Chapter 1: What Do Business Do and What Do Layers for Businesses Do?A. Why Does someone own a business or an interest in a business?

1. The Epstein-Freer view and the Roberts-Shepherd view2. Views of other “gonster machers”3. Views of the court and legislatures

A.P. Smith Mfg. Co. v. Barlow: the court held that corporations’ power to make reasonable charitable contribution absent statutory provisions is intra vires (within its power) because it would aid in public welfare as well as advance the interests of the corporation and the community in which it operates.

a. Business in corporate structure is a separate legal entityb. Both statutory and case law controls the actions of that separate entityc. Real persons act for that corporation as “agents”d. A corporate business with more than one owner can distribute and use funds in ways

that are opposed by at lest some of its owners.B. How does the owner of a business make money from the business?

1. Distributions of all or part of the money the business has earned2. sell all or part of the ownership interest in the business for more than paid for

C. How does the owner of a business (and her lawyer) know how much money the business has mad and how much money the business is worth?1. the income statement: computes profit during a given period based on data about revenues

and costs2. the cash flow statement: measures the cash made available to a business from its operations

during a given period3. the balance sheet: shows the company’s assets, liabilities and the owners’ “equity” in the

business4. cash flow statements5. financial statements and the value of a business

D. The Sarbanes-Oxley Act and corporate governance1. the motivation for fraud: bonuses for putting out “good numbers”2. types of fraud:

a. Enron: “off-balance sheet” transactions: move liabilities off its balance sheetb. WorldCom: inflate profits by hiding costs so company would meet earning targets

and the price of stock would rise, or at lest remain highc. Most: Either representing the company’s financial condition as better than it is, or

misappropriating the wealth of the company for private gain3. the intent of Sarbanes-Oxley

a. Clarify certain responsibilities of auditors, company management, and board and audit committees, as well as impose new process and responsibilities on these parties

b. Section 404: company must evaluate its own internal controlsc. CEO and CFO must attest to the accuracy of accountability

E. What does a lawyer for a business do?1. Help the business make money2. Help her get money from the business3. help the business and her protect the money from the claims of others

F. What are the legal structures for businesses?1. What choices are available? (tax treatments and liability exposures are the most important

factors in the decision of choosing the legal structure)a. Sole proprietorship: the individual and the business are one an the same for tax and

legal liability purposesb. The partnership

i. General partnership: earnings are distributed according to the partnership agreement with pass-through taxation; each of the partners are jointly and severally liable

ii. Limited partnership: has pass through taxation with a general partner that assumes the management responsibility and unlimited liability for the business; there is a limited partner with no voice in management and is

legally liable only for the amount of capital contribution plus any other debt specifically accepted.

iii. Limited liability partnership: c. The corporation

i. C-corporation: most common legal structure for large business because the owners are generally protected from personal liability, but it has double taxation

ii. S-corporation: has pass-through taxation and protection from personal liability

iii. Non-profit: operates for public benefit that need no pay corporate income tax

d. The LLC: pass-through taxation with limited liability for the owners2. How do you choose?

a. Who will own the business?b. Who will manage it?c. Who will reap any profit?d. Who will bear the risk of any loss?e. Who will pay income tax on business profit?

Chapter 2: What is a Sole Proprietorship and How Does It Work?A. What is a sole proprietorship? What is sole proprietorship law? What are the problems in starting a

business as a sole proprietorship?B. What are the problems in operating a business as a sole proprietorship?

1. Employees and Introduction to Agency Principles: a. Agency law (RSA 1):

i. Agency is a “fiduciary relation”ii. There must be some “manifestation of consent by one person [the principal]

to another [the agent] that the other [the agent] shall act on his [the principal’s] behalf and subject to his [the principal’s] control.”

iii. There also must be “consent by the other [agent] so to act.”b. Authority

i. actual authority(1) actual express authority: P expressly gave A the power to undertake the

act on P’s behalf(2) actual implied authority: A has the authority to do what is reasonably

necessary to get the assigned job done, even if P did not spell it out in detail

ii. apparent authority (“implied authority”)(1) creation:

- must be attributable to P- must get to third party (TP)- must lead TP reasonably to conclude that A is an agent

for P (2) does not require detrimental reliance by TP on P’ manifestation(3) Could be misleading as P does not really authorize A to act on his

behalf; indeed P may have privately forbidden A to actProblems: Liability of the sole proprietor for contracts of his employeeProblems: liability of the sole proprietor for torts of her employee

2. Other Agency Relationships in Businessa. Attorney-client

Hayes v. national Service Industries, Inc.: where the attorney has apparent authority (but not actual authority) to enter into binding agreement (here, settlement agreement) on behalf of a client, such agreement is enforceable against the client.

b. Franchise and other business relationshipsMiller v. McDonald’s Corporation: where franchisor-principal has the requisite degree of control over the franchisee-agent, agency will arise despite the boilerplate provision in the franchising agreement that the

parties doe no intend an agency relationship; here, McDonald’s control over 3k presented factual issues as to whether actual or apparent agency relationship exists, and thus preclude summary judgment.

