BUSINESS ASSOCIATIONS (CONDENSED) ~ WAGNER ~ FALL 2007

I. AGENCY O OPERATING AGREEMENT

O PIERCING LLC VEIL
O AGENCY FORMATION O FIDUCIARY OBLIGATIONS
O LIABILITY OF PRINCIPAL TO 3RD PARTIES IN CONTRACT O DISSOLUTION
O Actual Authority (Express & Implied)
O Apparent Authority V. DUTIES OF OFFICERS & DIRECTORS
O Inherent Authority
O Ratification O DUTY OF CARE
O Estoppel O Duty to Reach Informed Decisions
O Liability of Agent to 3rd Parties in Contract O Duty to Monitor (Comply with the Law)
O LIABILITY OF PRINCIPAL TO 3R PARTIES IN TORT O DUTY OF LOYALTY
O Servant versus Independent Contract O Directors & Managers
O Tort Liability & Apparent Agency O Corporate Opportunities
O Scope of Employment O Dominant Shareholders
O Liability for Torts of Independent Contractors O Ratification
O FIDUCIARY OBLIGATIONS OF AGENTS
O Duties During Agency
O Duties During & After Termination of Agency VI. SECURITIES REGLATION

O DISCLOSURE & FAIRNESS

II. PARTNERSHIPS O Introduction
O Definition of a Security
O PARTNERSHIP FORMATION O Registration Process
O Elements O Anti-Fraud Provision & SEC Rule 10b-5
O Characterizations  Insider Trading
O Partners Compared w/ Employees • §10(b) – Rule 10b-5
O Partners Compared w/ Lenders O Classic Theory
O Partnership by Estoppel O Tippee/Tipper Theory
O FIDUCIARY OBLIGATIONS OF PARTNERS O Misappropriation
O Introduction to Fiduciary Obligations Theory
O Fiduciary Obligations – • §14(e) – Rule 14e-3(a)
 After Dissolution O Tender Offers
 When Grabbing & Leaving • §16(b) – Short-Swing Profits
 Regarding Expulsion
O PARTNERSHIP PROPERTY
O RIGHTS OF PARTNERS IN MANAGEMENT VII. MISCELLANEOUS ISSUES
O PARTNERSHIP DISSOLUTION
O Right to Dissolve O INDEMNIFICATION & INSURANCE
O Consequences of Dissolution O PROBLEMS OF CONTROL
O Sharing of Losses O Shareholder Proposals
O Buyout Agreements
O Law Partnership Dissolution

III. CORPORATIONS

O INTRODUCTION
O PROMOTER LIABILITY & CORPORATE FORM
O CORPORATE FORM & LIMITED LIABILITY
O SHAREHOLDER DERIVATIVE ACTIONS
O Introduction
O Requirement of Demand on Directors
O Role of Special Committees
O ROLE & PURPOSE OF CORPORATIONS

IV. LIMITED LIABILITY COMPANY

O INTRODUCTION
O FORMATION
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 AGENCY

AGENCY FORMATION ~ WHO IS AN AGENT?

o Test for Agency Formation ~ Restatement 2nd of Agency §1 (Restatement 3rd of Agency §1.01) ~
o (1) Manifestation of consent (assent) by the principal; &
o (2) That the agent shall act on principal’s behalf & subject to the principal’s control; &
o (3) Consent (assent) by the agent so to act for the principal.

o Characteristics of Agency Formation –

o In order to find an agency relationship ….
 Court does not require the relationship between the principal & agent to necessarily involve a business
matter.
 Rather, the Court requires that the relationship be one such that “A” undertakes to transact some business
or manage some affair for “P” by authority & on account of the “P”.
o Regarding Authority …
 It is not essential to the existence of authority that there be a contract between “A” and “P” or that the
agent promise to act as such. ~ §§ 15 & 16.
o Regarding Compensation …
 It is not essential to the relationship of principal and agent that they receive compensation. ~ §16.
· It is typical, however, for the principal to benefit in some way from the agent’s actions.
o Hallmark Characteristic of Agency …
 Look for *Control*

o Gorton v. Doty (1937) ~

o Facts –
 A teacher allowed the football coach to driver her car to drive to the game. The football coach was in an
accident, killing himself & injuring the Π’s son.
o Holding –
 The Court looked to Restatement 2nd of Agency, §1 and determined …
· [1] By designating the coach as the driver, the teacher consented;
· [2] The teacher alluded that the coach should act for her and on her behalf while driving the car
to and from game; &
· [3] The coach consented by driving the car.
 Therefore, because of the agent-principle relationship which had arisen b/w the teacher and the
coach, the teacher can be held liable as the principle.
o Policy of Majority … Teacher-principle is in a better position to cover the Π’s loss & prevent such an outcome.
o Dissent … Argues that agency requires more than passive permission (need a command or instruction).

o A. Gay Jensen Farms Co. v. Cargill, Inc. (1981) ~

o Facts –
 Farmers (Π)  Warren (agent)  Cargill (∆-principal)
 Farmers were selling grain to Warren who then would sell the grain the Cargill.
· Warren was financed by Cargill (Cargill was both creditor & buyer).
· Warrant went bankrupt, so Farmers went after Cargill.
o Holding –
 The Court found Cargill to be a principal over agent-Warren & therefore Cargill was liable for the
damages arising from Warren’s breach of contract with the Π-Farmers.
· Elements of Agency Relationship …
o [1] Cargill manifested consent by controlling Warren’s business operations, interfering
with Warren’s internal controls, & sending its employees to run Warren’s grain
elevators.
o [2] Warren acted on Cargill’s behalf by collecting grain for Cargill’s benefit & in the
procurement of grain for Cargill, Warren was totally financed by Cargill;
o [3] Warren assented by allowing Cargill to control its operations.
 While the test for agency is a fact-intensive analysis, the Court looked at the factors denoting that Cargill
crossed the line & was “controlling” Warren, rather than merely acting as a creditor or buyer.
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 · While many of the factors taken individually could indicate a non-agency relationship, the factors
– taken as a whole – denote an Agency Relationship existed.
o *Key Fact = Cargill directed Warren to implement its recommendations (Cargill went
too far).

o Test for Agency Formation in Creditor/Debtor Situation ~ Restatement 2nd of Agency, §14O ~
o A 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.
 Comments …
· A creditor’s retention of a veto power does not denote agency relationship.
o *Typical loan agreement = Veto power / Right of Entry for Audits / Power to Discontinue
Financing.
· However, if the creditor takes over management of the debtor’s business & directs what contracts
may or may not be made, the court will likely find an agency relationship exists.
· *The point at which the creditor becomes a principal is that point at which the creditor
assumes de facto control over the conduct of the debtor.*

o Test for Agency Formation in Buyer/Supplier Situation ~ Restatement 2nd of Agency, §14K ~
o One who contracts to acquire property for a 3rd person & 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.
 Comments …
· Factors indicating that one is a supplier, rather than an agent . . .
o (1) Supplier receives a fixed price for the property irrespective of the price paid by him.
o (2) Supplier acts in his own name & receives title to property which it thereafter transfers.
o (3) Supplier has an independent business in buying & selling similar property.
· Under §14K, it must be shown that the supplier has an independent business before it can be concluded that
supplier was not an agent.

LIABILITY OF PRINCIPAL TO 3RD PARTIES

(1) ACTUAL AUTHORITY (Express or Implied) ~ IF ACTUAL AUTHORITY IS FOUND, PRINCIPAL MAY BE BOUND TO CONTRACT &
LIABLE ~

o Authority in General ~ Restatement 2nd of Agency, §7 ~

o “Authority” is the …
 Power of the agent to affect the legal relations of principal done in accordance with principal’s
manifestation of consent to agent.

o Test for the Creations of Authority ~ Restatement 2nd of Agency, §26 ~

o (1) Objective manifestation of principal; &
o (2) Agent’s reasonable interpretations of that manifestation; &
o (3) Agent’s belief that she is authorized to act for principal.

o Test for Implied Authority ~ Restatement 2nd of Agency, §35 ~

o Implied authority is inferred to extend to [incidental] acts which usually accompany or are reasonably necessary to
accomplish a transaction.
 *Implied authority fills in the gaps in express authority.
o Implied authority is the actual authority circumstantially proven in which the principal actually intended the agent to
possess & includes such powers as are practically necessary to carry out the duties actually delegated.

o Mill Street Church of Christ v. Hogan (1990) ~ Proving Implied Authority ~

o Facts –
 Church hired Bill Hogan to paint its chapel. Bill believed that he needed help to finish the job & that he
would not be able to finish without another person.
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  Bill believed he had the authority to hire Sam Hogan because he had been permitted to hire Sam in the past.
 Sam fell from a ladder while working & sued the Church for compensation.
o Holding –
 Court determined that Bill Hogan (agent) had the implied authority of the Church (principal) to hire
Sam Hogan (agent #2). This implied authority bound Church-principal as liable for Sam’s injury.
· Proving Implied Authority …
o *Focus on the agent’s understanding of his/her authority.
 Determine whether the agent reasonably believed that because of his present or
past conduct with the principal that the principal wished him to act in a certain
way or to have certain authority.
o *Factors:
 Nature of the task;
 Prior similar practices by the agent;
 *Specific conduct by the principal in the past permitting the agent to exercise
similar powers.*
o Burden of proving implied authority is on the party alleging agency existed.
(2) APPARENT AUTHORITY ~ IF APPARENT AUTHORITY IS FOUND, PRINCIPAL MAY BE BOUND TO CONTRACT & IS LIABLE ~

o Test for the Creation of Apparent Authority ~

o Restatement 2nd of Agency, §§ 8 & 27 ~

 (1) OBJECTIVE MANIFESTATION from one party (apparent principal) …
 (2) Which reaches the 3rd party …
 (3) Causing the 3RD PARTY TO REASONABLY BELIEVE that another party (apparent agent) is authorized to
act for the apparent principal.

o Restatement 3rd of Agency, §2.03 ~

 3RD PARTY REASONABLY BELIEVES actor (apparent agent) has authority to act on behalf of apparent
principal.
 This belief is TRACEABLE TO THE APPARENT PRINCIPAL’S MANIFESTATION.

o Comments on Apparent Authority ~

 The manifestation by the apparent principal must be …
· Made directly by the principal to the 3rd party; or
· Made to the community by signs or advertising; or
· Made by authorizing the agent to state that he is authorized; or
· Made by continuously employing the agent.
 ** It may be enough to meet the 1st element (objective manifestation) due to the title & position of the
apparent agent.

o Lind v. Schenley Industries, Inc. (1960) ~

o Holding –
 Court held that there was enough evidence suggesting that there was an agency relationship b/w Kaufman
(agent) and the ∆-Corporation (principal) giving Kaufman the apparent authority to Π-Lind’s salary.
· Rationale for Apparent Authority …
o (1) & (2) VP of ∆ told Lind to see Lind’s supervisor (Kaufman) concerning promotion &
new salary.
o (3) It was reasonable for Π to believe that his direct supervisor was acting as an
unofficial spokesman for the company (especially after conversation with VP) when
articulating new salary.
o Dissent –
 The dissent questioned the reasonableness of Π-Lind (gets to 3rd prong – 3rd Party Reasonably
Believes ...) because the new salary was higher than Kaufman’s & everyone else in the company’s except
for the President.

o Three-Seventy Leasing Corporation v. Ampex Corporation (1976) ~

o Holding –

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  Court held that Kays (salesman & agent of Ampex) had the apparent authority to act on behalf of
∆-Ampex (Principal) in entering contractual matters with Π-370 Leasing. Therefore, ∆-Ampex was bound
to liability for breaching the contract Kays & Π agreed upon.
· Rational for Apparent Authority …
o (1) & (2) Objective Manifestation of Principal-Ampex to Π-370 Leasing:
 2 official documents Kay sent to Π . . . (1) Invitation to offer & (2) Acceptance
 Course of dealing & context of Kays as a salesperson.
o (3) It was reasonable for Π to rely on Kays (apparent agent):
 It was certainly reasonably for 3rd parties to presume that one employed as a
salesman has authority to bind his employer in contracts to sell goods.
 Moreover, ∆-Ampex (apparent principal) did nothing to expel this reasonable
inference.
 ∆ continuously conducted the negotiations via Kays through entire process.

(3) INHERENT AUTHORITY ~ IF INHERENT AUTHORITY IS FOUND, PRINCIPAL MAY BE BOUND TO CONTRACT & IS LIABLE ~

o Test for Inherent Authority – Restatement 2nd of Agency §§ 8A, 161, 194, 195 ~
o The principal is liable for acts done on his account that usually accompanies or are incidental to transactions that the
agent is authorized to conduct.
  Focus on what is *CUSTOMARY*
  Inherent authority covers actions by a general agent or general manager.
· §3 – General Agent = Agent authorized to conduct a series of transactions involving a continuity
of services.
o Public Policy …
  Inherent authority exists for the protection of persons harmed by or dealing with a servant or agent.
· Prevents “mischievous consequences” (Watteau v. Fenwick).
o Easy for principal to escape liability otherwise / High cost of doing business with 3 rd
parties.
o Restatement 2nd of Agency & Inherent Authority –

o §8A ~ Inherent Agency Power –

 Inherent agency power is a term used . . . to indicate the power of an agent which is derived not from
[actual] authority, apparent authority, estoppel, but solely from the agency relation and exists for the
protection of persons harmed by or dealing with a servant or other agent.

o §161 ~ Unauthorized Acts of General Agent –

 A general agent for a disclosed or partially disclosed principal subjects his principal to liability for acts
done on his account which usually accompany or are incidental to transactions which the agent is
authorized to conduct if (although they are forbidden by the principal) the other party reasonably believes
that the agent is authorized to do them and has no notice that he is not so authorized.
 Inherent authority applies to cases where there is apparent authority, but includes cases in which there is
no apparent authority.
· NSC v. Atlantic Richfield Company ~ Apparent & Inherent authority are not mutually
exclusive.

o §194 ~ Acts of General Agents –

 A general agent for an undisclosed principal authorized to conduct transactions subjects his principal to
liability for acts done on his account, if usual or necessary in such transactions, although forbidden by the
principal.

o §195A ~ Unauthorized Acts of Special Agents –

 A special agent for an undisclosed principal has no power to bind his principal by contracts or conveyances
which he is not authorized to make unless:
· (a) The agent’s only departure from his authority is:
o (i) in not disclosing his principal, or
o (ii) in having an improper motive, or
o (iii) in being negligent in determining the facts upon which his authority is based, or
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 o (iv) in making misrepresentations; or
· (b) The agent is given possession or good or commercial documents w/ authority to deal with
them.

o Watteau v. Fenwick (1892) ~

o Holding –
 Court held that Humble (agent-general manager) had the inherent authority to make purchases
(cigars & non-alcoholic beer) and bind Fenwick (principal) to pay Π-Watteau for the products because
Humble was conducting what seemed to be a normal & necessary course of dealing for the pub’s
operations.
·  Buying cigars & drinks were customarily incidental transactions w/in the scope of manager of a bar.

o Nogales Service Center (NSC) v. Atlantic Richfield Company (ARCO) (1980) ~

o Holding –
 Court acknowledged that Joe Tucker (ARCO’s agent) told NSC that ARCO (Principal-∆) would give NSC
a 1 cent per gallon discount on all diesel fuel if it constructed a motel & restaurant at the truck stop. Court
noted that ARCO was acting both as a creditor & a contract partner with NSC.
·  Jury concluded that Tucker had no actual authority & no apparent authority (b/c they were
only instructed to decide on actual authority and/or apparent authority grounds)..
 However, an argument could be made for inherent authority …
· The case could have been decided on an INHERENT AUTHORITY THEORY:
o Tucker dealt with the various truck stop accounts in the area of special problems, on
matters of investment & discounts.
o Although the evidence was that Tucker did not have apparent authority to grant the
alleged across-the-board discount, Tucker did have the authority to grant certain
discounts (i.e. volume discounts, etc.).
o Could argue that negotiating such a discount with NSC showed Tucker was a general
agent performing a function CUSTOMARY & INCIDENTAL TO THE SCOPE OF HIS
AUTHORITY.

o Distinction Between Apparent & Inherent Authority –

o Apparent Authority –
 (1) OBJECTIVE MANIFESTATION from one party (apparent principal) …
 (2) Which reaches a 3rd Party …
 (3) Causing the 3rd Party to REASONABLY BELIEVE that another party (apparent agent) is authorized to act
for the apparent principal.
o Inherent Authority –
 Principal is liable for acts done on his account that usually ACCOMPANY OR ARE
INCIDENTAL/CUSTOMARY to the transactions the agent is authorized to conduct.
(4) RATIFICATION ~ IF RATIFICATION OF PRINCIPAL IS FOUND, PRINCIPAL MAY BE BOUND TO CONTRACT & IS LIABLE ~

o Test for Ratification ~

o Restatement 2nd of Agency, § 82, 83, 91 ~

 (1) Retroactive approval of a previously unauthorized act …
· Retroactive Approval = Affirmance through words, conduct, or silence that indicates consent.
 (2) Intent to approve …
 (3) Full Knowledge of all material facts.

o Restatement 3rd of Agency, Chapter 4 ~

 Important Aspect of the new restatement is the timing consideration …
· A principal cannot ratify a previously unauthorized act after events occurred that would tender the
ratification to have adverse/inequitable effects on a 3rd party.
o  In other words, a party cannot take a “Wait & See Approach.”

o Specific Sections of the Restatement 2nd of Agency –

 §82 – Ratification –

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 · Ratification requires acceptance of the results of the act with an intent to ratify, and with full
knowledge of all the material consequences.
 §83 – Affirmance –
· Affirmance is either …
o (a) A manifestation of an election by one on whose account an unauthorized act has been
done to treat the act as authorized; or
o (b) Conduct by him justifiable only if there were such an election.
 §98 –
· If the original transaction was not purported to be done on account of the principal, the fact that
the principal receives its proceeds does not make him a party to it.

o Botticellow v. Stefanovich (1979) ~

o Holding –
 Court held that Mary (one of the ∆’s who were tenants in common) did not ratify the Қ at issue b/w ∆’s and
Π-Buyer.
· Court’s Reasoning…
o Ratification is more than just sitting back & receiving benefits like Mary did.
o Ratification requires an affirmation of some kind (such an affirmation was not present
here).

(5) ESTOPPEL ~ IF ESTOPPEL IS FOUND, PRINCIPAL MAY BE BOUND TO CONTRACT & IS LIABLE ~

o Test for Estoppel ~

o Restatement 2nd of Agency, §8B –

 (1) Principal allows another (who has no authority – actual, apparent, inherent, or otherwise) to create the
appearance of authority & does not correct the misimpression;
 (2) Reasonable belief by the 3rd party; &
 (3) Change in the position of 3rd party (reliance).

o Restatement 3rd of Agency, §2.05 –

 (1) A person (potential principal) is liable to a 3rd party who has made a detrimental change (reliance) in
position due to the belief that it was for another person’s account (potential principal);
 (2) Such person (potential principal) intentionally or carelessly caused such a belief; &
 (3) With notice of such belief, such person (potential principal) did not take reasonable steps to notify
the 3rd person of the facts.

o Hoddeson v. Koos (1975) ~

o Facts –
 ∆ refused to reimburse Π for money she gave an alleged salesman imposter at ∆’s furniture store; Π sued.
o Holding –
 “Where a proprietor of a place of business by his dereliction of duty enables one who is not his agent to conspicuously
act as such and ostensibly lead a person of ordinary prudence to believe that the imposter was the proprietor’s agent,
the law will not permit the proprietor defensively to avail himself of the imposter’s lack of authority and thus escape
liability for the consequential loss thereby sustained by the customer.”
(6) LIABILITY OF AGENT TO 3RD PARTIES IN INTEREST ~

o Rules ≈ Liability of Agent Arising b/c of Extent Agent Disclosed the Principal’s Identity (if any) to the 3rd Party –

o §4. Fully Disclosed Principal ~ [Never personal liability for the agent ~ §321] –
 If, at the time of a transaction conducted by an agent, the 3rd party has notice that the agent is acting for a
principal and of the principal’s identify, the principal is a disclosed principal.

o §4. Partially Disclosed Principal ~ [Potential for agent to be personally liable ~ §321; See Atlantic Salmon Test]
–
 If the 3rd party has notice that the agent is or may be acting for a principal but has no notice of the
principal’s identify, the principal for whom the agent is acting is a partially disclosed principal.
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 · A person (potential agent) purporting to make a contract with a 3rd party for a partially disclosed
principal (as defined by §4) is a party to the contract. ~ §321.

o §4. Undisclosed Principal ~ [Always personal liability for the agent ~ §321] –
 If the other party has no notice that the agent is acting for a principal, the one for whom he acts is an
undisclosed principal.

o Effect of a Contract –
 An agent could absolve himself from liability w/o disclosing a principal if such a clause was in the Қ.

o Atlantic Salmon v. Curran (1992) ~

o Facts –
 ∆-Curran held himself out to Π’s as a representative for one or more principal’s (all of them non-existent or
dissolved at some point). ∆-Curran defaulted on payments & tried to avoid personal liability by saying he
was an agent.
o Holding –
 Court held that ∆-Curran was liable for the actions purportedly performed on behalf of the principal
because it is the agent’s duty to inform the 3rd party who that actual principal is, or else the agent risks
personal liability.

 Actual Knowledge Test ~

· To avoid personal liability . . .
o (1) The duty rests upon the agent to disclose his agency, & not upon others to discover
it.
o (2) The agent must bring the 3rd party to actual knowledge or else the agent is bound.
  It is not enough that the 3rd party has means of ascertaining the name of the
principal.
· Public Policy …
o There is no hardship to the agent in this rule.
o The agent always has the power to relieve himself from personal liability by fully
disclosing his principal & contracting only in the principal’s name.

LIABILITY OF PRINCIPAL TO 3RD PARTIES IN TORT

(1) SERVANT VS. INDEPENDENT CONTRACTOR ~ Principal Liable for Acts of Servants / Principal Not Liable for Acts of Independent
Contractors –

o TRADITIONAL MODEL –

o The distinction between servants & independent contractors is important because …

 Under the doctrine of Respondeat Superior . . . the master (employer-principal) is liable for the torts of his
servant (employee-agent) committed in the scope of employment. ~ §219.

o Restatement 2nd of Agency, §2 ~ Master / Servant / Independent Contractor –

 (1) A MASTER is a principal who employs an agent to perform a service in his affairs & who controls or
has the right to control the physical conduct of the other in the performance of the services.

 (2) A SERVANT is an agent employed by a master to perform service in his affairs whose physical conduct
in the performance of the service is controlled or subject to the right of control by the master.

