Business Organizations Outline Spring 2009

BUSINESS ORGANIZATIONS OUTLINE Hofstra Law, Professor Greenwood, Spring 2009

AGENCY LAW AGENCY I. Who is an Agent? A. Agency is the fiduciary relation which results from i. Consent by the principle for the agent to act ii.Agent acting on behalf of the principle (& both parties intend this) iii.Understanding that the agent is subject to control by the principle. a. Control only over the goal, not the means of accomplishing it (lawyers). B. There’s an asymmetrical fiduciary duty (agent has duty to principle, but not vice versa) C. An agency is inherently hierarchical - The principle controls (Courts will assume this fact) D. Formation & termination of an agency relationship i. Unlike a contract (which is negotiated etc.) an agency agreement is created very easily. Once A agrees to do something for P, and A is acting on P’s behalf & is subject to P’s control the agency relationship is created. a. Gorton v. Doty, 69 P.2d 136 (1937) – woman tells the football coach who needs to transport students to a game to use her car (but only he can drive it). She volunteered the use of her car, no compensation. Accident happens & suit against the woman, as the principle. Agency relationship existed here between woman & coach. Woman consented that coach act in her behalf in driving her car by volunteering her car & her condition that only he drive it shows the control she had. 1.How you describe it makes the diff on whether or not it’s agency: (a)Gave permission – this is a loan, not agency (b)Directed - telling him what to do – this is agency. 2.This is a little extreme b/c it almost looks like it was only a loan. But fact is that insurance is covering the woman, and the boy injured has no insurance. So looks like court just wanted to cover the boy. 3.Solution: if she had specified she is loaning the car to him, then that would have settled it. b.It is not essential that there be a contract between the principle and agent or that the agent promise to act as such, nor is it essential to the relationship of principle and agent that they, or either, receive compensation. ii.Agency can be terminated at the will of either party (notion that we don’t like involuntary servitude). Different from contract relationship which you cannot just breach & court will enforce. 1

E. Creditor-debtor relationship vs. agent-principal relationship i. A creditor who assumes control of his debtor's business may become liable as principal for the acts of the debtor in connection with the business ii.Gay Jenson Farms Co. v. Cargill, Inc., 309 N.W.2d 285 (1981) – Warren (W) is a local firm operating as a grain storage facility & as a middle man between the grain farmers & the worldwide dealer, Cargill (C). W then insolvent; doesn’t pay farmers, and farmers sue C. W & C had an agreement where C finances W, C buys grain from W & C has right of first refusal on the grain. a. The court found an agency relationship was created here. Existence of an agency may be proved by circumstantial evidence which shows a course of dealing between the two parties. 1.Consent by principle – C consented by directing W to implement certain procedures 2.Agent acting on behalf of principle – W acted on C’s behalf in procuring grain for C, as part of its normal operation which were totally financed by C. 3.Principle exercise control over agent - C had a lot of influence and control over W’s financial situation. b.An agreement may result in the creation of an agency even though parties didn’t call it an agency and did not intend the legal consequences of the relation to follow. c. Someone who contracts to acquire something from a 3rd person and convey it to another is an agent only if it is agreed that he is to act primarily for the benefit of the other. d. Problem - banks giving out loans being subject to agency 1.Difference for a bank is that the lender’s reason for financing is for the interest received. In Cargill, the reason for the financing was to establish a source of market grain for its business & took control of the operation for this purpose. 2.If you’re lending money to a borrower, you would probably take the steps Cargill did to make sure operating properly. Any of the measures Cargill took would be appropriate, but the problem in Cargill is that there is an extraordinary amount of control – too many of these things put together. II. Agency Power to Bind - Liability of Principle to third parties in contract A. Actual Authority - principle gave the agent the authority explicitly; completely clear B. Implied Authority - Implied authority is actual authority circumstantially proven which the principal actually intended the agent to possess and includes such powers as are practically necessary to carry out the duties actually delegated. i. To determine whether implied authority exists, it must be determined whether the agent reasonably believes because of present or past conduct of the principal that principal wishes him to act in a certain way or have certain authority. a. Sometimes may be necessary to implement express authority b. Prior similar conduct ii.Have authority because it’s something that normally goes along with the actual authority given. iii.Mill Street Church of Christ v. Hogan, 785 S.W.2d 263 (1990) – Church has hired Bill to paint in the past & has previously told Bill he can hire his brother Sam to help. Bill only uses Church’s tools & if he needs something goes to store & charges it to Church’s account. Church hires Bill again, needs help & goes to Church to ask for help. Church says to call Petty, but doesn’t tell Bill he must hire Petty, & told Bill that Petty’s hard to reach. Bill gets his brother Sam to help & Sam falls off a ladder owned by the Church. Church pays Sam for hours worked. Sam wants workers comp, but only employees get it. a. Bill is an agent of the Church (an employee – Church hires Bill & has control over Bill) b. Bill didn’t have actual authority to hire Sam, but had implied authority. 1.past conduct - Bill had been allowed to hire Sam for previous work.

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2.necessary to implement the express authority - in order to finish the work, Bill had to hire a helper. 3.agent reasonably believed he had the authority - practice in the past; Bill never told otherwise; Church even paid Sam for hours worked. C. Apparent Authority – when a principle acts in such a manner as to give the impression to a third party that the agent has certain powers which he may or may not actually possess. It is a matter of appearances on which third parties come to rely. i. 3rd parties have the right to believe the agent has the authority it is reasonable to believe they have. ii.Lind v. Schenley Industries, Inc., 278 F.2d 79 (1960) – Lind (Π) worked for Park. Park’s vicepresident, Herrfeldt (Herr) gave Π job with Kaufman, & told Π that Kaufman would tell him duties and salary. Kaufman tells Π he will get a specified commission, and Herr confirms this. Is kind of commission is not common in the industry (very weird to get it). Π later terminated & sues for the commission. Kaufman didn’t have actual authority to give this commission. a. Park can be held accountable for Kaufman’s action on the principle of apparent authority. Kaufman is Π’s direct supervisor; as far as Π is concerned, Kaufman is spokesperson for Park. Π reasonable to think Kaufman has authority to offer commission. iii.Three-Seventy Leasing Corporation v. Ampex Corporation, 528 F.2d 993 (1976) – Joyce, the only employee of 370 corp, is in negotiations to buy HW from Ampex & is speaking to Ampex’s employee, Kays (salesperson). Kays sends Joyce an offer at the direction of Kays’ superior. a. An agent has apparent authority sufficient to bind the principal when the principal acts in such a manner as would lead a reasonably prudent person to suppose that the agent had the authority he purports to exercise. b. Absent knowledge on the part of 3rd parties to the contrary, an agent has the apparent authority to do those things which are usual and proper to the conduct of the business which he is employed to conduct. c. Kays was employed by Ampex as a salesman; it is reasonable for 3rd parties to presume that a salesman has the authority to bind the employer to sell. d. Ampex's actions furthered this belief; Document was given to Joyce at the direction of Mueller, Kay's superior, and also Mueller agreed that all communication with 370 would be through Kays. Doesn’t matter if, internally, Kays really didn’t have this power. D. Inherent Agency Power – authority that comes from the role/status that comes with being an agent. The agent (in the role/status) ordinarily possesses certain powers. i. A servant acting within the scope of his employment has inherent authority to commit torts basically same thing as respondeat superior. ii.Watteau v. Fenwick, Queen's Bench (1892) - Humble sold business to Fenwick, but Humble still manager, and Humble name on the door. Humble was only supposed to buy bottled ales and mineral water, but he buys cigars and other supplies on credit. Π, 3rd party, sues to recover payment. 3rd party doesn’t even know Fenwick exists, and that he actually owns it. a. Rest (2nd) Agency § 194 - an undisclosed principle is liable for acts of an agent done on his account, if usual or necessary in such transactions, although forbidden by the principle. b. Rest (2nd) Agency § 195 - an undisclosed principal who entrusts an agent with the management of his business is subject to liability to third person with whom the agent enters into transactions usual in such business and on the principal’s account, although contrary to the directions of the principal. iii.Kidd v. Thomas A. Edison, Inc. 239 Fed. 405 (1917) - Kidd (3rd party) enters into K with Fuller (Δ's agent) believing she was signing up for an unconditional singing tour/recitals. Δ says that

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agent’s only authority was to sign her up with specific recitals (be a booking agent), and the dealer would pay for the performance. a. Custom to hire singers for recitals & reasonable to believe they intend to pay them. Agent in this industry is typically empowered to do these things in this type of situation. b. J. Learned Hand - "It makes no difference that the agent may be disregarding his principal's direction, secret or otherwise, so long as he continues in that larger field measured by the general scope of the business entrusted to his case." iv.Nogales Service Center v. Atlantic Richfield Company, 613 P.2d 293 (1980) - Π and Δ have been in business in the past. Δ's employee-agent made oral contract with Π to give Π a discount on gas. Δ disapproves the discount; Π sues for breach of K. Δ argues that agent was not authorized to give this type of discount. a. Rest (2nd) Agency § 161. A general agent for a disclosed or partially disclosed principal subjects his principal to liability for acts done on [the principle’s behalf] which usually accompany or are incidental to transactions which the agent is authorized to conduct if, although they are forbidden by the principal, the other party reasonably believes that the agent is authorized to do them and has no notice that he is not so authorized.

LIABILITY OF PRINCIPAL TO THIRD PARTIES IN TORT I. Servant VS Independent Contractor A. A master is subject to liability for the torts of his servants committed while acting in the scope of their employment. As a general rule, a principle is not liable for the torts of his non-servant agents i.e., independent contractors. i. Servant-Master Relationship – respondeat superior; master liable for torts of his servants a. Master/servant relationship exists where the servant has agreed to work on behalf of the master and to be subject to the master's control or right to control the "physical conduct" of the servant (the manner in which the job is performed as opposed to the result alone). ii.Independent contractors a. Agent-type independent contractor - one who has agreed to act on behalf of another, the principal, but not subject to the principal's control over how the result is accomplished (over the physical conduct of the task). b. Non-agent independent contractor - one who operates independently and simply enters into arm's length transactions with others B. Whether the relationship between the parties is an agency relationship does not depend on what the parties call it, but what it actually is. The parties cannot effectively disclaim it by formal consent. i. Humble Oil & Refining Co. v. Martin, 222 S.W.2d 995 (1949) – Love gives her car to gas station owned by Humble for servicing. Negligence by gas station & Martin injured by the car. Humble liable for negligence? Humble says no b/c gas station operated as an independent contractor, Schneider. Neither Humble nor Schneider considered Humble the employer. a. Court says it’s a servant-master relationship, so Humble is liable. Humble had “strict financial control & supervision” over the gas station.

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1.Humble furnished the station location, equipment, advertising, and a substantial part of the operating cost (they gave a 75% commission on Schneider's payment of utilities, so Humble was effectively paying 75% of the utilities). Hours of operation controlled by Humble. Humble could terminate at will Schneider's occupation of the premises. Schneider had to do whatever Humble told them to do. The only thing Schneider had the discretion to do was hiring, firing, payment and supervision of the few employees. So looks more like Schneider is an employee just being paid based on commission. C. Control is an essential element of an agency relationship, whether a servant or an independent contractor. To determine whether the relationship is master-servant, the court will look at whether the principle had control over the day-to-day operations. i. Hoover v. Sun Oil Company, 212 A.2d 214 (1965) – gas station employee negligently caused a fire at a service station owned by Barone. Πs brought suit against Sun Oil, Barone & the employee. Barone leased the gas station from Sun, & had a dealer’s agreement that dictated the K between them. Barone not obligated to do what Sun would recommend, & determined the day-to-day operations. Barone could sell whatever he wanted, although there were rules on what he used Sun’s products for. a. Held independent contractor - the close contact between the two show merely that they have a mutual interest in the sale of Sun products and in the success of Barone's business. Sun did not have control over the day-to-day operations. Control or influence over the results alone is insufficient. D. Franchise agreement - the franchisee will agree to operate its business in certain ways, as required by the franchisor, in exchange for the use of the license. The purpose of this is to create standardization in all the franchises nationwide (to achieve the "brand"). However, a franchise could still be a servant-master relationship if there is sufficient control by the franchisor. i. Murphy v. Holiday Inns, Inc., 219 S.E.2d 874 (1975) - Betsey-Len Motor Hotel Corporation had a licensing agreement (franchise) with Holiday Inns, to use their name/logo. Architecture of Betsey must be approved by Holidays Inn, Betsey not allowed to sell stock w/o approval, Betsey must operate under Holiday’s rules of operation & make quarterly reports & submit to periodic inspections by Holiday. A customer had a slip & fall and sues Holiday Inn for the negligence. a. Not servant-master, this is a typical franchise agreement. Holiday Inn does not have the control or right to control the methods or details of doing the work. The purpose of the provisions was to "achieve a system-wide standardization of business identity, uniformity of commercial services …. for the benefit of both contracting parties." Betsey still had the control over the dayto-day operations, and most other powers customarily exercised by an owner. ii.Rationale for allowing a certain level of control in franchising agreements: a. The problem of free-riding: franchisee would take advantage of other people’s investments (establishment of the brand name) and exploit it. If the franchisee could do whatever they wanted, it would ruin the brand name. II. Tort Liability and Apparent Agency A. Advantages of setting up a business as a franchise: i. Establish a brand name – ppl can walk in any location and know what to expect ii.Less liability for the national company than having branches a. But national wants some control since they’re promising something iii.Owners will work harder than managers, even though same money & same job B. Policy Issue for franchises – should we allow businesses to insist that they present themselves as one enterprise for purpose of advertising, but then turn around for tort purposes and say we’re 2 enterprises? On its face it looks like consumer fraud. Although it’s ok for contract purposes, not clear if it’s ok for tort purposes. C. Miller v. McDonald's Corp., 945 P.2d 1107 (1997) - Π sues McDonalds for injuries b/c she bit into a stone while eating a burger. McDonald’s was a franchise, owned by 3K, & had an operating agreement 5

that required 3K to operate in a manner consistent with the McDonald’s system, and described how it should be operated in a lot of detail. K also explicitly stated 3K not an agent for any purposes. i. Liability under Actual Agency: The Control Test – If the franchise agreement goes beyond the stage of setting standards, and gives the franchisor the right to exercise control over the daily operations of the franchise, an agency relationship exists. a. If McDonald’s retained sufficient control over 3K's daily operations, then an actual agency relationship would exist (jury question). Agreement didn’t just set standards - it required 3K to use the precise methods that McDonald’s established. McDonald’s enforced the use of those methods by regular inspections & retained power to cancel the Agreement. ii.Apparent Agency - One who represents that another is his servant or other agent and thereby causes a third person justifiably to rely upon the care or skill of such apparent agent is subject to liability to the third person for hard caused by the lack of care or skill of the one appearing to be a servant or other agent as if he were such. a. Question for jury whether McDonald’s held 3K out to be its agent & whether Π justifiably relied on that representation 1.(Representation) Everything about the appearance of the restaurant identified it with McDonald's - this image the McDonald’s had worked to create - reputation, etc. 2.(Reliance) General public not expected to understand how franchise works. McDonald’s cannot ignore its own efforts to lead the public to believe that all McDonald's are the same. III. Scope of Employment A. Conduct of a servant is within the scope of employment if it is actuated, at least in part, by a purpose to serve the master. i. Ira S. Bushey & Sons, Inc. v. United States, 398 F.2d 167 (1968) - Sailor (works for U.S.) arrived back at his ship drunk, and negligently caused damaged to the ship & drydock (owned by Π). U.S. argues it’s not liable b/c sailor acting outside scope of employment. a. The sailor's conduct was not so unforeseeable as to make it unfair to hold the government liable. The employer should be held to expect risks, to the public also, which arise 'out of and in the course of' his employment of labor. It is foreseeable that a drunken sailor might cause damage while crossing a drydock on the way back to his ship. B. A servant's acts may be within the scope of employment although consciously criminal or tortious (except serious crimes). A servant's use of force against another is within the scope of employment if the use of force is may be expected by the master. i. Ex: the owner of a nightclub probably would be held liable for injuries inflicted by a bouncer in ejecting someone from the bar. The owner presumably hired the bounder for the very purpose of using force to eject drunken or otherwise undesirable patrons. ii.Manning v. Grimsley, 643 F.2d 20 (1981) – professional baseball game, pitcher threw a ball at Π & injured him (Π heckling him, and evidence that pitcher did it intentionally). Court found employer liable for pitcher’s action b/c he was acting within the scope of his employment. a. To recover damages from an employer for injuries resulting from an employee's assault, it must be shown that the assault was in response to the Π's conduct which was presently interfering with the employee's ability to perform his duties successfully. 1.The heckling was conduct that had affirmative purpose to interfere with employee’s performing his duties successfully, and the pitcher's assault was not a mere retaliation for past annoyance, but a response to continuing conduct which was presently interfering with his ability to pitch in the game. IV. Statutory Claims A. Just b/c an employee behaves in an unacceptable manner (i.e. against company policy and/or law) does not mean that the conduct is obviously outside the scope of employment. B. Factors to consider to determine whether an employee is acting within scope of employment:

