liability for debts
 Procedure for offering to buy or sell
o Distribution following Dissolution
 Partnerships establish capital accounts for each partner where the following are recorded:
 Additions: initial capital contributions and additional capital contributions, fair market value of
contributed assets at time of contribution, profits allocated to partners from ongoing activities
 Subtractions: interim withdrawals of capital, losses allocated to partners from ongoing activities
 Post-contribution appreciation or depreciation of contributed asset does not affect capital accounts.
 In a rightful dissolution, where the partnership is liquidated, the assets are sold.
 Out of the proceeds, partners receive value of their capital accounts after creditors and partner loans
are paid off.
 Profits are what remains and that is divided according to the default rule of equal sharing or as
agreed by the partners.
 In a wrongful dissolution, settling among partners is the same except breaching partner share is decreased
by damages under UPA §38(2)(a)(II)
 EXAMPLE of how capital accounts might be kept in a partnership
 A & B form partnership
 Agree to share profits equally
 A contributes $10K
 B contributes value of his legal services in drafting partnership agreement (labor; aka services
partnership)
 Capital Accounts upon formation
o A = $10K
o B=0
 Interim Profits
o Partnership has profits of $10K after first year which are shared equally
o Capital Accounts
 A = $15K
 B = $5K
 Interim Losses
o Partnership has losses of $2K after second year which are shared equally
o Capital Accounts
 A = $14K
 B = $4K
 After a number of years, partnership decides to dissolve. At this point, it has assets with a fair market
value of $30K and owes $3K to outside creditors.
o HOW ARE ACCOUNTS SETTLED?
 Assets of partnership = $30K
 Less payment to creditors ($3K)
  Less discharge of A’s capital account ($14K)
 Less discharge of B’s capital account ($4K)
 Amount remaining for distribution as profits = $9K
 This amount is shared equally by A & B ($4.5K each)
o Jewel v. Boxer
 Issues that arise in partnerships that provide services for fees (such as law firm partnership)
 Partnership % in Jewel, Boxer & Elkind (old firm)
 Howard Jewel (30%)
 Stewart Boxer (27%)
 Peter Elkind (27%)
 Brian Leary (16%)
 What were the relationships among the parties?
 Old firm split into 2 separate firm
 Jewel and Leary formed 1 firm and Boxer and Elkind formed the other firm
 The old law firm dissolved into 2 new law firms
 What led to the dispute?
 There was a dispute over legal fees from matters from the old firm
 What is the issue in this case?
 How to allocate legal fees that are received after the date of dissolution by cases that began before
dissolution but weren’t resolved until after so payment didn’t come until after
 Did the partners have an agreement about how to handle this issue?
 No and there was no written partnership agreement at all (bad practice)
 What was the result at the trial court level?
 The trial court allocated the legal fees on a quantum merit basis
 The trial court created a formula based on three factors:
o The time spent by each firm in the handling of each case
o The source of each case (which was always the old firm)
 The court allocated 25% of the total fees to the old firm
o In the personal injury contingency fee cases, the result achieved by the new firm
 J and L was determined to owe $115,041.16 to the old firm
 B and E was determined to owe $291,718.60 to the old firm
 Did the appeal court agree?
 They did not agree and reversed the lower court decision
 Why or why not?
 The fees should not be allocated on this basis and should be allocated based on the partners’
respective interests in the old firm
 This was regardless of whether the former partner in the old firm provided legal services in the case
after the date of dissolution
 Legal fees were to be distributed based on the original percentages
 Rationale for this was that the trial court method was inconsistent with UPA 18(f)
 Jewel v. Boxer: Rule Against Extra Compensation
 Under the UPA, a dissolved partnership continues until the winding up of unfinished partnership
business. No partner (except a surviving partner) is entitled to extra compensation for services
rendered in completing unfinished business. UPA §18(f)
 What is the relevance of §18(f) to the result in this case?
o Because the partners had no agreement on how they were going to resolve disputes about
legal fees that came in after the date of dissolution
o In this case there was no surviving partner
 What are the sound policy reasons for and against such application?
o The rule prevents partners from competing for the most remunerative cases during the life of
the partnership in anticipation that they might retain those cases should the partnership
dissolve
o It discourages former partners from soliciting a firm’s existing clients upon dissolution
 Would there be an unfair result if rule applied?
o The allocation of fees according to each partner’s interest in the former partnership should
not work an undue hardship as to any partner where each partner completes work on the
partnership’s cases which are active upon its dissolution
o This unfair result is mitigated by fiduciary duties
  How do fiduciary duties mitigate such undue hardship?
o Each former partner has a duty to wind up and complete the unfinished business of the
dissolved partnership (this would prevent a partner from refusing to furnish any work an
disposing this obligation totally on the other partners, thus unfairly benefiting from their
efforts while putting forth none of his or her own)
o No former partner may take any action with respect to unfinished business which leads to
purely personal gain
o Thus, the former partners are obligated to ensure that a disproportionate burden of
competing unfinished business does not fall on one partner or one group of former partners,
unless the former partners agree otherwise
 How could this result have been avoided?
o Planning question
o The partners should have thought about this issue in advance when they entered into the
partnership at the beginning and they should have had an agreement about how to allocate
o They also should have had a written partnership agreement to begin with
o Partnership Review Question #3
 What are Jane’s obligations to Michael?
 Can she terminate the partnership at this point in time?
 What does Jane owe Michael?
 Module 2 Quizzes:
o Quiz 7: Formation of Partnerships; Partnership by Estoppel 
 In Fenwick v. Unemployment Compensation Commission, the existence of a written partnership agreement
was considered conclusive evidence that Chesire and Fenwick were partners. (T/F)
 False 
 What is the UPA test for determining if a partnership exists?
 The parties are operating a business for profit under co-ownership
 According to the court in Young v. Jones, the court found there was no partnership by estoppel because
investors did not rely on a representation of any Price Waterhouse-US partner about the existence of a
partnership with Price Waterhouse-Bahamas and investors did not extend credit to either Price Waterhouse-
US or Price Waterhouse-Bahamas. (T/F)
 True 
 Which of the following is not required for a finding of partnership by estoppel?
 The parties enter into a written partnership agreement
 Under the UPA, partners may be jointly and severally liable for debts and obligations of the partnership.
(T/F)
 True 
o Quiz 8: Limited Partnerships; Partnership Fiduciary Duty 
 In a limited partnership, both general partners and limited partners are personally liable for all debts and
obligations of the partnership. (T/F)
 False 
 Formation of a limited partnership requires the filing of a certificate with a state government official. (T/F)
 True 
 In Meinhard v. Salmon, Justice Cardozo court determined that Salmon was not entitled to enter into a new
lease as sole lessee in 1922 because he was a fiduciary and should at least have disclosed the existence of the
new lease opportunity to Meinhard. (T/F)
 True 
 Partnership duty of loyalty claims is an umbrella term. Which of the following is not included under the duty
of loyalty?
 Duty not to act in a manner that is grossly negligent or reckless or involves intentional or willful
misconduct or a knowing violation of law in the conduct of partnership business 
 Which of the following states best describes Salmon’s wrongful conduct in Meinhard v. Salmon?
 He violated the duty not to take an opportunity belonging to the business for himself
o Quiz 9: Partnership Property & Management
 Under the UPA, Partners in a general partnership are entitled to receive a pro rata share of profits of the
business. (T/F)
 False
 Under the UPA, if partners in a general partnership do not have an agreement about sharing of losses, a court
will allocate any losses according to the formula for sharing of profits. (T/F)
  True
 Under the UPA, all partners have equal rights in the management and conduct of the partnership business.
(T/F)
 True
 The court in Putnam v. Shoaf found that Mrs. Putnam was not entitled to any share of the recovered funds
because she had conveyed her entire interest in the partnership and retained no ownership rights in specific
items of partnership property. (T/F)
 True
 The court in National Biscuit Company (Nabisco) v. Stroud found that Stroud’s notice to Nabisco that he
would not be liable for future bread purchases by Freeman prevented Nabisco from collecting payment for
such bread from Stroud. (T/F)
 False
o Quiz 10: Partnership Dissolution
 In Owen v. Cohen, the court found that Owen was entitled to judicial dissolution and was entitled to be
repaid $6,986.63 he lent to the partnership before any other distribution was made to the partners. (T/F)
 True
 Which of the following statements about partnership dissolution under the UPA is NOT true?
 A partner who dissolved a partnership in breach of the partnership agreement is entitled to request
liquidation of the business.
 The court in Page v. Page found that a partner who dissolved a partnership at will must have done so in good
faith and may become liable for damages for breach of fiduciary duty if he did not. (T/F)
 True
 The court in Jewel v. Boxer found that former law firm partners must split legal fees pertaining to cases
pending on the date of dissolution but resolved after that date on a quantum meruit basis. (T/F)
 False
 Under the UPA, in the event of dissolution, the claims of third party creditors have priority over the claims
of the partners. (T/F)
 True
 MODULE THREE: INTRODUCTION TO CORPORATIONS (note that we are talking about general rules of corporations;
some business corporations (such as forming a bank) requires more stringent procedures and requirements)
o COMPARISON CORPORATIONS & PARTNERSHIPS
 CORPORATION
 Formalities required
o Such as gov filing of certificate of corporation and keeping a corporate record book
 Limited liability
o Shareholders are not liable for debts of the corporation which exceed its ability to pay
o With limited exceptions
 Free transferability
o Ownership interests can be traded freely
o Corporation continues to exist even when an owner transfers his interest
 Continuity
o Most corporations have no defined duration
o They continue to exist until a government filing dissolves the corporation
o As long as they are in good standing with the state, they may stay a corporation, even if they
are inactive (payment of fees would have to continue even if inactive)
 Centralized management
o Separation of ownership and control
o Owners and shareholders are not making the important business decisions
o Management is in the board of directors who delegate to officers of the corporation
 Double taxation
o Corporate entity is subject to taxation on income and the shareholders are taxed on
distributions made to them
 PARTNERSHIP
 Informal
o No filing required and no other formalities required
 Unlimited liability
 Not freely transferable
o This is a default rule
 o Partner’s exit leads to a dissolution of the partnership
 At will
o Default rule
o At will unless parties agree to a specified term of years
 Equal management rights
o Hands on control by owners
 Single taxation
o No entity level tax
o Profits and losses go to owners
o STEPS IN SETTING UP A CORPORATION
 Choice of corporate form
 Advise clients of availability of different forms of business associations in respective states and
client will choose which is best
 Choice of state of incorporation
 Can choose any jurisdiction, even if that state is not where business has principal office
 Internal affairs doctrine = conflict of laws principle that the law of the state of incorporation is
applied to resolve matters relating to internal governance of the business
 Law of the place of operation will resolve all other matters such as employment, labor, contract, tort,
and property issues
 Focus on Delaware General Corporation Law (DGCL)
 We’re in Missouri. Why are we studying the law of Delaware in this course?
o This is the most popular state of incorporation for large corporations because the code is
modern and up to date and favorable to management
o Because of this, there is a well-developed body of law in the courts which many other
jurisdictions look to for guidance
o Cases in the book are drawn from DE court decisions
 Reserve corporate name
 Name must be cleared with DE secretary of state office to avoid duplication
 Name must be distinctive
 Indicate corporate status in the name (such as Inc. or Corp.)
 Draft, sign and file certificate of incorporation
 File with DE secretary of state
 Hold first meeting of directors
 If directors named in certificate of incorporation, then they are required to hold a first meeting in
which certain important business will take place
 If directors not named, hold meeting of incorporators
o Meeting is held by incorporators rather than directors
 At first meeting of directors, directors adopt by-laws and take other action
 Issue shares and accept paid in capital
 Ownership interest in the business and the acceptance paid in capital
 No min amount of money that must be paid into the corporation for a business to be a corporation
 Stock can be issued with par value or without par value (par value of stock has no relation to its
market value)
o Par value of a share = the value stated in the corporate charter, below which shares of that
class cannot be sold upon initial offering. The issuing company of the shares promises not to
issue further shares below par value so investors can remain confident that no one else will
receive a more favorable issue price
o Par value = nominal value of a security which is determined by the issuing company to be
min price
 Take steps to qualify as a foreign corporation in all states where corporation will be doing business
 Necessary to file in the states where the corporation is doing business but is not incorporated with
sec of state as foreign corp and pay certain fees to the state
o CERTIFICATE OF INCORPORATION
 DGCL §102
 Mandatory Provisions = must be included or else it will not be accepted
o Corporate name
 Include the words Inc. or Corp.
 Name must be pre-cleared with secretary of state
 o Address
o Business/Purpose of corporation
 Can be very broad
 Such as any lawful business
o Capitalization structure
 Capitalization = share structure of business
 Common stock = most common
 Shareholders have identical rights unless specified
o Incorporators’ names and addresses
o Directors’ names and addresses
 If they are to be named in the certificate
 Optional Provisions = can be included but isn’t required
o Provisions on management and provisions limiting powers of corporation, directors,
shareholders
 However these are usually included in by-laws
o Preemptive shareholder rights (aka anti-delusion provisions)
 Refers to contractual clause which gives shareholders the right to buy additional
shares in any future issue of the company’s common stock before the shares are
available to the general public for purchase
 These people are usually early investors/owners who want to maintain the size of
their stake in the company if/when additional shares are offered
o Provisions changing the voting rules of DGCL
o Limit on duration of business
 Not common
o Exceptions to limited liability of shareholders
 If shareholders decided they wanted to be liable for debts and obligations of the
corporation
o Limits on monetary damages for director breach of fiduciary duty
 Note that some fiduciary duties in the DGCL cannot be eliminated
o INCORPORATORS (people who are going to incorporate the business by filing the certificate of incorporation)
(they do not have to play a significant role in the business and they do not have to become shareholders, directors, or
officers) (they are often employees) (role is limited)
 DGCL §101 = Any person may incorporate a corporation by filing certificate with Division of Corporations
of Secretary of State
 DGCL §103 = Signed & dated, pay filing fees
 DGCL §107 = If no directors named in certificate, incorporators will manage the business until directors are
elected
 Distinguish roles of shareholders, directors, & officers in the corporation
 Shareholders = the individuals who have an ownership interest in the business by owning equity
shares or stock shares in the corporation; they have voting rights; they typically do not have strong
control rights in the management of the corporation; delegate to directors; aka stockholders
 Directors = individuals who make important policy and business decisions on behalf of corporation;
limited in number; cannot handle day-to-day operations; delegate to officers
 Officers = take care of the day to day operations which the directors delegate to them
o FILING REQUIREMENT
 DGCL §101(a) = File with Division of Corporations of the Secretary of State
 This is not a difficult process. Secretary of state will simply make sure that the min requirements are
met in the statute and make sure the fee has been paid
 File certificate of incorporation with the secretary of the state
 Must be signed, dated, and filed
 Filed documents are a matter of public record
 Amendments permitted
 DGCL §241 & §242
o COMMENCEMENT OF CORPORATE EXISTENCE
 DGCL §106 = Corporation exists from the date of filing until dissolution
o REGISTERED OFFICE
 DGCL §131 = Registered office required; may or may not be place of business of corporation
 Corporations do not have to have their HQ/principle place of business in the state in which they are
incorporated in
  Must appoint a registered office which is where the service of process can be delivered in the state
 Receives service of process within the state
 Must be a resident person or corporation
o BY-LAWS (longer document)
 DGCL §108 = By-laws adopted at organization meeting of directors or incorporators
 DGCL §109 = May contain provisions on conduct of affairs, rights or powers of shareholders, directors,
officers
 May be amended by directors until payment of initial capital; after that, shareholders must vote to
amend
 Not a matter of public record
 Detailed provisions about the incorporation
 Not filed with the Secretary of State
o DISSOLUTION
 DGCL §275: Procedure for dissolution
 (a) & (b) = Resolution to dissolve by majority of the old board + vote of majority of outstanding
stock entitled to vote, and filing of Certificate of Dissolution with Secretary of State,
 OR
 (c) = All shareholders consent to dissolution in writing and filing of Certificate of Dissolution with
Secretary of State
 (d) = Certificate of Dissolution must be executed, acknowledged & filed in accordance with DGCL
§103;
 (d) = Minimum contents:
o Name of corporation;
o Date dissolution authorized;
o Whether authorized under (a) and (b) or under (c);
o Names and addresses of directors and officers; and
o Filing date of original certificate of incorporation
 (f) = Corporation will be dissolved upon certificate becoming effective in accordance with DGCL
§103
o PROMOTER’S LIABILITY (promoters are not mentioned in corporate law statutes and they have no clearly defined
or specified role in the business) (refers to someone who has an economic interest in setting up the enterprise and
who make take certain actions in setting up the business prior to the filing of the certificate of incorporation)
 Fiduciary duties
 Problem of self-dealing
 Promoter has status akin to joint venturer or partner
 Duties owed among promoters and to corporation to be formed
 Therefore, it is a breach of fiduciary duty to act on behalf of interest of self instead of corporation
 Liability for pre-incorporation contracts
 If promoter forms corporation later:
o Can corporation become party to contract?
 A corporation can become a party to the contract if the corporation adopts the
contract later
 Can be done expressly through formal board resolution
 Also can be done implicitly if the corporate directors or officers who have authority
to take action on behalf of the corporation knew about an acquest in the contract
 Can also be done through later acts which are consistent with or in furtherance of
the contract such as making payments or accepting benefits
o Can promoter avoid liability?
 Under principals of agency law, the promoter can become liable for pre-
incorporation contract
 Restatement 2nd §326 = purported agent (promoter) acting for a non-existent
principal (corporation yet to be formed) can become a party to the contract so the
purported agent (promoter) can be liable unless otherwise agreed
 Can be changed by contract provision
 If corporation is never formed or if promoter forms a different corporation:
o Who is liable?
 Defective incorporation
  Theories recognize the existence of a corporation under certain circumstances even
if the incorporation process is incomplete and even if the a corporation other than
the original is formed
 Corporation by estoppel
 Would earn a windfall if allowed to evade liability based on absence of incorporation
 Person acted as though he was dealing with a corporation
 Test: were substantial rights affected by the fact that a corporation other than what was originally
contemplated was formed or no corporation was formed at all?
 De Facto Corporation
 Promoters tried in good faith to incorporate and
 Had a legal right to do so and
 Acted as a corporation
 But somewhere along the line there was a defect and the corporation was never validly formed
o Example: the certificate of incorporation was formed but somebody in the office forgets to
file the certificate so the corporation is never formed
o Court may still acknowledge the existence of the corporation if these factors are met
o Walkovszky v. Carlton
 Parties
 Walkovszky
o Plaintiff
o He was injured when he was rundown by a taxi owned by defendant
 Carlton
o Defendant
o Shareholder of 10 corporations, including Seon Cab Corp.
 Marchese
o Defendant
o Operated the cab which hit plaintiff
 Seon Cab Corporation
o Defendant
o Owned two cabs and no other assets
o Maintained minimum liability insurance required under New York State law
 Nine other corporations with same assets and insurance
 Procedure
 Defendant C moved to dismiss the complaint saying it fails to state a cause of action
 Trial court granted the motion
 Appeals court reversed saying there was a cause of action
 It is now on appeal to the highest court
 What was the basis for Walkovszky’s complaint?
 Personal injury
 Theories for liability were:
o (1) he wanted all 10 corporations that were owned by C to be liable (enterprise liability)
 Enterprise liability is premised on the notion that if the owner of the multiple
corporations doesn’t keep them separate, then the court shouldn’t respect that
corporate separation and all assets of all corporations should be available to
creditors
o (2) C and his associates, each individually, should be liable for the damages because they
were operating in a way that was wrongful and fraudulent (piercing the corporate veil)
 According to the court’s opinion, did the complaint state a cause of action?
 No, it did not state a cause of action on a piercing theory
 Why or why not?
 This was because there was no allegation that C was conducting business in his individual capacity
 Piercing is based on agency concepts, not fraud
 The undercapitalization is not sufficient to justify piercing
 There is no fraud because each individual had the minimum required insurance and it is up to
legislature to provide for higher amount
 What was the result in this case?
 Appellate ruling that there was a cause of action is reversed with costs
  Order of trial court should be reinstated
 Plaintiff was able to file an amended complaint
 What are the main points raised by the dissenting judge?
 The very nature of the defendant’s business, operating a taxi business which essentially served to
provide transportation to the public, created a risk to the public and the defendant shouldn’t be able
to just hide behind the insurance statute minimums
 The shareholders should be liable if there is insufficient capital to pay the claims of injured plaintiffs
 There was no legislative acquiescence because the purpose of the statute was to provide minimum
insurance, not to shield shareholders from liability
 The corporations should have carried more insurance and if not, the shareholders should be liable
o ENTERPRISE LIABILITY VS. PIERCING
 Enterprise Liability
 Treat all corporations as one single entity
 All assets available to creditor
o Example: Assets of all ten corporations owned by Carlton available to satisfy judgment in
favor of Walkovszky
 To succeed, plaintiff would have had to prove that C didn’t respect the separate
identities of the corporation (the corporations were not separately operated when it
came to the assignments of the cabs, use of bank accounts, ordering of supplies and
other similar matters)
 Other examples include: common record keeping in place, central accounting
functions, one corporation pays employees of another corporation, using the same
business name, undocumented transfers, unclear allocation of profits and losses, and
having the same shareholders and officers in all corporations.
o NOTE: normally, corporate affiliates (corporations that are under common ownership) are
not responsible for the debts of other affiliates (so enterprise liability would be an exception
to the general rule)
 Compare Piercing the Corporate Veil
 Shareholder’s personal assets may be available to creditor who is seeking to recover from the
personal assets of a shareholder
o This is an exception to the general rule of limited liability which holds that the shareholder
cannot be held liable for debts and obligations of the business beyond its available assets
o You must allege that the shareholder has ignored the existence of the corporation
o NOTE: many states require that there also must be some proof of wrongdoing or injustice
that would result from allowing limited liability to stand under the circumstances
o Example: Carlton’s personal assets available to satisfy judgment in favor of Walkovszky
o HYPOTHETICAL #C1
 How should Walkovszky draft his complaint:
 To recover from Carlton individually?
o This would be piercing the corporate veil
o He should have alleged that Carlton ignored the existence of the corporation rather than
trying to use fraud to prove wrongdoing.
o He should have specifically alleged that Carlton was conducting the business in his
individual capacity and used evidence to support the theory
o He is transferring personal funds in and out of the corporation
 To recover from the assets of the other cab corporations?
o This would be enterprise liability
o He should have alleged that Carlton didn’t respect the separate identities of the corporation
by claiming that the corporations were not separately owned
o He could have pointed to the fact that the assignment of taxis were not separately operated
and probably that the corporations have the same shareholders and officers
 What facts would Walkovszky hope to discover and seek to prove in support of each theory?
 He would hope to discover facts that would prove that all of the corporations are connected in a way.
He should look at bank accounts to see how funds are being transferred and how the members are
being paid
 Look at records and see if they are all being kept in one place and if all accounting transactions are
being done together
o Sea-Land Services, Inc. v. Pepper Source
 Parties
 Sea-Land Services, Inc.
o Ocean carrier who shipped peppers on behalf of The Pepper Source
o Plaintiff in original action
 Marchese (owner of the following business entitles) (all were solely owned by M except Tie-Net)
o The Pepper Source
 Stiffed Sea-Land on the freight bill
 Dissolved the corporation and was left with no assets
 Defendant in original action
o Caribe Crown, Inc.
o Jamar Corp.
o Salescasters Distributors, Inc.
o Tie-Net International Inc.
 M only owns half of this corporation
 Facts
 Sea Land shipped peppers for Pepper Source and Pepper Source never paid.
 Sea Land sued and obtained a default judgement for the amount owed
 At this time they found out that Pepper Source had dissolved and was nowhere to be found
 Pepper Source had no assets
 Sea Land then sued Marchese and the 5 corporations in which he owed shares in and wanted to hold
M liable individually for the debt and hold each corporation liable
 Who is plaintiff suing and what is the cause of action?
 Sea Land is suing to recover from individual shareholder M and all other businesses owned by him
 What is plaintiff’s theory of liability?
 Piercing the corporate vail where creditors of the corporation seek to go after the personal assets of
the shareholder
 Plaintiff also mentioned reverse piercing but the court didn’t go much into this
o Reverse piercing = creditor seeks to recover debts owned by the corporation’s owner from
other corporations assets
 What is the test under Illinois law? (when citing to this test, call it the Van Dorn test) (ON THE EXAM we
will use this 2 prong test and then mention the third prong of assumption of risk and go through that but
make sure to mention that this prong isn’t used in the majority of jurisdictions)
 A corporate entity will be disregarded and the veil of limited liability pierced when two requirements
are met:
o (1) there must be such unity of interests and ownership that the separate personalities of the
corporation and the individual or other corporation no longer exist; and
 NOTE: this prong of the test is called Unity of Interest or Alter Ego
o (2) circumstances must be such that the adherence to the fiction of separate corporate
existence would sanction a fraud or promote injustice
 Under the first part of the test, factors considered include:
o (1) the failure to maintain adequate corporate records or to comply with corporate
formalities
 Court says M never held a single corporate meeting, thereby meeting this prong and
no corporate documents
o (2) the commingling of funds or assets
 Used the funds for his own use
o (3) undercapitalization and
o (4) one corporation treating the assets of another corporation as its own
 Under the second part of the test, this requires sanctioning of fraud or promoting injustice if piercing
does not occur
o The court says unless piercing occurs, some wrong beyond a creditor’s inability to collect
would result such as the common sense rules of adverse possession would be undermined,
former partners would be permitted to skirt the legal rules concerning monetary obligations,
a party would be unjustly enriched, a parent corporation that caused a sub’s liabilities and its
inability to pay for them would escape those liabilities, or an intentional scheme to squirrel
assets into a liability-free corporations while heaping liabilities upon an asset-free
corporation would be successful.
 Can plaintiff succeed on this theory?
  The court says no
 The court says that the first prong is met but the second prong is not
 Plaintiff argued that the second prong was met because unless piercing were to occur, Sea Land,
creditor, would not be paid
 The court said that this second prong needed more than a creditor’s inability to collect otherwise this
prong would be satisfied in every case because that is the basis of these lawsuits
 What happened on remand?
 The lower court found in favor of Sea Land and said that piercing was appropriate because there was
evidence showing M, if he were to avoid liability, there would be injustice
 This evidence was tax fraud, paying personal expenses with corporate funds, and avoiding payment
of corporate debt
o PIERCING THE CORPORATE VEIL
 Factors
 Unity of interest (alter ego)
o Van Dorn test (Illinois):
 Failure to maintain corporate formalities, commingling of assets/funds,
undercapitalization, one corporation treats assets of another as its own
 Fraud or injustice
o Need more than creditor’s inability to collect
 Undercapitalization as a factor in piercing
 Definition = Shareholder siphoning of available corporate assets without disclosure to creditors, such
that corporation is deliberately made insolvent, justifies piercing in some cases.
 This is because deliberate insolvency defeats creditor’s expectation that business will set aside
adequate reserves to pay corporate obligations when due.
o Example: Flemming was the sole shareholder of a fruit brokerage business in which he acted
as a middleman between growers and buyers. He collected the sales price from the buyers,
deducted his commission and the transportation charges, and sent the balance to the growers.
However, he also paid himself a salary from time to time that included the amount withheld
from the growers’ payment to take care of transportation charges. When truckers sued for
unpaid bills, he claimed insolvency. Court pierced and held Flemming personally liable.
 De Witt Trucking v. Flemming (4th Cir. 1976)
 Assumption of risk in contract cases
 Some courts impose a third prong in contract cases: assumption of risk
o Did the creditor know of the risk of nonpayment? If so, creditor should have taken steps to
mitigate the risk.
o Even if the first 2 prongs are met in the piercing the corporate veil test, some courts may
now allow piercing if they find that the creditor assumed the risk of nonpayment
o Example: Shareholder set up a corporation with no assets solely to make payments under a
supply contract. Corporation defaulted. Court refused to pierce since supplier knew the facts
and was not misled. Supplier could have taken steps to protect itself, like demanding a
personal guarantee, but failed to do so. Supplier assumed the risk of loss.
 Brunswick Corp. v. Waxman (2d Cir. 1979)
 Judicially created exception to the legal rule of limited liability
 NOTE: piercing is a judicially created exception
 The legal rule for liability for shareholders is limited liability
 Only used when individuals are the shareholders of corporations
 Not used when large corporation has many shareholders
 Does not do away with limited liability, it is simply an exception to the rule
o In re Silicone Gel Breast Implants Products Liability Litigation
 Parties
 Injured female patients who had breast implant surgery with defective implants
o Plaintiffs
 Mechanical Engineering Corporation (MEC)
o A major supplier of breast implants
o Subsidiary corporation
 Bristol-Myers Squibb Co.
o Defendant who filed summary judgment
o Sole shareholder of M
 o Never itself manufactured or distributed breast implants
o Parent corporation
 The relationship among M and B is called a parent-subsidiary relationship
o Parent corporation owns all of the shares of subsidiary corporation
 Which company manufactured the defective implants?
 Mechanical Engineering
 Which one was named as defendant?
 Bristol-Myers
 What legal theories tie defendant to manufacturer?
 Piercing
 Direct liability
 What must plaintiffs show to succeed on each theory?
 Piercing
o Substantial domination test
 Direct liability
o Restatement 2nd of Torts §324A
 How does court rule on motion?
 It says that B is not entitled to summary judgment
 What rationale?
 There are material facts in dispute
 Piercing:
o The court said there was evidence where someone could conclude that there was substantial
domination
 Court looks to the fact that M is supposed to have a separate board of directors
separate from B but the court finds substantial ties between the two such as 2/3
directors on M’s board were also on B’s board
 Evidence of common departments that were shared
 B used M’s assets as its own
 The court didn’t believe that M was operated as a separate business
o If fraud/injustice is necessary, the court says that this prong would be satisfied
 Believes there is evidence of this because M was undercapitalized
 No sufficient funds
 B allowed its name to be used on M products to enhance sales
 Because of this, it would be unjust to not make B liable because it was reasonable
for people to rely on the fact that their name was on the product
 Direct liability:
o By allowing their name to be on the packaging, they held themselves out as supporting the
product to increase sales
o B also had press releases stating that the product was safe
o Because of the marketing and use of B name, cannot deny liability
 Substantial Domination Test
 Whether or not there is evidence that B controlled M so that M is not viewed as an independent
business
 A second prong of fraud/injustice might also apply
 Factors of Substantial Domination
 Common directors & officers
 Common business departments
 File consolidated financial statements/tax returns
 Parent formation & financing of subsidiary
 Gross undercapitalization
 Payment of salaries and other expenses
 All business of subsidiary provided by parent
 Parent uses property of subsidiary
 Daily operations not separate
 Failure of subsidiary to maintain corporate formalities
 Direct liability (Restatement 2nd Torts, §324A)
 One who undertakes to render services is subject to liability to third party for physical harm due to
failure to exercise reasonable care if:
 o Failure to exercise reasonable care increased risk of harm
o Undertaken to perform duty owed by the other to third party
o Harm by third party suffered because of reliance
o HYPOTHETICAL #C2
 How should plaintiffs draft their complaint to state a cause of action against Bristol-Myers Squibb:
 On a piercing theory?
o Think about what is required for piercing when parent-subsidiary relationship
o The plaintiffs should look at the factors of substantial domination and allege that the
companies have common directors and officers, common business departments, the business
of M is provided by B and other factors like this.
 On a direct liability theory?
o They could point to the negligence claim and say that B didn’t exercise reasonable care
because they promoted the product but maybe didn’t actually evaluate it enough
o By promoting the product and putting their name on the packaging, it can be argued that B
undertook to perform the duty owed
o It was definitely reasonable for the plaintiffs to rely on the fact that B might have been
behind the product since they did promote it and say it was safe and their name was on the
packaging.
o CORPORATION REVIEW QUESTION #1
 Clockstoppers, Inc.
 Alfred
o Took earnings out in the form of salary
o Maintained a separate bank account for business
o Failed to hold directors’ and shareholders’ meetings
 All Right Realty, Inc.
 Can All Right Realty, Inc. collect the remaining lease payments from Alfred?
 Discuss whether or not any of the case precedent discussed in this lecture is relevant to answering
the question
 Think about the theories we talked about and the case law with individual shareholders and a parent-
subsidiary relationship
 Which case if any is relevant here?
