BUSINESS ASSOCIATIONS OUTLINE (Professor Rosen)

CHAPTER 1—AGENCY

1. WHO IS AN AGENT? (Who is an agent? (1-12))

Gorton v. Doty, Idaho Sup. Ct.. 69 P.2d 136 (1937) (Page 1)

Facts  The Respondent son was a high school football player who was traveling to a high school
football game.
 The coach of the team was driving Respondent son in a car owned by Appellant teacher.
The car was in an accident wherein Respondent son suffered injuries, and the coach was
deemed negligent.
 Respondents claimed that Appellant was liable for the damages because a principal-agent
relationship was formed between Appellate teacher and the coach once she loaned him the
car.
Issue Was the coach considered an agent of the teacher/school?
Rule of Law Where one undertakes to transact some business or mange some affair for another by
authority and on account of the latter, the relationship of principal and agent arises.
Reasoning  Appellate is liable for damages because a principal-agent relationship was established
between Appellate and the driver of her car.
 The agency was created once the agent coach consented to act on the behalf of Appellate
teacher, and in turn Appellate consented to have the coach act on her behalf. In this case,
Appellate consented for the coach to drive on her behalf, and she instructed that the coach
drive.
Holding The coach was acting as an agent of the school.
Notes

 Vicarious Liability: Restatement (Third) § 2.04—“An employer is subject to liability for torts committed by
employees while acting within the scope of their employment.”

 Legal Standard: Restatement (Third) § 1.01—Agency is the fiduciary relationship that arises when:
o One person (a “principal”) manifests assent to another person (an “agent”) that the agent shall act
 on the principal’s behalf and
 subject to the principals control
o and the agent manifests assent of otherwise consents to the act

 Question of control: Restatement (Third) § 1

A Gay Jenson Farms Co. v. Cargill, Inc., Minn. Sup. Ct., 309 N.W.2d 285 (1981) (Page 6)
Facts  Warren operated a grain elevator and purchased grain from farmers for resale.
 Cargill financed Warren for Warren’s operations to the extent that both defendants’ names
appeared on drafts that Warren dispersed.
 Cargill also had a significant amount of control over Warren, including approving any
expenditure over $5,000, approving of any stock sale or dividends, and instructing Warren
to explain the nature of any withdrawals on the account.
o The defendants also contracted into unrelated agreements that clearly
established a principal-agent relationship. Warren also sold a majority of its
grain to Cargill.
o Warren had financial problems that worsened until Plaintiffs began questioning
the ability of Warren to make payments, and Cargill reassured Plaintiffs
otherwise.
 Warren was forced to close, owing Plaintiffs $2 million. Plaintiffs brought suit against
both, claiming Cargill was a principal of Warren.
Issue The issue is whether Cargill, through its control and influence over Warren, became liable as a
principal over Warren?
Rule of Law A creditor who assumes control of his debtor’s business may be held liable as principal for the
acts of the debtor in connection with the business.
Reasoning  Cargill consented to be a principal once Warren agreed to implement the changes and
policies that Cargill suggested.
 Cargill’s subsequent interference in Warren’s internal operations further established the
relationship.
Holding Cargill was a principal over Warren and is therefore liable for the damages sustained by
Plaintiffs.
Notes
2. LIABILITY OF PRINCIPAL TO THIRD PARTIES IN CONTRACT (Contractual liability of principal
for agent’s actions (12-31))

A. THE AGENTS AUTHORITY

Mill Street Church of Christ v. Hogan, Ky. Ct. App., 785 S.W.2d 263 (Page 12)
Facts  Mill St. Church contracted with Hogan to paint the church, Bill Hogan had previously done
work for the church.
 Bill needed assistance finishing the job, spoke to the church supervisor who suggested
hiring Gary Petty, Bill was never told to hire petty nor that he couldn’t hire anyone else.
 Bill then hired Sam Hogan (petitioner), his brother, who fell from a ladder and was injured.
Hogan then filed a claim under the Worker’s Compensation Act.
 Petitioner argues that Bill had the implied authority, as an agent of Mill St. Church, to hire
Sam and therefore, as the principal, Mill St. Church was liable for Sam’s injuries.
Issue Did Bill Hogan possess the implied authority as an agent of Mill Street Church, to hire Same
Hogan?
Rule of Law A person possesses implied authority as an agent to hire another worker where such implied
authority is necessary to implement the agent’s express authority.
Reasoning  “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.”
o “Apparent authority on the other hand is not actual authority but is the
authority the agent is held out by the principal as possessing. It is a matter of
appearances on which third parties come to rely.”
 “In examining whether implied authority exists, it is important to focus upon the agent’s
understanding of his authority. It must be determined whether the agent reasonably
believes because of present or past conduct of the principal that the principal wishes him to
act in a certain way or to have certain authority.”
 “The existence of prior similar practices is one of the most important factors.”
Holding  Bill Hogan was an agent of the Mill Street Church and did possess the implied authority to
hire Sam.
o Reasons included: (1) the fact that Bill had hired Sam in the past; (2) Bill
needed to hire an assistant to complete the job; and (3) maintaining the church
is part of Mill Street Church’s function as an entity.
Notes

 Types of Agency:
 Express Agency: an agency that occurs when a principal and an agent expressly agree to enter into an agency
agreement with each other.
o Can be oral or written unless Statute of Frauds applies
 Apparent Agency: agency that arises when a principal creates the appearance of an agency that in actuality does
not exist.
o principal is estopped from denying the agency relationship
o principal’s actions create apparent agency
o Restatement (Second) § 267: “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 harm caused by the lack of care or skill of the one appearing to be a servant
or other agent as if he were such.”
 Agency by Ratification: an agency that occurs when:
o a person misrepresents himself as another’s agent when in fact they are not, and
o the purported principal ratifies (accepts) the unauthorized act.
Three-Seventy Leasing Co. v. Ampex Co., 528 F.2d (5th Cir. 1976) (Page 15)
Facts  Plaintiff was a leasing company that approached Defendant company’s representative,
Thomas Kays, to purchase computer hardware.
 Plaintiff was going to act as a middle-man between Defendant and a second purchaser of
the hardware that Plaintiff found.
 Defendants submitted an unsigned purchasing agreement to Plaintiff, and Plaintiff signed
the agreement.
 Kays followed the exchange with a letter indicating that part of Plaintiff’s order would be
shipped directly to the second purchaser.
Issue Did Kays entered Defendant into a contract with Plaintiff under an apparent authority to act in
that capacity?
Rule of Law A salesperson binds his employer to a sale if he agrees to that sale in a manner that would
lead the buyer to believe that a sale had been consummated.
Reasoning  When Kays sent the letter to Joyce confirming the dates of delivery for the memory unit
this constituted acceptance because in the eyes of Joyce Kays had apparent authority to
accept an offer.
 “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. . . Further absent knowledge on the part of third 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. . . .”
 Reasons included: (1) nothing in the letter suggested that Kays did not have the authority to
sign on behalf of Ampex; (2) all communication took place through Kays, no one at
Ampex informed Joyce that acceptance would not come from Kays.
Holding Kays possessed the apparent authority to enter into contract on behalf of Ampex.
Notes

 Termination of an Agency Relationship:

o Agreement of the parties
o Agency at will
o Fulfillment of the purpose of the agency relationship
o By operation of law

 Principal’s Liability in Contract: Restatement § 144—a principal “is subject to liability upon contracts made by
an agent acting within his authority if made in proper form and with the understanding that the principal is a
party.”

 Types of Authority:
 Actual Authority:
 Apparent Authority:
o Restatement § 8: “Apparent authority is the power to affect the legal relations of another person by
transactions with third persons, professedly as an agent for the other, arising from and in accordance with
the other’s manifestations to such third persons.”
o § 27: “… apparent authority to do an act is created as to a third person by written or spoken words or any
other conduct of the principal which, reasonably interpreted, causes the third person to believe that the
principal consents to have the act done on his behalf by the person purporting to act for him.”
-Implied Authority by custom:
 Implied authority is “a kind of authority arising solely from the designation by the principal of a kind of agent
who ordinarily possesses certain powers”
o Implied actual authority: act of putting agent in such a position leads agent to reasonably believe he
has authority
 o Implied apparent authority: act of putting agent in such a position leads third party to reasonably
believe agent has authority
 Inherent Authority:
o Restatement § 8A—“Inherent agency power is a term used in the restatement of this subject to
indicate the power of an agent which is derived not from authority, apparent authority or estoppel, but
solely from the agency relation and exists for the protection of persons harmed by or dealing with a
servant or other agent.”
o Third Restatement abandons inherent authority and groups it with apparent authority.
 Estoppel:
 Ratification:
o A acts without authority (of any kind) and there are no grounds for estoppel.
o P will only be bound if P ratifies the contract
o Ratification requires
 A valid affirmation by P
 Can be express or implied
 Restatement (Third) § 4.01(2): Affirmation definition
 To which the law will give effect
 Restatement (Third) § 4.02(2); Restatement (3d) § 4.05—when ratification is not
effective

Watteau v. Fenwick, Q.B., 1 Q.B. 346 (1892) (Page 18)

Facts  Defendant owned a hotel-pub that employed Humble to manage the establishment.
 Humble was the exclusive face of the business; Humble’s name was on the bar and the
license of the pub.
 Defendant explicitly instructed Humble not to make any purchases outside of bottled ales
and mineral waters, but Humble still entered into an agreement with Plaintiff for the
purchase of cigars.
 Plaintiff discovered that Defendant was the actual owner and brought an action to collect
from Defendant.
Issue Is the Defendant liable for damages resulting from an agreement between Plaintiff and
Humble, who is knowingly acting outside his actual authority as an agent for Defendant?
Rule of Law When one holds out another as an agent, that agent can bind the principal on matters
normally incident to such agency, even I he was not authorized for a particular type of
transaction.
Reasoning  Humble was acting with an authority that was inherently reasonable for an agent in that
position. The situation is analogous to a partnership wherein one partner is silent but is still
liable for actions of the partnership as a whole.
 The decision could not be based on apparent authority because the principal is disclosed
under that doctrine.
 The principal is held liable for actions by an agent that are expressly forbidden, but the
case limits a principal to actions of an agent that are reasonable under the circumstances.
Holding Defendant was held liable.
Notes
B. RATIFICATION

Botticello v. Stefanovicz, Conn. Sup. Ct., 177 Conn. 22, 411 A.2d 16 (1979) (Page 22)
Facts  Defendants, Walter and Mary Stefanovicz (husband/wife) each owned one half of an
undivided interest in a farm.
 Plaintiff and Walter discussed Plaintiff’s potential purchase of the farm, and Mary told
Walter she would never sell the farm for less than $85,000.
 Plaintiff entered a lease with an option to buy the farm.
 Plaintiff dealt exclusively with Walter and did not know that Walter possessed only a half
interest. Mary did not know the specifics of Walter and Plaintiff’s agreement, and she
never consented to the sale.
 Prior to the agreement at issue, Walter handled a majority of the business but Mary always
offered her signature other matters associated with the farm.
Issue Did Mary agreed to allow Walter to act as her agent by ratifying his conduct when she
received the proceeds of the agreement at issue?
Rule of Law (1) An agency relationship cannot be established where the fair preponderance of the
evidence does not indicate that the purported principal has authorized or agreed to the
purported agent acting on her behalf.
(2) A person cannot ratify a prior act where the person neither intends to do so nor has
full knowledge of all the material circumstances.
Reasoning  “Agency is defined as ‘the fiduciary relationship which results from manifestation of
consent by one person to another that the other shall act on his behalf and subject to his
control, and consent by the other so to act. . . .’Restatement (Second), 1 Agency §1.”
o “three elements required to show the existence of an agency relationship
include: (1) a manifestation by the principal that the agent will act for him; (2)
acceptance by the agent of the undertaking; and (3) an understanding between
the parties that the principal will be in control of the undertaking. ’Restatement
(Second), 1 Agency §1, comment b (1958).”
o Not Martial status nor the fact that the property was owned jointly prove agency
 Plaintiff argued that Mary was bound by her husband’s contract because she ratified it
through her subsequent conduct.
 “Ratification is defined as ‘the affirmance by a person of a prior act which did not bind him
but was done or professedly done on his account.’ Restatement (Second), 1 Agency §82
(1958).”
o The court then decided that Walter had the ability to convey his half of the
property but not that of Mary. Since he contracted to convey the full title and
didn’t he could be held liable for breach of contract.
o Since Walter never stated that he was working on behalf of his wife, Mary was
not bound and specific performance could not be ordered.
o Further there was no apparent authority because the plaintiff never knew that
Mary was the principal.
Holding Walter was not acting as an agent on behalf of Mary
Notes
C. ESTOPPEL

Hoddeson v. Koos Bros., N.J. Super. Ct. App. Div., 47 N.J. Super. 224, 135 A.2d 702 (1957) (Page 26)
Facts  Plaintiff and her family entered Defendant’s store to purchase bedroom furniture. A man
approached Plaintiff purporting to be a salesman for Defendant store.
 Plaintiff gave salesman cash for furniture to be delivered to her home at a later date
because the salesman said that it was out of stock. Plaintiff did not get a receipt for the
transaction.
 After the delivery date lapsed without a delivery, Plaintiff contacted Defendant. Defendant
did not have a record of the transaction, and Plaintiff and her family were not able to
identify the salesperson from Defendant’s staff.
 A jury found for Plaintiff, and Defendant appealed, arguing that there was a lack of
evidence to establish an agency relationship.
Issue Is a company liable for a third party imposter agents actions?
Rule of Law To establish apparent agency, the appearance of authority must be shown to have been
created by the manifestation of the alleged principal and not solely by the supposed agent.
Reasoning  “the liability of a principal to third parties for the acts of agents may be shown by proof
disclosing (1) express of real authority which has been definitely granted; (2) implied
authority, that is, to do all that is proper, customarily incidental and reasonably appropriate
to the exercise of the authority granted; and (3) apparent authority, such as where the
principal by words, conduct, or other indicative manifestations has “held out” the person to
be his agent.”
 “It matters little whether for immediate purposes we entitle or characterize the principals of
law in such cases as “agency by estoppel” or “a tortious dereliction if duty owed to an
invited customer.” –mentioned by Rosen in class
 “Broadly stated, the duty of the proprietor also encircles the exercise of reasonable care
and vigilance to protect the customer from loss occasioned by the deceptions of an
apparent salesman.”

Holding Reversed, and a new trial was ordered in order to allow Plaintiff to establish a duty of care.
Notes

D. THE AGENT’S LIABILOTY ON THE CONTRACT

Atlantic Salmon A/S v. Curran, Mass. App. Ct., 32 Mass. App. Ct. 488, 591 N.E.2d 206 (1992) (Page 28)
Facts  Defendant held himself out to Plaintiffs as a representative for one or more principals, all
of them non-existent or dissolved at some point. Defendant gave false information
regarding the principal, but also maintained false titles, falsely advertised and did not
properly maintain corporate filings.
 Plaintiffs brought this action after Defendant owed Plaintiffs over $250,000 combined.
 Defendant maintained that he was acting as an agent of a now-dissolved corporation,
Marketing Designs, Inc.
 The trial court held that Plaintiffs could have found what principal Defendant represented
through public records.
Issue Can an agent be held personally liable if they do not disclose the principal to the other party?
Rule of Law It is the duty of an agent, in order to avoid personal liability on a contract entered into on
behalf of the principal, to disclose not only that he or she is acting in a representative
capacity, but also the identity of the principal.
Reasoning  “’If the other party [to a transaction] has notice that the agent is or may be acting for a
principal but has no notice of the principal’s identity, the principal for whom the agent is
 acting is a partially disclosed principal.’ Restatement (Second) of Agency §4(2) (1958).”
 “’Unless otherwise agreed, a person purporting to make a contract with another for a
partially disclosed principal is a party to the contract.’ Id. at § 321.”
 “Actual knowledge is the test. . . . ‘The duty rests upon the agent, if he would avoid
personal liability, to disclose his agency, and not upon others to discover it. It is not,
therefore, enough that the other has the means of ascertaining the name of the principal; the
agent must either bring to him actual knowledge or, what is the same thing, that which to a
reasonable man is equivalent to knowledge or the agent will be bound. There is no hardship
to the agent in this rule, as he always has it in his power to relieve himself from personally
liability by fully disclosing his principal and contracting only in the latter’s name. If he
does not do this, it may well be presumed that he intended to make himself personally
responsible.’ 1 Mechem of Agency § 1413 (2d ed. 1914).”
Holding Judgement reversed against the defendant.
Notes

 Agent Liability on the Contract:

 Disclosed Principal—P’s existence and identity are known
 No liability to agent unless; clear intent of all parties to be bound, or agent made a contract without
authority
 Partially Disclosed Principal—P’s existence is know but identity is not known
 Agent treated as a party to the contract, third party picks who to sue
 Undisclosed Principal—P’s existence and identity are not known
 Agent is liable

3. LIABILITY OF PRINCIPAL TO THIRD PARTIES IN TORT (Tort liability of principal for agent’s
actions (31-63))
A. SERVANT VERSUS INDEPENDENT CONTRACTOR

 Independent Contractors: an independent contractor is a person who agrees to carry out some task but is not subject
to the principal’s control in doing so.
 Independent contractor (agent type)—subject to limited control by P with respect to the chosen results
 A has the power to act on P’s behalf
 Nonagent Independent Contractor—less control on P’s part
 A has no power to act on P’s behalf.
 P usually not liable for an independent contractor’s torts, but exceptions apply:
 P retains control over the aspect of the work in which the tort occurs
 P engages an incompetent contractor
 Nondelegable duty
 Activity contracted for is a “nuisance per se”

Humble Oil & Refining Co. v. Martin, Tex. Sup. Ct., 148 Tex. 175, 222 S.W.2d 995 (1949) (Page 32)
Facts  Love left her car at a service station to get the brakes repaired. The station was operated by
W.T. Schneider through a “Commission Agency Agreement” with Humble.
 Love did not correctly secure the car before handing control to the station, and the station
did not check the car immediately to secure it. Love’s car rolled downhill, out of the station
lot and into Plaintiff’s property, striking Plaintiff and his two children.
 Trial Court entered a judgement against both Humble and Mrs. Love jointly and severally
and gave later judgement against Humble, the Court of Civil Appeals affirmed the
judgement.
 Humble maintained that they were not liable because Schneider was an independent
contractor.
Issue What is the difference between an independent contractor and a servant; and which was
Schneider (worker) in regards to Humble (owner) in this situation?
Rule of Law A party may be liable for a contractor’s tort if he exercises substantial control over the
contractors operations.
Reasoning  Humble maintained considerable control over Schneider by dictating several important
aspects of Schneider’s business.
 Humble had significant financial control and supervision, rendering Schneider’s station a
retail marketing enterprise for Humble’s products.
 “The ‘Commission Agency Agreement,’ which evidently was Schneider’s only title to
occupancy of the premise, was terminable at the will of Humble.” –Big one for Rosen
 “the agreement required Schneider in effect to do anything Humble might tell him to do.”
Holding A master-servant relationship exists between Humble and Schneider
Notes

Hoover v. Sun Oil Company, Del. Super. Ct., 58 Del. 553, 212 A.2d 214 (1965) (Page 34)
Facts  Plaintiffs entered Barone’s service station to fill their vehicle with gas. Smilyk, and
 employee of Barone, negligently started a fire while filling Plaintiffs’ car.
 Plaintiffs brought an action against the three defendants to recover damages from the fire.
 Sun Oil contended that the facts of the case indicate that Barone operated the station
independently from Sun Oil, and consequently Sun Oil was not responsible for his actions.
 Trial Court entered Summary judgement in favor of Sun Oil Co.
Issue What is the difference between an independent contractor and a servant in regard to a
relationship between two businesses; and which was Barone in regard to Sun Oil?
Rule of Law A franchisee is considered an independent contractor of the franchisor if the franchisee retains
control of inventory and operations.
Reasoning  Barone controlled all day-to-day operations of the station.
 Although Sun Oil worked closely with Barone in several day-to-day operations, Barone
was not required to follow Sun Oil’s advice.
 Barone was also able to sell competing products even if he elected not to do so.
o Even though the station advertised under Sunoco; Barone’s employee’s wore
Sunoco uniforms (rented from an independent company); and Barone attended
Sunoco school for service station operators; this was not enough to bind Sun
Oil Co. with the liability.
 “Barone’s contacts and dealings with Sun were many and their relationship intricate, but he
made no written reports to Sun and he alone assumed the overall risk of profit or loss in his
business operations. Barone independently determined his own hours of operation and the
identity, pay scale and working conditions of his employees, and it was his name that was
posted as proprietor.”
 “the test to be applied is that of whether the oil company has retained the right to control
the details of the day-to-day operations of the service station; control or influence over
results alone being viewed as insufficient. . . .”
Holding Sun Oil is not responsible for the negligence of Smilyk because he is an employee of Barone,
who in turn is an independent contractor.
Notes

Murphy v. Holiday Inns, Inc., Va. Sup. Ct., 216 Va. 490, 219 S.E.2d 874 (1975) (Page 38)
Facts  Plaintiff slipped and fell on a puddle of water that was dripping from an air conditioning
unit at the hotel. Plaintiff wanted to hold Defendant accountable for her injuries.
 A third party owned the hotel, but they agreed to a franchise agreement with Defendant
that dictated the name and look of the building and fixtures.
o The agreement also required the third party to submit reports and pay Defendant a
certain amount per room per day.
Issue Whether the franchise contract between Betsy-Len Corp. and Holiday Inn Inc. was a master-
servant contract to the degree that Holiday Inn could be held liable for franchisee’s torts?
Rule of Law If a franchise contract so regulates the activities of a franchisee as to vest the franchisor with
control within the definition of agency, a principal-agent relationship arises even if the parties
expressly deny it.
Reasoning  “Actual agency is a consensual relationship. ’Agency is the fiduciary relation which results
from the manifestation of consent by one person to another that the other shall act on his
behalf and subject to hid control, and consent by the other so to act.’ Restatement (Second)
of Agency § 1 (1958).”
o “’It is the element of continuous subjection to the will of the principal which
distinguishes the agent from other fiduciaries and the agency agreement from
other agreements.’ Id., comment (b).”
 “in determining whether a contract establishes an agency relationship, the critical test is the
 nature and extent of the control agreed upon.”
 “The fact that an agreement is a franchise contract does not insulate the contracting parties
from an agency relationship. If a franchise contract so “regulates the activities of the
franchisee” as to vest the franchisor with control within the definition of agency, the
agency relationship arises even though the parties expressly deny it.”
 Many of the provisions of the contract were in place to protect Defendant’s trademark.
However, normal day-to-day operations, such as hiring, price structure and business
expenditures were still controlled by the third party hotel owner.
Holding The contract did not establish a master-servant relationship. Summary Judgement in favor of
the defendant.
Notes

B. TORT LIABILITY AND APPARENT AGENCY

Miller v. McDonald’s Corp., Or. Ct. App,, 945 P.2d 1107 (1997) (Page 43)
Facts  Miller bit into a stone while eating a Big Mac and then sued McDonald’s. 3K Restaurants
owned and operated the restaurant under a License Agreement (franchise).
 The trial court granted summary judgment for McDonald’s – it didn’t own or operate the
restaurant, 3K did.
Issue Could a jury find that either actual or apparent authority existed between the two companies as
to which McDonald’s would be held liable for the franchisee’s torts?
Rule of Law For purposes of determining tort liability, a jury may find that an agency relationship exists
between a franchisor and a franchisee where the franchisor retains significant control over the
daily operation of the franchisee’s business and insists on uniformity of appearance and the
standards designed to cause the public to think that the franchise is part of the franchisor’s
business.
Reasoning  Actual Authority:
o McDonalds required 3K to operate in compliance with their standards,
policies, practices, and procedures; to only serve food it designed; to follow
their restaurant/equipment plans; maintain the building up to their standards;
operate under hours they prescribed; wear their uniforms; use their specific
packaging and advertisement; use ingredients up to their standards; handle food
to their standards.
o McDonalds enforced these standards through regular inspections.
 Apparent Authority:
o “Restatement (Second) of Agency, § 267. . .: ‘One who represents that another
is his servant or other agent and thereby causes a third person justifiably to rely
upon the care or skills of such apparent agent is subject to liability to the third
person if harm caused by the lack of care or skill of the one appearing to be a
servant or other agent as if he were such.’”
o Plaintiff went to the restaurant under the assumption that the defendant owned
and controlled it. She relied on the signs on the building and the uniforms the
employees wore that had the defendant’s insignia. Plaintiff believed that the
defendant was the only company to sell the “Big Mac.”
o Plaintiff relied on the defendant’s reputation and because she wanted the same
quality of service she had received in previous experiences.
Holding The Court held that a jury could find both actual and apparent authority were present.

Ira S. Bushey & Sons, Inc. v. United States, 398 F.2d 167 (2d Cir. 1968) (Page 48)
Facts  Lane returned to Plaintiff’s dry-dock after a night of drinking. For some unexplained
reason, Lane opened three water intake valves, flooding the dry-dock. The dry-dock and
 vessel were damaged by Lane’s actions.
Issue Whether the actions of Lane could be said to be within the scope of his employment as to
impose liability to the Government (his employer)?
Rule of Law Conduct of an employee may be within the scope of employment even if the specific act does
not serve the employer’s interest.
Reasoning  “Lane’s conduct was not so “unforeseeable” as to make it unfair to charge the Government
with responsibility. We agree with a leading treatise that “what is reasonably foreseeable in
this context (of respondent superior) *** is quite a different thing from the foreseeably
unreasonable risk of harm that spells negligence***.”
o “The proper test here bears far more resemblance to that which limits liability
for worker’s compensation than to the test for negligence. The employer should
held to expect risks, to the public also, which arise ’out of and in the course of
his employment of labor.”
 The court then stated had the injury been the result of something outside of his seafaring
activities (something to do with his domestic life for example) vicarious liability would not
follow.
Holding Defendant is liable for the actions of Lane.
Notes

C. SCOPE OF EMPLOYMENT

Manning v. Grimsley, 643 F.2d 20 (1st Cir. 1981) (Page 52)

Facts  Grimsley was warming up in the bullpen at Fenway Park while fans heckled him. After
three innings of the fans heckling him, Grimsley threw a ball at a ninety-degree angle from
his normal pitching target and into the stands, hitting Plaintiff.
 Plaintiff contends that the Baltimore ball club is liable for damages because the pitch was
thrown by Grimsley in an attempt silence the hecklers so he could warm up effectively.
 District court directed a verdict for the defendants on the battery count and the jury
returned a verdict for defendants on the negligence count.
Issue Can the ballpark be held liable for the pitchers actions?
Rule of Law To recover damages from an employer for injuries from an employee’s assault, the plaintiff
must establish that the assault was in response to the plaintiff’s conduct which was presently
interfering with the employee’s ability to perform his duties successfully.
Reasoning  In MA “where a plaintiff seeks to recover damages from an employer for injuries resulting
from an employee’s assault. . . [w]hat must be shown is that the employee’s assault was in
response the plaintiff’s conduct which was presently interfering with the employee’s ability
to perform his duties successfully. This interference may be in the form for the affirmative
attempt to prevent an employee from carrying out his assignments.” Miller v. Federal
Department Stores, Inc., 664 Mass. 340, 349-350 N.E.2d 573 (1973).”
 Since a jury could have either found that the action was a retaliation (making the ball club
not liable) or it was response to conduct “presently interfering” with his ability to pitch
(making the ball club liable) the trial court should have submitted this question of fact to
the jury.
Holding The court reversed vacated and remanded for new trial on the battery count
Notes

D. STATUTORY CLAIMS

Arguello v. Conoco, Inc., 207 F.3d 803 (5th Cir) (Page 55)
Facts  Plaintiffs all alleged that they were discriminated by employees of Conoco gas stations.
 Some of the plaintiffs were accosted at stations owned by Defendant, while another group
were accosted at stations not owned by Conoco but were branded as a Conoco station. The
incidents at issue occurred when Plaintiffs were paying for gas, using restrooms or
otherwise utilizing typical gas station services. Employees used racial epithets, treated
minority customers differently or refused service.
 Plaintiffs asserted that Defendant was not only liable over its employees in the stores it
owned, but also a master over the Conoco-branded stores through an ambiguous
“Petroleum Marketing Agreement” (“PMA”) between Defendant and the other stores.
 The PMA reference the treatment of customers (should be treated fairly, honestly and
courteously) and a provision allowed Defendant to terminate the agreement if the
franchisees did not follow the agreement.
 District Court dismissed the impact claim under 42 USC §2000a; and granted summary
judgement to Conoco on the appellants remaining 42 USC §§ 1981 and 2000a claims
Issue (a) Whether there was an agency relationship between Conoco, Inc. and Conoco-branded
stores?;
(b) Whether Conoco employees acted within the scope of their employment when they
conducted the alleged discriminatory acts?
Rule of Law To impose liability under civil rights legislation for the discriminatory actions of a third party,
the plaintiff must demonstrate an agency relationship between the defendant and the third
party.
Reasoning  (a) The plaintiffs were required to show an agency relationship between Conoco and it’s
branded stores.
o Plaintiffs argued that Conoco made PMA’s (Petroleum Marketing Agreements)
with the stores that: required the branded stores to maintain their business in
accordance with the PMA’s; allowed Conoco to control customer service
dimensions; gave Conoco the power to de-brand stores that did not abide; and
conducted biannual checks on stores.
o The court held “The language of the PMA, while offering guidelines to the
Conoco-branded stores, does not establish that Conoco, Inc. has any
participation in the daily operations of the branded stores nor that Conoco, Inc.
participates in making personnel decisions. Therefore, we find that there is no
agency relationship. . . .”
 (b) The plaintiffs were required to find that the employee acted within the scope of their
employment in order to hold Conoco liable for the tort claim.
o “Under general agency principals a master is subject to liability for the torts of
his servant while acting in the scope of their employment. See Restatement §
219. Some of the factors used when considering whether an employee’s acts are
within the scope of employment are: 1) the time, place and purpose of the act;
2) its similarity to acts which the servant is authorized to perform; 3) whether
the act is commonly performed by servants; 4) the extent of departure from the
normal methods; and 5) whether the master would reasonably expect such act
would be performed.”

Holding 
(a) Defendant did not establish a master-servant relationship with the Conoco-branded,
independently-owned stations.
 (b) Employees at the Defendant-owned stores could have been working within the scope of
their employment when they discriminated against the customers.
E. LIABILITY FOR TORTS OF INDEPENDENT CONTRACTORS

Majestic Realty Associates, Inc. v. Toti Contracting Co., N.J. Sup. Ct., 30 N.J. 425, 153 A.2d 321 (1959)
(Page 59)
Facts  The Parking Authority hired Toti to demolish several buildings near Plaintiffs to make
room for a parking structure. Plaintiffs’ property was damaged when Toti began
demolishing the building that adjoined Plaintiffs’ building.
 The Parking Authority hired Toti as an independent contractor and did not control the
manner in which Toti demolished the buildings.
Issue Was the Parking authority liable for the negligence of their independent contractor?
Rule of Law Although a person who engages a contractor, who conducts an independent business using its
own employees, is not ordinarily liable for negligence of the contractor in the performance of
the contract, such a person is liable when the contractor performs inherently dangerous work.
Reasoning  “[T]he long settled doctrine that ordinarily where a person engages a contractor, who
conducts and independent business by means of his own employees, to do work not in
itself is a nuisance, he is not liable for the negligent acts of the contractor in the
performance of the contract. . . . Certain exceptions have come to be accepted, i.e., (a)
where the landowner retains control of the manner and means of the doing work which is
the subject of the contract; (b) where he engages an incompetent contractor, or (c) where,
as noted in the statement of the general rule, the activity contracted for constitutes a
nuisance per se. . .“
 The court then defined “nuisance per se” as meaning the same thing as “inherently
dangerous.” The court defined inherently dangerous as “an activity which can be carried on
safely only by the exercise of special skills and care, and which involves grave risk of
danger to persons or property if negligently done.”
o The court also distinguished inherent danger from ultra-hazardous danger in
that no exercise of special care or skills can make the activity less dangerous.
Holding The Parking Authority is liable for Toti’s negligence because the demolition work was so
inherently dangerous that a party cannot delegate the liability.
Notes

4. FIDUCIARY OBLIGATIONS AGENTS (Fiduciary duties of agents (63-72))

 Fiduciary Duties of Agents: Restatement (Third) of Agency § 1: Agency is the fiduciary relationship that arises
when one person (a “principal”) manifests assent to another person (an “agent”) that the agent shall act on the
principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act.
o Fiduciary relationship: “any relation existing between parties to a transaction wherein one of the parties
is ... duty bound to act with the utmost good faith for the benefit of the other party.”
o “Such a relation ordinarily arises where a confidence is reposed by one person in the integrity of another,
and in such a relation the party in whom the confidence is reposed, if he voluntarily accepts or assumes to
accept the confidence, can take no advantage from his acts relating to the interest of the other party
without the latter's knowledge or consent.” Wolf v. Superior Court, 107 Cal.App.4th 25, 29 (2003)
 Agent’s Fiduciary Duties:
 Duty of Care:
 Restatement (Third) § 8.08: Subject to any agreement with the principal, an agent has a duty to the
principal to act with the care, competence, and diligence normally exercised by agents in similar
circumstances.
 Duty of Loyalty:
 Kickbacks
 Secret Profits
o From transaction with principal
o Use of position
 Restatement (Third) § 8.02 -- Material Benefit Arising Out of Position:
 An agent has a duty not to acquire a material benefit from a third party …
through the agent's use of the agent's position.
 Restatement (Third) § 8.05 -- Use of Principal’s Property; Use of Confidential
Information:
 An agent has a duty (1) not to use property of the principal for the agent’s own
purposes or those of a third party ….
 Usurping Business Opportunities from the P
 “Grabbing and Leaving”
o Restatement (Third) § 8.04: Throughout the duration of an agency relationship, an agent has a
duty to refrain from competing with the principal and from taking action on behalf of or
otherwise assisting the principal's competitors.
 During that time, an agent may take action, not otherwise wrongful, to prepare for
competition following termination of the agency relationship.
o Restatement (Third) § 8.05: An agent has a duty:
 not to use property of the principal for the agent's own purposes or those of a third party;
and
 not to use or communicate confidential information of the principal for the agent's own
purposes or those of a third party.

A. DUTIES DURING AGENCY

Reading v. Regem, K.B., 2 K.B. 268, 2 All E.R. 27, W.N. 205 (1948) (Page 63)
Facts  Plaintiff served in the army in Cairo. Plaintiff was hired to help smuggle goods by wearing
his army uniform and escorting goods on the bed of a truck. Upon discovery of his second
job, Defendant dismissed Plaintiff from the army and confiscated his earnings from his
second job.
 Plaintiff argued that Defendant did not suffer any damages or reduced profits.
Issue The issue is whether Plaintiff is entitled to the money earned while escorting goods during his
second job.
Rule of Law An agent who takes advantage of the agency to make a profit dishonestly is accountable to the
principal for the wrongfully obtained proceeds.
Reasoning  “It matters not that the master has not lost any profits nor suffered any damage, nor does it
matter that the master could not have done the act himself. If the servant has unjustly
enriched himself by virtue of his service without his master’s sanction, the law says that he
ought not to be allowed to keep the money, but it shall be taken from him and given to his
master, because he got it solely by reason of the position which he occupied as a servant of
his master.”
 The court distinguished this case where a servant may breach his contract and the principal
can only sue under breach of contract, but would have no claim to the money they gained.
Holding The master is entitled to the profits regardless of whether or not they were damaged or lost
profits.
Notes

Rash v. J.V. Intermediate, Ltd, 498 F.3d 1201 (10th Cir. 2007) (Page 66)
Facts  Rash was a manager at one of JV Intermediate’s industrial plants. JV claims that Rash
actively participated in and owned at least four other businesses, none of which were ever
disclosed to JV. One of those businesses was Total Industrial Plant Services, Inc. (TIPS), a
scaffolding business.
 TIPS bid on projects for JV, and with Rash as its manager, often selected TIPS as a
subcontractor. Between 2001 to 2004, JV paid over $1 million to TIPS.
 At some point during Rash’s tenure, JV started its own scaffolding business. Rash resigned
and then sued JV for breach of contract and fraud. He claimed the company purposely
understated the net profits and equity of the Tulsa branch and therefore did not properly
pay him the net profit and equity bonuses.
 JV countered that Rash
(1) materially breached his employment agreement,
(2) breached his duty of loyalty, and
(3) breached his fiduciary duty.
Issue (1) The existence and scope of a fiduciary duty between an agent and a principal?
(2) Did Rash breach his a fiduciary duty in reference to the scope of that duty?
Rule of Law An employee has a fiduciary duty, as the employer’s agent, to disclose to the employer what
the employer, as a principal, has a right to know.
Reasoning (1) The court concluded Rash was an agent because (1) he was hired to build the Tusla
division of JVIC and had sole management responsibilities at that branch; (2) Rash’s contract
states “ devote [his] full work time and efforts to the business and affaits of JVIC; (3) Rash
didn’t deny being an agent
(2) “[S]everal basic duties a fiduciary owes the principal: Among the agent’s fiduciary duties
to the principal is the duty to account for profits arishing out of the employment, the duty not
to act as, or on account of, an adverse party without the principal’s consent, the duty not to
compete with the principal on his own account or for another in matters relating to the subject
matter of the agency, and the duty to deal fairly with the principal in all transactions between
 them. . . . Restatement (Second) of Agency § 13, cmt. A (1958).”
Holding (1) Rash’s agency relationship with JV created a fiduciary obligation.
(2) Fee forfeiture is a proper equitable remedy in response to a breach of contract claim
Notes

B. DUTIES DURING AND AFTER TERMINATION OF AGENCY: HEREIN OF “GRABBING AND

LEAVING”

Town & Country House and Home Services, Inc. v. Newbery (Page 69)
Facts  Plaintiff operated a home cleaning business. The husband and wife who ran Defendant
company started the business by making several hundred calls and screening entire
neighborhoods that were likely candidates for their services. After time, the list grew to
over 200 customers.
 Defendants worked for Plaintiff, but they eventually quit and worked third shift at another
company. Defendants decided they would begin their own home-cleaning company, and
they solicited Plaintiff’s customers for their own business. Some customers decided to
switch from Plaintiff’s company to their company.
 Plaintiff sought damages for the lost profits, and wanted Defendants cease their operations,
claiming they compromised his trade secrets.
Issue Was the defendant liable for damages based of work performed after their employment ended
with the plaintiff?
Rule of Law Former employees may not use confidential customer lists belonging to their former employer
to solicit new customers.
Reasoning  The only trade secret in question was the plaintiff’s list of customers.
 “[E]ven where a solicitor of business does not operate fraudulently under the banner of his
former employer, he still may not solicit the latter’s customers who are not openly engaged
in business in advertised locations or whose availability as patrons cannot readily be
ascertained but ‘whose trade and patronage have been secured by years of business effort
and advertising, and the expenditure of time and money, constituting a part of the good will
of a business which enterprise and foresight have built up.’ (Witkop & Holmes Co. v.
Boyce, 61 Misc. 126, 131, 112 N.Y.S. 874, 878, affirmed 131 App.Div. 922, 115 N.Y.S.
1150, . . .). . . .”
Holding Defendants owe Plaintiff the profits they made from customers taken from Plaintiff, but they
do not have to cease their operations
Notes

 Gratuitous Agents: Restatement (Third) § 8.08 comment: In general, the standard of care applicable to a gratuitous
agent should reflect what it is reasonable to expect under the circumstances. Relevant circumstances include the skill,
experience, and professional status that the agent has or purports to have.

CHAPTER 2—PARTNERSHIPS
1. WHAT IS A PARTNERSHIP AND WHO ARE THE PARTNERS? (Partnership formations (73-89))

A. PARTNERS COMPARED WITH EMPLOYEES

 Advantages of Partnerships: Simplicity; single layer of taxation; more resources than sole proprietorship; cost
sharing; broader skill and experience than sole prop; longevity
 Disadvantages of Partnerships: Unlimited liability; potential for conflict; expansion, succession, and
termination issues.
o Each partner is deemed an agent of the other; also each partner is a fiduciary of the other.
 Can bind other partners into contracts; torts can result in vicarious liability

 Partnership Creation:
o Section 202. Formation of partnership …
o (c) In determining whether a partnership is formed, the following rules apply:
 (1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property,
or part ownership does not by itself establish a partnership, even if the co-owners share profits
made by the use of the property.
 (2) The sharing of gross returns does not by itself establish a partnership, even if the persons
sharing them have a joint or common right or interest in property from which the returns are
derived.
 (3) A person who receives a share of the profits of a business is presumed to be a partner in the
business, unless the profits were received in payment:
 (A) of a debt by installments or otherwise;
 (B) for services as an independent contractor or of wages or other compensation to an
employee;
 (C) of rent;
 (D) of an annuity or other retirement or health benefit to a deceased or retired partner or a
beneficiary, representative, or designee of a deceased or retired partner;
 (E) of interest or other charge on a loan, even if the amount of payment varies with the
profits of the business, including a direct or indirect present or future ownership of the
collateral, or rights to income, proceeds, or increase in value derived from the collateral;
or
 (F) for the sale of the goodwill of a business or other property by installments or
otherwise.
o UPA (1997) § 105: (a) Except as otherwise provided in subsections (c) and (d), the partnership agreement
governs: (1) relations among the partners as partners and between the partners and the partnership … (b)
To the extent the partnership agreement does not provide for a matter described in subsection (a), this
[act] governs the matter.
 EXAM NOTE: Have “two or more persons” associated together “to carry on as co-owners a business for profit”?
o When in doubt, refer to rules of UPA (1914) § 7 or UPA (1997) § 202

 Common Clauses in Partnership Agreements:

o Ownership of partnership and partnership assets; Accounting procedures; Distribution of profits and
losses; liability of each partner to the other; compensation for services; procedure if partner resigns or
dies; dispute resolution; termination procedure; etc. . .

Fenwick v. Unemployment Compensation Commission, N.J. Err. & App. (Page 73)
Facts  Appellant, the Unemployment Compensation Commission, sought a review of the Supreme
 Court of New Jersey’s decision to designate Respondent and Chesire partners.
 Chesire, a receptionist for Respondent’s beauty salon, repeatedly asked for a raise from her
fifteen dollars per week. Respondent was not certain if the amount of business would
generate enough revenue to pay Chesire a higher salary.
 Respondent wanted to retain Chesire, so they entered an agreement wherein Respondent
would pay Chesire her salary plus twenty percent of the profits.
 In the agreement, the parties are designated “partners”, but Chesire’s duties never changed
post-agreement.
Issue Whether or not the employee was considered a partner of the business as was explicitly stated
in the contract?
Rule of Law A partnership is an association of two or more persons to carry on as co-owners a business for
profit.
Reasoning  The court mentioned several factors that courts take into consideration when determining
the existence of a partnership: (1) the intention of the parties; (2) the right to share in the
profits; (3) obligation to share in the losses; (4) ownership and control of the partnership
property and business; (5) the community of power in administration; (6) the language in
the agreement; (7) the conduct of the parties toward third persons; (8) the rights of the
parties on dissolution.
 After review of these elements the court stated: “we think that the partnership has not been
established, and that the agreement between these parties, in legal effect, was nothing more
than one to provide a method of compensating the girl for the work she had been
performing as an employee.”
Holding Chesire is an employee despite Respondent and Chesire’s agreement that termed her as a
partner.
Notes

B. PARTNERS COMPARED WITH LENDERS

Martin v. Peyton, NY Ct. App. (Page 78)

Facts  Hall was a friend of Respondents, and Hall’s brokerage business was suffering.
 Respondents discussed helping Hall and his business, but they needed to ensure that Hall’s
business would discontinue their speculative, unwise investments.
 Respondents agreed to loan Hall $2.5 million in securities for Hall to secure $2 million in
loans.
 In return, Respondents received Hall’s more speculative collateral and would receive a
percentage of Hall’s profits. Respondents acquired the ability to review Hall’s books and
veto certain investments.
Issue The issue is whether the conditions of the agreements between Respondents and Hall
constituted a partnership between the two parties?
Rule of Law Although the absence of an explicit partnership agreement does not itself preclude he creation
of a partnership, it must be proven that investors in an enterprise have intent to carry ion as
co-owners of the enterprise a business for profit before they can be considered partners of the
enterprise.
Reasoning  Although Respondents ensured that they had some control over the operations of Hall’s
business, the controls they bargained for were to ensure that their investment was secure.
Immediately prior to Respondent’s investment, Hall’s business was doing poorly due to
bad decision-making and Respondents needed to prevent further bad decisions.
 Hall still was able to control the day-to-day affairs, and Respondents never had control to
initiate their own ideas
Holding The agreements did not establish a partnership.
Notes

Southex Exhibitions, Inc. v. Rhode Island Builders Association, Inc., 279 F.3d 94 (1st Cir. 2002) (Page 82)
Facts  Defendant wanted to stage home shows at a newly constructed civic center.
 SEM was already a successful producer of other home shows, and in some cases had some
ownership in home show ventures in other regions. SEM was not certain how successful
Defendant’s home shows would be, so they expressly declined any ownership of a joint
venture and instead came to terms with Defendant using the 1974 agreement at issue.
o The agreement split the net show profits (55% to SEM, 45% to Defendant), had
renewable 5-year terms, and gave SEM first refusal on producing all of
Defendant’s home shows.
o However, Defendant was not responsible for any losses, SEM conducted third-
party business under their own name, the parties never gave their relationship a
separate business name, and they never filed taxes as a partnership.
 Plaintiff bought SEM’s interest and when Defendant was unsatisfied with Plaintiff’s
performance they hired another producer for its home shows.
 Plaintiff maintains that they obtained a partnership with Defendant when they bought
SEM’s interest, and their partnership precluded Defendant from switching to another
producer.
Issue Whether or not the 1974 agreement between the two companies constituted a partnership
under Rhode Island Law?
Rule of Law The existence of a partnership normally must be determine under the totality-of-the-
circumstances test.
Reasoning  The based its findings on: (1) the fact that the 1974 agreement was titled “Agreement”
rather than partnership agreement; (2) the agreement was for a fixed duration; (3) the two
companies did not share the obligation of losses (SEM took all the risk); (4) Southex
conducted business with third parties; (5) the mutual association was never given a name;
(6) never filed a state of federal partnership tax return; (7) there was no jointly-owned
partnership property.
 Southex then argued that Rhode island statue made profit sharing prima facie evidence of
partnership and that the district court erred in in not finding that a partnership was formed
as a matter of law.
o The court applied the “totality of circumstances test” since a partnership can be
created without any written formalities.
o The court stated that Southex cited no authority that stated an evidentiary
presumption created by profit sharing can be overcome only by establishing it
did not fit the 5 exceptions mentioned in the statute.
o The court required that Southex provide competent evidence, other than the
pertinent factors provided indicating the absence of an intent to form a
partnership mentioned above.
Holding The 1974 agreement between Defendant and SEM does not establish a partnership, and
therefore Defendant owes no obligation to Plaintiff arising from the 1974 agreement.
Notes

C. PARTNERSHIP BY ESTOPPEL

 Partnership by Estoppel: to establish, four elements must be proven:

 o 1. Plaintiff must establish a representation, either express or implied, that one person is the partner of
another—i.e., that there was a holding out of a partnership
o 2. The making of the representation by the person sought to be charged as a partner or with his consent
o 3. A reasonable reliance in good faith by the third party upon the representation
o 4. A change of position, with consequent injury, by the third person in reliance on the representation.

