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Olta Bejleri

Business Associations Outline

GENERAL PARTNERSHIPS
OVERVIEW

Does not require filing or written agreement


Under RUPA profit-sharing presumes partnership
RUPA allows for significant flexibility but not as to loyalty, due care, or access to bookkeeping RUPA
103(b)

Advantages:
Flow-through taxation unlike corps (which are double-taxed at the corporate level as well as on
dividends paid to SHs), partnerships are only taxed once on profits
Disadvantages:
Mutual agency each partner has equal ability to bind the other partners regardless of the size of their
ownership interest
Partners get one vote, regardless of the size of their ownership interest. UPA 401(f)
Unlimited liability of each partner (ameliorated somewhat to the extent business is insured)
Restricted alienability of partnership interest; assignee may receive partnership distributions, but will
not have a partners other rights RUPA 502, 503(d); much harder to transfer partnership than corp.
Automatic dissolution upon death, bankruptcy, or expulsion of any partner (ameliorated by a
partnership continuation agreement)
Buy/Sell Provisions
Redemption agreement entity may or must buy the departing owners interest
Cross-purchase agreement some or all remaining owners may or must buy departing owners interest

DEFINITION & CHARACTERISTICS OF PARTNERSHIPS


Fenwick (NJ 1945) (Provides factors courts will consider to determine whether there was a partnership v.
just employment relationship)(partners v. ee)
Facts: Owner of hair salon gave EE 20% of profits at years end so she didnt leave. NO PARTNERSHIP.
She was mere employee being compensated in part based on profits.
Rule: Burden of proving the partnership is on the one who alleges its existenceUPA of 1914 6(1)
establishes a multi-factor test:
FACTORS RELEVANT TO THERE BEING A PARTNERSHIP
1) LANGUAGE OF THE AGREEMENT to suggest INTENT (said partnership);
a. NOTE: Written agreement not necessary
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2)
3)
4)
5)
6)
7)
8)

b. Using word partnership doesnt mean there is partnership


c. Now: Intent is immaterial; can form partnership w/o intending to do so
RIGHT TO SHARE IN PROFITS (20%)
ASSUMPTION OF LIABILITIES/Obligation to share in losses (none)
CONDUCT TOWARD THIRD PARTIES (filed partnership tax returns, but didnt present
themselves as partners to 3rd persons)
INTENTION OF THE PARTIES (no more than compensation agreement)
OWNERSHIP/CONTROL OF PARTNERSHIP PROPERTY (none)
COMMUNITY OF POWER IN ADMINISTRATION (none)
RIGHTS UPON DISSOLUTION (Fenwick retained all rights)

UPA 18: (a) Upon dissolution, each partner shall be repaid his contributions and share equally in the
profits and surplus; (e) the rights and duties of the parties in relation to the partnership shall be determined,
subject to any agreement between them, by the following rules: . . . All partners have equal rights in the
management and conduct of the partnership business.
Notes: Section 5(b) of the UPA can be circumvented in two ways: 1) if the partners delegate the power to
manage to committees or other partners so that at the moment of contract formation, there was a partnership,
or 2) the partners will consult on all matters or voting will be weighed by % of ownership.
Partners Compared with Lenders
Martin v. Peyton (NY 1927) (significance of partner v. lender status for avoiding others creditors.)
Facts: Rich friends refused to become partners, but negotiated a lending agreement 40% of profits until the
return of their securities was made (not less than $100k, not more than $500k), controlled Hall as their man
on the inside with a veto power, retained some control over the management of the loaned securities, had
the right to essentially fire partners, and had all KNK partners assign their partnership interest to PPF.
Holding: NO PARTNERSHIP bc they lacked mutual agency, duration was limited, and their potential
profits were capped at $500K.
Black Letter: The Revised UPA changes factor (1) so that intent of the parties to form a partnership is
immaterial. Instead, we look at the objective manifestation of subjective intent. So, one can form a
partnership just through voluntary association, without intending to do so.
Black Letter: An agreement that offers a degree of control by a first party to protect that partys assets
should not be considered a partnership if factors as a whole indicate that the other party still maintains dayto-day control over the business. (The question of degree of control is often the determining factor.)
A HIGH-RISK LOAN AGREEMENT MAY APPROACH PARTNERSHIP WITHOUT
ACTUALLY REACHING IT, IN THE ABSENCE OF ESSENTIAL CHARACTERISTICS LIKE
MUTUAL AGENCY
FULL PROFITS
UNLIMITED DURATION
Fiduciary Duties Owed Between Partners

Meinhard v. Salmon (NY 1928) (fiduciary duties of partners) (Cardozo)


Remedy: Ms interest should be measured by half of the entire lease, not merely by half of some undivided
part, but the number of shares allotted to M should be reduced to such an extent as to preserve to S the
expected measure of control indicated in the initial agreement.
Notes: Had the offer to Salmon to enter into a different lease been in a remote location (not an extension of
the current lease he held with Meinhard), there would not have been an obligation to disclose.
PARTNERS FIDUCIARY DUTY REQUIRES NOTICE AND DISCLOSURE OF NEW
OPPORTUNITIES AND POST-PARTNERSHIP PLANS. THIS DUTY DOES NOT MEAN
AUTOMATIC INCLUSION
RUPA 404(b)(1): Duty of loyalty includes the duty to account for and hold in trust any property,
including appropriation of a partnership opportunity (opportunity is incident of the enterprise)
RUPA 404(b)(3): must also refrain from competing with partnership pre-dissolution
Partnership Property
Putnam v. Shoaf (Tenn. 1981) (Deals with transfer of partnership interest)
Facts: Wife sold her shares in partnership after hubby died; new owners found embezzlement by acct and
got 60k. Now wife wants part of 60k bc she says embezzlement happened when she was partner.
Rule: A person can become partner only with unanimous consent of all partners (UPA and RUPA)
because partners do not want to take on risks that new person will subject them to liability. But partners can
transfer their economic rights in a partnership to someone, even though they cannot transfer their
management rights.
UPA PROVIDES FOR PARTNERSHIP PROPERTY RIGHTS IN:
1) RIGHTS TO USE OF SPECIFIC PARTNERSHIP PROPERTY (a possessory right incident to
the partnership that does not exist absent the partnership)
2) * INTEREST IN PARTNERSHIP* (his share of the profits and surplus and the same is personal
property.) ONCE THIS IS CONVEYED; the other two rights are also conveyed.
3) MANAGEMENT RIGHTS
A PARTNERS RIGHT TO PROPERTY (1) IS MERELY INCIDENTAL/INDIRECT TO THEIR
DISTRIBUTION INTEREST (2)
Partners Managerial Powers
UPA 18(e) provides that in the absence of an agreement to the contrary, all partners have equal rights in
the management and conduct of the partnership business.
UPA 18(h) provides that any difference arising as to ordinary matters connected with the partnership
business may be decided by a majority of the partners.

National Biscuit Company (NC 1959) (no majority = all partners can bind partnership for usual biz)
ONLY A MAJORITY VOTE CAN LIMIT A PARTNERS MUTUAL AGENCY
IF PARTNERSHIP AGREEMENT LIMITS A PARTNERS POWERS AND THE 3rd PARTY
KNOWS OF THIS LIMITATION
Each partner has an equal right to the management of the business and any business performed under the
scope of the partnership can only be contravened by a majority of the partners. But these UPA rules are
only default rules that may be contracted around.
RUPA 703 (a) dissociated partner is not liable for a partnership obligation incurred after
dissociation; (b) unless at the time of the transaction the 3rd party reasonably believed the dissociated
partner was still a partner, and had no notice of the dissociation
Partnership Profit and Loss Sharing
UPA 18(a): Unless otherwise determined between the parties, each partner shall be repaid his
contribution, whether by way of capital or advances to the partnership property and share equally in the
profits and surplus remaining after all liabilities, including those to partners, are satisfied; and must
contribute towards the losses, whether capital or otherwise, sustained by the partnership according to his
share of the profits. AKA: Unless contracted otherwise, partners share profits equally, and share losses
in the same proportion to profits. (UPA and RUPA)
UPA 40(b): Unless contracted otherwise, upon dissolution, liabilities of the partnership shall be paid in
the following order: (1) Those owing to creditors other than partners; (2) Those owing to partners other
than for capital and profits; (3) Those owing to partners in respect of capital; (4) Those owing to partners in
respect of profits/surplus.
Kovacick v. Reed (CA 1957) (Contribution of capital v. services)(home remodeling that was unprofitable)
SERVICE-ONLY PARTNER: WHERE ONE PARTNER CONTRIBUTES ALL THE MONEY AND
THE OTHER CONTRIBUTES HIS WORK, THE LATTER IS NOT PERSONALLY LIABLE FOR
MONETARY LOSS. (Rationale: both the capital-only partner and the service-only partner have both lost
their investment.)

CORPORATIONS I
The Role and Purpose of Corporations
THREE Theories of the Corporations: The Big Picture
1) Aggregate Theory - SH Primacy; corp. as extension of SHs, corp. as property of SHs (see Dodge v.
Ford Case)
2) Artificial Entity Theory - Legislative/Public Interest Primacy: corp as creator of state, as subordinate
to state and subject to regulation to promote the public welfare
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Justice Brandeis Dissent in Liggett v. Lee (1933) (Represents the artificial entity theory)
Thesis: Case involved state statute discriminating against chain stores to protect the independently
owned stores. Argues that the state may manipulate the corporation in any way to which it deems fit
to protect the public welfare. Corps put a lot of money in the hands of a few; and the difference in
power between a corp and individual business justifies treating them differently.

Race to the Bottom - states competing with each other to give corporations the least
restraints.

Genius of American Federalism - states as laboratories is the flip side of race to the bottom
and is the idea, coined by Roberto Romano, that states compete with each other to come up with the
most efficient form of corporate management.
3) Real/Separate Entity Theory - Director Primacy: corp controlled by Board of Directors, not
subordinate to State or SHs. DELAWARE follows this!
Comparison with Partnerships
Principal Distinctions

Partnership

Corporation

Formation

Informal, by contract

Filing w/ sec. of state

Liability

Unlimited

Limited

Management

Shared equally

Centralized

*Transferability

Restricted

Freely alienable

Duration

Limited

Perpetual

Cost to set up

Free

Filing, attorney fees

Default Rules

UPA/RUPA

State law

Tax

Flow-through

Double

* Limited liability & centralized management make for easy transferability, making raising capital easier and
lowering transaction costs
Dodge v. Ford Motor Co. (1919) (Duties of directors to SHs) AGGREGATE THEORY
Facts: Ford wanted to reinvest profits in comp so he can pay his EEs more and lower prices; SHs sued bc
they wanted dividends.
CORPORATION MAY ENGAGE IN LIGHT PHILANTHROPY BUT MAY NOT REDEFINE
ITSELF TO BE A NON-PROFIT
Corp is primarily for the profit of the SHs. The powers of the directors are to be employed for that end.
Business Judgment Rule

