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Agency
Key Feature of Agency

Welcome to Law of • Agency acts to promote principal’s best interest, not her own selfish
best interest.

Business Entities First-Year Curriculum (which no longer includes Agency)

• Fundamental Structure of Capitalism: Very cold harsh place.
• Question: Where does acting as group show up?
• Common ownership of property.
• Conspiracy (Joint tortfeasors)

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Conspiracy
Two Key Features of Conspiracy (Criminal Analog of Partnership)
• Vicarious liability
• Relaxed actus reus standard.

Question Role of Business

• Why is government so worried about conspiracy?

Question
• How many “made” members of NYC (city of 8 million) 5 crime
families?
• How many “made” member of Philly crime family?

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A.P. Smith Mfg. Co. v. Barlow Alternative Facts

• Facts: Rich CEO gives corporate money to
Princeton.
• Issue: Is this use of corporate funds okay?
• Facts: Rich CEO gives corporate money to St. Jude (children’s
hospital). Is this okay?
• Facts: Rich CEO gives corporate money to Planned Parenthood (pro-
choice advocacy group). Is this okay?
• Facts: Rich CEO gives corporate money to National Right to Life (pro-
life advocacy group). Is this okay?

• Facts: Rich CEO gives corporate money to his buddy, Chip. Is this
okay? Do you need to know more about Chip?

• Facts: Rich CEO “gives” corporate money to his bank account. Is this
okay?

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Relevant Considerations? Two Primary Views of Corporation

• Does your answer depend upon effect on stock price?
• Does your answer depend upon effect on social welfare? What if
increase comes at expense of stock price?
• Does it matter whether CEO has shareholder approval?
• Shareholder Model: Primary obligation of corporation is to maximize
shareholder wealth.
• Stakeholder Model: Obligations owed to other stakeholders (e.g.,
employees, suppliers/customers, creditors, and local communities)
should all be held in equal importance to shareholder returns.

• Big Picture Question: What is the CEO paid to do? Act in the best
interests of firm? What does that mean? Do best interests mean
those of shareholders? All corporate stakeholders? Society at large?

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Key Stakeholders Stakeholder Model

Core stakeholders include:
• Employees
• Customers
• Suppliers
• Investors
• Creditors
• Community
• Environment

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Stakeholder Model Other Models of Corporate Purpose

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Triple-Bottom Line An Obvious Critique

Corporation must be assessed, not just according to profits and • Question: How do you balance competing demands of
dividends, but according to triple bottom line: stakeholders?
• Profits
• Mathew 6:24: No man can serve two masters: for either he will
• Impact on people hate the one, and love the other; or else he will hold to the one,
and despise the other.
• Impact on planet
• One virtue of shareholder primacy is its clarity: CEO knows exactly
what to do.

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Is This All Theoretical Nonsense?

• Hypothetical: Corporation A acquires Corporate B only to acquire its
proprietary intellectual property. Upon acquiring this asset,
Corporation A liquidates Corporation B’s assets and fires all B’s at-
will employees.
AGENCY
• Have either of corporation’s CEOs done something wrong? Legally?
Morally?
RELATIONSHIPS
• Which stakeholder are you in this transaction?

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Agency Agency Relationships

• One of most common, important, and pervasive legal
relationships is that of agency.

• Agency Relationship: One party (agent) is authorized (and

agrees) to represent or act on behalf of another
(principal).

• Principal has right to control agent’s conduct in matters

entrusted to agent.

• Agency is form of delegation.

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Critical to Business Operations Source of Agency Law

• Agency relationships are crucial in business world. • States have not codified general principles of agency.

• By using agents, principal can conduct multiple business • Restatements of Agency: ALI has published 3
operations at same time in different locations. Restatements of Agency.

• Only way certain business entities can function is through • Restatement (Second) denote R-2
agents.
• Restatement (Third) denote R-3.

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Three Primary Agency Costs in Corporate

Economic Definition of Agency Cost Law
• Agent is given powers to make decisions on behalf of • Shareholders vs. Management
principal.

• Parties have different incentives. • Shareholders vs. Bondholders

• Information Economics: Principal cannot directly ensure • Majority Shareholders vs. Minority Shareholders
that agent is acting in principal’s best interests (because
monitoring/bonding is costly).

• Example: Moral Hazard, Proverbial Corporate Jet

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Separation of Ownership & Control Jensen & Meckling (1996)

• Shareholders want to • Thesis: Agency costs arise from separation of ownership
maximize shareholder (shareholder-principals) and control (management-agents)
value, while management
may sometimes make
decisions that are not in • Solution: High-powered incentive contracts (e.g., stock
best interests of option plans)
shareholders (i.e., those
that benefit themselves). • Evidence: Performance of companies taken private (in
LBO) improved significantly.

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Hourly Fee Contingency Fees

Attorney Objective Function • Contingency Fees: Fees charged for attorney’s services
wxH only if lawsuit is successful (or is favorably settled out of
where w = hourly wage, H = hours. court).

• Calculated as percentage of client’s net recovery (fees as

Client Objective Function
high as 33% to 45% of final recovery are considered
pxR–wxH reasonable).
where p = probability of success, R = remedy.

Upshot: Attorney cares only about billable hours, and not

whether case is won or lost. 25 26

25 26

Contingency Fees
Attorney Objective Function:
γ x (p x R)
where γ = contingency fee percentage, p = probability of
success, and R = remedy
Creation of Agency
Relationship
Client Objective Function:
(1 – γ) x (p x R)

Upshot: Attorney and client incentives are better aligned;

both now have stake in outcome of litigation.
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Agency Defined Agency by Agreement

R-3 §1.01 Agency Defined
• Agency is fiduciary relationship that arises when one
person (principal) manifests assent to another person
(agent) that agent shall act on principal’s behalf and
subject to principal’s control, and agent manifests assent
or otherwise consents so to act.
Two Steps
Creation of agency relationship by agreement necessarily
involves 2 steps:
• Principal must “manifest assent” that agent will act on
principal’s behalf.
• Agent must “manifest assent or otherwise consent” to act

as agent for principal.

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Objective Standard Consent Through Conduct

• Objective Standard: To determine consent, law looks to Example:
outward manifestations, not subjective intent. • Larry, owner of Mocha Joe, writes to Jerry: “Please act as

my broker to sell Mocha Joe.”

• Conduct: Given objective standard, party’s conduct can • Jerry puts “For Sale” sign outside of Mocha Joe.
constitute evidence of consent. • Jerry has manifested necessary consent through conduct.

• Implication: 2 parties can create agency relationship even

if neither has subjective desire to do so.

.
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Control
• Control: To create agency relationship, reciprocal consent
must include understanding that principal is in control of
relationship.
Fiduciary
• Control need not be total or continuous and need not
extend to manner in which agent performs.
Relationships
• At minimum, principal must have right to control objective
of relationship.

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Fiduciary Relationships Agent’s Fiduciary Duties

• Fiduciary Relationship: Special relationship based on trust Agent owes following 5 fiduciary duties to principal:
and confidence that gives rise to certain fiduciary duties • Performance
depending on type of fiduciary relationship that exists. • Notification

• Loyalty
• Agency relationship is type of fiduciary relationship
characterized by specific fiduciary duties owed by agent • Obedience
and principal. • Accounting

• Student Tip: Keep this slide in mind when we discuss

insider trading.
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Fiduciary Duties of Agent Performance: Duty of Care

• Implied condition in every agency relationship is agent’s
agreement to use reasonable diligence and skill in
performing work.

• Due Care: Degree of skill or care required of agent usually

is that expected of reasonable person under similar
circumstances.

• If agent has represented herself as possessing special

skills, however, then agent is expected to exercise degree
of skill claimed (What does this remind you of?).
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Notification
• Agent is required to notify principal of all matters that
come to her attention concerning subject matter of
agency.
• In general, law assumes that principal is aware of any
information acquired by agent that is relevant to agency—
regardless of whether agent, in fact, passes on
information to principal.
Loyalty
• Agent has duty to act solely for benefit of principal and
not in interest of agent or third party.
• Any information or knowledge acquired through agency
relationship is confidential (e.g., trade secrets and
customer lists compiled by the principal).
• Breach of loyalty to disclose such information either
during agency relationship or after its termination.

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Obedience Accounting
• When acting on behalf of principal, agent has duty to • Unless agreed upon otherwise, agent must keep and make
follow all lawful and clearly stated instructions of available to principal account of all property and funds
principal. received and paid out on principal’s behalf.

• Any deviation from such instructions is violation of this • Agent has duty to maintain separate account for
duty (except during emergency situations when the principal’s funds and must not intermingle funds with
principal cannot be consulted). agent’s personal funds.

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Principal’s Fiduciary Duties Fiduciary Duties of Principal

Principal has fiduciary duties to agent relating to:
• Compensation

• Reimbursement & Indemnification

• Cooperation

• Safe working conditions

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Compensation
• Principal has duty to pay agent for services rendered and
to pay that compensation in timely manner.
• Principal must pay agreed-on value for agent’s services.
• If no amount has been expressly agreed on, then principal
owes agent customary compensation for such services.
Reimbursement
Principal has duty to reimburse agent:
• Whenever agent distributes funds at request of principal
• For any necessary expenses incurred in course of
reasonable performance of agency duties.

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Indemnification (Loss Shifting) Cooperation

• Principal has duty to indemnify (reimburse) agent for • Principal has duty to cooperate with agent and to assist
liabilities incurred while performing agency duties. agent in performing her duties.

• Duty of indemnification also applies to agent's liabilities • Principal must do nothing to prevent that performance.
incurred as a direct result of authorized agency duties.

• If agent’s actions result in third-party bringing cause of

action against agent (e.g., breach of contract), then
principal will be responsible for any losses agent suffers in
defense of that lawsuit, including damages awarded to a
third-party. (Does this sound familiar?)
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Safe Working Conditions

• Common law requires principal to provide safe
working premises, equipment, and conditions for
all agents and employees. Relationship to
• Principal has duty to inspect working areas and to Contract Law
warn agents and employees about any unsafe
conditions.

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Not Contractual Relationship Nature of Cause of Action

• Agency is not subcategory of contract law: not all bilateral • Question: Can agency relationship exist WITHOUT
relationships belong to law of contract. contract?

• Although agents and principals often superimpose • Answer: YES.

contracts on top of agency relationship, agency
relationship is not contract. • Question: If so, does claim sound in tort or in contract?

• Answer: Breach of fiduciary duty sounds in tort: agency is

not dependent upon existence of contractual relationship.

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Nature of Cause of Action Agency vs. Contract

• Question: Can agency relationship exist WITH contract?
• Answer: YES.
Counterparties in Contract
• Both parties operate in their own self-interests.
• Parties are subject only to duty of good faith and fair dealing.
• Zero-sum (with respect to cooperative surplus)

• Question: If so, does claim sound in tort or in contract? Counterparties in Agency

• One counterparty (agent) operates in best-interest of other
• Answer: BOTH. Breach of fiduciary duty sounds in tort counterparty (principal).

and breach of contract sounds in contract. • Parties are subject to fiduciary duties.

Student Tip: Recall that these are not mutually exclusive relationships.
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Agency Law as Gap-Filler

Agency law fills in gaps in contract.

Agency Law
Some Theory
Contract

Question: Why would contract have gaps (or be incomplete)?

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Impossibility Doctrine Contract Law as Gap-Filler

• Impossibility Doctrine: Defense that can be used as • Suppose there was no impossibility doctrine or courts
excuse for non-performance when unforeseen event adopted balancing test.
occurs (after the contract is made) that makes
performance impossible. • Question: How can contracting parties make sure that A
bears this risk of loss?
• Example: A promises to fully renovate B’s house in
exchange for $100K. B’s house burns down. • Answer: State so in contract.

• Default Rule: Impossibility Doctrine provides default rule

• In Non-Plain English: Doctrine shifts risk of loss onto A. that governs (unless contract says otherwise), saving
contract parties costs of having to draft rule themselves.
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Is This All Theoretical Nonsense? Mandatory vs. Default Rules

• “Parties can, however, contract around the impossibility • Mandatory Rule: Parties cannot alter (e.g., duty of
doctrine, because it is just a gap filler.” loyalty).
• Wis. Elec. Power Co. v. Union Pac. R.R. Co., 557 F.3d 504, 506
(7th Cir. 2009)
• Default Rule: Parties can contract around by agreement of
the parties (e.g., duty of care).
• “The doctrine of impossibility is an ‘off-the-rack’
provision that governs only if the parties have not drafted
a specific assignment of the risk otherwise assigned by • Tort Law Review: Where in your tort class did you see
parties attempting to contract around tort liability?
the provision.”
• Commonwealth Edison v. Allied-General Nuclear Servs., 731 F.
Supp. 850, 855 (N.D. Ill. 1990)
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Hypothetical
• Hypo: Suppose Bunting has foolishly signed employment
contract with no wage term.

• Question: Is Bunting screwed? LIABILITY IN AGENCY

• Answer: Under agency law, principal has fiduciary duty to
RELATIONSHIPS
pay reasonable value for agent’s services (duty of
compensation).

• Comment: Contract could specifically state that Bunting is

to work on voluntary basis (i.e., for no wage). 61

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Liability in Agency Relationships

• Question: Which party—principal or agent—should
be held liable for:
o Contracts: Contracts formed by agency,
o Torts: Torts and crimes committed by agent.
CONTRACT

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Two Separation Questions

When agent enters contract on behalf of principal:
• Is principal bound by that contract?

• Is agent bound as party to that contract? PRINCIPAL’S LIABILITY

IN CONTRACT

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Is Principal Bound by Contract?

• General Rule: Principal is obligated to perform under
contract only if agent acts with authority (has authority to
enter contract).

• Logical Equivalent: If agents acts without authority, then Authority

principal is not obligated to perform under contract.

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Types of Authority
Agent’s authority can be either:
• Actual (Express or Implied)

• Apparent

• Inherent
Actual

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Actual Authority Creation of Actual Authority

R-3 §2.01. Actual Authority R-3 §3.01. Creation of Actual Authority
• Agent acts with actual authority when (at time of taking • Actual authority is created by principal’s manifestation to

action that has legal consequence for principal) agent agent that (as reasonably understood by agent) expresses
reasonably believes, in accordance with principal’s principal’s assent that agent take action on principal’s
manifestations to agent, that principal wishes agent so to behalf.
act.

• Plain English: I am doing what I believed you wanted me

to do.

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Creation of Actual Authority
• Creation of actual authority requires:
o Objective manifestation by principal
o Followed by agent’s reasonable interpretation of that
manifestation
o Which leads agent to believe that agent is authorized to
act for principal.
• Standard requires agent’s belief be reasonable (objective
standard) and that agent, in fact, hold this belief
(subjective standard).
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Hypothetical
Hypo
• P, photographer, employs A as business manager.
• P authorizes A to endorse and deposit checks P receives
from publishers of photographs taken by P.
Questions
• Does A have actual authority to endorse and deposit check
from T, magazine publisher, made payable to P?
• To enter into purchase agreements on behalf of P?
• To release claims that P has against TP?
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Hypothetical
Hypo:
• Epstein (principal) tells his chauffeur, Freer (agent), to
have car serviced at Roberts Service Station (third-party).
• Freer takes car to Roberts for servicing.
Question:
• Is Epstein obliged to pay for service?
• Answer: YES. Freer had actual authority to bind Epstein
to deal.
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Scope of Actual Authority
R-3 §2.01. Scope of Actual Authority
• Agent has actual authority to take:
o Actions (1) designated or (2) implied in principal’s
manifestations to agent, and
o Incidental Authority: Acts necessary or incidental to
achieving principal’s objectives.
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Example: Power of Attorney
• Agent who holds power of attorney is called attorney-in-
fact for principal (of course, agent need not be attorney-
at-law).
• Power of attorney is written document and usually
notarized.
• Power of attorney can be (1) special (permitting agent to
perform specific acts only), or (2) general (permitting
agent to transact all business for principal).
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Hypothetical
• Hypo: Shepherd asks his assistant to make travel
arrangements for him to attend law professor conference.
Although Shepherd does not say anything specifically
about airline reservations, his assistant makes such
reservations for him.
• Does assistant have actual authority to make purchase for
Shepherd?
• Answer: Yes, making airline reservations is within scope of
assistant’s actual authority as it is incidental to achieving
Shepherd’s objective of attending law conference. 78
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Hypothetical Types of Actual Authority

• Hypo: Shepherd slams pamphlet about upcoming law Actual authority can be either:
professor conference on desk of his assistant. Although • Express, or
Shepherd does not say anything specifically about wanting
• Implied
to attend this conference, Shepherd has attended every
year for the last 15 years and each time his assistance has
made travel arrangement for him to attend.

• Does assistant have actual authority to make travel

arrangements for Shepherd?

• Answer: Yes, actual authority is implied.

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Express Actual Authority Implied Actual Authority

• Express Actual Authority: Authority declared in clear, • Implied Actual Authority: Authority that can be gleaned
direct, and definite terms, orally or in writing. from reasonable inferences with respect to principal’s
conduct, position, or even inaction.

• Implied authority refers to agent’s power to act on behalf

of principal without express authorization from principal.

• Incidental authority is type of implied actual authority.

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Note on Terminology
• Some courts (erroneously) refer to apparent authority as
implied authority.

• Implied authority is type of actual authority.

Apparent

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Apparent Authority Key Distinction

R-3 §3.01. Apparent Authority
• Apparent authority is power held by agent (or other actor)
to affect principal’s legal relations with third party when:
• Third party reasonably believes actor has authority to
act on behalf of principal, and
• That belief is traceable to principal’s manifestations.
• Actual authority (express or implied) arises from what
principal makes clear to agent.
• Apparent authority arises from what principal causes
third-party to believe regarding agent’s authority.

• Authority that is only apparent, not real.

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Creation of Apparent Authority Notable Modes of Manifestation

• Apparent authority exists when: • Through Intermediaries
o One party (“apparent principal”) makes manifestation,
• By Position
which
• By Acquiescence
o Somehow reaches third-party, and

o Which alone or (more often) in context of other

• By Inaction
circumstances causes third-party to reasonably believe
that another party (“apparent agent” is authorized to
act for apparent principal.

• Apparent and actual authority are not mutually exclusive

and coexist. 87 88

87 88

Hypothetical Joey Hypothetical

Hypo: • Joey brings his broken watch to Jill, a watch-repair
merchant. Jill enters sales contract with Bunting in which
• Epstein (principal) tells Roberts (third-party), who runs
Jill agrees to sell watch to Bunting.
Roberts Service Station, that Freer is Epstein’s agent for
having car serviced.
• Question: Does Jill have apparent authority?

Questions: • Answer: Trick question. No agency relationship here, only

• Does Freer have apparent authority? contractual relationships (Joey-Jill, Bunting-Jill).
• What if Epstein had privately told Freer that Freer had no

authority to get car fixed? • Question: Why is law firm unable to publicly incorporate?
What is agency cost problem here?
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Important Exam/Bar Tip

• Looking Ahead: As agents of partnership, partners have
apparent authority to bind partnership to any contract
within scope of partnership business.

• If contract is outside scope of partnership business, then Inherent

partnership generally will not be bound UNLESS partner
had actual authority.

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Inherent Authority Hypothetical

• Inherent Authority: Authority that arises from
relationship between parties itself.
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• Hypo: Shepherd is president of XYZ Corporation.
• In that capacity, Shepherd signs contract that obligates XYZ
Corporation to buy ordinary supplies from TP.
• Shepherd did not have actual authority to do this.
• Neither did he have apparent authority, because corporation
made no manifestation to TP that Shepherd could bind it.
• Rather, corporation is bound on contract because Shepherd, as
president, had inherent agency power to bind it.
• Generally, corporation’s president has authority (by virtue of
being president) to bind company to contracts in ordinary
course of business.
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Restatement Third Approach Question About Law

• R-3 abolishes concept of inherent authority.
• R-3 expands notion of what constitutes “manifestation by
principal to third-party,” which broadens scope of
apparent authority.
• Question: How do you hold corporation liable on contract
with third-party under R-3 approach?
• Answer: Apparent Authority. Corporation manifested to
third-party (by giving Shepherd title of president) that
Shepherd had authority to bind corporation to deals in
ordinary course of business.

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Is Agent Bound as Party to Contract?

Liability for contracts formed by agent depends on:

• Authority: Whether agent acted with authority,
AGENT’S LIABILITY and

IN CONTRACT • Type of Principle: Whether principal is (1)

disclosed, or (2) undisclosed.

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Without Authority Remedies Against Unauthorized Agent

• General Rule: If agent enters contract on behalf of
principal acting without authority, then agent is obligated
to perform under contract.
• Recall that principal is not obligated to perform under
contract (i.e., agent cannot bind principal to contract
without authority to do so).
• Example: Bunting stupidly attempting to bind Stetson Law
to some cockamamie real estate deal.
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R-3 §6.10 Agent’s Implied Warranty of Authority
• Person who purports to make contract with third-party on
behalf of another person lacking power to bind that person
gives implied warranty of authority and is subject to liability
to third party for damages for loss caused by breach of that
warranty (including loss of benefit expected from performance
by purported principal).
• Plain English: Third-party gets to sue agent for expectation
damages, and not just rescission of contract.
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Principal Does Not Exist With Authority

R-3§6.04 If agent acted with authority, then next determine whether
• Person who makes contract with third-party purportedly principal was:
as agent on behalf of principal becomes party to contract • Disclosed
if purported agent knows that purported principal does • Undisclosed
not exist.
Student Tip: Let’s not worry about unidentified principals in
this course (or on state bar).

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Disclosed Principal Undisclosed Principal

R-3§ 6.01. Agent for Disclosed Principal R-3§ 6.03. Agent for Undisclosed Principal
• If agent acting with authority makes contract on behalf of • If agent acting with authority makes contract on behalf of

disclosed principal, then agent is not party to contract. undisclosed principal, then agent is party to contract.

• Example: Sprint employee paid to get prospective • Rationale: Basis for treating agent as party to contract is
customers to sign cellphone contracts. expectation of third-party: agent has dealt with third party
as if agent were sole party whose legal relations would be
affected by contract.

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In Pictures Illustration
• T enters contract with A in which A promises to manage
T’s investment portfolio.
Without Authority With Authority
• A does not disclose that A makes contract on behalf of P.

Agent • P offers to manage T’s portfolio.

Disclosed Undisclosed
• T is free to reject P’s offer of performance and insist upon
performance by A.
Principal Principal or Agent
• T has substantial interest in receiving investment-
105
management services from A. 106

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Disney Example
• Question: Would seller of land be bound by contract in this
circumstance?

• Answer: Third party cannot void contract merely because Pair-&-Share

third-party contracted with agent.
Problems 0
• There might be some other type of misrepresentation that
seller can rely on to void contract.

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107 108

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Hypothetical Hypothetical
Hypo: Hypo:
• Carhart hires Agee as cook and tells her that part of job • After several months, it becomes clear that Agee has been

will be to order food for restaurant. ordering too much food.

• Agee does so by ordering meat and veggies and other • Carhart instructs Agee to reduce food purchases from TP
essential ingredients for business from TP, telling TP that from $2,200 a month to $1,000 a month.
she is ordering food for Carhart. • Despite this clear instruction, for next month, Agee orders

• TP delivers food to Carhart. $2,200 of new food from TP.

Question: Question:
• Is Carhart legally obligated to pay for food? • Is Carhart legally obligated to pay $2,200 to TP?

• Is Agee legally obligated to pay for food? 109 • Is Agee legally obligated to pay $2,200 to TP? 110

109 110

Apparent Authority by Inaction

• In limited circumstances, apparent principal’s inaction
might constitute manifestation.

• In these circumstances, apparent principal’s silence

Creation of
constitutes manifestation known to third-party (Really?)
Agency
• This factual circumstance is better dealt with through
doctrine of agency by estoppel.

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Creation of Agency Relationship

Agency relationship is created by:
• Agreement (Express or Implied)

• Estoppel, or
Agency by
• Ratification by Principal.
Estoppel

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Agency by Estoppel Apparent Authority vs. Estoppel

R-3§ 2.05 Estoppel to Deny Existence of Agency Relationship
Person, who has not made manifestation that actor has authority
as agent, is subject to liability to third party who justifiably is
induced to make detrimental change in position because
transaction is believed to be on that person’s account if:
• Action: Person intentionally or carelessly caused such belief, or
Similarity
• Both doctrines focus on principal creating impression that
putative agent might act on her behalf.
Differences
• Estoppel does not require manifestation of authority to

• Inaction: Having notice (including constructive notice) of such
belief and that it might induce others to change their
positions, person did not take reasonable steps to notify them
of facts.
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third-party—instead, principal must have contributed to
(or failed to dispel) third-party’s belief that one is agent of
principal.
• Estoppel requires showing of detrimental reliance by
third-party—apparent authority does not. 116

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Hypothetical: Agency by Estoppel Hypothetical: Agency by Estoppel

• Hypo: Vanek, Azur’s personal assistant, took unauthorized • Azur is estopped (or prevented) from arguing that Vanek
cash advances from Azur’s credit card account with Chase did not have authority to withdraw funds from his credit
Bank over a 7-year period. card account.

• Azur finally discovers this, fires Vanek, and closes credit • What is impact on banking sector if court rules other way?
card account.

• Question: As Azur’s attorney, what do you argue?

• Vanek did not have authority to withdraw funds from his

Chase Bank account.
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Equity Gap-Filler
• Agency by estoppel is rare.

• Rationale: Agency by estoppel allows courts to prevent

injustice when asserted principal’s inaction cannot serve
Agency by
as manifestation.
Ratification

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Ratification Defined Ratification in Plain English

R-3§ 4.01
• Ratification is affirmance of prior act done by another,
whereby act is given effect as if done by agent acting
with actual authority.
• Ratification is effective immediately even if fact of
ratification is not communicated to third-party or agent.
• If agent acts without authority, then principal can bind
herself to contract if principal ratifies transaction.
• Ratification: Principal’s ex post facto approval of
transaction.
• Example: Stetson thinks Bunting’s real estate deal is not so
crazy after all and decides to proceed forward with deal.

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121 122

Manner of Ratification Evans vs. Ruth: Facts

Purported principal ratifies an act by either:
• Express Ratification: Making manifestation that (viewed
objectively) indicates choice to treat unauthorized act as
authorized (e.g., Stetson tells Bunting’s contract
Facts
• Principal had contract with State to provide crushed stone
for use in highway construction.
• Principal’s foreman, without authority, hired Company to

counterparty that they want to proceed with deal), or haul stone to construction site.
• Principal had received “weigh slips” from Company, which
• Implied Ratification: Engaging in conduct that is justifiable Principal submitted to State for payment.
only if purported principal has chosen to treat
unauthorized act as authorized (e.g., Stetson sends check
in amount of purchase price to Bunting’s contract
counterparty). 123 124

123 124

Evans vs. Ruth: Holding Hypothetical

Holding: Hypo:
• Principal was liable to pay Company for transportation.
• Cook calls local newspaper and tells advertising director that she
is running restaurant for its owner, Carhart (which is not true).
Rationale: • Cook places series of 4 full-page ads for restaurant with
• Having accepted benefit of what Company had done,
newspaper. Carhart is aware of these facts.
Principal impliedly ratified deal between foreman (agent)
and Company (third-party). Question:
• Is Carhart liable to newspaper for advertisements placed by
Cook?
• Answer: YES. By accepting benefit of advertising (conduct)
BEFORE asserting problem exists, Carhart has implied ratified
125 deal Cook struck. 126

125 126

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Undisclosed Principal Elements of Ratification

• Ratification by undisclosed principal does not eliminate
agent’s liability to third party on transaction because agent
for undisclosed principal has such liability when acting with
actual authority.
• Effect of ratification is to treat agent as though agent had
actual authority to enter transaction.
• Purported agent must have acted on behalf of principal
who subsequently ratified action.
• Principal must know all material facts involved in
transaction.
• Agent’s action must be affirmed in its entirety by principal.

127 128

127 128

Level of Awareness Rumsfeld’s Known Unknowns

• Intent: Ratification requires intent to affirm contract.

• Awareness: Intent requirement implies principal must be

aware of contract.

• Question: What level of awareness is required?

129 130

129 130

Knowledge Requisite for Ratification Arizona Land Advisors: Facts

R-3§ 4.06. Knowledge Requisite to Ratification
• Person is not bound by ratification made without
knowledge of material facts involved in original act when
person was unaware of such lack of knowledge (i.e.,
unknown unknown).
131
• L was manager of SC but was removed from office July 17,
2012 after which L has no actual authority.
• With no actual authority, L (agent) enters listing agreement
(contract), on behalf of SC (principal), with LA (third-party)
giving LA exclusive right to sell realty owned by SC.
• SC goes into bankruptcy, which is resolved by settlement
agreement that does not involve LA.
• Settlement gives L authority to sell realty for SC (ratification
of listing agreement between L and LA???).
• SC sells land and LA does not get commission under contract.
• LA sues for breach of listing agreement.
132

131 132

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Arizona Land Advisors: Issue Arizona Land Advisors: Holding

• Issue: Did SC ratify listing agreement contract
between L (on behalf of SC) and LA in giving L
authority to sell realty for SC in settlement
agreement?
• Holding: Court rules SC did not ratify L’s listing agreement.
• Rationale: Ratification requires (1) principal know of act
taken by agent (i.e., known known), or (2) that principal
chose to ratify with awareness that she does not know
ALL relevant material facts (i.e., known unknown).

133 134

133 134

Arizona Land Advisors: Questions

• Question: Would result have been different if LA (broker)
was party to bankruptcy settlement?

• Answer: Maybe, SC would at least have been aware of LA.

TORT
• Question: What if SC knew L had been trying (with actual
authority) to enter deal with LA?

• Answer: Getting warmer…. Court could conclude that SC

acted knowing that it was without knowledge of whether
L entered deal with LA.
135

135 136

Two Separate Questions

Suppose agent is negligent and injures third party.

Two separate questions: Agent’s Liability in

• Is agent liable?

• Is principle liable?
Tort

137

137 138

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Agent’s Liability
• Rule: Agent is liable for own torts (or crimes).

• Example: You can always sue custodial guy… Principal’s Liability

• Why might you not want to bring that lawsuit?
in Tort

139

139 140

Types of Liability
Principle liability may be:
• Vicarious

• Direct
Vicarious Liability

141

141 142

Vicarious Liability Principal’s Vicarious Liability

• Vicarious Liability: Indirect liability imposed on one party
for actions of another party (because of relationship
between 2 parties).
• Vicarious liability is type of strict liability in that liability is
imposed regardless of fault.
General Rule: Principal is subject to vicarious liability to
third party harmed by agent’s conduct when agent’s
conduct:
• Is within scope of agency (or ratified by principal), and
• Is tortious.
Rationale: Principal has control over agent. Do you buy this?
Is this fair?

143 144

143 144

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Rationales for Vicarious Liability Vicarious Liability for Agent’s Crimes?

Rationales • General Rule: Principal is not liable for agent’s crime even
• Compensation: Agent more likely to be judgement-proof. if crime was committed within scope of agency.
• Risk-Spreading: Principal better able to bear risk of loss in
• Rationale: Private citizens should not be obligated to
spreading cost over entire business enterprise.
engage in law-enforcement.
• Risk Avoidance: Principal better able to avoid loss (e.g.,

creates incentive for principal to hire able agents). • Exception: Principal may be liable for agent’s crime if
principal and agent are part of criminal conspiracy.

• Conspiracy: Roughly speaking, you can think of conspiracy

as criminal analog of general partnership (in terms of
145
liability). 146

145 146

Respondeat Superior Employer-Employee Relationship

• Employer-employee is type of principal-agent relationship Fiduciary Relationships
in which Principal = Employer and Agent = Employee.
Principal-Agent
• Respondeat Superior: General rule regarding principal’s
vicarious liable applied to employer-employee
relationship. Employer-Employee

147 148

147 148

Independent Contractor Life of a Shot Girl

• Independent Contractor: Employer-employee is to be
distinguished from independent contractor who is hired
to do job but is not told specifically how to do it.

• Independent contractor relationship is contractual (and

thus no vicarious liability).

149 150

149 150

25

Hypothetical
Hypo:
• Roberts hires Shepherd to build sunroom.
• Roberts knows nothing about construction and does not
care how Shepherd does job—so long at job gets done to
Robert’s satisfaction.
• Shepherd is independent contractor.
• Question: Is nanny independent contractor? An
employee? Something else?
151
151
Contracting Costs
• Question: Why have employees at all? Why not do
everything with independent contractors?
• Answer: Control.
• Theoretical Question: Why not try to get that control
through contract?
• Answer: Too damn costly! I want default rules (or gap-
fillers) that agency law provides me.
153
153
Scope of Employment
R-3 §4.06. Employee Acting Within Scope of Employment
• Employee acts within scope of employment when (1)
performing work assigned by employer, or (2) engaging in
course of conduct subject to employer’s control.
• Employee’s act is not with scope of employment when act
occurs within independent course of conduct not intended
by employee to serve any purpose of employer.
155
155
11/13/23
Agent for Contract Purposes
• Hypo: Suppose that when Roberts hires Shepherd, Roberts
gives him actual authority to purchase necessary supplies
at Home Depot and charge them to Roberts’ account.
• Shepherd is agent independent contractor.
• Although Roberts would be liable in contract to Home
Depot for supplies that Shepherd purchases on Roberts’
behalf (because Roberts has actual authority), Roberts
would not be liable in tort for any tort that Shepherd
commits.
152
152
Scope of
Employment
154
Hypothetical (Frolic)
Hypo
• Roberts works as delivery driver for TL.
• On his way to make delivery, Roberts makes a side trip to
stadium to buy tickets to upcoming game.
• Roberts commits tort in stadium parking lot.
Question
• Is this frolic, meaning TL (principal) would not be liable?
• Was this trip motivated in any way to serve principal?
156
156
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Hypothetical (Detour) Alms vs. Baum: Facts

Hypo
• On his way to make delivery, Roberts goes slightly out of
his way to get lunch at Whole Foods.
• Roberts commits tort in Whole Foods parking lot.
Question
• Is this detour, meaning TL (principal) would be liable?
157
• Baum, Berger, and Delanty were unpaid volunteers for Ronald
McDonald House (RMH).
• They attended mandatory meetings on Friday afternoon and
were required back on Saturday morning.
• Friday night, however, they were “on their own.”
• They drove to bar, where Delanty worked on camp papers
while Baum and Berger watched basketball game on TV and
drank beer.
• After 2 hours, during which Baum drank 5 beers, 3 got back
into Baum’s car.
• Baum crashed, killing Berger and injuring Delanty.
158

157 158

Alms v. Baum: Issue Alms v. Baum: Holding

• Issue: Is RMH (principle) vicariously liable for tortious • Holding: NO. Tort did not occur within scope of agency.
conduct of Baum (agent)?

159 160

159 160

Alms v. Baum: Balancing Test Question of Fact

Key Facts Pointing to Not Within Scope of Agency Question
• Baum was not required to be at camp on Friday night. • How can Baum be employee if job is unpaid?

• Baum drove his own car.

• Baum used evening to further his own hedonist pleasures. R-3 §7.07(3).
• Employee is agent whose principal controls or has right to

Key Facts Pointing to Within Scope of Agency
• Baum was returning counselors to camp where their
presence was required next morning.
control manner and means of agent’s performance of
work, and
• Fact that work is performed gratuitously does not relieve
principal of liability.

161 162

161 162

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Questions of Law
Questions
• Would result have been different if 3 counselors were

required to spend night at camp and were returning to

camp for that purpose when crash occurred?
Direct Liability
• What if 3 had discussed camp business while drinking beer
at Keg Room?

163

163 164

Direct Liability
• Direct Liability: Principle can be directly liable for tort of
agent because of some separate basis of liability (i.e.,
some negligent act by principal caused or resulted in this
other tort or crime committed by agent).
Negligence Review
• Example: Employer was negligent in hiring or supervision
of employee.

165

165 166

Negligence Elements of Negligence

• Negligence: Arises when person suffers injury because of To succeed in negligence action, plaintiff must prove 4
another’s failure to satisfy required duty of care. elements:

• Duty: Existence of legal duty that defendant owed to

• Unintentional: Tortfeasor neither wishes to bring about
consequences of act, nor believes that such will occur. plaintiff

• Breach: Defendant’s breach of that duty

• Causation: Proof that defendant’s breach caused injury

• Damages: Plaintiff’s sufferance of injury.

167 168

167 168

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Legal Duty To Whom? Legal Duty

• Question: To whom do I owe legal duty of due
care?
• Question: Why is Stetson not on hook when UF law
school trips and falls?
• Zone of Danger: Person (ordinarily) has legal duty
to exercise reasonable care when that person’s
conduct creates risk of physical harm to others.

169 170

169 170

Defining Legal Duty

When countervailing public policy warrants limiting liability,
court may decide that
• Defendant has no duty, or

• Ordinary duty of reasonable care requires modification.

Negligent Hiring
Student Tip: Do not think about foreseeability as limiting
principle at this stage of negligence analysis.

171

171 172

Negligent Hiring Yunker v. Honeywell: Facts

• Employer who knows or should know that employee has
propensity for committing tortious acts is liable for
employee’s acts even if such acts would not ordinarily be
considered within scope of employment.
• Significantly expanded liability of principals.
173
• Landin worked for Honeywell from 1977-1979.
• Landin was imprisoned from 1979 to 1984 for strangling
to death his girlfriend, fellow Honeywell co-employee.
• Honeywell rehired Landin upon his release from prison in
August 1984.
• After Landin was involved in some workplace disputes,
Honeywell transferred Landin twice, assigning Landin to
Nesser’s maintenance crew where two became friends.
• When Landin expressed romantic interest, Nesser stopped
spending time with him.
174

173 174

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Yunker v. Honeywell: Facts Yunker v. Honeywell: Issue

• Landin began to harass and threaten Nesser at work and • Issue: Did Honeywell, as matter of law, have duty to
at home. Nesser to exercise reasonable care in hiring, retaining, or
• On July 1, 1988, Nesser found death threat scratched on supervising Landin?
her locker door.
• On July 19, approximately 6 hours after her Honeywell
shift ended, Landin killed Nesser in driveway with close-
range shotgun blast.
• Landin was convicted of first-degree murder and
sentenced to life imprisonment.

175 176

175 176

Yunker v. Honeywell: Holding Yunker v. Honeywell: Holding

Decision to Hire Decision Not To Fire
• Holding: Honeywell did not owe legal duty to Nesser at • Holding: Honeywell did owe legal duty to Nesser arising

time of Landin’s hiring (because public policy supports out of Honeywell’s continued employment of Landin (not
limitation on this cause of action). outweighed by public policy considerations).

• Rationale: Honeywell made reasonable decision to give
Landin second chance in position of maintenance worker
where Landin had limited contact with other people.
177
• Rationale: Ex-felon’s “opportunity for gainful employment
may mean difference between recidivism and
rehabilitation,” but this cannot predominate over need to
maintain safe workplace when specific actions point to
future acts of violence.
178

177 178

Problem 1
Facts
• Carhart hires Servantes to work as a waiter at TL.

Pair-&-Share • Servantes negligently spills scalding coffee on customer.

Problems 1 Questions
• Is Carhart liable in tort to customer?
• What if Carhart specifically told Servantes, both verbally and in
writing, that his job description did not include spilling scalding
liquids of any kind on customers?
• Is Servantes also liable in tort to customer?
180

179 180

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Problem 2 Problem 3
Facts Facts
• While commuting to work in his automobile, Servantes • Carhart hires Agee to work as cook.
(agent) negligently injures pedestrian. • When Agee overhears customer criticizing her cooking, Agee
hits customer over head with skillet.
Questions
Questions
• Is Carhart liable in tort to pedestrian?
• Is Agee liable in tort to customer?
• Is Servantes liable in tort to pedestrian?
• Is Carhart liable in tort to customer? What if Carhart knew
about Agee’s anger management problems when Carhart
hired Agee.
181 182

181 182

Other Agency-Type Relationships

• Franchisor-Franchisee
• Ride-Sharing
OTHER AGENCY-TYPE
RELATIONSHIPS

184

183 184

Some Terminology
• Franchisor: Seller of franchise

Franchisor- • Franchisee: Purchaser of franchise

Franchisee

186

185 186

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Some Facts about Franchises Franchise Agreement

Franchise
• Not separate business entity.
• Bilateral arrangement in which owner of intellectual
property provides license to others in exchange for fee to
use intellectual property in selling of goods or services.
Some Facts
• Over 760,000 franchise units in U.S.
• Franchise Agreement: Contract that spells out terms of
bilateral relationship including franchise payment,
purchase of products from franchisor, and cost of
advertising (as well as amount of royalty fees).
• If either party fails to perform its contractual duties, then
that party may be subject to lawsuit for breach of
contract.

• Account for 1/3 of all retail sales.

• Employ more than 8.2 million.

187 188

187 188

Payment of Franchise
• Franchisee must pay
o Initial investment costs Top 10 Franchises
o Franchisee fee (i.e., cover charge for entry into franchise
system) According to
o Royalty fees (and advertising fees) calculated as
percentage of gross sales.
Entrepreneur
Magazine
• Building cost is typically most expensive item associated
with initial investment in franchise.

189

189 190

No. 10 Sport Clips

No. 9 Hardee’s

LOW: $1,400,000
LOW: $189,000
Investment: HIGH: $355,000 Investment: HIGH: $1,900,000

191 192

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No. 8 Taco Bell No. 7 Great Clips

LOW: $525,000 LOW: $137,000

Investment: HIGH: $2,600,000 Investment: HIGH: $258,000

193 194

No. 6 Sonic Drive-IN No. 5 RE/MAX

Restaurants

LOW: $1,100,000 LOW: $38,000

Investment: Investment:
HIGH: $2,400,000 HIGH: $225,000

195 196

No. 4 UPS Store No. 3 Dunkin’ Donuts

LOW: $178,000 LOW: $229,000

Investment: HIGH: $403,000 Investment: HIGH: $1,700,000

197 198

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No. 2 Seven Eleven No. 1 McDonald’s

LOW: $38,200 LOW: $1,000,000

Investment: HIGH: $1,100,000 Investment: HIGH: $2,220,000

199 200

Miller v. McDonald’s: Facts Miller v. McDonald’s: Question

• Plaintiff was injured when she bit into gemstone found in Question:
Big Mac purchased at McDonald’s in Tigard, OR. • Licensing agreement between McDonalds and 3K states

• Tigard McDonald’s is franchise, owned and operated by that no agency relationship exist
3K Restaurants. • Why is this not dispositive?

• Plaintiff sues McDonald’s, not 3K (Why?)

Answer:
• Agency is determined by relationship between parties,

not by fiat in contract.

201 202

201 202

Miller v. McDonald’s: Plaintiff Argues Actual Agency

Two Theories General Rule
• Control of daily operations (not merely suggestions, setting
• Actual Agency standards).
• Tort committed in scope of agency.
• Apparent Agency
Application
• 3K was required to use McDonald’s precise methods, including
how to handle and prepare food.
• McDonalds had right to control franchise, specifically part of
business that resulted in plaintiff’s injury.
203
• McDonalds enforced methods by regular inspection. 204

203 204

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Apparent Agency Apparent Authority vs. Apparent Agency

General Rule • Apparent agency creates agency relationship that does not
• Holding Out Rule: One holds out that another is agent. otherwise exist, while apparent authority expands authority of
actual agent.
• Justifiable Reliance: Third party justifiably relies on care and
skill of such apparent agent.
• Apparent authority is relevant only if actual agency already has
been established.
Application
• Defendant Argues: McDonald’s argues that plaintiff did not
show sufficient reliance on its holding 3K out as agent.
• Holding: Court concludes that plaintiff thinking all McDonald’s
were owned by same corporation was sufficient to prove
reliance.
205 206

205 206

Practice Tip
Question
• Can you see now why franchisee’s stationary and advertising
often state, “This company is independently owned and
operated”?
TERMINATION
Answer
• To defeat any claims of apparent authority.

• Of course, boilerplate statement cannot overcome facts that

might show sufficient control to justify finding of liability
(actual authority).

207

207 208

Termination of Agency Relationship

Agency law resembles contract law in that both agency and

General
contract may be terminated:
• By voluntary act of parties, or

ships
Partner
• By operation of law.

Once principal-agent relationship has ended, agent no

I
longer has right to bind principal.

209

209 210

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Entrepreneur Starting a Company

• Entrepreneur: One who initiates and assumes financial
risk of new business enterprise and undertakes to provide
or control its management.

• One of first decisions an entrepreneur must make is which

form of business organization will be most appropriate for
new endeavor.

• Primary motive of entrepreneur is to make profits.