C. How does a sole proprietorship grow?1. Funding by the owner: Money that goes into the business is in the form of an investment

(equity) and not as loan (debt)2. overview of debt and equity: equity v. debt

a. debti. creditor gets both repayment + interest

ii. riskier: lender can sue and force business into bankruptcyiii. debt has a fixed cost: repayment + interest

b. equity i. equity holder gets ownership (higher return + higher risk)

ii. less risky: equity owner has no right to repaymentiii. cost is uncertain as the ownership shares the success of the company; also

gives up some control of company3. borrowing money:

a. Pledge personal or corporate assets again the loan, as a form of collateral to secure the loan

b. Promise to pay the money back in a short time (easier for creditor to judge the health of the business)

c. Give creditor some measure of control over the business (seat on the board)

Chapter 3: What is a Partnership and How Does It Work?A. What is a partnership

1. Unlike sole proprietorship, partnership is composed of multiple owners and is treated legally as an entity separate from its owners.

a. RUPA 201: “an entity distinct from its partners”b. UPA: “aggregate theory” an aggregate of its partners

2. Has flow-through taxation; however, the owners are not shielded from the liability of the business

B. What is partnership law?1. partnership agreement (if only concerning rights and obligations)

a. if not written, UPA and RUPA is defaultb. it’s a contract that can change much of the statutory law that otherwise would govern

(ex: management decisions are to be by majority vote of the partners and profits will be shared equally regardless of contribution)

2. state partnership statute3. case law

C. What are the legal problems in starting a business as a partnership?1. partnership agreement is very important, although many partnerships do not have them.2. vague language can be very problematic:

a. mutual agreement: unanimous or majority?b. Partners: majority is default

D. What are the problems in operating a business as a partnership1. who owns what property?

a. Partnership owns partnership propertyb. Owners do not own partnership property

2. partnership decisionsa. disputes between partnership and some “outside” third party

i. relevant provision of partnership statuteii. common law principles

b. disputes among the partnersi. partnership agreement

ii. provisions of relevant partnership statuteiii. common law principles

Meinhard v. Salmon: where the defendant’s lucrative position arose from the creation of the joint venture, the defendant may not take advantage of such position without informing the plaintiff partner. Here, the plaintiff and defendant were joint venture partners leasing shops and offices, and the plaintiff take advantage of an opportunity arose from being partners of the JV and entered into an agreement without disclosing to the defendant; the court held that the defendant was entitled to proceeds as well reasoning that for joint adventures, like copartners, “not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavrio.”

3. Who is Liable for What to Whom?a. Liability of the partnership: under RUPA, partnership is a legal person and thus can

be held liable and can sue or be sued; the same is true under UPA although it does not expressly adopt the “entity” theory

b. Liability of the partnersi. RUPA: partners are jointly and severally liable for all obligations

ii. UPA: partners are jointly (but not severally) liable in contract but jointly and severally liable in tort.

E. How does a partnership business grow?1. existing owners (arrangements should be found in the partnership agreement)

a. vote or events that trigger the obligation to contributeb. amount of contribution of each partnerc. time in which to make the additional contributiond. the consequences of a failure to contribute

2. “outside” lenders: often they will required guarantees from individual partners3. new investors

a. financial issues: investors will balance risk and return (return on equity) by measuring cash flow and assessing the debt of the business (higher debt = higher risk; leverage: the use of debt to finance a business

b. legal issues: under RUPA, the default is that approval for a new partner requires the consent of all existing partners; the new partner is not personally liable for all of the partnership’s existing debts.

4. earnings from business operations: earnings should be distributed unless the partnership has some lucrative use for the funds

F. How do the owners of a partnership make money?1. salary

a. RUPA 401 + 103 (pg 107)b. If salary is in the partnership agreement, any change would require the consent of all

partners, as any change would be a change in the partnership agreement2. profits:

a. RUPA 401(b): “each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner’s share of the profits.”

b. Distribution rights and voting rights are separatec. Everyone has equal vote and majority is required for distribution decisions.

3. sale of ownership interest to third partya. business and legal problems:

i. finding a buyerii. gaining any necessary approval from existing partners

iii. dealing with the question of “inherited” obligationsb. RUPA 502: “the only transferable interest of a partner in the partnership is the

partners share of profits and losses of the partnership and the partner’s right to receive distributions.”

4. sale of ownership interest back to the partnershipa. buy-sell agreements: agreement for sale of partnership interest back to the

partnership or other partners; should answer the following:i. are the other partners or the partnership obligated to buy or do they have the

option to buy?ii. What events trigger this obligation or option?

iii. How is the selling partner’s interest to be valued?iv. What is the method of funding the payment?

b. withdrawal of a partner: even absent such buy-sell agreements, a partner has the power to compel the partnership to pay for her partnership interest by withdrawing from the partnership:

i. is covered by (1) partnership agreements(2) partnership statutes(3) case law

ii. if UPA controls: (1) dissolution(2) winding up(3) termination

iii. if RUPA controls: (1) dissociation(2) dissolution(3) winding up(4) termination

G. Partnership endgame1. Dissolution, winding up and termination as endgame for the partnership

a. RUPA 601, 801, 802(b)b. Under RUPA, unless partners agree to the contrary

i. They share responsibility not only for the losses from operation of the partnership business but also for partners’ losses from investments in the partnership.

ii. The amount of each partner’s loss from her investment in the partnership is determined from her partnership account, a bookkeeping device

iii. The partnership is legally obligated to pay each partner an amount measure by the balance in her partnership account(1) Value of money or property, but not labor(2) Minus any distributions (3) Plus equal share of remaining value of the partnership(4) Where a partner has a negative balance, that partner will have to

contribute additional funds to the partnership in the amount of the negative balance.