 (3) An INDEPENDENT CONTRACTOR is a person who contracts with another to do something for him but
who is not controlled by the other nor is subject to the other’s right to control with respect to his
physical conduct in the performance of the undertaking. He may or may not be an agent.

o §2 ≈ Physical Control Test –

 Servant/Master Relationship = Principal has the right to control the physical conduct of the agent-servant.
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  Independent Relationship = No such right of physical control exists.

o Humble Oil & Refining Co. v. Martin (1949) ~

 Facts –
· Π brought suit against Humble Oil when Π was hit by a car that rolled down a hill as a result of
being negligently parked by Schneider’s gas station employee.
 Holding –
· Court found a master-servant relationship b/w Humble Oil & Schneider (gas station
owner/operator)
o  Liability for Humble Oil.
· A fact-intensive analysis drove the Court’s conclusion …
o Humble Oil maintained significant control over Schneider’s day to day operations by
dictating several aspects of Schneider’s business.
o Humble Oil had significant financial control & supervision, rendering Schneider’s
station a retail marketing enterprise for Humble Oil’s products.

o Hoover v. Sun Oil Co. (1965) ~

 Facts –
· Π sued Sun Oil when Barone (gas station owner)’s employee negligently set fire to Π’s car.
 Holding –
· Court found the gas station’s owner was an independent contractor for Sun Oil.
o  No Liability for Sun Oil.
· A fact-intensive analysis drove the Court’s conclusion …
o Barone controlled all day-to-day operations of the station (i.e. hours, employees,
products).
o Barone was not required to take Sun Oil’s advice (even though the 2 entities worked
closely together).
o Barone was not prohibited from selling competing products if he so chose.

Humble Oil v. Martin ~ LIABILITY ~ Master/Servant
Test = Physical Control
Mandatory reports & duties pursuant to Humble Oil’s request.
Rental payments to Humble were conditioned on sales (not
market).
Humble Oil maintained strict financial control/supervision.
Humble Oil controlled the gas station’s hours of operation.
Humble Oil paid the gas station’s utilities.
Hoover v. Sun Oil ~ NO LIABILITY ~ Independent Contractor
Test = Physical Control
No mandatory reports to Sun Oil.
Sun Oil did not control day-to-day operations.
Sun Oil was not required to take Sun Oil’s advice.
Sun Oil did not require the gas station to sell only Sun Oil
products.

 Physical Control Test Factors –

· (1) Risk
· (2) Rental Payments
o Payments tied to sales ≈ Cuts toward servant/master.
o Payments tied to the market ≈ Cuts toward independent contractor.
· (3) Hours of Operation
o Entity Control ≈ Cuts toward servant/master.
o Local Control ≈ Cuts toward independent contractor.
· (4) Title of Products Sold
o Entity Retains Title ≈ Cuts toward servant/master.
o Local Takes Title ≈ Cuts toward independent contractor.

o Restatement 2nd of Agency, §220 ~ Definition of Servant –

 (1) A servant is a person employed to perform services in the affairs of another and who with respect to the
physical control in the performance of the services is subject to the other’s control or the right to
control.
 (2) Factors …
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 · (a) Extent of control which the master exercises over the details of the work;
· (b) Whether or not the one employed is engaged in a distinct occupation or business;
· (c) Work done under direction of employer or by a specialist without supervision;
· (d) Skill required in the particular occupation;
· (e) Whether the employer or the workman supplies the instrumentalities & place of work;
· (f) Length of time for which the person is employed;
· (g) Method of payment (by time or by job);
· (h) Whether or not the work is a part of the regular business of the employer;
· (i) Whether or not the parties believe they are creating the relation of master/servant;
· (j) Whether the principal is or is not in business.
o APPLYING MASTER/SERVANT RULES TO FRANCHISE RELATIONSHIP –

o Franchise Relationship –
 Franchise = Licensing System
 Franchisor Obligations …
·  License use of valuable name & “system.”
 Franchisee Obligations …
·  Payment of royalties & advertising fees
·  Obligations to operate within system (embodied in operating manual & contract)
 Legal Aspects …
·  State contract law & franchise regulation (disclosure)
 *Franchisor-Franchisee Relationship can give rise to liability claims against the franchisor for franchisee
negligence.*

o Murphy v. Holiday Inn (1975) ~

 Facts –
· Π slipped & fell at a hotel that was franchised by Holiday Inn to a 3rd Party (Betsy-Len) & sued
Holiday Inn for negligence.
 Rule –
· A franchise agreement does not insulate contracting parties from agency (master/servant)
relationship.
· If a franchise agreement “so regulates the activities of the franchisee” as to vest the franchisor
with control within the definition of agency, an agency relationship arises even though the parties
expressly deny it.
 Holding –
· Court held that the franchise agreement/contract did not establish a master/servant (agency)
relationship.
o Contract provisions mostly just protected Holiday Inn’s trademark (i.e. system controls).
o However, normal day-to-day operations (such as hiring, price structure, & business
expenditures) were still controlled by the 3rd Party owner.

o PHYSICAL CONTROL TEST as applied to FRANCHISE AGREEMENTS ~

 (1) Control of the Franchisor’s “System” Standards
· No Master/Servant Relationship
o  No Liability
 (2) Control of Day-to-Day Operations
· Yes Master/Servant Relationship
o  Yes Liability

(2) TORT LIABILITY & APPARENT AGENCY ~

o MODERNIZED APPROACH TO FRANCHISE LIABILITY –

o Miller v. McDonald Corporation (1997) ~

 Facts –
· Π sought damages from McDonal’s for injuries suffered when biting into sapphire stone in Big
Mac.
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  Rule(s) –
· (1) Physical Control Test … Servant/Master Rule as Applied to Franchise Agreements …
o Agency Relationship Exists 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 franchise.
· (2) Restatement 267 … Apparent Agency …
o Agency Relationship Exists if …
 One who represents that another is his servant or other agent and thereby causes
a 3rd party justifiably to rely upon the care or skill of such apparent agent is
subject to liability to the 3rd person for harm caused by the lack of care or skill of
the one appearing to be a servant or other agent as if he were such.
· * Critical issue is whether the putative principal held out the 3rd party
& whether the Π relied on such representation.
o Test –
 (1) Did the principal represent another as his servant or agent?
 (2) Did representation cause 3rd party to justifiably rely on care/skill of such
agent?
 (3) Was the 3rd party harmed because of the lack of care or skill of such agent?

o Key Distinction –
 Apparent Agency = Creation of agency relationship where one does not
otherwise exist.
 Apparent Authority = Expansion of the authority of an actual agent.
 Holding –
· (1) Court believed that a jury could find that the ∆ retained sufficient control over 3K’s daily
operations that an actual agency relationship existed.
o Reasoning?
 Franchise agreement did not simply outline standards.
 Franchise agreement required 3K to use precise methods the ∆ established.
· ∆ enforced those methods w/regular inspections & retained power to
cancel agreement.
o A finding that the ∆ had the right to control the manner in which 3K performed food
handling & preparation was reasonable.
· (2) Court believed there is an issue of material fact about whether ∆ held out 3K as its agent.
o Reasoning?
 Everything about appearance/operation of 3K’s McDonald’s store identified it
with ∆.
· ∆ worked to create a common image for all McDonald’s restaurants
through nat’l advertising, common signs & uniforms, common menus,
common appearance, and common standards.
o The possible existence of a sign identifying 3K as the operator does not alter the
conclusion that there is an issue of apparent agency for the jury.

o How can a franchisor attempt to alleviate liability in such a circumstance?

 (1) Try to provide obvious notice to customers as to the legal distinction b/w franchisee & franchisor.
·  Miller shows that this will probably not work.
 (2) Negligence Insurance
 (3) Indemnity Clause in license agreement.
 (4) Terminate “sloppy” franchises for breach of contract (i.e. franchises were failing to adhere to system
standards).

(3) SCOPE OF EMPLOYMENT FOR SERVANTS/EMPLOYEES ~

o Restatement 2nd of Agency, §228(1) – When Conduct is Within the Scope of Employment –
o Bases for determining scope of employment …
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  (1) Of the kind he is employed to perform;
 (2) Within authorized time & space limits;
 (3) Purpose is to serve the master (historically, this basis has been expansive);
 (4) If force is intentionally used, use of force is not expected by the master.

o Restatement 2nd of Agency, §299 – Factors –

o (1) Scope of Employment ≈ Conduct must be of the same general nature that is authorized, or incidental to the
conduct authorized.
o (2) In determining acts incidental to the conduct authorized as to within the scope of employment, . . . Factors …
 (a) Whether or not the act is one commonly done by such servants;
 (b) The time, place, & purpose of the act;
 (c) The previous relations b/w the master & the servant;
 (d) The extent to which the business of the master is apportioned b/w different servants;
 (e) Whether or not the act is outside the enterprise of the master or has not been entrusted to any servant;
 (f) Whether or not the master has reason to expect that such an act will be done;
 (g) The similarity in quality of the act done to the act authorized;
 (h) Whether the instrumentality by which the harm is done has been furnished by the master to the servant;
 (i) The extent of departure from the normal method of accomplishing an authorized result;
 (j) Whether or not the act is seriously criminal.

o Ira S. Bushey v. United States (1968) ~ Employer will be liable under Respondeat Superior if actions of employee arise out of
course or employment ~
o Facts –
 Seaman Lane (Coast Guard of US) was responsible for damage done to a dry dock owned by Π when Lane
opened 3 water intake valves upon Lane’s return to his berth after a night of drinking.
o Holding –
 United States is liable b/c Lane’s actions were found to be within his scope of employment.
· District Court  Used “actuated by purpose to serve the master” theory.
· Court of Appeals (Judge Friendly)  Used “foreseeability test.”
o Conduct characteristic to that of the employee  Liability for Employer (i.e.
foreseeable.)
o Private life problems are not foreseeable to the employer  No Liability for Employer.
o Clover v. Snowbird Ski Resort (Utah 1991) ~
o Facts –
 Employee of ski resort was expected to ski between restaurants where he worked as a chef.
 Employee was monitoring a restaurant on the mountain & then skied down to monitor another restaurant.
On the way down the mountain, the employee recklessly executed a jump in which he struck & injured the
Π.
o Holding –
 Utah Supreme Court …
· Concluded that SJ for the ∆-Resort was not appropriate.
· Believed that the only doubt about scope of employment arose because the employee did not
return to the restaurant at the foot of the mountain immediately after monitoring the restaurant on
the mountain.
· Reasoned that a jury reasonably could find that the employee had resumed his employment & that
his deviation was not substantial enough to constitute total abandonment of his employment.
 Test:
· Substantial deviation/abandonment of employment = Cuts towards no scope of employment (NL
for Employer).
· No substantial deviation/abandonment of employment = Cuts towards scope of employment (L for
Employer).

o Restatement 3rd of Agency, §7.07 – Employee Acting Within Scope of Employment –

o (1) An employer is subject to vicarious liability for a tort committed by its employee acting within the scope of
employment.
o (2) An employee acts within the scope of employment when:
· Performing work assigned by the employer or
· Engaging in a course of conduct subject to the employer’s control.
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  An employee’s act is not within the scope of employment when:
· It occurs within an independent course of conduct not intended by the employee to serve any
purpose of the master.
 *Drafter’s reject Judge Friendly’s Foreseeability Test.

(4) LIABILITY FOR TORTS OF INDEPENDENT CONTRACTORS ~

o Restatement 2nd of Agency, §220 – Liability for Torts of Independent Contractors –

o General Rule = One who hires an independent contractor is not liable for such contractor’s negligent actions.
  Exceptions …
· (1) Retention of control of the manner & means of doing work (somewhat conflates w/ threshold
test determining servant/master relationship);
· (2) Engages an incompetent independent contractor:
o Refers to:
 (a) Skill & Expertise
 (b) Perhaps financial responsibility (depending upon the court)
· (3) Hires the independent contractor to engage in inherently dangerous activity.
o Restatement of Torts, §416 ~
 One who hires an independent contractor to conduct inherently dangerous
activities requiring precautions is liable if the contractor is negligent in taking
precautions.
o Distinction b/w Inherently Dangerous Activities & Ultra-Hazardous Activities –
 Inherently Dangerous:
·  Peculiar risk of harm to members of public unless special
precautions are taken.
 Ultra-Hazardous:
·  Necessarily involves a serious risk of harm to the person, land, or
chattels of others which cannot be eliminated by the exercise of utmost
care.
  This distinction is important because the liability is absolute where the
work is ultra-hazardous.
· Public Policy = Injured party no control over relation w/independent
contractor.

o Majestic Realty v. Toti Contracting (1959) ~

o Facts –
 Π’s (Building Owner Majestic Realty & tenant Bohen’s Incorporated) brought an action against ∆
(Independent Contractor for Toti Contracting & the Parking Authority of the City) for the damage done to
the property while ∆ was demolishing an adjoining building.
o Holding –
 Court found that the ∆ (although he hired an independent contractor) was liable for the independent
contractor’s negligence because he hired the independent contractor to engage in an inherently
dangerous activity.
· How may the ∆ who hired IC have avoided liability?  Try to get out of Exception 2 or 3;
Insurance; Indemnity Clause; Build Risk of Liability into the Қ price; Қ for indemnity as long as
IC follows custom.
FIDUCIARY OBLIGATIONS OF AGENTS

(1) FIDUCIARY DUTY DURING AGENCY ~

o Reading v. Regen (1948) ~

o Facts –
 Π is a sergeant in army who is trying to reclaim money he earned as a smuggler taken from him by ∆-
Army.
o Rule –
 Agent has a duty to act solely for the master, & any profit earned while violating this duty belongs to the
master. It matters not that the master has lost any profit nor suffered any damage.
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 o Holding –
 If the servant (agent) has unjustly enriched himself by virtue of his service w/o his master’s sanction, the
law says that the servant (agent) ought not be allowed to keep the money.
· The money shall be taken from the servant (agent) and given to his master (principal) because the
servant (agent) got it solely by reason of the position which he occupied as a servant (agent) of
his master (principal).

o Fiduciary Relationship Rules –

o §1 ~ Agency is a Fiduciary Relationship –

 A FIDUCIARY RELATIONSHIP IS ONE INVOLVING TRUST & CONFIDENCE.
 AGENT MUST PLACE PRINCIPAL’S INTERESTS OVER HER OWN.

o §387 ~ Duty of Loyalty –

 Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of the
principal in all matters connected with agency.

o §388 ~ Duty to Account for Profits Arising Out of Employment –

 Unless otherwise agreed, an agent who makes a profit in connection with transactions conducted by him
on behalf of the principal is under a duty to give such profit to the principal.

o §404 ~ Liability for Use of Principal’s Assets –

 An agent who, in violation of his duty to his principal, uses for his own purposes or those of a 3rd person
assets of the principal’s business is subject to liability to the principal for the value of the use.
· If the use predominates in producing a profit he is subject to liability, at the principal’s election,
for such a profit.
· He is not, however, liable for profits made by him merely by the use of time which he has
contracted to devote to the principal unless he violates his duty to act adversely or in connection
with the principal (“moon-lighting exception”).

o Hypotheticals –
o (1) War hero who wears uniform into restaurant & receives complimentary meals …
 Violation of fiduciary duty leading to restitution to the army?
· NO … He wasn’t using army assets to get such benefits.
o The benefits were a by-product of his fame was a hero.
o (2) General writes a biography after his military career & never wore his uniform to any book signings …
 Violation of fiduciary duty leading to restitution to the military?
· NO … Same.

o General Automotive Manufacturing Co. v. Singer (1963) ~

o Facts –
 ∆-Singer, an expert machinist well-known in the industry, worked for the Π.
 Though ∆ had a loyal history to the Π, Π engaged in behavior that created a conflict of interest b/w ∆’s
role as Π’s general manager & ∆’s attempt to make extra money on the side.
·  ∆ was working as a broker for his own profit in field were by Қ the ∆ had engaged to do the
work for ∆.
o Holding –
 Court held that such behavior created a conflict of interest that conflicted with ∆’s duty of loyalty to the ∆.
· An employee will be held to his contractual duty of loyalty, & their fiduciary duty would
forbid them from engaging in activities that are competitive with their employer.

o **Remember … The fiduciary duty of loyalty (for agents) is a default rule that may be contracted around.
  The duty only kicks in where there is an absence of an agreement.
o Restatement 2nd of Agency (echoes rules from Singer) ~
o §393 – Competition as to Subject Matter of Agency –
 Unless otherwise agreed, an agent is subject to a duty not to compete with the principal concerning the
subject matter of his agency.
o §394 – Acting for One w/ Conflicting Interests –
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  Unless otherwise agreed, an agent is subject to a duty not to act or to agree to act during the period of his
agency for persons whose interest conflicts with those of the principal in matters in which the agent is
employed.

o Restatement 3rd of Agency, §8.04 ~ Competition –

o Throughout the duration of an agency relationship, an agent has a duty to refrain from competing with the
principal and from taking action on behalf of or otherwise assisting the principal’s competitors.
o During that time, an agent may take action, not otherwise wrongful, to prepare for competition following
termination of the agency relationship.

(2) FIDUCIARY DUTY AFTER TERMINATION OF AGENCY ~

o Restatement 2nd of Agency, §396 – Using Confidential Information After Termination of Agency –
o Unless otherwise agreed, after the termination of the agency, the agent:
 (a) Has no duty not to compete with the principal;
· Exceptions …
o (1) Cannot use confidential information (see below);
o (2) No deceit;
o (3) Non-compete Contract Clauses
 (b) Has a duty to the principal not to use or disclose to 3rd persons …
· Trade secrets, written lists of names, or other similar confidential matters ….

o Restatement 2nd of Agency, §395 – Acting for One with Conflicting Interests –
o Unless otherwise agreed, an agent is subject to a duty to the principal not to use or communicate confidential
information … unless the information is a matter of general knowledge.

o Restatement 3rd of Agency, §8.05 – Use of Principal’s Property; Use of Confidential Information –
o An agent has a duty to:
 (1) Not to use property of the principal’s for the agent’s own purpose or those of a 3rd party; &
 (2) Not to use or communicate confidential information of the principal for the agent’s own purposes or
those of a 3rd party.

o Town & Country House & Home Services, Inc. v. Newberry (1958) ~
o Facts –
 ∆’s (Newberry et al.) are former employees of Π’s house cleaning service.
 Π sued after ∆’s started their own competing house cleaning service company which targeted Π’s
customers.
o Holding –
 Court held that …
· (1) ∆’s owe Π the profits that they made from the customers taken from the Π.
o ∆’s had a duty to protect Π’s trade secrets (i.e. customer lists) & are prohibited from the
secrets even after ∆’s employment with Π-Company had ended.
· (2) ∆’s do not have to cease operations.
o While the customer lists were formulated through much effort on behalf of the Π’s (&
thus were protected), the methods of cleaning a house were nothing so secretive as to
prohibit ∆’s from continuing their cleaning service business.
 Public Policy Issues –
· Most people are at-will employees wherein either side can terminate employment at any time.
o However, public policy dictates that an employee should be able to continue in the field
of work while not having a right to exploit the information that was held in confidence at
their prior employment.

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 PARTNERSHIPS

PARTNERSHIP FORMATION

(1) ELEMENTS OF A PARTNERSHIP ~

o PRELIMINARY ISSUES –

o Uniform Partnership Act (UPA) of 1914 ~

 Model for state legislatures (binding on states to the extent to which it has been adopted by the states).
o Default Rules vs. Contract Clauses ~
 Default Rules = UPA provides many default rules which are baseline rules unless the parties contract
around them.
 Contract Clauses = Usually upheld unless (1) they are against public policy or (2) agreed to by fraudulent
means.

o PARTNERSHIPS IN GENERAL –

o UPA, §6(1) – Definition –

 A partnership is “an association of two or more persons to carry on as co-owners as a business for profit.”

o Judicial Factors [Fenwick v. Unemployment Compensation Commission]–

 (1) Parties’ Intention*
 (2) Sharing of Profits*
 (3) Sharing of Losses
 (4) Contribution of Capital & Share in Capital Upon Dissolution
 (5) Control of Business**
 (6) Language in Agreement
 (7) Conduct towards 3rd Parties

o UPA, §7(4) – Sharing of Profits –

 The receipt by a person of a share of profits is prima facie evidence of partnership, but no such
inference shall be made if such profits were received in payment:
· [Exceptions]
o (a) As debt by installments or otherwise;
o (b) As wages of an employer or rent to a landlord;
o (c) As an annuity to a widow or representative of a deceased partner;
o (d) As interest on a loan, though the amount of payment may vary with the profits of the
business;
o (e) As the consideration for sale of a good-will of a business or other property by
installments or otherwise.

o UPA, §18(e) – Equal Control Rights –

 All partners have equal rights in management and conduct of the partnership business.

o UPA, §15 – Partners’ Liability –

 All partners are jointly & severally liable for debts & obligations of the partnership.

o PARTNERS COMPARED TO EMPLOYEES –

o Fenwick v. Unemployment Compensation Commission (1945) ~

 Facts –
· Employer (Fenwick) entered an agreement with employee (Arline Chesire), wherein they referred
to themselves as partners. The agreement was formed to potentially increase Chesire’s
compensation.
 Issue –

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 If an agreement is drawn that explicitly terms the relationship as a partnership, but the only
·
indications a partnership exists is such intent & the sharing of profits, may a court conclude that
no partnership exists?
 Holding –
· Yes … The sharing of profits is but one factor in determining whether a partnership exists.
o Court looked at several other factors that did not indicate a partnership existed in this
case:
 (1) Obligation to share losses;
 (2) Ownership & Control;
 (3) Conduct towards 3rd Parties;
 (4) Rights of dissolution;
o When Court weighed factors against the parties’ intent & the sharing of profits, the scales
tipped in favor of an employer-employee relationship. [SUBSTANCE OVER FORM
ANALYSIS]
o PARTNERS COMPARED WITH LENDERS –

o Martin v. Peyton (1927) ~

 Facts –
· Peyton (PPK) entered into an agreement with a broker (John Hall ) to loan Hall collateral to keep
Peyton’s business (PPK) afloat. Martin interpreted the agreement as forming a partnership & went
after PPK when Hall defaulted on a loan with Martin.
 Issue –
· Did a partnership exist b/w Peyton & Hall such that Peyton could be held jointly/severally liable
for Martin’s debts?
 Holding –
· While this was a close case, the Court said that the agreement did not establish a
partnership.
o An agreement (b/w Party 1 and Party 2) that offers a degree of control by Party 1 to
protect Party 1’s assets should not be considered a partnership if factors as a whole
indicate that Party 2 still maintains day-to-day control of the business.
 Although PPK had some control over the operations of Hall’s business, the
controls PPK bargained for were simply to ensure that PPK’s investment was
secure.
 Immediately prior to PPK’s investment, Hall’s business was doing poorly due to
his bad decision-making. PPK was guarding against further poor decisions.
 Hall still retained the control of day-to-day affairs, & PPK never had control to
initiate their own ideas – just to veto Hall’s decisions.
· Veto power is not uncommon in a lender relationship.

o PARTNERSHIP BY ESTOPPEL –

o Test for Partnership by Estoppel –

 UPA, §16 – Estoppel –
· (1) If a person represents himself as a partner in an enterprise (or allows another to so
represent him) &
· (2) 3rd Party relies on that representation & enters into a transaction w/ supposed partnership (has
given credit) &
· (3) That person is liable to 3rd party on that transaction.

o Young v. Jones (1992) ~

 Facts –
· Π-Young relied on an unqualified audit letter from ∆-PB-Bahamas that validated financial
statements of SAFIG & subsequently invested $550,00 with a South Carolina bank in SAFIG’s
name.
· When the investment went bad, Π’s argued that PW-Bahamas & PW-US were partners (so that Π
could collect from PW-US).
 Issue –
· Was a partnership formed b/w PW-US & PW-Bahamas by estoppel?
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  Holding –
· NO …
o (1) Court held there was no partnership by estoppel b/c there was no proof that Π’s relied
upon acts or statements by ∆’s that a partnership existed b/w PW-Bahamas & PW-US.
 The only evidence Π’s had tying PW-Bahamas to PW-US was a brochure,
which Π’s found about after-the-fact.
o (2) Moreover, Π’s didn’t enter transaction w/ supposed partnership, but rather with
SAFIG.