211 212

211 212

5 Major Business Forms Business Forms Compared

• Sole Proprietorship • When deciding which form of business entity to choose,
entrepreneurs normally consider several factors, including:
• General Partnership o Ease of creation

o Control over business operations

• Limited Partnership o Liability of owners
o Ability to raise capital
• Corporation o Tax considerations

• Limited Liability Company • Each major form of business organization offers distinct
advantages and disadvantages with respect to these factors.
213 214

213 214

Financing Growth Bank Loans

• Raising capital is critical to growth of most small
businesses.
• In early days of business, business owner may be able to
contribute sufficient capital, but as business becomes
successful, more funds may be needed.
• Obtaining bank loan is beneficial for small businesses,
because owner can retain full ownership and control of
business.
• Contractual Covenants: Bank may place some restrictions
on future business decisions as condition of granting loan.

• Owner may want to raise capital from external sources to • Bank may require personal guaranty from owner (placing
expand business: one way to do this is to borrow (debt owner’s personal assets at risk).
financing).
215 216

215 216

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 11/13/23

SBA Loans Why Joint Ownership?

• Loans with desirable terms may be available from U.S. • Question: Why does sole proprietor not solely borrow to
Small Business Administration (SBA). raise capital?

• One SBA program provides loans up to $25,000 to following • At some point, selling ownership stake may be less costly
businesspersons: (1) women, (2) low-income individuals, than borrowing (e.g., creditors find additional lending to
and (3) members of minority groups. business too risky).

• SBA requires business owners to put some of their own Agency Costs of Equity < Agency Costs of Debt
funds at risk in business.

217 218

217 218

Advantages of Sole Proprietorship

• No profit-sharing
• Easy to form
Sole • No double-taxation
Proprietorships • Absolute control over business

219 220

219 220

Formation
• No documents must be filed with government to form
sole proprietorship (although business may be required to
obtain other government forms such as business license).
• Starting sole proprietorship is easier and less costly than
starting any other kind of business, because few legal
formalities are required.
Taxation
• NO Double Taxation: Sole proprietor pays only personal
income taxes on business’s profits.
• Profits are reported as personal income on proprietor’s
personal income tax return.
• Separate tax return is not filled for business entity.

221 222

221 222

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Schedule C Control
• Sole proprietor has total control of business
operation.

• Sole proprietors can make any decision concerning

business, including what kind of business to
pursue, whom to hire, and when to take vacation.

223 224

223 224

Disadvantages of Sole Proprietorship Personal Liability

• Personal Liability: Sole proprietor’s personal assets • In Theory: Sole proprietor has unlimited personal
at risk. liability for obligations of business: both personal
• Lack of continuity. and business assets of sole proprietor are at risk of
• Limited ability to raise capital. seizure by creditors.

• In Practice: Liability can be limited by holding

property jointly with spouse, hiring independent
contractors, or by purchasing liability insurance.

225 226

225 226

Duration Financing
• Lack of Continuity: If owner dies, then so does • To raise capital, proprietor is limited to personal funds
business: business is automatically dissolved. and any loans that she can obtain for business.

• No Equity Financing: Owner cannot take advantage of

equity financing (i.e., cannot sell piece of business to
raise funds).

227 228

227 228

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General Partnership
• Partnership arises from agreement (express or
implied) between 2 or more persons to carry on
General business for profit.

Partnerships • Partners:
o Are co-owners of business
o Have joint control over its operation
o Have right to share in its profits

229 230

229 230

Limited Partnership
• Limited Partnership (LP): Consists of least 1 general
partner and 1 or more limited partners (often referred to
as silent partners).
Limited
Partnership • Examples: Real estate development projects, film industry.

231 232

231 232

Structure of Generic Private Equity

Fund

Corporation

233 234

233 234

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Key Players
• Corporate personnel include:
• Shareholders
• Board of Directors GENERAL
Corporate Officers (e.g., CEO, CFO)
•
PARTNERSHIPS

235 236

235 236

General Partnership Defined What is Partnership?

• Definition: Partnership is association of 2 or more persons
to carry on as co-owners of business for profit.
• Default business structure for 2 or more people (like sole
proprietorship for 1 person).
• Sole Proprietor: Business with only 1 owner.
• Partnership: Business with 2 or more owners.
• Question: Can business be both sole proprietorship and
partnership?

• Question: Can 2 corporations form partnership?

237 238

237 238

Source of Partnership Law Partnership Agreement

• Uniform Partnership Act (UPA): Exists in few states • Primary source of partnership law is partnership
(including New York) agreement.

• Revised Uniform Partnership Act (RUPA): Exists in
most states (including Florida)
• Rationale: Businesspeople should be left to structure
relationship as bests suits them.
• Gap-Filler: If matter is not reflected in partnership
agreement, then matter is resolved according to default
provisions of RUPA (or UPA).

239 240

239 240

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Definition of Partnership Agreement Two Types of Partnerships

Partnership agreement governs all following:
• Relations among partners as partners and between
partners and partnership
• Internal business of partnership
• Means and conditions for amending partnership
agreement.
• Partnership At-Will: Partners have not agreed to remain
partners UNTIL expiration of definite term or completion of
specific undertaking.
• Term Partnership (or Joint Venture): Partners have agreed
explicitly (or implicitly) to remain partners for definite term or
UNTIL completion of specific undertaking.

To extent partnership agreement does not provide for • Student Tip: Although term, joint venture, is sometimes used
matter described, partnership law (RUPA) governs. more broadly, let joint venture = term partnership in this
course.
241 242

241 242

Aggregate Theory (UPA) Entity Theory (RUPA)

• Aggregate Theory: Partnership is aggregate of its owners. • Entity Theory: Partnership is separate legal entity.

• Example: A, B, & C are partners. If ownership changes, then

partnership ends: if B walks away, then this destroys • Exception
partnership, and business must be liquidated. • No taxation at entity level.

• Exception:
o Partnership is bound by wrongful acts of its partners in
ordinary course of business.
o Partnership is treated as entity with respect to
partnership property.
243 244

243 244

Formation
• Agreement: No formal agreement is required to form
partnership: parties’ intent can be implied from conduct.

Writing: No writing required to form partnership.

Formation •

• Capacity: Anyone who is capable of entering into binding

contract can be partner.

• Legality: Partnership formed to achieve illegal purpose is

void.
245 246

245 246

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Proof of Partnership Existence 5-Factor Test for Formation

• Because no formalities are required to form partnership, To determine whether partnership exists, courts consider:
sometimes difficult to determine if relationship among • Intention of parties,
parties constitutes partnership. • Sharing of profits and losses,

• Mutual right of control or management of enterprise,

• 5-Factor Test: Court use 5-Fact Test to determine whether
• Capital investment by each partner, and
partnership exists.
• Common ownership of property.

247 248

247 248

Profit-Sharing & Control Partner or Lender?

• Profit-sharing and control are most important factors in
this common law balancing test.
• In determining whether partnership is formed, however,
sharing of gross returns does not by itself establish
partnership, even if persons sharing them have joint
interest in property from which returns are derived.
• Example: Person can be lender even if she shares in profits
of enterprise.
249
• Hypo: Suppose Ruth loaned Kalil and Hugh $350K to use in
operating restaurant on June 4, 2022.
• Loan agreement stated that loan was to be repaid not later
than April 15, 2023 and that UNTIL loan was repaid:
o Ruth was to receive 40% of profits of firm, not exceeding $50K and
not less than $10k.
o Kalil and Hugh were to consult Ruth as to important matters in
conduct of restaurant.
o Ruth could veto any business deemed too speculative or injurious.
• Question: Is Ruth partner of Hugh and Kalil?
250

249 250

Martin v. Peyton: Facts Martin v. Peyton: Plaintiff Argues

• Peyton made loan of $2.5 million to Martin under terms Martin’s creditors argued that:
described in preceding slide. • Peyton’s sharing in profits coupled with Peyton’s power to

• Martin became insolvent. veto certain business decisions made Peyton partner with
Martin, and
• Peyton, as partner, was liable for partnership’s debts.

251 252

251 252

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Martin v. Peyton: Holding

• Holding: Peyton was not partner.

• Rationale: Peyton “may not initiate any transactions as a

partner may do.”
Property
• Common Law Concept
Ownership
• Reactive Control: Veto power (not indicative of partner)

• Active Control: Power to initiate decision (indicative of

partner).
253 254

253 254

Property Ownership
Key Distinction
• Partnership Property

• Partnership Interest Partnership

Property

255 256

255 256

Partnership Property What is Partnership Property?

• Partnership Property: Everything that partnership • No restrictions on what might be partnership property.
legally owns.
• RUPA has different provisions depending on whether the
property is:
o Titled (Real Property)

o Untitled

257 258

257 258

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Titled Property Titled Property

Property Deemed Partnership Property Property Presumed Partnership Property
• Property titled in partnership name, or • Property purchased with partnership funds (regardless of in

• Property titled in name of 1 or more partners, and whose name title is held)
instrument transferring title (deed) notes titleholder’s
capacity as partner or existence of partnership.

259 260

259 260

Titled Property Untitled Property

Property Presumed Partner’s Separate Property
• Property is held in name of 1 or more partners and
• Instrument transferring title does not indicate person’s
capacity as partner or mention existence of partnership,
and
• Partnership fund were not used to acquire property.
261
In case of untitled property, courts look to following criteria to
determine if property was intended to be partnership property:
• Acquisition with partnership funds.
• Use of property by partnership in conducting partnership’s
business
• Entry of property in partnership books as partnership asset.
• Close relationship between property and business operations of
partnership
• Improvement of property with partnership funds, and
• Maintenance of property with partnership funds.
262

261 262

Rights of Partner in Partnership

Property
• Partner is not co-owner of partnership property and has no
interest in any specific item of partnership property.

• Exam Tip: Partner has no right to use partnership property Partnership

other than for benefit of partnership.
Interest
• Personal (or outside) creditor of partner cannot proceed
against any specific items of partnership property to satisfy
personal obligation of partner: creditor can only proceed
against partner’s partnership interest.
263 264

263 264

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Cash Flow Rights Characteristics of Interest

• Each partner has transferable interest in partnership that Partner’s interest in partnership is
consists of partner’s share of partnership profit, losses,
and distributions. • Treated as personal property

• Transferable (either voluntarily or involuntary) without

dissolving partnership or causing transferring partner’s
dissociation.

• Attachable (i.e., can be seized to satisfy final judgment).

265 266

265 266

Transfer of Partnership Interest Control Rights

• Transfer of partnership interest gives transferee no rights
with respect to operation of partnership:
• Transfer merely entitles transferee to receive profits to
which transferring partner would otherwise be entitled.
• Pick-Your-Partner Rule: Unless partnership agreement
provides otherwise, no partner can transfer control rights
to another person (or substitute another person for itself
as partner) with consent of all other partners.

267 268

267 268

Problem 1
Question
• Are cash and credit card receipts from operation of

Pair-&-Share restaurant after partnership’s formation

partnership property?
Problems 2

269 270

269 270

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Problem 2 Problem 3
Facts Facts
• After formation of partnership, restaurant uses funds • Maria (partner) has recipe for fabulous 17-ingredient

provided by Ruth (partner) to purchase parcel of land— sauce that Hugh (another partner) uses when preparing
1200 Blackacre Road—for second restaurant. dishes at restaurant.

Questions Questions
• Is Blackacre Road partnership property? • Does this recipe developed by Maria before formation of

• What if seller deeds property to Ruth?

partnership become partnership property if recipe is used
by partnership?

271 272

271 272

Partner’s Right
• Default Rule: All partners have equal rights in
management of partnership business (absent agreement
otherwise).

Control Rights

273 274

273 274

Voting: Default Rule

Decided by Majority Vote
• Matters in ordinary course of business of partnership.

Decided by Unanimous Consent Fiduciary Duties

• Matters outside ordinary course of business of
partnership (e.g., merger, sale of all assets, adding
new partner).

275 276

275 276

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Fiduciary Duties To Whom Are These Duties Owed?

Each partner owes 2 principal fiduciary duties (1) to • From Meinhard and Day, partner owes fiduciary duty to
other partners, and (2) to partnership. other partners.

• Duty of Loyalty • From statutory rules, partner also owes fiduciary duty to
partnership: all partners serve as general agents of
• Dure of Care
partnership (principal).

277 278

277 278

Meinhard v. Salmon: Facts

• Salmon are Meinhard were “coadventures subject to
fiduciary duties akin to those of partners.”

Salmon leased building from Gerry for 20 years.

Duty of Loyalty
•

• Under deal, Salmon ran building and Meinhard

contributed money.

• Both shared in profits over span of lease.

• 4 months before expiration of lease, Gerry approached
Salmon with plan.
279 280

279 280

Bristol Hotel Meinhard v. Salmon: The Plan

• Gerry owned building Salmon was leasing and 5 adjacent
buildings.
• Gerry proposed that Salmon lease entire tract, with grand
plans for future development.
• Salmon agreed.
• Salmon had his corporation, Midpoint, enter deal.
• Salmon told Meinhard nothing about Gerry’s proposal.
• Upon discovering Midpoint had entered lease on new
project, Meinhard sued Salmon.
281 282

281 282

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5th Ave & 42nd Street Today Meinhard v. Salmon: Holding

• Holding: Meinhard wins because Salmon breached
fiduciary duty to partner.

• “Many forms of conduct permissible in a workaday world

for those acting at arm’s length (i.e., contract) are
forbidden to those bound by fiduciary ties.”

• Key Quote: Partners owe other partners “the duty of the

finest loyalty … not honesty alone, but the punctilio of an
honor the most sensitive.”
283 284

283 284

Meinhard v. Salmon: Questions Hypotheticals

• What duty did Salmon owe Meinhard? What did Salmon Hypo 1
do wrong?
• What should Salmon have done differently? What

should Salmon’s lawyer have done differently?

• Was expanded Gerry proposal new deal or continuation of
original deal? Why would this matter?
• What was legal relationship between Salmon and
Meinhard? Cardozo calls them “coadventurers.”
• Is it relevant that Salmon managed building?
285
Hypo 2
• Assume that Gerry approached Salmon about new
expanded lease and development because Gerry
had married Salmon’s sister. Would Cardozo have
reached same result?
286

285 286

Agape, Filio, Morality, and Business Law Day v. Sidley & Austin: Facts
• Plaintiff-partner in law firm is unhappy with after-effects
of firm’s merger with another law firm: appointment of
co-chairmen and relocation of office.

• Plaintiff alleges that partners on Executive Committee

breached fiduciary “by not revealing changes that would
occur as result of merger.”

287 288

287 288

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Day v. Sidley & Austin: Holding The Essence of Disloyalty

• Holding: Court rules in favor of defendants. $
• Rationale: Essence of breach of fiduciary duty between
partners is one partner has advantaged herself at Disloyal Act
expense of partnership: defendants did not gain
financially and did not acquire more power within firm—
facts here all relate to internal firm management.

• Question: Can you distinguish this case from Meinhard?

0 $
Partnership Partner
289 290

289 290

Types of Disloyalty Usurpation of Opportunity

Three Common Types of Partner Disloyalty
• Usurpation of Partnership Opportunity
• Competition with Partnership
• Duty to account to partnership and hold as trustee for it any
property, profit, or benefit derived by partner in or form any of
following:
• Conduct or winding up of partnership’s business
• Use by partner of partnership’s property

• Self-Dealing Transactions • Appropriation of partnership opportunity (see Meinhard)

• Plain English: Partnership property usurped by partner (including

misappropriation of partnership opportunity) is held in
constructive trust for partnership: partnership can recover any
money or property misappropriated by intransigent partner.
291 292

291 292

Aside: Constructive Trusts Constructive Trusts Explained

Constructive Trust: Form of equitable remedy.

Constructive trust is superior to money damages insofar as

constructive trust allows tracing:
• Tracing Profits: Allows plaintiffs to “trace” into defendant’s
profits (e.g., plaintiff has purchased asset with plaintiff’s
property and this asset has appreciated in value).

• Tracing Property: Allows plaintiffs to “trace” into hands of

third-party (e.g., defendant has transferred plaintiff’s property
to third-party—non-bona fide purchaser—and plaintiff wants
this third-person to return property). 293 294

293 294

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Constructive Trust in Action Competition with Partnership

• If partner improperly usurps partnership opportunity, • Duty to refrain from competing with partnership in
then court will impose constructive trust (as equitable conduct of partnership’s business before dissolution of
remedy) on usurped opportunity (e.g., property). partnership.
• Under this trust, usurper will be required to hold property
usurped for benefit of partnership. • Plain English: Partner must refrain from competing with
• If usurper has property, then constructive trust requires partnership in conduct of partnership business.
usurper to sell property back to corporation at price paid
for property.
• If usurper has sold property at profit, then firm can
recover this profit.
295 296

295 296

Compared to Usurpation Self-Dealing

• Improper Competition: To compete with partnership is to • Duty to refrain from dealing with partnership in conduct
seek and take opportunities (i.e., customers) from which or winding up of partnership business as (or on behalf of)
partnership might have benefited. person having interest adverse to partnership.

• Usurpation of partnership opportunities includes larger set • Plain English: Partner must not engage in self-dealing (i.e.,
of corporate opportunities. from being on opposite side of transaction with
partnership).
• Example: Fill in later.

297 298

297 298

Duty of Dure Care

• Duty of Care: Requires partner to refrain from engaging in
negligent, reckless, or intentional misconduct.

Duty of Care

299 300

299 300

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Mandatory Rules Or Default Rules?

Partnership agreement cannot:
• Alter or eliminate duty of loyalty.
• Unreasonably alter or eliminate duty of care.
• Alter or eliminate obligation of good faith and fair dealing.
Question: Partners have greatest power to contract around
which fiduciary duty?
301
Partnership agreement can:
• Identify specific types or categories of activities that do
not violate duty of loyalty, if not manifestly unreasonable.
• Identify specific types or categories of activities that do
not violate good faith and fair dealing, if not manifestly
unreasonable.
302

301 302

In Favor of Default Rule In Favor of Mandatory Rules

Question Question
• What are arguments in favor of default rules in partnership • What are arguments in favor of mandatory rules in

law? partnership law?

Answer
• Freedom of Contract: Partners should have freedom to
define their relationship as they wish.
• Equal Bargaining Power: Persons entering into partnership
relationship ordinarily bargain from approximately equal
position—equality created by fact that each party typically
has something of near-value to offer other. 303
Answer
• Externalities: Prevent harm to third-parties (e.g., licensor-
licensee attempting to contract around third-party liability
deriving from agency relationship).
• Paternalism: Prevent harm to contract parties.
304

303 304

Partnership May Be Sued

• Partnership may sue and be sued in its own name.

Types of Legal • Judgement against partnership alone is not judgement

against individual partners.

Actions

305 306

305 306

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Partnership Against Partner Partner Against Partnership

• Partnership can bring action against partner for (1) breach • Partner can bring action against partnership (or other
of partnership agreement, or (1) breach of fiduciary duty. partners) to enforce any right created by partnership
agreement or partnership law (e.g., RUPA).

307 308

307 308

Application of Agency Law

• Every partner is agent of partnership for purpose of its
business.

Act performed by any partner either with actual or

Agency Redux •
apparent authority (or that is ratified by partnership) will
bind partnership (and thereby other partners).

• Authority to bind partnership when dealing with third-

parties basically follows general agency law.

309 310

309 310

Apparent Authority Apparent Authority

• Any act of any partner for apparently carrying on in
ordinary course of partnership business or business of
kind carried out by partnership binds partnership UNLESS:
o Partner had no authority to act for partnership in
particular manner, and
o Person with whom partner was dealing knew or had
received notification that partner lacked authority.
• As agents of partnership, partners have apparent
authority to bind partnership to any contract within scope
of partnership business.
• If contract is outside scope of partnership business, then
partnership generally will not be bound UNLESS partner
had actual authority.

311 312

311 312

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Actual Authority
• Partnership will be bound by act of partner if partner has
actual authority.

Actual authority is authority partner reasonably believes

•
that partner possesses based upon communication Liability
between partnership and partner.

• Actual authority derives from (1) partnership agreement,

or (2) vote of partners.

313 314

313 314

Two Types of Liability

Partner has exposure to:
• Civil Liability

• Criminal Liability

Civil Liability

315 316

315 316

Liability of Partnership for Partner’s Liability of Partners for Obligations of

Conduct Partnership
• Partnership is separate legal entity and can be held liable • Unless otherwise agreed upon, all partners are joint and
for obligations owed. severally liable for all obligations of partnership (whether
arising in contract or tort).
• Each partner is agent of partnership for purpose of its
business.

• Partnership is vicariously liable (1) for all contracts

entered into by partner in scope of partnership business
(or with authority of partnership), and (2) for all torts
committed by partner within ordinary course of
partnership business.
317 318

317 318

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Multiparty Liability Several Liability

• 3 Forms of Multiparty Liability: • Each party is liable only for percentage of entire liability.
o Several Liability
• Tort Example: Percentage is determined according to
o Joint Liability
percentage at fault.
o Joint and Several Liability
• Partnership Example: Percentage is determined according
• In this course, partnership obligation are joint and to respective ownership interest.
severally liable.

319 320

319 320

Joint Liability Joint and Several Liability

• Each party is liable for entire obligation. Joint and Several Liability
• Creditor may pursue partner individually: creditor does not

• True even if party is individually 0% at fault for liability or
obligation!!!
• Distinctions between (1) joint liability, and (2) joint and
several liability relate not to each partner’s personal
liability, but to steps creditor must take to pursue
partners.
need to include all partners as defendants in same lawsuit.
• Creditor may release claim against one of partners without
undermining its claim against other partners.
Joint Liability
• Creditor must sue all partners in same action.
• Creditor’s release of any partner releases all partners.

321 322

321 322

Right of Contribution Extent of Liability

• Right of Contribution: If partner has paid more than fair • Personal Liability: Each person is personally and
share of obligation, then that party will have claim against individually liable for entire amount of partnership
other partners for their respective shares of loss. obligations (with rights of contribution and
indemnification).

• Partner can be held liable even if she did not participate

in, know about, or ratify conduct that gave rise to
obligation (e.g., final judgment).

323 324

323 324

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Hypothetical 1 Hypothetical 2
• Hypo: A, B, and C are all equally negligent with respect to • Hypo: A, B, and C are all equally negligent with respect to
tort injury suffered by V in amount of $9,000,000. tort injury suffered by V in amount of $9,000,000.
• V sues A. • V sues A.

• Question: Under several but not joint liability, what is • Question: Under joint and several liability, what is
maximum amount V can collect from A? maximum amount V can collect from A?

• Answer: V can demand that A pay V up to $3,000,000 • Answer: V can demand that A pay V full $9,000,000.
(= 1/3 x $9,000,000). A could, in turn, demand contribution from B and C.
If B or C cannot pay, however, then A must pay the full
325 $9,000,000. 326

325 326

Liability for Tort Liability for Contract

Partnership Liable for Partner’s Actionable Conduct
• RUPA§305: Partnership is liable for loss or injury caused
to person as result of wrongful act or omission (or other
actionable conduct) of partner acting in ordinary course
of business of partnership (or with authority of
partnership).
• Partner carrying on in ordinary course of partnership
business binds partnership in contract UNLESS
o Actual: Partner did not have actual authority to act for
partnership in particular matter, and
o Apparent: Person with whom partner was dealing knew
or had notice that partner lacked authority.

• Partner not carrying on ordinary course of partnership

business binds partnership in contract only if contract was
authorized by all other partners.
327 328

327 328

Problem 1 Liability of Incoming Partner

Facts • Incoming partner is not personally liable for obligations of
• Partnership agreement states that managing partner shall have BEFORE person became partner.
power to do following: Make all contracts for and on behalf of
partnership in conduct of its business

Questions
• Is partnership liable for obligation arising from contract signed
only by Managing Partner if contract was not in ordinary course
of business?
• Is partnership liable for obligation arising from contract signed by
partner other than Managing Partner if contract was in ordinary
course of business? 329 330

329 330

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Liability of Outgoing Partner

• Outgoing partner remains liable for obligations arising
while partner in partnership UNLESS there was payment,
release, or novation.

Criminal Liability

331 332

331 332

Criminal Liability
• Partner will not be criminally liable for crimes of other
partners committed within scope of partnership UNLESS
partner participated in commission of crime either as
principal or accessory. Enforcing
Judgments

333 334

333 334

Aside: Creditor-Debtor Law Enforcement of Judgment

• If debt is past due, then unsecured creditor can bring
legal action against debtor to collect debt.
• If action is successful, then court awards creditor
judgment against debtor (usually for debt amount plus
any interest and legal costs incurred).
• Judgment Creditor: Party to which debt is owed that has
proved debt in legal proceeding and is entitled to use
judicial process to collect debt.
335
• To collect on judgment, creditor may request court order
authorizing sheriff to seize or (levy upon) certain
property of debtor.
• Writ of Execution: Court’s order to seize debtor’s
property is known as writ of execution (if issued after
judgment).
• Writ of Attachment: Court’s order to seize debtor’s
property is known as writ of attachment (if issued before
judgment).
336

335 336

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Writ of Execution Garnishment

• Writ of Execution: Court’s order after judgment has been
entered against debtor, directing sheriff (or similar
official) to seize and sell any of debtor’s nonexempt real
or personal property in sheriff’s sale.
• In practice, sheriff usually takes possession of money
from defendant's bank account.
• Garnishment: Legal process used by creditor to collect
debt by seizing property of debtor (e.g., wages) that is
being held by third-party (e.g., debtor’s employer).
• Many types of property can be garnished including
wages, funds in bank account, tax refunds, pensions, and
trust funds.

• Writ applies only to property within court’s geographic

jurisdiction.
337 338

337 338

Legal Action Against Partnership Exhaustion of Partnership Assets

• Partner may be (1) joined in action against partnership, or
(2) named in separate action.
• Judgment against partnership alone is not judgment
against individual partner.
• Judgment creditor of partner cannot levy execution
against assets of partner to satisfy judgment based upon
claim against partnership (for which partner is personally
liable under§306) UNLESS creditor has exhausted
partnership assets.

• Partners resemble guarantors (and not principal debtors)

• Judgment against partnership may not be satisfied from
partner’s assets UNLESS there is also judgment against on partnership obligations or debt.
this partner.

339 340

339 340

Actions Against Partners

P1 P2

Vicarious Liability (§306)

Pair-&-Share
Partnership
Problems 3
Vicarious Liability (§305)

Direct Liability
P3 CREDITOR 341 342

341 342

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Problem 1 Problem 2
Facts Facts
• Doctors Freer and Shepherd practice medicine together in • Suppose Roberts sues Emory Family Practice Partnership

Emory Family Practice Partnership. and obtains judgment against the partnership only.
• Patient Roberts is injured through professional negligence
of Freer. Questions
• How can Roberts enforce that judgment? Whose assets

Questions are available to collect judgment?

• Can Roberts sue Freer?

• Can Roberts sue Shepherd, who was not involved in

Roberts’ care?
343 344

343 344

Problem 3 Problem 4
Facts Facts
• Suppose Roberts also sues Freer and Shepherd and • Your client, First Bank, is making loan to Emory Family

obtains a judgment against both Freer and Shepherd. Practice Partnership.

Questions Question
• Can Roberts go after Freer’s personal assets? • Is there any reason to require Doctors Freer and Shepherd

• Can Roberts go after Shepherd’s personal assets? to sign personal guarantees?

(This is tricky).

345 346

345 346

Problem 5 Outside-In Exposure

Facts • Personal creditor of partner can seize interest in
• Your client, Roberts, is considering investing $100K in partnership to satisfy creditor’s claim against partner
restaurant and becoming partner. (unrelated to partnership business).

Question • Personal Creditor: Obligation arises outside of partnership

• Is there any possibility that Roberts might lose more than
business.
$100K from this investment?
• Student Tip: Keep in mind difference between partnership
creditor and personal creditor.

347 348

347 348

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Charging Order
• Partner’s individual creditor must petition court for
charging order.
General
ships
Partner
• Charging Order: Order granted by court to judgment-
creditor that entitles creditor to attach partnership
interest. II
• Recall: Judgment-creditor is not given management rights
in business entity.

349

349 350

Topics
• Financing
• Capital Accounts

Financing

351 352

351 352

Financing Debt Financing

Debt Financing • Partnership can obtain additional funding by borrowing.
• Outside Lenders

• Debtor can ask for personal guarantees.

Equity Financing
• Existing Owners • Debt financing allows business to enjoy leverage.
• New Investors (Adding New Partners)

353 354

353 354

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Equity Financing Equity Financing

Existing Owners New Partners
• Partnership agreement often includes provision requiring • Partnership can obtain additional funding by bringing in

initial and additional contributions (capital calls). new partners.

Two Questions
• Do all existing partners have to approve new partner?

• Is new partner personally liable for all partnership’s

existing obligations?

355 356

355 356

Becoming Partner How Partners Make Money

After formation of partnership, person becomes partner in Partners make money from ownership of partnership
any of following ways: through:
• As provided in partnership agreement, or • Salary

• Unanimous Consent: With affirmative vote or consent of • Profit Allocations

all partners. • Sale of Transferable Interest

357 358

357 358

Salary
• Remuneration: Partner has no right to remuneration
for services rendered to partnership (absent
agreement to contrary).

Salary

359 360

359 360

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Problem 1 Current Cravath Associate Scale

Facts
• Bairds, Carhart, Wade, and Randall are partners in

partnership.
• Wade, Kalil Baird, and Hugh Carhart are employed by
partnership, but Ruth Baird and Randall are not.

Questions
• Can Kalil Baird, Carhart, and Wade receive salary from
partnership?
• Can Randall compel partnership to employ him and pay

him salary? 361 362

361 362

Profit Allocation
Profit Allocation: Unless otherwise provided, each partner is
entitled:
• Profits: To equal share of partnership profits, and

• Losses: Is chargeable with share of partnership losses in

Profit Allocation proportion to partner’s share of profits.

363 364

363 364

Distributions PPP Formula

• Right: Partner does not have right to receive distribution • Profits Per Formula (PPP) is given by following formula:
of profits credited to capital account.

• Timing: Distribution of profits is matter arising in ordinary 𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑜𝑓 𝐹𝑖𝑟𝑚

course of business (to be decided by majority vote of 𝑃𝑃𝑃 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑃𝑎𝑟𝑡𝑛𝑒𝑟𝑠
partners).

• Practice Tip: Most partnership agreements contemplate

some type of annual distribution.

365 366

365 366

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Profits Per Equity Partner Profits Per Equity Partner

367 368

367 368

Problem 1
Facts
• Assume restaurant had good year, earning $99K in profits.

• Ruth Baird (partner) comes to you and asks whether Ruth

Pair-&-Share can compel partnership to distribute share of profits to her.
Problems 4 Question
• How do you answer her question?

369 370

369 370

Problem 2 Problem 3
Facts Facts
• Now assume that 2022 was bad year for partnership. • Assume restaurant intends to distribute $100K to its 4 partners.
• Restaurant had to use earnings retained from prior years’ operation • Ruth Baird invested $350K in partnership, Carhart has invested
to pay bills. $100K, and Wade has invested $50K.
• 2022 was also bad year for Carhart and Wade personally. • Kalil Baird did not make capital contribution—Kalil works for
• Carhart and Wade come to you and ask whether partnership can partnership and draws salary (as do Wade and Carhart).
make distribution to partners notwithstanding bad year.
Question
Question • Do these different capital contributions matter under statutory
• How do you answer their question? defaults?
• Does your answer change if partnership’s loan agreement with bank • Can you draft partnership agreement that allocates profits and
prohibits distributions to partners UNTIL bank loan is fully repaid. 371 losses on basis of contributions?
372

371 372

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Partnership Taxation Partnership Losses

• Pass-Through: Partnership entity is not taxed on profits: Allocation of Losses
partners pay taxes on partnership profits. • Partnership losses are also portioned out to partners.

• Partners must individually pay tax on share of partnership

profits, regardless of whether partnership makes Example
distribution. • Partnership is formed by 2 equal partners and partnership
losses $100K in first year.
• Distributions are not themselves taxable. • Each partner receives $50K in losses.

• Losses can be used to offset other personal income,

• Example: Business begin with $200K in capital, borrows “sheltering” income and lowering overall tax burden.
$100K, and distributes $50K to each of 2 founding partners.
Distribution is not taxable. 373 374

373 374

Partnership Interest
• Partnership Interest: Partner’s right to receive
distributions.

Transfer of • This interest is personal property (like shares of stock in

company).
Partnership Interest

375 376

375 376

Transfer of Partnership Interest Rights, Duties & Obligations

Key Rules
• Transfer of partnership interest in partnership is permissible.
• Transfer does not cause partner’s dissociation.
• Transfer does not entitle transferee to participate in
management or conduct of partnership’s business.
• Transferee has right to receive distributions to which
transferor-partner would otherwise be entitled.
Rights
• Transferee has right to receive distributions to which
transferor would otherwise be entitled.
• Transferee is not personally liable for partnership losses.
Duties
• Transferor retains rights other than interest in distributions
transferred.
• Transferor retains all duties and obligations of a partner.

377 378

377 378

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 11/13/23

Problem 1
Facts
• Roberts receives Wade’s transferable partnership interest.

Pair-&-Share Questions

Problems 5 • Will Roberts have right to participate in partnership

decisions?
• Assuming no, what is possible policy reason?

379 380

379 380

Problem 2 Buy-Sell Agreements

Facts • Partner can also sell share of partnership back to
• Roberts receives Wade’s transferable partnership interest, partnership itself.

Questions • Buy-Sell Agreement: Partnership agreement often

• Will Wade retain right to participate in management of
partnership?
• What incentive does Wade have to participate actively in
partnership management at this point?
• Does Wade remain personally liable for partnership
obligations?
381
provides for sale of ownership interest back to partnership.
• Key Point: Even if no buy-sell agreement, partner has
power to compel partnership to pay for partnership
interest by voluntarily withdrawing from partnership.
382

381 382

Dissociation
• Dissociation: Change in relationship caused by partner’s
ceasing to be associated in carrying on of business.

Dissociation • Dissociation does not necessarily result in dissolution and

winding up of partnership business.

383 384

383 384

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Events of Dissociation Effects of Dissociation

Dissociation is caused if:
• Partner’s express will to withdraw,
• Happening of agreed-upon event,
• Expulsion of partner pursuant to: (1) partnership agreement,
(2) unanimous vote of other partners if unlawful to carry on
business with that partner, or (3) judicial decree upon
partner’s misconduct,
• Bankruptcy, death, or incapacity of partner, or
• Termination of entity-partner.
385
If person is dissociated as partner, then
• Rights: Person’s right to participate in management of
partnership business terminates,
• Fiduciary Duties: Person’s fiduciary duties terminates with
respect to matters arising after person’s dissociation, and
• Obligations: Person’s dissociation does not discharge person
from any obligation to partnership incurred while partner.
• Dissolution: Partner’s dissociation does not necessarily cause
dissolution of partnership (see supra).
386

385 386

Wrongful Dissociation Effects of Wrongful Dissociation

Term Partnership • Damages: Person that wrongfully dissociates as partner is
• Dissociation is wrongful if it occurs BEFORE expiration of liable to partnership and to other partners for damages
term or completion of undertaking. caused by dissociation.

At-Will Partnership • Buyout Delay: Person that wrongfully dissociates as partner

from term partnership is not entitled to payment of buyout
• Dissociation is wrongful only if it violates partnership price until expiration of term or completion of undertaking
agreement. (unless person can establish earlier payment will not cause
undue hardship to business of partnership).

387 388

387 388

Upon Dissociation Upon Dissociation

Two Possibilities
• RUPA§701: Partnership does buyout. Dissociation
• RUPA§801: Partnership dissolves.

Aside: Under UPA, partnership automatically dissolves if RUPA§701 RUPA§801

partner dissociates (no buyout option).

Buyout Dissolution

389 390

389 390

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Buyout Price Liquidation Value

• If person is dissociated as partner, then partnership must Fundamental Equation of Accounting:
purchase person’s interest at buyout price (even if
dissociation is wrongful—damages offset by buyout price). Assets = Liabilities + Owner’s Equity

• Liquidation Value = Net Asset = Assets – Liabilities

• Buyout Price: Equal to greater of:
o Liquidation value, or
o Value based on sale of entire business as going concern.
• Example: Consider firm with 2 partners. If assets of firm equal
$10 million and liabilities equal $5 million, then partner is
entitled to buyout of $2.5 million (assuming equal profit-
sharing).

• Capital account is accounting record that tracks equity stake of

391 partners. 392

391 392

Going Concern Chuck McGill Fired From HHM

• Going Concern: Market price or value of business.

• Example:
• Consider firm with 2 partners. Suppose assets of firm equal
$10 million and liabilities equal $5 million.
• Market price of business is $18. Why might this number be
higher than liquidation value?.
• Partner is entitled to buyout of $9 million (assuming equal
profit-sharing).

393 394

393 394

Plot Hole? Plot Hole?

Liquidation Value Going Concern
• Yes, this is a plot hole. • No, this is not a plot hole.

• In law firm, liquidation value = assets – liabilities likely • Value of law firm as going concern might be very large.

closely approximates total value of partners’ capital • Value might significantly exceed total value of partners’
accounts. capital accounts.
• Thus, it should be easy to buy out Chuck. • Thus, it should be very difficult to buy out Chuck.

395 396

395 396

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Problem 1
Facts
• Restaurant is partnership.

• Bairds, Carhart, Wade, and Randall are partners.

Pair-&-Share
Problems 6 Question
• Can 2020 partnership agreement provide that partners

cannot dissociate?
• What is difference between power to withdraw and right
to withdraw?

397 398

397 398

Problem 2 Bohatch v. Butler & Binion: Facts

Facts
• Suppose partnership provides that no partner can dissociate
UNTIL 2030.
Question
• Can Wade dissociate in 2023?
• What if partnership had no provision with respect to
dissociation but does provide that partnership is to have
10-year term?
• What if partnership had no provision with respect to
dissociation and no provision with respect to term?
• Bohatch became partner in law firm.
• Bohatch became concerned another lawyer was overbilling
client.
• Bohatch told managing partner who investigated and
found no evidence of overbilling.
• Firm fired Bohatch—expelled her from partnership.
• Bohatch sues on 2 theories: (1) tort theory of fiduciary
399
duty, and (2) contract theory. 400

399 400

Bohatch v. Butler & Binion: Holding Questions About Law

• Holding: No breach of fiduciary duty in expelling Bohatch
for good-faith but erroneous report of concern about
overbilling by another lawyer.
• Rationale: Partnership is consensual relationship, and no
one can force partnership to keep someone as partner.
• Bohatch’s charge made it difficult for others to work with
her: “trust relationship between partners is more
important than permitting whistleblowing.”
401
• Would Texas Supreme Court have reached different result if
Bohatch had been correct and was still expelled?
• Is Bohatch consistent with Meinhard?
• Can law firm expel partner because practice is no longer
profitable? Because other partners find partner annoying?
• When Bohatch was expelled, did she have right to be paid
share of value of partnership? Was she relieved from any
liability for debts of partnership?
402

401 402

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Judicial Dissociation Giles v. Giles Land Company: Holding

On application by partnership or partner, judicial determination
that person:
• Wrongful Conduct: Engaged in wrongful conduct that has
adversely and materially partnership’s business
• Material Breach: Committed willfully or persistently material
breach of partnership agreement or fiduciary duty
• Conduct: Engaged in conduct relating to partnership’s business
which makes it not reasonably practicable to carry on business
with person as partner.
403
• Holding: Court affirms trial court ruling that Kelly can be
dissociated by court order.
• Rationale: “In light of animosity that Kelly harbors toward
his partners and his distrust of them, it is clear that Kelly
can no longer do business with his partners and vice
versa.”
404

403 404

Questions About Law

• How did Kelly “materially affect [partnership business] or
“make it not reasonably practicable to carry on the
business in partnership with the partner”

• Why didn’t the “remaining members of the partnership”

simply vote to expel Kelly? Is it relevant that Kansas
Dissolution
partnership statute provides that dissociation by judicial
expulsion is wrongful dissociation?

405 406

405 406

Dissolution Types of Dissolution

• Dissolution: Formal disbanding of partnership, 3 Types of Dissolution:
corporation, or other business entity. • By act of parties,

• By operation of law, or
• Partner dissociates, while partnership dissolves. • By court order.

• Dissociation does not necessarily cause dissolution Default Rule

• Partnership agreement can change or eliminate only

dissolution triggered by act of partners.

407 408

407 408

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Dissolution By Act of Partners Dissolution By Act of Partners

At-Will Partnership
• If partner withdraws by express will, then partnership is
dissolved and its business must be wound up.
• If partner dissociates in any other way, then remaining
partners have option of: (1) dissolution, or (2) buyout.
Editorial Point. (contract around it tho)
Term Partnership
• Partnership is dissolved and its business must be wound up
if:
o Within 90 days after partner’s death, bankruptcy, or
wrongfully dissociation, at least half of remaining
partners wish to wind up partnership.
o All partners consent to wind up business, or

• That partner can still voluntarily blow up at-will partnership o Term expires or undertaking is completed.
(unless partnership agreement otherwise provides) represents
big exception to claim that RUPA makes partnerships more
stable.
409 410

409 410

Power to Dissolve By Operation of Law

• Key Point: Harder to dissolve term partnership that at-will
partnership: requires vote of partners, and not just
unilateral act by single partner.
• Example: Withdrawal of partner in term partnership does
not automatically result in dissolution (must be wrongful
and requires partnership vote).
• Dissolution by operation of law occurs if illegal to continue
business (or substantially all of business).
• Example: Firm’s business is manufacture and distribution
of trans fats. Law is enacted making it illegal to do just
that. Firm would dissolve by operation of law.

411 412

411 412

By Court Order By Court Order

• Dissolution by court order can occur on application by Question
partner. • Why might this be highly inefficient.

• Court may order dissolution upon application by transferee
of partner’s transferable interest (creditor) if court
determines such is equitable.
• Example: If creditor obtains charging order against Paul
Partner and obligation cannot reasonably be paid by firm,
then court can order dissolution such that creditor is paid
from liquidated assets of firm.
413
Liquidation Value < Going Concern Value
• What are external effects? Who else gets hurt here.
Creditors? Employee? Local community?
• Power of court to dissolve partnership places far-reaching
equitable limit on principle of freedom of contract.
414

413 414

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Judicial Dissolution Palmer v. Mellen: Facts

On application by partner, judicial determination that:
• Economic Purpose: Economic purpose of partnership is likely
to be unreasonably frustrated,
• Partner Conduct: Partner has engaged in conduct relating to
partnership business that makes it not reasonably practicable
to carry on business with that partner, or
• Business Operations: It is not otherwise reasonably practicable
to carry on partnership business in conformity with
partnership agreement.
415
• Family partnership owns real property that is declining in
value.
• Partnership agreement requires that all partners consent to
sale of property.
• Partnership has management committee.
• 4 of 5 members voted to sell.
• Chris Mellen who wants to buy property with his brother
voted against sale.
• Plaintiff partners filed complaint seeking judicial dissolution.
416

415 416

Palmer v. Mellen: Holding Questions About Law

• Holding: Court concluded that facts supported judicial • Question: Why did plaintiffs seek judicial dissolution of
dissolution on all 3 grounds set out in RUPA§801. Watkins Enterprises Land Trust/Partnership instead of
judicial dissociation of Chris Mellen?

• Answer:
• Plaintiffs wanted more than to simply be relieved from
having Mellen brothers as partners (i.e., dissociation):
Plaintiffs wanted to sell partnership property and
terminate partnership (i.e., dissolution).
• By deciding to dissolve partnership, judge, in effect,
417
decided that partnership property be sold. 418

417 418

Capital Accounts
Partner’s Capital Accounts: Each partner has capital account
in amount equal to:

Capital Account = Partner’s Contribution + Partner’s Share

Capital Accounts of Profit (or Losses) – Distributions

419 420

419 420

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Composition of Capital Accounts

Increases Capital Account
• Money contributed by partner.

• Property contributed by partner.

• Allocations to partner of partnership profits.

Distribution of
Decreases Capital Account
Assets
• Money distributed to partner.

• Property distributed to partner.

• Allocation to partner of partnership losses.

421 422

421 422

Dissolution Process Winding Up

Dissolution involves 2-step process: Winding Up: Firm’s assets are collected, liquidated, and
distributed, and liabilities are discharged.
• Winding up

• Termination Winding up includes:

• Selling partnership assets,

• Discharging liabilities, and

• Distributing net balance (if any) to partners in cash

according to partnership interest.

Partnership stays in business during winding up process.

423 424

423 424

Disposition of Assets Order of Distribution

• In winding up its business, partnership shall apply its • Partnership assets are reduced to cash and partnership
assets to discharge partnership’s obligation to creditors, liabilities are paid in following order:
(including partners that are creditors). o Creditors (including partners who are creditors)

o Partners’ capital accounts

• If partnership assets are insufficient to satisfy its
obligations, then each person that was partner (when
obligation was incurred) shall contribute to partnership for
purpose of enabling partnership to satisfy obligation.
425
• If capital account has positive balance, then amount is
distributed to partner.
• If capital account has negative balance, then partner must
contribute amount of deficiency to partnership—this
represents personal liability.
426

425 426

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Distribution Procedure
To determine amounts owed to partner,
• Creditors: Deduct from assets left at dissolution any amounts
still owing to creditors (including partners who are creditors).
• Equityholders: Next, deduct partner’s capital contributions. Pair-&-Share
Money that remains is profit to be divided among partners per
Problems 7
•

agreement (or equally absent agreement).