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i. The time, place and purpose of the act ii.Its similarity to acts which the servant is authorized to perform iii.Whether the act is commonly performed by servant iv.The extent of departure from normal methods v. Whether the master would reasonably expect such act would be performed C. Arguello v. Conoco, Inc., 207 F.3d 803 (2000) – Several incidents of racial discrimination by employees working at gas stations with the Conoco name. Conoco not liable b/c stores were independently owned. Since Conoco did not control the details of daily operations of those stores, there was no agency relationship. i. Time & place - Employee acted while on duty as an employee ii.Purpose - Employee acted while carrying out her employment duties iii.Although employee departed from normal methods of her duties and the conduct was not expected, it took place while employee was carrying out her normal duties as a clerk. iv.No evidence that Conoco would have expected the employee to act this way. V. Liability for Torts of Independent Contractors A. Ordinarily when a person engages an independent contractor (who conducts an independent business by means of his own employees), he is not liable for the negligent acts of the contractor in the performance of the contract, but there are exceptions: i. When landowner retains control of the manner & means of the work contracted for ii.Where he engages an incompetent contractor iii.Where the activity contracted for constitutes a nuisance per se. B. Liability imposed upon a landowner who engages an independent contractor to do work which is inherently dangerous (a nuisance per se). i. Inherently dangerous - an activity which can be carried on safely only by the exercise of special skill and care, and which involves grave risk of danger to persons or property is negligently done. ii.Ultra-hazardous - an activity which necessarily involves a serious risk of harm to the person, land or chattels of others which cannot be eliminated by the exercise of the utmost care, and is not a matter of common usage. Liability is absolute where the work is ultra-hazardous. C. Majestic Realty Associates, Inc. v. Toti Contracting Co., 153 A.2d 321 (1959) - Authority hires Toti to demolish a building which was adjacent to Π's. In the process, there was damage to Π's building. Evidence showed that it was hazardous work. Authority held liable b/c the work was inherently dangerous.

FIDUCIARY OBLIGATIONS OF AGENTS I. Duties during Agency A. Reading v. Regem, 2 KB 268 (1948) - sergeant in the British army paid a lot of money by escorting a smuggler's trucks through Cairo (so the police wouldn’t inspect the trucks). Crown gets the money. i. Servant is liable to his master if he takes advantage of his service and violates his duty of honesty & good faith to make a profit for himself, and the position he occupies is the cause of obtaining the money, rather than providing the opportunity for him to get it. Doesn’t matter if 7

master hasn’t lost any profit or sustained any damage, or that master couldn’t have done the act himself. ii.Examples: a. Money goes to master - Police officer accepts bribes to direct traffic away from crime scene. The only reason he had any authority to be able to direct traffic away & the only reason he got paid, was b/c of his position as a police officer & his uniform. b. Servant keeps the money - Employee during time he's supposed to work, gambles. Employer can sue him for breach of K, but the money he makes from the gambling is his. B. Agent has the fiduciary duty to act solely for the benefit of the principle. An employee violates this duty by failing to disclose all facts relating to his work and by receiving secret profits from it. i. General Automotive Manufacturing Co. v. Singer, 120 N.W.2d 659 (1963) – Singer worked for General. Employment K says Singer would devote his entire time, skill, labor and attention to said employment and not to engage in any other business. Singer doesn’t think General can fill some orders & gets them filled somewhere else, making himself a profit. a. Singer violated his fiduciary duty to act solely for the benefit of General, so he is liable for the amount of the profits he earned in his side business. He had a good faith duty to disclose the fact that he didn’t think General could fill the orders; then General could decide what to do.

II. Duties during and after termination of Agency A. Post-termination competition with a former principle is permitted, but the former agent is barred from disclosure of trade secrets or other confidential information obtained during his employment. B. Soliciting former employer’s clients i. Town & Country House & Home Service, Inc. v. Newbery, 3 N.Y.2d 554 (1958) - Δ was an employee of Π, a house cleaning service. Δ leaves employment, then sets up a competitive business. Δ had breached the confidential relationship (b/c it stole the plan, which was unique) and also solicited customers (which it had built over the years). a. A former employee may not solicit his former employer’s customers if those customers cannot be readily ascertained by means other than knowledge b/c of the employment. Where the customer list was secured by years of business effort & advertising, and the expenditure of time & money, constituting a part of the good will of a business. C. General Rules i. While an employee you can't compete with employer b/c you have a fiduciary duty. ii.You can terminate the agency at will, however, so once you quit, you no longer owe a fiduciary duty & you can compete. a. Knowledge received by employment, reputation, etc. – you can take this with you. What you can't do is walk away with a client list on paper. b. Reason: Otherwise, it would be like slavery – either you stay with the same company forever, change careers, or pay royalties to previous employer. 1.Exception – information that’s confidential like patents. But this is addressed by noncompetes (contract), so unnecessary to address in agency law.

PARTNERSHIPS WHAT IS A PARTNERSHIP? 8

I. Elements of a Partnership A. 5 Elements of a Partnership - UPA § 6. Partnership is an association of "two or more persons to carry on, as co-owners, a business for profit." i. Association of two or more a. agreement necessary, but no written contract. Agreement is to associate, not to form a partnership. b. no formal partnership agreement required c. no governmental registration required d. If you fit the elements of a partnership, you’re a partnership. ii. Persons a. Person can be a corporation (or any other business entity) or a natural person. Some "people" are not "persons" under definition of law - minors, etc. b. can't form a partnership with yourself, but you could with a corporation of which you were the sole shareholder. iii. As co-owners a. not employee/employer. iv. In a business a. Not a church, not a share of stocks b. co-ownership of a rental property as joint tenants is not enough v. For profit. a. Not-for-profits don't count b. Just b/c no profit made won't mean it’s not a partnership, as long as they intended to make profit B. UPA § 7: Rules for determining existence of a partnership i. Joint tenancy/joint property/part ownership doesn’t of itself establish partnership ii. Sharing of gross returns doesn’t of itself establish a partnership iii. UPA § 7(4) Receipt of a share of profits of a business is prima facie evidence of partnership, but no such inference shall be drawn if (exceptions): a. Wages or rent (even if calculated based on profit) - store may pay landlord rent based on profits of the store w/o landlord becoming its partner. b. Debt repayment - if business owes ex-partners money, this doesn’t make them a partner, it makes them a creditor. c. Annuity to deceased partner - if you want to retire, your payments should not be based on profits; but they may be if you are dead. d. Interest - If you lend money to the partnership & take as interest a share of profits, you are not a partner. But if you invest money in the partnership & take a share of the profits, you are. 1. So what becomes important is the level of control. e. As consideration for sale - the distinction between allowing in a new investor and selling the business is going to be tough to make if the seller still receives a share of profits. C. Liability Rules of a partnership i. Profit Sharing Default Rule – profits are split per person/partner, w/o regard to money or labor contribution. But you can change the default rule by agreeing to something else in the partnership agreement. ii. Splitting losses default rule - losses follow profits. So if you make agreement on profits, losses also split that way. a. 3rd party breach of K or torts - Sue the partnership & collect. But if partnership is insolvent? 1. Partners held jointly and severally liable for the obligations of the partnership (UPA §15). Each partner is a guarantor of the partnership’s full debts. b. Partnership agreement can say how losses (debts) will be split. If agreement says Partner A is liable for 90% of debts, B 10% of debts, you can still sue B for full debt and collect. But then B can sue/collect from A the 90%. 9

iii. iv. v. vi.

1. Reasoning: 3rd parties entitled to rely on the entity, plus that each individual partner puts their individual credit behind the partnership. UPA § 9: Every partner is agent of the partnership for purpose of its business. The act of every partner for carrying on the usual way of business binds the partnership, unless he has no authority to act in particular manner and 3rd party knows. UPA § 13: Partnership liable for any wrongful act or omission of any partner acting in the ordinary course of the business or partnership or w/ authority of co-partners UPA § 17: Person admitted into existing partnership liable for all obligations of the partnership arising before his admission Federal Income tax purposes – income and losses of the partnership are attributed to the individual partner; the partnership itself does not pay taxes.

II. Partners Compared with Employees A. UPA § 42: The sharing of profits is prima facie evidence of partnership, but no such inference shall be drawn if such profits were received in payment as wages of an employee. B. Fenwick v. Unemployment Compensation Commission, 44 A.2d 172 (1945) - Chesire works for Fenwick & asks for a raise. Fenwick agrees only if he’s making enough money, so he gets a lawyer to write an agreement, which said Chesire is a partner (so Chesire gets share of profits). Chesire leaves employment, & Fenwick refuses to pay into the unemployment fund b/c she wasn’t an employee within the meaning of the statute. Δ said the agreement was not a partnership agreement, but just an agreement fixing the compensation of the employee. Court held that no partnership created, the K was nothing more than a method to provide for compensation. Just b/c the agreement says they are a partnership, doesn’t make it so. i. Court looks at the characteristics of a partnership: a. The intention of the parties – just b/c K said partnership, doesn’t make it so. The real reason for the K was to provide calculation for an increase in compensation, but to protect Fenwick in case he couldn’t afford it. b. The right to share profits – not every agreement that gives a right to shares profits is a partnership, so not conclusive. c. The obligation to share losses – only Fenwick liable for debts of partnership. d. The ownership and control of the partnership property & business - Fenwick contributed all the capital & Chesire had no right to share capital upon dissolution. Fenwick also retained all control. e. Community of power in administration - Fenwick had exclusive control of mgmt of the business. f. Language in the agreement – K called it a partnership, but also excluded Chesire from most of the ordinary rights of a partner. g. Conduct of the parties towards third persons – didn’t hold themselves out as partners, she was still working as the receptionist. h. The rights of the parties on dissolution- No diff for Chesire than if she quit i. Co-ownership – agreement only to share profits, Fenwick had ownership.

III.Partners compared with Lenders A. The determination of whether a business organization constitutes a partnership is done on a case-by-case analysis of all factors to determine whether they reveal the intent to do business as co-owners; no single factor is dispositive. Thus, an explicit partnership agreement may be deemed not to create a partnership, and an agreement specifically denying a partnership exists may be found void. B. The sharing of profits is not conclusive evidence of a partnership. i. ***Martin v. Peyton, 246 N.Y. 213 (1927) - KNK, a partnership, was in financial difficulty, and Hall, a partner there, arranged for the Δs (Peyton + others) to loan them some securities, to be used as collateral for a bank loan to KNK. KNK creditors sued to get their money, and argued that the 10

loan to KNK by Δs was actually a partnership agreement, so Δs would also be liable for KNK's debts b/c they were partners. Although the agreement said no partnership, the rule is to look at what actually is the case. Court looked at circumstantial evidence, & decided no partnership formed. a. Although profit sharing (which happened here) is considered an element of a partnership, not all profit-sharing arrangements indicate the existence of a partnership relationship. All of the features of the agreement are consistent with a loan agreement, so no partnership has been formed. b. Note: If KNK had been organized as a corporation, LLC, or LLP, Δs here would have avoided any risk of liability. Under those forms of business organization, as equity investors, Δs could not have been held personally liable for the firm's debts. ii. Southex Exhibitions, Inc. v. Rhode Island Builders Association, Inc., 279 F.3d 94 (2002) – Δ had entered into an agreement with SEM, Π’s predecessor, in the production of shows. The agreement provided for profit-sharing and was said Δ wished to participate in the shows as “sponsors and partners.” SEM said he didn’t want ownership of the show, and described himself as a “producer.” Then Π takes over SEM, and Δ dissatisfied with performance, so Δ enters into K with another producer. Π sues, arguing that it was a partnership, and Δ liable for breach of fiduciary duty by wrongful dissolution. a. Court looks at the totality of the circumstances, and decides not a partnership. Evidence is: 1. The agreement was titled “Agreement,” not “Partnership Agreement” 2. Agreement was for a fixed term, not indefinite. 3. SEM had to advance all money for the shows and indemnify Δ for all show-related losses. (a) Partnership usually sharing of operating costs (b) Generally, presumption that partners share equally in partnership losses. (c) SEM responsible for the majority of mgmt decisions in the relationship (d) Π conducted business with 3rd parties in its own name, rather than that of the putative partnership. In fact, the partnership never had a name and Π never filed a partnership tax return. (e) The joint endeavor simply involved a periodic event, which neither generated nor necessitated ownership interests in tangible properties (f) SEM’s pres said he merely regarded Δ as a producer of the shows. b. While evidence of profit sharing is prima facie evidence of the existence of a partnership, it is not dispositve, and other factors may indicate no partnership was intended. IV. Partnership by Estoppel A. General Rule: Persons who are not actual partners as to each other are not partners as to third persons. i. Exception: A person who represents, or who expressly or impliedly consents to such a representation, that she is a partner, is liable to any third person who extends credit in goodfaith reliance on such representations. (UPA § 16) B. Young v. Jones, 816 F.Supp 1070 (1992) – Price Waterhouse Bahamas (PW-Bahamas) is Bahamian partnership, and price Waterhouse United States (PW-US) is a NY partnership. Π invests money in a company, based on an audit letter from PW-Bahamas, and later the money disappears. Π sues PWBahamas for negligence, and saying that b/c the 2 are partners by estoppel, PW-US is also liable. Π say b/c PW-Bahamas’ letterhead only identified it as Price Waterhouse & used that logo, and also b/c Price Waterhouse advertised that it had offices all over the world. i. Since the 2 firms are organized separately, there is no partnership in fact. ii. Also, there is no partnership by estoppel. Π doesn’t contend that he relied on the advertising or letterhead in investing. Plus, the exception in UPA §16 only applies to reps made to 3rd person who give credit to the partnership. No credit was extended here, this is a case of liability for negligence. Also, Π didn’t show that they relied on any conduct by PW-US that they had a partnership with PWBahamas. 11

THE FIDUCIARY OBLIGATIONS OF PARTNERS I. The Fiduciary Obligations of Partners A. Each partner has a fiduciary duty to all other partners. i. The only fiduciary duties a partner owes to the partnership & the other partners are the duty of loyalty & the duty of care. (UPA §404). a. A partner’s duty of loyalty is limited to the following: 1. every partner must account to the partnership for ANY benefit and hold in trust all profits derived by or for the partnership 2. refrain from dealing with the partnership in conduct or winding up as or on behalf of an party with adverse interest to the partnership 3. refrain from competing with the partnership before dissolution b. A partner’s duty of care is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law. c. Partner required to act in good faith and fair dealing with regard to the partnership & other partners d. A partner does not violate a duty or obligation merely because the partner’s conduct furthers the partner’s own interest (partner CAN further his own interests). e. A partner may lend money to and transact other business with the partnership & with regard to these transactions, the rights and obligations of the partner is the same as if he was not a partner. ii. Unless otherwise agreed (default), books of the partnership shall be placed at the principal place of partnership's business & all partners shall have access to the books at any time (UPA § 19). iii. All partners shall render information affecting the partnership to other partners (UPA § 20) B. Partners in a business have a fiduciary duty to inform one another of business opportunities that arise. Joint venture partners owe each other the highest obligation of loyalty as long as their venture continues. i. ***Meinhard v. Salmon, 249 N.Y. 458 (1928) – Salmon leased a hotel from Gerry for a term of 20 yrs; Salmon needs financing, & enters into a joint venture (partnership, but never actually called that) with Meinhard who would pay ½ the money needed for this, and would receive 40% of the profits for 5 yrs, and 50% after. Salmon had the sole power to manage the property & no interest in the lease ever assigned to Meinhard. Towards the end of the lease, Gerry approaches Salmon with a new, bigger opportunity, and Salmon enters this other lease w/o telling Meinhard. Meinhard finds out and demands he be let in on the new deal b/c the opportunity to renew the lease belonged to the joint venture. a. Holding: Meinhard gets % of the shares of the new deal. 1. Salmon (managing partner) owed Meinhard (investing partner) a fiduciary duty, and that this included a duty to inform Meinhard of the new leasing opportunity. Joint venturers owe each other the highest duty of loyalty, and the duty is even higher for a managing co-adventurer, b/c Meinhard relied on him to manage the partnership. 2. There was a close nexus between the original joint venture and the new opportunity, since it was essentially an extension & enlargement of the subject matter of the old one. This would be diff if the new opportunity didn’t involve the same thing. 3. Salmon was also an agent of the joint venture, and this new opportunity was only made available because he held that position in the joint venture. Salmon would never have had this opportunity were it not for Meinhard’s initial investment. 4. This case extended the duties of partnership far beyond duties under contract. b. Dissent: This isn't a partnership (where the majority would be correct), it’s a joint venture, which is a partnership for a very limited purpose & contemplated that it would end at a certain time.