Kovacik v. Reed: where the plaintiff and defendant entered into a joint venture wherein the plaintiff contributed money as against defendant’s skill and labor, upon losses of the venture, the plaintiff is not entitled to recover any part of it from the defendant. Where one party contributes money and the other contributes services, then in the event of a loss each would lose his won capital—the one his money and the other his labor, as by their agreement they share equally in profits, they have agreed that the values of their contribution were likewise equal.

2. Expulsion as an endgame for a partner: RUPA 601(3)-(5)3. freeze-out as an endgame for a partner: the holders of the majority interest force a minority

owner to sell or otherwise give up her interestPage v. Page: where the partnership has no definite term or specified any particular undertaking, a partner can dissolve the partnership by express will, unless there was bad faith by the terminating partner who violated fiduciary duties by attempting to appropriate to his own use the new prosperity of the partnership without adequate compensation to his co-partner, in which case, the dissolution would be wrongful and the terminating partner would be liable. Here, the supplying partner of an oral partnership, which suffered losses for eight years wanted to terminate the partnership despite slight improvements in the next two years, was allowed to terminate the partnership absent showing of bad faith, as there lacked a showing that the improved profit situation was anything more than temporary.Chapter 4: What is a corporation and how does a business become a corporation?

A. What is a corporation and what is corporation law?1. A corporation is whatever the relevant state law says it is: corporate charters were granted

primarily for public purposes, including the establishment of towns, churches, cemeteries,

colleges, and charities; general incorporation laws were created to cure the special privileges conferred by the corporate charters, allowing all those meeting the statutory requirements with equal access to the corporate form.

a. State statutes provides:i. A corporation is a separate legal entity

ii. Limited liability: Owners (shareholders/stockholders) are generally not personally liable for the debts of the corporation

b. Corporation law facilitates wealth creation through innovation of tradable share interest, centralized management, limited liability, and the entity concept itself.

c. The economics of corporation:i. a way to reduce “transaction costs” compared to frequent transactions in

marketsii. not so much as an entity, but as a set of contractual relationship among the

suppliers of all of the corporation’s inputsiii. control of agency costs

2. Corporate law a. State statutesb. Articles of incorporation (certificates of incorporation) , bylaws and other

agreementsc. Case laws

i. Interpret and apply the provisions in corporate statutes and in a corporation’s articles and bylaws

ii. Fill gaps in the law—resolve problems not covered or not fully covered by statutes, articles, or bylaws

d. Federal statutes: there are no general federal corporation statute; there are, however, important federal statutes that govern certain corporate activities

B. What are the legal problems in starting a business as a corporation?1. Preparing the necessary papers:

a. a corporation does not exist until the AoI are properly executed and filed with the appropriate state agent or agency (usually the Secretary of State)

b. traditionally, corporation codes have not required that a corporation have bylaws; the MBCA, however, mandates a corporation to adopt bylaws (no need to file, as they are internal); bylaws contains provision for managing the business and regulating the affairs of the corporation not inconsistent with laws or AoI.

2. contracting before incorporatinga. Promoter liability if corporation is never formed: jointly and severally liable, MBCA

2.04b. Corporation liability after formation: the corporation will only be liable if it take

some action to adopt it3. The “secret profit” rule; there is a duty to disclose the promoter’s profit in dealing with the

corporation. (pg. 156: retroactive prohibition?) 4. Issuing stocks: MBCA 6.03(a): A corporation may issue the number of shares of each class or

series authorized by the articles of incorporation. Shares that are issued are outstanding shares until they are reacquired, converted or canceled.”

a. Preferred stock: class of stock to be treated more favorably than other class of stocki. Dividend rights

ii. Liquidationiii. Redemption rights

b. Common stock: class of stock that is not preferredc. Par value: the minimum price (not fixed price) for which a corporation can issue its

shares; this provides for the keeping of two separate accounts:i. “stated capital”: aggregate par value of all issued shares of par value stock

ii. “capital surplus”: funds in excess of par5. choosing the state of incorporation and qualifying as a “foreign corporation”

a. the law of the state of incorporation will become the default rules that govern the “internal affairs” of a business (procedures for corporate action and rights and duties of directors, shareholders, and officers)

b. to qualify to transaction business in a state as a foreign companyi. obtain authorization from appropriate state agent or agency

ii. appointing a registered agent in the stateiii. filing annual statements in the stateiv. paying fees and franchise taxes to the state

Chapter 5: how does a corporation operate?A. Who is liable to the corporation’s creditor?- Although shareholders are generally shielded from the liabilities of the corporation, third parties

often refuse to extend credit to the corporation with limited assets unless that corporation’s shareholders agree to be personally responsible.