If assets at dissolution are less than money owed to creditors and

capital contributions, then shortfall is loss to be divided among
partners per agreement (or like profits absent agreement).

427 428

427 428

Problem 1 Problem 2
Facts Facts
• On dissolution, partnership owes $100K to its creditors, • Suppose partnership has no assets.

including $20K lent to partnership by one of partners,

Ruth Baird. Question
• Can creditors collect unpaid balance of their claims from
Question partners individually?
• Should debt owed to Ruth Baird be treated differently from
debt owed to other creditors?

429 430

429 430

Problem 3 Accounting Formulas

Facts Key Accounting Formulas
• Partners agree to share profits equally.
• Capital Account = Shareholders’ Equity
• At dissolution, partnership has net assets worth $200K.

• Ruth contributed $100K to partnership, Wade contributed • Shareholder’s Equity = Assets – Liabilities = Net Assets
$8K, and Hugh contributed $2K.
• Shareholders’ Equity = Contributed Capital + Retained Earnings
Question
• Retained Earnings = Net Income – Distributions
• How should $200K be distributed?

431 432

431 432

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Solution Procedure Problem 3: Answer

Process
• Capital Account = Shareholder’s Equity = Net Assets
• First Stage: Capital Account = $30K = Net Assets.
• Second Stage: Capital Account = $0K = Net Assets, which
implies that partnership has made a loss (because net
income moves equity up or down).
• Final Step: Allocate loss (or profit) equally across initial
capital accounts.
• Check Your Work: Following must hold true:
Capital Accounts (Total) = Net Assets.
433
• Partners invested $110K in total (= $100K + $8K + $2K).
• Net assets now equal $200K, which implies that
partnership made $90K in profits.
• Profits are divided equally among partners.
• Ruth receives $130K (= $100K + $30K).
• Wade receives $38K (= $8K + $30K).
• Hugh receives $32K (= $2K + $30K).
• Note: RUPA provides that Hugh gets no credit for work
devoted to partnership. 434

433 434

Capital Losses Problem 4

• Default Rule--RUPA §401(b): Each partner is chargeable Facts
with share of partnership losses in proportion to partner’s • Same facts as above.
share of profits. • At dissolution, partnership has cash and property worth

$20K.

Question
• How should $20K be distributed?

435 436

435 436

Problem 4: Answer Problem 5

• Partners invested $110K in total (= $100K + $8K + $2K). Facts
• Net assets now equal $20K, which implies that partnership • Ruth invests $10K in partnership and Wade invests $20K.

has lost -$90K, • Partnership has $0K in net assets.

• This loss is divided equally among partners.

Distribution
• Ruth receives $70K (= $100K – $30K).
• How should assets be distributed?
• Wade pays -$22K (= $8K – $30K).
• Where did $30K go?
• Hugh pays -$28K (= $2K – $30K).
• There must have been loss (net income is negative):
Update capital accounts accordingly.
• Check: $70K – $22K – $28K = $20K
437 438

437 438

73

Problem 5: Answer
• Partners invested $30K in total (= $10K + $20K).
• Net assets now equal $0K, which implies that partnership
has lost -$30K,
• This loss is divided equally among partners.
• Ruth receives $5K (= $20K – $15K).
• Wade pays -$5K (= $10K – $15K).
439
Kovacik v. Reed: Facts
• Kovacik and Reed entered general partnership to operate kitchen
remodeling business.
• Kovacik made initial capital contribution of $10K.
• Reed made no capital contribution but did contribute promise of
future services.
• Kovacik and Reed agreed to share profits equally but made no
provision for allocating loses.
• Reed apparently took no salary.
• Kovacik dissolved partnership after 10 months and claimed
partnership had lost $8,680.
• Kovacik sought to recover ½ of partnership’s capital loss from
Reed.
441
Problem 4 Redux
• Note: Court assumes here that Reed’s labor is equal to
cash loss incurred.
• Kovacik’s account balance = $10K, Reed’s account balance
= $8,680K.
• Partnership has lost $17,360 , which is divided equally
among partners.
• Kovacik receives $1,320K (= $10K – $8,680K).
• Reed receives $0K (= $8,680K – $8,680K).
443
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Negative Equity
Question
• What does negative equity imply?
Answer
• Negative equity = Personal liability (you must reach into
your personal assets to pay negative amount).
• Example: Value of home = $700K. Mortgage loan = $800K.
What is your equity in home? What does this imply if
mortgage loan is recourse (meaning borrower is
439 personally liable on loan)? 440
440
Kovacik v. Reed: Holding
• Holding: If one partner contributes money capital as
against other’s skill and labor, then neither party is liable
to other for contribution for any losses sustained.
• Rationale: Each partner has lost own capital in event of
loss (one money, other labor); if this happens but parties
agree to share profits equally, then parties view each
other’s contributions as equal in value.
441 442
442
Questions About Law
• Question: Were creditors of partnership paid? If so, who
paid creditors of partnership?
• Answer: Partnership had already paid its obligation to
creditors: partnership had paid these third-parties with
partnership funds invested by Kovacik. Partnership ended.
• Question here was not whether creditors of partnership
would recover on claims, but whether Kovacik would
recover anything on investment in partnership.
443 444
444
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Question About Law Kovacik: Result under RUPA

• Question: Would result in this case have been different if
court had applied RUPA?
• Answer: RUPA expressly rejects Kovacik: partner who does
not contribute capital is liable for partnership’s losses in
proportion to share of profits.
• Note: RUPA does not credit partnership for value of labor.
• Kovacik’s account balance = $10K, Wade’s account balance
= $0K.
• Partnership has lost $8,360, which is divided equally
among partners.

• Kovacik receives $5,660K (= $10K – $4,340K).

• Reed pays -$4,340K (= $0K – $4,340K).

445 446

445 446

Hypothetical 1 Hypothetical 2
Facts Facts
• Ruth contributed capital of $100K to partnership. • Ruth contributed capital of $10,000,000 to partnership.

• Wade contributed only labor. • Wade contributed only labor.

• Partnership now has Net Asset = $0. • Partnership now has Net Asset = $0

Questions Answer
• At dissolution, how would $100K be distributed under • RUPA: Wade must pay $5 million to Ruth (loses are

RUPA? distributed equally between Wade and Ruth).

• At dissolution, how would $100K be distributed under • Kovacik: Ruth loses total investment (loses are distributed
Kovacik? equally between Wade and Ruth but Wade is assumed to
447 have made $5 million contribution) 448

447 448

Question About Law Shareholder’s Equity

• Question: Is RUPA rule (that labor partner is liable for • Corporations do not use capital accounts.
losses) unfair to partner who contributes labor?
• Shareholders purchase shares
• Does answer depend upon whether partnership pays for
labor of partner (whether labor is “truly” contributed)?

449 450

449 450

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Shareholder’s Equity To Summarize

• Insert example • RUPA: Splitting losses equally ignores labor partner’s labor.

• Kovacik: Pushing ALL losses onto equity partner implies

value of partnership losses equals value of labor partner’s
labor (as our analysis shows).

• Optimal Approach: Estimate true value of labor and credit

labor partner’s capital account in that amount.

451 452

451 452

Termination
• When winding up is completed, partnership entity
terminates.

Termination represents death of business entity.

•
In Summary

453 454

453 454

Advantages Disadvantages
• Easy to form (no filing requirements) • Personal joint and several liability

• Pass-through • Lack of transferability (can only transfer financial interest,

not partnership interest)
• No formalities of operation
• Management responsibilities
• Incredibly flexible (lots of default rules)
• Fragile (at will partnership dissolves if partner withdraws,
unless partnership agreement provides otherwise)

• Fiduciary duties
455 456

455 456

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Limited Partnership Defined

• Limited Partnership: Distinct legal entity comprised of 1 or
more general partners and 1 or more limited partners.
LIMITED
Limited partnership is required to have both general
PARTNERSHIPS •
partners and limited partners.
(LPS)
• Governed by state law containing mainly “default rules.”

457 458

457 458

Use of Limited Partnerships Sources of Partnership Law

• Limited partnerships are generally used as financing vehicle 2 Sources of Limited Partnership Law
to raise cash for business project.
• State Statute

• Partnership Agreement
• Limited partnerships are common in real estate
development projects and film industry.

459 460

459 460

State Statute Partnership Agreement

• Revised Uniform Limited Partnership Act (RULPA 1985):
Has been adopted in most states (including Delaware and
Florida)
• If RULPA (1985) is silent with respect to certain issue, then
courts will consider applicable general partnership law.
• General partnership law applies to general partners.
• Primary source of limited partnership law is partnership
agreement.
• Rationale: Businesspeople should be left to structure
relationship as bests suits them.
• Gap-Filler: If matter is not reflected in partnership
agreement, then matter is resolved according to default
provisions of RULPA.

461 462

461 462

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Underlying Policy Freedom of Contract

Stated Purpose
• “It is the policy of [the Act] to give the maximum effect to
the principle of freedom of contract and to the
enforceability of limited partnership agreements.”
463
• “The Act’s basic approach is to permit partners to have
the broadest possible discretion in drafting their
partnership agreements and to furnish answers only in
situations where the partners have not expressly made
provisions in their partnership agreements. Truly, the
partnership agreement is the cornerstone of a Delaware
limited partnership, and effectively constitute the entire
agreement among the partners …. Once partners exercise
their contractual freedom in their partnership agreement,
the partners have a great deal of certainty that their
partnership agreement will be enforced in accordance
with its terms.” 464

463 464

Formation
Formation of limited partnership requires:
• Certificate of Limited Partnership

• Records Office

Formation • Agent for Service of Process

• Partnership Agreement

465 466

465 466

Certificate of Limited Partnership Certificate of Limited Partnership

• Certificate of Limited Partnership: Document (signed by
each general partner) setting forth:
o Name of partnership

o Name and address of agent for service of process

o Name and address of each general partner, and

o Whether partnership is limited liability partnership.

• Question: Why do limited partnership statutes condition

existence of limited partnership on public filing of certificate
of limited partnership but general partnership statutes do
not? 467 468

467 468

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Records Office Agent for Service of Process

• Limited partnership must maintain office with records of: • Limited partnership must maintain agent for service of
o Certificate of limited partnership, process.
o Partnership agreement, and

o Partnership’s tax return for 3 most current years. • Limited partnership can change its agent by filing statement
with department of state.
• Registered office can be changed by filing statement of
change with department of state.

469 470

469 470

Partnership Agreement Name of Partnership

• Every limited partnership must have a writing that sets out: • Partnership name must contain words, “limited
o Amount of cash or agreed value of all property or partnership” or “limited,” or abbreviations “L.P.,” “Ltd.,” or
services to be contributed by each partner, “LP.”
o Times at which future contributions are to be made,

o For any person who is both general partner and limited • Question: Why do limited partnership statutes requires
partner, specification of transferable interest person this?
owns in each capacity, and
o Any events of dissolution.

471 472

471 472

Dual Capacity Question on Formation

• Person can be both (1) general partner, and (2) limited
partner.
• Person who is both general and limited partner has rights,
powers, duties, and obligations in each of those capacities.
• Question: Can limited partnership, doing business only in
Florida, be structured as limited partnership organized in
Delaware?

• Example: Person can vote in capacity as both limited

partner and as general partner.

473 474

473 474

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Annual Report
• Between January 1 and May 1 of each year, limited
partnership must renew certificate of authority by filing
report with Department of State and paying required fee.

Cash Flow Rights

475 476

475 476

Conflicting Policy Objectives Separation of Ownership & Control

Partnership Law
• Pick-Your-Partner Rule: Owners cannot be forced into business
venture with stranger without owner’s consent.
UCC
• Alienability: UCC wants to facilitate voluntary transfers of
personal property (e.g., facilitate transfers of property as
security for repayment of loans).
Policy Resolution
• Bifurcate ownership into: (1) cash flow rights, and (2) control
• Transferability requires (1) separation of ownership &
control, and (2) no personal liability.
Transferability Liquidity Access to Capital
• Limited partnership interest is more likely to be transferable,
the less control limited partner exerts over business (ideally,
pure cash flow right with no liability).
• Roughly Speaking
o Limited Partners (Ownership) v. General Partners (Control)

rights. 477 o Shareholders (Ownership) v. Managers (Control) 478

477 478

Transfer of Partnership Interest Default Rules

• Transfer of partnership interest in limited partnership to
third-party by either general partner or limited partner is
generally governed by limited partnership agreement.
• If and only if limited partnership agreement does not
address partners’ transferring partnership interest to third-
party, do you look to default rules of limited partnership
statute (of state in which business has filed its certificate of
limited partnership).
Default Rules
• Transfer (in whole or in part) of partner’s transferable
interest is permissible.
• Transfer does not cause partner’s dissociation.
• Pick-Your-Partner Rule: Transfer does not entitle
transferee to participate in management or conduct of
limited partnership’s business.
• Transferee has right to receive distributions to which
transferor-partner would otherwise be entitled.

479 480

479 480

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Rights, Duties & Obligations

Rights
• Transferee has right to receive distributions to which
transferor would otherwise be entitled.
Transferee is not personally liable for partnership losses or
Distributions
•
other obligations.

Duties
• Transferor retains rights other than interest in distributions
transferred.
• Transferor retains all duties and obligations of a partner.
481 482

481 482

On Basis of Contributions Charging Order

• EXCEPTION: UNLESS otherwise provided in partnership • Charging Order: On application by judgment creditor of
agreement, distributions are made on basis of partners’ partner, court can enter charging order against
contributions (i.e., in proportion to value of each partner’s transferable interest of judgment debtor for unsatisfied
contributions). amount of judgment.

• Note: Differs from general rule under RUPA which provides • Lien: Charging order constitutes lien on judgment debtor’s
that profit and losses are to be shared equally. transferable interest and requires partnership to pay over
to judgment creditor any distribution that otherwise
would be paid to judgment debtor.

483 484

483 484

Asset Partitioning
• Asset Partitioning: If limited partnership does not make
distributions, then judgment creditor receives nothing: all
undistributed assets and accrued cash flow remain inside
limited partnership.
Control Rights
• Looking Ahead: In FL, judgement creditor of single-
member LLC can use reverse veil-piercing to get at
undistributed assets of business.

485 486

485 486

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Pick-Your-Partner Rule Control Rights of General Partners

• Pick-Your-Partner Rule: Unless partnership agreement
provides otherwise, no partner (whether general or limited)
can transfer control rights to another person without
consent of all other partners.
• Ordinarily transferee is not automatically entitled to
exercise any rights or powers of partner.
• UNLESS limited partnership agreement specifies otherwise,
general partner of limited partnership has all same control
rights of partner in regular general partnership.
• Unless limited partnership agreement otherwise provides,
if more than 1 general partner, then each has equal control
rights.

• Comment: Rule is counterintuitive insofar as limited

partners are more like shareholders than partners and
ought to be able to transfer more than partnership interest.
487 488

487 488

Control Rights of Limited Partners

• UNLESS limited partnership agreement specifies otherwise,
limited partners have right:
o To “participate” in management and control of limited
partnership without becoming personally liable for limited
partnership’s obligation,
Pair-&-Share
o To receive information, and Problems 8
o To sue for wrongful act by partnership or other partners
(e.g., breach of fiduciary duties).

• This right is limited: exercise of “too much” control by limited

partner can result in limited partner becoming personally
liable for limited partnership’s obligations (see infra). 489 490

489 490

Problem 1 Problem 2
Facts Facts
• Restaurant is limited partnership in which Carhart is one • Assume that Carhart is also limited partner in restaurant.

of several general partners. • Carhart transfer his limited partnership interest to

Epstein.
Question
• If Carhart transfer his partnership interest to Roberts, will Question
Roberts have right to participate in management of • Does Epstein have right to vote on removal of general
limited partnership? partner?
• Will Carhart retain his right to participate in

management?
491 492

491 492

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Master Limited Partnerships

• Master Limited Partnership (MLP): Publicly traded limited
partnership.

Investors can buy units in publicly traded limited

•
partnership on public securities market (e.g., NYSE, Fiduciary Duties
NASDAQ).

• Those who buy into MLP are limited partners: Pick-Your-

Partner default rule is shut off in this business structure.

493 494

493 494

Duties of Limited Partner Duties of General Partner

• General Rule: Limited partner has no fiduciary duty to • General Rule: General partner owes same fiduciary duties
limited partnership solely by reason of being limited to limited partnership and other partners as general
partner. partner owes to general partnership and other partners.

• Exception: To extent limited partner has management

duties under partnership agreement, limited partner owes,
with respect to exercise of those duties, duties of loyalty
and care.

495 496

495 496

Statutory Construction of Partnership

Agreement
Corporate General Partner
• Statute gives maximum effect to principle of freedom of • General partner in limited partnership generally is
contract. corporation.

• Partner’s fiduciary duties may be expanded, restricted, or
eliminated by provision of partnership agreement EXCEPT
FOR duty of good faith and fair dealing.
• Corporate general partner owes fiduciary duty to limited
partnership.
• Looking Ahead: Officer or director of corporation owes
fiduciary duty to corporation.

• Question: What duties do these corporate officers or

directors owe to limited partners of limited partnership?
497 498

497 498

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 11/13/23

Corporate General Partner In Re USACafes, L.P.: Facts

Corporate Officers
Corporation
Corporate General Partner
Limited Partnership
Limited Partners
• USACafes is L.P. with corporate general partner.
• Corporation is owned by Wyly brothers and is run by
board of directors on which Wyly brothers sits.
• Plaintiffs (investors in L.P.) allege managers of corporation
???
sold assets of limited partnership to third-party (Metsa)
for too low price (because managers received kickbacks).
• Plaintiff sued individual managers as well as corporate
general partner itself.
499 500

499 500

In Re USACafes, L.P.: Defendants Argue In Re USACafes, L.P.: Holding

Defendants Argue • Holding 1: Directors of general partner owe duty to limited
• Concede that corporation owes fiduciary duties to limited
partners (but court does not give full delineation of limits of
partner investors. duty owed, content to say that one exists on facts alleged).

• Defendant-directors of corporation, however, owe duties

• Holding 2: General partner itself was wrongdoer and
to corporation but not directly to limited partners.
defendants owed duties to that entity.
• Thus, case can proceed against corporation, but not
against Wyly brothers as individuals.

501 502

501 502

Questions About Law Hypothetical

• Why were plaintiffs so eager to sue Wylys?
Hypo
• Assume Hotel, Inc. is general partner of Hotel Limited Partnership.
• Roberts and Shepherd are 2 of 3 directors of Hotel, Inc.
• They learn of new hotel opportunity that might be of interest to
either limited partnership or corporate general partnership.

Question
• Does USACafes holding expose Roberts and Shepherd to liability if
Hotel, Inc. takes opportunity for itself?
• Would following language in limited partnership agreement be
helpful to Roberts and Shepherd: “Directors of corporate general
partner do not owe fiduciary duty to limited partnership or limited
503 partners? 504

503 504

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 11/13/23

Critiques of USACafes
• Contravenes business entity law principles of legal
separateness, imposing onto controllers of fiduciary entity
duties formally owed by fiduciary entity (cf. piercing
corporate veil).

• Conflicts with freedom of contract insofar as parties agreed

Liability
entity, and not entity’s controllers, would stand in position
of fiduciary.

• Imposes potentially irreconcilable fiduciary duties on

controllers simultaneously owed to fiduciary entity
(corporate GP) and beneficiary entity (LP). 505 506

505 506

General Partner’s Liability Hypothetical

• Mandatory Rule: General partner of limited partnership is
personally joint and severally liable for all obligations of
limited partnership.
• Liability of Incoming Partner: Person who becomes
general partner of existing limited partnership is not
personally liable for preexisting obligations.
Facts
• Assume Carhart is general partner in limited partnership.
Question
• Can creditors of limited partnership collect unpaid debts of
limited partnership from Carhart personally?
• Can provision in limited partnership agreement limit

personal liability of general partner, Carhart, to creditors

of limited partnership for unpaid debts of limited
partnership?
507 508

507 508

Limited Partner’s Liability Control Rule Exception

• General Rule: Limited partner is not personally liable for
obligation of limited partnership solely by reason of being
limited partner (even if limited partner participates in
management and control of limited partnership).
• Rationale: Limited partners (like shareholders) have no (or
only limited) control over business.
• Control Rule (Common Law): Limited partner who exerted
“control” over business of limited partnership can become
liable for obligations of limited partnership.
• Rationale: Limited partner has become general partner by
exercising control over business.
• Common law control rule overridden by RULPA statute.

• Aside: Limited partnerships have existed in U.S. since 1822,

when New York passed first Limited Partnership Act.
509 510

509 510

85
 11/13/23

RULPA Statutory Rule Statutory Safe Harbors

Limited partner is not liable for obligations UNLESS:
• Limited partner is also general partner, OR
• Limited partner (1) participates in control of business, AND
(2) person suing who transacted business with limited
partnership reasonably believed (based upon limited
partner’s conduct) that limited partner is general partner.
Comment: Statutory rule adds justifiably reliance to
common law control rule (this provides significant protection
to limited partner—arguably more so than statutory safe
harbors). 511
Limited partner does not participate in control of business if:
• Officer, director, or stockholder of corporate general partner,
• Consults with or advises general partner,
• Acts as surety,
• Requests or attends meeting of general partners,
• Votes on transactions related to disposition of partnership
assets, change in partnership indebtedness, change in nature
of business, amendment to partnership agreement, or
admission/removal of new general or limited partner.
512

511 512

Liability of Limited Partner In Summary

Was partnership properly
formed? NO

Partner does not have

YES limited liability.

Is partner acting as YES

general partner?

NO

Partner’s liability is limited

to capital contribution. 513 514

513 514

Dissociation of GP
• General Rule: Same events cause dissociation of general
partner in limited partnership as cause dissociation of
partner in general partnership.

Dissociation

515 516

515 516

86
 11/13/23

Effect of Dissociation of GP LP’s Power to Dissociate

• Rights: Upon dissociation as general partner, person has no
further rights as general partner.
• Fiduciary Duties: Upon dissociation as general partner,
fiduciary duties owed to limited partnership terminate.
• Whether limited partner has power to dissociate depends
on whether partnership agreement (1) states specific term
for partnership, and (2) authorizes limited partner
withdrawal.

• Obligations: Dissociation as general partner does not • In certain cases, limited partner has neither power nor
discharge person from any obligation to limited partnership right to withdraw. Really!!!
incurred while general partner.

• Dissolution: General partner’s withdrawal threatens but does

not necessarily cause dissolution (details in next section).
517 518

517 518

Dissociation as LP Dissociation as Limited Partner

Case 1: Case 2:
• If limited partnership agreement provides for limited • If limited partnership agreement (1) does not provide for

partner withdrawal, then limited partner can withdraw limited partner withdrawal, and (2) does not provide for
only as provided in partnership agreement. specific term for partnership, then limited partner can
withdraw on 6 months’ written notice.

• Comment: Situation is unlikely to occur, because RULPA

requires certificate of limited partnership to state definite
term.

519 520

519 520

Dissociation as Limited Partner Summary

Case 3: Partnership Agreement
Partnership Agreement
• If limited partnership agreement (1) does not provide for Does NOT Provide for
Provides for Withdrawal
limited partner withdrawal, and (2) provides for specific Withdrawal
term for partnership, then limited partner cannot
Can withdraw per
withdraw. Term Partnership
partnership agreement
Cannot withdraw

• In this case, limited partner has neither power nor right to Can withdraw per
withdraw. Can withdraw on 6-
Not Term Partnership partnership agreement
month’s notice

• Locked-Up: First time that we have seen limitation on

person’s right to withdraw from business entity.
521 522

521 522

87

Questions
• Question: What are reasons that limited partner would
decide to withdraw from limited partnership? Are possible
reasons that general partner would decide to withdraw
from limited partnership different?
• Question: Why would limited partnership statute provide
different rules for withdrawal by general partner and
withdrawal by limited partner? Do these different rules
make sense?
523
523
Dissolution
525
525
Judicial Dissolution
• Limited partnership can be judicially dissolved upon
application by partner if not reasonably practicable to
carry on limited partnership in conformity with
partnership agreement.
• Comment: Limited partnership can also be
administratively dissolved by Department of State for
failure to pay fees, file records, or deliver annual report.
527
527
11/13/23
Effect of Dissociation by LP
• Rights: Upon dissociation as limited partner, person has no
further rights as limited partner.
• Obligations: Dissociation as limited partner does not
discharge person from any obligation to limited partnership
incurred while limited partner.
• Dissolution: Withdrawal of limited partner cannot cause
dissolution (provided withdrawal does not result in 0 limited
partners).
• Buyout: Unless partnership agreement provides otherwise,
limited partner who withdraws has right to buyout. 524
524
Types of Dissolution
2 Types of Dissolution
• Judicial, and
• Non-Judicial
526
526
Non-Judicial Dissolution
UNLESS judicially dissolved, limited partnership is dissolved (and activities
wound up) only upon occurrence of any of following:
• Happening of event specified in partnership agreement
• Consent of all general and limited partners;
• After dissociation of general partner, if there is at least 1 remaining
partner, consent to dissolve of ALL partners.
• After dissociation of general partner, if there are no remaining general
partners, passage of 90 days after dissociation UNLESS before end of 90-
day period all remaining partners consent to continue activities of
limited partnership and to admit at least one general partner (and do).
• Passage of 90 days after dissociation of last limited partner UNLESS
before end of 90-day period limited partnership admits at least one
limited partner.
528
528
88
 11/13/23

Effects of Dissolution Winding Up

• If general partner’s withdrawal results in dissolution, then
consequences are same as dissolution of general
partnership (i.e., winding up & termination).
• If partnership avoids dissolution, then former general
• Limited partnership continues after dissolution only for
purposes of winding up its activities.
• In winding up, partnership:
o May preserve limited partnership business or property as

partner has right to buyout (unless otherwise provided in
partnership agreement).
• Wrongful Dissociation: If withdrawal breached
partnership agreement, then buyout is subject to any
damages caused by breach (or delay).
529
going concern for reasonable time, prosecute and defend
actions and proceedings, transfer property, settle disputes by
mediation or arbitration, and perform other necessary acts;
o Must address liabilities, settle and close partnership activities,
and distribute assets, and
o May file statement of termination.
530

529 530

Distribution of Assets
• Assets are distributed first to creditors (including partners
who are ordinary creditors of partnership).
LIMITED LIABILITY
Any surplus is then paid in cash as distributions.
•
PARTNERSHIPS
• If limited partnership’s assets are insufficient to satisfy all (LLPS)
obligations to creditors, then those who were general
partners at time obligation was incurred must contribute to
satisfy obligation.

531 532

531 532

Limited Liability Partnership Formation

• RUPA allows creation of limited liability partnerships. • Name: Must end with words “Registered Limited Liability
Partnership” or “Limited Liability Partnership” or
• Limited Liability Partnership: Partners are not personally abbreviations “R.L.L.P.”, “RLLP,” “L.L.P.” or “LLP.”
liable for limited liability partnership’s obligations.
• Filing: Partnership must file statement of qualification.
• Designed for professionals who normally do business as
partners (e.g., lawyers, doctors, and accountants).

533 534

533 534

89
 11/13/23

Liability of Partners Hypothetical

• Partner of limited liability partnership is not personally Facts
liable for obligations of partnership (whether arising in • Acme, Baker, and Carr form law firm, Acme & Baker LLP.
contract, tort, or otherwise). • Parker, who is Carr’s client, sues Carr for legal malpractice

and win $500K judgment.

• Partner remains personally liable for
o Own wrongful acts, or Question
• Can Parker collect on judgment from Carr?
o Wrongful acts of someone under partner’s direct • From Acme & Baker, LLP?
supervision.
• From Acme?

535 536

535 536

Limited Liability Limited Partnerships WARNING!

• Limited partnership may become limited liability limited • MATERIAL COVERED ON FINAL EXAM ENDS HERE!
partnership by obtaining necessary approval, filing • in this PPT until Corporate finance PPT*
statement of qualification, and complying with name
requirements.

• Limitations on liability of partners in limited liability

limited partnership apply to both general and limited
partners of limited liability limited partnership.

537 538

537 538

Purpose
• Limited liability company offer its owners both:
o Liability: Protection from liability for business’s debts

LIMITED LIABILITY (like liability protection of shareholders of corporation),

and
CORPORATIONS o Pass-Through Taxation: Same pass-through income tax

(LLCS) characteristics of partnership.

539 540

539 540

90
 11/13/23

LLC Terminology Sources of LLC Law

Terminology 2 Sources of Limited Liability Company Law
• Limited liability company is referred to as LLC. • State Statute

• Owners of LLC are referred to as members. • Operating Agreement

541 542

541 542

State Statute Operating Agreement

• Each state has statute authorizing creation of LCCs.
• LLC statutes vary greatly from state to state.
• In Florida, LLC are governed by Florida Revised Limited
Liability Company Act (RLLC).
• Courts must look to terms of Owners’ Agreement to
determine rules applicable to operation of LLC.
• Only where Operating Agreement is (1) ambiguous, (2)
contrary to law, or (3) does not contain any provision for
specific matter at issue, do LLC statutory provisions control.

543 544

543 544

Formation Management
• Articles of Organization: One or more organizers files 2 Types of LLCS
Articles of Organization with state. • Member-Managed LLC: Members manage business.

• Manager-Managed: Managers manage business.

• Articles of Organization must include:

o Name
o Mailing Address of Principal Office

o Registered Agent and Registered Office

o Continuity of Life: LLC has perpetual existence.

545 546

545 546

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 11/13/23

Member-Managed LLC Manager-Managed LLC

• Decision-making authority of members of member-managed • Decision-making authority of managers of manager-
company is much like that of partners in general partnership. managed company is much like corporation with board of
directors: professional managers and separation of
ownership and management.

• Manager of LLC can also be member of LLC.

• Manager is selected or removed by consent of majority-in-

interest of members.

547 548

547 548

Voting Powers
• Member-Managed LLC: All members are entitled to vote, • LLC has most of statutory powers accorded to corporation
and each vote is weighed in proportion to member’s then- including:
current percentage (or other allocable interest) in profit of o Capacity to sue or be sued as entity,
LLC.
o To hold property, and

o To adopt operating agreement to govern its internal

• Manager-Managed LLC: Each manager has equal rights in
affairs.
management and conduct of LLC’s activities.

549 550

549 550

Fiduciary Duties Agency Authority

• Each manager of manager-managed LLC and member of • If management is vested in membership, then individual
member-managed LLC owes fiduciary duties of care and members have apparent authority to bind company
loyalty to LLC and other members.. contractually.

• If management is vested in elected managers, then only

such managers normally have such authority.

551 552

551 552

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 11/13/23

LLC’s Liability Member’s Liability

Vicarious Liability Limited Liability
• LLC is business entity and is vicariously liable for actions and • Members and managers (generally) are not personally

inactions of its managers or its members. liable for company debts.

• Creditors of LLC must look exclusively to assets of

Example: company to satisfy claims.

• Hugh, Kalil, and Maria are members of Todos, LLC.
• To obtain catering contract for GGG for its annual convention,
Kalil falsely represents that Todos’ burritos are gluten-free.
• More than 100 GGG members who attended GGG convention
and ate burritos that were not gluten-free became ill.
• Is Todos LLC liable? 553 554

553 554

Finance Transferability of Interest

• Profits and losses are shared among partners on basis of • Cash Flow Rights: Member can freely transfer interest in
agreed value of capital contribution. profits and losses.

• LLC can make distribution to members, but no distribution
can be made if LLC would be insolvent after distribution.
• Member is entitled to return of capital contribution on
dissolution.
• Control Rights: Member cannot transfer interest in
managing company without unanimous consent of other
members (unless otherwise provided in operating
agreement).

555 556

555 556

Dissociation
• Person has power to dissociate as member of LLC at any
time (although wrongfully dissociating member might be
liable for damages).
• Causes: Events that will cause dissociation of partner in
general or limited partnership (generally) will also cause
dissociation of member of LLC.
Dissolution
LLC is dissolved:
• Upon occurrence of event specified in operating
agreement,
• Upon unanimous consent of all members,
• Upon passage of 90 days (if there are no members left),
• When court orders dissolution, or
• When Department of State files statement of

administrative dissolution.

557 558

557 558

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 11/13/23

Topics
• Pass-Through Entities
• Corporate Income Tax
CORPORATE • Preferential Tax Treatment of Debt
Tax Avoidance
TAXATION
•

559 560

559 560

Pass-Through Entity
• Pass-Through Entity: Business entity that has no tax
liability: entity’s income is “passed through” to owners of
entity who pay personal income taxes on distribution.
Pass-Through
Entities • Following business entities are pass-through:
o Sole proprietorship

o General partnership

o Limited partnership
o Limited liability company

561 562

561 562

No Double Taxation IRS Form 1065

• NO Double Taxation: Profits or losses that partnership
incurs “pass through” to partners who pay taxes on share
of profits.
• Partnership itself pays no taxes and is responsible only for
filing information return (Form 1065) each year with IRS.
• Allocation of profits or losses for all partners is calculated
and recorded on Form 1065 at end of each fiscal year.
• Form reports partners’ gains, losses, credits, and
deductions to Internal Revenue Service.
• No tax reported on Form 1065 because partnership is
pass-through entity, and partners report and pay taxes on
their personal income tax returns.

563 564

563 564

94
 11/13/23

IRS Form 1065 Schedule K-1

• Separate Schedule K-1 forms are filled out and distributed
to each partner.

• Schedule K-1 details share of income, credits, and

deductions that each partner reports on individual income
tax returns.

• Partners are not employees and are not issued W-2 tax
form.

565 • 566

565 566

Schedule K-1 IRS Form 1040

• Individual 1040 tax returns will carry respective K-1
amounts as part of total income for year.

• Partner pays tax on this amount equal to personal income

tax rate.

567 568

567 568

IRS Form 1040 Personal Income Tax Rate

569
• Income Tax: Maximum personal income tax rate is 37%. 570

569 570

95
 11/13/23

Personal Income Tax Rate Personal Income Tax Rate

• Income Tax: Maximum personal income tax rate is 37%. • Income Tax: Maximum personal income tax rate is 37%.

571 572

571 572

Some Old Facts about Pass-Throughs

• Most Businesses Were Pass-Through: Of 26 million
businesses in 2014, 95% were pass-through, while only 5%
were C-corporations.
Corporate Income
• Most businesses are small: In 2014, almost 99% of all Tax
businesses had $10 million or less in sales or receipts.

• Pass-through businesses earn majority of business income:

In 2013, only 44% of income of business owners was
earned through C-corporations.
573 574

573 574

Corporate Income Tax Corporate Income Tax over Time

• Corporate profits are subject to federal and state
corporate income tax.

• Tax Cut and Jobs Act (TCJA) reduced federal corporate

income tax rate from 35% to 21%.

575 576

575 576

96
 11/13/23

Corporate Income Tax in Context

577 578

577 578

Double Taxation
• Double Taxation: Corporate profits are taxed by federal
and state government and share of profits (or dividends)
distributed to shareholders is taxed again on shareholder’s
Taxes on Corporate personal income tax returns.
Payouts
• Editorial Comment: Double taxation is price paid by
corporation for full limited liability.

579 580

579 580

Corporate Earnings Dividends

• Corporation can either: (1) distribute profits to
shareholders in form of dividends, or (2) retain profits in
form of retained earnings.
• Capital Gains: Retained earnings (if invested properly) yield
higher corporate profits and, in turn, higher stock price:
shareholders reap benefits of retained earnings in form of
future capital gains from sale of stock.
• Distribution: Payment by corporation to shareholder
depending on number of shares owned.
• Dividend (Special Type of Distribution): Payment to
shareholders by corporation out of its retained earnings in
proportion to number of shares owned by shareholder.
• Example: Salary is not distribution, because payment does
not depend on number of shares owned.

581 582

581 582

97
 11/13/23

Taxation of Dividends Capital Gains

• General Rule: Maximum tax rate for qualified dividends is • Capital Gains: Profit realized on sale of non-inventory
20%. asset (stock).

• Double Taxation: Distribution is taxed at corporate level (at • Capital Gains Tax: Tax on individual capital gains.
21%) and again at individual level (at 20%).
• Corporate Income Tax ≠ Capital Gains Tax
• Effective Tax Rate on Dividends ≈ 37% = 1 – (79% x 80% ≈
63%)

583 584

583 584

Taxation of Capital Gains

• General Rule: Maximum tax rate for capital gains is 20%
(lower than maximum personal income tax rate of 37%).

• Double Taxation: Profit is taxed at corporate level (at 21%) Preferential Tax
and again at individual level (at 20%). Treatment for Debt
• Effective Tax Rate on Capital Gains ≈ 37% = 1 – (79% x
80% ≈ 63%)

585 586

585 586

Income Statement
• Income Statement: Measures performance over specific
period (e.g., quarter, year)

• Report revenues and then deduct any expenses for

relevant period.

• End-Result: Net Income = “Bottom Line”

587 588

587 588

98
 11/13/23

Interest Payments Are Deductible

• “Taxes” corresponds to tax paid by corporate entity.

• Debt receives preferential tax treatment: interest

payments are deductible (fall under expenses), but
dividends are not. Tax Avoidance
• Addition to Retained Earnings = Net Income − Dividends

• Net Income is an after-tax number.

589 590

589 590

Avoiding Double Taxation S-Corporation (S-Corp)

To avoid double taxation, firm that wants to adopt corporate • Taxation: S-corporation is pass-through entity and pays no
form can: income tax at corporate level.
• Form S-corporation
• Liability: Stockholders are also insulated from personal
• Zero-out shareholder payments liability.

• Question: So, why not set up all corporations under this

form?

591 592

591 592

Restrictions on Use (Aside) Zero-out Shareholder Payments

S-Corporations must satisfy following conditions: • Corporation with relatively few shareholders (e.g., close
• Domestic, corporations) can distribute profits to shareholders as
• Entity must be stand-alone (i.e., not a member of an affiliated group salaries rather than as dividends (or capital gains).
of corporations), and
• Have only 1 class of stock. • Salaries (expense) are tax-deductible.

Shareholders must: • If corporation distributes all profits as salaries, then no

• Be individuals, estates, or certain trusts and tax-exempt profit and no income tax.
organizations,
• Be equal to, or less than, 100 in number, and • NO Double Taxation: Only tax paid is personal income tax
• Not include a non-resident alien. shareholder-employees pay on salaries from corporation.
593 594

593 594

99
 11/13/23

Too Much of Good Thing Amazon’s Tax Avoidance

• If compensation is not reasonable (i.e., not reasonably How Amazon Paid $0 in Federal Income Tax
related to value of services rendered), then IRS will treat • Reinvesting Revenue (Lowers Net Taxable Income)

compensation as non-deductible dividends.

• Tax Credits (primarily for R&D)
• Stock-Based Compensation (Lowers Net Taxable Income)
• Off-Shore Tax Havens?

595 596

595 596

Three Concepts
• Financial Statements
• Valuation
Financing
CORPORATE
•

FINANCE

597 598

597 598

Process of Accounting

Business document is
Business Transactions prepared (e.g., order
form, invoice)

FINANCIAL
STATEMENTS Debits and credits
posted to accounts in a
Information entered
chronologically into a
ledger journal

Financial Statements
prepared

599 600

599 600

100
 11/13/23

Fundamental Equation of Accounting Financial Statements

Fundamental Equation: 4 Main Financial Statements

• Balance Sheet

Assets = Liabilities + Owner’s Equity • Income Statement

• Statement of Shareholder Equity

Double Entry Accounting • Cash Flow Statement

• Uses system of debits and credits to post accounting

transactions and keep fundamental equation balanced

601 602

601 602

Balance Sheet

Liabilities

BALANCE SHEET Assets

Equity

603 604

603 604

Some Definitions Value versus Cost

Asset Cost
• Probable future economic benefits owned by firm. • Under Generally Accepted Accounting Principles (GAAP),

audited financial statements of firms in U.S. generally

Liabilities carry assets at historical cost.
• Probable future economic sacrifices.
Market Value
• Price at which assets, liabilities, or equity can be
Equity
purchased or sold—completely different concept from
• = Assets – Liabilities
historical cost.
• Referred to as shareholders’ equity, net book value (or net

assets), or residual claim. 605 606

605 606

101
 11/13/23

Sample Balance Sheet: Assets Sample Balance Sheet: Liability

Chapter 1. Corporate Finance, Accounting, and Cash Flows 9 10 Corporate Finance

TABLE 1-2 Year Ended

Bogartco, Inc. Balance Sheet December 31,
Bogartco, Inc., A Leading Maker of Trench Coats and Fedorasä
(In millions) 2020 2019

Year Ended Liabilities and stockholders’ equity

December 31, Current liabilities:
Accounts payable $3,654 $4,025
2020 2019 Short-term debt 1,000 1,000
Accrued compensation 2,252 3,283
Assets Income taxes 2,136 1,074
Current assets: Short-term unearned revenue 12,767 13,652
Cash and cash equivalents $8,161 $5,505 Securities lending payable 909 182
Short-term investments (including securities Other 3,139 2,931
loaned of $683 and $62) 36,012 31,283

Total current liabilities 25,857 26,147

Total cash, cash equivalents, and short-term 44,173 36,788
investments Long-term debt 9,665 4,939
Accounts receivable, net of allowance for Long-term unearned revenue 1,152 1,178
doubtful accounts of $312 and $375 9,646 13,014 Deferred income taxes 540 229
Inventories 1,242 740 Other long-term liabilities 7,384 7,445
Deferred income taxes 2,344 2,184
Other 2,176 2,950 Total liabilities 44,598 39,938
Commitments and contingencies
Total current assets 59,581 55,676 Stockholders’ equity:
Property and equipment, net of accumulated Common stock and paid-in capital—shares
depreciation of $8,942 and $8,629 7,771 7,630 authorized $24,000; outstanding $8,562 and
Equity and other investments 9,211 7,754 $8,668 61,935 62,856
Goodwill 12,471 12,394 Retained deficit, including accumulated other
Intangible assets, net 1,077 1,158 comprehensive income of $1,519 and $1,055 (14,993) (16,681)
Other long-term assets 1,429 1,501
Total stockholders’ equity 46,942 46,175
Total assets $91,540 $86,113
607 608
Total liabilities and stockholders’ equity $91,540 $86,113

607 608 Notice that some categories are now subdivided. Current assets are cash and
things that can be turned into cash relatively quickly. Cash here means not only
currency, but also bank account balances and other relatively riskless things like
U.S. Treasury obligations.

Shareholders’ Equity
• Shareholders’ Equity: Amount owners invested in
company (Contributed Capital) + Company’s
STATEMENT OF earnings/loses since inception (Retained Earnings).

SHAREHOLDER • Contributed Capital = Par Value + Additional Amounts

EQUITY Paid-In

• Retained Earnings (or Deficit): Net income not distributed

to stockholders (in form of dividend).

609 610

609 610

Shareholders’ Equity Formulas Sample Balance Sheet: Liability

10 Corporate Finance

Key Formulas
Year Ended
December 31,

2020 2019

• Shareholders’ Equity = Contributed Capital + Retained Liabilities and stockholders’ equity

Current liabilities:

Earnings Accounts payable

Short-term debt
$3,654
1,000
$4,025
1,000
Accrued compensation 2,252 3,283
Income taxes 2,136 1,074

• Retained Earnings = Net Income – Dividends Short-term unearned revenue

Securities lending payable
Other
12,767
909
3,139
13,652
182
2,931

Net Income = Revenue – Expenses

Total current liabilities 25,857 26,147
Long-term debt 9,665 4,939
• Long-term unearned revenue 1,152 1,178
Deferred income taxes 540 229
Other long-term liabilities 7,384 7,445

Total liabilities 44,598 39,938

Commitments and contingencies
Stockholders’ equity:
Common stock and paid-in capital—shares
authorized $24,000; outstanding $8,562 and
$8,668 61,935 62,856
Retained deficit, including accumulated other
comprehensive income of $1,519 and $1,055 (14,993) (16,681)

Total stockholders’ equity 46,942 46,175

611 612
Total liabilities and stockholders’ equity $91,540 $86,113

611 612 Notice that some categories are now subdivided. Current assets are cash and
things that can be turned into cash relatively quickly. Cash here means not only
currency, but also bank account balances and other relatively riskless things like
U.S. Treasury obligations.

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Problem 1
Problem Set 1.1 Question:
• If assets minus liabilities equal equity, then how would you

interpret negative equity?

Answer:
• INSOLVENCY.

• Equity is merely placeholder that balances assets and

61
3
liabilities: this placeholder can be negative.

614

613 614

Problem 4 Problem 3
Question: Bacall Tin Whistles:
• If firm adds more money to retained earnings, then what • Firm has current assets of $5.7 millions, fixed assets of

entry would firm make on left-side of balance sheet? $4.3 million, current liabilities of $3.9 million, and long-
term debt of $1.1 million.
Answer:
• Cash (or some other asset) would increase by To Do:
corresponding amount. • Construct simple balance sheet.

