CORPORATIONS

Corporation Partnership
 Formalities Required  Informal
 Limited Liability  Unlimited Liability
 Free Transferability (Partnership does not  Not Freely Transferable (Default rule:
matter. Shareholders can come and go.) matters who is partner. Can’t come and go)
 Continuity  At will
 Centralized Management  Equal Management Rights (Association of
 Double Taxation [Govt taxes Art. of equals)
Incorp. and Shareholders income  Single Taxation (partners pay tax when
(dividends example corporation has to file income from business is dispersed)
taxes for that too)]
Formation of Corporation
Articles of incorporation §101, 102, 106
Incorporators §107
First meeting §108
By-laws §109
Registered office §131
Promoters & liability for pre-incorporation contracts

 Setting up a Corporation
Steps in Setting Up Corporation
Choice of corporate form  Can chose sole proprietor, partnership, corporation, LLC
 Ask what are your objectives, what kind of liability are you
comfortable with?
Choice of state of  Can choose any jurisdiction, even though not the state where
incorporation business has principal office
 Internal affairs doctrine – If you chose Missouri law, then you are
subject to internal affairs doctrine.
 Focus on Delaware General Corporation Law
o We’re in Missouri. Why are we studying the law of
Delaware in this course?
 Some of the largest corporations are incorporated
there. But most do not have headquarters there.
Delaware has a liberal corporate law for
relationship between managers and shareholders.
 So many cases that construe that law. Delaware
Court of Chancery. Experts on corporate law so
wide body of doctrine which is influential in other
state courts.
 Casebook is very heavy on Delaware corporate
law.
o If chose Delaware law, then govern internal affairs but will
not apply to relationship with third parties.

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Reserve corporate name  Name must be distinctive
(*Remember that this is  Let people know that they are doing business with an entity that
not a mere formality.) has limited liability. Indicate corporate status if an LLC, must
specify (Westec)
Draft and file certificate  Provisions in Delaware law and other states that list reqs.
of incorporation including filing requirement.
 Certificate of Incorporation (§101, 102, 106)
 Bylaws (§109)

Hold first meeting of  Adopt by-laws, issue shares for consideration & take other action
directors (§108) (if directors designated in certificate; if not hold meeting of
incorporators)
 Incorporators – people who sign AoI filed with state.
 Directors – Managers (either appointed or elected)

Issue shares and accept  Must be issued to have a legitimate corporation.

paid in capital  No minimum requirement.

Qualification as a foreign  Register with state and

corporation in all states  Receive a Certificate of Authority
where doing business

Delaware General Corporation Law

Certificate of Mandatory Provisions
Incorporation  Name (include the words Inc. or Corp)
§102  Address
 Business/Purpose (any lawful business)
 Capitalization structure (shareholders have identical rights unless
specified otherwise)
o Common or Preferred Shares
 Incorporators’ names and addresses
 Directors’ names and addresses

Optional Provisions
 Management provisions/provisions limiting powers of corporation,
directors, shareholders
 Preemptive shareholder rights
 Provisions changing the voting rules of DGCL
 Limit on duration of business
 Exceptions to limited liability of shareholders
 Limits on monetary damages for director breach of fiduciary duty
(some fiduciary duties cannot be eliminated)
Incorporators  Owners – Shareholders (Partnership would be managers)
(Should not be  Management – Board of Directors (Shareholder delegate management

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confused with to BofD) 1st Tier, 2nd Tier Officers [Delegated BoD management, get
management of into Agency problems(Temptation to run for own benefit, will come
business. Do not back to fiduciary duty, and will encounter securities regulation)]
need to have a Incorporators
business interest.  §101 – any person may incorporate a corporation by filing certificate
Dummies, with Division of Corporations of Secretary of State
administrator duty.)  §103 – signed & dated, pay fees
 §107 – if no directors named in certificate, incorporators manage
business until directors elected
 Distinguish roles of shareholders, directors, & officers in the
corporation
Requirement of  §101(a) File with Division of Corporations in the Department of State
Filing  Filed documents are a matter of public record
o This is “publicly available information”
Commencement  §106 – corporation exists from the date of filing until dissolution
of Corporate
Existence
(when corporation
comes to life)
Registered Office  §131 – Registered office required; may or may not be place of business
 Receives service of process within the state
 Must be a resident person or corporation
By-Laws Private and more extensive. Election of directors process and a lot of
(Certificate of interesting information. Not filed with the government.
Incorporation +  §108 – By-laws adopted at organization meeting of directors or
Bylaws = incorporators
“constitution” of  §109 – May contain provisions on business, conduct of affairs, rights or
incorporation) powers of shareholders, directors, officers, employees
o May be amended by directors until payment of initial capital;
after this, the shareholders must vote to amend (subject to
contract)
o Not filed with the Secretary of State