 Look at the tests and theories used in the cases
 Finding the tests, how do you apply the facts to the reasoning?
o Cohen v. Beneficial
 Shareholder derivative lawsuit
 Who is the plaintiff?
 Shareholder, Cohen, who owned 100/2M outstanding shares of Beneficial Industrial Loan
Corporation
 Petitioner’s decedent
 Who were the defendants?
 Corporation and certain beneficiaries
 Beneficial Industrial Loan Corporation (DE corp; doing business in NJ)
 What is the cause of action?
 Plaintiff claimed there was mismanagement and fraud in the company over an 18 year period that led
to waste in corporate assets exceeding $100M
 What is the legal issue?
 Whether the court should apply a NJ statute for security against expenses in the shareholder
derivative suit
 This raises a constitutional law issue
 What is a derivative lawsuit?
 One in which the shareholder is suing in the name and right of the corporation to redress wrongs that
are done to the corporation
 Although managers of the corporation are supposed to handle all business for shareholders including
handling litigation matters involving the corporation in a derivative lawsuit scenario it is claimed
that the managers cannot act independently in the best interest of the corporation because they are
interested or biased
 Gives standing to shareholders to go against managers who will not sue themselves or their friends
 Why did it arise?
  The shareholder demanded that corporate institute proceedings against defendants but by their
control, the individual defendants prevented it from doing so.
 What is a strike suit?
 Non-meritorious suits brought for their settlement value but they are unlikely to succeed on their
merits
 These benefit lawyers but not shareholders
 As a result, states pass statutes to eliminate these suits (aka nuisance suits)
 Statutes impose barriers such as security against expenses suits (discussed here)
 New Jersey Statute: In derivative actions, persons holding less than 5% or $50K in value must give security
for reasonable expenses, including attorneys’ fees
 Why does plaintiff challenge the statute?
o Plaintiff doesn’t want to post the bond because that would require him to come up with
money to bring the suit
 On what grounds?
o The statute is unconstitutional on due process and equal protection grounds
 Who wins and why?
o Defendants win
o Statute doesn’t violate the constitution
o There is no due process violation because only security for reasonable expenses is required
under the statute
o There is no equal protection violation because the state is entitled to use a percentage of
ownership interest in a corporation as a measure of a plaintiffs good faith and responsibility
o Someone with such a small interest might not be acting in good faith so this is why the
legislature has this requirement
o This is not an unconstitutional classification
 Is the NJ statute applicable here?
o Federal courts sitting in diversity should apply state substantive rules, but not state
procedural rules
o This court classifies the statute as substantive because it creates a new liability where none
existed before: plaintiff can become liable for expenses of defendant if plaintiff loses and
this is secured through the procedure of posting bond
o Eisenberg v. Flying Tiger Line, Inc.
 This case discusses the distinction between direct and derivative lawsuits
 This is important because certain procedural requirements only apply to derivative and not direct
lawsuits
 Who are the parties?
 Max Eisenberg
o Shareholder of The Flying Tiger Line, Inc.
o Plaintiff
o Suing on behalf of himself and all other shareholders of the corporation similarly situated
 Flying Tiger Line, Inc. (air carrier) (DE corp; principle place of business in CA)
o Flying Tiger Corporation
 Wholly owned DE subsidiary organized by parent Flying Tiger Line
o FTL Air Freight Corporation
 Wholly owned DE subsidiary
 Took over as owner
 What was the corporate transaction described in this case?
 Overturning a reorganization and merger
 What was the purpose of the corporate transaction?
 Defendants argue that the purpose was to diversify the company in order to get certain tax benefits
that would be available and they wanted to do so in accordance with the requirements of a regulator
 Steps in the corporate reorganization and merger:
 Before the reorganization and merger
o Max Eisenberg was a shareholder in Flying Tiger Line, Inc.
 Step 1:
o Flying Tiger Line, Inc. (original) formed 2 subsidiaries:
 Flying Tiger Corporation (first tier subsidiary)
 FTL Air Freight Corporation (second tier subsidiary)
  Step 2:
o Original company merged into second tier subsidiary and only the second tier survived
o Original company ceased to exist and second tier subsidiary took over ownership and
operation
o Shares of original company were converted into an identical number of shares for the first
tier corporation
 Step 3:
o New second tier subsidiary changed its name to Flying Tiger Line, Inc. (same as original)
o They did this to avoid confusion
 NOTE:
o By converting the shares to the first tier subsidiary instead of the second, which took over
operations, the shareholders now had shares in the holding company rather than the
operating company
 Why is Mr. Eisenberg bringing this lawsuit?
 Plaintiff claims that he and other minority shareholders were deprived of any vote or any influence
over the affairs of the newly spawned company
 He claims that as a result of the merger, his voting rights were diluted
 He wanted voting rights as a shareholder of an operating company, not voting rights as a shareholder
of a holding company
 What rights did Mr. Eisenberg have before and after the reorganization?
 Before the reorganization, he had the right to vote on fundamental changes to the parent company of
Flying Tiger Line, Inc.
 After the reorganization, he still had voting rights, but they were voting rights with respect to the
holding company, not the operating company
 Why is the distinction between shareholder derivative lawsuits and shareholder direct lawsuits relevant to
Eisenberg’s claim?
 If the claim that he is bringing is viewed as derivative, he will be required to post bond under the NY
securities against expenses statute
 If the court determines that the lawsuit is direct, then no bond is required
 How does Eisenberg categorize his claim?
 He says this is a direct lawsuit because he claims he lost the right to vote on the business of the
operating subsidiaries and he is directly injured by this
 He can now only vote on the business of the holding company
 He cannot vote on any mergers or sales of assets of the operating company
 How does Flying Tiger categorize Eisenberg’s claim?
 This is a derivative lawsuit because the corporation, which Eisenberg originally held shares, was the
party that was harmed when it was merged out of existence and shareholders were only indirectly
harmed
 Defendants argue that the corporation would first have to be revived before the shareholders could
be helped
 What test does the court use to determine whether this suit is derivative or direct?
 If the complaint alleges injury to the corporation then the suit is derivative
 If the injury is to the plaintiff as a shareholder, and to him individually and not the corporation, the
suit is direct because it is individual in nature
 However the court finds this distinction not to be as helpful because this case was very borderline.
 Defendants argued that the court should follow Gordon v. Elliman’s test which said:
o Whether the object of the lawsuit is to recover upon an action belonging directly to the
shareholders, or whether it is to compel the performance of corporate acts which good faith
requires the directors to take in order to perform a duty which they owe to the corporation,
and through it, to its shareholders
 NOTE: this precedent has now been limited to its facts in other cases
 Defendants argued that this applied to the case because if Flying Tiger Line’s directors had a duty
not to merge the corporation, that duty was owed to the corporation and only derivatively to its
shareholders.
o The court did not accept defendant’s argument
o Defendants interpretation of this case takes away the distinction between derivative and
direct actions
 Instead, the court refers to Lazar v. Knolls, which says:
 o If plaintiff does not challenge acts of the management on behalf of the corporation, but
instead claims the defendants are interfering with the plaintiff’s rights and privileges as
shareholders, security for costs should not be required
 This is more what the case is alleging
 The court said plaintiff’s strongest case was Eisenberg v. Central Zone Property Corp
o This was a case he brought years ago which he claimed that the change in voting rights
deprived him of a voice in the operation of his company which would be run in the future by
the trustees of the voting trust
 Who wins and why?
 Eisenberg wins
 This is because his suit is direct and shouldn’t have been dismissed because he failed to post security
bond against expenses of defendants
o DELAWARE SUPREME COURT TEST: DIRECT OR DERIVATIVE?
 Tooley v. Donaldson, Lufkin, & Jenrette, Inc. (Del. 2004)
 The law to be applied henceforth in determining whether a shareholder’s claim is derivative or direct
turns solely on the following questions:
o (1) who suffered the alleged harm (was it the corporation or the suing shareholder,
individually); and
o (2) who would receive the benefit of any recovery or other remedy (would it be the
corporation or the shareholder, individually).
 Would Eisenberg v. Flying Tiger Line be different if this test were to be applied?
 No
 This is because Eisenberg argued that the reorganization harmed them from a voice in corporate
affairs, not that the corporation was injured and because the remedy being sought was an injunction
on the merger, not monetary recovery by the corporation
o DERIVATIVE LAWSUITS
 A derivative lawsuit is one in which a shareholder sues on behalf of corporation to enforce rights of
corporation
 Two suits in one
o Sues corporation in equity
 Corporation is a nominal defendant;
 Alleged wrongdoers are directors and officers and are named as defendants
o Purpose is to bring an action to enforce corporate rights
 Modern derivative suit is treated as one suit
 Recovery, if shareholder is successful, runs directly to corporation
 Involve allegations of mismanagement, waste, fraud by corporate officers and directors, breach of
fiduciary duty
 Attorney’s fees
 If suit is successful, the corporation will pay plaintiff’s fees and expenses.
 Some state statutes mandate fee shifting to plaintiff if suit was brought without reasonable cause or
for an improper purpose.
 Security for fees statutes are now uncommon.
o DIRECT LAWSUITS
 Shareholder suit in personal capacity to enforce rights as an individual shareholder
 Examples:
o Denial or dilution of voting rights;
o Compel payment of dividends declared but not distributed;
o Compel inspection of corporate books and records,
o Require holding of a shareholder meeting
o CLASS ACTIONS
 Shareholder sues in his own capacity as well as on behalf of other shareholders similarly situated
 Group of shareholders assert their individual direct claims through a representative
 Procedural rules applicable to class actions such as plaintiff must be representative of other shareholder
interests and settlement must be approved by court
 Some derivative suit procedural hurdles (like demand) may not apply to class actions but other procedural
hurdles may apply (like giving notice to class members)
o Grimes v. Donald (Delaware)
 This case discusses the demand requirement that is built into state procedural law governing shareholder
derivative lawsuits
 Shareholder Grimes is suing CEO Donald and Board of Directors of DSC Communications Corporation
 What did the defendants allegedly do wrong?
o Plaintiff claims that the board has breached its fiduciary duties by abdicating its authority,
failing to exercise due care, and committing waste.
o Defendants entered into an employment agreement with CEO, Donald.
o This agreement, according to plaintiff shareholder, was one in which the board advocated its
responsibility to run the corporation and it constituted a waste of corporate assets and a
breach of fiduciary duty of care
 Waste of corporate assets = suggests that a transaction approved has been so one-
sided that no reasonable board of directors could have approved the transaction;
there is no valid consideration and the board is throwing money out the window
 What relief is Grimes seeking?
o He is seeking a declaration of the invalidity of the employment agreements between the
CEO, Donald, and the company
o He also seeks an award of damages against Donald and other members of the board for
breach of fiduciary duty of care and waste of corporate assets
 Are his claims direct or derivative?
o The court divides the claims into two parts:
 Abdication claim = direct claim because plaintiff isn’t trying to get a monetary
damage. Instead, he wants the court to invalidate the employment agreement
 Waste & breach of fiduciary duty claims = derivative claims because the wrong that
has happened is to the corporation and the relief that is being sought is monetary
 Abdication claim
 How did the directors allegedly abdicate?
o This claim is based on a clause in the Constructive Termination Without Cause Clause in the
employment agreement
o Constructive Termination Without Cause
 Donald can declare a constructive termination without cause by the company of his
employment as a result of inter alia unreasonable interference, in the good faith
judgment of Donald, by the board or a substantial shareholder of the company in
Donald’s carrying out duties & responsibilities under the employment agreement.
 What argument does plaintiff construct to challenge this provision as an abdication of the board’s
responsibility to the corporation?
o Based on the duty of the board to run the corporation
o The board is supposed to have authority over corporate business
o Plaintiff claims that the potentially severe financial penalties which the company would
incur in the event that the board attempts to interfere in Donald’s management of the
company will inhibit and deter the board from exercising its duties under DGCL §141(a)
 How does the provision in the contract challenge the power structure of the modern business
corporation under DGCL §141(a)?
o If there is a constructive termination without cause under this provision, the result is that the
corporation would have to pay a large amount of money in severance payments to Donald so
it would cost a lot of money if this provision was triggered
o Plaintiff argues that this provision suggests that Donald has the ultimate say, not the board.
If he believes that the board is interfering with the performance of his duties as he would
like to perform them, he can terminate his employment and get a large severance package
payable by the corporation
 Does the court agree that the board abdicated?
o No, there was no abdication by the board under the agreement
o The court said the agreement doesn’t formally stop the board from exercising its statutory
powers and fulfilling its fiduciary duties
o The decision to delegate a task is within the board’s valid exercise of its business judgment
o Business decisions are not an abdication of directorial authority merely because they limit a
board’s freedom of future action
o This is an unusual contract with an unfortunate choice of language but it is not an abdication
of directorial duty
 Derivative claims (waste, excessive compensation, breach of fiduciary duty)
 Is demand required under Delaware law for derivative lawsuits?
o Yes
o It is built into procedural law in the state of Delaware
o Delaware Court of Chancery Rule 23.1
o Quote from Chester County Employees’ Retirement Fund v. New Residential Investment
o Demand is required unless the plaintiff shareholder can show that the demand would be
futile which would in turn satisfy the demand requirement
o Failure to demand or otherwise show a demand would be futile results in the case being
dismissed
 What is the purpose of the demand requirement?
o The demand requirement serves a salutary purpose:
 First, by requiring exhaustion of intracorporate remedies, the demand requirement
invokes a species of alternative dispute resolution procedure which might avoid
litigation altogether
 Second, if litigation is beneficial, the corporation can control the proceedings
 Third, if demand is excused or wrongfully refused, the shareholder will normally
control the proceedings
 The demand requirement protects corporate boards from harassment and
discourages strike suits (extra reason on slide)
 When is demand excused under Delaware law?
o Plaintiff must be able to allege facts with particularity creating a reasonable doubt regarding
board independence
o The basis for claiming excusal would normally be that:
 (1) a majority of the board has a material financial or familial interest
 (2) a majority of the board is incapable of acting independently for some other
reason such as domination or control or
 (3) the underlying transaction is not the product of a valid exercise of business
judgment
o Board independence
 A director is not supposed to appear on both sides of a transaction and it is not
expected to derive any personal financial benefit from it in the sense of self-dealing,
as opposed to a benefit which would fall upon the corporation or all of the
shareholders generally.
 Independence in this context means the director's decision is based on the merits of
something that comes before the board for its approval rather than extraneous or
outside considerations or influences
 In order to establish lack of board independence and therefore demand excusal or
demand futility you need to show one of the criteria that's articulated above.
o Valid business judgment
 Requires a showing that there is a situation, a rare case, in which a transaction is so
egregious on its face that board approval cannot possibly meet the test of business
judgment and a substantial likelihood of director liability exists
 A substantial likelihood of director liability exists when you can show with
particularized facts that it is difficult to conceive that a director could have
satisfied his or her fiduciary duties
 Why might this standard be difficult to meet?
o No discovery will have taken place at this stage of the proceedings when the plaintiff
shareholder is asked to plead and prove demand futility
o Standard = particularized allegations, not conclusory allegations; so it would not be
sufficient in a complaint to say that demand should be excused because the board is not
independent or that their actions are not the product of a valid business judgment
o Must have particularized allegations of reasonable doubt regarding board independence
o Plaintiff has little to work with without discover. They are limited to using the tools at hand
such as publicly available government findings and press releases by the company
 Why would a plaintiff try and use demand futility as an argument rather than making demand?
o Boards of directors, if they are confronted with demand or a shareholder derivative lawsuit,
will reject the demand and move to dismiss the lawsuit
o This is because it is the same people who are being sued that serve on the board of directors
 o This is structural bias (when board members would rather not be sued or have their friends
be sued regarding shareholder derivative actions)
 Was demand required in this case?
o Yes because of the Delaware Court Chancery Rule
o The court never gets to this issue because the plaintiff made demand
 Did plaintiff make demand in this case?
o Yes
o It consisted of the letter that plaintiff sent to the board of directors when he found out about
the employment contract
o He demanded that the board abrogate the agreement
o The board refused the demand
 Can plaintiff assert demand futility at this stage?
o The court says it is too late
o This is because the letter sent to the board covers all later theories of liability that he may
advance so the fact that he made a demand, and that demand was refused, means that he has
now waived his right to claim demand futility and to contest the independence of the board
 What is wrongful refusal?
o This can be used by plaintiffs who make demands and are refused
o Under wrongful refusal, plaintiff in theory can challenge that refusal by alleging facts with
particularity that create a reasonable doubt that the board is entitled to the presumption of
the business judgment rule
o This can be done by alleging facts that the board acted independently or with due care in
responding to the demand
 Once the board has made a decision, in most cases it is going to be protected by the
business judgment rule
 This means that the courts defer to the reasoning and decision making powers of the
directors and they are not going to try and step into the shoes of the board and
second guess the board on business decisions
o This is a difficult burden for plaintiff shareholder to overcome (more difficult than demand
futility)
 Does wrongful refusal apply in this case?
o No plaintiff doesn’t meet the standard because his complaint asserted only conclusory
allegations and what is required to succeed is to plead with particularity
 What is the holding in this case?
 First, an abdication claim can be stated by a shareholder as a direct claim, as distinct from a
derivative claim, but here the complaint fails to state a claim upon which relief can be granted.
 Second, when a shareholder demands that the board of directors take action on a claim allegedly
belonging to the corporation and demand is refused, the shareholder may not thereafter assert that
demand is excused with respect to other legal theories in support of the same claim, although the
shareholder may have a remedy for wrongful refusal or may submit further demands which are not
repetitious
 Plaintiff loses on both claims and the court affirmed the lower court’s decision
o ROLE OF BOARD OF DIRECTORS
 Delaware General Corporation Law §141(a)
 The business and affairs of the corporation shall be managed by or under the direction of the board
of directors.
o DEMAND REQUIREMENT
 Delaware Court of Chancery Rule 23.1
 The complaint shall allege that the plaintiff was a shareholder and shall also allege with particularity
the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or
comparable authority and the reasons for the plaintiff’s failure to obtain the action or for not making
the effort.
 A shareholder plaintiff may satisfy the demand requirement by either making demand on the board to
undertake corrective action or demonstrating that any such demand would have been futile and therefore,
that demand is excused. Where the plaintiff fails to comply with the demand requirement and fails to plead
with particularity why a demand would be futile, the complaint will be dismissed.
 Chester County Employees’ Retirement Fund v. New Residential Investment Corp. (Del. Ch. 2016)
 Purpose
  Allow dispute to be resolved by corporation outside of court
 Allow corporation to take over the lawsuit if it is beneficial to corporation
 If demand is excused or wrongfully refused, shareholder will be allowed to control proceedings
 Protect corporate boards from harassment and discourage strike suits
o DEMAND FUTILITY
 Delaware (Aronson v. Lewis)
 Allege facts with particularity creating reasonable doubt regarding board independence
 Either:
o Majority has material financial or familial interest, OR
o Majority is incapable of acting independently for another reason like domination or control,
OR
o Underlying transaction is not the product of a valid business judgment
 No single approach to demand requirement
 Contrast New York approach (Marx v. Akers)
 Allege facts with particularity that either:
o Majority of the board is interested in the transaction, OR
o Directors failed to inform themselves as reasonably necessary about the transaction, OR
o Directors failed to exercise their business judgment in approving the transaction
 Contrast universal demand requirement in some states
 Universal demand requirement = does away with demand futility. In its place, there is a requirement
that there be a written demand upon the board in all cases and it prevents the shareholder from
bringing a lawsuit for a certain number of days after demand is made unless injury would result or
the board rejects the demand
o WRONGFUL REFUSAL
 Delaware
 Board decision on demand is protected by the business judgment rule
 To overcome, plaintiff must allege facts with particularity creating reasonable doubt that board acted
independently or with due care
o HYPOTHETICAL #C3
 Agricorp Corp. owns and operates farms
 Five member board, including Alice (Chairman of Board and CEO)
 Adams learns of a farm for sale in Indiana.
 She and two other directors decide to buy it.
 Assume this is self-dealing and is a breach of duty of loyalty.
 Is this a direct or derivative lawsuit?
o Look at case-law distinctions
 If this is considered a derivative action, is demand required?
 Vary the facts so only Alice will buy the farm.
 She discloses the opportunity to the other directors.
 The other directors vote to have the corporation reject the opportunity and to approve Alice’s purchase.
 If a derivative suit is brought, is demand required?
o Consider cases and statutes and consider exceptions
o BUSINESS JUDGMENT RULE
 Delaware General Corporation Law §141(a) = The business and affairs of the corporation shall be managed
by or under the direction of the board of directors.
 This is the basis for judicially-created rebuttable presumption that directors and officers carry out
their functions in good faith, after sufficient investigation, and for valid business reasons
 Protects most board decision-making
o SPECIAL LITIGATION COMMITTEES
 Board Committees (permits boards to take action through a committee structure) (allowing board
committees to be formed)
 Permitted under DGCL §141(c)(2)
o The full board may designate one or more committees, each consisting of one or more
directors
o The board committee may exercise all the powers and authority of the full Board
 A subgroup of board members can take action to bind the corporation without
having to get permission from the full board
 Types of board committees commonly used in large corporations:
 o Audit committee
o Compensation committee
o Nominating and governance committees
o Specialized committees
 Healthcare and drug development
o Zapata v. Maldonado (Delaware)
 Special litigation committee in the context of shareholder derivative litigation
 An exception to the business judgment rule
 Facts
 Maldonado was a shareholder of Zapata and initiated a derivative suit alleging breach of fiduciary
duty against certain officers and all the directors of the corporation
 The shareholder did not make demand, claiming demand futility because all directors were named as
defendants in the action
 A few years after that action, 4 of the defendant-directors were no longer on the board and 2 new
directors were appointed
 Why was a Special Litigation Committee (SLC) formed?
 The independent investigation committee, which was composed of only the 2 new directors, was
formed to investigate M’s actions, as well as a similar derivative action then pending in TX, and to
determine whether the corporation should continue any or all of the litigation
 It was formed to examine the claims of M in the suit where he alleged breach of fiduciary duty
 Who served on the SLC and what powers did the SLC have?
 The 2 new board members who joined after the alleged wrongdoing
 Their determination was stated to be final and not subject to review by the board of directors and
thereby binding on the corporation
 What action was recommended by the SLC?
 The committee concluded that each action should be dismissed because their continued maintenance
is adverse to the company’s best interests
 What action did the board take in response?
 The board moved to dismiss the cases and filed for summary judgment
 What was the legal issue in this case?
 Whether the committee has the power to cause the present action to be dismissed
 The lower courts never reached this issue because judge decided that M could maintain the action
o The lower court stated that the business judgment rule does not confer power to a corporate
board of directors to terminate a derivative suit
 Whether, after an objective and thorough investigation of a derivative suit, an independent board
committee can cause its corporation to file a pre-trial motion to dismiss the derivative suit
 How did the court decide this issue?
 Even in demand futility, the board acting through its committee, can move to dismiss the derivative
lawsuit
 Does the court give deference to the SLC decision?
 The court does not give business judgment rule deference to that committee decision because the
board is alleged to be tainted and allegedly lacks the independence required to make a good decision
on behalf of the corporation with respect to M’s complaint
 The court develops an intermediate approach
 The court is seeking to balance the right of plaintiff shareholder to bring a derivative lawsuit in good
faith with the right of the corporation to move to dismiss litigation that would be detrimental to it
 Conclusion
 The court remands the case back to the lower courts for rehearing consistent with the discussions of
this opinion
 What standard of review does the court adopt in this case? (holding)
 The intermediate standard of review as a 2 part inquiry
 (1) the court should inquire into the independence and good faith of the committee and the bases
supporting its conclusions.
o Limited discovery may be ordered to facilitate such inquiries
o The corporation should have the burden of proving independence, good faith, and a
reasonable investigation, rather than presuming independence, good faith, and
reasonableness.
 o If the court determines either that the committee is not independent or has not shown
reasonable bases for its conclusions, or, if the court is not satisfied for other reasons relating
to the process, including but not limited to the good faith of the committee, the court shall
deny the corporation’s motion
o If, however, the court is satisfied under summary judgment standards that the committee was
independent and showed reasonable basis for good faith findings and recommendations, the
court may proceed, in its discretion, to the next step.
 (2) the court should determine, applying its own independent business judgment, whether the motion
should be granted
o This means that instances could arise where a committee can establish its independence and
sound bases for its good faith decisions and still have the corporation’s motion denied
o This step is intended to thwart instances where corporate actions meet the criteria of step 1,
but the result does not appear to satisfy its spirit, or where corporate actions would simply
prematurely terminate a shareholder grievance deserving of further consideration in the
corporation’s interest
o The court must carefully consider and weigh how compelling the corporate interest in
dismissal is when faced with a non-frivolous lawsuit
o The court should, when appropriate, give special consideration to matters of law and public
policy in addition to the corporation’s best interests
o If the court’s independent business judgment is satisfied, the court may proceed to grant the
motion, subject to any equitable terms or conditions the court finds necessary or desirable
 What are the court’s reasons for using this standard?
 The court notes that the corporation’s board still has the authority to control the business of the
corporation including to control litigation, even though the board is tainted
o Tainted = in the context of demand utility, it is premised on the notion that the board is
lacking independence
 This does not deprive the board of managerial powers
 Business judgment rule deference isn’t warranted because this is a demand utility case
 The court is aware of structural bias on the parts of board of directors and decides to scrutinize
special litigation committees because it recognizes the right of shareholders to bring such actions and
it wants to protect against abuse of board power
o In re Oracle Corp. Derivative Litigation (Delaware)
 The meaning of independence in the context of a special litigation committee
 Parties (aka trading defendants)
 Ellison:
o Chairman, CEO, largest shareholder, founder
 Henley:
o CFO, Executive VP, director
 Lucas:
o Director; chair of executive committee and finance and audit committee
 Boskin:
o Director, chair of compensation committee, member of finance and audit committees
 What was the claim of wrongdoing by the defendants?
 Alleged insider trading
o Insider trading = the use of material, non-public business information for an insider’s
personal and financial advantage
 Plaintiffs allege that trading defendants above breached their duty of loyalty by misappropriating
inside information and using it as the basis for trading decisions
 Plaintiffs also allege that, as to the other defendants who are members of the board who did not
trade, a Caremark violation in the sense that the board’s indifference to the deviation between the
company’s December guidance and reality was so extreme as to constitute subjective bad faith
 In response to the filing of the complaint, Oracle formed a SLC.
 Who served on the SLC and what powers did it have?
o 2 board members were named to the SLC and both of them joined the board more than 6
months after the disputed issue. They also both are tenured professors at Stanford University
 They agreed to receive no special litigation committee-related compensation
because they wanted to make sure they were viewed as independent and impartial.
 They agreed to return any compensation they received if that was needed to preserve
their independence
 They claimed to have no material ties with Oracle
o The committee was to determine whether the corporation should press the claims raised by
the plaintiffs, settle the case, or terminate it
 What steps did the SLC take to investigate?
o The committee also had legal counsel (Simon Thacher & Bartlett LLP) they had not
performed material amounts of legal work for the corporation or any of the individual
defendants before its engagement
o National Economic Research Advisors (NERA) was retained to perform some analytical
work
o They reviewed records
o Counsel interviewed 70 witnesses (some twice) this included the trade defendants
o They had 35 meetings among each other totaling 80+ hours
o One of the board members devoted even more time than this
o They produced a 1,100 page report at the end
 What conclusion did the SLC reach?
o They concluded that the corporation should not pursue the plaintiffs’ claims against the
trading defendants or any of the other directors serving on the board
o They concluded that even a hypothetical Oracle executive who possessed all information
regarding the company’s performance in December and January would not have possessed
material, non-public information that the company would fail to meet the earnings and
revenue guidance it provided the market in December.
o Even though Ellison and Henley had the most access to inside information, they did not
possess material, non-public information
o Lucas and Boskin did not receive the weekly updates that allegedly showed a weakening in
the corporation’s performance during the time so there was even less of a basis to infer
wrongdoing on their part
 What information was omitted from the SLC report?
o Any disclosure of several significant ties between the corporation or trading defendants and
Stanford University
 Boskin ties:
 T.M. Friedman Professor of Economics at Stanford University
 Taught one of the board committee members (Grundfest) when he was a
PhD student
 The two stayed in contact over the years and occasionally discussed public
policy
 B & G are both senior fellows and steering committee members at the
Stanford Institute for Economic Policy Research
 Both publish papers for this and the institute helps publicize their research
 Lucas ties:
 A Stanford alumni for both undergraduate and graduate degrees
 He has made numerous financial contributions to Stanford and he is
affiliated with a family foundation
 He is an important alumni and generous contributor to the law school and
the institute for economic research (mentioned above)
 Ellison ties:
 One of the wealthiest men in America
 A major figure in the community in which Stanford is located
 A major figure in technology industry
 Makes major contributions to Stanford
 What is the primary legal issue discussed in this case report?
 About the independence of the special litigation committee
 Defendant’s arguments?
 The court should look to financial ties
 The facts regarding the ties among Oracle, the trading defendants, Stanford, and the SLC members
do not impair the SLC’s independence
 A director is not independent only if he is dominated and controlled by an interested party
  Much of the law focuses on the bias inquiry on whether there are economically material ties between
the interested party and the director whose impartiality is questioned, treating the possible effect on
one’s personal wealth as the key to the independence inquiry
 They cited to DE cases concluding that directors who are personal friends of an interested party were
not, by virtue of those personal ties, to be labeled non-independent
 Plaintiff’s arguments?
 They said the court should also look at personal ties
 They claim the law should not ignore the social nature of humans and should take into consideration
the loss of independence that might be the consequence of close human ties like those involving the
trading defendants and those who served on the special litigation committee
 Did the court uphold the decision of the special litigation committee and grant motion?
 No it denied the motion to dismiss because they believe that the special litigation committee was not
truly independent
 What test did the court use for judging the independence of the special litigation committee?
 The question of independence turns on whether a director is, for any substantial reason, incapable of
making a decision with only the best interests of the corporation in mind
o Focus is on impartiality and objectivity
o For any substantial reason = not just economic or financial ties, but also personal ties
 They examined the question of whether the special litigation committee can independently make the
difficult decision entrusted to it: to determine whether the trading defendants should face suit for
insider trading-based allegations of breach of fiduciary duty
 Who has the burden of proof?
 The special litigation committee to establish the absence of a material dispute of fact about its
independence
 The court says the facts raise a reasonable doubt that the committee was impartial in its assessment
and recommendation
 It was the social ties that convinced the court that the committee was not independent even though
the committee attempted to disprove this and make itself look independence
o CORPORATION REVIEW QUESTION #3
 Monster Seed Corporation (MSC) (Delaware)
 Keynes, MSC shareholder
 John Smith, CEO and Chairman of Board
 Food for All (FFA)
 Ricardo Smith, Founder (son of John Smith)
 Loan from MSC to FFA in default and Keynes wants to force MSC to enforce collection
 1. If Keynes files a lawsuit challenging board’s failure to enforce terms of loan agreement, what type
of lawsuit would that be? Direct or derivative?
 2. Under Delaware law, would Keynes be required to make demand on MSC board before filing
such lawsuit?
 3. Would you advise Keynes to make demand?
 If not, what argument should he make regarding the demand requirement?
 4. How will MSC respond to filing of lawsuit by Keynes?
 5. If Keynes claims demand futility, MSC may decide to form a special litigation committee.
o Why would they form such a committee?
o If the committee recommends that complaint be dismissed, is court bound by that
recommendation?
o Smith v. Barlow
 Corporate philanthropy & role and purposes of corporations
 What was the transaction that led to the lawsuit?
 Case involved charitable donation of $1.5K from AP Smith to Princeton University
 It was approved by corporation’s board of directors
 Why was the gift challenged as ultra vires?
 Ultra vires = outside the power of the corporation to take part
 What is the relevance of the plaintiff’s certificate of incorporation?
 Shareholder objected that the donation was an ultra vires because the certificate of incorporation did
not explain or expressly authorize the contribution and under the common law the company did not
possess any implied or incidental power to make the donation
 What is the relevance of the New Jersey statute?
  This allowed corporations to make gifts as directors thought would contribute to protection of
corporate interests
 However, gifts more than 1% of capital stock required notice and shareholder approval
 The shareholders claimed that the statute could not be constitutionally applied to permit the gift
because the corporation was created before the statute was enacted
 What is the relevance of the New Jersey constitution?