• Question: What is shareholders’ equity?

615 616

615 616

Bacall Tin Whistles, Inc.

INCOME
STATEMENT

617 618

617 618

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Income Statement Simple Income Statement

Income Statement:
• Measures financial performance over given period.

Net Income Formula:

Net Income = Revenue – Expenses

Note: Net Income is after-tax number, meaning corporate

income tax expense is included as expense in above
equation.
619 620

619 620

Sample Income Statement Fundamental Equation of Accounting

Chapter 1. Corporate Finance, Accounting, and Cash Flows 15

TABLE 1-4
Bogartco, Inc. Income Statement
Bogartco, Inc., A Leading Maker of Trench Coats and Fedorasä
• Substituting preceding formulas, fundamental equation of
Income Statement
(In millions, except per share amounts)
accounting can be rewritten as follows:
Year Ended
December 31,

Revenue
2020
$16,195
Assets = Liabilities + Contributed Capital + Revenue −
Operating expenses:
Cost of revenue 3,139 Expenses − Dividends
Research and development 2,196
Sales and marketing 2,806
General and administrative 938
Total operating expenses
Operating income
9,079
7,116
• This equation implies that Revenue = Liability Account, and
Other income
Income before income taxes
114
7,230 Expenses = Asset Account (for debit/credit purposes).
Provision for income taxes 1,820
Net income $5,410

Earnings per share:

Basic
Diluted
$0.63
$0.62
• Random Question: Why is “debit” card not called “credit”
Weighted average shares outstanding:
Basic 8,614
card: don’t I credit (decrease) cash account when I withdraw
Diluted

Cash dividends declared per common share

8,695

$0.16 621 cash? 622

Net income is often expressed per share of stock outstanding—that is, as earnings
per share (“EPS”). This allows for easy comparison of companies in similar

621 industries. This is calculated as:

EPS = Net Income ÷ Shares Outstanding

622
____________

EBITDA is a considerably more important measure than net income, and one that
is often referenced in corporate finance transactions. EBITDA is pronounced
exactly as it is spelled—E-BIT-DA. It stands for earnings before interest, taxes,

Fundamental Equation of Accounting Accrual Accounting

Accrual Accounting involves 2 key principals:
• Revenue Recognition Principal
• Matching Principal (or Expense Recognition)

Comment: Much of complexity in accounting follows from

use of accrual accounting (as opposed to cash accounting).

623 624

623 624

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Revenue Recognition Principle Matching Principle

Revenue Recognition Principle Matching Principle
• Revenue is recognized on income statement when realized and • Expenses on income statement is reported in period in which
earned—not when cash is received. related revenue is earned.

Example: • Example: Company’s sales are made entirely through sales

• Company completes service for $5K on Dec. 28. representatives who earn 10% commission.
• On same day, company bills customer $5K with credit terms of • Commissions are paid on 15th day of month following
net 30 days. calendar month of sales (e.g., if company has $60K of sales in
Dec., then company will pay commissions of $6K on Jan. 15).
• One month later (on January 29), company receives $5K.
• Matching principle requires that $6K of commissions expenses
• On Dec. 28, company records $5K increase in income
be reported on Dec. income statement along with related
statement account: Revenues Earned. 625 Dec. sales of $60K. 626

625 626

Deferred (Prepaid) Expense Depreciation

Prepaid Rent: Rent paid in advance of the rental period. The journal entries for prepaid rent are as follows:
• Company acquires production equipment for $100K that has
Initial journal entry for Prepaid Rent (Asset, NOT Expense):
projected useful life of 10 years.

• Matching principle dictates that cost of asset must be

expensed over useful life while used by company to produce
revenue (depreciation expense “matches” cost of equipment
with revenue generated by equipment).
Adjusting journal entry as Prepaid Rent expires:

• Straight-Line Depreciation: Company charges cost of

equipment to depreciation expense at (straight-line) rate of
$10K per year for 10 years.

627 • Note: Depreciation is example of deferred expense. 628

627 628

Accrued (Unpaid) Expense

Utility Payable: Utility remains unpaid on payment date. The journal entries for utility payable are as
follows:

Initial journal entry for Utility Payable (Liability, NOT Cash):

CASH FLOW
STATEMENT
Adjusting journal entry as the Utility Payable expires: Utility Payable - Journal Entry

629 630

629 630

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Cash Flow Statement Elements of Cash Flow Statement

• Cash Flow Statement: Reports cash inflows and cash outflows that • Cash flow statements are divided into 3 main parts:
occurred during same time interval as income statement.
o Operating Activities: Net cash from operating activities.
• Bottom line of cash flow statement shows net increase or decrease in
cash for period. o Investing Activities: Includes purchase or sale of long-
term assets (e.g., property, plant & equipment) and
• Important Point: Under accrual-based accounting, income statement investment securities.
does not measure (or report) amounts of cash flowing in and out of
Financing Activities: Includes cash raised by selling
18 Corporate Finance
company. o
stock or bonds or borrowing from banks. TABLE 1-5
Bogartco, Inc. Cash Flow Statement

• Income statement can tell you whether firm made profit; cash flow Bogartco, Inc., A Leading Maker of Trench Coats and Fedorasä
Cash Flow Statement
statement can tell you whether firm generated cash. (In millions)
Year Ended
December 31,
631 632
2020

631 632 Operations

Net income
Adjustments to reconcile net income to net cash from operations:
$5,410

Depreciation, amortization, and other noncash items 694

Stock-based compensation 528
Net recognized losses (gains) on investments and derivatives (29)
Excess tax benefits from stock-based compensation (5)
Deferred income taxes (148)
Deferral of unearned revenue 5,881
Recognition of unearned revenue (6,862)

Sample Cash Flow Statement: Sample Cash Flow Statement:

Changes in operating assets and liabilities:
Accounts receivable 3,674
Inventories (468)
Other current assets 208

Operating Activities
18 Corporate Finance Investing & Financing Activities
Other long-term assets
Accounts payable
Other current liabilities
62
(400)
(911)
Other long-term liabilities 560
TABLE 1-5 Net cash from operations 8,194
Bogartco, Inc. Cash Flow Statement Financing
Bogartco, Inc., A Leading Maker of Trench Coats and Fedorasä Short-term borrowings, maturities of 90 days or less, net 814
Cash Flow Statement Proceeds from issuance of debt, maturities longer than 90 days 4,721
(In millions) Repayments of debt, maturities longer than 90 days (814)
Year Ended
December 31,
Common stock issued 177
Common stock repurchased (4,399)
2020 Common stock cash dividends paid (1,118)
Excess tax benefits from stock-based compensation 5
Operations Other Chapter 1. Corporate Finance, Accounting, and Cash Flows
(25) 19
Net income $5,410
Adjustments to reconcile net income to net cash from operations:
Depreciation, amortization, and other noncash items 694 Net cash used in financing (639)
Stock-based compensation 528 Investing
Net recognized losses (gains) on investments and derivatives (29) Additions to property and equipment (564)
Excess tax benefits from stock-based compensation (5) Acquisition of companies, net of cash acquired 0
Deferred income taxes (148)
Purchases of investments (7,417)
Deferral of unearned revenue 5,881
Maturities of investments 870
Recognition of unearned revenue (6,862)
Sales of investments 1,427
Changes in operating assets and liabilities:
Accounts receivable 3,674 Securities lending payable 727
Inventories (468) Net cash used in investing (4,957)
Other current assets 208 Effect of exchange rates on cash and cash equivalents 58
Other long-term assets 62
Net change in cash and cash equivalents 2,656
Accounts payable (400)
Cash and cash equivalents, beginning of period 5,505
Other current liabilities (911)
Other long-term liabilities 560 Cash and cash equivalents, end of period $8,161
Net cash from operations 8,194 633 634
Financing
5. CONSOLIDATED REPORTS
Short-term borrowings, maturities of 90 days or less, net 814

633 634
Proceeds from issuance of debt, maturities longer than 90 days 4,721
Repayments of debt, maturities longer than 90 days (814) In casual conversation, it is common to speak of a firm when legally we really
Common stock issued 177 mean a group of firms. For example, normal people (i.e., nonlawyers) often speak
Common stock repurchased (4,399) of “Bank of America.” But in fact, the thing known as Bank of America is
Common stock cash dividends paid (1,118) comprised of hundreds of separate legal entities, including a few actual banks,
Excess tax benefits from stock-based compensation 5 grouped under a single Delaware holding company based in North Carolina.
Other (25) Although corporate, commercial, and insolvency law might treat Bank of
America as hundreds of entities, as a matter of securities and tax law it is treated
as a single legal entity, and Bank of America will prepare a single set of
consolidated financial statements under the accounting rules. Essentially
a new, hypothetical entity is created as a matter of accounting, and it is
this entity that files Securities and Exchange Commission (SEC) reports and pays
taxes.
Every subsidiary that the parent company owns more than a 50 percent interest

Capital Expenditures To Capitalize vs. To Expense

in will be consolidated within the consolidated entity. As a result, the parent
company must eliminate transactions between the parent and its subsidiaries for
accounts receivable and accounts payable to avoid counting revenue twice and
giving the impression that the consolidated entity has more profits or owes more
money than it actually does.
If the parent company owns all of the equity interests of its subsidiaries, the
consolidated revenues will be equal to the aggregate revenues of the group, less

• Capital Expenditures: Purchases of new property, plant, Capitalize intercompany sales, and net income should equal the aggregate net income of the
group, less the effect of intercompany transactions. It is slightly more complicated
if the subsidiary is majority owned, but not wholly owned. Then an adjustment

and equipment. • Recognize expense on balance sheet as asset (and then

must be made to account for the cash flows that belong to the minority
shareholders.

regularly reduce value of that asset overtime by

• Capital expenditures do not appear immediately as depreciation expense in income statement).
expenses on income statement: rather, firm deducts • Income Statement: Depreciation expense.

depreciation expenses over time.

Expense
• Recognize expense in income statement in same period
incurred (rather than spreading expense over several
periods as in case of capitalized expenses).
635 • Income Statement: Expense 636

635 636

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 11/13/23

WorldCom’s Accounting Fraud Consolidated Financial Statements

• Consolidated Financial Statement: Takes financial results
of subsidiaries and includes them in single financial
statement for parent company (i.e., parent company and
subsidiaries are treated as one entity).

• Normally the entity still wants to maintain legal separation

– to avoid “veil piercing” etc.

637 638

637 638

Three Rules of Time-Travel

3 Rules
• Rule 1: Only values at same point in time can be compared

or combined.
TIME VALUE OF • Rule 2: To move cash flow forward in time, you must

MONEY compound cash flows.

• Rule 3: To move cash flow backward in time, you must
discount cash flows.

639 640

639 640

Comparing Values
• Dollar today and dollar in 1 year are not equivalent.

COMPARING VALUES • To compare or combine cash flows that occur at different

points in time, you must move cash flows to same point in
time.

• You can do so through (1) compounding, and (2)

discounting.

642

641 642

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 11/13/23

Time Value of Money

Time Value of Money
• Money received in present is worth more than same sum of

money received in future. COMPOUNDING

Rationales
• Money now can be invested and earn return, creating

larger amount of money in future.

• Risk that money might not be received in future.

• Inflation

643

643 644

Future Value Simple Interest

Future Value Formula Simple Interest
• $1,000 in 5 years with 5% simple interest:
FV = C0×(1 + r) • $1,000 + $250 = $1,250.

• r = Appropriate discount or interest rate.

• C0 = Principal amount.

645 646

645 646

What is APR? APR

• Annual Percentage Rate (APR): Annual rate of interest
charged to borrowers and paid to investor

• APR is calculated as periodic interest rate multiplied by

number of periods per year.

• APR does not take compound interest into account.

647 648

647 648

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 11/13/23

APR Formula APR Sample Calculations

Formula:
𝐹𝑖𝑛𝑎𝑛𝑐𝑒 𝐶ℎ𝑎𝑟𝑔𝑒 365 Finance Loan Term
𝐴𝑃𝑅 = × Charge Amount (Days) APR
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑛
$5 $500 14 26%
• Finance Charge = Total interest paid over term of loan (plus $12 $200 21 104%
any additional fees). $5 $750 14 17%
• Principal = Loan amount.
• n = Number of days in loan term.
Example: (5/500) x (365/14) = 0.01 x 26 = 0.26 = 26%

649 650

649 650

Payday Loan Example Payday Loan Data

• Payday Loan: Short-term unsecured loan, often Here is what payday loan of $500 can cost you in
characterized by high interest rates. different cities across U.S.:

• Term “payday” in payday loan refers to when borrower

writes post-dated check to lender for payday salary but
receives part of that payday sum in immediate cash from
lender.

651 652

651 652

APR Comparison Legality of Payday Loans

• Looking at this city sample, it can cost between $55 and
$102.27 to borrow $500.
• In contrast, if you had $500 loan with 30% APR, then you
would only pay extra $12.50 in interest for 1-month term,
making total cost of loan $512.50.
• 12 states and District of Columbia prohibit payday loans.
• 6 states allow only low-cost payday loans by severely
restricting interest rate and fees payday loan companies
can charge.
• Why regulate interest rate that companies can charge?
What are competing policy tradeoffs?

653 654

653 654

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Legality of Payday Loans by State Compound Interest

Compound Interest
• $1,000 in 5 years with 5% compound annual interest:

FV = C0×(1 + r)T = $1000×(1.05)5 = $1,276.28

• Note: All numbers, including t are r, must be in same units.

655 656

655 656

Future Values and Compounding Multi-Period Future Values

General Formula
5
$1, 000 × (1.05)
$1, 000 × (1.05)4 FV = C0×(1 + r)T
3
$1, 000 × (1.05)
$1, 000 × (1.05)2 • C0 = Cash flow at time 0.
$1, 000 × (1.05) • r = Appropriate interest rate.
$1, 000 $1, 050 $1,103 $1,158 $1, 216 $1, 276 • T = Number of periods over which cash is invested.

0 1 2 3 4 5

658

657 658

Present Value
Hypo
• Imagine that you will receive $105 in 1 year.

DISCOUNTING • Money in bank earns 5% annually.

Question
• How much is future payment of $105 worth today?

Answer
• $100

660

659 660

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 11/13/23

Discount Factor Discount Rate

Questions Rate of Return
• Would you prefer $11,000 now or $11,000 1 year from now? • Want to give D specific functional form: what rate of return
• Would you prefer $0 now or $11,000 1 year from now? on my investment r do I need to be indifferent between money
today and some other amount of money in future?
• Discount rate r > 0 solves equation: Current Value x (1 + r) =
Discount Factor
Future Value.
• Suppose you are indifferent between 10,000 now or 11,000 1
• Preceding Example:
year from now.
o Discount rate r solves: 10,000 x (1 + r) = 11,000, which implies r = 0.1
• Discount factor D < 1 solves equation: 10,000 = D x 11,000.
o Need to make at least 10% to give up money today for some other
• Time Value of Money: Discount factor D < 1 (you value money amount of money in future.
in future less). o Dividing through by (1 + r) gives you Present Value Formula.
661 o Note that D = 1 / (1 + r). 662

661 662

Present Value Formula

Present Value Formula Problem Set 2.1
C0 = 1 / (1 + r) x C1 = C1 / (1 + r)
where C0 = Current Value and C1 = Future Value.

• Present value formula transforms some future amount into

“today” dollars.
66
4

• Note: Present Value formula is transformed version of

Future Value formula. 663

663 664

Problem 1 Problem 3
Hypo Question
• Suppose P sues D for breach of contract. • What happens to future value when you decrease r?

• D agrees to settle suit for payment of $1K in 1 year, which • What happens to present value when you decrease r?
D asserts has value of $943.

Question
• What discount rate is D using?

• Answer: $1K / $943 = 1.06 = 1 + r, which implies that

discount rate r = 0.06 or 6%.

665 666

665 666

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 11/13/23

Multiperiod Discounting Present Value Formula

• How would investor have to set aside today to earn $1,000
5 years from now if discount rate = 5%?

PV $1,000 Ct
PV =
0 1

$1, 000
2 3 4 5
(1+ r)t
$783.53 =
(1.05)5

667 667 668

667 668

Problem 1
Problem Set 2.2 Hypo
• You want to put money in bank today so that you will have

$10K in 10 years.
• Bank will pay 4% on 10-year certificate of deposit.

Question
• How much should you deposit?

66
9 • Answer: $10K / 1.04
10 = $6,755.64

670

669 670

Problem 3 Time Travel in Excel

Hypo Excel Workbook
• Project A: Earn simple interest on $100K for 3 years at 10%. • Access Excel workbook for Time Value of Money and

• Project B: Earn annually compounded interest for 3 years at Present Value calculations by clicking on link below:
9.5%.

Question
• Which project pays more, and by how much?
TVM & NPV
Example
• Answer: Project A = $100K + 3 x $10K = $130K, and
Project B = $100K x 1.0953 = $131,293.24
671 672

671 672

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 11/13/23

Financing Methods
2 Types of Financing Methods
• Internal Financing

• External Financing

FINANCING

673 674

673 674

Internal Financing
• Internal Financing: Process of firm using retained earnings
(profits) as source of capital to fund new project or
investment.
Internal
Internal financing is generally thought to be less expensive
Financing
•

for firm than external financing because: (1) firm does not
have to incur transaction costs to obtain such financing,
and (2) firm does not have to pay taxes associated with
paying dividends.

675 676

675 676

External Financing
• External Financing: Financing that firms obtains
from outside of firm.

External • Two Main Types: (1) Debt, and (2) Equity.

Financing

677 678

677 678

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 11/13/23

Capital Structure Debt/Equity Ratio

Capital Structure • Debt/Equity Ratio: Simplest measure of proportion of debt
• Refers to long-term investment in corporation. in company’s total financing is debt-to-value ratio or debt to
• Right-hand side of balance sheet.
equity ratio:
• Indicates how firm’s assets are financed. ! !
Debt-to-Value Ratio = =
" !#$
Debt and Equity and
!
• Both debtholders and equity-holders must be compensated Debt-to-Equity Ratio =
$
for money invested in firm.

679 680

679 680

Key Questions
• Should firm finance new projects with equity or debt?

• Should firm return excess cash to shareholders or invest it

back into firm?
Debt Financing
• What is optimal debt-equity ratio?

• What are benefits of using debt instead of equity?

681 682

681 682

Debt Maturity Date

Creditor Interest • Maturity Date: Date on which borrower’s final loan
• Long-term debt (e.g., bonds) represent creditor interest. payment is due.

Bond: • Bonds vary in maturities (e.g., 5, 10, 30 years).

• Contract between borrower and lender that specifies:

o Par (face) value.

o Coupon rate

o Coupon payment
o Maturity date

683 684

683 684

114
 11/13/23

Types of U.S. Government Debt Zero-Coupon Bond

• Bills: Treasury discount securities that when issued have • Make no periodic interest payments (coupon rate = %0).
maturity equal to or less than 1 year, are issued with
original issue discount (OID), and pay no coupon. • Entire yield to maturity derives from difference between
• Note: Coupon-bearing security which when issued has purchase price and par value.
original maturity between 1 and 10 years.
• Example: Treasury Bills
• Treasury Bond: Coupon-bearing security which when
issued has original maturity greater than 10 years.

685 686

685 686

Yield-to-Maturity Zero-Coupon Bond Example

• Bond price is sum of present value of future cash flows. • Consider $1,000 zero-coupon corporate bond that has 1
year until maturity. Suppose price of bond is $925.
• Each cash flow is present-valued using same discount
factor. • Question: What is yield of this bond?

• Yield-to-Maturity = Discount Factor • Answer: DCF Formula implies

$&,(((
Bond Price = $925 = &# )*+,-

• Solving above equation gives: 𝑌𝑖𝑒𝑙𝑑 = 8.1%

687 688

687 688

Yield as Return on Investment Credit Ratings Agencies

• Consider $105 zero-coupon corporate bond that has 1 year • Rating: Risk of bond is measured bond’s rating or grade
until maturity. Suppose price of bond is $100. and are calculated by ratings agencies.

• Question: What is yield of this bond? • 3 Main Ratings Agencies: (1) Standard & Poor, (2) Moody’s,
and (3) Fitch.
• Answer: Rewrite DCF Formula as follows:
• S&P Example
$100 𝑥 1 + 𝑌𝑖𝑒𝑙𝑑 = $105
which implies that 𝑌𝑖𝑒𝑙𝑑 = 5%. • For S&P, AAA is highest rating; D is lowest rating.
• BBB is lowest “investment grade” level.
• Note: Yield can be loosely interpreted as rate of return on • Bonds below investment grade are referred to as “junk” or
investment. 689 “high-yield.” 690

689 690

115
 11/13/23

Bond Ratings Bond Ratings

Bond Rating 5-Year Yield 10-Year Yield

US Treasury 2.76 2.96
AAA 3.02 3.52
B 5.52 6.84

Comments
• U.S. Treasuries (or bonds) have lowest yields.
• Longer term bonds have higher yields.
• Lower rated bonds have higher yields.

691 692

691 692

Terminology
Ownership Interest
• Equity (e.g., shares of common stock) represents

ownership interest.

Equity Financing Common Stock

• Corporation must have at least one class of common stock
(voting or nonvoting) representing residual ownership of
corporation and claim to assets upon liquidation.

693 694

693 694

Preferred Shares Dividend Rights

• Preferred Stock: Class of company stock that enjoys • Dividend Right: Dividend must be paid to preferred stock
special treatment (not common stock). before any dividend is paid to common stock.

• Favorable treatment relates to 1 or more of following

financial attributes of ownership:
• Dividend Rights

• Liquidation Rights

• Redemption Rights

695 696

695 696

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 11/13/23

Liquidation Rights Redemption Rights

• Liquidation Rights: Priority right allowing right-holder to
get paid ahead of other classes of stock in event of
liquidation.
• Investors may be given up to 2x or 3x liquidation
preference, entitling them to multiple of original
investment (double or triple) before common stockholders
get paid anything.
• Liquidation preferences are frequently used in venture
capital contracts.
• Redemption Rights: Requirement that in absence of
liquidation event (e.g., IPO or merger), shareholder will
have right to call on board to redeem (buyback) investor’s
stock at agreed upon price.
• Downside Protection: Gives investors opportunity to exit
investment by exercising redemption rights.
• Question: What is likelihood that firm will have cash to
buyback investors’ shares?
697 698

697 698

Convertible Debt
• Convertible Bond: Fixed-income corporate debt security
that yields interest payments but can be converted into
predetermined number of common stock.

• Conversion from bond to stock can be done at certain times Debt vs Equity
during bond’s life (or term) and is usually at discretion of
bondholder.

699 700

699 700

Stockholders versus Bondholders Liquidation Priority

Stocks Bonds
• Priority of Claims: Bondholders have claim against assets of
Stocks represent ownership. Bonds represent debt. corporation that must be met BEFORE claims of
Stocks (common) do not have a fixed dividend Interest on bonds must always be paid, even if stockholders.
rate. no profit is earned.
Stockholders elect the board of directors which Bondholders usually have no voice in, or
controls the corporation. control over, management of the corporation. • If firm goes into liquidation, then all its assets are
Stocks do not have a maturity date. Bonds have a maturity date at which point the distributed to its creditors based on pre-determined
corporation is to repay the bondholder the face
value of the bond. priority order.
All corporations issue or offer to sell stock— Corporations do not necessarily issue bonds.
this is a defining characteristic of a corporation.
Stockholders have a claim against the property Bondholders have a claim against the property • Shareholders are often last in line to receive proceeds (with
and income of the corporation after all and income of the corporation that must be preferred stock shareholders getting better treatment than
creditors’ claim have been met. met before the claims of the stockholders.
common stock shareholders).
701 702

701 702

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 11/13/23

Debt-Equity Tradeoff
Advantages of Debt
• Tax Benefit

• Decreases Agency Costs (Between Managers &

Shareholders)
AGENCY COSTS BETWEEN
Disadvantages of Debt MANAGERS &
• Expected Bankruptcy Costs
SHAREHOLDERS
• Increases Agency Costs (Between Creditors &

Shareholders)
• Loss Flexibility
703

703 704

Added Discipline Implications

Agency Costs Between Managers & Equity-Holders • As separation between managers and equity-holders
• Manager of firm with no debt and large cash flows each increases, benefits to using debt will go up.
year may become complacent, resulting in investment in
poor projects (as there little or no cost borne by the
managers).

• Forcing firm to borrow money can be antidote to this .

complacency as manager now must ensure that
investments made will earn at least enough return to cover
interest expenses—cost of not doing so is bankruptcy and
termination of employment.
705 706

705 706
.

Agency Costs
Agency Costs Between Bondholders & Equity-Holders
• In Theory: No conflict of interests between equity-holders

and debtholders.
AGENCY COSTS BETWEEN
In Practice: Equity-holders and debtholders have different
CREDITORS &
•

objectives: debtholders are concerned about safety and

repayment of principal whereas equityholders tend to think
SHAREHOLDERS more about upside potential.

708

707 708

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Examples of Conflict Hypothetical: Risk-Free Project

• Dividend Surge: When firms pay cash out as dividends, Project A (Risk-Free)
lenders to firm are hurt because firm becomes riskier with • Company earns $500K with probability, p = 1.
less cash. • Company pays back $100K in debt to bondholders and
• Risk-Shifting: When firm takes riskier projects than those keeps $400K as net profits.
agreed to at outset, lenders are hurt because lenders base
interest rates on risk perceptions of firm’s present
investments.

• Borrowing More on Same Assets: If lenders do not protect

themselves (through contract), then firm can borrow more
money and make all existing lenders worse off. 709 710

709 710

Hypothetical: Risky Project Hypothetical: Key Point

Project B (Risky) Expected Payoffs of Project A Expected Payoffs of Project B
Stockholders $500K - $100K = $400K 0.5 x $900K + 0.5 x $0K = $450K
• Stockholders earn $1 million with probability, p = 0.5, and
Bondholders $100K 0.5 x $100K + 0.5 x $0K = $50K
$0K with probability, p = 1/2 (i.e., firm is completely wiped
out).
• When company earns $1 million, stockholders pay back Key Point
$100K in debt to bondholders and keep $900K as profits. • Bondholders: Prefer risk-free Project A ($100K) over risky
• When company earns $0, bondholders and stockholders Project B ($50K).
get nothing. • Stockholders: Prefer risky Project B ($450K) over risk-free
Project A ($400K)

711 712

711 712

Leverage Upside of Leverage

• Equity-holders can increase risk through leverage. 100% Equity
• Partners invest $100K.

• Leverage: Magnification of expected returns compared to • Business earns $10K.

direct (cash) investment. • ROI = 10%.

• Two Common Sources of Leverage 10% Equity / 90% Debt

o Use of borrowed money to purchase asset (e.g., debt). • Partners invest $10K and borrow $90K.
o Use of financial instrument that gives exposure in excess
• Business earns $10K.
of capital invested in asset (e.g., derivatives).
• ROI = 100% = ($10K / $10K).

713 714

713 714

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Downside of Leverage Implications

100% Equity • Firms where lenders can monitor or control how their
• Partners invest $100K. money is used should be able to borrow more than firms
• Business losses $10K.
where this is costly to do.
• ROI = -10%

10% Equity / 90% Debt

• Partners invest $10K and borrow $90K.

• Business loses $10K

• ROI = 0% = ($0K / $10K):

• Equityholder wiped out. 715 716

715 716

Some Terminology
• Private Corporation: Non-governmental, for-profit
business that has been incorporated under state statute.

NATURE OF • Publicly-Held (or Public) Corporation: Private corporation

whose shares trade on public exchange (e.g., NYSE,
CORPORATION NASDAQ).

• Privately-Held (or Close) Corporation: Private corporation

whose shares are not traded on public exchange.

717 718

717 718

Some Empirical Facts

• Approximately 6 million corporations file federal tax
returns each year.

Fewer than 4,000 corporations are listed for trading on U.S.

Sources of Law
•

stock exchanges.

719 720

719 720

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Sources of Corporate Law State Statutes

4 Sources of Corporate Law State Statute
• State Statutes • Each state has its own general corporation statute.

• Articles of Incorporation & Bylaws • Some provisions in state statute are mandatory rules;

• State Common Law • Others are default rules that apply only if articles of

• Federal Statutes
incorporation or bylaws are silent.

721 722

721 722

State Common Law Federal Law

Case law serves 2 corporate law functions: No Federal Corporate Law
• No general federal corporation statute.
• Interpretation: Interprets provisions in corporate statutes
• Specific federal statutes govern certain corporate activities
and in corporation’s articles and bylaws.
(e.g., sales of stock, tender offers).
• Gap-Filling: Fill in gaps in law (often in context of corporate
fiduciary duties).

723 724

723 724

Issues
Key Issues
• Corporate Personhood

• Corporate Powers and Liabilities

• Formation
Corporate
• Liability Personhood

725 726

725 726

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Corporation Defined Entity or Aggregate?

Corporation is: • Should business entity be treated as:
o Aggregate of individuals, or
• Separate legal entity, and
o Separate legal entity?
• Owners (or stockholders) are generally not personally liable
for debts of corporation (loss is limited to capital
investment). • Question: Which is less likely to enjoy same rights and
privileges under state and federal law that U.S. citizens
enjoy?

727 728

727 728

Constitutional Amendment In Praise of Corporations

• “I weigh my words when I say that … limited liability
corporation is greatest single discovery of modern times.”
--Nicholas Murray Butler

• “[T]he elemental purpose of corporation law is facilitation

of cooperative activity that produces wealth. A net
increase in total wealth, other things remaining
unchanged, is an absolute good.” -- William T. Allen

729 730

729 730

Frankenstein View Advantages of Corporate Form

• “Limited liability, of course, cannot be regarded as Advantages
unmitigated good…. This historical perception may be • Limited liability of shareholders for corporate obligations.
described in terms of morality play featuring two • Separation of ownership & control
important characters. One of these characters is hapless
• Continuity of existence
public, completely unaware that smiling individual
handling out cups of lemonade is not personally and • Transferability of interest

completely on line for contents of those cups. The other is

Dr. Frankenstein.” -- Theresa Gabaldon

731 732

731 732

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Disadvantages of Corporate Form Taxation

Disadvantages • Double Taxation: Corporate earnings paid to shareholders
• Limited Liability (from perspective of third-parties to are subject to double taxation.
corporation).
• S-Corporation: Small business corporations can avoid this
• Many Formal Requirements
by electing taxation under Subchapter S of Internal
• Double Taxation
Revenue Code (which taxes corporate income directly to
shareholders in proportion to their ownership).

733 734

733 734

Obligations to State Failure to Comply

Corporations qualified to do business in FL must file annual report
with Department of State disclosing:
• Corporation’s name and state or country of incorporation;
• Date of incorporation (or if foreign corporation, date admitted
to do business in this state);
• Address of its principal office and mailing address of
corporation;
• Federal employer identification number;
• Names and business street addresses of its principal officers
and directors, and;
• Street address of its registered office and name of its
registered agent at that office.
• Corporation not complying with its reporting obligations
cannot bring action in FL courts UNTIL report is filed and
may be involuntarily dissolved.
• Corporation may be required to provide certain other
information to state upon request (including identity of
equity owners).
• Each corporation must maintain registered office and
agent in state.
735 736

735 736

Corporate Powers
• Broad statutory powers are conferred upon all
corporations to allow them to carry out their purposes.

CORPORATE • These powers can be limited or expanded by articles.

POWERS

737 738

737 738

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List of Statutory Corporate Powers

Unless otherwise provided by its articles, every FL corporation, by
statute, has following general powers:
• To sue and be sued in its corporate name;
• Perpetual duration and succession in its corporate name;
Statutory Powers • To have corporate seal;
• To purchase, receive, lease, or otherwise acquire, hold, own, use,
and improve real and personal property, or any legal or equitable
interest in property (wherever situated);
• To sell, mortgage, convey, pledge, lease, exchange, create security
interest in and dispose of all or any part of tis property;
• To lend money to and use its credit to assist its officers and
employees when such may reasonably be expected to benefit
739 740
corporation;

739 740

List of Statutory Corporate Powers List of Statutory Corporate Powers

• To purchase, receive, subscribe for, or otherwise acquire, vote, own,
hold, use, sell, mortgage, lend, pledge, otherwise dispose of shares
or interests in, or other obligations of, other corporations,
partnerships, and governments;
• To enter into contracts, borrow money, and guarantee debts;
• To lend invest, and reinvest money for its corporate purpose;
• To elect directors and appoint officers, employees, and agents and
fix their compensation;
• To adopt and amend bylaws for administration and regulation of its
affairs;
• To make donations for public welfare or for charitable, scientific, or
educations purposes;
741
• To transact any lawful business in aid of governmental policy;
• To pay pensions and establish pension and profit-sharing plans and
other employee incentive plans;
• To enter into general or limited partnerships or joint ventures;
• To indemnify corporate officers, directors, agents, and employees
and purchase liability insurance thereof;
• To provide life insurance for its benefits on directors, officers, or
employees, or shareholder for purpose of acquiring shares of
deceased’s stock; and
• Implied or Incidental Powers: To conduct its business, locate offices,
and exercise all other powers necessary or convenient to effect its
purpose.
742

741 742

Political Contributions
• Direct Contributions: Corporations can contribute within
limits to candidates for state or local office.

Political • Expressive Expenditures: Corporations are otherwise as

Contributions free as individuals to expend funds to support or oppose
(1) ballot referendums, or (2) candidate for political office
(if spending is independent of candidate) (See, e.g.,
Citizens United v. FEC (2010)).

743 744

743 744

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Ultra Vires Act

Ultra Vires Act:
• Act that lies beyond powers conferred upon corporation:

o By its Articles of Incorporation, or

Ultra Vires o By Laws of State of Incorporation.

• Ultra vires transaction cannot be ratified by shareholders,

(even if shareholders desire act to be ratified).

745 746

745 746

Ultra Vires Act

Question
• Which acts are properly characterized as ultra vires?
o Corporate donation to St. Judes’ Children’s Hospital.

o
o
Corporate donation to Princeton University.
Corporate donation to CEO’s friend Chip.
FORMATION

747 748

747 748

Corporate Formation
Two Key Players
• Promoter

• Incorporator

Promoters

749 750

749 750

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Promoter Incorporators
General Definition of Promoter Incorporator Defined
• Purported agent of corporation who takes initiative in • One who signs articles of incorporation and may or may not

founding and organizing business or enterprise. be promoter.

• In this class, lets also define promoter as person acting as
agent for corporation that this person reasonably believes
exists—but does not.

• Practice Tip: Persons, such as attorney, acting in

professional advisory capacity are not considered
promoters.
751 752

751 752

Fiduciary Duty Contracts Before Incorporating

• Fiduciary Duty: Promoters (as purported agent of
corporation) must act in good faith and in best-interest of
all investors.
• Conflict of Interest: Promoter who profits from sale to
corporation can be liable to corporation for profits or
forced to rescind sale UNLESS conflict was fully disclosed to
and approved by directors or shareholders.
753
• General Rule: Except as otherwise provided, promoter
remains personally liable on contracts entered into on behalf
of corporation, even after corporation adopts contract,
UNLESS contract parties agree to novation.
• Novation: Agreement made between 2 contracting parties to
allow for substitution of new contract party for existing
contract party.
• Limitation on Personal Liability: No personal liability to third-
party who also had knowledge that there was no valid
incorporation (no principal). 754

753 754

Principal Does Not Exist Contracts After Incorporation

R-3§6.04
• Person who makes contract with third-party purportedly as
agent on behalf of principal becomes party to contract if
purported agent knows that purported principal does not
exist.
• Corporation is not automatically liable for contracts entered
into by promoter.
• 2 ways corporations can become liable for such contracts:
• Corporation expressly adopts contract; or

• Corporation implicitly adopts contract (by accepting

• Comment: Purported agent here remains party to contract benefit of contract).
even if principal eventually does come into existence and
adopts (or ratifies) contract.
• R-3§6.04: Promoter is STILL personally liable even if
corporation adopts (or ratifies) pre-incorporation contract
(need novation to release from liability).
755 756

755 756

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Bar Tip Expenses & Failure to Incorporate

Test • Expenses & Compensation: Promoter has no general right
• Bar examiners often test promoter liability. of action to recover expenses or salary from corporation.

Remember • Failure to Incorporate: If corporation is never formed, then

promoter must return all subscribers’ money (even if no
• Before Incorporation: Promoter will generally be

personally liable on pre-incorporation contract UNLESS wrongdoing).

contract clearly negates personal liability.
• After Incorporation: Even after corporation is formed and

adopts pre-incorporation contract, promoter remains

personally liable UNLESS there is novation.
757 758

757 758

Problem 1
Facts
• Baird negotiates and executes lease with L & L.

• Baird signs lease “Baird for Todos, Inc.”

Pair-&-Share • Articles of incorporation are not filed for Todos, Inc.

Problems 11
Questions
• Can L & L enforce lease against Baird?

• What if Baird signs lease “Todos, Inc. corporation to be

formed”?
759 760

759 760

Problem 2 Problem 3
Facts Facts
• Assume that articles of incorporation are filed forming • Assume that articles of incorporation are filed forming

Todos, Inc. after Baird has signed lease with L & L. Todos, Inc. after Baird had signed lease with L & L.

Questions Questions
• Is corporation liable on lease?
• Regardless of whether corporation adopts lease, can L & L
• NO. enforce lease against Baird.
• Does corporation become liable when it comes into
existence? • YES, see R x 6.04.
• NO. Liable only if some action is taken to adopt or ratify

lease. 761 762

761 762

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Five Steps to Incorporate

5 Steps
• Incorporator

• Prepare Articles of Incorporation

Incorporation • File Articles of Incorporation

• Organizational Meeting

• Bylaws

763 764

763 764

Incorporator Articles of Incorporation

• Incorporator (or Organizer): One or more natural persons • Articles of Incorporation: Constitutes agreement among
or entity (such as corporation, partnership, or association) incorporators regard details of corporation’s organization.
can act as incorporator.
• Can be thought of as “constitution” of corporation.
• No further qualification (e.g., age, residency, or citizenship)
are required.

765 766

765 766

Articles of Incorporation Statutory Requirements

Articles of incorporation must include:
• Corporation’s name (which must indicate corporate status).
• Number of shares and distinguishing characteristics of each
class or series;
• Address of initial registered office;
• Name of initial registered agent together with agent’s written
acceptance;
• Names and addresses of incorporators; and
• Address of principal office (if known) and mailing address of
corporation.
767 768

767 768

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Question Possible Additional Inclusions

Rule Articles of incorporation may include:
• Under Delaware law, corporate name must include • Number of directors constituting initial board (and names and
“corporation,” “company,” “incorporated,” or “limited.” addresses of each member thereof);
• Par value of stock (or statement that stock shall have no par
Question: value);
• Imposition of personal liability on shareholders to specific
• Why must corporate name include such magic words?
extent and on specific conditions;
• Initial purpose (which may include any lawful business); and
• Any other provision not inconsistent with law regarding
managing business or defining powers of corporation,
directors, and shareholders.
769 770

769 770

General Purpose Clause Bar Tip

Initial Purpose:
• Most corporations state that purpose of corporation is to
engage in any lawful act or activity for which corporations
may be organized under state law.
• Default Rules: Not necessary to set forth in articles any of
corporate powers enumerated in statute.
• Bar Tip: Bar examiners often test on what must be included
in articles as opposed to what may be included.

771 772

771 772

Procedure Organizational Meeting

Incorporation Procedure
• Incorporators deliver articles to Department of State (which
files them if all legal requirements are met).
• Birth of Corporation: Corporate existence begins when
Department of State files articles, creating (at that moment)
de jure corporation.
• De Jure Corporation: Corporation that exists at law.
• After incorporation, initial directors (if named in articles of
incorporation) or incorporators will hold organizational
meeting to complete organization of corporation by
appointing officers, adopting bylaws, etc.
• Directors or incorporators calling meeting must give at
least 2 days’ notice to each director or incorporator, stating
time and place of meeting.

773 774

773 774

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Bylaws Articles vs. Bylaws

Corporate Bylaws
• Incorporators or board of directors will adopt initial bylaws
for corporation.
• Bylaws: Bylaws may contain any provision for managing
business and regulating affairs of corporation that is not
inconsistent with law or articles of incorporation.
• Supremacy: If conflict exists between articles of
incorporation and bylaws, then articles prevail over
bylaws (conflict unlikely, in practice, because articles
typically contain minimal information).
• Ease of Amendment: Bylaws are easier to amend than
articles of incorporation.

• No Filing: Bylaws are not filed with Department of State. • Analogy to Democratic Government: Articles of
Incorporation are like constitution of corporation, whereas
bylaws can be likened to individual laws that must be
775 consistent with Articles of Incorporation. 776

775 776

Defective Incorporation
• Above, we dealt with promoter who acts on behalf of
corporation that promoter knew did not exist (yet).

Defective • What if “promoter” reasonably believed that corporation

Formation did exist—but corporation was not, in fact, formed?
• Here promoter reasonably believes that she is, in fact, agent of
corporation that exists.

777 778

777 778

De Facto Corporation De Facto Corporation: Example

• De facto corporation may exist (even if substantial defects Example
exist in formation) provided: • Jennie wants to incorporate business selling cupcakes to be

o There has been good-faith effort to incorporate, called “Jennie’s Cupcakes.”

o “Colorable compliance” with formation requirements • She completes all statutory requirements and fills out
(came close to forming de jure corporation), and Articles of Incorporation.
o Actual use of corporate status. • But instead of filing with Secretary of State’s office, she files

with Florida Department of Health.

• Key Result: Promoters are not personally liable. • Because she substantially complied with state law, she has

strong case for de facto corporation.

• Applies in both contract and tort cases.
779 780

779 780

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Corporation by Estoppel Estoppel Review

Corporation by Estoppel Doctrine
• Equitable doctrine that may be applied when persons have
dealt with defectively formed corporation as if corporation
were legal corporation.
• If person deals with business as corporation and treated
business as such, then this person may be estopped from
denying that business is corporation (from avoiding contracts
or attempting to hold shareholders personally liable on
grounds of defective corporate status).
• Applies only in contract, and not in tort. Why?
781
Types of Estoppel
• Promissory Estoppel: Person is estopped from denying
existence of contract, because person has dealt with
counterparty as if contractual relationship exists.
• Agency by Estoppel: Person is estopped from denying
existence of agency, because person has dealt (or failed to
deal) with counterparty as if agency relationship exists.
• Corporation by Estoppel: Person is estopped from denying
existence of corporation, because person has dealt with
corporation as if corporation exists.
782

781 782

Corporation by Estoppel: Example Corporation by Estoppel: Example

Hypo: Background Facts
• Suppose Jennie She wants to form corporation called
“Jennie’s Cupcakes,” but fails to include word like
“corporation” or “limited liability corporation” in name.
• She also never appoints corporate agent and fails to file
articles of incorporation.
• Jennie does appoint board of directors who adopt governing
set of bylaws.
• To start business, Jennie contracts with vendor for 1,000
pounds of baking flour.
783
Hypo: Vendor Actions
• Vendor is sophisticated baking goods manufacturer who has
been in business for 20 years.
• Vendor also has in-house corporate legal team.
• When vendor’s general counsel reviews order, she notices
that Jennie’s company is not properly named
• General counsel also checks Florida’s Secretary of State’s
Division of Corporations website to determine whether
Jennie’s company is registered corporation—it is not.
• General counsel decides to agree to contract anyway.
784

783 784

Corporation by Estoppel: Example Corporate Status

Question
De Facto Estoppel
• Assess vendor’s possible defenses to enforcement of contract Method of Good faith attempt to Parties act as if
with Jennie’s Cupcakes. Formation incorporate under corporation exists: no
statute, colorable requirement of following
compliance with statute, statutory provisions.
Answer
and actual exercise of
• This course of conduct shows that vendor did business with corporate powers.
Jennie’s Cupcakes as if it were bona fide corporation. Effect on Personal Insulates promoter (or Insulates promoter (or
• Vendor cannot deny existence of corporation—court will likely Liability shareholder) against shareholder) against
“create” corporation by invoking doctrine of corporation by personal liability personal liability in
estoppel. contract, but not in tort.

785 786

785 786

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Possible Exam Hypo

Facts
• Some people want to incorporate business as corporation.
• People execute incorporation documents but there is some

•
technical problem that results in document not being filed.
People start doing business as corporation.
Issuing Stock
• At some point, it comes to light that no corporation was
formed.

Question
• Are these people personally liable?
787 788

787 788

Shares of Stock Consideration For Shares

Shares of Stock Forms of Consideration
• Units of ownership in corporation. • Shares may be issued for cash, other property, past

• Corporation may issue number of shares (of each class or services, or promises to perform services evidenced by
series) authorized by articles of incorporation. written contract.
• Shares that are issued are outstanding shares until • Amount and adequacy of consideration is determined by

reacquired, converted, or cancelled. board of directors.

789 790

789 790

FL Bar Tip Terminology

• FL statute greatly expands traditional acceptable forms of Important Definitions
consideration for issuance of stock. • Authorized Shares: Maximum number of shares

corporation can issue (per articles of incorporation).