BJR: The judgment of the directors of corporations enjoys the benefit of a presumption that their decision
was formed in good faith and was designed to promote the best interests of the corporation they serve.
A.P. Smith v. Barlow (NJ 1953) (Lays out the BJR; donations to charties)
Board donated $1,500 to Princeton; SHs challenged it. BJR!
Courts will give a lot of leeway to a business decision to donate as long as the donation achieves
corporate ends (can be very attenuated), and as long as the corp is not donating to a pet project or
giving an absurdly large amount of money.
[The IRS limits deductibility to 10% of taxable income. Anything above 5% is too much. Target is
famous for 2%, but thats about the highest a corp can go.]
Notes: Here, the corporate benefits purported were: 1) to win good will for the corp; 2) create a good
business environment; and 3) * promoting a steady flow of well-trained employees.
State requirement for corporate benefits in donations:
DE 122(9) gives corp the power to make donations, but says nothing to for the corporate benefit
BUT such a requirement can be implied since the basic purpose of the corp. is to maximize profits.
NY 202(a)(2) gives power to make donations irrespective of corporate benefit, for the public welfare
or for community fund, hospital, charitable, educational, scientific, civic, or similar purpose, and in
time of war or other national emergency in aid thereof.
PA says that directors may, in considering the best interests of the corporation, consider the effects of
their actions on any or all groups affected by such actions, including SHs, employees, suppliers,
customers and creditors of the corp, and upon communities in which offices or other establishments of
the corp are located and provides that directors shall not be required, in considering the best interests
of the corp or the effects of any action, to regard any corporate interest or the interests of any
particular group affected by such action as a dominant or controlling interest or factor.
NJ see A.P. Smith case Needs some corporate benefit (can be attenuated bc ct applies BJR)
Class Problem: Is there a problem in giving anonymously to a donation in which the corps
CEOs good friend is involved? No benefits b/c no P.R. but would still pass maybe because
improving community life is considered good enough? So you would remove him from decision
making process and delegate, or 2 step sanitation process of: 1) full disclosure of all material
facts to committee, and; 2) an informed decision making vote by a group that does not have a
conflict of interest.
Black Letter: Only material donations or when money is given to someone with familial
relationship to corp must be disclosed to SHs of publicly traded corp!
Internal Affairs Rule (IAR): Law of the state of incorporation controls on issues relating to a corporations
internal affairs, which includes responsibilities of directors to shareholders (e.g. conflicts between SH and
management figures such as the board of directors and corporate officers). {A corp that is headquartered in
PA, does most of its biz in PA, but incorporated in DE = DE law controls!!}(some exceptions to this!)
Exceptions to the IAR
1) Bond posting statute (Cohen v. Beneficial Loan Corp.) Court sitting in diversity will apply bondposting statute of the forum state.
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2) SH inspection statutes (Crane Co. v. Anaconda) Most states will allow SH to use the law where
the corporation does business.
Shlensky v. Wrigley (Ill. 1968) (Illuminates extreme deference given on account of BJR).
Facts: Director felt that baseball was a daytime sport & didnt install lights in stadium (even though other
stadiums had them and was making this stadium unprofitable). No fraud, illegality, or conflict of interest,
but rather mere difference as to business policy. Thus, BJR applied.
POOR BUSINESS JUDGMENT IS NOT ACTIONABLE, EVEN IF UNPROFITABLE.
A COURT WILL NOT INTERFERE WITH AN HONEST BUSINESS JUDGMENT, ABSENT A
SHOWING OF FRAUD, ILLEGALITY, OR CONFLICT OF INTEREST.
Piercing the Corporate Veil
Walkovszky v. Carlton (NY 1966) (facts for piercing corporate veil)(here, no piercing)
Class: INADEQUATE CAPITALIZATION AND INADEQUATE INSURANCE ALONE IS NOT
ENOUGH TO PIERCE THE CORP VEIL, absent a showing that they did not follow the formalities.
Facts: D had 10 different corpss that consist of 2 taxis each, and each cab only carries the min amount of
insurance. P got hit and recovered a min amount, but contends that D deliberately has formed multiple
severely undercapitalized companies for the purpose of defrauding victims of negligence, and this calls for
piercing the corporate veil.
PIERCING THE CORPORATE VEIL:
1) ENTERPRISE LIABILITY (AGENCY) large corporation is held liable as principal of the
smaller agent corporations it conduct business through
2) RESPONDEAT SUPERIOR (AGENCY) individual is held liable as principal of the
corporation, if the individual is merely conducting personal business through it
3) Disregard of the corporate entity (piercing the corporate veil) - FRAUD in order to
prevent the perpetration of a fraud on the public. If there is nothing illegal or fraudulent about
having the min insurance on one car, theres noting about doing it with ten cars.
Rather, lack of corporate formalities is the key, including the failure to separate personal and corporate
funds. To pierce the corporate veil, P must show that Ds are controlling the corporation for their personal
benefit at the expense of the corporation.
Notes: P had two separate legal doctrines to plead: 1) enterprise liabilitywhere entities can be held jointly
liable for some action on the basis of being part of a shared enterprise; 2) disregard of the corporate
entity/piercing the corporate veil.
How to Avoid Piercing the Corporate Veil (from Sea-Land Services)
1) Do not mingle personal and corporate funds
2) Issue stock certificates
3) Adopt and comply with a certificate of incorporation and bylaws
4) Appoint a board of directors
5) Hold regular board and SH meetings
6) Keep minutes of those meetings
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7) Keep corporate financial books and records, and keep them completely separate from personal records
8) Comply with any statutory capital and/or insurance requirements
9) Take funds out of the corporation in the form of salary and/or dividends paid on a regular basis, being
careful not to draw funds out half hazardly or as needed for personal matters
Sea-Land Services, Inc. v. Pepper Source (7th Cir. 1991)(TEST to pierce corp veil)
Facts: Corp used P sea carrier to ship large amounts of peppers and ditched the bill. By the time P obtained
a default judgment, the corporation had dissolved. P then endeavored to sue the sole stockholder, Marchese,
as well as 5 other corporations he owned. Discovery revealed that he ran all of them from the same office,
caused the corporations to borrow from each other, and uses corporate bank accounts to pay personal
expenses.
TWO STEP TEST FOR PIERCING CORP. VEIL:
1) SHARED CONTROL/UNITY OF INTEREST: Such that distinct personalities no longer exists
and have collapsed into one entity. This arises from failure to follow corporate formalities,
commingling of funds, undercapitalization, SHs treating assets as their own, or one corp treating
the assets of another corp as its own.
2) HONORING THE SEPARATE CORPORATE EXISTENCES WOULD SANCTION FRAUD
OR PROMOTE INJUSTICE: This means something beyond leaving the P with an unsatisfied
judgment. (E.g. Allowing a president and shareholder to possess adversely against his own corp,
allowing cosigners to a note taken out by former partners to become assignees of the note though a new
corporate entity in order to sue the non-paying partner, unjust enrichment)
Holding: (1) The First prong was met where defendant operated all corporations out of one office, used one
phone line, same expense account, borrowed money between corporations without interest, and used money
for his own personal use. (2) As to the second prong, P has not yet pleaded that injustice would otherwise
occur, but will be able to do so if it can establish that defendant used the corporate form to avoid its
responsibilities to creditors, or that he or his corporation was unjustly enriched.
Mechanics of a Corporation
Certificate of Incorporation. Few hundred dollar filing fee. You can choose any state to incorporate in.
Internal affairs of corp is governed by the state laws of the state in which the corp is incorporated.
Changing this usually requires vote by the shareholders, more elaborate procedure to change than bylaws.
By-laws. (forms you will see online) are very lengthy documents that are the operating manual for the
corp.
Initial Meeting. Issue stock to initial SHs (common stock a bundle of potential rights that are divided
into economic rights and voting rights, where economic rights entitle the share/stockholder to receive
the residual assets of a corporation when everybody else has been paid off, but dont have a right to
demand dividends unless BOD says theyre entitled to receive them, while voting rights mean that they
have the right to vote for directors at annual meetings where vote is weighed by the number of shares
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that you own, also get right to vote on certain other major events such as 1) changes to certificate of
incorp and 2) merger or reorganization.
Delaware Law. Gives high level of discretion and freedom to managers to operate the business as they
wish. Predictable and huge body of case law in DE is compelling to corporate lawyers. Big corporate
lobbying bar. DE has a Chancery Court that is famous for being sophisticated, high profile and top
notch quality of corporate law thinking and jurisprudence, and doesnt have jury. Extremely
experienced and sophisticated local corporate bar.
Direct v. Derivative Actions
Derivative Actions: An equitable remedy. Any monetary recovery goes to corporation itself, not individual
SH who sues. In determining whether a suit is direct or derivative, ask: 1) who has been harmed? and; 2)
Who will get recovery?
Cohen v. Beneficial Loan Corp. (US 1949) (bond posting exception to IAR; discourages strike suits)
PROCEDURAL MECHANISMS LIKE POSTING COSTS-BOND MAY BE EMPLOYED TO
DISCOURAGE STRIKE SUITS
PROCEDURAL MECHANISMS = LAWS OF FORUM STATE (not state of inc.)
NY TEST: Eisenberg v. Flying Tiger Line (2d Cir. 1971) (dilution of voting rights = direct suit)
A SUIT BY SH ALLEGING DILUTION OF VOTING RIGHTS IS A DIRECT SUIT, BECAUSE
THE INJURY IS PERSONAL.
TEST: Whether the object of the lawsuit is to recover upon a claim belonging directly to the SH, or
whether it is to compel the performance of corporate acts which good faith requires the directors to take in
order to perform a duty which they owe to the corporation, and through it, to their stockholders.
Holding: Where plaintiff alleged that his voting rights and those of other minority SHs were diluted as a
result of the companys reorganization, the Court held that he did not have to post bond pursuant to NY
States bond posting statute. The Court applied the NY test, and found that because the harm suffered
herethe dilution of voting rightsis personal, the suit is direct. Because the bond posting statute only
applies to derivative suits, plaintiff/SH did not have to post bond.
DE TEST: Tooley v. Donaldson (2004) (Established test for direct v. derivative actions)
(1) Who suffered the alleged harm, the corporation or the suing stockholders, individually; AND (2) Who
would receive the benefit of any recovery or remedy, the corporation or the stockholders, individually.
Why is direct v. derivative status significant?
1) Determines who gets monetary damages - individual SH(s) or corp.
2) If direct, a SH suing in a state that requires a bond to be posted for derivative suits brought by minority
SHs would not apply.
3) Affects the issue of demand: If the claim is direct, the suing SH does not have to make a demand on the
board of directors prior to instituting the suit. However, if the claim is derivative, the SH will have to either
plead demand or demand futility. The idea behind the demand requirement is that because a SH suit
technically belongs to the corporation, a SH wanting to bring a suit must first demand that it be brought by
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the directors. The demand requirement is recognition of the fundamental precept that directors manage the
business and affairs of the corp.
*When SHs are seeking only injunctive relief, courts will generally defer to the SHs characterization
of their suits as either direct or derivative.
Demand
A SH filing a derivative suit must either: (1) allege WRONGFUL REJECTION of his pre-demand suit;
OR allege DEMAND FUTILITY/EXCUSAL.
o WRONGFUL REJECTION/REFUSAL TEST:
1) A majority of board has a material financial or familial interest in deciding demand;
2) A majority of the board is incapable of acting independently in deciding demand for some other
reason such as domination or control;
3) The decision to refuse demand was not the product of a valid exercise of the BJR
**notice the narrow focus here on demand
Once the SH complies with demand, he waives the right to later argue demand futility, but
instead must argue that demand refusal was wrongful. Grimes v. Donald.
However, in that case, the board rejecting the demand is entitled to the presumption of the
BJR, unless the SH can allege facts with particularity creating a reasonable doubt that the
board is entitled to the benefit of the presumption.
If there is reasonable doubt that the board acted independently or with due care in
responding to the demand, the stockholder may have the basis, ex post, to claim wrongful
refusal. The SH then has the right to bring the underlying action with the same standing
which the SH would have had, ex ante, if demand had been excused as futile. [Isnt this
the same thing as just alleging futility??]
The effect of demand will apply to all of plaintiffs stated claims arising out of the
transaction for which demand of one claim was made. Donald v. Grimes.
Reasons why a corporation would chose not to sue: 1) negative exposure; 2) the director/counsel
will be angry at being called out; 3) expensive lawsuit; and 4) awkward to pursue claims against
friends or colleagues.

DEMAND FUTILITY/EXCUSAL TEST- allege with particularity why the SH was justified in not
making a demand
o NEW YORK TEST: demand futility can be shown by alleging with particularity one of the
following:
1) A majority of the board is interested in the challenged transaction, either by way of
financial benefit or under control by interested director; or
2) Directors did not fully inform themselves about the challenged transaction to the extent
reasonably appropriate under the circumstances; or
3) The challenged transaction was so egregious on its face that it could not have been the
product of sound BJ of the directors.
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o DELAWARE TEST: demand futility can be shown by alleging with particularity one of the
following:
1) A majority of the board has a material financial or familial interest in the transaction
[most common], or
Directors are self-interested in a transaction where they will receive a benefit from
the transaction that is different from the benefit to SHs generally. Marx v. Akers
2) A majority of the board is incapable of acting independently for some other reason
such as domination or control
[ex: majority of board is beholden in a material financial way against the
interested director], or;
3) The underlying transaction is not the product of a valid exercise of BJ [very hard to
prove].
o (The NY and DE tests are virtually the same thing, just organized differently.)
o To allege with particularity even before discovery, a SH should use the tools at hand: 1)
public filings that are retained by the SEC, if dealing with a public company; 2) state laws allow
SH in their state to inspect corporate books and records so long as they can show proper purpose
for their inspection; 3) media reports, business press.
A SH cannot simply argue that excusal is warranted because they are objecting to some
transaction that the directors voted on.
Demand is not excused simply because plaintiff has chosen to sue ALL the directors.

Grimes v. Donald (DE 1996) (demand test)


Facts: In 1990, DSC Communications entered into a series of agreements with the corporations CEO,
James Donald. The Employment Agreement gives Donald general management over the company and
the power to fire himself with an incredible severance package if he perceives unreasonable interference.
The Income Continuation Plan supplements his severance package with lifetime income. One SH sued.
DERIVATIVE PLAINTIFF MUST EITHER:
1) MAKE DEMAND: UPON BOARD REFUSAL, ALLEGE WITH PARTICULARITY WHY
REFUSAL WAS WRONGFUL BY DISPUTING THE INDEPENDENCE OF THE BOARD
USING THE TOOLS AT HAND (220 inspection of books & records)
2) FORGO DEMAND: ALLEGE PARTICULARIZED FACTS THAT ESTABLISH
REASONABLE DOUBT AS TO BOARDS INDEPENDENCE, THUS MAKING DEMAND
FUTILE
a.
Majority of the board has financial/familial interest in the underlying transaction or
otherwise would be affected by the boards actions
b.
Majority of the board is incapable of acting independently due to domination/control by
an interested board member
c.
Underlying transaction not the product of valid business judgment
By first making a demand, a plaintiff waives his right to later claim demand futility. Must allege w/
particularity why demand refusal was wrongful.
The effect of a demand will apply to all of plaintiffs stated claims, bc otherwise its harassment of the BoD.
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Marx v. Akers (NY 1996) (demand futility/excusal test; requires MAJORITY of BoD to be interested)
Facts: Marx seeks to institute a shareholders derivative action against IBMs board, claiming that they
wasted corporate assets during a period of declining profitability by awarding excessive compensation to
15/18 outside directors and 1/3 inside directors. Demand here was held futile, because the challenged
conduct necessarily involved self-dealing by a majority of the board.
THREE WAYS TO EXCUSE DEMAND (New York Futility Standard)
1) Complaint alleges with particularity that a majority of the board is interested in the
transaction, either directly or through control by a dominant interested director. (BREACH
OF LOYALTY)
2) Complaint alleges with particularity that the directors did not fully inform themselves about
the transaction to the extent reasonable under the circumstances. (BREACH OF DUE CARE)
3) Complaint alleges with particularity that the transaction was facially egregious and manifestly
not the product of valid business judgment
Directors are self-interested in a transaction where they will receive a benefit from the transaction (which is
different from the benefit to SHs generally).
________________________________________________________________________
P Demand

Board adopts the claim


OR
Board rejects demand

No BJR (fraud, illegality, self


dealing)
OR
BJR SJ

P No Demand Demand Excused Directors Interested Form SLC


OR
No BJR
________________________________________________________________________
Special Litigation Committees
Auerbach v. Bennett (NY 1979) (NY TEST for evaluating SLC)(ct refers to SLC BJ)
Even if a board of directors is self-interested, they can vote to make a committee of independent
people.
Holding: Upon hearing of the allegations that some of its directors were involved in bribes and kickbacks,
the board took the following procedural steps: referred the matter to an audit committee, which made a
report and published it to the SEC, and thereby the SHs; formed a SLC that found they should not pursue
the claim because it would be against the interest of the corporation on account of potential for harm to
reputation, costs, time and talents of managers, and the fact that none of the directors benefited personally.
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TEST: 1) procedural component: Was procedure in forming the SLC sufficient? (burden of proof is on
the corp, and the court will answer this question), and; 2) substantive component - Was the decision
correct? (the court will defer to the SLC).
Zapata Corp. v. Maldonado (DE 1981) (DE TEST for evaluating SLC) (Ct applies own BJ)
A corps SLC has the power to terminate a lawsuit that was properly commenced by a SH because demand
was excused.
The interested board may legally delegate its authority to a committee of two disinterested directors. DCGL
144 is designed to permit disinterested directors to act for the board.
TEST: 1) IS THE SLC INDEPENDENT, ACTING IN GOOD FAITH, AND ACTING AFTER
REASONABLE INVESTIGATION? (BURDEN OF PROOF IS ON THE CORP); AND 2) COURT
APPLIES ITS OWN BJ, TO DETERMINE WHETHER THE SLCS BUSINESS JUDGMENT
DECISION TO TERMINATE WAS RIGHT OR WRONG. [Perhaps because DE courts more business
savvy than NY courts.]
SLC is presumed bias, burden is on BOD to show that the SLC was independent from the conflicted board.
Oracle Corp. Derivative Litigation (DE 2003) (goes to procedural prong of SLC)( sociological /
psychological/emotional connections can taint independence of SLC)
Facts: SLC composed of the Stanford professors to investigate corporate issue. Did NOT meet burden of
independence. They investigated & terminated a SH derivative action.
SLC BEARS THE BURDEN OF SHOWING IT IS 100% INDEPENDENT
Although no financial ties existed between the SLC members and the trading Ds, there were significant
financial and social ties between Stanford and the trading Ds. Donations, academic relationships, etc. all
ended up impugning the SLCs objectivity and their motion to terminate was denied.

THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS


Duty of Care
Applies generally to BJ where no conflict of interest is implicated and where a violation of BJR is not
established absent gross negligence. Usually a procedural issue.
DGCL 141(a). The business and affairs of every corporation shall be managed by or under the direction of
a board of directors.
DGCL 141(b). In order to have a valid board vote, there must be a quorum (a majority of the directors on
the board must be present), and the measure becomes effective only after a majority of those present vote.
(This majority rule can be altered by certificate of incorporation.)
Kamin v. American Express (NY 1976) (BJR triumphs if no fraud, gross negligence, etc.)
Facts: BOD decides to take a loss instead of taking action that would later affect their stock prices. Spend
some $ now so that they dont have bad stock later. SH sued. BJR!
BJR PROTECTS MISFEASANCE (plain negligence or poor judgment)

13

BJR DOES NOT PROTECT MALFEASANCE (self dealing, fraud, gross negligence) OR NONFEASANCE (intentional dereliction of duty = bad faith)
Note: Duty of care is very much a procedural issue. Here, BoD organized a meeting for the purpose of
addressing this specific issue, analyzed the issue, included a discussion of the issue meeting minutes, and
discussed downside of their plan, Ps had a very high hurdle proving a breach of the duty of care.
Efficient Capital Markets Hypothesis (ECMH): (1) Strong the market swiftly incorporates all
market information into prices, even information that is not publicly available; (2) Semi-strong the
market reflects everything that is already known; (3) Weak markets are only able to incorporate
historical data such as published past prices and do not instantly absorb or reflect new information.
Smith v. Van Gorkom (Trans Union case) (DE 1985) (gross negligence standard = breach of duty of care)
Facts: Company was not able to generate enough taxable income to take advantage of investment tax
credits, so Prez began speaking with senior management about the possibility of an LBO with a company
that had taxable income. He rushed the deal and much of the sr management wanted to resign. Didnt tell
BoDs or SHs how they came up with the price; rushed the mtgs; 20 min presentation; and there was no rush
or emergency. Court held that the board failed to adequately inform itself as to the companys intrinsic
value and the bidding process failed to create a bidding environment sufficient to protect shareholders, and
without any reasonable investigation.
GROSS NEGLIGENCE STANDARD: BOARD FAILS TO ADEQUATELY INFORM ITSELF OF
ALL MATERIAL INFORMATION REASONABLY AVAILABLE
Holding: Ct imposed personal liability BUT in response to this decision, the DE Legislature promulgated
DGCL 102(b)(7), which allows a corporation to exonerate directors for personal monetary liability for
breaches of duty of care. Thus, directors of DE corporations can behave in a grossly negligent fashion
without having to fear being held liable for monetary damages.
BJR

OVERCOME BY BREACH OF
CARE, LOYALTY, GOOD FAITH

BURDEN SHIFTS TO
ENTIRE FAIRNESS:
Timing
Initiation
Negotiation
Structure
Disclosure/Approval
o Board
o SHs

Francis v. United Jersey Bank (NJ 1981) (Corps owe duty of care to 3rd parties; rudimentary
understanding of biz)
Facts: Wife inherited hubbys shares after he died and became the sole director. She lost her mind. Sons
stole from corp and she didnt realize it. Corp was a reinsurance compwho got money from ppl to hold
similar to a trust.