Young v. Jones, 816 F. Supp. 1070 (D.S.C 1992) (Page 87)

Facts  Plaintiffs invested $550,000 in a South Carolina bank after they were reassured by
Defendants, through an unqualified audit letter, that the investment entity was legitimate.
The audit letter was based upon a falsified financial statement.
 Plaintiffs dealt primarily with one Defendant, PW-Bahamas, to obtain the audit letter, but
they included the United States Price Waterhouse (“PW-US”) firm as well as individual
members of the PW-US firm.
 PW-US and its individual members did not directly handle the failed investment, but
partners are jointly and severally liable for the actions of one party of a partnership.
Therefore, if Plaintiffs could establish a partnership between PW-Bahamas and PW-US
then PW-US could be held liable.
 Plaintiffs argued that a partnership by estoppel was established through pamphlets by
Defendants that linked the various offices worldwide.
Issue The issue is whether a partnership by estoppel was established between PW-Bahamas and PW-
US to hold PW-US liable for the missing investment money.
Rule of Law A person who represents himself, or permits another to represent him, to anyone as a partner
in an existing partnership or with others not actually partners, is liable to persons to whom
such a representation is made who has given credit to the actual or apparent partnership.
Reasoning  “[A] person who represents himself, or permits another to represent him, to anyone as a
partner in an existing partnership or with others no actual partners, is liable to any such
person to whom such a representation is made who has, on the faith of the representation,
given credit to the actual or apparent partnership. S.C.Code Ann. § 33-41-380(1) [U.P.A.
§16(1)]. . . .”
 The court reasoned that the plaintiff did not rely on the brochure presented as evidence nor
did they rely on the existence of a partnership when they made the decision to invest their
money.
Holding There was no partnership by estoppel because there was no proof that Plaintiffs relied upon
any acts or statements by Defendants that a partnership existed between PW-Bahamas and
PW-US.
Notes

2. THE FIDUCIARY OBLIGATIONS OF PARTNERS (Fiduciary duties of partners (89-117))

A. INTRODUCTION
  Partnership Fiduciary Duties:
o UPA (1997) § 409. General Standards of Partner’s Conduct:
 (a) The only fiduciary duties a partner owes to the partnership and the other partners are the duty
of loyalty and the duty of care set forth in subsections (b) and (c).
o Duty of Care: UPA (1997) § 409(c). General Standards of Partner’s Conduct:
 (c) A partner’s duty of care to the partnership and the other partners in the conduct and winding
up of the partnership business is limited to refraining from engaging in grossly negligent or
reckless conduct, intentional misconduct, or a knowing violation of law.
 UPA (1997) § 105 Effect of Partnership Agreement
 (a) Except as otherwise provided in subsections (c) and (d), the partnership agreement
governs: (1) relations among the partners as partners and between the partners and the
partnership …
 (b) To the extent the partnership agreement does not provide for a matter described in
subsection (a), this [act] governs the matter.
 (d)(3) If not manifestly unreasonable, the partnership agreement may:
o (A) alter or eliminate the aspects of the duty of loyalty stated in Section 409(b);
o (B) identify specific types or categories of activities that do not violate the duty
of loyalty;
o (C) alter the duty of care, but may not authorize conduct involving bad faith,
willful or intentional misconduct, or knowing violation of law …
 Manifestly Unreasonably: UPA (1997) § 409(c). A partner’s duty of
care to the partnership and the other partners in the conduct and winding
up of the partnership business is limited to refraining from engaging in
grossly negligent or reckless conduct, intentional misconduct, or a
knowing violation of law.
o Duty of Loyalty: § 409. General Standards of Partner’s Conduct:
o (b) A partner’s duty of loyalty to the partnership and the other partners is limited to the following:
 (1) to account to the partnership and hold as trustee for it any property, profit, or benefit derived
by the partner:
 (A) in the conduct or winding up of the partnership’s business;
 (B) from a use by the partner of the partnership’s property; or
 (C) from the appropriation of a partnership opportunity;
 (2) to refrain from dealing with the partnership in the conduct or winding up of the partnership
business as or on behalf of a person having an interest adverse to the partnership; and
 (3) to refrain from competing with the partnership in the conduct of the partnership’s business
before the dissolution of the partnership.
 Actions that might violate this duty: competing with the partnership; taking away
business from the partnership; using partnership property for personal profit; conflicts of
interest

Meinhard v. Salmon, NY Ct App (Page 89)

Facts  Walter J. Salmon (Defendant) entered into a lease for a hotel. Defendant, while in course of
treaty with the lessor as to the execution of the lease, was in course of treaty with Meinhard
 (Plaintiff), for the necessary funds.
 Plaintiff and Defendant were involved in a joint venture in regards to the property, for
better or worse. Defendant was the manager of the property.
 Near the end of the lease, Elbridge Gerry became the owner of the reversion, and he
approached Defendant. The two entered into a new lease, which is owned and controlled
by Defendant.
 Defendant did not tell Plaintiff about it.
 When Plaintiff found out about the new lease, he demanded that the lease be held in trust
as an asset of the venture between Defendant and Plaintiff, which Defendant refused.
Issue Can one partner benefit from the partnership without disclosing the benefit to the other
partner?
Rule of Law Joint adventurers own one another the highest fiduciary duty of loyalty while the enterprise is
ongoing.
Reasoning  “Joint adventurers, like copartners, owe to one another, while the enterprise continues, the
duty of the finest loyalty. . . . Not honesty alone, but the punctilio of an honor the most
sensitive, is then the standard of be havior.”
 “The trouble about his conduct is that he excluded his co adventurer from any chance to
compete, from any chance to enjoy the opportunity from benefit that had come to him
alone by virtue of his agency.”
 “A managing adventurer appropriating the benefit of such a lease without warning to his
partner might fairly expect to be reproached with conduct that was underhand, or lacking,
to say the least, in reasonable candor, if the partner were to surprise him in the act of
sighing the new instrument.”
Holding No, joint ventures, like copartners owe each other a duty of loyalty.
Notes

 Doctrine of Organizational Opportunities: Agency Restatement § 387: “Unless otherwise agreed, an agent is
subject to a duty to his principal to act solely for the benefit of the principal in all matters connected with his
agency.” (Corporate opportunities doctrine)

Sandvick v. LaCrosse, ND Sup Ct (Page 96)

Facts  In May 1996, Sandvick, Bragg, LaCrosse, and Haughton purchased three, 5-year oil and
gas leases in North Dakota. The leases were known as the “Horn leases.” Empire Oil
Company, owned by LaCrosse, held record title to the leases.
 In November 2000, Haughton and LaCrosse purchased three oil and gas leases on the Horn
property. These leases were referred to as the “Horn Top Leases” and were set to begin at
the expiration of the initial Horn Leases.
 Prior to purchasing the top leases, LaCrosse and Haughton twice offered to purchase
Sandvick’s and Bragg’s interests in the Horn leases, but Sandvick and Bragg refused.
Haughton testified he did not inform either Sandvick or Bragg that he and LaCrosse had
purchased the top leases.
 Sandvick and Bragg then sued LaCrosse and Haughton, claiming they breached their
fiduciary duties by not offering Sandvick and Bragg an opportunity to purchase the top
leases with them.
 The District Court dismissed the complaint, holding that neither a partnership nor a joint
venture existed.
Issue (1) Did the parties form a partnership or a Joint Venture?
(2) Was a fiduciary duty breached?
Rule of Law (1) A partnership does not exist where a business undertaking is more limited than a series
 of acts directed to an end.
(2) A joint venture exists between parties who purchase assets from their credits in a
single checking account in equal shares, where the assets are titles in a single entity’s
name, and where profits, if any, are to be shared.
(3) Joint venturers breach their fiduciary duty of loyalty to co-joint venturers where they
take for themselves an opportunity that belongs to the joint venture without giving their
co-joint venturers the chance to participate in that opportunity.
Reasoning (1) “A joint venture is similar to a partnership but is more limited in scope and duration, and
principals of partnership law apply to the joing venture relationship. SPW Associates, LLP v.
Anderson, 2006 ND 159, ¶ 8, 718 N.W.2d 580.”
 “For a business enterprise to constitute a joint venture, the following four elements must be
present: (1) contribution by the parties of money, property, time or skill in some nature; (2)
a proprietary interest and right of mutual control over the engaged property; (3) an express
or implied agreement for thr sharing of profits, and usually, but not necessarily, of losses;
and (4) an express or implied contract showing a joint venture was formed.” Id. at ¶ 10.”
 The court found that a joint venture was formed in reference to the Horn leases, because
they used a joint checking account to purchase the lease, they shared the title Empire Oil
rather than the parties names, and profits were going to be shared if the lease was sold.
(2) Under the UPA (1997) §404(a) a partner owes duties of loyalty and care to the other
partners. UPA (1997) §404(b) sets forth this duty.
 Court cites Meinhard v. Salmon. “Joint adventurers, like co-partners. Owe to one another,
while the enterprise continues, the duty of the finest loyalty.”
 The court found that LaCrosse and Haughton extended the original Horn leases by
purchasing the new leases, creating a conflict of interest before the original leases expired,
and that this breached their fiduciary duty by taking advantage of a partnership opportunity
without telling the other partners.
Holding (a) The parties formed a joint venture which is governed by partnership laws;
(b) Yes, a fiduciary duty was breached by not informing the other partners of the new lease
opportunity
Notes

B. GRABBING AND LEAVING

 What is “Manifestly Unreasonable”?:

o UPA (1997) § 105(d)(3): If not manifestly unreasonable, the partnership agreement may:
 (A) alter or eliminate the aspects of the duty of loyalty stated in Section 409(b);
 (B) identify specific types or categories of activities that do not violate the duty of loyalty;
o UPA (1997) § 105(e):
o (e) The court shall decide as a matter of law whether a term of a partnership agreement is manifestly
unreasonable under subsection (c)(6) or (d)(3). The court:
 (1) shall make its determination as of the time the challenged term became part of the partnership
agreement and by considering only circumstances existing at that time; and
 (2) may invalidate the term only if, in light of the purposes and business of the partnership, it is
readily apparent that:
 (A) the objective of the term is unreasonable; or
 (B) the term is an unreasonable means to achieve the term’s objective.

Clearly Proper Questionable Clearly Improper

Solicit fellow partners to leave Negotiate merger with another Take client files
too firm
 Contact clients before leaving Take desk files Contact clients before
firm, so long as disclosed announcing departure
Remind clients they have a right Keep plans confidential Not informing clients of right to
to choose counsel have counsel of own choice
Locate Space, etc. . . Solicit subordinates Lying about plans

Meehan v. Shaughnessy, Mass Sup Jud Ct (Page 101)

Facts  Plaintiffs were long-time partners at Defendants’ firm. Both were very successful lawyers
within the firm but became dissatisfied.
 Once Plaintiffs decided to leave, they gave thirty days notice (instead of the agreed upon
three months – but this was waived by a partner in the firm), took other attorneys from the
firm with them and contacted referring attorneys and clients about their imminent departure
and provided forms to clients to switch to Plaintiffs’ new firm.
 Plaintiffs denied their intentions to leave on several occasions. However, Plaintiffs
maintained their usual standard of performance during their entire association with the
firm.
 When Plaintiffs left, they took 142 of the 350 pending contingent fee cases.
 Trial Court ruled in favor of the plaintiff finding they did not breach their fiduciary duty
when removing clients from the defendant’s firm. Defendant appeals.
Issue Whether the plaintiff fulfilled their fiduciary relationship to their former partner?
Rule of Law A partner breaches his fiduciary duty by using his position of trust and confidence to the
disadvantage of the partnership.
Reasoning  “As a fiduciary, a partner must consider his or her partners’ welfare, and refrain from
acting for purely private gain.”
 “fiduciaries may plan to compete with the entity to which they owe allegiance, ‘provided
that in the course of such arrangements they [do] not otherwise act in violation of their
fiduciary duties’ Chelsea Indus. v. Gaffney”
 The court found that in their preparation for obtaining client’s consent, the secrecy
concerning the client’s they were going to take, and the substance and method of
communication with these clients gave them an unfair advantage over the the former
partners.
o Specifically, the court took issue with the fact that they were ready to move
once notice was given and the letters they sent the clients did not give them a
clear choice between firms.
 UPA § 20 a partner has an obligation to “render on demand true and full information of all
things affecting the partnership to any partner.”

Holding Yes, the Court ruled that the leaving partners breached their fiduciary duty to their former
partner.
Notes

C. EXPULSION

Lawlis v. Kightlinger & Gray, Ind. Ct. App (Page 108)

Facts  Plaintiff was a long-time member of Defendant firm, but after time he suffered from
alcoholism. After concealing his problem for several months, Plaintiff missed several
months of work to seek treatment.
 Defendant firm outlined conditions for his return. The agreement outlining his return did
not provide any second chances, but when Plaintiff continued to have problems Defendant
firm gave him a second chance. Defendant lightened Plaintiff’s workload and kept him as a
senior partner.
 Three years after Plaintiff first came to Defendant with his alcohol problem, once he made
a complete recovery, Plaintiff asked for his shares to be increased dramatically.
 Defendant responded by recommending his senior partner status be severed, and he was
eventually expelled from the firm per the procedures outlined in the partnership agreement.
Issue Whether the firm’s vote to expel the plaintiff was made in “good faith” under the partnership
agreement and the UPA?
Rule of Law When a partner is involuntarily expelled from a business, his expulsion must have been in
good faith for dissolution to occur without violating the partnership agreement.
Reasoning  Plaintiff first argued that the actions prior to expulsion by the firm were a dissolution of the
partnership.
o UPA § 31(d) states that dissolution is caused by the explosion of any partner
from the business bona fide in accordance with such a power conferred by the
agreement.
o The court found that the prior actions did not constitute a dissolution
 Plaintiff then argued that the explosion was made for “predatory purposes” of increasing
the partner/client ratio.
o The court found this claim had no merit because even when plaintiff was
unproductive due to his condition, the firm still allowed him to take his draw;
and the firm gave him a second chance to recover even when they did not have
to.
 Plaintiff finally argues that the expulsion was fraudulent because it breached the fiduciary
duty between partners to exercise good fair and fair dealings.
o The court found no fault with the “guillotine method” [involuntary severance
that is immediate termination by partnership vote without notice or hearing] and
that it was be in the best interest of the partners.
o The court also found that this claim had no merit because the senior partners
also offered the plaintiff a 6 month severance package that he refused, which
showed compassion.
Holding Yes, the partnership vote for explosion was made in good faith.
Notes

3. PARTNERSHIP PROPERTY (Partner Powers (117-125))

 Rights of a Partner:
 o Control Rights: UPA (1997) §401(h): “Each partner has equal rights in the management and conduct of
the partnership business.”
o Economic Rights: UPA (1997) §401(b): “Each partner is entitled to an equal share of the partnership
distributions and … is chargeable with a share of the partnership losses in proportion to the partner’s
share of the distributions.”
o Partnership Property:
 UPA (1997) § 501: “A partner is not a co‑owner of partnership property and has no interest in
partnership property which can be transferred, either voluntarily or involuntarily”
 UPA (1914) § 25(1): “A partner is co-owner with his partners of specific partnership property
holding as a tenant in partnership”
o Partnership Capital: UPA (1997) § 401(a)
 Capital Account: a running balance showing each P’s ownership equity

Putnam v. Shoaf, Tenn Ct. App (Page 113)

Facts  Putnam and her husband owned one half of a business, Frog Jump Gin, with another
couple. After Putnam’s husband died the business became unprofitable, and Appellees
offered to take Putnam’s share of the business.
 Putnam and the other partners would put $21,000 into the partnership and then Putnam
would convey her share of the business.
 After Putnam conveyed her interest, Appellee’s discovered that the former bookkeeper was
stealing money from the business.
 The business collected $68,000, but Appellant asserts that Appellee’s share is rightfully the
estate of Putnam’s because the misconduct happened while she was a partner.
Issue Whether the plaintiff conveyed her rights to money collected as result of a judgement for an
act that occurred during the time she possessed an interest in the partnership?
Rule of Law A co-partner owns no personal specific interest in any specific property or asset of the
partnership, and may only convey an undivided interest in the value or deficit of the
partnership.
Reasoning  The court found under the UPA the plaintiff’s rights consisted of (1) right in specific
partnership property, (2) interest in the property, (3) right to participatate in the
management.
 “The real interest of a partner, as opposed to that incidental possessory right before
discussed, is the partner’s interest in the partnership which is defined as ‘his share of the
profits and surplus and the same is personal property’ . . . . The partner’s interest is an
undivided interest, as a co-tenant in all partnership property. . . . That interest is the
partner’s pro rata share of the net value of the partnership.”
 Since the plaintiff could only convey her “partnership interest” and had no such specific
interest in the judgement, the court found that the plaintiff had no right over any of the
money judgement.
 “mutual ignorance of the existence of oil would not, in our opinion, warrant a ‘reformation
of the contract for sale of the partnership interest, or warrant a decree in favor of the
transferor for a share of the value of the oil.”
Holding No, plaintiff only had a partnership interest to convey and that is what she intended to convey.
Notes

 The Partnership Interest: the partner’s interest is the partner’s share of profits and losses
o UPA (1997) § 503(a)(2) codifies prior law that transfer of an interest does not effect a dissolution of the
partnership
  A partner who has transferred his interest remains a partner
 UPA (1997) § 601(4) expulsion for transferring substantial amount of partners interest.

 Creditor’s Access to Firm and Personal Assets:

o UPA (1997) § 306. Partner’s Liability
 (a) Except as otherwise provided in subsections (b) and (c), all partners are liable jointly and
severally for all obligations of the partnership unless otherwise agreed by the claimant or
provided by law.
 (b) A person admitted as a partner into an existing partnership is not personally liable for any
partnership obligation incurred before the person’s admission as a partner.
o UPA (1997) § 501. Partner Not Co‑owner of Partnership Property: A partner is not a co‑owner of
partnership property and has no interest in partnership property which can be transferred, either
voluntarily or involuntarily.
o UPA (1997) § 504. Partner’s Transferable Interest Subject to Charging Order
 (a) On application by a judgment creditor of a partner or of a partner’s transferee, a court having
jurisdiction may charge the transferable interest of the judgment debtor to satisfy the judgment.
The court may appoint a receiver of the share of the distributions due or to become due to the
judgment debtor in respect of the partnership and make all other orders, directions, accounts, and
inquiries the judgment debtor might have made or which the circumstances of the case may
require.

4. THE RIGHTS OF PARTNERS IN MANAGEMENT

 Actual Authority:
 o § 5.3. Limitations on Rights and Powers of Partners. No partner, without the consent of the Managing
Partner, may:
 (a) Borrow money in the Partnership name for Partnership purposes or utilize collateral owned by
the Partnership as security for loans.
 (b) Assign, transfer, pledge, compromise, or release any of the claims or debts due to the
Partnership except on payment in full.
 (c) Make, execute, or deliver:
 (1) Any assignment for the benefit of creditors;
 (2) Any bond, confession of judgment, guaranty, indemnity bond, or surety bond; or
 (3) Any contract to sell, bill of sale, deed, mortgage, or lease relating to any substantial
part of the Partnership assets or his or her interest in the Partnership.
 (d) Make any purchases in excess of ________ Dollars ($________).
o UPA (1997) § 410. Actions by partnership and partners.
 (a) A partnership may maintain an action against a partner for a breach of the partnership
agreement, or for the violation of a duty to the partnership, causing harm to the partnership.

 National Biscuit/Summers v. Dooley

o These cases show a clash of two principals:
 1. All partners are agents of the partnership with power to bind the partnership
 2. All partners have equal rights to participate in the management of the partnership

National Biscuit Company v. Stroud, NC Sup Ct (Page 117)

Facts  Stroud and Freeman decided to dissolve their business February 25, 1956. Several months
prior to February 25, Stroud informed Plaintiff that he was not going to be held liable for
any deliveries made by Plaintiff.
 Plaintiff still made deliveries to the business through Freeman’s consent.
 After the business dissolved, Stroud agreed to liquidate the business’ assets and discharge
the debts, and Stroud ended up losing his own personal money in the process.
 Stroud disputed the money owed to Plaintiff because he specifically requested that Plaintiff
not make any deliveries or else he would not be liable.
Issue Whether defendant can be held liable for money owed to the plaintiff, after informing the
plaintiff to stop making deliveries, but kept doing so at the request of the defendant’s partner?
Rule of Law A partner may not escape liability for debts incurred by a co-partner merely by advising the
creditor, in advance, that he will not be responsible for those debts.
Reasoning  G.S. § 59-39 (1) “Every partner is an agent of the partnership for purposes of its business, .
. . unless the partner so acting has in fact no authority to act for the partnership in the
particular matter, and the person whith whom he is dealing has knowledge of the fact that
he has no such authority.”
 G.S. § 59-45 “all partners are jointly and severally liable for the acts and obligations of the
partnership.”
 G.S. § 59-48 (e) “All partners have equal rights in the management and conduct of the
partnership business.”
 G.S. § 59-48 (h) “Any differences arising as to ordinary matters with the partnership
business may be decided by a majority of the partners; but no act in contravention of any
agreement between the partners may be done rightfully without the consent of all the
partners.”
 The court found that so long as the activity being preformed was a going concern of the
business then one partner in a 50/50 partnership could not restrict the others actions
because they were not a majority.
Holding Yes, Stroud could be held liable for the deliveries made by the plaintiff.
Notes
Summer v. Dooley, Idaho Sup Ct (Page 119)
Facts  Plaintiff and Defendant agreed to operate a trash-collecting business.
 They decided to perform the work themselves, and if either was unable to perform then that
partner was responsible for paying a third party to work on his behalf.
 Plaintiff was unable to perform his duties and suggested that the business hire an
employee.
 Defendant objected but Plaintiff hired another person anyway, personally costing Plaintiff
$11,000. Plaintiff wanted to be reimbursed for half of the costs.
Issue Could the plaintiff be held liable for expense incurred by the defendant that the plaintiff
specifically objected to?
Rule of Law Business difference in a partnership must be decided by a majority of the partners provided no
other agreement between the partners speaks to the issues.
Reasoning  UPA (1914) § 18(h) “Any difference arising as to ordinary matters connected with the
partnership business may be decided by a majority of the partners ***.”
 UPA (1914) § 18(e) bestows equal rights in the management and conduct of the
partnership business upon all of the partners.
 The court in reading these two statutes together found that § 18(h) required that business
differences be decided by a majority vote, provided that no other agreement between the
partners speaks to the issues.
Holding No, the court found it unjust to hold the plaintiff liable for an expense that only benefitted one
partner and not the other.
Notes

Day v. Sidley & Austin, 394 F.Supp. 986 (D.D.C. 1975) (Page 121)
Facts  Plaintiff was a senior partner with a long, distinguished career. Plaintiff worked for
Defendant out of Washington, D.C.
 Defendant’s executive committee inquired into merging with another firm, but partners not
on the committee were not aware of the deliberations. However, once the firm decided to
merge, the proposed merger was brought to a vote for the partners at Defendant firm.
 Plaintiff voted in favor of the merger but was not aware that the firm intended on merging
the Washington offices wherein he would share the chairmanship title with the former chair
of the other firm.
 Plaintiff argued that he had a contractual right to the title of chair of the Washington office,
and that the title change was intentionally kept from him when he voted in favor of the
merger. If he would have known of the change, Plaintiff would not have voted in favor of
the merger – and therefore there would not have been a unanimous vote to merge – and no
merger would have taken place.
 Plaintiff argued that he was professionally humiliated by the title change.
Issue Whether the defendants breached their fiduciary duty by not informing other partners of the
negations of a merger and not informing other partners of the effects of the merger?
Rule of Law Partners have a fiduciary duty to make a full and fair disclosure to other partners of all
information that may be of value to the partnership.
Reasoning  “The basic fiduciary duties are: 1) a partner must account for any profit acquired in a
manner injurious to the interest of the partnership, such as commissions or purchases on
the sale of partnership property; 2) a partner cannot without consent of the other partners,
acquire for himself a partnership asset, nor may he divert to his own use a partnership
opportunity; and 3) he must not compete with the partnership within the scope of business.
 . . .”
 The court found that none was left better or worse off as a result of the merger and that
management powers were specifically designated in a executive committee in the
partnership agreement. Further, the plaintiff did not have any authority in the partnership
contract to vote for or against such a modification.
Holding No, the defendants were within their fiduciary rights.
Notes

5. PARTNERSHIP DISSOLUTION (The Death of Partnerships (125-157))

A. THE RIGHT TO DISSOLVE

 Dissolution:
 o Effect on partnership: If no agreement between partners to carry on the business, the partnership must be
wound up.
 If the business will not continue then winding up process contemplates that the firm’s assets are
distributed to the partners.
 Authority of partners to act on behalf of partnership terminated except in connection with
winding up of partnership business. UPA (1914) § 33; UPA (1997) § 804

Dissociated
Dissociation per Remaining
partner is bought
Article 7 partners continue
out
Partner
Dissociates
Dissolution per Partnership is Partnership is
Article 8 wound up liquidated

Owen v. Cohen, Cal. Sup. Ct. (Page 125)

Facts  Respondent and Appellant agreed to operate a bowling alley together. Respondent lent the
business almost $7,000 to be repaid through profits of the business.
 As soon as the business started the partners had a poor working relationship. Appellant in
particular contributed to the disharmony with numerous slights and constant badgering
over the business affairs. Appellant went so far as to challenge the salary withdrawals from
the business.
Issue Whether or not the evidence presented by the Respondent warrants a decree of dissolution of
the partnership?
Rule of Law A court may order the dissolution of a partnership where there are disagreements of such a
nature and extent that all confidence and cooperation between the parties has been destroyed
or where one of the parties by his misbehavior materially hinders a proper conduct of the
partnership business.
Reasoning  “Whether the disharmony was the result of a difference in disposition or other causes, the
effect is the same.”
 “courts of equity may order the dissolution of a partnership where there are quarrels and
disagreements of such a nature and to such extent that all confidence and cooperation
between the parties has been destroyed or where one of the parties by his misbehavior
materially hinders a proper conduct of the partnership business. It is not only large affairs
which produce trouble.”
 Plaintiff cited UPA §32(1)(c); (d); (f)
Holding The evidence presented did support a dissolution of the business. A partner may move for a
dissolution of the business when another partner’s conduct negatively affects the business or
another partner willfully or repeatedly breaches the partnership agreement.
Notes

o § 602. Partner’s Power to Dissociate; Wrongful Dissociation

 (a) A partner has the power to dissociate at any time, rightfully or wrongfully, by express will
pursuant to Section 601(1).
 (b) A partner’s dissociation is wrongful only if:
 (1) it is in breach of an express provision of the partnership agreement; or
  (2) in the case of a partnership for a definite term or particular undertaking, before the
expiration of the term or the completion of the undertaking:
o (i) the partner withdraws by express will, unless the withdrawal follows within
90 days after another partner’s dissociation by death or otherwise under Section
601(6) through(10) or wrongful dissociation under this subsection;
o (ii) the partner is expelled by judicial determination under Section 601(5);
o (iii) the partner is dissociated by becoming a debtor in bankruptcy; or
o (iv) in the case of a partner who is not an individual, trust other than a business
trust, or estate, the partner is expelled or otherwise dissociated because it
willfully dissolved or terminated.
 (c) A partner who wrongfully dissociates is liable to the partnership and to the other partners for
damages caused by the dissociation. The liability is in addition to any other obligation of the
partner to the partnership or to the other partners.

 Judicial Dissolution: UPA § 32(1)(c) and (d), which provide that a partnership may be judicially dissolved where
a partner’s conduct prejudices the carrying on of the business or where the partner willfully and persistently
breaches the agreement or where he conducts himself in such a way as to make it impractical to carry on the
business with him

Collins v. Lewis, Tex App Div (Page 129)

Facts  Appellant and Appellee agreed to form a partnership to run a cafeteria business together.
The agreement stipulated that Appellant would provide the financial backing while
Appellee would manage the business.
 Startup costs were twice as much as originally estimated, but evidence presented by
Appellee showed that much of the overrun was due to unforeseeable external
circumstances.
 Once the business was up and running, it failed to turn a profit, but Appellee presented
proof that Appellant’s interference in the management of the business played a significant
role in the non-profitability. Appellant argued that because the business was unprofitable
and because they were in hopeless disagreement that a dissolution of the business should
be granted.
Issue Whether the Appellant stated a cause for dissolution of the partnership?
Rule of Law A partner who has not fully performed the obligations required by the partnership agreement
may not obtain an order dissolving the partnership.
Reasoning  “as we construe the partnership agreement, it was Collin’s obligation to furnish all the
money needed to build. . . the cafeteria for business, With particular reference to the notes,
it was Collins’ obligation to protect Lewis against any demand for payments so long as
Lewis met his obligation of repaying money advanced by Collins at the rate agreed upon.
Failure on Collins’ part to protect Lewis on his obligation to the bank would constitute a
breach of contract by Collins.”
 The excess amounts were the obligation of Collins and Lewis properly paid it out of
partnership earnings because Collins’ refused to pay. Thus Lewis met his obligation, and
the trial court denied foreclosure on Lewis.
Holding The petition for dissolution should not be granted because the party petitioning for the
dissolution is the only party that is not abiding by the partnership agreement.
Notes

 Dissociation: UPA § 601. Events Causing Partner’s Dissociation

o (5) on application by the partnership or another partner, the person is expelled as a partner by judicial
order because the person:
  (A) has engaged or is engaging in wrongful conduct that has affected adversely and materially, or
will affect adversely and materially, the partnership’s business;
 (B) has committed willfully or persistently, or is committing willfully or persistently, a material
breach of the partnership agreement or a duty or obligation under Section 409; or
 (C) has engaged or is engaging in conduct relating to the partnership’s business which makes it
not reasonably practicable to carry on the business with the person as a partner;

 Continuation per Agreement:

Giles v. Giles, Kan App Ct (Page 134)

Facts  Giles Land Company, L.P. (partnership) (defendant) was a family-owned farming
company. The partners were all related. The partnership held a meeting to consider
converting the partnership to a limited liability company (LLC).
 One of the Giles children, Kelly (plaintiff), was unable to attend the meeting, but later
received notice of the partnership’s determination to convert to an LLC. Kelly formally
requested the partnership’s books and records for his review. He was not satisfied with the
books and records turned over, so he brought suit against the partnership and the other
partners (defendants), claiming that he was improperly denied access to the books and
records.
 The defendants filed a counterclaim, arguing that Kelly should be dissociated from the
partnership. The defendants presented evidence that Kelly had threatened them and that the
family relationship was broken beyond repair. The defendants also presented evidence that
they did not trust Kelly and vice versa.
 The trial court ruled in favor of the defendants on all counts, finding that it was not
practicable to continue the partnership with Kelly as a partner. [UPA (1997) §601(5)(iii);
601(5)(i)]
 Kelly appealed the trial court’s order regarding his dissociation from the partnership to the
Kansas Court of Appeals, arguing that he had not engaged in conduct relating to the
partnership.
Issue Whether Kelly’s conducts made it practically unreasonable to carry on the business in
partnership with Kelly?
Rule of Law (1) In a family partnership, a partner may be dissociated from the partnership where the
partnership has threatened the other partners; the family relationship between the
partners and other partners is broken; and there is only distrust between the partner
and other partners.
(2) In a family partnership, a partner may be dissociated from the partnership where the
 partner’s conduct toward the other partners has led to a standstill so that the
partnership can no longer carry on its business to the mutual advantage of the other
partners.
Reasoning  “Brennan v. Brennan Associates, 293 Conn.. 60, 977 A. 2d 107 (2009). . . . The Brennan
court held that ‘an irreparable deterioration of a relationship between partners is a valid
basis to order dissolution, and, therefore, is a valid basis for the alternative remedy of
dissolution.’”
 “Kelly has created a situation where the partnership could not longer carry on its business
to the mutual advantages of the other partners.”
 “There was also evidence that Kelly had frustrated the partnership’s opportunity to
purchase more land. . .”
Holding Kelly’s threats to his parents constituted wrongful conduct. Further none of the member being
able in interact with him and the testimony of the father stating the partnership was at a
standstill was enough evidence that Kelly was materially or adversely affecting the
partnership.
Notes

B. THE CONSEQUENCE OF DISSOLUTION

o Effect on Departing Partner: entitled to accounting (fair value of partnership + interest from the date of
dissolution)
o Departing partner remains liable on all firm obligations unless released by creditors. UPA (1914) §
36; UPA (1997) § 703.
o Effect on New Partners: If a new partner joins the firm when it continues after a dissolution, the new partner
is also liable for the firm’s old debts, but such liability can only be satisfied out of partnership property. UPA
(1914) § 41(1); UPA (1997) § 306(B).
o The new partner cannot be held personally liable for the old debts, unless he or she expressly agrees
to be so held.

Prentis v. Sheffel, Ariz. Ct. App. (Page 141)

Facts  Defendant and Plaintiffs were partners in the owning and operation of a shopping center.
 Defendant was unable to pay his share of the operating losses. His debt to the partnership
as well as several differences between the parties led Plaintiffs to exclude Defendant from
managerial activities.
 Plaintiffs moved for a dissolution of the partnership, and Defendant moved to appoint a
receiver. The receiver liquidated the business assets, and Plaintiffs submitted the highest
bid.
 Defendant challenged the sale of the business to Plaintiffs, claiming the repurchase was
done in bad faith.
 Trial Court concluded that a partnership at will existed which was dissolved as a result of
the defendant being frozen-out by the plaintiffs.
Issue Whether the plaintiffs freezing out of the defendant was made in bad faith and thus a forced
sale of the defendants partnership interest?
Rule of Law Majority partners in a partnership-at-will may purchase the partnership assets at a judicially
supervised sale where a minority shareholder has been frozen out of the partnership and the
parties’ relationship has deteriorated to the partnership’s detriment.
Reasoning  “there was no indication that such exclusion was done for the wrongful purpose of
obtaining the partnership assets in bad faith, rather than being the result of the inability of
the partners to harmoniously function in a partnership relationship.”
 The court also stated that the defendant failed to show injury because the plaintiff’s highest
bid at the sale actually gave the defendant a 15% increase on the sale of the assets.
  The court found that no forced sale had happened because the defendant had the same
opportunity to purchase the business at the judicial sale but decided not to.
Holding No, the freezing out was not a bad faith attempt to aquire partnership assets.
Notes

Pav-Saver Corp. v. Vasso Corp., Ill. App Ct (Page 144)

Facts  Plaintiff had the intellectual property and know-how for designing the machines, and
Defendant was responsible for the financing. The partnership agreement stipulated that
Plaintiff would contribute the relevant trademarks and patents, and that the agreement was
permanent unless there is a mutual agreement between the two parties to terminate the
partnership. The agreement also stated that in the event of termination, the terminating
party would pay four times the amount the company made in the 1974 fiscal year, with
equal payments over a ten-year period.
 The business operated at a profit, but an economic downturn made the business
unprofitable.
 Plaintiff moved to terminate the agreement.
 Defendant took over the business, continued to use the patents and trademarks, and refused
to reimburse Plaintiff for the use of the property.
 Plaintiff moved to reacquire the patents and trademarks, or alternatively to receive the
value of the patents and trademarks.
 Plaintiff also contested the liquidated damages as being unenforceable. Defendant
countered that the liquidated damages should be paid immediately rather than over ten
years.
Issue Whether the plaintiff was entitled to the intellectual property?
Rule of Law When a wrongful partnership dissolution occurs, partners who have not wrongfully caused the
dissolution shall have the right to continue the business in the same name and to receive
damages for breach of the agreement.
Reasoning  UPA § 38(2)(b) that the none dissolution partner that desires to continue the business may
do so for as long as the partnership was supposed to be for. They may pay a bond to the
court or pay to the partner who has caused the dissolution wrongfully.
 “the right to possess the partnership property and continue in business upon wrongful
termination must be derived from and is controlled by the statute [not the operating
agreement].”
Holding Plaintiff is not entitled to the patents and trademarks because they are necessary to continue
the business.
Notes

C. THE SHARING OF LOSSES

 Unlimited Liability in General Partnership

o UPA (1914) § 15 “All partners are liable: (a) Jointly and severally for everything chargeable to the
partnership under sections 13 and 14 [i.e., mainly torts]; (b) Jointly for all other debts and obligations of the
partnership....”
o UPA (1997) § 306(a): “... all partners are liable jointly and severally for all obligations of the partnership
unless otherwise agreed by the claimant or provided by law”

(No Longer good Law, very strange case)

Kovacik v. Reed, Cal Supp Ct (Page 149)
Facts  Plaintiff was a building contractor, and Defendant was a job superintendent and estimator
for several companies.
  Plaintiff solicited Defendant to enter a partnership to do kitchen remodeling work. Plaintiff
agreed to supply the financing if Plaintiff agreed to perform the work, and they would split
the profits equally. The parties did not discuss how potential losses would be allocated.
 When the business became unprofitable, Plaintiff sought to collect one half of the losses
from Defendant.
Issue The issue is whether partners who agreed to split profits equally are also equally responsible
for financial losses.
Rule of Law In a joint venture in which one party contributes funds and the other labor, neither party is
liable to the other for contributions for any loss sustained.
Reasoning  “The rationale of this rule . . . is that where o0ne party contributes money and the other
contributes services, then in the event of a loss each would lose his own capital—the one
his money and the other his labor.”
Holding The court held that the defendant was not liable for the monetary losses because he had
suffered his losses in labor.
Notes

D. BUYOUT AGREEMENTS

Outline for issues and alternatives for buyout agreements:

I. “Trigger” events
a. Death
b. Disability
c. Will of any partner
II. Obligation to buy versus option
a. Firm
b. Other investors
c. Consequences of refusal to buy
i. If there is an obligation
ii. If there is no obligation
III. Price
a. Book Value
b. Appraisal
c. Formula (e.g., five times earnings)
d. Set price each year
e. Relation to duration (e.g., lower price in first five years)
IV. Method of payment
a. Cash
b. Installments (with interest?)
V. Protection against debts of partnership
VI. Procedure for offering either to buy or sell
a. First mover sets price to buy or sell
b. First mover forces others to set price

G&S Investments v. Belman, Ariz Ct App (Page 134)

Facts  Nordale and Appellees were partners in owning and operating an apartment complex.
Nordale separated from his wife and became addicted to drugs. He moved into one of the
apartment units and showed signs of abnormal behavior. He began harassing other tenants,
and he showed poor judgment in decisions affecting the partnership. He also was unable to
 pay for his share of partnership expenses.
 Appellees filed for a dissolution of the partnership to push Nordale out, and they cited his
many problems.
 Before a court reviewed the filing, Nordale died.
 Appellant believes that the estate would be worth more if Appellees would have to follow
the dissolution filing, so he filed this suit.
Issue Whether the partnership was dissolved or whether the partners invoked the buy out provision
from the operating agreement?
Rule of Law (1) The mere filing of a complaint seeking dissolution of a partnership does not require
liquidation of the partnership assets and distribution of the net proceeds.
(2) A partnership buyout agreement is valid and binding even if the purchase price is less
than the value of the partner interest, since partners may agree among themselves by
contract as to their rights and liabilities.
Reasoning  The court found that merely filing for dissolution is not enough for a dissolution. The court
found that only a court order can dissolved the partnership. UPA § 38; § 32
 The court also found that “Partnership buy-out agreements are valid and binding although
the purchase price agreed upon is less or more than the actual value of the interest at the
time of death.”
Holding The operating agreement specifically article 19 governed the buy-out agreement at the time of
the partners death, the partnership was not dissolved.
Notes

ALTERNATIVES TO INCORPORATION

6. LIMITED PARTNERSHIPS (Limited Partnerships (157-167))

 Limited Liability Limited Partnership: a limited partnership that elects limited liability limited partnership status by
filing an application for LLLP registration.
o All partners in the limited partnership, including the general partners, have personal liability protection
o Other than the limited liability component, an LLLP maintains all other characteristics of a LP
o In an LP the general partners have full personal liability, but a corporation may serve as general partner
 In an LLLP the general partners, whether individual, unincorporated association, or corporation, gets
limited liability.
 Limited Partner Liability in Limited Partnerships:
o ULPA (1976): “A limited partner shall not become liable as a general partner, unless, in addition to the
exercise of his rights and powers as a limited partner, he takes part in the control of the business.”
o ULPA (1985) § 303(a): Only limited partners who participate in control can be held liable
o ULPA (1985) § 303(b): Safe harbors for conduct not deemed to participate in control
 Being an agent, employee, or contractor for the limited partnership;
 Consulting with the advising a general partner with respect to the business of the limited partnership;
 Approving or disapproving of an amendment to the partnership agreement; or
 Voting on specified matters.

Holzman v. De Escamilla, Cal Ct App (Page 157)

Facts  Defendants were partners raising crops on farmland in Sand Diego. The business named de
Escamilla as a general partner and the other two defendants, James Russell and H.W.
Andrews, were listed as limited partners.
 However, when decisions were made regarding what to plant, the limited partners chose
the crops. The limited partners were able to draw on the business accounts while de
Escamilla was required to get one of their signatures on any checks on the accounts. The
limited partners checked in on the business twice a week.
 The business went bankrupt, and Plaintiff was appointed as trustee.
Issue Whether the limited partners could be liable as general partners to the creditors of the
partnership?
Rule of Law If a limited partner participates in or exercises control over the partnership business, he
becomes a general partner.
Reasoning  “Section 2483 of the Civil Code provides as follows: “A limited partner shall not become
liable as a general partner, unless, in addition to the exercise of his rights and powers as a
limited partner, he takes part in the control of the business.”
Holding The facts show that the limited partners took “control of the business” therefore were liable as
general partners.
Notes

In re: El Paso Pipeline Partners, L.P. Derivative Litigation, Del Ch Ct (Page 159)
Facts  El Paso MLP is a master limited partnership that has a corporate “sponsor,” El Paso
Corporation (Parent). Parent owns 100 percent of El Paso MLP’s general partner (General
Partner) (defendant).
 As the sponsor, in place for tax purposes, Parent initially contributed certain assets to El
Paso MLP and subsequently sold other assets to El Paso MLP from time to time. These
sales are known as “drop-downs.”
 In 2010, Parent offered to sell El Paso MLP interests in two liquid natural gas (LNG)
companies: Southern LNG and Elba Express. The revenue of these two companies came
primarily from contracts (Service Agreements) with subsidiaries of Shell and British Gas.
Shell and British Gas could walk away from the Service Agreements, however, if they
became unprofitable—the subsidiaries that were parties to the Service Agreements were
essentially shell companies with no assets. These proposed transactions created a conflict
 of interest for the General Partner. El Paso MLP’s limited partnership agreement provided
that in such a scenario, the transactions would need to be approved “by a majority of the
members of the Conflicts Committee acting in good faith.”
 The Conflicts Committee obtained substantial information on Southern LNG and Elba
Express, including details on the Service Agreements. After reviewing the information and
meeting five times, the Conflicts Committee approved the transactions.
 Contemporaneously with Parent’s proposal to sell these LNG assets to El Paso MLP and
while “touting their value,” Parent declined to exercise an option it had to purchase other
LNG assets for itself at a more favorable earnings before interest, taxes, depreciation, and
amortization (EBITDA) multiple.
 The Conflicts Committee was not aware of Parent declining this option.
 The plaintiffs brought suit in the Delaware Court of Chancery against the General Partner
and its board of directors, arguing that the Conflicts Committee acted in bad faith by
approving the Southern LNG and Elba Express transactions. The defendants filed a motion
for summary judgment.
Issue (1) Where a limited partnership agreement eliminates directors’ common law fiduciary
duties and replaces them with contractual obligations, are those express obligations
breached where directors have acted in accord with the contractual obligations?
(2) Where a limited partnership agreement does not expressly eliminate the obligation of
the general partner to act in good faith, does the general partner breach the implied
covenant of good faith a fair dealing where the agreement suggests if the parties had
addressed the issue, no obligation to act in good faith would have been imposed?
Rule of Law (1) Where a limited partnership agreement eliminates directors’ common law fiduciary
duties and replaces them with contractual obligations, those express obligations are
not breached where directors have acted in accord with the contractual obligations.
(2) Where a limited partnership agreement does not expressly eliminate the obligation of
the general partner to act in good faith, the general partner does not breach the
implied covenant of good faith and fair dealing where the agreement suggests if the
parties had addressed the issue, no obligation to act in good faith would have been
imposed.
Reasoning (1) Under Delaware law, the standard for good faith that applies to the Conflicts Committee
requires a subjective belief that the determination or other action is in the best interest of El
Paso MLP.
 The Court found that the Conflicts Committee acted in good faith because is understtod the
state of the natural gas industry and did not consciously disregard the risk that Shell and
British Gas might breach their service agreements. The Conflicts Committee considered
the revenue risk, and believed that the guarantees were meaningful and that even if the
guarantees covered only a portion of the service agreements revenue, neither Shell nor
British Gas would default. The Court found that this behavior was not extreme enough to
constitute bad faith.
 The Court further stated that in this case the El Paso Parent did not inform the Conflicts
Committee of its decision to forgo purchasing a stake in another LNG terminal for a
substantially lower price had no bearing on the Conflicts Committee’s subjective good
faith. The Conflicts Committee would have had to have known about such pricing issues in
order for a factual dispute regarding good faith to be raised. Plaintiffs conceded that the
Conflicts Committee did not have knowledge.
(2) The LPA did not expressly eliminate the obligation of the General partner or El Paso Parent
to act in good faith.
 The Court decided that it had to fill the gap and determine what the parties would have
agreed to had they addressed the issue. Looking at the LPA’s express provisions and its
structure, it is likely no such obligation would have been imposed. Therefore, the LPA has
 not been breached.
Holding (1) Summary Judgement for the defendant
(2) Summary Judgement for the defendant
Notes

CHAPTER 4—THE LIMITED LIABILITY COMPANY (Limited Liability Companies (259-297))

1. FORMATION

 Limited Liability Companies: Cross between a partnership and a corporation

o Tax advantages of partnerships
 o Limited liability of corporations
o None of the restrictions (e.g., number and type of shareholders) applicable to S corporations
o Funding
 Members typically contribute capital
 Contribution may be cash, property, services rendered, a promissory note, or other obligation to
contribute cash, property, or to perform services. ULLCA § 401.
o Liability
 Members stand to lose capital contributions, but their personal assets are not subject to
attachment
o Tax Consequence
 Income passes through to members
 LLC does not pay taxes
 Advantages of Pass Through Taxation vs. Corporate Taxation:
o Profits are not subject to double taxation
o Losses flow through to owners
o Capital gains flow through to owners and retain their tax attributes (i.e., are
subject to lower rates)
 There is no penalty tax for accumulating profits within the entity
o There are fewer negative consequences to transfers of assets between the entity
and owner(s)

 Formation of LLC:
o Legal Steps:
 File articles of organization in the designated State office. ULLCA 202(a)
 Required and optional contents in ULLCA 203
 Filing fees and $800 min franchise tax (California)
o Other steps:
 Choose and register name. Usually have to have the word or abbreviation LLC in the name
 Designate a principal place of business and agent for service of process
 Draft operating agreement
 Add need for annual report to tickler list

 Member’s Interest:
o Financial interest
 Right to distributions and liquidation participation
 Profit and Loss Sharing
 Absent contrary agreement, most statutes allocate profits and losses on the basis of the
value of members' contributions
 Compare partnership law’s equal division
o ULLCA uses partnership like equal shares rule
 Withdrawal
 Member may withdraw and demand payment of his/her interest upon giving the notice
specified in the statute or the LLC's operating agreement
o Management rights
 Absent contrary agreement, each member has equal rights in the management of the LLC
 Most matters decided by majority vote
 Significant matters require unanimous consent
 E.g., merger, admission of new member, dissolution, etc...
 Manager-managed LLC option available
 Can be structured as a “board of directors,” a CEO, or both
o Must be specified in articles of organization
  Assignment of LLC Interest: Analogous to partnership rules
o Unless otherwise provided in the LLC's operating agreement, a member may assign his financial interest
in the LLC
 An assignee of a financial interest in an LLC may acquire other rights only by being admitted as a
member of the company if all the remaining members consent or the operating agreement so
provides.