• Traditional Rule: Jurisdictions did not allow stock to be
issued in exchange for promissory notes or promises to
perform service in future.
• FL Rule: These forms of consideration are acceptable.
791
• Issued Shares: Shares corporation does, in fact, issue.
• Outstanding Shares: Issued shares that corporation has not
reacquired (corporation can buy stock back).
• Treasury Stock: Reacquired shares (e.g., if corporation
issues 40K shares and buys back 10K, then this 10K is
treasury stock and 30K are outstanding shares). 792

791 792

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Par Value Accounts

Par Value Stated Capital
• Minimum price for which corporation can issue its shares. • Aggregate par value of all issued shares of par value stock.

• Par value is minimum issuance price, not actual price paid • Cannot be distributed to shareholders

for stock.
Capital Surplus
• Par value impact only issuance price and has no effect on
resale price. • Received funds for its issuance in excess of par value.

• Can be distributed to shareholders in dividends.

793 794

793 794

Benefits of Par Value Watered Stock

Creditor Protection Watered Stock
• Par value results in stated capital account that acts as • Shares issued by corporation to someone in exchange for

cushion to protect creditors against unwanted risk-taking consideration that is worth less than par value of share
by shareholders. issued.

Investor Protection Example

• Par value protects investors against dilution in era of
• Someone provides $5K worth of assets for $10K of par
limited available information: investors can be confident value stock.
that no one else will receive more favorable issue price.
• Balance sheet would record value of assets at par value of
stock, allowing corporation to inflate true value of
795 company. 796

795 796

Watered Stock Fraud Watered Stock Fraud

Fraud Scheme
• Fraudster exchanges property for stock—par value of

which far exceeds actual value of property. $200,000 $500,000 Par Value $500,000 Cash
• Fraudster issues stock to public at par value, earning profit
equal to difference between (1) true value of property, and
(2) par value of stock sold.
• Public does not know true value of property.

• When company goes bankrupt, corporate creditors do not

get paid because company is under-capitalized.

• Company’s stated capital was not accurate representation

of real capital of corporation. 797 798

797 798

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Watered Stock Liability Watered Stock Example

Liability: Example
• Creditors of corporation can collect unpaid balance • Corporation sells 10K of $2 par value stock for $15K instead

(difference between (1) par value, and (2) value of of $20k. Who is liable?
consideration given in exchange for stock) from holders of • Shareholder who bought below par value stock (watered
watered stock. stock) are personally liable for $5K difference if creditors
• Exception: Shareholder who (typically in return for in-kind foreclose on corporation’s assets.
services or for property) is issued shares for less than par
value is personally liable to corporation’s creditors for
difference between par value, and value given for stock.

799 800

799 800

Of Limited Relevance Today

Two developments have significantly limited practical impact
of par value:
• Most states have eliminated requirement for par stock
(including FL).
Pair-&-Share
• In states that have retained requirement, corporations Problems 12
often set par value at penny or fraction of penny.

801 802

801 802

Problem 1 Problem 2
Facts Facts
• Articles of incorporation provide that Class A stock shall have $2 • Carhart invests $100K in corporation and receives stock.
par value.

Questions Questions
• Can corporation issue 2,000 shares of Class A stock for $1 a • Does Carhart care about par value of stock?

share? • Does Carhart care whether corporation sells stock to

• Can corporation issue 3,000 shares of Class A stock for $5 a others, or for what price?
share?
• Can shareholder sell $2 par value Class A stock for $1 a share?
• Can corporation issue 100,000 shares of $2 par value Class A
stock in exchange for Blackacre? 803 804

803 804

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State of Incorporation
General Rule
• Corporation can choose to incorporate in any state, even if

corporation does not conduct business in that state.

STATE OF • Most publicly-held corporations are incorporated in
INCORPORATION Delaware.

805 806

805 806

Delaware Court System Why Delaware?

3 Main Factors
• History

• Ongoing Maintenance: Delaware legislature regularly

updates corporate law to keep current with court

decisions.
• Efficiency: More efficient if parties do not need to

research and learn laws of different states to do deal.

Delaware earns over $1 billion annually in entity filing fees

and franchise tax (e.g., Amazon’s annual franchise tax is
807 $250K). 808

807 808

History of DE Chancery Court Key Delaware Courts

Court of Chancery
• Non-trial court that has jurisdiction to hear and make

determinations in equity cases covering matters related to

corporate law, estates, land sale disputes, trusts,
questions concerning real estate titles, and commercial
and contractual matters generally.

Supreme Court
• Court of last resort and has 5 judgeships.

809 810

809 810

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Me at DE Court of Chancery Terminology

• Domestic Corporation: Corporation that does business in
state in which it is incorporated.

• Foreign Corporation: Corporation that is incorporated

under laws of one state and does business in another
state.

• Example: Corporation incorporated in TX is domestic

corporation in TX and registered foreign corporation in all
other states.
811 812

811 812

Qualification Internal Affairs Doctrine

Qualification Internal Affairs Doctrine
• Every foreign corporation must qualify to do business in • Laws of state of incorporation govern “internal affairs” of

foreign state. corporation.

How to Qualify to Do Business?

• Obtain authorization from appropriate state agency,

• Appoint registered agent,

• File annual statements, and

• Pay fees and franchises taxes to state.

813 814

813 814

Lidow v. Superior Court LA County:

Internal Affairs Defined Facts
Internal Affairs Facts
• Includes issues such as shareholder liability, validity of • Plaintiff brings wrongful termination claim under CA

stock issues, mergers, voting agreements, election of employment law that is barred under DE corporate law.
directors, relative rights and duties of officers, directors
and shareholders.
• Applies to existing intra-corporate relationships

• Does not include rights of third-parties with respect to

corporation.

815 816

815 816

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Lidow v. Superior Court LA County: Lidow v. Superior Court LA County:

Issue Conflict of Law
Issue: • DE corporate law essentially bars corporate officers from
• Should court apply internal affairs doctrine (conflict of law
bringing wrongful termination claims as matter of law.
principle) to bar plaintiff’s action under DE law? • By contrast, judicially created exception to CA “at-will”
employment statute allows employees to bring tort actions
against employers for wrongful termination in violation of
public policy.

• Thus, ex-CEO’s wrongful termination claims brought DE

corporate law and CA employment law into conflict,
because CEO was both DE corporate officer and CA
employee.
817 818

817 818

Lidow v. Superior Court LA County: Lidow v. Superior Court LA County:

Trial Court Appellate Court
Holding Holding
• Trial court invokes internal affairs doctrine to apply DE law. • Claims at issue are not part of corporation’s internal affairs.

Rationale Rationale
• DE law provides that officer may not sue for wrongful • CEO contended he was terminated not for normal business
termination (unless certain conditions exist that are not reasons, but because he had complained about possible
present in this case). ethical breaches and illegal conduct within company.
• Because removal was allegedly retaliatory, employer’s
actions went “beyond internal governance” and, instead,
touched on matters of public policy (where have you seen
819 this public policy rationale before?). 820

819 820

Questions of Law •
California’s Aggressive Approach
Rationale: Court relies on Restatement of Conflict of Law that
provides internal affairs doctrine should not apply with respect
Questions California
to specificJurisprudence
issue on which another state has more significant
• Has Lidow now won this case?
relationship with parties and transaction.
• California loves to apply CA law to DE corporations: CA is

• Why does hiring and firing of officers not fall under internal very plaintiff-friendly state (whereas DE is arguably
• Question: Has Lidow now won this case?
affairs of corporation? relatively defendant-friendly state?).
• Do you like this case if you are freedom-of-contract person?
• California wants to protect whistle-blowers (cf. Bohatch).
Why? How about if you care about business uncertainty?
• Bottomline: In CA, common law cause of action exists for
retaliatory firing: not all states would do this.

821 822

821 822

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Problem 1
Facts
• Business leaders have described Alabama as “torts hell.”

Pair-&-Share Question
Problems 13 • Can corporation avoid application of Alabama tort laws to
accidents in its Alabama stores by incorporating in
Delaware?
• Answer: No

823 824

823 824

Problem 2
Questions
• If corporation is incorporated in DE but operates only in AL,

will AL shareholder have to sue in DE?

• Is expertise of DE courts only relevant if lawsuit is tried in
DE? LIABILITY

825 826

825 826

First General Rule of Liability No Ultra Vires Defense

• First General Rule: Corporations are liable for their • General Rule: Except otherwise provided, validity of corporate
contracts and for torts committed by their agents (e.g., action (e.g., entering into contract) cannot be challenged on
employees). ground that corporation lacks power to act.

• Punitive Damages: Corporation can be held liable for
punitive damages if (1) employee or agent engages in
intentional misconduct or is grossly negligent, and (2)
corporation participates in or condones conduct or is itself
grossly negligent.
827
• Ultra Vires Defense: If corporation enters into contract that is
beyond its powers to act (ulta vires contract), then lack of
power to act cannot be used by corporation as defense to
enforcement of contract.
• Rationale: Became near impossible to specifically define
scope of business of corporation, making it too easy for
corporation to use as defense to contract enforcement. 828

827 828

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Bar Tip Second General Rule of Liability

• Given broad statutory powers conferred on FL corporations • Second General Rule: Creditors of corporation (including
by statute, corporations generally can do anything that is judgment creditors) can recover from corporation’s assets.
rationally related to business purpose (except donate to
candidates for federal office).
• Example: If corporation fails to pay rent to its landlord,
then landlord can sue corporation and collect on any
• Unless corporation’s articles restrict its powers, you generally
judgment by garnishing corporate bank account or levying
should not find any rational act to be beyond its “powers to
on other corporate assets.
act.”

• You should not allow corporation to get out of contract

merely because contract is outside corporation’s powers:
ultra vires defense is very limited! 829 830

829 830

Third General Rule of Liability Exceptions to Third General Rule

• Third General Rule (Corporate Veil): Shareholders are not Four Exceptions to Third General Rule
personally liable to corporation’s creditors. • Personal Conduct

• Personal Guarantees

• Example: If corporation fails to pay rent to its landlord, • Piercing Corporate Veil Doctrine
then landlord can sue corporation and collect on any
• Enterprise Liability
judgment by garnishing bank account or levying on other
corporate assets: landlord cannot collect on assets of
corporation’s shareholders.

831 832

831 832

Personal Conduct Breach of Fiduciary Duty

• First Exception: Shareholder is personally liable for actions Reality Check:
taken in personal capacity (e.g., shareholder is personally • Why is corporation not vicariously liable for breach of
liable in tort if she personally commits tort at issue). fiduciary by director or officer?

• Example: Owner of lumber yard who personally stacks cord Answer:

of wood in negligent manner will have personal liability for • Corporation-plaintiff (or shareholders on its behalf) sues
harm caused by this act of negligence. manager-defendant for breach of fiduciary duty owed to
corporation.
• No third-party here.

833 834

833 834

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Personal Guarantees Piercing Corporate Veil (PCV)

• Second Exception: Shareholders can be liable to
corporation’s creditors because of personal guarantees.
• Example: Landlord can refuse to rent building to
corporation unless certain shareholders personally
guarantee rent payments.
• Piercing Corporate Veil (PCV): Action of court to disregard
corporate entity and hold shareholders personally liable to
creditors of corporation.
• Piercing corporate veil is judicial exception.
• Piercing corporate veil holds shareholders personally
liable, and not directors or officers.

835 836

835 836

Social Costs of Limited Liability Hiding Behind Corporate Veil

• Suppose assets of corporation are $1 million.
• Corporation invests in project with equal probability of $5
million in tort losses or $3 million in economic gains.
• Expected Profit Without Limited Liability
0.5 x $3 million – 0.5 x $5 million = –$1 million < 0
• Expected Profit With Limited Liability
0.5 x $3 million – 0.5 x $1 million = $1 million > 0
• Key Point: Project yields shareholders positive expected return
($1 million) while producing net social loss (–$1 million). 837
• Example: Harvey and Barbara own Aqua Clear Technologies,
which installs home water-softening systems. Technology
used by company results in significant pollution of town
water supply. Town sues Aqua Clear.
• Town wins $12 million dollar judgment against Aqua Clear
that Aqua Clear cannot pay. Aqua Clear files for
bankruptcy.
• Meanwhile, Harvey and Barbara’s $8 million in personal
assets remains protected behind corporate veil.
838

837 838

When to Pierce? Empirical Fact

Questions: • Piercing corporate veil is ordered in only close
• Under what circumstances do courts choose to pierce corporations.
corporate veil?
• What if shareholder to be held liable is another • No case has pierced corporate in corporation with more
corporation? than 9 shareholders.

839 840

839 840

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DeWitt Truck Brokers: Facts DeWitt Truck Brokers: Holding

Facts Holding
• Fruit growers engage Flemming (corporation) to sell fruit. • Trial court pierced corporate veil, holding Mr. Flemming

• Flemming receives sale proceeds and pays growers. personally liable.

• Flemming hired Dewitt to haul fruit but failed to pay. • 4th Circuit affirms trial court decision.

• Dewitt sues Flemming and Mr. Flemming personally to

recover approximately $15K in unpaid trucking fees.
• Mr. Flemming owned 90% of corporation’s stock.

841 842

841 842

Balancing Test Questions

Court pierces corporate veil if enough of following factors are Questions
present: • Is Mr. Flemming now personally liable for all other debts of

• Undercapitalization (which includes siphoning funds) corporation?

• Nonpayment of dividends? • Answer: No.
• Insolvency (True by definition, no?) • Are other stockholders of Flemming corporation now also
• Administrative laxity (which includes failure to observe personally liable to plaintiff?
corporate formalities, non-functioning officers or directors, • Answer: No.
absence of corporate records)

Showing of fraud is not necessary.

843 844

843 844

Undercapitalization Practice Advice

• Undercapitalization (or Thin Capitalization): Shareholders • If shareholder does not maintain wall between herself and
did not put enough funding into corporation to cover corporation, then court may come to equate shareholder
prospective liabilities. with corporation.

• Question: If corporation is adequately capitalized when
formed but later loses money, is it then undercapitalized for
piercing corporate veil purposes?
• Question: Is it less justifiable to allow piercing based upon
undercapitalization in contract case?
845
• Alter Ego Doctrine: To protect yourself, act like separate
entity and respect separation between ownership and
control: take corporate procedure seriously (e.g., director
meetings, shareholder meetings, maintain meeting
minutes, corporate records).
846

845 846

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Parent-Subsidiary Relationship Parent-Subsidiary Relationship

• Wholly-Owned Subsidiary: Corporation where all
outstanding stock is owned by another corporation
(parent corporation).

• Partially-Owned Subsidiary: Corporation where majority

of outstanding stock is owned by another corporation
(parent corporation).

847 848

847 848

In Re Silicone Gel Breast Implants:

Parent Liability
• Limited Liability: Parent corporation is not liable for
obligations of its subsidiary corporation UNLESS
contractual or judicial exception exists to general rule that
shareholders are not liable to corporation’s creditors.
Facts
• Bristol owns all stock of MEC.
• MEC manufactures and distributes breast implants.
• Bristol has never manufactured or distributed breast
implants.

849 850

849 850

In Re Silicone Gel Breast Implants: In Re Silicone Gel Breast Implants:

Plaintiff Argues Holding
Plaintiff asserts product liability against Bristol on 2 theories: • Holding: Court rejects denies Bristol’s motion for summary
• Piercing corporate veil judgment.
• Direct liability

• Rationale: Court emphasizes that it must look at “totality

of circumstances” and laid out series of factors to balance
in determining whether parent has substantially
dominated subsidiary.

• Court concludes that showing of fraud is not required for

piercing corporate veil in torts case.
851 852

851 852

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In Re Silicone Gel Breast Implants:

Balancing Factors
Reverse Veil Piercing
List of balancing factors includes • Reverse Veil Piercing: Instead of disregarding entity status
• Common directors of business to allow creditors of business to look to assets
• Common departments of owners to satisfy claims against business (veil piercing),
• Consolidated financial statements reverse veil piercing disregards entity status of business to
• Parent finances subsidiary allow creditors of owners to look to assets of business to
• Parent causes incorporation of subsidiary satisfy claims against owner.
• Undercapitalization
• Parent pays salary and other expenses of subsidiary
• Subsidiary only receives business from parent
• Parent uses subsidiary property as its own.
• Administrative laxity
853 854

853 854

Sky Cable v. DIRECTV Type of Reverse Veil Piercing

Facts Two Types of Reverse Veil Piercing
• Randy Coley stole cable television from DirectTV • Insider Reverse Piercing

• Plaintiff-DirectTV is awarded $2.3 million judgment. • Outsider Reverse Piercing

• Prior to judgment, Coley transferred significant personal

assets to single-member LLC.

Holding
• Applying DE law, circuit court affirms lower court’s decision

to reverse pierce veil of single-member LLC.

855 856

855 856

Insider Reverse Veil Piercing Outsider Reverse Veil Piercing

Insider Reverse Veil Piercing Outsider Reverse Veil Piercing
• Applies when controlling member or shareholder urges • Applies when outside third-party (often creditor) urges

court to disregard corporate entity that otherwise court to render company liable in judgment against its
separates such member or shareholder from corporation. member.
• Court strongly oppose allowing company’s veil to be • States that have barred outsider reverse piercing have done

pierced for benefit of individual who herself created so because of potential harm to innocent shareholders or
company. members.

857 858

857 858

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Enterprise Liability
Horizontal Veil Piercing
• Corporations (although technically separate) are

commonly-owned and engage in one enterprise should be

treated as single legal entity for purposes of liability.

859 860

859 860

A Hippy-Dippy Theory In Practice

Exception Form of Relief
• Relief is rarely granted in enterprise liability cases because

those very few and far between cases “typically involve

truly egregious misconduct.”

861 862

861 862

Walkovszky v. Carlton: Facts Walkovszky v. Carlton: Strategy

• Plaintiff was injured when hit by taxicab. Pierce Corporate Veil
• Cab was operated by corporation owned by Carlton. • Pierce through 1 corporation that operated cab that hit

• Corporation’s assets consisted of 2 cabs (not fully paid), him to recover from shareholder-Carlton.
medallion, and minimum amount of insurance required by
law for each cab. Enterprise Liability
• Carlton owned 9 other similarly structured corporations. • Treat all 10 companies as 1 and recover from combined

• All 10 taxicab companies operated out of single garage, assets of all 10 companies.
with single dispatching systems. • Aim is not to go after assets of shareholders, but to go

after assets of related companies.

863 864

863 864

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Questions In Summary
Questions Shareholder/Owner Judgment Personal Creditor
• If you represented plaintiff in Walkovszky, which would you

have asserted—piercing corporate veil or enterprise Reverse Veil Piercing

liability? Corporate Veil
• Is court more likely to impose enterprise liability in torts Veil Piercing
case than contracts case? Corporation 1 Enterprise Liability Corporation 2

Vicarious Liability

Agent Judgment Business Creditor

865 866

865 866

FTX Org Chart Keep It Simple, Stupid

• It’s clear Sam designed the organizational structure to be
intentionally convoluted to keep various employees and
companies in the dark about what was happening outside
of their specific walled garden within the greater structure

• FTX’s complex, perhaps intentionally convoluted, structure

likely aided Bankman-Fried’s mismanagement.

• Fooled smart money players like Sequoia Capital.

Chart lists 100+ entities for FTX, which only employed about 300 people.
867 868

867 868

Social Benefit of Limited Liability

• Transfer of Shares: Law generally recognizes owner’s right
to transfer stock to another person.

• Transferability requires (1) no personal liability, and (2) CORPORATE

separation of ownership & control.
CONTROL
• Benefit of Limited Liability: Limited liability gets you capital
markets (i.e., no one will invest with no control and personal
liability).

869 870

869 870

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Agency Costs Economic Definition of Agency Costs

Agency Costs
• Agency costs relate to actions taken by directors and
officers.
• Agency costs can be subdivided into (1) competence costs,
and (2) conflict costs.
o Competence Costs: Include lack of expertise, inadequate
information, overconfidence bias, optimism bias.
o Conflict Costs: Include shirking (reduced effort), self-
dealing, entrenchment, inefficient compensation.
871
• Agent is given powers to make decisions on behalf of
principal.
• Parties have different incentives.
• Information Economics: Principal cannot directly ensure
that agent is acting in principal’s best interests (because
monitoring/bonding is costly).
• Example: Moral Hazard, Proverbial Corporate Jet
872

871 872

Separation of Ownership & Control Greed is Good

• Shareholders want to
maximize shareholder
value, while management
may sometimes make
decisions that are not in
best interests of
shareholders (i.e., those
that benefit themselves).

874

873 874

Principal Costs Who Should Run Firm?

• Principal costs relate to actions taken by shareholders. • Managerial Model: Officers

• Principal costs can be subdivided into (1) competence • Director Primacy Model: Board of Directors
costs, and (2) conflict costs.
o Competence Costs: Include lack of expertise, inadequate • Shareholder Primacy Model: Shareholders
information, duplicative efforts, cognitive myopia.
o Conflict Costs: Include collection action problems, • Market for Corporate Control: Market
rational apathy, holdouts, different horizons.

875 876

875 876

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Optimal Governance Structure Shareholder Protection

• Thesis: Firm’s optimal governance structure minimize total Shareholders in publicly-traded corporations are provided
control costs. protection through 4 principal mechanisms:

• Contract
• Total Control Costs = Principal Costs + Agency Costs
• Corporate Governance
• Key Point: Theory helpfully places more weight on benefits
• Market for Corporate Control
created by separation of ownership and control.
• Wall Street Walk (Selling)

877 878

877 878

Shareholder Protection
Shareholders can obtain protection from agency cost
problem through following contractual mechanisms:

• Articles of Incorporation and Bylaws

CONTRACT • Shareholder Manager Agreements (SMAs)

• Equity-Based Pay (Stock Options)

879 880

879 880

Shareholder Management Agreement Authorization of SMA

• Shareholder Management Agreement (SMA): Allows
shareholders to:
o Eliminate board of directors or restrict discretion or
powers of board of directors
o Govern authorization or making of distributions
o Establish who shall be directors or officers of corporation
o Transfers to 1 or more shareholders (or other persons) all
or part of authority to exercise corporate powers or to
manage business and affairs of corporation.
• Shareholder management agreement (SMA) must be set
forth in articles of incorporation or bylaws and approved by
all shareholders at time of agreement.
• If agreement ceases to be effective for any reason, then
board of directors may adopt amendment to articles of
incorporation or bylaws, without shareholder action, to
delete agreement.

881 882

881 882

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Equity-Based Compensation Stock Option

• High-Powered Incentive Contracts: Some corporations
have sought to align financial interests of management with
those of company’s shareholders by providing officers with
share-based compensation.
• Stock Options: Give holder option to buy:
o Specified number of shares of firm’s stock
o At specified exercise price
o During specified period.

• Most Common Types

o Stock Options

o Restricted Stock

883 884

883 884

Features of Stock Options Some Problems

General Features
• No actual shares issued at time of stock option grant: no
voting or other rights exist until option is exercised.
• Any benefit realized to option holder depends upon
difference between value of stock over option price
• Stock Value < Exercise Price → Value of Stock Option = 0
• Stock options typically have expiration date.
885
• In general, options have proven to be imperfect device for
encouraging effective governance.
• Fraud: Executives in some companies have been tempted
to “cook” company’s books to keep share prices higher so
that stock can be sold for profit.
• Back-Dating: Executives have experienced no losses when
share prices dropped because options were “repriced” to
negate price decline.
886

885 886

Restricted Stock Units (RSUs) Vesting Schedule

Restricted Stock Units Vesting Schedule
• Type of equity compensation that grants employees • Dictates when ownership rights are activated.

specific number of company shares subject to vesting
schedule.
• Restricted stock units will vest at some point in future and
will have some value upon vesting unless underlying
company stock becomes worthless.
• Time-Based Vesting: Shares are awarded over specified
time-period.
• Performance-Based Goals: RSUs can have other restrictions
beyond time-based vesting schedule that are often related
to performance (e.g., company must reach certain
milestones).

887 888

887 888

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Features of RSUs Benefits of RSUs

General Features Benefits
• Subject to forfeiture if recipient of RSU fails to meet any of • Simplicity: Vesting schedule specifies when recipients will

required conditions (e.g., continued employment at receive shares and easier to estimate value compared to
company). stock option.
• Restricted stock units do not carry voting rights until stock • No Purchase Necessary: Shares become yours upon

becomes vested vesting; no purchase necessary unlike stock option.

• Restricted stock units do not receive dividends. • Retain Value: Unless the share price of your company goes
to $0, RSUs will still have value, whereas stock options
might not.

889 890

889 890

Corporate Governance
In theory, stockholders control management through 2 key
disciplining mechanisms:

CORPORATE • Shareholder Rights

o Discretionary Control Rights: Right to Inspect Corporate
GOVERNANCE Documents, Shareholder Voting (Direct Democracy)
o Duty-Enforcement Rights: Derivative Suits

• Board of Directors (Representative Democracy)

o Corporate Fiduciary Duties

891 892

891 892

Corporate Rights
• Principal (shareholders) and agent (management) agree to
general allocation of:
o Control Rights: Govern apportionment of decision-
making power over firm. CONTROL RIGHTS
o Cash-Flow Rights: Govern apportionment of firm-
generated value.

• Conflicts arise as to allocation and use of these 2 types of

rights (because corporate contract are always incomplete).
893 894

893 894

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3 Key Corporate Players

• Shareholders (Electorate): Elect directors annually and vote
on fundamental corporate transactions. Do not participate
in managing corporation’s business and cannot act on
behalf of corporation
SHAREHOLDERS
• Board of Directors (Executive): Board has ultimate
authority for running corporation.

• Officers (Bureaucracy): Delegated day-to-day management

of corporation and are answerable to board of directors.
895 896

895 896

Shareholders FL Bar Tip

• Shareholders normally do not have power to control day-
to-day management of corporation (but can be given
management power by articles).
• Shareholders exercise indirect management by:
o Electing directors,
o Amending article or bylaws, or
o Approving fundamental corporate changes.
• If asked about power of shareholders to run day-to-day
affairs of their corporation, you should generally find that
shareholders have no such power: that power is vested in
board of directors.
• Exception: Shareholder may agree to dispense with board
or restrict board’s discretion or power by shareholder
agreement.

897 898

897 898

Shareholder Powers Shareholder Rights

• Shareholders have following powers:
• Elect and remove directors
• Vote on fundamental corporate changes
• Initiate (on very limited basis) corporate reforms
• Right to Inspect Books & Records: Shareholders have
absolute right to inspect, during regular business hours at
corporation’s principal office, such items as articles,
bylaws, minutes of all meetings of (and records of all
actions taken without meeting by) its shareholders, all
written communications within past 3 years to
shareholders, lists of names and business addresses of
current directors and officers, and most recent annual
report.

899 900

899 900

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Shareholder Cash Flow Rights Shareholder Duties

• Dividends: Shareholders cannot compel directors to • Shareholders have no fiduciary duty to corporation and
declare dividends: absent bad faith, directors are given may act in their personal interest.
wide discretion in this area.
• Exception: Controlling shareholders cannot use their
• Once declared, dividend cannot be revoked, EXCEPT when power to defraud or oppress minority shareholders.
payment would be illegal.
• Shareholders (like directors) are not agents of corporation.
• Declaration of dividend creates enforceable debt owed to
shareholders.

901 902

901 902

Shareholders Action Types of Shareholder Meetings

• Shareholders can act in 2 ways: • Two Types of Shareholder Meetings
o Meeting o Annual Meetings
o Unanimous written consent.
o Special Meeting

• In publicly-traded corporation, all shareholder actions will

• Shareholder meetings can be held within or outside state of
occur at meeting and not through written consents.
incorporation.

903 904

903 904

Annual Meetings Berkshire Hathaway Annual Meeting

Annual Meeting
• Must be held annually for election of directors and other
business.

• If annual meeting is not held within any 15-month period,

then any shareholder can apply to court for order requiring
meeting.

905 906

905 906

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Special Meetings Record Date

Special Meetings • Record Date: Corporation fixes record date before meeting
and only record owners as of that date are entitled to
• Can be called for any appropriate purpose by (1) board of
directors, (2) holders of at least 1/10 of all outstanding notice and vote at meeting.
voting shares, or (3) other such persons as authorized in • General Rule: Record date shall not be more than 70 days
articles or bylaws. before meeting.
• Notice: Shareholders must be notified in writing of
meetings (including purpose of special meetings) at least
10 days in advance.

907 908

907 908

Hypothetical Quorum
Facts • Quorum: Number of members of decision-making body
• McDonalds sets record date of June 8.
that must be present before business may be transacted.
• John, who owns 120 shares of McDonald’s stock, sells • Default Rule: Quorum consists of majority of shares
stock to Shephard on June 10. outstanding (do not count treasury stock).

Questions • Articles or bylaws may authorize quorum to consist of less

• Who votes at annual meeting?
than majority but no fewer than 1/3 of total shares
outstanding.
• Suppose John transfers stock to Shepherd on June 5.

• Who votes at annual meeting? • Consequence: If no quorum, then no meeting, and

shareholders cannot act.
909 910

909 910

Quorum: Example Voting by Proxy

• What matters is number of shares, and not number of • Shareholder can cast vote either (1) in person, or (2) by
people. proxy.

• Example: Suppose corporation has 1 million shares

outstanding held by 50,000 shareholders. 500,001 must be • Most stockholders do not attend meetings and vote shares
by proxy.
represented at meeting.

Question • Proxy: Agency relationship in which shareholder (principal)

• Do we have quorum if 60,000 shareholders attend meeting? grants proxy-holder (agent) power to vote her shares as
• What about 300,000 shares?
directed by shareholder.
• 600,000?
911 912

911 912

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Proxy Requirements Proxy Appointment Card

• Shareholder can appoint proxy by signing appointment
form or by transmitting telegram or other electronic
communication.
• Proxy appointment is valid for term provided in
appointment.
Proxy Card
• Ballot that “registered owners” or “record holders”
(shareholders whose names company keeps on record as
owners of company's shares) can use to vote at company
meetings.
• Proxies are often solicited by management itself.

• If no terms is provided, then proxy expires after 11 months

(UNLESS appointment is irrevocable).

913 914

913 914

915 916

915 916

Revocability Irrevocable Proxy

• Proxies are revocable at pleasure of shareholder UNLESS
o Proxy states that it is irrevocable, and
o Proxyholder has interest in shares (e.g., as pledgee or
employee).
• In 2017, Shepherd borrow $100K from First Bank and
pledges McDonald’s stock as collateral for loan.
• First Bank wishes to vote pledged share and requires
Shepherd execute irrevocable proxy.
• Proxy is coupled with interest, because First Bank holds
proxy and interest in stock itself, and proxy is, therefore,
not revocable.

917 918

917 918

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Types of Shareholder Action

3 Types of Shareholder Action
• Election of Directors

Shareholder • Fundamental Changes

Action • Ordinary Matters

919 920

919 920

Election of Directors
• Election of Directors: Shareholders elect directors at
annual meeting.

Election of
Directors

921 922

921 922

Voting for Directors Plurality of Votes

• General Rule: In shareholder vote for directors, candidate Election of 1 Director
must receive plurality of votes UNLESS articles provide for • Corporation has 100 shares outstanding.
cumulative voting (see infra).
• 70 shares are represented at annual meeting.

• Quorum exists because more than 50 shares are

• Plurality: Candidate with most votes wins, even if represented.
candidate did not receive majority of votes cast.
• Candidate A receives 30 votes.

• Candidates B and C each receive 20 votes each.

• Candidate A is elected with plurality of votes (but not

majority of votes).
923 924

923 924

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Two Types of Terms Rationale for Staggered Boards

Two Types of Boards Board Continuity
• Annual Election: Director serves 1-year term—from • Longer term perspective

annual meeting to annual meeting. • Less transition costs (e.g., training)

• More experienced board members

• Staggered Boards: Directors are elected to 3-year terms:
1/3 of board stands for election each year.
Anti-Takeover Provision
• Is this a benefit?

925 926

925 926

Anti-Takeover Provision Two Types of Voting

• Hostile bidder must wait at least 1 year (if not longer Two types of voting regimes to elect directors:
depending on number of director classes) to gain control of
board through voting. • Regular Voting

• Cumulative Voting
• Hostile bidder must wait for elections to be held for each
specific director class.

927 928

927 928

Regular Voting Cumulative Voting

• Elect each director in separate election (seat by seat).
• Shareholder cannot give more than 1 vote per share to
any single candidate.
• Tyranny of Majority: Majority shareholder has power to
select every director.
Cumulative Voting
• One election for all director seats.
• Each shareholder is entitled to total number of votes equal to
number of board members to be elected multiplied by
number of voting shares that shareholder owns.
• Shareholder can split votes among multiple candidates or
apply them to just one candidate.
• Gives minority shareholders more voting power.

929 930

929 930

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Must Opt-In Cumulative Voting Hypo

Not Default Rule Hypo
• Cumulative voting is opt-in provision. • Corporation has 10,001 shares issued and outstanding.

• If articles are silent, then no cumulative voting. • Minority shareholders hold 4,001 shares, and majority

shareholders hold 6,000 shares.

• 3 board members are to be elected.

• Majority shareholders’ nominees are A, B, and C.

• Minority shareholders’ nominee are D and E.

Question
• Suppose you are majority shareholder? How do you vote?
931 932

931 932

Cumulative Voting Hypo Cumulative Voting Formula

Answer Minimum number of shares required to elect N directors:
• You should stack all your votes on 2 candidates.

• If you stack all your votes on all 3 candidates, then minority

𝑆
𝑁𝑥 +1
shareholder will stack equally across 2 candidates, win 𝐷+1
both, and now have majority of board.
where:
Comment N = Number of director seats desired
S = Total number of shares voting at meeting
• Minority shareholder can guarantee itself at least 1 board

seat. D = Total number of directors to be elected at meeting

• How do we know this?
933 934

933 934

Intuition Cumulative Voting Hypo (Cont.)

• Consider N = 1, where 1 director seat is sought. • In hypothetical above (assuming 10K shares), minimum number
• Suppose S = 10,000 total shares and D = 3 seats up for vote. shares required to elect 1 director is given by:
• Minority shareholder seeking 1 director seat will stack all votes on 1 10,000 𝑥 1
candidate. + 1 = 2,501
3+1
• Majority shareholder will stack equally on other 3 candidates to
prevent minority shareholder from obtaining seat. • Suppose board consists of 9 directors. What is minimum number of
• When is x > 3x? shares required to elect 1 director?

10,000 𝑥 1
2,500
v 2,500 2,500 2,500 + 1 = 1,001
9+1

• What is impact of staggered board (in which 1/3 of entire board is

IF S/4 votes gets you 1 seat, then you need N times that number to
elected each year) on minority shareholders?
obtain N seats on board (i.e., N x S/4). 935 936

935 936

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Removal of Directors
• Removal: UNLESS otherwise provided, director can be
removed by shareholders at any time, with or without
cause.
Fundamental
• Plurality Vote: Directors can be removed if number of
votes cast to remove director exceed number of votes
Changes
cast not to remove directors (except to extent articles or
bylaws require greater number).

937 938

937 938

Fundamental Corporate Changes Required Number of Votes

• Shareholders must vote on fundamental corporate • FL Rule: To approve fundamental corporate change,
changes initiated by board of directors. majority of all outstanding shares must assent to approve
action (UNLESS articles or bylaws require greater number).
• Fundamental changes include:
o Amendments to Articles of Incorporation,
o Statutory merger,

o Sale of substantially all corporation’s assets, and

o Dissolution.

939 940

939 940

Hypothetical Amendment of Articles

Hypo • Corporation can amend its articles of incorporation at any
• 6,000 shares are outstanding. time.
• 3,600 are represented at meeting.
• 2,000 shares vote on proposed fundamental change. • Amendments can include any provision that would be
lawful and proper to include in original articles at time of
Question: Would many votes required under Fl Law? making amendment (thereby permitting existing
corporations to take advantage of changes in law).
Answer: 3,001

941 942

941 942

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Approval Process Required Vote

• Amendments first must be adopted by board.
• Board then must recommend amendment to shareholders
(unless board determines that, because of conflict of
interest or other circumstances, it should not make
recommendation and informs shareholders of this).
• Board can set conditions for approval of amendment by
shareholders or effectiveness of amendment.
• Unless otherwise provided, amendment must be approved
by:
o Majority of all outstanding shares, and
o If proposed amendment would adversely impact specific
class of shareholders, majority of that class (even if
nonvoting).

943 944

943 944

Required Vote: Exceptions

• Unless articles provide otherwise, board can adopt
amendments to corporation without shareholder approval
that
o Extend duration of corporation,
Ordinary Matters
o Delete names of initial directors, and

o Make certain changes to corporate name.

945 946

945 946

Required Number of Votes Hypothetical Redux

• For ordinary matters, votes cast in favor must exceed votes Hypo
cast against to approve action (unless articles or bylaws • 6,000 shares are outstanding.
require greater number). • 3,600 are represented at meeting.
• 2,000 shares vote on ordinary matter.
• Note distinction between shareholder voting on ordinary • 1,600 vote yes.
matters and shareholder voting on fundamental changes:
ordinary matters can be approved by majority of votes cast Question: Would measure pass?
at meeting (as long as quorum exists), whereas
fundamental corporate change must be approved by Answer: YES, need at least 1,001 shares to vote Yes.
majority of all outstanding shares—not just those
represented at meeting.
947 948

947 948

158
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To Review
• Ordinary Matters: Can be approved by majority of votes cast
at meeting (provided there is quorum).

• Fundamental Corporate Changes: Must be approved by

majority of all outstanding shares entitled to vote—not just
those represented at meeting.

949 950

949 950

Meaningful Disciplining Mechanism?

Power of shareholders to act at shareholder meetings is diluted by
at least 3 key factors:
Most small shareholders do not attend shareholder meetings.
Shareholder
•

• Shareholder meetings are tightly-scripted events (difficult for

rebelling shareholders to raise issues not to management’s Proposals
liking).

• For large shareholders, path of least resistance is often to take

“Wall Street walk” (i.e., simply sell shares).

951 952

951 952

Shareholder Proposals
• Shareholder-Initiated Change: Shareholders can initiate
on their own changes in corporate governance and
structure.

• Shareholder Proposals: Shareholders can make

nonbinding precatory recommendations about
management of corporation to be voted on by
shareholders.

953 954

953 954

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Shareholder Initiatives Common Carrier Obligation

• Federal proxy rules help shareholder communicate with
other shareholders in 2 ways:
• Rule 14a-7: Management compelled to help shareholder
communicate with fellow shareholder but at shareholder’s
expense.
• Rule 14a-8: Management (in limited circumstances) must
include proper shareholder proposals in company’s proxy
mailing to shareholders—at corporation’s expense.
955
• Common Carrier Obligation: Management must mail,
(either separately or together with corporation’s proxy
materials) any shareholder solicitation materials if
shareholder agrees to pay corporation’s reasonable
expenses.
• Management can avoid common carrier obligation by
providing list of shareholder: management is often
reluctant to do this as this list can be used in proxy contest.
956

955 956

Shareholder Proposals Proxy Access

• Rule 14a-8: Allows shareholder to propose resolution
using company-financed proxy machinery.
• Long list of 13 reasons for management to exclude
shareholder proposal.
• If shareholder proposal cannot be excluded, then
management must include proposal in company’s proxy
statement and permit shareholders to vote in proxy card.
• Proxy Access: Gives shareholders (holding at least 3% of
company’s voting shares for at least 3 years) power to
nominate short slate of director-candidates for inclusion in
company’s proxy materials.
• Short Slate = Not majority
• Proxy access has become mainstream:
o 76% of S&P 500 companies

o 51% of Russell 1000 companies

957 958

957 958

Universal Proxy Access

• Competing Proxy Cards: Historically, shareholders were
forced to choose between mutually exclusive slates of
directors.

• Universal Proxy Cards: Beginning in September 2022, new

rules allow shareholders to elect directors from full list of
candidates nominated by both company and dissident in
contested board elections.

959 960

959 960

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Board of Directors
• Number of Directors: Corporation may have 1 or more
directors, where number of directors is set in either bylaws
or articles of incorporation.
BOARD OF
DIRECTORS • Director must be natural person 18 years of age or older.

• Directors need not be shareholders, residents of state of

incorporation, or have any other special qualifications or
expertise.

961 962

961 962

Definition of Independent Director Chairperson

• Chairperson: Head of board of directors (sets agenda,
schedules meetings, coordinates action of committees).

• Chairperson can also be CEO.

• Pairing of CEO-chairperson is subject of much debate.

963 964

963 964

Election of Board of Directors Director Powers

• Shareholder democracy is not direct democracy: • Powers: Directors have powers as necessary to manage
shareholder only vote on fundamental corporate changes business of corporation, including power:
and are limited in capacity to initiate shareholder o To select and remove officers,
proposals. o To declare dividends,

o To determine capital structure of corporation, and

• Shareholder democracy is principally representative
o To initiate fundamental changes for submission to
democracy: shareholders elect directors to board at annual
meeting to serve best interests of shareholders. shareholders for approval.

• Corporation can dispense with or limit authority of board of

directors.
965 966

965 966

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Director Rights Director Cash Flow Rights

• Rights: Directors have right:
o To inspect corporate records,
o To reasonably rely upon information provided by
management and experts,
o To be reimbursed for expenses, and
o To be (generally) indemnified in defending their actions
taken in good-faith.
• Compensation: Most states permit corporate bylaws to
authorize compensation for directors.
• Directors also receive indirect benefits (e.g., business
contacts, prestige).
• Compensation of directors is usually lower than
compensation of CEO and is not equity-based, but fixed.

• Directors’ compensation is set in bylaws. • For 200 largest publicly-held U.S. corporations, median total
compensation for outside directors was $291,667.
967 968

967 968

A Difficult Job 3 Main Tasks of Board of Directors

• Key Tension: Board holds ultimate decision-making power,
but often cannot understand business as well as officers
and employees who work there day-to-day.

• Role of Corporate Board?: “Show up every quarter and

decide whether to fire the CEO.”

969 970

969 970

Director Duties Director Action

• Directors are fiduciaries of corporation and its shareholders • Board can act in 2 ways:
and owe corporate fiduciary duty of care and loyalty. o Meeting

o Unanimous Written Consent: Each director signs consent

• Directors are not agents of corporation: individual directors describing action to be taken and delivers consent to
have no authority. corporation.

• Directors act only as group: board of directors (and not • Director action must adhere to required level of formality.
individual directors) make decisions.

971 972

971 972

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Types of Director Meetings Notice Requirement

• Board of directors holds 2 types of meetings: • Notice need not specify purpose of special meeting.
o Regular Meeting: No notice requirement.

o Special Meeting: Written notice must be given at least 2
days in advance.
• Presence at Meeting: Meetings may be by phone
conference or similar equipment, and such participation
constitutes personal presence at meeting.
• Directors cannot vote by proxy at board meeting.
973
• If director does not receive required notice and does not
attend special meeting, then any action taken at meeting is
unauthorized.
• Director who attends special meeting without objection
waives notice requirement.
974

973 974

Quorum Required Number of Votes

• Quorum: Number of members of decision-making body • To approve action, majority of directors present must
that must be present before business may be transacted. assent (unless articles or bylaws require greater number).

• Quorum consists of majority of authorized number of

board of directors.

• Articles or bylaws may authorize quorum to consist of less

than majority but no fewer than 1/3 of number of
directors.

975 976

975 976

Popular FL Bar Hypo Extraordinary Contracts

• Director takes some action with no meeting.
• Example: Director enters into extraordinary contract with
another entity on corporation’s behalf, either on her own
accord or with approval of some of directors, or with approval
of all directors who were called individually.
• Director does not have power to bind corporation on
extraordinary contract UNLESS there exists actual authority
to act.
• Actual authority can arise only if:
o Proper notice was given for directors’ meeting,

o Quorum was present, and

o Majority of directors approved action.

977 978

977 978

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Board Committees Compensation Committee

• Not all corporate matters are deliberated by full board: Duties
some matters are delegated to board committees. • Sets compensation for senior management team

• Approves grants of stock options

• Listed companies are required to have following 3

committees:
Independence Requirement
o Audit
• Each member of listed company’s compensation
o Compensation committee must be independent director.
o Nominating/Governance

979 980

979 980

Governance & Nominating

Audit Committee Committee
Duties Duties
• Hires and fires company’s auditors • Recommend to board proposed nominees for election to

• Hold confidential meetings (i.e., without management board.

present) with audit team. • Evaluate corporate governance practices

981 982

981 982

Corporate Officers
• Corporate officers (e.g., CEO, CFO) are elected or appointed
by board of directors and carry out their duties under
general supervision of board in accordance with corporate
policy.
OFFICERS
• Corporation must have officers described in its bylaws or
appointed by board, but one person may hold 2 or more
offices.

983 984

983 984

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Agency Fiduciary Duties

• Corporate officer is agent of corporation (ordinary rules of • Fiduciary duties of officers are like those of directors.
agency apply to employment).