Promoters
Promoter’s Liability
Before the date of certificate filing. Future directors or others with an economic interest in the corporation may not
wait till the filing, so will want to start business dealings before. Do they have liabilities?
Fiduciary Duties  Problem of self-dealing
(purpose to protect o Example: selling real estate they own
corporation to be formed.)  Promoter has status akin to joint venturer or partner (not drawing
on corporate fiduciary duties because the corporation is not
formed)
 Duties owed among promoters and to the corporation to be
formed
Liability for Pre-  Generally a corporation is not liable to contract unless adopted

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Incorporation Contracts o A Corporation can become a party to a promoter’s contract if
they adopt the contract.
o Promoter is liable for contracts unless relieved
 If a promoter forms a corporation later, can that corporation
become party to K?  Yes
o Typically has to be some form of ratification formal act,
informal act, oral agreement, ect. showing intent to be bound
 Can a promoter avoid liability?  Yes
o Has to be put in the K, and substitute the corporation
o Based on the Restatement of agency
 If corporation is never formed, or promoter forms a different
corporation, who is liable?
o Issue of defective incorporation
o Example: Southern-Gulf Marine
C. Third Parties  Where a party has contracted with what he has acknowledged to
be a corporation, he is stopped from denying the existence or legal
validity of such a corporation. Southern-Gulf Marine
 Southern-Gulf Marine v. Camcraft, Inc. (Texas Ship Company that went to
Caymans; Defective incorporation)
 Facts: Alleged Breach of K, D argues no cause of action
o Letter Agreement December 6, 1978
 Bowman signed as Camcraft President
 Barrett signed individually and as SGM President
o Vessel Construction Contract dated May 30, 1979
 Bowman signed form contract on behalf of Camcraft
 Barrett signed as President of SGM, a Texas corporation, and warrant that
SGM was a U.S. person under the Shipping Act of 1916
o Letter regarding SGM incorporation in Cayman Islands dated February 21,
1980
 Signed by Barrett for SGM and stated SGM board adopted contract
 Bowman signed acceptance for Camcraft
 Holding: The court held that the defendant should not be permitted to escape
performance (prevent windfall) because the plaintiff relied on the K and secured
financing for it. Furthermore, the defendant likewise relied on the K and began
construction and Southern-Gulf’s de facto status did not affect any of its substantial
rights (had right to promote).
 Rule: Where a party has contracted with what he has acknowledged to be a
corporation, he is stopped from denying the existence or legal validity of such a
corporation.
 Reasoning: What was the doctrine relied on by the court?
o Doctrine of Corporation by Estoppel
 Would earn a windfall if allowed to evade liability based on absence of
incorporation
 Person acted as though he was dealing with a corporation
o Test used by Court: “were substantial rights effected?”

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  Court says D “should not be permitted to escape performance by raising an
issue as to the character of the organization to which it is obligated, unless its
substantial rights might therefore be effected”
 Corporation by Estoppel
o If a creditor always dealt with the principals as if they were a corporation, he will
be estopped from later alleging that the corporation is defective if that would
unjustly harm the principals
o Likewise, a D that had held itself out to be a corporation cannot try to avoid
liability by claiming the P has no cause of action because the D is not a legal
entity
o Not defense in tort claims
o Can be relevant in K claims where a prior business relationship exists
 De Facto Corporation
o Another doctrine of Promoter’s liability in defective incorporation
o Promoters tried in good faith to incorporate, had a legal right to do so
o Acted in good faith as though they were a corporation
o De Facto Status insulates SHs and directors from liability except in a direct claim
by the state
o Not very common today the state must approve the articles before they are
filed, and a statement by the state of the fact of incorporation is conclusive
evidence of incorporation

The Corporate Entity and Limited Liability

Limited Liability
General Rule  Investors are protected by limited liability and are only liable to the
extent of their investment (Walkovsky v. Carlton)
Enterprise Liability  Treat all corporations as one and make all assets available to creditor
 Treat fractured corporation as one and make all assets available to
creditor. Generally cannot go after sister corporations.
 Example: Walkovsky assets of all 10 companies owned by
Carlton available to satisfy judgment in favor of Walkovsky
Piercing the  Judicial exception to limited liability
Corporate Veil (Small  The judicial act of imposing personal liability on otherwise immune
Closely Run) corporate officers, directors, or shareholders for corporation’s
wrongful acts
 Shareholders personal asset’s may be available to creditor
 Example: Walkovsky Carlton’s personal assets available to satisfy
judgment in favor of Walkovsky
Two Prong Test for PCV
1) Unity of Interest (alter ego) – There must be such unity of
interest that the separate personalities of the corporation and the
individual (or other corporation) no longer exist
o Van Dorn Factors: 1) Failure to maintain corporate formalities
2) Commingling of assets/funds 3) Undercapitalization 4) One
corporation treats assets of another as its own.