14

CORPORATION MAY OWE FIDUCIARY DUTY OF CARE TO 3rd PARTIES (NOT


CORPORATION OR SHs) WHO GIVE THE CORPORATION MONEY TO HOLD IN IMPLIED
TRUST (i.e. BANK-LIKE)
RULE: A director should acquire a rudimentary understanding of the business of the corporation, look
through its financial records, and in the event that the records give rise to a suspicion of wrong doing, the
director has a duty to inquire further into matters revealed by those statements.
RULE: Where a director is entirely passive and fails to even make a business judgment, they are not
privy to the BJR, have acted with gross negligence, and have breached their duty of care to the corp.
Duty of Loyalty Conflicts of Interest (IDTs)
Three Scenarios Triggering IDT
1: K between director and corporation
2: Transaction between directors corp and another corp in which the director has a significant financial
interest
3: Transaction between two corp where same person is a director of both corps.
Bayer v. Beran (NY Sup. Ct. 1944)(director self-interest = rigorous scrutiny; hiring family member)
Facts: Direcotr hires wife to sing for company commercial. No other wrongdoing. The court found no
wrongdoing, the BJR protecting their decision to do a radio program and then applying a rigorous
scrutiny to whether or not the wife was a qualified singer. In other words, because the contract is fair, it is
valid even though disinterested directors have not formally ratified it.
HIRING OF FAMILY MEMBERS SUBJECTS DECISION TO RIGOROUS SCRUTINY BC OF
SELF-INTEREST
ALSO LOOK FOR STRUCTURAL BIAS WHERE THE HIREE IS RELATED TO A VERY
IMPORTANT BOARD MEMBER
If a K is fair, it is valid even though disinterested directors have not formally ratified it.
Benihana Case (DE 2006)(safe harbor statute for brd member on both sides of transaction)
Facts: Brd member was on both sides of the transactiondirector at two companies in deal.
Safe harbor statute for interested transactions:
144(a) A BOARD MEMBER ON BOTH SIDES OF A TRANSACTION IS NOT VOIDABLE
SOLELY FOR THAT REASON, IF:
1) MATERIAL FACTS OF RELATIONSHIP ARE DISCLOSED TO FULL DISINTERESTED
BOARD WHO AUTHORIZES IN GOOD FAITH, OR
2) MATERIAL FACTS ARE DISCLOSED TO SHAREHOLDERS, AND AUTHORIZED IN
GOOD FAITH, OR
3) THE TRANSACTION IS FAIR
Duty of Loyalty Corporate Opportunity Usurpation
Broz v. Cellular Information Systems, Inc. (DE 1996)(Corp. opp. test & defense)(Cell phone tower license
case)(No breach bc comp couldnt afford it)
15

Note: In DE, the fact that Broz did not present the opportunity to the board would not hurt him, whereas in
other states full presentation is mandatory.
Guth Test/DE TEST for Determining whether a Corporate Opportunity Exists:
These are FACTORSnot elements. Totality of the circumstances, fact-based test.
A corporate opportunity is one that:
(1) the corp. is financially able to undertake
a. If ID can prove that the corp to which he has a fiduciary obligation was not financially able to
undertake the transaction = defense to corporate opportunity.
(2) is in the corps line of business and is of practical advantage to it
(3) is one in which the corp. has a legally cognizable interest OR a reasonable expectancy
Legally cognizable interest: something in which the corporation has a preexisting contractual (legal)
right to. Ex: option to purchase a lease.
Expectation: something to which the corp. does not necessarily have a legal right, but given other
contractual dealings or business plans of the corp, is something to which the corp has an expectation
would be offered to it. Ex: if lease were up for renewal, but interested director came in and tried to
lease.
(4) where by embracing the opportunity the self-interest of the officer or director will be brought into
conflict with that of the corp.
[(5) whether officer or director learned of the opportunity in an individual or corporate capacity. Used in
Broz as probative, but not dispositive because it is often difficult to decipher.]
eBay Case (DE 2004)(IPO $ to directors = corp opp bc line of biz & they were influenced)
Facts: eBays investment bank underwriter was Goldman Sachs, and at some point they started spinning
IPO shares to eBays directors, which personally made them millions. These were investment opportunities
apparently given to reward prior business and secure future business.
FAVORABLE INVESTMENT OPPORTUNITIES MAY BE USURPED CORPORATE
OPPORTUNITIES IF THE CORPORATION INVESTS IN MARKETABLE SECURITIES
RULE: Receiving millions of dollars from an IPO opportunity is actually a corporate opportunity that
should go directly into a corporate treasury.
The SEC would now regard Goldman Sachs behavior as a bribe.
Note: Ct rejected Ds MTD for failure to make a demand to the BoD. Ct said demand was excused bc it
would have been futile.
Beam ex. rel. Martha Stewart: (DE 2004) (line of biz = core operations)
After Martha Stewart unloaded a large amount of shares just prior to the corporations plan to make a
significant public issuance, the corporation argued she usurped a corporate opportunity by flooding the
market with her shares and devaluing their issuance. Court held that the corporation wasnt really in the
business of selling its shares for profit; it sold home advice for profit, thus this was outside of their line of
business.
LINE OF BUSINESS MEANS CORE OPERATIONS OF THE CORPORATION

16

Duties of Dominant SHs Parent-Subsidiary Dealing


Dominant SHs owe a duty of loyalty to minority SHs.
A dominant SH is anyoneeither a group of individuals or an individualwith the power to select a
board of directors and approve or disapprove fundamental changes to a corp.
Often, these cases involve a parent-subsidiary relationship, where one corp (parent) owns a majority of
another corps (subsidiary) stock.
o The threshold to make something a subsidiary is 50% ownership, but ALI has suggested a 25%
threshold, and for our purposes, once a corp owns anything higher than 20% of another
corporation, we should ask whether we are dealing with dominant SHs.
o NOTE: If parent owns 100% of subsidiary, there is no duty of loyalty problems!!
Breach Claims brought by SH of subsidiary:
TEST: In parent-subsidiary dealings: (1) whether parent received a benefit to the exclusion and at the
receipt of the subsidiary/whether there was self-dealing. (2) If no, apply BJR. (3) If yes, majority SH
must prove fairness.
1) When transaction between parent and subsidiary does not involve self-dealing/where parent receives
nothing to the exclusion of the subsidiary apply BJR burden on plaintiff to overcome BJR must
show gross negligence
2) Where there is self-dealing/where parent receives a benefit to the exclusion and at the receipt of the
subsidiary apply Intrinsic Fairness Test Directors have burden of proving fairness
Sinclair Oil Corp. v. Levien (1971)(Intrinsic Fairness Test applies when parent benefits at exclusion of
subsidiary)
WHERE A PARENT CORP CAUSES A PARTIALLY-OWNED SUBSIDIARITY TO BENEFIT
THE PARENT WHILE EXCLUDING THE SUBSIDIARY, IT HAS ENGAGED IN SELFDEALING INTRINSIC FAIRNESS TEST
Here the dividends did not exclude the minority, because they were paid their fair potion, so no selfdealing occurred. However, the contracting was self-dealing.
When the situation involves a parent and subsidiary, with the parent on both sides of the transaction
(controlling the transaction and fixing the terms), the test of intrinsic fairness, with its resulting shift of the
burden of proof to the parent, is applied. Parent companys motives are immaterial so long as all the SHs
benefit from the transaction/there is no self-dealing. Where the parent did not receive a benefit to the
exclusion and at the receipt of the subsidiary, the business judgment rule will apply.
If parent chooses to bind itself with subsidiary, it must comply with the terms of the K because otherwise
it will have received a benefit at the expense of the subsidiary.
Zahn v. Transamerica Corp. (3d Cir. 1947) (dominant SHs owe duty of loyalty; directors act on behalf of
maj SH)
Note on Classes of Stock: Preferred v. Common. The rule of thumb is that when a company owes
fiduciary duties to different classes of stock, directors should protect the interests of the investors bearing
the greatest risktypically, the common stock holders who do not get preferred dividends or preferred
liquidation.
17

FAILURE TO DISCLOSE MATERIAL FACTS WHEN REDEEMING A CLASS OF STOCK


DOMINATED BY MINORITY SHs FOR THE BENEFIT OF ANOTHER CLASS OF STOCK
DOMINATED BY MAJORITY SHs IS SELF-DEALING (especially if the excluded class had the
ability to convert to the non-excluded class)
WHERE DIRECTORS OF ONE COMPANY ARE IN EFFECT INSTRUMENTS OF THE
COMPANYS MAJORITY SH (OFTENTIMES, ANOTHER COMPANY) AND WHERE THOSE
DIRECTORS WERE VOTING IN FAVOR OF THEIR SPECIAL INTERESTTHAT OF THE
MAJORITY SHTHE DIRECTORS BREACH THE DUTY THEY OWE TO THEIR
SHAREHOLDERS.
In short, where a puppet-puppeteer relationship exists between the directors of one company and another,
and the puppeteering company makes a decision in self-dealing, liability will be imposed upon the
puppeteering company.
Zetlin v. Hanson Holdings, Inc. (NY 1979) (controlling SH free to sell/purchaser free to buy at controlling
shares at premium price)
Minority SHs are not entitled to share equally in any premium paid by a purchaser of stocks to a dominant
SH for a controlling interest in the corporation. Absent looting of corporate assets (selling to someone who
the dominant SH knows or has reason to know will steal form the corp), conversion of corp. opportunity,
fraud, or other acts of bad faith, a controlling SH is free to sell, and a purchaser is free to buy, that
controlling interest at a premium price.
Duty of Loyalty Ratification of Conflicts of Interest
DGCL 144/Safe Harbor Statute will apply if it is ratified by either a majority of disinterested directors,
OR a majority of SHs.
If (1) a majority of the disinterested directors who are on the board (not just at the meeting) vote to
ratify the transaction [even though the disinterested directors be less than a quorum, and the presence of
interested directors may be counted to determine a quorum] after (2) full disclosure of specific
directors involvement in the transaction, the transaction is presumed valid. The Court will apply the
BJR, and burden shifts to P to show why BJR should be overcome; OR
o When the Court considers the ratification by the board, it will apply the BJR to the decision of the
board to affirm the IDT unless the interested director has dominion or control over the members of
the board, in which case directors must prove fairness.
If (1) a majority of SHs entitled to vote thereon vote to ratify the transaction after (2) full disclosure,
the transaction is valid. The burden shifts to the P to prove unfairness, (because the SHs dont get the
benefit of the deference of the BJR).
Ineffective or no ratification: The transaction is invalid unless the directors can show intrinsic fairness.
Questions to Ask in Ratification Cases
1) Is this an IDT or a dominant SH transaction?
2) Who has the burden, and what is the burden?
18

A) IDT burden on director to prove intrinsic fairness, unless there has been effective ratification by
either a majority of disinterested directors or a majority of SHs after full disclosure. If there has been
ratification, P has burden of either overcoming the BJR (if ratification was done via directors) or
showing unfairness (if transaction was ratified by majority of SHs.)
B) Dominant SH transactions burden on dominant SH to prove fairness, unless the transaction has
been ratified by a majority of disinterested minority SHs, in which case the burden shifts to the P to
prove unfairness.
Fliegler v. Lawrence (DE 1976)(when an IDT is freshened disinterested SH vote)
INTERESTED TRANSACTION IS FRESHENED WHEN RATIFIED BY A DISINTERESTED
SH VOTE BURDEN SHIFTS BACK TO CHALLENGER TO DEMONSTRATE GIFT, WASTE,
ETC.
Here, the Agau board also voted the ratification, so nothing was freshened.
RATIFICATION BY INTERESTED SHAREHOLDERS STILL NEEDS INTRINSIC FAIRNESS
Holding: SH ratification of the IDT was ineffective where the majority of shares voted in favor of
exercising the option were cast by defendants in their capacity as Agua SHs, and not by a majority of
disinterested voters. Because there was ineffective ratification, the burden of proof remained with the IDs to
show intrinsic fairness. IDs succeeded in showing fairness where the corp received a promising, potentially
self-financing, and profit generating enterprise with proven markets and commercial capability it sorely
needed to undertake further exploration and development of its own properties if not to stay in existence,
and where given this information, the price paid by USAC SHs was a fair price to pay.
In re Wheelabrator Tech. SHs Lit. (DE 1995)(when SH maj & control corp BJR applies)
A SH ratification automatically extinguishes a duty of care claim, even if it is found that the boards
decision was not based on a valid BJ.
A SH ratification does not automatically extinguish a duty of loyalty claim, but it does make the BJR the
applicable standard that a P would have to overcome (bc no control is exercised).
The BJR (rather than the intrinsic fairness test) will apply to a merger where the acquiring party was
not a dominant SH and did not have control over the target corp.
Rationale: This case involved the agreement of a merger between Waste (which initially owned 22% of
WTI stock) and WTI; that Waste would acquire 33% of WTIs stock; and that WTI SHs would receive .574
WTI shares and .469 Waste shares for each WTI share they had. The merger was approved by a majority of
WTIs disinterested SHs. Ct found that the board properly disclosed all material information, and rejected
Ps argument that the boards statement that it carefully considered the financial, business, and tax aspects
of the merger was misleading since the board only met for 3 hrs before agreeing to the merger, reasoning
that the inference that the board could not have made a meaningful decision purely because they only met
for 3 hrs is unreasonable, given the two corps history, the presentations given during the meeting, and the
description of the proxy statement of all the factors the board considered.
Duty of Loyalty Obligation of Good Faith

19

BJR is a presumption that in making a decision the directors of a corporation acted on an informed basis, in
good faith, and in the honest belief that the action taken was in the best interests of the company. SO
what does a P have to prove to show bad faith?
Walt Disney Case (DE 2006) (executive compensation; BF/GF standard; waste standard)
Facts: A year into the new Disney presidents job, they wanted to get rid of him but couldnt figure out a
way to fire him for cause, and firing him without cause would trigger the jumbo severance. The court
analyzed first the hiring and compensation package according to the duty of good faith, and determined that
the board had adequately informed itself with a reasonable investigation as to all material facts
reasonably available thus no breach.
BAD FAITH
1) INTENTIONALLY HARMFUL CONDUCT
2) INTENTIONAL VIOLATION OF THE LAW
3) CONSCIOUS DISREGARD FOR KNOWN DUTIES
4 Points of Doctrinal Significance:
1) For directors to get the benefit of the BJR, they do not need to follow best practices. Failure to follow
best practice is not significant enough to rise to the level of a duty of care violation.
2) A board may delegate responsibilities and even major decisions to a committee. (The compensation
committee had the power to approve Ovitzs care package without referring the matter to the full board.)
Caremark Claim: Generally, where a claim of directorial liability for corporate loss is predicated upon
ignorance of liabilitycreating activities within the corporation, a sustained or systematic failure of
the board to exercise oversightsuch as an utter failure to assure a reasonable information and
reporting system exists [or failure to make reasonable efforts to monitor compliance with those rules and
procedures]will establish the lack of good faith that is a necessary condition to liability.
3) To succeed in a derivative suit, SHs must overcome the BJR by showing that directors: did not act on an
informed basis; did not act in good faith; or that they were acting out of a desire to harm the company.
Alternatively, SHs may succeed without overcoming presumption of the BJR by showing waste.
WASTE TEST (extremely difficult to succeed) waste claim will arise only in the rare
unconscionable case where directors irrationally squander or give away corporate assets.
4) The issue of good faith: There are three different categories of fiduciary behavior for the bad faith
pejorative label
(i) subjective bad faith fiduciary conduct motivated by an actual intent to harm the corporation =
BAD FAITH
(ii) lack of due care fiduciary action taken solely by reason of gross negligencefailure to inform
ones self of available material facts, and without any malevolent intent = NOT BAD FAITH, THIS IS
A DUTY OF CARE CONCEPT.
(iii) intentional dereliction of duty, a conscious disregard for ones responsibilities failure of
oversight = BAD FAITH/Caremark Claim
Note: Disney was viewed as a high water mark of state law deferring to board of directors for executive
compensation.