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Where the parties engage in a joint enterprise each owes to the other the duty of good faith in all that relates to their common venture. Their fiduciary relationship only exists within that scope. II. After Dissolution A. A partner who retires ceases to be a partner, and his former partners no longer owe him a fiduciary duty. i. Bane v. Ferguson, 890 F.2d 117 (1989) – Bane was a partner in a law firm which entitled partners to a retirement pension, but the benefits would end if/when the firm dissolved w/o a successor. Bane retires, and a few months later the firm merges with a bigger firm. Then, that firm dissolves & retirement benefits cease. Bane sues old partners, alleging that they acted unreasonably in deciding to merge, & that their negligent mismanagement led to the firm’s dissolution. a. Partners can't do anything that makes it impossible to carry on the ordinary business of the partnership, unless authorized by all the partners (UPA §9(3)(c)). Also, a partner is a fiduciary of his partners, & owes this duty against negligence. But neither apply here, b/c Bane was no longer a partner once he retired. The only complaint he could have had was if there was fraud or deliberate misconduct (where no fiduciary relationship is necessary). 1. The business judgment rule protects the firm from liability for mere negligent operation.

III.Withdrawing Partners Removing Clients from Firm A. Fiduciaries may plan to compete with entity to which they owe allegiance, provided that in the course of these arrangements they don’t otherwise act in violation of fiduciary duties. i. Partners owe each other fiduciary duty of "utmost good faith and loyalty," must consider other partners' welfare & refrain from acting for purely private gain. ii. A partner has an obligation to render on demand true and full information of all things affecting the partnership to any partner iii. Meehan v. Shaughnessy, 535 N.E.2d 1255 (1989) – 2 partners in a law firm were planning to leave & set up their own firm. They asked another partner & some associates to leave with them. They had a list of cases they were going to take with them & sent out letters to the clients to consent to removal of their files from the firm. As they were preparing to leave, they denied that they were leaving when asked by the partners. a. The fiduciary duty of a partner does not prevent that partner from secretly preparing to start his own law firm. But they breached their duty of loyalty by acting in secret and obtaining an unfair advantage over the firm by (1) denying (lying) they were leaving, (2) preparing notices to go out immediately (before firm could compete) to the clients, and (3) delaying to provide the firm with a list of clients they intended to solicit until they had already obtained authorization from most of them. Also, the letters to the clients were unfairly prejudicial – it did not indicate to the clients that they had a choice on whether to remain with the firm, but only that they were leaving and needed permission to remove the files from the firm. IV. Expulsion of a Partner A. Dissolution is caused: (1) without violation of the agreement between the partners, (d) by the expulsion of any partner from the business bona fide in accordance with such power conferred by the agreement between the partners. [UPA § 31]. When a partner is involuntarily expelled from a business, his expulsion must be bona fide or in good faith, for a dissolution to occur without violation of the partnership agreement. B. Lawlis v. Kightlinger & Gray, 562 N.E.2d 435 (1990) – Lawlis was a senior partner in a law firm and began using alcohol, so he didn’t practice for several months b/c of this, & b/c he was seeking treatment. He later informed his partners of his problems, and they set forth some conditions with no 2nd chance. When he relapsed, they did give him a 2nd chance, where if he met certain conditions, they would return him to full partnership status. He didn’t consume alcohol after that. However, Lawlis was then told they would recommend his expulsion & a few days later the firm’s files were removed from his office. Lawlis’s expulsion was voted on by a majority vote of the senior partners, as per the partnership agreement. 13

i. Lawlis claims that the notification of the impending recommendation of expulsion & removal of files was a dissolution of the partnership, and this was wrongful b/c it wasn’t authorized by the majority vote. a. Court disagrees. Everyone still considered him a partner even after this, and Lawlis still acted like a partner. The notification was merely to say what they planned to do. The dissolution occurred when they voted by majority for his expulsion, in accordance with the partnership agreement. ii. Lawlis also claims that his expulsion was a breach of the fiduciary duty between partners, which requires each to exercise the duty of good faith and fair dealing b/c he was expelled for the “predatory” purpose of increasing the firm’s lawyer-to-partner ratio. a. Court disagrees. When the firm found out about the alcoholism problem, it sought to help him, even though he was taking substantial time off work. Even after he violated the conditions set forth at first, the firm still gave him a 2nd chance. And instead of recommending immediate expulsion, the firm proposed to allow him to stay for a while so he could find other employment & retain insurance coverage.

PARTNERSHIP PROPERTY, RAISING CAPITAL & RIGHTS OF PARTNERS IN MANAGEMENT I. Partnership Property A. What constitutes partnership property? Issue is whether property is partnership property or the individual property of the partner. All property originally brought into the partnership or subsequently acquired, by purchase or otherwise, for the partnership, is partnership property. [UPA § 8(1)] i. Where there is no clear intention expressed as to whether property is partnership property, then courts consider all the facts related to the acquisition and ownership of the asset. Some of the factors considered are: a. How title to the property is held b. Whether partnership funds were used in the purchase of the property c. Whether partnership funds have been used to improve the property d. How central the property is to the partnership’s purposes e. How frequent and extensive the partnership’s use is of the property f. Whether the property is accounted for on the financial records of the partnership. B. Rights and Interests i. The property rights of an individual partner in the partnership property are (i) her rights in specific partnership property, (ii) her interest in the partnership, and (iii) her right to participate in the management of the partnership. [UPA §24] a. Each partner is a tenant-in-partnership with her co-partners as to each asset of the partnership [UPA §25(1)] (Each partner, collectively, owns the whole partnership). 1. Each partner has an equal right to possession for partnership purposes (but no right to partnership property for any other purpose w/o consent of all other partners). 2. The right to possession is not assignable, except when done by all the partners individually or by the partnership as an entity 3. The right is not subject to attachment or execution except on a claim against the partnership 4. The right is not community property 5. On the death of a partner, the right vests in the surviving partners. b. A partner’s interest in the partnership is her share of the profits and surplus, which is personal property. [UPA §26] 1. A partner may assign her interest in the partnership and such assignment will not dissolve the partnership (unless partnership agreement says otherwise). [UPA §27(1)]

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(a) The assignee has no right to participate in the management of the partnership. But the assignee is liable for all partnership obligations. (b) C. Co-partners do not own any asset of the partnership; the partnership owns the asset and the partners own interest in the partnership. The interest is an undivided interest. i. Putnam v. Shoaf, 620 S.W.2d 510 (1981) – Putnam sold her partnership interest to Shoaf; the business had a negative financial position of $90k. Shoaf agreed to assume all personal liability for partnership debts, and Putnam was relieved of any partnership liability. The partnership then recovered a lot of money from a lawsuit (which was not known to any partners before the conveyance). Putnam sues to get a share of the money. a. It is evident that Putnam intended to convey her entire interest in the partnership to Shoaf. Had she intended to convey less, she would have remained a partner unknown to herself or the other partners. She would not have been liable for the partnership’s debts either. b. Entity vs Aggregate 1. Aggregate – what she sold belonged to Putnam, but she couldn’t have sold the right to the money from the lawsuit if it didn’t exist at that time (no meeting of the minds). So the rule would be that it remains with her. 2. But partnership is viewed as an entity, not an aggregate. So, the partnership actually owns all assets and when a partner coveys her interest in the partnership, she does not convey property held by the partnership, but only her interest in the partnership. She just sold whatever that interest was – even if she didn’t know it was worth a lot more than she thought.

II. Raising Additional Capital A. Partnerships sometimes need to raise additional capital to finance their activities. Sometimes the issue is addressed in the partnership agreement itself. Examples: i. “Pro rata dilution” provision – permits a call to each partner for a certain sum and provides for a reduction in partnership shares of any partner who does not contribute the requested sum. ii. Provision might allow partners to invest in the firm at a reduced price or require partners to make loans that will bear interest at a higher rate. iii. May provide for the sale of new partnership assets to people outside the partnership, similar to a corporation’s placing new shares on the stock market. III. The Rights of Partners in Management A. UPA §18 sets out basic rights and duties, but these are default rules which can be changed by agreeing otherwise (in partnership agreement). i. §18(a) – Equal shares of profits per person. Losses follows profits. ii. §18(b) – if a partner advances money on behalf of partnership, the partnership needs to indemnify (b/c it’s the partnership’s expense, and partnership’s liabity). iii. §18 (c, d): a. The distinction between contributions and loans. b. No interest on capital contributions. iv. §18(e): All partners have equal rights in management – equal votes (even if sharing of profits is unequal). Meaning a voice, a right to information, and a right to vote. v. §18 (f): No partner entitled to salary for acting in partnership business vi. §18(g): black ball rule – need unanimous vote of all existing partners to become a partner. vii. §18(h): Any difference arising as to ordinary matters connected with the partnership business may be decided by a majority of the partners. viii.§18(i): Distinction between legislative and constitutional matters a. Constitutional matters - things that require change in partnership agreement requires unanimous consent (this rule can't be changed) b. Legislative matters (ordinary matters) - decided by majority vote (this is a default rule, it can be changed in the partnership agreement). 15

B. The acts of a partner within the scope of the partnership business bind all partners; all partners are severally and jointly liable for the acts and obligations of the partnership (unless no authority to act & 3rd party knows the restriction). A majority of partners can make a decision and inform creditors and will thereafter not be bound by acts of minority partners in contravention of the majority decision. i. National Biscuit Company v. Stroud, 106 S.E.2d 692 (1959) – Stroud and Freeman enter into a partnership to sell groceries. There were no restrictions in the partnership agreement on the management functions or authority of either partner. Stroud notifies Biscuit (Π) that he would not be responsible for additional bread delivered. But Freeman orders bread, Biscuit delivers it. Partnership is dissolved, Stroud responsible for winding up partnership’s affairs, and refuses to pay Biscuit. a. Court holds that Freeman’s purchases of bread bound the partnership. The purchase was an “ordinary matter connected with the partnership business” within the scope of the business and Stroud could not be a majority (b/c only 2) of the partners to make a decision otherwise. C. Where equal partners exists, differences on business matters must be decided by a majority of the partners. i. Summers v. Dooley, 481 P.2d 318 (1971) – Summers & Dooley form partnership to operate trash collection business. Summers wants to hire a 3rd person to help, but Dooley says no. Summers hires someone anyway & paid him from his own funds. Dooley finds out & objects. Summers then sues Dooley for reimbursement from partnership funds for money paid to the 3rd person. a. Dooley refused consent to hire the 3rd person & objected when he found out Summers still did. A partner who has actively opposed expense incurred individually and for the benefit of one partner rather than partnership as a whole is not liable for the cost D. Partnerships are distinct entities from their partners. A partnership must indemnify a partner for injuries that occurred in the ordinary course of the partnership business. There is no corresponding right of indemnity for the partnership against the partner. i. Moren ex rel. Moren v. JAX Restaurant, 679 N.W.2d 165 (2004) – Moren, a partner in JAX (restaurant) brought her son to work on a busy day. Son gets injured when his hand goes into the dough press. Son (father actually) sued JAX, and JAX responded with a 3rd party negligence claim against Moren. a. Moren’s conduct was in the ordinary course of business, and so her negligence rests with the partnership (even if her conduct partly served her personal interests). She was acting for the benefit of the partnership at the time of the injury even though she was simultaneously acting in her role as a mother. E. The essence of a breach of fiduciary duty between partners is that one partner has advantaged himself at the expense of the firm. i. The basic fiduciary duties are: a. a partner must account for any profit acquired in a manner injurious to the interests of the partnership, such as commissions or purchases on the sale of partnership property; b. a partner cannot without the consent of the other partners, acquire for himself a partnership asset, nor may he divert to his own use a partnership opportunity; and c. he must not compete with the partnership within the scope of the business ii. Day v. Sidley & Austin, 548 F.2d 1018 (1976) – Day was a senior partner & chairman at Sidley, and signed an agreement for the firm to merge with another firm. Then they set up a new location, despite Day’s objection. Day then resigned, saying the relocation & appointment of a new cochairman made his continued service with the firm intolerable. a. Day alleges misrepresentation by Sidley that no partner would be worse off because of the merger, & he was worse off b/c no longer sole chairman. But Day had no legal right for Day to remain chairman of the DC office. Also, even if he did know this to begin with, & he changed his vote, it would have no effect, b/c all that was needed was majority vote (not unanimous). b. Day also alleges breach of Sidley’s fiduciary duty b/c they began the merger negotiations w/o informing all partners & didn’t reveal changes that might occur b/c of the merger. But the only 16

breach would be if one partner has advantaged himself at the expense of the firm, and this wasn’t the case here. Concealing merger plans didn’t produce profit for the other partners or financial loss for partnership as a whole.