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 2) Fraud or injustice: need more than creditor’s inability to collect
(Sea-Land Services)
o Circumstances must be such that adherence to the fiction of
separate corporate entities would sanction a fraud or promote
injustice
3) Optional 3rd Prong: Assumption of risk in K cases
o Did the creditor know of the risk of nonpayment? Creditor
should have taken steps to mitigate the risk.
o Example: Shareholder set up a corporation with no assets solely
to make payments under a supply contract. Corporation
defaulted. Court refused to pierce since supplier knew the facts
and was not misled. Supplier could have taken steps to protect
itself, like demanding a personal guarantee, but failed to do so.
Supplier assumed the risk of loss. Brunswick Corp. v. Waxman
(2d Cir. 1979)
o *Note: Not in Torts. Assumption in Ks is that a creditor is
sophisticated enough to measure the risks and mitigate the risks.
“Substantial o Evaluate by totality of the circumstances!
Domination” Test Substantial Domination Test:
(Parent-Subsidiary o Common directors & officers subsidiary is supposed to be
Relationship) separately managed from parent company
o Common business departments
o File consolidated financial statements/tax returns
o Parent formation & financing of subsidiary
o Gross undercapitalization
o Payment of salaries and other expenses
o All business of subsidiary provided by parent
o Parent uses property of subsidiary
o Daily operations not separate
o Failure of subsidiary to maintain corporate formalities (In re
Silicone Gel Breast Implants)
o *Note: Don’t need fraud in tort claim
Direct Liability- Restatement 2nd of Torts, Section 324A
 One who undertakes, gratuitously or for consideration, to render
services to another which he should recognize as necessary for the
protection of a third person or his things, is subject to liability to the
3rd person for physical harm resulting from his failure to exercise
reasonable care to perform his undertakings if:
o Failure to exercise reasonable care increased risk of harm
o Undertaken to perform duty owed by the other to 3P
o Harm by 3P suffered because of reliance (In re Silicone Gel
Breast Implants)
 Undercapitalization as Factor in Piercing
 Deliberate insolvency

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 o Shareholder siphoning of available corporate assets without disclosure to
creditors, such that corporation is deliberately made insolvent, justifies
piercing in some cases
o Deliberate insolvency defeats creditors’ expectation that business will set
aside adequate reserves to pay corporate obligations when due
 Example: Flemming was the sole shareholder of a fruit brokerage business in
which he acted as a middleman between growers and buyers. He collected the
sales price from the buyers, deducted his commission and the transportation
charges, and sent the balance to the growers. However, he also paid himself a
salary from time to time that included the amount withheld from the growers’
payment to take care of transportation charges. When truckers sued for unpaid
bills, he claimed insolvency. Court pierced and held Flemming personally liable.
De Witt Trucking v. Flemming (4th Cir. 1976)
 Walkovsky v. Carlton (Taxi Cabs and Piercing the Corporate Veil)
 Facts: Personal injury Case
o Walkovsky injured party, hit and critically injured by taxi
o Carlton owned 10 individual corporations (cab companies)
 Seon Cab Corporation: Owned two cabs and no other assets. Maintained
minimum liability insurance required under New York State law ($10,000)
 Nine other corporations with same assets and insurance
o P’s injuries were a lot more than the insurance held by Seon
o P wanted to hold D personally liable for amount of damages. Also says he
should get to collect from other cab companies because they all worked as a
“single enterprise” (enterprise liability).
 Holding: The court held that it would pierce the corporate veil to prevent fraud or
achieve equity, which may be invoked through agency rule of respondent
superior. However it is not enough to show that the corporation’s assets and
liability insurance count not ensure recovery.
 Rule: Whenever someone uses the corporation to further his own rather than the
corporation’s business, he will be liable for the corporation’s acts. Respondeat
superior extends beyond negligence to commercial dealings. However where a
corporation is a fragment of a larger corporate combine (Enterprise liability)
which actually conducts the business, a court will not hold the individual SHs
liable (can’t go after sister corporations).
 Sea-Land Services, Inc. v. Pepper Source (Couldn’t go After PS so went after
Marchese)
 Sea-Land Services, Inc. Shipped peppers on behalf of Pepper Source. PS didn’t
pay the freight bill.
o Wants to pierce PS’s corporate veil and hold Marchese personally liable
 Marchese shareholder of 5 businesses
o The Pepper Source has been legally dissolved and apparently had no assets
before it was dissolved
o Caribe Crown, Inc.
o Jamar Corp.
o Salescasters Distributors, Inc.