• Officer have power to bind corporation in dealings with

third-parties.

• Authority can be actual (express or implied) or apparent

(created by manifestations of principal).

• President (CEO) has implied authority to do act in ordinary

course of business, but not extraordinary acts.
985 986

985 986

Hypothetical
Facts
• Assume 9 directors on board of directors of corporation.

Pair-&-Share Questions
At meeting, 4 directors show up. Can board take action?
Problems 14
•

• Assume 6 directors show up. How many must vote “yes” for
proposal to pass?
• Assume 5 directors show up. On proposal, 2 vote “yes,” 2 vote
“no,” and 1 abstains. Does proposal pass?
• Assume 5 directors show up. On proposal, 3 vote “yes,” 2 vote
“no.” Does proposal pass? Even if approved by only 1/3 of total
987 number of directors? 988

987 988

Agency Redux Agency Redux

Facts Answer
• You receive letter from Victor, Vice President-Legal of • Express Authority: Yes, if V has express authority to hire.

corporation, offer position as staff attorney.

• Apparent Authority: If not, then corporation does not have
to hire you if no apparent authority (no manifestation
Questions
from corporation to you that V had authority to hire).
• Does letter obligate corporation to hire you?

• Inherent (or Apparent) Authority: Does V have inherent

authority to hire by virtue of position? Who knows?
Perhaps? [Exam Tip—Make sure to argue either way]

989 990

989 990

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Board as Disciplining Mechanism

• In theory, board of directors represents stockholders and
acts as check on officers.

• Unlike elected politicians, electoral accountability is CONTROL IN CLOSED

supplemented by fiduciary duties.
CORPORATION
• Directors are considered fiduciaries of corporation because
relationship with corporation (and its shareholders) is one
of trust and confidence.

991 992

991 992

Close Corporation
• Closed corporation has 3 characteristics:

o Few shareholders

o Stock is not publicly traded

Voting in Closed
Corporation
o Shareholders often participate in managing corporation
(because they are either member of board or managers)

993 994

993 994

Collective Voting Agreements Voting Trust

• In closed corporation, shareholders may attempt to pool • Voting Trust: Shareholders can establish voting trust to
voting power to have more influence through either: irrevocably confer upon trustee right to vote their shares.

o Voting Trusts • Trustee has fiduciary duty to vote as instructed by

beneficiary.
o Voting Agreements
• Trust agreement must be deposited with corporation and is
subject to inspection by any shareholder.
• Trust certificates representing shares are freely
transferable, but transferee is bound by agreement.

995
• Remedy: Specific performance 996

995 996

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Advantages & Disadvantages Voting Agreement

Advantages of Voting Trust • Voting Agreement: Shareholders contractually agree to
• Specific performance vote their shares certain way.

• Agreement must be in writing and signed.

Disadvantages of Voting Trust
• Costly to set up (because it requires shareholders to • Transferee of shares is bound if (1) existence of agreement
establish true trust—to transfer legal title of their stock to is noted on share certificate, or (2) transferee otherwise
voting trustee). has notice of agreement.
• Voting agreement (which is simply contract) is less costly
• Remedy: Ignore votes of breaching party.
way for shareholders to pool their votes.

997 998

997 998

Voting Trust vs. Voting Agreement Ringling Brothers: Background

Voting Trust Voting Agreement • Ringling Brothers Circus merged with Barnum & Bailey Circus.
Purpose Any proper purpose Any proper purpose • Control is in 3 camps:
o Edith Ringling (and son Robert): 315 shares
Duration Can be perpetual Can be perpetual o Aubrey Haley (and husband): 315 shares
o John North (with sister and mom, Ida): 370 shares
Share Legal ownership transferred Shareholder retain both
• John North ran things for years.
Ownership to trustee; shareholders legal and beneficial
retain beneficial ownership. ownership. • In 1943, Edith Ringling and Aubrey Haley entered voting agreement
Remedy Specific performance Ignore votes of breaching to pool votes to elect 5 of corporation’s 7 directors.
party
• Edith and Aubrey did elect 5 directors and seized control.
• Robert Ringling became president and Mr. Haley was vice-president.
999 1000

999 1000

Ringling Brothers: Background Ringling Brothers: Facts

• In 1944, fire at RB-B&B show: 180 people died and 500 were injured.
• CT prosecuted Mr. Haley for manslaughter in failing to have sufficient
staff.
• Mr. Haley was convicted and imprisoned.
• John North visited Mr. Haley in prison: Robert Ringling ignored him.
• Mr. Haley was released in 1945 and allied himself with John North.
• Key Point: This explains why, in 1946 election, Aubrey Haley refuses
to vote with Edith Ringling.
1001
• Directors are elected through cumulative voting.
• Voting Agreement:
o Aubrey Haley votes for herself and husband.
o Edith Ringling votes for herself and her son Robert.
o Aubrey and Edith agree on 5th person to elect.
o Failing agreement, Mr. Loos will tell them what to do.
• Failing to agree, Mr. Loos instructs Aubrey and Edith to vote for
themselves and Mr. Dunn (whoever he is).
• Edith does so.
• Aubrey does not vote for Dunn.
1002

1001 1002

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Ringling Brothers: Votes Ringling Brothers: Holding

• DE Supreme Court upholds voting agreement.
Edith Aubrey Aubrey John North
(As Instructed by Loos) (Actual Votes)
• Remedy: Court refuses to grant specific performance to
882 for Mrs. Ringling 882 for Mrs. Haley 1103 for Mrs. Haley 864 for Mr. Woods
count Aubrey’s votes per agreement as remedy: instead,
882 for her son, Robert 882 for Mr. Haley 1102 for Mr. Haley 863 for Mr. North Court orders Aubrey’s votes be ignored.

441 for Mr. Dunn 441 for Mr. Dunn 863 for Mr. Griffin • Only 6 people are elected: 3 are in North camp, 2 are in
Ringling camp, and there’s Mr. Dunn.

• Edith wins case in that voting agreement is valid but loses

in real-life because remedy for breach of this valid contract
1003 results in Edith losing control of board. 1004

1003 1004

Directors McQuade v. Stoneham: Facts

• Directors owe non-delegable fiduciary duties to • Stoneham is majority shareholder.
corporation, which require directors to use individual
• McGraw and McQuade are minority shareholders.
judgment in considering board matters.
• 3 men enter agreement to use best efforts to
• General Rule: Directors cannot enter voting agreement or o Elect each other as directors

voting trusts with respect to board matters. o Elect each other as officers to be paid specific salaries
(McQuade was to be treasurer at annual salary of $7.5K).

• Stoneham and McGraw replace McQuade as director and officer.

• McQuade sues Stoneham and McGraw, seeking reinstatement as

1005
treasurer at given salary (now $10K annually). 1006

1005 1006

McQuade v. Stoneham: Holding

• Holding: NY Court of Appeals reverses judgment of lower
court and holds that complaint should be dismissed.

• Rationale: While shareholders have right to agree to elect

specific persons (including themselves) as directors,
CASH FLOW RIGHTS
shareholders cannot agree on how to act once elected.

• Such agreements are void against public policy in restricting

discretion of board: directors must be free to exercise
independent judgment.
1007 1008

1007 1008

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Cash Flow Rights Payout Policy

Cash flow rights concern: Two types of corporate payouts:
• Payout Policy • Buybacks

• Restrictions on sale of stock • Dividends.

• Dissolution

1009 1010

1009 1010

Payout Policy Dividends

• Dividends: Board determines amount per share that will be
paid and decides when payment will occur.

• Cum-Dividend: Just before ex-dividend date, stock is said

to trade cum-dividend (“with dividend”) because anyone
who buys stock will be entitled to dividend.

1011 1012

1011 1012

Key Dates Key Dates

• Declaration Date: Date on which board authorizes
dividend: firm is now legally obligated to make payment.

• Record Date: Firm will pay dividend to all shareholders of

record on specific date.

• Ex-Dividend Date: Because it takes 3 business days for

shares to be registered, only shareholders who purchase
stock at least 3 days prior to record date receive dividend.

• Payable Date: Date on which firm pays dividend.

1013 1014

1013 1014

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Share Repurchase
• Share Repurchase: Firm uses cash to buy shares of its own
outstanding stock.

• Shares are generally held in corporate treasury and can be

resold if company needs to raise money in future. Dividends

1015 1016

1015 1016

Declaration of Dividends Legality of Payment

• Shareholders cannot compel directors to declare dividends.
• Absent bad faith, directors are given wide discretion in this
area.
• Once declared, dividend cannot be revoked EXCEPT when
payment would be illegal.
• Declaration of dividend creates enforceable debt owed to
shareholders.
1017
• Two tests must be met for distribution (other than
distribution of corporation’s own shares) to be legal:
• Equity Test: Distribution is permissible only if (after
giving it effect) corporation will be able to pay its debts
as debts become due in usual course of business, AND
• Bankruptcy Test: Distributions are limited to amount by
which total assets exceed sum of total liabilities and
liquidation preferences of preferred shares (i.e.,
Distribution < Assets – Liabilities – Dissolution
Preferences).
1018

1017 1018

Who Does This Protect? Liability for Improper Distributions

• Review Question: Why does state’s corporate code limit Directors
director’s discretion in declaring dividends? Who will • Director who votes for or assents to any improper distribution
complain if directors distribute too much to shareholders? (e.g., dividend) is personally liable to corporation for amount
of distribution in excess of amount legally available.

• Director can argue, in defense, that director reasonably relied,

in good faith, on financial statements prepared by
management or corporation’s public accountant.

• Directors may also base determination that distribution is not

prohibited on basis of fair valuation of corporation’s assets.
1019 1020

1019 1020

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Liability for Improper Dividends Zidell v. Zidell: Facts

Shareholders
• Shareholders are liable to corporate creditors for amount of
improper dividends received (even if they did not know
corporation was insolvent).
• Personal liability for contribution to director can exist if
shareholder received dividend knowing that receipt was
improper.
1021
• Arnold (plaintiff) owns 3/8 stock of corporation.
• Emery owns 3/8 and his son, Jay, owns remaining 2/8.
• Until 1973, all 3 worked for corporation and drew salaries.
• Arnold wanted raise.
• Others refused and Arnold resigned.
• Arnold demands that corporation pay dividends.
• Corporation pays only nominal dividends while increasing
salaries and bonuses to Emery to Jay (though not
unreasonably so).
• Arnold sues.
1022

1021 1022

Zidell v. Zidell: Holding Business Judgment Rule

• Holding: Oregon Supreme Court holds that corporation is not • What the hell is the business judgment rule?
required to declare larger dividends.

• Rationale:
• Burden on plaintiff to “prove bad faith on part of directors in
determining amount of corporate dividends”
• Trial court rejected argument that Emery and Jay acted in
bad faith.

• Rule: Authorization of dividends is management decision

subject to protection of business judgment rule. ???
1023 1024

1023 1024

Partnership Review
Control Over Business Entity
• General partners cannot transfer entire interest in business

to third-party: general partners can only transfer

partnership interest (and not right to management).
Maintaining Control
• Choose-Your-Own Partner Rule: New partners can be
admitted only upon unanimous vote of partners (unless
partnership agreement specifies otherwise).

1025 1026

1025 1026

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Stock Transfer Maintaining Control

• Corporation: Transfer of stock transfers ALL rights Question
(including management and voting rights). • How can shareholders in closely-held corporation maintain

control by preventing transfer of ownership interests to

• Creditors-Debtor Review: Personal creditor of shareholder “outsiders”?
can obtain ownership of stock in the corporation: in this
event, creditors step into shareholder’s shoes and become Answer
co-owners of the incorporated business. • Shareholders can maintain control through 2 mechanisms:

o Preemptive Rights

o Restrictions on Transfer of Stock

1027 1028

1027 1028

Preemptive Rights Rights Included

• Preemptive Rights: Shareholder’s preemptive right entitle
shareholder to purchase number of shares of new stock or
treasury shares that are being issued sufficient to maintain
relative voting strength.
• Example: Kalil owns 1/3 of outstanding stock. Preemptive
rights would entitle Kalil to buy 1/3 of new issuance.
• Statement included in articles that “corporation elects to
have preemptive rights” means that following principles
apply (except to extent provided otherwise):
o Shareholders have preemptive right, granted on uniform
terms and conditions prescribed by board, to acquire
proportional amounts of corporation’s unissued shares and
treasury shares upon decision of board to issue then, and

• Shareholders have no preemptive rights to acquire o Shareholder may waive preemptive right: written waiver
unissued shares or treasury share UNLESS granted by is irrevocable.
articles.
1029 1030

1029 1030

Hypothetical
Facts
• Corporation has issued 10,000 shares

Pair-&-Share • Shepherd owns 2,000.

• Corporation is planning to issue additional 5,000 shares in

Problems 15 exchange for cash

Questions
• If Shepherd has preemptive rights, then how many shares
can he purchase of new issuance?
1031 1032

1031 1032

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Restrictions on Transfer of Stock Right of First Refusal

• Restrictions on transfer of stock (e.g., right of first refusal
upon sale) are common in close corporation.
• Restrictions will be enforced if reasonable.
• Right of First Refusal: Obligates shareholder first to offer
restricted shares for sale to corporation.
Hypo
• Suppose articles impose stock transfer restriction requiring
that, before any shareholder transfer stock, she must offer to
sell stock to corporation.
• Shareholder finds third-party who is willing to pay $30K.
• Pursuant to stock transfer restriction, corporation offers to
pay $5K for stock.

Question
• Is shareholder legally obligated to sell stock to corporation for
1033 $5K? 1034

1033 1034

Restriction Requirements
• Certificates must summarize on their face any restrictions
pertaining to their transfer or state that corporation will
furnish full statement thereof.

• Third-party who purchases stock without notice of

Oppression of
restrictions can compel corporation to transfer stock to him
on its books (even though transfer violates existing
Minority Interests
agreement).

• If third-party purchases stock with notice of restriction,

then third-party has no rights against corporation for failure
to transfer (but may recover from seller). 1035 1036

1035 1036

Oppression of Minority No Redemption Right

• Control: Restrictions on transfer of stock can help • No Right to Cash-Out : Corporate law does not create
shareholders in closely-held corporation maintain control. redemption right.

• Oppression: Restrictions on transfer of stock (including lack
of market for shares of corporation) can also help majority
shareholders in closely-held corporation oppress minority
shareholders.
• Redemption Right: General right of shareholder to redeem
or sell stock back to corporation.
• Illiquid Investment: Because no public market exists for
stock of close corporation, shareholder might not be able to
sell shares.

1037 1038

1037 1038

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 11/13/23

Partnership Review Possible Saving Graces

• Dissociation: Partnership law solves this illiquidity problem
with concept of dissociation.
• Partner who desires to cash out partnership interest can
voluntarily withdraw from partnership, triggering either
(1) buyout, or (2) dissolution.
• Shareholders in closed corporation can use 3 possible
mechanisms to solve illiquidity problem:
o Buy-sell agreement
o Judicial dissolution
o Suit for breach of fiduciary duties

1039 1040

1039 1040

Buy-Sell Agreements Villar v. Kernan: Facts

• Buy-Sell Agreement: Contract that requires corporation to
purchase shares in specified situations at specified price.
• Agreement protects minority shareholders who would
otherwise be forced to sell shares to majority shareholder-
owners at unfairly low price.
1041
• Villar and Kernan form corporation, Ricetta’s Inc., to operate pizza
business.
• Kernan holds 51% of stock and Villar holds 49%.
• Kernan and Villar have oral agreement (as shareholders) that
neither will draw salary.
• Each transfers 1% to Stephan.
• Kernan and Stephan remove Villar from board (non-cumulative
voting).
• Board votes to give Kernan salary of $2K per week in violation of
prior the oral agreement between Kernan and Villar.
1042

1041 1042

Villar v. Kernan: Issue Oppression of Minority Shareholder

• Issue: Terms of consulting agreement are very good for Kernan but Control Rights
plainly violate oral shareholder agreement between Kernan and
• Villar has no voting power as shareholder.
Villar.
• Villar is not on board.

Cash-Flow Rights
• Villar (minority shareholder) receives no dividend or salary.

• Villar cannot sell his shares because nobody wants to be

minority shareholder of pizza business organized as closed
corporation.
1043 1044

1043 1044

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Villar v. Kernan: Holding Villar v. Kernan: Upshot

• Villar sues in federal court to enforce oral shareholder
management agreement (SMA).
• Lower court determines Villar should recover UNLESS§618
of ME corporation code renders agreement unenforceable.
• Holding: Supreme Court rules that Section 618 requires
agreement vesting power in shareholders must be in
writing (and thus SMA is not enforceable).
1045
• There is nothing Villar can do.
• Villar should have had their understanding—that there will
be no salaries—reduced to writing.
• Absent such agreement, power to determine things like
salaries, dividends, buybacks, etc. remain with board of
directors.
• And board has approved salary for Kernan.
1046

1045 1046

Closed Corporation vs. Partnership

Question
o Suppose pizza business was organized as partnership.

What could Villar do to solve illiquidity problem?

Answer
DISSOLUTION
• Every general partner has power to withdraw from
partnership by express will.
• In at-will partnership, this triggers dissolution of business.

• Villar can leverage forced dissolution of business.

• In closed corporation, not much Villar can do.

1047 1048

1047 1048

Dissolution Types of Dissolution

• Dissolution: Legal termination of corporate entity. • 2 Types of Dissolution
o Voluntary Dissolution
• Liquidation (or Winding Up): Process of marshalling
corporation’s assets, paying all its debts, and distributing o Involuntary Dissolution
residual property or proceeds (if any) to shareholders.

1049 1050

1049 1050

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Voluntary Dissolution Involuntary Dissolution

• Voluntary Dissolution: Corporation may voluntarily
liquidate and dissolve at any time without judicial
supervision.
• Notice must be given to all know creditors.
• Shareholder can bring action to have corporation involuntarily
liquidated and dissolved if:
o There is deadlock of directors and corporation is threatened
with irreparable injury, or corporation’s business and affairs
cannot be conducted to advantage of shareholders because of
deadlock, or both;
o Shareholders are deadlocked in voting power and unable to

• Corporation already in voluntary liquidation can later move elect successor directors,
to have liquidation continued under court supervision. o There is waste or misappropriation of corporate assets, or

o Directors (or those involved in control of corporation) are acting,

will act, or have acted illegally or fraudulently.
1051 1052

1051 1052
• Notice must be given to all know creditors.

• Corporation already in voluntary liquidation can later move

to have liquidation continued under court supervision.

Remedies Other Actors

• Involuntary dissolution is not available for shareholders in • Creditors: Unsatisfied judgment creditors can sue to
public companies. liquidate insolvent corporation.

• Involuntary liquidation is discretionary and usually will not be

granted UNLESS necessary (1) to prevent irreparable injury, • State: State may seek administrative (involuntary)
and (2) is in best interest of corporation and of shareholders
dissolution of corporation for fraud, illegality, abuse of its
as whole. corporate powers, or failure to file annual report or appoint
registered agent.
• In action for dissolution, court has alternative remedies (e.g.,
appointment of receiver or provisional director) that court
may impose instead of dissolution: judicial dissolution is
strongly disfavored if corporation is profitable. Why?
1053 1054

1053 1054

Proceedings After Dissolution

1056

• Dissolution does not impair any remedy available to, or

against, corporation if action is commenced within 3 years
after dissolution.

• Same applies to claims by or against any officer, director, or

shareholder.

1055 Aswath Damodaran 1056

1055 1056

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Corporate Fiduciary Duties

We will examine fiduciary duties owed by following
key corporate players:
• Directors and officers
FIDUCIARY DUTIES
• Shareholders

1057 1058

1057 1058

Tort Law Possible Solutions

Question: Private Solutions
• What problem is tort law trying to solve?
• Contracts

• Torts
Answer
• Force potential tortfeasors to take optimal precautionary
Public Solutions
effort
• Regulation

Pure Market Solution

• Wall Street Walk
1059 1060

1059 1060

Corporate Governance “Tort-Based” Solution

Question Shareholders (owners) control management (directors &
• What central problem is corporate governance trying to officers) through 2 key disciplining mechanisms:
solve?
• Shareholder Control Rights
o Voting Control Rights: Shareholder Voting
Answer
o Duty-Enforcement Control Rights: Corporate Fiduciary
• Find way to better align mismatched incentives between
Duties
managers and shareholders

• Board of Directors (Representative Democracy)

o Corporate Fiduciary Duties

1061 1062

1061 1062

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Corporate Fiduciary Duties

Fiduciary Relationship
• Directors and officers are fiduciaries and act on behalf of

corporation.

FIDUCIARY DUTIES Three Corporate Fiduciary Duties

• Duty of Care

• Duty of Loyalty

• Duty of Good Faith

1063 1064

1063 1064

To Whom Are Fiduciary Duties Owed? Pharma Bro

Beneficiary of Fiduciary Duties
• Directors and officers owe fiduciary duties to corporation

and to shareholders collectively (not to individual

shareholders).
• Breach of corporate fiduciary duties harms business entity.

1065 1066

1065 1066

How Did This End? Valeant CEO

Criminal Sanctions
• Federal judge gave Shkreli 7-year sentence and ordered
forfeiture of more than $7.3 million in assets

Civil Sanctions
• Tax warrant for $1.26 million for unpaid taxes.

• Ordered to return $64.6 million in wrongfully obtained profits

from anticompetitive scheme to delay entry of generic

competition for at least 18 months.
• Ordered to pay a $1.39 million fine for violating securities laws
and banned from serving as officer or director of any publicly
traded company for life. 1067 1068

1067 1068

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And How Did This End? Structural Causation

Civil Sanctions Hypo
• SEC ordered Pearson to pay civil penalties of $250,000, and • Professor gives open-book take-home exam at UF law.

to reimburse Valeant $450,000 for misstated revenue
transactions and included erroneous revenue allocations.
Executive Compensation
• Pearson earned $183 million while CEO of Valeant.
• Just kidding. Earned that in 2015 alone.
• Students are expected to stop taking exam after 2 hours.
• Each additional hour spent on exam is almost certain to
increase final score by full grade.
• Unobserved: 20% of UF law students cheat by spending
additional time on exam (beyond 2 hours).

• But stock went up 30%. Question

• Just kidding. Stock went down 30% in 2015. • Who is villain in this story? Student? Professor?
1069 1070

1069 1070

Competing Mechanisms Enacting Social Change Through:

2 Mechanism To Implement Social Change Democratic Process
• Democratic Process • Define fiduciary duties narrowly to include only corporate
• Fiduciary Duties
self-interest.
• Use democratic process to enact laws (and corresponding
sanctions) that give companies right incentives (where
pursuing corporate self-interest yields desired societal
outcomes).

1071 1072

1071 1072

Enacting Social Change Through: Radical Reimaging of Economy?

Fiduciary Duties Questions
• Define fiduciary duties broadly to include desired • What does it mean to say that CEO has fiduciary obligation

corporate behavior (e.g., maximization of social welfare). to act in best interest of all corporate stakeholders
• Ignore democratic process (that is perceived to be broken). including society?
• Substitute social welfare for self-interest. • Isn’t self-interested profit-maximizing private behavior vital

engine of capitalistic economic system?

• Why does this apply only to corporations? Why subject
business to higher standard than individuals? Are we
asking too much of this purely legal construct?

1073 1074

1073 1074

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Shlensky v. Wrigley: Facts

Facts
• Mr. Wrigley held about 80% of stock of Chicago Cubs.

BUSINESS • Mr. Wrigley was convinced baseball was meant to be

JUDGMENT RULE played in daylight only and refused to install lights at

Wrigley Field (despite every other MLB team having done
(BJR) so).
• Shlensky was minority stockholder in team.

1075 1076

1075 1076

Shlensky v. Wrigley: Arguments Shlensky v. Wrigley: Holding

Plaintiff: Holding:
• Shlensky sues in attempt to force team to install lights • Court grants defendant’s motion to dismiss for failure to

(having provided evidence to show that night baseball was
more profitable than day baseball).
Defendant:
• Mr. Wrigley (and other directors) believe night baseball will
harm neighborhood (e.g., more crime).
state claim.
Rationale (BJR Presumption):
• Court will not second-guess management decision UNLESS
there is showing of fraud, illegality, or conflict of interest.

1077 1078

1077 1078

Questions Board Runs the Show

Questions 1 §141(a)
•DGCL
• Did court conclude that it was dumb decision for Cubs to • Business and affairs of every corporation shall be managed
play only day games? Did court care whether it was dumb by or under direction of board of directors.”
decision? • This delegation of plenary authority to board of directors
• What can Shlensky do now? has important implications as to allocation of power
between shareholders and directors.

1079 1080

1079 1080

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Business Judgment Rule (BJR) Justifications for BJR

Business Judgment Rule Possible Justifications
• Presumption that all business decisions made by • Free Choice: Shareholders choose to invest in specific

management reflect sound business judgment.
Practical Effect
• Court will uphold defendant’s motion to dismiss plaintiff’s
cause of action alleging breach of corporate fiduciary duty
UNLESS court finds that plaintiff has successfully rebutted
BJR presumption.
1081
corporations, and voluntarily undertake risk by so doing.
• Encourages Risk Taking: Directors may become inefficiently
risk-averse: shareholders expect board to take business risks
and can reduce risk by holding well-diversified portfolio.
• Avoids Judicial Meddling: Court are not well-positioned to
make routine business decisions and can suffer from hindsight
bias.
• Encourages Directors to Serve: Encourages qualified persons to
serve as directors by minimizing financial risk.
1082

1081 1082

Ex Post Facto Assessment Professor Allen’s Take

Project Directors
• Benefit: $10 million with probability, p = 0.5 and -$2 million • Benefit: Enjoy only small proportion of any upside gain earned

with probability, p = 0.5.
• Cost: $1 million.
Expected Value of Project
• 0.5 x $10 million - 0.5 x $2 million - $1 million = $3 million
Question: As CEO, would you have invested in Project? As
shareholder of company, would you sue if bad state of world is
realized (i.e., company loses $2 million).
by corporation on risky investment projects (set equal to 0).
• Cost: Bear full cost if found liable for corporate loss from risky
project on ground that investment was too riksy.
Expected Value of Project From Director’s Private Perspective
• 0.5 x $0 million - 0.5 x $2 million - $1 million = -$2 million
Upshot: Board fails to authorize profitable investment project.
1083 1084

1083 1084

Behavioral Biases Counteracting Legal Acts

Hindsight Bias Behavioral Take
• Tendency to view event as more likely or predictable after • Courts guard against hindsight and outcome bias with

event occurred than event, in fact, was before event respect to corporate directors through business judgment
occurred. rule, which protects management from liability.
• Although hindsight evidence might be probative of failure

Outcome Bias to exercise due care, business judgment rule places thumb
• Tendency to judge decision-making in view of outcome,
on scale in favor of directors for policy reasons—to
independent of how likely or predictable outcome was. encourage risk-taking so shareholders can see high returns.

1085 1086

1085 1086

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So Close…. How to Rebut BJR Presumption

• Depending upon which fiduciary duty defendant is alleged
to have breached, to rebut BJR presumption, shareholder
must establish:
o Substantive Due Care: Irrational decision that amounts
to waste.
o Procedural Due Care: Gross negligence with respect to
decision-making process.
o Loyalty: Usurpation of corporate opportunity,
competition with corporation, or self-dealing.
o Good Faith: Intentional misconduct.

1087 1088

1087 1088

Burden of Proof Shifts Entire Fairness Review

Burden-Shifting Entire Fairness Review
• If plaintiff rebuts business judgment presumption, then • Most exacting standard of review.

transaction is assessed under entire fairness review. • Under entire fairness review, defendant bears burden of

• Entire fairness review places burden of proof on defendant proving BOTH:

to establish that transaction was entirely fair. o Fair Dealing, and
o Fair Price

• In determining entire fairness of transaction, court does

not focus on one component over other.

1089 1090

1089 1090

Two Components of Entire Fairness Analogy to Constitutional Law

• Fair Dealing: Encompasses questions of process, including
how transaction is timed, initiated, structured, negotiated,
and disclosed and how approvals of directors and
stockholders are obtained.
• Fair Price: Relates to economic and financial terms of
transaction, including any relevant factors that affect
intrinsic or inherent value of company’s stock, such as
market value and assets of company, pro forma analysis
and other valuation metrics, and fairness opinion.
1091
BJR Presumption
• Rational Basis Test: Like rational basis test, court asks
whether substance of transaction has rational basis.
• High Deference: Judiciary gives high level of deference to
board’s business judgment.
Entire Fairness
• Strict Scrutiny: Like strict scrutiny, court subjects business
decision of board to stringent strict scrutiny.
• Low Deference: Judiciary gives low level of deference to
business judgment. 1092

1091 1092

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BJR Framework in Pictures

BJR PRESUMPTION

SUBSTANTIVE PROCEDURAL LOYALTY GOOD FAITH

DUE CARE DUE CARE DUTY OF CARE
Irrationality Gross Disloyal Intentional
(Waste) Negligence Conduct Misconduct

ENTIRE FAIRNESS TEST

1093 1094

1093 1094

Types of Due Care

Two Types of Due Care
• Substantive Duty of Care: Exercise of reasonable care with

respect to substance of decision made by management.

• Procedural Duty of Care: Exercise of reasonable care with
SUBSTANTIVE
respect to decision-making process.
DUE CARE

1095 1096

1095 1096

Hypothetical Joy v. North: Facts

Facts Facts
• Joey becomes director of Busch Gardens. • North was CEO and dominant force in Citytrust.

• Joey convinces other directors to open park in Portugal. • North called all shots:

• This business decision proves to be very bad idea. • Directors were not given agendas or materials before

board meetings.
• Citytrust made loans to Katz for real estate venture.
Question
• Citytrust kept lending more and more money to Katz
• Can Joey and other directors be held liable for bad

decision? despite venture being losing deal.

• If so, to whom?

1097 1098

1097 1098

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Joy v. North: Plaintiff Argues Joy v. North: Holding

Plaintiff: Holding:
• Joy (shareholder of Citytrust) sues, claiming board • Court overturned recommendation of special litigation

breached duty of care owed to corporation in loaming committee and concluded that plaintiff would likely win in
money to Katz. underlying action.

1099 1100

1099 1100

An Outlier Case Corporate Waste

Comments
• Joy v. North is included in casebook to show that some
business decisions are so irrational that decision does not
enjoy protection from BJR presumption.
• In practice, it is EXTREMELY RARE for court to conclude
that business decision is irrational. Why?
1101
Property Law
• As general rule, tenants (or life tenant) have duty not to
commit affirmative waste on the property where they reside,
meaning they cannot deplete land of its natural resources.
Corporate Law
• Transaction “for consideration so disproportionately small as
to lie beyond range at which any reasonable person might be
willing to trade—act equivalent to “gift” or “spoliation” of
corporate assets.
• Waste claims are regularly made and almost never succeed.
1102

1101 1102

Procedural Due Care Violations

Misfeasance
• Board acted in making bad business decision.

PROCEDURAL • Causation is clear.

• Examples: Joy v. North, Van Gorkum

DUE CARE
Nonfeasance
• Board failed to act.

• Causation is less clear.

• Examples: Barnes v. Andrews, Francis v. United Jersey Bank,

1103
In re Caremark. 1104

1103 1104

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Smith v. Van Gorkom: Facts Smith v. Van Gorkom: Board Meeting

Facts
• Van Gorkum was CEO of Trans Union (publicly-traded
corporation).
• Van Gorkum approached financier Jay Pritzker to see
whether Pritzker would be interested in acquiring Trans
Union.
• Van Gorkum and Pritzker agreed to cash-out merger:
Pritzker would purchase each share of Trans Union for $55
(which represented $17 premium over market price of
$38).
1105
• Board meeting lasted only 2 hours.
• Only 2 of 10 directors knew purpose of meeting was proposed
merger.
• Only 2 members of senior management attended meeting, each
learning of proposal only 1 hour before meeting.
• General counsel attended meeting with no advanced notice of
purpose of meeting.
• Van Gorkum made 20-minute presentation, with no written
summary.
• Board received no documentation that $55 was adequate.
• Board approved proposal.
• Trans Union shareholders also approved proposal. 1106

1105 1106

Smith v. Van Gorkom: Holding Smith v. Van Gorkom: Rationale

• Rule: Directors have duty to inform themselves of all Court addresses 4 factors defendant relies upon to sustain
material information reasonably available: standard for finding that decision was informed”
determining whether board was properly informed is gross • $17 Premium over Current Market Price
negligence. • Market Test

• Expertise of Board
• Holding: Court holds that board was grossly negligent with • Reliance on Corporate Counsel
respect to decision-making process: board “lacked
valuation information adequate to reach an informed
business judgment as to fairness of $55 per share for sale
of company.”
1107 1108

1107 1108

Premium Market Test

Majority Majority
• Premium alone absent sound valuation information does • Questions whether directors were authorized to receive

not provide adequate basis to assess fairness of price.
• Market price of stock was undervalued
• Really? How does court know this?
• Market price does not include control premium.
• Now this interesting….
other competitive bids.
• Don’t directors have fiduciary duty to accept better offer
notwithstanding existing contractual commitment by Board
• Does not like no-shop provision and stock lock-up
provision.
• Aren’t these provisions normally included in suite of common deal
protections?

1109 1110

1109 1110

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Board Expertise Reliance on Corporate Counsel

Majority Majority
• Not impressed by qualification of Board • Counsel’s advice is meaningless if directors did not have

before them adequate information regarding intrinsic

Dissent value of company.
• Meaningless? That seems harsh.
• Very impressed by qualification of Board.

• Stresses sophistication and experience of directors.

1111 1112

1111 1112

Gross Negligence Standard Questions of Law

Procedural Due Care Violation Questions
• One way to rebut BJR presumption is to establish that • Is Joy. v. North procedural due care case like Van Gorkum?

business-making process was grossly negligent. • Did court in Van Gorkum review merits of board’s decision
• Court does not assess whether business decision itself (substantive due care) or merely process by which decision
constitutes gross negligence: BJR Rule requires only that was reached (procedural due care)?
business decision substantively was not irrational.

1113 1114

1113 1114

Hypothetical
• Would director decision-making still be grossly negligent if
o $55 offer price was $17 higher than current market price
for share of Trans Union;
o Offer would be rescinded if not approved by Trans Union Exculpation
board by end of next day;
o Trans Union in-house attorney advised directors that “they Statutes
might be sued if they failed to accept the deal”; and
o 69.9% of outstanding shares of Trans Union were voted in
favor of merger and only 7.25% were voted against
merger?

1115 1116

1115 1116

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Exculpation Statutes Requirements

Exculpation Statutes
• Money Damages: In response to Van Gorkom, most states
enacted exculpation statutes that authorize amendments to
articles of incorporation shielding directors from personal
liability for monetary damages for breach of duty of care.
• Injunctive Relief: Suits for injunctive relief are still permitted,
but Chancery Court judges are loath to enjoin transaction
where shareholders are (1) offered premium, and (2) have
opportunity to vote either for or against transaction.
Requirements
• Exculpation clauses apply only to breach of duty of care,
not breach of duty of loyalty or good faith.
• Exculpation statutes must be included in articles of
incorporation, and not bylaws (because provision impacts
rights of shareholders).

1117 1118

1117 1118

Delaware’s Exculpation Statute Legacy of Van Gorkom

Del.§102(b)(7)
• Provision eliminating or limiting personal liability of director
to corporation or its stockholders for monetary damages for
breach of fiduciary duty as director, provided that such
provision shall not eliminate or limit liability of director for:
o Breach of director’s duty of loyalty to corporation
o For acts or omissions (1) not in good faith, or (2) which
involve intentional misconduct or knowing violation of law,
o Transaction from which director derived improper personal
benefit (e.g., insider trading).
1119
Power of Social Norms
• Practice made standard by Van Gorkum include: providing
copies of merger agreement and related documents
sufficiently in advance of meeting; providing copies of
adviser reports at meeting; holding more than 1 meeting
about transaction; ensuring active involvement of board in
negotiation of sale transaction; and formally retaining legal
and financial advisors.
• Lack of “legal stick” demonstrates extent to which
corporation actors are highly influenced by social norms of
transactional community (sometimes as much as by formal
legal rules). 1120

1119 1120

McPadden v. Sidhu: Facts McPadden v. Sidhu: Holding

Facts Directors
• I2 Technologies sold subsidiary (TSC) for $3 million to firm • Court reads complaint as stating that directors were

led by Dubreville (who was also officer of TSC, but not grossly negligent in selling TSC on cheap.
director). • Because gross negligence constitutes breach of duty of

• 2 years later, TSC was sold for $25 million to third-party. care, and duty of care can be exculpated, court dismisses
• Suit is brought against i2 directors who approved sale and claims against directors.
Dubreville.
• I2 Technologies has exculpation provision under

DE§102(b)(7).

1121 1122

1121 1122

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McPadden v. Sidhu: Holding Subsequent Change in Law

Officer
• As an officer, Dubreville is not covered by exculpatory
provision: claim for breach of duty of care can proceed
against him.
Editorial Aside
• Dubreville appears susceptible to claim for breach of duty of
loyalty: he was on both sides of sale of TSC–as officer of
company being sold and principal in group buying company.
• This conflict would constitute breach of duty of loyalty
against which exculpatory provision would be useless anyway.
1123
Amendment
• On August 1, 2022, DGCL§102(b)(7) was amended to
extend exculpation rights to executive officers.
• New amendment permits corporation to adopt exculpatory
language in its certificate of incorporation to limit personal
liability of not only directors, but also officers.
• Amended Section 102(b)(7) applies only to certain senior
officers.
1124

1123 1124

Joey Hypothetical Revisited Entire Fairness & Due Care

Hypothetical • Empirical Fact: There has not been single duty of care case
• How do we sue Joey for breach of duty of due care? in DE where BJR presumption was rebutted, and entire
fairness test applied.
Procedural Due Care
• Attack decision-making process that led to decision.
• Standard of Review: Gross negligence
• Joey can protect himself by including exculpation provision in articles.

Substantive Due Care

• Attack decision itself
• Standard of Review: Rationality (or Corporate Waste)
• Joey cannot protect himself with exculpation provision. 1125 1126

1125 1126

Types of Disloyalty
3 Common Types of Corporate Disloyalty
• Competition with Corporation

• Usurpation of Corporate Opportunity

DUTY OF LOYALTY • Self-Dealing Transactions

1127 1128

1127 1128

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Duane Jones v. Burke: Facts

Facts
• Duane Jones Co. was leading advertising agency.

• Company begins to falter after founder, Duane Jones,

Competing with begins to behave erratically.
Corporation • Several of company’s officers and directors secretly set up

new advertising agency to compete with Duane Jones Co.

while still employees of Duane Jones Co.
• Once officers and directors had set up new agency, they

quit Duane Jones Co.

1129 1130

1129 1130

Duane Jones v. Burke: Holding Other Possible Causes of Action

Holding Contract
• Jury found for plaintiff and judgment upheld on appeal. • Existence of non-compete agreement can make director

• Defendants breach their fiduciary duty of loyalty to Duane liable for breach of contract.
Jones Co.
• That defendants received profits from new agency only Tort
after they had quit old agency was not relevant: they had • Stealing trade secrets would give rise to tort claim.
arranged everything while still employees of Duane Jones
Co.

1131 1132

1131 1132

Potential Remedies Practice Tip

• Constructive Trust: Standard remedy in competing venture
is constructive, meaning if breaching fiduciary goes into
competition with corporation and makes profit, that profit
can be held in constructive trust for benefit of plaintiff-
corporation.
• Injunction: Corporation can also obtain injunction to stop
competition
• Damages: If competition harmed corporation, then
damages might also be available.
1133
Facts
• Suppose director of Mexican restaurant wishes to open
new restaurant nearby that also sells healthy Mexican
food.
Question
• What can director do to reduce risk of legal liability for
wrongfully competing with restaurant?
• Answer: Resign from restaurant and then go set up
competing venture. Is director likely to do this?
1134

1133 1134

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Usurping Corporate Opportunity

• Competing with corporation can be viewed as subset of
concept of usurping corporate opportunity.

Usurping Corporate • To compete with corporation is to seek and take

opportunities (i.e., customers) from which corporation
Opportunity might have benefitted: corporate opportunities are
broader in scope.

• Same principle as in Meinhard v. Salmon.

1135 1136

1135 1136

Illustrative Examples Illustrative Examples

Example: Example
• Rather than go into direct competition by establishing • Jerry, director in biotech corporation, knows that corporation

store adjacent to corporation’s existing store, director buys
store in which corporation would have been interested
that does not compete directly with corporation.
1137
is looking to rent new office space and happens to know of
building suitable to house firm’s special scientific equipment.
• Jerry learns owner of this building is willing to lease or sell.
• Jerry decides that building would make sweet personal
investment.
• Jerry purchases building and enters into lease with another
company that does not compete with corporation.
• Although Jerry did not engage in direct competitive activity,
building could have been fruitful opportunity for corporation.
1138

1137 1138

Usurping Corporate Opportunity Key Tradeoff

• General Rule: Fiduciary must not seize for herself
something that would be considered opportunity for
corporation.
• Disclosure: Such acquisitions might be allowed if fiduciary
informs corporation of existence of opportunity and waits
for corporation to reject opportunity.
Doctrine attempts to reconcile 2 conflicting premises:
• Corporate Expansion: Corporation expects managers to
devote themselves to expanding corporation’s business (to
maximize corporate profitability).
• Manager Entrepreneurialism: Managers expect to have
individual freedom to pursue outside business interests.

• Considerable debate exists regarding what constitutes

corporate opportunity.

1139 1140

1139 1140

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Broz v. CIS: Facts Broz v. CIS: Issue

Facts Issue:
• Broz is director of CIS (which is just emerging from bankruptcy). • CIS sues Broz for usurpation of corporate opportunity.

• Broz is also owner of RFBC which competes with CIS.

• Mackinac holds Michigan-2 FCC cellular phone license, effective
for area adjacent to that served by RFBC.
• Mackinac approaches Broz to see if RFBC wishes to acquire
license.
• Mackinac does not approach CIS, because CIS no longer operates
in Midwest.
• PriCellular is attempting to acquire CIS and is interested in license.
• Broz acquires license from Mackinac without informing CIS board.
1141 1142

1141 1142

Broz v. CIS: Holding Guth Four-Part Test

Holding: 4-part Guth Test for Corporate Opportunity:
• Supreme Court finds Broz not liable: Broz did not usurp • Corporation must be financially able to exploit

opportunity of corporation. opportunity,

• Opportunity must be within company’s business line,

Rationale: • Company must have interest or expectancy in opportunity;

• Broz court relies on Guth Test. and

• By taking opportunity, fiduciary is place in “a position

inimical to his duties to corporation.”

1143 1144

1143 1144

Application of Guth Test Two Additional Points

• Court applies Guth test as follows: • That PriCellular ultimately acquired CIS is irrelevant: Broz is
o CIS is not financially able to exploit license. required to consider facts as they existed when he
o License is in CIS’s business line. acquired license.
o CIS has no expectancy in license.

o Acquiring license does not put Broz in inimical posture

• Disclosure Safe Harbor: Trial court was wrong to hold that
regarding CIS. Broz was liable because Broz failed to present opportunity
to CIS board: disclosure is safe harbor but is not required
to avoid liability.
• Court also stresses that Broz learned of opportunity in
individual capacity.

1145 1146

1145 1146

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Practice Tip
Question
• What could have Broz have done differently to avoid this

litigation?

Answer
Self-Dealing
• Broz could have presented opportunity to CIS board and
waited for board to reject deal.

1147 1148

1147 1148

Hypothetical Compared to Usurpation

Facts Self-Dealing
• Corporation wishes to lease building owned by Jill, who is • Director transacts business with corporation rather than

director and majority shareholder. director taking business from corporation.

Conflict of Interest
• Jill , in her role as landlord, wants corporation to pay
highest price possible, putting money in her pocket.
• Jill, as director, wants corporation to pay lowest price

possible, keeping money in corporate treasury.

1149 1150

1149 1150

Cleansing Acts Disinterest

Conflicted Transaction Cleansed If: Disinterested Party
• Director Approval: Transaction approved by board where • Party who does not have “material interest” in outcome of

disinterested directors make up majority and vote in favor proceeding.

will receive protection of business judgment rule, OR
• Shareholder Approval (or Ratification): Transaction
approved by fully-informed vote of majority of
disinterested shareholders will receive protection of
business judgment rule.
• Example: To plead that director is interested, plaintiff must
show that director received “personal financial benefit
from transaction that is not equally shared by
stockholders.”

1151 1152

1151 1152

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Independence Special Committee

Independent Party Special Committee
• Party who does not have material relationship with person • Made up of disinterested directors empowered to

who has material interest in outcome of proceeding.
• Example: To plead that director is not independent, plaintiff
must show that director is sufficiently loyal to, beholden to,
or otherwise influenced by interested party to undermine
director’s ability to judge matter on its merits.
negotiate transaction on behalf of corporation.
• Special committee is intended to make corporation be able
to negotiate at arm’s length from its transacting partner
notwithstanding conflict.
• Use of special committee is strong evidence of effective
and fair sales process.