THE FIDUCIARY OBLIGATION OF PARTNERS

(1) INTRODUCTION TO FIDUCIARY OBLIGATIONS OF PARTNERS ~

o Meinhard v. Salmon (1928) ~ *LANDMARK PARTNERSHIP FIDUCIARY DUTY OF LOYALTY CASE*

o Rule –
 Each partner in a partnership owes the other partners a fiduciary duty of loyalty to act in the best
interests of the partnership over the interests of the individual matters concerning the partnership.
o Holding –
 ∆ had a fiduciary duty to *DISCLOSE* to Π the terms of the proposed lease b/c it was an opportunity
available to partnership.
 Cardozo’s Perspective …
· Fiduciary duty of loyalty among parties was a strong principle & one of “continuing obligation.”
· Thus, Cardozo believed ∆ was required to *DISCLOSE* to the Π a deal that encompassed their
prior partnership endeavor. (Π should have at least been given a right of 1st refusal.)
o UPA, §21(1) – Partner Accountable as a Fiduciary –
o Every partner must account to the partnership for any benefit, & hold as trustee for it any profits derived by him w/o
the consent of the other partners from any transaction connected with the formation, conduct, or liquidation of the
partnership or from any use by him of its property.

o RUPA, §404(b) – Duty of Loyalty –

o A partner’s duty of loyalty to the partnership and the other partners is limited to the following:
 (1) To account to the partnership and hold as a trustee for it any property, profit or benefit derived from a
use of partnership property, including the appropriation of a partnership opportunity;
 (2) To refrain from dealing with conflict of interest transactions;
 (3) To refrain from competing with the partnership before the dissolution of the partnership.

o Summary …
 A partner has a fiduciary duty of loyalty such that he may not profit at the expense of the partnership
by:
· (1) Competing with the partnership;
· (2) Taking business opportunities from the partnership;
· (3) Using partnership property for personal gain;
· (4) Engaging in conflict of interest transactions (usually hinges on disclosure)

o RUPA, §404(c) – Duty of Care –

o A partner’s duty of care to the partnership & the other partners in the conduct & winding up of the partnership
business is limited to refraining from engaging in:
 Grossly negligent or reckless conduct;
 Intentional Misconduct; or
 Knowing violations of the law.

(1) FIDUCIARY OBLIGATIONS OF PARTNERS AFTER DISSOLUTION ~

o Bane v. Ferguson (1989) ~

o Facts –
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  Π (Charles Bane) retired & collected a pension from a law firm that was then run by the ∆ (Law Firm).
 ∆’s dissolved the firm & the pension.
o Rule –
 Partners do not owe a duty to former partners that have retired from the partnership.
· Former partners cannot claim the current partners violated a duty to the retired partner by
negligent mismanagement of the firm under UPA, §9(3)(c).
o Holding –
 There is no common duty to retired partners.
· The pension agreement entered into by Π-Bane did not establish a duty.
o Furthermore, if there was such a duty, ∆’s would not have breached because they never
intended to dissolve the firm.
· *Former partners need to establish a duty through contract if they want to ensure that ongoing
partners meet any duty that the retiring partners want to rely upon, because the common law will
not protected retired partners. *

o Important Aspects of Bane –

o (1) Π incorrectly attempted to apply UPA, §9(3)(c) – Negligent Mismanagement …

· “Unless authorized by the other partners, … one or more but less than all of the partners have no
authority to do any act which would make it impossible to carry on the business of the
partnership.”
 This section applies to *PARTNERS* and not former partners.
·  It was intended to limit the liability to partners from foolish actions taken by 1 partner without
the consent of the others.

o (2) Bane illustrates a different flavor (more watered down version) of fiduciary duty than in Meinhard …
  Gone is the notion of “continuing obligations” between partners.

(3) FIDUCIARY OBLIGATIONS OF PARTNERS ASSOCIATED WITH GRABBING & LEAVING ~

o Meehan v. Shaughnessy (1989) ~

o Facts –
 Π’s (Meehan & Boyle) left the law firm of the ∆’s (Shaughnessy et al.).
 Π’s wanted money they believed was owed to them under their partnership agreement, & ∆’s contended
that the Π’s violated their fiduciary duty & interfered with ∆’s business.
o Rule –
 UPA, §20 ~
· A partnership has an obligation to render a true & full accounting (*Information*) of business
affecting the partnership.
 UPA, §19 ~
· Partners may inspect & copy partnership’s books.
 UPA, §21 or RUPA, §404(b) ~
· As a fiduciary a partner must consider his or her partners’ welfare & refrain from acting for purely
private gain.
o Holding –
 (1) Π’s did not violate a fiduciary duty by secretly setting up a new firm during their tenure at ∆-Law Firm.
· “We have stated that fiduciaries may plan to compete with the entity to which whey owe allegiance
provided that in the course of such arrangements they do not otherwise act in violation of their
fiduciary duties.”
· “We believe these logistical arrangements to establish a physical place for the new firm was
permissible.”
 (2) In breach of Π’s fiduciary duties, Π’s did obtain an unfair advantage over their former partners through
…
o (a) Π’s preparation for obtaining clients’ consent,
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 o (b) Π’s secrecy concerning which clients they intended to take, and
o (c) The substance & method of Π’s communications with such clients.
· “Partner has an obligation to render on demand true/full information of things affecting
partnership to any partner.”

o UPA, §20 – Duty of Partners to Render Information –

o Partners shall render on demand true & full information of all things affecting the partnership to any partner or the
legal representative of any deceased partner or partner under legal disability.

o UPA, §19 – Partnership Books –

o The partnership books shall be kept, subject to any agreement between the partners, at the principal place of
business of the partnership, and every partner shall at all times have access to & may inspect & copy any of them.

o RUPA, §403 – Partner’s Rights & Duties with Respect to Information –

o (a) – (b) … Partners may inspect & copy books & records.
o (c) Each partner & the partnership shall furnish to a partner …
 (1) Without demand, any information required concerning the partnership’s business & affairs reasonably
requested for the proper exercise of the partner’s rights & duties under the partnership agreement …
· Example …
o Rachel & Same are partners & Rachel is considering selling her transferable interest to
Sam. Sam has information that partnership is entering a boom period. Same must
disclose information to Rachel.
 (2) On demand, any other information concerning the partnership’s business & affairs, except to the extent
the demand or the information demanded is unreasonable or otherwise improper under the circumstances.

o Lawlis v. Kightlinger & Gray (1990) ~

o Facts –
 Π (Lawlis) was a partner of ∆ (Law Firm of Kightlinger & Gray).
 Π was expelled from the firm after a long battle with alcoholism.
o Holding –
 “Fiduciary relationships between partners – to which the terms bona fide & good faith relate – concern
business aspects/property of the partnership & prohibit partners from taking any personal advantage of
those subjects.”
 “In view of our holding that the executive committee had the right to expel Π without stating a reason or cause
pursuant to the Partnership Agreement, there was no breach of any fiduciary duty .”
· Motivation of the Π expulsion is not an issue when …
o (1) There is a “no cause” expulsion clause (guillotine clause) in the partnership
agreement; &
o (2) There was no wrongful withholding of any money/property of the Π; &
o (3) The ∆ followed procedures of partnership agreement when voting to expel Π from
firm.
 *Court noted that there is a possible breach of fiduciary good faith w/ expulsion …
· This occurs when there is an improper withholding of money/property entitled to the partner
being expelled (i.e. capital contribution).
o UPA, §31(d) –
o Dissolution is caused without violation of the partnership agreement by expulsion of any partner from the
business bona fide in accordance with such power conferred by the agreement between the partners.
  Π-Lawlis tried to read this clause as imposing a good faith requirement on the expulsion itself.
· The Court disagreed & saw the good faith requirement through the lens of the fiduciary duty of
loyalty requirement & applied such a requirement to the adherence of the partnership agreement
procedure for expulsion.

PARTNERSHIP PROPERTY

(1) FINANCIAL INVESTMENT & RETURN ~

o Partners contribute capital and/or labor.

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 o UPA, §18(a) – Rules Determining Rights & Duties of Partners –
o Default rules which may be contracted around …
 Each partner shall be repaid his contributions;
 Each partner shall share equally in the profits & surplus remaining after all liabilities;
 Each partner shall have an obligation to contribute to losses according to their profit share.

o UPA, §18(b) – Rules Determining Rights & Duties of Partners –

o Default rules which may be contracted around …
 The partnership must indemnify every partner against expenses & liabilities incurred in the ordinary &
proper conduct of its business.

o UPA, §24 – Extent of Property Rights of a Partner –

o The property rights of a partner are …
 (1) His rights in specific partnership property;
 (2) His interest in the partnership (economic rights); &
 (3) His right to participate in the management.

o UPA, §26 – Nature of Partner’s Interest in the Partnership –

o A partner’s interest in the partnership is his share of the profits & surplus, & the same is his personal property.

o UPA, §27 – Assignment of Partner’s Interest –

o A conveyance by a partner of his interest in the partnership does not of itself dissolve the partnership … but it
merely entitles the assignee to receive in accordance with his contract the profits to which the assigning partner
would otherwise be entitled.
 Under the default rules, assignment of economic interest in partnership only.

o Putnam v. Shoaf (1981) ~

o Facts –
 Π-Putnam sued ∆-Shoaf to collect money paid to Π’s partnership.
 ∆-Shoaf bought their interest of the partnership from Carolyn Putnam.
o Rule –
 A conveyance of partnership property by one partner held in the name of partnership is made in the name
of the partnership & not as a conveyance of the individual interests of the partners.
o Holding –
 Although the dishonest bookkeeping occurred while Π-Putnam was still a partner, Π-Putnam signed over
her undivided interest in the partnership to the ∆’s.
 A partner does not personally own any specific property of the partnership & therefore cannot retain
rights to the partnership after Π conveyed it to the ∆’s.
· Analogies …
o If a 3rd party had sought damages from the business for something that happened while Π
was a partner, the ∆’s would still be responsible for the damages because they took over
the Π’s interest completely.
o If a buyer finds oil on a property after the sale, the former owner cannot claim an
interest.

THE RIGHTS OF PARTNERS IN MANAGEMENT

o UPA Rules –

o §18(e) –
 In the absence of an agreement to the contrary, all partners have equal rights in management and
conduct of the partnership business.
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 o §18(b) –
 In the absence of an agreement to the contrary, any differences arising as to ordinary matters connected
with the partnership business may be decided by a majority of the partners.
o §9(1) –
 Each partner is an agent for the partnership in carrying out the business in the usual way.
o §15 –
 Partners are jointly & severally liable for acts & obligations of the partnership.
· If the partnership’s assets are insufficient, a party could go after the partners individually.

o National Biscuit Co. v. Sneed (1959) ~

o Facts –
 ∆ (Partner Stroud) refused to pay Π (National Biscuit Co.) for bread deliveries that the 2nd ∆ (Partner
Freeman) authorized while Stroud specifically attempted to disclaim responsibility.
o Rule–
 Each partner has an equal right to the management of the business & any business performed under the
scope of the partnership can only be contravened by a majority of the partners. ~ 18(e) & 18(b).
 Partners are jointly & severally liable for the actions of the partnership. ~ 15.
o Holding –
 Because Freeman’s conduct in allowing deliveries of breach was within the scope of the business, he had
the right to make those decisions unless a majority of the partners voted to deny him of this right
(logically, not restriction can be placed on the power to act).
· Since Stroud is only ½ of the partnership, and not a majority, Stroud is unable to prevent
Freeman from exercising his rights.

o Day v. Sidley Austin (1971) ~

o Facts –
 Π (Edwards Day) was a Washington DC attorney, worked as a senior partner for ∆ (Sidley Austin), a
Chicago-based firm. ∆ forced the Π to share the chairmanship position of the Washington DC officer after
they merged with a 2nd firm.
o Rule –
 The fiduciary duty of loyalty in a partnership ensures that a partner does not profit for themselves at
the expense of the partnership.
· This fiduciary duty is not breached simply because a partner feels as though their position
was de-valued in any manner.
o Holding –
 While the case turned on fiduciary duty, the case stands for a crucial proposition in terms of *Partnership
Mgt*
· In the ∆’s partnership agreement, not all partners were of equal status.
o Some partners were on an executive committee which screened potential financial
maneuvers before bringing any prospective moves to all of the partners for a vote.
 Advantage  Efficiency / Personal Preferences of Partners.
 Disadvantage  Possibility of hyper-sensitive partner / specialized interest not
represented.

PARTNERSHIP DISSOLUTION
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(1) THE RIGHT TO DISSOLVE ~

o Owen v. Cohen (1941) ~

o Rule –
 A partner can move to dissolve partnership if another partner’s conduct undermines/breaches partnership
agreement.
o Holding –
 “∆-Cohen, whose persistence in the commission of acts provocative of dissension & disagreement b/w the
partners made it impossible for them to carry on the partnership business, is in no position now to insist on
its continued operation.”
· Cohen contributed to the disharmony of partnership w/ numerous slights & constant badgering
over business affairs.
· Cohen went so far as to challenge salary withdrawals from the business.
o UPA, §32 – Dissolution by Decree of Court –
o (1) On application by partner to the court, the court shall decree a dissolution when:
 (a) A partner has been declared a lunatic in any judicial proceeding or is shown to be of unsound mind;
 (b) A partner becomes incapable of performing his part of the partnership contract;
 (c) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on of the business
(Cohen);
 (d) A partner willfully or persistently commits a breach of the partnership agreement, or otherwise so
conducts himself in matters relating to partnership business that it is not reasonably practicable to carry on
the business partnership with him (Cohen);
 (e) The business can only be carried on at a loss;
 (f) Other circumstances render a dissolution equitable.

o RUPA, §801(5) – A Partnership is Dissolved on Application by a Partner, by a Judicial Decree That –

o (i) The economic purpose of the partnership is likely to be frustrated; OR
o (ii) Another partner has engaged in conduct relating to the partnership business that makes it not reasonably
practicable to carry on the business in the partnership with that partner; OR
o (iii) It is not otherwise reasonably practicable to carry on the partnership business in conformity with the
partnership agreement.

o Page v. Page (1961) ~

o Facts –
 Π & ∆ were brothers who ran a linen supply business. After years of losses, Π wanted to dissolve the
business just as it became profitable.
o Rule –
 Unless specified otherwise, a partnership may be dissolved *At-Will* by any partner, providing the partner
is exercising good faith.
 “When a partner advances a sum of money to a partnership with the understanding that the amount was to
be a loan to the partnership and was to be repaid as soon as feasible from the prospective profits of the
business, the partnership is for the term reasonably required to repay the loan.” ~ Owen v. Cohen.
o Holding –
 “Π has the power to dissolve the partnership by express notice to the ∆. If, however, it is proved that Π
acted in bad faith & violated his fiduciary duties by attempting to appropriate to his own use the new
prosperity of the partnership w/o adequate compensation to his co-partner, the dissolution would be
wrongful & the Π would be liable for violation of the implied agreement not to exclude the ∆ wrongfully
from the partnership business opportunity.”
· Although factors may exist that would indicate that the parties meant to have a partnership for a
certain term of years (i.e. past partnership behavior or terms suggesting an agreement to stay
together until an objective is met) those factors did not exist in this case.
· However, Π could not dissolve the partnership in order to enrich himself at the expense of the
partnership.
o “Partner may not by use of adverse pressure freeze out a co-partner & appropriate
business to his own use.”

o Duration of Partnerships –
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 o (1) At-Will … There is no limit on duration (default rule).
o (2) Term …
 (a) Express … “Together for 5, 10, 15 years.”
 (b) Implied (Page g. Page) …
· Until certain number of money earned …
· Until one or more partners recoup investment …
· Until certain debts are paid …
· Until certain property is disposed of on favorable terms …

(2) CONSEQUENCES OF PARTNERSHIP DISSOLUTION ~

o Dissolution vs. Winding Up –

o UPA, §30 – Partnership & Termination by Dissolution –

 On dissolution the partnership is not terminated, but continues until the winding up of partnership affairs is
completed.

o Causes of Dissolution (Important Distinction Between Causes “In Violation” of Agreement & Causes “Not in Violation”) –

o UPA, § 31 – Causes of Dissolution –

 (1) Dissolution is caused without violation of the partnership agreement between the partners …
· (a) By the termination of the definite term or particular undertaking specified in the agreement;
· (b) By the express will of any partner when no definite term or particular undertaking is specified;
· (c) By the express will of all the partners either before or after the termination of any specified
term or particular undertaking;
· (d) By the expulsion of any partner under a clause in the partnership agreement.

 (2) Dissolution is caused with violation of the partnership agreement between the partners, where the
circumstances do not permit a dissolution under any other provision of this section, by the express will of
any partner at any time. [Leads to consequences …]

 (3) Dissolution is caused by an any event which makes it unlawful for the business of the partnership to be
carried on or for the members to carry it on in partnership;

 (4) Dissolution is caused by the death of any partner;

 (5) Dissolution is caused by the bankruptcy of any partner or the partnership;

 (6) Dissolution is caused by decree of the court under §32.

o Consequences of Partnership Dissolution –

o UPA, §38 – Rights of Partners in Application of Partnership Property –

 (1) When dissolution is caused without violation of the partnership agreement …

· … unless otherwise agreed upon, each partner may request liquidation.

 (2) When dissolution is caused by violation of the partnership agreement …

· (a) Each partner who has not caused the wrongful dissolution shall have …
o (i) Rights of liquidation; &
o (ii) Rights in damages against each partner who caused the wrongful dissolution.

· (b) Each partner who has not caused the wrongful dissolution …
o … may continue the business & possess the partnership property for that purpose (pay off
the wrongful dissolution partner less the damages).
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 · (c) A partner who has caused the wrongful dissolution shall have …

o (i) If the business is not continued …

 The rights of liquidation subject to damages.

o (ii) If the business is continued …

 The rights against his co-partners to have the value of his interest in the
partnership less any damages (in ascertaining the value of the partner’s interest,
the value of the good-will of the business shall not be considered).

o Pac-Saver Corp. v. Vasso Corp (1986) ~

o Facts –
 Π (Pac-Saver) formed a business with ∆ (Vasso Corp.) to sell concrete paving machines.
 Π moved to dissolve the partnership & sought a return of the trademarks & patents associated with the
business OR payment for the intellectual property.
o Holding –
 Court deemed partnership agreement stipulating the partnership was “permanent” as a partnership for a
term.
·  Since the partnership was for a “permanent” term, when the Π tried to dissolve, Π did so in
violation of the partnership agreement.
o  Therefore, under §38(2)(b), the ∆ had the right to continue the business & possess
the partnership property for that purpose.
  This right to continue the business trumped the contract provision
providing for the IP rights to revert to the Π upon dissolution because the court
deemed the IP rights necessary for the ∆ to be able to execute his right to
continue the business.
·  Furthermore, the Π is not entitled to collect for the value of the IP
rights because the value of the IP is primarily good will & UPA §38(2)
(c) does not allow a partner who has caused a wrongful dissolution to
collect goodwill as part of the value of his partnership interest.

(3) THE SHARING OF LOSSES

o Rules of Distribution Following Dissolution ~ Payment of Liabilities –

o UPA, §40 – Rules for Distribution (Default Rule) –

 (a) Each partnership shall be repaid his contributions . . . & share equally in the profits & surpluses
remaining after all liabilities including those to partners, are satisfied; and must contribute towards the
losses ... sustained by the partnership according to his share in the profits.

 (b) Liabilities to Partnership shall be paid in the following order …

· [1] Payment to creditors other than partners;
· [2] Payment to partners other than for capital or profits (meaning, partners who are also
creditors);
· [3] Payment to partners for capital contribution;
· [4] Payment to partners for profit.

 (d) Partners shall contribute, as provided by §18(a) amount necessary to satisfy the liabilities set forth in
§40(b).

o Kovacik v. Reed (1957) ~ [Minority Rule] ~

o Facts –
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  Kovacik contributed money to the partnership; Reed contributed services to the partnership.
o Issue –
 Whether partners who agreed to split the profits equally are also equally responsible for the financial
losses?
o Holding –
 In a partnership where one partner contributes capital & the other labor, the partner contributing capital
cannot hold the other accountable for money lost, just as the partner responsible for services cannot hold
the other responsible for any losses he suffered.

o ***Kovacik v. Reed is the minority rule.

o The majority rule follows the UPA:
 It is the general rule that in the absence of an agreement to the contrary, the law presumes that partners
intended to participate equally in the profits& losses of the common enterprise, irrespective of any
inequality in the amounts each contributed to the capital employed in the venture, with the losses being
shared by them in the same proportions as they share the profits.

(4) BUYOUT AGREEMENTS (BUY/SELL AGREEMENTS) ~

o Definition –
o A buy-out agreement is an agreement that allows a partner to end her relationship with the other parties & receive a
cash payment or series of payments, or some assets of the firm, in return for her interest in the firm.
  Provides a clean break to get out of the partnership by contract provision.

o G & S Investments v. Belman (1984) ~

o Holding –
 (1) Until a court decrees a dissolution, the dissolution has not yet taken effect & partners can still take
advantage of the buy-out provision.
 (2) Courts will follow provisions of an agreement that each party bargained for (in terms of buy-out
provision) rather than rely on fall-back statutes.
 (3) Court is open to pretty much any approach to valuing the partnership as long as it was bargained for.

(5) LAW PARTNERSHIP DISSOLUTIONS ~

o Jewel v. Boxer (1984) ~ LAW PARTNERSHIP DISSOLUTION USING UPA DEFAULT ~

o Rule –
 Absent an agreement otherwise, for law practice partnerships, the UPA requires that any fees paid to the
partners for cases in progress during the dissolution should be allocated to the former partners according
to their right to fees during the partnership.
·  This rule is rooted in UPA, § 18(f) – Rule Against Extra Compensation –
o Partner is not entitled to renumeration for acting in the partnership business except for
surviving partner receiving reasonable compensation for his services in winding up the
partnership.
o Holding –
 “We hold that in the absence of a partnership agreement, the UPA requires that attorney’s fees received on
cases in progress upon dissolution of a law partnership are to be shared by the former partners according
to their right to fees in the former partnership regardless of which former partner provides legal services in
the case after dissolution.”
o Public Policy Rationale –
 (1) Rule prevents partners from competing for the most renumerative cases during the life of the
partnership in anticipation that they might retain those cases should the partnership dissolve.
 (2) Rule also discourages former partners from scrambling to take physical possession of files & seeking
personal gain by soliciting a firm’s existing clients upon dissolution.

o Meehan v. Shaughnessy (1989) ~ LAW PARTNERSHIP DISSOLUTION USING CONTRACT PROVISION ~

o Public Policy Reasons For Upholding Contract Language:

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  (1) Protects the client by allowing them to retain the counsel of their choice. This protection outweighs any
professional benefits derived from the restrictive covenant create.
· Thus, Parker Coulter could not restrict a departing partner’s right to remove any clients who freely
chose to retain him or her as their legal counsel.
 (2) The provisions represent the partners’ strong intent to usurp the UPA’s default rule.
o Under the agreement, a partner who separates his practice from that of the firm receives:
 (1) The right to his capital contribution (capital account).
 (2) The right to a share of the net income to which the dissolved partnership is currently entitled.
 (3) The right to a portion of the firm’s unfinished business, and in exchange gives up other rights in the
dissolved firm’s remaining assets.
· Under the agreement, the old firm’s unfinished business is, in effect “wound up” immediately.
· The departing partner takes certain of the unfinished business of the old–dissolved Parker Coulter
on the payment of “fair charge,” and the new–surviving Parker Coulter takes the remainder of the
old partnership’s unfinished business.
· The 2 entities surviving after the dissolution possess “new business,” unconnected with that of the
old firm, and the former partners no longer have a continuing fiduciary obligation to windup for
the benefit of each other the business they shared in their former partnership.
o The Court next considers the remedy in those cases, if any, which the judge determines Meehan & Boyle
unfairly removed:
 Turns to UPA §21 
· Every partner must account to the partnership for any benefit, and hold as trustee for it any profits
derived by him w/o consent of the other partners from any transaction connected with the
formation, conduct or liquidation of the partnership.
 The Court notes that it has consistently applied this statute, and held that a partner must account for any
profits which flow from a breach of fiduciary duty.
·  If the judge determines that, as a result of this breach, certain clients left the firm, those that
breach a fiduciary duty must account to the partnership for any profits they receive on those cases
pursuant to the UPA, in addition to paying the partnership a fair charge on these cases pursuant
to the agreement.