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 o Tie-Net International Inc. only company with second shareholder
(Marchese is 50% owner)
 Rule: Van Dorn Test for PCV
o A corporate veil will be pierced when 2 requirements are met:
1. Alter Ego: there must be such unity of interest and ownership that the
separate personalities of the corp. and the individual [or other corporation]
no longer exist; and
2. Fraud or Promote Injustice: circumstances must be such that adherence to
the fiction of separate corporate existence would sanction a fraud or
promote injustice. Need something beyond a creditor’s inability to collect.
(Second Prong would collapse otherwise)
 Problem in the Case is with the fraud/injustice factor
o First part of the Van Dorn test was easily met
o P thought that performance with out payment is enough for injustice. Trial
court says no, there needs to be more
 Holding: Court held that the first part of the test had been met since corporate
records and formalities had been abandoned. And assets and funds had been
comingled. Corporate asset had been moved, tapped and borrowed w/o regard to
its source. Second prong was remanded to prove injustice.
 In re Silicone Gel Breast Implants Products Liability Litigation (Torts claim,
parent-subsidiary relationship)
 Injured female patients who had breast implant surgery with defective implants
 Bristol-Myers Squibb Co.  sole shareholder of MEC
 Mechanical Engineering Corporation (MEC)
o MEC manufactured the defective implants, but they are dissolved, they are no
longer available as a liability party
 Legal theories that tie D to manufacturer:
o Relationship between MEC and BMS was a parent-subsidiary relationship
o Corporate control claims piercing theory, Court also refers to as “substantial
domination”
o Direct liability claims
 Rule: The totality of the circumstances must be evaluated. Control must be
examined using the substantial domination test. Also use the direct liability rule.
 Holding: Court believed it would be inequitable and unjust to allow Bristol to
avoid liability to those induced to believe Bristol was endorsing/vouching for the
defective product. Because Bristol permitted its name to appear on breast implant
advertisements, packages to given the product additional credibility. Combined
with the evidence of potentially insufficient assets these facts would lead a
reasonable fact finder to conclude that the corporate veil should be pierced.
Fraud or like misconduct is not necessary in tort litigation because there is no
choice for the injured party. However fraud is necessary in K because a choice is
available to the contracting party.
o By allowing its name to be placed on breast implant packages and product
inserts, Bristol held itself out as supporting the product, apparently to increase

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 confidence in the product and to increase sales. A duty rose that Bristol
became liable for.
Shareholder Derivative Law Suits
 Derivative Action – A suit asserted by a SH on the corporation’s behalf against a 3rd
party (usually a corporate officer) because of the corporation’s failure to take some
action against the 3rd party
 “two suits on one” SH sues on behalf of corporation to enforce rights of
corporation
 Sues corporation in equity (defendant is a nominal defendant)
 To bring an action to enforce corporate rights
 Modern derivative suit is treated as one suit
 Recovery runs directly to corporation
 Usually involve allegations of mismanagement, waste, fraud by corporate officers
and directors
 Cohen “The SH demanded that corp. institute proceedings against Ds but by
their control, the individual Ds prevented it from doing so.”
 Attorney’s fees If suit is successful, the corporation will pay plaintiff’s fees and
expenses.
o Some state statutes mandate fee shifting to plaintiff if suit was brought
without reasonable cause or for an improper purpose.
o Security for fees statutes are now uncommon.
 Strike Suit- A suit (esp. a derivative action), often based on no valid claim,
brought either for nuisance value or as leverage to obtain a favorable or inflated
settlement.
 Direct Action – Stockholder sues Corporation to enforce rights of Shareholders.
Eisenberg v. Flying Tiger Line
 Examples: denial or dilution of voting rights; compel payment of dividends
declared but not distributed; compel inspection of corporate books and records,
require holding of a shareholder meeting
 Class Action - SH sues in his own capacity as well as on behalf of other SHs
similarly situated
 Group of SHs assert their individual direct claims through a representative
 Procedural rules applicable to class actions such as plaintiff must be
representative of other SH interests and settlement must be approved by court
 Some derivative suit procedural hurdles (like demand) may not apply to class
actions but other procedural hurdles may apply (like giving notice to class
members
 Business Judgment Rule (BJR)
 (DGCL) §141(a) – The business and affairs of the corporation shall be managed
by or under the direction of the board of directors. It is implied but not
specifically stated in the statute.
 Rebuttable presumption that directors and officers carry out their functions in
good faith, after sufficient investigation and for valid business reasons
Demand on  Demand – By virtue of a derivative suit a demand is required.
Directors Must ask the board to take over. They can reject the demand.