1153 1154

1153 1154

Failure to Cleanse Entire Fairness Review

Failure to Cleanse Conflicted Transaction Entire Fairness Review
• If board fails to cleans conflicted transaction, then board • To satisfy entire fairness review, defendant bears burden of

loses protection of business judgment rule presumption proof in showing BOTH:

and court will assess transaction under entire fairness. o Fair Dealing, AND

o Fair Price

1155 1156

1155 1156

Two Components of Entire Fairness Joey Hypothetical Revisited

• Fair Dealing: Encompasses questions of process, including
how transaction is timed, initiated, structured, negotiated,
and disclosed and how approvals of directors and
stockholders are obtained.
• Fair Price: Relates to economic and financial terms of
transaction, including any relevant factors that affect
intrinsic or inherent value of company’s stock, such as
market value and assets of company, pro forma analysis
and other valuation metrics, and fairness opinion.
1157
Hypothetical
• Suppose Joey personally owned the land that corporation purchased
to open new park in Portugal.
Question
• How do we sue Joey for breach of duty of loyalty?
Duty of Loyalty
• Attack decision itself as self-interested.
• If successful, then burden of proof shifts to defendant-Joey.
• Standard of Review: Entire fairness
• Joey is not protected by§102(b)(7) exculpation provision . 1158

1157 1158

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Entire Fairness: Example

Hypothetical
• Opening new park in Portugal required $1 million investment.
• Park resulted in $2 million in operating losses.
• Recall that probability of loss was equal to 1/2.
GOOD FAITH
Entire Fairness Review
• Despite apparent conflict of interest, Joey made good business
decision.
• Ex Post Facto Assessment: Nevertheless, Joey is likely to struggle
to convince court that transaction was fair to shareholders after-
the-fact given realized $3 million in losses.
1159 1160

1159 1160

Duty of Good Faith Types of Intentional Misconduct

Good Faith Violation 3 Types of Intentional Misconduct
• To rebut business judgment presumption, plaintiff can plead • Bad Faith: Acting with intent other than advancing best

facts showing intentional misconduct.
• Courts have been hesitant to provide single definition of good
faith.
• Fiduciary acts intentionally, abdicating obligations in ways
that implicate more than gross negligence, but do not meet
traditional loyalty test for conflicts of interest (e.g., director
intentionally misleads shareholders, yet lacks conflict of
interest).
1161
interests of corporation (that does not constitute self-
interested or disloyal intent).
• Intentional Violation of Law: Acting with intent to violate
law (even if act benefits shareholders).
• Intentional Disregard: Intentional dereliction of duty,
conscious disregard for one’s responsibilities
1162

1161 1162

Bad Faith Intentional Violation of Law

Bad Faith
• Plaintiff can rebut BJR presumption that management was
acting in good faith if plaintiff can show that directors acted
with intent or purpose other than that of advancing best
interest of corporation.
Intentional Violation of Law
• Plaintiff can rebut BJR presumption that management was
acting in good faith if plaintiff can show that directors
intentionally approved or condoned illegal behavior by
corporation.

Example
• Director approves merger transaction that director strongly
believes will not benefit corporation in long-run because of
subjective hostility that director currently feels toward
corporation cannot claim protection under BJR.
1163
Example
• Director who approves corporate waste-removal plan
knowing that this plan violates applicable state and federal
environmental laws cannot claim protection under BJR
(even if plan benefited shareholders).
1164

1163 1164

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Intentional Disregard Stone v. Ritter: Holding

Intentional Disregard
• Plaintiff can rebut BJR presumption that management was
acting in good faith if plaintiff can show that directors acted
in intentional dereliction of duty, a conscious disregard of
their responsibilities.
Example
• Directors can be liable for failing to call board meetings and
Question
• Is fiduciary duty to act in good faith part of triad of corporate
fiduciary duties (along with duty of care and duty of loyalty)?
Holding
• Duty to act in good faith is not independent corporate
fiduciary duty: duty of good faith is component (or subset) of
duty of loyalty.

acting as “stooges” for controlling shareholder. • Fiduciary duty of loyalty is not limited to various forms of
conflict of interest but also encompasses cases where
fiduciary fails to act in good faith.
1165 1166

1165 1166

Connection to Exculpation Provision Joey Hypothetical Revisited

Del.§102(b)(7) Hypothetical
• Recall that this provision does not permit corporation to • CEO decides to open new park in Portugal (not Joey).

eliminate liability for “acts or omissions not in good faith.” • CEO is also President of Portuguese company that sells land

to company.
Question • Joey is on board but rarely attends meetings or reads

• What impact do you think enactment of§102(b)(7) had on reports and is otherwise disengaged.
frequency with which plaintiffs asserted that fiduciary
failed to act in good faith? Question
• How do we sue Joey for breach of duty of good faith?

• What claims can we bring against CEO?

1167 1168

1167 1168

Joey Hypothetical Revisited

Answer
• Plead facts showing that Joey has intentionally disregarded

oversight responsibilities to company.

• Joey is not protected by§102(b)(7) exculpation provision.
Oversight

1169 1170

1169 1170

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Two Types of Board Action Barnes v. Andrews: Facts

Acts of Commission • Corporation was formed to manufacture engine starters for Ford
motors and aircraft.
• Board decides to take some action.
• In October 1919, Andrews became directors and served until
resigning in June 1920 (9 months of service).
Acts of Omission
• In Spring 1921, corporation was handed over to Barnes, as receiver,
• Board fails to take some action.
who discovered that corporation had no assets.
• Management was engaged in in-fighting that paralyzed corporation
and never produced starters.
• Andrews served on board as favor to friend Maynard, who was
president.
• During 9 months of service, Andrews never bestirred himself to ask
why company was not producing starters.
1171 1172

1171 1172

Barnes v. Andrews: Plaintiff Argues Barnes v. Andrews: Holding

Cause of Action Breach of Fiduciary Duty
• Barnes, as receiver, sued Andrews to recover for breach of • Court holds that Andrews breached fiduciary duty owed to
duty of care. corporation.
• Rationale: Andrews seems lazy.

Comment
• Today, Barnes would sue to recover for breach of good Causation
faith (which is component of duty of loyalty). • Courts holds, however, that Barnes plaintiff failed to show

that breach caused loss to corporation.

• Corporation would have likely incurred losses even if
Andrews had kept advised of corporate affairs.
1173 1174

1173 1174

Proving Causation Francis v. United Jersey Bank: Facts

Tort Law Standard
• In Barnes v. Andrews, court imposes tort law standard of
causation.
• Usually difficult to prove causation in nonfeasance case.
• Francis v. United Jersey Bank represents one of few cases in
which plaintiff succeeds in proving causation.
1175
• Lillian Pritchard inherited 48% of stock in family reinsurance
brokerage business from her husband.
Husband had founded and run corporation, which also employed
•
couple’s sons, Charles Jr. and William.
• When husband died, 2 boys (who owned rest of stock) took over and
helped themselves to client money.
• Lillian and 2 sons were directors.
• Lillian knew nothing about reinsurance business and did nothing to
inform herself: she never read corporate documents, went to office
only once, started drinking heavily.
• Company (involuntarily) filed for bankruptcy.
• Trustee in bankruptcy sued Mrs. Pritchard’s estate.
1176

1175 1176

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Francis v. United Jersey Bank: Holding Delaware Approach (Francis)

• Holding: Held estate liable for breach of duty of care, Rejects Tort Law Approach
finding that Mrs. Pritchard’s negligence was proximate • Plaintiff is not required to prove causation: causation is not
cause of misappropriations. element of duty of care claim.

• Rationale: Where reasonable to conclude that failure to Affirmative Defense

act would produce particular result and that result • Defendant can raise lack of causation as affirmative

followed, causation may be inferred. defense.

• Delaware approach is (curiously) relatively pro-plaintiff in

• Comment: Francis is outlier—Barnes reflects majority view this regard.

on causation (outside of DE).
Question: Why is causation primarily an issue only in non-
1177 feasance cases? 1178

1177 1178

In re Caremark: Facts In re Caremark: Plaintiff Argues

Facts Plaintiff Argues
• Caremark was charged with violating federal law that • Plaintiff-shareholders sue to recover $250 million.

prohibited kickbacks to doctors. • Plaintiffs argue that defendant-directors failed to

• Caremark settled actions for $250 million. adequately monitor business to uncover illegal behavior
(nonfeasance).

1179 1180

1179 1180

In re Caremark: Holding Caremark Duty

• Rule: Directors can be held liable for breach by “unconsidered Board must establish compliance system:
failure… to act in circumstances in which due attention would, • System must generate reports at board level.
arguably, have prevented loss.”
• Level of detail is board decision and is matter of business
judgment.
• Difficult to Prove: “Only sustained or systematic failure of board
• System does not have to be foolproof.
to exercise oversight—such as utter failure to attempt to assure
[that] reasonable information and reporting system exists—will • Need for system will depend on size of company.
establish lack of good faith that is necessary condition to
liability.” Board must monitor system:
• Board must read reports.
• Holding: Court finds no showing that board breached obligation
• Board must revisit issues.
imposed.
1181 1182

1181 1182

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Oversight Liability Chief Compliance Officer (CCO)

• Necessary conditions for director oversight liability include:
o Compliance System: Directors utterly failed to implement
any reporting or information system or controls, OR
o Monitoring: Having implemented such system or controls
consciously failed to monitor or oversee its operations thus
disabling themselves from being informed of risks or
problems requiring their attention.

• Scienter: In either case, imposition of liability requires showing

that directors knew that they were not discharging their
fiduciary obligations.
1183 1184

1183 1184

Duty of Care or Good Faith? Editorial Comments

• Where directors fail to act in fact of known duty to act, thereby
demonstrating conscious disregard for responsibilities, they
breach their duty of loyalty by failing to discharge that fiduciary
obligation in good faith.
• What a Minute!!!: Why does failure to monitor (i.e., conscious
disregard of responsibilities) constitute breach of loyalty? I
thought Caremark was duty of care case? Or good faith? But not
loyalty???
• Walt Disney & Stone: In these cases, DE Supreme Court decides
that conscious disregard implicates duty of good faith which is
component of duty of loyalty. 1185
• In theory, this make no sense: duty to monitor should be
component of duty of care (or duty of good faith),
encompassing failures to monitor that arise above gross
negligence.
• In practice, this greatly increases importance of corporate
compliance because failures to monitor cannot be
exculpated under Del.§102(b)(7) (recall that both loyalty
and good faith are expressly excluded from exculpation
statute).
1186

1185 1186

Section 404 of Sarbanes-Oxley Act

• Section 404: Corporation’s annual financial reports must
include statement that corporation has implemented
“adequate internal control structure and procedures for
financial reporting.” Executive
• Example of federal law supplementing (or supplanting?)
Compensation
corporate state law.

1187 1188

1187 1188

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Levels of Executive Compensation

Some Empirical Facts
• Average compensation for CEOs of 350 largest U.S. firms

was $18.9 million in 2017.

• From 1978 to 2017, compensation of these top CEOs
increased 1,070%.
• In 1965, CEO-to-worker compensation ratio was 20-to-1; in

2017, this ratio was 312-to-1.

• At publicly-held firms, share of net income devoted to

compensating 5 highest-paid executives is, on average,

approximately 10%.
1189 1190

1189 1190

1191 1192

1191 1192

Trends by Education Trends by Percentiles of Real Wages

1193 1194

1193 1194

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Trends by Percentiles of Real Wages

1195 1196

1195 1196

Two Competing Views Market Forces

At least 2 competing interpretations of this data Lucrative compensation can be explained by:
• Necessary to attract best talent globally.
• Market forces at work
• Demands on CEO are far greater than in earlier eras.
• Failure of corporate governance
• Justified by financial return American executives provide to

shareholders.

1197 1198

1197 1198

For Instance… Failure of Corporate Governance

Harvey Golub, CEO of American Express General Claim
• Received total compensation of more than $250 million • Executive will predictably prefer own private interests.

from 1993-2000. • Board (especially if executive sits on board) will predictably

• During this time, value of company increased $55 billion accede to executive’s wishes—at expense of corporate
(from $10 billion to $65 billion). interests.

Hock Tan, CEO of Broadcom

• Made $103.2 million in 2017

• During 5 years at helm, price of company stock rose 680%.

1199 1200

1199 1200

200
 11/13/23

Business Judgement Rule No Rational Business Purpose

Cleansing Conflicted Transaction Corporate Waste
• If executive compensation is approved by fully-informed • Challenger can overcome business judgment review by

board where disinterested directors make up majority of showing that compensation had no relation to value of
directors, then executive compensation is subject to services promises.
deferential business judgment review. • Example: Post-death payment to executive’s widow not

pursuant to agreement lacks consideration (i.e., is a gift)

and has no relation to rational business purpose.

1201 1202

1201 1202

Intentional Disregard In re Walt Disney

Lack of Oversight
• To rebut business judgment presumption, challenger can

plead facts showing that directors (even if disinterested and •

independent) did not act in good faith in approving

executive compensation.
• To show lack of good faith, challenger must show directors
“consciously disregarded” duties in approving
compensation.

1203 1204

1203 1204

Walt Disney: Facts Walt Disney: Plaintiff Argues

• In 1995, Walt Disney Company Chairman Michael Eisner selected • Several Disney shareholders brought derivative action in
Michael Ovitz to be executive president and director of company.
Court of Chancery against directors of Disney.
• Ovitz demanded large compensation that would increase yearly as
well as healthy exit package should hiring not work out.
• While some members of company’s compensation committee were • Plaintiff argued (among other things) that $130 million
aware of negotiations between Eisner and Ovitz, company moved severance payout was:
forward with hiring before Ovitz was approved by committee or o Breach of duty of due care,
completely vetted by outside experts.
o Breach of duty of good faith, and
• Less than a year later, Eisner lost confidence in Ovitz and decided to
terminate Ovitz’s contract. o Constituted corporate waste (i.e., no rational purpose).
• All parties agree firing was “no-fault,” meaning that Ovitz was •
entitled to full severance package.
• Ovitz was paid approximately $130 million for 14 months work. 1205 1206

1205 1206
•

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 11/13/23

Walt Disney: Holding—Duty of Care Walt Disney: Holding—Good Faith

Plaintiff Argues Holding
• Defendants were insufficiently informed in approving • Court holds that directors did not violate duty of good faith

Ovitz’s employment agreement (see Van Gorkum).
Holding
• Court disagreed, noting that compensation committee had
considered several reports that described that Ovitz would
(which requires conduct more egregious than that required
to violate duty of due care).
Rationale
• Court concluded that directors did not act in “intentional

be paid large amount if terminated without cause and that dereliction of duty, a conscious disregard of their
this provision was necessary to induce Ovitz to quit responsibilities.”
lucrative job at CAA.
1207 1208

1207 1208

Walt Disney: Holding—Waste Dodd-Frank Act

Holding
• Court holds that employment contract did not constitute
corporate waste.
Rationale
• Employment contract had rational business purpose—to
induce Ovitz to leave highly lucrative position at CAA: no
evidence that contract “irrationally incentivized Ovitz to get
himself fired.”
Dodd-Frank contains several provisions related to executive
compensation in publicly-traded companies including:
• Say on Pay: Shareholders have advisory (non-binding) vote on
executive pay.
• Clawbacks: Mandates that exchanges require listed companies
to adopt procedures to recover up to 3 years of incentive pay
from executives whenever company must restate its financials.
• Compensation Disclosure: Requires companies show
“relationship between executive compensation paid and
financial performance of issuer.”

1209 1210

1209 1210

Unintended Consequences Compensation Committee

• Disclosure requirement tended to increase executive Compensation Committee
compensation, not reduce such compensation. • Committee of directors with primary responsibility of

reviewing and approving compensation of company’s CEO

and other named executive officers.
• Both NYSE and NASDAQ require compensation committee

members be “independent” of management and company.

1211 1212

1211 1212

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Why Boards Might Not Be Effective Worst Board Ever?

Possible Arguments
• CEOs Hand-Pick Directors: While most companies have

outsiders involved in selection of directors, CEOs still

exercise considerable influence over process.
• Lack of Equity Stake: Directors often hold only token stakes

in company.
• Directors Are Insured: Directors are insulated against legal
action.

1213 1214

1213 1214

Additional Justifications
Other factors that work against board oversight of management
include
• Desire to keep job and not rock boat (e.g., pay for Fortune 500
directors averaged $234,000 with directors spending, on FIDUCIARY DUTIES OF
average, 4-5 hours a week on work relating to board).
• Director’s desire to preserve future business dealings with
SHAREHOLDERS
firm.
• Director’s lack of time and information.
• Directors are often CEOs themselves.
• Director often have prior social connections with CEO or other
senior executives.
1215 1216

1215 1216

Individual Shareholders Principal Costs

General Rule • Recall that optimal governance structure minimizes total
• Individual shareholder owes no fiduciary duties to control costs:
corporation or to other shareholders.
Total Control Costs = Principal Costs + Agency Costs

• Principal costs relate to actions taken by shareholders.

• Giving shareholders more control increases principal costs.

1217 1218

1217 1218

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Two Possible Fact Patterns

Questions
• Does controlling shareholder owe fiduciary duties to

minority shareholders?
• Does shareholder in close corporation owe fiduciary duties Controlling
to other shareholders individually?
Shareholders

1219 1220

1219 1220

Controlling Shareholders Sinclair Oil v. Levien: Players

Controlling (or Dominant) Shareholder Key Players
• Individual or corporation with sufficient voting power to • Sinclair Oil owns 97% of stock in Sinven: Siven is subsidiary

determine outcome of shareholder vote. of Sinclair.

• Levien (individual) owns 3% of stock in Sinven.

General Rule • Sinclair nominates all members of Sinven’s board of

• Controlling shareholder owes fiduciary duties to directors.

corporation and other shareholders individually.

1221 1222

1221 1222

Sinclair Oil v. Levien: Players Sinclair Oil v. Levien: Facts

Facts
• From 1960 through 1966, Sinclair Oil had Sinven pay $108
Parent Sinclair Oil
million in dividends ($38 million more than Sinven earned
in profits during period).
97% Shares
• Dividends came at time when Sinclair Oil needed cash.

Subsidiary Sinven 3% Shares Levien

1223 1224

1223 1224

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Sinclair Oil v. Levien: Plaintiff Argues Sinclair Oil v. Levien: Legal Rule
Plaintiff Argues Entire Fairness
• Levien argues that Sinclair Oil is making Sinven pay large • If Levien shows self-dealing (Sinclair Oil causing Sinven to

dividends to siphon cash to Sinclair Oil at expense of pay dividends to satisfy Sinclair Oil’s need for cash at
Sinven. expense of Sinven), then burden shifts to Sinclair Oil to
• Levien argues that Sinven should use cash to explore for oil show that dealings with Sinven were entirely fair.
and otherwise expand its business in Venezuela.
Business Judgment
• If Levien fails to show self-dealing, then Sinclair Oil’s dealing

with Sinven will receive BJR review (and Sinclair Oil will
likely win).
1225 1226

1225 1226

Sinclair Oil v. Levien: Holding

Holding:
• Court concludes that dividend policy does not constitute

self-dealing by Sinclair Oil.

• Business judgment review is applicable standard of review
(and so Sinclair Oil wins). Close Corporations
Rationale:
• No self-dealing because dividends were paid by Sinven to
ALL shareholders:
• Levien received same payment per share as Sinclair Oil.
1227 1228

1227 1228

Fiduciary Duties Close Corporations

Partnership Review Close Corporation
• Partners owe business and each other fiduciary duty of • Resemble partnerships where partners owe fiduciary

“utmost good faith.” duties to partnership and to other partners individually.

Connection to Close Corporations Majority Rule

• Because close corporation resembles partnership, courts • Shareholders owe fiduciary duties to corporation and to
have imported fiduciary duties owed by partners into close other shareholders individually.
corporations.

1229 1230

1229 1230

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Donahue v. Rodd Electrotype: Facts Analogy to Partnership

Facts • Freeze-Out: Like in partnership, potential for freeze-outs
• Donahue owns 50 shares of corporation. exists in closed corporations (Villar v. Kernan).
• Other 198 shares are owned by Harry (81) and his 3 children
(108). • Meinhard Duties: Standard of duty owed by shareholder
• Harry and son, Charles, agreed that corporation would buy 45 to other shareholders in close corporation is “highest and
of Harry’s shares at $800 per share. utmost duty of good faith and loyalty.”
• Donahue subsequently tendered her 50 shares, offering to sell
shares at same price.
• UNLIKE in partnership, shareholders in closed corporation
• Corporation refused.
cannot voluntarily withdraw, thereby forcing dissolution of
• Donahue sues. partnership or buyout by partnership.
1231 1232

1231 1232

Donahue v. Rodd Electrotype: Holding Donahue v. Rodd Electrotype: Remedy

Holding Remedy:
• MA Supreme Court held that shareholders in closed • Court required corporation either:

corporation owe each other same fiduciary duties as
partners in general partnership owe each other.
Equal Access Rule
• All shareholders in close corporation must be given equal
opportunity to sell stock to corporation (e.g., opportunity
cannot be made available only to controlling shareholders).
o Specific Performance: To purchase 45 shares from
Donahue at $800 per share, or
o Rescission: To require Harry to repay $36K (= 45 x $800)
to corporation in exchange for 45 shares (of
corporation’s treasury stock).

1233 1234

1233 1234

Questions Duty to Disclose

Questions Oppression of Minority Shareholders
• Would court have decided this case differently if bylaw • Corporation’s controlling shareholders can harm minority

provision allowed corporation to purchase shares from one shareholders by withholding important information
shareholder without offering other shareholders equal concerning value of their stock.
opportunity to sell shares to corporation? • Without this information, minority shareholders might sell

• Why did court limit equal access rule to close corporations? back their shares to corporation at unfairly low price.
• In states that reject the equal access rule even for close
corporations, is there any way that minority shareholders
can protect themselves?

1235 1236

1235 1236

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Berreman v. West Publishing: Facts Berreman v. West: Plaintiff Argue

Facts Plaintiff Argues:
• Berreman was long-time, high-level employee of West. • Berreman sues, arguing that West had duty to disclose

• Berreman had purchased stock pursuant to employee stock possible merger.

option plan that allowed West to buy stock back when
Berreman retired.
• Berreman retired on June 1, 1995.
• West paid him $2,088.90 per share (book value).
• Following year, West was acquired by Thomson.
• After acquisition, value of Berreman’s stock would have been
substantially higher.
1237 1238

1237 1238

Berreman v. West Publishing: Holding Materiality

General Rule • Court adopts sliding scale approach to materiality set forth
• Court states that controlling shareholders have common in Basic (see infra).
law duty to disclose material information.
• Probability (Very Low)
Holding o When Berreman retired, only preliminary discussion had

• Court concludes, as matter of law, that possibility of merger

been held within West:
with Thomson (or any other entity) was not material, and o No decision and no suitor had been identified.
thus, West did not breach duty to disclose.
• Magnitude (High)
o High given West’s long-time resistance to going public.

1239 1240

1239 1240

Salary
Illiquid Investment
• Shareholders in close corporation do not expect to make

money primarily by selling interest to third-party.

Earing Salary from
Corporation Salary
• Shareholders in close corporation often expect to make
money by being employed by business.
• Minority shareholder typically depends on salary as

principal return on investment.

1241 1242

1241 1242

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Wilkes v. Springside Nursing Home:

Facts
Facts
• Wilkes was 1 of 4 shareholders of corporation that owned
and operated nursing home.
• All shareholders worked at nursing home and were paid
salaries.
• After falling out with fellow shareholders, shareholders
forced Wilkes out of nursing home job and salary.
• Wilkes sued, alleging breach of fiduciary duty owed to him
Refining Donahue
Wilkes 3-Step Test
o Plaintiff must show that defendant breached duty of utmost
good faith by engaging in oppressive behavior.
o Burden shifts to defendant to justify behavior by showing
legitimate business purpose.
o Burden shifts back to plaintiff to show that legitimate
business purpose can be achieved in way that imposes less
harm to plaintiff.

by majority shareholders.

1243 1244

1243 1244

Wilkes v. Springside Nursing Home:

Holding
Oppressive Behavior
Holding: Oppressive Behavior
• Court held for Wilkes (plaintiff), because majority • Conduct of controlling shareholder that substantially

shareholders of nursing home (defendants) failed to establish defeats oppressed shareholder’s reasonable investment
legitimate business purpose in firing Wilkes. expectations (expectations central to shareholder’s
decision to join venture).

Employment-at-Will
• No reasonable expectation as employee to right to

employment in closed corporation.

1245 1246

1245 1246

McLaughlin v. Schenk: Facts McLaughlin v. Schenk: Holding

Facts
• Schenk was president and one of founders of corporation.
• Schenk hired McLaughlin in 1992 who became COO.
• McLaughlin had employment contract that allowed him to
purchase stock and stated that he could be fired without cause
(but with 6 months’ notice).
Holding
• Court adopts Donahue but concludes that Schenk did not violate
fiduciary duties owed to McLaughlin.
Rationale
• No oppression because termination did not thwart McLaughlin’s

• Schenk fired McLaughlin in 2004. reasonable investment expectations: his principal motivation
• McLaughlin sued corporation, arguing that Utah should was employment, not stock ownership.
recognize Donahue. • McLaughlin was not founding member of business, which was

well established when McLaughlin was hired.

• Stock ownership was not required and was not tied to his
1247 employment. 1248

1247 1248

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McLaughlin v. Schenk: Comment Questions

Comment Questions
• Very subtle difference between: (1) investor who makes • Can shareholder of corporation fire that corporation’s

money through salary, and (2) employee who happens to COO?

be investor. • Can corporation fire employee who is “founding member
• Upon joining firm, was reasonable expectation that of who created company with expectation of employment”?
investor or that of employee?

1249 1250

1249 1250

Criticism of Donahue Rule

• Donahue has been criticized for blurring lines: if owners
wanted to create partnership, then owners should have
created partnership.

• DE refuses to recognize special common-law fiduciary END HERE

duties in closed corporations: not going to incorporate
partnership law into corporate law.

• Minority shareholders can protect themselves by insisting

on contractual protections before investing in business
entity.
1251 1252

1251 1252

A Dilemma
• Derivative suit resolves dilemma created by 2 inconsistent
tenets of corporate law:

Shareholder o Directors owe fiduciary duties to corporation, and not

individual shareholders, and
Derivative Actions o Directors manages corporation’s business that includes
authorizing lawsuits in corporate name.

• Derivative litigation breaks stranglehold board would

otherwise have over fiduciary accountability.

1253 1254

1253 1254

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Derivative Suit Procedural Requirements

• Derivative Suit: Brought by shareholder to enforce 2 Main Procedural Requirements
corporate cause of action when board of directors has not
• Contemporaneous Ownership
sought to enforce corporation’s rights (for some reason).
• Demand on Board
• Shareholders right to sue derives from corporation’s right
to sue.

• Without this enforcement procedure, management’s

fiduciary duties to corporation would be meaningless: it
would be rare case that managers choose to sue
themselves.
1255 1256

1255 1256

Contemporaneous Ownership
• Contemporaneous Ownership: To bring derivative suit,
shareholder must (1) have owned stock in corporation at
time action commences, and (2) when alleged wrong took
place (or shares must have devolved upon her by operation Pair-&-Share Problem
of law from one who was such shareholder).
16*

1257 1258

1257 1258

Hypothetical Demand on Board Requirement

Facts • Demand: To bring derivative suit, shareholder must first
• Roberts hears of wrongdoing by directors of corporation.
make demand on directors that board prosecute suit
(UNLESS demand would be futile).
• Roberts wants to bring derivative suit but did not own
stock in corporation when claim arose.
• Shareholders must then wait 90 days before bringing
• Roberts buys one share of corporation stock.
lawsuit UNLESS:

Questions o Shareholder is notified sooner that demand has been

rejected; or
• Why can he not bring derivative suit?

• What is wrong with allowing him to “purchase” lawsuit in o Delay will cause irreparable injury.
this manner?
1259 1260

1259 1260

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Justifications Demand Futility (Optional)

Advantages • Demand Futility: Shareholder can bypass demand
• Serves as alterative dispute mechanism requiring
requirement if shareholder can show good reasons for not
challenging shareholder to exhaust intra-corporate going before board prior to filing derivative action to obtain
remedies. action of board.

Disadvantages • Law adding demand futility to Act may result in increase in

shareholder derivative lawsuits in FL.
• Provides defendants with advanced notice of lawsuit.

• Delays litigation
• Prior to this change most corporations in Florida had 90-
• Interpreted as concession that board can address problem.
day warning prior to action being taken.
1261 1262

1261 1262

Dismissal by Corporation Who Gets Paid?

• Court can dismiss derivative proceeding if court finds that 1 of • Because derivative suit vindicates corporation’s claim,
following groups has made good faith determination (after recovery goes to corporation.
conducting reasonable investigation) that maintenance of derivative
suit is not in best-interest of corporation:
• Most courts will allow successful shareholder to recover
o Majority vote of disinterested directors present (if such directors costs and attorney fees.
constitute quorum);

o Majority vote of committee consisting of 2 or more disinterested
directors appointed by majority vote of disinterested directors
(regardless of whether they constitute quorum); or
o Panel of 1 or more disinterested and independent individual
persons appointed by court (upon motion of corporation).
1263
• Shareholder’s loss is res judicata for other shareholders:
another shareholder cannot sue to vindicate corporation’s
claim second time.
1264

1263 1264

Direct Suits Litigation Strategy

• Direct Suit: Shareholder can maintain direct action against • Unlike derivative suit, direct suit is not brought on behalf of
another shareholder, director, officer, or corporation, to corporation.
protect shareholder’s personal interest.
• To avoid procedural requirements that apply to derivative
• Shareholder must plead and prove: (1) actual or suits, shareholders often seek to characterize suit as direct.
threatened injury to shareholder personally, or (2) actual
or threatened injury resulting from violation of statutory or
contractual duty owed by wrongdoer (even if injury is same
as that to company).

1265 1266

1265 1266

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Examples of Direct Suits Derivative vs. Direct

Direct suits include:
• Compel payment of dividend declared but not distributed;
• Compel inspection of shareholder list or corporate books;
• Require holding of shareholders’ meeting;
• Challenge fraud on shareholders in connection with voting,
sale, or purchase of securities;
• Challenge corporate restrictions on share transferability; and
• Challenge denial or dilution of voting rights.
1267
• Distinction between derivative claim and direct is not
always obvious.
• Direct suits generally vindicate individual shareholders’
financial, liquidity, or voting rights.
• Derivative suits generally enforce corporate fiduciary
duties.
• Student Tip: Focus on who was injured and who will receive
relief.
1268

1267 1268

Examples of Derivative Suits Shareholders Collectively

Actions resulting in possible deviation lawsuit include: • Review: Directors and officers owe fiduciary duties to
• Breach of fiduciary duties; corporation and to shareholders collectively (not to
• Greed or self-dealing; individual shareholders).
• Conflict of interest;
• Wasting corporate assets; • Example: Management can open new theme park in Lisbon
• Wrongdoing in accounting; even if this harms individual shareholder (because, say, this
• Misleading, inflated, or false financial statements; shareholder is looking to purchase home in Lisbon and new
theme park is likely to increase property values in Lisbon,
• Executive compensation that is inflated; and
making this planned home purchase more expensive for this
• Decisions of management or board that expose company to shareholder).
harm, violate consumer protection, or other laws.
1269 1270

1269 1270

Role of Special Litigation Committees

• In response to derivative suit, board can appoint special
litigation committee of disinterested directors with
exclusive power to decide if suit should proceed.
Special Litigation
Committees • Committee (often assisted by outside counsel) investigates
charges and prepares report.

• Committee invariably recommends that suit not proceed.

1271 1272

1271 1272

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Business Judgement Review Heightened Scrutiny

• SLC’s committee recommendation to dismiss litigation is • Delaware courts agree there might be “subconscious
like any other corporate business decision and is entitled to abuse” by members of SLC asked to pass judgment on
protection of business judgment rule. fellow directors.

• Does this sound death knell for derivative litigation? • In Zapata Corp. v. Maldonado, Delaware courts established
2-part inquiry into whether SLC’s recommendation to
dismiss must be respected:
o Mandatory Procedural Inquiry

o Discretionary Substantive Inquiry

1273 1274

1273 1274

Procedural Inquiry Substantive Inquiry

• Defendant-corporation carries burden of proof in rebutting
business judgment rule presumption.
• If corporation fails to rebut presumption, then derivative
litigation proceeds.
• If SLC’s recommendation passes first inquiry, then trial
judge may apply own “independent business judgment” to
determine whether action should proceed.
• This second inquiry is far more intrusive than even entire
fairness review.

• This substantive component is surprising because courts

are now required to make kind of business assessments
that judges are not trained to undertake.
1275 1276

1275 1276

Burden Shifting
• Zapata Test applies to SLC recommendations only in cases where
plaintiff establishes that demand on board is excused as futile (i.e.,
does not apply if demand is required).

• Plaintiff carries burden of proof in rebutting BJR when demand is

required, but not when demand is excused: when demand is
WHO REALLY PAYS?
required, Zapata test scrutinizes corporation’s refusal decision like
any other business decision.

• When demand is excused, burden of proof shifts to defendant-

corporation (first step).

1277 1278

1277 1278

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Director Protections Indemnification & Advancement

• Corporation can limit directors’ exposure to personal
liability for breach of fiduciary duty in 3 ways:
o Written Provision in Corporation’s Certificate of
Incorporation (eliminating or limiting director’s personal
liability for breach of duty of care).
o Indemnification and Advancement
o Directors and Officers Insurance (D&O Insurance)
1279
• Indemnification: Directors have right to indemnification if
found liable in proceeding related to service to
corporation.
• Advancement: Director may also seek advancement of
litigation expenses from the corporation.
• Expenses must be incurred for purpose of defending
oneself, not for initiating offensive litigation to vindicate
one’s own reputation.
1280

1279 1280

D&O Insurance
1282

• Delaware law permits corporations to buy insurance to

fund own indemnification obligations and for directors to
fill gaps in corporate indemnification (e.g., when director is
liable to corporation in derivative suit).

• D&O policies typically cover any liabilities or defense cost

arising from manager’s position in corporation.

• Insurance to protect directors from fraud, dishonesty, or

for violations of criminal law cannot be purchased.
1281 Aswath Damodaran 1282

1281 1282

Corporate Disclosure
• Corporate disclosure relates to both:
o Shareholder Information Rights
CORPORATE o Securities Regulation

DISCLOSURE

1283 1284

1283 1284

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Absolute Right to Inspect

• Absolute Right: Every shareholder has absolute right to inspect
(during regular business hours at corporation’s principal office)
such items as:
INSPECTION o Articles of Incorporation;

o Bylaws;

RIGHTS o Minutes of all meetings of, and records of all actions taken
without meeting by, its shareholders;
o All written communications within past 3 years to shareholders;

o Lists of name and business addresses of current directors and

officers; and
o Most recent annual report.

1285 1286

1285 1286

Inspection for Proper Purpose Grounds for Refusal

• Conditional Right: Stockholder can also inspect (1) minutes of
any meeting of board (or records of any actions taken without
meeting by board or any board committee), (2) financial
statements and accounting records of corporation, (3) record of
shareholders, and (4) any other books and records if:
o Proper Purpose: Demand is made in good faith and for
proper purpose;
o Shareholder describes with reasonable particularity purpose
and records sought; and
o Records are directly connected to such purpose.
• Corporation can refuse request if shareholder:
o Has within past 2 years offered for sale list of shareholders
of any corporation (or aided and abetted another in so
doing); or
o Has improperly used any information secured through any
prior examination of books of any corporation.
• Question: Why might corporation be reluctant to allow
shareholder to inspect record of shareholders (i.e., to have
access to shareholder contact info)?

1287 1288

1287 1288

Proper Purpose
Proper Purpose
• A purpose reasonably related to such person’s interest as

shareholder.
SECURITIES
Examples of Proper Purpose
• Inspection sought for purpose of determining value of stock
REGULATION
(in close corporation).
• Inspection sought for purpose of supporting litigation
against managers who have breached their fiduciary duties.

1289 1290

1289 1290

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Investor Protection Federal Securities Law

Federal securities law protect investors in 3 ways: 2 Main Federal Securities Laws
• Securities Act of 1933: Ensures full disclosure at time of
• Disclosure Requirements
first sale.
• Antifraud Provisions
• Securities Exchange Act of 1934: Regulates ongoing
• Prohibition on Insider Trading disclosure (also created Securities Exchange Commission
SEC).

Mandatory Disclosure
• Defining characteristic of U.S. securities regulation.

1291 1292

1291 1292

Securities Act of 1933

Securities Act of 1933
• Governs issuance of securities by corporation itself.

Securities Act of 1933 Primary Purpose

• To ensure that buyers of securities receive specific detailed

information about issuing company and its securities

before making investment.

1293 1294

1293 1294

Mandated Information Disclosure Command & Control Regulation

Mandated Information Disclosure • Command-and-Control Regulation: Typically involves 3
• Regulations that require disclosure of information held by elements:
regulated entity. o Identification of type of socially-harmful activity

o Imposition of specific conditions or standards on that

Asymmetric Information activity, and

o Prohibition of forms of activity that fail to comply with
• Disclosure of information is meant to remedy information
asymmetry between consumers and regulated entity. imposed conditions or standards.
• Fully informed consumers will not purchase products from

firm that operates too far outside social optimum. • Environmental Law Example: Government requires firm to
use “best available” technology to reduce pollution
1295 1296

1295 1296

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Not Command & Control Rationales for Mandated Disclosure

Investment Merit Rationales
• Government will not prevent security from being sold to • Accuracy Enhancement: Mandated disclosure provides

public because security lacks investment merit. information that leads to more accurate valuation of
securities (absent such disclosure, firms will not provide
Question: this information).
• Incentive Alignment: Aligns shareholder and managers
• Why is government less likely to embrace disclosure model
of regulation in context of consumer financial protection? incentives by increasing transparency.
• Demand-Side Intervention: Merits of company are judged

not by government but by investors armed with

information provided by mandated disclosure.
1297 1298

1297 1298

Criticisms of Mandated Disclosure Registration

Criticisms
• Signaling: Firms will voluntarily publicly disclose private
information as signal of profitability (assuming disclosure is
costless).
• Informational Overload: Disclosures are complex and of
uncertain utility (if any) to investors.
• Costly: Mandated disclosure imposes substantial direct
costs (e.g., production and verification costs) and indirect
costs (e.g., competitors, customers, and others can use
disclosed information to firm’s disadvantage).
1299
• Section 5 of Securities Act broadly provides that if security
does not qualify for exemption, then security must be
registered before being offered to the public.
• Issuing corporations must:
o File registration statement with SEC, and
o Provide all investors with prospectus.
1300

1299 1300

EDGAR Database Strict Liability

• All companies must file registration statements
electronically and are posted on SEC’s online EDGAR
(Electronic Data Gathering, Analysis, and Retrieval)
database.
• EDGAR database includes:
o Material on initial public offerings (IPOs)
o Proxy statements
• Company, underwriter and other individuals signing
registration statement are strictly liable for any inaccurate
statements in registration statement.
• Due Diligence: Strict liability exposure drives enormous
effort (due diligence) to ensure that registration statement
is complete and accurate.

o Annual reports
o Registration statements
1301 1302

1301 1302

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Registration Process Registration Exemptions

• Registration statement does not become effective UNTIL • 3 types of exemptions allow securities offerings to avoid
reviewed and approved by SEC (unless filed by well-known registration under 1933 Securities Act:
issuer). o Exempt Securities

o Exemption Transactions
• 1933 Act restricts certain types of activities at each stage of o Exempt Issuers
registration process: if issuer violates these restrictions,
then investor can rescind contract to purchase security.

1303 1304

1303 1304

Compliance Costs
• First-time registrant should expect to wait at least 6 months
until funds are received.

• Estimated costs for full registration for small business can

range between $350,000 and $500,000 (and can be much
higher for large companies).

• Question: To what extent do high costs of compliance with

securities law push companies into private markets?

1305 1306

1305 1306

Other Forms of Financing

Other Sources of Possible Finance
• Venture Capital

• Private Equity Capital

• Crowdfunding

1307 1308

1307 1308

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Securities Exchange Commission

SEC
• With this Act, Congress created following administrative

agency: Securities and Exchange Commission (SEC).

• Exchange Act empowers SEC with broad authority over all
Securities Act of 1934 aspects of securities industry.

1309 1310

1309 1310

Securities Exchange Act Disclosure Requirements

Securities Exchange Act of 1934 Public Company
• Primarily regulates securities transactions in secondary • Company subject to continuous, periodic disclosure

market (after issue), ensuring greater financial requirements of 1934 act.

transparency and less fraud or manipulation.
3 Events Triggers 1934 Act Disclosure Requirements:
Purpose o Registration under 1933 Act,
• Unlike 1933 Act, 1934 Act provides for continuous and o Listing on national securities exchange, or
periodic disclosures to enable SEC to regulate subsequent
o Meeting certain size thresholds.
trading in securities of publicly-traded companies.

1311 1312

1311 1312

Antifraud Provision
Rule 10b-5
• Prohibits commission of fraud in connection with purchase

or sale of any security.

• Applies to sale or purchase of ANY security (regardless of
whether security is exempt from registration under Torts Review
securities laws).

1313 1314

1313 1314

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Fraudulent Misrepresentation Elements of Claim

Fraudulent Misrepresentation 4 Elements of Fraudulent Misrepresentation Claim
• Tort of fraudulent misrepresentation represents • Material Misrepresentation

paradigmatic case of fraud. • Fraudulent Intent

• Person who buys stock from corporation as result of • Reliance (or Transaction Causation)
corporation’s false statements of fact can invoke tort law of
• Loss Causation
fraudulent misrepresentation to recover monetary
damages from corporation.

1315 1316

1315 1316

Truth Is Absolute Defense Types of Misrepresentations

• Truth is absolute defense to claim of misrepresentation. Active Misrepresentation
• Misrepresentation of Fact

• Active Concealment

Passive Misrepresentation
• Passive Concealment (Mere Silence)

1317 1318

1317 1318

False Statement of Fact Statement of Pure Opinion

Misrepresentation of Fact Statement of Pure Opinion
• Affirmatively false statement of fact is most common form • Not subject to fraud claim

of fraudulent misrepresentation.
Example
Statement of Fact is Objective and Verifiable • “Paulo’s makes best pizza in all of St. Pete’s.”

• Not Objective: I think Lane Kiffin is a real jerk.

• Not Verifiable: Life exists elsewhere in universe.

1319 1320

1319 1320

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Statement About Future Statement About Future

Statement about Future (Prediction or Projection)
• Does not support claim of fraud just because forecasted
event does not occur.
Example
• “This land will be worth twice as much next year.”
• Statement about future may give rise to fraud in at least 2
circumstances:
o Promise to perform may be fraudulent if promisor had
no intention to perform at time promise was made, or
o Predictions or projections may be fraudulent if they fail
to reflect past or present facts (e.g., optimistic forecasts
that are inconsistent with prior or current performance
can amount to fraud).

1321 1322

1321 1322

Active Concealment Case in Point

Active Concealment Example
• Misrepresentation occurs when party takes specific action, • Plaintiff purchased condominium unit from defendant and

behavior, or scheme to conceal fact that is material to sued after allegedly discovering that condominium building
contract. required remediation for mold and water damage.
• If seller by her actions or conduct prevents buyer from • Plaintiff alleged that defendants actively concealed mold

learning of some fact that is material to contract, then this and water damage in unit’s balcony and additionally
behavior constitutes misrepresentation by conduct. actively concealed defective conditions throughout
common areas of building.

1323 1324

1323 1324

Passive Misrepresentation Keeping Quiet

Duty to Disclose Example
• In general, neither party to contract has duty to disclose • Jim is selling car that has been in accident and has been

statement of fact. repaired. Jim does not need to volunteer this information
• Absent duty to disclose, mere silence is not fraudulent: to potential buyer.
• If person has duty to speak, then silence can be treated as • If, however, purchaser asks Jim if car has had extensive

false statement. bodywork, and Jim lies about this fact, then Jim has
committed fraudulent misrepresentation.
Securities Law
• Federal securities law transforms silence (failure to
disclose)—which ordinarily does not constitute fraud—into
fraud by imposing duty to disclose on public companies.
1325 1326

1325 1326

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Latent Material Defect Materiality

Real Estate Example: Material Fact
• If seller knows of serious potential problem that buyer • Fact is material if reasonable person under circumstances

cannot reasonably be expected to discover (latent
material defect), then seller has duty to disclose (to speak
up).
• If seller has duty to disclose, then omission (failure to
disclose latent material defect) can be fraudulent
statement.
1327
would regard fact as important in deciding what to do.
• Material fact substantially impact person’s decision to enter
transaction.
Objective Standard
• Materiality concerns whether reasonable person would
have acted upon representation (and not whether
individual plaintiff, in fact, did).
1328

1327 1328

Puffery World’s Best Coffee

Puffery
• Vague generalities and obvious exaggerations.