 De Facto Corporation: Grant shareholders limited liability as though in a de jure corporation if the organizers:
o in good faith tried to incorporate
o had a legal right to do so
o acted as a corporation.

 Corporation by Estoppel: Estop creditors from holding shareholders personally liable – as against only contract
creditors – If the person dealing with the firm:
o thought it was a corporation all along
o would earn a windfall if now allowed to argue that the firm was not a corporation

 Member/Manager Liability: ULLCA 304:

o (a) A debt, obligation, or other liability of a limited liability company is solely the debt, obligation, or
other liability of the company. A member or manager is not personally liable, directly or indirectly, by
way of contribution or otherwise, for a debt, obligation, or other liability of the company solely by reason
of being or acting as a member or manager. This subsection applies regardless of the dissolution of the
company.
o (b) The failure of a limited liability company to observe formalities relating to the exercise of its powers
or management of its activities and affairs is not a ground for imposing liability on a member or manager
for a debt, obligation, or other liability of the company.

Duray Development, LLC v. Perrin, Mich Ct App (Page 260)

Facts  Plaintiff is a residential development company with a single member. The member’s
responsibilities “were to locate and purchase property, and then work with engineering
companies and municipalities to have the property zoned and fully developed for
residential living.” Plaintiff entered into a contract with Defendant to excavate a property
purchased by Plaintiff. The member signed on behalf of Plaintiff and Defendant signed on
behalf of himself (Perrin) and Perrin Excavating.
 Shortly thereafter, Duray Development and Perrin entered into a new contract, which was
supposed to supersede the former contract. This contract was between Duray
Development and Outlaw – which is an excavation company that Perrin and Vining,
another owner of Outlaw. Perrin and Vining signed the new contract on behalf of Outlaw.
They both also held themselves as owners of Duray Development as well.
 Defendants then began excavation, but did not perform as expect on time.
 Duray Development then sued Defendants for breach of contract. Defendants later learned
that Outlaw did not obtain an adequate filing status as a LLC in time, thus Outlaw was not
a valid LLC at the time of the second contract.
 Defendant argues he isn’t personally liable because he signed on behalf of Outlaw, which
was treated by all parties as a properly formed LLC. In so doing he cites the de facto
corporation doctrine.
Issue Whether under the doctrines of de facto corporation and corporation by estoppel was the
defendant personally liable?
Rule of Law (1) The de facto corporation doctrine may be extended to a limited liability company
where its incorporators have (1) proceeded in good faith, (2) under a valid statute, (3)
for an acknowledged purpose, and (4) have executed and acknowledged articles of
 association pursuant to that purpose.
(2) A limited liability company by estoppel finding is appropriate where the parties enter
into a contract believing that a limited liability company has been validly formed, and
the parties proceeded under that belief, notwithstanding the in face limited liability
company was not validly formed at the time the contract was entered into.
Reasoning  The De Facto Corporation Doctrine
o 4 elements for a de facto corporation: “When incorporators have [1] proceeded
in good faith, [2] under a valid statute, [3] for an authorized purpose, and [4]
have executed and acknowledged articles of association pursuant to that
purpose, a corporation de facto instantly comes into being.” MI Supreme Court.
o The court found that since the Business Corporation Act and the Limited
Liability Company Act relate to the common purpose they should be interpreted
in a consistent manner and because of this the defendant was a de facto
corporation at the time the contract was signed.
 Corporation by Estoppel
o “Where a body assumes to be a corporation and acts under a particular name, a
third party dealing with it under such assumed name is estopped to deny its
corporate existence.” MI Supreme Court.
o “corporation by estoppel is an equitable remedy, and its purpose is to prevent
one who contracts with a corporation from later denying its existence in order
to hold the individual officers or partners liable. . . .”
Holding The court found that under both doctrines the defendant could not be held personally liable.
Notes  Rosen said the corporation by estoppel argument is strange, he agreed with the de
factor corp reasoning but not the estoppel reasoning.

2. THE OPERATING AGREEMENT

Elf Atochem North America, Inc. v. Jaffari, Del Sup Ct (Page 265)
Facts  In 1996, Appellant contracted with Appellee to form an LLC incorporated in Delaware that
would produce more environmentally-friendly maskants for the aerospace and aviation
industries. Appellant produces solvent-based maskants which have been classified as
hazardous. Appellant provided much-needed financial backing for Appellee’s operation,
while Appellee retained 70% of the profits from the newly formed LLC.
  The LLC agreement called for all disputes to be settled through arbitration in San
Francisco.
 Appellant brought this action in 1998 in a Delaware court against Appellee for breach of
contract, breach of fiduciary duty and tortuous interference.
 Appellant argued that since LLC was formed prior to the formation of the LLC agreement,
and because the LLC never signed the agreement then the agreement and its arbitration
provision are not effective over this dispute. Appellant also argued that the claims were
derivative instead of direct, and that the Delaware Court of Chancery has special
jurisdiction.
Issue (1) The first issue is whether an LLC agreement not executed by the LLC itself is valid.
(2) The second issue is whether the arbitration and choice of forum provisions are valid.
Rule of Law Because the policy of Delaware’s Limited Liability Company Act is to give maximum effect to
the principal of freedom of contract and to the enforceability of LLC agreements, the parties to
LLC agreements may contract to avoid the applicability of certain provisions of the Act,
including dispute resolution and forum selection provisions.
Reasoning  Section 17-1101(c) of the LP Act, provides “[i]t is the policy [of the Act] to give maximum
effect to the principal freedom of contract and to the enforceability of limited liability
company agreements.”
 It is irrelevant that the LLC itself did not assent to the agreement because the members of
the LLC, the Appellant and Appellee, consented to the agreement. This is true regardless of
whether the claims are derivative or direct because the parties agreed that all claims related
to the agreement should be subject to the agreement’s arbitration provisions.
 The arbitration and choice of forum provisions are valid. The Delaware laws regarding
LLC’s allow for parties to contractually determine how to settle disputes and where.
Holding (1) Yes, it is still valid under the operating agreement
(2) Yes, the provisions that the parties freely agreed to in the operating agreement are valid.
Notes

Fisk Ventures, LLC v. Segal, Del Ch Ct (Page 271)

Facts  Segal (Defendant) founded Genitrix, LLC (Genitrix), in which the equity was divided into
three classes of membership, Segal (Defendant) held 55 percent of Class A; Fisk Ventures,
LLC (Fisk) (Plaintiff), Johnson (who controlled Fisk (Plaintiff)), Freund, and Rose held the
Class B interests; and the Class C interests were held by passive investors.
 Genitrix’s LLC agreement (LLC Agreement) divided power among the Class A and Class
B members, but was drafted in such a way as to require the cooperation of the Class A and
B members.
 Defendant appointed two of the five board members, while the Class B members were able
to appoint the remaining three.
 The Class B members also had a put right, so they could, at any time, force the company to
purchase any or all of their Class B interests at a price determined by an independent
appraisal. If exercised, the put would subrogate what otherwise would be senior claims of
new investors. This made it difficult to raise money from new investors, but the Class B
members refused to relinquish or suspend their put right.
 The company had much difficulty raising capital, which caused a Fisk (Plaintiff) note to
convert to Class B equity, which diluted the Class A and C interests. Segal (Defendant),
who was desperately seeking to raise new money, drafted a Private Placement
Memorandum (PPM), but the Class B board representatives refused to consent to it,
claiming Defendant was acting in haste.
 Although the Class B representatives asked to discuss the PPM at a board meeting, the
meeting never occurred because the Class A representatives refused to take part in any
 meetings.
 Even though Plaintiff continued to make capital contributions throughout, the business
eventually ran out of operating cash and stalled, and Plaintiff brought suit to dissolve
Genitrix.
 Defendant made counterclaims against Plaintiff and third-party claims against Johnson,
Rose, and Freund. Specifically, Defendant contended that the counterclaim/third-party
defendants breached the LLC Agreement, breached the implied covenant of good faith and
fair dealing implicit in the LLC Agreement, and breached their fiduciary duties to the
company—mainly by standing in the way of proposed financing.
 The counter-claim/third-party defendants moved to dismiss Defendant’s claims, arguing
that he failed to state a claim upon which relief could be granted because his allegations
suggested little more than the exercise of their contractual rights.
Issue (1) Where an LLC agreement vests power in more than one equity class, and requires the
class to cooperate to effect LLC action, does one class breach the LLC agreement by
failing to acquiesce to the wishes of the other classes simply because the other classes
believe their approach is superior or in the best interests of the LLC?
(2) Where are LLC agreement vests power in more than one equity class, and requires the
class to cooperate to effect LLC action, does one class breach the LLC agreement’s
implied covenant of good faith and fair dealing by failing to acquiesce to the wishes of
the other classes simply because the other classes believe their approach is superior or
in the best interest of the LLC?
Rule of Law (1) Where an LLC agreement vests power in more than one equity class, and requires the
classes to cooperate to effect the LLC action, one class does not breach the LLC
agreement by failing to acquiesce to the wishes of the other classes simply because the
other classes believe their approach is superior or in the best interest of the LLC.
(2) Where an LLC agreement vests power in more than one equity class, and requires the
classes to cooperate to effect LLC action, one class does not breach the LLC
agreement’s implied covenant of good faith and fair dealing by failing to simply
because the other classes believe their approach is superior or in the best interest of
the LLC.
Reasoning (1) The Court found that while Defendant could be correct that the lack of cooperation by the
Class B shareholders were standing in the way of the company’s success, it can just as easily
be said that Defendant’s lack of cooperation with the Class B member’s could be the cause of
the businesses troubles
 It is not up to the court to decide which side’s business judgement was more in keeping
with the best interest of the company. Such a decision would go against the state’s LLC
Act promoting freedom of contract.
(2) The implied covenant of good faith and faith dealing requires a party in contractual
relationship to refrain from arbitrary or unreasonable conduct that has the effect of preventing
the other party to the contract from receiving the fruits of the bargain. Basically, it protects
what was actually bargained and negotiated for in the contract.
 Defendant argued that the Class B members breached this implied covenant by standing in
the way of financing. But neither the LLC agreement nor any other contract gave
Defendant the right to unilaterally decide fundraising options. Instead such decisions
required 75% of the board giving Class B members the ability to block the proposal.
 Negotiating forcefully and within the bounds of the LLC agreement does not translate to a
breach of the implied covenant on the part of the class B members.
Holding (1) The breach of contract claim is dismissed
(2) The claim for breach of the implied covenant of good faith and fair dealing is
dismissed.
Notes
3. PIERCING THE LLC VEIL

NetJets Aviation, Inc. v. LHC Communications, LLC, 537 F.3d 168 (2d Cir. 2008) (Page 277)
Facts  NetJets Aviation, Inc. (NetJets) (plaintiff) leased to LHC Communications, LLC (LHC)
(defendant) an interest in an airplane for a term of five years.
 LHC was a limited liability company (LLC) whose only member-owner was Zimmerman
(defendant). Zimmerman had sole authority to make all financial decisions with respect to
LHC.
 He often withdrew money from LHC’s account for personal use and transferred money
into LHC’s account from his own personal account. Zimmerman did not have any written
 agreements with LHC regarding this comingling of funds. Many withdrawals from LHC’s
account were for personal expenses, including a residence, phone and cleaning bills, a car,
and health insurance for his family. Much of the flight time used by LHC under the lease
with NetJets was used by Zimmerman and his family for personal trips.
 LHC terminated the lease agreement with NetJets about one year into the agreement. The
next year, LHC ceased operations, owing NetJets a balance of $340,840.39.
 NetJets brought suit against LHC and Zimmerman.
 NetJets presented evidence that, among other things, Zimmerman took more money out of
LHC’s account than he put in, continued withdrawing money for personal uses even while
refusing to pay debts LHC owed to NetJets, and identified his deposits to LHC as loans
when other evidence suggests that they were capital contributions.
 NetJets filed a motion for summary judgment.
 The district court granted the motion with respect to LHC, but denied the motion with
respect to Zimmerman’s personal liability.
 The district court sua sponte granted Zimmerman, personally, summary judgment and
dismissed the claims against him.
 NetJets appealed.
Issue Should claims against the owner of a company for the debts of the company be allowed to
proceed on the theory that the owner is the company’s alter ego where sufficient evidence had
been presented that the owner and company operated as one, and that the owner conducted the
company’s affairs in a fraudulent, illegal, or unjust manner?
Rule of Law Claims against the owner of a company for the debts of the company should be allowed to
proceed on the theory that the owner is the company’s alter ego where sufficient evidence has
been presented that the owner and company operated as one, and that the owner conducted
the company’s affairs in a fraudulent, illegal, or unjust manner.
Reasoning  Piercing the Corporate Veil: Although the shareholders of a corporation and the members
ofr an LLC generally are not liable for the debts of the entity, the entity’s corporate veil
may be pierced to reach the owners where there is fraud or where the entity is in fact a
mere instrumentality or alter ego of its owners.
o Alter Ego theory: To prevail under the alter-ego theory of piercing the
corporate veil, a plaintiff need not prove that there was actual fraud but must
show a mingling of the operations of the entity and its owners plus an overall
element of injustice or unfairness.
 The Court found that the evidence presented was ample to permit a reasonable factfinder to
find that Zimmerman (D) completely dominated LHC (D) and used its bank accounts as his
own personal pocket, which he reached into whenever he needed or desired funds for
personal expenses. The Court found that this sufficiently satisfied the first element of the
alter-ego theory.
 The Court further concluded that the evidence presented was sufficient in proving that
Zimmerman’s (D) conduct regarding the way he conducted the affairs of LHC (D) resulted
in fraud, illegality, or unfairness. Specifically he intentionally mischaracterized payments
and transactions to avoid paying taxes, and that his withdrawals may have violated the
state’s Limited Liability Company Act.
o Based on the evidence presented a reasonable fact finder could conclude that
Zimmerman (D) operated LHC (D) in his own self-interest in a manner that
unfairly disregarded the rights of LHC’s (D) creditors, and that there was an
overall element of injustice in Zimmerman’s (D) operation of LHC (D). The
Court found that this satisfied the second element of the alter-ego theory
presented by the plaintiff.
Holding Vacated and Remanded
Notes
4. FIDUCIARY OBLIGATIONS

 Fiduciary Obligations Absent Agreement to the Contrary: ULLCA § 409(b)

o (b)(1): “to account to the company ... for ... any property, profit, or benefit ... derived from a use by the
member of the company’s property, including the appropriation of a company’s opportunity”
o (b)(3): “to refrain from competing with the company in the conduct of the company’s business before the
dissolution of the company”

 Altering or eliminating Fiduciary Duties in the Operating Agreement:

o ULLCA § 105(d)(3): If not manifestly unreasonable, the operating agreement may:
  (A) alter or eliminate the aspects of the duty of loyalty …;
 (B) identify specific types or categories of activities that do not violate the duty of loyalty;

McConnell v. Hunt Sports Enterprises, Ohio Ct App (Page 283)

Facts  In 1996,the National Hockey League notified leaders of various cities that the league
would be adding several franchises. When the mayor of Columbus was contacted, he in
turn contacted McConnell and Ronald Pizzuti. Pizzuti contacted several other people,
including Hunt, and a consortium of groups formed an LLC, Columbus Hockey Limited
(CHL) for the purpose of obtaining a franchise for Columbus.
 Each member of CHL contributed part of the $100,000 application fee for the franchise.
 A referendum to finance a facility for the team failed to pass, and another party,
Nationwide Insurance, worked with Hunt, who was very visible in the negotiations and had
prior experience as a sports franchise owner, on obtaining a facility through private
financing.
 The commissioner of the NHL began giving Columbus deadlines to have a proposal, but
Hunt started rejected several leasing proposals for the new facility.
 When a deal seemed to be in jeopardy, Nationwide contacted McConnell, and McConnell
decided that he would personally move forward on a deal if CHL would not. CHL did not
respond to Nationwide’s deadline of May 30th, and the NHL’s deadline was only a few
days away (June 4th), so Nationwide notified the NHL that McConnell would apply for the
franchise if CHL would not.
 On June 4th, Nationwide let the NHL know that McConnell would apply, so the NHL
awarded Columbus, led by McConnell, a franchise.
 Other members of CHL entered with McConnell, and Appellants brought this action
against the group.
 Appellees asserted that Article 3.3 in the LLC allowed for members to compete directly
with the LLC, while Appellants claimed that Appellees violated their fiduciary duty to
CHL, and that Article 3.3 did not allow for Appellees to compete against CHL.
 Appellees counterclaimed to dissolve CHL based upon Hunt’s conduct.
Issue (1) Will extrinsic evidence be permitted for interpretation of an LLC operating agreement
the terms of which are ambiguous and unclear?
(2) Does a member of an LLC breach a fiduciary duty to the company by directly
competing against it where the operating agreement expressly permits such
competition?
(3) Is a directed verdict against an LLC member, which is based on operating agreement
violations, appropriate where the evidence shows that the member has violated the
operating agreement?
Rule of Law (1) Extrinsic evidence will not be permitted for interpretation of an LLC operating
agreement the terms of which are un ambiguous and clear.
(2) A member of an LLC does not breach a fiduciary duty to the company by directly
competing against it where the operating agreement expressly permits such
competition.
(3) A directed verdict against an LLC member, which is based on operating agreement
violations, is appropriate where the evidence shows that the member has violated the
operating agreement.
Reasoning (1) Section 3.3 of the operating agreement clearly stated “members may compete” in “any
other venture of any nature.” The argument present by the Defendants that members may
compete in any business venture that is different than that of the company goes against th plain
 language of the operating agreement.
(2) By permitting competition the operating agreement defined the parties general fiduciary
duties as to competition. Plaintiff did not breach anyother fiduciary duties to the members
because the evidence does not show that plaintiff interfered with the defendants own dealing
with the NHL. Instead Plaintiff said he would lease the arena after Defendant refused to do so.
(3) Hunt/HSE (D) wrongfully asserted that they were the operating members of CHL and
therefore, could only be held liable for willful misconduct. The operating agreement did not
mention an operating member instead it evenly allocated shares to all members. It further
stated that no member could act on behalf of CHL without a majority vote accounted for in the
company’s meeting minutes.
 There was no evidence that Defendant obtained approval prior to the actions at issue. There
was also no evidence that they even asked permission of any member to file the action let
alone get it in writing.
 Because Defendant acted unilaterally, a directed verdict on the issue of breach of contract
in favor of the Plaintiff was appropriate.
Holding (1) Affirmed
(2) Affirmed
(3) Affirmed
Notes

5. ADDITIONAL CAPITAL

Racing Investment Fund 2000, LLC v. Clay Ward Agency, Inc., Ky. Sup Ct (Page 289)
Facts  Racing Investment Fund 2000, LLC (Racing Investment) (defendant) purchased insurance
from Clay Ward Agency, Inc. (Clay Ward) (plaintiff).
 In May 2004, after falling behind on payments, Racing Investment agreed to a judgment.
Racing Investment, which by then had become defunct, failed to pay the entire judgment
when due.
 The trial court found that a provision of Racing Investment’s Operating Agreement
(Operating Agreement) requiring members to make occasional capital infusions for
business expenses was an available means to satisfy the judgment.
  The trial court ordered Racing Investment to satisfy the judgment accordingly.
 The Court of Appeals affirmed.
Issue May an LLC’s capital call provision be invoked by a court in order to obtain funds from the
LLC’s members to satisfy a judgement against the LLC?
Rule of Law An LLC’s capital call provision may not be invoked by a court in order to obtain funds from
the LLC’s members to satisfy a judgement against the LLC.
Reasoning  Defendant’s members did not agree to subject themselves to personal liability for the
LLC’s debts when they signed the operating agreement. Unless the members agree to the
contrary, the LLC entity form provides members immunity from personal liability for the
LLC’s debts, and such immunity is strong. Here, Defendants memebers did not agree to
waive this immunity.
 Plaintiff contents that a court ordered capital call will satisfy any unpaid judgements, but
action goes against the plain terms of the operating agreement and the letter and spirit of
the state’s LLC Act.
 The LLC Act rejects personal liability for an LLC’s debts unless the member or members,
as the case may be, have agreed through the operating agreement or another written
agreement to assume personal liability. Any such assumption of personal liability, which is
contrary to the very business advantage reflected in the name “limited liability company”,
must be stated clearly in unequivocal language which leaves no room for doubt about the
parties intent.
 Since the members did not agree to such a waiver the capital calls provision in the
defendants operating agreement cannot be used as a debt collection mechanism.
Holding Reversed
Notes

6. DISSOLUTION

 Dissociation v. Dissolution
o Dissociation:
 Withdrawal or expulsion of a member (ULLCA § 601)
 Dissociation w/o Dissolution:
o Dissociated member’s interest must be purchased by the LLC
 Judicial appraisal proceeding available
o Member’s right to participate in firm business terminates
 Exception for participation in a post-dissolution winding up process
o Dissolution:
  Winding up of LLC triggered (ULLCA § 801)
 Events of Dissolution:
o By operation of law:
 Upon the happening of any event specified in LLC operating agreement
 Vote of members (as specified in operating agreement)
 It becomes unlawful to carry on the business
o Upon court order:
 Economic purpose frustrated
 Misconduct by members

New Horizons Supply Cooperative v. Haack, Wis Ct App (Page 293)

Facts  Haack entered into business with her brother Robert Koch, forming Kickapoo Valley
Freight LLC. Haack filled out an application for a gas card from Defendant, but she argued
that she was signing on behalf of the LLC.
 When the gas card balance was overdue, Plaintiff contacted Defendant LLC for payment.
Plaintiff was directed to Haack, who said payment would come shortly.
 After there still was no payment, Haack explained that the LLC was dissolving but that she
would try to provide monthly payments – which she never did.
 At trial, Haack was unable to provide proof that Kickapoo Valley Freight actually filed for
LLC status except for Haack’s assertion that she used an attorney to file but never kept the
records.
 Haack also admitted that she never properly dissolved the LLC.
 With the missing documentation, the lower court decided that Kickapoo Valley Freight
should be considered a partnership, and therefore held Haack personally liable.
Issue Is a member manager of an LLC not personally liable for any debt, obligation, or liability of
the company only if the member or manager follows statutorily prescribed formalities of LLC
incorporation, dissolution, and creditor notice?
Rule of Law A member or manager of an LLC is not personally liable for any debt, obligation, or liability
of the company only if the member or manager follows statutorily prescribed formalities of
LLC incorporation, dissolution, and creditor notice.
Reasoning  The Court found that the lower court improperly applied the “piercing the corporate veil
doctrine” because the record did not support the fact that the Defendant organized,
controlled, and conducted company affairs to the extent that it had no separate existence
and that Defendant was using the entity to evade obligations, to gain unjust advantage, or
to commit injustice.
 The Court stated that the lower courts conclusion should have been reached because
Defendant failed to establish that she took appropriate steps to shield herself from liability
for the company’s debts following is dissolution and distribution of assets.
 Hence, although defendant correctly contends that the judgement cannot be sustained on
the ground relied upon by the trial court the record in favor of the Plaintiff is
insurmountable.
Holding Affirmed
Notes
CHAPTER 3—THE NATURE OF THE CORPORATION

1. THE CORPORATE ENTITY AD ITS FORMATION AND STRUCTURE (Corporate Formation (169-
178))

 Corporation-General Info
o Either Public (Publicly held) or Close (Closely held)
o Critical Attributes:
1. Legal Personality
 The corporation is an entity with separate legal existence from its owners
2. Limited Liability
 See, e.g., MBCA § 6.22(b): “Unless otherwise provided in the articles of incorporation, a
shareholder of a corporation is not personally liable for the acts or debts of the
 corporation except that he may become personally liable by reason of his own acts or
conduct.”
3. Separation of Ownership and Control
 MBCA § 8.01(b): “All corporate powers shall be exercised by or under the authority of,
and the business and affairs of the corporation managed by or under the direction of, its
board of directors….”
4. Liquidity

5. Flexible Capital Structure

 Rights of Shareholders
o Vote on limited range of issues
 Election of directors (MBCA §§ 8.03-.04)
 Any amendments to the articles of incorporation and, generally speaking, by-laws (MBCA §§
10.03, 10.20)
 Fundamental transactions (e.g., mergers; MBCA § 11.04)
 Odds and ends, such as approval of independent auditors
o Receive dividends when declared by the board
o Inspect corps. books and records
o Receive distribution upon termination
o Purchase proportionate shares of a new issuance of corporate stock to maintain current current ownership
% (Preemptive right )
o File derivative suit

 Issuance of Stocks: controlled by the board of directors

o Shareholder involved only if:
 Board wants to sell more shares than are presently authorized in its charter
 Board wants to issue a new class of shares not authorized in the charter

 Incorporation Process

 Formation:
o § 2.02 Articles of Incorporation
  (a) The articles of incorporation must set forth:
 (1) a corporate name for the corporation that satisfies the requirements of section 4.01;
 (2) the number of shares the corporation is authorized to issue;
 (3) the street address of the corporation’s initial registered office and the name of its
initial registered agent at that office; and
 (4) the name and address of each incorporator.
 (b) The articles of incorporation may set forth;
 (1) the names and addresses of the individuals who are to serve as the initial directors;
 (2) provisions not inconsistent with law regarding:
o (i) the purpose or purposes for which the corporation is organized;
o (ii) managing the business and regulating the affairs of the corporation;
o (iii) defining, limiting, and regulating the powers of the corporation, its board of
directors, and shareholders;
o (iv) a par value for authorized shares or classes of shares;
o (v) the imposition of personal liability on shareholders for the debts of the
corporation to a specified extent and upon specified conditions;
 (3) any provision that under this Act is required or permitted to be set forth in the bylaws;
 (4) a provision eliminating or limiting the liability of a director to the corporation or its
shareholders for money damages ….
 (5) a provision permitting or making obligatory indemnification of a director for liability
….
o § 2.03 Incorporation
 (a) Unless a delayed effective date is specified, the corporate existence begins when the articles of
incorporation are filed.

 Post-incorporation:
o Draft bylaws (MBCA § 2.06)
o Organizational meeting (MBCA § 2.05)
 Name directors, if necessary
 Adopt bylaws
 Appoint officers
 In California you must appoint (i) a President and CEO, (ii) a Secretary, and (iii) a
Treasurer or CFO.
 Authorize the sale of founders stock
 Issue stock

Boilermakers Local 154 Retirement Fund v. Chevron Corporation, Del Ch Ct. 2013 (Page 172)
Facts  Chevron Corporation’s (Chevron) (defendant) articles of incorporation authorized the
company’s board of directors to adopt bylaws without a vote by stockholders. Because
Chevron was often subjected to litigation in multiple forums involving the same issue, the
board adopted bylaws providing that any litigation involving the company would be
conducted in Delaware.
 Certain Chevron stockholders (plaintiffs) brought suit in the Delaware Court of Chancery,
alleging that the bylaws were both statutorily and contractually invalid.
 The plaintiffs’ statutory claim rested on the notion that the bylaws in question referred to
an external matter, rather than an internal matter, such as stockholder meetings, the board
of directors, and officerships.
 Relevant Delaware law stated: “bylaws may contain any provision, not inconsistent with
law or with the certificate of incorporation, relating to the business of the corporation, the
conduct of its affairs, and its rights or powers or the rights or powers of its stockholders,
 directors, officers or employees.”
Issue (1) Whether the forum selection bylaws are facially invalid under the DGCL; and
(2) Whether the board-adopted forum selection bylaws are facially invalid as a matter of
contract law?
Rule of Law (1) Where a corporation’s certificate of incorporation empowers its board to adopt,
amend, or repeal bylaws adopted by the board that requires litigation relating to the
corporation’s internal affairs to be brought in the corporation’s state of incorporation
is not statutorily invalid.
(2) Where a corporation’s certificate of incorporation empowers its board to adopt,
amend, or repeal bylaws, a bylaw unilaterally adopted by the board that requires
litigation relating to the corporation’s internal affairs to be brought in the
corporation’s state of incorporation is not contractually valid.
Reasoning  (1) Chevron and FedEx said they adopted the forum selection bylaws as a response to
“multiform litigation” where th3e corporation would be subject to litigation over a single
transaction or board decision in more than one forum simultaneously.
 “Plaintiff contends that the bylaws . . . attempt to regulate an “external” matter, as opposed
to, an “internal” matter of corporate governance.”
 “8 Del. C. § 109(b) has long been understood to allow the corporation to set ‘self-imposed
rules and regulations [that are] deemed expedient for its convenient functioning.’ The
forum selection bylaws here fit this description.”
 The court went on to explain that the bylaws would regulate external matter for example, if
a plaintiff (shareholder or other) brought a tort or contract claim and the bylaws attempted
to bind the plaintiff these types of bylaws would be outside the statutory language of 8 Del.
C. § 109(b). The reason was that “the bylaws would not deal with the rights and powers of
the plaintiff-stockholders as a stockholder. . . .”
 (2) “Supreme Court has made clear that the bylaws constitute a binding part of the contract
between a Delaware corporation and its stockholders. Stockholders are on notice tha, as to
those subjects that are subject of regulation by bylaw under 8 Del. C. § 109(b), the board
itself may act unilaterally to adopt bylaws addressing those subjects.”
 “[T]he statutory regime provides protection for the stockholders, through the indefeasible
right of the stockholders to adopt and amend bylaws themselves.”
Holding (1) Since the bylaws were self imposed and related to the rights and powers of the
stockholders the forum selection bylaw was valid under Del. law.
(2) Since Delaware gives parties the right to freely contract, and the stockholders had a
statutory protection, as a matter of contract law the forum selection bylaw was valid.
Notes

2. THE CORPORATE ENTITY AND LIMITED LIABILITY (Limited Liability (179-198))

 Liability for Pre-Incorporation Activity

o Once the articles are filed, does the corporation become a party to the contract?
 Yes, but not automatically. The corporation must “adopt” the contract.
 Adoption can be effected:
 Expressly (typically by a novation); or
 Implicitly (e.g., ratification by acceptance of benefits)
o Once the articles are filed, is the promoter liable if the corporation breaches the contract?
 MBCA § 2.04: “All persons purporting to act as or on behalf of a corporation, knowing there was
no incorporation under this Act, are jointly and severally liable for all liabilities created while so
acting.”
 If the corp adopts the contract then promoter may be released from liability by the other
party in the contract.
 o If the articles are not filed, is the promoter liable on the contract?
 Yes. Absent an agreement to the contrary, the promoter remains liable on the contract if the
corporation never comes into existence. MBCA § 2.04.
o If the articles are not filed or are defectively filed, can the defectively formed entity (or individuals)
enforce the contract?
 Yes, if de facto corporation. Requires
 Good faith effort to incorporate
 Legal right to do so
 Acted as a corporation
 No, if corporation by estoppel

 Limited Liability:
o MBCA § 6.22(b): “Unless otherwise provided in the articles of incorporation, a shareholder of a
corporation is not personally liable for the acts or debts of the corporation except that he may
become personally liable by reason of his own acts or conduct”
 It is not improper to incorporate for the purpose of avoiding liability or splitting a single business
into multiple corporations for the same reason.

Walkovszky v. Carlton, NY Ct App 1966 (Page 179)

Facts  Defendant was a shareholder in ten separate corporations wherein each corporation has two
cabs registered in its name. A single shareholder for multiple corporations is a common
practice for the cab industry.
 A cab from one of Defendant’s corporations hit Plaintiff, and Plaintiff brought this cause of
action to recover. Each cab has only $10,000 worth of insurance coverage, which is the
statutory minimum.
 Plaintiff contends that Defendant was fraudulently holding out the corporations as separate
entities when they actually work as one large corporation.
Issue Could the court “pierce the corporate veil” in order to hold the single shareholder liable for the
tort claim?
Rule of Law 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, but where a corporation is
a fragment of a larger corporate combine which actually conducts the business, a court will
not “pierce the corporate veil” to hold individual shareholders liable.
Reasoning  “Either the stockholder is conducting the business in his individual capacity or he is not. If
he is, he will be liable; if he is not, then, it does not matter—insofar as his personal liability
is concerned—that the enterprise is actually being carried on by a larger ‘enterprise
entity.’”
 “The corporate form may not be disregarded because the assets of the corporation, together
with the mandatory insurance coverage of the vehicle . . . are insufficient to assure . . . the
recovery sought.”
 “These taxi owner-operators are entitled to form such corporations . . . and we agree with
the court at Special Term that, if the insurance coverage required by statue ‘is in adequate
for the protection of the public, the remedy lies not with the courts but with the
Legislature.’”
Holding The fact that the corporations may have been one large corporation does not prove that
Defendant was controlling the corporations for his own behalf.
Notes  There are three possible legal doctrines that a plaintiff in a case like this one may invoke:
(1) enterprise liability; (2) respondent superior (agency); (3) disregard if the corporate
entity (piercing the corporate veil).

 Piercing the Corporate Veil:

 o Sea-Land: piercing the corporate veil is proper when:
 1. The corporation was the controlling shareholders alter ego; and
 2. Adherence to limited liability would “sanction a fraud or promote injustice”
 Factors Relevant to Alter Ego Prong:
o Commingling of funds
o Undercapitalization
o Disregard for corporate formalities:
 Failure to hold shareholder meetings
 Failure to hold board meetings
 Failure to keep minutes of said meetings
 Failure to keep separate books
 Failure to issue stock
 Failure to appoint a board
 Failure to adopt charter or by-laws
 Key Factors:
o Undercapitalization
o Nature of plaintiff’s claim
 Contract versus tort
 Claims by contract creditors ought to be disfavored because they
ca and should bargain ex ante
o Exception: misrepresentation
 Tort claimants can’t protect themselves through bargaining
o Nature of defendant
 Passive shareholder of close corporation
 Public corporation shareholder
 Parent of a subsidiary corporation

Sea-Land Services, Inc. v. Pepper Source, 941 F.2d 519 (7th Cir. 1991) (Page 184)
Facts  Plaintiff delivered a shipment of peppers for Pepper Source, but they were not paid.
Marchese was the sole shareholder of Pepper Source.
 Marchese was also the sole shareholder of several other corporations, and he was a co-
owner of an additional corporation. Plaintiff asserted that the corporations were shells
wherein Marchese shifted money around the different entities to avoid creditors collecting
from the corporations.
 Evidence was presented that showed Marchese treated the corporate accounts as his own
personal account, and he frequently shifted money around.
 The trial court entered judgement in favor of Sea-Land Services, Inc granting summary
judgement.
Issue Whether Plaintiff can hold Marchese and each of his corporations liable for the uncollected
debt?
Rule of Law The corporate veil will be pierced where there is a unity of interest and ownership between the
 corporation and an individual and where adherence to the fiction of a separate corporate
existence would sanction a fraud or promote injustice.
Reasoning  Trial court applied the test for corporate veil-piercing from Van Dorn Co. v. Future
Chemical and Oil Corp. “[A] corporate entity will be disregarded and the veil of limited
liability pierced when two requirements are met: First, there must be such unity of interest
and ownership that the separate personalities of the corporation and the individual [or other
corporation] no longer exist; and second, circumstances must be such that adherence to the
fiction of separate corporate existence would sanction a fraud or promote injustice.”
 “As for determining whether a corporation is so controlled by another to justify
disregarding their separate identities, the Illinois cases. . . focus on four factors: ‘(1) the
failure to maintain adequate corporate records to or to comply with corporate formalities,
(2) the commingling of funds or asset, (3) undercapitalization, and (4) one corporation
treating the assets of another corporation as its own.’”
 The court agreed with the district court that the “shared control/unity of interest and
ownership” element of the Van Horn test were met in this case due to the actions of the
single shareholder.
 The court then examined the second element of the Van Horn test stating “the Illinois test
does not require proof of such intent. Once the first element is established, either the
sanctioning of a fraud (intentional wrongdoing) of the promotion of injustice, will satisfy
the second element.”
 The court examined what it meant to “promote injustice” under Illinois case law and found:
o “Some element of unfairness, something akin to fraud or deception or the
existence of a compelling public interest must be present in order to disregard
the corporate fiction.” Pederson v. Paragon Enterprises.
o “Where such an injustice would result and there is such unity of interest
between the corporation and the individual shareholders that the separate
personalities no longer exist, the corporate veil must be pierced.” Gromer,
Wittenstrom & Meyer. P.C. v. Strom.
Holding The court found that the district court errored in finding that an unsatisfactory judgement was
enough to grant Sea-Land Services, Inc’s summary judgement and required that the plaintiff
present “evidence and argument that would establish the kind of additional “wrong” present in
the above cases.” Reversed and Remanded with instructions.
Notes

In re Silicone Gel Breast Implants Products Liability Litigation, 877 F. Supp. 1447 (N.D. Ala. 1995)
(Page 190)
Facts  Defendant purchased the shares of MEC, a maker of silicone breast implants. MEC was a
wholly-owned subsidiary of Defendant, and Defendant exerted a significant amount of
control over many MEC activities.
o A Vice President of Defendant held a position on the board of directors of
MEC, and he could not be outvoted.
o MEC used Defendant’s publicity departments, legal department, research
department, sales staff, and regulatory groups.
o MEC needed budget approval from Defendant, and Defendant set salaries for
MEC employees (which sometimes included Defendant’s own stock).
 Defendant also listed their name on MEC products to offer a higher degree of creditability.
Issue The issue is whether Defendant’s motion of summary judgment, arguing that evidence was not
provided to justify piercing the corporate veil, should be granted.
Rule of Law (1) Summary judgement will not be granted in multidistrict products liability litigation on
a piercing the corporate veil claim where there is evidence that tends to show that a
subsidiary that has manufactured and sold injurious product is the alter ego or
instrumentality of its sole-shareholder parents and that the parent has used the
subsidiary to effect fraud, inequity or injustice.
(2) A parent corporation may be held directly liable for injuries caused by the products of
its wholly owned subsidiary where the evidence tends to show that the parents has
committed the tort of negligent undertaking with regard to those products.
Reasoning  The plaintiff claimed both “corporate control” claims (piercing corp. veil), and direct
liability (products liability and tort claims).
 Corporate Control Claims “when a corporation is so controlled as to be the alter ego or
mere instrumentality of its stockholder, the corporate form may be disregarded in the
interest of justice.”
 “The totality of circumstance must be evaluated in determining whether a subsidiary may
be found to be the alter ego or mere instrumentality of the parent corporation.”
 Factors to consider when determining substantial domination include:
o Parent and sub have common directors/officers
o Have common business departments
o File consolidated financial statements and tax returns
o Parent finances the sub
o Parent incorporated the sub
o Sub has inadequate capital accounts
o Parent pays salaries and other expenses
o All subs business comes from the parent
o Parent uses subs property
o Daily operations are not separate
o Sub does not observe basic corporate formalities
 Because the evidence in court could support, under some state laws, that the corporate veil
should be pierced Bristol was not entitled to summary judgement.
 Direct Liability Claims “a duty that would not otherwise have existed can arise when . .
. [a] company nevertheless undertakes to perform some action. . . . The potential liability
for failure to use reasonable care in such circumstances extends to persons who may
reasonably be expected to suffer harm from that negligence.” See Restatement (Second) of
Torts § 324A, theory of negligent undertaking.
 Since Bristol put its name on the packaging to help market the product to doctors who
trusted the Bristol brand, it cannot now deny liability under § 324A.
Holding Bristol was not entitled to summary judgement.

Frigidaire Sales Corporation v. Union Properties, Inc. , Wash Sup Ct 1977 (Page 197)
Facts  Petitioner entered into a contract with Commercial.
 Commercial was a limited partnership wherein Mannon and Baxter were limited partners
and a second corporation, Union, was listed as the sole general partner. Baxter and Mannon
were the shareholders of Union.
 Baxter and Mannon never held themselves out as general partners of Commercial –
Petitioner knew of the relationship between the parties at the time of forming the contract.
 Commercial breached their agreement with Petitioner, and since Union was the only liable
partner of Commercial, and Commercial was undercapitalized, Petitioner sought damages
from Baxter and Mannon, claiming that they manipulated the limited partnership laws of
the state by forming a second corporation to be the general partner of the limited
partnership.
Issue The issue is whether the limited partners Baxter and Mannon can be held liable for
 Commercial’s breach of contract.
Rule of Law 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.
Reasoning  Since the state statute allowed limited liability partnerships to have a corporation as the
general partner, the court focused on the issue of whether the limited partners were liable
as general partners for keeping the partnership inadequately capitalized.
o “If a corporate general partner is inadequately capitalized, the right of a creditor
are adequately protected under the “piercing the corporate veil” doctrine of
corporation law.”
 “When the shareholders of a corporation, who are also the corporation’s officers and
directors, conscientiously keep the affairs of the corporation separate from their personal
affairs, and no fraud or manifest injustice is perpetrated upon third persons who deal with
the corporation, the corporation’s separate entity should be respected.”
Holding Since the creditor knew of the arrangement and the shareholders did not comingle personal
with corporate affairs the limited partners were not liable.
Notes

3. SHAREHOLDER DERIVATIVE ACTIONS (Derivative Actions (199-242))

A. INTRODUCTION

 Direct and Derivative Suits:

o Direct: brought by shareholder in an individual capacity that arises from an injury directly to the
shareholder
o Derivative: brought by a shareholder on behalf of the corporation fir an injury suffered by the entire
corporation
 Traditional Tests:
 Who suffered the most direct injury?
o If corporation, suit is derivative
 To whom did defendant’s duty run?
o If corporation, suit is derivative
  Delaware Approach:
 In Tooley v. Donaldson, Lufkin, & Jenrette, Inc., 2004 WL 728354 (Del.2004), the
Delaware supreme court adopted a two-pronged standard to be used in determining
whether a stockholder’s claim is derivative or direct:
o Who suffered the alleged harm, the corporation or the suing stockholders,
individually?
o Who would receive the benefit of any recovery or other remedy, the corporation
or the stockholders, individually?