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 Stockholder cannot proceed on own Grimes v. Donald
 Purpose of Demand Requirement
o Allow dispute to be resolved by corporation outside of
court
o Allow corporation to take over the lawsuit if it is
beneficial to corporation
o If demand is excused or wrongfully refused, SH will be
allowed to control proceedings
o Protect corporate boards from harassment and discourage
strike suits
 Demand Futility (Delaware)
 Allege facts with particularity creating reasonable doubt
regarding board independence
 Either:
1. Majority has material financial or familial interest, OR
2. Majority is incapable of acting independently for another
reason like domination or control, OR
3. Underlying transaction is not the product of a valid
business judgment
 Wrongful Refusal Doctrine (Delaware)
 Board decision on demand is protected by the business
judgment rule
 To overcome, plaintiff must allege facts with particularity
creating reasonable doubt that board acted independently or
with due care
 Abdication Claim – Not Derivative Grimes
Special  Can be a way to get around demand requirement and derivative
Litigation suits
Committees  Board may designate 1 or more committees, each consisting of 1
or more directors §141(C)(2)
 Board committee may exercise all the powers and authority of the
full board §141 (C)(2)
 Two Step Analysis of SLC’s Motion to Dismiss
1. Independence/good faith/good process and reasonableness of
SLC
o Lack of domination and control of committee members
o Independence and Social Factors (In re Oracle)
o Procedural Considerations
2. Court should apply their own BRJ
o More skeptical in a demand futility case than in a case
where demand would be required
 Cohen v. Beneficial Industrial Loan Corp. (Preventing Strike Suits, 5%
Threshold)

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 P  Cohen (stockholder who owns 0.0125% of the stock) brought, in 1943, an
action in the right of the Beneficial Industrial (DE corporation doing business in
NJ)
 D  the corporation and some of its managers and directors
 Complaint since 1929, the individual defendants engaged in a continuing and
successful conspiracy to enrich themselves at the expense of the corporation
o Specific charges of mismanagement and fraud for 18 years the assets were
wasted and diverted (exceeding $100M)
 P made a demand that the corporation institute proceedings for its recovery. This
demand was denied by the individual Ds
 1945: NJ enacted Statute
o New Jersey Statute: In derivative actions, persons holding less than 5% or
$50,000 in value must give security for reasonable expenses, including
attorneys’ fees
o Barrier for shareholders in states that have these statutes from bringing suits
o Way that states were trying to regulate/limit strike suits
 P denied the validity of the statute under the Constitution (under Equal Protection
and Due Process Clause)
 Court’s Reasoning Equal Protection
o This claim is based on the fact that the statute enables a stockholder who owns
5% (or more) of shares to proceed without either security of liability and
imposes both upon those who proceed with a smaller interest
o The state has plenary power over this type of litigation
 The state is not forbidden to use the amount of one’s financial interest,
which measures his individual injury from the misconduct to be redressed
 This is not unconstitutional
 Court’s Reasoning Due Process
o The statute imposes liability and requires security for the “reasonable
expenses, including counsel fees, which may be incurred”
o The state did not make unreasonable use of its power as to violate the
Constitution when it provides liability and security for payment of reasonable
expenses if a litigation of this character is adjudged to be unsustainable (to
solve the problem of strike suits)
o The statute is not merely a regulation of procedure
 Rules: 1) A stockholder who brings suit on a cause of action derived from the
corporation assumes a position of a fiduciary character, as a self-chosen
representative and a volunteer champion 2) A statute holding an unsuccessful
plaintiff liable for the reasonable expenses in defending a derivative law suit and
entitling the corporation to require security for such payment is constitutional. 3)
A federal court with diversity jurisdiction must apply a state statute providing
security for costs if the state court would require the security in similar
circumstances
 Holding: NJ Statute is upheld. Because the stockholder voluntarily brought the
suit the state has right to balance the action by considering the plaintiff’s financial
interest in order to construct a obstacle for those looking for a quick pay out by