20

Dodd-Frank Say on Pay 14A of the Securities and Exchange Act passed in 2010, imposes a nonbinding SH vote on executive compensation of top five most highly compensated employees, at least once
every three years. Traditionally, this area was reserved for state law. At least once every six years, SHs
must vote on how frequently to hold such an advisory vote. The vote must be tabulated and disclosed, and
larger corp must disclose whether and how their vote impacted results. But the results are non-binding on
the BoDs, and may not be deemed either to effect or affect the fiduciary duties of directors.
Another section of the Dodd-Frank Act mandates that the compensation committees of the board of
directors of public companies must be fully independent and that those committees be given responsibility
for setting CEO pay.
Duty of Loyalty Duty to Monitor/Oversight
Note on expectations of directors: Directors dont have to know in minute detail everything that happens
on a day-to-day basis. Director must have a rudimentary understanding of the biz and how it works;
keep informed about the firms activities; engage in a general monitoring of corp affairs; attend brd mtgs
regularly; and routinely review financial statements.
Stone v. Ritter (DE 2006) (oversight; subsidiary of duty of loyalty)(Caremark standard; corp compliance
standard)
Facts: In 2004, AmSouth was hit with $40 million in fines and $10 million in civil penalties for failing to
file suspicious activity reports required by ant-money laundering laws. Derivative suit was filed, claiming
that directors failed to monitor the procedures employees took, and the derivative Ps sought to have demand
excused, based on the fact that the duty to monitor is a non-exculpable or indemnifiable breach of good
faith/loyalty under the corporations 107(b)(7) provision.
CARAMARK STANDARD
DIRECTOR OVERSIGHT LIABILITY A NON-EXCULPABLE BREACH OF LOYALTY
1) DIRECTORS UTTERLY FAIL TO IMPLEMENT ANY REPORTING SYSTEM OR
CONTROLS
OR
2) HAVING SUCH SYSTEM, CONSCIOUSLY FAIL TO USE IT
BAD FAITH IS AN INDIRECT WAY OF BREACHING DUTY OF LOYALTY
Reasoning: Court dismissed the complaint on the basis that, under Caremark, directors can only be liable in
situations involving a sustained or systematic failure of the board to exercise oversight, and the Court found
that the complaint did not establish the requisite lack of good faith on which to base liability. The directors
here not only discharged their oversight responsibility to establish an information and reporting system, but
also proved that the system was designed to permit the directors to periodically monitor the corps
compliance with regulations: they nominated a BSA officer who reported to the directors each year; they
established a BSA/AML compliance department which is overseen by the boards audit committee;
established a corporate security and suspicious activity departments.

21

CLOSELY HELD CORPORATIONS


Characteristics
1) Stock held in relatively few hands
a. DE: no more than 30 SHs
2) Not publicly traded no secondary market
a. Wall-Street Rule (if SHs are unhappy with management they can just sell their shares), does not
apply to close corporations where there is no secondary market. Thus, SHs of close corporations
want to have an active role in management, so they seek to become officers and employees
through internal governance mechanisms such as:
i. Proxy/Irrevocable Proxy [DGCL 212(e)]
ii. Voting Trust [DGCL 218(a)]
1. Device specifically authorized by the corporation laws of most states. SHs who
wish to act in concert turn their shares over to a trustee, who votes all the shares,
in accordance with instructions in the document establishing the trust.
Particularly useful for family or group trying to maintain control over a
corporation, where there is a fear of shifting allegiances.
iii. Vote Pooling Agreement [DGCL 218(c)]
iv. Cumulative Voting [DGCL 214]
3) Stockholders are often simultaneously directors and officers too
a. Most do not pay dividends, but hire SHs as employees/officers instead. Thus, the impetus
behind investment into close corporations is often an expectation of long-term employment, and
resulting pay and benefits is the way that SHs can get a return on their investment.
Consequently, a denial of employment to a SH in a close corporation may pose a double harm to
the SH, preventing him from a fair return on his investment and leaving him unemployed.
Shareholder agreements often needed
b. Vulnerable to minority oppression because of uneven capital distribution and inability to get out
c. Alternatives to shareholder agreement
i. Employment agreement with corporation
ii. Buy/sell agreement
Voting Arrangements
Ringling Bros. Case (DE 1947)(voting pool agreement)
Plaintiff and Haley contracted to pool their votes, wherein each selected two members and then used their
remaining votes to select a fifth member of their choosing. K called for an arbitrator to resolve any
disputes. The contract was terminated a year later with the parties still bound by the arbitrator provision that
called for arbitrator to help decide how to vote. P didnt want to vote that way and sued.
VOTING POOLING AGREEMENTS ARE PERMISSIBLE.
Take-away from Case
1. Difficulty of being a minority SH in a closely held corporation
22

2. Difficulty for corporate planners in devising solutions to problems of control


3. Even solutions like vote pooling agreements can create their own problems by locking people into
alliances even after alliances shift
McQuade v. Stoneham (NY 1934)(indirect control of BoD is permissible; direct is not)
Note: Unlike Ringling, this case involves SHs other than the three directors involved in the suit.
Facts: Agreement - The parties (directors) will use their best endeavors to keep each as a director and
officer. No change in salary, capital, shares, or bylaws, salaries. However, and in contravention of the
agreement, once McQuade antagonized Stoneham, Stoneham linked up with McGraw to oust McQuade
as treasurer. McQuade hadnt done anything but challenge McQuades use of funds, trying to protect the
minority.
SH AGREEMENTS MAY NOT DIRECTLY CONSTRAIN DIRECTORS (tell them not to change
salaries, remove directors, bylaws, etc.)
INDIRECT CONTROL IS PERMISSIBLE, THROUGH VOTING AGREEMENTS (agreeing on
who to vote for in the first place)
Directors may not (by agreements entered into as SH) abrogate their independent judgment. SHs
may, of course, combine to elect directors. The power to unite is, however, limited to the election of
directors and is not extended to contracts whereby limitations are placed on the power of directors to
manage the business of the corporation by the selection of agents at defined salaries. A contract is illegal
and void so far as at it precludes the board of directors, at the risk of incurring legal liability (from
contractual breach), from changing officers, salaries, or policies or retaining individuals in office,
except by consent of the contracting parties.
Note: From corporate planning perspective, McQuade should have: insisted on a really long-term
employment contract; or maintained the vote pooling agreement but taken out the other language; or had a
plan/a buy-sell agreement for getting out of the investment.
A buy-out, or buy-sell, agreement is an agreement that allows a partner to end her or his relationship
with the other partners and receive a cash payment, or series of payments, or some assets of the firm,
in return for her or his interest in the firm.
When dealing with close corporations, ask whether there are other SHs involved that are not party to
the suit and thus would be harmed.
Clark v. Dodge (NY 1936)(SH agreement slightly constraining director decisions ok if . . . )
Note: Diff from McQuade bc the K is unanimousno harm to minority SHs (because there are no other
SHs).
Facts: Clark and Dodge owned 25% and 75% respectively and had an agreement where Clark would remain
director, general manager, if he remained faithful, efficient, and competent. Ct upholds K. Where the
public was not affected the parties in interest might by their original agreement limit their respective rights
and powers, even where there is conflicting statutory standard. Court confines the McQuade opinion to
those facts only.

23

UNANIMOUS (bc no other SH) SH AGREEMENTS THAT DIRECTLY CONSTRAIN DIRECTOR


DECISION-MAKING MAY BE OKAY IF NO HARM SHOWN (ex: no harm to bona fide purchasers,
creditors, minority SHs are not harmed). ALSO: SAVING CLAUSE REQUIRING THE ELECTED
INDIVIDUAL TO BE FAITHFUL, EFFICIENT, AND COMPETENT
NEGATIVES OF SHAREHOLDER AGREEMENTS:
1) SHAREHOLDERS ARE GENERALLY UNINFORMED
2) DIRECTORS ARE OBLIGATED BY FIDUCIARY DUTIES
3) POSSIBLE OPPRESSION OF MINORITY SHAREHOLDERS
ALTERNATIVES:
1) POOLING AGREEMENTS
2) CLASS DIVISION OF STOCK TO ALLOCATE VOTING RIGHTS
3) EMPLOYMENT AGREEMENT W/ CORPORATION
4) BYLAWS MAY PROHIBIT DISMISSAL OF OFFICERS WITHOUT A UNANIMOUS
VOTE
Galler v. Galler (Ill. 1964) (twist here is no other minority SHswhere both SHs agree to terms)
Facts: Brothers each owned an equal amount of stock and entered a SH agreement to protect their families
in the event of either brothers death. When 1 bro fell ill, wife stood to receive benefits of the corporation
including a seat as a director. The others refused to enforce the agreement, so wife sued to enforce.
SHAREHOLDER AGREEMENTS LEGITIMATE IF (even when not unanimous):
1) INVOLVES CLOSE CORP.
2) NO APPARENT PUBLIC INJURY
3) ABSENCE OF COMPLAINING MINORITY INTEREST (other than those party to the
contract)
4) NO APPARENT PREJUDICE TO CREDITORS
5) NO CLEAR STATUTORY PROHIBITION
The stated purpose of an agreement to provide income for the support and maintenance of ones immediate
families does not invalidate the contract so long as there is no detriment to minority stock interests,
creditors or other public injury.
Oppression & Abuse
Wilkes v. Springside Nursing Home, Inc. (Mass. 1976)(freeze-out; fiduciary duties btwn SHs in close corp)
Facts: Bad blood developed btwn SHs of close corp. The other SHs ganged up on him, and eventually
Wilkes said hed be selling his shares. Fired him to pressure to sell at low price. Mass recognizes a
fiduciary duty between shareholders in a close corporation, which would prevent majority shareholders
from freezing out the minority. Violated Fiduciary Duty!
WILKES BALANCING TEST: WHERE A MINORITY ALLEGES FREEZE-OUT:
1) CONTROLLING GROUP MUST FIRST DEMONSTRATE A LEGITIMATE BUSINESS
PURPOSE

24

2)

IF LEGIT BUSINESS PURPOSE, THEN MINORITY MUST SHOW THAT SAME RESULT
COULD HAVE BEEN ACCOMPLISHED BY PRACTICAL AND LESS HARMFUL
ALTERNATIVE MEANS

Holding: Because the behavior by three out of the four SH/directors of close corp was a designed freeze
out on account of spite or revenge, to which no legitimate purpose was given, particularly where the fourth
remained devoted to the corporation despite the falling out of friends, and the obvious meeting of the
directors was for the sole purpose of firing the fourth, the three SHs violated a breach of fiduciary duty.
Class Note: Significance of Corp not paying dividends then Wilkes wasnt getting anything (no return on
investment other than salary) after he was fired!
Note: If a SH in a close corporation wishes to ensure that he is not deprived of any return on investment, he
should have: 1) a buy-out agreement, or buy-sell agreement (formula where the other partners would have
the ability to buy at a reasonable price) and; 2) a long-term employment contract including terms relating to
benefits, salary, 401k, health and retirement, and; 3) a formal vote pooling agreement where they each agree
to work together to elect each other to the board.
Various Approaches to Fiduciary Duties between SH of a Close Corp
1) MA/Wilkes Balancing Test - Golden Rule. Cited by more than 25 states, imposes the highest
fiduciary duty of loyalty, akin to that between partners.
(Pros: Protects minority SHs because minority SHs have less bargaining power to begin with so they cant
really negotiate the best deals to protect themselves. A lot of close corps have close or familial relationships
and thus contracts are based on trust. If those relationships sower, then there is no protection for minority
SHs. Promotes investment bc minority SHs feel more protected.
Con: Encourages litigation; not as predictable.)
2) DE approach/Contract-based approach: You made your bed and you must lie in it. Denies that SHs
of a close corporation owe each other any fiduciary duty whatsoever; if you fail to contract to protect your
own interests, that is your loss.
(Pros: More predictable; courts arent contracting on behalf of parties.
Con: allows SHs to be exploited; can discourage investments bc minority SHs are scared/reluctant to
invest.) See Nixon v. Blackwell (Del. 1993) held signatories to a shareholder agreement, particularly
minority shareholders, do not need any special treatment because of their ability to enter into self-ordering
protections like buy/sell, employment contracts, pooling, voting trusts, etc. Thus, minority SHs have the
tools to bargain for protection before signing agreement. DELAWARE: NO SPECIAL TREATMENT
AFFORDED SIGNATORIES TO SH AGREE.
Ingle v. Glamore Motor Sales, Inc. (NY 1989)(no fiduciary duty to another SH if EE at will)(here, buyback
provision in agrmt = diff from Wilkes)
Absent an employment contract, an employee is an at-will employee when his shareholder agreement
provides a buyback provision of his shares if they are terminated for any reason. No fiduciary duty.
Court held that Ingle was not entitled to a fiduciary-rooted protection against termination despite his status
as a minority SH, because he was an employee at will. (Plaintiff had no expectation of long term
employment where the SH agreement stipulated that the buy-out applied if he is terminated for any reason.)
The written SH agreement entered into between Ingle and his employer provided for employer to buy out
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Ingles shares (buy-out agreement) if Ingle shall cease to be an employee of the corporation for any
reason. Plaintiff never asserted that the buyback amount was unfair, and therefore he suffered no harm.
Smith v. Atlantic Properties, Inc. (Mass 1981)(Wilkes fiduciary duty applies to minority SHs if they are
controlling)
Wolfsons veto power made him an ad hoc controlling interest, which imposes on him the same fiduciary
duty espoused in Wilkes. This was breached by Wolfsons reckless and unjustified risks with respect to
incurring tax penalties and failing to offer an alternative solution to declaring a dividend. (4 friends; 25%
each; need 80% for super majority; incurred IRS penalties bc one didnt want to vote)
MASS: AD HOC CONTROLLING INTERESTS MAY OWE FIDUCIARY DUTY
Minority SHs owe majority SHs a fiduciary duty in the same manner that majority owners owe
minority shareholders, and therefore the majority can seek judicial intervention for decisions that are
unjustifiable for the corporations interests.
Note: Strait-forward application of the Wilkes rule, with a twist that it applies to a minority SH if he or she
is controlling.
Involuntary Dissolution (Prof Lecture):
Every single state has provisions under which a minority SH in a close corp may petition a court seeking
involuntary dissolution under certain situations. This means that minority SHs have an alternative to a suit
for breach of fiduciary duty (common law remedy) to which SHs in a close corp owe to one another. They
can now use the dissolution statutes as a remedy. If granted, the dissolution remedy will lead to the winding
up and dissolution of firms assets followed by distribution of assets first to creditors, then to different SHs.
What kinds of circumstances generally justify dissolution? Differs in states, but 4 typical grounds are: 1)
deadlock among directors; 2) deadlock among SHs; 3) misuse or waste of corporate assetscan follow
from deadlock; 4) abuse or oppression of a minority SH (most controversial)In states that permit #4 (NY
and NJ), oppression is generally defined as: conduct that defeats the reasonable expectations of a minority
SH to participate in the management of the business or to be employed by the company. DE does not
recognize ground #4 because it will not get involved in drafting agreements for SHs that they should have
drafted in the first placenot going to come up with a judicially crafted buy-out agreement that was the
responsibility of the investors prior to getting involved in the investment.
Because this is such a drastic remedy (more so than breach of fiduciary duty) many states (NY and NJ as ex)
allow corp or other SHs to elect to purchase the shares of the petitioning investor in order to prevent the
dissolution of the company. Courts may choose to get involved in working out a fair buy-out price to avoid
shutting the corp down. But this is if the majority SH elect to do this, they are not forced to buy-out the
minority shares.