 Derivative Litigation Decision Tree

 Rational Plaintiff
o A rational plaintiff will file derivative suit before making demand
 Consequences of not making demand trivial - if required, slight delay while you make demand
 Preserves right to litigate:
 Direct v. derivative
 Demand futility

Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541 (1949) (Page 199)
Facts  Plaintiff, now deceased and represented by the executor of his estate, filed this action in
1943 in federal court due to diversity. The complaint asserts that since 1929 the managers
and directors of Defendant corporation have abused their positions to enrich themselves
personally at the expense of the corporation.
 In 1945, New Jersey passed a law that required shareholders who held less than 5% of the
total shares and less than $50,000 to pay the legal bills of the defendant corporation if the
suit was unsuccessful.
 Defendant wanted Plaintiff to post a $125,000 bond to ensure they would meet that
potential burden.
 Plaintiff argued that applying the statute to them would be unconstitutional because it was
enacted after they initially brought suit and because it was an unconstitutional hindrance to
bring a suit.
  They also argue that it is a procedural issue that should not be followed by the federal
courts.
Issue The issue is whether New Jersey’s statute requiring the payment of legal fees in the event of an
unsuccessful derivative suit should be followed by the federal courts.
Rule of Law A statute holding an unsuccessful plaintiff liable for the reasonable expenses of a corporation
in defending a derivative action is entitling the corporation to require security for such
payment is constitutional.
Reasoning  Due Process Analysis “it cannot seriously be said that a state makes such unreasonable
use of its power as to violate the Constitution when it provides liability and security for
payments of reasonable expenses if a litigation of this character is adjudged to be
unsustainable.”
 Rules Decision Act/ Erie R. Co. v. Tompkins State law applies in all federal actions that
do not deal directly with federal subject matter.
 Procedural Argument
Holding “We hold that the New Jersey statute applies in federal courts and that the District Court erred
in declining to fix the amount of indemnity reasonably to be exacted as a condition of further
prosecution of the suit.”
Notes

Eisenberg v. Flying Tiger Line, Inc., 451 F.2d 267 (2d Cir. 1971) (Page 203)
Facts  In July of 1969, Defendant, a Delaware corporation, organized a wholly owned subsidiary.
In August that wholly subsidiary in turn organized its own wholly own Delaware
subsidiary. The three corporations then reorganized and merged with the August subsidiary
being the only surviving corporation. The stockholders approved of this organization in
September 1969.
 Plaintiff asserts that this reorganization diluted his, and similar minority shareholders,
voting rights.
 Plaintiff brought suit to enjoin the reorganization.
 Defendant had the suit removed to the District Court for the Eastern District of New York,
and they asserted that under New York state law, shareholders with less than 5% share or
$50,000 of stock who file derivative suits must post security to pay for the opposing legal
expenses in the event of an unsuccessful suit.
 Plaintiff argued that his suit was not a derivative suit as contemplated by the statute, but
rather a suit for personal damages.
Issue The issue is whether Plaintiff must post security before proceeding with his suit.
Rule of Law A cause of action that is determined to be personal, rather than derivative, cannot be
dismissed because the plaintiff fails to post security for the corporation’s costs.
Reasoning  The court first analyses Gordon v. Elliman and finds that the reasoning in that case was too
broad to apply to this case The court found Lazar v. Knolls Corp to be far more similar.
 In Lazar, the court stated security for costs could not be required where a plaintiff: “does
not challenge acts of the management on behalf of the corporation. He challenges the right
of the present management to exclude him and other stockholders from proper participation
in the affairs of the corporation. He claims that the defendants are interfering with the
plaintiff’s rights and privileges as stockholders.”
 The recodification of corporate statutes in 1963 stated that suits were “derivative only if
brought in the right of a corporation to procure judgement “in its favor.” This was to
‘forstall any such pronouncement in the future as that made by the Court of Appeals in
Gordon v. Elliman.’ Hornstein, ‘Analysis of Business Corporation Law.’”
 The court found that since the reorganization deprived the minority stockholder of any
 voice in the affairs of the preciously operating company that the claim was not a derivative
claim and also that the reorganization was not permitted under NY law.
Holding The United States Court of Appeals for the Second Circuit held that Plaintiff does not have to
post security because the suit is not a derivative cause of action.
Notes

B. THE REQUIREMENT OF DEMAND ON THE DIRECTORS

 Delaware Legal Standard for Demand Futility

o Plaintiff must allege particularized facts (pre-discovery using the “tools at hand”) creating a reasonable
doubt that the board is capable of making a good faith decision on suit:
 1. Majority of board has material financial or familial interest
 2. Majority of the board lacks independence (domination and control by wrongdoers)
 3. Challenged transaction not product of valid exercise of business judgment
o Disjunctive
 Demand Futility in NY under Barr and Marx
o Three factor (disjunctive) standard:
 1. Majority of directors interested in challenged transaction
 2. Directors failed to inform themselves to degree reasonably appropriate
 3. Challenged transaction so egregious that it could not have been the product of sound business
judgment of the directors

Grimes v. Donald, Del Sup Ct 1996 (Page 208)

Facts  Plaintiff filed an action against the Board and Donald in order to invalidate Donald’s
employment agreement. Donald and the Board agreed upon an agreement that would run
until Donald’s 75th birthday.
 The agreement provided a salary, incentive plans and health insurance. The agreement
vested to Donald the “the general management of the affairs of the Company.” The
agreement further provided that if Donald was “constructively terminated without cause,”
(which would be when there is “unreasonable interference, in the good-faith judgment of
[Mr. Donald], by the Board or a substantial stockholder of the Company, in [Mr. Donald"s]
carrying out his duties and responsibilities under the Agreement”), he would be eligible for
a generous retirement package.
 Plaintiff understood this provision as the Board abdicating their management
responsibilities to Donald.
 Plaintiff wrote the Board, demanding that they invalidate the agreement. The Board
responded, explaining that a third part helped to develop the agreement, and that the Board
was still capable of managing the company with this agreement in place.
 Plaintiff then brought suit, and added additional claims against the conduct of the Board.
Issue The issue is whether Plaintiff’s pre-suit demand waives his right to contest the independence
of the Board on all of his claims.
Rule of Law (1) A claim that a board of directors has abdicated its statutory duty may be brought
directly.
(2) When a stockholder demands that the board of directors takes action on a claim
allegedly belonging to the corporation and demand is refused, the stockholder may not
thereafter assert that 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.
Reasoning  A pre-suit demand is a tool to avoid further litigation, but it would not serve that function
effectively if Plaintiff was allowed to bifurcate his claims and claim the demand was
excused for one set of claims.
  The court reasoned that the demand acted as a concession that demand would be required
for all claims that arose from the agreement.
Holding Plaintiff waived his right to contest the independence of the Board once he demanded that they
invalidate the employment contract.
Notes

Marx v. Akers, NY Ct App 1996 (Page 215)

Facts  Plaintiff challenged Defendants’ decision to increase three of the outside director’s
compensation to $55,000 plus 100 shares of IBM stock. The increase was above the rate of
the cost of living, and the company under Defendants has been struggling. Therefore,
Plaintiff asserted that the compensation was excessive.
 Defendants argued that only three directors were affected by the compensation increase,
and therefore a majority of the Board had no interest – and therefore demand was not
excused.
 Defendants also argued that Plaintiff only asserted conclusory statements and did not assert
with particularity any facts to establish that the compensation was excessive.
Issue (1) The first issue is whether demand was excused because the directors had an interest in
their own compensation.
(2) The second issue is whether Plaintiff asserted a factually-based claim against
Defendants.
Rule of Law Demand on a board of directors is futile if a complaint alleges with particularity that: (1) a
majority of the directors are interested in the transaction; (2) the directors failed to inform
themselves to a degree reasonably necessary about the transaction; or (3) the directors failed
to exercise their business judgement in approving the transaction.
Reasoning  NY law required that plaintiffs in shareholder derivative actions demand that the
corporation initiate an action, unless such demand was futile, before commencing an action
on the corp’s behalf. Three reasons for this law:
(1) relieve courts from deciding matters of internal corporate governance
(2) provide corporate boards with reasonable protection against harassment
(3) discourage “strike suits”
 Delaware Approach (Grimes) “The two branches of the [Delaware] test are disjunctive.
. . . Once director interest has been established, the business judgement rule becomes
inapplicable and the demand excused without further inquiry. . . . Whether a board has
validly exercised its business judgement must be evaluated by determining whether the
directors exercised procedural (informed decision) and substantive (terms of the
transaction) due care. . . .”
 Universal Demand “requiring a demand in all cases, without exception, and [prohibits]
the commencement of a derivative proceeding within 90 days of the demand unless the
demand is rejected earlier. . . . However, plaintiffs may file suit before the expiration of 90
days, even if their demand has not been rejected, if the corporation would suffer irreparable
injury as a result.”
 New York’s Approach to Demand Futility NY law appears much like the Delaware
approach. In NY “a demand would be futile if a complaint alleges with particularity that
(1) a majority if the directors are interested in the transaction, or (2) the directors failed to
inform themselves to a degree reasonably necessary about the transaction, or (3) the
directors failed to exercise their business judgement in approving the transaction. Barr v.
Wackman.”
 Barr also stated “[i]t is not sufficient * * * merely to name a majority of the directors as
parties defendant with conclusory allegations of wrongdoing or control by wrongdoers” to
justify failure to make a demand.
Holding The court held that since the plaintiff did not name a majority of the board members; directors
will be self-interested in any transaction that benefits them; and the compensation rates were
not excess; the plaintiff failed in asserting a cause of action and the complaint must be
dismissed.
Notes

C. THE ROLE OF SPECIAL COMMITTEES

 Delaware Standard for reviewing Special Litigation Committee Recommendations:

o Zapata two step:
 Step 1:
 Inquiry into the independence and good faith of the committee
 Inquire into the bases supporting the committee’s recommendations
 Step 2:
 Court may go on to apply its own business judgment as to whether the case is to be
dismissed
 Independence Contexts:
o Independent and disinterested decision makers key precondition to BJR:
o Demand futility
o SLC recommendation
o Approval of conflicted interest transactions
o Mergers and acquisitions
o Especially defenses against hostile takeover bids

 Board Functions: DGCL § 141(a): “The business and affairs of every corporation organized under this chapter
shall be managed by or under the direction of a board of directors….”
o Select, evaluate, replace senior management.
o Oversee: Strategies, management of corporate resources.
o Review, approve major plans and actions.
o Other functions prescribed by law.
 Board Committees: DGCL § 141(c)(2): “The board of directors may designate 1 or more committees, each
committee to consist of 1 or more of the directors of the corporation. … Any such committee, to the extent
provided in the resolution of the board of directors, or in the bylaws of the corporation, shall have and may
exercise all the powers and authority of the board of directors in the management of the business and affairs of the
corporation, and may authorize the seal of the corporation to be affixed to all papers which may require it; but no
such committee shall have the power or authority in reference to the following matter: (i) approving or adopting,
or recommending to the stockholders, any action or matter (other than the election or removal of directors)
expressly required by this chapter to be submitted to stockholders for approval or (ii) adopting, amending or
repealing any bylaw of the corporation.”
o Audit
o Nominating (sometimes corporate governance)
o Compensation
o Executive
o Human resources
 Corporate Officers:
o Officers serve at the pleasure of the Board of Directors.
o Act as agents for the corporation.
 Have fiduciary duties of agents, plus.
o In most states, one can be both officer and director.
 Fiduciary Duties: Directors and officers are fiduciaries of the corporation.
o Duty of Care: Directors/officers are expected to act in good faith and the best interests of the corporation.
Failure to exercise due care may subject individual directors or officers personally liable.
  MBCA § 8.30(a): “Each member of the board of directors, when discharging the duties of a
director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in
the best interests of the corporation”
o Duty of Loyalty: subordination of personal interests to the welfare of the corporation.
 No competition with Corporation.
 No “corporate opportunity.”
 No conflict of interests.
 No insider trading.
 No transaction that is detrimental to minority shareholders

Auerbach v. Bennette, NY Ct App 1979 (Page 221)

Facts  In 1975, after reports of several multinational companies offering bribes and kickbacks to
foreign officials, GTEC appointed outside counsel and auditors to determine if anyone at
GTEC was involved in similar conduct.
 After the outside consultants found wrongdoing by former and current members of
GTEC’s Board, Auerbach brought a shareholder’s derivative suit against the Defendant
Board.
 Defendants appointed a three-person special committee comprised of members who were
not on the board at the time of the wrongdoing. The committee reviewed the auditor
findings and decided that in the best interests of the company that they should not pursue
an action against the Board members.
 Wallenstein continued the suit after Auerbach declined, arguing that any committee
appointed by the corrupted directors should be considered interested parties.
Issue Whether the special committee appointed by the old BOD was an “interested party” to the
degree that their findings would conflict with the corporation’s overall goals?
Rule of Law While the substantive aspects of a decision to terminate a shareholder’s derivative action
against defendant corporate directors made by a committee of disinterested directors
appointed by the corporation’s board of directors is beyond judicial inquiry under the
business judgement doctrine, the court may inquire as to the disinterested independence of the
members of that committee and as to the appropriateness and sufficiency of the investigative
procedures chosen and pursued by the committee.
Reasoning  “the business judgement rule, at least in part, is grounded in the prudent recognition that
courts are ill equipped and infrequently called on to evaluate what are and must be
essentially business judgements.”
 “the rule shields the deliberations and conclusions of the chosen representatives of the
board only if they possess a disinterested independence and do not stand in a dual relation
which prevents an unprejudiced exercise of judgement.”
 “Courts have consistently held that the business judgement rule applies where some
directors are charged with wrongdoing, so long as the remaining directors are disinterested
and independent. . . .”
 “While the court may properly inquire as to the adequacy and appropriateness of the
committee’s investigation procedures and methodologies, it may not under the guise of
consideration of such factors trespass in the domain of business judgement.”
Holding The court held that there was no issue of fact on the independence of the committee and that
there was no insufficiency in regards to the procedures chosen by the special litigation
committee.
Notes

Zapata Corp. v. Maldonado, Del Supp Ct 1981 (Page 226)

Facts  Maldonado brought the derivative suit against ten officers and directors of Defendant,
 asserting that they breached their fiduciary duties.
 Plaintiff did not demand that the Defendant officers bring the action because all the
directors at the time were named in the suit.
 After the suit, Defendant corporation appointed an “Independent Investigation Committee”
comprised of two directors who were not part of the initial suit.
 The Committee decided that the derivative suits would be harmful to the company and
therefore moved to dismiss the litigation.
Issue Whether the authorized committee should be permitted to dismiss pending derivative suit
litigation?
Rule of Law When assessing a special litigation committee’s motion to dismiss a derivative action, a court
must: (1) determine whether the committee acted independently, in good faith, and made a
reasonable investigation; and (2) apply the court’s own independent business judgement.
Reasoning  “Directors of Delaware corporations derive their managerial decision making power, which
encompasses decisions whether to initiate, or refrain from entering, litigation, from 8
Del.C. §141(a). . . . The ‘business judgement’ rule is a judicial creation that presumes
propriety, under certain circumstances, in a board’s decision. Viewed defensively, it does
not create authority. . . . The judicial creation and the legislative grant are related because
the ‘business judgement’ rule evolved to give recognition and deference to directors’
business expertise when exercising their managerial power under §141(a).”
 The court below cited Sohland v. Baker, “whether [‘[t]he tight of a stockholder to file a bill
to litigate corporate rights’] exists necessarily depends on the facts of each particular case.”
Explaining the stockholder only has a right to the lawsuit, not an absolute right to control
it.
 The court also cited McKee v. Rogers, explaining the McKee rule “Board members, owing
awell-established fiduciary duty to the corporation, will not be allowed to cause a
derivative suit to be dismissed when it would be a breach of their fiduciary duty.”
 The court also explained an exception to this rule: “[A] stockholder may sue in equity in
his derivative right to assert a cause of action in behalf of the corporation, without prior
demand upon the directors to sue, when it is apparent that a demand would be futile, that
the officers are under an influence that sterilizes discretion and could not be proper persons
to conduct the litigation.” If no such exception exists the stockholder has not right to
initiate an action on behalf of the corporation.
 The court recognized the risk of stockholders being able to incapacitate an entire board
through abuse of “strike suits.” Based on this and the demand requirement the court found
that the board has the managerial power to dismiss the suit if there are “disinterested
directors” that can act on behalf of the board.
 Once the disinterested directors are established the “issues become solely independence,
good faith, and reasonable investigation.”
 Established a two step test:
(1)“First, the Court should inquire into the independence and good faith of the committee
and the bases supporting its conclusion. . . . If the Court is not satisfied . . . the Court shall
deny the corporations motion. If, however, the Court is satisfied under Rule 56 standards. .
. the Court may proceed, in its discretion, to the next step.
(2)”The second step provides [that t]he Court . . . determine, applying its own independent
business judgement, whether the motion should be granted.”
-The purpose is the catch cases that pass step one but go against the “spirit” of step
one.
Holding Reversed and Remanded for further proceedings consistent with this opinion.
Notes
In re Oracle Corp. Derivative Litigation, Del Ch Ct 2003 (Page 234)
Facts  Shareholders (Plaintiff) of Oracle Corp. (Oracle) brought a derivative action, claiming
insider trading by four members (Defendant) of Oracle’s board of directors—Ellison
(D), Henley (D), Lucas (D), and Boskin (D).
 Ellison (D) was Oracle’s Chairman and one of the wealthiest men in the world.
 The suit alleged those directors (Defendant) breached their fiduciary duty, as did the
non-trading directors (Defendant), whose indifference according to the plaintiff
shareholders (Plaintiff) amounted to subjective bad faith.
 The special litigation committee (SLC) was formed by Oracle to investigate the charges
in the derivative action and to decide whether to press the claims raised, terminate the
action, or settle.
 Two Oracle board members, having joined the board after the alleged breaches, were
named to the SLC. They were each professors at Stanford University and both agreed to
forfeit any compensation related to the SLC if their compensation was determined to
impair their impartiality.
 The SLC’s legal an analytic advisors’ independence was not challenged. Their
investigation was extensive, and the committee produced a very lengthy report that
concluded that Oracle should not pursue any of the derivative action claims. The SLC
based its opinion on Oracle’s quarterly earnings cycle, and determined that none of the
accused directors had possessed material, non-public information. The SLC, in its
report, took the position that its members were independent. In this regard, the report
pointed out that the SLC members received no compensation from Oracle other than as
directors, that neither were on the board at the time of the alleged wrongdoing, that they
were willing to return their compensation, and that no other material ties existed
between the SLC members and the defendants.
 However, the report failed to indicate that there were significant ties between Oracle, the
trading defendants (Defendant), and Stanford University (Stanford)—namely, in the
form of very large donations, or potential donations, that the SLC members were aware
of. Also, one of the SLC members had been taught by one of the trading Defendants,
and both were senior fellows and steering committee members of a Stanford research
institute. The SLC argued that even together, these facts regarding the ties among
Oracle, the Defendants, Stanford, and the SLC members did not impair the
independence of the SLC.
 In so arguing, the SLC placed great weight on the fact that none of the Defendants had
the practical ability to deprive either SLC member of their current positions at Stanford.
Given their tenure, neither did Stanford itself have any practical ability to punish them
for taking action adverse to Oracle or any of the defendants.
Issue Whether the board member on the special litigation committee and the other board member
being investigated held a relationship that one could reasonably infer that the board member
on the SLC was no longer independent?
Rule of Law A special litigation committee does not meet its burden of demonstrating the absence of a
material dispute of fact about its independence where its members are professors at a
university that has ties to the corporation and to the defendants that are the subject of a
derivative action that the committee is investigating.
Reasoning  Emphasis should not be placed on only domination and control when analyzing whether
the SLC was independent. Rather, the law should take into account human nature,
human motivations, and humans’ social nature.
 Therefore, a court would not consider only greediness, but would also consider envy,
love, friendship, respect among colleagues, and other similar motivators.
 In the end, the question of independence turns on whether a director is, for any
significant reason, not capable of making a decision with only the corporation’s best
 interests in mind. Therefore, in this case, the issue is whether the SLC can
independently make the difficult decision it has been entrusted with. In the context of
human nature, the SLC has not met its burden to show the absence of a material factual
question regarding its independence. This is the case since the connections between the
SLC, the trading defendants (Defendants) and Stanford are substantial enough to cause
reasonable doubt about the SLC’s ability to impartially consider whether the Defendants
should face suit.
 The SLC members were already being asked to consider whether the company should
level very serious accusations of wrongdoing against fellow board members. The SLC
members faced the added task of having to determine whether or not to press serious
charges against one of the trading defendants, Boskin (Defendant), a fellow professor at
their university.
 Even more daunting was that one of the SLC members had a long history with Boskin
(Defendant) and had served with him at a university research institute. That SLC
member would find it challenging to assess Boskin’s (Defendant) conduct without also
pondering his own associations and mutual affiliations with him. This would also likely
be the case with regard to those trading defendants (Defendants) who were significant
benefactors to the university.
 Further, the SLC has not made a convincing argument that tenured faculty are not
influenced by large contributors to their institutions, such that a tenured faculty member
would not be concerned about writing a report finding that a suit by the corporation
should proceed against a large contributor and that there was credible evidence that he
had engaged in illegal insider trading. To conclude otherwise, would depend on a
narrow-minded understanding of the way collegiality works in institutional settings.
 Lastly, Ellison (Defendant) had made it known publicly that he would make substantial
contributions to Stanford, and it is highly doubtful that the SLC members had no
knowledge of his intentions. Motion to terminate denied.
Holding No. A special litigation committee is unable to meet the burden of demonstrating the
absence of a material dispute of fact about its independence where its members are
professors at a university that has connections to the corporation and to the defendants that
are the subject of a derivative action being investigated by the committee.
Notes

4. THE ROLE AND PURPOSE OF CORPORATIONS (Corporate Social Responsibility (242-258))

 Dividends:
o Courts will generally leave dividends to the discretion of the directors
o But will intervene if refusal to pay amounts to “such an abuse of discretion as would constitute a fraud, or
breach of … good faith”

 Business Judgement Rule: In the absence of a showing of fraud, illegality or self-dealing by the directors, their
decision is final and not subject to review by the courts

A.P. Smith Mfg. Co. v. Barlow, NJ Sup Ct 1953 (Page 242)

Facts  Plaintiff corporation, founded in 1896, had a history of donating minor sums of money to
various charities and institutions.
 In 1956 Plaintiff voted to give $1,500 to Princeton University.
 Plaintiff instituted a declaratory judgment action after Defendant stockholders questioned
the proposed gift. Although a state statute allows corporations to contribute to charities,
Defendants assert that the corporation’s certificate of incorporation does not allow the gift,
and the corporation was incorporated prior to the statute that authorizes the gift-giving.
Issue Can a corporation make charitable contributions without the permission of the shareholders?
Rule of Law State legislation adopted in the public interest can be constitutionally applied to preexisting
corporations under the reserve power.
Reasoning  “modern conditions require that corporations acknowledge and discharge social as well as
private responsibilities as members of the communities within which they operate. . . .”
 “State legislation adopted in the public interest and applied to pre-existing corporations
under the reserved power has repeatedly been sustained by the United States Supreme
Court above the contentions that it impairs the rights of stockholders and violates
constitutional guarantees under the Federal Constitution. . . .”
o “the public policy supporting the statutory enactment under consideration is far
greater and the alteration of preexisting rights of stockholders much lesser than
in the cited cases sustaining various exercises of the reserve power.”
 The court found the facts that: there was no personal gain; it was made to a university; it
was a modest amount within statutory limits; and the director believed that it would help
the corp in th long run; all were relevant factors.
Holding Yes, a corporation can make charitable contributions within the statutory limits.
Notes

Dodge v. Ford Motor Co., Mich Sup Ct 1919 (Page 248)

Facts  Defendant corporation was the dominant manufacturer of cars when this case was initiated.
At one point, the cars were sold for $900, but the price was slowly lowered to $440 – and
finally, Defendant lowered the price to $360.
 The head of Defendant corporation, Henry Ford, admitted that the price negatively
impacted short-term profits, but Ford defends his decision altruistically, saying that his
ambition is to spread the benefits of the industrialized society with as many people as
possible.
 Further, he contends that he has paid out substantial dividends to the shareholders ensuring
that they have made a considerable profit, and should be happy with whatever return they
get from this point forward.
 Instead of using the money to pay dividends, Ford decided to put the money into expanding
the corporation.
Issue Can shareholders force the BOD to increase the price of their goods and limit charitable
contributions to increase their dividend distribution?
Rule of Law A corporation’s primary purpose is to provide profits for its stockholders.
Reasoning  Ford stated “Although a manufacturing corporation cannot engage in humanitarian works
as its principal business, the fact that it is organized for profit does not prevent the
existence of implied powers to carry on with humanitarian motives.”
 “A business corporation is organized and carried on primarily for the profit of the
stockholders. The powers of the directors are to be employed for that end.”
 “it is not within the lawful powers of a board of directors to shape and conduct the affairs
of a corporation for the merely incidental benefit of shareholders and for the primary
purpose of benefiting others . . . if the avowed purpose of the defendant directors was to
sacrifice the interest of shareholders, it would not be the duty of the courts to interfere.”
Holding The court could not interfere with the board if they wanted to expand the business and make
charitable contributions. They uphold the portion of the lower courts decree ordering the
payment of a dividend of $19.3 million.
Notes
Shlensky v. Wrigley, Ill App Ct 1968 (Page 252)
Facts  Defendant is the director of the Chicago National League Ball Club, which is the company
that owns the Chicago Cubs.
 Although every other major league team had installed lights, Defendant did not install them
for the Cubs because he was concerned that night baseball would be detrimental to the
surrounding neighborhood.
 Plaintiff argued that the team was losing money, and that the other Chicago team, the
White Sox, had higher attendance during the weekdays because they played at night.
 Therefore, reasoned Plaintiff, the Cubs would draw more people with weekday night
games. Plaintiff asserts that Defendant’s first concern should be with the shareholders
rather than the neighborhood.
Issue Whether the court should overrule decisions made by Defendant absent a showing of fraud,
illegality or a conflict of interest?
Rule of Law A shareholder’s derivative suit can only be based on conduct by the directors that borders on
fraud, illegality, or conflict of interest.
Reasoning  The court cited Toebelman v. Missouri-Kansas Pipe Line Co., “In a purely business
corporation. . . the authority of the directors in the conduct of the business of the
corporation must be regarded as absolute when they act within the law, and the court is
without authority to substitute its judgement for that of the directors.”
 The court found that the motives alleged in the complaint showed no fraud, illegality, or
conflict of interest. The Court noted that those elements are not absolutely required, but
they felt the allegation must at least boarder one of them.
 The Court also found that the complaint failed to allege damage to the corporation. “we do
not agree with the plaintiffs’ contention that failure to follow the example of other major
league clubs in scheduling night games constituted negligence.”
Holding The court affirmed the dismissal of the complaint by the trial court for failure to show fraud,
illegality, or conflict of interest and also failing to show damage to the corporation.
Notes

CHAPTER 5—THE DUTIES OF OFFICERS, DIRECTORS, AND OTHER INSIDERS

1. THE OBLIGATION OF CONTROL: DUTY OF CARE (Corporate Insider Fiduciary Duties (299-332))

 Two Ways of Thinking About the Business Judgement Rule:

o 1. As a standard of liability
 No liability for negligence
 Instead liability based on:
 Fraud
 Illegal conduct
 Self-dealing
o 2. As an abstention doctrine
 Court will not review BoD decision
 Preconditions:
 No fraud
 No illegality
 No self-dealing
  Traits of an Efficient Market
o An efficient market exhibits certain behavioral traits:
 Price movement is random (unpredictable from past patterns)
 Reacts to new information quickly and accurately

 Legal Effect of a Merger: DGCL §259(a): “When any merger … shall have become effective …, for all
purposes of the laws of this State the separate existence of all the constituent corporations … except the one into
which the other … constituent corporations have been merged … shall cease and the [surviving] corporation
[shall possess] all the rights, privileges, powers and franchises ..., and [be] subject to all the restrictions,
disabilities and duties of each of such corporations so merged or consolidated … and all property, real, personal
and mixed, and all debts due to any of said constituent corporations … shall be vested in the corporation surviving
… from such merger … but all rights of creditors … of any of said constituent corporations shall be preserved
unimpaired, and all debts, liabilities and duties of the respective constituent corporations shall thenceforth attach
to said surviving … corporation …”

Kamin v. American Express Company, NY Sup Ct 1976 (Page 299)

Facts  Defendant corporation purchased common stock for $29.9 million, and now the stock has a
market value of $4 million. The directors decided to declare a special dividend, giving the
shares of stock to the shareholders.
 Plaintiff demanded that Defendants sell the stock on the open market and use the $25.9
million capital gains loss to offset other capital gains. The offset would save Defendant
corporation $8 million in taxes.
 Plaintiffs decided not to pursue Plaintiff’s demand, reasoning that the significant loss
would adversely affect the value of Defendant’s stock.
 Plaintiff then brought suit, classifying the directors’ decision as negligent decision-making.
Issue Whether a shareholder can bring suit against a BOD for not issuing dividends?
Rule of Law The decision to declare a dividend or make a distribution is exclusively a matter of business
judgement for the board of directors, so that courts will not interfere with the board’s decision
as long as it is made in good faith.
Reasoning  The Court first cites Leslie v. Lorillard, explaining that the stockholders may only bring
suit on the acts of the directors when there is an illegal or unconscientious abuse of director
power or if their acts appear fraudulent or collusive. “Mere errors of judgement are not
sufficient as grounds for equity interference, for the powers of those entrusted with
corporate management are largely discretionary.” Id.
 The court also cited Liebman v. Auto Strop Co. stating “It is for the directors to say, acting
in good faith of course, when and to what extent dividends shall be declared. The statute
confers upon the directors this power.”
 The court reasoned that a complaint that alleges that another course of action taken by the
BOD would have been more aventagous does not give rise to a cause of action. In support
of this the Court explained Section 720(a)(1)(A) gives shareholder the right to sue for “the
neglect of, or failure to perform, or other violations of his duties in the management.” This
“negligence” applied to neglect of duties and not misjudgment.
Holding No, the issuance of dividends is at the sole discretion of the BOD and absent fraud or
negligence, there is not cause of action.
Notes

 Mergers effect on Shareholders: DGCL § 251(b)(5): The plan of merger shall specify “the manner of converting
the shares of each of the constituent corporations into … cash … securities of any other corporation or entity
which the holders of such shares are to receive in exchange for [their] shares”

 Business Judgement Rule post-Van Gorkom:

 o A standard of liability
 Directors may be held liable for gross negligence in failing to make an informed decision
o A rule of abstention
 Will court review substance of BoD decision?
 No
 Court will examine decision making process
o The extent to which BoD made an informed decision
 Directors Defense to Business Judgement Rule:
o DGCL § 141(e) provides a defense for directors who rely on reports from officers.
 BUT, BoD has a duty of inquiry, they cannot rely blindly

 Consensus v. Authority
o Consensus
 Collective decision making
 Requires constituents with:
 Similar interests
 Comparable access to information
 Minimal collective action issues
 E.g., partnerships
o Authority
 Central decision making body
 Arises where constituents have:
 Differing interests
 Unequal information
 Collective action problems
 E.g., public corporation
 Authority-based decision making is essential for public corporations (Kenneth J. Arrow, The
Limits of Organization(1974))
 Large number of constituencies with differing access to information
 Diverse constituencies with conflicting interests
 Intractable collective action problems

Smith v. Van Gorkom, Del Supp Ct 1985 (Page 303)

Facts  Trans Union had large investment tax credits (ITCs) coupled with accelerated depreciation
deductions with no offsetting taxable income.
 Their short term solution was to acquire companies that would offset the ITCs, but the
Chief Financial Officer, Donald Romans, suggested that Trans Union should undergo a
leveraged buyout to an entity that could offset the ITCs. The suggestion came without any
substantial research, but Romans thought that a $50-60 share price (on stock currently
valued at a high of $39 ½) would be acceptable.
 Van Gorkom did not demonstrate any interest in the suggestion, but shortly thereafter
pursued the idea with a takeover specialist, Jay Pritzker. With only Romans’ unresearched
numbers at his disposal, Van Gorkom set up an agreement with Pritzker to sell Pritzker
Trans Union shares at $55 per share. Van Gorkom also agreed to sell Pritzker one million
shares of Trans Union at $39 per share if Pritzker was outbid. Van Gorkom also agreed not
to solicit other bids and agreed not to provide proprietary information to other bidders.
 Van Gorkom only included a couple people in the negotiations with Pritzker, and most of
the senior management and the Board of Directors found out about the deal on the day they
had to vote to approve the deal.
 Van Gorkom did not distribute any information at the voting, so the Board had only the
word of Van Gorkom, the word of the President of Trans Union (who was privy to the
 earlier discussions with Pritzker), advice from an attorney who suggested that the Board
might be sued if they voted against the merger, and vague advice from Romans who told
them that the $55 was in the beginning end of the range he calculated.
 Van Gorkom did not disclose how he came to the $55 amount.
 On this advice, the Board approved the merger, and it was also later approved by
shareholders.
Issue Whether the BOD’s decision to approve the merger was an informed decision?
Rule of Law The business judgement rule shields directors or officers of a corporation from liability only if,
in reaching a business decision, the directors or officers acted on an informed basis, availing
themselves of all material information reasonably available.
Reasoning  The Delaware Supreme Court held the business judgment to be gross negligence, which is
the standard for determining whether the judgment was informed.
 The Board has a duty to give an informed decision on an important decision such as a
merger and can not escape the responsibility by claiming that the shareholders also
approved the merger.
o [8 Del.C. § 141(a). The rule itself “is a presumption that in making a business
decision, the directors of a corporation acted on an informed basis, in good faith
and in the honest belief that the action taken was in the best interest of the
company.”]
o [8 Del.C. § 251(b). outlines the directors duty to act in an informed manner in
approving a proposed merger prior to presenting it to shareholders.]
 The directors are protected if they relied in good faith on reports submitted by officers, but
there was no report that would qualify as a report under the statute.
o [8 Del.C. § 141(e), “directors are fully protected in relying in good faith on
reports made by officers.” “At a minimum for a report to enjoy the status
conferred by § 141(e), it must be pertinent to the subject matter upon which a
board is called to act, and otherwise be entitled to good faith, not blind,
reliance. Pg 308]
 The directors can not rely upon the share price as it contrasted with the market value. And
because the Board did not disclose a lack of valuation information to the shareholders, the
Board breached their fiduciary duty to disclose all germane facts.
Holding No, the decision reached by the BOD was not an informed decision.

Francis v. United Jersey Bank, NJ Sup Ct 1981 (Page 316)

Facts  P&B was a broker between ceding insurance companies and reinsurance companies. They
earned a commission on the transactions between the two entities. Typically, brokers in the
reinsurance business hold funds from the ceding and reinsuring companies in a separate
account and pay each party from that account.
 The former CEO of P&B, Charles Pritchard, Sr. (the husband of Lillian Pritchard) did not
practice this method, but he still ensured that the funds deposited by third parties were
never used as personal funds.
 Charles Pritchard, Sr., eventually stepped down and his two sons controlled the business.
 Once the sons had control they took out personal loans from the account but never paid
back the loans or any interest. This practice of misappropriating funds continued until P&B
could no longer meet their obligations, and they went into bankruptcy.
 During the entire period that the sons controlled P&B, Lillian was the majority shareholder
and sat on the Board as a director. During her tenure as director, she never participated in
any business matters of P&B.
 Defendant argued that Lillian was elderly and sick, and therefore should be excused for her
absence.
Issue Whether Lillian was personally liable as a board member, for not stopping the
 misappropriation of funds by her sons?
Rule of Law Liability of a corporation’s directors to its clients require a demonstration that: (1) a duty
existed; (2) the directors breached that duty; and (3) the breach was a proximate cause of the
client’s losses.
Reasoning  The Court stated that as a general rule directors should have a rudimentary understanding
of the business the corp. conducts.
 “Directors are under a continuing obligation to keep informed about the activities of the
corporation.”
 Directors cannot avoid liability by shutting their eyes to misconduct, they have a duty to
look for it.
 The Court cited N.J.S.A. 14A:6-14 explaining that directors are immune from liability if, in
good faith, they rely on the the opinion of counsel or they rely of professionally prepared
financial statements or reports, or if the president makes a misrepresentation of information
that the director relies on as true.
 “Upon discovery of an illegal course of action, a director has a duty to object and, if the
corporation does not correct the conduct, to resign. . . .”
 The court also noted that the director-corporation-shareholder relationships are fiduciary as
is the director-creditor relationship upon insolvency.
 The Court found 2 main reasons for holding her liable:
(1) ”She did not resign until just before the bankruptcy.”
(2) ”The nature of the reinsurance business distinguishes it from most other commercial
activities in that reinsurance brokers are encumbered by fiduciary duties owed to third
parties.”
o The Court found that the scope of her duty extended beyond objection and
resignation and included reasonable attempts to prevent the misappropriation of
the trust fund due to the nature of the business and the fiduciary duty she held.
Holding Yes, the mother was held personally liable for failing to satisfy her fiduciary duty.
Notes

2. DUTY OF LOYALTY (Duty of Loyalty (332-342))

A. DIRECTORS AND MANAGERS

 Road Map:
o Exercise of Business Judgement?  Waste?  Fraud?  Conflict of interest?  Illegal Action? 
Egregious Decision?  Uninformed Decision?  Bad Faith?  Business Judgement Rule applies court
abstains
 Egregious Decision:
 Brehm: “Courts do not measure, weigh or quantify directors’ judgments. We do not even
decide if they are reasonable in this context. Due care in the decisionmaking context is
process due care only.”
 “Irrationality is the outer limit of the business judgment rule. Irrationality may be the
functional equivalent of the waste test or it may tend to show that the decision is not
made in good faith ….”
 Caremark: “whether a judge or jury considering the matter after the fact, believes a
decision substantively wrong, or degrees of wrong extending through “stupid” to
“egregious” or “irrational,” provides no ground for director liability, so long as the court
 determines that the process employed was either rational or employed in a good faith
effort to advance corporate interests.”

 Delaware Law on Contracts between the Corporation and a Director’s Interest: DGCL § 144
o (a) No contract or transaction between a corporation and 1 or more of its directors or officers, or between
a corporation and any other corporation, partnership, association, or other organization in which 1 or more
of its directors or officers, are directors or officers, or have a financial interest, shall be void or voidable
solely for this reason, or solely because the director or officer is present at or participates in the meeting
of the board or committee which authorizes the contract or transaction, or solely because any such
director’s or officer’s votes are counted for such purpose, if:
 (1) The material facts as to the director’s or officer’s relationship or interest and as to the contract
or transaction are disclosed or are known to the board of directors or the committee, and the board
or committee in good faith authorizes the contract or transaction by the affirmative votes of a
majority of the disinterested directors, even though the disinterested directors be less than a
quorum; or
 (2) The material facts as to the director’s or officer’s relationship or interest and as to the contract
or transaction are disclosed or are known to the shareholders entitled to vote thereon, and the
contract or transaction is specifically approved in good faith by vote of the shareholders; or
 (3) 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.
o (b) Common or interested directors may be counted in determining the presence of a quorum at a meeting
of the board of directors or of a committee which authorizes the contract or transaction.

 Delaware Quorum Statutes:

o § 141(b): Quorum is “. . . A majority of the total number of directors shall constitute a quorum for the
transaction of business unless the certificate of incorporation or the bylaws require a greater number. . . .”
o § 144(b): “Common or interested directors may be counted in determining the presence of a quorum”

Bayer v. Beran, NY Sup Ct 1944 (Page 322)

Facts  Defendants are the directors of Celanese Corporation of America. Celanese is a product
that is similar to rayon, but the corporation makes the effort to distinguish the two in order
to generate a market for their products. When the Federal Trade Commission (FTC) ruled
that celanese would need to be designated as rayon, there was a need to expend more
resources to make the distinction between celanese and competing products.
 The former advertising budget was $683,000 per year, but the president (who is also a
director), Dr. Camille Dreyfus, suggested a $1 million radio campaign built around a radio
musical program.
 One of the stars of the program is also his wife.
 The Board approved the campaign, and it has subsequently been renewed. The Board also
continues to approve an employment agreement for Dr. Camille Dreyfus’ brother, Dr.
Henri Dreyfus, who was a co-founder with his brother of the technology behind the
company’s products. Henri does not participate in the company as actively as Camille, but
the agreement prevents him from working elsewhere.
Issue The issue is whether the Board, through Dr. Camille Dreyfus’ ties with his wife and his
brother, breach their fiduciary duty of loyalty to the corporation by approving the radio deal
 and employee contract at issue?
Rule of Law Policies of business management are left solely to the discretion of the board of directors and
may not be questioned absent a showing of fraud, improper motive, or self-interest, even
though the decision may later be judged unwise or unprofitable.
Reasoning  The court did give heightened scrutiny to the decisions of the Board that normally would
be safely insulated under the business judgment rule.
 The radio agreement and the employee contract both withstand the scrutiny of analysis
under the duty of loyalty standard.
o The radio advertising made sound business sense because the company had to
increase their profile due to the FTC’s designation of celanese as a type of
rayon.
o There was nothing exorbitant about the amount paid to Camille’s wife, and
there was evidence, through the ratification by the board by renewing the
advertising, that it worked.
o The employment agreement for Henri Dreyfus made sense as well because the
agreement ensured that he would not work for any other company, and when
the deal was considered as one part of the package paid to both Dreyfus
brothers it was clear that the company received adequate compensation.
Holding No, after being analyzed under heightened scrutiny the board did not breach any fiduciary duty
due to conflict of interest.
Notes

Benihana of Tokyo, Inc. v. Benihana, Inc. , Del Sup Ct 2006 (Page 327)
Facts  Benihana of Tokyo, Inc. (BOT) (plaintiff) and its subsidiary, Benihana, operated
restaurants across the world. Many of Benihana’s restaurants needed renovation, but the
company did not have the necessary funds.
 Benihana hired Fred Joseph to analyze the company’s financial needs and determine a plan
of attack. Joseph recommended that Benihana issue convertible preferred stock, which give
the company the funds necessary for renovation.
 Subsequently, John Abdo, a Benihana board member, informed Joseph that BFC Financial
Corporation (BFC) was interested in buying the convertible stock. Abdo was also a
director of BFC, and he negotiated with Joseph for the sale of the stock on behalf of BFC.
 At a subsequent Benihana board meeting, Abdo made a presentation on behalf of BFC
regarding its proposed purchase of the stock. He then left the meeting. The Benihana board
(defendants) knew that Abdo was a director of BFC and Joseph informed the Benihana
board that Abdo had approached him about the sale on behalf of BFC.
 At the same meeting, the Benihana board voted in favor of the sale to BFC.
 Two weeks later, BOT’s attorney sent a letter to the Benihana board, asking it to abandon
the sale on account of concerns of conflicts of interests, the dilutive effect on voting of the
stock issuance, and the sale’s “questionable legality.” The board nonetheless again
approved the sale.
 BOT then brought suit against the Benihana board of directors, alleging breach of its
fiduciary duties.
Issue Did the board breach their fiduciary duty in allowing the sale of preferred stock to a board
member working on behalf of another company?
Rule of Law (1) A statutory safe harbor for transactions involving interested directors is satisfied
where the disinterested directors do not know that the interested director negotiated a
financing transaction on behalf of a potential buyer, but know that the interested
director is a principal of the buyer, and approached the company on behalf of the
buyer, about entering into the transaction.
 (2) An interested director does not breach his duty of loyalty where the director neither
sets the terms of the transaction nor deceives, nor controls or dominates the
disinterested directors’ approval of the transaction.
(3) A board validly exercises business judgement where it subjectively believes a
transaction it is approving is in the company’s best interests and for a proper
corporate purpose.
Reasoning  “Section 144 of the Delaware General Corporation Law provides a safe harbor for
interested transactions, like this one, if ‘[t]he material facts as to the director’s . . .
relationship or interest and as to the contract or transaction are disclosed or are known to
the board of directors . . . and the board . . . in good faith authorizes the contract or
transaction by the affirmative votes of a majority of the disinterested directors. . . .’”
 The court found that the record indicated that the board was informed of Adbo’s
involvement and thus made an informed decision.
 The court also found that Adbo: did not set the terms of the deal; did not deceive the board;
did not dominate or control the other directors decision. Thus, he did not breach his duty of
loyalty.
Holding No, since the transaction was decided by an informed board and no bad faith or deception took
place neither the board nor Adbo breached their fiduciary duties.
Notes

B. CORPORATE OPPURTUNITIES

 Corporate Opportunity Doctrine:

o Objective:
 To deter appropriations of new business prospects “belonging to” the corporation
o Targets:
 Officers & Directors of corporation
 Dominant Shareholders who take active role in managing firm
 o Delaware Test:
 A corporate opportunity exists where:
 1. Corporation is financially able to take the opportunity
 2. Opportunity is in the corporation's line of business
 3. Corporation has an interest or expectancy in the opportunity
o Interest: Something to which the firm has a better right
o Expectancy: takes something which, in the ordinary course of things, would
come to the corporation
 4. Embracing the opportunity would create a conflict between director’s self-interest and
that of the corporation

 Waiver of Duty under Delaware Law:

o § 122. Specific powers
 Every corporation created under this chapter shall have power to: …
 (17) Renounce, in its certificate of incorporation or by action of its board of directors, any interest
or expectancy of the corporation in, or in being offered an opportunity to participate in, specified
business opportunities or specified classes or categories of business opportunities that are
presented to the corporation or one or more of its officers, directors or stockholders.