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 using the statute for harassment reasons. It created liability where liability did not
exist before, therefore it is substantive.
 Eisenberg v. Flying Tiger Line, Inc. (Derivative vs. Direct Suits. Personal Action
Not Derivative, No Security)
 P Eisenberg stock holder of FTL
o Seeking to overturn a reorganization and merger which FTL effected in 1969
 Reorganization: Flying Tiger Line, Inc. (parent) organized  Flying Tiger Corp.
(Subsidiary, Holding Co.) (Parent) organized  FTL Air Freight Corp.
(Operating Subsidiary, later changed the name to Flying Tiger Line, Inc.)
 Relationship: Max Eisenberg (Shareholder)  Flying Tiger Corp. (Holding Co.)
(Parent)  FTL Air Freight Corp. (Operating Subsidiary). Then, Flying Tiger
Line merged with FTL, and only FTL survived.
o Flying Tiger Line, Inc. = operating subsidiary
 P (SH of the original Flying Tiger Line, Inc.)  P’s shares were converted to
Flying Tiger Corporation (holding company, Parent: Now, Eisenberg owns stocks
in this company)
o SH sued Flying Tiger (D) to enjoin the effectuation of a plan of reorganization
and merger
 D moved for an order to require SH to comply with NY Business Corporation
Law which requires a P using derivatively on behalf of a corporation to post
security for the corporation’s costs
 Issue: Whether SH should have been required to post security for costs as a
condition to prosecuting his action (whether this suit was derivative or direct?)
 P’s argument
o Diluting P’s voting rights
 The end result of the reorganization plan was to deprive minority
stockholders of any vote or any influence over the affairs of the newly
spawned company
 He cannot vote for the operating subsidiary (thus, not being able to assert
some control over the management of the operating subsidiary)
 These stockholders’ rights never belonged to Flying Tiger itself, but
belonged to the stockholders per se.
o DE law must be applied here, and DE law does not require security posting
o NY courts would not invoke the NY statute because the section exclusively
applies to derivative actions.
 P’s class action is representative not derivative
o Voting rights of shareholders
 Vote for the board of directors Appointing or removing members of the
board of directors
 Vote if there are significant changes in the business (i.e. Mergers, Sale of
assets)
 Distinction between derivative vs. direct lawsuit important here
o Derivative claim concerns the whole company, not just the individual
o Statute applies when there is a derivative claim, NOT when there is a direct
claim

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 Court’s Reasoning
o NY clearly has indicated that NY statute will be applied in its courts whether
or not NY substantive law controls the merits of the case. Since NY courts
would invoke its own law on security for costs rather than DE, we are
required to do the same (Cohen)
o Test Used by Court If the gravamen of the complaint is injury to the
corporation, then the suit is derivative
 BUT, if the injury is one to the plaintiff as a stockholder and to him
individually and not to the corporation, then the suit is individual in
nature and may take the form of a representative class action
o “Suits are now derivative only if brought in the right of a corporation to
procure a judgment in its favor”
o The harm has to be done to the corporation for the suit to be derivative. Thus,
the judgment (recovery) would go to the corporation
 Rule: Direct /Derivative Dichotomy - If the injury is one to the plaintiff as a
stockholder and to him individually and not the corporation the suit is
representative in nature and may take the form of a representative class action. If
suit is brought in the right of a corporation to procure a judgment in its favor then
the suit is derivative.
 Holding: The court held that suit was not derivative because the stockholder was
suing to restore his and other’s right to vote. The aim was personal and not for
favor of the corporation. Therefore the suit could not be dismissed because he did
not post security. It was not necessary since not derivative.
o P’s position was stronger than in the ordinary merger case Here the
reorganization deprived him and other minority stockholders of any voice in
the affairs of the previously existing operating company
 Demand Futility
 No single approach to demand requirement
o Contrast NY approach (Marx v. Akers)
o Contrast universal demand requirement
 Delaware (Grimes)
o Allege facts with particularity creating reasonable doubt regarding board
independence
o Either:
1. Majority has material financial or familial interest, OR
2. Majority is incapable of acting independently for another reason like
domination or control, OR
3. Underlying transaction is not the product of a valid business judgment
 New York (Marx)
o Allege facts with particularity that either:
1. Majority of the board is interested in the transaction, OR
2. Directors failed to inform themselves as reasonably necessary about the
transaction, OR
3. Directors failed to exercise their business judgment in approving the
transaction