- As oppose to in contract and like in torts, a finding of fraud, injustice or inequity is not necessary to pierce the corporate veil.

DeWitt Truck Brokers, Inc. W. Ray Flemming Fruit Company: - where injustice occurs when a corporation is incorporated for illegitimate purposes, the corporate

veil will be pierced and the corporation and its stockholders will be treated as identical; the factors in the balancing test is whether the corporation was grossly undercapitalized (risked none while standing to gain everything), whether the stock is owned by one or a few individuals, failure to observe corporate formalities, non-payment of dividends, the insolvency of the debtor corporation, siphoning of funds of the corporation by dominant stockholder, non-functioning of officers or directors, absence of corporate records, and the fact that the corporation is merely a façade for the operations of the dominant stockholder(s).

- Here, the corporate stock is owned by one individual (Flemming), the corporation was grossly under capitalized, failure to observe corporate formalities, withdrawal of corporate funds, and assurance to be personally liable for corporate liabilities (this alone may be enough), and an element of injustice or fundamental unfairness, the courts have allowed the piercing of the corporate veil to establish liability.

- Is everyone liable now?In re Silicone Gel Breast Implants Liability Litigation:

- In determining whether a subsidiary may be found to be the alter ego or mere instrumentality of the parent corporation and thus piercing the corporate veil, the factors are:

o Common directorso Common business departmentso File consolidated financial statements and tax returnso Parent finances the subsidiary caused the incorporation of the subsidiaryo Subsidiary operates with grossly inadequate capitalo Parent pays for salaries and expenses of the subsidiaryo The subsidiary receives no business except that given to it by the parento The parents uses the subsidiary’s property as its owno The daily operations of the two corporations are not kept separateo The subsidiary does not observe the basic corporate formalities, such as keeping separate

books and records and holding shareholder and board meetings- Where the subsidiary is potentially undercapitalized, the companies have common directors and

departments, consolidated tax returns, and met many of the aforementioned factors, and the parents permitted its name to appear on the subsidiary’s products to improve sales by giving the product additional credibility (parent vouching for the product), the court found that it would be inequitable and unjust o allow parent to avoid liability.

- Notes:o piercing the veil liability - pierces through the corporation and recover from the

shareholdero agency liability – ???o direct liability - ???

o “enterprise liability” – pierces the walls of one corporation not to go after the assets of a shareholder, but to go after the assets of related companies

B. Who gets to make decisions for the corporation?1. Board of directors and officers

a. “Neither the board of directors nor an individual director of business, is, as such, an agent of the corporation or its members [shareholders].” Restatement (second) of Agency

b. Functions of BoD of publicly-held corporation:i. Select, evaluate, fix compensation of and replace senior executives

ii. Oversee conduct of corporation’s businessiii. Review and approve the corporation’s financial objective and major

corporate plansiv. Review and approve auditing and accounting principles in preparation of

the corporation’s financial statementsv. Make recommendation to shareholder

vi. See page 196-197c. Officers of a corporation are agents of the corporation; as such, they are affected by

state corporation law, company bylaws, and agency law.McQuade v. Stoneham: voting agreement among directors was contrary to public policy and void: “A contract is illegal and void where it precludes the board of directors, as the risk of incurring legal liability, from changing officers, salaries, or policies or retaining individuals in office, except by consent of the contracting parties.” Unlike election of directors where the shareholders may unite, this power is not extended to board of directors, as they have a duty to the corporation to act according to their best judgment. Here, the plaintiff was also a city magistrate, which would preclude him from holding position as a board of directly anyway. (still good law, but irrelevant????)

2. Shareholders’ decisions instead of directors’ decisions: However, many states have statutes permits shareholders of corporation with relatively few shareholders to enter into agreements controlling board decisions (include both Delaware and all states that have adopted the MBCA).

Villar v. Kernan: under Main law, written agreements between shareholders are enforceable even if they (1) relate to a phase of affairs of the corporation, such as the management of the corporation, payment of dividends, or employment of shareholders, (2) restrict director discretion, or (3) transfer management duties to shareholders, as long as such agreements satisfy certain conditions. Here, however, the agreement that the shareholders would not receive salaries from the corporation was not enforceable as it was oral agreement, which did not satisfy the statute.

3. Shareholders’ decisions about directors and cumulative votinga. Direct voting: voting is on a seat-by-seat basis; majority shareholder will be able to

elect every directorb. Cumulative voting (only for electing and removing directors): voting is based on an

at-large basis and the top vote-getters would be elected to the board; the shareholders would have to vote intelligently to enable them to elect the desired directors

4. Shareholders’ voting on directors’ decisions on “fundamental corporate changes”a. Fundamental corporate changes:

i. Amendments of the AoIii. Dissolution

iii. Merger with another corporationiv. Sale of all or substantially all of the assets of the corporation

b. Difference between voting on directors and voting on fundamental corporate changesi. Former is a shareholder action; later is a shareholder reaction

ii. Former may require a supermajority approval according to the state’s corporation code or the corporation’s articles for fundamental corporate changes

iii. There is no cumulative voting on fundamental corporate changes5. Where shareholders vote, and who votes

a. Annual meetingb. Special meeting

c. Owner record - person who has the legal right to vote at an annual meeting or special meeting

d. Record date – a fixed date so that only the record owners as of that date are entitled to notice of and a vote at the meeting

e. Street name – investors (“beneficiary owners”) buys shares through a broker (“record owner”); the certificate is held in a depository company, maintained by a group of brokerage firms and the investor is shown as the owner in the brokerage firm’s record, commonly referred to as “street name ownership”

f. Proxy – person who is entitled to vote authorizes another person to vote for her6. Who votes (and what are proxies)?