PARTNERSHIP DISSOLUTION I. Dissolution A. Dissolution of a partnership does not immediately terminate the partnership. The partnership continues until all of its affairs are wound up. [UPA §30] B. Causes of Dissolution: Unless otherwise provided in the partnership agreement, the following may result in dissolution: i. Expiration of the partnership term a. Even if partnership is for a fixed term, partners can still terminate at will. But since this will be breach the other partners can sue for damages. ii. Any partner can terminate the partnership at will (b/c a partnership is a personal relationship which no one can be forced to maintain). Where the partnership is for a term or where it is a partnership at will but the dissolution is motivated by bad faith, it may be a breach of the agreement. iii. Assignment. Although an assignment of a partner’s interest is not an automatic dissolution, an assignee can get a dissolution decree upon expiration of the partnership term or at any time in a partnership at will [UPA §§30-32]. iv. Death of a partner. On the death of a partner, the surviving partners are entitled to possession of the partnership assets and are charged with winding up the partnership affairs without delay [UPA §37]. The surviving partners are also charged with a fiduciary duty in liquidating the partnership and must account to the decedent’s estate for the value of the decedent’s interest. v. Withdrawal or admission of a partner. Partnerships only exist if same partners. a. This only works if very few partners, where one person makes a difference. But in a large partnership, it doesn’t work every time one partner leaves the partnership changes. This is a default rule, which you can change. b. Most partnership agreements provide that losing or admitting a new partner will not result in dissolution. New partners may become parties to the preexisting agreement by signing it at the time of admission to the partnership [UPA §13(7)]. When an old partner leaves, there are usually provisions for continuing the partnership and buying out the partner who is leaving. vi. Illegality. Dissolution results from any event making it unlawful for the partnership to continue in business. vii. Death or Bankruptcy. (Default rule) The partnership is dissolved on the death or bankruptcy of any partner [UPA §31(4), (5)] viii.Dissolution by court decree. Court may do this in its discretion. Some circumstances may be insanity of a partner, incapacity, improper conduct, inevitable loss, or whenever it is equitable [§32]. II. The Right to Dissolve A. Dissolution by court decree – Significant disagreement between partners that undermines the business of the partnership. i. “On application by or for a partner the court shall decree a dissolution whenever … (c) A partner has been guilty of such conduct as tends to affect prejudicially the carrying on of business, or (d) A partner willfully or persistently commits a breach of the partnership agreement or otherwise so conducts himself in matters relating to the partnership business that it is not reasonably practicable to carry on the business in partnership with him. [UPA §32]. a. Owen v. Cohen, 119 P.2d 713 (1941) – Π and Δ were partners in a bowling alley, with no duration time set. Π loans the partnership $6,986 to be paid back to him from prospective profits. 17

Bowling alley running at a profit, but then the partners started having disagreement over how the business should be run, and these conflicts affected the profitability. Π sues for dissolution. 1. Court found that Δ’s actions severely undermined the success of the partnership. There were bitter, antagonistic feelings between the parties while the arrangement required cooperation, coordination & harmony. The partners were no longer able to carry on the business of their mutual partnership. B. There is no such thing as an indissoluble partnership only in the sense that there always exists the power, as oppose to the right, of dissolution. But without a legal right to dissolution, there will be damages because it is a breach of the partnership agreement. i. Collins v. Lewis, 283 S.W.2d 258 (1955) – Π and Δ entered into partnership to operate a cafeteria. Π was to finance the project & Δ was to supervise development & manage it. Π would be paid back from the profits, and the rest of the profits would be split equally. When they opened, they were not making a profit. Δ said it was because Π refused to pay additional development costs, so that money was coming out of the revenue. Π sued for dissolution. a. Π has the power to dissolve the partnership, but not the right to do so without damages since his conduct is the source of the partnership problems and amounts to a breach of the partnership agreement. C. A partner at will is not bound to remain in a partnership, regardless of whether the business is profitable or unprofitable. Exercising the power to dissolve, however, must be exercised pursuant to the fiduciary duty of good faith. i. Page v. Page, 55 Cal.2d 192 (1961) – Π and Δ partners in a linen supply business; no written agreement. Π was also a creditor of the partnership. Business losing money for 8 years, but then started to make profits. Π sued to dissolve the partnership. a. Court found no evidence that the partnership was for a term. Since it is at will, a partner can terminate the partnership at any time, whether profitable or not. However, partners are still bound to the fiduciary duty of good faith. A partner may not dissolve a partnership to gain benefits of the business for himself, unless he fully compensates his co-partner for his share of the prospective business opportunity (this would be a separate action, but here the issue is whether it’s at will). III. The Sharing of Losses A. In the absence of an agreement to the contrary, it is presumed that partners and joint venturers intended to share equally in profits and losses. However, where one partner or joint venturer contributes the capital while the other contributes skill and labor, neither party is liable to the other for losses. (The reason behind this rule is that in the event of loss, each party loses the value of his own capital or contribution). i. Kovacik v. Reed, 49 Cal.2d 166 (1957) – partnership in a business to remodel kitchens, where Π invested $10k and Δ would be the job superintendent & estimator. They would share 50-50 in profits, but the matter of sharing losses was not discussed. After a year, Π tells Δ the venture had lost money & demanded that Δ contribute to the losses. Δ said he never agreed to share losses & refused to pay. a. Neither party is liable for any loss. The party who contributed $ isn’t entitled to recovery from the party who contributed only services. Where one party contributing $ and the other contributes service then in the event of a loss each would lose his own capital – one his $ the other his labor. B. RUPA (1997) § 401(b) expressly cites and rejects Kovacik: “Each partner is entitled to an equal share of the partnership’s profits and is chargeable with a share of partnership losses in proportion to the partner’s share of the profits.” [losses follow profits] IV. Buyout Agreements A. G& S Investments v. Belman, 145 Ariz. 258 (1984) – limited partnership to receive ownership of an apt complex. One of the partners (Nordale) starts using cocaine & caused a lot of problems that affected the business. Other partner, G&S files a complaint, seeking dissolution. Before it went to court, Nordale

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dies. Nordale’s estate says the complaint was a dissolution of the partnership, so partnership needs to be liquidated & net proceeds go to partners. i. Court says filing of the complaint was not a dissolution; only a court decree could do that. But Nordale dies before such decree could be entered, so partners have the option of a buyout, as per the partnership agreement. ii. Because partnerships result from contract, the partners’ rights and liabilities are subject to the agreement made among them. The agreement here provided for a buyout if one of the partners’ died. Although the exact provision in the agreement calculated the value of the interest as less than the fair market value, court says that parties must be bound by the contracts into which they enter, absent a showing of fraud or duress in the inducement. a. Buyout provision here – if the remaining partners choose to continue the business, it must purchase the interest of the departed partner (interest that belongs to the estate). Here, the buyout formula is the capital account of the deceased partner plus the average of the prior 3 yrs’ earnings. (Capital acct = partner’s capital contribution to partnership minus losses and reduced by any distributions already made). B. Other ways to create a system for determining the price of the buyout i. If both parties solvent, set it up where one party names the price, and the other decides whether to buyer. This is the most fair outcome. (think about 2 little children sharing a piece of cake – one cuts it in half, the other gets to choose which half. This way the one cutting will try to be as fair as possible – cutting it equally). ii. Appraisal - but must determine what kind of appraisal a. Each side picks an appraiser, and the 2 appraiser pick a 3rd appraiser (that's if they have money) iii. Base the amount on gross revenues a. Small business, less money - most common formula is book value 1. Book value - something you need to generate anyway. But problem is that the book value can easily be manipulated - must trust the accountant. iv. Buy life insurance on the dead partner to ensure the dead partner is solvent

CORPORATIONS LIMITED LIABILITY I. The Corporate Entity and Limited Liability A. Characteristics of the Corporation i. Separate Legal Entity. A corporation is a separate legal entity (created by the law of a specific state), apart from the individuals that may own it (shareholders) or manage it (directors, officers, etc.). Thus, the corporation has legal rights and duties as a separate legal entity. ii. Limited Liability. The owners (shareholders) have limited liability; debts and liabilities incurred by the corporation belong to the corporation and not to the shareholders, since they are separate legal entities. (Also vice versa, corporation not responsible for debts of shareholders.) iii. Continuity of existence. The death of the owners (shareholders) does not terminate the entity, since shares can be transferred. iv. Management and control. Management is centralized with the officers and directors. Each is charged by law with specific duties to the corporation and its shareholders. 19

v. Corporate powers. As a legal entity, a corporation can sue or be sued, contract, own property, etc. B. Exceptions to the Limited Liability Rule – In some circumstances, the court may “pierce the corporate veil” and dissolve the distinction between the corporate entity and its shareholders so that the shareholders may be held liable as individuals despite the existence of the corporation. i. Fraud or Injustice. Where the maintenance of the corporation as a separate entity results in fraud or injustice to outside parties (i.e. creditors). ii. Disregard of corporate requirements. Where the shareholders do not maintain the corporation as a separate entity but use it for personal purposes. The rationale is that if the shareholders have disregarded the corporate form, then the entity is really the alter ego of the individuals and decisions made are for their benefit and not the entity’s. This is most likely to occur with close corporations. iii. Undercapitalization. Where the corporation is undercapitalized given the liabilities, debts, and risk it reasonably could be expected to incur. iv. Fairness. The veil may also be pierced in any other situation where it is only fair that the corporate form be disregarded.

II. “Piercing the Corporate Veil” A. Piercing the corporate veil is allowed whenever necessary to prevent fraud or to achieve equity. Whenever anyone uses control of the corporation to further his own, rather than the corporation’s business, he will be liable for the corporation’s acts. i. Walkovsky v. Carlton, 18 N.Y.2d 414 (1966) – Π was severely injured in a taxicab accident, and sues the cab driver, the corporation owning the cab, and the Δ. Δ owned that corporation and 9 others, each corporation had 2 cabs each with the min $10k liability insurance coverage required by state law. Π alleged that the corporations operated as a single entity & constituted a fraud to the public. a. Court says no reason to pierce the corporate veil. 1. (1) Nothing wrong with one corporation being part of a larger corporate enterprise (i.e. subsidiary). The only issue would be whether there was a disregard of the corporate form, but Π did not allege this. (2) (Undercapitalization) The state has set minimum insurance requirements & all other cab corporations have taken out the min insurance. If insurance protection is inadequate, the remedy is the legislature. b. Dissent: Corps were intentionally undercapitalized to avoid responsibility for accidents, which were likely to happen. All income was continuously drained for this purpose. B. Alter Ego theory –Two requirements must be met before the corporate veil can be pierced: (1) such a “unity of interest and ownership” that the corporation and the individual are not separate personalities, and (2) circumstances are such that not piercing the veil would “sanction a fraud or promote injustice.” i. To determine whether a corporation is so controlled by an individual or another corporation that the court would be justified in disregarding their separate identities, courts looks to four factors: a. The failure to comply with corporate formalities or to keep sufficient business records b. A commingling of corporate assets c. Undercapitalization; and d. One corporation’s treatment of another corporation’s assets as its own. ii. Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519 – Π received a judgment from Sea-Land for breach of contract, but when Π attempted to collect, Sea-Land was dissolved. Π sues Sea-Land’s sole shareholder (Δ) and Δ’s other business entities. Π wanted to pierce Sea-Land’s corporate veil so that Δ could be held personally liable, then “reverse pierce” Δ’s other corporations (to get the money the other corporations have). Court held that the corporate veil could be pierced. a. Unity of interest and ownership - There was no differentiation/separation between the corporation and the owner. Δ used same office, same phone line, & expense acct to run most of the corporations. None of the corporations ever held a meeting. Δ borrowed funds from corporation for personal expenses, and the corporations would borrow money from each other. Δ didn’t even have a personal bank acct. 20

b. Separate corporate existences would sanction a fraud or promote injustice - must be something more than just a creditor not being able to recover. 1. Comment: On remand, court found in Π’s favor, b/c by receiving countless benefits at the expense of Π and other creditors, Δ insured that his corporations had insufficient funds with which to pay their debts. iii. When a parent corporation controls several subsidiaries, a subsidiary is not liable for the actions of the other subsidiaries. a. Roman Catholic Archbishop of San Francisco v. Sheffield, 15 Cal.App.3d 405 (1971) – Π goes t Switzerland and contracts to buy a dog for $175 from a Catholic monastery, to be paid in $20 installments. Π makes 2 payments. Monastery refuses to ship the dog until all payments made, plus additional fees, and refuses to refund the money. Π sues the Roman Catholic Church (parent), the Roman Catholic Archbishop of San Francisco (subsidiary) & others. 1. Unity of interest and ownership - Δ was a distinct legal entity from the monastery had no knowledge of the contract, and no dealings with the monastery. Π did not allege that Δ was involved in the transaction. Although the monastery may have been an alter ego of the Catholic Church, that’s not the case here. There is no respondeat superior between subagents. 2. Non-piercing would sanction fraud or promote injustice – Not enough that Π won't be able to collect if not permitted to sue Δ. iv. A parent corporation is expected to exert some control over its subsidiary. When, however, a corporation is controlled to such an extent that it is merely the alter ego or instrumentality of its shareholder, the corporate veil should be pierced in the interest of justice. a. In Re Silicone Gel Breast Implants Products Liability Litigation, 887 F.Supp. 1447 (1995) – Δ is the sole shareholder of MEC (they have a parent-subsidiary relationship). Δ highly involved in MEC’s daily operations. MEC sued in tort & Πs want to pierce the veil & hold parent liable. 1. There is sufficient evidence here that MEC is Δ’s alter ego. 2. To determine if a subsidiary is merely the alter ego of the parent, the court must evaluate the totality of the circumstances, considering factors like (1) same directors or officers, (2) they file consolidated taxes, (3) the subsidiary is undercapitalized, (4) the subsidiary gets all its business from the parent, (5) the parent uses the subsidiary’s property for its own, (6) the parent pays expenses or wages for the subsidiary, (7) their daily operations are commingled. b. To determine whether to pierce the veil in a parent-subsidiary situation, no showing of fraud is required under DE law. Most states that require fraud only do so in contracts cases, not torts. 1. Even in fraud required – MEC’s funds may be insufficient to satisfy Π’s claims. Also, Δ may have induced ppl to believe it was vouching for MEC, so allowing Δ to escape liabily would be unjust. C. Limited partners do not incur general liability for the limited partnership’s obligations simply because they are officers, directors, or shareholders of the corporate general partner. Undercapitalization is no reason to open liability to limited partners who control the general partner, but there’s the remedy of piercing the corporation’s veil. i. Frigidaire Sales Corporation v. Union Properties, Inc., 88 Wash.2d 400 (1977) – Commercial is a limited partnership. Δs were limited partners of Commercial, and the only general partner was Union, a corporation. Δs were also Union’s officers, directors, and shareholders. Commercial breached contract with Π; and Π wants to pierce Unions veil to make Δs liable. a. Just b/c undercapitalized, can't go after the partners in Commercial. Need to pierce the corporation’s veil. But here, no reason to pierce Union’s veil. Π entered into K with Commercial, and Δs signed the contract only through their capacities as officers of Union (Commercial’s general partner). Court refused to pierce veil, and found that Δs “scrupulously separated” their actions on behalf of Union from their personal actions, and Π never had cause to believe Δs were general partners in Commercial.

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ii. Contract vs Tort – Courts are more willing to pierce the veil b/c of undercapitalization in tort cases than in contract cases. This is b/c in K cases, the Π had an opportunity to investigate the financial resources of the corporation & had chosen to do business with it. Almost like assumption of the risk.

THE INTERNAL AFFAIRS DOCTRINE AND THE RACE TO THE TOP/BOTTOM. I. Internal Affairs Doctrine A. The Internal Affairs Doctrine is a choice of law rule. It provides that the “internal affairs” of a corporation will be governed by the corporate statutes and case law of the state in which the corporation is incorporated. i. Internal vs External Affairs a. Internal – shareholder voting rights, distribution of dividends, corporate property, fidcuairy obligations of mgmt, etc. b. External – labor & employment issues, tax liability 1.External affairs – governed by the law of the state in which the corporation is doing business. B. McDermott Inc. v Lewis, 531 A.2d 206 (1987) – DE corporation is a subsidiary of a Panama corporation (all DE corporation stock owned by the Panama corporation). But Panama corporation has shares owned by the De corporation, so what’s happening is that the Bd is electing themselves – it’s a self-perpetuating corporation. In DE, can’t have this circular way of electing the Bd. i. Nonetheless, it is a fundamental principle of our law that corporate laws can be evaded by incorporating somewhere else (Panama).