Broz v. Cellular Information Systems, Inc., Del Sup Ct 1996 (Page 332)
Facts  Defendant was presented an opportunity by Mackinac Cellular Corp. that targeted RFBC
as a potential buyer of a cellular license, Michigan-2, which was adjacent to another license
held by RFBC.
 At the time of the offer, CIS was undergoing a Chapter 11 reorganization after they came
into financial straits from being overaggressive in other acquisitions.
 Another company, PriCellular, was also bidding for the license while also trying to
purchase CIS. PriCellular was eventually successful at acquiring CIS, but only after several
delays and shaky financing.
  Meanwhile, Defendant outbid PriCellular for the Michigan-2 license. CIS, now owned by
PriCellular, brought this action against Defendant, claiming he usurped a corporate
opportunity belonging to Plaintiff.
 Plaintiff also argued that Defendant had a fiduciary duty to PriCellular since they were
trying to acquire CIS. Defendant countered that he held a fiduciary duty only to CIS, and
they did not have the resources or the desire to bid for Michigan-2.
Issue Whether Defendant usurped a corporate opportunity from Plaintiff when he outbid them for
the Michigan-2 license?
Rule of Law The corporate opportunity doctrine is implicated only in cases where the fiduciary’s seizure of
an opportunity results in a conflict between the fiduciary’s duties to the corporation and the
self-interest of the director as actualized by the exploitation of the opportunity.
Reasoning  The court applied the “doctrine of corporate opportunity” which basically states that a
corporate fiduciary agrees to place the interest of a corporation before their own interest in
appropriate circumstances.
 The court noted that Broz became aware of the Michigan-2 opportunity in an individual
capacity not a corporate capacity.
 The court also analyzed the issues the trial court took issue with
o CIS was not financial capable of exploiting the Michigan-2 opportunity
o Even though the opportunity was in the same line of business it was not clear
that CIS had a cognizable interest or expectancy in the license
o Broz acquiring and profiting from the Michigan-2 opportunity created no
conflict between those duties and the ones he held with CIS.
 Since the corporate opportunity doctrine is implicated only in cases were the fiduciary’s
seizure of an opportunity results in a conflict the court found that the trial court erred.
Holding Broz did not breach his fiduciary duty to CIS.
Notes

In re eBay, Inc. Shareholder Litigation, Del Ch Ct 2004 (Page 337)

Facts  Goldman Sachs was hired to underwrite the initial public offering of eBay stock. In doing
so, Goldman Sachs allocated shares of the initial eBay stock to eBay “insiders,” including
members of eBay’s board of directors.
 Shareholders of eBay (plaintiffs) brought suit against the directors (defendants), alleging
that the directors’ acceptance of the private allocations violated their fiduciary duty to eBay
by usurping eBay’s corporate opportunity in that eBay could and would have purchased the
stock that was allocated.
 It is undisputed that eBay could afford the stock financially, that it was in the business of
investing in securities, and that eBay was never given an opportunity to turn down the
allocations.
 The directors filed a motion to dismiss the claim.
Issue Whether Goldman Sachs’ IPO allocations to the directors of eBay were to be considered
corporate opportunities within the context of the “corporate opportunity doctrine?”
Rule of Law Where a corporation regularly and consistently invests in marketable securities, a claim for
usurpation of corporate opportunity is stated where it is alleged that the corporation’s officers
and directors accepted IPO share allocations at the initial offering price instead of having
those allocations offered to the corporation.
Reasoning  The court focused its analysis on four main facts: (1) eBay was financially capable of
exploiting the oppurtunity, (2) eBay was in the business of investing securities, (3)
investing was integral to eBay’s cash management strategies and a significant part of it’s
business and, (4) the argument that IPO’s are risky investments is not a defense for
application of the corporate opportunity doctrine.
  The court also took issue with the fact that large underwriters like G.S. would allocate
these IPO’s to directors for their repeat business. The court found that this exchange could
create future conflict of interest.
Holding eBay’s motion for dismissal was denied
Notes

C. DOMINANT SHAREHOLDERS (Duties of Controlling Shareholders (342-358))

 Parent and Subsidiary Corporations:

o Wholly-owned subsidiary—parent owns 100% of the subs. stock
o Majority-controlled subsidiary—parent owns 50.1% of the subs. stock
o Minority-controlled subsidiary— <50% of subs. stock owned by the parent
 Standards of review in Parent/Subsidiary Transactions:
o Business Judgement Rule
 Burden of proof on plaintiff to rebut
o Intrinsic fairness
 Burden of proof on defendants to show transaction was fair to subsidiary
 Intrinsic fairness used when parent has received a benefit to the exclusion of the minority
shareholders of the subsidiary and at the expense of the minority shareholders of the subsidiary

Sinclair Oil Corp. v. Levien, Del Supp Ct 1971 (Page 342)

Facts  Sinven was a subsidiary of Defendant with operations exclusively in Venezuela.
 Defendant, as the majority shareholder of Sinven, caused Sinven to pay dividends that
were so large that the amount exceeded the earnings of Sinven. The dividends provided
cash to Defendant as well as minority shareholders, but it left no resources for Sinven to
expand its operations.
 Defendant also neglected to meet the terms of the contract between them and Sinven. The
agreement required Sinven to sell all of its products to Defendant at specified prices, but
Defendant was late in payments and did not fulfill their minimum purchasing obligations.
 Plaintiff therefore brought this action, claiming the dividends were excessive and that
Defendant breached the contract with Sinven.
Issue The issue is whether Defendant was improperly engaging in self-dealing when they issued
excessive dividends and breached their contract with Sinven.
Rule of Law The intrinsic fairness test should not be applied to business transactions where a fiduciary
duty exists but is not accompanied by self-dealing.
Reasoning  Dividends:
 “The motives for causing the declaration of dividends are immaterial unless the plaintiff
can show that the dividend payments resulted from improper motives and amounted to
waste. See 8 Del.C. § 170.
 “Since Sinclair received nothing from Sinven to the exclusion of and the detrimental to
Sinven’s minority shareholders, there was no self-dealing.”
 The court found that in deciding which subsidiaries Sinclair would choose for its expansion
purposes fell under the business judgement rule.
 Contract:
 “Although a parent need not bind itself by a contract with its dominated subsidiary,
Sinclair choose to operate in this manner. As Sinclair has received the benefits of this
contract, so must it comply with the contractual duties.”
 The court found that Sinclair failed to show that not enforcing the contract with Siven was
intrinsically fair to the minority shareholders of Siven and thus they breached the contract.
Holding Reversed
Notes

Zhan v. Transamerica Corporation, 162 F.2d 36 (3d Cir. 1947) (Page 346)
Facts  A-F was a tobacco company that had as its principal asset leaf tobacco which they bought
in late 1942 and early 1943 for $6,361,981. By April of 1943 the value of the tobacco was
about $20 million. Defendant, a holding company, was the majority shareholder which
entitled them to control nearly every aspect of A-F’s operations.
 Defendant converted all of their Class A stocks to class B stocks, and then called for a
redemption of outstanding Class A stocks at $80.80 per share. The company’s charter
allowed for the redemption, but the timing of it was suspicious because right after the
redemption Defendant liquidated A-F.
 As a result, owners of Class A shares lost out on what Plaintiff valued to be a $240 per
share return. Plaintiff redeemed some Class A shares, so Plaintiff sought equitable relief to
turn in outstanding shares at $240 per share and sought the difference between the $80.80
and $240 for the redeemed shares.
 Defendant argued that they followed the corporate charter when they voted for the
redemption.
Issue The issue is whether Plaintiff is entitled to equitable relief for a decision made by the majority
shareholder that was otherwise allowable under the corporate charter.
Rule of Law Majority shareholder owe minority shareholder duty similar to the duty owed by a director,
and when a controlling shareholder is voting as a director, he violates his duty if he votes for
his own personal benefit at the expense of the minority stockholders.
Reasoning  Southern Pacific Co. v. Bogert, the Supreme Court stated, “The majority has a 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.”
 The court differentiated voting as a majority shareholder (were one could act in their own
interest) and voting as a director (were one acted as the trustee of all shareholders and
could not vote for their personal benefit).
 The court analyzed the relationship between the directors of Axton-Fisher and
Transamerica and found that a “puppet-puppeteer relationship existed” thus establishing
that the directors were not acting independently (as required by the AF charter).
Holding Judgement reversed.
Notes

D. RATIFICATION

Fliegler v. Lawrence, Del Sup Ct 1976 (Page 351)

Facts  One of the Defendant directors, acting in his individual capacity, purchased a lease option
for antimony (metal) rights. He offered the rights to Agau but the directors agreed that
Agau’s financial position would not allow the purchase.
 The director then transferred the rights to a company formed for the specific purpose of
holding those rights. He then gave Agau a long-term option to purchase the holding
company. A few months later, Agau’s directors voted to exercise the option.
 A majority of shareholders voted the same way, but the directors also comprised a majority
of shareholders.
 Plaintiff argued that Defendant directors usurped a corporate opportunity for their own
 individual benefit, and that the transaction was inherently unfair.
 Defendants responded that their voted was ratified by shareholders, thereby shifting the
burden of proof to Plaintiff to prove that the transaction was fair, but they also offered
proof that it was fair.
Issue Whether a transaction is legitimately ratified by shareholders when a majority of shares are
held by the directors?
Rule of Law Ratification of an “interested transaction” by a majority of independent, fully informed
shareholders shifts the burden of proof to the objecting shareholder to demonstrate that the
terms of the transaction are so unequal as to amount to a gift or a waste of corporate assets.
Reasoning  Defendants relied on 8 Del.C. § 144(a)(2) and Gottlieb v. Heyden Chemical Corp. stating,
“shareholder ratification of an “interested transaction,” although less than unanimous,
shifts the burden of proof to an objecting shareholder to demonstrate that the terms are so
unequal as to amount to a gift or waste of corporate assets.”
o The court found that this would not shift the burden of proof to the plaintiff
because only 1/3 of disinterested shareholders voted
 In reference to 8 Del.C. § 144(a)(2) the court interpreted that a transaction could not be
invalidated solely because an interested officer or director is involved given that the
statue’s terms are met.
 After analyzing the economics of the transaction, the court concluded that the defendants
successfully proved the intrinsic fairness of the transaction.
Holding Affirmed.
Notes

In re Wheelabrator Technologies, Inc. Shareholder Litigation, Del Ch Ct 1995 (Page 354)

Facts  Defendant corporation was in the waste management field, specifically in the refuse-to-
energy field. This field was shared in part by Waste Management. At one point, Waste
management became the largest stockholder of Defendant, and they were eager to
streamline both companies through a merger.
 Waste Management offered to pay a ten percent premium to acquire 55% of Defendant’s
shares. Defendant directors (which did not include directors appointed by Waste
Management) voted to accept the offer.
 A majority of shareholders other than Waste Management voted in favor of the merger as
well.
 Plaintiffs accused Defendant directors of breaching a fiduciary duty when they withheld
pertinent information regarding a merger of Defendant target corporation Wheelabrator
into Waste Management. Plaintiffs also accused Defendant directors of breach of loyalty
and care in negotiating the merger by misrepresenting the time the directors took to
deliberate about the merger.
 Defendants claim that the shareholders, by voting for the merger, ratified the decision,
thereby extinguishing any duty of loyalty claims.
 Plaintiffs countered that at most the shareholder vote only turned the burden of proof on to
Plaintiffs under an entire fairness standard.
Issue Whether the shareholders, by voting in favor of the merger, ratified the directors’ decision
which in turn extinguished any claims of a fiduciary breach by the directors?
Rule of Law (1) A duty of disclosure claim must be dismissed where it lacks evidentiary support.
(2) An informed shareholder vote on a merger has the effect of extinguishing duty of care
claims brought in connection with the merger.
(3) As to a duty of loyalty claim not involving a controlling shareholder, fully informed
shareholder ratification serves not to extinguish the claim but to make the business
judgement rule the applicable review standard with the burden of proof resting on the
 plaintiff stockholders.
Reasoning  A. Duty of Care Claim:
 The Court cited the Supreme Court in Smith v. Von Gorkom “The parties agree that a
discovered failure of the Board to reach an informed business juudgement constitutes a
voidable, rather than a void, act. Hence, the merger can be sustained, not withstanding the
infirmity of the Board’s actions, if its approval by majority vote of the shareholders is
found to have been based on an informed electorate.”
 B. Duty of Loyalty Claim:
 The court focused on the two kinds of Deleware ratification decisions that involve duty of
loyalty:
o A. “interested” transactions cases between the corporations and its controlling
shareholders
 8 Del.C. § 144(a)(2) provides that an interested transaction of this kind
will not be voidable if it is approved in good faith by a majority of
disinterested stockholders.
o B. cases involving a transaction between corporation and its controlling
shareholders
 In parent-subsidiary merger the standard of review is “entire fairness”
with the burden of proof on the directors
 But when the merger is dependent on a “majority of the minority
shareholders” vote the standard of review remains the same and the
burden of proof shifts to the plaintiff.
 In this action the review standard for the merger is the business judgement and the
plaintiffs have the burden of proof.
Holding Since no party has been heard regarding the proper application of review the issue could not be
determined based on the motion, required further proceedings and supplemental motion for
summary judgement.
Notes

3. THE OBLIGATION OF GOOD FAITH (Duty of Loyalty (358-381))

 Delaware law protecting BOD breaching duty of care: 8 Del. C. § 102(b)(7): “the certificate of incorporation
may also contain… A provision eliminating or limiting the personal liability of a director to the corporation or its
stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provisions shall
not eliminate or limit the liability of a director: (i) For any breach of the director’s duty of loyalty to the
corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve the intentional
misconduct or a knowing violation of law; (iii) under § 174 of this title [concerning unlawful dividend payments
or stock purchases or redemptions]; or (iv) for any transaction from which the director derived an improper
personal benefit”
 Delaware law allowing BOD to rely on professional or expert competence: 8 Del. C. § 141(e): “A member of
the board of directors, or a member of any committee designated by the board of directors, shall, in the
 performance of such member’s duties, be fully protected in relying in good faith upon the records of the
corporation and upon such information, opinions, reports or statements presented to the corporation by any of the
corporation’s officers or employees, or committees of the board of directors, or by any other person as to matters
the member reasonably believes are within such other person’s professional or expert competence and who has
been selected with reasonable care by or on behalf of the corporation.”
 Delaware law requirement of BOD’s good faith:
o Courts often refer to the business judgment rule as “a presumption” that the directors or officers of a
corporation acted on an informed basis, in good faith, and in the honest belief that the action taken was in
the best interests of the company
o DGCL § 141(e) provides: “A member of the board of directors, or a member of any committee designated
by the board of directors, shall … be fully protected in relying in good faith upon [specified documents
and persons]
o DGCL § 102(b)(7) provides that a corporation’s articles of incorporation may (but need not) contain: “A
provision eliminating or limiting the personal liability of a director to the corporation or its stockholders
for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not
eliminate or limit the liability of a director: … for acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of law….
o DGCL § 145(a) and (b) only authorize indemnification of a director or officer who “acted in good faith.”
o Bad Faith = “Failure to Act in the Face of a Known Duty to Act”
 “Intentional dereliction of duty, a conscious disregard for one's responsibilities”
 “Fiduciary conduct of this kind, which does not involve disloyalty (as traditionally
defined) but is qualitatively more culpable than gross negligence, should be proscribed.”
 Section 102(b)(7) “distinguishes between ‘intentional misconduct’ and a ‘knowing
violation of law’ (both examples of subjective bad faith) on the one hand, and ‘acts ... not
in good faith,’ on the other. Because the statute exculpates directors only for conduct
amounting to gross negligence, the statutory denial of exculpation for “acts ... not in good
faith” must encompass the intermediate category of misconduct captured by the
Chancellor's definition of bad faith.
o Caremark on Good Faith: “[I]n my opinion 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
exits – will establish the lack of good faith that is a necessary condition to liability.” Chancellor Allen
o Stone on Good Faith: “[T]he Caremark standard for so-called ‘oversight’ liability draws heavily upon the
concept of director failure to act in good faith.
 That is consistent with the definition(s) of bad faith recently approved by this Court in its recent
Disney decision, where we held that a failure to act in good faith requires conduct that is
qualitatively different from, and more culpable than, the conduct giving rise to a violation of the
fiduciary duty of care (i.e., gross negligence).
 In Disney, we identified the following examples of conduct that would establish a failure to act in
good faith: ... where the fiduciary intentionally fails to act in the face of a known duty to act,
demonstrating a conscious disregard for his duties.
o Disney on Good Faith:
 “To act in good faith, a director must act at all times with an honesty of purpose and in the best
interests and welfare of the corporation … a true faithfulness and devotion to the interests of the
corporation and its shareholders…”
 The Court identified two types of fiduciary behavior as possible bases for finding that directors
who committed them acted in bad faith:
 conduct motivated by subjective bad faith (i.e., an actual intent to do harm)
 “intentional dereliction of duty, a conscious disregard for one’s responsibilities”
 Gross negligence ≠ bad faith
 Court declined to decide whether there is a distinct fiduciary duty to act in good faith independent
of the duties of loyalty and due care.
  Lays the groundwork for the establishment of bad faith as an independent basis of
liability.
o If bad faith is non-exculpable and non-indemnifiable, as the Court indicated, it
presumably can give rise to liability.
o But see Stone v. Ritter

A. COMPENSATION

 Corporate Waste: A transaction “that is so one sided that no business person of ordinary, sound judgment could
conclude that the corporation has received adequate consideration”

In re The Walt Disney Co. Derivative Litigation, Del Sup Ct 2006 (Page 359)
Facts  Michael Ovitz was hired as the president of The Walt Disney Company (Disney). Ovitz
was a much respected and well known executive, and in convincing him to leave his
lucrative and successful job with Creative Artists Agency (CAA), Disney signed Ovitz to a
very lucrative contract.
 The contract was for five years, but if Ovitz were terminated without cause, he would be
paid the remaining value of his contract as well as a significant severance package in the
form of stock option payouts.
 The contract was approved by Disney’s compensation committee after its consideration of
term sheets and other documents indicating the total possible payout to Ovitz if he was
fired without cause.
 The compensation committee then informed Disney’s board of directors of the provisions
of the contract, including the total possible payout to Ovitz. The board approved the
contract and elected Ovitz as president.
 After Ovitz’s first year on the job, it was clear that he was not working out as president and
that he was “a poor fit with his fellow executives.” However, Disney’s CEO and attorneys
could not find a way to fire him for any cause, so Disney instead fired him without cause,
triggering the severance package in the contract.
 Ovitz ended up being paid $130 million upon his termination. Disney shareholders
(plaintiffs) brought derivative suits against Disney’s directors for failure to exercise due
care and good faith in approving the contract and in hiring Ovitz, and, even if the contract
was valid, for breaching their fiduciary duties by actually making the exorbitant severance
payout to Ovitz.
 The Delaware Court of Chancery found that although the process of hiring Ovitz and the
resulting contract did not constitute corporate “best practices,” the Disney directors did not
breach any fiduciary duty to the corporation. The Disney shareholders appealed.
Issue Whether the Disney directors breached their duty of good faith in regard to the compensation
package agreed upon in regards to Ovitz compensation package?
Rule of Law (1) An individual cannot be deemed to be a de facto corporate officer where that
individual has not assumed or purported the assume the duties of a corporate office.
(2) Due care and bad faith may be treated as separate grounds for denying business
judgement rule review.
(3) An entire board of directors does not have to consider and approve an officer’s
employment agreement.
(4) Members of a compensation committee do not breach their duty of du care where,
although they do not follow the best practices, they are sufficiently informed about all
material facts regarding a decision they make.
(5) Directors do not breach their duty of due care in electing an officer where they are
informed of all material information reasonably available regarding their decision.
(6) “Intentional dereliction of duty, a conscious disregard for one’s responsibilities” is an
 appropriate legal definition of bad faith.
(7) Where a corporation’s governing instruments vest authority in the CEO/Chairman as
well as in the entire board of directors to terminate an officer, the entire board of
directors does not breach the fiduciary duties of due care and good faith by failing to
terminate an officer and by permitting the CEO/Chairman to do so.
(8) A CEO/Chairman does not breach the duty of care or the duty to act in good faith by
making a decision that is based in fact and that is made within his business judgement.
(9) Where the directors rely on advice that is accurate, and their reliance is made in good
faith, they do not breach any fiduciary duties.
(10) Where payment provisions of a corporate contract have a rational business
purpose, directors do not commit waste of corporate assets by making payment under
contract.
Reasoning (1) A de facto officer is one who has assumed possession of an office under the claim and
color of an election or appointment and who is actually discharging the duties of that office.
 The shareholders (P) argue that Ovitz (D) was a defacto officer at the time by virtue of his
contacts, receipt of confidential information, and request for reimbursement of certain
expenses, which vested him with apparent authority.
 The Court found that Ovitz (D) conduct did not meet the definition of a de facto officer,
either factually or legally, because he did not assume, or purport to assume, the duties of
Disney’s President until after he signed the OEA. Ovitz (D) owed no fiduciary duty to
Disney’s shareholders (P) until after the contract was effective. Therefore, the Chancery
Court did not err as to this issue.
(2) Under the Business Judgement Rule, director action is presumed to have been made on an
informed basis, in good faith, and in the honest delief that the action taken is in the
corporation’s best interest. Those presumptions can be rebutted if the plaintiff shows that the
directors breached their fiduciary duty of care or loyalty of acted in bad faith. If that is shown,
the burden then shifts to the director defendants to demonstrate that the challenged act or
transaction was entirely fair to the corporation and its shareholders.
 The shareholders (P) did not bring a claim for breach of the duty of loyalty, therefor, the
only way to rebut the business judgement rule presumption is to show that the directors (D)
breached their duty of care or had not acted in good faith, which they failed to do.
(3) There is nothing in the state’s statute that require the entire board to make decisions
regarding executive compensation. Further, the corporation’s governing instruments allocate
that decision to a compensation committee.
 Since the corporations internal governance vested authority in the compensation committee
the Chancery Court did not err in ruling that only the Compensation Committee could
consider and approve the OEA.
(4) The shareholders (P) claim that the Chancery Court’s decision was erroneous because the
evidence showed that the compensation committee members did not properly inform
themselves of the material facts, so they were grossly negligent in approving the NFT
provisions of the OEA.
 The compensation committee considered a term sheet that summarized the material terms
of the OEA, including the results of a non-fault termination, granting Ovitz (D) $40 million
cash plus the value of the accelerated options. The question becomes whether the
compensation committee knew that those accelerated options could reach a value of more
than $90 million.
 The compensation committee derived its information of the potential magnitude of an NFT
payout from two sources. First, the was the value of the “benchmark” options (previously
granted to other officers), along with their valuations. Second, was the amount of downside
protection Ovitz (D) was demanding.
 In leaving his former job Ovitz was walking away from a large sum of commissions. He
 wanted protection in case the job with Disney did not workout in the form of $50 million
“up-front” signing bonus. In refusing to grant this the compensation committee knew the
value of the options had to be greater.
 They also knew that under the NFT the earlier that the OEA was terminated without cause
the greater the severance payment would be.
(5) Plaintiffs contend that the directors (D) breached their duty of care in electing Ovitz (D)
because they were not informed about their decision.
 The board (D) knew they needed a new president. They knew of Ovitz’s (D) qualifications
and that Eisner (D) believed that Ovitz (D) would work well with the company. They knew
Ovitz (D) was walking away from CAA, a very profitable business. They knew that the
public, Eisner, and other officers supported the decision. They were informed of the key
terms of the OEA and that it was approved by the compensation committee.
 Nothing in the record proves the contention of the shareholders (P)
(6) “Intentional dereliction of duty, a conscious disregard for one’s responsibilities” is a proper
definition of bad faith because there are at least 3 different categories of fiduciary conduct that
can give rise to bad faith claims.
(i) “Subjective bad faith” which is the fiduciary conduct motivated by an actual
intent to do harm;
(ii) lack of due care, which does not involve malevolent intent, but sounds in
gross negligence (gross negligence by itself cannot constitute bad faith, as these
are clearly distinguished in common law and by statute);
(iii) the category that falls between the first two, and is the one used by the
Chancery Court in this case. The question is whether such misconduct is
properly treated as a non-exculpable, non-indemnifiable violation of the of the
fiduciary duty to act in good faith; the answer is “yes.” That is because
fiduciary misconduct is not limited to self-interested disloyalty or to gross
negligence, but may lie somewhere in between these extremes. Such an
intermediate category of bad faith is also recognized statutorily.
(7) Although the board had the authority to terminate Ovitz (D), it did not have the duty to do
so, since Disney’s governing instruments could permit Eisner (D) to terminate Ovitz (D) and
the board (D) understood this to be the case. Because Eisner (D) had concurrent power with
the board (D) to terminate lesser officers, board (D) approval was not necessary for Eisner (D)
to terminate Ovitz (D).
(8) Eisner (D) correctly concluded that Ovitz (D) could not be terminated for cause. Moreover,
Eisner (D) also acted within his business judgement in pursuing termination of Ovitz (D) and
triggered the NFT, since the other option was to keep Ovitz (D) as president or to offer him
another position at Disney, which would have also triggered the NFT and a possible lawsuit,
which would have been very costly.
(9) The advice given to the board (D) by Eisner (D) and Litvack (D), that Ovitz could not be
terminated for cause was accurate, and the directors relied on this information in good faith.
(10) To recover on a claim of corporate waste, plaintiff must prove that the exchange was “so
one sided that no business person of ordinary, sound judgement could conclude that the
corporation has received adequate consideration.” This very high standard for waste is a
collary of the position that where the business judgement presumptions are applicable, the
board’s decision will be upheld unless it cannot be “attributed to any rational business
purpose.”
 The claim that the payment of NFT amount to Ovitz (D) constitutes waste is meritless on
its face, because at the time the NFT amounts were paid, Disney was contractually
obligated to pay them.
 The question becomes whether the OEA and NFT were wasteful to begin with. Since they
were formed to lure Ovitz (D) away from his very profitable position at CAA they served a
 rational business purpose and could not constitute waste.
Holding (1) Affirmed; (2) Affirmed; (3) Affirmed; (4) Affirmed; (5) Affirmed; (6) Affirmed; (7)
Affirmed; (8) Affirmed; (9) Affirmed; (10) Affirmed
Notes

B. OVERSIGHT

 Standard of Demand Excusal in Oversight Cases

o Grimes/Aronson standard of demand futility:
 “The basis for claiming excusal would normally be that: (1) a majority of the board has a material
financial or familial interest; (2) a majority of the board is incapable of acting independently for
some other reason such as domination or control; or (3) the underlying transaction is not the
product of a valid exercise of business judgment.”
o What happens when the business judgment rule is inapplicable where the board did not exercise business
judgment. Is demand automatically excused in oversight cases?
 No. Use Rales v. Blasband standard
o Stone adopts Rales v. Blasband standard:
 “a court must determine whether or not the particularized factual allegations of a derivative
stockholder complaint create a reasonable doubt that, as of the time the complaint is filed, the
board of directors could have properly exercised its independent and disinterested business
judgment in responding to a demand”

Stone v. Ritter, Del Supp Ct 2006 (Page 375)

Facts  AmSouth Bancorporation (AmSouth) and a subsidiary paid $40 million in fines and $10
million in civil penalties, which arose from bank employees’ failure to file particular
reports required by the federal Bank Secrecy Act (BSA) and other federal anti-money-
laundering (AML) regulations.
 Evidence was shown that the corporation dedicated considerable resources to its
BSA/AML compliance program, put various procedures and systems in place and in an
effort to ensure compliance, and that these procedures and systems permitted the Defendant
to regularly monitor the corporation’s compliance with BSA/AML regulations and
requirements. On a regular basis the board (Defendant) received reports and training in
these BSA/AML compliance systems and enacted written policies and procedures to
ensure BSA/AML compliance.
 The shareholders (Plaintiff) of AmSouth brought a derivative action against the
corporation’s directors (Defendant) based on these events, claiming they breached their
oversight duties, before making demand on the board. They contended that demand was
excused because the Defendant faced a good chance of liability of personal liability that
would render them incapable of exercising independent and disinterested judgment in
response to a demand request.
 AmSouth’s certificate of incorporation contained a provision that would exculpate its
directors for breaches of their duty of care, provided they acted in good faith.
 The Chancery Court held that the Plaintiff failed to sufficiently plead that demand would
have been futile, finding that the Defendant had not been alerted by any “red flags” that
violations of law were occurring. Review was granted by the state’s highest court.
Issue When specified facts do not create a reasonable doubt that the directors of a corporation acted
in good faith in exercising their oversight responsibilities, will a derivative suit be dismissed
for failure to make demand?
Rule of Law A derivative action will be dismissed for failure to make demand where alleged particularized
facts do not create a reasonable doubt that the corporation’s directors acted in good faith in
exercising their oversight responsibilities.
Reasoning  The court focused its analysis on Graham and Caremark
o In Graham the Court held, “absent cause for suspicion there is no duty upon the
directors to install and operate a corporate system of espionage to ferret out
wrongdoing which they have no reason to suspect exists.”
o In Caremark the court narrowly construed its decision in Graham “as standing
for the proposition that, absent grounds to suspect deception, neither corporate
boards nor senior officers can be charged with wrongdoing simply for assuming
the integrity of employees and the honesty of their dealings on the company’s
behalf.”
 “The failure to act in good faith may result in liability because the requirement to act in
good faith ‘is a subsidiary element’ i.e., a condition, ‘of the fundamental duty of loyalty.’”
 Two doctrinal consequences for the above view:
o (1) Only violation of the duty or care or loyalty may directly result in liability
but violation of good faith may only indirectly result in liability, i.e. duty of
good faith is not an independent fiduciary duty on the same footing as the other
two.
o (2) Duty of loyalty encompasses not only financial or other cognizable
fiduciary conflict of interest but also cases where the fiduciary fails to act in
good faith.
 “We hold that Caremark articulates the necessary conditions predicate for director
oversight liability: (a) the director utterly failed to implement any reporting or information
systems or controls; or (b) having implemented such a system or controls, consciously
failed to monitor or oversee its operations thus disabling themselves from being informed
of risks or problems requiring their attention.”
 The facts reveal that Defendant had established a reasonable information and reporting
system and had set up various departments and committees to oversee AmSouth’s
compliance with federal banking regulations. This system also enabled the board to
periodically monitor such compliance.
 While it is clear with hindsight that the organization’s internal controls were inadequate
there were also no “red flags” to notify the board of any wrongdoing. Defendant took the
steps they needed to ensure that a reasonable information and reporting system was in
place.
 Therefore, although there ultimately may have been failures by employees to report
deficiencies to the board, there is no basis for an oversight claim seeking to hold the
directors personally liable for such failures by the employees.
Holding Affirmed, Complaint was properly dismissed
Notes

C. DERIVATIVE ASPECTS (CORPORATE COMPLIANCE) (Corporate Compliance (381-395))

 Analytical Sequence:
o 1. Direct or Derivative?
o 2. If derivative, demand excused or required? Standard:
 Complaint create reasonable doubt BoD could have exercised independent judgment in
responding to a demand?
 Substantial risk of monetary liability?
o 3. Risk of liability analysis depends on whether 102(b)(7) clause is present
o 4. If so, is there reason to believe plaintiff can show loyalty or bad faith?
 BoP? Probably defendant, b/c 102(b) is an “affirmative defense”
o 5. If only care claim, 102(b)(7) precludes liability and demand required
 In real world, plaintiff probably goes away
 o 6. If bad faith or loyalty, liability cannot be exculpated
o 7. Liability risk high enough to excuse demand?
 If so, defendants probably settle
 If not, SLC?
 If not, pre-trial substantive motions: remember determinations to this point all “reasonable doubt”
based on pleadings and limited discovery

In re China Agritech, Inc. Shareholder Derivative Litigation, Del Ch Ct 2013 (Page 382)
Facts  China Agritech, Inc. (Agritech) was a fertilizer manufacturer headquartered in China.
Albert Rish (plaintiff), a shareholder, filed a derivative suit in the Delaware Court of
Chancery against Agritech’s board of directors (defendants), which included Agritech’s
two co-founders.
 Among other claims, Rish asserted that the defendants breached their obligation of good
faith due to a systematic lack of oversight at Agritech. In 2008, Agritech established an
Audit Committee comprised of directors.
 In 2009 and 2010, Agritech engaged in a series of major transactions, including acquiring
additional interest in a company Agritech’s co-founders owned.
 At the time, Agritech had five directors including the co-founders. The three other directors
sat on the Audit Committee. Despite this and other major transactions, there is no evidence
that the Audit Committee met in 2009 or 2010.
 In August 2010, Agritech disclosed in its Securities and Exchange Commission (SEC) 10-
Q filing that material weaknesses had undermined its controls and procedures. In its
following 10-Q, Agritech claimed that the weaknesses were fixed and, days later, fired its
outside auditor. The Audit Committee approved the firing, but there is no record of the
Audit Committee meeting during this time.
 In addition, Rish alleged that in four of five years, Agritech reported significant profits to
the SEC, but reported losses to the parallel regulatory agency in China.
 Rish argued that making a litigation demand on the defendants would have been futile.
 The defendants moved to dismiss Rish’s claims on the ground that Rish did not
successfully plead demand futility.
Issue (1) Will a derivative action be dismissed where the plaintiff has pleaded particularized
facts that support a reasonable inference that a majority of the members of the board on
whom demand would have been made were not independent or disinterested and would
face a substantial risk of liability for oversight violations?
(2) Where a corporation has a provision in its certificate of incorporation that exculpates
directors for a breach of the duty of care, does such a provision sheidl directors from
claims that implicate the duty of loyalty and its embedded requirement of good faith?
Rule of Law (1) A derivative action will not be dismissed where the plaintiff has pleaded particularized
facts that support a reasonable inference that a majority of the members of the board
on whom demand would have been made were not independent or disinterested and
would face a substantial risk of liability for oversight violations.
(2) Where a corporation has a provision in its certificate of incorporation that exculpates
directors for breach of the duty of care, such a provision does not shield the directors
from claims that implicate the duty of loyalty ad its embedded requirements of good
faith.
Reasoning (1) Because Rish did not make a litigation demand on the board, and the company opposed his
efforts to pursue litigation, he must allege with particularity the reasons for not making the
effort to make a litigation demand. The Court must then determine based on those allegations
whether demand was excused because the directors were incapable of making an impartial
decision regarding whether to institute such litigation. Once Rish pleaded particularized
allegations, he would be entitled to all reasonable inferences that logically flowed from the
alleged particularized facts.
 Aronson v. Lewis when a derivative plaintiff challenges an earlier board decision made
by the same directors who remain in office at the time suit is filed, the court must decide
whether, under the particularized facts alleged, a reasonable doubt is created by: (1) the
directors were disinterested ad independent, and (2) the challenged transaction was
otherwise the product of a valid exercise of business judgement.
 Rales v. Blasband a director cannot consider a litigation demand if the director is
interested in the alleged wrong-doing, not independent, or would face a “substantial
likelihood” of liability if suit were filed.
o To show that a director faces a “substantial risk of liability,” a plaintiff does not
need to demonstrate a reasonable probability of success on the claim, but rather
only make a threshold showing, through the allegations of particularized facts,
that the claims have some merit.
 The Complaint challenged at least three events that involved actual decisions: the Yinglong
transaction; the termination of the outside auditors; and the Special Committee’s
determination to take no action.
 Because the majority of the board members held their seats at the time those decisions
were made (5 out of 7), Aronson would provide the demand futility standard for those five
directors. Rales would provide the standard for the other two but there is no need because
the Aronson analysis alone established demand futility.
 In re Caremark Int’l. Inc. Deriv. Litig a board has a fiduciary obligation to adopt internal
information and reporting systems that are reasonably designed to provide senior
management and to the board itself timely, accurate information sufficient to allow
management and the board, each within its scope, to reach informed judgements
concerning both the corporation’s compliance with the law and its business performance.
o If a corporation suffers losses proximately caused by fraud or illegal conduct,
and if those directors failed to attempt in good faith to assure that an adequate
corporate information and reporting system existed, then there is a sufficient
connection between the occurrence of the illegal conduct and the board level
action or conscious inaction to support liability. “Caremark claim.”
 Here Risk’s allegations support a reasonable inference that China Agritech had a formally
constituted audit committee that failed to meet, based on the company’s failure to product
any audit committee meeting minutes for the period which the company “engaged in the
Yinglong Transaction, conducted the Offering, disclosed a material weakness in its
disclosure controls and procedures. Claimed to have fixed the problem, terminated Crowe
Horwath as its outside auditor, hired Ernst & Young as its new outside auditor, and named
Dai’s daughter as head of China Agritech’s internal audit department.”
 Discrepancies in the company’s filings with governmental agencies reinforce the inference
of an audit committee that existed in name only, and it can be further inferred that the
members of the audit committee acted in bad faith in the sense that they consciously
disregarded their duties.
 Three of the directors faced substantial risk of liability for their involvement in the audit
committee for knowingly disregarding their duties of oversight, thus, these directors could
not validly consider a litigation demand.
 Dai, one of those members, could not validly consider a litigation demand for the
additional reason that during this period his daughter served as vice president of finance,
and then as head of the internal audit department. This is because close family relationships
create a reasonable doubt as to the independence of a director.
 Chang, too, could not have considered demand because he would face a substantial risk of
liability in that Ernst & Young pointed the finger directly at Chang as having engaged in
fraud and making misleading statements.
  Because the directors who would be unable to consider demand comprised a majority of
the Demand board, demand was futile under Rales for purposes of the Caremark claim.
(2) 8 Del. C. § 102(b)(7)allows corporations to put provisions in their governing instruments
that exculpates directors from liability for breaches of the duty of due care.
 China Agritech had such a provision but the defendants could not invoke that provision at
this stage, since Rish has asserted claims that implicate the duty of loyalty and the
requirement of good faith.
 The challenged Yinglong Transaction was an interested transaction with a controlling
shareholder, so that entire fairness is the standard of review. Under that standard the
inherently interested nature of the implicated transactions renders the claims inextricably
interwined with issues of loyalty.
 Other claims also raise the issue of whether the directors acted in good faith.
 Thus, the defendants may not invoke the company’s exculpatory provision at this stage.
Holding (1) The Court held that demand was futile
(2) The 8 Del. C. § 102(b)(7) provision in the articles of incorporation did not protect the
directors.
Notes

 Limited Liability Statutes:

o DGCL §102(b)(7) provides that a corporation's articles of incorporation may (but need not) contain:
 A provision eliminating or limiting the personal liability of a director to the corporation or its
stockholders for monetary damages for breach of fiduciary duty as a director ....
 “…. provided that such provision shall not eliminate or limit the liability of a director:
 (i) For any breach of the director's duty of loyalty to the corporation or its stockholders;
 (ii) for acts or omissions not in good faith or which involve intentional misconduct or a
knowing violation of law;
 (iii) under §174 of this title [relating to liability for unlawful dividends];
 or (iv) for any transaction from which the director derived an improper personal benefit”

o Possible Claims Exculpated by 102(b)(7)

 o Notes:
 Applies only to directors
 Although officers also are subject to a duty of care, they are denied exculpation by
charter provision.
 Limits only the monetary liability of directors—equitable remedies are still available
 A §102(b)(7) provision is an affirmative defense
 Distinguishes self-dealing ("improper personal benefit") and bad faith from the duty of care.

4. DISCLOSURE AND FAIRNESS (Introduction to Securities (409-411, 425-442))

  US Capital Markets:
o New York Stock Exchange (NYSE)
o NASDAQ
o American Stock Exchange (AMEX)
o Over the Counter Bulletin Boards (OTCBB)
o Pink Sheets

 Securities Laws:
o Securities Act of 1933
 Regulates the offering and sale of new securities
o Securities Exchange Act of 1934
 Regulates secondary market activity
o Purpose of Securities laws is full disclosure for investors and fraud prevention.

 Disclosure:
o Securities Act
 Transactional
 Registration statement filed with SEC
 Prospectus distributed to investors
 Required in connection with any public sale
o Securities Exchange Act
 Periodic
 Form 10 (once)
 Fork 10-K (annual)
 Form 10-Q (quarterly)
 Form 8-K (episodic)
 Only required of registered companies

NOTE ON SECURITIES ACT CIVIL LIABILITIES (409-411)

 Selling Securities under the Securities Act of 1933

 Important Civil Liabilities:

 o 1933 Act § 11
 Fraud in the registration statement
 Due diligence defense
o 1933 Act § 12(a)(1)
 Strict liability for illegal offers and sales
 Rescission remedy
o 1933 Act § 12(a)(2)
 Fraud in a prospectus or oral sales communication
o Implied private rights of action
 1934 Act § 10(b) and SEC Rule 10b-5
 1934 Act § 14(a) and proxy rules

 Securities Act §11—the principal express cause of action directed at fraud committed in connection with the sale
of securities through the use of a registration statement.
o May not be used in connection with an exempt offering because material misrepresentation no omission
must be in the registration statement.
o Neither reliance nor causation are generally elements of the plaintiff’s prima facie case
o Defendant has the burden of proof that the misconduct did not cause the plaintiff’s damages.
o Potential defendants could include anyone who signed the registration statement, directors in or about to
become directors at the time of the registration statement, all experts certifying the statement.
 Securities Act §12(a)(1)—imposes strict liability on sellers of securities for offers or sales made in violation of
§5.
o Seller improperly fails to register the securities, or fails to deliver a statutory prospectus
o Main remedy is rescission: the buyer can recover the consideration paid, plus interest, less income
received on the security.
 Securities Act §12(a)(2)—imposes private civil liability on any person who offers or sells a security in interstate
commerce, who makes a material misrepresentation or omission in connection with the offer or sale, and cannot
prove he did not know of the misrepresentation or omission and could not have known even with the exercise of
reasonable care.
o Prima facie case has six elements: (1) the sale of a security; (2) through instruments of interstate
commerce or the mails; (3) by means of a prospectus or oral communication; (4) containing an unture
statement or omission of a material fact; (5) by a defendant who offered or sold the security; and (6)
which the defendant knew or should have known if the untrue statement.
o Plaintiff need not prove reliance.
o Liability arises only with respect to material misrepresentations or omissions made in written documents
or oral communications used in connection with public offerings. No liability in secondary market
transactions or private placements.
o Defendants other than the issuer the degree of fault required is essentially a negligence standard, burden
of proof is on the defendant.
 Defendant who conducted reasonable investigation cannot be held liable.
 Exchange Act §10(b)—requires the plaintiff to prove that the defendant acted with scienter.

NOTE ON INTEGRATED DISCLOSURE AND EXCHANGE ACT DISCLOSURES (425)

 The Securities Act requires disclosure with respect to particular transactions and the Exchange Act imposes a
system of periodic disclosures on certain companies.
 The SEC adopted a modern integrated disclosure system:
o Form 10—the first time the issuer registers a class of securities
o Form 10-K—annual; contains audits financial statements and management’s reports of the previous
year’s activities and usually also incorporates the annual report
o Form 10-Q—first 3 quarters; contains unaudited financial statements and management’s report on
material recent developments.
o Form 8-K—filed 4 days after certain important events affecting the company’s operations or financial
condition.
o Form S-1—basic registration form requires detailed disclosure about the transaction and the issuer
 o Form S-3—requires only disclosure about the transaction, but the issuer must be both large and seasoned.