 The court refers to the reserve power under the NJ constitution which allows corporate charters to be
altered in the discretion of the legislature when the change is in the public interest
 Doctrine suggests that there cannot be a change of the charter which effects rights between
shareholders and corporations and among shareholders
 Other cases in the state have recognized that where justified by the advancement of the public
interest the reserved power may be invoked to sustain later charter alterations even though they
affect contractual rights between the corporation and its shareholders and between shareholders
 What arguments did Smith Manufacturing Company advance in favor of sustaining the gift?
 They presented testimony that the gift was in the best interests of the corporation because:
o The public expects corporations to engage in philanthropy
o Corporation obtains good will in the community by doing so
o Charitable donations create a favorable environment for their business operations
o Recipient of gift might later train employees
o The importance of a liberal education
 Does the court sustain the gift?
 Yes the court allowed the gift
 What are the legal grounds?
 This was a lawful exercise which came within the express authority of the legislative statute
 NJ constitution allows changes to corporate charters if compelling public interest and the court here
believed there was a compelling public interest at stake because corporate charitable giving advances
worthy causes in the community and alleviates the government from supporting such charities
through taxes
 How has the view of the importance of charitable giving changed in recent history?
 The view from the corporation has changed from the view of private profits and common law view
that no corporate gifts are permitted unless they would benefit the Corporation
 Now courts take a more liberal view of such gifts and sustain them upon findings that the donations
tended reasonably to promote corporate objectives
 Corporate gifts have increased and corporations are now expected to discharge social and private
responsibilities as members of the communities in which they operate
 Are all corporate gifts to charity permissible?
 No, there are limitations
 Are there any limitations?
 Yes
 The gift has to not be made discriminately or to a pet charity of the corporate directors in furtherance
of personal rather than corporate ends
 They must be reasonable in amount and within statutory limitations if there is a state statute
restricting amounts of such gifts
o Decided relative to profits and size of corporation
 They must be voluntarily made in the reasonable belief that it would aid the public welfare and
advance the interests of the corporation and as part of the community in which it operates
o The corporate benefit can be general and doesn’t have to be quid pro quo
o HYPOTHETICAL #C4
 What is elephant bumping?
 CEOs who like to go to the places where other big CEOs are because it reaffirms the fact that when
they look around the room and they see all these other CEOs, they must be important because why
else would they be there
 Should corporate management be allowed to make charitable donations to charity?
o HYPOTHETICAL #C5
 You are counsel to public corporation manufacturing auto parts. Chief executive officer wants to make a
$100K donation to a friend’s charity. Corporate before tax earnings are $20M. CEO states that gift must be
anonymous to avoid ill will with other people who are soliciting donations for other charities.
 Is this gift permissible:
 o Under the rule of Smith v. Barlow?
o Under the statutes listed in the casebook?
o CORPORATE POWERS & ULTRA VIRES ACTS
 Delaware General Corporation Code §102(A)(3): Purpose of a Corporation
 Certificate of incorporation is required to set forth the nature of the business or purposes to be
conducted or promoted.
o Only a general statement is needed
 May simply say any lawful act or activity
 May contain restrictions
 Delaware General Corporation Law §124: Ultra Vires Actions on Behalf of Corporation
 No act or transfer of property shall be invalid because ultra vires but lack of capacity or power may
be asserted:
o Shareholder suit to enjoin corporation from entering into such act or transfer of property
o Corporate suit against directors and officers
o Suit by state attorney general
o CHARITABLE DONATIONS
 Delaware General Corporation Law §122
 Every corporation shall have the power to sue and be sued, acquire real or personal property and
dispose of same, conduct its business within or without this state, appoint officers, wind up and
dissolve, make donations for the public welfare or for charitable, scientific or educational purposes,
make contracts and borrow/lend money, pay pensions, buy insurance for its benefit on life of
directors, officers, employees, or any shareholder.
o Underlined portion is what allows corporations to make donations
 California Corporations Code §207(3):
 Power to make donations regardless of specific corporate benefit for the public welfare, or for
community fund, hospital, charitable, educational, scientific, civic or similar purposes
o We aren’t sure what specific corporate benefits are
 New York BCL §202(a)(12):
 Make donations irrespective of corporate benefit for the public welfare or for community fund,
hospital, charitable, educational, scientific, civic or similar purposes, and in time of war or other
national emergency in aid thereof
 Pennsylvania Code §102(d):
 Directors may in considering the best interests of the corporation consider the effects of their actions
on any and all groups affected by such actions, including shareholders, employees, suppliers,
customers and creditors of the corporation, and upon communities in which offices or other
establishments of the corporation are located
o Dodge v. Ford Motor Company
 The business judgment rule and what would need to be shown to overcome the presumption of the business
judgment rule; also an expression of the role and purpose of the modern business corporation
 Facts:
 Dodge brothers were a minority shareholder in Ford Motor Company
 Henry Ford held 58% and was on the board of directors
 The company was very successful and made it a policy to issue huge dividends
 At a point, Ford announced he would stop issuing the dividends and instead use that money to
reinvest in the business in building a new Ford production plant
 Who initiated the lawsuit?
 The Dodge brothers
 Who did they sue?
 Henry Ford
 What relief were they seeking?
 They wanted Ford to reinstitute the special dividend payments and they wanted the court to stop the
building of the new plant
 What legal argument did the plaintiffs advance?
 Their argument turned on abuse of discretion by the board of directors that had approved the
decision to terminate the dividends and build the new plant
 Plaintiffs claimed that directors had changed the purpose of the company from a profit making
institution that was supposed to be generating returns for investors and instead turned it into a
charitable enterprise
  What legal argument did the defendants advance?
 There was an implied corporate power to engage in charitable works such as using corporate funds
for purposes other than paying dividends to investors, as long as they are incidental to the to the
main business of the corporation
 What was the holding of the court?
 The court decided that the payment of the dividends must be reinstituted
 They did not agree that the construction of the plant should be enjoined and stopped
 What reasoning did it use to justify its decision?
 The court said the board did not act within its lawful powers with respect to the decision about the
dividends
 The directors’ actions lacked good faith and they abused their business discretion
 The court was not able to find a lack of good faith in the expansion of the business to build the plant
 What is the relevance of Hunter v. Roberts?
 Discussed in the case
 Important because it talks about the extent to which courts will grant deference to business decision
making
 Just because a business is profitable doesn’t mean the directors need to pay out a dividend
 The provision also talks about when the court will not give business judgment deference to the
board’s decisions (underlined)
 Payment of Dividends
 Hunter v. Roberts (Michigan S.Ct):
o It is a well-recognized principle that directors alone have power to declare a dividend and
determine its amount. Courts of equity will not interfere in the management of the directors
unless they are guilty of fraud or misappropriation of the corporate funds, or refuse to
declare a dividend when the corporation has a surplus of net profits and when a refusal
would amount to abuse of discretion as would constitute fraud or breach of good faith.
 DGCL §170(a):
o Directors may declare and pay dividends out of surplus or net profits, subject to restrictions
in certificate of incorporation.
 What does this case tell us about the nature and purpose of the modern business corporation?
 It stands for the proposition that in the normal course of business, a court will uphold a director’s
decision under the business judgment rule
 They will not uphold such business judgment if there are exceptional circumstances such as fraud
and other bad faith
 This doesn’t mean that directors can never take action to benefit constituents other than shareholders
such employees and customers
 Was this case correctly decided?
 Some say this case is short cited because the court is looking at short term problems rather than
looking at long term benefits to the corporation
 The court may not have fully taken into account the conflict between Ford and Dodge at the time
 Ford wanted to raise the wages of his employees. This was not for charitable donations and the court
did not take this into account
o Berle-Dodd Debate:
 What is the nature and purpose of the modern business corporation?
 Berle: Private Property (privacy view)
o Viewed the corporation as private property and viewed the directors as trustees for
shareholders who should act solely in their best interest
o He later went on to write a book about corporate governance where he articulated this view
 Dodd: Social Institution (stakeholder view)
o Viewed the corporation as social institutions which had social responsibilities
o HYPOTHETICAL #C6
 American Law Institute Principles of Corporate Governance §2.01
 Corporation’s objective is to conduct business with a view to enhancing corporate profits and
shareholder gain
 Even if corporate profit and shareholder gain are not enhanced, corporation is obliged to act within
bounds of the law, may take into account ethical considerations appropriate to conduct of business,
may devote reasonable amount of resources to public welfare, humanitarian, educational and
philanthropic purposes
  What view do the drafters of the ALI Principles of Corporate Governance have about the purpose of the
modern business corporation?
 Would they agree with Berle or with Dodd?
o THE NEW CORPORATE SOCIAL RESPONSIBILITY
 Corporate Social Responsibility = companies should voluntarily decide to respect and protect the interests of
a broad range of stakeholders and to contribute to a cleaner environment and better society through active
interaction with all
 Corporate social responsibility goes beyond compliance with laws to capture voluntary initiatives to
do more than what is legally required
 Supported by company level, industry level, and international codes of conduct
 Developed by business, civil society, national governments and intergovernmental organizations
 Areas of coverage
 Core labor and employment standards
 Green environmental standards
 Reject bribery and corruption of government officials to facilitate business
 Respect human rights
o TRIPLE BOTTOM LINE
 John Elkington of SustainAbility (facilitates sustainable businesses)
 Businesses should take into account finances as well as:
 People
 Planet
 Profit
o CORPORATION REVIEW Q #2B
 Is the lawsuit involving PI direct or derivative?
 What is the test for direct v. derivative?
 How would you apply the test to facts in problem?
o CORPORATION REVIEW Q #2A
 Is the board decision protected by the Business Judgment Rule?
 Module 3 Quizzes:
o Quiz 11: Incorporation Process
 The internal affairs doctrine means that the law of the jurisdiction of incorporation governs all legal matters
involving the corporation. (T/F)
 False
 Under Delaware law, a corporation comes into existence as of the date and time the executed certificate of
incorporation has been filed with the secretary of state’s office. (T/F)
 True
 Under Delaware law, a corporation must maintain a registered office in such state, which is the same as its
principal place of business. (T/F)
 False
 Under Delaware law, which of the following is not required to be included in the certificate of incorporation?
 A statement of the management structure of the corporation.
 Which of the following is not a characteristic of a corporation?
 Equity owners are liable for debts and obligations of the business that exceed its ability to pay.
o Quiz 12: Piercing the Corporate Veil
 In the case of Walkovszky v. Carlton, the plaintiff’s complaint was adequate in pleading grounds for
piercing the corporate veil and holding the shareholder of Seon Corporation personally liable for damages
caused by the taxicab. (T/F)
 False
 Enterprise liability would allow a judgment creditor to collect from other corporations under common
ownership with the corporate debtor. (T/F)
 True
 In the case of Sea Land v. Pepper Source, the court applied Illinois law on piercing the corporate veil, which
required a finding of unity of interest between the corporation and the shareholder along with a
determination that failing to pierce would sanction fraud or promote injustice. (T/F)
 True
 In the case of Sea Land v. Pepper Source, the court stated that the inability of a creditor to collect on a debt
owed by a corporation out of such corporation’s assets was sufficient evidence of the fraud or injustice
needed for veil piercing. (T/F)
  False

The test for veil piercing discussed by the court in the case of In Re Silicone Gel Breast Implants Products
Liability Litigation required an evaluation of the totality of the circumstances and a showing that the
subsidiary substantially dominated the operations of the parent. (T/F)
 False
o Quiz 13: Shareholder Derivative Litigation Part I
 In a shareholder derivative lawsuit, a shareholder is suing in the name of the corporation alleging harm to the
corporation and seeking recovery for the benefit of the corporation. (T/F)
 True
 Which of the following claims would likely be brought as a derivative (rather than a direct) lawsuit?
 Claims that corporate directors wasted corporate assets and breached fiduciary duties
 In Eisenberg v. Flying Tiger Line, Inc., Eisenberg claimed that his voting rights had been negatively
impacted by the reorganization and merger and the court categorized his lawsuit as direct. (T/F)
 True
 In Grimes v. Donald, the court categorized the abdication claim as derivative and categorized the
compensation claims as direct. (T/F)
 False
 Under Delaware law, which of the following is not a required element for demand futility?
 All directors are named as defendants in the lawsuit
o Quiz 14: Shareholder Derivative Litigation Part II
 In Zapata v. Maldonado, the court refused to grant business judgment deference to the decision of the special
litigation committee. (T/F)
 True
 In Zapata v. Maldonado, the court used a two part test for assessing the motion to dismiss by the special
litigation committee: whether the committee was independent and if so, whether the court agreed that the
lawsuit was not in the corporation’s best interest. (T/F)
 True
 In Oracle Corp. Derivative Litigation, the court stated that only economic ties were relevant to determining
the independence of directors serving on the special litigation committee. (T/F)
 False
 A plaintiff in a shareholder derivative lawsuit who makes demand on the board of directors is entitled to
proceed with the lawsuit even if the board rejects demand. (T/F)
 False
 A plaintiff in a shareholder derivative action who makes demand on the board that is rejected may proceed
with the lawsuit if she pleads facts with particularity creating doubt that business judgment rule deference is
warranted. (T/F)
 True
o Quiz 15: Role & Purpose of Corporation
 In Smith v. Barlow, the court found that making the gift to charity was not within the powers of the
corporation. (T/F)
 False
 In Dodge v. Ford, the court found that the board was justified in discontinuing the special dividends because
declaring dividends falls within the board’s discretion. (T/F)
 False
 The business judgment rule is a judicial presumption that directors act in good faith and in the best interests
of the corporation. (T/F)
 True
 Courts will defer to board decision-making under the business judgment rule, except in cases involving
fraud, illegality, conflict of interest, lack of due care, or abuse of discretion amounting to bad faith. (T/F)
 True
 Corporate social responsibility means that corporations should do more than what is legally required and
take voluntary actions that benefit not just shareholders, but other corporate shareholders and society
generally. (T/F)
 True
 MODULE FOUR: LIMITED LIABILITY COMPANIES
o INTRODUCTION
 Hybrid form of business association
 Can combine best features of corporations with best features of partnerships
 Can combine limited liability and flow through tax treatment
  Created under state statutes enacted in all 50 states
 Began in the 1990s
 ULLCA provides rules for structure, governance, and operation of LLCs
 ULLCA §108(a): LLC is a legal entity distinct from its members
 IRS Tax Treatment
 Corporate Characteristics
o Limited liability
o Free transferability
o Continuity of life
o Centralized management (versus member management)
 Tax treatment:
 Prior to 1997, LLC could only receive flow through tax treatment if it had 2 or fewer of the
following attributes:
o Limited liability
o Free transferability
o Continuity of life
o Centralized management
 IRS 1997 Check the Box regulations simplify tax treatment of LLCs
o DOCUMENTS REQUIRED FOR FORMATION (how are LLCs formed?)
 Filing of Articles of Organization with secretary of state in the relevant jurisdiction
 Contents are dictated by statute
 Execution by members of Operating Agreement
 Not filed with the secretary of state and not publicly available
 Much longer than the articles of organization
 Often cover topics such as membership, governance, finance, dissolution
 Flexible structure can be used to revise default rules subject to limits spelled out in ULLCA §105
o FORMATION – ARTICLES OF ORGANIZATION
 ULLCA §201: One or more persons (organizers) may form LLC, consisting of one or more members, by
filing articles with secretary of state
 The LLC comes into existence when the articles are filed with the secretary of state and at least one person
has become a member
 Member = owner of the business
 Limited liability is not available prior to filing the articles
 ULLCA §201: Contents of Articles of Organization
 REQUIRED
o Name of company: must comply with ULLCA §112
o Street and mailing address of principal office
o Name and address of company’s registered agent
 OPTIONAL
o Other provisions can be added but must not be inconsistent with §105(c) and §(d)
 ULLCA §202: Amendment of Articles of Organization
 When filing an amendment, you must state the name of the company, date of filing of initial
certificate, and text of the amendment
 Must be filed with the secretary of state
o Westec v. Lanham
 This case is about filing of a certificate of formation and why it is important.
 It is about the liability of an agent if the principle is not fully disclosed under agency law.
 It is about the constructive notice provision of the LLC statute.
 Suit for money due for services performed under contract.
 Who were the parties to the contract?
 Donald Lanham, manager and member of the Preferred Income Investors LLC, contracted with
Westec, a construction company, to perform engineering work
 Who negotiated the contract?
 Contract was negotiated by Larry Clark who was acting on behalf of Mr. Lanham
 Who did Westec believe was its client?
 No knowledge of any business entity
 Only dealt with Clark and Lanham
  Because W knew Clark was acting as L’s agent, it is clear that C isn’t liable
 According to the trial court, who is liable on the debt?
 Lanham and the PII LLC
 The trial court dismissed Clark because he couldn’t be personally liable
 Does the first appeals court (district court) agree with the trial court?
 They reversed
 Why or why not?
 They relied on the notice provision of the LLC act
o This states that the filing of articles of organization serve as constructive notice of a
company’s status as a limited liability company
 Business card given to Westec:
 Name of Clark
 Address of Lanham (also used as address for PII)
 PII
o There is no mention of the fact that PII was a limited liability company.
o This could have easily been achieved if LLC was after PII
 What is the legal issue addressed by the court?
 Does LLC Act notice provision supplant the partially disclosed principal doctrine?
o Notice that the court is deciding whether the agency rule of liability of agent on contract
involving partially disclosed principal or the notice provision of the LLC Act should be
applied in this case.
 Whether the members or managers of a limited liability company are excused from personal liability
on a contract where the other party to the contract did not have notice that the members or managers
were negotiating on behalf of a limited liability company at the time the contract was made
 What is the argument of Westec (plaintiff)?
 Law of partially disclosed principal not supplanted by LLC notice provision.
 Notice provision applies only where third party seeks to impose liability on LLC members and
managers simply due to status as members or managers.
 Under common law of agency, agent is liable on a contract entered into for a principal if principal is
not fully disclosed.
 If both existence and identity of agent’s principal are full disclosed, agent does not become a party to
any contract he negotiates.
 If the third party knows that the agent is acting on behalf of an undisclosed principal, agent is liable. 
 Liability of agent on a contract where principal is not fully disclosed
o If both the existence and identity of the agent’s principal are fully disclosed to the other
party, the agent does not become a party to any contract which he negotiates. But where the
principal is partially disclosed (the existence of a principal is known but his identity is not),
it is usually inferred that the agent is a party to the contract.
 What is the argument of Lanham (defendant)?
 Westec was on constructive notice that LLC had limited liability because of filing.
 Constructive notice provision provides conclusive presumption that third party dealing with agent of
LLC always has constructive notice of existence of agent’s principal.
 Notice Provision of LLC Act
o The fact that the articles of organization are on file in the office of the secretary of state is
notice that the limited liability company is a limited liability company and is notice of all
other facts set forth therein which are required to be set forth in the articles of organization.
 Who wins this case and why?
 Westec wins this case.
 The court says that the LLC notice provision does not supplant the common law rule of agency on
Agent’s liability on contract involving a partially disclosed principal. 
 Court says that this notice provision means that managers and members won’t be liable simply due
to their status as managers or members.
 It does not mean that a third party who deals with the agent of limited liability company always has
constructive notice of the existence of the agent’s principal. 
 What judicial analysis/reasoning underlies its holding?
 Defendant’s argument exaggerates plain meaning of language of statute.
 It would be necessary to name and state fact of existence as LLC for that to be known by the other
party in this case; it would be an invitation to fraud to apply the notice provision
  Statutes in derogation of common law are strictly construed
 Other sections of the LLC Act reinforce the conclusion that you need to use LLC designation and
observe formalities to get the protections of the Act. 
 How could the losing party have protected itself?
 Losing party could have told Westec that PII was an LLC, as required by the LLC Act.
o Elf v. Jaffari
 This is a case about the LLC operating agreement and what it may contain.
 Derivative lawsuit on behalf of a Delaware LLC.
 Who formed Malek LLC?
 Elf Atochem North America, Inc. (PA corp.) contributed $1M in exchange for 30% ownership
interest in Malek LLC.
 Malek Inc. (CA corp.) contributed its rights in water based maskants in exchange for 70% ownership
interest in Malek LLC.
o Jaffari is president of Malek Inc.
 The purpose of the LLC was to manufacture and distribute chemical maskant is used in the
aerospace industry.
 What documents were executed in connection with the formation and operation of the LLC?
 Certification of Formation for Delaware LLC.
 Operating Agreement: arbitration clause and forum selection. (The Agreement)
 Exclusive Distributorship Agreement. Elf is named as exclusive distributor for Malek LLC.
 Employment Agreement: Jaffari who is owner of Malek was employed as manager of Malek LLC.
 Who filed suit and what were the allegations in the complaint?
 Elf sued Jaffari and Malek LLC individually and derivatively on behalf of Malek LLC seeking
equitable remedies for breach of fiduciary duties to Malek LLC, pushing LLC to insolvency brink by
withdrawing funds for personal purposes, interfered with business opportunities, failure to disclose,
poor manufacturing and violation of environmental regulations
 Why did the Court of Chancery grant the defendants’ motion to dismiss?
 Court of Chancery dismissed for lack of subject matter jurisdiction
 Contract governed the question of jurisdiction and only a court of law or arbitrator in California is
empowered to decide these claims.
 What were the issues raised in the appeal?
 Elf argued that the arbitration clause was unenforceable for various reasons.
 (1) whether the LLC which did not itself execute the LLC agreement defining its governance and
operations (only the individual members signed but no one signed on behalf of the LLC itself) is
nevertheless bound by the Agreement and
 (2) whether contractual provisions directing that all disputes be resolved exclusively by arbitration or
court proceedings in California are valid under the Act.
 How does this court decide those issues?
 The court held that the agreement is binding on the LLC as well as its members and since the Act
does not prohibit the members of an LLC from vesting exclusive subject matter jurisdiction in
arbitration proceedings or court enforcement of arbitration in California to resolve disputes, the
contractual forum selection provisions must govern. 
 What are the Delaware policies that support the court’s decision?
 Delaware policies are to give maximum freedom of contract to parties forming an LLC and also
another policy favoring alternative dispute resolution.
 In this case, the arbitration provision in the contract stripped the Court of Chancery of subject matter
jurisdiction.
 Operating Agreement for Malek LLC
 §13.8: Any controversy or dispute arising out of this Agreement, the interpretation of any of the
provisions hereof, or the action or inaction of any Member or Manager hereunder shall be submitted
to arbitration in San Francisco, California
o This first provision is an arbitration provision.
 Arbitration is a private dispute settlement conducted outside of the government
judicial system. It is frequently used in a commercial context.
 Some of the advantages of arbitration include the fact that the parties are better able
to control the proceedings, it is considered faster, and the results are typically kept
confidential.
 Effect is to oust the jurisdiction of other courts and should be upheld by those other
courts where suit may be filed.
  §13.8: No action based upon any claim arising out of or related to this Agreement shall be instituted
in any court by any Member except an action to compel an arbitration or an action to enforce an
arbitral award
o This second provision states that disputes may not be brought in courts unless such suits are
needed to force the parties to conduct arbitration or once an arbitration has concluded
o And if an award has been issued, to enforce that award.
 §13.7: All Members consent to the exclusive jurisdiction of the state and federal courts sitting in
California in any action on a claim arising out of, under or in connection with this Agreement or the
transactions contemplated by this Agreement provided such claim is not required to be arbitrated
pursuant to §13.8 and to personal jurisdiction in California.
o This third provision is a choice of forum provision that requires any court proceeding to be
brought in California courts as long as such claims are not subject to the arbitration clause
o FORMATION - OPERATING AGREEMENT (content)
 ULLCA §105(a): Members of LLC may enter into Operating Agreement that governs:
 Relations among members and between members of an LLC
 Rights and duties of a person acting as manager of an LLC
 Activities and affairs of LLC
 Means and conditions for amendment
 Unless changed by Operating Agreement, the default rules of the ULLCA apply per §105(b)
o NOTES:
 This provision of the Uniform Limited liability Company act sets forth the scope,
function, and limitations of the operating agreement.
 Note that unless changed by the operating agreement, the default provisions of the
uniform Limited Liability Company Act apply.
 It is not possible to change provisions of the ULLCA specified in §105(c)
 It is necessary to comply with limitations in §105(d)
 NOTES:
o There are limitations on what may be included in the operating agreement.
o For example the operating agreement may not eliminate liability for conduct involving bad
faith, willful or intentional misconduct or knowing violation of law.
o Hypothetical #LLC1
 In Elf v. Jaffari, Elf signed the Operating Agreement but later sued challenging the arbitration clause in that
agreement.
 Why did Elf agree to include the arbitration clause in the Operating Agreement?
o One explanation might be that the lawyer for Malek Inc., which was a California
corporation, might have insisted on this provision. It is possible that the lawyers for elf
believed at the time of accepting the agreement that the portion would be unenforceable.
o Another possibility is that the parties did not contemplate the possibility of disputes arising
in the future.
 Can we draw any lessons about how to draft such contracts?
o One lesson to be drawn, is that lawyers should carefully scrutinize such contract provisions
and consider the implications should disputes arise.
o Hypothetical #LLC2
 The court in Elf v. Jaffari stated that the policy of the Delaware LLC statute was to give the maximum effect
to the freedom of contract and to the enforceability of LLC agreements
 Should there be any limits to the freedom of contract principle for LLCs?
o There are limitations set forth in the statute that the parties must abide by. §105(c)&(d)
o Courts will be unwilling to enforce provisions that they believe are contrary to public policy.
 Suppose the parties had included the following provision in their LLC Operating Agreement:
 Each member agrees that the other shall be relieved of and immune to liability for any act against the
other or against the LLC, whether in tort or contract or in law or equity, regardless of any allegation
of willfulness, intention, or gross negligence.
o Would a court uphold such a provision?
 It seems unlikely that a court would enforce such provision. It would probably be
said to be in violation of public policy.
 ULLCA §105(c)(8), for example, provides that an operating agreement may not
unreasonably reduce the duty of care.
  This is designed to make the point that there are limits on freedom of contract and
that the court in the present case relied in part on the policy in favor of arbitration.
o Kaycee v. Flahive
 This is a case about piercing the LLC veil of limited liability.
 Facts
 Flahive Oil & Gas is a Wyoming LLC with no assets.
 Kaycee Land and Livestock entered into a contract with Flahive
 Roger Flahive was the managing member of Flahive Oil & Gas.
 Kaycee alleges that Flahive caused environmental contamination to its real property.
 Kaycee is trying to pierce the LLC veil of Flahive Oil & Gas in order to hold Roger Flahive, its
managing member, personally liable for the contamination.
 What was the issue addressed by the court in this case?
 The certified question is whether piercing can be applied to LLCs.
 Is a claim to pierce the limited liability entity veil or disregard the limited liability company entity in
the same manner as a court would pierce a corporate veil, an available remedy against a Wyoming
limited liability company?
 What is the argument made by plaintiff?
 Piercing is necessary to avoid an unjust result in this case because Flahive had no assets
 Because piercing is allowed in the corporate context, it should also be allowed in the context of a
limited liability company
 Argument made by defendant Flahive?
 He compares two provisions of Wyoming statutory law:
o Wyoming Business Corporation Act
o Wyoming LLC Act
 No language stating that member/manager can become personally liable
 The difference in the statutory language is significant and concludes that Wyoming law provides for
piercing in the case of a corporation but not for LLCs
 How does the court resolve the issue?
 Piercing is an available remedy for LLCs.
 The court stated that we can discern no reason, in either law or policy, to treat LLCs differently than
we treat corporations. If the members and officers of an LLC fail to treat it as a separate entity as
contemplated by statute, they should not enjoy immunity from individual liability for the LLC’s acts
that cause damage to third parties
 The factors used in the context of an LLC may differ from those applied in the corporate context.
 The court sent the case back to the district court stating that they must conduct a fact intensive
inquiry to determine whether piercing the corporate veil is appropriate under the circumstances of
this case
 What is its reasoning?
 Since piercing is an equitable doctrine, the paucity of statutory authority for LLC piercing should not
be considered a barrier to its application
 Lack of explicit statutory language should not be considered an indication of the legislature’s desire
to make LLC members impermeable
 Wyoming was the first state to enact LLC statutes and it is very unlikely that the legislature gave any
consideration to whether the common law doctrine of piercing the veil should apply to the liability
limitation granted by the statute
 Other states who have allowed this have done so under the corporate standards
 Wyoming Business Corporation Act:
 Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not
personally liable for the acts or debts of the corporation except that he may become personally liable
by reason of his own acts or conduct.
 Wyoming LLC Act:
 Neither the members of an LLC nor the managers of an LLC are liable under a judgment, decree or
order of a court, or in any other manner, for a debt, obligation or liability of the LLC.
o Limited Liability in LLCs and Piercing the Veil
 ULLCA §304
 Debts, obligations, liabilities of LLC belong solely to the company
 Members or managers are NOT personally liable for debts, obligations and liabilities of LLC,
whether arising in contract, tort or otherwise
  Failure to observe formalities or requirements for exercise of powers or management are NOT a
ground for imposing personal liability
o Hypothetical #LLC3
 Court in Kaycee v. Flahive stated that the various factors that would justify piercing the LLC veil would not
be identical to the corporate situation.
 What rationale would support piercing in an LLC case?
o A rationale that would support piercing would be that the entity is not operated separately
from the owner and it would be unfair to allow limited liability to protect the owner.
 What are the important differences between an LLC and a corporation that are relevant to piercing?
o Not spelled out in the case
o LLC can have direct management by members with no separation of ownership and control
and no board of directors. So neglect of formalities would not be the same level of
importance as in a corporation. Other formalities should not be ignored, like commingling
assets or bank accounts or signing in the name of an LLC and not in an individual name.
o The various factors to be applied must be determined by looking at the case law of the
relevant jurisdiction, just like in the case of corporate veil piercing.
o McConnell v. Hunt
 This is a case about fiduciary duties in LLCs. It is also about management of LLCs
 Suit for a declaratory judgment establishing McConnell’s legal right to take the Columbus NHL franchise.
 Facts
 Hunt and McConnell and business associates formed Columbus hockey Limited (CHL), an LLC, to
bring an NHL hockey franchise to Columbus, Ohio.
 After they failed to get public financing (by a sales tax) to build an arena, Nationwide Insurance
offered to build an arena and lease it to CHL.
 Hunt, purporting to act for CHL but without authority to do so, repeatedly rejected the lease offer.
 McConnell was willing to accept the offer.
 There was a meeting of the CHL members, at which Hunt and his followers persisted in the rejection
of the lease offer and McConnell and his associates expressed support.
 McConnell and his associates signed the lease offer for themselves and got the franchise.
 Hunt, failing to recognize that he had simply overplayed his hand and now wanting to be in on the
deal, made angry noises and threatened to sue, so McConnell and his associates sought a declaratory
judgment.
 Hunt filed an answer and counterclaims on behalf of CHL and his firm.
 Hunt also filed an action on behalf of CHL in a New York state court.
 How did McConnell and Hunt wind up competing for the franchise?
 They formed an LLC to bring the franchise to the city
 When they couldn’t get public financing to build an arena, Nationwide offered to pay and lease it to
them but Hunt rejected the offer so McConnell accepted it
 What did the Columbus Hockey Limited LLC Operating Agreement say about competition?
 Columbus Hockey Limited LLC Operating Agreement
o §3.3: Members May Compete.
 Members shall not in any way be prohibited from or restricted in engaging or
owning an interest in any other business venture of any nature, including any
venture which might be competitive with the business of the Company
 Holding?
 Hunt loses.
 CHL operating agreement expressly allowed competition and there was no basis for finding breach
of fiduciary duty or tortious interference. Hunt wrongfully acted on behalf of CHL; under the
operating agreement, he needed approval from the other members and never even tried to get it. And
he acted willfully.
 Directed verdict = no reasonable jury could find a decision to the contrary
 Did McConnell group breach its fiduciary duties?
 In general, there are fiduciary duties in the LLC context and normally there isn’t direct competition
allowed among members.
 The members here have waived their fiduciary duty not to compete in the operating agreement so
therefore, there is no breach of fiduciary duty
 Did it engage in the tort of interference with business relationships?
 The court said no
  It was a Hunt's own actions that caused the termination of any relationship with Nationwide and the
NHL, not the actions of McConnell.
 McConnell agreed to take the deal only if Hunt did not.
 Did Hunt breach the Operating Agreement?
 The court said yes
 Hunt acted like he was the manager but there is no evidence to bear this out. He was a member and
needed approval from the majority of members.
 He breached the operating agreement when he filed suit without getting approval from the other
members. He needed a majority to act. 