CORPORATE ROLE & PROFIT MAXIMIZATION I. The Role and Purpose of the Corporation A. Corporate Purpose and Power i. Corporations must have a purpose or goal. So the question is “What purposes are within the bounds set by the articles of incorporation and statutory law under which the corporation was formed?” ii. State law often sets forth the acts that a corporation may legally perform. These acts should be in the aid of a proper corporate purpose. iii. If the corporation engages in an improper purpose or uses an improper power, that purpose or act is said to be “ultra vires” (beyond the corporation’s powers). iv. Powers of a Corporation a. A corporation has express power to perform any act authorized by the general corporation laws of the state & those acts authorized by the articles of incorporation. b. In most states, corporations also have implied power to do whatever is “reasonably necessary” for the purpose of promoting their express purposes and in aid of their express powers, unless such acts are expressly prohibited by common or statutory law. B. Corporate Social Responsibility i. Debate about the responsibility of corporations: a. A corporation’s objective should be to produce the best possible goods and services, that no other legal standard is enforceable, and that any other standard allows an unhealthy divorce between management (making decisions) and ownership; VS b. Corporations have a “social responsibility” and that they must balance the interests of stockholders, employees, customers, and the public at large. C. Charitable Contributions 22

i. Charitable contributions tend reasonably to promote corporative objectives, and is a lawful exercise of implied corporate power. a. ***A.P. Smith Mfg. Co. v. Barlow, 346 U.S. 861 (1953) – Corporation gave a gift of $1500 to Princeton University; the gift was challenged by a shareholder. Corporation’s president & other execs say the gift was an investment (qualified graduates would work for them), that it created a favorable environment for the company, and that the public had a reasonable expectation of such “socially” oriented contributions by the corporation. It’s more like advertising; they’re furthering their corporate image. 1. A corporation may participate in the creation and maintenance of community, charitable, and philanthropic funds as the directors deem appropriate and will, in their judgment, contribute to the protection of corporate interests. 2. Del C. § 122: Ever corp created under this chapter shall have the power to...(9) Make donation for public welfare or for charitable, scientific or educational purposes D. Business Judgment Rule i. A corporation is organized primarily for profit of the stockholders, and the powers of the directors are to be used for that end. However, directors have reasonable discretion, to be exercised in good faith, to act for this end. Directors also have the power to declare dividends and their amounts. Their discretion will not be interfered with unless they are guilty of fraud, misappropriation or bad faith (when there are sufficient funds to do so w/o detriment to the business). a. ***Dodge v. Ford Motor Co., 204 Mich. 459 (1919) - Shareholders of Ford brought suit to prevent expansion of a new plant and to compel the director to pay add’l special dividends. Corporation had surplus and Ford wanted to use it to increase production and cut prices of cars to benefit the public (reinvestment). 1. Here, Ford’s discretion to expand the business and cut car prices is upheld. Past experience shows Ford mgmt has been capable & acted for the benefit of its shareholders, & it doesn’t look like any detriment to shareholders’ interests. Ford’s expansion plans can still be carried out & there would still be surplus available for dividends. So court says the surplus dividends after that should be distributed. ii. It is not the function of the courts to resolve a corporation’s questions of policy and management, and the judgment of directors will be accepted by the courts unless those decisions are shown to be tainted by fraud, illegality or a conflict of interest. a. Shlensky v. Wrigley, 95 Ill.App.2d 173 (1968) – minority shareholder of corporation that owns Wrigley field & the Chicago Cubs brought a derivative suits against directors for refusing to install light on the field & to schedule night games for the Cubs as other teams had done to increase revenues. Motivation in refusing to do this was the view of the majority shareholders that it wanted to preserve the surrounding neighborhood & believed baseball was a daytime sport. 1. Business judgment rule – presumption of good faith. No evidence that installing lights and scheduling night games will bring extra revenue, and there’s a detrimental effect on the neighborhood (if it brings neighborhood down, fans may not want to see games in poor areas; property value might go down). No evidence that the motives of directors are contrary to the best interests of the corporation and stockholders. 2. Corporations are not obliged to follow the direction taken by other, similar corporations. Directors are elected for their own business capabilities and not for their abilities to follow others.

SHAREHOLDER DERIVATIVE ACTION 23

I. Shareholder Derivative & Direct Action A. Derivative Suits. A shareholder may sue to enforce mgmt’s duties. If the claim is that mgmt’s breach reduced the residual value of the business, the shareholder must due derivatively in the name of the corporation. i. Problem - A person with a relatively small stake in the residual value of a business might want to bring derivative suit just to be bought off. Requiring the Δs to make payment to the corporation reduces this temptation for the complaining shareholder. The real party in interest here though, is the shareholder’s attorney, b/c he may legitimately demand payment from the corporation in connection with a settlement. B. Limiting Derivative “Strike” Suits i. In order to limit “strike” suits and otherwise protect against over-deterrence, most statutes limit shareholders who may bring derivative suits, and many states have enacted statutes requiring the Πshareholder in a derivative suit, under certain circumstances, to post a bond or other security to indemnify the corporation against certain litigation expenses if Π loses the suit. a. When security must be posted. Depends on the statute; some say when Π owns less than a specified % of stock; others say it is at the court’s discretion (& demanded only when there is no reasonable possibility that the action could benefit the corporation). b. Who is entitled to security. In most states, only the corporation may demand security & only its expenses may be paid. Some states allow directors/officers to demand it & receive reimbursement. c. Covered Expenses. Usually all expenses, including attorney’s fees. Also expenses of officers/directors that the corporation has obligated to pay b/c it has indemnified them may be covered (indemnification doesn’t usually apply for fraudulent actions, only for actions taken in good faith). ii. Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541 (1949) – Π brings derivative action in federal court in NJ against Beneficial & some of its mgrs/directors (Δs), alleging that Δs engaged in conspiracy to enrich themselves at the corporation’s expense. Π owned only .0125% of the total stock. NJ statute required less than 5% shareholders who bring a derivative action to post a security bond; the lower court here required the bond and Π appealed. a. A stockholder who brings a derivative action assumes a position of a fiduciary nature. He sues as a representative of a class that did not elect him as a representative as they elected the corporate director or manager. The state has plenary power to impose standards promoting accountability, responsibility, and liability upon such representation. b. Constitutionality 1. Doesn’t violate due process clause since it only imposes liability & requires security only for reasonable expenses. 2. Doesn’t violate the equal protection clause by making a classification based on the financial interest the representative has in a corporation; the classification serves only to insure some measure of good faith and responsibility. c. Erie Doctrine – using state law in federal court under diversity jurisdiction. The statute is substantive, so federal court will apply NJ statute. C. Direct Suits - If the claim is that mgmt’s breach deprived the shareholder of some other right (like right to inspect shareholder list), the shareholder must sue directly in her own name. i. If the Π-shareholder brings suit alleging that management is interfering with the rights and privileges of stockholders and is not challenging management’s acts on behalf of the corporation, it is a personal suit. Since this is not a derivative action, posting of a security bond is not required. a. Eisenberg v. Flying Tiger Line, Inc., 451 F.2d 267 (1971) – shareholder brings suit to prevent merger & reorganization, alleging that the purpose of the plan was to dilute his voting rights. Lower court demanded that the Π post a security bond & Π appeals. 24

1. Π is not challenging mgmt of the company on behalf of the corporation; Π claims that he has been deprived of any voice in the operation of their company. Therefore, the Court held that the action was personal, and not a shareholder derivative action, so no bond is required. The statute only applies to derivative actions. D. Note on Settlements and attorney fees i. When derivative suits reach settlement rather than proceeding to judgment, the company can pay the parties’ attorneys’ fees. When a judgment is rendered against the Δs, however, except as covered by insurance, the Δs generally will be responsible for attorneys’ fees and possibly costs. Often, the real beneficiary on the Π’s side is his attorney, who may accept a generous fee from the corporation to settle the lawsuit while the corporate managers who brought harm on the corporation are relieved of the risk of personal loss. E. Note on Individual Recovery in a Derivative Action i. In Lynch v. Patterson (1985), the Π, one of 3 shareholders, brought a derivative suit against the other shareholders who, in managing the corporation, had increased their own salaries, ultimately paying themselves an extra $266k. The court awarded the Π damages in his individual capacity, reasoning that allowing a corporate recovery would merely put the funds back in the hands of the wrongdoers. F. The Demand Requirement. In order to deter frivolous suits, a complaining shareholder is required to exhaust internal remedies before bringing suit. So before a shareholder may bring a derivative suit, he must request that the directors bring the suit, and they must refuse. Now the Business Judgment Rule comes into play – if the directors refuse on the basis of a good faith business judgment, the ct will dismiss the derivative suit. However, directors may sometimes refuse in bad faith. i. Purpose of the demand requirement: a. Creates a form of alternative dispute resolution by providing corporation directors with opportunities to correct alleged abuses, b. Helps insulate directors from harassment by litigations on matters clearly within the discretion of directors, and c. Discourages “strike suits” commenced by shareholders for personal gain rather then for the benefit of the corporation. ii. When a claim of harm belongs to the corporation, it is the corporation, through the Board, that must decide whether or not to pursue the claim. Shareholder derivative actions impinge on the Board’s managerial freedom; therefore, when a shareholder files a derivative action, he/she must show either Board rejection of his/her pre-suit demand, or justification why demand wasn’t made (futility exception). a. Grimes v. Donald, 673 A.2d 1207 (1996) – Π-shareholder claimed that the Bd of Directors failed to use due care, committed waste, approved excessive compensation, and unlawfully delegated its duties & responsibilities by entering into an agreement with the CEO which provided that the CEO could make decision w/o interference from the Bd, & if Bd did interfered, CEO could get damages. 1. An abdication claim can be stated by a stockholder as a direct claim, as distinct from a derivative claim, but here the complaint fails to state a claim upon which relief can be granted. When a stockholder demands that the board of directors take action on a claim allegedly belonging to a corporation and demand is refused, the stockholder may not thereafter assert that the demand is excused with respect to other legal theories in support of the same claim, although the stockholder may have a remedy for wrongful refusal or may submit further demands which are not repetitious. iii. Futility Exception to the demand requirement: no demand necessary when it is evident that directors will wrongfully refuse to bring such claims. a. To qualify for the futility exception, a shareholder must allege with particularity that: 1. Self-Interest. A majority of the bd of directors is interested in the challenged transaction, by virtue of self-interest in the transaction or “control” by a self-interested director

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2. Incapacity. that the bd of directors did not fully inform themselves about the challenged transaction to the extent reasonably appropriate under the circumstances, or 3. Lack of sound business judgment. that the challenged transaction was so egregious on its face that it could not have been the product of sound business judgment of the directors. b. Marx v. Akers, 644 N.Y.S.2d 121 (1996) – Without making a demand on Bd of IBM (Δ), Π filed a shareholder derivative suit alleging that the Bd had wasted corporate assets by awarding excessive compensation to IBM’s exec officers & to its outside directors. 1. Excessive compensation paid to exec officers - no futility. Less than a majority of the directors rec’d such compensation, indicating that the bd was not interested. 2. Excessive outside director compensation – futility (yes). The outside directors comprised a majority of the Bd indicated that a majority of the Bd was self-interested. So demand here is excused, but ct dismissed the complaint b/c there was no wrong to the corporation. (a) No cause of action – Π did not allege compensation rates excessive on their faces or other facts that would have questioned whether the compensation was fair to the corporation when approved, the good faith of the directors setting those rates, or that the decision to set the compensation could not have been a product of valid business judgment. G. The Role of Special Committees – Bd of Directors may create a special committee composed of disinterested directors to decide on whether to bring the derivative action. i. A Board may legally delegate authority to a committee of disinterested directors when the Board finds that it is tainted by the self-interest of a majority of directors. The Bd is not abdicating b/c the decision to create a committee is revocable. ii. An action must be dismissed if a committee of independent and disinterested directors conducted a proper review, considered a variety of factors and reached a good-faith business judgment that the action was not in the best interest of the corporation. iii. A committee must show that (i) its members are disinterested and used proper methodology, (ii) the committee is independent, (iii) it proceeded in good faith, and that (iv) it reasonably investigated the claim. a. In Re Oracle Corp. Derivative Litigation, 824 A.2d 917 (2003) – Π-shareholders file derivative suit alleging insider trading by 4 members of the Bd. Bd forms special litigation committee to investigate. The 2 Bd members who were named on the committee joined the Bd after the events alleged took place & were both Stanford professors. The committee also got expert advisors to help investigate. After the committee conducted an extensive investigation, they concluded that the corporation should not pursue the derivative suit. Issue is whether this was an Independent & Disinterested Committee. (a) Facts revealed during discovery: (i) one of the Δ-director was prof to one of the committee members & they have remained in contact with each other & both served on a Stanford committee, (ii) another Δ-director well-know alumnus of Stanford & generous contributor, (iii) yet another Δ-director had made major charitable contributions to Stanford. (b) Although none of the Δs could deprive the committee members of their prof positions at Stanford b/c they have tenure, ct notes that it’s not the only motivating factor of human behavior. Social influence may also direct behavior. The committee has not met it’s burden of showing their independence. The ties here are substantial enough to raise a reasonable doubt about the committee’s ability to impartially decide whether the derivative suit against the Δs should proceed.

LLCS AND PIERCING THE “VEIL” I. The Operating Agreement 26

A. Although LLCs are governed by statute, LLC statutes generally provide that the members can adopt an operating agreement with provisions different from the LLC statute. Generally, the operating agreement will control. B. Operating Agreement controls if there is no conflict with mandatory statutory provisions. i. Elf Atochem North America, Inc. v. Jaffari, 727 A.2d 286 (1999) – Elf (Π) and Jaffari (Δ) entered into an agreement to form an LLC, Malek LLC. Agreement contained an arbitration clause covering all disputes arising out of the agreement, and a forum selection clause providing for exclusive jurisdiction of CA state & Fed Cts. Π later brings a deritative suit on behalf of Malek LLC claiming that Δ breached its fidcuiary duty. a. The statute involved here provides broad discretion in drafting the LLC agreement & funishes default provisions only when the agreement is silent. It is designed to give maximum effect to the freedom to contract & to the enforceability of LLC agreements. Only when the agreement is inconsistent with mandatory statutory provisions will the agreement be invalidated. The statute allows parties to contract away their right to file suit in DE. b. Another issue Π brought up was Malek LLC, although in existence when the agreement was executed, did not sign the agreement, & thus never consented to those clauses; this is a derivative suit on behalf of Malek. Ct disagrees & says that since the members of the LLC executed the agreement, it is valid even though Malek LLC never signed.

II. Piercing the "LLC" Veil A. It is unlcear whether corporate principals of law, like piercing the veil, applies to LLCs. B. Uniform LLC Act § 303(b) – “The failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company.” C. Sometimes, though, the court will hold that the LLC veil may be pierced in a manner similar to piercing the corporate veil. i. Kaycee Land and Livestock v. Flahive, 46 P.3d 323 (2002) – Π entered into a K with FOG, which allowed FOG to use Π’s real property. Π alleges that during its use of the property, FOG caused environmental contamination of the property. FOG has no assets, and Π wants to pierce the veil to hold Δ, FOG’s managing member, liable. a. Every state that has enacted LLC piercing legislation has chosen to follow corporate law standards. There is no reason to treat LLCs differently than corporations. If members of an LLC fail to treat the LLC in the manner contemplated by statute, they should not be free from individual liability.

III.Fiduciary Obligation A. Limiting Fiduciary Duties by Agreement i. McConnell v. Hunt Sports Enterprises, 725 N.E.2d 1193 (1999) - LLC operating agreement provision states that”Members may compete. Members shall not in any way be prohibited from or restricted in engaing or owning in any other businss ventrue of any nature, including any venture which may be competitive with the business of the Company.” Hunt claims that McConnell & other members violated a fiduciary duty by forming and joining their new limited partnership. a. Limited liability partnership involves same fiduciary relationship as a partnership. 1. Normally this relationship would preclude direct competition btwn members of the company. However, terms of the operating agreement allow members to compete w/ business of the company. b. In competing, appellees didn’t engage in any acts that would constitute wrongful behavior. There is no evidence that McConnell acted in a secretive manner or that he tortiously interfered w/ prospective business relationship.

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THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS II. Introduction A. Directors are normally held to have the duty of mgmt of the corporation. These duties are normally delegated to the officers; so, the directors must supervise the officers. The legal duties of the directos and officers are owed to the corporation, so the performance of these duties is usually enforced by an action on behalf of the corporation brought by an individual shareholder (derivative action). B. Fiduciary Relationship of directors to the corporation. Directors have fiduciary duty to corporation and the mgmt of its affairs, since they manage on behalf of shareholders. i. Duty of Loyalty. Directors are bound by the rules of fairness, loyalty, honesty and good faith in their relationship, dealings and mgmt of the corporation, as are officers. ii. Duty of reasonable care. Directors must exercise reasonable care, prudence, and diligence in the mgmt of the corporation. iii. Business Judgment. When a matter of business judgment is involved, the directos meet their responsibility of reasonable care and diligence if they exercise an honest, good-faith, unbiased judgment. When this standard is applied, a director acting in good faith would only be liable for gross negligence or worse. COURTS WILL NOT SECOND GUESS A BUSINESS DECISION IF IT WAS MADE IN GOOD FAITH, WAS INFORMED, AND HAD A RATIONAL BASIS.