a. it is a form of agency: the owner is the principal and authorizes the proxy-holder to be her agent for voting

b. a proxy is revocable, even if it states that it is irrevocable, UNLESSi. the proxy states that it is irrevocable and

ii. is coupled with some interest in the stock7. Federal Proxy rules

a. False or misleading statements of factVirginia Bankshares, Inc. Sandberg:

- where the directors solicited shareholders stating that the shareholder would earn a “high” value and a “fair” price for their stock, and minority shareholder refuses to give proxy for a voting on a merger proposal because of disbelief or undisclosed motivation was insufficient for liability under Security Exchange Act and SEC rule.

- Statements of reasons, opinions, or beliefs are statements with respect to material facts, so as to fall within SEC rule prohibiting solicitation of proxies by means of materially false or misleading statements (may be actionable)

- Proof of mere disbelief or undisclosed motivation is insufficient- Director’s desire to avoid bad RP was insufficient to demonstrate causation of damages which

would allow implied private right of action to be brought under Act by minority shareholder whose votes were not required by law or corporate bylaw to authorize merger (not enough basis to extend private action pursuant to 15 USCS 78n(a))

James Surowiecki, Gadfly, Inc. (full-fledge proxy):- gadflies are those people who show up at annual meetings across the country to ask annoying

questions about what the managers are up to.- While shareholders can solicit proxies, any shareholder of a public company that engages in a full-

fledged proxy solicitation to elect directors and effect other changes must comply with the SEC proxy rules

b. Shareholder proposals (proxy)- rule 14a-9 requires a public corporation to include a shareholder’s proposal and supporting

statement of up to 500 words in its proxy statement- no-action letter is a recommendation by SEC staff that the full commission not challenge specified

conduct (but does not provide complete protection) SEC No-Action Letter, Xerox Corporation: in a shareholder proposal to replace the directors without meeting the requirements, the SEC granted a no-action letter allowing Xerox to exclude the proposal from its proxy materials.

8. Shareholders’ inspection rightsKortum v. Webasto Sunroofs, Inc.:

- The plaintiff was director of defendant company and president of a company that owned 50% of defendant company. The defendant company (really, the other company with 50% ownership) alleged that the plaintiff director and plaintiff company had ulterior motives for inspection of defendant corporation’s books and records. The courts held that (1) the plaintiff director may share the information so far as it did not conflict between his two fiduciary roles, and (2) that the stockholder’s status as a competitor may limit the scope of inspection but does not defeat the shareholder’s legal entitlement to relief.

- where a director and a stockholder of a joint venture corporation demand to see corporation’s books and records, a prima facie showing of entitlement to the documents has been made and the burdens shifts to the corporation to show why inspection should be denied or conditioned

- unlike a director, a stockholder who seeks inspection must prove by preponderance of the evidence that (1) its compliance with the form and manner of making a demand, and (2) the propriety of its purpose for seeking inspection and the scope of the requested inspection9. Shareholders’ voting agreements

Ringling Bros.-Barnum & Bailey Combined Shows, Inc. v. Ringling: where the shareholders have entered into an agreement over election of directors and later renegade, the court held that the agreement was binding, and in order to respect the voting rights of shareholders not parties to the agreement, vacated the votes of the renegade shareholder votes.

C. What are the responsibilities of a corporation’s decision makers and to whom are they responsible?1. What are the decision makers’ business responsibilities?

a. Privately-held companies: there is no principal-agent relationship???b. Publicly-held companies:

i. Financial results are publicii. Many owners affected by the performance of the company and the price of

the stockiii. Federal securities law other SEC rules require announcement and

explanation of any material actions or issues as they occuriv. There are entire industry devoted to analyzing and opining on the

attractiveness of the stock of every publicly trade company.2. What are the legal responsibilities?

a. Duty of carei. Breach of duty of care by board action

Shlensky v. Wrigley: - The court dismissed a stockholders’ derivative suit against the directors for negligence and

mismanagement for not installing lights at the baseball field and scheduling night baseball games, as directors are protected by the business judgment rule.

- The court held that absent showing of fraud, illegality, conflict of interest, or breach of faith, the business judgment of the directors of corporation enjoys the benefit of a presumption that it was formed in good faith and was designed to promote the best interests of the corporation they serve.

Joy v. North: - shareholder’s derivative suit

o an action against the corporation for failing to bring a specified suit and o an action on behalf of the corporation for harm to it identical to the one which the

corporation failed to bring.- Business judgment rule does not limit judicial scrutiny of recommendations of a special litigation

committee to terminate an action in a demand-not-required shareholder’s derivative suitSmith v. Van Gorkom:

- Where the board’s decision to approve proposed cash-out merger was not a product of informed business judgment-- the board acted in grossly negligent in approving the amendments to merger proposal and that the board failed to disclose all material facts which they knew or should have known before securing stockholders’ approval of merger--the business judgment rule protection is not warranted.