 There was a directed verdict after trial in favor of McConnell on the claim that Hunt breached the
contract in rejecting the lease and usurping control
 How was Columbus Hockey Limited LLC managed?
 It was member managed.
 Here is language from the Operating Agreement, §4.1:
o No member may take any action on behalf of the company unless such action is approved by
a majority of the units allocated.
 We can read this to mean that no member of the LLC can act without the approval
of a majority of the other members
o FIDUCIARY DUTY
 ULLCA §409(a): Standards of Conduct for Members and Managers Conduct
 Members owes duty of loyalty and care to member managed company and its other members
o These standards apply to member managed LLCs aka LLC where all members have the right
to manage
 ULLCA §409(b): Duty of loyalty includes the following duties:
 Account and hold as trustee any profit from winding up, use of company property, appropriation of
company opportunity
 Dealing as or on behalf of person with adverse interests
 Competing with company before dissolution
o NOTE:
 Duty of loyalty defined as accounting for profit from use of property of LLC and
appropriation of corporate opportunity, refrain from acting adversely to the LLCs
interests, refrain from competing with the company in the conduct of its business
before dissolution.
 ULLCA §409(c)
 Duty of care is to refrain from engaging in grossly negligent or reckless conduct, willful or
intentional conduct, or knowing violation of law
o Duty of care limited to not committing acts that are grossly negligent, reckless, intentional,
willful violation of law.
 ULLCA §409(i): Manager in a manager managed company owes duties of loyalty and care to company and
members
 Members who do not manage don’t owe such duties
 Members must discharge duties and exercise rights under ULLCA and operating agreement
consistent with contractual obligation of good faith and fair dealing
o NOTE:
 These standards apply to member managed LLCs (defined as LLC where all
members do not have the right to manage but instead appoint one or more managers
to run the business)
 Example:
 AB Industries LLC has two members, Ann and Barb.
 It is a manager managed company with Chris serving as nonmember manager.
 Chris may not compete with ABC.
 Ann and Barb may compete.
o Styles of LLC Management
 There are two styles of LLC Management:
 Member management and Manager management
 ULLCA §407(a): An LLC is member-managed unless the operating agreement expressly provides that it will
be manager-managed
  This indicates that member-management is the default rule and the parties who organize the LLC
must make a choice when organizing the business about which style to adopt
 ULLCA §407(b): Member-managed LLC
 Management is vested in members
 Members have equal rights in management
 Differences on ordinary business matters are decided by majority vote of members
 Affirmative vote or consent of all members required for taking actions outside the ordinary course of
business or for amending the operating agreement
 ULLCA §407(c): Manager-managed LLC
 Matters related to activities or affairs of company are decided exclusively by the manager or, if there
is more than one manager, by a majority of the managers
 If there is more than one manager, managers have equal rights in management
 Affirmative vote or consent of all members required for taking actions outside the ordinary course of
business or for amending the operating agreement
 Managers must be designated (appointed), removed, and replaced by a majority of Members
o No Agency of Members
 ULLCA §301
 A member is not an agent of LLC solely by reason of being a member of the LLC.
o Hypothetical #LLC4
 Hunt, after getting approval of other members of CHL, negotiated with Nationwide for the arena and was
nearing an agreement. McConnell then made a better offer to Nationwide and won the right to lease the
arena and based on that fact, was awarded the franchise.
 Would the result in McConnell v. Hunt be the same under the alternative set of facts?
o First part of opinion suggests that provision in operating agreement granting freedom to
compete would be dispositive and McConnell would win.
o Last part addressing fiduciary duty and tortious interference relies on Hunts rejection of
Nationwide deal and suggests result under either theory might have been different if Hunt
had not rejected the Nationwide proposal or if McConnell had acted in a sneaky or
contentious way.
o Hard to reconcile the two approaches.
o Hypothetical #LLC5
 That court in McConnell v. Hunt stated:
 We conclude that §3.3 is plain and unambiguous and allowed members of CHL to compete against
CHL for an NFL franchise
o Do you agree that language of §3.3 of the Operating Agreement was clear & unambiguous?
 No. The language is boilerplate and could be read more than one way.
o If not, how would you redraft that clause to remove all possible doubt about its meaning in
this case?
 Should have said including competition for award of hockey franchise for Columbus
o New Horizons v. Haack
 This case deals with dissolutions
 Suit for an unpaid debt.
 Facts
 Haack was one of the founders and members of Kickapoo Valley freight, LLC.
 Kickapoo went out of business owing $1009.99 to New Horizons, on an account in name of LLC.
 Haack had made representations that she was a partner and she would make payments on the bill.
 When the LLC was dissolved (in a non-technical sense, with no formal procedures), some assets
were distributed to Haack (though there is some indication that these may have been used to pay off
creditors other than New Horizons).
 New Horizons sued Haack on an alter ego theory.
 The trial court held Haack liable on the alter ego theory, relying in large part of the fact that the LLC
was treated as a partnership for tax purposes. Haack appealed
 What was the defendant’s defense?
 She said the account opened with New Horizons was in the business name, that she was not
personally liable for debts of the LLC (because of the principal of limited liability), and that she had
not personally guaranteed the obligation
 NOTE: Haack was not good about record keeping and didn’t follow formalities
 The trial court denied the defense. What was the basis for its decision?
  The trial court said Haack was liable because it was appropriate to pierce the veil and because the
company was treated as a partnership was evidence that she was liable because all partners are
jointly liable
 There was some confusion in trial court’s opinion because they considered her as a partner but she
claims to have organized under an LLC
 Holding of Appellate court
 The judgment against Haack upheld but on a different theory.
 Tax treatment is not conclusive as to alter ego, and Haack should prevail on that theory.
 Since she did not follow proper procedures for dissolution and did not prove that the amounts
distributed to her on dissolution were less than the amount of the debt to New Horizons, she is liable.
 Does this appellate court agree with the lower court’s decision?
 The appellate court agrees that Haack is liable but it uses a different rationale.
 This court said piercing does not make sense because there was no evidence that the LLC was
Haack’s alter ego.
 Court states that lower court erroneously deemed Kickapoo’s treatment as a partnership for tax purposes to
be conclusive. Is such tax treatment relevant to the question of liability in this case?
 Partnership tax treatment is not conclusive on the legal status of the entity under state law.
 Those are two separate legal issues.
 Partnership tax treatment does not mean that the entity is a partnership for state law purposes.
 Does Haack’s statement to New Horizons that she would start paying $100 per month on the account suggest
another theory of liability that plaintiff could have used in this case?
 She might have been issuing a guarantee with that statement
 It could also be interpreted simply to mean she would use her best efforts to see that New Horizons
would be paid
 Why did Kickapoo Valley Freight LLC fail to pay New Horizons’ bill?
 It was dissolved and the only assets were a truck which was secured by the bank and some accounts
receivable that they were trying to collect.
 There were insufficient assets left to pay the bill
 Did Haack follow the statutory steps for dissolution?
 NO she did not follow formalities.
 She did not have articles of organization or an operating agreement but the court seems to have
accepted the existence of the company as an LLC.
 She did not follow the statutory steps for dissolution.
 What is the court’s holding and rationale?`
 Appellate court agreed with the lower court but on different grounds
 The court says that she should be held liable because she failed to establish that she took appropriate
steps to shield herself from liability for the company’s debts following its dissolution and the
distribution of its assets.
 Court says that she did not establish at trial that the amount of New Horizon’s claim exceeded the
value of any liquidation distribution she may have received from the dissolved company.
 In this regard the court agreed with the trial court's comments regarding the lack of evidence in the
record to show the Kickapoo Valley's affairs were properly wound up following its dissolution
occasioned by Robert Koch's dissociation from the enterprise.
o DISSOLUTION under ULLCA (statutory steps of dissolution)
 §701 = Events of dissolution for an LLC
 §702 = Winding up after dissolution has occurred
 Includes filing of articles of termination
 §704 = Disposing of known claims against LLC by giving notice to creditors
 §705 = Disposing of other claims by publishing notice to creditors in a newspaper
 Other claims are barred
 ULLCA sets forth steps for formal dissolution of an LLC.
 §707 = Creditors must be paid first
 This includes paying members who have extended credit through the LLC
 Members are entitled to the return of their contributions only after creditors have been paid off
 §705(d)(2) = Member incurs liability to creditors only up to amount received in distribution from LLC
o Hypothetical #LLC6
 How could Members of LLC protect themselves from personal liability in the context of a dissolution?
  Follow procedure for notice to creditors and filing of claims by creditors. If they do this, a Member’s
total liability may not exceed the total value of assets distributed to the member in liquidation.
 In this case of New Horizons v. Haack, there is nothing in the record showing the disposition of
other company assets such as cash and receivables.
 Suppose that Haack had proved that she had invested $2K in the LLC and that she had paid off Kickapoo’s
debts and then pocketed $500 from what was left over.
 What would be her liability to New Horizons?
o She would be liable for the amount of the distribution to her of $500.
o This is in spite of the fact she invested $2K and had already lost $1.5K at the time of
distribution after payment of liabilities from assets.
o Statute relieves her of liability for the excess of the amount of the debt over the amount
received in distribution, meaning that the creditors would take a loss of $509.99 in this case
o LLC REVIEW QUESTION #1
 What legal issues does this fact pattern raise?
 Can Markus bind BADS to the contracts with BUSA and HOMU even though he exceeded the financial
limits set in the discussions with Pierre and Jorge?
 Look at info from Agency chapter
 Unlikely he had actual authority to enter into these contracts
 Maybe apparent authority
 Did Markus breach his fiduciary duty by taking the $2K per event facility for his own use for the ping pong
events?
 ULLCA §409(b)
 Can BUSA and HOMU recover from Markus, Pierre and Jorge on a piercing theory or because of the
informal way that Pierre and Jorge dissolved the LLC?
 We need more information
 Courts do recognize piercing in LLC cases
 Module 4 Quizzes
o Quiz 16: Limited Liability Companies I
 Which of the following is not a feature of limited liability companies?
 Double taxation
 The organizational documents for limited liability companies consist of the Articles of Organization and the
Operating Agreement; both documents must be filed with the Secretary of State’s office. (T/F)
 False
 In Westec v. Lanham, the court decided that Lanham was not liable for the debt to Westec because the filing
of the Articles of Organization with the Secretary of State’s office served as constructive notice of the
existence of Preferred Income Investors as a limited liability company. (T/F)
 False
 In Elf v. Jaffari, the court stated that jurisdiction was lacking because the parties had included an arbitration
clause in the Operating Agreement and that provision was consistent with the state’s policies on freedom of
contract and alternative dispute resolution and should be upheld. (T/F)
 True
 In Kaycee v. Flahive, the court stated that piercing the veil was an available remedy for limited liability
company cases and also stated that courts should apply the same factors they would use for corporate veil
piercing. (T/F)
 False
o Quiz 17: Limited Liability Companies II
 In McConnell v. Hunt, the court found that the McConnell group breached its fiduciary duties to Columbus
Hockey Limited LLC because they bid for and were awarded the National Hockey League franchise. (T/F)
 False
 In a member-managed limited liability company, members owe duties of loyalty and care to the company
and its members. (T/F)
 True
 In a manager-managed limited liability company, matters relating to the activities and affairs of the company
are decided by the manager(s), subject to certain enumerated exceptions. (T/F)
 True
 In New Horizons v. Haack, the appellate court found that Allison was liable for the debt owed by Kickapoo
Valley Freight LLC based on the theory of piercing the veil of limited liability. (T/F)
 False
 
Under the Uniform Limited Liability Company Act, where statutory dissolution procedures are followed and
assets of the company have been distributed after dissolution, a member’s liability to creditors could be
limited to the amount received by the member in the distribution. (T/F)
 True
 MODULE FIVE: CORPORATE FIDUCIARY DUTY
o Kamin v. American Express Company
 Derivative lawsuit brought by 2 minority shareholders of American Express Company against the board of
directors
 Why did plaintiff shareholders sue defendant directors?
 The complaint alleges that American Express acquired for investment 1,954,418 shares of common
stock of Donaldson, Lufkin and Jenrette, Inc. at a cost of $29.9M with a market value of $4M
 Shareholders are asking for a declaration that this dividend was a waste of corporate assets
 They are asking defendants not to proceed with the distribution or in the alternative for monetary
damages
 Defendants moved for an order dismissing the complaint or alternatively for summary judgment
 What was the defendants’ view of what to do with the DLJ stock that had declined in value?
 They decided it was in the best interest of the corporation to declare a special dividend to all
shareholders pursuant to which the shares of DLJ would be distributed in kind
 How did plaintiff think the stock should have been handled?
 They argued that American Express should have sold the shares on the market, sustained a capital
loss of $25M which could be offset against taxable capital gains on other American Express
investments resulting in projected tax savings of around $8M
 What did the board identify as an offsetting benefit to the losses identified by the plaintiff?
 Plaintiffs had argued that the board action meant that American Express would not receive the tax
saving benefits that would be available in the plaintiff’s option
 However, the board argued that the projected loss of $25M would be reflected as a reduction of
American Express net income which would cause the stock price to fall
 This loss would be a charge against earnings only in the event of a stock sale
 Therefore, the defendants argued that the offsetting benefit was avoiding a fall in the stock price of
American Express by distributing the stock of DLJ as a dividend in kind
 How did the plaintiff shareholders frame the alleged legal wrongdoing of the defendants in the complaint?
 They alleged that board of directors engaged in waste of corporate assets and engaged in negligence
in their decision making in violation of their duty of care to preserve American Express assets in the
same manner as those directors would preserve their own personal assets
 What is the standard adopted by the court for the duty of care of directors?
 The court adopted a gross negligence standard saying that a simple error of judgment (aka simple
negligence) is not enough to overcome the protection of the business judgment rule
 What must plaintiff shareholders allege to win a duty of care case?
 In order to overcome the presumption of the business judgment rule, it is necessary to allege
misconduct of a higher order of magnitude such as fraud, illegality, bad faith, malfeasance, or
nonfeasance
 Did the defendant directors violate their duty of care?
 The court says no
 The directors held a special meeting where they carefully considered and unanimously rejected. The
minutes from the meeting indicate that directors were fully aware that a sale rather than a
distribution of the DLJ shares might result in the realization of a substantial income tax savings
 The board rejected this due to countervailing considerations
 They acted appropriately by meeting as a board and having a valid business decision for their reason
 NOTE that the duty of care is process orientated. If a board in its decision making is fully informed
on an issue and if it deliberates fully and has a rational business purpose for its decision, it is likely
that the board’s actions will be upheld if challenged in the absence of gross negligence
 What is the relevance of the court’s comments that 4 of 20 directors were officers and members of the
American Express Executive Incentive Compensation Plan?
 Plaintiff shareholders had raised a highly speculative claim of self-dealing. The basis of this claim
was that the directors stood to profit from their decision to distribute the devalued stock because
their compensation was tied to net earnings
 This in essence was a duty of loyalty claim which the court rejected
  The court rejected it because only 4 of the 20 company directors were inside directors who might
have profited based on the claim and there was no evidence of domination or control of other board
members by those few who might have been impacted
 Conclusion?
 In this case it clearly appears that the plaintiffs have failed as a matter of law to make out an
actionable claim. Accordingly, the motion by the defendants for summary judgment and dismissal of
the complaint is granted
o Cash Out Merger
 One type of corporate combination
 In this transaction, an acquiring company pays shareholders of target company the value of their shares
 Target company is merged out of existence and shareholders have no interest in any company that results
from the merger
 Shareholders’ interests of the target company are, in principle, protected by fiduciary duties of directors
o Merger Approval Procedures (there are 2 separate levels of approval that are needed)
 DGCL §251(b): BOARD APPROVAL
 The board of each merging corporation shall adopt a resolution approving an agreement of merger
and declaring its advisability
 DGCL §251(c): SHAREHOLDER APPROVAL (even though shareholders have generally given up their
control rights, they are still able to have a vote when it comes to merger transactions)
 The merger agreement shall be submitted to shareholders for approval if recommended by the board
 Majority of shares entitled to vote must approve the merger
 If approved by requisite number of shareholders, the merger agreement (or certificate of merger) is
then filed and the merger becomes effective
o Management by Board of Directors (steps needed for valid board voting)
 DGCL §141(a): BOARD AUTHORITY
 Business and affairs of corporation shall be managed by or under the direction of a board of directors
 DGCL §141(b): BOARD COMPOSITION & ACTION
 A board is composed of one or more members
o This number is fixed in bylaws or certificate of incorporation
 In order to have valid board action, there must first be a quorum at the meeting at which action is
considered and then taken by the board of directors
o Quorum = majority of total number of directors
 This number can be reduced to 1/3 in the bylaws unless the certificate of
incorporation provides otherwise
o Valid board action consists of a vote of a majority of directors present at a meeting at which
a quorum present
 It is possible to require supermajority (larger number) of directors to vote in favor of
the merger in the certificate of incorporation or bylaws
o Shareholder Voting (how do shareholders take action?)
 DGCL §216
 Majority of shares entitled to vote shall constitute a quorum at a shareholder meeting
o Can reduce to 1/3 if provided in the certificate of incorporation or bylaws
 Vote of majority of those present or represented by proxy shall be the act of the shareholders
o Except for election of directors
o Directors can be elected by a plurality vote
o Corporate Voting Under DGCL and Model By-Laws
 Recall the case of Smith v. Van Gorkom.
 What type of voting was necessary to approve the transaction discussed in that case?
o
 Whose vote was required?
o
 What type of meeting was convened?
o
 What were the procedures for calling the meeting?
o
 What were the requirements for time and place of meeting?
o
 What number of votes was needed for valid action?
 o
o Smith v. Van Gorkom
 Duty of care case & cash out merger
 Case about a merger transaction
 Chronology of important events:
 8/27/80 & 9/5/80: Senior management & Van Gorkom discuss sale/leveraged buyout of TransUnion;
CFO & COO ran the numbers at $50 & $60/share
o The transaction used as a basis for running these numbers was a completely different
transaction from what was approved by the board of directors of TransUnion
o Leveraged buyout = a purchase of a company (sometimes purchased by a group of insiders)
which is financed by a relatively small amount of equity and a large amount of debt, which
provides the leverage. Often other assets of the company will be sold to pay off these debts
o The number of $50-$60 a share had to do with whether or not the company could borrow
enough money to pay the existing shareholders that amount of stock in the leveraged buyout
 9/13/80: Van Gorkom meets with Pritzker & offers him TransUnion at $55/share; the offer included
$17 premium per share over market price
o The current market price of TransUnion was $38/share
 9/15/80-9/19/80: Pritzker expresses interest in the offer to sell TransUnion
o This was subject to conditions
o It was subject to his ability to get financing, to a lock-up option and to board approval by
TransUnion within 3 days
 Lock-up option = it would be an agreement by TransUnion that would allow Mr.
Pritzker to buy 1M shares at $38 per share so assuming the shares would have been
sold to someone else for $55 a share it would lock the price for him of $17 premium
per share or a total of $17M
 9/20/80: Van Gorkom felt under pressure to get board approval for the deal and convened meeting of
senior management at 11 AM where he discussed the proposed deal (many were not happy); this
meeting was followed by board meeting at noon
o At the board meeting, it was requested that the board members proposed to accept the
proposed merger and vote in favor
o They were given no documentation of a merger agreement or a letter of intent
 Letter of intent = non-binding commitment
o No valuation study presented to board
 This means there was no information presented to the board about the $55 per share
price that V had thrown out to Pritzker
o Board approved after 2 hour meeting subject to conditions:
 Reserve right to accept better offer during market test period
 Market test period = mechanism in which TransUnion would be given the
opportunity to solicit other bids and to compare them to the deal with
Pritzker
 Retain the ability to share proprietary information about TransUnion with other
potential bidders
 10/8/80: Board meeting convened and approved proposed amendments to Merger Agreement sight
unseen; Salomon Bros. Retained to solicit offers for 3 month market test period
o Amendment signed by Van Gorkom were not consistent with authority granted by the board
o Also no documentation on merger agreement
o No other viable offers were made
o The board approved the merger and approved the amendments to the merger
 Remember that shareholder approval is also required for a merger to be effective
 2/10/81: Shareholders approve Pritzker merger proposal
o They were sent information about the merger and asked to vote in favor of the merger
o Some shareholders weren’t happy with the deal because of the $55 per share price and sue
 Shareholders now sue for rescission and damages against directors
 After trial, court grants judgment for defendant directors
 What is the issue on appeal?
 Whether the actions of the board were subject to protection under the business judgement rule
 This required the court to consider whether the board met the requisite standard of the fiduciary duty
of care
  Whether the board fulfilled its fiduciary duty of care by adequately informing themselves prior to
making a business decision of all material information reasonably available to be afforded the
presumption of the business judgment rule
 What presumption must the plaintiffs overcome to prevail on their claim?
 The presumption of the business judgment rule
 What is the standard for fiduciary duty of care articulated by the court?
 A director has a duty under DGCL §251(b), along with his fellow directors, to act in an informed
and deliberate manner in determining whether to approve an agreement of merger before submitting
the proposal to the shareholders. It must use all material information that is reasonably available
 Does the action of the Board meet the standard for fiduciary duty of care?
 The court analyzed this looking at 2 separate positions in time
 Analysis of September 20 meeting: Was the approval process for the merger agreement used by the
Board acceptable?
o The court says no
o The merger process was not acceptable because the board did not act with due care and
therefore the decision was not protected by the business judgement rule
o The board did not reach an informed business decision to sell the company because the
directors didn’t adequately inform themselves as to Van Gorkom’s role in forcing the sale of
the company and in establishing the per share purchasing price
o The directors were uninformed as to the intrinsic value of the company
o Given these circumstances, the directors were, at a min, grossly negligent in approving the
sale of the company upon two hours of consideration, without prior notice, and without the
exigency of a crisis or emergency
o DEFECTS IN THE BOARD PROCESS:
 No prior notice at the meeting
 No written documentation of terms of merger agreement
 No valuation study or an appraisal of the value of shares
 Analysis of post-September 20 conduct: Was the merger agreement amended to allow for a market
test to occur?
o The court says no
o The merger agreement was not amended to allow for a market test to occur
o The market test period was actually reduced, not extended
o There was no evidence that the merger agreement had been effectively amended to give the
board freedom to put TransUnion up for public auction for a higher price
 What was the holding?
 The directors of TransUnion breached their fiduciary duty to their shareholders
o (1) by their failure to inform themselves of all information reasonably available to them and
relevant to their decision to recommend the Pritzker merger and
o (2) by their failure to disclose all material information such as a reasonable shareholder
would consider important in deciding whether to approve the Pritzker offer
 On remand, the court of chancery shall conduct an evidentiary hearing to determine the fair value of
the shares represented by the plaintiffs’ class, based on the intrinsic value of TransUnion on 9/20/80
 Thereafter, an award of damages may be entered to the extent that the fair value of TransUnion
exceeds $55 per share
 Shareholder Ratification
 Shareholders voted to approve the transaction upon the recommendation of the Board and they did
approve the merger upon the vote
o 70% voted in favor and only 7% voted against; the rest didn’t vote
o Shareholder ratification is sometimes used to uphold a transaction that is under attack and
might otherwise be struck down by a court
 What is the argument that this protects the transaction from attack based on a flawed Board
procedure?
o Because the overwhelming majority of shareholders liked the price of $55 per share,
transaction should therefore be upheld on a theory of shareholder ratification
o Even though there was flawed board procedure, this argument would try to save the
transaction from attack and uphold the transaction because the shareholders agreed with the
price
 Does that argument work in this case to protect the merger?
 o The court doesn’t accept this argument because it believed that even though the shareholders
voted in favor of the merger price, the vote shouldn’t be considered as valid ratification to
save the transaction because the shareholders didn’t receive full and fair disclosure of the
underlying facts which they were supposed to base their decision
 How was this provision (DGCL §141(e)) used by the defendants in this case?
 Defendants argued that they based their decision on reports of senior officers at the board meetings
and therefore they should be entitled to rely on this provision
 They tried to say that they relied on the report given by Van Gorkom in the 9/20 meeting and on
other reports presented there
 Can directors rely on this provision (DGCL §141(e))?
 The court says no
 There is no evidence on any report that the Pritzker proposal was presented to the board
 The oral report was uninformed because VG hadn’t seen the agreement when he gave the report
 The CEO’s statement was irrelevant because it didn’t purport to be a valuation study
 What would qualify?
 The court says that at a minimum for a report to enjoy the status conferred by DGCL §141(e), it
must be pertinent to the subject matter upon which a board is called to act, and otherwise be entitled
to good faith, not blind, reliance
 What was the main point made by the dissenting judge?
 He argued that the board was composed of experienced business people who knew the company well
and knew business well and their collective experience substituted for adequate information and
deliberation with regard to the merger approval decision
 What happened after remand?
 The case was ultimately settled for $23M which was approved by the trial court
 $10M came from insurance covering the directors and almost $11M came from the Pritzkers. The
rest was paid by the directors but Van Gorkom paid substantially more than the 5 outside directors
 Premium over Market Price = $17 share
 Why were the plaintiffs unhappy with receiving a premium over market price?
o Fair price versus highest possible price
o Duty of directors to obtain highest possible price in sale of company
o Although the $55 per share price was higher than the market price, there was no valuation
study conducted so the premium over market price value could have been even higher had
this study been conducted
o The premium alone doesn’t provide an adequate basis of whether or not the price is fair
o The court criticized the board for failing to investigate how the price of $55 per share was
arrived at because the usual procedure used by companies is not to pull a number out or to
base it on an internal analysis for a completely different kind of corporate transaction
o The usual procedure is to obtain an evaluation study by outside experts and a fairness
opinion by those experts that will protect the shareholders to make sure they are receiving a
good price for their shares and it also protects the board of directors if they are sued
 Contrast facts of Cinerama case
o Use of fairness opinion by outside expert to justify price
o The board approved a merger transaction without much consideration
o They were found to be in violation of fiduciary duty of due care
o However, despite the procedural defects, the price was found to be fair so there was no harm
and no cause of action
o Good Faith Reliance on Records and Reports
 DGCL §141(e): In performing their duties, board members may rely in good faith on records of corporation
and on information, opinions, reports, statements presented to the corporation by corporation’s officers or
employees
o Limits on Director Liability
 DGCL, §102(b)(7)
 Certificate of incorporation may contain provision eliminating or limiting personal liability of
director for monetary damages for breach of fiduciary duty
 EXCEPTIONS
o Duty of loyalty
o Lack of good faith, intentional misconduct, knowing violation of law
o Violation of §174 on dividends
 o Transactions in which director derived improper personal benefit
o Francis v. United Jersey Bank
 An aspect of the duty of care which requires the board members to exercise oversight
 Facts/Background
 Pritchard & Baird was a reinsurance broker
o Reinsurance = business of spreading insurance risk
o Ceding company that has insured a risk assigns some or all of that risk to reinsurer along
with share of the premiums to the reinsurer
o Reinsurance broker acts as intermediary and receives funds from ceding company that are to
be paid to reinsurer
 Pritchard & Baird went bankrupt
 Lawsuit brought by trustee in bankruptcy on behalf of creditors of Pritchard & Baird seeking to
recover money that had been misappropriated by two if its directors (Charles Pritchard Jr. and
William Jr) against the estate of another director, Mrs. Pritchard
 How did Mrs. Pritchard become a shareholder and director?
 She inherited a 48% interest from her husband
 He was the largest shareholder
 She was then elected as a director
 Her sons were also directors
 How did the misappropriation of funds occur?
 The sons withdrew large sums of money from the corporation in the form of loans and never repaid
them
 In this context, misappropriated means that the funds were stolen by the sons
 What type of fiduciary duty claim was asserted against Mrs. Pritchard’s estate?
 Here, it was a breach of the fiduciary duty of care
 She had a duty to protect the clients of the corporation against policies and practices that would
result in misappropriation of money in the corporation and she breached that duty
 In most cases involving fiduciary duties of directors, the claim is made on behalf of the corporation
and its shareholders. Here trustee in bankruptcy is representing the interests of creditors.
 What was the basis for claiming that fiduciary duties were owed to creditors in this case?
 The reinsurance industry involves holding funds in trusts so there is an extra trust involved that the
directors will not sanction the conversion of funds
 Certain directors owe duties to creditors even when the corporation is solvent
 The directors of banking corporations owe duties to depositors who are creditors and the directors of
nonbanking corporations also owe duties when the corporation holds funds of others in trust
 Financial institution directors have an enhanced fiduciary duty because they are holding funds for
customers
 What is the applicable standard of care for someone in Mrs. Pritchard’s position?
 Good faith and due care
 The standard is the level of diligence that an ordinarily prudent director would exercise in the
management of his own affairs
 The nature and extend of due care depends on the nature of the business, the size of the business, and
its financial resources
 Bank directors are held to a heightened standard of care
 What steps should Pritchard have taken to discharge her duty to corporation?
 One duty was to acquire a rudimentary understanding of the business of the corporation
 Another duty is a continued obligation to keep informed about the activities of the corporation and
stay current with corporate activities
 They should attend meetings and read the board book and other information relevant about the
company
 Directors must not shut their eyes to corporate misconduct and then claim that because they did not
see the misconduct, they did not have a duty to look
 Directors must maintain familiarity with the financial status of the corporation by a regular review of
financial statements
 What did Mrs. Pritchard do in her capacity as a director of Pritchard & Baird?
 She is a case study in what not to do when you are a director of a business
 She essentially did nothing
 She was passive and never went to meetings
  She never looked at any of the financial statements. If she had done so, she might have noticed that
her sons were stealing from the company
 She didn’t know the business and didn’t make any efforts to learn anything about it
 She knew her sons were taking money but did nothing to prevent that from happening
 Although she was in poor health and mainly bedridden, the court did not accept her condition as an
excuse to failing to meet her fiduciary duties as a director of the company
 How did her behavior fall short of the expectations for directors under the duty of care?
 She discharged none of her responsibilities
 What should a director do if she discovers corporate misconduct, such as evidence of misappropriation in the
financial statements?
 Directors have a duty to inquire further if they notice evidence of wrongdoing
 They have a duty to object to such conduct and to take corrective action
 And they have a duty to resign if the corporation decides to not do anything about the misconduct
 Sometimes directors might have to seek legal advice to take reasonable steps to prevent the illegal
conduct by others within the corporation
 Note discussion of proximate cause at the end of the case.
 How can a director absolve herself of liability for corporate misconduct that she discovers?
o She should have informed other directors of the impropriety and voting for a proper course
of action
o A director who is present at a board meeting is presumed to concur in corporate action taken
at the meeting unless his dissent is entered in the minutes of the meeting or filed promptly
after adjournment
 How did Mrs. Pritchard’s inaction lead to a loss in this case?
o She didn’t attend meetings
o She wasn’t familiar with the business
o She may have known that money was being taken out without being repaid but she failed to
take any action to stop it
 The court says that by failing to take action, this constituted gross negligence
o To be liable, her negligence must be a proximate cause of the loss
o The court found that her passiveness, along with other factors, were in fact a proximate
cause of the company’s loss
o The fact that she was ill was no excuse
 Corporate directors may usually rely on lawyers and accountants BUT
 Must inquire further if financial statements disclosed problems on their face
 Must object and take corrective action
 May have to resign to avoid liability if misconduct continues
o In re Caremark Derivative Litigation
 Duty of due care for corporate directors
 Two lines of cases for duty of care
 Liability for directorial decisions that are grossly negligent
o Duty to act in good faith and on a rational basis and a good process in decision making
 Duty to monitor
o Requires boards to oversee the operations of the company and act to prevent illegal conduct
from occurring
o Corporate boards have affirmative duty to put corporation information and reporting system
in place to assure compliance with laws = COMPLIANCE PROGRAM
o Importance increased due to increased regulatory requirements and federal sentencing
guidelines
o The court said:
 A director's obligation includes a duty to attempt in good faith to assure that a
corporate information and reporting system which the board concludes is adequate
exists
 Failure to do so under some circumstances may in theory at least render a director
liable for losses caused by noncompliance with applicable legal standards
 Two Settlements
 United States lawsuit
o Basis for suit were alleged violations of Anti-Referral Payments Law (ARPL)
o Resulted in guilty plea and payments of fines
  Shareholder lawsuit
o Breach of duty of care for failing to monitor and detect violation of ARPL
 Facts
 Caremark was involved in the sale of healthcare services and it collected much of its revenues from
insurance companies and the federal government
 Under the ARPL it could not legally pay doctors to refer patients to it but it could legally hire
doctors under consulting agreements and because of research grants
 To help ensure compliance with the ARPL, Caremark undertook internal audits published warnings
in its employee manual and conducted training sessions
 In 1994 the federal government prosecuted Caremark for criminal violations of the ARPL and the
government argued that some of the consulting agreements and research grants with the doctors and
payments that were made as a result were disguised kickbacks for patient referrals
 In 1995 Caremark settled this action eventually and paid $250M in fines
 In 1995 several shareholders filed derivative suits against Caremark against its directors for fiduciary
duty breaches involving the ARPL they then negotiated a settlement under which the directors paid
nothing but Caremark promised to improve
 The plaintiffs’ attorneys collected about $1M
 This case is before the court for review of that proposed settlement
 The question is whether or not the court should approve what the parties agreed to
 How did Caremark allegedly violate the ARPL?