III.The Duty of Care A. Courts will not interfere with the business judgment of the Board unless it appears that the directors have acted or are about to act in bad faith and for a dishonest purpose. More than imprudence or mistaken judgment must be shown. i. Kamin v. American Express Company, 54 A.D.2d 654 (1976) – Πs (minority stockholders) bring derivative suit against Δ. Π claims that a certain dividend that is to be paid by Δ is a waste of corporate assets, and demanded that Δ rescind the distribution, but Δ rejected the demand. a. The question of whether a dividend should be delcared or a distribution of some kind should be made is exclusively a matter of business judgment for the Bd. Mere errors of judgment are not sufficient, so not enough to allege that the Bd made an imprudent decision. There is no claim of fraud or self-dealing, and no contention that there was any bad faith or oppressive conduct. b. The Bd carefully considered Π’s objections and unanimously rejected them. B. The determination of whether a business judgment is an informed one turns on whether the directors have informed themselves, prior to making a business decision, of all material information reasonably available to them. The concept of gross negligence is the proper standard for determining whether a business judgment reached by a board of directors was an informed one. i. ***Smith v. Van Gorkom, 488 A.2d 858 (1985) – Van Gorkom (Δ), Trans Union CEO, began to explore the opportunity to sell to a company w/ more taxable income. CFO tells him a leveraged buy-out by mgmt at $50/share would be easy, but $60/share difficult. CEO said he would take $55/share for his shares. CEO then met with a corporate takeover specialist, who agreed to make a cash-out merger offer at $55/share. Senior mgmt & CFO responded negatively to this, but he still brought it to the Bd. CEO gave the Bd a 20 min presentation & the Bd approved the proposed Merger agreement, w/o reserving the right to actively solicit alternate offers ($55/share higher than market price of $39/share). a. Πs attacking a Bd decision must rebut the presumption that its business judgment was an informed one. Directors are liable if they were grossly negligent in failing to inform themselves. Directors did not adequately inform themselves as to (1) the CEO’s role in forcing company’s sale & in establishing the per share purchase price, and (2) the intrinsic value of the company (not necessarily $39/share market). They were grossly negligent in approving the sale in such a short period of time & without important info. 28

b. The Bd breached their fiduciary duty of care to stockholders by (1) failure to inform themselves of all info reasonably available to them and relevant to their decision to recommend the merger and (2) failure to disclose all material info such as a reasonable stockholder would consider important in deciding whether to approve the offer. c. Dissent - Experienced directors such as these are not easily taken in by a "fast shuffle." Wouldn’t have entered into a multi-million dollar corporate transaction without being fully informed. ii. Brehm v. Eisner, 746 A.2d 244 (2000) – Disney hired Ovitz as President; employment agreement approved by Bd contained a generous severance package in the event Ovitz left Disney before 5yr term over and not fault of Ovitz. Shortly after, problems with Ovitz’s performance arose. Bd allowed Ovitz to terminate the K under the no-fault provision, & so Ovitz got the severance package which ended up being valued at over $140million. Π-shareholders filed derivative suit alleging Bd of directors breached their fiduciary duty in (1) approving an excessive & wasteful employment agreement and (2) in approving the no-fault termination of the employment agreement. a. The standard for judging the informational component of the Bd’s decision does not require that it be informed of every fact. The Bd is only required to be reasonably informed. 1. Although the Bd did not calculate the exact amt of the severance payout, it was fully informed of the manner the payout would be calculated. b. Reliance on an expert’s opinion is entitled a presumption that the Bd exercised proper business judgment in so relying. Π may rebut that presumption by showing that the reliance was not in good faith or that the expert was not selected with due care. 1. No evidence that reliance not in good faith or expert not selected with due care. c. A Bd’s decision on Exec compensation is entitled to great deference. It is the essence of business judgment for a Bd to determine if a particular individual warrants high compensation, and the ct will not second-guess the Bd, unless the transaction is so egregious on its face that the Bd cannot meet the business judgment test. 1. Parties negotiated for severance payment, & Bd considered the value of the employee vs the value of the contract. At time K negotiation, other companies also offering very attractive compensation packages to Ovitz. d. Agreement limited good cause for termination only to gross negligence or malfeasance, & Ovitz’s performance did not rise to this level. So they had to approve the no-fault. C. Directors must discharge their duties in good faith and with that degree of diligence, care and skill which ordinary prudent men would exercise under similar circumstances in like positions. A lack of knowledge about the business or failure to monitor the corporate affairs is not a defense to this requirement. i. Francis v. United Jersey Bank, 432 U.S. 814 (1981) – Mrs. Pritchard becomes director of P&B after her husband dies. She wasn’t involved in day-to-day ops and knew almost nothing about the business, and didn’t check anything. Her sons misappropriated millions and corporation went into bankruptcy. a. Directors have a duty to act in good faith as ordinary prudent persons would under similar circumstances in like positions. This standard is a relative concept, depending on the kind of corporation, the director’s corporate role, and the particular circumstances. b. Generally, director should have at least basic understanding of corp’s business and knowledge about its ongoing activities, which reqs a general monitoring of its affairs and policies (not necessarily detailed inspection of day-to-day affairs). Director has responsibility to attend board meetings and regularly review financial statements. If there is illegal conduct, there is a duty to object, and possibly take reasonable means to prevent such conduct or resign. Mrs. Pritchard didn’t fulfill any of the director’s obligations. c. Her failure to act contributed to the continuation of the misappropriation (if she had reviewed the financial statement she would have noticed it), and proximately caused it.

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D. Duty to Act lawfully. Officers and directors have a duty to act lawfully. If they knowingly cause their corporations to violate the law, they have violated this duty. Officers and directors also have a duty to ensure that the corporation has effective internal controls to prevent employees from engaging in illegal acts. i. To show that directors breached duty of care by failing to control employees, Πs must show either (1) that directors knew or (2) should have known that violations of law were occurring and, in either event, (3) that the directors took no steps in a good faith effort to prevent or remedy that situation and (4) that such failure proximately resulted in the losses. ii. In Re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (1996) – Caremark employees violated fed laws regarding payments to healthcare providers. Caremark indicted with multiple felonies & plead guilty to mail fraud; Caremark had to pay out $250million b/c of this crime. Derivative suit filed against Bd of directors (so corporation can recover money), alleging that Bd breached duty of care by failing to adequately supervise employees’ conduct, which exposed Caremark to this liability. a. A director’s obligation includes a duty to attempt in good faith to assure that a corporate information and reporting system exists, and that failure to do so under some circumstances may render a director liable for losses caused by non-compliance of applicable legal standards. However, only a sustained or systematic failure of the Bd to exercise reasonable oversight will establish the lack of good faith that is necessary for liability. 1. Good faith attempt here – committee charged with overseeing compliance w/applicable laws. 2. No evidence that the directors lacked good faith in monitoring responsibilities, or that they conscientiously permitted a known violation of the law to occur. b. In the absence of grounds to suspect deception, neither the Bd nor the officers can be charged with wrongdoing simply for assuming honesty and integrity of employees. iii. Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362 (2006) –Corporation ended up paying $50million in fines and penalties to fed govt to settle charges against corporation b/c it had failed to file “suspicious activity reports” as required by statute & money-laundering regulations. Πs file derivative suit against directors, claiming directors breached their duty to act in good faith b/c the company’s compliance program was not adequate to prevent the violations. a. Ct held that the “oversight” standard in Caremark was the appropriate standard for director duties with respect to corporate compliance issues. 1. Conditions for director oversight liability: (a) directors utterly failed to implement any reporting or info system or controls; or (b) having implemented such a system/controls, consciously failed to monitor or oversee its operations.

IV.The Duty of Loyalty A. Directors and Managers – Duty of loyalty means that the directors must place the interests of the corporation above their own personal gains. Problems arise though b/c directors have other business involvements (causing a conflict of interest), & it is often for this reason that they are placed on the Bd. i. Rules to determine whether a conflict of interest transaction is voidable: a. At early common law, the rule was that any contract between a director and her corporation, whether fair or not, was voidable. b. Disinterested Majority Rule. Voidable only if the director had not made a full & complete disclosure of the transaction of the transaction (its value, her interest, profit, etc.) to an “independent Bd” (quorum of disinterested directors), or the transaction was shown to be unfair and unreasonable to the corporation. Director has the burden of proof as to show the fairness of the transaction. c. Whether the transaction is fair to the corporation. Part of the “fairness” requirement is that the director’s interest be fully disclosed, however. If the Bd is not disinterested, the contract will be given very close scrutiny. ii. If a director has a conflict of interest with a corporation’s transactions, the motives of the directors are questioned, and the court will examine the conflict with the most scrupulous care. 30

The director has the burden to show not only good faith in the transaction, but also the inherent fairness to the corporation. a. Bayer v. Beran, 49 N.Y.S.2d 2 (1944) – Π-shareholders filed suit against the company’s directors (Δs) alleging that the directors were negligent in selecting the type of radio program during which to advertise, & that the directors were motivated by the purpose of fostering the singing career of the President’s wife, who was used in the commercials to sing. 1. It was for directors to decide whether or not to use radio ads, how much to spend, and during which programs (business judgment rule). 2. Regarding the fact that Pres’s wife would benefit (a) Wife is a competent singer & no evidence that another singer would have enhanced the quality of the ad. She was one of many singers used, and was in fact paid less than the other singers. (b) As long as the ad served a legitimate and useful corporate purpose, the fact that the wife might benefit is not enough to show breach of duty. iii. A corporate transaction in which directors had an interest other than that of the corporation is voidable unless the directors can show the transaction was fair and reasonable to the corporation a. Lewis v. S.L. & E., Inc., 629 F.2d 764 (1980) – Dad owns both SLE & LGT. SLE leases out property to LGT for $14,400/yr. After 10 yrs, the lease expires; no new lease, but LGT just paying the same amount. Π (son) is a SLE shareholder & brings a derivative suit, claiming that directors had committed waste by undercharging b/c property worth a lot more, but only leasing it for this much b/c LGT can’t afford to pay any more. 1. Δ fails to carry burden of proving that the transaction was fair & reasonable to the corporation. Property worth enough to justify a higher rent. Doesn’t matter if LGT can’t afford to pay a higher rent, SLE should rent the property to a diff party at fair rental value. B. Corporate Opportunities i. The duty of loyalty prevents directors and officers from taking opportunities for themselves that should belong to the corporation. 1. Directors/Officers may not: (a) use corporate property/assets for personal uses or to develop his own business ♦ Note: Although can’t use corporate assets to compete, a fiduciary may leave the corporation & form a competing business. But the conduct of the fiduciary while still with the corporation & preparing to leave to form new business may be questioned. (b) assume for himself properties or interests in which the corporation is “interested” or can be said to have a tangible “expectancy” or which are important to corporation’s business or purposes. 2. Defenses to charge of usurping corporate opportunity (a) Opportunity was presented to Δ in individual capacity, not as fiduciary of corporation (b) Corporation is unable to take advantage of the opportunity. Officer/dir may take advantage of corporate opportunity if it is disclosed to the corporation first, and it is unable to take advantage. (c) Corporation refuses the opportunity. If the corporation, by independent directors or SH, turns down an opportunity, then fiduciaries may take advantage of the opportunity. ii. A director may not seize for himself an opportunity from his corporation, when (1) it would present a conflict of interest between the director and his corporation, (2) the corporation is financially able to undertake the opportunity, (3) the opportunity is in the line of the corporation’s business, and (4) is an opportunity in which the corporation has an interest or a reasonable expectancy of interest, and is of practical advantage to the corporation. a. Broz v. Cellular Information Systems, Inc., 673 A.2d 148 (1996) – Δ owns RFBC, and also a member of Bd of directors for CIS (competitors). Both companies provided cell service. CIS was in financial difficulty and selling its cell service licenses. A cell service license was available 31

for sale from another company, and Δ was interested in it. He talked to CIS CEO, who told him CIS didn’t want that license. PriCellular interested in acquiring CIS. Δ and PriCell both put in bids on service license, and CIS knew PriCell was interested in that license. Δ got the license. PriCell completed acquisition of CIS, then sued Δ for breach of duty by usurping a corporate opportunity. 1. Δ found out about opportunity in his individual, not corporate capacity – company selling the license did not even consider CIS as a candidate to sell the license b/c in financial difficulty. 2. A formal presentation is not required under the circumstances in which the corporation does not have an interest, expectancy, or financial ability to pursue. (a) CIS was financially incapable of taking the opportunity. Also, it was getting rid of the licenses it did have, so clear they had no interest or expectancy in acquiring another license. (b) Δ only sought to compete with PriCell, an outside entity to which he owed no duty. b. In Re eBay, Inc. Shareholders Litigation, 2004 WL 253521 – eBay retained Goldman Sachs as lead underwriter of its IPO (initial public offering). Goldman “rewarded” favored clients, including director/officers of eBay by allocating to them thousands of IPO shares at the initial offering price, and they made huge profits. Other SHs sued those eBay directors/officers (Δs) for usurping corporate opportunity. Δs argue that this was just a collateral investment, not a corporate opportunity. 1. eBay was financially able to exploit the opportunity in question. eBay was in the business of investing in securities; investment was in fact integral to eBay’s cash mgmt strategies & a significant part of its business. It doesn’t matter that these were considered risky investments; the fact is that eBay was never given an opportunity to consider the risks. Although not every advantageous opportunity that comes to a director will be a corporate opportunity, here the below-market investment was offered as a direct reward for their dealings with Goldman Sachs, and this conduct placed the Δs in a position of conflict with their duties to the corporation. C. Dominant Shareholders i. Shareholders hold not duty to the corporation. SH can use info and give it to a competitor, use dividends to set up a competitor. SHs are not agents of the corporation, and are not responsible to it. BUT this rule changes when the shareholder dominates the corporation. ii. Majority shareholders have a fiduciary relationship to the corporation and the minority SH. a. This duty is manifest in several circumstances: 1. If a majority SH deals with the corporation (such as a contractual relationship), the transaction will be closely scrutinized to see that minority SH are treated fairly. 2. Also in corporate transactions, where the majority has the voting power to effectuate a transaction, the effect on minority SH may be reviewed by the cts to see that the majority acted in “good faith” and not to the specific detriment of the minority SH. b. A parent owes fiduciary duty to its subsidiary in parent-subsidiary dealings. When fiduciary duty is combined with self-dealing – when parent is on both sides of transaction – the intrinsic fairness standard applies. This standard involves a high degree of fairness and a shift in the burden of proof to the parent to prove that its dealings with the subsidiary were objectively fair. 1. Sinclair Oil Corp. v. Levien, 280 A.2d 717 (1971) – Δ (Sinclair) owned 97% stock of a subsidiary. Δ appointed Bd members & officers. Then Δ drained off dividends from subsidiary to meet its own needs for cash; the dividends exceeded current earnings. Π-SH claimed this limited subsidiary’s ability to grow and also that Δ had failed to pay on time for oil purchased from subsidiary & Δ did not purchase minimum contractual amounts per K. (a) Dividends – no self-dealing. b/c parent did not receive anything from the subsidiary to the exclusion or detriment of minority SH. They shared pro rata in the dividend distribution. 32