C. RULE 10b-5

 Rule 10b-5
o It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce, or of the mails or of any facility of any national securities exchange,
 (a) To employ any device, scheme, or artifice to defraud,
 (b) To make any untrue statement of a material fact 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
 (c) To engage in any act, practice, or course of business which operates or would operate as a
fraud or deceit upon any person,
o in connection with the purchase or sale of any security.
 Section 10(b)
o It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of
interstate commerce or of the mails, or of any facility of any national securities exchange.—
 (b) To use or employ, in connection with the purchase or sale of any security registered on a
national securities exchange or any security not so registered, … any manipulative or
deceptive device or contrivance in contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in the public interest or for the protection
of investors. …
 Elements:
o Jurisdictional nexus
o Transactional nexus
o Material misrepresentation or omission
 General standard of materiality?
 “whether there is a substantial likelihood that a reasonable shareholder would consider
the fact important” – TSC Indus., Inc. v. Northway Inc. (1976)
o When uncertain and contingent facts apply “a highly fact-dependent
probability/magnitude balancing approach”
o Reliance
 An element of claim
 Presumed in omission cases – Affiliated Ute Citizens of Utah v. US (1972)
 But Basic is a misrepresentation case
 Class certification implications
 “Fraud on the market” theory—Presumption that investor relied on integrity of market price—so
investor need not have seen misrepresentation
 Efficient Capital Markets Hypothesis (“ECMH”)—In an efficient market, current prices
always and fully reflect all relevant information about the commodities being traded
o Weak Form Efficiency— All information concerning historical prices is fully
reflected in the current price.
 Implication: prices change only in response to new information
o Semi-strong Form Efficiency—Current prices incorporate not only all historical
information but also all current public information.
 Implication: If correct, investors can not expect to profit from studying
available information because the market will have already incorporated
the information accurately into the price.
o Strong Form Efficiency— Prices incorporate all information, whether publicly
available or not
  Implication: If true, no identifiable group can systematically earn
positive abnormal returns from trading in securities – in other words,
nobody can outperform the market
 Once adjustment is made for risks and survivorship bias, mutual
funds don’t outperform the market, but insiders do
o Causation
 Two types of causation:
 Transaction causation
o Closely related to reliance
o But for the fraud, plaintiff would not have invested (or sold, etc….)
 Loss causation
o Akin to proximate cause
o Fraud caused the loss
 E.g., market doesn’t believe the misrepresentation, stock tanked due to
market decline
o Scienter
 State of mind:
 Intent to defraud (Sup Ct)
 Reckless disregard of falsity of statement (all circuits)
 Required in private party litigation – Ernst & Ernst v. Hochfelder (1976)
 Required in SEC actions – Aaron v. SEC (1980)
o Fraud or manipulation

 The Federal-State Balance

o States:
 1. Shareholder liability
 2. Corporate governance
 3. Director/officer fiduciary duties
 4. Shareholder rights/duties
o Federal:
 1. Transactional disclosure
 2. Periodic disclosure by public companies
 3. Fraud in connection with securities transactions
 Section 16(a): “Every person who is directly or indirectly the beneficial owner of more than 10 per centum of any
class of any equity security . . . or who is a director or an officer of the issuer of such security . . . within ten days
after the close of each calendar month . . . shall file with the Commission . . . a statement indicating his ownership
at the close of the calendar month and such changes in his ownership as have occurred during such calendar
month”
o Definitions:
 Officer: SEC definition includes president, CFO, chief accounting officers, VPs of principal
business units and any person with significant “policymaking function.”
 Beneficial Owner: (Rule 16a-1 cross references Rule 13d-3):
 a beneficial owner of a security includes any person who, directly or indirectly, through
any contract, arrangement, understanding, relationship, or otherwise has or shares:
o Voting power which includes the power to vote, or to direct the voting of, such
security; and/or,
o Investment power which includes the power to dispose, or to direct the
disposition of, such security. …
 A person shall be deemed to be the beneficial owner of a security … if that person has the right to
acquire beneficial ownership of such security … within sixty days, including but not limited to
any right to acquire: through the exercise of any option, warrant or right; through the conversion
of a security;
 o Forms:
 Form 3: Insiders must file no later than the effective date of the registration statement, or, if the
issuer is already registered, within ten days of becoming an officer, director, or beneficial owner.
 Form 4: Changes in ownership must be reported within two business days. Limited categories of
transactions are not subject to the two-day reporting requirement.
 Form 5: Insiders use this form to report any transactions that should have been reported earlier
on a Form 4 or were eligible for deferred reporting. If a Form must be filed, it is due 45 days after
the end of the company's fiscal year.
 Section 16(b): “any profit realized by [such beneficial owner, director, or officer] from any purchase and sale, or
any sale and purchase, of any equity security of such issuer . . . within any period of less than six months . . . shall
inure to and be recoverable by the issuer”
o Notes:
 § 16 applies only to companies that must register under the 1934 Act
 Applies only to officers, directors, or shareholders with more than 10% of the stock
 Applies to stocks and convertible debt only
 § 16(b) applies whether the sale follows the purchase or vice versa
 Any recovery goes to the company

Halliburton Co. v. Erica P. John Fund, Inc., 134 S.Ct. 2398 (2014) (Page 428)
Facts  Former shareholders of Halliburton Company (Halliburton) filed a class action lawsuit
against the company and argued that Halliburton falsified its financial statements and
misrepresented projected earnings between 1999 and 2001.
 In their petition for class certification, the shareholders invoked the "fraud on the market"
presumption to demonstrate their class-wide reliance on Halliburton's statements.
o The "fraud on the market" theory assumes that, in an efficient market, the price
of a security reflects any material, public representation affecting that security.
Therefore, under this theory, the law presumes that investors have relied on a
material misstatement when they purchase a security at an artificially high or
low price.
 The federal district court certified the shareholders as a class and prevented Halliburton
from introducing evidence that the statements did not impact its stock prices at all.
 The U.S. Court of Appeals for the Fifth Circuit affirmed and held that Halliburton could
not rebut the presumption that the plaintiffs relied on the statements until a trial on the
merits of the plaintiffs' claims.
Issue May Halliburton challenge the class certification of its former shareholders by introducing
evidence that the alleged fraud did not impact the price of the stock?
Rule of Law Defendants in a securities fraud class action, prior to the class being certified, may rebut the
presumption that plaintiffs relied on defendants’ misrepresentation by showing that the alleged
misrepresentation did not actually affect stock price.
Reasoning  The Court held that there was no reason to prevent defendants in a securities fraud case
from presenting evidence regarding the impact of alleged misinformation on stock prices
during the class certification stage.
 The Court also held that Halliburton was unable to provide adequate justification to
overrule the established precedent that plaintiffs in securities fraud cases only need to
prove a presumption of reliance on fraudulent information.
 The presumption standard is based on the generally agreed-upon principle that public
information affects stock prices. Without any evidence that this principle was
misunderstood or no longer reflects current economic realities, the presumption standard
should remain.
 Additionally, because Congress had the opportunity to pass a law that created a new
standard and chose not to do so, Congress clearly intended the presumption to stand.
  In her concurring opinion, Justice Ruth Bader Ginsburg wrote that, while allowing the
defendants to present price-impact evidence at the class certification stage may broaden
the scope of those proceedings, it should not present an undue burden to plaintiffs with
legitimate claims. Justice Stephen G. Breyer and Justice Sonia Sotomayor joined in the
concurrence.
 Justice Clarence Thomas wrote an opinion concurring in the judgment in which he
argued that the presumption of reliance standard should not be used because it is based
on a flawed understanding of economics and effectively lowers the burden of proof for
the plaintiffs. For these reasons, Justice Thomas argued that the decision in Basic v.
Levinson—the decision that established the “fraud on the market” presumption
standard—should be overruled. Justice Antonin Scalia and Justice Samuel A. Alito, Jr.
joined in the concurrence.
Holding [The disposition is not presented in the casebook excerpt]
Notes

West v. Prudential Securities, Inc., 283 F.3d 935 (7th Cir. 2002) (Page 437)
Facts  A stockbroker, James Hofman, worked for Defendant.
 Hofman told several investors, including Plaintiffs, that Jefferson Savings Bankcorp was
about to be acquired for a premium price. This inside, non-public information induced
Plaintiffs to invest in Jefferson Savings.
 The investors that were privy to the non-public information were violating a law when they
used the information, but Plaintiffs argued that unknowing investors who bought shares of
Jefferson Savings during that same time were harmed by the fraudulent information
because they purchased at an inflated price.
 Defendant argued that the information was never public so could not fall under the fraud-
on-the-market doctrine.
Issue Whether misinformation that was not available to the public can be the basis for a claim under
the fraud-on-the-market doctrine?
Rule of Law A class action may not be brought on behalf of everyone who purchased stock during a period
when a broker was violating securities laws by providing material non-public information.
Reasoning  The court found the lower court erred in applying the “fraud-on-the-market” approach
because “Oral frauds have not been allowed to proceed as class actions, for the details of
deceit differ from victim to victim, and the nature of the loss also may be statement-
specific. . . .”
 The court also found that it was difficult to find a correlation between the rise in stock
prices and the insider information. Since the information was not public the rise was based
on unsupported data and the court could not apply allow the class action to move forward.
Holding Reversed
Notes
10b-5 (455-480)

Securities and Exchange Commission v. Texas v. Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1969) (Page
455)
Facts  Defendants were officers, employees or were closely tied to employees of Texas Gulf.
Texas Gulf, utilizing a geological survey, was conducting mining exploration in Canada.
 One area, called Kidd 55, was deemed promising by the survey, and a hole was drilled with
the resulting core analyzed. The analysis showed that the minerals present in the area were
extremely rich in minerals. Several other samples verified the findings.
 Defendants did not disclose the results of the analysis to outsiders, including other officers
of Texas Gulf. Defendants did proceed to purchase shares and calls once they knew about
the results. The trading activity and sample drilling did prompt rumors in the industry of a
significant find by Texas Gulf, and on April 12, 1964 Defendants sent out a misleading
press release to calm the speculation.
 The press release misrepresented the actual results of the samples. Defendants decided to
announce the results on April 15, although the news did not reach the public until April 16.
Defendants still traded between April 12 and the announcement.
 Defendants claimed that the information was not material to the value of the company and
therefore did not feel obligated to publicly disclose the information. They also argued that
any trading after they released the news at midnight of April 16 was legitimate because
technically the news was disseminated to the public.
Issue Whether Defendants utilized material inside information when they purchase shares and calls
of Texas Gulf stock?
Rule of Law (1) Anyone in possession of material inside information must wither disclose it to the
investing public, or, if ordered not to disclose it to protect a corporate confidence,
abstain from trading in the securities concerned while such inside information remains
undisclosed.
(2) A company press release is considered to have been issued in connection with the
purchase or sale of a security for purpose of imposing liability under the federal
securities laws, and liability will flow if a reasonable investor, in the exercise of due
care, would have been misled by it.
Reasoning  The Court determined that the essence of Rule 10b-5 is “that anyone who, trading for his
own account in the securities of a corporation, has ‘access, directly or indirectly, to
information intended to be available only for a corporate purpose and not for the personal
benefit of anyone’ may not take ‘advantage of such information knowing it is unavailable
to those with whom he is dealing,’ i.e., the investing public. Matter of Cady, Roberts &
Co.”
 Also the Rule applies to anyone with material inside information, If someone possesses
they must either tell the investing public or they must refrain on trading or making
recommendations on that information.
o The Court then analyzed the Material Inside information finding that an
insider’s duty arose only in “those situations which are essentially extraordinary
in nature and which are reasonably certain to have a substantial effect on the
market price of the security if [the extraordinary situation is] disclosed.”
o “The basic test to materiality is whether a reasonable man would attach
importance. . . in determining his choice of action in the transaction in question.
Restatement, Torts § 538(2)(a).”
o “Whether facts are material within Rule 10b-5. . . will depend at a 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.”
  In regards to the individual defendant the Court found that all transactions in TGS stock or
calls by individuals with knowledge of the drilling results were made in violation of Rule
10b-5.
 In regards to the corporate defendant the Court found that they could not, based on the
record, definitively say that the press release made April 12 was deceptive or misleading to
the reasonable investor.
Holding Reversed the motion to dismiss for the individual defendant and remanded for further
proceedings for the corporate defendant.
Notes

Dirks v. Securities & Exchange Commission, 463 U.S. 636 (1983) (Page 465)
Facts  An insider that worked for Equity Funding of America told Petitioner that the company
was overstating their assets and that Petitioner, who was an officer that provided
investment analysis for a broker-dealer firm, should investigate the fraud. Petitioner
interviewed other employees who corroborated the fraudulent allegations.
 Petitioner contacted a bureau chief at The Wall Street Journal and offered his findings for
the purpose of exposing the fraud. The bureau chief, fearing a libel suit, declined to pursue
it.
 During this time, Petitioner told investors and clients about the fraud, and they reacted by
selling their stake in the company. When the stock was being heavily traded and dipped
from $26 to $15, the New York Stock Exchange halted trading and Respondent, The
Securities and Exchange Commission, investigated and found fraud.
 Respondents then filed suit against Petitioner for violations of Section:10(b) of the
Securities and Exchange Act of 1934 for using the insider information and perhaps receive
commissions from those clients.
 The trial court and appellate court agreed with Respondent, reasoning that anytime a tippee
knowingly has inside information that they should publicly disclose it or refrain from
acting upon it.
Issue Whether Petitioner violated Section:10(b) when he disclosed material nonpublic information
to clients and investors?
Rule of Law A tippee will not be liable for disclosing nonpublic information received from an insider where
the insider will not personally benefit from the disclosure so as not to be in breach of the
insider’s fiduciary duty.
Reasoning  In re Cady, Roberts & Co., SEC found that individuals other than corporate insiders could
be obligated to either disclose material nonpublic information or abstain from trading.
o Chiarella v. United States established two elements, set out in Cady, Roberts,
for Rule 10b-5 violation: “(i) the existence of a relationship affording access to
inside information intended to be available only for a corporate purpose, and
(ii) the unfairness of allowing a corporate insider to take advantage of that
information by trading without disclosure.”
o In Chiarella, the court also found that there is not general duty to disclose
nonpublic material information under §10(b) but rather such a duty arises when
there is a fiduciary relationship.
o But not all breaches of fiduciary duty will result in 10b-5 violation, unless there
is a “manipulation or deception.” “Thus, an insider will be liable under 10b-5
for inside trading only where he fails to disclose material nonpublic information
before trading on it an thus makes ‘secret profits.’ Cady, Roberts.”
 SEC interpretation: “[A] tippee breaches the fiduciary duty which he assumes from the
insider when the tippee knowingly transmits the information to someone who will probably
trade on the basis thereof.”
 Chiarella Court’s interpretation: “[a]nyone—corporate insider or not—who regularly
 receives material nonpublic information may not use that information to trade in securities
without incurring an affirmative duty to disclose.”
 This Court’s interpretation: “[A] tippee assumes a fiduciary duty to the shareholders of a
corporation not to trade on material nonpublic information only when the insider has
breached his fiduciary duty to the shareholders by disclosing the information to the tippee
and the tippee knows or should know that there has been a breach.”
o Test whether disclosure is a breach of duty: “whether the insider personally will
gain, directly of indirectly, from his disclosure.
 Based on the facts of the case the Court found that there was no actionable violation by
Dirks, that is, that Dirks had no duty to abstain from use of the inside information that he
obtained.
Holding Reversed
Notes

United States v. Hagen, 521 U.S. 642 (1997) (Page 472)

Facts  Respondent was a partner in a law firm, Dorsey & Whitney, which was representing a
company that was potentially tendering an offer for common stock of the Pillsbury
Company.
 Respondent was not personally involved in the representation, but he was aware of the
transaction enough to know that if he purchased Pillsbury securities now that they would
increase in value once the offer went through.
 Respondent was going to use the profits from this transaction to replace money that he
embezzled from the firm and its clients.
 After the offer went through, he made a $4.3 million profit.
 The SEC investigated Respondent’s transactions and claimed he violated Section:10(b) and
Section:14(e) for misappropriating confidential information.
 A jury convicted Respondent.
Issue  (1) The first issue is whether Respondent violated Section:10(b) and Rule 10b-5 when he
misappropriated nonpublic information to personally benefit through the trading of
securities.
 (2) The second issue is whether Rule 14e-3(a) exceeds the SEC’s rule-making authority as
granted by the Securities and Exchange Act.
Rule of Law (1) A person who trades in securities for a personal profit, using confidential information
misappropriated in breach of a fiduciary duty to the source of the information, is guilty
of violating Securities Exchange Act §10(b) and Rule 10b-5.
(2) The Securities and Exchange Commission (SEC) did not exceed it rulemaking authority
by promulgating Ryle 14e-3(a), which prohibits trading on undisclosed information in
a tender offer situation, even where the person has no duty to disclose the information.
Reasoning  Section 10(b) and Rule 10b-5 Analysis:
 “Classical Theory” violation occurs when a corporate insider trades in the securities of his
corporation on the basis of material, nonpublic information.
 “Misappropriation Theory” a person commits fraud “in connection with” a securities
transaction when he misappropriates confidential information for the securities purpose, in
breaching a duty owed to the source of the information.
o If a fiduciary discloses to a source that he plans to trade on nonpublic
information there is no § 10(b) violation because there is no “deceptive device.”
(may still be liable under state law).
o If a misappropriator trades on the basis of material nonpublic information he
gains an advantage by deception, deceiving the source of the information and
harms the investing public.
  “The misappropriation at issue here was properly made the subject of the § 10(b) charge
because it meets the statutory requirement that there be a “deceptive” conduct “in
connection with” securities transactions. . . .”
 Analysis of § 14(e) and Rule 14e-3(a):
 “we agree with the United States that Rule 14e-3(a), as applied to cases of this genre,
qualifies under § 14(e) as a ‘means reasonably designed to prevent’ fraudulent trading on
material, nonpublic information in the tender offer context.”
Holding  (1) Respondent did violate Section:10(b) and Rule 10b-5 because all of the element of the
rule were met.
 (2) Rule 14e-3(a) did not exceed the SEC’s rule-making authority.
Notes

Exchange Act § 14(e):

“It shall be unlawful for any person. . . to engage in any fraudulent, deceptive, or manipulative acts or
practices, in connection with any tender offer. . . . The [SEC] shall, for the purposes of this subsection,
by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and
pratices as are fraudulent, deceptive, or manipulative.”

SEC Rule 14e-3(a):

“(a) If any person has taken a substantial step or steps to commence, or has commenced, a tender offer
(the ‘offering person’), it shall constitute a fraudulent, deceptive or manipulative act or practice within
the meaning of section 14(e) of the [Exchange] Act for any other person who is in possession of material
information relating to such tender offer which information he knows or has reason to know is nonpublic
and which he knows or has reason to know has been acquired directly or indirectly from:
“(1) The offering person,
“(2) The issuer of the securities sought or to be sought by such tender offer, or
“(3) Any officer, director, partner or employee or any other person acting on behalf of the
offering person or such issuer,
“to purchase or sell or cause to be purchased or sold any of such securities or any securities convertible
into or exchangeable for any such securities or option or right to obtain or to dispose of any of the
foregoing securities, unless within a reasonable time prior to any purchase or sale of such information
and its source are publicly disclosed by press release or otherwise.”

Short-swing profits & D&O Insurance (480-501)

Reliance Electric Co. v. Emerson Electric Co., 404 U.S. 418 (1972) (Page 481)
Facts  Respondent bought 13.2% of Dodge’s shares for the purpose of taking over Dodge. Dodge
shareholders decided to merge with Petitioner instead.
 Respondent had little use for maintaining 13.2% of the ownership of a competitor, and
therefore decided to sell the shares.
 Under Section:16(b), a party that owns more than 10% of the shares of a company will
have to forfeit any profits of a sale of the stock to the parent company if the sale is within 6
months of the purchase.
 The shares at issue were worth more due to the merger, so the profits were a considerable
amount.
 Respondent’s attorney recommended that the company sell just enough shares to get under
a 10% ownership, and then make a second sale of the remaining shares to avoid liability.
 The district court held that Respondent was liable for the profits on both sales because the
split of the sale was done solely for the purpose of avoiding the Section:16(b) liability.
 The Appellate court reversed the decision regarding the second sale because the intent of
the selling party should not matter as long as they are following the statute.
Issue The issue is whether, under Section:16(b), Respondent is liable for surrendering the profits
from both sales.
Rule of Law When a holder of more than 10 percent of the stock in a corporation sells enough shares to
reduce its holdings to less than 10 percent, and then sells the balance of its shares to another
buyer within six months of its original purchase, it is not liable to the corporation for the
profits it made on the second sale.
Reasoning  When a shareholder with an interest greater than 10% sells to one buyer making him less
than 10%, then sells the remainder of his interest to a different buyer within six months of
first sale the shareholder is not liable to the corporation for the profits on the second sale.
 §16(b) imposes strict liability, regardless of the intent of the insider; but Congress did not
apply it to all transactions in which an investor relies on the information.
 A person avoids liability if he does not meet the statute’s definition of “insider,” or if he
sells more than six months after purchase.
 §16(b) states that a 10% owner must be such “both at the time of the purchase and sale. . .
of the security involved.” This language shows that a person may sell enough shares to be
below 10%, and later, but still within six months, sell additional shares free from liability
under statute.
Holding Affirmed
Notes

Foremost-McKesson, Inc. v. Provident Securities Company, 423 U.S. 232 (1976) (Page 483)
Facts  Respondent was a holding company that sought to liquidate its assets for its members.
Respondent agreed to sell assets to Petitioner in return for cash and convertible debentures
for Petitioner stock.
 The debentures were immediately convertible to Petitioner’s stock, and the total value was
greater than 10% of Petitioner’s stock. Because it was greater than 10%, Respondent was a
beneficial owner of Petitioner under Section: 16(b) of the Securities Exchange Act. The
shares were converted and distributed to the members of the Respondent holding company.
 Respondent, realizing that the value of their ownership in Petitioner made them a beneficial
owner, sought a declaratory judgment to affirm that they would not be liable for profits
realized on the shares.
 District court granted summary judgement and the court of appeals affirmed. Defendant
brought this appeal.
Issue In a purchase-sale sequence, must a beneficial owner account for profits only of he was a
beneficial owner before the purchase.
Rule of Law In a purchase-sale sequence, a beneficial owner must account for profits only if he was a
beneficial owner before the purchase.
Reasoning  In a purchase-sale sequence, a beneficial owner must account for profits only if he was the
beneficial owner before the purchase.
 §16(b) was intended to prevent officers, directors, and beneficial owners of more than 10%
interest from profiteering through short-swing securities sales based on insider information.
The section allows a corporation to retain profits realized on a purchase and sale, or sale
and purchase, of its securities within six months by officers, directors, or beneficial
owners.
 The last sentence of §16(b) provides that the provision should “not be construed to cover
any transaction where such beneficial owner was not such, both at the time of the purchase
and sale, or the sale and purchase, of the security interest.”
Holding Affirmed
Notes
 Indemnification: Agency Law
o Restatement (Third) § 8.14: Duty to Indemnify
o A principal has a duty to indemnify an agent
 (1) in accordance with the terms of any contract between them; and
 (2) unless otherwise agreed,
 (a) when the agent makes a payment
o (i) within the scope of the agent's actual authority, or
o (ii) that is beneficial to the principal, unless the agent acts officiously in making
the payment; or
 (b) when the agent suffers a loss that fairly should be borne by the principal in light of
their relationship.
o Partnership:
 UPA (1997) § 401(c): “A partnership shall reimburse a partner for payments made and indemnify
a partner for liabilities incurred by the partner in the ordinary course of the business of the
partnership or for the preservation of its business or property.”
o LLC:
 ULLCA § 403:
 (a) A limited liability company shall reimburse a member or manager for payments made
and indemnify a member or manager for liabilities incurred by the member or manager in
the ordinary course of the business of the company or for the preservation of its business
or property.
 (b) A limited liability company shall reimburse a member for an advance to the company
beyond the amount of contribution the member agreed to make.
 (c) A payment or advance made by a member which gives rise to an obligation of a
limited liability company under subsection (a) or (b) constitutes a loan to the company
upon which interest accrues from the date of the payment or advance.
o Delaware Law:
 Coverage:
 As to suits by shareholders or third parties, §145(a) authorizes the corporation – “a
corporation shall have power” – to indemnify the director or officer for expenses plus
"judgments, fines, and amounts paid in settlement" of both civil and criminal proceedings
o “if the person acted in good faith and in a manner the person reasonably believed
to be in or not opposed to the best interests of the corporation, and, with respect
to any criminal action or proceeding, had no reasonable cause to believe the
person’s conduct was unlawful”
 As to suits brought by or on behalf of the corporation, §145(b) authorizes – “a
corporation shall have power” – indemnification only for expenses, albeit including
attorney's expenses.
o “if the person acted in good faith and in a manner the person reasonably believed
to be in or not opposed to the best interests of the corporation”
o If the director or officer was held liable to the corporation, he may only be
indemnified with court approval
 Mandatory vs. Permissive Indemnification:
 Under §145(c), the corporation must indemnify a director or officer who "has been
successful on the merits or otherwise."
o As for directors and officers who are unsuccessful, check whether
indemnification is allowed by §145(a) or (b)
o If so, the corporation may – but need not – indemnify the director or officer
 Overview:
 145(a) 145(b) 145(c)

•Third party suits against •Suits by corporation against •Either third party suits or suits
director or officer director or officer by corporation against director
•Permissive •Including shareholder or officer
•Expenses plus "judgments, derivative suits •Mandatory, if director or
fines, and amounts paid in •Permissive officer "has been successful on
settlement" •Expenses only, but includes the merits or otherwise."
•Must have “acted in good faith legal fees
and in a manner the person •Only “if the person acted in
reasonably believed to be in or good faith and in a manner the
not opposed to the best person reasonably believed to
interests of the corporation, be in or not opposed to the
and, with respect to any best interests of the
criminal action or proceeding, corporation”
had no reasonable cause to •If the director or officer was
believe the person’s conduct held liable to the corporation,
was unlawful” he may only be indemnified
with court approval

 Advancement of Expenses:
 Under §145(e), the corporation may advance expenses to the officer or director provided
the latter undertakes to repay any such amount if it turns out he is not entitled to
indemnification.
o Sarbanes-Oxley prohibits loans by corporation to officers and directors. Some
think this provision may affect advancement of expenses.
o Majority view says no effect on state law
 Indemnification by Agreement:
 § 145(f) authorizes the corporation to enter into written indemnification agreements with
officers and directors that go beyond the statute: statutory indemnification rights "shall
not be deemed exclusive of any other rights" to indemnification created by "bylaw,
agreement, vote of the stockholders or disinterested directors or otherwise."

Waltuch v. Conticommodity Services, Inc., 88 F.3d 87 (2d Cir. 1996) (Page 490)
Facts  Plaintiff was a renowned silver trader. In 1979 and 1980, Plaintiff was vice-president and
chief metals trader for Defendant when the silver market price went up sharply as several
big groups bought large shares of silver futures, and then fell sharply soon afterward.
 Investors brought claims against Plaintiff and Defendant, and Plaintiff was dismissed from
the suits while Defendant paid out about $35 million.
 Plaintiff still spent $1.2 million in legal expenses. Plaintiff spent another $1 million
defending himself against CFTC charges of fraud and market manipulation.
 Waltuch brought this action to recover his legal expenses pursuant to Article Ninth of
Defendant’s articles of incorporation.
 Defendant countered that Section: 145 of Delaware’s General Corporation Law prohibits
indemnification when there is no indication of a corporate officer’s good faith.
 Plaintiff believed that the statute allowed a company to circumvent the good-faith
requirement, which they did under Article Ninth which did not contain a good-faith
requirement.
 Plaintiff also argues that since he was not responsible for paying anything in the private
suits that he fell under the “successful on the merits or otherwise” language of the statute
which would then require Defendant’s indemnification.
 Defendant argues that their private suit payments were on behalf of Plaintiff and therefore
he should not be considered successful on the merits.
 District Court ruled for defendant on this issue as well, reasoning that the plaintiff was not
 successful on the merits or otherwise because defendants settlement payments to the
plaintiff were partially on plaintiffs behalf. Plaintiff brought this appeal.
Issue (1) The first issue is whether a company can bypass the Section: 145(a) good faith
requirement.
(2) The second issue is whether Section: 145(c) regardless of good faith requires
Defendant to indemnify Plaintiff because he was successful on the merits or otherwise
in the private lawsuits.
Rule of Law (1) A provision of a corporations articles of incorporation that provides for
indemnification without including a good-faith limitation runs afoul of a statute that
permits indemnification only if the prospective indemnitee acted in good faith, even if
the statute also permits the corporation to gran rights in addition to indemnification
rights.
(2) A corporate director of officer who has been successful on the merits or otherwise
vindicated form the claims asserted against him is entitled to indemnification from the
corporation for expense reasonably incurred.
Reasoning (1) §145(a) limits a corporation’s indemnification powers to situations where the officer or
director to be indemnified acted in good faith.
 Defendant based his argument in §145(f) which only acknowledges that one seeking
indemnification may be entitled to rights other than indemnification, it does not mention
corporate power and cannot be read to free a corporation of the good faith requirement in
§145(a).
 For this reason plaintiff is not entitled to indemnification under article Ninth, which
exceeds the scope of §145(a).
(2) Escape from adverse judgement or other detriment, for whatever reason, is determinative.
“Success is vindication.” To go behind the successful result is in appropriate.
 Once Plaintiff achieved his settlement gratis, he achieved success “on the merits or
otherwise.” According defendant must indemnify plaintiff under §145© for the $1.2
million in unreimbursed legal fees he spent defending the private lawsuit.
Holding (1) Affirmed on issue 1
(2) Reversed on issue 2
Notes

Citadel Holding Corporation v. Roven, Del Supp Ct 1992 (Page 497)

Facts  Plaintiff served as the director of Defendant company from 1985 to 1988. In 1987, Plaintiff
requested, and Defendant agreed to, an amendment to strengthen his indemnification
rights.
 The amendment provided for an advancement to Plaintiff for legal expenses he may incur
for litigation stemming from his position with the company.
  Defendant brought an action under Section: 16(b) of the Securities Exchange Act after
Plaintiff purchase shares of Defendant stock. Plaintiff then sought an advance for the legal
expenses, but Defendant refused, arguing that the indemnification agreement was not
meant to include Section: 16(b) actions.
 The trial court ruled that Defendant should advance Plaintiff the money but did not force
Defendant to pay the accrued interest.
Issue May a corporation advance reasonable costs of defending a suit to a director even when the
suit is brought by the corporation?
Rule of Law A corporation may advance reasonable costs defending a suit to a director even when the suit
is brought by the corporation.
Reasoning  Reasonable expenses are expenses related to the corporation’s business. The General
Corporation Law of Delaware, a corporation may advance such costs to a director. and in
this case,
 In this case, the intent of the indemnification agreement was to extend Plaintiff’s
protection. it became mandatory for the corporation advance the amount to the Plaintiff,
since the proceedings were related to proceedings that deal with the Defendant
Corporation’s line of business, thus are reasonable.
Holding Affirmed the prejudgment and postjudgment-interest awarded to Plaintiff.
Notes

CHAPTER 6—PROBLEMS OF CONTROL

1. PROXY FIGHTS (Proxy fights (503-513,523-531,537-547))

A. STRATEGIC USE OF PROXIES

 Voting at annual (or special) meetings
o DGCL § 216: Decisions must be approved by the vote of a majority of the shares present
 A few matters require approval by a majority of the outstanding shares; e.g.:
 Mergers
 Amendments to the charter
 Election of directors traditionally required a plurality of votes cast.
 Proxy Contests
o A shareholder (a.k.a. the insurgent) solicits votes in opposition to the incumbent board of directors
 Electoral contests: Insurgent runs a slate of directors in opposition to slate nominated by
incumbent board
 Issue contests: Shareholder solicits votes against some proposal
o Shareholder appoints a proxy (a.k.a. proxy agent) to vote his/her shares at the meeting
o Appointment effected by means of a proxy (a.k.a. proxy card)
 Can specify how shares to be voted or give agent discretion
 Revocable
 SEC Proxy Rules:
o Proxy Card Requirements: mostly Rule 14a-4
o Securities Exchange Act § 14(a): “It shall be unlawful for any person, by use of the mails or by any
means or instrumentality of interstate commerce or of any facility of a national securities exchange or
otherwise, in contravention of such rules and regulations as the Commission may prescribe as necessary
or appropriate in the public interest or for the protection of investors, to solicit … any proxy … in respect
of any security … registered pursuant to Section 12 of this title”
o 14a-3: Incumbent directors must provide annual report before soliciting proxies for annual meeting
 Anyone who “solicits” a proxy must provide a written proxy statement BEFORE soliciting the
proxy.
o Rule 14a-1(l)(2)(iv) exempts public statements of how the shareholder intends to vote and its reasons for
doing so
o Rule 14a-2(b)(1), subject to numerous exceptions, exempts persons who do not seek "the power to act as
proxy for a security holder" and do not furnish or solicit "a form of revocation, abstention, consent or
authorization
 Consequently, for example, a newspaper editorial advising a vote against incumbent managers is
now definitively exempted
 LILCO ad probably okay now
o Rule 14a-2(b)(2) exempts solicitations of 10 or fewer persons
o Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice by someone with whom the shareholder
has a business relationship
 Solicitation
o “Solicit” includes not only “direct requests to furnish, revoke or withhold proxies, but also ...
communications which may indirectly accomplish such a result or constitute a step in a chain of
communications designed ultimately to accomplish such a result.”—Long Island Lighting Co. v. Barbash,
779 F.2d 793, 796 (2d Cir.1985).

 Time Line for a Contested Annual Meeting

Levin v. Metro-Goldwyn-Mayer, Inc., 246 F. Supp 797 (S.D.N.Y 1967) (Page 504)
Facts  Plaintiffs and Defendants were fighting for control of MGM, and each was campaigning
for their directors to be elected at the annual shareholder’s meeting.
 Defendants used resources of the company and hired outside assistance to promote their
candidates, but Plaintiffs did not allege any fraud or corruption.
 MGM limited the proxy solicitation budget to $125,000.
Issue Whether directors of a company can use company resources to solicit proxies for an upcoming
vote for directors?
Rule of Law 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.
Reasoning  The proxy statement filed by Defendant stated that Defendant would bear all of the costs
incurred in the solicitation of the proxies. The statement also disclosed what companies
were solicited and for what amounts.
 The proxy statement also disclosed that $125,000 would be spent, excluding amounts that
would normally be spent on solicitation of proxies and costs for salaries and wages of
employees and officers.
 The proxy statement fully disclosed this situation to stockholders.
 The sums were not excessive under the circumstances.
Holding Motion for injunction denied.
Notes

B. REIMBURSEMENT OF COSTS

 Reimbursement of Expenses
o Management can use corporate funds to pay for expenses they incur in conducting their proxy solicitation
as long as the amounts are “reasonable” and the contest involves “policy” questions rather than just a
“purely personal power struggle”—Rosenfeld
 What would be a “reasonable” expense?
 Disclosure statements to shareholders
 Telephone solicitations
 In person visits to major shareholders
o Wining and dining said shareholders
o Private jet to bring major shareholders to company HQ
 Giving corporate contract to major shareholder
o Insurgent can use corporate funds to pay for expenses it incurs in conducting their proxy solicitation if it
is approved by the shareholders and the board must act first.
 Proxy contests are relatively rare because:
 Costly: only reimbursed if win; most of the benefit to free riders
 Shareholder apathy

o Reimbursement Bylaws:
  In 2009, DGCL § 113 adopted:
 (a) The bylaws may provide for the reimbursement by the corporation of expenses
incurred by a stockholder in soliciting proxies in connection with an election of directors,
subject to such procedures or conditions as the bylaws may prescribe, including:
o (1) Conditioning eligibility for reimbursement upon the number or proportion of
persons nominated by the stockholder seeking reimbursement or whether such
stockholder previously sought reimbursement for similar expenses;
o (2) Limitations on the amount of reimbursement based upon the proportion of
votes cast in favor of one or more of the persons nominated by the stockholder
seeking reimbursement, or upon the amount spent by the corporation in soliciting
proxies in connection with the election;
o (3) Limitations concerning elections of directors by cumulative voting pursuant
to § 214 of this title; or
o (4) Any other lawful condition.

Rosenfeld v. Fairchild Engine & Airplane Corp., NY Ct App 1955 (Page 507)
Facts  The old board of directors and the new board spent over $120,000 each in soliciting
proxies for a shareholder vote for new directors.
 After the new board won, they authorized Fairchild to reimburse the old board for most of
their expenses, and they voted to have Fairchild reimburse their own expenses.
 Plaintiff did not allege any fraudulent behavior, and agreed that the expenses were
reasonable, but nonetheless not legal.
 Appellate court affirmed the judgment of an official referee who dismissed plaintiffs claim,
concluding this was an issue of corporate policy. Plaintiff appealed to the highest court
Issue Whether directors can use the company treasury to fund the solicitation of proxies?
Rule of Law In a contest over policy, corporate directors have the right to make reasonable and proper
expenditures from the corporate treasury for the purpose of persuading the stockholders of the
correctness of their position and soliciting their support for policies that the directors believe,
in good faith, are in the best interest of the corporation.
Reasoning  Corporate directors are allowed to use reasonable expenditures to protect their corporate
interest, if not, incumbent directors would have no means to do so.
 The old board was reimbursed for reasonable and proper expenditure defending their
positions.
 Stockholders have the right to reimburse successful contestants for their reasonable
expenses. As such the new board was also reimbursed.
Holding Affirmed
Notes

C. PRIVATE ACTIONS FOR PROXY RULE VIOLATIONS

 Proxy Litigation:
o Fraud:
 Rule 14a-9 under 1934 Act § 14(a) prohibits misrepresentations or omissions of a material fact in
proxy materials
o Other Violations:
 Soliciting without providing proxy statement
 Failing to file proxy materials w/ SEC
 Company soliciting proxies without first providing annual report
 Miscellany

 Stock Options
 o Stock options are rights to purchase shares at a specified price during a specified period of time.
 Stock options are the most popular long-term incentive compensation approach used in U.S.
companies.
o Compensatory Stock Option Dates
 Grant date - time begins on an option at this date. Strike price is usually FMV & set at this date.
 Vesting date - when option recipient can first exercise option.
 Exercise date - when option recipient purchases the shares and takes control of the options.
 Sale date - when option recipients sells the shares and takes the option profit.
 Expiration date - end of option term, normally about 10 years after grant date.
o Exercising Stock Options
 Cash exercise – option holder pays company cash; company often uses it to buy stock back to
reduce dilution
 Cashless exercise - no investment or risk on part of recipient.
 Broker buys shares from company and immediately sells them; then delivers difference in
cash to recipient

Seinfeld v. Bartz 2002 WL 243597 (N.D. Cal. 2002) (Page 523)

Facts  Defendants wanted to increase the amount of stock options offered to outside directors
when they join and what they would receive annually.
 Defendants, in their proxy statement, listed the retainer fee for each director as $32,000.
 Plaintiff contends that if the options were valued under the Black-Scholes option valuation
method, the compensation for each outside director would be valued at $369,500 at the
issuance of the options and over $1 million at the date of the proxy statement.
 Plaintiff also argues that Defendants did not disclose the adverse tax consequences for the
company.
 Defendant argues that there is neither a statutory basis for disclosing the tax consequences
nor a requirement for the Black-Scholes value of the options.
Issue Whether the non-disclosure of the option value under the Black-Scholes method, or the tax
consequences of the options, were material omissions under Section: 14(a) of the Securities
Exchange Act?
Rule of Law Valuations of option grants to outside directors are not material information that must be
included in a corporation’s shareholder statement to solicit proxy votes.
Reasoning  Black-Scholes method for valuation of the options was not material information as a matter
of law. While the formula is complex it is the most widely accepted method for valuing
options. But no specific regulation of the SEC required Defendant to use the Black-Scholes
method.
 While some tax regulations requie that options be valued at the time of the grant, nothing
required Defendant to calculate the value of the options at the time of the grant.
 The Court reasoned that there was no substantial likelihood that the disclosure of omitted
facts would have been viewed by the reasonable investor as having significantly altered the
“total mix” of information made available.
Holding Judgement for Defendant
Notes

D. SHAREHOLDER PROPOSALS
  Shareholder Proposals
o Many companies have advance notice bylaws.
 Require advance notice of shareholder proposals and director nominations to ensure orderly
annual meeting process and to give company adequate time to strategize and prepare proxy
materials.
 Delaware Chancery Court narrowly construes these provisions and resolves ambiguities in favor
of dissident shareholders.
o Rule 14a-8: Allows qualifying shareholders to put a proposal before their fellow shareholders
 And have proxies solicited in favor of them in the company’s proxy statement
 Expense thus borne by the company
o Responses to Proposals
 Attempt to exclude on procedural or substantive grounds
 Must have specific reason to exclude that is valid under Rule 14a-8
 Include with opposing statement
 Negotiate with proponent
 Wide range of possible compromises
 Adopt proposal as submitted
o Exclusion Under Rule 14a-8

o Eligibility
 Timing: The proposal must be submitted to the corporation at least 120 days before the date on
which proxy materials were mailed for the previous year's annual shareholder's meeting.
 Holdings: 14a-8(b)(1): Proponent must have owned at least 1% or $2,000 (whichever is less) of
the issuer's securities for at least one year prior to the date on which the proposal is submitted.
 Length: 14a-8(d): Proposal plus supporting statement cannot exceed 500 words
 Submitting Proposals:
 14a-8(d): Proposal plus supporting statement cannot exceed 500 words
 14a-8(d): Proposal plus supporting statement cannot exceed 500 words
 Repeat Proposals: 14a-8(d): Proposal plus supporting statement cannot exceed 500 words

Lovenheim v. Iroquois Brands, Ltd., 618 F. Supp. 554 (D.D.C. 1985) (Page 527)
Facts  Plaintiff wanted to insert a proposal to determine whether a supplier of pate de fois gras
force-fed the geese in order to enlarge the livers.
 The pate represented less than .05 percent of Defendants sales, and the product operated at
a loss. Therefore, Defendants wanted to omit the proposal.
 Defendants believed that only a proposal related to economic purposes are required to be
accepted per Rule 14a-8(c)(5), and that the 5% threshold was not exceeded.
 Plaintiff argued that material social issues that were relevant to the business would not fit
under the Rule’s exception.
Issue Whether a company could refuse a shareholder proposal for a proxy statement if the proposal
concerned less than 5% of the business sales, and the proposal was not economically based?
Rule of Law A shareholder proposal can be significantly related to the business of a securities issuer for
non-economic reasons, including social and ethical issues, and therefore may not be omitted
from the issuer’s proxy statement even if it relates to operations that account for less than 5
percent of the issuer’s total assets.
Reasoning  In an exception to the general requirement of Rule 14a-8 of the SEC regulation, Rule 14a-
8(c)(5), management may omit information from a proxy statement if it concerns a matter
relating to less than 5% of its net earnings and gross sales, or is not “otherwise significant.”
 In 1983 the SEC adopted the 5% test as an objective yardstick in deciding whether
information in a shareholder proposal merited inclusion in a proxy statement.
o But the Commission stated that proposals would be includable notwithstanding
their “failure to reach the specific economic threshold if a significant
relationship to the issuer’s business” is demonstrated on the face of the
proposal.
o Thus, the rule shows that the meaning of “significant” is not limited to
economic significance and other factors such as those of ethical and social
relevance, may also be considered.
 The Court found in light of the ethical and social significance that Plaintiff’s proposal and
the fact that it implicates a significant level of sale Plaintiff has shown a likelihood of
prevailing of the merits with regard to the issue of whether his proposal is otherwise
significantly related to the defendant’s business.
Holding Motion for Injunction granted.
Notes

CA, Inc. v. AFSCME Employees Pension Plan, Del Supp Ct 2008 (Page 537)
Facts  A shareholder of CA, Inc., AFSCME, proposed a stockholder bylaw (the “Bylaw”) and
submitted it to be included in CA’s proxy materials for its annual meeting. If adopted, the
Bylaw would have instructed the board of directors of CA to "reimburse a stockholder or
group of stock- holders (together, the "Nominator") for reasonable expenses ("Expenses")
incurred in connection with nominating one or more candidates in a contested election of
directors to the corporation’s board of directors. . . ."
 CA’s present bylaws and certificate of incorporation fail to address the reimbursement of
proxy expenses, although its certificate of incorporation did state that the behavior of the
affairs of the corporation and the management of the business were vested in the board.
 The stance was taken by CA that the proposed bylaw was not the suitable subject of
shareholder action and sought a no-action letter from the SEC.
 Two questions were certified to the state’s highest court by the SEC: "1. Is the AFSCME
Proposal a proper subject for action by shareholders as a matter of [state] law?" and "2.
Would the AFSCME Proposal, if adopted, cause CA to violate any [state] law to which it
is subject?"
 The questions were answered by the state’s highest court.
Issue (1) Is a proper subject for action by shareholders a bylaw amendment that directs corporation’s
board of directors to pay back proxy expenses?
(2) When a bylaw amendment, proposed by shareholders, fails allow the directors to keep their
full power to exercise their fiduciary duty in determining if reimbursement is proper and
instead directs a corporation’s board of directors to pay back proxy expenses, is it in violation
of the law?
Rule of Law (1) A proposal seeking to require a company to reimburse shareholders for expenses
incurred in the election of directors is a proper subject for inclusion in proxy
statements as a matter of Delaware law.
(2) A proposal seeking to require a company to reimburse shareholders for the expenses
incurred in the election of directors, if adopted, would cause the company to violate
Delaware law to which it is subject.
Reasoning (1) Delaware law provides that a proper function of bylaws is not to mandate how the board
should decide specific substantive business decisions, but to define the process and procedures
by which those decisions are made. Such bylaws are appropriate for shareholder actions
 Bylaws cannot be viewed as limiting or restricting to the powers of the BOD, these
automatically fall outside the scope of permissible bylaws.
 That reasoning, taken to its extreme, would result in eliminating altogether the shareholders
statutory right to adopt, amend or repeal bylaws.
 The Court found that the AFSCME bylaw had both the intent and the effect of regulating
the process of electing directors of CA. Therefore, the bylaw is a proper subject for
shareholder action.
(2) The bylaw does not facially violate Delaware law so the issue is whether it violates
common law rule. The bylaw would prevent the directors from exercising their full managerial
power in circumstances where their fiduciary duties would otherwise require them to deny
reimbursement.
 AFSCME argues that the bylaw relieves them of the fiduciary duty entirely, but this goes
against the most basic tenets of Delaware corporate law which is the BOD has the ultimate
responsibility for managing the business and affairs of the corporation.
Holding (1) The bylaw is proper subject for shareholder action
(2) Delaware Corporate Law holds that the BOD has the ultimate responsibility for
managing the business and affairs of the corporation.
Notes

 CA v. AFSCME
o Key issue: Is this a proper proposal under state law? If not, excludable under 14a-8(i)(1)
o The dilemma
 DGCL §109(a) maintains shareholder right to amend bylaws relating to powers of directors
 DGCL §141(a) states that the business of a corporation is managed by BoD unless otherwise
provided in the certificate
o To be valid bylaws must be?
 Court declined to “articulate with doctrinal exactitude a bright line”
 Procedural and process-oriented
o – HELD:
 Under AFSCME’s proposed bylaw, the issuer’s BOD could not refuse reimbursement, even if the
board reasonably and in good faith concludes that doing so is contrary to the issuer’s best interest
 This is an infringement on the board’s substantive powers and invalid under 141(a)

E. SHAREHOLDER INSPECTION RIGHTS

3. CONTROL IN CLOSELY HELD CORPORATIONS (Closely-held Corporations (563-591, 603-606,
611-630, 643-656, 660-666))

 Close Corporations: Locked in and Frozen Out

o Solutions:
 Voting Trust
 An agreement among shareholders under which all of the shares owned by the parties are
transferred to a trustee, who becomes the nominal, record owner of the shares
o The trustee votes the shares in accordance with the provisions of the trust
agreement, if any, and is responsible for distributing any dividends to the
beneficial owners of the shares
 Advantages:
o No possibility of shareholder deadlock, since everybody puts their shares in the
trust and trustee votes
 Disadvantages
o Loss of control.
o Duration – most states limit to ten years
o Still possible for board to oppress
 Requirements:
o Per DGCL § 218, a copy of trust document must be filed with corporation’s
registered Delaware office
o Under older Delaware statute, voting trust duration could not exceed 10 years
o
 Shareholder Agreements
 Agreements relating to election of the BOD
 Agreements relating to limitations on the BOD’s discretion
o Require certain persons as officers
o Specify compensation and/or dividend policy
o Require shareholder approval of board actions
 Very Common

Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling, Del Supp Ct 1947 (Page 563)
Facts  Plaintiff and Haley each owned 315 out of 1000 shares of Defendant company, Ringling
Brothers-Barnum & Bailey Combined Shows, with the remaining 370 shares owned by
another defendant, John Ringling North.
 The company’s board was comprised of seven members, and if each shareholder voted
independently the most likely outcome would be for each shareholder electing two board
members with North selecting the extra member.
 However, in 1941 Plaintiff and Healey contracted to pool their votes, wherein each
selected two members and then used their remaining votes to select a fifth member of their
choosing. The contract called for an arbitrator, Karl Loos, to resolve any disputes.
 The contract was terminated a year later with the parties still bound by the arbitrator
provision that called for Loos to help decide how to vote.
 In 1946, Haley could not attend the meeting and sent her husband in her place, and instead
of following Loos’ advice he chose to move for adjournment.
 Plaintiff and Defendant voted their shares, and Plaintiff brought this action to force Healey
to vote according to Loos’ decision.
 Healey argued that the agreement between her and Plaintiff was invalid as it took the
voting power away from the shareholders and gave it to a third party (Loos).
Issue May shareholders lawfully contract with each other to vote their stock in a stock pooling
agreement that is not illegal and does not violate public policy?
Rule of Law Shareholders may lawfully contract with each other to vote their stock in a stock pooling
arrangement that is not illegal and does not violate public policy.
Reasoning  Common law and statute recognize the shareholder right to contract away their voting
rights while retaining other rights incident to stock ownership.
 The provision that the arbitrator settle voting disagreements was consistent with the goal of
the joint action was not illegal or revocable. The provision does not take unlawful
advantage of the other share holders and offends no rule of public policy or the state.
 Defendants failure to vote in accordance with the arbitrators advice was a breach of the
contract. But the election should not be held invalid. Instead the relief should be to not
count defendants votes valid, which will leave one seat open. This seat will be filled in the
1947 election.
Holding The lower court’s order was modified in accordance with this opinion.
Notes