 They had contracts with other physicians in the form of consulting agreements and research grants
and patient management agreements
 These physicians recommended Caremark’s products and services to their patients
 So the question is whether these fees or payments made to the physicians actually payments for
Medicare referrals in violation of the ARPL?
 How did the Caremark directors allegedly violate their fiduciary duty of care?
 They failed to adequately supervise the conduct of employees who were engaged in the kickback
arrangements and they failed to institute corrective measures thereby exposing the company to
lawsuits by the government
 The directors allowed the situation to develop and continue which exposed the corporation to legal
liability and in doing so, they failed to be active monitors of the corporation’s performance
 What were the steps taken by Board to comply with ARPL in response to HHS OIG investigation?
 The launched an investigation
 Discontinued management fees to doctors for services to Medicare and Medicaid patients
 Internal audit plans and external audits were reviewed by the Board Ethics Committee
 Employee ethics handbook
 Ethics hotline
 Local branch managers needed home office approval for disbursements involving healthcare
providers
 The CFO became a compliance officer
 What were the terms of the settlement?
 Caremark will not pay compensation to third parties or split fees with physicians in exchange for
referral of Medicare or Medicaid patients
 Board will discuss material changes in government health regulations semiannually
 Caremark will remove personnel placed in medical facilities for purposes of providing remuneration
in exchange for patient referrals involving Medicare and Medicaid
 What is the standard for review of the settlement agreement?
 The issue before the court was whether the above settlement agreement should be approved
 The standard for review is whether the settlement was fair and reasonable
 It must protect the best interest of the corporation and its shareholders because they will be barred
from further litigation if the settlement is approved
 The court must take into account the conduct of the directors in making its determination of whether
the settlement was fair and reasonable
 Why did the court approve the settlement in this case?
 Yes the court approved the settlement
 They did so even though it involved a series of steps that were simply adding on to the compliance
steps that the company had taken earlier and did not involve any payment by the director's because
of their misconduct
  This appears to have been a weak case on the merits and the court acknowledged that the
Corporation already had put a compliance program of some sort into place and the changes in
corporate practice that were a condition of the settlement were not very significant
 But still the court felt that they were acceptable because the claims in the derivative lawsuit did not
find evidentiary support in the record
 They were susceptible to a motion to dismiss meaning the case would likely not have gone forward
on the merits
 The court mentioned a couple of points about monitoring and oversight and directed by Billy
o They stated that in order to find a violation of the duty of care by failure to control
employees
o It would be necessary to show that the directors knew of the violation of law and they took
no steps to prevent such loss and that there was proximate causation to the loss complained
of
o Here there is no evidence that the directors were involved in, or knew of, the misconduct
o The misconduct related to a specific regional office and the directors appear to have been
unaware of such misconduct
o On a failure to monitor claim, only a systematic failure to monitor can lead to liability
o Here there was no evidence that they failed to monitor systematically, so those compliance
program elements that they put into place essentially worked in favor of the directors
 This case points out a couple of important things:
 (1) the two branches of the duty of due care
o The duty not to make decisions in a grossly negligent manner
 Directors must act in good faith in the decisions they make and they must have good
process and must review reasonably available information and must deliberate
before making a decision and they must have a rational business reason that explains
the decision
o The duty to monitor/the duty of oversight
 To make sure illegal conduct is not occurring
 (2) the value of the compliance program
o Discussed in the opinion
o Important because for a corporation to be a good corporate citizen, it must comply with the
law and there must be a system in place so the directors can oversee what is going on at all
levels of the business and make sure that such illegal conduct doesn’t occur
o Compliance programs can also be used defensively (as in this case)
o Bayer v. Beran
 Fiduciary duty of loyalty and conflict of interest
 Facts
 This is a case about the corporate fiduciary duty of loyalty and involves a Corporation called
Celanese Corporation which launched a radio advertising campaign featuring classical music an
opera singers it was called the Celanese Hour
 According to the plaintiff, why did the defendant directors act wrongfully?
 The corporate directors were guilty of negligence, waste and improvidence for launching a $1M
advertisement campaign which was larger than previous ad campaigns
 They also complained that the corporate directors were negligent in selecting the advertisement
campaign format (radio) and renewing the contract for that campaign
 Plaintiffs also complained about the motivation of the board of directors stating that they were
motivated by noncorporate purpose in causing the radio program to be undertaken and in expending
large sums of money
o This noncorporate purpose was employing an opera singer who was married to the president
of the company who is also one of the directors
 How did the defendant directors justify their actions?
 They claimed that it was needed to distinguish their brand name product from ordinary brands being
produced by other manufacturers
 So they needed to use a more expensive advertising platform as opposed to expanding advertisement
in print sources
 NOTE: the FTC required that all Celanese products were to be designated and labeled rayon and the
name Celanese could not be used alone
 Why did the Business Judgment Rule fail to shield the board decision from judicial scrutiny?
  Normally launching an advertisement campaign would be considered an ordinary business decision
that falls under the protection of the business judgment rule
 But here the court does not invoke the business judgment rule
 This was because the plaintiffs, in their complaint, alleged a conflict of interest on the part of the
board due to the employment of the president’s wife
 Question for the court?
 Whether the advertisement campaign was adopted to benefit the corporation or to benefit the singing
career of the president’s wife
 What standard does the court use for reviewing the transaction?
 Where there is an alleged conflict of interest on the part of the board of directors, the business
judgment rule will not apply and the court will instead apply a different standard of review
 Instead, the court will apply rigorous scrutiny
 The court is scrutinizing the transaction to determine whether the action of directors was intended or
calculated to subserve some outside purpose, regardless of the consequences to the company, and in
a manner inconsistent with its interests
 Who has the burden of proof?
 The burden is on the director not only to prove the good faith of the transaction but also to show its
inherent fairness from the viewpoint of the corporation and those interested therein
 What is the court’s holding about the alleged board misconduct?
 There was no breach of the fiduciary duty of loyalty
 There was no evidence that the program was designed to promote the singer’s career or that she
received any special treatment
 She received less than other artists, she had a standard form contract, and there was no special
attention given to her performance in the advertisement
 The court concluded that this advertisement campaign was necessary to better distinguish the
company’s product from other competitors
 Although there was some benefit to the singer, this was okay because there was also some benefit to
the corporation and the advertisement served a useful corporate purpose and the company received
the full benefit of the advertisement
 What was the defect in the board procedure for reviewing the contract?
 The alleged defect was that the board acted informally and it did not meet and pass a resolution
approving the advertisement campaign through normal corporate procedures and formal channels
 This was alleged to make the transaction illegal because boards are required to follow corporate
formalities
 Does it void the transaction?
 The court says that this defect in the procedure does not void the transaction
 The court states that the board was very closely connected and had acted informally in the past and
were successful in their business decision making on behalf of the corporation so there was no
problem with the informal procedure
 This may not always be the case though
 The board ratified the campaign and in doing so, this vote served as a proper ratification of all board
actions related to the advertisement campaign
o Conflict of Interest Transactions
 NYBCL §713: Covers contracts between
 (1) corporation and
 (2) a director of that corporation or another corporation in which director has substantial financial
interest or is a director or officer (interested director transaction)
 NYBCL §713: No contract or other transaction involving an interested director is void or voidable because
the interested director was present at a meeting and voted in favor if:
 There was material fact disclosure of a contract or other transaction and valid board approval
without counting vote of interested director the contract can be upheld even though there was a
conflict of interest OR
 Disclosure of material facts and approval of the contract by a valid vote of the shareholders OR
 If it is not possible to get disclosure and valid board approval or disclosure and contract approval by
shareholders, then it is up to the parties to show that the transaction was fair and reasonable to the
corporation
 NOTE:
 o Interested director = between a corporation and one or more of its directors or between a
corporation in which one or more of its directors are directors or officers or between a
corporation and another corporation in which a director has a substantial financial interest
o Ratification
 DGCL, §144(a): Interested director or officer transaction not void or voidable if
 (1) material fact disclosure and disinterested director approval; OR
 (2) material fact disclosure and shareholder approval; OR
 (3) contract is fair to the corporation
o Broz v. Cellular Information Systems, Inc.
 Corporate opportunity doctrine which is considered a subcategory of the corporate fiduciary duty of loyalty
 Cast of characters
 Broz
o President and sole shareholder of RFBC
 Has a financial interest in this company
o Also a board member of CIS
 As a board member, owes a fiduciary duty to the corporation
 When he learned about the sale from being the president of RFBC, he informally
approached the board of CIS about the potential sale
 RFB Cellular Inc. (RFBC)
o Engaged in the business of providing cell phone service
o Owned Michigan 4 cellular license
o Competitor of CIS
 Mackinac Cellular Corp. (Mackinac)
o Another cell phone service provider
o Interested in selling one of its cellular licenses
o Sought to divest Michigan 2 cellular license
o Used D&A/R to seek a buyer
 Daniels & Associates/Rhodes (D&A/R) – broker
o Contacted RFBC about Michigan 2 license acquisition
o They did not contact CIS because CIS was having financial problems
 Cellular Information Systems Inc. (CIS)
o Treibick, Bloch, Schiff rejected Michigan 2 cellular license
 These were the 3 individuals who Broz contacted about the potential offer
 They rejected because of the company’s financial issues
 Broz made the assumption that CIS was not interested in the offer because of this
 The court says that this was not Broz acting in bad faith and that it was not
necessary to have a formal presentation of the potential transaction presented to the
board and then rejected so he could go ahead and purchase the license on behalf of
his own corporation RFBC
o Competitor of RFBC
 Pricellular: launched tender offer for CIS
o Tender offer = another kind of corporate transaction; it is an offer to buy shares of stock
from shareholders who are invited to tender (sell) their shares to the offeror for purchase at a
specified price within some specified period of time; often the completion of the transaction
is made contingent on the offeror receiving some specified number of shares, sufficient, for
example, to give it control of the target corporation
o Used as a way to take over, control, and ultimately merge the target company
o There was ultimately a bidding war and Broz outbid Pricellular and he is awarded the
license
o After Broz acquired the license, Pricellular was able to complete its tender offer of CIS
making it now the owner of that company
o The acquisition is being challenged as a violation of the corporate opportunity doctrine
 What was the alleged wrongdoing in this case?
 Broz was offered the license and he took that opportunity
 What legal issue must the court address?
 Whether there was an unlawful taking of a corporate opportunity by Broz when he acquired the
license
 What is the legal standard for evaluating the alleged wrongful conduct?
  The court used the holding described in Guth v. Loft
 This stated that if there is presented to a corporate officer or director a business opportunity which
the corporation is financially able to undertake, is, from its nature, in the line of the corporation’s
business and is of practical advantage to it, is one in which the corporation has an interest or a
reasonable expectancy, and, by embracing the opportunity, the self-interest of the officer or director
will be brought into conflict with that of the corporation, the law will not permit him to seize the
opportunity for himself
 4 factors:
o (1) Financial ability of the company to take the business opportunity
o (2) The business opportunity must be in the same line of business
o (3) The company must have an interest or expectancy in that opportunity and
o (4) Taking the opportunity by the corporate director would create a conflict between the self-
interest and the interest of the corporation
o If all factors are met, there is a corporate opportunity and the individual cannot take the
opportunity for himself
o Exception is if the corporation, realizing the opportunity is out there, has rejected the
opportunity
 2 things need to happen:
 There must be an analysis by the corporate officer or director who is offered
the opportunity as to whether the corporate opportunity even exists &
whether these 4 factors are met.
o If the answer is no, then the corporate officer or director is free to
go ahead to take the opportunity for him/herself
 If there is a corporate opportunity, if that opportunity is presented to the
board and the board rejects it, then the corporate officer or director would be
fine to take the opportunity for himself
o The opportunity for the board to reject is a kind of ratification
 What is the court’s conclusion?
 Broz did not breach his fiduciary duties to CIS
 What reasons support its conclusions?
 Financial ability (no)
o CIS was not financially capable of exploiting the license opportunity
 Same line of business (yes)
o It could be said that the opportunity was within the CIS line of business
 Interest or expectancy (no)
o There was no interest in the license
o CIS was in the process of divesting its cellular license holdings
o CIS was not interested in the license
 Taking opportunity would create conflict between self-interest and interest of corporation (no)
o There was no conflict
o Broz’s interest in acquiring and profiting from the license created no duties that were
inimical to his obligations to CIS
o He took care not to usurp any opportunity which CIS was willing and able to pursue
 Was there an obligation to consider Pricellular post-acquisition plans for Cellular?
 No
 Broz was under no duty to consider the contingent and uncertain plans of Pricellular in reaching his
determination of how to proceed
 He only needed to look at the situation at the time, not having to take into consideration what might
happen later on
 By requiring him to do so would deprive Broz of his right to engage in business affairs outside of his
or her fiduciary capacity
o Corporate Opportunity Doctrine
 Delaware Test (Guth v. Loft)
 Financial ability
 Same line of business
 Interest or expectancy
 Taking opportunity would create conflict between self-interest and interest of corporation
 Persons covered by doctrine = corporate officer or director
  Formal presentation to the board & rejection
 Not required before individual can take opportunity
 But may act as a safe harbor (process would have avoided an allegation that he violated some legal
principle, obligation, or requirement)
o In re eBay, Inc. Shareholders Litigation
 Combining the corporate opportunity doctrine and duty of loyalty
 Background
 Shareholders of eBay filed derivative suits against directors and officers for usurping corporate
opportunities.
 Named as defendants were 5 different officers and directors of eBay
 Demand was excused as futile.
 What was the business relationship between eBay and the investment banking firm of Goldman Sachs?
 eBay had conducted a number of financial transactions using the investment Bank of Goldman Sachs
as its financial advisor
 One important transaction was called an initial public offering in which eBay sold its shares to the
public for the first time
 There were additional business relationships between these two companies including other offerings
of securities and an acquisition by eBay of PayPal
 For these services eBay had paid Goldman Sachs over $8M in a series of transactions
 In addition, another relationship between these two entities that involved a practice called spinning
o Spinning is now considered illegal and at the time it was a gray area of legality
o It is also viewed as being an unethical practice
o Spinning is a practice in which an investment bank (in this case it was Goldman Sachs)
authors shares of the company's initial public offering to senior executives of another
company (in this case it would be eBay) in exchange for future business directed to the
investment bank
o So in this case there were officers and directors of eBay who were named as defendants in
the lawsuit and those individuals had received allocations of initial public offering shares
from other companies
o This was in consideration of eBay's business to enhance Goldman Sach’s chance of future
eBay business
o This was considered a lucrative business opportunity from the perspective of the officers and
directors who receive these shares that had been issued in the initial public offering
o This is because initial public offering shares are often undervalued and underpriced because
there is a concern that if the public offering price is too high it will not lead to a successful
public offering
o Because of this, the shares that were offered are often lower than what the ultimate share
price will turn out to be so once the initial public offering shares have been sold then there is
trading in those shares in the secondary market
o In that secondary market trading the share price often pops up from the initial public
offering price so these transactions involving spinning
 If you're able as an officer or director of eBay to obtain these shares through the spinning practice
then you can later resell those shares into the market at a higher price and receive a profit
 This was allegedly why Goldman Sachs providing this opportunity to the select group of officers and
directors of eBay it was in the hopes that eBay would continue to hire Goldman Sachs to be its
financial advisor or what it's called what is called its under writer in connection with future offerings
of securities
 What was the alleged corporate opportunity in this case?
 The allocation of initial public offering shares of other companies to this select group of individuals
who were executives of eBay
 How did the court analyze the corporate opportunity claim?
 The court uses the same analysis as Broz and applies the Guth v. Loft factors
 Financial ability
o Yes
 Same line of business
o Yes
o eBay is an online auction platform but investing was also a line of business for eBay because
they have invested more than $550M in equity and debt securities
  Interest or expectancy
o Yes
o The facts alleged suggest that investing was integral to eBay’s cash management strategies
and a significant part of its business
 Taking opportunity would create conflict between self-interest and interest of corporation
o Yes
o This was a risky investment and eBay was never given the opportunity to turn down the
allocations as too risky
 Based on this analysis, how should the defendants have acted when presented with the opportunity?
 They should have offered the shares to eBay as a corporate entity itself rather than buying the shares
for their own accounts
 How did the court respond to the defendants’ criticism that every advantageous investment that comes to an
officer or director will be considered a corporate opportunity?
 The court rejects this argument by the defendants
 The court says that this was a unique below-value investment opportunity that were offered by
Goldman Sachs to the insider defendants as financial inducements to maintain and secure corporate
business
 This was not an instance where a broker offered advice to a director about an investment in the
marketable security
 What alternative theory could also be used as a basis for liability of the defendants, according to the court?
 The alternative theory would be to rely on the duty of loyalty of an agent
 This is because there is a duty of an agent to account for profits obtained personally in connection
with transactions related to his or her company
 The corporate opportunity doctrine is considered a sub branch of the duty of loyalty
o Corporation Review Q#4
 George, VP Marketing for Zapco Inc., offered marketing opportunity for voice recognition system for PCs
while testing games at arcade. Hired as marketing consultant by software engineers who formed Wordco Inc.
Assume Zapco is incorporated in Delaware.
 Has George violated the corporate opportunity doctrine?
 Is there a corporate opportunity?
 Did George act in a lawful manner?
 If not, what should he have done?
o Sinclair v. Levien
 Fiduciary duties of dominate shareholders
 Cast of Characters
 Sinclair Oil Corporation (Sinclair)
o In the oil business
o Operating as a holding company meaning operations are conducted through its subsidiaries
o Sinven and International are 2 of its subsidiaries
 Sinclair Venezuelan Oil Company (Sinven)
o Set up to develop Sinclair’s oil business
o 97% owned by Sinclair
o 3% owned by minority shareholders
 Sinclair International Oil Company (International)
o Set up to coordinate Sinclair’s operations
o 100% owned by Sinclair
 A contract was entered into by the 2 subsidiaries
o Under the contract, Sinven agreed to sell all of its crude and refined products to International
at specified prices with payment due on receipt
o The terms of the contract were subject to max and min quantities and prices
 What were the alleged wrongful acts of defendant?
 Plaintiff is seeking an accounting for damages because of 3 activities it alleges to be wrongful acts
 (1) related to the payment of dividends by Sinven to its shareholders
o It was claimed that this payment of dividends was excessive and it prevented Sinven from
using the money that was paid out for other purposes such as expansion of the business
activities of the company
o It was excessive because they were in excess of Sinven’s earnings over a 6 year period
however they stayed within the legal limitations
  DGCL §170 restricts payment of dividends out of surplus/net profits of the
corporation
o Plaintiff also claimed that these dividends were forced by Sinclair, the 97% owner, for
improper purposes with improper motive
 (2) related to allocation of business opportunities by Sinclair among its various subsidiaries
o Sinclair had a business strategy in which it had operations in many different locations
around the world and it had a practice of allocating business opportunities based on where
those opportunities were located geographically
o Plaintiff claims that Sinven was denied business opportunities for expansion
o There were business opportunities that the minority shareholders thought should have been
allocated but weren’t
 (3) related to breach of the contract between the two subsidiaries
o Plaintiff alleges a breach of contract in 2 respects
o First, although the contract called for payment on receipt, International’s payments lagged as
much as 30 days after receipt
o Second, the contract required International to purchase at least a fixed minimum amount of
crude and refined products from Sinven but International did not comply with this
requirement
 Who is alleged to have breached fiduciary duties in this case?
 Sinclair, the parent company, is alleged to have breached its fiduciary duties in the 3 wrongful acts
above
 NOTE: Derivative suits usually involve claims of breach of fiduciary duty by directors.
 Why is the parent deemed to owe fiduciary duties to its subsidiary in this case?
 Why didn’t the minority shareholders go against the directors of Sinven claiming that they had
breached their fiduciary duties? (this would be the normal situation)
 Normally it would be the directors that are required to protect Sinven against this alleged
wrongdoing because they are bound by fiduciary duties
 But the court says that the directors of Sinven were not truly independent of Sinclair because it
appears that Sinclair placed the directors of Sinven into their position and all of the directors were
officers or directors or employees of Sinclair or some other Sinclair related company
 Because of this domination, it is the parent company that owes Sinven fiduciary duties directly
 What standard of review does the plaintiff urge upon the court?
 The test of intrinsic fairness which involved a high degree of fairness
 Where does the burden of proof fall?
 The burden is on Sinclair to prove, subject to careful judicial scrutiny, that its transactions with
Sinven were objectively fair
 This means that Sinclair must prove that each action was fair to the corporation as a whole, not just
to Sinclair. It must also be fair to the 3% minority shareholders
 What standard of review does the defendant urge upon the court?
 Business judgment rule under which the court will not interfere with the judgement of a board of
directors unless there is a showing of gross and palpable overreaching
 Where does the burden of proof fall?
 Burden is on the plaintiff to prove that the transaction should not be subject to the business judgment
rule standard because the transaction amounts to waste or some egregious action such as fraud
 What standard of review does the court actually use to evaluate the claims?
 The court decides to use an intrinsic fairness standard only in a situation where reviewing the facts
of the alleged wrongdoing, the court sees self-dealing on the part of the dominate shareholder
 Self-dealing in this context would mean that Sinclair, by virtue of its domination of the subsidiary,
causes the subsidiary to act in such a way that Sinclair receives something from the subsidiary to the
exclusion of the minority shareholders of the subsidiary
 What is the holding?
 Payment of dividends
o The court says that there was no problem because Sinven stayed within the requirements of
DGCL §170 and the court didn’t think there was self-dealing because the minority received
a proportionate share of the dividends that were paid out
o This means that Sinclair did not engage in self-dealing because they did not receive
something that the minority shareholders did not receive
 Denial of business opportunities
 o The court says that they cannot find anything in the facts brought by plaintiff to prove this
o They prove no business opportunities which came to Sinven independently and which
Sinclair either took to itself or denied to Sinven
o All of Sinven’s operations have been conducted in Venezuela, and Sinclair had a policy of
exploiting its oil properties located in different countries by subsidiaries located in the
particular countries
 Breach of contract
o The court does believe there is self-dealing in this instance because Sinclair is the 97%
shareholder in Sinven and 100% shareholder of International so Sinclair got something
based on not enforcing the contract that the 3% minority shareholders did not get because
they have no shares in International
o As a result, the proper standard for the breach of contract claim is the intrinsic fairness
standard so the burden is on defendant to demonstrate that it was fair to Sinven that Sinclair
did not enforce the contract
o The court says that Sinclair is unable to bear its burden and therefore this is a breach of
fiduciary duty
 Overall holding
o The court decides to reverse that part of the Chancellor’s order that requires Sinclair to
account to Sinven for damages sustained as a result of dividends paid between 1960 and
1966, and by reason of the denial to Sinven of expansion during that period.
o The court affirms the remaining portion of that order and remand the case for further
proceedings
 Note after the case from Pepper v. Litton
 A director is a fiduciary. So is a dominate or controlling shareholder or group of shareholders. Their
powers are in trust. Their dealings with the corporation are subjected to rigorous scrutiny and where
any of their contracts or engagements with the corporation is challenged the burden is on the director
or shareholder not only to prove the good faith of the transaction but also to show its inherent
fairness from the viewpoint of the corporation and those interested therein
o Fliegler v. Lawrence
 Ratification
 Facts
 This is a shareholder derivative action brought on behalf of Agua Mines against the officers and
directors of Agua Mines and US Antimony Corporation
 Parties
 Plaintiff: Agau Mines Inc. (Agau)
o President Lawrence acquired undeveloped antimony properties
o Lawrence offered to transfer properties to Agau, but board decided Agau could not acquire
the properties on an undeveloped basis due to legal and financial problems
 Defendants: officers and directors of Agau, United States Antimony Corporation (USAC)
o USAC was formed to acquire antimony properties from Lawrence after the board of Agau
had rejected the opportunity and the majority stock was held by defendants;
o USAC developed the properties and sold to Agau under an Option Agreement
o The same individuals were directors, officers & shareholders of both Agau and USAC
 Option Agreement between Agau & USAC
 It was an option to purchase by Agau all of USAC including the antimony properties if the
shareholders approved
 Upon shareholder approval, Agau was to deliver 800K shares of its own stock in exchange for all of
the shares of USAC and therefore Agau would become the owner of USAC
 800K shares was calculated on the basis of reimbursement to USAC shareholders for the costs of the
acquisition value and the cost of developing properties to a point where they would become
commercially viable
 Agau board passes a resolution saying they want to exercise the option under this agreement and
they put it to a shareholder vote. A majority of Agau shareholders approved
 Once this happened, plaintiff filed this derivative lawsuit to recover the 800K and for an accounting
 According to plaintiff, what did the directors do that was wrongful conduct?
 The allegation was that the directors and officers of both corporations wrongfully usurped a
corporate opportunity belonging to Agau
  Plaintiff also alleged that defendants wrongfully profited by causing Agau to exercise an option to
purchase that opportunity
 According to defendants, how does DGCL §144 protect them from the allegations of the plaintiff?
 They claim they do not have to prove that there was fairness by reason of shareholder ratification in
the agreement because of this provision
 Defendants urge that the transaction is protected by DGCL §144(a)(2) which, they contend, does not
require that ratifying shareholders be disinterested or independent
 They also argue that there is no warrant for reading such a requirement into the statute
 What is the Gottlieb standard?
 The court stated that if there is shareholder ratification of an interested transaction, although less
than unanimous, shifts the burden of proof to an objecting shareholder (plaintiff here) to demonstrate
that the terms are so unequal as to amount to a gift or waste of corporate assets
 This standard freshens the atmosphere and a new set of rules are invoked where formal approval has
been given by a majority of independent, fully informed shareholders
 Defendants argue:
o The vote of the shareholders were cast by defendants in their capacity as Agau shareholders
o So they were able to get a majority because the interested voters were the same people
named as defendants in the lawsuit
 Does the Gottlieb standard apply in this case?
 No the court says they don’t read the statute as providing the board immunity for which defendants
contend. It merely removes an interested director cloud when its terms are met and provides against
invalidation of an agreement solely because such a director or officer is involved.
 Nothing in the statute sanctions unfairness to Agau or removes the transaction from judicial scrutiny
 In order to have valid shareholder ratification, you need to have a majority of independent
shareholders who are disinterested but here, only 1/3 of the disinterested shareholders actually voted
 What is the burden of proof on the defendants here?
 Burden is on defendants to show that the transaction was fair to Agau
 Have the defendants met their burden?
 Yes
 They did prove intrinsic fairness
 They entered into a transaction with Agau and Agau got its money’s worth and they got the value of
the property plus cost of development so there is fairness
 According to the court, have the defendants acted wrongfully?
 Because they are able to establish fairness, the defendants have not acted wrongfully in this case
o Ratification
 DGCL §144(a): Interested director/officer transaction not void or voidable if
 (1) material fact disclosure and disinterested director approval; or
 (2) material fact disclosure and shareholder approval; or
 (3) contract is fair
o Full language of DGCL §144(a)
 (a) no contract or transaction between a corporation and one or more of its directors or offices, or between a
corporation and any other corporation, partnership, association, or other organization in which one or more
of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable
solely for this reason, or solely because the director or officer is present at or participates in the meeting of
the board or committee which authorizes the contract or transaction, or solely because his or their votes are
counted for such purpose, if:
 (1) the material facts as to his relationship or interest and as to the contract or transaction are
disclosed or are known to the board of directors or the committee, and the board or committee in
good faith authorizes the contract or transaction by the affirmative votes of a majority of the
disinterested directors, even though the disinterested directors be less than a quorum; or
 (2) the material facts as his relationship or interest and as to the contract or transaction are disclosed
or are known to the shareholders entitled to vote thereon, and the contract or transaction is
specifically approved in good faith by vote of the shareholders; or
 (3) the contract or transaction is fair as to the corporation as of the time it is authorized, approved, or
ratified, by the board of directors, a committee, or the shareholders
o CORPORATIONS REVIEW QUESTION #5
 Silver Screen Cinema Inc (SSCI)
 Sam Golden: President, 30% SH, Director
  Board: Golden, Robbins, Lanvin, Wolfe, Greenman
 Cable TV Station
 Majority owned by Robbins
 Robbins Film Inc. (RFI)
 Owned by Robbins
 Has any SSCI director breached a fiduciary duty?
 Did the SSCI directors act properly with respect to corporate procedures?
 Alternate set of facts: Was the purchase of the film library properly ratified?
 Module 5 Quizzes:
o Quiz 18: Corporate Duty of Care I
 In Kamin v. American Express, the court stated that the standard for violation of the directors’ duty of care is
gross negligence. (T/F)
 True
 In Kamin v. American Express, the court found that the directors fulfilled their duty of care because they
were informed about the options concerning the stock transaction, met to discuss and engaged in
deliberation, and articulated a business reason for their decision. (T/F)
 True
 Under Delaware law, a merger transaction must be approved by a vote of both the board of directors and the
shareholders of the target corporation, conducted in accordance with the statutory requirements and the
organizational documents of the corporation. (T/F)
 True
 In Smith v. Van Gorkom, the directors were entitled to rely on Van Gorkom’s oral presentation to the board
about the merger transaction in discharging their duty of care, as permitted by §141(e) of the Delaware
General Corporation Law. (T/F)
 False
 In Smith v. Van Gorkom, the court found that the directors fulfilled their duty of care because they were
adequately informed about the intrinsic value of the corporation’s shares. (T/F)
 False
o Quiz 19: Corporate Duty of Care II
 In Francis v. United Jersey Bank, the court stated that directors who vote for or concur in corporate action
may become liable for injuries resulting from such action; to avoid liability, a director must dissent and such
objection must be entered in the minutes of the meeting. (T/F)
 True
 The traditional view is that fiduciary duties are owed by corporate directors to the corporation and its
shareholders; but in Francis v. United Jersey Bank, the court stated that corporate directors also may owe
duties to creditors if the corporation conducts a banking business or holds funds of others in trust. (T/F)
 True
 According to the court in Francis v. United Jersey Bank, which of the following is NOT required of
corporate directors in order to fulfill their fiduciary duty of care?
 Conduct a complete audit of the corporate books and records
 According to the court in the Caremark case, duty of care consists of two categories: those involving
potential liability for directorial decisions that are not the product of good faith and rational decision making
and those involving a failure to adequately monitor the activities of the corporation. (T/F)
 True
 The court in the Caremark case stated that the defendant directors were guilty of a sustained failure to
exercise their duty of oversight of the corporation. (T/F)
 False
o Quiz 20: Duty of Loyalty Corporate Opportunity Doctrine
 In Bayer v. Beran, the court stated that the advertising campaign was an ordinary business decision of the
board of directors and was therefore protected from judicial scrutiny by the business judgment rule (T/F)
 False
 Which of the following steps can be used to uphold a contract or transaction involving a director or officer
conflict of interest under statutory law in Delaware?
 Any of the following steps:
o Disclosure of the conflict to the board and majority disinterested director approval of the
contract or transaction
o Disclosure of the conflict to the shareholders and shareholder approval of the contract or
transaction
 o The contract or transaction is shown to be fair to the corporation as of the time it was
authorized, approved, or ratified
 According to the court in Guth v. Loft, which of the following factors is needed for the corporate opportunity
doctrine to apply?