(6) PARTNERSHIP EXERCISE*

o *Analysis*
o Look at the language of the partnership agreement with respect to certain areas & look at UPA default rules …
 Which Areas?
· (1) Duration*
· (2) Capital & Other Contributions to Partnership*
· (3) Management Rights**
· (4) Assignment & Transfer
· (5) Dissolution**

LIMITED PARTNERSHIPS

o Limited Partnerships vs. General Partnerships:

Characteristics Limited Partnership General Partnership

Formalities Need to file certificate of limited partnership. N/A
Liability Limited Liability for Limited Partners Unlimited Liability for General Partners
Management Limited Partners are Passive Investors General Partners Manage the Partnership
Profit/Losses Limited Partners share in profits/losses General Partners share equally in
based on their contributions. profits/losses.
Dissolution Dissolution of limited partner does not Dissolution of general partner does dissolve
dissolve the partnership. the partnership.

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o Holzman v. De Escamilla (1948) ~
o Rule –
 A limited partner will be held liable as a general partner if the limited partner acts to take part in the control
of the business.
o Holding –
 Although Russell & Andrews are listed as limited partners, their conduct made them accountable as
general partners.
· Factors of conduct …
o (1) Russell & Andrews had absolute power to withdraw money from the partnership.
o (2) Russell & Andrews exercised control by forcing de Escamilla to resign & appointed
his successor.
o (3) Russell & Andrews dictated which crops were to be planted, some against the will of
de Escamilla.

o RUPA §303 …
o (a) A limited partner is not liable for the obligations of a limited partnership unless the limited partner is also a
general partner or, in addition to his exercise of his rights & powers as a limited partner, he takes part in the control
of the business.
 However, if the limited partner takes part in the control of the business and is not also a general
partner, the limited partner is liable only to persons who transact business with the limited
partnership & who reasonably believe, based upon the limited partner’s conduct, that the limited partner is
a general partner.
o (b) A limited partner does not participate in control … solely by … (2) consulting with and advising a general
partner with respect to the business of the limited partnership.

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 CORPORATIONS

INTRODUCTION

(1) CHARACTERISTICS OF CORPORATIONS VS. PARTNERSHIPS

CORPORATION PARTNERSHIP
Formalities Required Informal
Limited Liability Unlimited Liability
Free Transferability Not Freely Transferable
Continuity At Will
Centralized Management Equal Management Rights
Double Taxation Single Taxation

(2) STEPS IN SETTING UP A CORPORATION

o § 101 – “Any person may incorporate a corporation by filing certificate with Division of Corporations of Secretary of State.”
o (a) Choice of Corporate Form …
o (b) Choice of State of Incorporation (Can choose any jurisdiction, even though not the state where the business has
a principal office) …
o (c) Reserve a Corporate Name …
o (d) Draft & File a Certificate of Incorporation …
o (e) Hold 1st Meeting of Directors to Adopt By-Laws/Issue Shares for Consideration/Take other actions …
o (f) Issue Shares & Accept Paid in Capital …
o (g) Qualification as Foreign Corporation in All States were it is Doing

(3) CERTIFICATE OF INCORPORATION

o § 102 – Contents of Certificate of Incorporation –
o Mandatory Requirements …
 Name (include the words “Inc.” or “Corp.”) / Address
 Business/Purpose (any lawful business)
 Capitalization Structure (shareholders have identical rights unless specified otherwise)
 Incorporators’ names & addresses
 Directors’ names & addresses
o Optional Items …
 Management provisions/provisions limiting powers of corporation, directors, shareholders
 Preemptive shareholder rights
 Provisions changing the voting rules of the Delaware General Corporate Law
 Limit duration on business
 Exceptions to limited liability of shareholders
 Limits on monetary damages for director breach of fiduciary duty (some fiduciary duties cannot be
eliminated)

(4) INCORPORATORS
o Delaware General Corporate Law –
o § 101 – “Any person may incorporate a corporation by filing certificate with Division of Corporations of Secretary
of State.”
o § 103 – “Signed & dated, pay fees”
o § 107 – “If no directors named in certificate, incorporators manage business until directors elected.”
o Difference b/w Shareholders, Directors, & Officers …
o Shareholders ~
 A shareholder is an individual or company (including a corporation) that legally owns one or more shares
in a joint stock company. A company’s shareholders collectively own that company.
 Stockholders are granted special privileges depending on the class of stock, including the right to vote
(usually one vote per share owned, but sometimes this is not the case).
 However, stockholder's rights to a company's assets are subordinate to the rights of the company's creditors
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 o Directors ~
 A Director is someone charged with oversight of the operations.
· A director may be an inside director (a director who is also an officer or promoter or both) or an
outside (independent) director.
 The directors collectively are referred to as a board of directors
o Officers ~
 2nd Level of Management Individuals in a Corporation. Officers manage the day-to-day operations.

(5) REQUIREMENT OF FILING

o § 101(a) – “File with the Division of Corporation in the Department of State.”
o Filed documents are a matter of public record.
 Gives notice to shareholders/creditors.

(6) COMMENCEMENT OF CORPORATE EXISTENCE

o § 106 – “Corporation exists from the date of filing until dissolution.”

(7) REGISTERED OFFICE

o § 131 – “Registered office required; may or may not be the place of business.”
o Receives service of process within the state.
o Must be a resident person or corporation.

(8) BY-LAWS
o § 108 – “By-Laws adopted at organization meeting of directors or incorporators.”
o § 109 – “By-Laws may contain provisions on business, conduct of affairs, rights or powers of shareholders, directors,
officers, employees.”
o By-Laws may be amended by directors until payment of initial capital.
 After payment of initial capital, the shareholders must vote to amend (subject to contract).
o By-Laws are not filed with the Secretary of State.

PROMOTER’S LIABILITY & THE CORPORATE ENTITY

(1) FIDUCIARY DUTY OF PROMOTER (Promoter = Parties in interest in setting up a corporation)

o (a) Problem of Self-Dealing;
o (b) Promoter has status akin to joint venturer or partner;
o (c) Duties owed among promoters and to corporation to be formed.

(2) PROMOTER’S LIABILITY FOR PRE-INCORPORATION CONTRACTS

o If the promoter forms a corporation later …
o Can a corporation become party to the contract? YES … see Southern Gulf-Marine (must be an affirmative
act/adoption).
o Can a promoter avoid personal liability? YES … Law of Agency (can disclaim by contract).
o If corporation is never formed or promoter forms a different corporation …
o Who is liable? ...

(3) DEFECTIVE INCORPORATION

o (A) Corporation by Estoppel –

o Test –
 (1) Person acted as though he was dealing with a corporation;
 (2) Person would earn a windfall benefit if allowed to evade liability based on absence of incorporation.
· … so long as the Person’s substantial rights are not affected.
o Southern Gulf-Marine v. Camcraft Inc. (1982) ~
 Rule –

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 · A party cannot justify the nonperformance of a contractual obligation by the other party’s
lack of corporate capacity or lack of stated corporate capacity – unless the corporate
capacity was relevant (substantial) to the contract.
 Holding –
· ∆ was not justified in failing to deliver the vessel merely b/c the ∆ was incorporated in a
different location than specified in the contract.
o The location of Π’s incorporation was not a substantial concern in performing the
contract.
o ∆ would most likely have held Π liable for the vessel under different circumstances, but
Π is correct in suspecting that nonperformance was due to the appreciation of the vessel.

o (B) De Facto Corporation –

o Test –
 (1) Promoters tried in good faith to incorporate;
 (2) Promoters had a legal right to do so;
 (3) The entity acted as a corporation.

THE CORPORATE ENTITY & LIMITED LIABILITY

GENERAL RULE = CORPORATIONS HAVE LIMITED LIABILITY & SHAREHOLDERS ARE NOT PERSONALLY LIABLE.

(1) ENTERPRISE LIABILITY THEORY TO RECOVER

o Arises in a situation where the Π believes all of the corporations are one.
o Treat all corporations as one.
o All assets available to creditor.
o Example ~ Assets of all 10 corporations owned by Carlton available to satisfy judgment in favor of Walkovsky (See Carlton
v. Walkovsky).

(2) RESPONDEAT SUPERIOR (AGENCY) THEORY TO RECOVER (EXCEPTION TO GENERAL RULE)

o Corporation is an agent of the principal-Shareholder.
o Personal asserts of principal would be available if proven.
o * It is hard to prove this theory because it is difficult to distinguish between the duty of the shareholder as a manager & the
duty of the Shareholder as a shareholder (In Closely Held Corporations).

(3) PIERCING THE CORPORATE VEIL THEORY TO RECOVER (EXCEPTION TO GENERAL RULE)

o Walkovsky v. Carlton (1966) ~ Look at Relationship b/w individual shareholder & corporation in closely held corporation ~
o Facts –
 Π was injured by a taxi owned by corporation owned ∆-Carlton.
 ∆ was a shareholder in 10 separate corporations wherein each corporation had 2 cabs.
 Each cab had only $10,000 worth of insurance coverage, which is the statutory minimum.
 Π sought to hold ∆ personally liable for his injuries, but Π plead enterprise liability.
o Rule –
 An individual can be held liable for the acts of a corporation if it can be shown that the individual
used his control of the corporation for personal gain (Piercing Theory Rule).
o Holding –
 The Π didn’t state a correct cause of action to recover from the ∆.
· ∆ would be held personally liable if he controlled the corporation for his personal benefit at the
expense of the corporation’s benefit.
o Π did not offer proof to make that claim; instead, Π offered proof that the 10 corporations
operated as 1 large corporation (enterprise liability)
o The fact that the corporations may have been 1 large corporation does not prove that the
∆ was controlling the corporations for his own behalf.
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  Majority was ok with ∆ manipulating the corporate form & believed that the legislature should be
the one to correct the abuse (& raise the statutory minimum for insurance coverage).
o Dissent …
 The dissent argued that the corporations were undercapitalized and the corporate entity was clearly used to
simply escape liability. Although ∆ carried the statutory minimum amount of insurance, the intent of the
legislature was not to use the insurance coverage as a means for justifying ∆’s use of corporate entities.
 The dissent wanted to pierce the corporate veil to achieve a more equitable result, but the majority believed
that it was the legislature’s responsibility to raise the mandatory insurance coverage.

o Sea-Land Services, Inc. v. Pepper Source (1991) ~ Look at Relationship b/w individual shareholder & corporation in closely
held corporation ~
o Judicially created exception to the legal rule of limited liability
 PIERCING TEST (varies slightly per jurisdiction)… Example: Van Dorn Test (Illinois):
· (1) Unity of interest b/w the individual & corporation (alter ego/mere instrumentality theory) ~
o Factors …
 Failure to maintain corporate formalities;
 Commingling of assets/funds;
 Undercapitalization (in other jurisdictions, this factor may be evidence of #2);
 One corporation treats assets of another as its own.
· (2) Allowing Unlimited Liability Would Promote Injustice or Sanction a Fraud (Need more
than a creditor’s in ability to collect) ~
o * A party would be unjustly enriched;
o * A parent corporation that caused a sub’s liabilities & its inability to pay for them
would escape liabilities;
o *Intentional scheme to squirrel assets into a liability-free corporation while heaping
huge liabilities upon an asset-free corporation.
o Facts –
 Π-Sealand had sold peppers to ∆–Pepper Source.
 ∆-Pepper-Source dissolved with no assets.
 Therefpre, Π-Sealand went after Marchese (sole shareholder of Pepper Source) & Marchese’s other
corporations w/o using enterprise liability.
· Instead, Π-Sealand argued a variation on piercing (Reverse Piercing) that Marchese’s
corporations were all alter egos/mere instrumentalities of each other.
o Holding –
 In case at hand, the Court held that the Π did not have evidence of the second prong (different result on
remand).

o Roman Catholic Archbishop of San Francisco v. Sheffield (1971) ~ Look at Relationship b/w Corporations ~
o PIERCING TEST (Similar to Sea-Land Rule) –
 The requirements for applying the “alter ego” principle are thus stated:
· (1) It must be made to appear that the corporation is not only influenced and governed by that
person or other entity, but that there is such a unity of interest & ownership that the individuality,
or separateness, of such person & corporation has ceased, and …
o Factors ~
 Commingling of funds & other assets of the two entities;
 Holding out by one entity that it is liable for the debts of the other;
 Identical ownership in the two entities;
 Use of the same offices & employees;
 Use of one as a mere shell or conduit for the affairs of the other
· (2) The facts are such that an adherence to the fiction of the separate existence of the corporation
would, under the particular circumstances, sanction a fraud or promote injustice.
o Holding --
 (1) Π’s have not shown that the Swiss Organization (Canons Regular of St. Augustine) is an alter ego of
the Archbishop or vice versa.
· ∆’s uncontroverted declaration that Archbishop had no dealings with the Canons Regular negates
any possibility that the Archbishop so controlled & dominated that organization so as to be liable
for its actions under the alter ego doctrine.

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 · The alter ego theory makes a parent liable for the actions of a subsidiary which it controls,
but does not mean that where a parent controls several subsidiaries, each subsidiary then
becomes liable for the actions of all other subsidiaries.
 (2) Moreover, the second requirement for application of the alter ego theory – that failure to pierce the
corporate veil would lead to an inequitable result – has not been met in this case.

o In re Silicon Implants Product Liability Litigation (1995) ~ Corporate Control Claim (Subsidiaries & Parent
Corporations) ~
o The potential for abuse of the corporate form is greatest when the corporation is owned by a single shareholder.
o However, the evaluation of corporate control claims cannot disregard the fact that a parent corporation is expected to
exert some control over its subsidiary  Limited liability is the rule, not the exception.
o PIERCING TEST …
 The totality of circumstances must be evaluated in determining whether a subsidiary may be found
to be the alter ego or mere instrumentality of the parent corporation …
· Factors …
o The parent & subsidiary have common directors or officers.
o The parent & subsidiary have common business departments.
o The parent & subsidiary file consolidated financial statements & tax returns.
o The parent finances the subsidiary.
o The parent caused the incorporation of the subsidiary.
o The subsidiary operates with grossly inadequate capital.
o The parent pays the salaries and other expenses of the subsidiary.
o The subsidiary receives no business except that given to it by the parent.
o The parent uses the subsidiary’s property as its own.
o The daily operations of the two corporations are not kept separate.
o The subsidiary does not observe the basic corporate formalities, such as keeping separate
books and records and holding shareholder and board meetings.

(3) DIRECT LIABILITY THEORY

o In re Silicon Implants Products Liability Litigation (1995) ~ Direct Liability Claim ~
o Under law in most jurisdictions, a parent-corporation may be subject to liability under a direct liability
claim.
 Restatement (Second) of Torts § 324A ~
· One who undertakes, gratuitously or for consideration, to render services to another which he
should recognize as necessary for the protection of a 3rd person or his things, is subject to liability
to the 3rd person for physical harm resulting from his failure to exercise reasonable care to
perform his undertakings …. if …
o (a) His failure to exercise reasonable care increases the risk of harm, or
o (b) He has undertaken to perform a duty owed by the other to the 3rd person, or
o (c) The harm is suffered because of a reliance of the other or the 3rd person upon the
undertaking.
o Under this theory, a duty that would not otherwise have existed can arise when an individual or company
undertakes to perform some action …
 The potential liability for failure to use reasonable care in such circumstances extends to persons who may
reasonably be expected to suffer harm from that negligence.

SHAREHOLDER DERIVATIVE ACTIONS

(1) INTRODUCTION

o Nature of a Derivative Lawsuit –

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 o A derivative lawsuit is brought to enforce corporate rights.
o The recovery flows directly to the corporation.
o Derivative lawsuits typically involve allegations of mismanagement, waste, or fraud by corporate officers/directors.
 Managers are supposed to be *acting for the best interests* of the corporation.
 When managers are not acting in the corporation’s best interests, the shareholders have the right to bring a
suit on behalf of the corporation’s interests.

o Parties –
o Π-Shareholder sues (not on behalf of himself personally) on behalf of the corporation to enforce the rights of the
corporation.
 Allegation = Direct Harm to Corporation; Indirect Harm to Shareholder
o The corporation is nominally the defendant.
o Derivative suit is brought in equity because the shareholder lacks standing to sue at law.

o Attorney’s Fees –
o If the derivative suit is successful, the corporation will pay the Π’s fees & expenses.
o If the derivative suit is settled before judgment, the corporation can pay the legal fees of the Π & of the ∆’s.
 If, on the other hand, a judgment for money damages is imposed on the ∆’s, the ∆’s will be required to pay
those damages & may be required to bear the cost of their defense as well. See Del.Gen.Corp.Law §145(b)
(“The corporation may pay the defendants’ expenses only if the court determines that despite the
adjudication of liability but in view of all the circumstances in the case, the defendant is fairly entitled to
indemnity.”).
 Therefore, corporate managers who have harmed the corporation generally will be relieved of risk of
personal losses if the corporation pays large fees to the plaintiff’s attorneys in return for their willingness to
accept a settlement.
o Some states mandate fee shifting to Π if the suit was brought w/o reasonable cause or for an improper purpose.
o Security for fees statutes (i.e. Cohen & Eisenberg) are now uncommon.

o Fee Shifting Statutes –

o Cohen v. Beneficial Industry Loan Corp. (1949) ~
 New Jersey Statute …
· “In a derivative action, persons holding less than 5% or $50,000 in value must be given security
for reasonable expenses, including attorney’s fees.”
· The New Jersey Statute is an example of a fee shifting mechanism that requires the posting of
bond/collateral.
 Purpose of Statute …
· The purpose of this statute is to discourage frivolous lawsuits from small shareholders who enjoy
little risk & a huge potential reward to bring a derivative suit.

o Distinction B/W Derivative & Direct Lawsuits –

o Eisenberg v. Flying Tiger Line, Inc. (1971) ~

 Rule – When injury was personal, rather than injury of corporation, suit should be considered
direct.
· Direct = Shareholder suit in personal capacity to enforce rights as shareholder.
· Derivative = Shareholder suit in corporate capacity to enforce rights of corporation.

o Examples of Direct Lawsuits …

 Personal injury is direct when …
· (1) Shareholder is alleging a denial/dilution of voting rights (i.e. Eisenberg);
· (2) Shareholder is trying to compel payment of dividends declared but not distributed;
· (3) Shareholder is trying to compel inspection of corporate books/records or is trying to require a
holding of a shareholder meeting.

o Tooley Test for distinguishing b/w Direct & Derivative Lawsuits …

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  Look at the complaint …
· (1) Who suffered the alleged harm (corporation or suing shareholders)?
· (2) Who would receive the benefit of any recovery or remedy (corporation or shareholder
individually)?
 *Distinction depends upon the nature of the wrong alleged & the relief which could result if the plaintiff
was to prevail. ~ Grimes.

o Procedural Hurdles …
 Direct Lawsuits do not require special procedural hurdles.
 Derivative Lawsuits do require special procedural hurdles (i.e. demand requirement).

o Class Actions –
o Derivative actions are not the same as a class action.
o In a class action …
 Shareholders sue in personal capacity on behalf of other shareholders similarly situated.
 A group of shareholders assert their individual claims through a representative.
 While some derivative suit procedural hurdles (like demand) may not apply to class actions, but other
special procedural hurdles may apply (like notice to class members).