McQuade v. Stoneham, NY Ct. App 1934 (Page 570)

Facts  In 1919, Plaintiff and Defendant John McGraw each purchased 70 shares of NEC stock
from the majority 1,306 shares that Stoneham owned. NEC was the company that owned
the New York Giants.
 At the time of purchase, the parties agreed to do everything in their power to keep
Stoneham as president, McGraw as vice-president and Plaintiff as treasurer.
 Plaintiff and Stoneham had a number of conflicts concerning the operations of NEC, and in
1928, the 7-member board of directors of NEC voted in a new treasurer (McGraw and
Stoneham abstained from the vote). Plaintiff was not removed for any misconduct or
ineptitude, but rather for his conflicts with Stoneham.
 Plaintiff brought this action to be reinstated as treasurer, and he cited the agreement that he
entered with McGraw and Stoneham that provided for each of them to use their “best
endeavors” to keep each other in their respective positions.
 Defendant argued that the agreement was invalid because it granted authority to
shareholders for a decision that is normally left to the judgment of directors.
 The lower court moved to reinstate Plaintiff.
Issue Is a shareholder agreement entered into by directors as shareholders illegal and void where the
agreement purports to abrogate the directors independent judgement?
Rule of Law A shareholder agreement entered into by directors as shareholders is illegal and void where
the agreement purports to abrogate the directors’ independent judgement.
Reasoning  Shareholders of a corporation possess an inalienable right to elect directors, and may form
voting trusts to elect director who will manage consistent with their views.
 Shareholders may not enter into contracts that interfere with the directors power to exercise
their judgement independently in management.
 There was no fiduciary duty between Plaintiff and Defendants, and had no obligation to
Plaintiff as an individual if doing so was against public policy. There was no evidence that
the Defendants acted outside their best business judgement.
 Second Plaintiff was city magistrate and there was a law against city magistrate conducting
business.
Holding Reversed
Notes
  McQuade v. Stoneham
o -HELD
 Directors must exercise their independent business judgment on behalf of all shareholders
 If directors agree in advance to limit that judgment, then shareholders do not receive the benefit
of their independence
 Agreement is therefore void as against public policy

Clark v. Dodge, NY Ct. App 1936 (Page 575)

Facts  Defendant companies, Bell & Company, Inc. and Hollings-Smith Company, Inc., were co-
owned by Plaintiff (25% of shares) and Defendant (the remaining 75% of shares). The
companies manufactured medicine, the formulae that were known only by Plaintiff.
 Plaintiff entered into an agreement with Defendant wherein Plaintiff agreed to disclose the
formulae to the son of Defendant in return for a promise that Defendant would keep
Plaintiff as a director and would be entitled to 25% of all net income providing that
Plaintiff was competent in his position.
 Afterwards, Defendant did not vote Plaintiff in as director, stopped delivering 25% of the
income to Plaintiff.
 Plaintiff sought reinstatement and money owed from the stopping of payments and money
wasted by Defendant.
 Defendant countered, citing McQuade v. Stoneham (263 N. Y. 323), that the agreement
was invalid because it required Defendant as a shareholder to usurp the directors’
judgment.
Issue Where the directors are also the sole stockholders of a corporation, is a contract between them
to vote for a specific person to serve as directors legal, and not in contravention of public
policy?
Rule of Law Where the directors are also the sole stockholders of a corporation, a contract between them
to vote for specific persons to serve as directors is legal, and not in contravention of public
policy.
Reasoning  The general rule is that the BOD has the responsibility of managing the daily operations of
the corporation’s business. Court’s have held any departure from this is against public
policy.
 However, in cases where the director are also the sole shareholders of the corporation,
where the agreement does not attempt to sterilize the board, and where there is no harm to
anyone, policy concerns of shareholder interference with management decisions are no
longer applicable.
Holding Reversed.
Notes

 Clark v. Dodge
o -HELD
 McQuade designed to protect minority shareholders who were not party to the agreement
 Where the corporation has no minority shareholders, the rule is unnecessary
 But note limiting language; maybe invalid if goes beyond those limited items
Galler v. Galler, Ill Sup Ct 1964 (Page 581)
Facts  Plaintiff’s late husband and his brother, Isadore Galler, owned all but 12 shares of a close
corporation, Galler Drug (each of the brothers sold six shares to a third party that was
subject to a buyback provision allowing each brother to reclaim their six shares).
 The brothers, in an effort to provide for their families if something were to happen to either
brother, entered a shareholder agreement that would guarantee that their spouses would be
elected to the board and that each would have equal representation on the board. The
agreement also provided an annual payout to the spouses. There was no set expiration date
of the agreement provisions.
 After Plaintiff’s spouse’s death, Defendants tried to destroy all copies of the agreement.
 Plaintiff sued to review the agreement in order to enforce the provisions therein.
 Defendant argued that the shareholder agreement was unenforceable because it violated
state statutes that render invalid shareholder agreements that seek to control management
decisions.
Issue Are shareholders in a closely held corporation free to contract regarding the management of
the corporation absent the presence of an objecting minority, and threat of public injury?
Rule of Law Shareholders in a closely held corporation are free to contract regarding the management of
the corporation absent the presence of an objecting minority, and threat of public injury.
Reasoning  The general rule is that the majority shareholders in a corp. have the right to select its
managers, but closely held corps must be distinguished from publicly traded ones. Publicly
traded corp shareholders have the option to sell on the open market while closely held corp
shareholders do not (they need more protection).
 Closely held corp shareholders often serve on the BOD and as officers so their shareholder
agreements are informed decisions and the safeguards for publicly held corps do not apply.
There is no reason to extend the durational limits imposed on voting trusts to a straight
voting control agreement if there is not fraud or disadvantage to minority shareholders.
Likewise, the provision for election of ascertained persons as officers for a definite period
should be upheld.
 The purpose of the contract to provide maintenance and support for the two families was a
valid one the provisions for minimum earned surplus requirement and salary continuation
are valid means of protecting the corporation’s interest.
Holding Reversed and remanded
Notes

 Galler v. Galler
o -HELD
 Agreement Valid
 Unanimity not required if:
 1. The corporation is closely-held
 2. The minority shareholder does not object
 3. The terms are reasonable
o Policy
 Galler rests explicitly on a conception of the close corporation as a sui generis entity having more
in common with a partnership than a public corporation:
 "the shareholders of a close corporation are often also the directors and officers thereof.
With substantial shareholding interests abiding in each member of the board of directors,
it is often quite impossible to secure, as in the large public-issue corporation, independent
board judgment free from personal motivations concerning corporate policy."
Ramos v. Estrada, Cal Ct App 1992 (Page 586)
Facts  Ramos owned 50% of the shares of Broadcast Corporation, a company formed by Ramos
to start a Spanish-speaking television station in Ventura, CA. The other shares were
distributed to five other couples.
 Broadcast Corp. merged with another company, Ventura 41 Television Associates, to form
Coasta del Oro Television, Inc. The Ventura 41 group would receive 5,000 shares, and the
Broadcast Corp. group would initially receive 5,000 shares with another two shares after
six months of operation. This allowed for each side to pick four directors and for Broadcast
Corp. to elect a fifth director once the board expanded to nine directors.
 Each member of the Broadcast group entered into a shareholder agreement that required
everyone to vote according to the will of the majority, thereby assuring that the group
would maintain a director majority.
 If a member of the group did not vote according to the majority, then they were required to
offer their shares for sale to the other members.
 After the merger, Defendants chose to vote with the Ventura 41 group and against the will
of the majority of the Broadcast Corp. group, declaring that the agreement was invalid.
 Plaintiffs then attempted to enforce the share buyback clause.
 The trial court upheld the agreement and ordered the sale of Defendants’ shares back to the
members of the Broadcast Corp. group.
Issue Do voting agreements binding individual shareholders to vote in concurrence with the majority
constitute valid contracts?
Rule of Law Voting agreements binding individual shareholders to vote in concurrence with the majority
constitutes valid contract.
Reasoning  Broadcast Group did not qualify as a closely held corporation but the contract was upheld
since voting agreements are valid in various other corporate forms.
 The agreement purport’s to limit transferability of shares consistent with the theme of
effectuating the majority’s interest. It expressly provides that in the event of a member’s
failure to vote in accordance with the majority, the member effectively elects to share his
shares to the other members.
 The agreement further provides for the remedy of specific performance in the event of a
breach.
Holding Affirmed
Notes

 Ramos v. Estrada
o Estrada’s Arguments
 1. The document is a proxy which is revocable
 Court found it was a vote pooling agreement
 2. Only statutory close corporations can have vote pooling agreement
 No. Statutory authorization of VPAs for statutory close corporations not intended to
preclude their use by other close corporations
 Statutory Close Corporations
o DGCL §342 allows election of close corporation status, if:
 Articles provide that company is a close corporation
 No more than 30 sharehholders
 The corporation did not issue stock in a “public offering”
 Stock is subject to one/more transfer restrictions specified in §202
 Offer of first refusal
 Mandatory redemption / Forced transfer
 Corporation or SH approval of the transfer
 Restriction on transfer to certain persons (unless manifestly unreasonable)
 “Any other lawful restriction on transfer or registration…”
 Special Rules
o DGCL §351: Articles may permit the corporation’s business to be managed by shareholders rather than
directors
o DGCL §350: Shareholder agreement between shareholders who hold a majority of the outstanding voting
stock is valid even if it interferes with the BoD’s discretion/power
 In such cases, the directors are relieved from their fiduciary duties and those duties are imposed
on the shareholders who are party to the agreement
o DGCL §354: Shareholder agreements are valid even if they operate the corporation as if it were a
partnership
4. ABUSE OF CONTROL

Brodie v. Jordan, Mass Sup Ct 2006 (Page 603)

Facts  Walter Brodie (Walter), Barbuto, and Jordan were the three directors of Malden, a
Massachusetts corporation. Each held one-third of the shares of the corporation.
 As Walter got older and wanted to be less involved, he requested multiple times that
Barbuto and Jordan (defendants) buy out his shares. They refused. Neither the articles of
organization nor corporate bylaws called for a buyout obligation upon request.
 Eventually Walter was voted out as president and director of Malden and died five years
later.
 Walter’s executrix (Brodie) (plaintiff) inherited Walter’s shares in Malden. Upon her
requests, the defendants repeatedly failed to provide her with various company
information.
 In addition, Brodie nominated herself as director, but was voted down by the defendants.
 Brodie also requested that the defendants buy out her shares, but they again declined.
 Brodie brought suit for breach of fiduciary duty.
 The Massachusetts Superior Court held that the defendants’ actions constituted a “freeze
out” and ordered the defendants to buy out Brodie’s shares.
 The defendants appealed, but only on the issue of the buyout order.
Issue Is a forced buyout an appropriate remedy for the freeze-out of a minority shareholder in a close
corporation where such a remedy effectively grants the minority a windfall or excessively
penalizes the majority?
Rule of Law A forced buyout is an inappropriate remedy for the freeze-out of a minority shareholder in
close corporations where such a remedy effectively grants the minority windfall or excessively
penalizes the majority.
Reasoning  The appropriate remedy for a freeze-out should be to restore the minority shareholders
benefits that she reasonably expects but has not received because of the fiduciary breach.
 The problem with the trial courts remedy is that is put the plaintiff in a significantly better
position than she would have be if there was no wrongdoing, and exceeded her reasonable
expectation of benefits from her shares.
 By ordering the buy back the trial court created an artificial market for her minority shares
of the closely held corporation, an asset that would not otherwise have a market value. This
put Plaintiff in a better position that if the breach did not occur.
 For quantifiable deprivations, monetary damages will be appropriate. Prospective
injunctive relief may be granted to ensure that Plaintiff is allowed to participate in
company governance, to enjoy financial and other benefits from the business, to the extent
that her ownership interest justifies.
Holding Reversed and remanded
Notes
  Brodie v. Jordan
o -HELD
 1. MA Supreme Judicial Court: Close corporation stockholders owe one another the same
fiduciary duty in operation of the enterprise that partners owe to one another
 Freezing out minority shareholder violates the duty
 “Majority shareholders in a close corporation violate this duty when they act to “freeze
out” the minority. We have defined freeze-outs by way of example:
o “[The defendants]
o “may refuse to declare dividends;
o “they may drain off the corporation’s earnings in the form of exorbitant salaries
and bonuses to the majority shareholder-officers and perhaps to their relatives, or
in the form of high rent by the corporation for property leased from majority
shareholders ...;
o “they may deprive minority shareholders of corporate offices and of employment
by the company;
o “they may cause the corporation to sell its assets at an inadequate price to the
majority shareholders....”
 What these examples have in common is that, in each, the majority
frustrates the minority’s reasonable expectations of benefit from their
ownership of shares.
 2. Remedial Aspects:
 Forced buyout of Brodie’s shares (as ordered by the trial court) is not a permissible
remedy. It gives her more than her reasonable expectations.
 The case is remanded for an “evidentiary hearing” on money damages or injunction, or
both, with the suggestion that the judge might require the two majority shareholders to
allow the plaintiff minority shareholder to “participate in company governance” and
“may consider, among other possibilities, the propriety of compelling the declaration of
dividends.”

Jordan v. Duff and Phelps, Inc, 815 F.2d 429 (7th Cir. 1987) (Page 611)
Facts  Plaintiff was a securities analyst for Defendant. Due to a falling-out between his wife and
mother, Plaintiff believed that it would best to relocate. Because Defendant could not use
his services except in the office he was currently in, Plaintiff landed a job with another
company in late 1983.
 While he was employed with Defendant, Plaintiff bought 188 (out of 20,100) shares at
book value and could have bought 62 more shares if he wanted them. Per the agreement,
Plaintiff was to receive book value of the shares upon the termination of his employment,
and the book value would be determined as the value of the prior December 31st.
 Plaintiff stayed with the company an extra period of time in order to get the book value for
December 31, 1983 instead of 1982.
 He received a check for $23,225, but before he cashed it he noticed that Defendant had
been in merger talks with another company (talks that took place before Plaintiff’s
resignation) that would have put the shares he was eligible for at a value of $452,000, plus
be entitled to another $194,000 in “earn-out” money.
 Plaintiff wanted his stock back, but Defendant refused. Plaintiff brought this action,
arguing that if he had information concerning the merger that he would have altered his
plans and staid with the company.
 Defendant argued that they were under no obligation to disclose information, especially in
this case where there was no agreement as to the price and structure of the merger.
 Defendant also argued that it was moot to give him the stock back after he resigned
because the share agreement provided that Plaintiff had to sell his shares back after he
resigned.
Issue Do close corporations buying back their own stock have a fiduciary duty to disclose material
facts?
Rule of Law Close corporations buying their own stock have a fiduciary duty to disclose material facts.
Reasoning  The relevance of the fact does not depend on how things turn out. Thus, a failure to
disclose an important beneficial event is a violation even if things later go sour.
 To recover Plaintiff would have to establish that upon learning if the merger negoations, he
would have dropped plans to change jobs and stayed for another year, finally receiving
payment for the leveraged buyout. A jury would be entitled to conclude that Plaintiff
would’ve remained.
Dissent  The mere existence of a fiduciary relationship between a corporation and its shareholders
does not require disclosure of material information.
 The contingent nature of Plaintiff’s status as a shareholder, that is, dependent on his
continued employment, negates the existence of a right to be informed and hence a duty to
disclose.
Notes Reversed and Remanded
5. CONTROL, DURATION, AND STATUTORY DISSOLUTION

 Dissolution
o All states have provisions under which a shareholder may seek an involuntary dissolution of the
corporation.
o Dissolution leads to a winding up and liquidation of the firm, followed by a distribution of the firm’s
remaining assets to creditors and then to shareholders.
o As seen in Alaska Plastic, the Alaska law provided several grounds for involuntary dissolution (as most
states do):
 Fraud, oppression, or illegality by the majority shareholders towards the minority
 Oppression: Oppression is defined as conduct that substantially defeats a minority
shareholder’s reasonable expectations.
o Reasonable expectations:
 Were reasonable under the circumstances.
 Known (or should have been known) to the majority.
 Central to the petitioner’s decision to join the venture.
 Waste of corporate assets
o Most statutes also provide two further grounds for dissolution (look at MBCA § 14.30):
 Deadlock among the directors
 3 conditions:
o 1. The directors must be evenly divided and therefore unable to make corporate
decisions,
o 2. The shareholders must be unable to resolve the deadlock.
o 3. The deadlock must threaten irreparable injury to the corporation or prevent the
business of the corporation from being conducted to the advantage of the
shareholders.
 Shareholder deadlock
 2 conditions:
o 1. The shareholders must be evenly divided.
o 2. Because of their division the shareholders must be unable to elect a board of
directors for two years running.
o Alternatives to Dissolution: order the shareholders to buy the plaintiff’s shares at a fair price.
 Best way to stop a freeze-out is to avoid it from the start with buyout agreements

Alaska Plastics, Inc. v. Coppock, Alaska Sup Ct 1980 (Page 622)

Facts  Appellee divorced one of the three Appellant directors, and was given 150 shares (1/6 of
the outstanding shares) in the divorce settlement.
 The directors did not notify, or did not notify adequately, Appellee of four annual
shareholder meetings. The directors collected a salary or fees from the company, and they
used company money to pay for their wives to attend business meetings.
 The directors offered to purchase Appellee’s shares for $15,000, but Appellee hired an
attorney and accountant to assess the value of the shares. The accountant valued her shares
between $23 and 40 thousand, not including property owned by Appellant corporation. The
directors increased their offer at one point to $20,000.
 The directors agreed to buy another company without first notifying Appellee (although
she ratified that with a subsequent vote of approval).
 After the initial company burned down without insurance, there was another offer by one
of the directors, acting individually, to buy her shares at $20,000.
 After Appellee filed an action for an equitable remedy, the lower court ordered Appellants
to purchase her shares for $32,000 and to pay attorney fees and interest.
Issue Does the breach of the fiduciary duty of utmost good faith and loyalty owed by majority
shareholders in a close corporation support an appraisal remedy whereby the corporation is
 required to purchase the minority shareholder’s stock at fair value?
Rule of Law Majority shareholders in a closely held corporation owe a fiduciary duty of utmost good faith
and loyalty to minority shareholders.
Reasoning  Since plaintiff rejected the corporation’s buyout offer, there is no authority that would
allow a court to order specific performance on the basis of an unaccepted offer.
 Plaintiff may be entitled to monetary judgement, because the Defendants enjoyed benefits
they did not share with the plaintiff (constructive dividends). This issue however should be
decided by the trial court under State law.
Holding Remanded
Notes

 Alaska Plastic v. Coppock

o -HELD
 Court said the directors may have breached their fiduciary duties to Muir under Donahue.
 Remedy
o “Equal treatment”— require that the directors treat Muir equally with the other
shareholders.
 If the other shareholders received disguised dividends (e.g., directors’
fees), Muir should receive them as well.
 Because the other shareholders did not have the right to sell their stock to
the firm, equal treatment does not require the firm to buy Muir’s stock.
o Dissolution: to dissolve, the plaintiff must show oppression or fraud and the
lower court made no such finding
 Accordingly, remand needed

Stuparich v. Harbor Furniture Mfg., Inc., Cal Ct App 2000 (Page 643)
Facts  Plaintiffs are two sisters who owned a majority of the non-voting shares and a smaller
percentage of voting shares of Harbor Furniture. Their brother, Malcolm, Jr., controlled
Harbor Furniture with his 51.56% voting share ownership. The shares were passed down
by family members to both parties.
 Harbor Furniture was comprised of two business ventures: a furniture company which lost
money, and a mobile home park which was lucrative.
 Malcolm, Jr. actively participated in the business early on, and he was able to collect a
majority of shares by buying his father’s stock at a reduced rate. He collected a salary (as
did his wife and son), but the company paid dividends to the shareholders.
 Defendants sometimes neglected to keep Plaintiffs informed of all business activities, and
Plaintiffs never had an active role in running the company.
 Plaintiffs at one point mistakenly believed that they had had a majority of voting shares of
the company, and they called for a vote to divide the two ventures. The vote was refused,
and Malcolm, Jr. repeatedly refused to buy out the Plaintiffs’ shares.
 The relationship between the parties became strained to the point where Malcolm, Jr.
physically injured one of the Plaintiffs.
 Plaintiffs then brought this action to dissolve the company, arguing that they were given no
role in the company while Malcolm, Jr. has a vested interest in continuing the venture (he
draws a salary), and the relationships were strained beyond repair.
 The trial court sided with Defendants and granted their summary judgment.
Issue Is statutory dissolution of a close corporation reasonably necessary for shareholder protection
on the grounds of animosity among the corporate directors?
Rule of Law Statutory dissolution of a close corporation is not reasonably necessary for shareholder
protection on the grounds of animosity among the corporate directors.
Reasoning  To provide a close corporation shareholder with a remedy, legislation permits any
 shareholder of a close corporation to initiate dissolution. Since this remedy is so drastic it
should be appropriately limited.
 Here there was no mismanagement, unfairness or even corporate deadlock, there was only
hard feelings and ill will among the directors.
 The only evidence Plaintiff brought was that they were not allowed meaningful
participation in the corporation and that they had an economic interest in reducing the
losses of the company.
 The court held that it should not become involved “in the tweaking of corporate
performance” and that such action was covered under the “business judgement rule.”
 The court also found that the distribution of the voting shares was in accordance with
California law and that it did not itself present reason for dissolution. The opportunity to
participate and speak, as here, is all the minority shareholder is entitled to and may expect.
Holding Affirmed
Notes

6. TRANSFER OF CONTROL

Frandsen v. Jensen-Sundquist Agency, Inc., 802 F.2d 941 (7th Cir. 1986) (Page 649)
Facts  Jensen-Sundquist was a holding company comprised of the First Bank of Grantsburg and a
small insurance company.
 In 1975, Walter Jensen owned all of the stock of Jensen-Sundquist, but gave 52% to family
and sold 8% to Plaintiff.
 Plaintiff also received a right of first refusal to purchase the majority block of shares, and
also had the right to have his shares purchased by the majority if they were to be sold to a
third party.
 In 1984, Jensen-Sundquist entered discussions with First Wisconsin, wherein First
Wisconsin would purchase Jensen-Sundquist for $62 per share.
 Plaintiff refused to go along, and the agreement between Defendants was modified to allow
Jensen-Sundquist to treat the First Bank of Grantsburg as an asset that would be sold off to
First Wisconsin for $88 per share.
 Plaintiff protested, arguing that he had the right of first refusal and that the only reason
they avoided offering that right to Plaintiff was to make sure the president of Jensen-
Sundquist did not lose his job under Plaintiff.
Issue In a transfer of control of a company, are the rights of first refusal to buy shares at the offer
price to be interpreted narrowly?
Rule of Law In a transfer of control of a company, the rights of first refusal to buy shares at the offer price
are to be interpreted narrowly.
Reasoning  Plaintiff’s right of first refusal was never triggered because there was never an offer within
the scope the stockholder agreement.
 The buyer never wanted to buy the majority of shares but wanted to acquire the bank so no
sale of stock was ever contemplated. A sale of the majority bloc’s stock is different than a
sale of the holding company’s assets.
 The sale of assets does not result in substituting a new majority bloc, and that possibility
was the one that the contract was aimed at, not the sale of the assets.
Holding Affirmed
Notes

Zetlin v. Hanson Holdings, Inc., NY Ct App 1979 (Page 653)

Facts  Plaintiff owned 2% of Gable Industries, Inc.
 Defendants owned 44.4% of the outstanding shares which they sold to Flintkote Co. for
$15, giving Flintkote the controlling majority.
 The open market value of the shares was $7.38 per share.
 Plaintiff brought this action, believing all of the Gable shareholders were entitled to the
premium paid by Flintkote.
Issue Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts
of bad faith, is a controlling stockholder free to sell, and is a purchaser free to buy, that
controlling interest at a premium price without the minority shareholders being entitled to
share in that premium?
Rule of Law Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts
of bad faith, a controlling stockholder is free to sell, and a purchaser is free to buy, that
controlling interest at a premium price without the minority shareholder being entitled to
share in that premium.
Reasoning  Minority shareholder are entitled to protection against abuse by majority shareholders, but
they are not entitled to inhibit the legitimate interest of the other stockholders.
 This is why control shares usually command a premium price, it is the amount the buyer is
willing to pay for the privilege of directly influencing the corporation’s affairs.
Holding Affirmed
Notes

Essex Universal Corporation v. Yates, 305 F.2d 572 (2d Cir. 1962) (Page 660)
Facts  Plaintiff offered to purchase between 566,223 shares at $8 per share ($2 more per share
than the market value) of Republic Pictures shares from Defendant. This represented
28.3% of the outstanding shares of Republic Pictures.
 Plaintiff was going to pay 37.5% of the total price up front and pay the rest over 24
monthly payments, during which time Defendant would hold on to the certificates as
security.
 Defendant agreed that once Plaintiff closed on the transaction that Defendant would have 8
of the 14 board members resign so Plaintiff could replace them with their own members.
 When the parties met to close the deal, Defendant refused.
 Plaintiff then brought this action for $2.7 million to recover the difference between their
price and what the shares were worth.
 Defendant argued that the agreement was invalid because it called for terminating
management.
Issue May a sale of controlling interest in a corporation include immediate transfer of control?
Rule of Law A sale of a controlling interest in a corporation may include immediate transfer of control.
Reasoning  It is the law that control of a corporation may not be sold absent the sale of sufficient
shares to transfer such control. This is based on the idea that that control of a corporation
derives from corporate voting, and is not a personal right.
 If a block of stock is sold which is sufficient to transfer control, the buyer can, through
normal director voting process, install a directorate of his choosing.
 This being so, there is no reason why such transfer should not be assignable upon sale.
 Transfer of control is inevitable is such a situation, and goals of corporate efficiency will
be promoted by allowing it in circumstances such as these.
Holding Remanded
Notes

CHAPTER 7—MERGERS, ACQUISITIONS, AND TAKEOVERS

1. MERGERS AND ACQUISITIONS (M&A (677-703))

B. FREEZE-OUT MERGERS

 Legal Effects of a Merger DGCL § 259(a): “When any merger … shall have become effective …, for all
purposes of the laws of this State the separate existence of all the constituent corporations … except the one into
which the other … constituent corporations have been merged … shall cease and the [surviving] corporation
[shall possess] all the rights, privileges, powers and franchises ..., and [be] subject to all the restrictions,
disabilities and duties of each of such corporations so merged or consolidated …and all property, real, personal
and mixed, and all debts due to any of said constituent corporations … shall be vested in the corporation
surviving … from such merger … but all rights of creditors … of any of said constituent corporations shall be
preserved unimpaired, and all debts, liabilities and duties of the respective constituent corporations shall
thenceforth attach to said surviving … corporation …”
o Merger One company absorbs another
o ConsolidationNew company formed

 Mergers: Step by Step

o 1. DGCL § 251(b)
 T and A boards adopt Merger Agreement
 DGCL § 251(b)(3): surviving entity’s charter can be amended at this point
 DGCL § 251(b)(5): Allows cash, property, and securities in addition to Acquirer common as
consideration
o 2. DGCL § 251(c)
 SH vote at A and T: majority of shares entitled to vote thereon
o 3. DGCL § 251(c)
 File articles of merger
 Merger effective at this point
o 4. DGCL § 262: Appraisal rights

 Mergers v. Asset Sales

o Initiation
 Mergers- Merger takes effect when the articles of merger are filed with the requisite state official
 Key events thereupon take place by operation of law
 Asset Sales- Statutory sale of assets is much more complicated
 As a result, the mechanics of transferring control and consideration are more complex
o Tax Consequence
 Mergers- If merger structured as tax-free reorganization, no tax consequences to shareholders.
 Asset Sales- Double taxation of asset sales:
 Tax at the corporate level based on difference in the depreciated tax book value of the
assets sold and the sum of the purchase price and the liabilities assumed.
 Tax at the shareholder level (assuming liquidation) based on the difference between the
tax basis of the shareholder’s stock and the liquidating distribution.
o Ease of Transferring Control
 Mergers- When a merger becomes effective, the separate existence of all corporate parties, with
the exception of the surviving corporation, comes to an end
 Asset Sales- In an asset sale, the target company remains in existence at least for a little while
after the asset sale has been completed
 Only title to the assets change hands, both corporations remain alive.

o Ease of Transferring Assets

 Mergers- In a merger, title to all property owned by each corporate party is automatically vested
in the surviving corporation
  Asset Sales- In an asset sale, documents of transfer must be prepared with respect to every asset
being sold and those documents must be filed with every applicable agency
o Successor Liability
 Mergers- In a merger, the surviving company succeeds to all liabilities of each corporate party
 Asset Sales- In an asset sale, the company purchasing the assets does not take the liabilities of the
selling company unless there has been a written assumption of liabilities
o Ease of Passing Consideration
 Mergers- In a merger, the consideration passes to non-dissenting shareholders
 Asset Sales- Because the target is still in existence, one option is to distribute the consideration as
a dividend
 More often the target is formally dissolved and its remaining assets (including the
consideration paid in the acquisition) are distributed to its shareholders in a final
liquidating dividend
o Shareholder Voting and Appraisal
 Mergers-
 Approval
o Both company’s boards
o Both company’s shareholders
 Appraisal
o Available to shareholders of both corporations
 Asset Sales-
 Delaware § 271 requires approval of a sale of substantially all the corporation’s assets by
the board and shareholders of the selling corporation
o Shareholder approval must be by a majority of the outstanding shares
 Delaware does not require that the shareholders of the purchasing corporation approve
the transaction. Only the board of the purchasing corporation need approve the
transaction
 Nobody gets appraisal rights under Delaware law in an asset sale transaction

 Triangular Transactions—Provides the transaction cost-minimizing advantages of an asset sale, while also
providing the advantages a merger.
o Froward Triangular Merger

o Reverse Triangular Merger

 Effects:
 Old Target Shareholders: DGCL § 251(b)(5): The plan of merger shall specify “the
manner of converting the shares of each of the constituent corporations into … cash …
securities of any other corporation or entity which the holders of such shares are to
receive in exchange for [their] shares”
 Target Perspective: The target ends up as a wholly owned subsidiary of the buyer
o Former target shareholders either become shareholders of the acquirer or are
bought out
  Acquirer’s Perspective: the parent company itself would be the only shareholder of the
newly formed subsidiary
 Successor Liability: the target in effect remains in being as a wholly owned subsidiary of
the true acquirer.
o The target is solely responsible for its obligations, unless P can pierce the
corporate veil.
 Freeze Out Techniques

o Freeze Out Merger

o Short Form Merger

o Reverse Stock Split

 Tender Offer + Merger

o Unilateral two step freeze out vs. Negotiated two step freeze out
 Reasons and benefits of freezing out minority shareholders
o Minority shareholders trade-off the private benefits of control and benefits associated with the monitoring
function of a large shareholder.
o Possible private benefits of freeze-out
 Eliminates reporting and registration costs
 Lower contracting cost
 Eliminates holdup
 No requirement for market-based transfer pricing
 Asset/output specificity
 Information asymmetry:
 Market price does not reflect the private information known to the controlling
shareholder
o Limitations of the private benefits of control
 A difference in review standards underlies “core self dealing” vs. “business judgment”.
 Transfer pricing
 Asset transfers
 Cross collateralization
 Transactions involving “interested” parties
 Fairness review potentially applied to all transactions that have an asymmetric affect across
shareholders.
o Freeze-out motives
 Bad actor/controller:
 Changes in shareholder wealth associated with the freeze-out bid accrue
disproportionately to controlling shareholders
o Board representation is inadequate
o Third-party bid competition is unlikely
o Legal recourse is costly/inadequate
 Gains sharing:
 Changes in shareholder wealth associated with the freeze-out bid accrue roughly equally
(on pro rata basis) to controlling and minority shareholders
o Remedies
 Weinberger:
 Relief for unfair mergers usually is limited to the appraisal remedy
 In cases of fraud, misrepresentation, self-dealing, deliberate waste of corporate assets or
gross and palpable over-reaching, relief may be available outside appraisal

 Standards of review
 o Legal Background: Alternative standards of judicial review for claims of breach of fiduciary duties in
sales transactions
o Standard of review has implications for the cost and uncertainty of fiduciary duty lawsuits – regardless of
the merits, the standard of review impacts the stage at which non-meritorious suits can be dismissed and,
therefore, the settlement value
 Business judgment rule significantly increases likelihood of potential dismissal of claims without
merit; likelihood of winning at trial when motion to dismiss is denied
o Business Judgment Rule
 Courts typically do not probe substantive basis of Board’s decision
 Motions to dismiss or for summary judgment are routinely granted
 Plaintiff has burden of proving that directors breached their fiduciary duties
o Entire Fairness
 Much higher bar than deferential business judgment rule
 Motions to dismiss or for summary judgment are rarely granted
 Defendant has burden of proving two prongs
 (1) Fair Dealing
o Weinberger, “embraces questions of when the transaction was timed, how it was
initiated, structured, negotiated, disclosed to the directors, and how the approvals
of the directors and the stockholders were obtained.”
 E.g. Conflicted target board; Use of confidential information; Lack of
disclosure to target board; Misrepresentations to target board or
shareholders; Undue time pressure
 (2) Fair Price
o Weinberger, “relates to the economic and financial considerations of the
proposed merger, including ... assets, market value, earnings, future prospects”
 E.g. Quasi-Appraisal

Weinberger v. UOP, Inc., Del Sup Ct 1983 (Page 677)

Facts  Signal sold off a subsidiary company for $420 million in cash and desired to turn around
and reinvest the money.
 In 1975, Signal decided to purchase a majority stake in UOP. Signal paid $21 per share (it
was trading at around $14) to obtain 50.5% of UOP’s shares.
 In 1978, Signal still had a great deal of money left over, and with no other attractive
investments they decided to acquire all remaining shares of UOP. At this point, Signal had
placed seven directors, including the president and CEO James Crawford, on the 13-
member board. Two directors that served on both the board of Signal and of UOP, Charles
Arledge and Andrew Chitiea, performed a study using information obtained from UOP that
determined it would be in Signal’s interest to get the remaining shares of UOP stock for
anything under $24 per share. The Signal board decided to offer between $20-21.
 Signal discussed the proposal with Crawford, and he thought the price was generous,
provided that employees of UOP would have access to decent benefits under Signal. He
never suggested a price over $21.
 Crawford hired James Glanville to render a fairness opinion despite the fact that
Glanville’s firm also did work for Signal. Glanville also had a short amount of time to
prepare the opinion, and his number was the same as Signal’s.
 The UOP board, using the fairness opinion as its guide but not the Arledge-Chitiea study,
voted unanimously to recommend the merger.
Issue Is a freeze-out merger approved without full disclosure of share value to minority shareholders
valid?
Rule of Law A freeze-out merger approved without full disclosure of share value to minority shareholders
 is invalid.
Reasoning  For a freeze-out merger to be valid the transaction must be fair. To be fair two conditions
must be met: (1) shareholders must be informed of all relevant facts prior to voting, and (2)
the price given must be fair.
 A plaintiff in suit challenging a cash out merger must allege specific acts for fraud,
misrepresentation, or other items of misconduct to demonstrate the unfairness of the
merger to the minority.
 Initially the burden of proof is on the plaintiff to demonstrate some basis for invoking the
fairness obligation, then the burden is on the majority shareholder to prove fairness. Where
a corporate action have been approved by a majority of the minority, the burden shifts to
the plaintiff to show the transaction was unfair to the minority. Throughout, the majority
shareholder has the burden of showing that all material facts were completely disclosed.
 Here the fiduciary duty to disclose was breached because material information in the form
of the report stating anything under $24 per share would be advantageous to the Defendant
yet they voted on $21 because they lacked this information. Since this material information
was withheld the merger was not fair, as to fair price and fair dealing, and should be
voided.
 The remedy should be appraisal, but with a valuation process that accounts for proof of
value by all current and widely accepted methods of valuation, including but not limited to,
discounted cash flows. The injured minority shareholders are entitled to fair value based on
relevant factors, including elements of future value that are not speculative and that are
susceptible of proof.
 The court also abolished the “prior business purpose test” as it no longer provided any
additional, meaningful protection to minority shareholders.
Holding Reversed and Remanded
Notes

 Evolving Standards of Review

 A Unified Standard Emerges; Kahn v. MFW

o Intended benefits of Kahn v. MFW

  Encourage use of both shareholder protections
 “By giving controlling stockholders the opportunity to have a going private transaction
reviewed under the business judgment rule, a strong incentive is created to give minority
stockholders broader access to the transactional structure that is most likely to effectively
protect their interests"
 Permit early-stage dismissal of spurious shareholder litigation and minimize legal costs and delay
o Potential limitations of Kahn v. MFW
 Continued likelihood of costly discovery (significant opportunity for complaints to survive
motion to dismiss)
 Risk of adopting unwaivable majority-of-the-minority condition
 Unclear whether settlement costs will be substantially reduced (vs. entire fairness cases)
 For those defendants that choose to go to trial, potential to win even under entire fairness by
demonstrating effective special committee without majority of the minority condition
 Uncertainty regarding consequences of controlling stockholder deviating from “promise” to only
move forward with shareholder protections

Kahn v. M & F Worldwide Corp., 88 A.3d 635 (2014) (Page 687)

Facts  MacAndrews & Forbes Holdings, Inc. (M & F) (defendant) was a 43 percent stockholder
in M & F Worldwide Corp. (MFW). M & F proposed to buy the remaining common stock
of MFW to take the corporation private.
 The transaction was subject to two stockholder-protective procedural conditions: (1) the
approval of a special committee to be appointed by the MFW board of directors, and (2)
the approval of a majority vote of MFW minority stockholders. The MFW board
established the special committee, which approved the transaction. The minority
stockholders voted to approve the merger.
 Kahn, et al. (plaintiffs) brought suit, arguing that even both protections combined are
inadequate to protect minority stockholders, because directors on the special committee
may be inept or timid and MFW minority stockholders may be subject to improper
influence.
 The plaintiffs claimed that the entire fairness standard should apply to the merger.
 In addition, the plaintiffs alleged that the special committee was not independent because
of various relationships between members of the special committee and M & F.
 The Delaware Court of Chancery ruled in favor of M & F.
 The plaintiffs appealed.
Issue Will a going private, controller buyout merger be reviewed under the business judgement
standard of review if, and only if: (i) the controller conditions the procession of the transaction
on the approval of both a special committee and a majority of minority stockholders; (ii) the
special committee is independent; (iii) the special committee is empowered to freely select its
own advisors and to say no definitively; (iv) the special committee meets its duty of care in
negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion
of the minority?
Rule of Law A going private, controller buyout merger will be reviewed under the business judgement
standard of review if, and only if: (i) the controller conditions the procession of the
transaction on the approval of both a special committee and a majority of the minority
stockholders; (ii) the special committee is independent; (iii) the special committee is
empowered to freely select its own advisors and to say no definitively; (iv) the special
committee meets its duty of care in negotiating a fair price; (v) the cote of the minority is
informed; and (vi) there is no coercion of the minority.
Reasoning  This case presents an issue of first impression: what should the standard of review for a
merger between a controlling shareholder and its subsidiary, where the merger is
conditioned ab initio upon the approval of both an independent, adequately empowered
 special committee that fulfills its duty of care, and the uncoerced, informed vote of a
majority of the minority shareholders?
 The Chancery Court reasoned that by giving controlling stockholders the opportunity to
have a private transaction reviewed under the business judgement rule was an incentive to
have both procedural protections in place for the minority shareholders.
 Khan (P) argues that neither of these protections is adequate in protecting minority
shareholders because director’s timidity may undermine the special committee requirement
and the majority-of-the-minority requirement may be influenced by shareholders
institutional bias that only look for premiums, no matter how insignificant.
(i) The Court found that the dual protections were effective despite Kahn’s argument. First,
shareholders effectively protect the shareholders, and when they don’t there is a remedy,
second minority stockholders will vote against going private not for fear of retribution, but
instead for premiums. The business judgement rule is the correct standard of review.
 A controller that uses only one of the dual procedural protections continues to receive
burden shifting within the entire fairness standard of review framework.
 The Court then shifted to analyzing whether the standard for business judgement review of
a controlled merger had been met.
(ii) Kahn claimed that 3 or the 4 special committee members were not independent, but he
failed to adduce sufficient evidence that they controlled by Perelman (D) that they would not
be able to make independent decisions regarding the merger.
o Webb (D)—engaged in business dealings with Perelman 9 years before but this
did not raise a triable fact issue regarding his independence.
o Dinh (D)—the fees that his law firm received from M & F (D) was de minimus
and would not have influenced his decision making process. The relationship
between Dinh (D), M & F (D), and Schwartz (D) did not create a triable issue
of fact because Schwartz (D) could not influence Dinh’s (D) tenure, and
Schwartz (D) invited Dinh (D) the join the board of another company months
after the merger.
o Byorum (D)—no triable facts as to independence because no evidence was
presented to show that she had an ongoing economic relationship with
Perelman (D) that was material to her in any way.
 Therefore, there was insufficient evidence, applying the subjective standard, that the
directors’ ties with Perelman (D) or M & F (D) and its affiliates were material, in the sense
that the alleged ties could have affected the impartiality of any individual director.
Accordingly, the special committee was independent.
(iii) The committee was empowered to hire its own advisors, and to negotiate with M & F (D)
over the deal terms. The committee also had the power to reject the deal outright if it believed
the deal was not in the best interest of the minority shareholders. The committee did not have
the authority to sell MFW (D) to buyers other than M & F (D), the committee nevertheless
explored other sales options that might generate more value for shareholders.
(iv) The committee also exercised due care, meeting frequently, and reviewing the rich body of
financial information relevant to whether and at what price a going private transaction was
advisable.
(v)(vi)It was undisputed that the majority-of-the-minority vote was informed and uncoerced.
 Therefore, all conditions under the standard are met.
Holding Affirmed
Notes ab initio—from the beginning; starting at the beginning

 Tender Offers
 o In its basic form, a tender offer is simply a public offer usually made to all shareholders of the target
corporation in which the buyer offers to purchase target company shares
o Most potent weapon in the hostile corporate raiders arsenal
 Advantages over major alternatives, such as asset sales or mergers:
 Approval by the target’s board of directors is a necessary prerequisite to statutory
transactions
o Tender offer permits the bidder to bypass the target’s board and to purchase a
controlling share block directly from the stockholders
o Until the late 1960s, almost total lack of legal rules applicable to cash tender
offers

Coggins v. New England Patriots Football Club, Inc., Mass Sup Jud Ct 1986 (Page 697)
Facts  Defendant president, William Sullivan, Jr., bought the New England Patriots in 1959 for
$25,000. Four months later, he had nine others buy into the team for $25,000 each, and
each of the ten owners was given 10,000 shares. Another four months later, 120,000
nonvoting shares were issued for $5 each.
 In 1974 the other owners removed Sullivan from his presidency but by November of 1975,
after securing a personal loan for over $5 million, he owned all 100,000 voting shares (at
$102 per share) and put in his own directors.
 The loan required Sullivan to use the Defendant corporation’s profits and assets to repay
the loan, but he could not do this without complete ownership.
 Sullivan then created a second corporation, appointed the same directors, and then voted to
merge the two companies into the new one. The shareholders of the old company would
receive $15 per share.
 Plaintiff was a fan of the team and proudly owned ten shares of the corporation.
 Plaintiff brought this action after he was forced to sell his shares pursuant to a freeze-out
merger initiated by directors who, he asserted, violated their fiduciary duties when they
voted while holding directorships for both companies.
 Defendants argued that each class of shares approved of the merger.
Issue Do Controlling stockholders violate their fiduciary duties when they cause a merger to be
made for the sole purpose of eliminating minority shareholders on a cash-out basis?
Rule of Law Controlling stockholders violate their fiduciary duties when they cause a merger to be made
for the sole purpose of eliminating the minority shareholders on the cash-out basis.
Reasoning  To be valid a freeze-out merger must be “fair.” To be fair, two conditions must be met: fair
dealing and fair price.
 Fair dealing means the majority shareholder must act not only for his own benefit, but for
the benefit of the corporation as a whole. It must serve a business purpose. If the majority
shareholder acts only for his own benefit then fair dealing is not present.
 The court found that the reason for the freeze-out merger was that under state corporation
laws the nonvoting stock had to be extinguished in order for the New England Patriots (D)
to assume Sullivan’s (D) personal liabilities incurred in his quest to regain control of the
franchise. This clearly was to benefit Sullivan and not the corporation so the transaction is
illegal.
 The remedy should not be to void the merger because it has been 10 years and this would
be harsh. Instead, the lower court should consider the present value of the Patriots and
award what the stockholders would have if the merger were rescinded (rescissory damages)
Holding Reversed and Remanded
Notes  M.A. state law says that for a merger all shareholders vote, even the non-voting
shareholders.
 Required Business Reason can be simple as we don’t want to pay public reporting costs.