CORPORATIONS II

26

Federal Securities Law


Two important federal statutes:
1) Securities Act of 1933 (33 Act): Governs primary market transactions, where stocks are first
introduced in the market as sold by issuer to initial investor. Focuses on mandating disclosure of
material information and prevention of fraud.
2) Securities Exchange Act of 1934 (34 Act): Governs secondary market transactions, where investors
trade securities among themselves without any significant involvement by the original issuer. Governs
insider trading, securities fraud, short-swing profits by corporate insiders, regulations of SH voting via
proxy solicitations, requirement of periodic disclosures by publicly held corporations. Created the
SEC as the primary fed agency charged with administering the various securities laws5
commissioners and no more than 3 can be from the same political party. We will deal mostly with this.
Purposes of the statutes: Protect investors engaged in securities transactions & Encourage public
confidence in the integrity of the market.
Blue sky laws laws regulating the primary market.
Security - 2(1) of the Securities Act includes stock, bond, notes. Also includes a general list such as
evidence of indebtedness, investment contracts and any instrument commonly known as a security.
Rule 10(b)-5 and Misrepresentation (Securities fraud)
Section 10b of the Exchange Act Applies to both publicly traded companies and securities of closely
held corp/ privately traded corps.
Rule 10b-5 (SEC Rule that gives Section 10b substance) promulgated in 1942
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact (emphasis added) or to omit to state a material fact
necessary in order to make the statements made, in the light of the circumstances under which they were
made, not misleading, [must be material!] or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit
upon any person,
in connection with the purchase or sale of any security.
(P may only have a cause of action if he bought or sold shares, not if he refrained from doing so. Blue
Chip Stamps v. Manor Drug Stores)
**Liability for issuance of a false or misleading statement requires proof of a state of mind referred to as
scienter; that is, the person making the false statement must have made it with an intent to deceive,
manipulate, or defraud. Recklessness suffices.
**No implied private right of action against those who aid and abet violations/no secondary liability.
Central Bank of Denver v. First Interstate Bank (US 1994).
27

**The scope of conduct prohibited by 10(b) is controlled by the text of the statute. If language absent,
Courts must infer how 1934 Congress would have ruled on the issue.
3 Potential Types of Actions that come up under 10b-5 (look at caption to figure out which one)
1) Private causes of action (Basic v. Levinson)
2) Civil enforcement action brought by SEC (SEC v. . . .)
3) Criminal action (U.S. v. . . . )
Basic Inc. v. Levinson (US 1988) (test for MATERIALITY & rebuttal of reliance)
Est. the foundation for vast majority of rule 10b-5 class actions. Issue: When do merger discussions become
material so that they must be disclosed if discussed at all?
TEST FOR MATERIALITY:
WHETHER A REASONABLE INVESTOR WOULD CONSIDER IT IMPORTANT TO
WHATEVER CONTEXT IS AT ISSUE.
BALANCING TEST: BALANCES PROBABILITY OF SUCCESS (indicia of interest, e.g. board
resolutions, instructions to investment bankers, actual negotiations) AGAINST MAGNITUDE OF THE
TRANSACTION (as measured by size of the entities, size of control premium)
Note: denying something can make it material; better to stay silent or say no comment.
Note: It doesnt matter whether it turns out that the contingent event never happened (that the merger didnt
go forward), you test materiality at the time the statements were made!!

REBUTTAL OF RELIANCE TEST (know for exam!)


WHERE MISLEADING STATEMENTS ARE MADE TO AN EFFICIENT AND IMPERSONAL
MARKET, REBUTTABLE PRESUMPTION OF RELIANCE BY INVESTORS ALLOWS CLASS
CERTIFICATION (fraud on the market theory)
D MAY REBUT PRESUMPTION OF RELIANCE BY SHOWING
Statements did not distort the price - events analysis
Individuals would have traded anyway
Stock was not widely traded or analyzed
Analysts actually knew the truth (news of the merger discussions credibly made its way into
the market)
Even if there is a low likelihood that a merger will occur, its magnitude will likely outweigh its minimal
probability, and the merger will be material.
Directors do not have an obligation to disclose merger negotiations, but if they do, they cant say something
thats either false or misleading/omission. Rather it must be accurate--meaning including all material
information--where material is defined by the probability/magnitude balancing test. If they have made an
inaccurate statement, they have a duty to correct it.
Even a slight probability of merger occurring is probably going to be considered material because
a merger is a huge event in a corps life: except if for a giant company acquiring a little tiny company.
28

To be actionable, a statement must also be misleading. Silence, absent a duty to disclose, is not
misleading under rule 10b-5. No comment statements are generally the functional equivalent of
silence.
FRAUD-ON-THE MARKET THEORY: The fraud on the market theory is based on the hypothesis
that, in an open and developed securities market, the price of a companys stock is determined by the
available material information regarding the company and its business. Misleading statements will
therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.
The causal connection between the defendants fraud and the plaintiffs purchase of stock in such a case
is no less significant than in a case of direct reliance on misrepresentations.
Elements of Private Cause of Action for Misrepresentation Under Rule 10b-5: (CONJUNCTIVE
TEST ALL ELEMENTS MUST BE SATISFIED!)

1) Misrepresentation or Misleading Omission


2) Materiality** (use Basic standard) (all actions for fraud/misrep and insider trading will focus on this)
Materiality: whether a reasonable investor would consider the information important in whatever
context. In re to events that are contingent or speculative, apply the probability/magnitude balancing
test to determine whether information is material.
3) Scienter (person making the false statement must have made it with intent to deceive, manipulate or
defraud or recklessness disregard standard for individual or civil suit; for criminal actions actual intent is
required, recklessness is insufficient. Rule 10b-5(1) establishes that it is sufficient to show that one traded
while in possession of insider information.
4) In connection with purchase or sale of securities (Blue Chip Stamps Case: deciding not to buy stock
because of negative prospectus by companyeven if misleadingdoes not give standing to sue)
5) Reliance (aka Transaction Causation) the material representation actually caused the purchase or
selling by the stock; the transaction was caused in some way by the misstatement/omission
a) Class Action Suits: Fraud on the market theory (ECMH-semi strong theory) enables class of SHs to
establish a prima facia case to satisfy requirement of reliance without having to prove individual
reliance on a person by person basis. However, the fraud on the market theory is a rebuttable
presumption that can be belied by: expert evidence or testimony showing that the fraud on the market
theory is inaccurate; showing that plaintiffs sold for personal reasons and were not motivated by the
market price but rather by a need for liquidity (expensive endeavor); truth on the market defense- the
information somehow seeps out (bring out experts to show that in fact the stock market movement did
reflect abnormal activity that was evidence of merger talks)
b) Private Suits: Individual must prove actual reliance, which can be undermined by a showing that
plaintiff was motivated to sell by other means, such as a need for liquidity.
6) Loss causation requires showing that the misrep/omission actually caused the stock price to actually
fall or rise (show adversity to plaintiff as to the stock price)
7) Damages

INSIDER TRADING AND THE USE OF INSIDE INFORMATION


29

THEORIES & LIABILITY FOR INSIDER TRADING


1) Classical Theory/ Disclose or Abstain Rule. TGS
- Applies when duty owed to SHs
- If disclose info to SHs before trading no liability
2) Misappropriation Theory. OHagan case
-Applies when duty owed to another in trust or confidence: employees to employer; constructive insider such
as accountant/lawyer; three examples in Rule 10b(5)-2.
-If disclose intent to trade to person who entrusted you with info no liability
3) Tipping/Tipper Liability. Dirks
- Go through Tipper prong first. If no tipper liability no tippee liability
4) Rule 14e-3 for TENDER OFFERS only
-No duty requirement
-Prohibits trading on information of tender offer once substantial steps are taken to commence tender offer,
where substantial steps includes retaining counsel or investment banking firm and forming confidentiality
agreement.
Overview
Defenses to Insider Trading: Efficient and inexpensive way of compensating directors for doing their jobs.
Its a nice option for companies to be able to disclose info to the market through insiders selling their stocks
and without having to issue a negative press release.
Classical Theory (Disclosure or Abstain Rule) (TGS case)
Insiders are under NO obligation to disclose confidential non-public information material to the
company, as there are perfectly legitimate business reasons why a company would want to keep things
confidential. However, they may not trade unless they disclose.
Thus, an insider has two options:
1) Disclose and wait a reasonable amount of time before trading; OR Reasonable
amount of time = insiders must wait until they have no advantage over everyone else on
the market; length of time is set by exchanges and companies often make their own time
lines.
2) Do not disclose, and do not trade.
Disclose or Abstain rule does not apply in every caseonly where defendant owes a duty to
those with whom he is transacting! (Chiarrella)
Goodwin v. Agassiz (MA 1933) (purchaser owes no fiduciary duty to seller)
A purchaser of stock on the market does not owe a fiduciary duty to a seller to disclose the
information that the purchaser may know, even when the purchaser is in a position that provides
insider information (such as being a director of a company).
No fiduciary duty (even though director bought from SH). First, Defendant did not buy the shares from
Plaintiff directly they were purchased through a broker and were impersonally traded on the Boston Stock
Exchange. Plaintiff was an intelligent investor. Second, the information did not disclose an absolute
30

certainty that copper would be found, but rather was only an opinion too speculative and would risk
creating false hope.
Public policy for no disclosure here: dont want to burden directors/officers bc then no one of quality
would serve in those positions; dont want to create disincentives for people of wealth; insider trading is a
nice way to compensate corporate insiders; people can figure out the status of the company by seeing if
insiders buy/sell their stock.
SEC v. Texas Gulf Sulfur (TGS Case) (2nd Cir. 1968) (disclose or abstain rule)
Insiders cannot act on material information (information that a reasonable man would deem
important to the value of the stock) until the information is reasonably, publicly disseminated.
MATERIALITY: whether a reasonable investor would attach importance to the info; balance probability
that event will occur AND MAGNITUDE of event in light of the totality of the company activity.
Material facts include: info disclosing the earnings and distributions of comp, and facts which might
affect the desire of investors to buy, sell or hold the comps securities.
Rule 10b-5 based in policy on the justifiable expectation of the securities marketplace that all investors
trading on impersonal exchanges have relatively equal access to material information. Requires equal
footing!
When info is disclosed, there must be a reasonable waiting period during which insiders may not take
advantage of their advance opportunity. (Ex: Cant call broker the second it hits the new stations; you
have to wait until story is complete.)
o Dont focus on it just becoming public; you have to wait until the public absorbs and
disseminate it! Public has to figure out who the source of the info is, if the source is credible,
what the actual info is and how that is relevant to the stock (positive so buy more; or negative so
sell fast).
Misappropriation (OHagan)
Holds that a person commits fraud in connection with a securities transaction, and thereby violates
10(b) and rule 10b-5, when he misappropriates confidential information for securities trading purposes,
in breach of a duty owed to the source of the information/those who entrusted him with the
information. . . . The misappropriation theory premises liability on a fiduciary-turned-traders
deception of those who entrusted him with access to confidential information. BUT if misappropriator
discloses his intent to trade to those whom he does owe a fiduciary dutyin OHagan that would mean
his law firm and the client, there is no breach.
Rule 10b-5(2) Provides a non-exclusive list of three situations in which a person has a duty of
trust or confidence for purposes of the misappropriation theory: 1) when someone agrees to
maintain information in confidence; 2) two people who have a pattern or practice of sharing
confidences such that speaker expects hearer to maintain confidentiality; 3) duty exists when
people receive material nonpublic info from spouse, parent, child, or sibling.
[In the full text of the rule, there is an opportunity to rebut the presumption built into these
relationships that a trust necessarily exists. So the defense attorney can say that the parties have a
history of disloyalty.] Reference to trust or confidence means that there does not necessarily
have to be a fiduciary/legal duty in order for one to be liable under misappropriation theory.

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People who are not employees, officers, or directors of corp (not insiders) but have access
to inside information (temporary/constructive insiders) can be prosecuted just as
insiders can under misappropriation. Look for fiduciary or contractual relationship when
looking for constructive insiders. Ex: outside accountants; attorneys.
FIRST: IS THE INFORMATION MATERIAL?
SECOND: TO WHOM IS A DUTY OWED?
o If to SHs Classical Theory applies.
o If duty is owed to constructive insider, employer, client, or three examples in 10b-5,
Misappropriation Theory applies.
THIRD: DID PARTY DISCLOSE?
o If Classical Theory applies did party disclose information to SHs before trading?
o If Misappropriation Theory applies did party disclose his intent to trade to the party who
entrusted him with information?
US v. OHagan (US 1997)(misappropriation theory)
D was partner at law firm; knew of tender offer bc it was one of their clients and used that knowledge to buy
stocks. Made a lot of $.
SC adopts a misappropriation theory of insider trading, which imposes a duty to abstain or disclose on a
non-fiduciary outsider with no tipper. This gives rise to a duty to abstain or disclose to the source of the
information the intention to trade on the information. If partner had told the firm and the client of his intent
to buy stock, then no problem. (This wouldnt happen in real life bc state law would interfere.)
MISAPPROPRIATION THEORY OF INSIDER TRADING MAKES UNLAWFUL TRADING ON
MATERIAL NONPUBLIC INFORMATION IN BREACH OF A DUTY OF TRUST OR
CONFIDENCE OWED TO THE SOURCE OF THE INFORMATION
Call options represent to the court that you had insider knowledge. Bad fact; must plea out.
United States v. Chestman (US 1992) - To be liable as an aider and abettor under the misappropriation
theory, the tipper must owe a fiduciary duty of confidentiality to the corporation and the aider and abettor
must know of the tippers breach of fiduciary duty. Here, husband owed no fiduciary duty of confidentiality
to the wife or her family. In response to this case, the SEC enacted the following:
10b5-2(b) Enumerated duties of trust or confidence
1) Whenever a person agrees to maintain information in confidence.
2) Whenever[there is] a history, pattern, or practice of sharing confidences
3) Whenever a person receives or obtains material nonpublic information from his or her spouse,
parent, child, or sibling.
Note: Can rebut by saying that there was a history of deception & mistrust.

Tipping (Dirks case)


If insider cant use inside info, they cant simply give it to an outsider to trade it on.
In Dirks the Court held that Secrest (former Equity Funding employee who tipped Dirks off as to fraud
in the companys books), as an insider, was not liable under tipper theory because he did not gain a
32

benefit from the tip, even though he did owe a fiduciary duty to Equity SHs. Therefore, Dirks, who was
neither insider nor temporary insider, but rather a third party investment analyst, could not be held
derivatively liable. In the absence of a breach of duty to SHs by the insiders, there was no derivative
breach by Dirks.
Test for Tipper (one who discloses) Liability
1) Did the defendant breach a duty of loyalty by disclosing the information (and thereby gain an
improper personal benefit)?
2) Did the defendant know [for criminal actions] or have reason to know/should have known that the
tippee in question would use the information to trade?
**10b-5 doesnt bar trading on information inadvertently revealed by an insider, so duty of care breach
by tipper is not sufficient for tipper liability.
Test for Tippee (one who receives information) Liability
1) Did the primary tipper breach a duty of loyalty by disclosing the information (and thereby gain an
improper personal benefit)?
Best arg as defense attorney: tipper was trying to disclose fraud; then tipper was motivated by
altruistic motiveno economic benefit, no social or reputational benefit.
A benefit is much broader than immediate financial gain; includes either immediate or delayed
financial gain (promise to get financial benefit years later in exchange for giving the tip); can
also include conveyance of a gift where there is either an implicit or explicit expectation of
future or current benefitidea that either financial or reputational benefit or friendship
developing will be reaped from giving the tip. Court in Dirks doesnt see emotional benefit as a
gain.
2) Did the defendant know [for criminal actions], or should have known that the information was
obtained in breach of a duty?
* Both prongs have to be demonstrated to ferret out liability. There cannot be tippee liability without
tipper liability.
Note: The more attenuated the tippee gets from the original tipper, the easier it is to prove that the tippee
did not know that the information was revealed in breach.
Hypo: College football coach was attending track meet to watch his son compete. CEO of oil and
gas company was there too. Coach was laying down on bleacher seats and overheard the CEO tell
his wife that he was going to be having a busy week and would be difficult to reach bc a subsidiary
was going to be either sold or taken over. Coach told his friends what he heard and they all placed
orders for shares in the subsidiary oil and gas company. Does the coach have any liability here?
o No duty and thus no liability under the Classical Theory
o Misappropriation Theory there was no duty to the CEO
o Tippee Liability (1) The original tipper (CEO) did not breach a duty by disclosing the info
to his wife bc he just disclosed it for the purposes of letting her know that he would be busy,
and he did not gain an improper personal benefit. Bc this is a conjunctive test, and prong 1
fails, the test will fail.
Personal benefit/gain if its not specified that it needs to be pecuniary, then anything can be a gain
(good reputation, revenge, etc.)
33

Dirks v. SEC (US 1983)(tipper/tippee liability)


Facts: D was told allegations of fraud by tipper, investigated and tried to expose it to WSJ. They didnt
bite. No liability bc tippe didnt get anything out of it. Here, the tippee was not breaching any duty by
reporting real fraud, so D could not be derivatively liable.
A tippees duty only arises when the info is conveyed improperly by an insider, i.e., when the insider-tipper
has breached their own fiduciary duty to the corporation.
TIPPEES DUTY IS DERIVATIVE OF THE TIPPERS DUTY, AND ACTUAL OR
CONSTRUCTIVE KNOWLEDGE OF TIPPERS BREACH IMPOSES TIPPEE LIABILITY
10b5-1(a) manipulative or deceptive devices prohibited by 10(b) include, the purchase or
sale of a security of any issuer, on the basis of material nonpublic information about that security or
issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the
issuer of that security.
SEC Rule 14e-3 (SECs response to Chiarella loss) (TENDER OFFERS)
Prohibits trading on undisclosed information where any person has taken a substantial step or steps to
commence, or has commenced a tender offer, even if there is no duty.
This rule is sweeping because it dispenses with the duty requirement, but is limiting in that it only
applies to tender offers!!! Not mergers, not TGS situation, etc.
Courts have interpreted substantial step broadly. Ex: when acquiring company retains a law
firm to work on the tender offer; when the offering person hires an investment banking firm;
entering into a confidentiality agreement with the issuer or some other source of information
with the issuer.
Chiarella v. United States (US 1980)(Duty requirement to impose insider trading liability)
The SC held that Chiarella was not an insider of the target corporation and received no confidential info
from the target company, thus he had no duty to the company of which he traded shares. The duty to
abstain or disclose arises from the relationship of trust between a corporations shareholders and its
employees. A purchaser of stock who has no duty to a prospective seller because he is neither an insider
nor a fiduciary has been held to have no obligation to reveal material facts.
INSIDER TRADING LIABILITY REQUIRES THE EXISTENCE OF A DUTY
SEC Response to Chiarella (No duty required herevery sweeping; ONLY tender offers; not mergers)
SEC RULE 14e-3(a) (TENDER OFFER) If any person has taken a substantial step or steps to
commence a tender offer, it is DECEPTIVE for any other person who is in possession of material
information relating to such tender offer which information he knows or has reason to know is nonpublic
and which he knows or has reason to know has been acquired directly or indirectly from 1) the offering
person 2) the issuer of securities 3) any insider of the offering person or issuer.
Not just any tender offer; it has limits. It is not triggered until the tender offeror has taken substantial
steps into making an offer.
34

o Substantial step hiring investment bank to look into finances; hiring law firm; drafting documents
(similar to our analysis of whether a merger would occur)

ACQUISITION OF CONTROL
3 Methods of Acquisition of Control
1) Proxy fights for control over BoDs
2) Mergers
3) The Hostile Takeover conducted via the device known as the tender offer.