(2) DERIVATIVE LAWSUIT PROCEDURE & DEMAND REQUIREMENT

o Derivative Lawsuit Procedure –

o (1) Determine Direct or *Derivative (if derivative, continue with procedural hurdles)

o (2) Possible fee shifting mechanism/requirement

o (3) Demand Requirement upon the board as a prerequisite to the suit [§104(a) Delaware Law].
 Exception to Demand Requirement … Demand Futility = Court is lead to believe that demand is
unnecessary:
· Futility/Excusal Exception = Demand requirement waived upon shareholder’s particular
showing of:
 Grimes (Delaware Law) …
· Allegation of facts with particularity creating “reason to doubt”
regarding board independence, such as facts that allege …
o (a) Majority has material financial or familial interest; OR
o (b) Majority is incapable of acting independently for another
reason like domination or control; OR
o (c) Underlying transaction is not the product of a valid
business judgment (i.e. such a crazy decision).
 Marx (New York Law) …
· Allegation of facts with particularity creating “reason to doubt”
regarding board independence, such as facts that allege …
o (a) Majority of the board is interested in the transaction; OR
o (b) Directors failed to inform themselves as reasonably
necessary about the transaction; OR
o (c) Directors failed to exercise their business judgment in
approving the transaction.
· ** Demand futility/excusal is a very hard pleading standard to meet.
o If demand futility standard met  Shareholders are allowed to sue.
o If demand futility standard not met  Shareholders cannot sue (& cannot subsequently
claim demand).
o (4) Demand Requirement (if no exception)
 Directors choose to accept demand (rare)  Shareholders now have no reason to sue.
 Directors reject demand  Shareholders now have to attack Board (& presumption of BJR) w/ wrongful
rejection theory.
· §141(a) ~ BJR – “Business affairs of corporation shall be managed by or under the direction of
the board of directors.”
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 o Rebuttable presumption that directors carry out functions in good faith, after sufficient
investigation, & for valid business reasons.

o Derivative Procedural Flowchart –

Transaction or Occurrence
Liability of Transaction
Directors or
Direct Suit … b/c the Occurrence
Derivative Suit …
 Π must showDirector/Bo
personal  Suit to enforce rights of
injury. ard failed to corporation.
adequately
monitor.
Francis,
In re
Care Possible Security
mar Requirement (i.e. Cohen)
k
Directors If not met = Direct Suit
must
Π suit is …
impl
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nt cannot ask show
infor for demand. personal
Demand matiRequirement Exception to Demand
injury.
on/r Requirement (Demand Futility)
Exc No
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epti
ting Boar criteria as listed in the state
on syste d demand futility statutes
to
Yes = Board Acceptance msNo = Board Reje Rejection (Delaware or New York).
No Suit De 
withi Π must attack Board’s Business
ction
Judgment (Wrongful Refusal Theory) to
Tough Standard
man n the Π
d orgaprevail (tough standard to prevail over
must
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Req nizat attac ve Suit
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man If met = If not met =
ly Judg e
d Suit Continues Π suit is over & cannot
desi ment rights
Futi gned ask for demand.
(Wro of
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o Purpose of Demand
 Requirement
prov –
l ation.
o AllowΠ disputeide to be resolved Refuby corporation outside of court.
o Allowmuscorporation
accu to take over sal the lawsuit if it is beneficial to corporation.
o If demand
t rate
is excused or wrongfully
Theo refused, the shareholder will be allowed to continue proceedings.
o Protects infor boards from
corporate ry) harassment & discourages strike suits.
mee mati
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o Business Judgment
out Rule –
for ail Law, §141(a) …
o Delaware
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(tou

the “Business
ctors & affairs gh
of corporation shall be managed by or under the direction of the board of directors.”
3 ·
to Rebuttable stanpresumption that directors & officers carry out their functions in good faith, after
crite reac sufficientdard investigation, & for valid business reasons.
ria h· BJR = Rule to of Judicial Restraint
as infor prev
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· In Delaware, demand is required when reasonable.
T
 Holding
perf –
oug orm
· Direct vs. Derivative Claims …
h ance o Claims of due care, waste, & excessive compensation are derivative in nature.
Stan in
o Claims of abdication of managerial power from board to individual are direct in nature.
dard orde
r to
satis
·
fy Demand Futility …
the o Demand will be excused when …
duty  (1) A majority of the board has a material financial or familial interest; OR
to  (2) A majority of the board is incapable of acting independently for some other
adeq reason as domination or control; OR
uatel  (3) The underlying transaction is not a valid exercise of business judgment.
y
·
moni
Wrongful Refusal …
tor. o If demand is made, the stockholder has spent one arrow in the quiver. The spent arrow is
the right to claim that the demand is excused.
 If demand is made & rejected, the board rejecting the demand is entitled to the
presumption of the business judgment rule unless the stockholder can allege
facts with particularity creating a reasonable doubt that the board is entitled to
the benefit of such a presumption.
· Whether the board validly exercised its business judgment must be
evaluated by determining whether the directors exercised procedural
(informed decisions) and substantive (terms of the transaction) due
care.
· To overcome BJR, Π must allege facts with particularity creating
reasonable doubt (“reason for doubt”) that the board acted
independently or with due care.
o Thus, by making a demand, the Π waived his right to contest demand futility.

o Marx v. Akers (New York 1996) ~

 Rule = Demand is Required unless showing for Demand Futility …
· Demand Futility Elements in New York …
o Allegation of facts with particularity creating “reason to doubt” regarding board
independence, such as facts that allege …
 (a) Majority of the board is interested in the transaction; OR
 (b) Directors failed to inform themselves as reasonably necessary about the
transaction; OR
 (c) Directors failed to exercise their business judgment in approving the
transaction.
 Holding –
· (1) Officers Competence Claim …
o The allegations that the Board used faulty accounting procedures to calculate executive
compensation levels were “conclusory allegations of wrongdoing” insufficient to excuse
demand.
· (2) Directors Competence Claim …
o The Court found that a director who voted for a raise in directors’ compensation was
always interested because that person received a personal financial benefit from it.
 Consequently, demand was excused as to the allegations that the compensation
set for outside directors was excessive.

(3) ROLE OF SPECIAL LITIGATION COMMITTEES

o Special Litigation Committees –

o Permitted under DGCL §141(C)(2) ~
 “Board may designate 1 or more committees, each consisting of 1 or more directors.”
 “Board committee may exercise all the powers & authority of the full board.”

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  *The objective of the special litigation committees (SLC) is to determine whether or not to move forward
w/ the derivative action.
o SLCs typically arise after demand is requested by the Π, but are also a strategy for board to make an end-run around
the demand futility exception.
 Despite this tactical maneuver, Board decisions to create an SLC are protected by the business judgment
rule.

o Cases –
o Auerbach v. Bennet (New York 1979) ~
 Facts –
· ∆-Board appointed a 3-person committee comprised of members who were not on the board at the
time of the board’s alleged wrongdoing.
· The committee reviewed the auditor’s findings & decided that in the best interests of the
corporation that they should not pursue an action against the Board members.
 Issue –
· To what degree does the BJR shield from judicial scrutiny the decision of a 3-person minority
committee of the Board of Directors not to prosecute a shareholder’s derivative claim?

 Holding –
· (1) Despite the threat of taint over the Board, the Board still possessed the authority to
appoint the SLC (this decision is protected by BJR).
· (2) There is a 2-Tier Level of Inquiry in NEW YORK…
o 1st Tier = Inquire as to the adequacy & appropriateness of the SLC’s independence,
good faith, proper procedures after sufficient investigation (procedural issues which
judges have expertise in reviewing) …
 If 1st Tier failes, SLC judgment to dismiss will not be upheld.
 If 1st Tier satisfied, proceed to 2nd Tier.
o 2 Tier = BJR protects the SLC’s substantive decision.
nd

 Judges do not have the expertise to overturn the SLC’s substantive decision.
· BJR is grounded in the prudent recognition that courts are ill equipped
& infrequently called on to evaluate what are & what must be
essentially business judgments.
o Summary …
 In the context of SLC’s the BJR shields the deliberations & conclusions of the
chosen representatives of the Board only if the representatives possess a
disinterested independence & do not stand in dual relation which prevents an
unprejudicial exercise of judgment.
 Thus, once the SLC is deemed to be impartial & disinterested in the issue at
hand, their decision is entitled to deference by the court under the BJR.
 [SLC’s decision to dismiss was upheld in this case.]

o Zapata Corp. v. Maldonado (Delaware 1981) ~

 Facts –
· Π did not demand that the ∆-directors bring the action b/c all the directors at the time were named.
· ∆’s appointed an SLC comprised of 2 directors who were not part of the initial suit.
· The SLC decided that the derivative suits would be harmful to the corporation & moved to
dismiss.
 Rule –
· The Court should first determine if a ∆-corporation proves that the appointed committee is
independent, and then determine, when applying their business judgment standard, whether the
motion to dismiss the derivative suit should be granted.
o Deleware §141(a) ~
 Fount of directorial powers: The business judgment rule is a judicial creation
that presumes propriety in a board’s decision.
o Deleware §141(c) ~
 Allows a board to delegate all of its authority to a committee.
 Holding --
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 · DELAWARE COURT applied 2-step Test to determine if the SLC should be permitted to
dismiss suit IN DEMAND EXCUSED CASES:
o *(1) Court will examine how the decision was made by the SLC ….
 “We do not think that the interest taint of the board majority is per se a legal bar
to the delegation of the board’s power to an independent committee composed of
disinterested board members.”
· Limited discovery may be ordered to facilitate such inquiries.
 Inquiry Independence / Good Faith / Sufficient Investigation?
o 2) Court will examine the merits/substance of the decision (Court less deferential than
NY)
 Inquiry  Was the SLC’s decision in the best interests of the Corporation?
 Business Judgment Rule should not apply …because Court was suspicious of
SLC’s ability to truly be independent & distance themselves from the potentially
“tainted” board.
 Court was suspicious of “structural bias” & feared that SLC, while nominally
independent, will decide in favor of the Board of Directors who appointed him.
o In re Oracle Derivative Litigation (Delaware 2003) ~
 Rule –
· “At bottom, 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 a corporation in mind …
cases ultimately focus on impartiality & objectivity.”
· *The Court expanded the test for judging the independence of an SLC …
o Factors should contemplate human nature … The test is not just about substantial
dominion or control but includes economic interests & personal relationship Interests.

o In Characteristics Pre-Suit Demand Special Litigation Beam ex

Committees rel.
Burden of Persuasion Burden on Π to plead particular facts of Burden is on the Corporation Martha
Board impropriety to prove the SLC’s Stewart
(Board Independence is presumed) independence Living
(2-Part Test)
Discovery Available Grimes Court says there are “tools as hand.” More discovery is available.
 8 Del.C. § 220 …
o Llimited shareholder right to
inspect books & records.
Publicly available information.
 Filings with govt agencies (i.e. SEC)
*However, it is very hard to meet the
pleading standard required to show demand
futility

Omnimedia, Inc. v. Stewart (Delaware 2004) ~

 “An SLC is a unique creature that was introduced into Delaware law by Zapata v. Maldonado in 1981. The
SLC procedure is a method sometimes employed where presuit demand has already been excused & the
SLC is vested with the full power of the board to conduct an extensive investigation into the merits of the
corporate claim with a view toward determining whether – in the SLC’s business judgment – the corporate
claim should be pursued.”
 “Unlike the demand-excusal context, where the board is presumed to be independent, the SLC has the
burden of establishing its own independence. . . . Moreover, unlike the presuit demand context, the SLC
analysis contemplates not only a shift in the burden of persuasion, but also the availability of discovery into
various issues, including independence.”

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ROLE & PURPOSE OF CORPORATIONS

(1) CORPORATE POWERS & ULTRA VIRES ACTS

o History of Ultra Vires Doctrine –

o AP Smith v. Barlow (NY 1953) ~

 Holding –
• Corporate gift-giving (charitable donations) is an allowable method of increasing goodwill.
o The gift must be (1) reasonable in amount & (2) may not be a “pet charity.”
 “Pet Charity” = Gift in personal interests of directors & not in benefit of
corporation.
• Corporate gift-giving increases the goodwill of the corporation & public policy should be to
encourage corporations to provide to charities in same manner as individuals are encouraged to
give.
• The Court did not accept the ∆-Shareholder’s reasoning that the donation should not be allowed
because the corporation preceded the statute authorizing corporate gift-giving.

o Corporations used to have “narrow purposes” built into its by-laws.

 If you didn’t specifically enumerate a power, then you couldn’t engage in that purpose/transaction.
 Thus, the courts proactively allowed corporations to engage in philanthropic acts for good of Public Policy
in the form of the ultra vires doctrine.
 Today, corporations define their power as “any lawful act or activity” & thus the broad sweeping phrase
de-emphasizes the importance of the ultra vires doctrine.
• DGCL §102(A)(3) …
o Certificate of incorporation shall set forth the nature of the business or purposes to be
conducted or promoted.
 May simply say “any lawful act or activity”
 May contain restrictions

o Modern Ultra Vires Statutes –

o DGCL §122 ~ Charitable Donations …

 “Every corporation shall have the power to [with the approval of the board of directors]… 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 purpose, … make contracts & borrow/lend money, … pay pensions,
… buy insurance for its benefits on life of directors, officers employees, or any shareholder …”
o DGCL §124 …
 No act or transfer of property shall be invalid because ultra vires but lack of capacity or power may be
asserted by:
• Shareholder suit to enjoin corporation from entering into such act or transfer of property
• Corporate suit against directors and officers
• Suit by state attorney general
o California Corporations Code §207(3):
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  “Power to make donations regardless of specific corporate benefit for public welfare, or for community
fund, hospital, charitable, educational, scientific, civic or similar purposes.”
o New York Business Corporations Law §202(a)(12):
 “Power to 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.”
o 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 officers or other establishments of the
corporation are located.”

o Applications of Business Judgment Rule –

o Dodge v. Ford Moter Co. (Michigan 1919) ~

 Plaintiff’s Legal Argument …
• Corporations exist solely for the shareholders & ∆-Ford is arbitrarily withholding special
dividends.
 Rule –
• “It is a well established principle that directors alone have power to declare a dividend &
determine its amount …
o [Exception] Courts of equity will not interfere in the management of the directors unless
… they are [1] guilty of fraud or [2] misappropriation of the corporate funds, or refuse to
declare a dividend when the corporation has a surplus of net profits … and [3] when a
refusal would amount to abuse of discretion as would constitute fraud or breach of good
faith.”
 Holding –
• (1) The Court ordered the payment of the special dividends to the Dodge Brothers …
o Court said the ∆’s abused their discretion because that court had a very narrow view of
the purpose of corporation. Court interfered with directors’ judgment on the issue of
dividends.
 Wagner says this was a dying view ~
• Court’s decision is the high water mark of the view of a corporation as
pure property exclusively belonging to shareholders w/ no
consideration to society at large.
• The Court denied the injunction against the expansion b/c protected under BJR.
o Court thought expansion was a good justification & deferred to the directors’ judgment
on the issue of expansion.
 Wagner says in this sense the court is forward-looking.

o Mainstream View …
 Generally, Courts now sees charitable giving (better wages, working conditions, & cleaning up the
environment) as a valid purpose of the corporation, in addition to garnering profits for the shareholders.
 Perhaps even Dodge was wrongly decided because the Court focused on the SHORT-TERM & did not
focus on the LONG TERM BUSINESS PERSPECTIVE.
 DGCL Section 170(a):
• Directors may declare and pay dividends out of surplus or net profits, subject to restrictions in
certificate of incorporation.

o Schlensky v. Wrigley (Illinois 1968) ~

 Plaintiff’s Legal Argument …
• Corporations exist solely for the shareholders & ∆-CUBS are arbitrarily refusing to install lights
for night baseball.
 Rule –
• A court will not interfere with an honest business judgment absent a showing of [1] fraud,
[2] illegality, or [3] economic conflict of interest.
 Holding –
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 • The Court would not overturn the ∆’s decision not to install lights at the ballpark.
• The Court asserts that business decisions should not be disturbed just because a Π-Shareholder can
make a reasonable case that the policy chosen by the company may not be the wisest policy
available.
o Long run policy/business decisions are entitled to judicial deference.
o Social responsibility could lead to more consumers, more investors, & better employees.
• “Not following the pack” is not per se negligence nor per se an adequate rebuttal to the BJR.

o Summary of BJR Rules –

 Dodge v. Ford Motor Company:
• Courts will uphold directors’ decisions unless [1] fraud, [2] misappropriation, or [3] abuse of
discretion showing bad faith
 Schlensky v. Wrigley:
• Courts will uphold directors’ decisions unless [1] fraud, [2] illegality or [3] conflict of interest

o Current State of Corporate Purpose & Social Responsibility –

o Berle-Means Debate –
 Issue = Social Responsibility by Corporations
• Implication on Purpose of Corporation …
o Private Property (Dodge– Corporation exists solely for shareholder)
vs. Social Institution (Ford & Wrigley’s View)
 Berle …
• Managers were “trustee” for shareholders who existed solely *for* the shareholders (view of
Dodge Court)
 Means …
• Managers existed for shareholders & other constituencies & impact on society (i.e. employees,
community, society, etc. ~ view of Henry Ford & Mr. Wrigley)

Partnerships Corporations LLC

Limited Liability No Yes Yes
Free Transferability No Yes --
Continuity of Life No Yes --
Centralized Mgt No Yes Maybe
Flow through Tax Treatment Yes No Yes

o *Law has not come down solely on either side of the debate –
 But … the current state of the law can be summarized by ALI, § 2.01 …
• ALI §2.01 of Principles of Corporate Governance …
o (a) A corporation should have as its objective the conduct of business activities with a
view to enhancing corporate profit & shareholder gain.
o (b) Even if corporate profit & shareholder gain are not thereby enhanced, the corporation,
in the conduct of its business:
 (1) Is obliged to act within the boundaries set by law;
 (2) May take into account ethical considerations that are reasonably regarded as
appropriate to the responsible conduct of business; &
 (3) May devote a reasonable amount of resources to public welfare,
humanitarian, educational, & philanthropic purposes.

o The New Corporate Social Responsibility –

 Corporate Social Responsibility =
• Companies voluntarily decide to respect & protect the interests of a broad range of stakeholders &
to contribute to a cleaner environment & better society through active interaction with all …
 Supported by company level, industry level, & international codes of conduct …
• Areas of coverage …
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 o Core labor standards
o Green environmental standards
o Reject bribery & corruption in business
o Respect human rights

LIMITED LIABILITY COMPANY

INTRODUCTION

(1) CHARACTERISTICS OF LIMITED LIABILITY COMPANIES (LLC)

o LLC is embodied in state law across all 50 states –

o LLC’s are viewed as a “hybrid” business arrangement because it can combine the best features of the corporate form
& of a partnership.
 Best Features:
·  Limited Liability Shield protecting the personal assets of the LLC’s members (like Corporate
form).
·  Flow through (single-tax) treatment (like in Partnership law).
·  Flexibility of the management structure (like in Partnership law).
 Member-Managed LLC’s vs. Manager-Managed LLC’s:
· Member-Managed:
o  LLC may be managed by all of its members (like in a Partnership); OR
· Manager-Managed:
o  Members of the LLC may delegate power to managers, who may or may not be
members of the LLC (like the Corporate form).

o Uniform Limited Liability Act (ULLCA) ~ [Uniform Acts are not binding until adopted by State Legislature] –
o ULLCA provides rules for structure, governance, & operation.
o ULLCA §201 … Provides that an LLC is a legal entity distinct from its members.

LLC FORMATION

(1) ULLC PROVISIONS

o LLC formation requires 2 formalities:

o (1) Filing of Articles of Organization with the state (similar to the articles of incorporation in the corporate form)
…
 Birth of the LLC begins at the filing …
· ULLCA §202 … One or more members may form LLC by filing articles with the Secretary of
State.
· ULLCA §203 … Provides for the requisite contents of articles.
· ULLCA §204 … Provides for the amendment of articles.
o (2) Execution by members of an Operating Agreement (similar to the by-laws in the corporate form) . . .

o Westec v. Lanham (Colorado 1998) ~

o Facts –
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  Westec entered Қ with LLC (Clark & Lanham) ... But, Clark did not disclose LLC & simply gave Westec
card w/ …
· (1) Name of Clark / (2) Address of Lanham / (3) “P.I.I.”
o Issue –
 Whether the members of an LLC are excused form personal liability on a contract where the other party to
the contract did not have notice that the members were negotiating on behalf of an LCC at the time of
contract?
o Rule –
 Law of partially disclosed principal (rooted in agency law) is not supplanted by the LLC notice provision.
· LLC notice provision applies only where 3rd party seeks to impose liability on LLC members &
managers *simply due to their status as members or managers.*
o Holding –
 Court held Agency common law dispositive. To avoid personal liability, Clark & Lanham had a duty to
disclose the identity of their LLC (formality of LLC law). To hold otherwise would invite fraud.

LLC ~ OPERATING AGREEMENT

(1) ULLC PROVISIONS & CASE

o ULLCA §103:
o §103(a) –
 Members of LLC may enter into operating agreement to regulate the conduct of business& relations
among members, mangers & company (default rule).
o §103(b):
 Members cannot, by contract, change provisions specified in ULLCA §103(b) …
· Cannot contract to …
o Restrict access to records or information …
o “Unreasonably reduce” (eliminate) duty of good faith & fair dealing or loyalty or care
…
o Change the right to expel a member …
o Vary requirements to wind up LLC in case of dissolution …
o Avoid potential criminal liability …
o Restrict the rights of persons (other than manager, member, transferee) …
o Summary:
o There is significant freedom of contract to change the Operating Agreement.
o This freedom of contract, however, has limitations found in a policy-driven list in ULLCA §103(b).

o Elf v. Jaffari (Delaware 1999) ~

o Facts –
 Elf Inc. + Malek, Inc. = Formed to create Malek LLC
· Operating agreement contained a clause that provided for private dispute resolution through
arbitration.
o Holding –
 Although Delaware ULLC law provides for these types of cases to be heard in Delaware, Court upheld
Arbitration Clause.
· Court concluded the arbitration clause was valid because it was contracted for b/w the parties
when the operating agreement was formed & such a clause was not prohibited by ULLCA
§103(b).

LLC ~ PIERCING THE “LLC” VEIL

(1) ULLC PROVISIONS / CASE / STATE PROVISION

o ULLCA §303 –
o (a) Member or manager NOT personally liable for debts, obligations & liabilities of LLC, whether arising in
contract, tort or otherwise.
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 o (b) Failure to observe formalities or requirements for exercise of powers of management is NOT a ground for
imposing personal liability.
o (c) Members are LIABLE for debts etc. if there is consent in writing & included in provisions of the articles.

o Kaycee Land & Livestock v. Flahive (2002) ~

o Holding –
 Piercing is an equitable doctrine & “the [lack] of statutory authority for LLC piercing should not be
considered a barrier to its application.”
 As a matter of public policy, it would be illogical to allow persons to abuse LLC’s in a manner that has
been prohibited for corporations.

o Minnesota Statute –
o “Case law that states the conditions & circumstances under which the corporate veil of a corporation may be
pierced under Minnesota law also applies to limited liability companies.”
  Therefore, by statute, Minnesota makes piercing doctrine identical for both corporations & LLC’s.
· Advantages = Law is already developed & Predictability
· Disadvantages = LLC’s & Corporations are not identical entities.
o Tom Thumb Food Markets, Inc. v. TLH Properties, LLC (Minn.App. 1999) ~
 Test …Courts will pierce the [LLC] veil if :
· (1) An entity ignores formalities & acts an the alter eco or instrumentality of a shareholder &
· (2) The liability limitations of the [LLC] results in injustice or is fundamentally unfair.
 “The practice of piercing . . . is generally a creditor’s remedy used to reach an individual who has used a
corporation as an instrument to defraud creditors.”

LLC ~ FIDUCIARY OBLIGATIONS

(1) ULLC PROVISIONS / CASE

o ULLCA §409 … Fiduciary Duties …

o Duties Owed –
 Members owe duty of loyalty & care to member-managed company & its other members.
 Managers in a manager-managed company owes duties of loyalty & care (members who do not manage
owe no duties).
o Duty of Loyalty Defined –
 As accounting for profit & use of property of LLC & appropriation of corporate opportunity …
 Refrain from acting adversely to LLC’s interests …
 Refrain from competing with the company in the conduct of its business before dissolution …
o Duty of Care Defined –
 Not committing acts that are grossly negligent, reckless, intentional, willful violation of law …

o ULLCA §404 … Management …

o If the LLC is member-managed (more like a partnership) …
 Default Rule:
·  Equal Rights in management for all members & majority voting.
o If the LLC is manager-managed (more like a corporation) …
 Default Rule:
·  People to manage (managers) are selected …
·  Equal rights in management by the managers …
·  Among those managers, majority voting …
o Managers must be designated, removed, or replaced by a majority of members.
o Consent of all members is required for certain critical events.

o McConnell v. Hunt Sports Enterprise (Ohio 1999) ~

o Facts –
 McConnell, Hunt, & others formed an LLC to purchase an NHL team.

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  NHL deadline was fast approaching & the LLC needed to secure a lease agreement for purpose of arena
construction.
 Hunt unilaterally continued to reject leasing proposals.
 Because deal seemed in jeopardy, McConnell stepped in & moved forward on the deal, even though
Hunt/LLC would not.
o Fiduciary Duty Issue –
 Given that the LLC’s operating agreement “allowed competition b/w members & LLC”, did McConnell
breach any fiduciary obligations to LLC?
· Holding –
o NO …
 Normally, the presence of the fiduciary relationship b/w members & the LLC
precludes direct competition b/w members of the company (breaches duty of
loyalty).
 However, the operating agreement in this case expressly limited the scope of the
fiduciary of loyalty & by its terms allows members to compete with business of
the company… Therefore, no breach.
o Management Issue –
 Under LLC management rules, was Hunt’s unilateral rejection of the lease agreements permissible?
· Holding –
o NO …
 Hunt viewed LLC as a manager-managed company & he was the sole manager.
 However, because there was no mention that the LLC was a manager-managed
company in the operating agreement, ULLCA §203 presumed LCC to be a
member-managed company in which all members had equal rights in
management & majority voting.
 Therefore, Hunt was obligated to seek a majority vote to reject such lease
proposals.