• Puffery is generally allowed and not considered material

misrepresentation.

1329 1330

1329 1330

Fraudulent Intent Innocent Misrepresentation

Two Components of Fraudulent Intent Innocent Misrepresentation
• Intent to Induce Reliance: Defendant intended to induce • If person makes statement of fact that she believes to be

plaintiff to act in reliance upon misrepresentation
(distinguishes fraud from lie).
• Knowledge of Falsity: Representation must be made with
knowledge of falsity (or reckless disregard thereof).
true but, in fact, misrepresents material facts, then this
person can be liable only for innocent misrepresentations
(not fraud).
• Aggrieved party can rescind contract, but (usually) cannot
seek damages.

1331 1332

1331 1332

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Reliance (Transaction Causation) Actual Reliance

Two Components of Reliance (Transaction Causation) Transaction Causation
• Actual Reliance • Plaintiff must, in fact, rely upon false representation to her

• Justifiable Reliance
detriment: plaintiff must establish that misrepresentation,
in fact, affected her conduct.
• Misrepresentation need not be sole cause of plaintiff’s

conduct, but it must have been substantial factor in

causing plaintiff to act.

1333 1334

1333 1334

Justifiable Reliance Examples of Unjustifiable Reliance

Justifiable Reliance: Examples
• Fraudulent misrepresentation requires that deceived party • Not reasonably justified for plaintiff to rely on statement

must have justifiable reason for relying upon that plaintiff knows is false.
misrepresentation under circumstances. • Not reasonably justified to rely on statement that is
• Reasonable reliance shifts focus from wrongdoing by obviously false or preposterous.
defendant to reasonableness of plaintiff.
• Not reasonably justified to rely upon statement that is
• Reliance is reasonable if plaintiff used common sense, paid obviously just hype or sales talk and nothing more.
attention to facts, and did not blindly rely upon
misrepresentation when even very brief examination would
have shown statement to be false.

1335 1336

1335 1336

Some Due Diligence Required Loss Causation

No Red Flags Loss Causation:
• Plaintiff cannot act upon representation without first • Plaintiff must show that misrepresentation caused plaintiff

having independently investigated truthfulness of to suffer loss.

representation if certain facts should have alerted plaintiff
to statement’s possible falsity. • PSLRA imposes requirement that private plaintiff in Rule
10b-5 action must prove loss causation.
Rhetorical Question:
• What level of due diligence in ascertaining true facts

should be expected of plaintiff in given circumstance?

1337 1338

1337 1338

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Loss Causation Hypo Loss Causation Hypo

Hypothetical Analysis
• D tells P that corporation will do very well because
• P can show transaction causation, because P would not
corporation has just perfected new method for marketing have purchase stock but for D’s misrepresentation.
widgets.
• P cannot show loss causation, because stock lost value for
• This is lie—corporation does not have new such method.
reasons unrelated to D’s misrepresentations.
• P buys stock in corporation on basis of this

misrepresentation.
• Suppose stock plummets in value for reasons entirely

unrelated to D’s lie (e.g., market for widgets plummets due

to broader macroeconomic forces).
1339 1340

1339 1340

Remedies
• If innocent party is victim of fraudulent misrepresentation,
then innocent party can either:
o Rescission: Elect to rescind transaction and be restored
to original position (status quo), or
REMEDIES o Compensatory Damages: Seek compensatory damages
for harm resulting from fraud.

1341 1342

1341 1342

Rescission No Showing of Loss Causation

Rescission Loss Causation Not Required
• Equitable remedy that sounds in contract available where • Courts do not require showing of loss causation in action to

party wishes to cancel (or void) contract and restore rescind contract.
parties to pre-transaction status quo. • Remedial Theory: Misrepresentation renders contract void
• Rescission disaffirms contract and asks court to declare (due to lack of agreement between parties).
contract void from its inception and return parties to pre-
transaction status quo rather than award money damages
for breach.

1343 1344

1343 1344

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Misrepresentation in Contract Misrepresentation in Contract

When Misrepresentation Makes Contract Voidable:
(Restatement Second of Contracts§164)
• If party’s manifestation of assent is induced by fraudulent
or material misrepresentation by other party upon which
recipient is justified in relying, then contract is voidable by
recipient.
When Misrepresentation Is Material
(Restatement Second of Contracts§162)
• Misrepresentation is material if it would be likely to induce
reasonable person to manifest his assent (or if maker
knows that it would be likely to induce recipient to do so).

Comment
• Plaintiff can sue to rescind contract based on material

representation even if defendant lacks fraudulent intent.

1345 1346

1345 1346

Misrepresentation in Contract Compensatory Damages

When Fault Makes Reliance Unjustified Compensatory Damages
(Restatement Second of Contracts§172) • Legal remedy that sounds in tort available where party

• Recipient’s fault in not knowing or discovering facts before wishes to recover compensatory damages for losses
making contract does not make his reliance unjustified resulting from defendant’s fraudulent misrepresentation.
unless it amounts to failure to act in good faith and in • Standard measure of compensatory damages in fraudulent

accordance with reasonable standards of fair dealing. misrepresentation action is expectation damages (and not
reliance damages as is standard for tort claim).

Loss Causation Required

• To recover compensatory damages, proof of loss causation

1347 is required. 1348

1347 1348

Reality Check: Why Plead Fraud? Reality Check: Why Plead Fraud?
Hypo Answer
• Matt and Jessica each buy vintage Stratocaster. • Rescission: Matt should choose contract cause of action:

• On each instrument, pickguard has been replaced. Matt does not want guitar and wishes to unwind entire
• Seller fraudulently represented that all parts were original. transaction.
• Fraud: Jessica should choose fraudulent misrepresentation
• Matt, collector, does not want guitar with replacement parts.
• Jessica, rock musician, wants to play instrument.
cause of action: this will allow her to retain instrument but
receive money damages (in amount of expected value of
guitar less its actual value).
Question
• How would you advise Matt (or Jessica) to proceed?
• What cause of action would you recommend to your client?
1349 1350

1349 1350

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Legal Remedies Review Compensatory Damages in Tort

2 Types of Legal Remedies IN TORT
• Compensatory Damages: Paid to compensate plaintiff for
Compensatory Damages = Reliance Damages
harm suffered.
• Punitive Damages: Awarded for purpose of punishing Reliance Damages
defendant in civil action. • Restores plaintiff to status quo position or plaintiff’s

position before tort committed by defendant.

• Think of these damages as compensating plaintiff for “out-
of-pocket” expenses.

1351 1352

1351 1352

Compensatory Damages in Contract

IN CONTRACT
A B
Compensatory Damages = Expectation Damages
Position after Status Quo
Wrong Expectation Damages
• Restores plaintiff to promised position under contract or

plaintiff’s position after contract performance by

defendant.
Reliance Damages = B – A • Think of these damages as giving plaintiff “benefit of the

bargain.”

1353 1354

1353 1354

Consequential Damages
Consequential (or Indirect) Damages
A B C • Legal damages that are indirectly associated with wrongful

act.
Position after Status Quo Promised Position
• Consequential damages do not flow directly and
Wrong Under Contract
immediately from defendant’s wrongful act, but from some
of causal consequences of act.

Expectation Damages = C – A Example

• Lost wages because injuries suffered in accident prevent
you from going to work.
1355 1356

1355 1356

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Hypo Extent of Litigation Exposure

Hypo Question
• Suppose plaintiff suffered two broken legs as result of • Do I have to pay compensatory damages for all indirect

defendant’s negligence. harms caused by my wrongful conduct (e.g., by my breach

Direct Damages
• Plaintiff’s medical expenses constitute direct damages.
Consequential Damages
• If plaintiff is truck driver who is now unable to work for
several months, then consequential (or indirect) damages
would compensate for lost wages.
of due care)? All types of harms caused? Full extent of
harm caused?
Necessary Limiting Principles
• In theory, causation is limitless: but-for causation can imply
infinite causal chain of damages.
• As practical matter, law must establish limiting principles.
1357 1358

1357 1358

Consequential Damages in Tort

Consequential Damages
• Person who causes injury to another person is liable for full

extent of harm caused (even if extent of harm is

unforeseeable).
TORT REMEDIES
Example:
• If Dallas is negligently driving through poor rural town and

collides with LeBron’s Ferrari, then Dallas is liable for full

amount of damage caused to car (even if not reasonably
foreseeable to find this type of car in this town).
1359 1360

1359 1360

Eggshell Skull Rule Limiting Principles in Tort

Eggshell Skull Rule
• You take your victims as you find them.
Example
• If accident would normally only cause few thousand dollars’
worth of harm, but defendant suffers from rare bone
disease and requires over $100K in medical treatment
Tort law limits litigation exposure (made large by lack of
reasonable foreseeability requirement for extent of harm)
through various limiting principles including:
o Iron Skull Rule
o Proximate Cause (limits type and manner of harm, BUT
NOT extent of harm)
o Economic Loss Rule

because of accident, then plaintiff is liable for full extent of

injuries suffered by defendant in accident.
• Vosburg v. Putney

1361 1362

1361 1362

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Non-Economic Damages Punitive Damages

General Rule General Rule
• In tort, courts generally allow compensatory damages for • Punitive damages are generally available in tort action if
non-economics harms (e.g., pain and suffering). defendant has engaged in outrageous, malicious, or gross
misconduct.

Example
• Liebeck v. McDonald’s Restaurants: Jury awarded $160,000

in compensatory damages and $2.7 million in punitive

damages.

1363 1364

1363 1364

Limiting Principle in Contract

Consequential Damages
• Breaching party is liable only for damages that were

reasonably foreseeable at time of contract formation.

CONTRACT • Reasonable foreseeability limitation in contract law closely

resembles proximate causation limitation in tort law.

REMEDIES • Unlike in tort, however, reasonable foreseeability limitation
in contract also applies to extent of harm.

1365 1366

1365 1366

Reasonable Foreseeability Punitive Damages

Examples General Rule
• Cost to complete unfinished work on time can pale in • In general, punitive damages are not available in breach of

comparison to loss of operating revenue that owner might contract action.

claim as result of late completion.
• Hadley v. Baxendale. Exception
• To recover punitive damages for breach of contract, breach
must be actionable as independent tort for which punitive
damages are available, conduct must be sufficiently “severe
and egregious,” AND there must be evidence of pattern of
similar behavior directed at public generally.
1367 1368

1367 1368

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Non-Economic Harms
General Rule
• In general, plaintiffs are not entitled to damages for non-

economic harm (e.g., pain and suffering experienced as

result of breach of contract).
REALITY CHECK
Exception
• Courts will make exception for contracts whose clear and

principal purpose is not to satisfy any economic goal, but

rather to give contracting party emotional, sentimental or
psychic benefit (e.g., weddings, funerals).
1369 1370

1369 1370

Why Plead Fraud? Advantages of Tort Claim

Question
• Why plead fraudulent misrepresentation as opposed to
breach of contract if damages (expectation damages) are
same and fraudulent misrepresentation requires proof of
fraudulent intent?
Hypo Revisited
• Instead of fraudulent misrepresentation, why not advise
Jessica to sue for breach of contract: vendor failed to
deliver guitar as promised per contractual agreement.
1371
Advantages of Tort Claim
• Eggshell Skull Rule: Tort does not require extent of harm to be
reasonably foreseeable (unlike contract law which requires all
consequential damages be reasonably foreseeable).
• Tort allows for punitive damages (very rarely allowed in contract).
• Tort damages for misrepresentation might include emotional distress
damages (very rarely allowed in contract).
• No need to establish existence of contract (e.g., might be no contract
because of statute of frauds violation).
• Problematic contractual provisions (e.g., clause in contract that limits
or caps damages available for breach of contract).
• Tort claim will often require more extensive discovery, making
1372
defendant more likely to settle coercive suits.

1371 1372

Criminal Fraud
• Fraud is broadly criminalized (under federal law) through
following causes of action:

o Mail Fraud
Criminal Fraud o Wire Fraud

1373 1374

1373 1374

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Fyre Festival Elements

• Elements of mail and wire fraud include
o Use of mail or wire communication
o Scheme to defraud
o Fraudulent intent
o Material misrepresentation

1375 1376

1375 1376

Communication by Mail or Wire Scheme to Defraud

• Mail or wire communication is not essential to scheme to • Scheme to Defraud: Any plan, pattern, or course of action
defraud (i.e., referring to scheme once by mail or wire may to deceive another in order to obtain money or property
be enough for conviction). by misrepresenting (or concealing) material fact.

• Defendant does not have to use mail or wire; it is enough if
scheme causes victim to mail or wire something of value.
• Wire = interstate telephone call or electronic
communication (e.g., e-mail).
1377
• Only scheme to defraud is required (not actual fraud),
meaning that person may be liable even if she never
defrauded anyone.
• Reliance is not element of mail or wire fraud (unlike
fraudulent misrepresentation).
1378

1377 1378

Materiality No Injury Requirement

• Although not expressly mentioned in statute, courts have • Government does not need to prove that victim of fraud
held that scheme to defraud must involve material was injured (unlike fraudulent misrepresentation).
misrepresentation of some kind.

• Material Misrepresentation: Misrepresentation that

objectively tends to influence (or is capable of influencing)
victim of fraud.

1379 1380

1379 1380

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Penalties Separate Offenses

• Penalties for mail and wire fraud are quite severe.
• Convicted defendant can face up to 20 years in prison and
substantial fines.
• For crime that affects financial institution, enhanced
penalties include fines of up to $1 million and
imprisonment for up to 30 years.
• Each individual mail or wire communication constitutes
separate and additional count.
• Example: Someone engaged in scheme to defraud, who
made 10 phone calls to victims as part of that scheme,
committed 10 separates acts of wire or mail fraud.

1381 1382

1381 1382

Administrative Rulemaking
• SEC promulgated Rule 10b-5 under Section 10(b) of
Exchange Act, which authorizes SEC to regulate securities
fraud.

Rule 10b-5 Claim • Question: Why do we need antifraud laws related to

purchase or sale of securities?

1383 1384

1383 1384

Elements of Rule 10b-5 Claim SEC Enforcement

In private securities lawsuit alleging violation of Rule 10b-5, • In public enforcement proceeding, SEC does not have to
plaintiff must prove: prove (1) reliance, or (2) loss causation.
• Material misrepresentation in connection with purchase or
sale of securities, • SEC must still prove (1) materiality, and (2) defendant’s
scienter.
• Scienter: Knowledge of falsity (or reckless disregard thereof
in civil case),

• Reliance (Transaction Causation), and

• Loss Causation
1385 1386

1385 1386

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 11/13/23

Elements of Rule 10b-5 Claim Two Major Differences

• What the Hell!: These 4 elements look just like 4 elements • Rule 10b-5 securities fraud claim differs from fraudulent
for common-law fraud claim only restricted to purchase or misrepresentation common-law claim in 2 key respects:
sale of securities. o Fraudulent intent not required
o Relaxed approach to reliance

1387 1388

1387 1388

Intent to Induce Reliance Silence

• Intent to Induce Reliance: Plaintiff need not show that
seller (buyer) of securities misrepresented material fact
with intent to induce buyer (seller) to purchase (buy)
security.
• Plaintiff only must show that representation was made
with knowledge of falsity (or reckless disregard thereof in
civil case).
• Absent duty to disclose, silence is not misleading under
SEC Rule 10b-5 (and thus, does not constitute securities
fraud).
• Company has duty to disclose material nonpublic
information if regulation, statute, or rule requires (or
mandates) disclosure (e.g., 10-K, 10-Q, 8-K).

1389 1390

1389 1390

Fraud-on-the-Market Presumption
• Fraud-on-the-Market Presumption: When investor buys or sells
stock at market price, reliance may be presumed, assuming
investor pleads facts showing that:
o Information allegedly misrepresented was publicly known,
o Information was material, Thinking Tool
o Stock traded in efficient market (in semi-strong sense), and
o Plaintiff traded in stock in relevant period.

• Rationale: Contrary rule “would place unnecessarily unrealistic

evidentiary burden on Rule 10b-5 plaintiff who has traded on
impersonal market.”
1391 1392

1391 1392

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Efficient Market Hypothesis (EMH) Weak Efficient Market Hypothesis

In efficient market, set of information is fully and immediately • Weak Efficient Market Hypothesis (EMH): Investor cannot
reflected in market prices. predict future stock prices based upon historical or past
stock prices.
Forms of Set of Information
Efficiency Reflected in Security Prices • Weak EMH is shot aimed directly at technical analysis.
Weak Previous prices of securities

Semi-Strong All public information

Strong All information (both private and

public) 1393 1394

1393 1394

Semi-Strong EMH Fraud-on-the-Market Theory

• Semi-Strong Efficient Market Hypothesis (EMH): Investor Common Law
cannot use any publicly available information (e.g., annual
reports or financial statements, reports in financial press, Material Investor
historical data) to predict future prices. Misrepresentation Reliance

• Semi-strong EMH is shot aimed directly at fundamental

analysis (i.e., nothing to be gained from paying somebody Fraud-on-the-Market Theory
to analyze financial data for you!).
Material Price Investor
Misrepresentation Reliance
• Causal link exists between material public
misrepresentation and stock price.
1395 1396

1395 1396

Practical Impact Strong EMH

• Fraud-on-the-Market Presumption: Allows plaintiff to prove • Strong Efficient Market Hypothesis (EMH): Everything that is
reliance (which is necessary element of Rule 10b-5 claim) even knowable—even non-public information—is fully reflected in
if plaintiff was not aware of statement. current stock prices.

• This presumption effectively eliminates requirement that
plaintiff asserting Rule 10b-5 claim prove reliance.
• Comment: Judicial presumption presumes that markets are
semi-strong efficient.
• How? Through what mechanism? Corporate leaks?
• Comment: Strong EMH implies that corporate insiders cannot
make profit trading on inside information.

1397 1398

1397 1398

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A Similarity Materiality Defined

• Materiality: Materiality requirement for 10b-5 claim is • Materiality: Statement is material if substantial likelihood
basically same as for common-law fraud claim. exists that reasonable investor would consider statement
important in making decision to invest.

• In Basic, U.S. Supreme Court adopts sliding scale approach

that considers:
• Probability that event will occur (e.g., merger will go
through), and
• Magnitude of possible event (e.g., impact of merger
itself).
1399 1400

1399 1400

Basic v. Levinson: Facts Chronology

• Combustion wanted to acquire Basic.
• Companies had high-level meetings to discuss possibility of
merger, stating in September 1976.
• During 1977 and 1978, Basic issued 3 public statements
denying possible merger with anyone.
• On December 18, 1978, Basic had NYSE suspend trading in its
shares and issued press release that Basic had been approached
for merger.
• Next day, Basic board accepted Combustion’s offer of $46 per
share for all outstanding shares.
Three Public Statements by Company
• 10-21-77: President opines that he “knew no reason for the
stock’s activity.”
• 9-25-78: Management was “unaware of any present or pending
company development” that would affect stock price.”
• 11-6-78: Company says that it “remains unaware of any present
or pending developments to account for high stock volume and
price fluctuations.”

1401 1402

1401 1402

Basic v. Levinson: Plaintiff Argues Basic v. Levinson: Holding

• Plaintiff sold stock after first public statement (10-21-77).
• Plaintiff Argues: Plaintiff claims that they sold company’s
stock on public market at allegedly depressed prices due to
public statements made by company that were both
material and misleading (and thus violated Rule 10b-5).
• Question: Was there any showing (or reason to believe)
that plaintiffs read 10-21-77 edition of Cleveland Plain
Dealer newspaper?
1403
• Holding 1: Supreme Court adopts sliding scale approach to
determine materiality and holds that misstatements were
material.
• Rationale: Because merger is high-magnitude event,
statements about merger can be material at a relatively
low level of probability.
• Holding 2: U.S. Supreme Court adopts fraud-on-the-
market theory.
1404

1403 1404

234

Practice Tip
Hypothetical:
• Your client T (target), a public corporation, is involved in preliminary,
secret merger discussions with A (acquirer), a public corporation.
• A has repeated told T that if news of merger discussions is disclosed
prematurely, then A will “walk away from the deal.”
T’s CEO receives telephone message from business reporter of local
•
newspaper who has heard rumors that T and A are negotiating
merger.
• Reporter want to talk with T’s CEO about merger rumors.
Question:
• How would you advise T’s CEO?
1405
1405
EP MedSystems v. EchoCath: Facts
• EchoCath (EC) researches, develops, and markets health care products
and has line of women’s health products based in part on ultrasound
technology.
• Had IPO in 1996, issuing prospectus that contained typical cautionary
language about how investing in securities can be risky.
• MedSystems (MS) became interested in buying large amount of EC
stock.
• EC’s CEO represents to MS that EC is on verge of signing deals with
major medical companies (including Johnson & Johnson), representing
that such deals are “imminent” at several meetings.
• MS invests $1.4 million to buy EC stock.
• More than year later, EC has secured no deals with any medical
companies. 1407
1407
EP MedSystems: Defendant Argues
• Defendant Argues: EC argues that statement in prospectus
about investments being risky render misrepresentations
about imminent deals not material under bespeaks
caution doctrine.
1409
1409
11/13/23
Bespeak Caution Defense
• Bespeak Caution Defense: Common law doctrine that
provides that cautionary language renders alleged omissions
and misrepresentations not material as matter of law.
• Defense applies only to forward-looking statements (e.g.,
predictive statements) and requires cautionary statement be
sufficiently related to misrepresentation or omission.
• Very similar to “forward-looking statement” safe harbor
provision in Private Securities Litigation Reform Act (PSLRA).
1406
1406
EP MedSystems: Plaintiff Argues
• Plaintiff Argues: MS sues under Rule 10b-5, asserting that
CEO’s statements were material and misleading and made
with knowledge of falsity (or reckless disregard thereof).
1408
1408
EP MedSystems: Holding
• Holding: Reversing lower court, Third Circuit holds that EC
misrepresentations did not qualify for protection under
bespeaks doctrine, because such representations were
statements of present fact (and not forward-looking) and
were not closely related to misrepresentations about
imminent deals.
• Rationale: Court emphasizes that present case is not
typical securities case: here, there were face-to-face
meetings.
1410
1410
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 11/13/23

Questions Loss Causation

• Question: Why did court not discuss fraud-on-the-market?
• Question: Would court have decided case differently if,
after each of his statements about imminent deals, EC’s
CEO had added statement: “Of course, that is just my
opinion. I could be wrong.”
• Loss Causation: Plaintiff must show that misrepresentation
caused plaintiff to suffer loss.
• PSLRA imposes requirement that private plaintiff in Rule
10b-5 action must prove loss causation.

1411 1412

1411 1412

Art of War

INSIDER TRADING

1413 1414

1413 1414

Source of Law SEC v. Texas Gulf Sulphur

• Insider trading cases are Rule 10b-5 omission cases.
• Insider tradition prohibition is purely creature of SEC
administrative actions and judicial opinions (and is only
very loosely tied to statutory language).
• SEC Argues: SEC argues that securities law prohibits all
transactions in which buyer or seller of securities has more
information than other party to transaction.
• Holding: Supreme Court rejects this argument, holding that
not every instance of financial unfairness constitutes
fraudulent activity under §10(b): there is not general duty
to forgo actions based on material, nonpublic information.

• Plain English: It is possible to trade on basis of MNPI.

1415 1416

1415 1416

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Common Law Definition Duties Under Law

• Insider Trading: Common law defines insider trading as
prohibition on trading in securities based on material, non-
public information (MNPI) in breach of duty of trust or
confidence (i.e., fiduciary relationship).
• Disclose or Abstain: Any person who possess material,
non-public information (MNPI) in breach of fiduciary duty
must either:
o Disclose: Disclose that information prior to trading
security, or
o Abstain: Abstain from trading in security.

1417 1418

1417 1418

Who May Be Liable? Misrepresentation

Potential violators include: • Insider trading charge alleges misleading omission of
material fact (as opposed to making of untrue material
• Corporate Insiders (Including Temporary Insiders):
Individuals at or connected to company with access to MNPI. statement).

• Misappropriators: Corporate outsiders who gain access to • For omission (or silence) to be actionable, duty to disclose
MNPI.
must exist.
• Tippers: Individuals who provide MNPI to third-party in
breach of duty and in exchange for personal benefit. • Fiduciary Duty: Duty to disclose stems from some
• Tippees: Individuals who receive MNPI from someone (tipper) preexisting fiduciary duty.
in breach of that person’s duty.
1419 1420

1419 1420

Materiality
• Material: Information is material if substantial likelihood
exists that reasonable investor would find information
important in making investment decision by having
significantly altered total mix of information available.
Non-Public
• Non-Public: Information is non-public if information has yet
to be disseminated broadly to marketplace and has not yet
permeated proper channels.
• Information is generally not considered to be public UNTIL
fully internalized by market.

1421 1422

1421 1422

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Reliance
• Reliance: Reliance (or transaction causation) is presumed in
omission cases.
• Question: Where have we seen this same approach to
causation with respect to act of omission?
Scienter
• Intent: Intent inquiry focuses on mental state regarding
trading based upon material, non-public information in
breach of fiduciary duty.
• Criminal violation requires knowledge.

• Civil violation requires recklessness (negligence is not

sufficient to establish insider trading violation).

1423 1424

1423 1424

Classical Theory
• Classical Theory: Corporate insider (e.g., director, officer,
and employee of company) is prohibited from trading in
securities of that corporation based upon MNPI obtained
in connection with insider’s position.
Classic Theory
• Theory premises liability on violation of duty of trust and
confidence (i.e., fiduciary duty) owed to shareholders.

1425 1426

1425 1426

Hypothetical Temporary Insiders

Facts • Temporary (or Footnote 14) Insiders: When corporate
• CEO secretly learned results of testing showed that information is revealed legitimately to outsider (e.g.,
consumption of company’s product had heretofore unknown underwriter, accountant, lawyer, consultant), outsider can
health benefits. become temporary insider (fiduciary of corporation).
• CEO expects that this information will cause company’s stock to
increase when made public.
• Under certain circumstance, law deems certain outsiders
(e.g., lawyers, accountants, consultants) corporate insiders.
Questions
• Does CEO’s purchase of her company stock violate Rule 10b-5?
• Does your answer change if hypothetical involves employee of
company who is not CEO?
1427 1428

1427 1428

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Hypothetical
Hypothetical
• Attorney works for Company A (acquiring company) on
planned merger transaction with Company T (target
company). Misappropriation
• Attorney trades on this information by purchasing shares in
Company T (not in Company A to which attorney owes Theory
fiduciary duty as temporary insider).

Question
• Is attorney liable under classical theory? If not, why?
1429 1430

1429 1430

Misappropriation Theory Expectation of Confidentiality

• Misappropriation Theory: Corporate outsiders are
prohibited from trading based upon material, non-public
information in breach of fiduciary duty owed to source of
information.
• Theory premises liability on violation of duty of trust and
confidence (fiduciary duty) owed to source of information.
• Relevant question is whether source disclosed information
with expectation of confidentiality (i.e., with expectation
that such information would not be shared with others).
• If source of information has no objection to recipient
trading based upon that information, then no breach of
fiduciary duty (for purposes of insider trading).

1431 1432

1431 1432

U.S. v. O’Hagan: Facts U.S. v. O’Hagan: Procedural History

• O’Hagan was partner in major MN law firm (D&W). • O’Hagan was convicted on all 57 counts in indictment,
• D&W represented Grand Met that was seeking to take over including Rule 10b-5 violations.
Pillsbury. • Eighth Circuit reversed on Rule 10b-5 convictions, holding
• O’Hagan learned about this from fellow partner. that misappropriation theory was not applicable.
• O’Hagan lost money in stock market and had dipped into client
funds.
• To cover shortfall in client accounts, O’Hagan purchased
Pillsbury stock and options.
• When news of tender offer by Grand Met went public, price of
Pillsbury stock rose, and O’Hagan sold making $4.3 million in
profit.
1433 1434

1433 1434

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U.S. v. O’Hagan: Holding Questions

• Holding: U.S. Supreme Court adopts misappropriation • Question: Could O’Hagan have been charged as temporary
theory and reinstates convictions. insider?

• Rationale: O’Hagan deceived those who entrusted him
with access to confidential information (i.e., D&W and its
client): this breach of trust and confidence constitutes
fraudulent behavior required for violation of Rule 10b-5.
1435
• Question: What if O’Hagan informed his law firm of his
intentions before purchasing Pillsbury stock?
• LLP Review Question: Could Grant Met have sued Whitney
& Dorsey for misappropriation by O’Hagan? Could Grand
Met have sued other partners of law firm? Do you find it
interesting that firm did not become LLP until 1996?
1436

1435 1436

Some Terminology

Tipper-Tippee
Tipper Tippee
Tipper/Tippee MNPI
Liability
Tipping Chain
Tipper Remote Tipper Tippee
MNPI MNPI

1437 1438

1437 1438

Tipper Liability Derivative Duty to Disclose or Abstain

• Tipper liability: Tipper breaches fiduciary duty in violation
of Rule 10b-5 if:
o Duty: Tipper has duty to disclose MNPI or abstain from
trading (obtained derivatively if remote tipper),
• Derivative Duty: Tippee (or remote tipper) inherits duty to
disclose MNPI or abstain from trading if:
o Knowledge: Tippee (or remote tipper) knows (or should
know) that initial tipper breached fiduciary duty.

o Personal Benefit: Tipper discloses MNPI to tippee for • Comment: To have knowledge of breach, tippee (or remote
personal benefit, and tipper) must know (or should know) that initial tipper
received personal benefit from disclosure of MNPI: no
o Trade: Tippee trades on tip. need to know all details of personal benefits.

1439 1440

1439 1440

240

Tippee Liability
• Tippee Liability: Tippee breaches fiduciary duty in
violation of Rule 10b-5 if:
o Duty: Tippee has duty to disclose MNPI or abstain from
trading (obtained derivatively), and
o Trade: Tippee trades on tip.
1441
1441
Dirks v. SEC: SEC Argues
• SEC Argues: SEC asserts that Dirks (remote tipper) inherited
from Secrist (original tipper) duty to disclose MNPI or
abstain from trading, and Dirks breached this derivative
duty by providing tip received from Secrist to his clients
(remote tippee).
• Comment: Assumes Secrist (as former officer of EF) has
duty to disclose MNPI about EF (evidence of EF’s fraudulent
business practices) or abstain from trading.
1443
1443
Questions
• Question: What did Dirks do wrong? Does he deserve
punishment or reward (for acting as whistleblower)?
• Question: If tipper provides tip to tippee, but tippee does
not act on this tip, has either violated Rule 10b-5?
• Question: Why is there no tippee liability if there is no
tipper?
1445
1445
11/13/23
Dirks v. SEC: Facts
• Dirks was securities broker.
• Secrist, former officer at EF, contacted Dirks and told him that EF was
overvalued and engaged in fraud.
• Secrist wanted Dirks to investigate.
• Dirks investigated and discovered evidence of fraud.
• Neither Dirks nor his firm owned or traded EF stock, but Dirks openly
disclosed evidence of EF’s fraud with clients and investors.
• 5 investment advisors who had spoken with Dirks sold stock holdings of
more than $16 million in EF.
• During Dirk’s 2-week investigation, price of EF stock fell from $26 to $15.
• SEC halted trading and commenced investigation.
• EF went into receivership.
1442
1442
Dirks v. SEC: Holding
• Holding: U.S. Supreme Court holds that Secrist (as well as
other employees and former employees who spoke with
Dirks) are not tippers under Rule 10b-5 (and thus Dirks
cannot be remote tipper).
• Rule: To be tipper, tipper must receive personal benefit.
• Rationale: Secrist is not tipper, because Secrist received no
personal benefit in revealing information: his purpose was
not to enrich Dirks, but to expose fraud.
1444
1444
Personal Benefit
• For Personal Benefit: Can mean (1) receiving something of
value in exchange for insider tip, or (2) making “gift of
confidential information to trading relative or friend.”
• Sale: Receiving something of value is akin to selling
information to third-party (who trades on information)
rather than personally trading on information.
• Gift: Making gift of inside information to relative or friend
is akin to personally trading on information and gifting
profits to relative or friend. 1446
1446
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 11/13/23

Two Examples of Personal Benefit U.S. v. Newman

• 2 clear-cut examples of personal benefit:
o Pecuniary: Pecuniary gain (e.g., cash kickback from
tippee)
o Reputational: Reputational benefit that will translate
into future earnings (e.g., tipper cultivates relationship
with influential tippee who tipper believes can help
secure more lucrative job).
• Holding: Second Circuit holds that for gift of MNPI to
constitute personal benefit (as required under Dirks),
there must be (1) meaningful close personal relationship
that generates exchange that is objective, consequential,
and represents (2) at least potential gain of pecuniary or
similarly valuable nature.

1447 1448

1447 1448

Salman v. U.S.: Facts Salman v. U.S.: Players

• Maher was investment banker.
• Maher provided confidential information about bank to
beloved brother, Michael. Tipper Remote Tipper/Tippee Tippee
• Maher gave information as gift to Michael (to help him). Maher Michael Salman
• Maher knew that Michael would trade on information.
• Michael, in turn, passed information to his brother-in-law,
Salman, who also traded on information.
• Salman knew that information came from Maher.

1449 1450

1449 1450

Salman v. U.S.: Defendant Argues Salman v. U.S.: Holding

• Defendant Argues (Citing Newman): For tipper
liability to attach in case of gift of MNPI to trading
relative or close friend, tipper must receive
concrete or tangible pecuniary or other financial
benefit in exchange.
• Holding: U.S. Supreme Court holds that gift of information
to relative or friend can constitute personal benefit even if
tipper does not receive concrete, pecuniary benefit in
exchange for tip: no proof of something resembling
pecuniary benefit is required.
• Comment: Tippee liability applies to Salman, because
Salman knew that Maher (initial tipper) was breaching duty
in gifting information to much-beloved brother, Michael.

1451 1452

1451 1452

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Questions U.S. v. Martoma

• Question: What if gift is not made to close friend or family
member (e.g., alumni of same school, member of church
congregation)?
• Question: What if source of MNPI (i.e., alleged “tipper”) is
simply boasting or engaging in loose talk about work, and
no direct evidence suggests that source intended to provide
gift to alleged tippee?
Intent to Benefit Test
• Second Circuit has subsequently weakened personal
benefit test in holding that defendant can receive personal
benefit when she discloses inside information with intent
to benefit tippee (regardless of whether tipper and tippee
share meaningful close personal relationship).
• This holding flips personal benefit test on its head, focusing
inquiry on whether tippee (and not tipper) received
personal benefit.

1453 1454

1453 1454

Questions Moving Forwards

• Question: Does holding in Martoma effectively eliminates
any meaningful burden on government to show personal
benefit to tipper?
Pair & Share
• Question: Does this holding potentially raise gossip to level
of criminal offense?
Problems 16

1455 1456

1455 1456

Problem 1 Problem 2
Hypothetical Hypothetical
• Law student is standing in elevator minding own business • Company has hired law firm.

and overhears CEO discussing company’s product test • While representing company, one of firm’s lawyers hears
results. about positive test results in connection with company’s
product.
Question
• Does it violate Rule 10b-5 if student buys stock in Question
company? • Does it violate Rule 10b-5 if lawyers then buys stock in
company?

1457 1458

1457 1458

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Problem 3 Problem 4
Hypothetical Hypothetical
• CEO decides that company will purchase another company. • CEO tells one of players on ultimate frisbee team about

product test results.

Question • Teammate pays CEO $5K for information.

• Does it violate Rule 10b-5 if CEO purchases stock not in her

own company, but in this other company, anticipating that Question
stock price will jump when acquisition is announced to • Does it violate Rule 10b-5 if teammate buys stock in CEO’s
public. company?

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Problem 5 Problem 6
Hypothetical Hypothetical
• Company hires printing company to print legal documents • In elevator, Jill overhears following conversation between 2 much-
beloved brothers.
for purchase of company.
• “Buy Teldar Paper.”
• Receptionist at printing company rummages through
• “How do I know this is a good tip, brother?”
garbage, finds draft of documents, figures out that
• “I illegally paid the CEO $200K for this info. It is pure gold, baby.”
company is acquisition target, and purchases stock in
company.
Question
• Can Jill trade? Note that Jill has knowledge of breach of fiduciary
Question duty by CEO-insider necessary for derivative duty to attach.
• Has receptionist engaged in illegal insider trading?

1461 Answer: NO tip. Tipper must willfully provide information to tippee. 1462

1461 1462

Problem 7 Bernie
Hypothetical
• Osama Bin Laden, knowing in advance of September 11, 2001 attacks
on World Trade Center, apparently sold short stock of various U.S.
airlines (allowing him to bet that stocks will decline).
• When prices of airline stocks declined sharply after 9/11, short sales
earned profits of approximately $2.5 million.

Question
• Was Bin Laden guilty of insider trading under Rule 10b-5?

Answer: NO.

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Problem 8 Ponzi Scheme

Hypothetical
• Bernie Madoff ran largest Ponzi scheme in history, cheating

approximately $65 billion from investors.

• Ponzi Scheme: Form of fraud that pays profits to earlier
investors with funds from more recent investors.

Question
• Did Madoff’s fraudulent scheme violate Rule 10b-5? If not,
why?

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Other Potential White-Collar Charges

• Securities Fraud (Falsifying Book & Records)
• Investment Adviser Fraud
• Mail Fraud
• Wire Fraud
Martoma Case Study
• Money Laundering
• False Statements
• Perjury
• Making False Filing with SEC

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Mathew Martoma Some Background Facts

• Martoma was SAC Capital portfolio manager responsible for
investment decisions in public companies in health care sector,
including pharmaceutical companies Elan and Wyeth, that were
involved in development of experimental drugs to combat
Alzheimer’s Disease.

• To obtain MNPI about Drug Trial, Martoma, began using expert

networking firms to speak to doctors involved in Drug Trial who had
access to confidential information.

• Martoma arranged dozens of paid consultations with one of Drug

Trial’s principal investigators, Dr. Joel Ross, and chairman of Drug
Trial’s Safety Monitoring Committee, Dr. Sidney Gilman.
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Some Facts of Drug Trial Some Facts about Trading

• Through exploitation of Martoma’s personal and financial
relationships with these doctors, Martoma obtained Inside
Information about results of Drug Trial, which were
negative, particularly in comparison to market
expectations.
• Elan and Wyeth planned to release full results of Drug Trial
to investing public at International Conference on
Alzheimer’s Disease (ICAD Presentation) on July 29, 2008.
• On Sunday, July 20, 2008, Martoma sent Cohen email in which he
wrote that “…It’s important [that we speak,]” which they did for
approximately 20 minutes.
• Over next 7 days, SAC Capital liquidated its entire equity position
in Elan and almost all its equity position in Wyeth–total of 17.7
million shares worth approximately $700 million.
• SAC Capital also shorted Elan and Wyeth by approximately 7.75
million shares: Trading represented over 20% of reported U.S.
trading volume in Elan and 11% of volume in Wyeth.

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Outcomes Steven A. Cohen

• Day after ICAD presentation, Elan stock closed approximately 42%
lower and Wyeth shares fell approximately 11%.

• Through its trading activity, SAC Capital earned profits and avoided
losses of approximately $275 million.

• Martoma was found guilty on all charges brought against him and, in
November 2014, began serving 9-year prison sentence.

• Martoma was also ordered to forfeit $9.3 million, representing bonus

earned through insider trading, as well as interests in Florida home
and several bank accounts.
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Why Did SAC Hire Martoma? EMH Explanations

• Question: Why did SAC Capital hire Martoma in first place? Weak EMH Explanation
• Was Martoma’s hiring based on raw analytic ability and future
expectations of success?
• Fact: Martoma did not have particularly stellar track-record
as successful investor in 3 years at Sirios Capital
Management prior to employment at S.A.C. Capital. Semi-Strong EMH Explanation
• Or did SAC Capital (correctly) sense that Martoma would be
willing to do whatever it takes to “get information”?

• Relevant Facts?: Martoma had been expelled from Harvard Law

School for forging his transcript when applying for judicial
clerkships and did not disclose this fact to Stanford Business
1475 School—Stanford later revoked his MBA degree. 1476

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How Do You Explain This? EMH Explanations

Weak EMH:
• Abnormal positive returns are evidence of superior

fundamental market analysis (e.g., Buffet, Lynch, Gross)

(or evidence of insider trading).

Semi-Strong EMH:
• Abnormal positive returns are necessarily evidence of
trading on basis of material, non-public information.

Strong EMH:
1477 • Abnormal positive returns cannot be explained. 1478

1477 1478

Weak Support for Strong EMH Why is Inside Trading Illegal?

• Empirical support for Strong EMH is weak insofar as inside
information appears to have economic value.
• Pervasive: Most major news announcements by firms are
preceded by stock price run-up, suggesting trading on
MNPI ahead of news.
• Criminal Gains: When insiders are caught trading illegally,
such insiders invariably have made killing on illegal
investments.
1479
• Example: If geologist knows that there exists high
likelihood of discovery of petroleum under Smith’s land,
then geologist is legally entitled to make Smith offer for
land, and purchase land, without first disclosing to Smith
results of geological survey.
• Question: Why is this transaction treated differently than
sale and purchase of securities based on MNPI?
• Answer: No fiduciary relationship! Relationship is purely
contractual.
1480

1479 1480

Rationales for Legality Rationales Against Legality

• Compensation: Profitable use of non-public material
information can be viewed as form of management
compensation.
• Information Dissemination: Allows for all information to
be reflected in security’s price (not just public information),
making financial markets more efficient.
• Market Integrity: Enforcement of insider trading protects
integrity of market and prevents investors fleeing because
market is viewed as rigged against them (assumption:
financial markets are special and require greater protection
than other markets).
• Fairness: Gives insiders unfair advantage in market.

• Private Property Rights in Information: Like intellectual

property law, prohibiting insider trading creates economic
incentive to produce socially valuable information.
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My Take
• Property Rights Approach: Inside information should be
treated as form of intellectual property.

• This approach would cover eavesdropping cases. SHORT-SWING

TRANSACTIONS
• Rationale: Financial success should be function of what
you know, and not who you know: People should not be
able to monetize their rolodex.

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Short-Swing Transactions Regulatory Scope

• Section 16(b): Section 16(b) of Securities Exchange Act of
1934 requires certain statutory insiders to return to
corporation all short-swing profits.
• Short-Swing Profits: Profits from any (1) purchase and sale,
or (2) sale and purchase of shares of corporation within 6-
month period.
• Section 16(b) applies to publicly held corporations:
o Whose shares are traded on U.S. exchange, or
o That have at least 2,000 shareholders (or 500
shareholders who are not accredited investors) in any
outstanding class of stock and more than $10 million in
assets.

• Statutory Insiders: Officers, directors, or shareholders who • Accredited Investor: High income or net worth individuals
owns more than 10% of corporation’s shares. and officers or directors of issuer.
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Example of Section 16(b) Violation Reliance Electric v. Emerson Electric

Hypo Facts
• Officer of company buys 100 shares at $5 in January 2023 • June 16: Emerson acquired 13.2% of common stock of Dodge
Manufacturing at $63 per share.
and sells these same shares in February 2023 for $6.
• Dodge announced merger with Reliance.
• Officer makes profit of $100.
• Emerson decides to get out.
• August 28: Emerson sells shares at $68 per share to bring its holding
Result under Section 16(b)? in Dodge down to 9.96%.
• Because shares were bought and sold within 6-month • September 11: Emerson sells remaining Dodge stock (9.96%) at $69
period, officer would have to return $100 to company per share.
under short-swing profit rule.

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Reliance Electric v. Emerson Electric Reliance Electric v. Emerson Electric

Holding Holding
• Sale that took Emerson’s holdings from 9.96% to 0 is not • Emerson conceded that the 16 June purchase that took it
subject to section 16(b). from zero to 13.2 percent was covered. It
• To be covered as one who holds more than 10% of stock • should not have done so. In a subsequent case, as discussed
under statute, one must own more than 10% at time of in Note 1 following the case, the Court held
purchase or sale. • one is not covered on a purchase unless she owned more
• Here, at the time of sale on 11 September, Emerson owned than ten percent of the stock in the corporation
only 9.96%, so that sale is not covered. • at the time of the purchase. So Emerson’s purchase on 16
June—from zero to 13.2 percent—should not
• have been included. Note 1 discusses these holdings and
suggests a mechanical “snap shot” approach for
1489 1490
• determining what buys and sells are covered.
1489 1490
• CHAPTER TEN BUSINESS STRUCTURES TEACHER’S MANUAL

• 210
• So, because it conceded that the 16 June purchase was
covered, Emerson was liable under section
• 16(b) for a profit of $5 per share (bought at $63 and sold at
Snapshot Approach Strict Liability Offense
$68) on the 3.24 percent of the stock it sold on
• 28 August.

Holding • Section 16(b) requires no showing of (1) bad faith, or (2)

• Emerson conceded that the 16 June purchase that took it that statutory insider traded on material non-public
from zero to 13.2 percent was covered. It information—all short-swing profits must be returned to
corporation.

• Strict Liability Offense: No scienter is required.

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