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  Universal demand requirement
o 11 states have adopted the Model Business Corporation Act
o Applies a bright line rule - requires a demand in all cases without exception
General rule: Demand is always required unless you can show demand futility or
demand excusal
 As a P’s attorney, you would advise not to file a demand but to try to argue
demand futility or demand excusal = P must plead with particularity]
 If demand was made, then P’s only option is to argue wrong refusal = harder to
do because P must overcome business judgment rule (S.141(a)) and argue that the
board grossly lacked info
 Grimes v. Donald (Wise to Not Make a Demand if You Know it Will be Rejected)
 Facts: Shareholder Grimes is suing CEO Donald and Board of Directors of DSC
Communications Corporation
 P filed his complaint against Donald (CEO) and the Board of Directors (the
“Board”) of DSC Communication Corporation, seeking a declaration of the
invalidity of the Agreements between Donald and other members of the
Board, and alleging that the Board has breached its fiduciary duties by
abdicating its authority, failing to exercise due care and committing waste
 Excessive amount of compensation for Donald (the Employment Agreement)
o The Agreement runs until the earlier of Donald’s 75th birthday or his
termination (1) by reason of death or disability; (2) for cause; or (3)
without cause
o Donald can declare a “constructive termination without cause” by the
Company as a result of “unreasonable interferences”
o In the event of a Termination without cause (constructive or otherwise),
Donald is entitled to the following:
 Continued payment of his base salary for the remainder of his term of
years (61/2 years unless Donald dies or turns 75 first)
 Annual incentive awards for the remainder (equal to the average of the
3 highest annual bonuses awarded)
 Medical benefits for Donald and his wife, and his children until 23
 Continued participation in all employee benefit plans
 Writing to the Board, P demanded that the Board abrogate the Agreements.
The Board refused the demand in a letter
o Donald’s duties as described in the Employment Agreement do not
constitute an impermissible delegation of the duties of the Board of
Directors
 Issues: 1) distinction between a direct claim and a derivative claim 2) a direct
claim of alleged abdication by a board of directors of its statutory duty 3) when a
pre-suit demand in a derivative suit is require or excused 4) the consequences of
demand by a stockholder and the refusal by the board to act on such a demand
 P’s argument wants the court to declare the Agreement is invalid and shouldn’t
be enforced (abdication claim)
o Constructive termination clause = abdication by the Board because Donald
can exercise unfettered control (due to a very high cost to the Board)

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 Abdication Claim
o This is a direct claim P seeks only a declaration of the invalidity of the
agreements; monetary recovery will not accrue to the corporation as a result
o P = the potentially severe financial penalties which the Company would incur
in the event that the Board attempts to interfere in Donald’s management of
the Company will inhibit and deter the Board from exercising its duties under
Section 141(a)
o Termination clauses
 Constructive termination without clause = if there is unreasonable
interference by the Board in Donald’s carrying out his duties and
responsibilities under the Agreement, then Donald can assume
constructive termination and get a huge amount of compensation for
termination (basically, Donald can threaten the Board under this clause)
 This would indicate that Donald would have more power than the Board
(which is counter-intuitive as a general Business Law: SHs are the owners
and the Board is elected by SH)
o Court = If a K could have the practical effect of preventing a board from
exercising its duties, it would amount to a de facto abdication of
directorial authority
 Directors may not delegate duties which lie “at the heart of the
management of the corporation”
 A court cannot give legal sanction to agreements which have the effect of
removing from directors (in a substantial way) their duty to use their own
best judgment on management matters [Abercrombie v. Davies]
 In an independent and informed board, acting in good faith, determines
that the services of a particular individual warrant large amounts of
money, whether in the form of current salary or severance provisions,
the board has made a business judgment
 This business judgment will normally receive the protection of the BJR
unless the facts show that such amounts, compared with the services to be
received in exchange, constitute waste or could not otherwise be the
product of a valid exercise of business judgment
o Here, it is unusual contract, but not a case of abdication.
 No legal impediment for the Board to exercise its business judgment
 The Agreement does not formally preclude the DSC board from exercising
its statutory powers and fulfilling its fiduciary duty
 Derivative Claim
o P = the due care, waste and excessive compensation claims (breach of
fiduciary duty)
o Demand requirement exists in most jurisdictions
 Before SH can proceed with complaint alleging waste, mismanagement
and breach of fiduciary duty brought in the name of entire corporation
seeking relief awarded to the corporation
o A stockholder (filing a derivative suit) MUST allege either;
 He made a demand that the board assert the corporation’s claim, but the
board rejected his pre-suit demand (wrongful refusal); OR