LLC ~ DISSOLUTION

(1) ULLC PROVISIONS / CASE

o ULLCA –
o §801 … Events of dissolution –
 An event is one specified in operating agreement.
 Consent of a number or percentage of members specified in operating agreement.
 Event that makes it unlawful to continue the business.
 Application by member / judicial decree.
 Application by transferee / judicial determination.
o §802 … Winding up after dissolution …
o *§805 … Filing of articles of termination …
o *§806 …
 Creditors must be paid! (including members);
 Members entitled to return of contributions.
o *§806(d)(2) …
 Member liability to creditors limited to the amount received in distribution connected with dissolution.
o *§807 … Disposing of known claims by giving notice to creditors …
o §808 … Disposing of other claims by publishing notice to creditors in a newspaper.

o New Horizons Supply Co-op v. Haack (Wis.App. 1999) ~

o Facts –
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  Haack entered formed an LLC with her brother.
 LLL entered contract with Π; LLC subsequently dissolved & Π is trying to hold Haack personally liable for
debt incurred on a contract.
o Issue –
 Did Haack take appropriate steps to shield herself from personal liability upon the dissolution of her LLC?
o Holding –
 NO … Members of an LLC can be held personally liable for debts of their LLC if they fail to properly
dissolve the LLC under the relevant statutes.
· Court noted that the statutory requirements for proper dissolution of LLC’s are not flexible.
o  Under the rules for dissolution Haack should have …
 (1) Filed articles of termination under §805; &
 (2) Disposed of claims by giving notice to creditors under §807/808.
· Furthermore, Haack took assets of the dissolving LLC (as a return of contribution under §806)
…
o Evidence showed that the assets taken could have covered the debts owed to Π …
  Therefore, in comporting with §806(d)(2) …
· Haack personally owed the Π the outstanding balance to the extent she
received in distribution connected with the dissolution.
 “We conclude that entry against Haack on Π’s claim was proper because Haack failed to establish that she
took appropriate steps to shield herself from liability of LLC’s debts following its dissolution & distribution
of assets.”

CORPORATIONS & DUTIES OF OFFICERS, DIRECTORS & OTHER INSIDERS

FIDUCIARY DUTY OF CARE

(1) INTRODUCTION TO THE DUTY OF CARE

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 Liability of Directors b/c the Board Decision was potentially
uninformed (made w/o care).
Kamin, Smith, Eisner, In re Disney
Yes = Board Whether a court believes a decision substantively wrong provides no ground
for director liability; under the BJR, so long as the court determines
Acceptance
that that process employed in arriving at such decision was either
Fiduciary Duty of Care No Suit rational or employed in a good faith effort to advance corporate
Process interests.
Liability of Directors b/c the Director/Board failed to adequately
monitor.
Francis, In re Caremark
Directors must implement information/reporting systems within the
organization that are reasonably designed to provide accurate
information for directors to reach informed judgments concerning both
the corporation’s compliance with the law & its business performance
in order to satisfy the duty to adequately monitor.

(2) DUTY OF CARE & “INFORMED” DECISIONS OF THE BOARD

o Kamin v. American Express Co. (NY 1976) ~ Duty of Care Case where BJR Prevails ~
o Facts –
 The board & shareholders disagreed over what to do with a particular stock asset that lost value.
· Board  Wanted to issue a dividend in kind to potentially raise stock prices.
· Shareholders  Wanted to sell the stock in order to record a capital loss to reap a tax benefit.
 Π-Shareholders brought suit classifying directors’ decision as a breach of the duty of care & negligent
waste.
o Holding –
 Standard/Rule Adopted by the Court –
· Court will not interfere with a decision of a company’s directors, pursuant to the presumption of
the Business Judgment Rule, unless there is evidence of fraud, dishonesty, malfeasance, or
nonfeasance.
 Specific Holding –
· “The question of to what extent a dividend is paid/declared & the manner in which it shall be paid
is ordinarily subject only to the qualification that the dividend be paid out of surplus.”
· “The Court will not interfere unless a clear case is made out of fraud, oppression, arbitrary
action, or breach of trust.”
 General Conclusion –
· At most, the decision to distribute dividends in kind could be a mistaken decision (i.e. stupid).
o This is not sufficient to overcome the presumption of the Business Judgment Rule.
o The decision must be more grossly negligent (malfeasance/nonfeasance) to overcome the
presumption of the Business Judgment Rule.
· Additionally, because the Board informed themselves & deliberated to arise at a decision,
the Court deemed the shareholder’s pleading insufficient.

o Smith v. Van Gorkum (Delaware 1985) ~ Landmark Duty of Care Case in which BJR Presumption was Rebutted ~
o Facts –
 Background –
· Cash Out Merger …
o This is one type of corporate combination in which the acquiring company pays
shareholders of a target company the value of their shares.
o As a result, target company is merged out of existence & shareholders have no interest in
the company that results from the merger.
 Therefore, the shareholders are protected by the fiduciary duty of care, so that
shareholder interests are represented when the Board agrees on the share
price.
· Merger Approval Procedures …
o DGCL §251(b) – Board Approval …

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  Board of each merging corporation shall adopt a resolution approving the
merger agreement & declaring its advisability.
o DGCL § 251(c) – Stockholder Approval …
 The merger agreement must be submitted to the stockholders for approval.
 The majority of shares entitled to vote must approve.
 If approved by stockholders, the merger agreement is then filed & becomes
effective.
· Management by Board of Directors …
o DGCL §141(a) – Board Authority …
 Business & affairs shall be managed by or under the direction of board of
directors.
o DGCL §141(b) – Board Composition & Action …
 Composed of one or more members (fixed in by-laws or certificate).
 Quorum … Majority of total # of directors (can reduce 1/3 in by-laws or
certificate).
 Valid Board Action … Vote of a majority of directors present at a meeting with a
quorum present (can require a supermajority in by-laws or certificate).
· Shareholder Voting …
o DGCL §216 – Shareholder Voting …
 Majority of shares entitled to vote shall constitute a quorum at a shareholder
meeting (can reduce 1/3 in by-laws or certificate).
 Vote of majority of those present or represented by proxy shall be the act of the
shareholders (except for the election of the directors).
 Critical Facts –
· CEO of Trans Union (∆) chose to engage in a cash-out merger, selling the stock at $55/share.
o No valuation study/repots/expert opinions discussing whether $55 is an adequate price.
o No documentation, no merger agreement, etc.
o Holding –
 1st Step … The Π-Shareholder must overcome the presumption of the BJR to prevail …
· Business Judgment Rule –
o “Presumption that in making the Business Decision, the Directors acted on an informed basis, in
good faith & in the honest belief that the action was in the best interests of the company .”
· Standard is Gross Negligence.
 2nd Step … In this case …
· “In specific context of proposed merger, a director has a duty under DGCL §251(b) to act in an informed &
deliberate manner in determining whether to approve agreement of merger.”
o Informed Decision –
  Sufficient Research/Investigation/Study
  Good faith reliance on reports by officers [DGCL §141(e)].
o Deliberate Decision –
  Sufficient Discussion
 3rd Step … Therefore …
· Because the because the CEO did not submit any information/reports/investigation capable of
creating a sufficient discussion at the Board Meeting, the Board decision amounted to blind
reliance.
o Board decision to enter into a cash-out merger was procedurally insufficient &
therefore uniformed. [BJR pierced].

 Conclusion / Rule of Smith v. van Gorkum …

· (1) Duty of Care = Procedural Duty

o Courts are concerned about the process for which Directors’ use to arrive at its
decision.
o Courts are not concerned so much about the substance of such decision [protected by
BJR].

· (2) The directors cannot rely upon the share price as contrasted with the market value in
attempting to justify their decision as informed. Why?
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 o There is a difference b/w “intrinsic” value of stock & market price of stock …
 Intrinsic Value = Takes into consideration full economic value of the shares,
including “controlling” interests.
 Market Price = Value of a minority position.

· (3) Good Faith Reliance on Records & Reports can be a defense for Board … DGCL
§141(e).
o “In performing their duties, board members may rely in good faith on records of
corporation & on information, opinions reports, statements presented to the corporation
by corporation’s officers or employees.”
 Records = Formalized document resulting from investigation/study.

o Cinerama, Inc. v. Technicolor (Delaware) ~

o Holding –
 Although CEO was deemed to have investigated thoroughly & bargained hard for the deal, his presentation
to the board for a decision was inadequate from an informational standpoint (no reports/no market study).
·  CEO made a deal quickly, presented it to the Board, which approved it quickly w/o adequate
information & adequate deliberation and/or a market check.
 On the issue of damages …
· Entire Fairness of Transaction Analysis –
o Consider factors, such as …
 Timing / Initiation / Negotiation /Structure of Transaction /Disclosure &
Approval by the directors /Disclosure to & Approval by shareholders.

o Delaware’s Legislative Response to Personal Liability of Directors for Breach of Duty of Care –
o DGCL §102(b)(7) … Delaware legislature allows a corporation to include in its certificate of incorporation:
 “A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for
monetary damages for breach of fiduciary duty as a director. . . .”
· Exception … “[P]roviding that such a provision shall not eliminate or limit the liability of a
director:
o (i) For any breach of the director’s duty of loyalty to the corporation or its stockholders;
o (ii) For acts/omissions not in good faith or involve intentional misconduct or knowing
violation of the law;
o (iii) Under §174 of this title relating to payment of dividends; or
o (iv) For any transaction from which the director derived an improper personal benefit.

o Brehm v. Eisner (Deleware 2000) ~ Duty of Care Case ~

o Facts –
 CEO-Eisner & Board entered into an employment agreement with Michael Ovitz to be President of
Disney.
 Employment Agreement = $1M Salary / Bonus $ / Stock Options / Non-Fault Termination Clause.
 Shareholders brought suit criticizing 2 Board Decisions:
· (1) Decision to approve Ovitz’s employment agreement (Breach of Duty of Care).
· (2) Decision to terminate Ovitz under the non-fault termination clause (Corporate Waste).
o Holding –
 Rule(s) –
· The standard for judging the informational component of the director’s decision-making under the
BJR does not mean that the board must be informed of every fact.
o The Board is responsible for considering only material facts that are reasonably
available.
· Board is entitled to good faith reliance on records of corporation & upon information, opinions,
reports, or statements by experts. ~ DGCL 141(e).
· To survive a motion to dismiss a shareholder derivative suit in a due care case where an expert
has advised the board in its decision-making process, the complaint must allege particularized
facts (not conclusions) showing:
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 o (a) Directors did not in fact rely on the expert;
o (b) Directors’ reliance was not in good faith;
o (c) Directors didn’t reasonably believe that the expert’s advice was w/in the expert’s
professional competence;
o (d) Expert was not selected with reasonable care or on behalf of the corporation, & the
faulty selection process was attributable to the directors;
o (e) Subject matter that was material & reasonably available was so obvious that the
board’s failure to consider it was grossly negligent regardless of the expert’s advice or
lack of advice; or
o (f) Decision of the board was so unconscionable as to constitute waste or fraud.
 Standard for Due Care (1st Board Decision) –
· Procedural Due Care only; Directors must consider all material information reasonably
available & director’s process is actionable only if grossly negligent.
· In this case, the financial analyst’s belief in hindsight that he should have calculated cost of the severance
package for non-fault termination of Ovitz did not rebut the presumption that the board of directors relied on
the analyst in good faith when approving the employment agreement & exercised proper business judgment .
 Standard for Corporate Waste (2nd Board Decision) –
· There is an outer limit to the discretion of the board of directors’ decisions.
o A transaction “that is so one-sided that no business person of ordinary, sound judgment could
conclude that the corporation has received adequate consideration .”
· Employment agreement for Ovitz was not “waste” despite the large amount of compensation; the board of
directors believed that it had to offer an expensive compensation package to attract Ovitz .

o Notes Following Case ~

o Arguably, the Board’s decision in Brehm v. Eisner was dumber than the Board’s decision in Smith v. Van Gorkum.
 Yet, the Court found against the Board in Smith & for the Board in Brehm, in terms of the duty of care
breach. Why?
· (1) Duty of Care is about procedure leading to the decision & not the substantive of the
decision.
· (2) Different types of transactions warrant different levels of due care scrutiny by Directors.

o In re Walt Disney Co. Derivative Litigation (Delaware 2005) ~

o Facts –
 Π-Shareholders in Brehm v. Eisner were allowed to amend their complaint.
 Π-Shareholders then lost in a jury trial; Π-Shareholders appealed.
o Holding –
 (1) The Delaware Supreme Court unanimously affirmed the jury’s decision.
· Court concluded that Delaware Law’s minimal standard of due care demanded that Director’s
prevail.
o However, the minimal standard of due care is not the “Best Practices” of Directors …
 “Best Practices” when Directors Approve an Employment Agreement:
·  Provide a spreadsheet prepared by compensation expert.
·  Expert should explain the spreadsheet to the committee.
·  The spreadsheet should be included in the minutes.
 (2) The Court discussed a novel theory of “Good Faith”.
· Not a well-defined area of Delaware Law.
· Independent duty distinct from Duty of Care.
· Test … Breach of Duty of Good Faith if:
o (1) Subjective Bad Faith (fiduciary conduct motivated by actual intent to do harm); OR
o (2) Intentional dereliction of duties, conscious disregard for one’s responsibilities.

(2) DUTY OF CARE & DUTY TO ADEQUATELY MONITOR

o Francis v. United Jersey Bank (NJ 1981) ~

o Facts –
 P&B is a reinsurance broker.
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 · P&B is entrusted with $$$ to find insurance for other companies trying to reinsure from ceding
companies willing to take on the risk.
· Basically, P&B spreads the risk of ordinary insurance companies with larger insurance companies
who are willing to take on larger risks.
· Lots of $$$ was flowing through P&B that was not P&B’s, but was being held in trust.
 Lillian was an “absent” director of P&B & her sons ran the business & misappropriated funds “held in
trust.”
o Rule(s) –
 If a director neglects to provide ordinary care of staying current with corporate affairs as one would
normally do in that position, the director will have violated the duty of care & could be liable if that
neglect is the proximate cause of damages. [Reasonable Person Standard].
· “Directors are under a continuing obligation to keep informed about the activities of the corporation .”
· “Directorial management does not require a detailed inspection of day-to-day affairs, but rather a general
monitoring of corporation affairs & policies.”
o “Directors owed that degree of care that a businessman of ordinary prudence would exercise in the
management of his own affairs.”
o “If one feels that he has not sufficient business experience to qualify him to perform the duties of
the director, he should acquire the knowledge by inquiry.”
o “Directors may not shut their eyes to corporate misconduct & then claim that because they did not
see the misconduct, they did not have a duty to look.” [Ignorance is no defense].
o “Upon discovery of an illegal course of action, a director has a duty to object and, if the
corporation does not correct the conduct, the director has a duty to resign.”
· “With certain corporations, directors are deemed to owe a duty of care to creditors & other 3 rd parties.”
o Holding –
 (1) Lillian, as a director of the Board, had a duty of care in managing the business to have a baseline
understanding of the finances & important activities. Lillian breached this duty by failing to monitor
her sons’ activities (i.e. the misappropriation).
· “Lillian’s relationship to the clientele of P&B was akin to that of a director of a bank to its depositors .”
 (2) “Lillian’s neglect of her duty contributed to the climate of corruption .”  Proximate Cause of Damages.

o In re Caremark International Inc. Derivative Litigation (Delaware 1996) ~

o Facts –
 Two Settlements …
· (1) Department of Justice Charges Brought against Caremark …
o Basis of Charges = Violation of Anti-Payment Referral Law (anti-kickback violations)
o Settlement = $250 Million in civil/criminal fines.
· (2) Shareholder Suit …
o Shareholders brought a suit alleging a breach of duty of care by directors in failing to
monitor & detect violation of APRL law earlier (because if they had done so, they could
have avoided the DOG charges & $250 Million in fines).
o Rule(s) –
 Directors have an affirmative duty to monitor & establish compliance programs …
· On-going Duty to Investigate / On-going Duty to Monitor
· “Only a sustained or systemic failure of board to exercise oversight will establish lack of good faith
necessary to find liability.”
 Directors are potentially liable for a breach of a duty to exercise appropriate attention if …
· (1) Board knew or should have known that employees were violating the law;
· (2) Board declined to make a good faith effort to prevent the violation; &
· (3) Board’s lack of action was the proximate cause of the damages.
 Without directors assuring themselves that information/reporting systems exist within the organization that
are reasonably designed to provide accurate information for directors to reach informed judgments
concerning both the corporation’s compliance with the law & its business performance, the directors may
not satisfy their obligation to monitor corporation’s activities.
o Holding –
 Directors appeared to have followed procedures to inform themselves regarding contracts with health
care providers before authorizing the corporation to pursue contractual obligations, so as to be
protected under BJR from claims of personal liability when impermissible contracts were entered into.
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FIDUCIARY DUTY OF LOYALTY

(1) DIRECTORS & MANAGERS

o Bayer v. Beran (New York 1944) ~ Duty of Loyalty Case ~

o Facts –
 Π’s filed a derivative shareholder action against ∆-Directors contesting their decision to pay for a radio
advertising campaign that employed the Director’s wife as a singer.
o Issue –
 Whether the Board, through the Director’s ties with his wife, breached their fiduciary duty of loyalty to the
corporation by approving the radio advertising campaign?
o Rule –
 A director has a duty of loyalty to support the corporation’s interest over his/her own conflicting
interests & any conflicting interest renders the Business Judgment Rule inapplicable .
· BJR is rebutted when …
o Fraud, Illegality, Malfeasance, Nonfeasance (Review from Duty of Care cases) …
o *Conflict of Interest (Duty of Loyalty).
  Situations where (X) deals with (Y) in such close relation with (X) where that
possible advantage to (Y) might influence (X)’s judgment, consciously or
subconsciously.
 Therefore, because of the conflict of interest present in this corporate transaction, the Court has the
power to rigorously scrutinize the transaction to determine if the actions of the Director/Board were intended
to serve some outside purpose, regardless of the consequences of the company.
· Court has the power to substitute its own judgment if it deems necessary.
 When there is a conflict of interest, the burden is on the ∆-Board/Director to show:
· (1) Good faith of the transaction; &
· (2) Inherent fairness from the viewpoint of the Corporation.
o Holding –
 The radio advertising campaign survived the scrutiny of analysis under the duty of loyalty standard.
· (1) The radio advertising campaign made sound business sense because the company had to
increase their profile to the Federal Trade Commission’s designation of celanese as rayon.
· (2) Director’s wife was well-qualified & her compensation was fair & not exorbitant.

o Note on Bayer v. Behren Case –

o Π’s also alleged there was a defect in the Board Procedure since the Board never formally met to approve the Қ.
 General Rule = Directors acting separately & not collectively as a Board cannot bind a corporation.
· Why? …
o (1) Collective Procedure is necessary &
o (2) Directors are agents of the shareholders who are given no power by law to act except
as a Board.
 Here, the Court overlooked that defect because the members of the Board were in daily association with
each other & it was customary for them to act “informally” – but, still “collectively.”
· Some corporation codes permit Board action by written consent & through use of conference
calls or similar means.

o Lewis v. S.L. & E., Inc. (2nd Cir. 1980) ~ Duty of Loyalty Case ~
o Facts –
 Π-Lewis brought a derivative suit against ∆’s (directors of SLE Corp.) for corporate waste after ∆’s did not
raise the rent paid to SLE by a company (Lewis General Tires, Inc. – LGT) that ∆’s owned.
· Π & ∆’s were brothers, but only ∆ owned shares of LGT.
· SLE leased property to LGT. After the lease expired, SLE & LGT never entered into a new lease
& never increased the rent.
· ∆ testified that he did not seriously thing of SLE as a separate entity, but instead as a shell for
LGT.

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 · Thus, when it came time for SLE to merge with LGT, SLE shares were artificially low because of
the actions for ∆ (Directors for LGT).
o Rule –
 Directors that have a conflict of interest in a corporate transaction do not enjoy the presumption of the BJR
& have the burden to prove that no waste was committed & that the transaction was fair/reasonable.
 New York Law …
· NYBCL §713 … Covers transactions between:
o (1) Corporation &
o (2) Director of corporation in which director has substantial financial interest or is a
director/officer.
· NYBCL §713 …
o No Қ involving an interested director is void or voidable because director was present &
voted in favor if:
 (1) Full disclosure & valid board approval w/o counting vote of interested
director.
·  Form of ratification.
 (2) Full disclosure & contract approved by shareholders.
·  Form of ratification.
 (3) *In other cases, Board must show its actions were fair & reasonable.
·  ∆’s (Directors of LGT) fell here.
o Holding –
 Because the ∆ (directors of LGT) did not offer proof that there was no other tenant willing to pay more, or
that the value of the rent was fair, the lower court’s holding for the ∆’s was reversed. [Π’s win.]

(2) CORPORATE OPPORTUNITY DOCTRINE

o Broz v. Cellular Information Systems, Inc. (Delaware 1996) ~ Corporate Opportunity Doctrine Case ~
o Facts –
 ∆-Broz was the sole stockholder of RFB Cellular, Inc, (RFBC) while also acting as an outside director for
Π (Cellular Information Systems, Inc. – CIS).
 Π brought an action against ∆-Broz when Broz purchased a cellular license for RFBC over a bid by CIS.
o Issue –
 Did ∆-Broz usurp a corporate opportunity from Π-CIS when he outbid them for a cellular license?
Rule –
 Corporate Opportunity Test (Guth v. Loft) …
· Persons Covered … Corporate officer or director.
o 1st Inquiry … Was there a corporate opportunity?
 Financial Ability? &
 Same Line of Business? &
 Interest or Expectancy? &
 Taking Opportunity would create conflict b/w self-interest & interest of
corporation?
o 2nd Inquiry …
 If no corporate opportunity  Party can take it without consequences.
 If yes corporate opportunity  Party must take it to the Board first. (Duty of
Loyalty).

· Safe Harbor …
o It is not legally required for an officer or director to formally present the opportunity to
the Board & await a rejection before the officer/director seizes the opportunity, so long as
the opportunity truly is not a “corporate opportunity.”
 However, such action would amount to safe harbor & place his actions above
reproach.
 Holding –
· In this case, the opportunity ∆-Broz took was not a corporate opportunity b/c:
o Π-CIS did not have the financial ability to purchase the license.
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 o Π-CIS was not interested or expecting to purchase licenses; in fact CIS was selling
theirs.
o The fact that PriCellular acquired CIS afterwards is irrelevant.