(b) Limiting ability to grow – since Δ did not usurp any opportunities that normally would have gone to the subsidiary, the BJR applies, & ct will not disturb the transaction unless there is a showing of gross overreaching, which there was not. (c) Contract – Δ rec’d the benefits of the K, so it must comply with its contractual duties. Under the intrinsic fairness standard, Δ could not meet its burden to prove that its causing the subsidiary to not enforce the K was intrinsically fair. c. The majority has the right to control; but when it does so, it occupies a fiduciary relation toward the minority, as much so as the corporation itself or its officers and directors. 1. Zahn v. Transamerican Corporation, 162 F.2d 36 (1947) – Π owned class A common stock. Δs owned almost all of class B stock; so Δ controlled the Bd. Upon liquidation, preferred stock got set amount, and Class A got double what Class B got. Assets worth a lot more than the SHs thought. When they liquidated the assets, they paid off the preferred shares & then paid itself (since it controlled almost all of class B stock). Πs (Class A SH) sued, claiming they should have rec’d $240 per share, not the $80 per share they actually got. (a) A majority SH may vote according to its own interests, but also has a fiduciary duty to the corporation and the minority SHs the same as the dirs. Actions taken by the majority must, therefore, meet standards of good faith & fairness. (b) Disinterested directors could have called the Class A stock. But here, the directors were controlled by majority SH. Directors owed the duty of acting in best interests of all SHs, these only acted in bests interests of majority SH. (c) There was no business purpose for call of Class A, then liquidation except to benefit Class B SHs at expense of Class A SHs. D. Ratification - Ratification is not a complete defense. SH must be disinterested and well-informed to properly ratify a transaction i. DE corporation statute §144: A contract or transaction btwn a corporation and one or more of its directors or officers will not be void or voidable solely for this reason if the contract or transaction is fair as to the corporation as of the time it is authorized, approved or ratified by the board of directors, a committee, or the shareholders. ii. When a transaction is properly ratified by SHs, the transaction is not voidable simply b/c interested directors participated; in this case, the Π still has the burden proof to demonstrate that the terms of the transaction are so unequal as to amount to a gift or waste of corporate assets. However, if a majority of the shares voted were cast by interested SHs, the Bd is not relieved of its burden of proving fairness. a. Fliegler v. Lawrence, 361 A.2d 218 (1976) – Lawrence, director & officer of Agau, individually acquired some properties & offered them to Agau, but Bd agreed it couldn’t pursue the opportunity. So individual Bd members (Δs) then formed a closely-held corporation, USAC, & properties transferred to USAC for development w/no risk to Agau. USAC granted Agau option to acquire USAC, if they decided it was worth it. A yr later, the option was executed. Upon approval by Agau SHs, Agau was to deliver 800k shares of Agau in exchange for all shares of USAC. 1. Since the majority of the votes cast were by interested SHs, the interested SHs (Δs) bear the burden of proving the transaction was fair. Δs have proven this. Agau was in serious financial difficulty & by exercising the option to purchase, rec’d properties which were of substantial value, and potentially profit-generating. iii. In Re Wheelabrator Technologies, Inc. Shareholders Litigation, 663 A.2d 1194 (1995) – Waste bought 22% of WTI stock & elected 4 of its directors to WTI’s 11-member Bd. Waste & WTI began negotiating merger, unanimously approved by non-Waste directors. WTI SHs file against directors claiming that proxy statement was materially misleading & that the WTI Bd didn’t carefully consider the proposal b/c meeting only lasted 3 hrs. a. Directors have the fiduciary duty to disclose fully and fairly all material facts within its control that would have a significant effect upon a stockholder vote. 33

1. The 2 corps had business relationship for > 20 yrs. This would indicate that WTI had a substantial working knowledge of W before the actual merger discussion. 2. Merger vote was approved by a fully informed vote of a majority of SHs. Since this vote was fully informed, the claim that the board failed to exercise due care in negotiating and approving the merger must be extinguished. b. When a Bd’s action has been ratified by SHs, the standard of review and burden of proof depends on the type of underlying transaction: 1. In “interest director” transactions, approval by fully informed, disinterested SHs invokes the BJR which limits judicial review to issues of waste or gift. 2. In transactions btwn the corporation & a controlling shareholder (usually parentsubsidiary mergers), the standard of review is normally entire fairness, with the directors having the burden of proof. c. Here, Waste was not a majority shareholder, so standard of review is BJR.

DISCLOSURE AND FAIRNESS I. Federal Law – Rule 10b-5 A. Rule 10B-5 – makes it unlawful in connection with the purchase or sale of any security 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, to: i. Employ any device, scheme, or artifice to defraud ii. Make any untrue statement of a material fact 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 are made, not misleading. iii. Engage in any act, practice, or course of business conduct which operates or would operate as a fraud or deceit upon any person II. The elements of a 10b-5 cause of action A. The person is an “insider.” Two elements of an insider: i. The person must have a relationship giving access, directly or indirectly, to information intended to be available only for a business purpose and not for the personal benefit of anyone. ii. There must be the presence of an inherent unfairness where a party takes advantage of such information, knowing it is unavailable to those with whom he is dealing. B. Materiality i. Basic Inc. v. Levinson, 485 U.S. 224 (1988) – officers & directors of Basic, including Δs, opened merger discussion with Combustion. Basic denied 3 times it was conducting merger negotiations. Then Basic halted trading saying it had been approached; later announced that the Bd approved Combustion’s $46/share tender offer. Πs-SHs sold their stock after the denial and before the trading halt. They sued under Rule 10b-5. a. Materiality: There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable shareholder as having significantly altered the ‘total mix’ of information made available. Materiality will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity. 1. Mergers are too uncertain to occur. Therefore, it is difficult to ascertain whether an investor would have considered the omitted information significant at the time. 2. A denial of merger negotiations cannot itself render them material because Rule 10b-5 requires the Π to show that “the statement were misleading as to a material fact,” not just that they were false or incomplete. 34

C.

D.

E.

F.

3. Case is remanded to determine whether or not the fact was material. Reliance i. Reliance provides a causal connection between a Δ’s misrepresentation and a Π’s injury. ii. Basic Inc. v. Levinson, 485 U.S. 224 (1988) - see above a. Fraud on the market theory 1. However, requiring Π to show reliance (by acting differently had the omitted material info been disclosed or if misrepresentation never made) places an unrealistic evidentiary burden on him. 2. So the court will presume reliance b/c market price of shares reflect publicly available information and an investor relies on that information to determine the price (and thus make decisions). Δ may rebut this presumption. b. Dissent: Shouldn’t use the fraud on the market theory - investors don’t always share the court’s presumption that a stock’s price is a reflection of its inherent value. Many purchase or sell stocj b/c they believe this price inaccurately reflects the corporation’s worth. iii. Fraud-on-the-market theory to prove reliance does not apply where the false statements are not public and do not reach the market. a. West v. Prudental Securities, 282 F.3d 935 (2002) – Δ told his customers that Prudential was certain to soon be acquired at a big premium, while in fact there was no acquisition pending. People who relied on this information bought the stock & sued Δ when they found out it wasn’t true. 1. Fraud on the market theory – public information reaches professional investors, whose evaluation of that information influences securities prices. However, Δ didn’t release false information to the public, and therefore they didn’t affect the market. Fraud or deception i. Rule 10b-5 was designed to protect investors by requiring full and truthful disclosure so that investors could make informed choices as to their course of action. There is nothing in 10b-5 that indicates any intention to prohibit conduct that doesn’t involve manipulation or deception. a. Sante Fe Industries, Inc. v. Green, 430 U.S. 462 (1977) – SF owned 90% of the stock of the subsidiary, and in order to eliminate the minority SHs, used a short-form merger as specified by statute. They (1) paid minority SHs above-appraisal price for the shares, (2) gave notice of merger (3) gave minority SHs notice of their right to an appraisal action in state court to dispute the price, and (4) disclosed all material info relative to the subsidiary’s stock value. Minority SHs sued under 10b-5 claiming no other purpose than to freeze out the minority & b/c the price offered was grossly inadequate. So although no material misrepresentation, SHs claimed there was a breach of their fiduciary duty. (a) There was no manipulation or deception. Here the investors were fully informed of their rights and options and had an adequate state remedy (appraisal) for the wrong alleged. Causation and Causation-in-fact – the Δ’s action must have caused the Π’s injury. i. Reliance – reason for reliance requirement is to insure that the Δ’s conduct caused the Π’s injury ii. Materiality – Causation depends on materiality. Once it’s shown that Δ misrepresented or omitted a material fact, then it can be concluded that Δs conduct caused the Π’s injury. Purchase or Sale of securities i. Rule 10b-5 expressly covers only the purchase and sale of securities. Purchase and sale defined as any contract to purchase or sell – there must be something more than a mere offer to purchase. ii. To have standing to maintain a 10b-5 cause of action, the Π must either be an actual purchaser or seller of securities. a. Where Π has not sold stock but argues the stock depreciated in value due to the misrepresentation made by the Δ, the Π has no standing b/c no actual purchase or sale. b. Where Π would have purchased stock but for the misrepresentation made by Δ, Π has no standing. Rationale is b/c it’s too easy for a Π to make the claim that he “would have” done that but for Δ’s actions, and the claim cannot be verified. 35

c. However, for derivative actions (b/c on behalf of corporation), Π doesn’t have to be an actual purchaser or seller, but there must at least have been a purchase or sale by the corporation. d. Exception: where Π seeks an injunction against Δ’s market manipulation that violates rule 10b-5. Π’s status as a SH is sufficient w/o actual purchase or sale. iii. The definition of a security includes an option to purchase stock. a. Deutschman v. Beneficial Corp., 841 F.2d 502 (1988) – Δ made knowingly false public misrepresentations in order to stop the decline of the market price of their stock. Π had purchased options in the stock & suffered losses when they became worthless as a result of the misrepresentations. 1. Π has standing b/c he was a purchaser of security, although he never bought the stock. Rule 10b-5 specifically includes option contracts in the definition of security. G. Scienter - In order to be held liable under Rule 10b-5, the Δ must have scienter. i. Scienter is defined as the mental state embracing the “intent to deceive, manipulate, or defraud.” ii. Some courts have also held that recklessness also satisfies the scienter requirement.

III.Inside Information A. Insider Trading. This is when someone related to the corporation is in a position to have inside information about how the corporation is doing & what the corporation’s stock is or will be worth (“insider”). The insider then buys stock (with advantages over the seller) or sells it (with advantages over the buyer). The issue concerns what duty the corporate insider may owe to the other party. B. In certain circumstances, a director with superior knowledge must act as a fiduciary to SHs in buying and selling stock. If a director personally seeks a stockholder for the purpose of buying his shares w/o making disclosure of material facts within his particular knowledge and not within the reach of the stockholder, the transaction will be closely scrutinized. i. Goodwin v. Agassiz, 283 Mass. 358 (1933) – Π decides to sell his stock to on an exchange. Δ, a director of that company, knew of a theory that he believed had value & wanted to have the company test the theory. Δ purchased the stock in an exchange transaction w/o disclosure of the plan. Theory was correct & stock price went up. a. Π acted on his own judgment when selling the stock; he didn’t ask Δ or other officers anything. Δ made no reps to anyone about his theory. The purchase was impersonal, on an exchange. There was no privity, relation or personal connection. b. Materiality - The theory was only a hope, not a proven reality. C. The essence of Rule 10b-5: Anyone who is privy to material information intended to be available only for a corporate purpose and not for his personal benefit may not take advantage of such information knowing it is unavailable to those with whom he is dealing, i.e. the investing public. i. Securities and Exchange Commission v. Texas Gulf Sulphur Co., 401 F.2d 833 (1969) – Texas detected a promising mineral deposit, drilled a test hole, and collected a sample which contained an extraordinary level of mineral content. Some officers who knew of this purchased stock on the open market. There was reumor of the testing, but Texas issued a press release downplaying the significance of the findings, & stated that more testing was necessary to determine the commercial value, if any. SEC brings the suit for violating Rule 10b-5. a. Basic test for materiality: Whether a reasonable person would attach importance to the information in making choices about the transaction. Whether facts are material when they relate to a particular event will depend upon a balancing of probability that the event will occur and anticipated magnitude of event in light of totality of company activity. 1. The testing yielded results which were considered “impressive.” The undisclosed facts here might very well have affected the price of the stock, & would certainly seem important to a reasonable investor. b. Fraud/Deception: The court couldn’t definitely conclude that the press was deceptive or misleading to the reasonable investor, so remanded.

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D. Mere possession of material, nonpublic information does not give rise to a duty to disclose or abstain. A fiduciary relationship between the insider and the shareholders must already be in place before the tippee’s role will be examined. i. Dirks v. Securities & Exchange Commission, 463 U.S. 646 (1983) – Δ (not affiliated with EF) rec’d a tip from a former officer of EF that due to fraudulent practices, EF’s assets were grossly overstated. Several regulatory agencies had failed to act. Δ tried to get it published in wall street journal, but they refused. Neither Δ nor his company owned or traded EF stock. Δ discussed this info w/ his clients, who sold the stock. EF stock dropped & its fraudulent practices became known. SEC charging Δ for aiding/abetting violation of 10b-5. a. Recipients of inside information only have a duty to disclose or abstain if the insider improperly disclosed the information. So first, it must be determined that the insider’s “tip” breached the insider’s fiduciary duty. The test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent personal gain, there is no breach of duty. 1. Insider who gave Δ the info did not receive any personal benefit, but were motivated by desire to expose the fraud. Δ wasn’t under any derivative obligation. E. Misappropriation Theory i. A person commits fraud in connection with a securities transaction (violating 10b-5) when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. a. The misappropriation theory premises liability on a trader’s deception of those who entrusted him with access to confidential information. The trader’s duty is not owed to another trader, but to the source of the information. ii. United States v. O'Hagan, 521 U.S. 642 (1997) – Δ was a partner in a law firm. Law firm (not Δ) represented Grand in a potential tender offer for common stock of Pillsbury. Δ bought Pillsbury stock options & common stock. When Grand announced the tender offer, the price of the stock shot up & Δ sold his stock for $4mm profit. Criminal indictment for violation of 10b-5. a. Misappropriation of information must involve some deceptive device or connivance. 1. Here, Δ’s feigned fidelity to his source of the confidential information, while secretly converting the information for personal gain. It would have been fine if Δ told source he planned to trade on this nonpublic information. b. Must be in connection with the purchase or sale of a security. 1. Δ’s fraud was consummated when he used the information to purchase, and the sell, securities (not when he obtained the confidential information). c. It is not required that there is deception of an identifiable individual, only that the deception was in connection with the sale and purchase of securities.

PROBLEMS OF CONTROL I. Proxy Fights A. Introduction i. Shareholder Voting. Shareholders are the owners of the corporation, the objects of management’s fiduciary duty, and the ultimate sources of corporate power. Shareholders have two ways to exercise this power – the vote and the derivative suit. The right to vote may be allocated to others not owning the shares through a proxy or voting trust. ii. Proxy. A proxy is a power of attorney to vote shares owned by someone else. A proxy establishes an agency relationship, so it generally can be revocable at any time. iii. Controlling Corporation via Proxy Votes. Few shareholders own enough shares to make any difference at meeting (voting), and few shareholders even attend these meetings. Because the

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outcome of the meeting depends on the number of votes cast, the person with the most proxies usually wins. So minority shareholders will try to collect proxies in order to control the corporation. iv. Proxy Fights. This results when an insurgent group tries to oust incumbent managers by soliciting proxy cards (SH’s signed authorization to allow them to be their proxy) and electing its own representatives to the Board. v. Tender Offers. Tender offers are another method of acquiring control of a corporation by offering to purchase shares for a price higher than market value. Both proxy fights & tender offers are regulated by the 1934 Securities Exchange Act (SEA). B. Paying for Proxy Fights i. Solicitation (1934 SEA §14): a communication to security holders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy. ii. Incumbent directors may use corporate funds and resources in a proxy solicitation contest if the sums are not excessive and the shareholders are fully informed. Such a rule protects incumbents from insurgent groups with enough money to take on a proxy fight. a. Levin v. Metro-Goldwyn-Mayer, Inc., 264 F.Supp. 797 (1967) – MGM has a conflict for control between 2 groups in its mgmt with different ideas about how to run the company; each intending to vote for their own directors at the SH meeting. Each group actively solicited proxies. Π-SHs filed action against one the groups (Δs) alleging they wrongfully committed MGM to pay for attorneys . PR firms, and other proxy-soliciting orgs in connection with the proxy fight. Π says the individual directors should pay these expenses personally. 1. Court’s concern is that shareholders are fully and truthfully informed as to merits of contentions of contesting parties. 2. Sums are not excessive - $125k cost, and MGM big corporation worth over $251mm. iii. When directors act in good faith to defend their position in a bona fide proxy contest, they may recover the reasonable expenses of soliciting proxies from the corporation. a. Rosenfeld v. Fairchild Engine & Airplane Corp., 309 N.Y. 168 (1955) – Π-SH files a derivative action seeking to compel the return of $260k paid out of corporate treasury to reimburse expenses to both sides in a proxy contest. 1. If in good faith, court will allow reimbursement of proxy fight expenses. To hold otherwise would place directors at the mercy of anyone wishing to challenge them for control so long as such persons have amply funds to finance a proxy contest. Directors must have the right to incur reasonable expenses for proxy solicitation and in defense of their corporate policies. 2. No reimbursement if the funds were used for personal power, individual gain, or private advantage and not in the best interest of the corporation. C. Regulation of Proxy Fights: 34 Act § 14(a) i. §14(a) of the 1932 SEA prohibits people from soliciting proxies in violation of SEC rules. a. A shareholder does not fall under the general SEC filing reqs if it does not solicit proxies for itself. Ex: a pension fund that submits a shareholder proposal may not be subject to SEC reqs even if it campaigns on behalf of its proposal, b/c it is not asking SHs to give it proxies. b. People who solicit proxies must furnish each SH with a shareholder proposal. In it, they must disclose information that may be relevant to the decision the SH must make. SH proposal would include an annual report, and anyone soliciting proxies must disclose conflicts of interest and any major issues he expects to raise at the SH meeting. Must be extensive disclosure. Parties soliciting proxies must file copies of the material with the SEC. c. When an insurgent group wants to contest mgmt & solicit proxies, mgmt may either mail the insurgent’s group material directly to SHs (insurgents paying), or it can give the insurgent group the SH list to distribute themselves. Normally, mgmt wants to keep SH list confidential, so more likely to mail it themselves. Also, sometimes insurgents have the right to the SH list, so this rule isn’t invoked. D. Shareholder Proposals – Rule 14(a)