2. TAKEOVERS (Takeovers (712-784, 795-807))

A. INTRODUCTION

 Planning for Defense

o Start early when implementing defenses
o John Coates’ (Harvard) found distinction between Wall Street and Silicon Valley lawyers
 Latter did not take companies public with defenses in place
 Creating defenses pre-IPO generally safest; avoids later shareholder objections

 Shark Repellents
o Provisions in the articles of incorporation or bylaws; articles better, see DGCL § 109(a)
 Examples:
 Limit shareholder right to call a special meeting (so that they can’t remove directors)
 Prohibit removal of directors other than for cause
o Fair Price Provision
 No backend or freeze-out merger unless bidder pays a fair price (as determined per provision) or
transaction approved by a majority of the disinterested shareholders (as defined)
o Redemption Provision
 Gives post-tender offer minority shareholders a put option to sell at a fair price (as defined)
o Business Combination Provision
 Precludes a freeze-out merger for a specified period of time; and even then typically requires
approval by disinterested shareholders
o Classified boards
 Divide board into classes (usually 3)
 Each class serves a multiyear term (equally to the number of classes)
 Only one class elected per year
 Poison Pills
o The term “poison pill” refers to the adoption by the target board of directors of a stockholder rights plan
that has the effect of deterring any corporate raider or would-be hostile party from purchasing stock of the
target corporation beyond a specified trigger level without approval of the target board.
 First Generation Preferred Stock Pill Example (Lenox 1983):
 Getting the preferred stock out to shareholders:
o Issue a dividend consisting of nonvoting, convertible preferred stock , the
dividend issuing at the ration of one preferred share for every X amount of
common stock
 Antitakeover effect: Based on the conversion feature of the preferred stock
o If the company is acquired the preferred stock is convertible to common stock of
the acquiring company and well below the market price (i.e. a flip over pill)
 The second generation discriminatory “flip-in/flip-over” pill
o The board declares a dividend of one stock purchase right for each outstanding common share (the
company also enters into a rights agreement with a bank or trust company acting as rights agent, and this
agreement embodies the terms of the rights plan).
o The “right” has no economic value unless and until a bidder acquires a specified percentage of the target’s
voting stock without board approval. Doing so causes the bidder to be treated as a non-board-approved
owner, and regardless of bidder’s intentions, allows all other stockholders to purchase additional voting
stock at a discount from the current market price (the “flip-in”).
o In addition, if, after a flip-in event, the company is involved in a business combination or substantial asset
sale with any person, all stockholders (except the raider) become entitled to purchase, at a discount to
market price, the most senior voting securities of the ultimate corporate parent resulting from the
transaction (the “flip-over”).
o Almost all “rights” are subject to expiration and potential redemption by the board.
  Delaware Code § 157: Authorizes rights “entitling the holders thereof to purchase from the
corporation any shares of its capital stock”
 Analogy to anti-destruction provisions in convertible securities
 NOL Pills
o Losses accumulated in prior periods can be used to offset future profits
o Under IRS regulations, NOLs are are forfeited if an “ownership change” occurs at the company.
 An ownership change occurs (simplified) if any shareholder owning 5 percent or more of the
company increases its ownership by more than 50 percent
o Companies have been adopting NOL poison pills to protect tax status of their NOLs.
 Very low triggers of 4.99% stockownership
 Purportedly to ensure compliance with the tax code
 But the net effect is that shareholders cannot go over the 4.99 percent threshold without
board approval
 Hence, an NOL pill also has the ancillary effect of being a substantial antitakeover device
that can be justified for economic reasons
 Dead Hand and No Hand Pills
o The traditional pill’s key vulnerability is its redemption feature.
 A determined hostile bidder could trigger the pill launch a proxy contest for control of the target’s
board of directors, and, if successful, cause the newly-elected board to redeem the pill.
o Toll Brothers: Could be redeemed only by those directors who had been in office when the shareholder
rights constituting the pill had become exercisable (or their approved successors).
 Closes the proxy contest/redemption loophole in standard poison pills by precluding newly
elected directors from redeeming the pill.
 Court held it was coercive and that it violated Unocal
 Poison Debt: Target issues bonds or notes with terms that make target less attractive
o Forbid an acquirer from burdening the target with further debt
o Forbid an acquirer from selling target assets
o Make a change of control an event of default
 Very effective defense against leveraged takeovers
 Shareholder Self-help: Anti-pill Bylaws:
o Bylaw amendments are one of the very few corporate actions shareholders allowed to initiate under state
law
 Federal shareholder proposal rule (Rule 14a-8) gives shareholders a mechanism to put a proposed
bylaw on the ballot
o Statutory Conflict:
 DGCL § 109(b): “The bylaws may contain any provision, not inconsistent with law or with the
certificate of incorporation, relating to the business of the corporation, the conduct of its affairs,
and its rights or powers or the rights or powers of its stockholders, directors, officers or
employees.”
 DGCL § 141(a): “The business and affairs of every corporation organized under this chapter shall
be managed by or under the direction of a board of directors, except as may be otherwise
provided in this chapter or in its certificate of incorporation.”
 Implies substantive limits on the appropriate subject matter of bylaws
 CA v. AFSCME (Del. 2008)
o Bylaws banning pills should be invalid
o Bylaw requirement that board submit pill to shareholder vote would fare batter.
Cheff v. Mathes, Del Sup Ct 1964 (Page 712)
Facts  Defendants were directors of Holland, including the CEO. Holland manufactured furnaces
and air conditioners, and it directly hired its retail sales staff (a practice that the directors
believed was a key to Holland’s success). Holland performed well during 1946 to 1948, but
sales declined until 1956.
 In 1957 the company reorganized and cut some unprofitable stores and it resulted in a
healthier bottom line.
 At the same time, shares of Holland were being bought on the open market by Arnold
Maremont, which increased share price. Maremont was well-known for taking over
companies and then liquidating their assets.
 At the very least, Maremont contacted the Holland CEO, P.T. Cheff, to inquire about a
merger with his company and altering the sales model to only sell to wholesalers. Cheff
discussed this with other directors, and they agreed to thwart Maremont’s attempts to buy
Holland in order to keep Holland running in its current state.
 Some directors agreed to personally buy the shares from Maremont if the board decided
not to do so, but the board voted to use Holland funds to purchase the shares at a premium
price of $20 per share (the net quick asset value was $14).
 Plaintiffs argued that the directors used Holland’s funds to ensure that their positions with
the company remained intact.
 The Vice-Chancellor of the lower court agreed, and therefore upheld the suit against the
defendants that had a vested interest in the purchase as a result of their positions with the
company.
Issue May corporate fiduciaries use corporate funds to fend off what they, in good faith and pursuant
to reasonable investigation, believe is a threat to corporate policy and effectiveness?
Rule of Law Corporate fiduciaries may use corporate funds to fend off what they, in good faith and
pursuant to reasonable investigation, believe is a threat to corporate policy and effectiveness.
Reasoning  Corporate fiduciaries may not use corporate funds to increase their control of the
corporation. Corporate funds may only be used for the good of the corporation.
 Activities that are undertaken for the good of the corporation that have incidental effect of
maintaining the directors’ control are permissible, but acts effected for no other reason than
to maintain control over the company are invalid. As a result the same action may or may
not be appropriate, depending on the motives of the directors.
 Burden of proof: initially it is presumed that the BOD acted in good faith, and this
presumption can be overcome by an affirmative showing of bad faith or self-dealing.
However, a repurchase is a form of self dealing so the burden should be on the directors to
show there was a legitimate business purpose.
o To satisfy this burden they must show reasonable ground to believe a danger to
corporate policy and effectiveness by the presence of the Maremont stock
ownership. They must also show they acted in good faith and with reasonable
investigation.
 The Court held that in viewing the history of Maremont’s (P) corporate takeovers and asset
sales that this was a legitimate threat to Holland’s (D) policies. This fact should have been
given weight by the lower court.
 The Court also found that the premium price paid for the Block stock should not have an
effect on the analysis because it was normal to pay premiums for large portions of stock.
 The Court held that these factors would validate the actions taken by the directors of
Holland.
Holding Reversed and remanded
Notes
B. DEVELOPMENT

Unocal Corporation v. Mesa Petroleum Co., Del Sup Ct 1985 (Page 724)
Facts  Plaintiff was a corporation led by a well-known corporate raider.
 Plaintiff offered a two-tier tender offer wherein the first tier would allow for shareholders
to sell at $54 per share and the second tier would be subsidized by securities that the court
equated with “junk bonds”.
 The threat therefore was that shareholders would rush to sell their shares for the first tier
because they did not want to be subject to the reduced value of the back-end value of the
junk securities.
 Defendant directors met to discuss their options and came up with an alternative that would
have Defendant corporation repurchase their own shares at $72 each.
 The Directors decided to exclude Plaintiffs from the tender offer because it was
counterintuitive to include the shareholder who initiated the conflict.
 The lower court held that Defendant could not exclude a shareholder from a tender offer.
Issue Is a selective tender offer, effected to thwart a takeover, in itself invalid?
Rule of Law A selective tender offer, effected to thwart a takeover, is not itself invalid.
Reasoning  In the context of a battle for corporate control, the usual deference given to the decisions of
the board of directors under the business judgement rule is somewhat circumscribed by the
fact that directors in such a situation are in an inherent conflict of interest, as self-
preservation is an issue they face.
 In spite of this threat to their corporate survival, directors must continue to put the interests
of shareholders first. Therefore, acts of the directors to defeat a takeover must be shown to
have been done because the takeover represented a danger to corporate policy and
effectiveness.
 Further, the conclusion that such a threat existed must have been made after reasonable
investigation and in good faith.
 Finally, the severity of the tactic must be reasonable in relation to the level of the perceived
threat.
 Here, the directors of Unocal (D) were faced with a situation where a coercive tender offer
had been made by a reputed “greenmailer.” The response was to effect a counteroffer that
excluded the would-be acquirer to ward off the takeover.
 Given the facts available to the board, it appears that their response was commensurate to
the threat, and therefore was valid.
Holding Affirmed
Notes This case established the “Unocal Rule” which is the standard used in assessing a takeover
defense. As the opinion states, the business judgement rule is not automatically applied to
defensive tactics. Rather, a reviewing court must look at the reasonableness of the defensive
tactic employed, due to the high possibility of interested acts on the part of the board.
 Unocal
o Standard of Review:
 Not business judgement rule because the “omnipresent specter that a board may be acting in its
own interest
 Conditional BJR “an enhanced duty which calls for judicial examinations at the threshold before
the protections of the business judgement rule may be conferred”
o Burden of Proof:
 Initially on board of directors.
 If the directors carry their burden?
o BOP shifts back to the plaintiff, who must rebut the BJR.
 If not?
o The defense must pass muster under the intrinsic fairness standard of the duty of
loyalty.
o Defining the Unocal Test:
 Was the action within the power or authority if the board?
 Requires two questions: (1) does the statute authorize this defense; and (2) if it is okay
under the statute does the firm’s charter impose any restrictions on the use of this
defense?
 Does the board have reasonable grounds for believing that a danger to corporate policy and
effectiveness exists?
 Defendant satisfy this by showing good faith and reasonable investigation
o Good faith = primary purpose not entrenchment
o Reasonable investigation = Van Gorkom
 Was the defense reasonable in relation to the threat posed?
o Post-Unocal Standards of Review:
 Traditional BJR, i.g. Van Gorkom
 Traditional duty of loyalty, i.g. Weinberger
 The new conditional BJR, set out by Unocal
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., Del Sup Ct 1985 (Page 733)
Facts  Pantry Pride’s CEO approached Revlon’s CEO and offered a $40-42 per share price for
Revlon, or $45 if it had to be a hostile takeover.
 The CEO’s had personal differences, and the court noted this as a potential motivation for
Revlon to turn elsewhere.
 Revlon’s directors met and decided to adopt a poison pill plan and to repurchase five
million of Revlon’s shares. Pantry Pride countered with a $47.50 price which pushed
Revlon to repurchase ten million shares with senior subordinated notes.
 Pantry Pride continued to increase their bids, and Revlon decided to seek another buyer in
Forstmann. Revlon offered $56.25 with the promise to increase the bidding further if
another bidding topped that price.
 Instead, Revlon made an agreement to have Forstmann pay $57.25 per share subject to
certain restrictions such as a $25 million cancellation fee for Forstmann and a no-shop
provision.
 Plaintiffs, MacAndrews & Forbes Holdings, Inc., sought to enjoin the agreement because it
was not in the best interests of the shareholders.
 Defendants argued that they needed to also consider the best interests of the noteholders.
Issue Are lockups and other defensive measures permitted where their adoption is untainted by
director interest of other breaches of fiduciary duty and where value to shareholders is
maximized?
Rule of Law Lockups and related defensive measures are permitted where their adoption in untainted by
directors interests or other breaches of fiduciary duty and where the value to shareholders is
maximized.
Reasoning  While a board is not required to be blind to all others having an interest in the corporation,
their main responsibility is to the shareholders. This means maximizing share prices.
 When, like in this case it becomes clear that the corporation is going to be taken over, it
becomes the obligation of the directors to maximize the sale price, like an auctioneer.
 Here the board of Revlon (D) to stop a hostile takeover, negotiated a sale to a suitor that
effectively ended the bidding for the corporation, preventing a higher share price.
 The deal the directors worked out was improper because once it became clear that Revlon
(D) was going to be sold, the board was obligated to seek the highest price for the shares.
This deal favored the noteholders over the shareholders.
 This invalidated the entire transaction with Forstmann (D).
Holding Affirmed
Notes This case gave rise to the “Revlon Rule” which holds that when it is clear that a target is going
to be sold, the directors basically become auctioneers and their duty is to maximize
shareholder value. Long-term corporate interests no longer matter. (Delaware Corporate Law)
 Revlon
o Several rounds of bidding, with Pantry Pride topping every Forstmann offer
o Revlon accepted Forstmann's last bid. To end auction, granted Forstmann an asset lock-up option
 The option gave Forstmann the right to buy two Revlon divisions at below market price;
exercisable if another bidder gets 40% of Revlon shares
 Divisions were Vision Care and National Health Laboratories
o Also:
o $25 million cancellation fee
o No shop clause
 Delaware Supreme Court’s Responses:
o Asset Lock-up option—invalid
 Standard of Review—Unocal
 The court treated the lock up as a take-over defense
 Violated the board of directors' fiduciary duties.
o Because the lock-up ended the bidding prematurely: “In reality, the Revlon board
ended the auction for very little improvement in the final bid”
 Distinguish between lockups that draw a bidder in and lockups that end an active auction
o No Shop—Invalid
 No shops are not per se illegal
 But this no shop is invalid. Why?
 Required the BOD to treat Forstmann more favorably than Pantry Pride
 The agreement to negotiate only with Forstmann helped end the auction prematurely
 Rule of Law from Revlon:
o When the board puts the company up for sale, they have a duty to maximize the company's value by
selling it to the highest bidder:
 "The directors' role changed from defenders of the corporate bastion to auctioneers charged with
getting the best price for the stockholders at a sale of the company."
o Triggering Revlon:
 If the transaction would result in a change of control Revlon
 If the control would not change hands as a result of the transaction  Unocal

 Non-shareholder Constituencies:
o Unocal: Target directors may consider the impact of their decisions on non-shareholder constituencies—
i.e., employees, customers, creditors, communities, and the like
o Revlon: Once an auction begins the board may no longer consider non-shareholder interests.
 Outside the auction: “A board may have regard for various constituencies in discharging its
responsibilities, provided there are rationally related benefits accruing to the shareholders.”

 Relationship between Van Gorkom and Revlon:

o Van Gorkom requires that decision to merge be an informed one
 Case implicitly approved shopping the company as a means of gathering information, but did not
require the directors to do so
o Delaware addressed in Barkan
 Holding: Revlon does not require that every control transaction be preceded by a bidding contest
 When the board is considering a single offer and has no reliable grounds for judging its
adequacy, a concern for fairness demands that the market be canvassed
o But when directors possess a body of reliable evidence with which to evaluate
the fairness of a transaction, they may approve it without an active survey of the
market
Paramount Communications, Inc. v. Time Incorporated, Del Sup Ct 1989 (Page 744)
Facts  Time decided to seek a merger or acquire a company to expand their enterprise. After
researching several options, Time decided to combine with Warner. Time was known for its
record of respectable journalism, and Warner was known for its entertainment
programming. Time wanted to partner with a company that would ensure that Time would
be able to keep their journalistic integrity post-merger.
 The plan called for Time’s president to serve as CEO while Warner shareholders would
own 62% of Time’s stock.
 Time was concerned that other parties may consider this merger as a sale of Time, and
therefore Time’s board enacted several defensive tactics, such as a no-shop clause, that
would make them unattractive to a third party.
 In response to the merger talks, Paramount made a competing offer of $175 per share which
was raised at one point to $200. Time was concerned that the journalistic integrity would be
in jeopardy under Paramount’s ownership, and they believed that shareholders would not
understand why Warner was a better suitor.
 Paramount then brought this action to prevent the Time-Warner merger, arguing that Time
put itself up for sale and under the Revlon holding the directors were required to act solely
to maximize the shareholders’ profit.
 Plaintiffs also argued that the merger failed the Unocal test because Time’s directors did not
act in a reasonable manner.
Issue May directors of a corporation involved in an ongoing business enterprise take into account all
long-term corporate objectives in responding to an offer to take over the corporation?
Rule of Law Directors of a corporation involved in an ongoing business enterprise may take into account
all long-term corporate objectives in responding to an offer to take over the corporation.
Reasoning  When a corporation is an ongoing enterprise, and is not effectively “up for sale,” the
directors are more than just auctioneers, trying to get the highest price.
 A board’s decision will be upheld under the business judgement rule if the directors can
show that the decision was not dictated by a selfish attempt to keep their jobs, but rather
was in the best interest of the corporation.
 Share price is a part of the analysis, but isn’t the only component. If the directors arrive at
the decision to reject an offer after appropriate analysis and consideration of legitimate
factors, a court will not substitute its judgement for that of the directors.
 The act of Time’s board was appropriate because the board elected to continue with a
deliberately conceived corporate plan for long term growth, rather than accept an
opportunity for short term gain.
Holding Affirmed
Notes Application of the Unocal Analysis

 Paramount Communications v. Time:

o Deal Structure
 Merger of equals
 Required the approval of both boards
 Lock-ups
 Share Exchange agreement, in effect a lock-up:
o Each party had option to trigger an exchange of shares:
 Warner would receive shares representing 11% Time’s outstanding stock
 Time would receive shares representing 9% of Warner’s outstanding
shares
 Asset lock-up (a.k.a. crown jewel option):
o Target firm grants favored bidder an option to acquire a key asset
  Stock lock-up:
o Target gives favored bidder an option to buy authorized but unissued shares
 No Shop provision
o Paramount makes a cash tender offer for Time
 Rejected by Time board as inadequate
 Warner triggers the share exchange
o Deal Restructured
 Time would make a cash tender offer for a majority block of Warner shares to be followed by a
freeze-out merger in which remaining Warner shares would be acquired
 Tender offer requires the approval of the Time BOD
 Freeze out would require the approval of the subsidiaries board and shareholders also
approval of Warner board and shareholders
o Chancellor Allen, correctly identified the “heart of the matter.”
 Where does the “locus of decision-making power. . . reside” ? With the board of the
shareholders?
 Chancellor Allen determined that the merger agreement would not result in a transfer of control
because control of the combined entity remained “in a large, fluid, changeable and changing
market.”
 Hence, no Revlon duties
 Delaware supreme court indicated Allen’s change of control analysis was correct “as a matter of
law,” but it rejected plaintiffs’ Revlon claims on “broader grounds”:
 “Under Delaware law there are, generally speaking and without excluding other
possibilities, two circumstances which may implicate Revlon duties. The first, and
clearer one, is when a corporation initiates an active bidding process seeking to sell
itself or to effect a business reorganization involving a clear break-up of the
company. However, Revlon duties may also be triggered where, in response to a
bidder’s offer, a target abandons its long-term strategy and seeks an alternative
transaction also involving the breakup of the company.”
o Aspects reviewed under Unocal:
 Grant of option and no shop – i.e., the “structural safety devices”
 Decision to recast merger as a tender offer
 Time had to identify the threat to corporate policy posed by Paramount’s offer and
demonstrate that its actions were a reasonable response to that threat.
o Threats the court identified as justifying Time’s response:
 The risk that shareholders might incorrectly value the benefits of sticking
with management’s long-term business plan
 The difficulty of comparing Paramount’s bid to the benefits of the
Warner acquisition
 The possibility that Paramount’s bid might "upset, if not confuse," the
shareholder vote
o The court rejected any inference that directors are obliged to abandon a pre-
existing business plan in order to permit short-term shareholder gains
 Because Time’s plan was "not aimed at ‘cramming down’ on its
shareholders a management-sponsored alternative, but rather had as its
goal the carrying forward of a preexisting transaction in an altered form"
and "did not preclude Paramount from making an offer for the combined
Time-Warner company," those actions were both reasonable and
proportionate in light of the threat posed by Paramount.
Paramount Communications Inc. v. QVC Network Inc., Del Sup Ct 1994 (Page 752)
Facts  Paramount was looking for possible merger or acquisition targets in order to remain
competitive in their field. The CEO of Paramount had a meeting with the CEO of Viacom
wherein they discussed Paramount merging into Viacom.
 The discussions hit a dead end until QVC sought to acquire Paramount. The discussions
between QVC and Paramount were renewed, and the parties entered a merger agreement
that had several defensive measures to prevent other companies, namely QVC, from
bidding against Viacom.
 There was a no-shop provision that prevented Paramount from soliciting other bidders; a
termination fee provision that paid Viacom $100 million if they were eventually outbid;
and a stock option provision that allowed Viacom to purchase 19.9% of Paramount’s
shares at $69.14 per share.
 The stock option provision also allowed Viacom to pay for the stock in subordinated notes
or Viacom could elect to get a cash payout for the difference between the option price and
market price.
 The stock option was significant because Paramount’s shares rose sharply and would have
led at one point to a $500 million payout to Viacom if the merger fell through.
 QVC started bidding against Viacom’s offer which forced Viacom to renegotiate with
Paramount to raise their offer – although the defensive measures were never renegotiated.
QVC raised their offer even further, but the Paramount believed that the offer was too
conditional (similar to Viacom’s offer, it was two-tiered) and the board still felt that the
merger was not in the company’s best interests.
 Therefore, the Paramount board turned down a QVC offer that could have been about $1
billion more than Viacom’s offer.
 In the lower court, Plaintiffs successfully enjoined Defendants from carrying out the
merger agreement.
Issue May the directors of a corporation targeted by two or more suitors institute tactics that favor
one suitor in such a manner as to allow the favored suitor of offer less than it otherwise would
have?
Rule of Law The directors of a corporation targeted by two or more suitors may not institute tactics that
favor one suitor in such a manner as to allow the favored suitor to offer less than it otherwise
would have.
Reasoning  Generally the BOD is given great latitude under the business judgement rule but one
exception to this rule is in the area of tactics employed to defeat an unfriendly takeover.
This is because the board is in an inherent conflict in that there is a likelihood that they will
be ousted. The specter of self-interest, rather than corporate interest, is therefore present.
 When the corporation is up for sale the board is obligated to seek the transaction that will
maximize the shareholders’ value.
 Directors are not limited in this regard to cash value only, but may analyze the entire
situation, both in short and long term. Nonetheless, when directors by their acts do
something that lessens the value that the shareholders would otherwise receive, they have
breached their fiduciary duty.
 The directors of Paramount (D) knew that a sale to either Viacom (D) or QVC (P) was
inevitable and that one of the two would end up with control of Paramount (D).
 While Paramount’s directors were free to conclude that Viacom offered Paramount the best
deal in the long run, they took steps that effectively cut off the bidding process.
 The Court found it clear that Viacom would’ve raised the ante to gain control if it needed
to do so and by cutting off the bidding, the directors of Paramount made it unnecessary to
do so. In doing this they breached their fiduciary duties to Paramount’s Shareholders.
Holding Affirmed
Notes This case is an extension of Revlon v. MacAndrews & Forbes Holdings
 QVC v. Paramount
o Paramount agrees to a merger with Viacom Inc.
 Array of defensive measures:
 Poison pill
 No shop provision
 $100 million termination fee
 Lock-up option on approximately 19.9% of Paramount’s common stock
o QVC makes a more generous offer, conditioned on a canceling of the defensive measures
 Paramount refuses on the grounds that it would be inconsistent with their contractual obligation to
Viacom.
o Authority versus Accountability
 Transactional accountability
 Conflict of interest for managers of target
 Systemic accountability
 Market for corporate control as constraint on agency costs
o Paramount relied on Time to argue that the Revlon duties had not triggered
 Paramount had neither initiated an active bidding process nor approved a breakup of the company
 A successful Paramount—Viacom merger would not have legally precluded QVC from
attempting to purchase the combined Viacom-Paramount entity
o Court rejected Paramount’s application of Time in favor of enhanced scrutiny
 In explaining need for enhanced scrutiny, the opinion stated: “Such scrutiny is mandated by: (a)
the threatened diminution of the current stockholders’ voting power; (b) the fact that an asset
belonging to public shareholders (a control premium) is being sold and may never be
available again; and (c) the traditional concern of Delaware courts for actions which impair or
impede stockholder voting rights.”
 Rejected Paramount’s reading of Time
 While the relevant passage listed initiation of an active bidding process and approval of a
break-up of the company as events triggering Revlon, it did so “without excluding other
possibilities”
 In this case, one of the “other possibilities” was present; namely, a change of control
o Accordingly, Revlon was triggered
 The QVC court did not overrule Time, but limited Time to its unique facts
o Boundaries of the Change of Control test from QVC
 So long as the acquiring entity is publicly-held, neither triangular nor non-stock for stock mergers
should be deemed a sale of control
 QVC really concerned with creation of a large block of stock held by an identifiable
control group
o Enhanced Scrutiny:
 Under QVC, the enhanced scrutiny test is basically a reasonableness inquiry to be applied on a
case-by-case basis:
 “The key features of an enhanced scrutiny test are: (a) a judicial determination regarding
the adequacy of the decision making process employed by the directors, including the
information on which the directors based their decision; and (b) a judicial examination of
the reasonableness of the directors’ action in light of the circumstances then existing.”
 “Delaware’s Motive-Based Balance”:
 Under the Unocal/Revlon regime, the board retains full decision making authority —
including the authority to foreclose shareholder choice — unless it acted from improper
motives
Lyondell Chemical Company v. Ryan, Del Sup Ct 2009 (Page 764)
Facts  Dan Smith (defendant) was chairman and CEO of Lyondell Chemical Company (Lyondell)
(defendant). Leonard Blavatnik owned Access Industries (Access), which owned
Luxembourg company Basell AF (Basell).
 Basell’s 2006 offer to acquire Lyondell was rejected. A year later, an affiliate of Access
filed a Schedule 13D disclosure indicating its right to purchase more than eight percent of
Lyondell’s stock from another company and Blavatnik’s interest in Lyondell.
 Lyondell’s directors (defendants) called a meeting. Though the Schedule 13D made clear
that Lyondell was “in play,” the directors elected not to take any action at that time.
 Blavatnik renewed his offer to Lyondell at $40 per share on July 9, 2007. Lyondell’s board
had a series of meetings to consider the offer.
 After negotiating with Blavatnik, the offer was increased to $48 per share. The board’s
independent financial and legal advisers concluded that the offer was fair and a better deal
was unlikely.
 On July 16, 2007, the board voted to recommend the merger to Lyondell’s shareholders.
The shareholders almost unanimously approved the merger.
 Ryan and others (plaintiff) filed a class action suit in the Court of Chancery against
Lyondell and its directors claiming breach of fiduciary duties regarding the negotiations
and final merger agreement.
 The trial court dismissed all claims except the claims that the merger negotiation process
was inadequate and the directors should not have agreed to the protection provisions.
Issue Are there legally prescribed steps that directors must follow to satisfy Revlon duties to
maximize price in a sale of control transaction, such that failure to take those steps during the
sale of their company demonstrates a conscious disregard of their duties?
Rule of Law There are no legally prescribed steps that directors must follow to satisfy their Revlon duties
to maximize price in a sale of control transaction, such that failure to take those steps during
the sale of their company demonstrates a conscious disregard of their duties.
Reasoning  Directors are required to act reasonably not perfectly and the Chancery Court erred in not
granting summary judgement. The Chancery Court acted under a mistaken view of the
applicable law.
 First, the Chancery Court erroneously imposed Revlon duties of the Lyondell directors (D)
before they either had decided to sell, of before the sale had become inevitable.
 Second, the court read Revlon and its progeny as creating a set of requirements that must
be satisfied during the sale process.
 Third, the Chancery Court equated an arguably imperfect attempt to carry out Revlon
duties with a knowing disregard of one’s duties that constitute bad faith.
 There is only one Revlon duty: Get the best price possible for the shareholders at the sale of
the company. Courts cannot dictate how directors reach this goal because there they face a
unique combination of circumstances, many of which are out of their control.
 Revlon duties arise when the company embarks on a change-of-control transaction, not
simply where a company is “in play.”
 Here, the Revlon duties arose in July, when negotiations began. The Chancery Court should
have focused on the week during which the directors considered Basell’s offer—during
which they met several times; Smith (D) tried to negotiate a better price; they evaluated the
proposed transaction; and they approved it.
 At best, the directors (D) conduct may have demonstrated a lack of due care, but did not
demonstrate bad faith, i.e., a conscious disregard of their duties.
 The trial court approached the record from the wrong perspective: instead of asking
whether the directors (D) did everything in their power to obtain the best sales price, they
should have asked whether those directors utterly failed to attempt to obtain the best sale
 price.
 The record shows they took steps to maximize price even though they neither conducted a
market check nor prepared for Basell’s offer once Lyondell (D) was in play.
 The directors (D) are entitled to summary judgement.
Holding Reversed
Notes

 Discouraging Competitive bidding

o Options:
 Exclusive Merger Agreements
 Best efforts clause
o Requires each party to use its best efforts to get the deal done.
o Also requires the parties to recommend the deal to their shareholders and to use
their best efforts to obtain shareholder approval.
 If a competing bid is better than this one a board member has a fiduciary
duty to present the better bid to the shareholders
 No-shop clause
o Forbids the target from soliciting other bids.
o May also forbid the target from negotiating with other bidders (a.k.a. “no
negotiation” clause).
o May also forbid target from providing information to other bidders (a.k.a. “no
talk” clause).
 Cancellation fee
o Requires target to pay the acquirer some amount in case the deal is not
consummated by a specific drop dead date.
 In effect, a liquidated damages provision.
 Lockups
 Broadly defined as any arrangement by which the target corporation gives the favored
bidder a competitive advantage over other bidders.
o Stock lockup option: Target gives bidder an option to buy some specified
percentage of authorized but unissued (or treasury) shares.
 Depending on size may function as a cancellation fee or a lockup.
o Asset lockup option: Target gives bidder an option to buy a crown jewel asset.
o Stockholder Lockups
 Outright purchase of control block raises fiduciary duty issues.
 Get controlling shareholders to sign agreements pursuant to which they
promise to approve the deal.
 Buttress with irrevocable proxies.
 Three-step Acquisitions

C. EXTENSION OF THE UNOCAL/REVLON FRAMEWORK TO NEGOTIATED ACQUISITIONS

Omnicare, Inc. v. NCS Healthcare, Inc., Del Sup Ct 2003 (Page 771)
Facts  Genesis Health Ventures, Inc. (Genesis) (defendant) entered into negotiations to acquire
NCS Healthcare, Inc. (NCS) (defendant). At the urging of Genesis, the parties entered into
an exclusivity agreement, which prevented NCS from engaging in any negotiations in
regards to a competing acquisition or transaction.
 Subsequently, Omnicare, Inc. (Omnicare) (plaintiff) contacted NCS about a proposed
transaction, but NCS did not respond due to the exclusivity agreement with Genesis.
 Complementary to Genesis’s merger proposal was a voting agreement under which Jon
Outcalt, Chairman of the NCS board, and Kevin Shaw, NCS President and CEO, agreed to
vote all of their shares—combined, a majority of NCS shares—in favor of the merger
agreement.
 This voting agreement effectively meant that NCS shareholder approval of the merger was
guaranteed even if the NCS board did not recommend its approval.
 The merger agreement, which contained a clause restricting the rights of NCS to discuss an
alternative merger with a third party, was then executed.
o The merger agreement did not contain a fiduciary out clause, which would have
given the NCS board the opportunity to opt out of the agreement if it needed to
do so to discharge its fiduciary duties to the corporation.
 Meanwhile, before the official—although futile—NCS shareholder vote on the Genesis
merger proposal, Omnicare submitted a merger proposal that was superior to that of
Genesis.
 At that point, the NCS board withdrew its recommendation that the shareholders vote in
favor of the Genesis merger agreement.
o However, the Genesis merger agreement provided that the proposal still must
be submitted to a shareholder vote and, because of the Outcalt/Shaw voting
agreement and the omission of a fiduciary out clause, that meant that the merger
agreement was going to be approved no matter what.
 Omnicare brought suit.
Issue Are lock-up deal protection devices, which when operating in concert are coercive and
preclusive, invalid and unenforceable in the absence of a fiduciary out clause?
Rule of Law Lock-up deal protection devices, which when operating in concert are coercive and preclusive,
are invalid and unenforceable in the absence of a fiduciary out clause.
Reasoning  Defensive measures required enhanced scrutiny because of the inherent potential conflict
of interest between a board’s interest in protecting a merger it has approved and the
shareholders statutory right to have the final say.
 In applying this enhanced judicial scrutiny to the defensive measures the court must
determine (1) that those measures are not preclusive or coercive, (2) before shifting its
focus to a “range of reasonableness” proportionality determinations.
o When the focus shifts to the range of reasonableness, Unocal applies special
scrutiny to the defense measures. (devices must be proportionate to the threat)
 In this case the threat to NCS (D) was the potential loss of the Genesis transaction, leaving
NCS with no alternative.
 The Court found that these defensive measures where neither reasonable nor proportionate.
 The Court then found that the defensive measures were both preclusive and coercive, and,
therefore, draconian and impermissible because any stockholder vote would be “robbed of
its effectiveness.”
 Alternatively, they are unenforceable because the merger agreement completely prevented
the board from discharging its fiduciary responsibilities to the minority shareholders when
Omnicare (P) presented its superior transaction.
 Here, the NCS board could not abdicate its fiduciary duties to the minority shareholders by
 leaving it to the shareholders to approve or disapprove of the merger because two
shareholders join to make up a majority that made the outcome of the stockholder vote a
foregone conclusion.
o The NCS board was required to negotiate a fiduciary out clause to protect the
NCS shareholders if the Genesis transaction became inferior.
Holding
Notes Del 102(b)(7)

 Omnicare
o - RULES
o Deal Protection Devices Require Enhanced Scrutiny
 Defensive devices adopted by the board to protect the original merger transaction must withstand
enhanced judicial scrutiny under the Unocal standard of review, even when that merger
transaction does NOT result in a change of control.
 When Revlon doesn’t apply to Defensive Devices, Unocal does.
 Just as defensive measures cannot be draconian, however, they cannot limit or
circumscribe the directors’ fiduciary duties.
o A board has no authority to execute a merger agreement that subsequently
prevents it from effectively discharging its ongoing fiduciary responsibilities.
o Unocal Test
 The second stage of the Unocal test requires board directors to demonstrate that their defensive
response was “reasonable in relation to the threat posed.”
 This inquiry involves a two-step analysis.
o 1) The board directors must first establish that the merger deal protection devices
adopted in response to the threat were not “coercive” or “preclusive,” and;
 Coercive
 A response is coercive if it is aimed at forcing upon stockholders
a management-sponsored alternative to a hostile offer.
 Preclusive
 A response is preclusive if it deprives stockholders of the right to
receive all tender offers or precludes a bidder from seeking
control by fundamentally restricting proxy contests or otherwise.
o NOTE: If defensive measures are either preclusive or
coercive they are draconian and impermissible.
 2) Then demonstrate that their response was within a “range of reasonable responses” to the
threat perceived.
 NOTE: A stockholder vote may be nullified by wrongful coercion “where the board or
some other party takes actions which have the effect of causing the stockholders to vote
in favor of the proposed transaction for some reason other than the merits of that
transaction.”
o - HELD
o Defensive Devices
 The defensive devices employed by the NCS board are preclusive and coercive in the
sense that they accomplished a fait accompli.
o Fait accompli - a thing that has already happened or been decided before those
affected hear about it, leaving them with no option but to accept.
 Despite the fact that the NCS board has withdrawn its recommendation for the Genesis
transaction and recommended its rejection by the stockholders, the deal protection devices
approved by the NCS board operated in concert to have a preclusive and coercive effect.
 The defensive devices made it “mathematically impossible” and “realistically
unattainable” for the Omnicare transaction or any other proposal to succeed, not matter
how superior the proposal.
  Genesis’ Ultimatum for Complete Protection in Futuro
o By accepting this, the NCS board disabled itself from exercising its own
fiduciary obligations at a time when the board’s own judgment is most important
(i.e. receipt of a subsequent superior offer).
 The merger agreement and voting agreements are inconsistent with the NCS directors’ fiduciary
duties and are invalid and unenforceable.
 - PROF
 Strangest decision*
o Genesis had recently lost a bidding war to Omnicare so it did not want to enter
another bidding war with them.
o Genesis’ Deal Protection Devices «
o - HELD
 1) Standard of Review applicable to decision to merge with Genesis?
 Chancery held BJR rather than Revlon.
o Why not Revlon?
 Stock for stock merger not a sale of control.
 2) Does a board have “authority to give a bidder reasonable structural and economic defenses…”?
 Yes, subject to enhanced scrutiny per Unocal. Refer to [RULES].
 The NCS board assured shareholder approval – COERCIVE
o In the absence of a fiduciary out clause, this mechanism precluded the directors
from exercising their continuing fiduciary obligation to negotiate a sale of the
company in interest of the shareholders. - PRECLUSIVE
 3) The problem NCS’s deal with Genesis was that there was no fiduciary out.

o Revlon issues
o When do directors stop being “defenders of the corporate bastion” and become “auctioneers”?
o Are Revlon duties really different from those imposed from Unocal?
o Omnicare says there is something special about Revlon situations.
 It is an enhanced scrutiny test.
 If Revlon applies – you get the price
 If it does not, Unocal applies:
o Board must show threat to corporate policy.
o Response must not be coercive or preclusive.
o Response must be reasonable in relation to threat.
o Omnicare seems to be a duty of care case. Even if they breach their duty of care, they have no liability.

E. STATE AND FEDERAL LEGISLATION

CTS Corporation v. Dynamics Corporation of America, 481 U.S. 69 (1987) (Page 795)
Facts  Appellee owned 9.6% of Appellant, CTS Corporation and announced a tender offer to
increase their ownership to 27.5%.
 Six days before their announcement, an Indiana law, Indiana’s Control Share Acquisitions
Act, came into effect. The Act allows for disinterested shareholders to hold a shareholders’
meeting to discuss the merits of a tender offer for controlling shares.
 Appellee argues that the Act is preempted by a federal law, the Williams Act. The
Williams Act provides guidelines that offerors need to follow when making a tender offer.
 Appellee also argues that the Indiana Act violates the Commerce Clause because it treats
in-state entities differently from out-of-state entities.
Issue (1) Is a law permitting in-state corporations to require shareholder approval prior to
significant shafts in corporate consistent with the provisions and purposes of the
Williams Act and is not pre-empted thereby?
(2) Is a law permitting in-state corporations to require shareholder approval prior to
significant shifts in corporate control constitutional as not violating the Commerce
Clause?
Rule of Law (1) A law permitting in-state corporations to require shareholder approval prior to
significant shifts in corporate control is consistent with the provisions and purposes of
the Williams Act and is not pre-empt thereby.
(2) A law permitting in-state corporations to require shareholder approval prior to
significant shifts in corporate control is constitutional as not violating the Commerce
Clause.
Reasoning (1) The Indiana Act protects independent shareholders from the coersive aspects of tender
offers by allowing them to vote as a group, and thereby furthers the Williams Act’s basic
purpose of placing investors on equal footing with takeover bidders.
 Further, the Indiana Act does not give either management nor the offeror an advantage in
communicating with shareholders, nor imposes an indefinite delay on offers, nor allow
state governments to interpose its views of fairness between willing buyers and sellers.
 The Court found that the possibility that the Indiana Act would delay some tender offers
was not enough for preemption. The Court based this on the fact that they 50 day delay fell
within the 60 day period Congress established for tendering shareholders to withdraw their
unpurchased shares.
 The Court also stated that the longstanding prevalence of state regulation in this area
suggested that if Congress had intended to preempt all such state laws, it would have said
so.
(2) The Indiana Act’s limited effect on interstate commerce is justified by the State’s interest
in defining attributes of its corporations’ shares and in protecting shareholders.
 The principal objects of dormant commerce clause scrutiny are statues discriminating
against interstate commerce, but that is not the case here because the law applies to in state
and out of state residents.
 The court of appeals found the Indiana Act unconstitutional because it had great potential
to hinder tender offers, but this Court found this was an insufficient reason to invalidate the
state Act.
 The Court found that since corporations are creatures of state law, the states are free to
regulate them, so long as they do not discriminate against in state or out of state
buyers/sellers.
Holding (1) Reversed
(2) Reversed
Dissent (White) drew a distinction between investors and shareholders. The law undermines the policy
of the Williams Act by effectively preventing minority shareholders, in some circumstances,
from acting in their own interest by selling their stock.
Notes  DGCL § 203 –3 year waiting period
 o Provides opportunity for takeovers

o Williams Act (1968)—Federal regulation of tender offers. Disclosure; Procedural requirements, albeit
mainly to make the disclosure requirements more effective
 § 13(d): Requires disclosure (Schedule 13D) by persons or groups who acquire beneficial
ownership of more than 5% of any publicly traded equity securities.
 13(d)(2)—Reporting parties must file an amendment to their Schedule 13D promptly in
the event of any material change in the facts set forth in the statement
o “Material” is defined to include (but is not limited to) any acquisition or
disposition of at least 1 percent or more of the class of securities in question
 13(d)(3) defines a person or group and generally requires some kind of agreement before
it can be said that a group exists.
 If aggregate holdings exceed 5% upon formation of the group majority view is that they
have an immediate filing requirement
 13(d)(3)(a) defines beneficial ownership as having or sharing, directly or indirectly, the
right to vote or dispose of (or direct the voting or disposition of) the stock).
 Required Disclosure includes:
o Identity
o Plans and intentions
 Including whether you intend to seek or are considering seeking control
of the issuer.
o Any contracts, arrangements, understandings or relationships with respect to the
securities of the issuer
 Litigating §13(d) cases
o Standing: Target corporation standing to sue a Schedule 13D filer either for
failing to file or filing a misleading disclosure statement:
 No standing to seek damages
 Most courts hold that there is standing to seek equitable relief
o Equitable relief: Available options:
 Injunction requiring corrective disclosures
 Injunction against further purchases or the making of a tender offer
 Rescission of stock purchases made during the period of the violation
 Divestiture of stock acquired during the period of the violation
 Suspension of voting rights and/or of the right to conduct a proxy contest
 Severe consequences for failing to file or filing an inaccurate
report are highly unlikely
 § 13(e): Regulates purchases by an issuer of its own publicly traded securities, including
purchases subsequent to commencement of a tender offer or a self-tender offer.
 § 13(f): Requires disclosure by institutional investment managers exercising investment
discretion with respect to accounts holding Section 13(f) securities if the aggregate fair market
value of such account exceeds $100 million.
 § 13(g): Requires disclosure by institutional investors who acquire beneficial ownership of more
than 5% of any publicly traded equity securities and elect to file a Schedule 13G in lieu of a
Schedule 13D.
 § 14(d): Regulates substantive aspects of, and requires disclosure (Schedule TO) in connection
with, tender offers by bidders who, upon consummation of the tender offer, would beneficially
own 5% or more of a publicly traded equity security.
 Required Disclosures: On date offer commences, bidder must file a disclosure document
on Schedule TO with the SEC
o Bidder will also:
 Announce offer via newspaper ad
 Mail Schedule TO to shareholders
  Incumbent management must either mail for bidder or provide
NOBO and CEDE lists
 § 14(e): Prohibits fraud and certain other practices in connection with a tender offer; including
establishing specific time periods for, and a target company’s disclosure obligations with respect
to, a tender offer.
 Sections 14(d) and 14(e) triggered when any person commences a tender offer for more
than five percent of a class of a target’s equity securities
o The provisions of Section 14(d) and Regulation 14D do not apply to a tender
offer by an issuer for its own the securities.
 Such tender offers are instead subject to Section 13(e) and, especially,
Rule 13e-4 which, in addition to prescribing filing, disclosure and
dissemination requirements for tender offers by an issuer for its own
equity securities, also duplicates some of the antifraud provisions
contained in Section 14(e).
 Rule 13e-4 applies to issuers with any class of equity security
registered pursuant to Section 12 of the Securities Exchange Act
of 1934 or that are required to file periodic reports under Section
15(d) of the Securities Exchange Act of 1934, as well as to
certain investment companies.
 Rule 14e-2(a) requires the target, no later than 10 business days from date of
commencement, to disclose its position with respect to the offer on Schedule 14D-9.
o This applies whether the tender offer is friendly or hostile. However, it is
customary in friendly deals for the target’s response to be filed and mailed
simultaneously with the bidder’s materials.
 § 14(f): Requires disclosure if, other than at a shareholder meeting, majority control of a target
company’s board of directors is to be changed subsequent to a transaction subject to Section
14(d) or 13(d).
o Key Procedural Rules:
 Withdrawal rights, per SEC rule 14d-7, throughout period tender offer remains open
 Minimum offer period of 20 business days
 Extension for at least 10 business days after certain material changes in the offer’s terms
 Pro rata purchase in partial tender offers (Rule 14d-8)
 14d-8: “if any person makes a tender offer or request or invitation for tenders, for less
than all of the outstanding equity securities of a class, and if a greater number of
securities are deposited pursuant thereto than such person is bound or willing to take up
and pay for, the securities taken up and paid for shall be taken up and paid for as nearly
as may be pro rata, disregarding fractions, according to the number of securities
deposited by each depositor during the period such offer, request or invitation remains
open”
 Purpose is to ban bidders from “first come first served” offers
 Best price and all holders (Rule 14d-10)
 (a) No bidder shall make a tender offer unless:
o (1) The tender offer is open to all security holders of the class of securities
subject to the tender offer ….
 Remedy:
 If bidder violates the Best Price Rule, plaintiffs allege that bidder
is required to pay the “higher” price to all shareholders.
 Rule 14e-5 prohibits bidder purchases outside of a tender offer from the time of
announcement until completion.
o Definition of Tender Offers: Found nowhere in the statute
 Various transactional strategies resulted:
 Creeping tender offers
 o A group of individuals gradually acquires target company shares in the open
market, in order to circumvent §§ 14(d) and 14(e)
o Note that still must comply with § 13(d)
 Street sweeps
o Bidder commences then terminates a classic tender offer. Then buys controlling
block of target stock from arbitrageurs through private purchases. Basically a
first-come, first-serve tender offer that circumvents best price and all-holders
rules
 Block purchases