(3) DOMINANT SHAREHOLDERS

o Sinclair Oil Corp. v. Levien (Delaware 1971) ~ Dominant Shareholders Case ~

o Facts –
 Π-Levien brought a suit as a minority shareholder of Sinclair Venezuelan Oil Company (Sinven), which
was a subsidiary of ∆-Sinclair Oil Corporation. Π alleged that:
· (1) ∆ caused Sinven to pay out excessive dividends, &
· (2) ∆ breached their contract with Sinven.
o Issue –
 Was ∆ improperly engaged in self-dealing when they issued excessive dividends & breached their Қ with
Sinven?
o Rule –
 A standard of intrinsic fairness will be applied in any self-dealing transaction by a parent corporation whose
majority ownership places a fiduciary duty of loyalty upon the parent corporation.
· Intrinsic Fairness Standard …
o  High degree of fairness & shift in burden of proof to ∆ to show that the transactions
were objectively fair.
o  Will be applied only where there is self-dealing on the part of the parent corporation.
 Self-Dealing …
· Situation when a parent is on both sides of the transaction with its
subsidiary.
· Occurs when the parent (by virtue of its domination or the subsidiary)
causes the subsidiary to act in such a way that the parent receives
something from the subsidiary to the exclusion of, & detriment to, the
minority stockholders of the subsidiary.
o Holding –
 (1) Because ∆-Parent Corporation received no benefit from Sinven to the exclusion & detriment to
Sinven’s stockholders, there was no self-dealing.
· Therefore, the BJR was the proper standard for which to evaluate ∆-Parent Corporation’s
expansion policies.
o Court mentions there are instances where intrinsic fairness test can be applied to a
dividend declaration …
 That situation would be one in which the subsidiary was directed by the parent
to pay dividends only on the class of stock owned by the parent.
 (2) Because the contract breach was to the detriment of Sinven and its minority shareholders with
the positive effect being exclusive to the ∆-Parent Corporation, there was self-dealing present.
· Therefore, under the intrinsic fairness standard, ∆-Parent Corporation must prove that causing
Sinven not to enforce the contract was intrinsically fair to the minority shareholders of Sinven.
o ∆-Parent Corporation failed to meet this standard.

(4) SHAREHOLDER RATIFICATION

o DGCL §144(a) –
o Interested director/officer transaction not void or voidable if:
 (1) Material fact disclosure & disinterested director approval; OR
 (2) Material fact disclosure & [disinterested] shareholder approval; OR
 (3) Contract is fair [Intrinsic Fairness Test].

o Interested Director/Officer Transaction =

 Transaction b/w a corporation and 1 or more of its directors or officers;
 Transaction b/w a corporation & another corporation, partnership, etc. where 1 or more of its directors is
involved in the other corporation, partnership, etc.
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o Fliegler v. Lawrence (Delaware 1976) ~ Ratification Case ~
o Facts –
 Π-Fliegler brought a suit on behalf of Agau Mines Inc., against ∆-Directors (Lawrence et al.) after they
voted to exercise an option to purchase shares of another company (interested director/officer
transaction).
o Issue –
 A majority of the shareholders ratified the board decision, but the directors also comprised a majority of
shareholders. Therefore, interested shareholders (which comprised the majority) approved an interested
transaction.
· Is this sufficient for ratification under DGCL §144(a)(2)?
o Rule –
 Precedent & Statutory Law –
· DGCL §144(a)(2) –
o Interested director/officer transaction not void or voidable if … material fact
disclosure & shareholder approval.
· Gottlieb v. Heyden Chemical Corp. (Delaware 1952)
o “Shareholder ratification of interested transactions, although less than unanimous, shifts
burden of proof to objecting shareholder to demonstrate the terms are so unequal as to
amount to waste of corporate assets.”
o Holding –
 (1) Shareholder Ratification:
· Defines Correct Interpretation of §144(a)(2):
o Despite the literal wording in §144(a)(2), the Fliegler Court stated “we do not read the
statute as providing broad immunity for which the ∆’s 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.”
o §144(a)(2) should be read as …
 “Material fact disclosure & [disinterested] shareholder approval.”
· As Gottlieb suggests, shareholder ratification could be used to shift burden to the Π to show that
the transaction was not legitimate, but this burden-shifting pre-supposes that the shareholder
ratification was exercised by a majority of disinterested shareholders.
o  In this case, interested shareholders ratified; thus, ratification was not legitimate.
 (2) If the board of directors fail to meet the first 2 prongs of §144, they must satisfy the intrinsic
fairness test:
· In this case, ∆’s did prove the transaction was intrinsically fair.
o Agau received properties of substantial value.
o Agau also received an enterprise with proven markets & commercial capability which
could be expected to provide Agau with the cash it needed to undertake further
exploration & development of its own properties.

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 FEDERAL SECURITIES REGULATION

DISCLOSURE & FAIRNESS

(1) INTRODUCTION

o Trading in corporate securities (such as stocks or bonds) takes place on 2 basic types of markets –
o (1) Primary Market (issuer of securities – i.e. company that created the securities – sells them to investors); &
o (2) Secondary Market (investors trade securities among themselves w/o any significant participation by the
original issuer).

o Securities Act of 1933 –

o Principally concerned with the primary market.
o 2 Goals …
 (1) Mandating disclosure of material information to investors; &
·  As to disclosure, the Securities Act follows a transactional disclosure model – i.e. mandating
disclosures by issuers in connection with primary market transactions.
 (2) Prevention of fraud.

o Securities & Exchange Act of 1934 –

o Principally concerned with secondary market transactions.
o Covers …
 Insider trading;
 Short-swing profits by corporate insiders;
 Regulation of shareholder voting via proxy solicitations; &
 Regulation of tender offers.

o Exchange Act –
o Created the Securities & Exchange Commission (SEC) –
 SEC is the primary federal executive agency charged with administering & enforcing the various securities
laws.
 SEC has delegated authority to make rules & adjudicate matters arising under the Federal Securities
Statutes.
o Makeup …
 5 Commissioners (who must be confirmed by the Senate & no more than 3 of whom can belong to the same
party);
 Professional Staff …
· 3 Functions …
o (1) Provides interpretative guidance to private parties raising questions about the
application of the securities laws to a particular transaction;
o (2) Advises the Commission as to new rules or revisions of existing rules; &
o (3) It investigates and prosecutes violations of the securities laws.

o Policy of the Federal Securities Laws –

o The Federal Securities Laws arose in the wake of the Great Depression & were part of FDR’s New Deal Program.
o The Federal Securities Laws serve 2 major purposes:
 (1) Protection of Investors [Consumer Protection]; &
 (2) Integrity of Markets [Market Perception].

o Scope of Federal Securities Laws –

o (1) Disclosure Provisions (Government is trying to ensure that investors have the information they need to make
decisions);
o (2) Anti-Fraud Provisions (Directors/Officers could incur liability for material misrepresentations or omissions);
o (3) Regulation of Markets & Market Professionals.

o State Blue Sky Laws –

o State Blue Sky Laws pre-date federal securities laws.
o Corporations, Officers, & Directors must comply with both federal & state law.
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   There is some overlap b/w the 2 regulatory schemes.

(2) DEFINITION OF SECURITY

o It is important to distinguish whether or not a particular type of instrument or investment will be deemed a security –
o (1) The Federal Securities Regulations apply *only* to securities.
  Generally, securities must go through registration process.
  Non-securities are not subject to securities regulations.
o (2) The Federal Securities Regulations regarding *antifraud* provisions apply *only* to securities.
  In general, Π’s have a much easier time when they bring suit under securities laws than they would if
they had to bring suit under state common law fraud rules.
· Elements of federal securities fraud are less demanding & thus easier to prove.
· Certain procedural advantages, such as liberal venue & services of process provisions.

o Statutory Definition of a Security –

o §2(a)(1) of the Securities Act is divided into broad categories …

 (1) A list of rather specific instruments …
· Stocks / Notes / Bonds
 (2) A list of general, catch-all phrases, such as …
· “Evidence of indebtedness” / “Investment Contracts” / “Any instrument commonly known as a
security.”

o §2 ~ Provides that the terms used in the Act shall be defined in accordance with the various provisions of §2, “unless
the context otherwise requires.”
  “Context Clause” is an escape hatch.
· Courts have sometimes used it to hold that although an instrument appears to fall within one of the
listed types of securities, the instrument shall not be held to constitute a security for the purposes
of the securities laws if “the context otherwise requires.”
o Context Clause can say … “Yes, this thing looks like a security, but given the nature of
the transaction, we’re going to hold that it doesn’t come within the scope of the Securities
Act.”

o Great Lakes Chemical Corp. v. Monsanto Co. (Delaware 2000) ~

o  Securities laws are meant to regulate investments rather than commercial ventures.
 Therefore, a security can be a traditional stock or alternatively an investment contract that consists of [1] an
investment of money [2] in a common enterprise with [3] profits to come solely from the efforts of others.

o Robinson v. Glynn (4th Cir. 2003) ~

o Facts –
 Glynn lied to Robinson regarding Robinson’s investment (membership interest) in Glynn’s LLC.
 Robinson brought an action against Glynn under 1934 Securities Exchange Act 10(b) & SEC Rule 10b-5.
o Issue –
 Was Robinson’s membership interest in the LLC a security & therefore subject to the Federal Securities Laws?
· (1) Was Robinson’s interest an investment contract?
· (2) Was Robinson’s interest a stock?
o Rules –
 Securities Act of 1933, §2(a)(1):
· “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.
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  Implications of an interest falling into the definition of a security under the Federal Securities Laws:
· Disclosure & anti-fraud provisions apply.
o Holding –
 As a threshold matter, Robinson’s claim was dismissed b/c his interest was not a security.

· (1) Characteristics of Investment Contract …

o Howey Test (USSC 1946) … Defines Investment Contract as:
 A contract, transaction or scheme whereby a person …
· (1) Invests his money …
· (2) In a common enterprises …
· (3) With expectation of profits to come solely from the efforts of
others.
 The economic reality is more important than the form of the investment scheme .
·  Agreements cannot invoke securities laws simply by labeling.

o Application to of the Howey Test to Robinson’s scenario:

 The economic reality of Robinson’s investment is that Robinson was not a
passive investor relying on the efforts of others, but a knowledgeable executive
actively protecting his interest & position in the LLC.

· (2) Characteristics of a Security …

o Landreth Timber Test (USSC 1985) …
 Characteristics of Stock …
· (1) Right to receive dividends contingent upon apportionment of
profits;
· (2) Negotiability;
· (3) Ability to be pledged or hypothecated (i.e. freely transferable);
· (4) Conferring voting rights in proportion to number of shares owned;
· (5) Capital Appreciation.
o Application of the Landreth Timber Test to Robinson’s scenario:
 Court looked at these indicia of stock & deemed Robinson’s argument to b/c
Robinson’s interest looked more like a membership interest in an LLC than a
traditional stock.

o Hypotheticals –
o Assuming the facts in Robinson v. Glynn …
 (1) What if Glynn’s company was a corporation?
· Robinson’s interest would likely be classified as a stock (& therefore a security).
 (2) What if Glynn’s company was a general partnership?
· Robinson’s interest would likely not be classified as stock.
· Robinson’s interest would likely not be classified as an investment contract b/c the control rights
in a partnership will usually cut against the 3rd Prong of the investment contract test.
 (3) What if Glynn’s company was a limited partnership?
· Robinson’s interest would likely be classified as an investment contract b/c limited partners by
definition are passive investors.

(3) THE REGISTRATION PROCESS

o 1933 Securities Act, §5 –

o General Rule –
 Unlawful to sell or offer for sale securities in interstate commerce unless securities are registered with SEC.
· To register securities, the issuer must give the SEC extensive information about its finances &
business.
· When the SEC reviews a registration statement, it does not ask whether the security would be a
good investment.
o SEC asks whether the registration statement & the prospectus from the issuer contain the
disclosures required by the statute/SEC.
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 o SEC asks whether that information appears to be accurate.
o Specific Rules –
 (1) A security may not be offered for sale through the mails or by use of other means of interstate
commerce unless a registration statement has been filed with the SEC;
 (2) Securities may not be sold until the registration statement has become effective (i.e. SEC has approved
the disclosures made in the prospectus);
 (3) The prosepectus (a disclosure document) must be delivered to the purchaser before a sale.
o Consequences of Not Registering –
 Recission under §12 of the Securities Act.

o 1933 Securities Act, §4(2) –

o General Rule –
 The provisions of §5 shall not apply to transactions by an issuer not involving a public interest.
o Examples –
 Certain types of securities (i.e. US Government Securities);
 Certain types of transactions (i.e. private placements).

o Doran v. Petroleum Mgt Corp (5th Cir. 1977) ~

o Facts –
 Doran purchased an interest in a Limited Partnership (interests in LP’s usually are securities) from ∆-Corp.
 When Doran became unhappy with the business arrangement, he sued under Federal Securities Law
because the issuer never registered with the SEC (Doran, therefore, never received a prospectus).

o Issue –
 Was the issuing a public offering (subject to Registration) or a private placement (exempt from
Registration)?
o Rule –
 Private Offering vs. Private Placement –
· Ralston Purina Test …
o “Did the offerees need protection of the registration provisions of the 1933 Act or were
they able to fend for themselves?”
· 5th Circuit’s Four Factor Test …
o  Look at relationship illustrating knowledge of risk & benefits of the transaction:
 1st Factor = Number of offerees & relationship to each other & issuer.
o  Look at the indicators of private placement:
 2nd Factor = Number of units offered;
 3rd Factor = Size of offering;
 4th Factor = Manner of the offering.
o Holding –
 5th Circuit reversed the District Court’s conclusion that the investment was a private placement exempt
from the 1933 Act.
· Policy Reasoning …
o The court is concerned about the offerees.
 Sophisticated Investor = Investor understanding risks & rewards of investment
opportunity.
 5th Circuit disagreed with District Court’s holding that sophistication is critical
determination.
·  Sophistication means nothing without access to information.
o 1933 Act was meant to protect investors & protect the integrity of the market.
 “Purpose of Act was to protect investors by promoting full disclosure of information
thought necessary to informed investment decisions.”

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 ·  Thus, the critical inquiry is whether the investors in a private
placement have the same information at their disposal as investors
would have at a public offering.

o Anti-Fraud Provisions Applied to the Registration Process … Securities Act of 1933, § 11 –

o Purpose …
 §11 serves a DETERRENCE function.
o Scope …
 §11 reaches material misstatements or omissions in the registration statement.
 §12 reaches material misstatements or omissions outside of a registration statement.
o Cause of Action …
 §11 & §12 create express private rights of action.

o Escott v. BarChris (New York 1968) ~

o Facts –
 Π-Escott purchased a debenture (debt security) from ∆ & allege that there were material misrepresentations
and/or omissions on the registration statement.
o Issues –
 (1) Was the misstatement and/or omission a material one? (2) Was the ∆ entitled to any affirmative
defense?
o Rule –
 Securities Act of 1933, §11 … [Express Private Right of Action]
· Elements …
o (1) Material Misstatement or omission in a registration statement …
o (2) Proper Π …
 A person acquiring such security (purchased directly from the issuer or in a
chain issuance) without knowledge of the misrepresentation at the time of the
purchase has an express right of action.
o (3) Proper ∆ … Action can be brought against …
 (a) Any person who signed the registration statement;
 (b) Any director;
 (c) Any expert who prepared/certified part of registration statement (i.e.
accountants, engineers, appraiser, but not lawyers).
o (4) Affirmative Defenses …
 (a) Loss Causation … Capital Market declining & not traceable to misstatement
or omission.
 (b) Due Diligence … [See Below]
o (5) Remedy … Damages = (Price Investor Paid) – (Market Price w/ “proper”
information).

o Holding –
 (1) The registration statements listed material misrepresentations and/or omissions regarding its
erroneous listings of assets & liabilities.
· Definition of Material …
o  Information that average prudent investor ought reasonably to be informed about
before purchasing registered security.
 (2) Due Diligence Defense:
· Expertised Portion of the Registration Statement –
o Expert …
 A due diligence defense will succeed for an expert if the expert can show that he
reasonably believed after a reasonable investigation that the information is true .
o Non-Expert …
 A due diligence defense will succeed for a non-expert if the non-expert had no
reason to believe that the information (provided by the expert) is false.
· Non-Expertised Portion of the Registration Statement –
o Expert …
 Experts are entitled to a due diligence defense (and therefore incur no liability)
with respect to the non-expertised portion of the registration statement.
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 o Non-Expert …
 A due diligence defense will succeed for a non-expert if the non-expert can
show that he reasonably believed after a reasonable investigation that information is
true.
· SEC Rule 176 = Sliding Scale for the due diligence defense (varies by degrees with education,
position, etc.)

(4) SEC RULE 10B-5 –

o Note on Integrated Disclosure & Exchange Act Disclosures –

o Disclosure:
 Securities Act requires disclosure with respect to particular transactions (registers offerings).
 Exchange Act requires disclosures on certain companies (registers companies).
o Integrated Disclosure:
 In response to the substantial regulatory burden created by the overlap b/w the reports for the 2 acts, the
SEC adopted the modern disclosure system.
 What is filed with the SEC? … 10-K / 10-Q / 8-K

o In securities law, there is an implied private right of action under Securities Exchange Act §10(b) & SEC Rule 10b-5
…

o Securities Exchange Act §10(b) provides …

 In connection with the purchase or sale of securities, using jurisdictional means, it is unlawful to use or
employ any manipulative or deceptive device in violation of SEC Rules.

o SEC Rule 10b-5 …

 In connection with the purchase or sale of securities, using jurisdictional means, it is unlawful:
· (a) To employ any device to defraud;
· (b) To make material misstatements & omissions; OR
· (c) To engage in any act operating as a fraud or deceit.

o Types of Cases Covered Under §10(b) and Rule 10b-5 –

 Defective Corporate Disclosure (i.e.Basic Inc. v. Levinson);
 Insider Trading (i.e. SEC v. Texas Gulf Sulphur Co; Chiarella v. United States);
 Broker-Dealer (i.e Dirks v. United States);
 Customer Dealings.

o Elements of the Implied Private Right of Action under 10b-5 –

· (1) Material Misrepresentation/Omission (Total Mix ~ TSC Industries & Probability/Magnitude ~
Basic);
· (2) Scienter (intent to deceive, recklessness);
· (3) Reliance (Fraud-on-the-Market Presumption ~ Basic);
· (4) Causation;
· (5) Damages (Congress amended §21(d) of 1934 Act to allow SEC to seek civil penalty up to 3x
insider’s profits)
 Justice Rehnquist ~ “Rule 10b-5 is now a judicial oak which has grown from little more than a legislative
acorn.”

o Basic Inc. v. Levinson (USSC 1988) ~ [Defective Corporate Disclosure]

o Facts –
 Π’s (Max Levinson et al.) held shares in ∆-Corporation. Π’s brought the action after misleading statements
concerning a potential merger induced them to sell their shares at a depressed price.
o Issue –
 Did the Π’s rely on ∆’s statements & were those statements materially misleading?
o Holding –
 (1) Materiality …
· Total Mix Test ~
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 o TSC Industries v. Northway (USSC 1976) ~
 “Information is material if there is a substantial likelihood that the disclosure
of the omitted fact would have been viewed to an average reasonable investor
as having significantly altered the total mix of information available.”
· Court did not adopt ∆’s agreement-in-principle test …
o Agreement-In-Principle Test (3rd Circuit Test) –
 Merger discussions do not become material until agreement-in-principle as to the
price & structure of the transaction has been reached b/w the would-be merger
partners.
 By definition then, information concerning any negotiations not yet at the
agreement-in-principle stage could be withheld or even misrepresented w/o a
violation of Rule 10b-5.
o Court rejected the agreement-in-principle test because –
 “Disclosure and not paternalistic withholding of accurate information is the policy
chosen & expressed by Congress. We have recognized time and again, a fundamental
purpose of the various Securities Acts was to substitute a philosophy of full disclosure for
the philosophy of caveat emptor and thus to achieve a high standard of business ethics in
the securities industry.”
· Court adopted the probability/magnitude test –
o “Under such circumstances, materiality will depend at any given time upon a balancing of both the
indicated probability that the event will occur and the anticipated magnitude of the event in light of
the totality of the circumstances.”
  In this case, a merger bears a high magnitude on investor decisions &
therefore the probability of a successful merger does not have to be as absolute
as more trivial topics.
· Therefore, materiality depends upon the significance the reasonable
investor would place on the withheld or misrepresented information.
 (2) Reliance …
· Fraud on the Market Theory –
o Efficient Capital Market Hypothesis –
 “The fraud on the market theory is based on the hypothesis that, in an open &
developed securities market, the price of a company’s stock is determined by the
available material information regarding the company and its business . . .
Misleading statements will therefore defraud purchasers of stock even if the
purchasers do not directly rely on the misstatements. . . . The causal connection
between the ∆’s fraud and the Π’s purchase of stock in such a case is no less
significant than in a case of direct reliance on misrepresentations.”
o Presumption of Reliance is Created by the Fraud on the Market Theory –
 “An investor who buys or sells stock at the price set by the Market does so in reliance on
the integrity of that price. Because most publicly available information is related in the
market price, an investor’s reliance on public material misrepresentations may be
presumed for the purposes of Rule 10b-5.”
o Ways ∆ Could Rebut Presumption –
 (1) ∆’s could show market makers were privy to the truth & thus market was not
affected.
 (2) ∆’s could show that news credibly entered the market & dissipated effects of
the misstatements.
 (3) ∆’s could show that Π’s acted w/o relying on the integrity of the market.
· Dissent …
o Dissent does not like the fraud on the market theory because “for adopting a presumption
of reliance, the Court also assumes that buyers & sellers rely – not just on the market
price – but on the integrity of that price as well.”
o Santa Fe Industries, Inc. v. Green (USSC 1977) ~ [USSC draws line b/w Breach of Fiduciary Duty Claims & 10b-5 Claims]
o Facts –
 Π’s (Green et al.) were minority shareholders of Kirby Lumber Corporation.
 Π’s brought action to recover a greater share price after ∆-Majority Shareholder (Santa Fe Industries)
forced Π’s to sell their shares pursuant to Delaware’s Short-Form Merger Statute (DGCL § 253).
· Short Form Merger Statute: DGCL § 253 –

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 o A parent company owning at least 90% of the stock can merge with the subsidiary (upon
approval of the Board of Directors so long as you execute & file a certificate of
corporation by another corporation) & force the minority shareholders to sell their
shares.
 Minority Shareholders Rights?
·  No right to approve merger.
·  Appraisal Rights under DGCL § 262.
·  Must receive notice within 10 days after the merger.
·  No prior notice required.
 Federal Cause of Action … SEC Rule 10b-5
· Π’s allege Santa Fe obtained a fraudulent appraisal from Morgan Stanley & offered $25 above
the appraisal in order to lull the minority stockholders into erroneously believing they were being
generous.
· Π’s allege that this course of conduct was a “violation of Rule 10b-5 because ∆’s employed a
‘device, scheme, or artifice to defraud’ and engaged in an act, practice or course of business
which operates or would operate as a fraud or deceit upon any person, in connection with the
purchase or sale of any security.”
o  Claim boiled down to an allegation that Santa Fe squeeze them out as minority
shareholders.
 Alternatively …
· Π’s could have gone to the state courts of chancery pursuant to their appraisal rights under
DGCL 262.
o Issue –
 Where is the line drawn between claims of a breach fiduciary duty & claims of fraud pursuant to 10b-5 ?
o Rule –
 Securities Exchange Act §10(b) and SEC Rule 10b-5 prohibit conduct involving manipulation or deception
but are not so expansive as to necessarily govern incidences of fiduciary breach.
· Securities Act of 1934, §10(b) …
o It is unlawful for any person to use or employ any manipulative or deceptive device or
contrivance if contravention of SEC Rules.
· SEC Rule 10b-5 (promulgated by SEC under §10(b) of the Securities Act) …
o Prohibits, in addition to nondisclosure & misrepresentation, any artifice to defraud or
any act which operates or would operate as a fraud or deceit.
 Claim under 10b-5 is an Implied Private Right of Action ~ Cort v. Ash (USSC 1975).
· (1) Is the plaintiff a member of a class for whose special benefit the statute was enacted?
· (2) Any legislative intent to create or deny a private right?
· (3) Consistent with purpose of statute to imply a private right?
· (4) Is the cause of action one traditionally relegates to state law?
 *POINT OF THE CASE*
·  A claim of fraud & fiduciary breach states a cause of action under any part of Rule 10b-5
*ONLY* if the conduct alleged can be fairly viewed as “manipulative or deceptive” within the
meaning of the statute.
o Test for 10b-5 Violation = Manipulative/Deceptive
·  USSC delineates the scope of 10b-5.
o Holding –
 The ∆’s short-form merger (if carried out as alleged in the Π’s complaint) was neither deceptive nor
manipulative & therefore did not violate either §10(b) of the Securities Act or Rule 10b-5.
· (1) Precedent does not support the proposition that a breach of fiduciary duty by majority
stockholders (without any deception, misrepresentation, or nondisclosure) violates the §10(b) &
10b-5.
· (2) The language of §10(b) refers to manipulation & deception, and there is no evidence that the
legislature intended those terms be read expansively.
o Manipulation is a term of art generally referring to practices like …
 Wash sales, matched orders, or rigged prices intended to mislead investors.
 Artificially affecting market activity in order to mislead investors.
 Nondisclosure is usually essential to the success of a manipulative scheme.
o Police of Securities Act …

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  §10(b)’s general prohibition or practices deemed by SEC to be “manipulative”
is fully consistent with the purpose “to substitute a philosophy of full
disclosure.”
·  Corporate mismanagement, where essence of complaint is that the
shareholders were treated unfairly by a fiduciary, does not fall w/in
scope of §10(b).

o Insider Trading Rules –

o §10(b) – 10b-5 ... 3 Avenues to Find Liability for Insider Trading:

 (1) Classic Theory of Insider Trading (i.e. SEC v. Texas Gulf Sulphur )
·  Applies to –
o Insiders (employees, directors, and/or officers)
o Temporary Insiders (underwriter, accountant, lawyer or consultant who may become
fiduciary of shareholders in some situations ~ Dirks v. SEC, footnote 14).
·  Rule –
o Disclose or Abstain Rule.