Proxy Fights and Proxy Rules


Note: Proxy agent SH sends to vote on SHs behalf at SH mtgs. Proxy card the document by which
the SH appoints the agent. Bc outcome of SH mtgs depends on the most votes, the person with the most
proxies usually wins. Generally, incumbent managers of a large firm will solicit proxies from SHs directly.
Shortly before an annual mtg, they will write to the SHs and ask them to sign and return the enclosed proxy
cardauthorizing the management to vote on the SHs behalf. Proxy fights result when an insurgent
group tries to oust incumbent managers by soliciting proxy cards and electing its own reps to the BoD.
Proxy fights are subject to the 1934 Sec Ex Act and to state corporate statutes.
Reimbursement of costs for proxy fight (state law issue, not regulated by SEC)
Levin v. MGM (SDNY 1967) (strategic use of proxy fighting)
INCUMBENT DIRECTORS MAY SPEND REASONABLE CORPORATE FUNDS AND EXPLOIT
INTANGIBLE RESOURCES (e.g. goodwill) IN REPELLING AN INSURGENT, BUT CANNOT BE
EXCESSIVE, UNFAIR OR ILLEGAL; Proxy statement must disclose expenditures.
Ct overlooks the clear conflict of interests that directors have in keeping their jobs because of the supreme
importance of directors communicating with SHs, and because of deference to the BJ of managers
(adherence to the BJR).
SHs vote on: (1) mergers and consolidations; (2) sale of all or substantially all the assets of the company;
(3) dissolution of a company; (4) changes to the certificate of incorporation; (5) SHs have the right to elect
directors. NOTE: All of these things have to be approved first by the executive officers and the BoD, then
recommended to SHs.
Problems on p. 520
Rosenfeld v. Fairchild Engine & Airplane Corp. (NY 1955) (victorious insurgents get reimbursed only w
SH approval; incumbents get reimbursement even if they lose)
AS LONG AS PROXY DISPUTE IS OVER A BONA FIDE POLICY CONTEST (not a personal
power contest), DIRECTORS MAY REIMBURSE REASONABLE EXPENSES IN DEFENDING,
AND MAY ALSO REIMBURSE SUCCESSFUL CHALLENGERS (if SHs approve)
DGC 113 ALLOWS FOR REIMBURSEMENT OF PROXY CONTEST COSTS
35

Problem on page 527


o Kane Is there mixed motive yes. Purely personal? - likely not. Prob reasonable under BJR.
o Geddes if he wins, he will likely get reimbursement. But if he loses, under current rules, he will
not get reimbursement no matter how honest his fight was.
Summary of Rules from Prof (class notes):
A corp may only reimburse either party (incumbent or challenger) if the dispute concerns questions of
policy, as opposed to a purely personal power contest.
A corp may only reimburse only reasonable and proper expenses. But the reas and proper is construed
very broadly.
A corp may reimburse incumbents whether they win or lose.
The firm may reimburse insurgents (challengers) ONLY IF they win and ONLY IF the SH ratify the
payment.
Shareholder Proposals: SEC Rule 14a-8** (ON EXAM) Only applies to publicly traded companies!
14a-8: Permits individual SHs to place proposals before the entire body of SHs through the corps proxy
statement, which would contain SHs proposal and 500 word essay that the SH can provide. SH must be
eligible & follow certain procedures.
[Corp can exclude SH proposal ONLY AFTER submitting its reasons to the Commission.]
(1) What is a proposal? The recommendation or requirement that you the company/its BoD take action
which you intend to present at the mtg. Should clearly state the action you want the Comp to follow. If
proposal is placed on proxy card, SHs must have option to: approve, disapprove, abstain.
(2) Eligibility to submit proposal. SH who holds at least $2,000 in value or 1% of stock at the mtg and have
held them for at least 1 YEAR.
(3) Number of proposals allowed to submit. No more than 1 for a particular SHs mtg.
(4) Length of proposal. Proposal INCLUDING accompanying supporting statement may not exceed 500
WORDS.
(5) . . . missing . . .
(6) Failure to follow the above requirements. Comp may exclude your proposal ONLY AFTER it has
notified you of the problem and you have failed to correct it. Comp must notify you of any eligibility
probs w/i 14 days of receiving your proposal and must provide timeframe for your response. You must
respond w/i 14 days of receiving comps notification.
a. Note: If you fail to submit a deficiency that cant be remedied (ex: fail to submit proposal by
deadline), Comp doesnt have to notify you.
b. If Comp excludes your proposal, it will make submission under Rule 14a-8 and provide you w/
copy. (See Q10)
(7) Burden of persuading Commission/staff that proposal can be excluded. Buren is on Comp to
demonstrate that it is entitled to exclude proposal.
(8) Must I appear personally at the SHs mtg to present the proposal?
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a. You OR representative (qualified under state law to present proposal on your behalf) MUST
attend mtg.
b. If Comp holds SH mtg in whole or in part via electronic media and permits you or your rep to
present proposal via such media, then you can just appear through electronic media.
c. If you/your rep fail to appear without good cause, Comp can exclude your proposal for 2
calendar years.
(9) If I have complied with the procedural requirements, on what other bases may a company rely to
exclude my proposal?
a. Improper under state law if proposal is not a proper subject for action by SHs in jurisdiction
of Comps org.
i. [Note: depending on subject matter, some proposals that bind the company after the SH
vote are improper. Generally, proposals drafted as recommendations/suggestions are
proper unless Comp demonstrates otherwise.]
b. Violation of law If proposal, if implemented, would cause Comp to violate any state, federal,
or foreign law to which it is subject. [Note: Cant use this in cases where compliance w/ foreign
law violates state/federal law.]
c. Violation of proxy rules violates proxy rules, including prohibition of false/misleading
statements in proxy soliciting materials as per Rule 14a-9.
d. Personal grievance; special interest Proposal cant relate to redress of a personal claim or
grievance against the Comp or any other person; proposal cant be designed to result in a benefit
to you or to further a personal interest that is not shared by the other SHs at large.
e. Relevance If proposal is not significantly related to the comps business; relates to less than
5% of comps total assets at the end of its most recent fiscal year; less than 5% of its net earnings
and gross sales for its most recent fiscal year.
i. See Lovenheim case below allowing proposal relating to social/ethical issues even
though matter comprised of less than 5%.
f. Absence of power/authority if comp would lack power/authority to implement proposal.
g. Management Functions If proposal deals w/ matter relating to the comps ordinary biz
operations (kind of BJR)
h. Director Elections If the proposal: (1) disqualifies nominee standing for election; (2) removes
director from office before term expires; (3) questions competence, BJ, or character of
nominees/directors; (4) seeks to include a specific individual in the comps proxy materials for
election to the BoD; OR (5) could otherwise affect outcome of upcoming election of directors.
i. Fate of the relates to election exception: AS IT STANDS, WE HAVE COMPANYBY-COMPANY APPROACH TO SH ACCESS TO PROXY PROPOSALS.
i. Conflicts w/ Comps Proposal If proposal directly conflicts w/ the Comps own proposals to
SHs. [Company needs to specify points of conflict when trying to exclude proposal.]
j. Substantially Implemented If comp has already substantially implemented proposal.
k. Duplication if proposal substantially duplicates another proposal to be voted on in the same
mtg.
l. Resubmissions deals w substantially same issue as another proposal included in the comps
proxy materials w/ the preceding 5 calendar years; comp may exclude it from any mtg held w/i 3
calendar ys of the last time it was included if the proposal received: (1) less than 3% of vote if
37

proposed once w/i preceding 5 ys; (2) less than 6% of the vote on its last submission if proposed
twice w/i 5 ys; (3) less than 10% of the vote on its last submission if proposed 3 times or more
w/i last 5 ys.
m. Specific Amount of Dividends If proposal relates to specific amounts of cash or stock
dividends.
(10)
Procedures comp must follow to exclude proposal. Comp must file reasons w Commission (and
send copy to you) at least 80 days before it files its proxy w Commission. Commission can allow even
before 80 days if comp shows good cause for missing deadline. Comp must file 6 paper copies of: (1)
proposal; (2) explanation for exclusion that refers to the most recent applicable authority; (3) supporting
lawyer opinion if exclusion reason based on state/foreign law.
(11)
Can I respond to Companys request for exclusion? Yes, but not required. Need 6 copies of
your response.
(12)
If Comp includes proposal in proxy materials, what info about the proposing SH must it include
w proposal itself? Proposing SHs name, address, & voting shares. If comp chooses to, it may not
provide this info but make it available upon other SHs request.
(13)
If comp includes in its proxy statements reasons why SHs should vote against proposal. Comp
has right to provide its reasons against your proposal. BUT, if comps statement has materially false or
misleading info that could violate SECs anti-fraud statute, then you can write to Commission and
explain your reasons w as many facts and supporting docs as possible; you may also try to resolve
matter w comp.
a. Thats why SEC makes comp provide you w copies of its statements opposing your proposal, so
you can see if any of the statements are false.
SEC refuses to allow SH nominees to be placed in a companys proxy materials!!!! Companies may
decide to allow SH nominees to be placed in the companys proxy materials. Now we have a
company-by-company approach to proxy access.
Role of SEC: The burden is on corp to show that the proposal falls under the grounds for exclusion. What
are grounds for exclusion? 13 separate grounds. SEC will review and issue a letter for inclusion. OR, it
may side with comp and issue a No Action letter that the comp can exclude it.
SH proposals fall into 2 major categories:
1) Corporate social responsibility - social/environmental justice
Proposals for corp to take responsibility for environmental impact; proposals to increase diversity of
board; anything to do with social justice
1968 Medical Committee for Human Rights v. SEC- court ruled that 14a-8 is important device for
SH democracy and control of management.
Lovenheim v. Iroquis Brands, Ltd.- set standard for allowing social justice proposals
Given the low rate of social justice proposals, why do SHs bother to submit them? Consciousness
raising value - highlight issues that you care about and make people aware of them (even if you
ultimately wont win).
If these proposals hardly ever pass, why does management bother to resist them? Bc the association
with an alleged social or environmental injustice could ruin a comps good reputation. Comps fight
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them as a matter of policy bc if they dont, then other SHs will be encouraged to keep submitting
proposals; they want to deter proposals.
2) Corporate governance proposals relate to how firm is managed and to structure of firm
o often: proposal for an independent chairman of the board and CEO of the company
o pushes for annual election of entire board of directors
o proposals that directors should see a majority vote or they dont get elected, rather than plurality
o post Citizens United proposals that call for greater disclosure of political expenditures
o by-laws requiring SH approval of corp political expenditures
o proposals to separate roles of President and CEO, etc.
o proposals to de-classify the board (so that all directors are up for reelection at the same time)
Lovenheim v. Iroquis Brands, Ltd. (DDC 1985) (significantly related = not limited to $ significance/can
be ethical/social issues; thus, can be less than 5% of assets/profits and still be significantly related & eligible
for proxy proposal)(SH of chicken liver production comp was against animal cruelty)
Otherwise significantly related to the issuers business encompasses proposals that are related to ethical
and social issues that are significantly related to the issuers business as demonstrated on the face of the
resolution or supporting statements. [T]he meaning of significantly related is not limited to economic
significance.
Note: A SH proxy can have as its sole purpose social stuff. SH inspection rights/access to books and
records cannot.
AFSCME v. AIG , Inc. (2d Cir. 2006) OVERRULED BY SEC AMENDMENT 14a-8(i)(8) Exception:
Makes excludable SH proxy materials that relate to an election. NOW COMP-BY-COMP RULES.
Holding: Proxy bylaw proposals are non-excludable under Rule 14a-8(i)(8) (even if relate to an election),
based upon SEC interpretation of its own regulations, which defined the relates to an election exclusion
narrowly to refer to a particular election, rather than SH proposals dealing with matters such as cumulative
voting and general director requirements, and such issues are the province of the SEC, not the Court.
Shareholder Inspection Rights
Because a SH cannot require the corp to include his slate in its solicitation materials, it will need to do its
own proxy solicitation. Under Rule 14a-7, the corp can choose to either mail your material and bill you for
the costs or give you the SH list. SH list is valuable, because then you will know who the big players are
and how to spend time contacting. Inspection rights are also important outside of proxy fights. DE courts
have encouraged SHs to use 220 of DE law allowing for inspection prior to filing a derivative suit to get
evidence. Same goes with SHs accusing directors of fraud. Access may be important to SH seeking to
acquire control of the company through a tender offer.
DE Law on Inspection Rights, Section 220: Any SH shall, upon written demand under oath stating the
purpose thereof, have the right during the usual hours of business to inspect for any proper purpose the
corps stock ledger, a list of its SH, and its other books and records, to make copies or extracts therefrom. A
proper purpose shall mean a purpose reasonably related to such persons interest as a stockholder.
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And if a corp refuses to allow this, the SH has the right to go to the Chancery Ct to compel inspection.
In a suit to get access to a SHs list, the corp must prove that the SH has an improper purpose
burden on corp.
A different burden of proof applies to books and records burden is on the SH to show that they
have a proper purpose.
A SH can put forward more than one purpose, but the primary purpose in DE has to be one that is
germane to investment return/an economic interest.
Crane Co. v. Anaconda (NY 1976) (tender offer = proper purpose; SH who makes tender offer can get SH
list and selectively and directly approach other SHs who want to sell their stock)
When state statutes require SHs who are seeking access to SH list a proper purpose for condition of access,
the desire to take over a company qualifies as a proper purpose, because a tender offer will affect the
future of the company and also the continued vitality of the SHs investment.
A selective and direct approach to other SHs by one SH who wants to make a tender offer is not improper.
Rule rooted in property rights of SHs in their stock and the protection of that interest; SHs want to hear
more about the possibility of a tender offer bc it affects their stocks value.
Pillsbury v. Honeywell, Inc. (Minn. 1971) (pushing one SHs political agenda like being anti-war = not
proper purpose for records)
(Based on DGCL 220) Where petitioner admitted that he bought the stock for the sole purpose of pushing
his political agenda (didnt want comp to make war materials bc he was against Vietnam war) irrespective
of the economic consequence to the corp, and where he was not interested in the long-term well being of
corp nor the enhancement of the value of his shares, he did not have a bona fide interest in access = not
proper purpose. Proper purpose generally related to the $ interest of SHs.
Freeze-Out/Cash Out Mergers (always friendly)(going private merger)
Remember: Mergers must be approved by both boards and the SHs of both corps.
Weinberger v. UOP, Inc. (DE 1983) (DUTY OF COMPLETE CANDOR when parent tries to buy out min
SH of subsidiary)
(Challenges SH vote to approve merger on the grounds that material information was never disclosed to
minority SHs, such as a report to Signal that a higher price was fair, and the conflict of interest between
the directors of the boards)
PARENT CORPORATION OWES DUTY OF COMPLETE CANDOR TO SUBSIDIARY;
REQUIRES DISCLOSURE OF ALL MATERIAL INFO
WHERE A DOMINANT PARENT CORPORATION SEEKS TO BUY OUT THE MINORITY
SHs IN SUBSIDIARY, IT IS SELF-INTERESTED AND ON BOTH SIDES OF THE
TRANSACTION