 All of the factors are needed:
o The opportunity must be in the same line of business as the corporation
o The corporation must have the financial ability to take the opportunity
o The corporation must have an interest or expectancy in the opportunity
o There is a conflict between the corporate officer’s or director’s self-interest and the best
interests of the corporation
 The court in Broz v. Cellular Information Systems held that Broz violated the corporate opportunity doctrine
because he did not formally present the cellular license opportunity to the board members of CIS and receive
their rejection in writing. (T/F)
 False
 The court in the eBay Shareholders Litigation case held that the corporate opportunity doctrine did not apply
to the allocation of initial public offering shares to eBay officers and directors because investing in
marketable securities was not in the same line of business as the company, which is engaged in running an
online auction platform for merchandise. (T/F)
 False
o Quiz 21: Duty of Dominant Shareholders and Ratification
 According to the court in Sinclair Oil Corp. v. Levien, which of the following owed fiduciary duties to
Sinclair Venezuelan Oil Company and its shareholders?
 Sinclair Oil Corporation
 According to the court in Sinclair Oil Corp. v. Levien, which of the following decisions relating to Sinclair
Venezuelan Oil Company was not protected by the business judgment rule?
 Failure to enforce the terms of a defaulted contract
 According to the court in Sinclair Oil Corp. v. Levien, the intrinsic fairness standard should be used to
review challenged transactions when there is self-dealing involved. (T/F)
 True
 In Fliegler v. Lawrence, the court found that valid shareholder ratification under the Delaware statute could
not be found based on a majority vote of shareholders with a financial interest in the challenged transaction.
(T/F)
 True
 Under the Gottlieb standard, shareholder ratification of an interested transaction in Delaware shifts the
burden of proof to an objecting shareholder to demonstrate that the terms are so unequal as to amount to a
gift or waste of corporate assets. (T/F)
 True
 MODULE SIX: FEDERAL SECURITIES REGULATION ETC.
o REGULATORY SCHEME
 Federal Securities Laws
 Policy: protection of investors and integrity of markets
o Reform legislation
o There are also other securities statutes
 Securities Act of 1933: primary market
o AKA the 1933 act
o Primary market = when a company seeking to raise capital issues investments called
securities into the public market (the issuer of the securities, such as the company that
created the securities, sells them to investors)
 Example = initial public offering
 Securities Exchange Act of 1934: secondary market
o AKA the 1934 act
o Secondary market = involves regulation of trading activities that take place on securities
exchanges (investors trade securities among themselves without any significant participation
by the original issuer)
 Example = trading between investors on the floor of the NY Stock Exchange
 Also governs the business of public companies
  Public companies = those that meet certain definitions within the Federal
Securities Laws and are subject to periodic reporting requirements and
certain kinds of regulations that other companies are not subject to
 Scope
o Disclosure provisions
 An aspect to pursue the policies above using a disclosure-based approach
 The Federal Securities Laws do not guarantee investors that they will be purchasing
safe or good investments
 The purpose of the Federal Securities Regulations is to force disclosure to
participants in the primary and secondary markets
 Role of the SEC = promulgate regulations and adjudicate disputes, but they are not
charged with enforcing and administering the Federal Securities Laws
 The SEC will just make sure that a company has complied with the
disclosure requirements
o Anti-fraud provisions
 Another aspect to pursue the policies above
 This is a backstop against non-disclosure by companies
 If there has been a violation of the disclosure provisions, the wrongdoing can be
covered under the anti-fraud provisions
o Regulation of markets and market professionals
o We will be focusing on the protection of the investors and the integrity of the markets
 Securities and Exchange Commission (SEC)
 Created under the 1934 Act
 Executive agency of the federal government charged with administration & enforcement of statutes
 Delegated authority by Congress to make rules and adjudicate matters arising under the statute
o They are binding to the same extent as if they were passed by congress
o They can bring enforcement proceedings involving any provision of the federal securities
laws
 Headquartered in Washington DC with regional offices
o Closest one to STL is in Chicago
 Blue sky laws
 State level regulation of securities that predates federal securities laws
 Statutes that protect investors from speculative schemes which have no more basis than so many feet
of blue sky
 Regulated entities must comply with both federal and state law
 Some overlap between the two regulatory schemes but they are separate levels of regulation which
are subject to federal preemption
 Missouri securities regulation authority is in the Office of the Secretary of State
 Regulates sales of securities and operations of broker-dealers & investment advisers and prosecutes
securities fraud
o Robinson v. Glynn
 What is a Security & the reach of the Federal Securities Laws
 The Federal Securities Laws apply only if there is an investment instrument called a security
 If there is a security, then both the disclosure requirements and the anti-fraud provisions apply
 If there is no security, then the Federal Securities Laws do not cover the transaction
 NOTE: this is a common area of malpractice for lawyers especially in the failure of lawyers to
identify for their clients the existence of an investment opportunity that involves a security and
therefore involves a regulated transaction
 Who was plaintiff, who were the defendants, what was the transaction that gave rise to the lawsuit?
 James Robinson = plaintiff
o A businessman with no prior telecommunications experience who was recruited to be an
investor
o He agreed to make a $1M loan to GeoPhone in order to perform a field test of the GeoPhone
system and the CAMA technology
o GeoPhone’s treasurer and appointed to the board of managers and the executive committee
 Thomas Glynn = defendant
o GeoPhone’s majority shareholder & chairman
 Glynn Scientific, Inc. = defendant
  GeoPhone Company LLC = defendant
 Evidential documents
o Letter of Intent dated August 1995
 Refers to an agreement in which Robinson pledged to invest up to $25M in
GeoPhone if the field test indicated that CAMA worked in the GeoPhone system
 The $25M consisted of:
 Initial $1M loan for the field test
 Immediate $14M investment upon successful completion of the field test
 A later $10M investment
o Agreement to Purchase membership Interests in GeoPhone (APMIG)
 Robinson agreed to convert his $1M loan and his $14M investment into equity and
subsequently to invest the additional $10M
 Equity = ownership interest
o Amended and Restated GeoPhone Operating Agreement (ARGOA)
 Detailed the capital contribution, share ownership, and management structure of
GeoPhone
 Robinson received 33,333 of GeoPhone’s 133,333 shares
 Established the board
 Vested management of GeoPhone in Robinson and Glynn based on each member’s
ownership share
o Share certificates with restrictive legend
 The legend referred to the certificates as shares and securities
 It specified that the certificates were exempt from registration under the Securities
Act of 1933 and stated that the certificates could not be transferred without proper
registration under the federal and state securities laws
 Facts
o Glynn formed a company called GeoPhone with the intent of developing and marketing the
GeoPhone telecommunication systems using a type of technology referred to as the
Convolutional Ambiguity Multiple Access (CAMA) technology
o A field test was performed but it did not use the CAMA technology, which was a pre-
condition to Robinson’s agreement to be an investor
o Glynn still told Robinson that the field test had been successful & lied about using the
CAMA technology
o There was a 7 person board of managers that was authorized to manage GeoPhone’s affairs
 2 of the managers were to be appointed by Robinson with the remaining 5 to be
appointed by Glynn and his brother
 What was the alleged wrongful conduct?
 Goes back to the field test and the failure to use the CAMA technology
 Robinson did not learn about the misrepresentation until 1998
 Failure to use the CAMA technology which was a precondition to his investments in the first place
 What was the legal basis for the suit?
 A violation of §10(b) of the 1934 Act
 Also a violation of Rule 10b-5 (an SEC rule)
 NOTE: these 2 rules are usually pleaded together in Securities laws litigation and they are the most
widely used anti-fraud provisions
 The district court granted summary judgment to Glynn because it found that Robinson’s membership
interest in GeoPhone did not constitute a security under the federal securities laws
o If you don’t have a security, you cannot use the federal courts to allege you have been
defrauded in connection with an investment that you have made
 What is the legal issue addressed in this appeal?
 Whether or not the transaction is subject to the federal securities laws
 Why is resolution of this issue in the plaintiff’s favor necessary for the lawsuit to proceed to the adjudication
of the alleged wrongdoing?
 The question of what is a security is considered a threshold issue in federal securities law
 Threshold issue = an issue that plaintiff must overcome in order to be able to proceed with the merits
of a claim, here being the alleged fraud
o So unless Robinson can convince the court that this was a security interest, the court will not
get to the merits of the claim and the case will be dismissed
 Plaintiff’s arguments?
 He had purchased an investment instrument that was covered by the federal securities law
 His argument that he made relates to the definition of the word security in the federal securities laws
o Securities Act of 1933 §2(a)(1)
 He argued that he had purchased either an investment contract or, in the alternative, he purchased
stock
 Defendants’ arguments?
 Robinson did not purchase a security
 What he purchased was neither an investment contract nor a stock
 What is meant by an investment contract?
 Investment contract (Howey) (SCT 1946)
o Definition:
 A contract, transaction or scheme whereby a person invests his money in a common
enterprise and is led to expect profits solely from the efforts of the promoter or a
third party
o Elements (all of which must be satisfied; if one is missing, the claim fails)
 Investment of money
 In a common enterprise
 With the expectation of profits
 To come solely from the efforts of others
o What element of the test is at issue in this case?
 The disagreement concerns whether Robinson expected profits solely from the
efforts of others, most notably Glynn
 So it is the last element that is at issue
 What is meant by stock?
 Stock (Landreth Timber) (SCT 1985)
o The characteristics typically associated with common stock are:
 The right to receive dividends contingent upon an apportionment of profits
 Negotiability
 The ability to be pledged or hypothecated
 The conferring of voting rights in proportion to the number of shares owned
 The capacity to appreciate in value (aka Capital Appreciation)
 Why can an item called stock be excluded from the definition of a security?
o Economic realities test = it is the economic reality of a particular instrument, rather than the
label attached to it, that ultimately determines whether it falls within the reach of the
securities laws
 Looking at the nature of the transaction rather than the name that is used by parties
o The securities laws apply when an instrument is both called stock and bears stock’s usual
characteristics
 How does the court rule on this issue? Why?
 Investment contract
o There was no investment contract because Robinson was not relying solely on the efforts of
other people to get a profit on his investment
o He negotiated for control rights in the company so he was not a completely passive investor
o He served on the board of managers and had the right to appoint 2/7 members of the board
o He was also on the executive committee and served as treasurer and had access to a lot of
financial information about the company
o Because of the strong control rights, he cannot satisfy the test
o He did not purchase an investment contract because he was not relying solely on the efforts
of others
 Stock
o The court concludes that the characteristics of stock are not satisfied by Robinson’s
ownership interest in the company.
o There was no sharing in profits in proportion to the number of their shares. Robinson was to
receive 100% of GeoPhone’s net profits up to a certain amount, only after which were funds
to be distributed pro rata to the members in proportion to their relative shares
 o Robinson’s membership interests were not freely negotiable. Robinson could only transfer
his interests if he first offered other members the opportunity to purchase his interests on
similar terms
o Robinson could pledge his interest, but the pledgee would acquire only distribution rights
and not control rights
o From the very beginning, the parties viewed Robinson’s investment as a membership
interest and never as a stock. All of the investment documents termed Robinson’s
investment as a membership interest
o He did not purchase stock in the sense that it was defined in the Supreme Court case because
the characteristics of the membership interest do not correspond with the characteristics of
stock in the case
 Why does the court decline to rule broadly?
 The parties wanted the court to rule broadly in this case, asking that we generally classify interests in
LLCs as investment contracts (in Robinson’s view) or non-securities (in Glynn’s view)
 The court declines to do this because it is very difficult to categorize LLCs under the federal
securities laws because state law statutes allow LLCs to be organized with different types of
management structures (member-managed LLC & manager-managed LLC)
 Under state law there might be circumstances where it would be difficult to say whether or not
something is actually an investment contract because the last prong of the test would not be satisfied
 There also could be different kinds of management structures other than what was in this case where
management decisions were in the hands of one or more managers rather than all of the members
managing equally. Under these circumstances it might be possible to say that the members who are
not managers were relying solely on the efforts of those managers to make profits
 Does the court get around to adjudicating the merits of the dispute?
 The merits would be whether or not Robinson had been defrauded by not using CAMA technology
 The court never gets around to adjudicating the merits of the dispute
 Why not?
 Robinson was unable to get past the threshold issue of showing what he purchased was a security
 §10(b) of the Securities Exchange Act of 1934:
 It shall be unlawful for any person to use or employ, in connection with the purchase or sale of any
security, any manipulative or deceptive device or contrivance in contravention of rules and
regulations of the Securities and Exchange Commission
 Rule 10b-5: (states what a manipulative or deceptive device consists of)
 It shall be unlawful for any person
o (a) to employ any device, scheme or artifice to defraud,
o (b) to make any untrue statement of a material fact or material omission, or
o (c) to engage in any act, practice, or course of business which operates as a fraud or deceit
upon any person
 Securities Act of 1933, §2(a)(1) – definition of security
 Security means, unless the context otherwise requires, any note, stock, treasury stock, bond,
debenture, evidence of indebtedness, investment contract or in general any interest or instrument
commonly known as a security
 Implications of calling an investment opportunity a security
o Disclosure and antifraud provisions apply, including 1934 Act §10(b) and SEC Rule 10b-5
o Robinson v. Glynn: Hypothetical
 What result in this case if Geophone had been organized as: (can each of these be viewed as a security?)
 A close corporation?
o A close corporation is a corporation that has a small number of shareholders. It is the
opposite of a public corporation which has shares that are held by the general public with
hundreds of thousands of shareholders
o Normally viewed as a family business
o As long as it has the common characteristics of stock then it could be classified as a
common security
 A general partnership?
o Analyzed using the investment contract analysis
o Focus on the management rights of general partners which is equal rights in management of
all partners
 o Usually this would not be a security because the final prong of the test would not be satisfied
because of equal rights in management default rule
 A limited partnership?
o Analyzed using the investment contract analysis
o There is typically a general partner with unlimited liability and full control rights and limited
partners with no control rights and have limited liability
o These have been viewed to be securities because a limited partner can argue that they rely
solely on the efforts of the general partner to make a profit
o Types of Securities
 Type of security
 Common stock (equity)
o Cash flow rights = residual and discretionary dividend
o Liquidation rights = residual
o Voting rights = yes
 Preferred stock (equity)
o Cash flow rights = fixed and discretionary dividends cumulate if not paid
o Liquidation rights = medium
o Voting rights = contingent
 Bonds (debt)
o Cash flow rights = fixed and certain interest payments
o Liquidation rights = highest
o Voting rights = none
 One other dimension along which the different securities differ:
 Fiduciary duty obligation of corporate officers and directors
o Generally common shareholders are owed a fiduciary duty
o Preferred stock and bond holders must look to contractual rights for protection
 Preferred shareholder contractual protections typically (but all this is negotiated) include:
 Fixed interest payment (but at discretion of the board)
 Dividends cumulate if not paid (and must be paid before common receives anything)
 Liquidation preference over common
 Voting rights if a specified number of quarters have based without a dividend payment
 Conversion right into common stock
 Debt holder contractual protections can include (again all negotiated):
 Restrictions on dividends
 Restrictions on sale of certain assets
 Specified maximum debt-equity ratio.
o Doran v. Petroleum Management
 Registration and Exemptions from Registration
 Registration requirement under §5 of the 1933 Act
 This states that a security cannot be offered for sale through the use of interstate commerce unless a
registration statement with a long and detailed disclosure document has been filed with the SEC
 The securities themselves may not be sold until the registration statement has become effective
 Also, the purchasers of the securities receive a prospectus
o A prospectus = a portion of the registration statement minus certain exhibits and opinions
that are typically not provided
 Remedies for §5 violations are contained in §12 of the 1933 Act.
o Primary remedy is recission of the contract/deal
 Who was the plaintiff, who were the defendants, and what was the alleged wrongful conduct?
 William H. Doran, Jr. = plaintiff
o Has some familiarity with investments
o He purchased a limited partnership interest in PMC for $125K
o He was to put in $25K and for the rest of the investment, he agreed to assume the liability of
the limited partnership on a note owed to Mid-Continent
o He was obligated to pay this note as payments on the note became due
o He assumed he would be able to make these payments using his share of the production
payments he would receive from the oil wells
 o He soon found out that PMC deliberately over-produced in violation of certain limits on
production allowances established by the WY Oil and Gas Conservation Commission
 As a consequence, the wells were ordered sealed for 338 days
 When production resumed, the wells yielded a production income level below that
obtained prior to the closure
o Because of the closure and decline in production, Doran defaulted on his note with Mid-
Continent and had judgement entered against him for $50,815
 Petroleum Management Corporation (PMC) = defendant
o Engaged in drilling and operating oil wells
o Organized a CA limited partnership for the purpose of drilling and operating 4 wells in WY
 Alleged wrongful conduct?
o Plaintiff alleges that there was conduct that violated a number of different legal rights that he
had and he alleged there was misrepresentations and omissions
o He claims he purchased a security that should have been registered but was not registered
 What is plaintiff’s cause of action under the federal securities laws and what is the remedy for the alleged
violation?
 Filed suit seeking damages for breach of contract, rescission of the contract based on violations of
the Securities Acts of 1933 and 1934, and a judgment declaring the defendants liable for payment of
the state judgment obtained by Mid-Continent
 Plaintiff claims that he purchased a security which should have been registered but PMC failed to do
this to comply with §5
 Remedy is rescission where he is back to the point he was at before purchasing the limited
partnership interest
 What affirmative defense is advanced by the defendants?
 Defendants raise an affirmative defense that the relevant transactions came within the exemption
from registration found in §4(2) of the 1933 Act, the private offering exemption or private placement
transaction
 They contend that the offering of securities was not a public offering, it was a private placement
o This was because there was only a small number of people offered the opportunity and
plaintiff was the only one to accept
 As a result, they claim they did not have to register the securities
 What must the defendants prove to establish such defense?
 Defendants must bear the burden of proving that the offering was private
 First look to the Ralston Purina test!!
 There are 4 factors the court describes:
o The number of offerees and their relationship to each other and the issuer
o The number of units offered
o The size of the offering
o The manner of the offering
 The first factor is most important
o If the offerees had access to information in some way other than through a registration
statement, then that could be considered to be a private placement transaction
o If the offerees did not have access to information, then they would not fall within the private
placement transaction
 Have the defendants met their burden of proof?
 No they have not met their burden on the question of the private placement exemption
 There is nothing in the record that would indicate that the offerees had access to information
 What is the holding?
 We hold that in the absence of findings of fact that each offeree had been furnished information
about the issuer that a registration statement would have disclosed o that each offeree had effective
access to such information, the district court erred in concluding that the offering was a private
placement. Accordingly, we reverse and remand
 What must defendants show on remand?
 They must show that all of the offerees had access to the same kind of information that would have
been provided in a registration statement given to the offeree if it had been filed with the SEC
 This can be done by showing they were given a memo with such information or they had access to
files and records which would contain that information
  The question that must be answered is whether the offerees knew or had a realistic opportunity to
learn facts essential to an investment judgment
 Sophistication issue
 Defendants raised the argument that it was okay to sell to plaintiff because he was a sophisticated
investor and therefore did not need the protection of full blown §5 registration
 The court rejects this argument stating that evidence of a high degree of business or legal
sophistication on the part of all offerees does not suffice to bring the offering within the private
placement exemption
 You still need access to information and investment sophistication
 Sophistication itself is not sufficient
 Ralston Purina test: Did the offerees need the protection of the registration provisions of the 1933 Act or
were they able to fend for themselves?
 Lead case on the definition of a private placement transaction under §4(2)
 Turns on access to information
o Whether or not there was access to information on behalf of the offeree
o If the offerees had access to information in some way other than through a registration
statement, then that could be considered to be a private placement transaction
o If the offerees did not have access to information, then they would not fall within the private
placement transaction
 Access of information can turn on one of 2 things:
o Either the issuer (the company trying to sell the securities) has provided information
equivalent to the information provided in a registration statement filed with the SEC
o OR
o The offerees had access to information by having the ability to look at files and records of
the company that contained equivalent information
 NOTE:
o In a private placement transaction, there is no requirement that a registration statement be
filed with the SEC. However, there is a requirement to provide access to information
 This information is typically given in a memo containing disclosure
o THIS IS WHERE YOU WILL START IN YOUR ANALYSIS!!!
 Four factors (5th Circuit)
 Number of offerees and the relationship to each other and issuer
 Number of units offered
 Size of the offering
 Manner of the offering
 Securities Act of 1933, §5
 Unlawful to sell or offer for sale securities in interstate commerce unless securities are registered
with the SEC
 Issuer must provide disclosure in a prospectus
 Remedy for selling unregistered securities is rescission
 Securities Act of 1933, §4(2): (exemption defense raised by defendants)
 The provisions of §5 shall not apply to transactions by an issuer not involving a public offering
o No definition of public offering in the Securities Act of 1933
 Exemptions from registration
 Certain types of securities
o Congress felt that purchasers/investors of certain types of securities did not need the
protection of the federal securities laws (disclosure requirements & anti-fraud provisions)
o Example = U.S. government securities
 Certain types of transactions
o Exempt because of the manner in which they are sold to purchasers/investors
o Only applies to the specific sale of securities. It doesn’t apply to the securities going forward
o Example = private placement
 Regulation D exemption
o Provides a series of safe-harbors that issuers can use to come within the private-placement
exemption and avoid or reduce their required disclosure
o More detailed in the requirements that must be met to satisfy the exemption
o It is a series of requirements that must be satisfied by the issuer to fall under the transaction
exemption
o Escott v. BarChris
 §11 Fraud in Registration Statement
 Securities fraud and insider trading and due diligence
 Who were plaintiffs, who were defendants, what was the alleged wrongdoing?
 Plaintiffs = investor purchasers of convertible subordinated 15 year debentures of BarChris
Construction Corporation suing on their own behalf and on behalf of all other present and former
holders of the debentures
o Debentures = a type of corporate debt
 Defendants = BarChris, the persons who signed the registration statement, the underwriters, and
BarChris’s auditors
 Alleged wrongdoing = false information on registration statements filed with the SEC
 Facts:
 BarChris built bowling allies and was in the business during the massive spike in popularity
 Plaintiff purchased the debentures during a public offering
 What is cause of action?
 This action is brought under §11 of the Securities Act of 1933 alleging that the registration statement
with respect to the debentures filed with the SEC contained material false statements and material
omissions
 §11 covers fraud in a registration statement
 What are the legal issues?
 (1) did the registration statement contain false statements of fact, or did it omit to state facts which
should have been stated in order to prevent it from being misleading?
 (2) if so, were the facts which were falsely stated or omitted material within the meaning of the Act?
 (3) if so, have defendants established their affirmative defenses?
 How does the court rule on each issue?
 Misstatement or omission in the registration statement
o The court says there was a misstatement or omission in 2 separate parts of the registration
statement which were material
o They find misstatements or omissions in 2 separate parts of the registration statement
o Misstatement of sales and earnings figures
 Were the misstated or omitted facts material?
o The court says yes
 What is the holding?
 Plaintiffs have met their burden of showing that there were material misstatements or omissions in
the registration statement
 Defendants’ motion to dismiss is denied because they were unable to establish complete due
diligence defenses
 Materiality
 A threshold issue
 Definition of materiality: information that an average prudent investor ought reasonably to be
informed about before purchasing the registered security
o The facts which tend to deter him from purchasing a security are facts which have an
important bearing upon the nature or condition of the issuing corporation or its business
o This is an objective reasonable person standard
 Were there material misstatements or omissions in the registration statement?
o Yes
 Due diligence defense
 What is the legal standard?
o It depends on where the omission or misstatement occurred and who the defendant is
regarding their position in the company and their expertise
o The first question you must ask is where does the alleged material misstatement or omission
appear in the registration statement? Is it in the expertised portion or the nonexpertised
portion?
 Here, the expertised portion consisted of the audited financials
 The court found material misstatements in both the expertised and nonexpertised
portions of the registration statement
o Then you ask is the defendant deemed to be an expert or a non-expert?
 Here, the only expert is the Peat Marwick Accounting Firm
  Must reasonably believe after reasonable investigation that the information
in the registration statement is true
 Held to a professional standard
 They have no liability as to the nonexpertised portion
 The rest of the defendants are non-experts
 Entitled to rely upon the audit and opinion letter issued by Peat Marwick
 What is the effect of establishing the defense?
o If defendant meets its burden, it can avoid liability on a case by case basis
 Did any of the defendants establish a defense?
 BarChris
o The issuer cannot claim a due diligence defense
o Because of this, this defendant did not establish a defense
 Vitolo President & Pugliese Vice President
o Unable to establish a defense
o They could not have believed that the registration statement was wholly true and that no
material facts had been omitted
o There is nothing to show that they made any investigation of anything which they may not
have known about or understood
o They were founders of the business and they were president and vice president
 Kircher Treasurer & CFO
o Unable to establish a defense
o He withheld information from others and knowing the facts, he had reason to believe that the
expertised portion of the registration statement was partially incorrect
o He could not shut his eyes to the facts and rely on the experts
o Issue of credibility
 Birnbaum In-House Lawyer & Secretary
o Unable to establish a defense except as to the original figures because he was only hired
after the first round and only signed the amendments, not the original
o He made no investigation and relied on the others to get it right
o He should have known he was required to make a reasonable investigation of the truth of all
the statements in the nonexpertised portion of the document which he signed
o Having failed to make such investigations, he did not have reasonable grounds to believe
that the statements were true
 Auslander Outside Director (Chairman of Valley Stream Bank)
o Unable to establish a defense for the nonexpertised portions of the registration statement
except as to the original figures because he was only hired after the first round and only
signed the amendments, not the original
o He believed the expertised portion of the registration statement to be true because he had
confidence in Peat Marwick and had no reasonable ground to believe otherwise
o As to the nonexpertised portions, he incorrectly believed that Peat Marwick was responsible
for all portions
o He made no investigation of the accuracy and relied on the assurance of Vitolo and Russo
o A prudent man would not act in an important matter without any knowledge of the relevant
facts in sole reliance upon representations of strangers
o He is unable to get off the hook just because he is new to the business
o Entitled to a partial defense
 Grant Outside Director (Law firm was counsel in offering)
o Unable to establish a defense for the nonexpertised portion except as to the original figures
because he was only hired after the first round and only signed the amendments, not the
original
o Held to a higher standard because of his legal expertise
o He was obligated to make a reasonable investigation and he did not do this
o He was entitled to rely on Peat Marwick for the expertised portion because he had no
reasonable grounds to believe them to be inaccurate
o He gets a partial defense
 Peat Marwick Accountants
o Unable to establish a defense
 o Considered an expert because they are the firm that audited the financial statements
o Asked questions, got answers which he considered satisfactory, and did nothing to verify
them
o Did not fulfill the professional standards for an accounting profession
o Only liable for the expertised portion of the registration statement
 The Underwriters
o Unable to establish a defense
o They asked questions of the offices and relied on the answers without checking into the facts
o Asking questions without verifying answers is not sufficient
o §11 of the 1933 Act: Fraud in Registration Statement
 Material misstatement or omission in a registration statement is actionable fraud
 (1) there must be a misstatement or omission
 (2) there must be materiality
 (3) it must be contained in a registration statement
 Person acquiring such security has standing to bring this express private right of action
 Who can bring suit
 Against any person who signed the registration statement, any director, any expert who prepared or certified
part of registration statement, underwriters
 Who are the people who can be sued
 Expert = accountant, engineer, appraiser, but not lawyer
 Subject to defenses of loss causation and due diligence
 Once plaintiff has met its burden of proof, the burden shifts to defendants to prove defenses
 Loss causation defense = you as a defendant are able to show that the reason plaintiff suffered loss
was not due to the material misstatement or material omission in the registration statement but was
due to some other factor
 Statute of limitations defense = contained in §13 of the 1933 Act
 Remedy = damages
 If plaintiff meets its burden and defendants cannot establish one of the defenses then the remedy is
damages equivalent to the difference between the price paid for the shares and the value of the
securities
 Serves DETERRENCE function = intended to force directors and officers to do sufficient due diligence
before putting information out to the public
 §11 reaches material misstatements or omissions in registration statement
 §12 reaches material misstatements or omissions outside of a registration statement
 §11 and §12 create express private rights of action
 Compare implied private right of action (§10(b) of 1934 Act)
o Due Diligence Defense under §11 of the 1933 Act
 Expertised Portion = a portion of the registration statement that contains a statement by an expert as defined
in the statute upon which investors would rely
 EXPERT: Reasonably believes, after reasonable investigation, that the information contained in the
registration statement is true
o Experts are held to a professional standard
 NON-EXPERT: No reason to believe that the information in the expertised portion is false
o They are entitled to rely upon the expert’s judgment
 Nonexpertised Portion = everything else
 EXPERT: No liability with respect to the nonexpertised portion
 NON-EXPERT: Reasonably believes, after reasonable investigation, that the information in the
nonexpertised portion of the registration statement is true
o Corporation Review Q#6
 US Way
 Sales agents sell microwaves door to door
 Keep 6% commission & forwards 94% to supervisor
 Supervisor keeps 6% commission and sends 88% to headquarters
 Wholesalers and officers are paid from 88%
 Sales agents can become managers if they recruit other sales agents subject to 15% commission cap
 Issue: Must stock be registered?
 March: Scientists discover risk of cancer from use of product
 April: USW issues stock without disclosing cancer risk
  Issues:
 If registration statement is materially misleading, will plaintiff recover from directors?
 Does plaintiff need to read the registration statement?
 What are the damages?
 Is the accounting firm that audited financials liable?
o §10(b) of 1934 Act & SEC Rule 10b-5
 A judicial oak which has grown from little more than a legislative acorn
 §10(b) of the 1934 Act is the most widely used anti-fraud provision in the federal securities laws
 §10(b) of the 1934 Act:
 In connection with the purchase or sale of securities, using jurisdictional means, it is unlawful to use
or employ manipulative or deceptive devices in violation of SEC rules
o Using jurisdictional means = involving interstate commerce
o Manipulative or deceptive device = explained in SEC Rule 10b-5
 SEC Rule 10b-5:
 In connection with the purchase or sale of securities, using jurisdictional means, it is unlawful to
employ any device to defraud, to make material misstatements and omissions, or to engage in any
act operating as a fraud or deceit
 Types of Cases:
 Defective corporate disclosure
o Corporate disclosure that is deemed to be materially misleading
o Can occur in the context of a required government filing or a voluntary statement
 Insider trading
 Fraud in dealings between broker-dealer & their customers
o Broker-dealer firms are the firms that are in the securities business and they buy and sell
securities for the accounting customers
 §10(b) is considered to be an implied private right of action that is well-established by the courts
 Elements of Private Right of Action:
o Material misrepresentation or omission
o Scienter
 A knowing state of mind & you knew you were telling an untruth in connection with
the investment
o Reliance
 The investor has to have heard the misleading statement and there has to be
affirmative proof that they relied on the misleading statement
o Causation
 A relationship between the alleged misstatement and the loss that was caused
o Damages
o NOTE: there is a substantial burden on plaintiff
o SEC v. Texas Gulf Sulphur
 §10(b) Insider Trading Prohibition & defective corporate disclosure
 Who was plaintiff, who were defendants, what transactions gave rise to the lawsuit?
 Plaintiff = SEC
 Defendants = Texas Gulf Sulphur (TGS) (a mining company)
o Vice president = Richard Mollison & Charles Fogarty
o Electrical Engineer = Richard Clayton
o President = Claude Stephens
o Director = Frances Coates
o Secretary = David Crawford
 Transactions giving rise to suit:
o False press releases
o Individuals within the company purchasing shares of stock
 Facts:
o They drilled into material with high mineral content suggesting that the property would be
commercially viable
o They bought the land where the drilling occurred along with the surrounding land for further
exploration
o There was also trading going on by individuals within the company through the purchasing
of shares because they had insider knowledge of this good news before it got to the public
  What was the alleged fraud?
 Defendant put out false and misleading press releases to the public stating there were rumors of their
find but then downplayed the finding and stated there was no information available to conclude this
 This was a voluntary press release. It was not required
 Insider trading
 Court addresses the following issues:
 Issue #1: Insider trading prohibition
 Issue #2: Materiality of information
 Issue #3: Interpretation of statutory language: in connection with the purchase or sale of a security
 What legal principle does the court articulate on each point?