- Absent from meeting at which merger agreement and amendments were approved did not relieve the director from personal liability

- “the determination of whether a business judgment is an informed one turns on whether the directors have informed themselves on all material information reasonably available to them.”

ii. Breach of duty of care by board inaction Barnes v. Andrews:

- plaintiff incumbent-director, suing defendant former director for general liability for the collapse of the enterprise, must show that the defendant’s performance would have avoided loss, and what loss it would have avoided.

- “in an action against an inattentive director, a complaining shareholder must establish some linkage between the director’s bad behavior and corporate loss—or in legal terms, “causation.” (However, the Sarbanes-Oxley Act adds to the duty of care that a corporation’s management

owes the corporation that all of a corporation’s annual financial reports must now include a statement that the corporation has implemented an “adequate internal control structure and procedures for financial reporting.”)

In re Caremark int’l, Inc. Derivative Litigation:- previously, in Graham v. Allis-Chalmers Mfg. Co., the court held that directors were not required

to set up a monitoring system until they has some reason to suspect that the employees were not being honest.

- director liability for a breach of duty arises in two distinct contexts (297)o liability may follow from a board decision that results in a loss because that decision was

ill advised or “negligent” (“gross negligence” is the standard)o liability to the corporation for a loss may be said to arise from an unconsidered failure of

the board to act in circumstances in which due attention would, arguably, have prevented the loss.

- “only a sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability.” (pg 301-302)

- Van Gorkom and In Re Caremark are companion cases which explore the duty of care that the board of directors owes to the corporation and its stockholders. Van Gorkom deals with the care required in evaluating the merits of a merger and determining whether to recommend it to stockholders. Caremark, on the other hand, concerns the duty of care applicable to overseeing more routine decisions made by officers and employees of the corporation.

McCall v. Scott:- Gross negligence is the standard for asserting director’s neglect of duty and finding liability- ???

iii. The special case of executive compensationb. Duty of loyalty: generally arises when the director (i) competes with the company,

(ii) takes for herself a “corporate opportunity,” or (iii) has some personal pecuniary interest in a corporation’s decisions.

i. Competing with the corporationJones Co., Inc. v. Frank Burke, Jr.:

- the defendant officers lured away clients and key employees to the new agency and forced the plaintiff founder to either sell his shares or they will all quit en mass within 48 hours and start the new agency.

- The court held that the defendants breached their fiduciary duties to plaintiff by conspiring while in its employment to form a new agency and take with it accounts and employees.

- Notes: MBCA 5.06: directors and executives may not advance their pecuniary interest by engaging in competition with the corporation unless:

o Harm to corporation < benefit to corporationo Competition is authorized in advance or ratifiedo Etc…(pg 316)

ii. “usurping” a corporate opportunityNortheast Harbor Golf Club, Inc. v. Harris (standard for defining “corporate opportunity”):

- “line of business test”/ ”Guth test” (321):o The test: “whether the opportunity was so closely associated with the existing business

activities as to bring the transaction within that class of cases where the acquisition of the property would throw the corporate officer purchasing it into competition with his company.”

o Weakness: (1) whether a particular activity is within a corporation’s line of business is conceptually difficult to answer, and (2) the corporation must have the financial ability to take advantage of the opportunity

- “American Law Institute (ALI) test” (322):o Director or senior executive may not take advantage of a corporation opportunity unless:

(1) the corporate opportunity is first offered to the corporation and the conflict of interest is disclosed; (2) the corporation rejects the corporate opportunity; and (3) either (a) the

rejection is fair to the corporation or (b) the opportunity is rejected in advance, or (c) the rejection is authorized in advance or ratified…

o “The central feature of the ALI test is the strict requirement of full disclosure prior to taking advantage of any corporate opportunity.” (324)

- Where the officer purchased real estate next to the corporation’s golf course, such purchase was a corporate opportunity under the ALI test, which only requires that the opportunity be closely related to the business in which the corporation was engaged. As such, the officer had fiduciary duty to disclose information concerning any potential conflict of interest, to offer the opportunity to the corporation, and the opportunity must have been formally rejected, before the officer may take advantage of such opportunity.

Broz v. Cellular Information Systems, Inc.- using the Guth test, the corporation must have the ability to make use of the opportunity and must

have the intent to do so- there is no requirement that a fiduciary must present to the board prior to acceptance of

opportunity, if the corporation does not have interest, expectancy or financial ability to pursue opportunity

- Here, were the opportunity was presented to the defendant as stockholder of a competitor and not as a director of corporation, which just filed chapter 11 bankruptcy and has no interest or opportunity to purchase the cellular telephone service license, the defendant did not need to present the opportunity formally and that there was no breach of fiduciary duty (did not usurping corporate opportunity.)

iii. Being on both sides of a deal with the corporation (‘interested director transaction”)

HMG/Courtland Properties, Inc. v. Gray:- Two defendant officers of HMG both held interests in another corporation (NAF) in a major real

estate deal. Only one of two discloses the interest and abstained from voting on the proposed deal. On these facts, the court held that this undisclosed, buy-side interest in the transaction was a classic case of self-dealing, which, “in itself, is sufficient to rebut the presumption of the business judgment rule and invoke entire fairness review.” (335). The defendants fialed both parts of the test.