 (2) Tippee Theory of Insider Trading (i.e. Dirks v. SEC)

·  Applies to –
o Outsiders trading on information received from an Insider
·  Rule –
o Tippee is liable when:
 [1] Tipper (insider) breaches fiduciary duty to shareholders by disclosing
material inside information to the tippee to realize some personal benefit;
AND
 [2] Tippee (outsider) knows or should have known there has been a breach (i.e.
tipper knows she received the information improperly).

 (3) Misappropriate Theory (i.e. United States v. O’Hagan)

·  Applies to –
o Outsiders trading on information misappropriated of material inside information.
·  Rule –
o A person commits fraud in connection with a securities transaction (and thereby violates
§10(b) & 10b-5) when he misappropriates confidential (material & inside) information
for securities trading purposes in breach of a duty owed to the source of the information.

o §14(e) – 14e-3(a) …
 Transactions in Securities on the Basis of Material, Non-Public (Inside) Information in the Context of
Tender Offers [Is Prohibited] –
· §14(e) of 1934 Act –
o In connection with a tender offer, it shall be unlawful to make material misstatements or
omissions or to engage in fraud.
· SEC Rule 14e-3(a) –
o 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 information obtained from offeror, issuer or any
officer, director, partner, or employee to either offeror.

o §16(b) …
 Directors, Officers, & Beneficial Owner & Short-Swing Profits In Context of Insider Trading–
· §16(b) of 1934 Act –
o Interesting Notes –
 16(a) requires insider reporting of transactions in equity securities.
 16(b) was intended to be the primary mechanism/weapon to combat insider
trading (but, over time, §10(b) – 10b-5 became the weapon of choice).
o Rule Language –
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  “Officers, directors, & beneficial owners (10%+ shareholders) must pay to the
corporation any profits they make, within 6 month period, from buying & selling .”
· Who is covered?
o  Officers, directors, & beneficial owners (10%+ shareholder)
· What is covered?
o  Insider Trading
· What is the remedy if a covered person engages in a covered activity?
o  Pay Corporation any profits made within a 6 month period.

o CLASSIC INSIDER TRADING PURSUANT TO 10B-5 –

o SEC v. Texas Gulf Sulphur (2nd Cir. 1968) ~ [Classic Insider Trading Scenario under 10b-5]
 Facts –
· Π (SEC) brought this suit against ∆ (Corporation & Directors) after ∆’s bought shares of Texas
Gulf while they secretly had positive information regarding mining activities carried out by Texas
Gulf, but sent out a misleading press release to calm the speculation.
 Issue –
· Did ∆’s engage in the practice of insider trading actionable under 10(b) – 10b-5?
 Rule –
· Definition of Materiality –
o In the context of historical context …
 Reasonable Investor & Total Mix Test … TSC Industries v. Northway (USSC 1976)
· “The basic test of materiality is whether a reasonable man would
attach importance in determining his choice of action in the transaction
in question.”
· “To fulfill the materiality requirement, there must be a substantial
likelihood that the disclosure of the omitted fact would have been
viewed by the reasonable investor as having significantly altered the
‘total mix’ of information made available.”
o In the context of an event that is contingent or speculative in nature …
 Probability & Magnitude Test … Basic Inc. v. Levenson (USSC 1988)
· “Material facts include not only information disclosing the earnings &
distributions of a company, but also those facts which affect the
probable future of the company and those which may affect the desire
of investors to buy, sell, or hold the company’s securities.”
· “Whether facts are material under Rule 10b-5 will depend at any given
time upon a balancing of both the indicated probability that the event
will occur & the anticipated magnitude of the event in light of the
totality of the company activity.”

· Insider Trading is Illegal & Actionable Under SEC Rule 10b-5 –

o What is the duty of an insider in possession of material, non-public (inside) information ?
  Classic Insider Trading Rule =
·  Applies to Insiders / Temporary Insiders
·  Disclose or Abstain Rule
o “Insider’s duty to disclose information or his duty to abstain
from dealing in the company’s securities arises only in those
situations which are essentially extraordinary in nature &
which are reasonably certain to have a substantial effect on
the market price.”

· “In connection with the purchase or sale of any security …” –

o This broad language means that …
 No contemporaneous trading by corporations is required to trigger a 10b-5
claim/violation.
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  SEC may bring cases under 10b-5 even when the insider/corporation has not
benefited from its deceptive practice.
 Holding –
· If an insider is in possession of material inside information, the insider may not trade in the
stock of his company, unless & until the insider makes the information publicly available.
o Where is the element of deception required pursuant to §10(b) – 10b-5?
 Deception = Acting on inside information breaches the trust to shareholders.
· (1) ∆-Individuals …
o Violation of Insider Trading pursuant to 10b-5.
· (2) ∆-Corporation …
o Violation of Insider Trading pursuant to 10b-5.

o TIPPER/TIPPEE THEORY OF INSIDER TRADING PURSUANT TO 10B-5 –

o In re Cady Roberts Co. (SEC 1961) ~

 SEC recognized a common law duty of corporate insiders to disclose inside information.

o Chiarella v. United States (USSC 1980) ~

 Facts –
· Chiarella was not an insider of the corporation, but rather an individual who was contracted for a
job and pieced together informational facts until he discovered a very useful slice of “inside
information.”
 Holding –
· The Court held that the duty to disclose (or abstain) does not arise from the mere possession of
material inside information.
· The Court held that the duty to disclose (or abstain) arises from the relationship of trust between a
corporation’s shareholders & its employees.
o Since there was no “relationship of trust” between the corporation’s shareholders whose
shares he traded, Chiarella was not an “insider” and had no duty to “disclose or abstain.”

o Dirks v. SEC (USSC 1983) ~

 Facts –
· ∆-Dirks was a stock broker who received material, inside information from insiders who wanted
Dirks to report the fraudulent practices occurring in their corporation.
· ∆-Dirks contacted the bureau chief at the WSJ & offered the information exposing the fraud, but
the WSJ declined to pursue the story.
· During this time, ∆-Dirks told investors & clients about the fraud & those investors & clients
reacted by selling their stake in the company.
· When the stock was being heavily traded, the stock price dipped from $26 to $15 & the NYSE
halted the trading, investigated, & found fraud.
 Issue –
· Can an outsider be found to have violated the rule against insider trading pursuant to §10(b)–
10b-5?
 Rule –
· Tippee/Tipper 2-Part Test –
o (1) As an insider, the tipper owes fiduciary relationship of trust to the corporation’s
shareholders.
 To satisfy the 1st Prong …

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 · The tipper must relay material, inside information to the tippee (an
outsider) to realize a financial/personal benefit, thus breaching the
relationship of trust to the shareholders.
o (2) As an outsider, the tippee owes no fiduciary duty/relationship of trust.
 To satisfy the 2nd Prong …
· Examine the Tippee’s knowledge …
o  If tippee knew or should have known of tipper’s breach …
 Tippee assumes Tipper’s breach & inherits the
duty to disclose or abstain. [10b-5 violation in play].
o  If tippee did not know nor should have known of tipper’s
breach …
 Tippee does not inherit a duty to disclose or
abstain. [10b-5 violation out of play].
 Holding –
· “The tipper’s received no monetary or personal benefit for revealing their corporation’s secrets, nor was
their purpose to make a gift of valuable information to ∆-Dirks. As the facts of this case clearly indicate, the
tippers were motivated by a desire to expose the fraud. . . . In the absence of a breach of duty to shareholders
by the insiders (tippers), there was no derivative breach by ∆-Dirks. . . . ∆-Dirks therefore could not have
been a participant after the fact in an insider’s breach of fiduciary duty .”
o USSC held that §10(b) should not be read so broadly as to hold outsider-tippees liable
when they use inside information received from insider-tippers who were not breaching
their fiduciary duties in their disclosure.
  USSC held that the insider-tipper must first breach a fiduciary duty
(relationship of trust) & then the outsider-tippee’s conduct will be examined to
determine if they inherited the duty.

o MISAPPROPRIATION THEORY OF INSIDER TRADING PURSUANT TO 10B-5 –

o United States v. O’Hagan (USSC 1997) ~

 Facts –
· O’Hagan was a partner of a law firm representing a tendering company, which was “buying
controlling shares at a premium” of a target corporation.
· Because of the nature of O’Hagan’s employment at his law firm, O’Hagan had access to material,
inside information belonging to the tendering company.
· O’Hagan was then charged with insider trading because he used the inside information regarding
the pending merger to buy call options for the tendering company. [When the tendering offer went
through, O’Hagan made $4.3M.]
 Issue(s) –
· (1) Whether ∆-O’Hagan violated §10(b)–10b-5 when ∆ traded on inside information?
 Rule –
· Traditional / Classic Insider Trading Test –
o §10(b)–10b-5 are violated when a corporate insider trades in securities of his corporation
on the basis of material, non-public (inside) information.
  Trading on such information qualifies as a deceptive device under §10(b)
because a relationship of trust & confidence exists b/w the shareholders of a
corporation & those insiders who have confidential information by reason of
their position with that corporation.
 That relationship gives rise to a duty to disclose [or to abstain from trading]
because of the necessity of preventing a corporate insider from taking unfair
advantage of uninformed stockholders.
 *Targets*
·  Corporate Insider’s breach of fiduciary duty to his corporation’s
shareholders.

· Misappropriation Test –
o The misappropriation theory holds that a person commits fraud in connection with a
securities transaction (and thereby violates §10(b)–10b-5) when the outsider
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 misappropriates confidential (material & inside) information for securities trading
purposes, in breach of a duty owed to the source of the information.
 *Targets*
· Integrity of the securities markets against abuses by outsiders to a
corporation – who have access to confidential information that will
affect the corporation’s security price when revealed – but who owe no
fiduciary duty to that corporation’s shareholders.
 *Deceptive Element*
·  A misappropriator who trades on the basis of material, non-public
information gains his advantageous market position through deception;
o He deceives the source of the information & simultaneously
harms members of the investing public.
 SEC Rule 10b5-2 provides non-exclusive list of 3 situations where a person
has a duty of trust/confidence for purposes of the misappropriation theory:
· Such a duty exists …
o (1) Whenever someone agrees to maintain information in
confidence; OR
o (2) Between 2 people who have a pattern or practice of
sharing confidences such that the recipient of the information
knows or reasonably should know that the speaker expects the
recipient to maintain the information’s confidentiality; OR
o (3) When someone receives or obtains material non-public
information from a spouse, parent, child or sibling.
 *Defense*
·  Although conceptually confusing & controversial, the USSC stated
that disclosure by the misappropriator to the source of the
information will cure the breach & preclude a 10b-5 claim.
 Holding –
· ∆-O’Hagan violated the §10(b)–10b-5 provisions by misappropriating inside information.

o §14(E) OF 1934 ACT & SEC RULE 14E-3(A): INSIDER TRADING PROHIBITION IN TENDER OFFERS –

o Language of Statute/Rule –
 §14(e):
· In connection with a tender offer,…
o It shall be unlawful to make material misstatements or omission or to engage in fraud,
deception or manipulation.
 SEC Rule 14e-3(a):
· If a tender offer has been commenced, …
o It is unlawful to purchase or sell securities on the basis of material inside information if
trader knows information obtained from offeror, issuer or any officer, director, partner,
or employee to either offeror or issuer.
 *Key Distinction* –
· §14(e)–14e-3(a) requires no demonstration of a breach of fiduciary duty in order to find a
party in violation of the rule.

o United States v. O’Hagan (USSC 1997) ~

 Issue –
· Whether SEC Rule 14e3(a) exceeds the SEC’s rule-making authority as granted by the 1934 Act?
 Holding –
· NO …
o The Chevron Doctrine makes it difficult to reject a rule promulgated by an administrative
agency because administrative regulations carry a presumption of validity.

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  “The SEC, cognizant of the proof problem that could enable sophisticated trades
to escape responsibility, placed in Rule 14e-3(a) a “disclose or abstain from
trading” command that does not require specific proof of a breach of fiduciary
duty. That prescription is a means reasonably designed to prevent fraudulent
trading on material non-public information in the tender offer context.”
o ∆-O’Hagan fell into the category defined in SEC Rule 14e-3(a) as an …
 “employee to the offeror.”

O §16(A) OF 1934 ACT: INSIDER TRADING & SHORT-SWING PROFITS –

o Language of Statute –
 16(a) ~ Requires insider reporting of transactions in equity securities.
 *16(b) ~ Intended to be the primary mechanism (weapon of choice) to prosecute insider trading violations.
· “Officers, directors, & beneficial owners (10must pay to the corporation any profits they make, within 6
month period, from buying & selling stock.”
o Who is covered by the rule?
 Officers, Directors, & beneficial owners (10% + shareholders)
o What activity is covered?
 Insider Trading
o What is the remedy if a covered person engages in a covered activity?
 Pay corporation any profits made w/in a 6 month period.

o Reliance Electric v. Emerson Electric (USSC 1972) ~

 Facts –
· ∆-Emerson bought 13.2% of Dodge’s Co., in a tender offer (for the purpose of taking control).
· ∆-Emerson’s tender offer did not result in a takeover; Dodge’s merge with Π-Reliance Electric.
· ∆-Emerson had no use for keeping 13.2% of a competitor, & therefore decided to sell.
o Sale #1 = ∆ sold 3.24% Sale #2 = ∆ sold 9.96%
 Rule –
· A company can split its sale of shares into more than one part to reduce their holdings under
the statutory minimum percentage of shares (10%) to reduce their liability under §16(b).
 Holding –
· USSC held that ∆-Emerson was not liable for the profits from the 2nd Sale.
o The fact that the ∆ split the sale intentionally to avoid liability on 2nd sale does not matter,
as long as the 2nd sale was not to the same person & separated from the 1st temporally.
  §16(b) is over- & under-inclusive because it does not turn on intent.

CORPORATE CONTROL & INDEMNIFICATION/INSURANCE

o Most states have detailed statutory provisions covering …

o The authority or obligation of a corporation to indemnify officers & directors …
 (1) For any damages they might incur in connection with their corporate activities; and/or
 (2) For any damages they might incur at the expense of defending themselves.

o DGCL, §145. Indemnification of officers, directors, employees & agents; Insurance ~

o (a) … Indemnification for 3rd Party Actions …

 Corporation may indemnify directors/officers/employees/agents … AGAINST expenses & judgments …
IF person acted in GOOD FAITH.

o (b) … Indemnification for Derivative Suits …

 Corporation may indemnify directors/officers/employees/agents … AGAINST expenses … IF person
acted in GOOD FAITH.

o (c) … Mandatory Indemnification …

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  If the director/officer/employee/agent is SUCCESSFUL on the MERITS … such person SHALL be
indemnified against expenses.

o (f) … Extra Indemnification by Contract …

 Indemnification rights are NOT EXCLUSIVE.

o (g) … Authorizes Insurance …

 Insurance is AUTHORIZED for directors/officers/employees/agents against liability arising out of status
w/ Corp.

o Waltuch v. Conti (2nd Cir. 1996) ~

o Facts –
 Π-Waltuch sought indemnification for unreimbursed legal expenses from his former employer (∆-Conti)
after Waltuch defended himself from investors & the CFTC for work performed while Waltuch was
working for ∆.
• 1st Suit = $1.2 Million of legal expenses in private lawsuits …
o Settled by Conti.
o Waltuch dismissed & no contribution.
• 2nd Suit = $1M of legal expenses in CFTC enforcement proceeding …
o Waltuch paid fine plus 6 month trading ban.
o Issues –
 (1) Does Article 9 of Conti Articles of Incorporation (contractual provision) override the good faith
requirement Section 145(a)?
 (2) Does DGCL section 145(c) permit reimbursement for Waltuch in the 1st Suit? What is “success on the
merits”?
o Holding –
 1st Holding …
• A corporation’s grant of indemnification rights cannot be inconsistent with the substantive
statutory provisions of §145, notwithstanding §145(f).
o The “consistency rule” provides that §145(f) merely acknowledges that one seeking
indemnification may be entitled to “other rights” of indemnification, but §145(f) does not
be read to free a corporation from the “good faith” limit explicitly imposed in §145(a)-
(b).
 In other words, indemnification rights may be contracted to be broader than
those set out in the statute, but cannot be contracted so that they become
inconsistent with the scope of the statute.
•  Thus, the contractual provision in the Conti Articles of Incorporation which omitted a good faith
requirement for indemnification did not override §145 provisions – Good Faith Requirement still exists.
 2nd Holding …
• §145(c) requires companies to indemnify officers when the officers were “successful on the merits.”
o Successful on the Merits = Vindication
 “In equating success with vindication, . . . vindication when used as a synonym for
‘success’ under §145(c), does not mean moral exoneration. Escape from an adverse
judgment or other detriment, for what ever reason, is determinative.”
• “Success” in criminal = Anything less that a conviction per charge.
• “Success” in civil = Anything less than paying.
•  Thus, once “Waltuch achieved his settlement gratis, he achieved success ‘on the merits or
otherwise.’ And, . . . success is sufficient to constitute vindication. Waltruch’s settlement thus
vidicuated him.” [Entitled to $1.2M].

CORPORATE CONTROL & SHAREHOLDER PROPOSALS

o Proxy –
o A written authorization given by shareholder for someone else (usually the company’s management) to cast his/her
vote at a share holder meeting or at another time.

o Proxy Statement –
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 o A document which the SEC requires a company to send to its shareholders that provides material facts concerning
matters on which the shareholders will vote.

o State Law –
o Statutory Law …
 DGCL, §212(b) permits the use of proxies.
• §211(b) requires annual meetings of shareholders for election of directors.
o Case Law …
 Common law exists detailing the legality of strategically using proxies & cost reimbursement in proxy
contests.

o *Federal Law* –

o §14(a) of the 1934 Act –

 Requires proxy solicitations for reporting companies to comply with SEC Rules.
• SEC rules require:
o Disclosure to accompany proxy solicitation;
o Specification as to form of proxy card;
o Prior filing & review of proxy statement & proxy card;
o Prohibition of false/misleading proxy solicitations.

o SEC Rule 14a-5 – Shareholder Proposal Rule –

 Definition …
• “If any security holder of an issuer notifies the issuer of his intentions to present a proposal for
action at a forthcoming meeting of the issuer’s security holders, the issuer shall set forth the
proposal in its proxy statement & identify it in its form of proxy and provide means by which
security holders [presenting a proposal may present in the proxy statement . . . in support of the
proposal].”
o Proposal is a recommendation/requirement that the company & board of directors take
action.
 The proposal is to be presented at the meeting of the company’s shareholders.
o Company must include information in the proxy statement & identify it in form of proxy
subject to procedural limitations.

o SEC Rule 14a-8 – Exceptions to Shareholder Proposal Rule –

 (1) Improper under state law
 (2) Violation of Law
 (3) Violation of Proxy Rules
 (4) Personal Grievance / Special Interest
 (5) Relevance**
 (6) Absence of Power/Authority
 (7) Management Functions
 (8) Relates to Election
 (9) Conflicts with Company’s Proposal.
 (10) Substantially Implemented
 (11) Duplication
 (12) Resubmissions
 (13) Specific Amount of Dividends.

o **Remember … In General, Shareholders’ Activity is Rather Limited –

o 3 Major Shareholder Activities:
 (1) Vote on the Board of Directors;
 (2) Vote on major transactions (i.e. mergers);
 (3) Propose Items for the Agenda at Meetings [SEC RULE 14a-8].
•  Trend is to propose environmental issues & other socially conscious items relating to business
activities.

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o Lovenheim v. Iroquis Brands (DDC 1985) ~ [Shareholder Proposal Case] ~
o Facts –
 Π-Lovenheim sought a preliminary injunction against ∆-Iroquoi Brands in order to insert information in a
proxy statement regarding whether the geese liver pate the corporation supplied force fed the geese in an
unduly cruel manner.
o Issue –
 Whether a company could refuse a shareholder proposal for a proxy statement if the proposal concerned
less than 5% of the business sales and if the proposal was not economically based? [Does the exception to
14a-8 apply in this case to omit Π’s information?]

o Rule –
 SEC Rule 14a-8 –
• “Issuer shall set for the proposal in its proxy statement & identify it in its form of proxy …”
 Exception under SEC 14a-8([i])(5) …
• An issuer of securities may omit a proposal from its proxy statement on relevance grounds …
o “If the proposal …
 [1] Objective Economic Element –
• “ … relates to operations which account for less than 5% of the
issuer’s total assets at the end of its most recent fiscal year, and for less
than 5% of its net earnings & gross sales for its most recent fiscal
year”
AND
 [2] Subjective Policy Significance Element –
• “ … is not otherwise significantly related to the issuer’s business.”
o Holding –
 The Court held that “in light of the ethical & social significance of the Π’s proposal and the fact that it implicates
significant levels of sales, the Π has shown a likelihood of prevailing on the merits with regard to the issue of whether
his proposal was “otherwise significantly related.”
•  SEC said that the applicability of the exception to exclude shareholder proposals from proxy
statements should NOT HINGE SOLELY on the ECONOMIC RELATIVITY of the proposal.
o  Therefore, shareholder proposals would likely survive the exception to §14a-8 if the
proposal has an “ethical or moral concern” relating to the business activities, even if the
proposal was not substantially related to economic concerns.
  Moreover, a proposal could be “otherwise significantly related to the issuer’s
business” for non-economic reasons.

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