 Issue #1: What is the disclose or abstain rule and who does it apply to? (insider trading issue)
o Those in possession of material inside information must either disclose it to the investing
public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or
he chooses not to do so, must abstain from trading in or recommending the securities
concerned while such inside information remains undisclosed
 Issue #2: What standard of materiality does the court adopt?
o The reasonable investor standard refined to reflect the facts of this case
o An insider’s duty to disclose information or his duty to abstain from dealing in his
company’s securities arises only in those situations which are essentially extraordinary in
nature and which are reasonably certain to have a substantial effect on the market price of
the security if the extraordinary situation is disclosed
o The court uses the probability magnitude test which is used when talking about speculative
information
 Speculative information = information that as of the point in making the decision on
whether to invest to disclose or not disclose, the future event is uncertain
o 2 factors should be looked at:
 (1) the probability that the future event will occur
 (2) the magnitude of impact on the company if the uncertain event does happen in
the future
o If high magnitude and high probability, the information would be considered to be material
 Issue #3: How does the court’s interpretation of the in connection with requirement expand the
category of lawsuits that may be brought under §10(b)?
o It seems clear that Congress intended only the device employed, whatever it might be, be of
a sort that would cause reasonable investors to rely and in connection therewith so relying
causes them to purchase or sell a corporation’s securities
o All that is needed to be shown is that the investor relied on the statements made by the
company in the press releases and that is what caused them to purchase or sell the securities
o Privity of contract is not necessary
o There is a broad scope of the use of this statute
 What is the outcome in the lawsuit?
 The court remanded the case back to the district court to determine the character of the press releases
in the light of the facts existing at the time of the release, by applying the standard of whether the
reasonable investor, in the exercise of due care, would have been misled by it
 There was material inside information and the insiders should not have been trading
 They should have first disclosed the true information about the samples to the public and only after
that would they be permitted to trade under the disclose or abstain rule
 Because the district court did not use the proper standard of materiality, the case is being remanded
o Other Precedent on §10(b) Insider Trading Prohibition & the disclose or abstain rule
 In re Cady Roberts Co. (SEC 1961)
 SEC recognized common law duty of corporate insiders (includes officers, directors, and control
shareholders) to disclose inside information when dealing in securities
 But it remained unclear who inherited these duties
 Chiarella v. U.S. (SCOTUS 1980)
 Facts
o An individual learned about inside information because of the work he was involved with
but the information didn’t actually say who the company was going to buy-out. However, he
figured it out by doing research in the financing journals.
 o He ended up buying shares and when the tender offer was announced, the value of his shares
went way up so this tells us that the information was clearly material
o He ended up getting convicted for insider trading under SEC Rule 10b-5
 Issue
o Whether or not his conviction under SEC Rule 10b-5 was proper and whether or not he had
violated Rule 10b-5
 SEC said the conviction was proper because he acquired the information as an insider and therefore
should be subject to the disclose or abstain rule
o The Supreme Court said the conviction was not proper because in order to have a violation
of rule 10b-5 based on insider trading conduct, there has to be a relationship of trust and
confidence that exists
o Here, there was no violation because he was not an insider of the company and therefore had
no obligation of trust and confidence with respect to that information
 In order for there to be fraud, there must be a breach of a duty of trust and confidence and taking that
information and trading on it for one’s own personal gain
o This rule applies to corporate insiders who do have this duty of trust and confidence
o It does not apply to a corporate outsider
 Corporate insider must abstain from trading in the shares of his corporation unless he has first
disclosed all material inside information known to him
 Duty to abstain arises from this relationship of trust between a corporation’s shareholders and its
employees; duty does not arise from mere possession of material inside information
 Holding:
o No liability because Chiarella did not have a relationship of trust with shareholders of
company in whose stock he traded
o Dirks v. SEC
 §10(b) Insider Trading Prohibition & Tippee liability
 Who was Dirks?
 Dirks was an officer of a NY broker-dealer firm who specialized in providing investment analysis of
insurance company securities to institutional investors
 He received information from Secrist, a former officer of Equity Funding of America. He alleged
that the assets of Equity Funding, a diversified corporation primarily engaged in selling life
insurance and mutual funds, were vastly overstated as the result of fraudulent corporate practices
 He urged Dirks to verify the accounting fraud and disclose it publicly
 Why did the SEC start an enforcement proceeding against him?
 Because although he did not own any shares of Equity Funding, his clients did and they began
selling their shares before the stock price crashed down
 They claimed he violated the rules because he repeated the allegations of fraud to members of the
investment community who later sold their Equity Funding stock
 Would the classic rule against insider trading apply to him?
 The classic rule against insider trading would be the disclose or abstain rule
 No this rule would not apply to him because he was not an insider of Equity Funding. He was a
broker who got information from a former insider
 He owed no duty of trust and confidence because he was not an insider of the company
 What theory did the SEC advance?
 Anyone who gets information that is material and not public information from an insider inherits the
Cady Roberts duty to disclose or abstain
 This says that for establishing a Rule 10b-5 violation, 2 elements must be met:
o (1) the existence of a relationship affording access to inside information intended to be
available only for a corporate purpose and
o (2) the unfairness of allowing a corporate insider to take advantage of that information by
trading without disclosure
 Did the Supreme Court accept or reject SEC’s argument?
 They rejected the SEC’s theory because they had previously rejected this argument in the Chiarella
case and there is no requirement of equal information among traders
 Only some people under some circumstances will be barred from trading while in possession of
material and nonpublic information
 What rule does Supreme Court fashion to deal with potential liability of people like Dirks?
 Tippee liability
  A tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material
nonpublic information only when the insider has breached its fiduciary duty to the shareholders by
disclosing the information to the tippee and the tippee knows or should know that there has been a
breach
 There must be a tipper who breached a fiduciary duty and a tippee who knew or should have known
of the tipper’s breach of fiduciary duty
 A tippee assumes the duty to disclose or abstain not because they receive insider information, but
rather because it has been made available to them improperly
 What does it mean to have received the tip improperly?
 There must be a direct personal benefit that the tipper gets from passing along the information
 This is what gives rise to the breach of fiduciary duty
 Thus, the test is whether the insider personally will benefit, directly or indirectly, from his
disclosure. Absent some personal gain, there has been no breach of duty to shareholders and absent a
breach by the insider, there is no derivative breach
 Direct personal benefit examples:
o Punitary benefit/gain
o Reputational benefit
o Gift of confidential information
 Was Dirks liable for a violation in this case?
 No
 Secrist didn’t breach a fiduciary duty because he did not receive a personal benefit when he passed
the information to Dirks
 He was motivated to make the public aware of the fraud, without any personal benefit
 What about Secrist, was he liable?
 He also was not liable because he did not breach a fiduciary duty
 The first part of the test was not met
 Conclusion
 We conclude that Dirks, in the circumstances of this case, had no duty to abstain from use of the
inside information that he obtained.
 In the absence of a breach of duty to shareholders by the insiders, there was no derivative breach by
Dirks
 TIPPEE LIABILITY
 (1) Tipper breached a fiduciary duty
o Mere possession of material inside information does not give rise to a duty to disclose
o Existence of breach turns on receipt of direct personal benefit by tipper
o Temporary insider
 Footnote 14: Underwriter, accountant, lawyer or consultant may become fiduciaries
of shareholders
 The corporation must expect the outsider to keep the disclosed nonpublic
information confidential and the relationship at least must imply such a duty
 (2) Tippee knew or should have known of breach
o Insider Trading Hypotheticals
 Would Dirks have been liable under these alternative sets of facts:
 If Dirks and Secrist had routinely exchanged stock tips?
o Yes he would have been liable
o This constitutes a personal benefit and thus there would have been a breach of fiduciary duty
 If Secrist had disclosed the Equity Funding fraud in part because he had been fired over an unrelated
matter?
o No benefit
o Could fall under reputation benefit
o This one is unclear whether he would be liable or not
 If Dirks overheard Secrist describing the fraud to another person in an elevator?
o No breach because no personal benefit
 What if Secrist disclosed negative inside information (not involving fraud) because Dirks bribed
him. Dirks then advised his clients to sell their Equity Funding stock. Dirks would have violated
Rule 10b-5. Would his clients also have violated the rule?
o The clients in this case would be considered second-tier tippees and would apply the same
test as a normal tippee
 o If the clients knew or should have known about the bribe then they would have been liable
o What COUNTS AS A PERSONAL BENEFIT UNDER DIRKS?
 For tippee liability, Dirks requires, among other things, that the insider-tipper will benefit, directly or
indirectly, from his disclosure.
 This benefit test encompasses whether the insider receives a direct or indirect personal benefit from the
disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.
 Dirks also tells us that: The elements of fiduciary duty and exploitation of nonpublic information also exist
when an insider makes a gift of confidential information to a trading relative or friend.
 Questions that remain undecided after Dirks:
 What must plaintiff show to demonstrate pecuniary gain or a reputational benefit in cases where the
insider-tipper makes a gift of confidential information to a trading relative or friend?
 Does the plaintiff need to demonstrate evidence on top of the existence of the gift that the insider-
tipper’s goal in making the gift was to obtain a pecuniary or similar valuable nature, such as money,
property, or something of tangible value?
o These questions are answered in the next case
o Salman v. U.S.
 Who was the defendant and what was the insider trading transaction he engaged in?
 Petitioner Bassam Salman was convicted for conspiracy and insider trading
 He received lucrative trading tips from an extended family member, Michael Kara, who had received
the information from Salman’s brother in law, Maher Kara, and Salman then traded on that
information
 Who gave him material non-public information?
 The original source was Maher
 He received the information through his job because he worked as an investment banker in
Citigroup’s healthcare investment banking group
 What was the motivation for the tip?
 Maher shared the information with his brother Michael to receive help understanding the scientific
concepts relevant to the job
 Michael began trading on such information and at first Maher didn’t know about this but when he
learned of it, his motivation for allowing it to continue was to help his brother who was struggling
financially
 What was the legal issue in the case?
 Whether a gift to a family member of material nonpublic information counts as a personal benefit of
the tipper that would lead to a breach of fiduciary duty under the Dirks test
 How did the Supreme Court answer the question presented?
 The court says that disclosing information to one’s brother does count as a personal benefit to the
tipper under Dirks because Salman knew about this relationship between the brothers and knew
Maher was the source of the information
 The gift from Maher to Michael fulfilled the personal benefit aspect of the test and Salman knew
about the relationship thereby fulfilling the second prong of the test
 What was the Court’s reasoning?
 Dirks requires a breach of fiduciary duty involving a personal benefit
 A personal benefit can take the form of either a direct pecuniary payment or a quid pro quo
arrangement that benefits the tipper
 But in the Dirks language, this also includes a gift of information to a trading relative or a friend
 The gift alone is sufficient to constitute a breach. Nothing of value needs to actually be exchanged
 What counts as a personal benefit after Salman?
 Quid pro quo arrangement
 Gift to a family member or a friend without an additional requirement of value
 What is excluded?
 The gift aspect does not apply to nonrelatives and nonfriends
 The government tried arguing that a gift to anyone would count but the court rejected this argument
 Conclusion
 We reject Salman’s argument that Dirk’s gift-giving standard is unconstitutionally vague as applied
to this case. Dirks created a simple and clear guiding principle for determining tippee liability. At
most, Salman shows that in some circumstances assessing liability for gift-giving will be difficult
o U.S. v. O’Hagan
 §10(b) Outsider Trading Prohibition & the misappropriation theory
 Who was O’Hagan and why did the U.S. start an enforcement proceeding against him?
 James Herman O’Hagan was a partner in the law firm of Dorsey & Whitney
 The law firm was representing Grand Met regarding a potential tender offer for the common stock of
Pillsbury Company
 During the representation, O’Hagan began purchasing call options for Pillsbury stock. Each option
gave him the right to purchase 100 shares of Pillsbury stock by a specified date
 By the time the tender offer went public, O’Hagan owned more than 2,500 Pillsbury options which
was more than any other individual investor. He also purchased around 5,000 shares of Pillsbury
common stock
 When the offer was announced, Pillsbury stock increased by $20 a share so O’Hagan sold his call
options and common stock making a profit of $4.3M. He used this money to conceal other illegal
activities he was engaged in such as embezzling client funds
 He was convicted on 57 counts alleging that he defrauded his law firm and its client by using for his
own trading purposes material and nonpublic information regarding the planned tender offer
 He was charged with 20 counts of mail fraud, 17 counts of securities fraud in violation of §10(b) of
the 1934 Act and Rule 10b-5, 17 counts of fraudulent trading in connection with a tender offer in
violation of §14(e) of the 1934 Act and Rule 14e-3(a), and 3 counts of violating federal money
laundering statutes
 Would the classic rule against insider trading apply to him?
 This is the disclose or abstain rule. This is violated when a corporate insider trades in the securities
of his corporation on the basis of material and nonpublic information
 This would not have been applicable here because he was not an insider to the company he was
purchasing shares for
 Would the rule governing tippee liability apply to him?
 No because he was not tipped off and didn’t receive the information from an insider of Pillsbury
 He instead received the information through his own employment
 What theory of §10(b) liability did the U.S. government advance?
 The misappropriation theory
 This holds that a person commits fraud in connection with a securities transaction and thereby
violates §10(b) and Rule 10b-5 when he misappropriates confidential information for securities
trading purposes, in breach of a duty owed to the source of the information
 How would O’Hagan’s conduct be captured under such theory?
 He took information provided in a business context and used it for his own personal trading
advantage thereby breaching a duty of confidentiality
 Did the U.S. Supreme Court accept or reject that theory as a basis for liability on the §10(b) counts?
 The court accepts this theory as a basis for liability
 This theory outlaws trading on the basis of nonpublic information by a corporate outsider in breach
of a duty owed not to a trading party, but to the source of the information
 Misappropriation involves a deceptive device or contrivance used in connection with the purchase or
sale of securities
 The misappropriator deals in deception and a person who pretends loyalty to the principal while
secretly converting the principal’s information for personal gain, dupes or defrauds the principle
 The in connection with element is satisfied because the fiduciary’s fraud is consummated, not when
the fiduciary gains the confidential information, but when, without disclosure to his principal, he
uses the information to purchase or sell securities
 What additional theory of insider trading did the U.S. government advance?
 §14(e) which specifically addresses insider trading in tender offer transactions
 How would O’Hagan’s conduct be captured under such theory?
 This was a tender offer transaction and he received material and nonpublic information that was
obtained from the offeror
 He is clearly falling within the rule
 How did O’Hagan attack that count of his conviction?
 He couldn’t say that it did not apply to him or there was a misapplication of the rule
 Instead he attacked the validity of the whole rule saying that the Commission exceeded its
rulemaking authority under §14(e) when it adopted Rule 14e-3(a) without requiring a showing that
the trading at issue entailed a breach of fiduciary duty
 How did the Supreme Court rule on that issue?
  They held that the Commission, in this regard and to the extent relevant in this case, did not exceed
its authority
 The court rejected O’Hagan’s argument on this point
 They say they are not going to decide whether there is a difference between the Commission’s
authority under the rules because the rule itself is a means reasonably designed to prevent fraudulent
trading on material and nonpublic information in the tender offer context
 The court uses Chevron Deference rule which says that you should give the expert executive agency
in charge with enforcement of a particular area of law deference when it is within their area of
expertise
 The court upheld the convictions
o Misappropriation Theory
 Outsider violates §10(b) and 10b-5 when he trades on material non-public information in breach of a duty
owed to the source of such information
 Disclosure to source of information absolves breach
 The purpose is to protect integrity of markets against abuses by outsiders who have access to confidential
info that will affect a company’s stock price but who owe no fiduciary duty to corporation’s shareholders
o §14(e) of 1934 Act & SEC Rule 14e-3(a): Insider Trading Prohibition in Tender Offers
 §14(e): In connection with a tender offer, it shall be unlawful to make material misstatements or omission or
to engage in fraud, deception or manipulation
 Rule 14e-3(a): If a tender offer has been commenced, it is unlawful to purchase or sell securities on the basis
of material inside information if trader knows info obtained from offeror, issuer or any officer, director,
partner, or employee to either offeror or issuer
 Full language of §14(e) = it shall be unlawful for any person to engage in any fraudulent, deceptive, or
manipulative acts or practices, in connection with any tender offer. The SEC shall, for the purposes of this
subsection, by rules and regulations define, and prescribe means reasonably designed to prevent, such acts
and practices as are fraudulent, deceptive, or manipulative.
 Full language of Rule 14e-3(a) = if any person has taken a substantial step or steps to commence, or has
commenced, a tender offer (the offering person), it shall constitute a fraudulent, deceptive, or manipulative
act or practice within the meaning of §14(e) of the 1934 Act for any other person who is in possession of
material information relating to such tender offer which information he knows or has reason to know is
nonpublic and which he knows or has reason to know has been acquired directly or indirectly from:
 (1) the offering person
 (2) the issuer of the securities sought or to be sought by such tender offer, or
 (3) any officer, director, partner or employee or any other person acting on behalf of the offering
person or such issuer,
 To purchase or sell or cause to be purchased or sold any of such securities or any securities
convertible into or exchangeable for any such securities or any option or right to obtain or to dispose
of any of the foregoing securities, unless within a reasonable time prior to any purchase or sale such
information and its source are publicly disclosed by press release or otherwise
o Outsider Trading Hypothetical
 Court states that there would be no liability if O’Hagan had disclosed to the source of the information that he
planned to trade on the non-public information.
 To whom should he have made disclosure?
o The source of the information
o This would likely include both his law firm and the client Grand Met
 What is the effect of making such disclosure?
o By making such disclosure, he would have done away with the fiduciary duty breach and
cure fraud and liability
 How does such disclosure solve the problem?
o Once a disloyal agent discloses his imminent breach of duty, his principal may seek
appropriate equitable relief under state law
o §16(b) of 1934 Act: Short-Swing Profits
 §16(a) requires insiders of public companies to report to the SEC transactions in equity securities by insiders
of public companies (issuers)
 Insiders are directors and officers of issuers and persons who directly or indirectly are the beneficial
owners of more than 10% of any class of equity security of issuers (covered persons)
 §16(b): For the purpose of preventing the unfair use of information which may have been obtained by such
beneficial owner, director or officer by reason of his relationship to the issuer, any profit realized by him
from any purchase and sale, any sale and purchase of any equity security of such issuer within any period of
 less than six months shall inure to and be recoverable by the issuer. This subsection shall not cover any
transaction where such beneficial owner was not such both at the time of the purchase and sale or the sale
and purchase of the securities involved
 §16(b) was intended by Congress to be the primary avenue to address the problem of insider trading
 Who is covered by the rule?
o Beneficial owners, directors, and officers
 Beneficial owner = an entity/person who owns more than 10% of any class of equity
securities
 What activity is covered?
o A matched purchase and sale or a matched sale and purchase within a 6-month time frame
 What is the remedy if a covered person engages in a covered activity?
o Disgorgement of those profits
o Additional Notes on §16(b)
 Issuers
 §16(b) applies only to companies that register their stock under the 1934 Act
 These include companies with stock traded on a national exchange, and companies with assets of at
least $10M and 500+ shareholders
 Officers
 §16(b) applies to trades by directors and officers who are at least 10% owners.
 Officer = an issuer’s president, principal financial officer, principal accounting officer, any vice
president of the issuer in charge of a principal business unit, division or function, and other officer
who performs a policy-making function, or any other person who performs similar policy-making
functions for the issuer
 Stock classes and convertible debentures
 To determine stock percentages under §16(b), courts consider classes of stock separately.
 A shareholder who owns 10% of one class of stock is subject to §16(b), even if he or she does not
own 10% of another class, or 10% of the company’s total stock
 That shareholder will be liable for the short-swing profits that he or she makes on any class of stock
 §16(b) applies only to equity securities which covers convertible debt but not other bonds or
debentures
 §16(b) Litigation
 Although recovery under §16(b) accrues to the corporation, shareholders can enforce it derivatively
 They generally obtain the information about the inside trades by scrutinizing the stock transaction
reports that the insiders must file with the SEC
 Matching stock
 To calculate a company’s recovery under §16(b), a court must match a defendant’s purchases with
her or his sales
 The courts match stock sales and purchases in whatever way (within the confines of the rules)
maximizes the amount the company can recovery
 They do not use any of the standard accounting tools or let shareholders identify specific shares of
stock
 They match the lowest priced purchases and the highest priced sales
o Reliance Electric v. Emerson Electric (SCOTUS)
 §16(b)
 If there is a covered person who engages in a covered activity, then the remedy is disgorgement of
profits
 Purchase of shares:
 Emerson purchased 13.2% of Dodge in a tender offer
 Tender offer did not result in a takeover
 Dodge subsequently merged into Reliance
 The purpose of this tender offer was for Emerson to gain control of Dodge but it failed to do so
 Emerson ended up with a minority interest and now wants to sell the shares that it ended up with
 Sale of shares:
 Sale #1: Emerson sold 3.24% of Dodge
 Sale #2: Emerson sold remaining 9.96% of Dodge
 Issues: Liability under §16(b)
 Is Emerson liable for profits on sale #1?
o Yes
 o Emerson is a covered person under the statute
o Emerson held 13.2% of the shares, which is more than the statutory minimum of 10%
o Therefore, it falls within the covered persons definition within the statute
o So Emerson owes profits on the difference between the amount they purchased the shares
for and the amount they sold the shares for
 Is Emerson liable for profits on sale #2?
o No
o They are not a covered person within the language of the statute
o They do not own more than 10% at this point
o They are not liable for profits on the second sale
 Conclusion & Reasoning
 As long as the 2 sales are not legally tied to each other and are made at different times to different
buyers, the splitting of the block is permissible
 It cannot be part of a single plan but if it is 2 separate sales, this is acceptable
 Reliance cannot recover profits derived from the second sale
 Congress, when it enacted §16(b), intended to put into place a flat rule that would take the profits out
of a class of transactions in which congress believed there was a possibility of abuse
 A 6-month trading window was considered to be evidence that the covered person who engaged in
the purchase and sale and then the sale and purchase was trading based on material nonpublic
information. However, if you are able to break it up and still stay within the statutory timeframe, as
Emerson did, this is not an issue
o This rule is under inclusive because it does not capture some instances of insider trading
 If the purchase and sale took place not within a 6-month timeframe, but outside that,
it would not be covered by the rule even if the person did have access to material
nonpublic information and that motivated their trading
o The rule is also over inclusive
 It can capture some transactions that are not based on the use of material nonpublic
information
 As long as you fall within the requirements of the statute, it is covered and there is
no inquiry as to whether or not the trading person used material nonpublic
information
o Short-Swing Profits Example
 Bill is CEO of SCLaw, Inc. (SCLI), a chain of proprietary law schools in southern California. SCLI stock is
registered under the 1934 Act, and 1M shares are outstanding. On January 1, Bill purchased 200K shares of
SCLI common stock for $10 per share. Determine his liability, if any, under §16(b) (is Bill required to
disgorge profits?)
 If he sells all 200K shares on May 1 for $50 per share?
o Yes he is required to disgorge profits
o He is a covered person because he is the CEO which is included under the statute
o This is a covered transaction because he purchased on Jan 1 and sold on May 1 which is
within the 6-month timeframe of the statute
o He realized a profit
o Because he is a covered person engaged in a covered activity, the remedy is disgorgement of
profits in the amount of $40 per share x 200K shares (total = $8M)
 If he sells all 110K shares on May 1 for $50 per share, and the remainder on May 2 at the same
price?
o Yes, he is liable to the same extent as the first question.
o The fact that after the first sale he may have become less than 10% shareholder is irrelevant
because he is still a covered person within the meaning of the statute at the time of both sales
o Both sales occur within a 6-month timeframe
o Therefore, the result is the same as directly above
 If he sells 110K shares on May 1 for $50 per share, resigns from SCLI, and sells the remainder on
May 2 at the same price?
o Same result because he became liable as a covered person by virtue of being CEO and
officers and directors are covered persons under the statute
o They are subject to §16(b) if they were officers or directors either at the time of the purchase
or the sale transaction
 NOTE:
 o The language in the fact pattern about 1M outstanding shares is very important because in
order for §16(b) to be triggered, it has to be a company that is a public company whose stock
is registered under §12 of the 1934 Act
o Corporation Review Question #8
 Missouri Cellular Corporation manufactures and sells cellular telephones to consumers.
 Alfred is the CEO and Chairman of the Board.
 January 3: Alfred is informed by Barbie, head of research and development, that field tests of new
technology have failed. Alfred files the information.
 February 1: MCC raises capital by doing a public offering of common stock. No mention of failed field tests.
 Alfred owns 5% of stock of MCC and purchases shares in public offering.
 April 1: Alfred sells most of his stock and earns a profit.
 April 2: MCC issues press release on failed field tests and discontinuation of development efforts.
 Stock falls sharply.
 Has any provision of the federal securities laws been violated?
o List possible areas and analyze.
o INDEMNIFICATION & INSURANCE DGCL §145
 Most states have detailed statutory provisions covering the authority or obligation of a corporation to
indemnify officers and directors for any damages they might incur in connection with their corporate
activities, and for the expenses of defending themselves
 There are several different situations that might give rise to liability
 The risk of liability may be remote, but the amount of the damages can be large in relation to the
individual wealth of the officers and directors and there may be forms of relief other than monetary
damages
 Corporations may be able to buy insurance to cover damages and expenses of defenses, but if they
are allowed to do that, the question arises, why not allow them to become self-insurers?
 Officers and directors need to be concerned about the possibility that the corporation will be taken
over by people hostile to them which can affect the value of a right to reimbursement that is within
the discretion of the board
 Delaware corporations have power to indemnify, grant advances and insure covered persons as specified.
 Covered persons = any person who becomes a party to legal action by reason of service as director, officer,
employee or agent
 Delaware’s protective provision = §102(b)(7)
 This applies only to liability of a director to the corporation or its shareholders for monetary
damages for breach of fiduciary duty as a director
 Indemnification permitted/allowed
 Third party suits §145(a): allowed for expenses, fines, judgments; acted in good faith
 Derivative suits §145(b): allowed only for expenses with judicial approval; acted in good faith
 Indemnification required §145(c): expenses must be reimbursed if defendant was successful on the merits
 Advances of expenses to officers and directors §145(e): corporation may grant advances with written
undertaking to repay if not entitled to indemnification
 Advances = giving money payments to a covered person, such as officers and directors, to allow
them to pay their fees and legal expenses while a lawsuit is pending against them
 This provision is optional, not mandatory
 Additional rights may be granted by contract §145(f): this is of most interest to officers, directors, and other
employees; it expressly contemplates agreements that provide greater protection than does the statute itself
 Insurance §145(g): corporation may insure covered persons against liability (directors and officers
insurance)
 Most publicly held, and many privately held, corporations carry director & officer liability insurance
 These are very expensive
o PROXIES: Introduction
 Proxy = the agent appointed by a shareholder to attend a shareholder meeting and vote on their behalf; the
document by which the shareholder appoints the agent is also called the proxy
 Form:
 What is the purpose of the proxy?
o To get authorization from shareholders that these named individuals can vote the shares of
the shareholders at an annual meeting
 What voting items does the proxy cover?
o Election or re-election of the board of directors
o Appointing an accounting firm as the accountant
 o Shareholder proposals
o Approval/disapproval of a merger
o Whether to amend the articles of incorporation & limit director liability
o To liquidate the firm
o To sell all or substantially all of the assets
 Uses:
 Solicit shareholder votes needed to hold meetings and take valid shareholder action
o Note that an annual shareholder meeting is required and voting tends to occur during these.
Many people won’t want to physically travel to the location of the meeting so they appoint
proxies to attend and vote on their behalf
o The proxy is a process that is used to solicit shareholder votes that are needed in order to
hold a meeting in which a valid corporate decision by shareholders can be taken
 Proxy fights to gain corporate control of the corporation
o These result when an insurgent group tries to oust incumbent managers by soliciting proxy
cards and electing its own representatives to the board
o Proxies: Regulation
 State law general
 Statutory:
o DGCL §212(b) permits use of proxies for shareholder voting
o Remember that §211(b) requires annual meetings of shareholders for election of directors
 Case law on strategic use of proxies and cost reimbursement in proxy contests (2nd use)
 State law on cost reimbursement
 Annual meeting of shareholders with uncontested board election = incumbents may charge the firm
for proxy costs
o Courts will scrutinize
o Limits imposed by courts
 Proxy contest: Incumbents may charge firms for proxy costs; Insurgents may be reimbursed if they
win and shareholders ratify
 Federal law
 §14(a) of 1934 Act requires proxy solicitations for reporting companies to comply with SEC rules
o This prohibits people from soliciting proxies in violation of the SEC rules
 SEC rules require disclosure to accompany proxy solicitation, specify form of proxy card, require
prior filing and review of proxy statement and proxy card, prohibit false and misleading proxy
solicitations
 SEC Rule 14a-8: Shareholder Proposals
 Definition:
o Recommendation or requirement that company and/or the board of directors of that
company take action which you intend to present in the form of a resolution at meeting of
shareholders
 Company must include information in proxy statement and identify it in form of proxy subject to
procedural limitations and the right to exclude
 This is another opportunity for shareholders to put an item on the ballot to be voted on during an
annual shareholder meeting
 Procedural limitations = limitations on who is a qualified shareholder to present a proposal for
voting at a meeting of shareholders
o Must own $2K or 1%
o May only submit one proposal per shareholder
o The proposal must not exceed 500 words
 Management must include the shareholder proposal in the annual proxy solicitation unless the
management can meet burden of proof of showing proposal may be legitimately be excluded
o Management must notify shareholder that their proposal is being rejected and give them the
opportunity to correct the proposal and make it within the limitations of the rule
o Management must file reasons for rejection with the SEC
 Shareholders typically don’t approve these proposals
 SEC Rule 14a-7: Common Carrier Obligation
 Management must mail shareholder materials or provide shareholder with a list of names and
addresses of other shareholders
 This gives management a choice:
 o They can either mail the insurgent group’s material to the shareholders directly and charge
the group for the cost
o OR
o They can give the group a copy of the shareholder list and let it distribute its own material.
o Levin v. MGM
 What was the proxy fight about?
 Corporate control of management
 The fight was about use of corporate funds in connection with a proxy contest and whether it was
appropriate to use funds of the corporation by the incumbents to wage a proxy fight
 Plaintiff included Levin, who is a director of MGM and all plaintiffs hold substantial blocks of
MGM common stock
 He is joined by 5 other shareholders (known as the Levin group)
 They would like to take over control of MGM because they are not happy with the existing
management so they are contesting the proxies that have been sent out by defendants
o Defendants are the incumbents
 What is the basis for plaintiff’s complaint in this case?
 The fact that the incumbents used corporate money and funds to wage a proxy fight and defend their
position in the proxy fight and they used the money for purposes that the Levin group claim was
wrongful
 They used money for the proxy solicitation process and wrongfully committed the company to pay
for the services of specially retained attorneys, a public relations firm and proxy soliciting
organizations, and, in addition, have improperly used the offices and employees of MGM in proxy
solicitation and the good-will and business contracts of MGM to secure support for the present
management
 What is the issue?
 Whether there were unfair or illegal means used by the incumbents in connection with fighting off
the plaintiffs in the proxy contest
 What is plaintiff seeking?
 Plaintiffs pray for temporary and permanent injunctive relief against defendants’ continuing this
method of solicitation of proxies and against defendants’ voting the proxies so obtained at the annual
meeting
 They also seek money damages of $2.5M on behalf of MGM from the individual defendants
 Who wins and why?
 Defendants win
 The court says that it was appropriate for the incumbents to expend funds for the purposes of the
proxy fight because the shareholders have a right to be fully informed when it comes to a proxy
contest
 What limitations does the court impose on costs incurred for proxy contests?
 The court says that there were no illegal or unfair means of communication used
 The court appears to include some limitations as well:
o The proxy fight must turn on the differences relating to policy regarding running the
company
o The amounts spent
o Violation of federal statute
 Here, the fundamental policy differences between the groups concerned:
o The annual number of feature pictures MGM should produce
o Slow release of pictures to TV showing
o Build up cash funds available for productions by reducing dividends
o Rosenfeld v. Fairchild Engine
 Who is plaintiff and who is he suing?
 Plaintiff is an attorney shareholder who owns 25 out of over 2.3M shares of Fairchild Engine
 Plaintiff is suing the board of directors of the company through a shareholder’s derivative lawsuit
 Basis for complaint?
 Has to do with reimbursement of expenses in connection with a proxy contest
 Plaintiff seeks to compel the return of $261,522 paid out of the corporate treasury to reimburse both
sides in a proxy contest for their expenses
 This was a proxy contest where the incumbents were challenged by a new board and the new board
won the proxy contest and both parties were reimbursed for expenses
  The new board was the ones that approved the payment reimbursement to the old board
 What is a proxy contest?