- “where directors stand on both sides of a transaction, they have the burden of establishing its entire fairness, sufficient to pass the test of careful scrutiny by the courts” (335) – two components:

o Fair dealing – embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approval of the directors and the stockholders were obtained.

o Fair price – related to the economic and financial considerations of the proposed merger, including all relevant factors: assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock (336)

D. Who sues and who recovers?1. what is a derivative suit and why do we have them?

a. A shareholder stands in the shoes of the corporation in asserting the claim. The suit is “derivative” because the shareholder’s right to bring it “derives” from the corporation’s right. (350)

b. There are at least 2 reasons why the corporation might not sue (through management decision). We are concerned about the second:

i. The directors might decide that litigation would strain the relationship unduly or that litigation is not beneficial.

ii. The directors might refuse to have the corporation bring suit because of personal reasons

c. “security for expenses” – the shareholder is required to post a bond or other security to ensure that the corporation’s expenses, including attorney’s fees, are covered if the shareholder’s suit is unsuccessful. However, many statutes provide an exception to this security requirement for shareholders who have substantial amounts of stock in the corporation whose claim they are asserting. (352)

Eisenberg . Flying Tiger Line, Inc. (derivative v. direct suit): - “suits are derivative only if brought in the right of a corporation to procure a judgment “in its

favor,” and that “where the corporation has no right of action by reason of the transaction complained of, the suit is not derivative.”

- Here, where a shareholder sues on behalf of himself and all others similarly situated to enjoin a proposed merger or consolidation, he is no enforcing a derivative right; he is, by an appropriate type of class suit, enforcing a right common to all the shareholders which runs against the corporation.”

- “reorganization plan which allegedly deprived shareholders of right to vote gave rise to personal, not derivative action.” (361)2. How does a derivative suit compare to a class action (and why are both so controversial)?

a. Derivative suit: the plaintiff is asserting the corporation’s claim and judgment goes to the corporation

b. Class action suit (a type of direct suit): plaintiff is asserting her own claim and recovers any judgment

c. However, for both, the driving force may be lawyers who may have incentives to settle the suit: as such, there are conflicting motives. Thus there are procedural requirements imposed on such (derivative) suits for several reasons (363):

i. To avoid frivolous litigationii. To deter strike suits

iii. To preserve the role of the directors in decision making3. procedural requirements of a derivative suit: (joinder of the corporation and alignment of the

parties, stock ownership and other standing requirements, security-for-expense, demand on directors)

a. Joinder of the corporation and alignment of the parties (the corporation is joined as a defendant, although in theory as involuntary plaintiff)

i. This is necessary because the recovery needs to go to the corporationii. Also, joinder of the corporation helps ensure that the judgment will have

claim preclusive (res judicata) effect.b. Stock ownership and other standing requirements

i. MBCA 7.41ii. Need “contemporaneous ownership” v. “continuing wrong” theory

iii. Case law: implied requirement that plaintiff in derivative action must fairly and adequately represent the interest of others similarly situated shareholders.”

c. Security-for-expense: as seen in the eisenberg case above; this is because vast majority of derivative suits brought in NY were filed by shareholders with minor holdings and were lacking in merit.

d. Demand on directors (important! This is the life and death for the case):i. FRCP 23.1 and NY 626(c): each imposes upon the derivative suit plaintiff a

requirement that she make a written demand on the directors that they assert a claim allegedly existing in favor of the corporation. But each also recognizes the possibility that such a demand might be excused for three reasons (366) MBCA 7.42:(1) if director has interest in the transaction(2) the directors did not fully inform themselves about the challenged

transaction(3) the transaction was so egregious it could not have been sound business

judgmentii. The demand requirement (requirement to “exhaust intracorporate

remedies”) places the issue squarely before the people who should be making the decision. Upon such, the decision makers could file suit or ignore it. In the later course, the shareholder can assert that the board erred in its decision not to have the corporation sue; however, this is almost always a loser, as the shareholder would in essence asserting that the director has violated the business judgment rule. According to the Delaware

Supreme Court, the fact that the plaintiff made the demand constitutes an admission that the directors were disinterested (there is no conflict of interest and that the decision is that of the directors). In other words, making the demand admitted that demand was not futile.

iii. The route, therefore, would be to NOT make the demand. The directors will seek to dismiss the action on the grounds that plaintiff should have made the demand. The issue would be if the demand was excused because it would have been futile. The motion whether demand was excused then is of life-and-death importance for the plaintiff’s case.

iv. Special litigation committee (SLC): To avoid having the court dismiss the directors’ motion to dismiss the derivative suit because the directors have some interest, the decision would be delegated to a SLC, made up of supposedly disinterested directors who weren’t themselves accused of wrongdoing.