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i. Shareholder Proposals. Instead of independently soliciting proxies, a SH may service notice on mgmt of his intention to propose action at the SH’s meeting. The SH may only propose such action is (1) he would be entitled to a vote at the SH meeting to which the mgmt’s proxy statement relates and (2) he is a SH at the time the proposal is submitted. a. Inclusion in Mgmt’s proxy statement. If SH’s notice of proposed action conforms to proxy rule, mgmt must include the proposal in its own proxy statement. If mgmt opposes the proposal, SH may also give a statement in support of proposal, and mgmt must send it out w/ its statement. 1. If mgmt wants to omit proposals, they have to file with SEC, including reason. SEC will review & agree/disagree. If agree, they issue a no-action letter. b. Mgmt’s may omit SH proposals if: 1. proposal is not a proper subject for action by the SHs, 2. proposal relates to ordinary business operations (SH not to interfere with day-to-day ops 3. proposal submitted for noncorporate purpose. (a) Noncorporate purposes are personal claims or grievances, matters not within the control of the issuer, matters not significantly related to issuer’s business, election of directors, proposals previously submitted. ii. Lovenheim v. Iroquois Brands, Ltd., 618 F.Supp. 554 (1985) – Π-SH wants Δ to include his proposal in proxy materials sent in preparation for SHs meeting. The proposal asks the directors to form a committee to study whether the method Δ’s supplier used (force-feeding geese) in the production of pate is immoral and inhumane. Δ doesn’t want to include it b/c it related to operations that account for less than 5% of Δ’s total assets & net earnings. a. Proposals should be included despite their failure to reach specific economic thresholds if a significant relationship to the issuer’s business is demonstrated on the face of the resolution or supporting statements. 1. In light of the ethical & social significance of Π’s proposal, Π has shown a likelihood of prevailing on the merits, and that he would be irreparably harmed if he were denied b/c he would lose his opportunity to communicate with other SHs. iii. The New York City Employees' Retirement System v. Dole Food Company, Inc., 969 F.2d 1430 (1992) – Π submits proposal to Δ requiring Bd to create a committee to evaluate impact of various healthcare reform proposals for the purpose of keeping Δs competitive & for Δ’s societal obligation to conduct its affairs in a way that promotes health to employees. Δ says not required to submit it b/c (1) part of ordinary business operations, (2) insignificant relation to business, and (3) beyond corporation’s control. a. Part of ordinary business operations – Court found for Π that it is not part of the ordinary business operations. Question of which healthcare plan to support has large financial consequences on Δ, and is an issue of social significance. b. Not significantly related to business – Δ’s annual health insurance constitute a large part of Δ’s income so is significantly related. c. Matters outside corporation’s control – proposal doesn’t attempt to influence the selection of any healthcare proposal, or to engage in political lobbying. Merely to make a research report on healthcare & Δ’s competitive standing. iv. Austin v. Consolidated Edison Company of New York, Inc., 788 F.Supp. 192 (1992) – Π-SHs send proposal to Δ endorsing changes to company’s pension fund, which allowed employees to retire after 30 yrs regardless of age. Δ wants to omit the proposal b/c it deals with the day-to-day ops, & designed to further the personal interest of its proponents, not the SHs generally. a. SEC has a long record of issuing no-action letters on the issue of companies seeking to exclude pension proposals. b. Πs have available the forum of collective bargaining. This issue is not so extraordinary that SH vote is the only or most effective forum. E. Shareholder Inspection Rights

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i. Introduction. Pursuit of SH interests may practically require inspection of some corporate records, especially the list of SHs. At CL, a SH had a right to inspect his corporation’s books and records if he had a “proper purpose.” ii. Under federal proxy rule 14a-7, a security holder, or tender offeror, may insist that the issuer either provide her with a list of security holders or mail her communications to them (at the holder’s expense). a. Crane Co. v. Anaconda Co., 39 N.Y.2d 14 (1976) – Π announced a proposed tender offer of Δ’s stock. Δ opposed the tender offer and sent 4 letter to SHs asserting that the offer was not in the best interests of the corporation. Π requested a list of Δ’s shareholders, claiming that Δ had a fiduciary duty to present SHs with all pertinent info regarding pending tender offer. Δ refused to provide the list b/c Π’s reasons for request didn’t relate to Δ’s business. 1. Access to corporate records such as SH lists must be permitted to qualified SHs on written demand. Petitioner must furnish an affidavit that the inspection is not desired for a purpose other than the business of the corporation, and that the petitioner has not been involved in the sale of stock lists within last 5 years. (§1315 Business Corp. Law). 2. Π complied with all statutory reqs. Π wants SH lists to communicate directly with SHs about pending tender offer & to reply to misleading statements by Δ. 3. Tender offer involved over 1/5 of corporation’s common stock, so it involves the purpose of the business of the corporation. iii. State Ex Rel. Pillsbury v. Honeywell, Inc., 291 Minn. 322 (1971) – Π-SH bought shares in Δ for sole purpose of giving himself a voice if Δ’s affairs so he could persuade Δ to stop producing weapons used in the Vietnam War. Π demanded access to Δ’s SH lists & other corporate records for the purpose of communicating with SHs to elect new directors who would represent his viewpoint. Δ refused. a. DE law: SH must provide a proper purpose to inspect corporate records other than SH lists 1. Proper purpose contemplates concern with investment return, and Π has no such interest. Π’s only interest was its social concern, not any economic benefit. b. DE court later says this case is no good. iv. Sadler v. NCR Corporation, 928 F.2d 48 (1991) – AT&T became the beneficial owner of 100 shares of Δ’s stock. AT&T then began a tender offer for Δ’s shares; Δ rejected the tender offer. AT&T responded by soliciting Δ’s SHs to convene a special meeting to replace majority of Δ’s directors. Sadler (Π) owned more than 6,000 shares of Δ. On behalf of AT&T, Π tried to acquire certain corporate records (CEDE lists – identifies brokerage firms & other records owners who bought shares for their customers; NOBO lists – names of persons owning beneficial interest in shares that consented to the disclosure of their identity). Δ refused to produce these lists. a. Δ argues that Πs are just agents of AT&T, and AT&T had no right to this request b/c they had not held Δ stock for six months. But court disagrees –no reason to deny Πs just b/c of the agreement with AT&T. b. Δ also argued that it doesn’t have NOBO lists, and although they can get them in 10 days, they are not required to hand over lists not in existence. Court disagrees. The statute is to be construed to facilitate communication among SHs regarding corporate affairs. c. Compilation of NOBO list properly ordered here also b/c under Δ’s corp charter, every share not voted at the special meeting is counted in favor of mgmt. Denying mgmt opponents access to NOBO lists is inconsistent w/ statute’s objective of seeking to place SHs of equal footing in terms of gaining access to SHs.

II. Abuse of Control A. Freezouts i. SHs in a close corporation have the duty of good faith and loyalty to one another. If several SHs combine to “freeze out” another SH by removing him from all decision-making roles and denying him a return on his investment, they have breached their fiduciary duty to him. 40

a. Wilkes v. Springside Nursing Home, Inc., 370 Mass. 842 (1976) – Π and Δs formed a close corporation to run a nursing home. Equal investment of cash, shares, responsibilities, profits & each would be a director participating actively in mgmt. Relations deteriorated. Δs voted to put themselves on salary from the corporation; Π didn’t get a salary. Δs then voted Π out of his office & position as director. 1. Applying the good faith standard strictly would hamper the ability of the controlling group to manage the corporation for the good of all concerned. Therefore, the rights of the majority must be balanced against its duty to minority SHs. So if the majority can show a legitimate business purpose for its actions, no breach of fiduciary duty. (a) There’s no valid purpose for taking Π’s directorship, mgmt position, and salary from him. He was ready at all times to perform his responsibilities to the corporation. b. Ingle v. Glamore Motor Sales, Inc., 73 N.Y.2d 183 (1989) – Δ hires Π as a sales manager. Π later acquires shares of Δ’s stock, making Π a minority SH. Then Π gets fired from his corporate position and sues Δ, alleging that in terminating him, Δ breached its fiduciary duty of loyalty and good faith they owed to him as a minority SH in a closely held corporation. 1. Must separate the duty a corporation owed to a minority SH as a shareholder from any duty it might owe to him as an employee. (a) Π was an at-will employee; thus corporation owed him no duty as an employee. (b) Shareholder agreement did not provide Π with employment security; thus the corporation owed him no duty as a shareholder either. c. Sugarman v. Sugarman, 797 F.2d 3 (1986) – 4 Brothers formed a corporation. Δ is the son of one of the original brothers; Πs are grandchildren of another original brother. At first, company was equally divided btwn the descendents, but after 1972, Δ controlled majority of the stock and all its mgmt. Family members are employed from time to time. Πs allege that Δ denied them employment, drained company earnings by excessive compensation, and refused to pay dividends. 1. In attempting to prove a freeze-out, the minority SH must show that the majority SH’s actions were part of a plan to freeze-out the minority SH. (a) Court found there was evidence of freeze-out here. Δ took action to ensure that Π would not receive any financial benefit from the corporation in the form of dividends or employment. Δ’s overcompensation was designed to freeze out Πs and that the offer to buy Π’s stock at a low price was part of this plan. (b) Don’t have to show every possible device to effectuating a freeze-out, but enough to show that it was Δ’s plan. d. Smith v. Atlantic Properties, Inc., 12 Mass.App.Ct. 201 (1981) – 4 people (3 Πs, 1 Δ) invested equal sums in corporation and were its only stockholders. Corporation’s bylaws provided that corporate decision must be approved by 80% of stock eligible to vote, effectively giving one stockholder veto power. Δ continually refused to declare dividends; he wanted earnings spent on improvements to property, but not much done there. B/c of failure to declare sufficient dividends, the IRS assessed penalty taxes against corporation, as Πs had warned Δ. Πs sue Δ for breach of fiduciary duty, for Δ’s removal as a director, for reimbursement by Δ of penalty, & for a court determination of dividends. 1. The 80% provision is a reasonable means of protecting minority stockholders. However, its exercise may violate the fiduciary duty stockholders in a close corporation owe each other. The court weighs the business interest of each side. (a) No good reason for Δ to refuse to declare dividends. He breached his fiduciary duty. e. More on closely held corporations 1. Usually no fiduciary duty among SHs in corporations, but there is for closely-held corps. 2. Reason for not paying out dividends and instead paying out salaries (a) Profits paid out as dividends are taxed (corporate income tax). You can avoid taxes by disguising the profits as salaries. 41

(b) Also, you can do this to freeze-out of majority SH, like in Wilkes. (c) So not only are you ripping off the government, but each other. (d) Problem: Hard to tell the difference between actual costs of the company & disguised dividends. So court says there's a fiduciary duty that shareholders owe to each other in a close corporation. B. Conflicting Roles i. Close corporations that purchase their own stock must disclose to the sellers all material information. a. Jordan v. Duff and Phelps, Inc., 815 F.2d 429 (1987) – Π is Δ’s employee and purchased shares of Δ’s stock. Prior to selling Π the stock, Δ made Π sign an agreement that stated upon a SH’s termination from employment, he would sell back his shares to the company for book value. Π quits & sells back his stock for $23k. Π then finds out that Δ is merging with another company, and if he had still been an employee, his stock would have been worth $452k. Π sues for breach of fiduciary duty after Δ refused to give him back the stock (Π hadn’t cashed the check yet). 1. Jury could reasonably conclude the merger was material. Π worked longer just so he could take advantage of a higher book value & Π could have decided to stay longer if he knew company involved in merger negotiations. Δ also allowed Π to decide when he would leave. 2. Π was an at-will employee & could have been terminated the day before the merger. But the court says that even in at-will employment situations, neither party may take opportunistic advantage of the other.

III.Transfer of Control A. Introduction. Problem involving the sale of corporate stock is when the majority SH (or controlling minority) sells that control in a transaction from which other SHs are excluded (controlling SH receiving a premium price on stock over book or market value); or where all sell, but the owner of the control shares receives more pr share than other SHs. Since a person purchasing “control” can dictate the affairs of the corporation, “control” is valuable. B. General Rule. A SH may sell his stock to whomever he wants to at the best price he can get. C. Types of Purchase Transactions: i. Direct from SHs – purchase of stock. Purchaser may approach the SH directly to purchase their shares. The purchaser may buy all or only a controlling portion of the outstanding stock. If all is purchased, one price may be offered to controlling SHs, and lower price to minority SHs. ii. Purchase of assets. Purchaser offers to buy the corporation’s assets; corporation SHs votes on the offer. If majority votes yes, purchaser pays the corporation, & $ distributed pro rata to all SHs. iii. Merger or consolidation. Purchaser offers to merge the company to be acquired into it; corporation SHs votes. If majority votes yes, company is merged into acquiring company. SHs of the merged company receive a pro rata interest in the purchase price. D. Frandsen v. Jensen-Sundquist Agency, Inc., 802 F.2d 941 (1986) – Jensen owned all stock in Δ, a holding company whose principle asset was a majority stock in Bank G. Jensen sold majority of stock to family. Π is a non-family minority SH. Agreement that if majority wants to sell stock, Π gets right of first refusal. Jensen negotiates with WI Corp. to buy Δ for cash, then merging Bank G into WI Corp.’s subsidiary. Π tries to exercise his right of first refusal, but majority refuses. Then they restructure the deal so that Δ would sell its shares in Bank G to WI Corp. & then liquidate. i. By selling shares in Bank G rather than selling Δ corporation, Jensen was selling a corporate asset, which Π could not block. But since the deal originally involved selling Δ corporation, Π argues that it doesn’t affect his right once he had already tried to exercise it. ii. Rights of first refusal are to be interpreted narrowly. The agreement was intended to protect Π from finding himself confronted with a new majority made up of strangers. The sale of the asset doesn’t result in the harm they were trying to protect against. Agreement did not provide Π with protection against a sale of the company.

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E. Zetlin v. Hanson Holdings, Inc., 48 N.Y.2d 684 (1979) – Π is a minority SH. SH-Δs sold their controlling interest in the corporation to another party for double the market price. Π wants to be paid the same price per share. i. A majority interest can control the affairs of the company. Absent looting, conversion of a corporate opportunity, or other acts of bad faith, a controlling SH can sell the right to control the affairs of the corporation for a premium price. F. Perlman v. Feldmann, 219 F.2d 173 (1955) – Πs are minority SHs. Δ (president) sold his shares (37% of common stock) for $20/share. The market price at the time was $12/share & book value was $17/share. After the sale, the new purchasers were appointed to the Bd. Π claimed the additional compensation was a corporate asset (power to control steel output in tight market) & was to be held in trust by Δ as a fiduciary for all the SHs. i. Although there’s no outright fraud, court said there was a breach of Δ’s fiduciary duty. Δ siphoned off corporate advantages derived from a favorable market situation for personal gain, which is not indicative of the necessary undivided loyalty owed by a fiduciary. G. EssexUniversal Corporation v. Yates, 305 F.2d 572 (1962) – Π contracted to purchase 28% of stock of a company traded on the stock exchange from Δ. Π had option to require majority of existing directors to resign and be placed with Π’s nominees. Stock sold for $8/share; market price was $6/share. i. It is illegal to sell a corporate office or management control by itself. a. A majority of stock may be sold with an agreement to replace directors immediately in some instances, even at a premium over market price. However, you can’t do this if seller should reasonably know that the buyers will loot the company, or if a transfer of a unique corporate asset is involved (like in Feldman). b. Δ has to prove that the interest transferred did not carry actual control.

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