 2 competing proxy solicitations
o One sent out by incumbents (old board)
o One sent out by insurgents (new board)
 The incumbents would be naming their own board of directors to be re-elected at the meeting
 The insurgents would name different individuals who want to become part of the board of directors
 So shareholders would receive 2 proxy cards and the shareholder needs to choose to return only one
of them
 Who wins and why?
 Defendants win
 Because the proxy contest involved questions of corporate policy
 The court distinguishes between expenses relating to corporate policy and expenses related to
matters of personal
 Here, there were questions of corporate policy involved rather than personal control and the
expenses were reasonable
 Who can be reimbursed for proxy contest expenses?
 Incumbents have the right to be reimbursed in connection with a proxy contest because they have a
good faith right to defend their positions as long as certain things are true:
o This involved a contest over policy
o The amounts spent were reasonable and proper
o The actions of the incumbents were taken in the best interest of the shareholders
 The shareholders of a corporation can reimburse successful contestants (the insurgents here) for
reasonable and good faith purchases
 What are the limits for reimbursement?
 Reasonable and proper in amount
 Contest over policy and not trying to maintain power for one’s own self interest
 Acting in good faith
 Dissent
 Mentions the fact that not all expenses that were incurred by incumbents were related to business
expenses and unrelated to policy
 It was unclear whether this was a dispute about policy and not personal because there was a dispute
regarding an employment agreement involving a former officer and director
 There was majority approval of the decision to reimburse but there should have been consent of all
shareholders given the circumstances of the case
o Corporation Review Q#9
 Can Kane charge his expenses to Inquirer Corp.?
 Can Geddes obtain reimbursement from the Inquirer Corp. if he wins?
 If he loses?
o SHAREHOLDER INSPECTION RIGHTS
 Definition:
 The ability of shareholders to obtain shareholder list or other corporate records
o This is regulated by state law statutes rather than federal statutes
 Compare the requests made by shareholders in Crane v. Anaconda and Pillsbury v. Honeywell
 What records were sought?
o Crane v. Anaconda
 Crane requested a copy of Anaconda’s list of shareholders
 The second request was a written request to produce its stock book for inspection
 With the second demand Crane accompanied it with an affidavit
o Pillsbury v. Honeywell
 He submitted 2 formal demands to Honeywell requesting that it produce its original
shareholder ledger, current shareholder ledger, and all corporate records dealing
with weapons and munitions manufacture
 Honeywell refused
 What was the reason for the request?
o Crane v. Anaconda
 Crane claimed that Anaconda had a fiduciary duty to its shareholders to present
them with all the information pertinent to the pending tender offer
  They wanted to contact the shareholders directly but Anaconda refused the request
 Anaconda refused because at the time of the request, Crane owned no shares of
Anaconda stock
 Crane then made a second request for the list after acquiring shares of Anaconda
 Anaconda rejected this second demand as well but offered to mail Crane’s
documents to its shareholders at Crane’s expense
 The request was made because they wanted to launch an exchange offer for the
common stock of Anaconda and they wanted to contact the shareholders to make
this offer
o Pillsbury v. Honeywell
 He wanted to give himself a voice in Honeywell’s affairs so he could persuade
Honeywell to cease producing munitions
 He wanted to communicate with other shareholders in the hope of altering
Honeywell’s board of directors and thereby changing its policy
 Was the request granted?
o Crane v. Anaconda
 No they didn’t want to provide the information but they offered to mail the
information to the shareholders directly
 Anaconda claims to have denied the second request because it was not a proper
purpose under the statute because it is not a proper purpose to contact the
shareholders to convince them to sell their shares and this did not involve the
business of the corporation
 The court concluded that Crane was entitled to receive the shareholder list
 Anaconda did not meet its burden of proving an improper purpose
 This was a proper purpose because shareholders should know what affects
the future direction of the corporation and the shareholder’s own interest
o Pillsbury v. Honeywell
 Honeywell denied the demand
 The court agrees with Honeywell and denies the shareholder’s request
 The court looks at the meaning of proper purpose
 It says that a proper purpose means a purpose that is economic in nature
when it comes to inspecting corporate records other than the shareholder list
 His stated goal was a type of political goal, not anything concerned with
economic effects involving the company
 Read and compare the governing statutes used in the two cases: NYBCL §1315 used in Crane and DGCL
§220 used in Pillsbury
 NYBCL §1315 Record of Shareholders: from Crane v. Anaconda
o (a) any resident of this state who shall have been a shareholder of record, for at least 6
months immediately preceding his demand, of a foreign corporation doing business in this
state, or any resident of this state holding, or thereunto authorized in writing by the holders
of, at least 5% of any class of the outstanding shares, upon at least 5 days’ written demand
may require such foreign corporation to produce a record of its shareholders setting forth the
names and addresses of all shareholders, the number and class of shares held by each and the
dates when they respectively became the owners of record thereof and shall have the right to
examine the record of shareholders or an exact copy thereof certified as correct by the
corporate officer or agent responsible for keeping or producing such record and to make
extracts therefrom
o (b) an examination authorized by paragraph (a) may be denied to such shareholder or other
person upon his refusal to furnish to the foreign corporation an affidavit that such inspection
is not desired for a purpose which is in the interest of a business or object other than the
business of the foreign corporation and that such shareholder or other person has not within
5 years sold or offered for sale any list of shareholders of any other corporation of any type
or kind, whether or not formed under the laws of this state, or abetted any person in
procuring any such record of shareholders for any such purpose
 DGCL §220 Inspection of Books and Records: from Pillsbury v. Honeywell
o (b) any shareholder shall, upon written demand under oath stating the purpose thereof, have
the right during the usual hours for business to inspect for any proper purpose
 (1) the corporation’s stock ledger, a list of its shareholders, and
 (2) its other books and records, and to make copies or extracts therefrom.
  A proper purpose shall mean a purpose reasonably related to such person’s interest
as a shareholder
o (c) If the corporation refuses to permit an inspection sought by a shareholder pursuant to
subsection (b) or does not reply to the demand within 5 business days after the demand has
been made, the shareholder may apply to the Court of Chancery for an order to compel such
inspection. The Court may summarily order the corporation to permit the shareholder to
inspect the corporation’s stock ledger, an existing list of stockholders, and its other books
and records, and to make copies or extracts therefrom; or the Court may order the
corporation to furnish to the shareholder a list of its shareholders as of a specific date on
condition that the shareholder first pay to the corporation the reasonable cost of obtaining
and furnishing such list and on such other conditions as the Court deems appropriate. Where
the shareholder seeks to inspect the corporation’s books and records, other than its stock
ledger or list of stockholders, such stockholder shall first establish that:
 (1) he has complied with this section respecting the form and manner of making
demand for inspection of such documents; and
 (2) that the inspection he seeks is for a proper purpose.
o Where the shareholder seeks to inspect the corporation’s stock ledger or list of shareholders
and has complied with this section respecting the form and manner of making demand for
inspection of such documents, the burden of proof shall be upon the corporation to establish
that the inspection such shareholder seeks is for an improper purpose.
 Type of shareholder that can request information from the corporation under the statute?
o Crane v. Anaconda
 Holder of at least 5% of any class of the outstanding shares
 At the time of the second request, Crane was Anaconda’s largest shareholder so it
went over the 5% requirement
o Pillsbury v. Honeywell
 Any shareholder
 Type of books and records that may be requested under the statute?
o Crane v. Anaconda
 The shareholder can request the shareholder list setting forth names and addresses of
shareholders, the number and class of shares held by each shareholder, and the dates
when they respectively became the owners of record
o Pillsbury v. Honeywell
 Any books and records
 The statute says that you can request a corporation’s stock ledger, a list of its
shareholders, and its other books and records, and to make copies or extracts
 Conditions to access for books and record?
o Crane v. Anaconda
 The request must be made at least upon 5 days written notice and it must be
accompanied by an affidavit stating the inspection is not desired for a purpose which
is in the interest of a business or object other than the business of the corporation
and that such shareholder has not within 5 years sold or offered for sale any list of
shareholders of any other corporation of any type or kind
o Pillsbury v. Honeywell
 Inspection must be for any proper purpose
 Shareholder must pay to the corporation the reasonable cost for obtaining and
furnishing the shareholder list
 Burden of proof on proper purpose?
o Crane v. Anaconda
 The burden of proof once the conditions have been met is on the corporation to
demonstrate that access is being requested for an improper purpose
o Pillsbury v. Honeywell
 Plaintiff shareholder must establish a proper purpose to obtain books and records
other than the shareholder list
 For the shareholder list, the burden is on the corporation to establish that the
inspection is for an improper purpose
o Corporation Review Question #2
 2C: are the directors entitled to receive the advances?
  2D: is the shareholder entitled to receive shareholder list and all books and records pertaining to audit of
overseas operations?
 Module 6 Quizzes:
o Quiz 22: Definition of Security; Registration and Exemptions
 The policy behind the Securities Act of 1933 and the Securities Exchange Act of 1934 is to protect investors
and the integrity of the securities markets through a focus on disclosure and anti-fraud measures. (T/F)
 True
 According to the Supreme Court’s opinion in SEC v. Howey, which of the following characteristics are
needed for an investment contract within the meaning of the definition of security in the Securities Act of
1933 and the Securities Exchange Act of 1934?
 All of the following:
o Investment of money
o In a common enterprise
o With the expectation of profit
o To come solely from the efforts of others
 The court in Robinson v. Glynn stated that the labels used by the parties are binding in determining whether
the federal securities laws are applicable; if the parties call an investment a stock then the federal court must
accept that a security is involved. (T/F)
 False
 The Supreme Court in SEC v. Ralston Purina stated that the test for the existence of a private placement was
whether the offerees needed the protection of the federal securities laws or whether they were able to fend
for themselves because they had access to information equivalent to what they would receive in a registered
public offering. (T/F)
 True
 The court in Doran v. Petroleum Management Corp. stated that the defendant had established that its
securities offering was a private placement because there were a small number of offerees and plaintiff was a
sophisticated investor who did not need the protection of the federal securities laws. (T/F)
 False
o Quiz 23: Securities, Fraud, and Insider Trading
 §11 of the 1933 Act creates an express private right of action for any purchase or sale of securities alleged to
involve material misstatements or omissions. (T/F)
 False
 Which of the following is an available defense in a lawsuit brought under §11 of the 1933 Act?
 All of the following:
o Defense based on running of the applicable statute of limitations
o Loss causation defense
o Due diligence defense
 Which of the following defendants in Escott v. BarChris was able to establish a complete due diligence
defense?
 None of the following:
o Peat Marwick
o BarChris
o Birnbaum
 The court in SEC v. Texas Gulf Sulphur found that the individual defendants violated the disclose or abstain
rule because they purchased Texas Gulf Sulphur shares and call options using material non-public
information. (T/F)
 True
 The court in SEC v. Texas Gulf Sulphur stated that the results of the core drilling samples might have been
considered material by a reasonable investor assessing the possibility of an ore strike of a significant
magnitude on the operations of Texas Gulf Sulphur. (T/F)
 True
o Quiz 24: Insider Trading
 In Chiarella v. U.S., the Supreme Court stated that the duty to disclose or abstain from trading on material
inside information under §10(b) of the 1934 Act and SEC Rule 10b-5 arises from a relationship of trust
giving rise to a fiduciary duty; it does not arise from the mere possession of material inside information.
(T/F)
 True
 
In Dirks v. SEC, the Supreme Court stated that a person who receives material non-public information from
a corporate insider may not trade on that information if such insider breached a fiduciary duty in providing
such information and the recipient knew or should have known of the breach. (T/F)
 True
 In Salman v. US, the Supreme Court stated that a corporate insider’s gift to a family member of material
inside information is insufficient to constitute a breach of fiduciary duty by the insider required under the
Dirks rule; some additional pecuniary benefit to the corporate insider in exchange for the gift is needed.
(T/F)
 False
 In U.S. v. O’Hagan, which theory of insider trading liability under §10(b) of the 1934 Act and SEC Rule
10b-5 was upheld by the Supreme Court?
 Outsider liability under the misappropriation theory
 In U.S. v. O’Hagan, the Supreme Court upheld the validity of SEC Rule 14e-3(a) relating to insider trading
in connection with tender offers. (T/F)
 True
o Quiz 25/26: §16(b); Proxies; Shareholder Inspection
 Which of the following is not part of a cause of action under §16(b) of the Securities Exchange Act of 1934?
 There must be evidence of use of inside information for the transactions
 Which of the following statements about the result in Reliance Electric v. Emerson Electric is accurate?
 Emerson was liable for trading profits on the first sale of 3.24% of its Dodge shares
 In the case of Levin v. MGM, the court found that the incumbents were entitled to reimbursement of
expenses for the proxy fight because shareholders have a right to be fully informed about policy differences,
no illegal and unfair means were used, and the amounts expended were not excessive. (T/F)
 True
 In the case of Crane v. Anaconda, the court found that Crane was not entitled to the shareholder list because
it did not have a proper business purpose for requesting it. (T/F)
 False
 In the case of Pillsbury v. Honeywell, the burden of proof was on the shareholder to show a proper business
purpose because he was requesting books and records of the corporation. (T/F)
 True
 SUMMARY REVIEW: Agency
o Source of Law:
 Common law
 Restatement Second of Agency
o 1. Who is an agent
 Definition = §1 creation of agency relationship test
 Gordon v. Doty
 Jensen v. Cargill
o Restatement distinguishes the agency relationship from other kinds of legal relationships
o Specifically talked about principal agent relationship v. credit debtor relationship
 Debtor creditor relationship is not automatically considered to be an agency
relationship if it involves normal commercial dealings
 If the creditor tries to assume control of the debtor’s business the creditor
may be deemed to be a principal and actions by the agent can be imputed to
the principal
 Distinguish principal-agent from debtor-creditor and buyer-supplier = §14O, §14K
 Buyer-supplier relationship can lead to a finding of principal agency
 The restatement gives a test
o Test turns on whether supplier was acting primarily for the other person or whether it had an
independent business
o Topics covered:
 Creation of an agency relationship
 To what extent can an agent bind a principal in the context of contracts & then in the context of torts
 Fiduciary duties
o 2.1 Liability of principal to third parties in contract for acts of an agent
 Actual authority = §1, §26
 Mill Street Church v. Hogan
o Actual authority can be either expressed or implied
 o This case talks about implied actual authority
 Agent has received instructions from the principal but the principal has not given
express instruction on a particular action but implied actual authority might exist if
what the agent does is incidental or reasonably necessary to accomplish a particular
transaction
 Apparent authority = §8, §27
 370 Leasing v. Ampex
o Apparent authority can be used when the agent is acting outside the scope of the instructions
from the principal and contrary to those instructions
o Turns on a manifestation from the principal that reaches a third party and causes a third
party to reasonably believe that the agent is authorized to act
 Manifestation can consist of a direct communication from the principal to the third
party
 Manifestation can also exist by virtue of someone’s title and other kinds of
manifestations shown in the restatement and slides from this chapter
o Also necessary to have a reasonable belief
 Is it reasonable to assume that someone in a particular position with a particular title
has the authority to bind the principal?
 Inherent authority = §8A, §194, §195
 Watteau v. Fenwick
o Dying theory
o Can be difficult to distinguish inherent authority and apparent authority
o Inherent authority can be used if an agent is acting contrary to the instructions of the
principal
o Turns on what is customary for an agent in a particular position to be able to do
o It exists for the protection of third parties
o Some jurisdictions restrict this to situations where the principal is a general agent or chief
executive
 CEO = general agent
o 2.2 Liability of principal to third parties in contract = Other principles of liability (do not turn on the existence of an
agency relationship)
 Ratification = §82
 Botticello v. Stefanovicz
o Ratification can be a viable theory if you have a party that although they did not initially
approve a transaction and there is some kind of affirmation through words or conduct or
sometimes silence that can be interpreted as consent
o There is also a requirement of intent on the part of that person who is approving and
affirming and they must have knowledge of all circumstances
 Estoppel = §8B
 Hoddeson v. Koos Bros
o Principal allowing someone to create the appearance of authority and not correcting that
misimpression, a reasonable belief by the third party, and a change in position
 Reliance is very important
 This is what distinguishes estoppel and ratification
o 2.3 Liability of principal to third parties in tort
 Principle of liability
 Doctrine of Respondeat superior = §219
 Master-servant relationship versus independent contractor status = §2
o Application in retail gasoline outlet cases
 Humble Oil v. Martin & Hoover v. Sun Oil
 Liability turns on whether or not the employer controls the physical conduct
of the employee
 Whether or not there is control over the day to day operations
 Use of actual agency and apparent agency principles to establish liability in franchise cases
o Form of licensing agreement in which the franchisor licenses the use of its valuable property
including trademarks, tradenames, and copyrights in exchange for payments from a
franchisee
 o
It is a condition of the contract that a franchisee maintain certain standards to uphold the
value of the property being licensed
o Holiday Inn & McDonalds cases
 System-wide control does not automatically lead to principal agent relationship
 Distinguishing system-wide control & day to day control
 Day-to-day control can lead to liability
o Apparent agency came up in McDonalds & §267
 Test is whether someone represents another as his servant or agent and causes a
third party to justifiably rely on the care or skill of such agent and as a result, that
first party who represents another as his agent can be liable for harm caused by lack
of skill
 Exception to non-liability for torts of independent contractors
o Whether or not you can become liable for torts committed by someone who is your
independent contractor rather than your employee or servant
o The general rule is that if the independent contractor commits a tort and they are negligent
then you would not be liable for that
o But in Majestic Realty case, they give an exception to this general rule
 If you are engaged in an inherently dangerous activity and your contractor does not
take normal commercial precautions against the risk of damage then you, as the
person who hired the independent contractor, could be liable
 Scope of employment (Respondeat superior is limited to actions within one’s scope of employment)
 Statement of doctrine = §228
 Kind of Conduct within Scope of Employment = §229
o 3. Fiduciary duties of agents
 Duties during agency
 Duty of loyalty = §387
o Reading Case
 Do not misuse assets of the employer or principal for personal advantage
o General Automotive v. Singer
 Not competing with your employer in the same line of business during the course of
employment
 Duty to account for profits = §388
 Liability for use of assets = §404
 Duties while leaving
 Use of confidential information = §396
o Town and Country v. Newberry
 Prohibition of using confidential information about employer’s business that you
learn during your course of business working with employer
 Use of confidential information is a breach of fiduciary duty both during and after
employment relationship
 Remedy is disgorgement
 SUMMARY REVIEW: Partnership
o Source of Law:
 Uniform Partnership Act (1914)
 Case law
o Characteristics of partnerships
 Individuals who have a preexisting relationship who want to have close control and management rights over
the business
 Equal sharing in the management of the business
o Default rules versus mandatory rules
 Default rules are the rules that a court would apply to the extent the parties have not already agreed
otherwise
 There are very few mandatory rules
o Formation (general partnership)
 Definition of actual partnership = §6
 Association of 2 or more people
 Indicators of partnership
 §7 = profit sharing is prima facie evidence subject to exceptions
 o Exception in Fenwick case was the exception for profit sharing which was seen as a bonus
for the employee
 Factors used by courts in Fenwick case
o Whether partnership agreement actually led to the formation of a partnership
o 8 partnerships factors
o Most important:
 Management/control of the business
 Sharing of profits
 Partnership distinguished from
o Employer-employee relationship
 Partnership by estoppel = §16
 When a party seeks to hold someone else liable
 Based on principle that partners are jointly and severally liable for the debts and obligations of the
business
o Young v. Jones
 Whether one accounting firm could be responsible for negligence caused by another
accounting firm. Both were separately organized
 Court rejected actual partnership because separately organized
 Introduced partnership by estoppel saying it can be applied if someone represents
another person as a partner or allows that person to represent itself as in partnership
with the first person and there is a third party who relies on that representation and
enters into a transaction on that reliance
o Fiduciary duties among partners
 Classic statement of duty of loyalty in Meinhard case
 Extension of lease covered the same property and some additional property and this was a business
opportunity that should have included the joint venturer
 He breached a fiduciary duty by taking a business opportunity for himself
 There should have been disclosure
 UPA §21
 RUPA §404
 You cannot take a business opportunity for yourself if that opportunity belonged to the partnership
as a whole
 Other duty of loyalty violations
 Competing with the business
 Using partnership property for personal gain rather than for partnership purposes
 Conflict of interest on both sides of the transaction
o Property rights
 Nature of property rights = §8, §26
 Right to use partnership property for partnership business, to share in income stream from
partnership, to participate in management
o Putnam v. Shoaf
o No right to claim pieces of property for yourself
 Sharing of profits and losses = §18(a)
 Default rule is equal sharing of profits even if there is unequal contributions of capital
 Can change default rule by contract
 Losses are usually shared the same way as profits
o Management rights = §18(e)
 Default rule is equal control rights
 NIBCO case
o Each partner acts as an agent for the partnership
o This can be changed by contract
 Use of management committees
 Can change default rule by contract
o Dissolution
 Causes of dissolution §31 & §32
 Without judicial involvement
 By judicial decree
 With and without violation of the partnership agreement
 o With violation of partnership agreement leads to additional consequences
 At will versus term partnership
 Term can be express or implied
o Express = partners agree they will be together for x years
o Implied = agreement that partners will stay together in business until they have paid off a
certain partnership debt
o No violation of partnership agreement if partnership is dissolved after the tern, whether
expressed or implied
 May impact whether a dissolution is in violation of the partnership agreement or not
 At will dissolution must be done in good faith
o This is from Page v. Page case
 Negative consequence of dissolving a partnership in violation of the partnership agreement
 Right of non-culpable party to damages for wrongful dissolution & right to continue the business
and possess partnership property = §38
 Right of culpable partner to receive value of partnership interest (excluding good will) less damages
payable to non-culpable partners
 Order of distribution of property = §40
o Limited Partnerships
 Definition
 Two categories of partners
o Unlimited liability for general partners
 There must be at least one general partner
 Right to control and run the business
 Informal formation
o Limited liability for limited partners
 Liable only up to the extent of their contribution to the partnership
 No joint and several liability for debts exceeding partnership’s assets
 Formal process
 Must file with government
 Limitation on limited partners’ right to manage
 May result in losing limited liability if limited partner participates actively in management
 SUMMARY REVIEW: Limited Liability Companies
o Source of Law:
 Uniform Limited Liability Company Act (1996)
 Case Law
 Articles of Organization
 Operating Agreement
o Characteristics: hybrid form
 Combines characteristics of partnerships and corporations
 Requires government filing for formation
o Formation
 Articles of Organization = §202, §203
 Filed with the secretary of state in the state where the formation is going to happen
 Operating Agreement = §103
 Not filed or publicly available
 More detailed information
o Piercing the LLC veil
 General rule of limited liability = §303
 Limited liability protects owners from paying for debts exceeding assets of the company
 Piercing the veil is an exception to this general rule
 Use of corporate piercing factors by state courts
 The court touches on piercing factors
 Factors are not identical to those from the corporate context
o Fiduciary duties of loyalty and care owed among members in member managed LLC = §409
 Member managed and manager managed (LLC management structures)
 Member managed = all members will be taking part in control of the business; fiduciary duties of
loyalty and care are owed among the members and to the LLC itself; equal control rights
  Manager managed = control rights for day to day business operations have been delegated by the
members/owners to one or more managers; managers are the ones who owe fiduciary duties
 Managers owe such duties in manager managed LLC
 Can be waived by contract subject to limitations contained in ULLCA and fiduciary duties that conflict with
public policy considerations
o Management
 Can designate either member-managed or manager-managed
 §404 = Rules for management and voting in LLCs
o Dissolution
 Articles of termination = §805
 Procedure for settling claims = §807, §808
 Orderly dissolution according to statutory procedures can limit liability to amount received in liquidation =
§808(d)(2)
 SUMMARY REVIEW: Corporations
o Source of Law:
 Delaware General Corporation Law
 Case law
 Articles of Incorporation
 Filed with the secretary of state
 Must be completed first
 Names directors
 By-laws
 Contains more information than the articles
 Detailed info about the governance structure
 Info about directors and shareholders meetings and voting
o Characteristics:
 Formation requires formalities
 Filing of articles
 Limited liability
 Continuity of existence
 Free transferability
 Publicly traded or transferred through private transfers
 Centralized management
 Board of directors = charged under state corporation law statutes for running the business and setting
policies and exercising oversight functions
 Officers of corporations = oversees day to day operations; gets authority from shareholders
 Separation between ownership and control
 Double taxation
 Negative feature
 The corporation is required to pay an income tax & distribution of dividends is also taxable by the
individual shareholders
o Formation
 Articles of incorporation = §101, §102, §106
 Preparing, executing and filing with the secretary of state office
 Some features are mandatory; others are optional
 Incorporators = §107
 Individuals charged with executing and filing the articles
 Doesn’t have to be people associated with the corporation
 First meeting = §108
 By-laws = §109
 Registered office = §131
 Required for service in litigation
 Promoters & liability for pre-incorporation contracts
 Promoters = someone who has the financial incentive to form the business; may later become a
shareholder, officer, or director
 Could be interested in getting the business up and running but could be liable for pre-incorporation
contracts under the theories of agency
o Piercing the Corporate Veil
  Legal rule of limited liability
 Equitable exception fashioned by courts when it would be unjust to allow limited liability to stand
 Tests
 Closely held corporations
o Alter ego
 First prong that must be satisfied
 Business is not separate from individual
 Courts use factors such as failure to follow corporate formalities
o Fraud or injustice
 Most courts require a second prong
 Sea Land Case
o Assumption of risk
 Some courts add a third prong
 Example in PowerPoints
 Contract scenario
 Sophisticated contract creditor had the opportunity to investigate the financial status
of the corporation and could have taken steps to mitigate nonpayment but failed to
do so, court might say even though the other prongs are satisfied, piercing isn’t
appropriate because you assumed the risk of loss by failing to take action to mitigate
the risk
 Parent-subsidiary relationships
o Substantial domination
 Bristol Myers case
 Court touched on whether a second prong of fraud or injustice should be required
o Shareholder derivative lawsuits
 Definition of derivative lawsuit
 Plaintiff shareholder is suing in the name of the corporation and on behalf of the corporation
asserting damage to the business by management as a result of breach of fiduciary duty or by
asserting corporate waste
o Waste = no value given to the corporation in exchange for the transaction being conducted
 Cohen case
 Eisenberg case
 Definition of direct lawsuit
 Claim being asserted by an individual shareholder that she has been personally harmed as a result of
certain actions taken by the managers of the business
 Eisenberg case
 Reasons for development of derivative lawsuits
 There is an issue with standing because the individual shareholders aren’t injured in a derivative
lawsuit so the court has to use its equitable powers to allow plaintiff shareholders to bring suit
 Potential for abuse by shareholders:
 Procedural restraints on use of derivative lawsuits like security for expenses statutes
 States enacted statutes to place limitations on shareholders bringing these actions
 Demand required actions:
 Procedural requirement for shareholder plaintiff to proceed with action
 Boards will likely move to dismiss if demand is made; shareholder cannot proceed with case
 Wrongful refusal cases = shareholder will likely fail unless she can overcome the business judgment
rule
o Business judgment rule = strong presumption in favor of corporate management; presumes
good faith and that they are acting in the best interest of the corporation
 Demand excused cases: demand futility & demand excusal
 Demand futility
o Grimes v. Donald
 Shareholder may proceed with the action if she can plead demand futility; courts may recognize
demand futility exception where can show lack of independence of board
 Use of special board committees to dismiss derivative actions; examples of cases in which demand
was not made because futile
o Two step scrutiny by court
 o Board is not supposed to be involved in making the decision because the plaintiff
successfully pled demand futility
o Role and purposes of the corporation
 Power and purposes = §122, §121
 Purpose of modern business corporation is to maximize shareholder value although some flexibility to
consider other constituencies
 Dodge v. Ford
 Charitable giving is a well-established power of corporations as long as there is some benefit to corporation
and within certain limits
 Smith v. Barlow
 The case also discusses limitations
 Shareholders are nominal owners and officers should comply with law
o Role of shareholders, directors and officers
 §141 = Corporation is run by the board of directors
 Shareholders delegate their control right to the directors by electing them at the annual meeting
 Board delegates day to day business decision making to officers
 Business judgment rule shield for most management decision making
 Control rights of shareholders are limited = electing directors, approving major corporate transactions such
as mergers
 Access to corporate shareholder list and other corporate books and records is regulated by state law
 Voting rules for shareholders and directors
 Use of proxies is regulated by state and federal law
o Fiduciary duties of officers and directors
 Duty of care
 Decision making
o Cannon v. American Express
o Smith v. Van Gorgon
o Focus on following proper procedure
o Gross negligence standard
o Use of reasonably available information
o Due deliberation
 Oversight
o Duties to become familiar with the business and to monitor activities & take action when
you become aware
 Taking action = investigating, checking
 Francis Case
o Value of compliance programs
 Caremark Case
 Used compliance program as a defense
 Duty of loyalty = §102(b)(7)
 Conflict of interest
o Identify the conflict of interest
 Existence of the conflict must be shown
o How is the conflict resolved?
 And the director took action to benefit themselves when they should have taken
action to benefit the corporation
 There must be a corporate benefit
 Judicial scrutiny to establish fairness
 Bayer v. Baran
o Director or stockholder ratification of conflict of interest transactions under DGCL §144
 Can substitute for proof of fairness to corporation with ratification
 Ratification can be by the directors or the shareholders
o Full disclosure to the board and the majority of disinterested
directors approve or
o Full disclosure to the shareholders and majority of disinterested
shareholders approve or
 Fliger v. Lawrence
o Prove fairness to the corporation
  Corporate opportunity doctrine
o Guth v. Loft factors for existence of corporate opportunity
 No corporate opportunity found:
 May take corporate opportunity
 No formal procedure for formal disclosure and rejection by corporation
required in Delaware but such procedure acts as safe harbor
o But other jurisdictions may require disclosure and rejection
 Corporate opportunity found:
 Must present to board and receive rejection before taking opportunity
 This is mandatory
o Fiduciary duties of dominant shareholders in a parent-subsidiary context
 Sinclair v. Levy
 Use total fairness test if self-dealing
 Self-dealing = parent company got something that the minority shareholder subsidiaries did not
receive
 Otherwise use business judgment rule
 SUMMARY REVIEW: Federal Securities Regulation
o Source of Law:
 1933 and 1934 Acts
 SEC Regulations
 Case law
o Threshold Issues
 Definition of security (threshold issue)
 Statutory definition
 Howey definition of investment contract
o Status of LLC interests as securities
o 4 part test
 Definitions of materiality (threshold issue)
 Reasonable investor test or total mix test (historical fact)
 Probability/magnitude test (speculative information)
o Substantive information
 Registration (disclosure)
 1933 Act §5
 Must register with SEC & file registration statement & provide prospectus to investors
 Private Placement exemption from registration (disclosure)
 1933 Act §4(2)
 Not a public offering & access to information
 Corporate disclosure fraud (antifraud provisions)
 1933 Act §11
 1934 Act §10(b)
 SEC Rule 10b-5
 Insider trading rules (breach of fiduciary duty)
 1934 Act §10(b)
 SEC Rule 10b-5
o Classic theory = disclose or abstain rule
 SEC v. Texas Gulf Sulfur
o Tippee liability = personal benefit or gifted benefit
 2 cases
o Misappropriation theory
 O’Hagan case
 SEC Rule 14e-3(a)
o O’Hagan
o Insider trading rule for tender offers only
o No need for breach of fiduciary duty
 Short swing profit rule of 1934 Act §16(b)
o Remedy is disgorgement of profits back to the corporation
 Final Exam Information
o Tips for Objective Portion
 Questions will be multiple choice and true/false including application of law to hypothetical facts.
 There is only one correct answer.
 There is no penalty for wrong answers.
o Tips for Essay Portion
 Questions will be similar in format to the review questions discussed in class.
 Answer all parts of all questions.
 If possible, use IRAC and IRAC headings.
 Most of your time should be spent on identifying and discussing relevant rules of law (R) and applying law
to facts in the hypothetical (A)
 Only discuss law that is relevant to answering the question presented.
 Not every rule of law discussed this semester will be relevant.
 Avoid extended policy discussions.
 Final exam questions are similar those on the bar exam. Try to answer the question presented using
black letter rules of law.
 Cite to relevant authority. Do not set forth general principles of law without citation.
 Cite to name of case or section number of statute or restatement or regulation that is the source of the
rule.
 Do not write out statutes, regulations or sections of the restatement provisions. Only the words or
phrases on which you are relying should be written out.
 Do not discuss the facts of cases you cite; only the principle of law that is relevant.