MUST SHOW INHERENT FAIRNESS:


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1) FAIR DEALING (duty of candor, time constraints, disclosures made, meaningful negotiation)
a. Duty of Candor - duty to disclose all information a reasonable SH would consider important
in determining whether to sell his stock
2) FAIR PRICE (using methods generally acceptable in the financial community to compute offer
price)
BURDEN STARTS ON P TO POINT OUT SELF-INTEREST OR UNFAIRNESS; BURDEN THEN
SHIFTS TO D TO SHOW INHERENT FAIRNESS
BUT
BURDEN STAYS ON P IF APPROVED BY AN INFORMED VOTE OF MINORITY SHs
So in a situation like this, you want a sub-committee of fully independent directors to negotiate and perform
a valuation. Then their decision is disclosed to the shareholders, and once approved by them, everyone is
protected. Anyone with a conflict of interest (dual directorship) should have recused themselves.
Ct asks what would have happened had Signal appointed a committee of independent directors (of UOP
who had no connection to Signal)? Brought up on FN 7 of case on page 711. Would that have changed the
test that the court applied here?
o The standard would still be fairness, but the burden would be on the minority SHs to prove it was
unfair. If there is either approval of the majority of the minority SHs on an informed basis of the
proposed merger OR if there is negotiation of an independent committee of directors working on
behalf of minority SHs either of these will shift the burden of proof from the majority or the
minority SH to prove that the merger was unfair.
How would you advise clients to avoid the Weinberger problem? Get people with a conflict of interest
(those with dual positions, etc.) to recuse themselves and be walled off from the transaction; set up
independent committee to look into the share price that would be fair; create feasibility report and provide it
to the directors prior to the vote so they can use the report in their consideration.
Classic Mergers
Companies A and B want to merge. A and B are both known as constituent companies (companies that
somehow are merged into each other). You have to follow the laws of both incorporating states (if
incorporated in different states).
TO MERGE IN DE: (1) a plan of merger has to be drafted specifying deals terms and conditions (and
DE has statues that describe what is needed); (2) plan of merger has to be approved by the BoD of each
company, and each BoD has to recommend it the SHs of both of those constituent companies; (3) plan of
merger has to be approved by SHs of each constituent company (need majority of ALL shares, not the
majority of only those who vote!!)a proxy statement has to be sent to all SHs along with a proxy card
(this is the step where lawyers are the most involved); (4) the articles of merger (assuming they are
approved by both SHs) have to be filed with the requisite state agency (in DE its the Secretary of State).
After the merger, only one company will survive. So, the surviving company (A or B) will succeed by
operation of law all of the rights, obligations, liabilities, assets, debts, etc of BOTH A and B.
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Triangular Merger (see drawing on page 706)


The ultimate company (A) will create a shell company and put in only what assets it needs to get B (cash,
stock, etc). So the constitutent companies here: B and shell company. These two will merge together (if
you merge target into the shell company = forward merger and shell company survives; or shell company
is merged into B = reverse merger and B is the survivor company). IMPORTANT: only the target
company here (B) needs to have SH vote on the merger. A (the ultimate acquiring company) does not
need to have its SHs to vote on the merger bc it is acquiring it through the shell company. A will have
the BoD sign a resolution saying we resolve that A will acquire/merge with B. this is much easier
than having all the SHs vote/agree.

TAKEOVERS VIA THE TENDER OFFER (HOSTILE OR FRIENDLY)


When we study takeovers Really the question is what kind of defenses can incumbent managers of a
corp take with respect to a hostile takeovers without violating the fiduciary duties to their SHs.
Themes repeated in the takeover section:
(1) duty of care and loyalty;
(2) protecting managements authority to manage corp and its discretion v. accountability to SHs in
takeover context, the question is: should the response to an unsolicited bid for a bid be something decided
by the BoD, or should it be a decision for the SH? Academics think its a question for the SH to make the
BoD accountable to the SH and to reduce the opportunity for the BoD to act in an opportunistic and selfdealing manner.
(3) Debate of role & purpose of corporation in American society and the theories of the corp such as: (a)
Aggregate Theory; (b) Artificial Entity Theory; (c) Real or Separate Entity Theory.
When it comes to hostile take-over cases, Courts look carefully at behavior of incumbent directors of target
board to ensure that they are acting in the best interest of the company rather than acting to perpetuate
themselves in office.
Tender offer: A public offer by an acquirer to the SHs of a target company, asking them to tender (to sell)
their shares at a specified price and during a specified time period. Usually conditioned on the tendering of
a minimum and maximum number of shares, and if that doesnt happen, the offeror can withdraw the offer.
Key feature: the acquiring entity or person contacts SHs directly. Tender offers can be hostile or friendly,
while mergers are always friendly. Diff from mergers whre the offeror approaches BoD and SHs vote after
BoD recommends merger.
Tender offer procedural rulesfederal rules:
1) Anyone who either singly or as part of a group (in other words, three people cannot each agree to buy
4.99%- the SEC aggregates each of the person in the entitys shares) acquires 5% of the stock of a
company, must identify himself with the SEC.
a. Prevents creeping tender offers where acquiring company sneaks up on incumbent board,
gaining a little bit of stock here or there. Also, after acquiring 5%, the person has 10 calendar
days in which to file notice, and can continue to acquire shares during this time- so in other
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words, a person can acquire more than 5% during the 10 calendar days following his acquisition
of the 5%.
2) Anyone making a tender offer must also file an elaborate and very expensive set of disclosure documents
that get sent to SHs and filed with the SEC, including what kinds of funding they will use to provide
consideration for the tender offer, etc.
3) Any acquirer who raises his or her price during the term of the tender offer must reimburse the earlier
SHs.
4) Offeror must accept stock on a pro-rata basis (in proportion to the number of shares that are tendered. If
they want to acquire 51%, must take 51% of stock that each person tries to tender.)
5) Any tender offeror must hold the tender offer open for 20 business days (about a month).
This is only a minimum. If offeror increases price at any point, you have to add 10 more business days.
Defensive Measures
Cheff v. Mathes (DE 1964)(GREENMAIL corp buys potential acquirers stock at a premium & selftender = ok if brd wants to maintain proper biz practices) (case with salesmen as part of biz)
VARIATION ON THE BJR IN THE CONTEXT OF A HOSTILE TAKEOVER: PRIMARY
PURPOSE MUST BE CORPORATE INTEREST, NOT ENTRENCHMENT
TEST: Can BoD show reasonable grounds to believe a danger to corporate policy and effectiveness
existed? Must show good faith and reasonable investigation. (p. 745)
If the actions of the board (in buying back their shares from a SH who they feared would take over the
corp) were motivated by a sincere belief that the buying out of the dissident stockholder was necessary to
maintain what the board believed to be proper business practices, the board will not be held liable for such
decision, even though hindsight indicates that the decision was not the wisest course. On the other hand, if
the board has acted solely or primarily because of the desire to perpetuate themselves in office, the use of
corporate funds for such purposes is improper.
Incumbent directors of the target company did not violate a duty of loyalty to SHs by buying back their
own stock at a greater than market price to prevent that shareholder from taking control where evidence
suggests that they did so upon the good-faith belief that Maremount would liquidate the company or change
the business model. Moreover, directors did not err in paying above-market value for Maremounts shares,
as they were paying for a premium.
Note: Greenmail- the purchase by a corporation of a potential acquirers stock at a premium over the
market price. Greenmail is considered a very crude technique to prevent takeover. The IRS imposes a
penalty tax of 50% on the gain from greenmail.
Unocal Corp. v. Mesa Petroleum (DE 1985)(Test for determining if takeover defense is proper) (Selftender Okay here but NOW PROHIBITED BY SEC)
Facts: Mesa owned 13% of Unocal stock, and came out with a two-tier front-loaded tender offer for the
rest. The entire board met and accepted the independent subcommittees recommendation, unanimously
approving the self-tender at $72, with restrictive covenants on activity and details on the debt securities
issued to finance the move. They also agreed that should Mesa succeed in its first tier, Unocal would also
buy the remaining 49% from shareholders with non-subordinated debt securities worth $72, and would
exclude Mesa from that offer.
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The court supported Unocals defensive measures, including the Mesa Exclusion. A corporation may
institute defensive measures in order to combat a takeover attempt that it determines in good faith is
inadequate and coercive, especially when the determination is made by independent outside directors;
essentially the same modified business judgment rule found in Cheff.
UNOCAL TEST
FOR DETERMINING WHETHER A DEFENSE TO A TAKEOVER WAS PROPER.
Threshold showing by Directors of the Target that:
1) They had reasonable grounds for believing that a danger to corporate policy and
effectiveness existed . . . This is proved by showing:
A) Good Faith desire to protect the corporate enterprise (not to retain control of the
company); and
B) Reasonable Investigation
o into: inadequacy of the price offered, nature and timing of the offer, questions of
illegality, the impact on constituencies other than SHs, the risk of non-consummation,
and the quality of securities being offered in the exchange (here: junk bonds).
C) Outside director approval will materially enhance boards ability to show both A
and B.
[In this prong the Court essentially affirms the Cheff test.]
2) Balance: The responsive action taken is reasonable in relation to the threat posed.
[Directors are likely to overreact when the future of their company is threatened.] Thus, board even
acting in good faith and with reasonable investigation can go too far in implementing an extreme
measure.
If directors of target satisfy this two-part test BJR.
BUT
SEC RULE 13e-4(f)(8) NOW PROHIBITS DISCRIMINATORY SELF-TENDERS!!
POISON PILLS know that they are effective; a change in the comps stock plan to make the corp
unattractive to the buyer; does not destroy the target comp (despite its name), but increases costs to
aggressor so that it is burdened if takeover succeeds.
Omnicare Extension of Unocal Test to Negotiated Acquisitions
(1) Reasonable grounds for believing danger to corp (ie. Loss of merger)?
(2) Proportionality?
a. A measure is coercive if designed to force a management-favored transaction on SHs.
b. A measure preclusive if designed to preclude another potential acquirer from bidding.
c. Defensive measures that protect a merger may be unenforceable unless they contain a fiduciary
out clause that allows a board to exercise its own fiduciary obligations when required (such as
when it receives a superior offer).
Revlon (dont read; know holding)
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The moment where the board of directors authorized management to negotiate a merger or buyout with the
third party was a recognition that the company was up for sale, and the point at which it became clear that
the existing SHs were going to be cashed out, the board stepped into Revlon territory and had the duty to
maximize profits for SHs. However, the companys self-tender offer and poison pill occurred before this
threshold moment, and thus are subject to a Unocal analysis.
Note: For sale has been narrowed and refined by the Court.
ONCE A BIDDING SITUATION IS TRIGGERED, THE BOARD HAS A DUTY TO MAXIMIZE
THE PAYOUT TO THE CORPORATIONS EQUITY INVESTORS AUCTIONEERING DUTY
(once sale becomes inevitable)
CLASS: Divide into TIME SLICES of when the company was resisting a tender offer v. when it
became clear that the break-up of the company is inevitable.
Paramount I v. Time (DE 1989) (clarifies when Revlon duties are triggered; here, Revlon doesnt apply-fluid aggregation of unaffiliated SHs)(NO SALE OF CONTROL here; Time would still be in control)
Here, ct determines that Time was not for sale simply because it was to merge with Warner, because it
was not giving up its continued existence. Thus, Revlon duties did not attach, and Times board had no
obligation to pursue or entertain Paramounts $200 offer. Rather, Times new deal with Warner was to be
analyzed under Unocal as defensive measures. Times board survives Unocal scrutiny, based on the
perception that the Warner deal was necessary to preserve Times culture and integrity. Time was not
obligated to abandon its carefully conceived plans for short-term SH gain.
Revlon duties are not triggered merely because a corp is in play or up for sale.
Two circumstances trigger Revlon duties:
(1) when a corporation initiates an active bidding process seeking to sell itself or to effect a
business reorganization involving a clear break-up of the company; and
(2) in response to a bidders offer, a target abandons its long-term strategy and seeks an
alternative transaction involving the break-up of the company.
If, however, the boards reaction to a hostile tender offer is found to constitute only a defensive
response and not an abandonment of the corporations continued existence, Revlon duties are not
triggered, though Unocal duties attach.
AS A GENERAL RULE, AN AGREEMENT TO UNDERTAKE A STOCK FOR STOCK MERGER
BETWEEN TWO PUBLIC COMPANIES, PURSUANT TO A STRATEGIC VISION OR PLAN, DOES
NOT TRIGGER REVLON DUTIES TO MAXIMIZE RETURNS TO SHs BECAUSE CONTROL
REMAINS IN THE MARKET, WITH THE FLUID AGGREGATE OF SHs.
Paramount II (QVC) (DE 1994) (specifies even more when Revlon duties will apply, also involved a
friendly stock for stock merger which a third party tried to interrupt)(here, control would change to 1 SH)
ENHANCED SCRUTINY WHEN:
1) APPROVAL OF A TRANSACTION RESULTING IN SALE OF CONTROL (bidding war,
inevitable dissolution/break-up, reorganization, or change in control from a fluid aggregation of
shareholders to an entity dominated by a sole shareholder) (Revlon)
OR
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2) ADOPTION OF DEFENSIVE MEASURES IN RESPONSE TO EXTERNAL THREAT TO


CORPORATE CONTROL (inherent conflict of interest) (Unocal)
ENHANCED SCRUTINY REQUIRES:
1) Judicial determination regarding adequacy of the decision-making process reasonable
investigation
2) Judicial examination of the reasonableness of directors action (not perfect, but within a range of
reasonable alternatives) (not preclusive or coercive)
In maximizing SH value, the board does NOT have to choose the company that offers the highest bid. In a
sale of control context, the directors must focus on the primary objective of getting the SHs the best value
reasonably available to them, where value takes into consideration such things as financing, bidder
identity, bidders plans. Directors do not have to choose the perfect option, as long as they can show that
they made reasonable efforts to select one of several reasonable alternatives. Moreover, directors are NOT
required to conduct an auction to satisfy Revlon. Rather, directors can rely on reasonable means to secure
the best value, including their own expertise of the market.
Defensive measures in Paramount II
o (1) No shop agreement Paramount board agrees that it wont discuss or negotiate or pursue other
bidders (unless the other bidders give them a final offer in writing).
o (2) $100 termination fee to discourage target from terminating agreement, and its reasonable bc
the acquiring company may have lost other opportunities.
o (3) Lock-up stock option agreement that gave Viacom the option to buy 19.9% of Paramounts
shares with junk securities (Note Feature) and could require Paramount to pay Viacom the difference
between the market price and the sale price (Put Feature), which was not capped and had the
potential to rise to unreasonable levels once bidding started Problem: no cap here.
o Ct invalidated the three defensive measures bc it was a sale of control.
Lyondell Chemical Company v. Ryan (DE 2009)(Revlon duties dont attach when company perceived to
be in play; only when comp is actually negotiating for sale of control)
Facts: Revlon duties did not attach simply by the perception that the company was in play, and also imposes
no specific course of conduct. Revlon duties didnt attach when Blavatnik filed the 13D; they attached when
he began actually negotiating for the sale of the company to him, wherein hed control. There is only one
Revlon duty to get the best price for the stockholders at a sale of the company. Breach of loyalty/bad
faith is only achieved by a knowing disregard of duties, i.e. utter failure to attempt to get the best price.
Where DGCL 102(b)(7) protects directors from monetary liability for breach of the duty of care, a plaintiff
trying to show breach of the duty of loyalty in respect to Revlon duties cannot show bad faith without a
showing that a director consciously disregard her known duty to act.
P. 804 Just how incompetent would Lyondells board of directors have been in order to have knowingly
and competently failed to undertake their responsibilities? The implication here is that bc of the
exculpatory provision is that the facts would have to be pretty egregious for the Ps to win a claim, bc bad
faith is a very high standard that involves knowing, not just negligence or bad judgment.
Problem # 3 on page 805:
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o (a): Maybe: Bc theyre in dire financial strains, then it is likely that they will take this offer. That
will likely trigger Revlon duties. Counter arg: P is only acquiring 35% of the Shares and only 3/9
members of the board. Thus, no control.
o (b): Yes, or probably yes. Here the issue is control of the BoD but not 50% of stock. Yes, Revlon
duties are triggered bc they are controlling the BoD. In general, the power to manage and elect the
BoD is very supportive of control of a crop.
o (c): If its a typical public company that has a dispersed group of SHs (rather than a main controlling
SH), then yes, the answers to A and B should change because: when two public companies combine
to create an entity, then there is not change of control bc the control of both companies was in the
public market. (Paramount I and II).
o (d): Yes, Revlon duties are triggered bc then they would be embarking on a transaction to change
control (bc its a private equity fund, not just that the comp is in play).