Auerbach v. Bennett: this along with Zapata is the leading competing case… how????Zapata Corporation v. Maldonado:

- self-interest taint of majority of the board was not per se bar to delegation of board’s power over litigation decisions to independent committee composed to two disinterested board members.

- However, courts must inquire into independence and good faith of the committee and the bases supporting its conclusions

- If independence and good faith were found, the court must exercise its own independent business judgment in determining whether a motion should be granted.

e. Demand on shareholders: although required is some states, this is often excused. (401)

f. Right to jury trial (402)i. Under federal law: on the underlying claim being asserted in the derivative

suit, there will be a jury trial if there would have been a jury had the corporation brought the suit

ii. However, this does not apply in state courts; so whether one gets a jury trial on a derivative suit in state court is a matter of state law.

g. Court approval of settlement or dismissal: unlike routine, non-representative, litigation, a derivative suit settlement must be approved by the court for fear of the motives of the prime movers behind the cases.

4. Recovery in derivative suits:a. Most courts will allow the successful shareholder to recover her costs from the losing

litigant and her attorney fees from the corporation. b. If the shareholder loses, usually, the shareholder’s attorney will have taken the case

on a contingency fee, and thus will not recover here.E. Who really pays?

1. Indemnity (405):a. Under generally agency principles, an agent has a right to be indemnified by its

principal. However, a director is not an agent of the corporation and thus does not have a common law right to indemnification from the corporation for any judgment or settlement that they have to pay for the litigation cost they incur in connection with their corporation duties.

b. Indemnifications of a director are found in indemnification statutes, AoI, the bylaws, and contracts.

c. See MBCA 8.51 for permitted indemnification and MBCA 8.52 for required indemnification.

d. Indemnification k (406)2. Insurance or Directors and officers (D&O) insurance (408):

a. Common questions:i. Business question: Whether to buy D&O insurance and, if so, what kind?

ii. Legal question: What is covered by the policy and who makes what decisions with respect to litigation and settling claims

b. Types:

i. Side A (last resort) coverage: it is usually much cheaper than traditional D&O insurance because it only comes into play when the corporation cannot, or does not, indemnify the directors and officers.

ii. Side B: the insurer agrees to “pay on behalf of” or “reimburse” the corporation for amounts the corporation has paid or is required to pay in indemnifying its directors and officers.

Chapter 6: how does a business structured as a corporation grow?A. Borrowing more money

1. who is going to make the loan?2. what covenants will the lender require?3. how is the corporation going to service the debt?4. what happens if the corporation defaults?

B. Issuing more stock(1) To whom?

a. preemptive rights and other rights of existing shareholdersi. preemptive rights: a share holder with preemptive rights has the right to

purchase that number of shares of any new issuance of shares that will enable the shareholder to maintain her percentage of ownership; this protects the shareholder

ii. whether a shareholder has preemptive rights depends upon:(1) what the state corporation code says about preemptive rights(2) what the AOI say about preemptive rights, and(3) what the purpose of the issuance is

iii. Upsides of NOT having preemptive rights? Although the shareholders would lose some of its control, they would own a piece of the corporation that is now more valuable because of the issuance of stock.

iv. MBCA 6.30: (1) by default, shareholders do not have preemptive rights(2) with preemptive rights, shareholder may acquire proportional shares(3) no preemptive rights, if shares sold otherwise than for money

Byelick v. Vivadelli: - stockholders in the close corporation owe one another substantially the same fiduciary duty in the

operation of the enterprise that partners owe to one another- ALI 7.01(d): With closely held corporation, the court in its discretion may treat an action raising

derivative claims as a direct action (and thus exempt it from restrictions and defenses and allow individual recovery), if it will noto Unfairly exposes the corporation or the defendants to a multiplicity of actionso Materially prejudice the interests of creditors of the corporation, oro Interfere with a fair distribution of the recovery among all interested persons.

- whether or not preemptive rights are elected, however, the director’s fiduciary duty extends to the issuance of shares.

b. selling to venture capitalistsi. what is venture capital?

(1) Venture capitals:- venture capital: substantial equity investment in a non-

public enterprise that does not involve active control of the firm

- “second tier” or “mezzanine”- “angels”

(2) Success and failure- 1/3 fails- 1/3 in limbo- 1/3 sucessful

ii. How venture capitalists protect their investments(1) “downside protection”

(2) “upside opportunities”(3) Voting and veto rights(4) “exit opportunities”

c. to a person (or a few people) or to the public2. What are the legal constraints on how a corporation issues its stock?

a. Registration requirements for public offeringsii. Some of what your clients might have learned about securities registration

in B-School(1) the reason to go public: raise money(2) how much to raise? Fear v. greed(3) how many additional shares to sell?

iii. Some of what you can learn about securities regulations from the SEC website

b. Common law fraud and misrepresentation and rule 10b-5 constraints on any stock issuance 10b-5: it shall be unlawful for any person, directly or…

i. To employ any device, scheme, or artifice to defraud,ii. To 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 were made, not misleading, or

iii. To engage in any act, practice, or course of business which operates, or would operate as a fraud or deceit upon any person,

in connection with the purpose or sale of any security.o Debts v. Equityo Using earnings