ANTI-TAKEOVER LEGISLATION (State v. Federal)


CTS Corp v. Dynamics Corp of America (US 1987)
- The Williams Act opened up the arena of regulating tender offers
- Many state laws have more stringent guidelines than the Williams Act
- Issues in this case preemption and violation of the Commerce Clause
- So long as state legislation does not alter the basic neutrality of the Williams Act or impose burdens that
conflict with the Williams Act regulations
- Court overturns a well-known decision by Judge Posner
o Market for corporate control the idea that this market needs to be protected from interference of
the state was proposed by Posner, but the Supreme Court does not accept it here
- Court lays out the power of states to control corporate law and regulate them as they see fit
- The Williams Act is one about neutrality, does not favor incumbent directors or acquirers, and instead
favors shareholders
o This has been subject to some debate that it is actually in favor of incumbents
- Court says the Act does not upset the neutral balance
- Here, Indiana Act allowed SHs to vote collectively to reject tender offers (instead of being coerced to accept
first offer and not be stuck with the second tier lower prices). Ct says Act furthers Williams Act bc it
empowers SHs and informs them to make the decision.
DE Anti-Takeover Statute See p. 846
Pros of Anti-Takeover:
protects stakeholders
*protects SHs against coercive offers cited by Sup Ct in CTS case
promotes competition among states for policies that are favorable to incumbent management and local corps
procedural reprimands protect tender offers from making rush takeover analysis -- CHECK THIS
promotes long term strategy/thinking on the part of BoDs and thus promotes efficiency of management
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Cons of Anti-Takeover:
law of state of incorporation controls markets, etc. (including stakeholders) outside of state
prevents SHs from setting a premium for their incumbent
may promote inefficiency of management by eliminating discipline of market for corporate control

LLCs
Features of LLC:
1) LLC not subject to two taxesonly distribution paid out to investors at their individual level are
taxed (similar to partnership); Losses of the LLC also pass through to the members and they can
declare their losses on their individual tax returns
a. A corp pays a tax on its profits as earned and the SHs pay a second tax when those profits are
distributed to them
2) Provide limited liability;
3) Provide great flexibility in the internal management of the business more than corps.
a. Can be managed by all its members (as in partnership), OR by managers who may or may
not be members/investors (as in corp).
Note: In LLC, investors are called members.
How to form an LLC?
Intended to be very easy to form. Investors simply file the articles of organization/ certificate of
formation (same doc, diff names in diff states) with Secretary of State. This is a bare-bones document.
Meat of management structure and operation of the LLC is put into Operation Agreement which is a
contract among investors of the LLC. Not filed with the state. The agreement functions similarly to the
bylaws of a corporation.
First issue, even before filing articles of organization, LLC investors will have to decide what kind of
management structure: centralized (model of corporation) or decentralized (model of partnership). LLC
statutes allow members of an LLC to elect for themselves whether the way to form a member-managed LLC
or manager-managed LLC. Default rule: member managed (decentralized model). But it is easy for
members to decide to follow corporate model where investors/members are relatively passive and managers
govern (bc members have delegated authority to them). Could choose to set up board of managers or use
single manager.
o ONLY downside to level of deference to partiesassumption that parties will be fairly well
financed and endowed to have adequate legal advice, because statutes themselves dont provide
much guidance, but rather are basically default rules which the parties can fall back on in the event
that their agreement is not fleshed out enough. Incentive for parties to develop their own contractual
remedies.
Tremendous diversity in statutes dealing with LLCs because the Uniform LLC Act was only improved after
all 50 States had already developed their own statutes. This is how its different from partnership law.
Formation
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Westec v. Lanham (Co. 1998) (Must give notice of LLC status)


Biz card said only personal address and P.I.I. Westec understood Clark to be Lanhams agent, but
recognized no other principal. PII never paid the $9k Westec was owed, and then claimed limited liability.
THIRD PARTIES MUST HAVE REASONABLE NOTICE OF LLC STATUS (should be on biz
cards, letterhead, contracts, etc.)
OTHERWISE, THE LLC PRINCIPAL IS UNDISCLOSED AND LIABILITY ATTACHES TO
THE AGENT (person who contracted)
AN AGENT WHO NEGOTIATES A K WITH A THIRD PARTY CAN BE SUED FOR ANY
BREACH OF THE K UNLESS THE AGENT DISCLOSES BOTH THE FACT THAT HE OR
SHI IS ACTING ON BEHALF OF A PRINCIPAL AND THE IDENTITY OF THE
PRINCIPAL.
The Operating Agreement
Elf Atochem North America, Inc. v. Jaffari (DE 1999) (Strong policy of freedom to contact)
LLC itself did not sign agreement; members did. One member sued derivatively & argued that by suing
derivatively, it had circumvented the forum selection and arbitration clause, since the operating agreement
bound only the members, not the entity itself.
LLC LEGISLATION IS MEANT TO GIVE MAXIMUM EFFECT TO THE PRINCIPLE OF
FREEDOM OF CONTRACT
MEMBERS ARE THE REAL PARTIES IN INTEREST HERE (not the non-signatory LLC), AND
COULD NOT CIRCUMVENT THEIR CONTRACT BY SUING DERIVATIVELY
The only provisions that are mandatory/non-waivable for LLCs under DE law are provisions
affecting 3rd parties. Provisions that affect the LLC, members/investors are waivable.
Note: DE has strong public policy in favor of arbitration. Doubts on the issue will generally be
resolved in favor of arbitration.
Note: Statutory provisions that generally are not waivable are those that protect third parties.
103(b) NON-WAIVABLE PROVISIONS UNREASONABLY RESTRICT RIGHT TO INFO,
DUTY OF CARE, GOOD FAITH, or ELIMINATE DUTY OF LOYALTY . . . .
Non-waivable: filing for LLCs; providing an address for service of process; have to have the word LLC or
spelled out when dealing with third parties, must ID yourself as LLC when dealing with third parties
things that will harm 3rd parties are generally non-waivable.
Some courts have accepted limitations of fiduciary duties by way of contract, but generally do not allow
for a sweeping elimination of the fiduciary duties Non-waivable but controllable under 103(b)(4).

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The Uniform Code on LLCs does NOT allow for elimination of fiduciary duties, but does allow for
limitation of those duties, so long as they are expressly stated. See McConnel v. Hunt Sports Enterprises
(finding that appellees did not violate their fiduciary duty owed to CHL when they made a bid for the NHL
franchise, because each member of CHL agreed that members could compete against the LLC). DE law
allows for elimination of all fiduciary duties, except for the implied contractual covenant of good faith
and fair dealing.
Good Faith and Fair Dealing Non-waivable but controllable under 103(b)(4)
Fisk Ventures, LLC v. Segal (Del. Ch. 2009) (no bad faith for deadlock when agreement allowed for such
deadlock; must dissolve comp. see case under DISSOLUTION)
Johnson refused to forgo his Put Right that allowed Fisk to redeem their equity interest for debt at any
time; new equity investors were deterred because theyd be subordinate to Fisks interest. Fisk sued for
dissolution, and Segal counterclaimed for breach of bad faith. Court said no bad faith here bc the SH
agreement provided for this kind of deadlock. Instead, dissolution was appropriate.
Where an LLC agreement vests power in more than one equity class and requires the classes to
cooperate to effect LLC action, one class does not breach the LLC agreement by failing to acquiesce
to the wishes of the other classes nor does it breach the LLC agreements implied covenant of good
faith and fair dealing simply because the other classes believe their approach is superior or in the best
interests of the LLC.
Piercing the LLC Veil
Four major approaches for piercing LLC veil general trend is that there is some form of LLC veil
piercing. But states vary in the factors/conditions to authorize it. There are 4 diff approaches.
Wyoming approach says nothing about veil piercing. Leaves up to Ct.
State LLC statutes contain provision stating that corporate principles should be applied to LLCs. P. 281;
note 1 example.
States that failure of LLC to observe the formalities/requirements of LLC when COUPLE WITH some
other wrongful conduct. (Westec case)
Uniform LLC Act Section 303(b) the failure to observe usual company formalities is NOT a ground
to impose personal liability to members/managers
Kaycee Land & Lakes v. Flahive (WY 2002) (LLC Piercing the Veil = Same as Corp)
a. Rule: In the absence of fraud, a claim to pierce the veil of an LLC is treated in the same
manner as a court would pierce a corporate veil
b. Facts: Flahive Oil & Gas is a LLC in Wyoming with no assets at this time. Kaycee Land &
Livestock entered into a K with Flahive Oil allowing Flahive to use the surface of its real property.
Roger Flahive is and was the managing member of Flahive Oil at all relevant times. Kaycee Land
and Livestock alleges that Flahive caused contamination to its real property in WY. Kaycee Land
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and Livestock seeks to pierce the LLC veil and disregard the LLC entity of Flahive and hold Roger
Flahive individually liable for contamination
c. Analysis: Piercing the veil is an equitable doctrine developed, and not a statutory provision in the
state's corporation act. Likewise, absence of a veil piercing provision in the LLC statute does not
preclude its application in this context.
a. There is no reason, in either law or policy, to treat LLCs differently than corporations are
treated in this regard
b. If the members & officers fail to treat it as a separate entity as contemplated by statute,
they should not enjoy immunity from individual liability for the LLCs acts that cause
damage to 3rd parties
To consider when deciding whether to pierce the LLC veil:
a. Is the company being treated as a company OR a person who is using the company as a front to
protect themselves on an individual level?
b. Look at the comingling of funds (if any) separate bank accounts? Movement between the
individual and LLCs accounts?
c. Does the LLC itself have any assets or are they all owned by the individual?
d. Parameters of whether an LLC is being met should be contained in the operating agreement
(sometimes) and the question to determine when considering whether to pierce the corporate veil is
to question whether the behavior meets the operating agreement standards
I.
In the LLC context less weight on noncompliance with corporate formalities, unless the
formalities were something agreed upon by the parties of the LLC during the creation of the
operation agreement.

Fiduciary Obligation
DELAWARE law allows for elimination of all fiduciary duties, except for the implied contractual
covenant of good faith and fair dealing.
LLCs can contract away certain duties: Ways to K-away fiduciary dutiesThrough Operating
Agreement:
a. LLC Act 103(b): the operating agreement may not (2) eliminate the duty of loyalty BUT the
agreement MAY (i) identify specific types or categories of activities that do NOT violate the duty of
loyalty, if not manifestly unreasonable
b. DE LLC 18-1101(c): to the extent that, at law or in equity, a member or manager or other person
has duties (including fiduciary duties) and liabilities relating to an LLC or to another member or
manager (2) the member or managers or other persons duties and liabilities may be expended or
restricted by provisions in an LLC agreement (freedom to K)
McConnell v. Hunt Sports Enterprises (OH 1999): (can compete aga LLC w/o violating duty of loyalty if
operating agreement allows it)(NFL case)

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c. Rule: (1) A member of an LLC does not breach a fiduciary duty to the company by directly
competing against it where the operating agreement expressly permits such competition.
(would breach it w/o agreement though) (2) Extrinsic evidence will not be permitted for
interpretation of an LLC operating agreement with terms that are unambiguous and clear. (3)
A directed verdict against an LLC member, which is based on operating agreement violations,
is appropriate where the evidence shows that the member has violated the operating
agreement.
d. Note:
i. Similar to a partnership, an LLC involves a fiduciary duty to other members, but that duty
can be contracted away
1. However, most states will not allow the operating agreement to provide for a blanket
waiver of all fiduciary duties of a manger
ii. TEST FOR UNAMBIGUOUS TERMS: Common words in a written K will be given their
ordinary meaning unless manifest absurdity results or unless some other meaning is clearly
evidenced from the face or overall content of the K.
Dissolution
Fisk Ventures, LLC v. Segal (Del. Ch. 2009) (Dissolution)
Genitrix LLC was set up with 3 classes of membership, arranged in such a way that decision making had to
be made by unanimous consent of the two classes of stock, owned respectively by Fisk-Johnson and Segal.
Johnson refused to forgo his Put Right that allowed Fisk to redeem their equity interest for debt at any
time; new equity investors were deterred because theyd be subordinate to Fisks interest. Fisk sued for
dissolution, and Segal counterclaimed for breach of bad faith. Court said no bad faith here bc the SH
agreement provided for this kind of deadlock. Instead, dissolution was appropriate.
DISSOLUTION WHEN:
1) MEMBERS VOTES ARE DEADLOCKED AT THE BOD LEVEL
2) AGREEMENT HAS NO WAY OF NAVIGATING THE DEADLOCK
3) NOT REASONABLY PRACTICABLE TO CARRY ON BUSINESS
4) EFFECTIVELY NO BIZ TO OPERATE DUE TO THE FINANCIAL CONDITION OF
COMPANY
New Horizons Supply Cooperative v. Haack (Wis. 1999)(be sure to take steps to pay creditors)(sister to pay
for fuel case)
Rule: A member or manager of an LLC is not personally liable for any debt, obligations, or liability
of the company only if the member or manager follows statutorily prescribed formalities of LLC
incorporation, dissolution, and creditor notice.
i. The entry of judgment against Haack was proper because she failed to establish that she took
appropriate steps to shield herself from liability for the Comps debts following its dissolution
and the distribution of assets. Because D received assets of the LLC upon its dissolution, it is
APPROPRIATE for the LLCs creditors to pierce the LLC veil and obtain, by holding D personally
liable, the LLCs debts.
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ii. Analysis:
1. Although the filing of articles of dissolution of a LLC is optional, the order for distributing the
assets of an LLC following dissolution is fixed by statute (WA 183.0907)
2. A dissolved LLC may dispose of known claims against it by filing articles of dissolution, and then
providing written notice to its known creditors containing information regarding the filing of
claims.
3. D did NOT file articles of dissolution even though there is evidence that she knew of Ps claims
against her at the time
b. Three takeaways from New Horizon
a. Reiterates the principle that (unlike partners in a general partnership) members of LLCs are not
personally liable for debts of the LLC
a. The fact that LLCs are treated like partnerships for tax treatments doesnt change that theyre
still a limited liability comp.
b. LLC members should be careful to identify themselves to 3rd parties in a representative capacity on
behalf of the LLC, and not in their personal capacity. Hawk was sloppy about doing this.
c. Members of LLCs should follow statutory procedures/formalities to carry out the dissolution of
the LLC, and typical features are: a) filing articles of dissolution; b) providing written notice to
known creditors about how to file claims against the LLC (creditors get priority over members of the
LLC in getting paid); c) distribute the LLCs assets in the order directed by the statutes (creditors get
first priority typically)
Does its treatment as a partnership for tax purposes have any relevance as to whether the members have
limited liability? Not relevant. Here, it was how she represented herself in her personal capacity.
Suppose that Haack had proved that she invested $2k in the LLC and upon dissolution she had pocketed
$500 (after paying off the LLCs other debts). For what amount would she be liable to New Horizons? She
would have to pay over only $500 to New Horizons bc creditors have priority over the individual members
of the LLC.

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