15
  Allege with particularity why the stockholder was justified in not
having made the demand (Demand futility or Demand excusal)
o Purpose of demand requirement (DGCL §141(a) = Board is supposed to
control the corporation)
 Allow dispute to be resolved by corporation outside of court
 Allow corporation to take over the lawsuit if it is beneficial to corporation
 If demand is excused or wrongfully refused, SH will be allowed to control
proceedings (wrongful refusal doctrine)
 Protect corporate boards from harassment and discourage strike suits
o Problem of structural bias (board members tend to favor their own people and
judgments) = usually the board will move to dismiss
 In response to this Doctrine of futile demand, demand excusal
 If a claim cannot be made under the doctrine of futile demand or demand
excusal, then SH must go ahead and make a demand and the doctrine of
wrongful refusal could be used once the demand is refused
 Holding: P looses on both claims. P waived his right to contest the independence
of the board when he demanded that they invalidate the employment K. The pre-
suit demand is a mechanism to avoid litigation and it would defeat its purpose if P
were allowed to bifurcate (“divide into 2”) his claims and claim that his demand
was excused for other set of claims.
o P wrote a letter demanding that the Board abrogate the Agreements and the
Board refused the demand  Court’s view = P made the demand and the
Board refused. Then, P’s (only) option would be to claim wrongful refusal
o Demand excusal (futile) doctrine under DE law
 A reasonable doubt exists that the board is capable of making an
independent decision to assert the claim if demand were made
o Reasonable doubt = there is reason to doubt
o Allege facts with particularity creating reasonable doubt regarding
board independence
 The basis for claiming excusal (any of the three)
1. A majority of the board has a material financial or familial interest; or
2. A majority of the board is incapable of acting independently for
another reason like domination or control; or
3. Underlying transaction is not the product of a valid business judgment
o Wrongful refusal doctrine
 Board has the presumption of valid business judgment rule unless the
stockholder can allege facts with particularity creating a reasonable doubt
that the board is entitled to the benefit of the presumption
 By making a demand, P waived his right to contest the independence of
the board A shareholder who makes a demand can no longer argue that
demand is excused
 Here, the complaint fails to include particularized allegations which would
raise a reasonable doubt that the Board’s decision to reject the demand
was the product of a valid business judgment
 Rule: If a demand is made and rejected, the board rejecting the demand is entitled
to the presumption of the Business Judgment Rule unless the stockholder can

16
 allege facts with particularity creating a reasonable doubt that the board is entitled
to the benefit of the presumption.
o If there is reason to doubt that the board acted independently or with due care
in responding to the demand, the stockholder may have the basis ex post to
claim Wrongful Refusal but must plead facts with particularity. The
stockholder then has the right to bring the underlying action with the same
standing, which the stockholder would have had, ex ante, if demand had been
excused as futile.

Special Litigation Committees

 Board Committees
 Permitted under DGCL §141 (C)(2)
o Board may designate 1 or more committees, each consisting of 1 or more
directors
o Board committee may exercise all the powers and authority of the full board
 Board management has used this to get around the demand requirement and
derivative suits
 Special litigation committees are often appointed of new, disinterested directors to
decide whether the corporation should proceed with the litigation
 If you use an SLC, they have figured out a procedure in which you can still make
a motion to dismiss the lawsuit even though demand has not been made on a
theory that the board has a right to control all aspects that relate to management,
and that includes litigation
 “Outside” directors are those who are not employed by the corporation
 The Business Judgment Rule
 DGCL §141(a) – The business and affairs of the corporation shall be managed by
or under the direction of the board of directors
 Rebuttable presumption that directors and officers carry out their functions in
good faith, after sufficient investigation and for valid business reasons
 Used as a defense to an attack on its sound decision
 Does not create any authority
 Zapata v. Maldonado (Nobody asked the Board to take over; BJR does not create
authority)
 Facts: Maldonado was a shareholder of Zapata and initiated a derivative suit
alleging breach of fiduciary duty against certain officers and all the directors. He
did not make demand, claiming demand futility because all directors were named
as defendants.
o Zapata created a SLC (composed solely of the two new “outside” directors
who were not on the board at the time of the wrongdoing alleged by P = “not
tainted”) to investigate P’s actions
o SLC’s determination was to be final and not subject to review by the Board
o Following an investigation, SLC concluded that each action should be
dismissed as the actions are detrimental to the corporation
o Subsequently, Zapata moved for dismissal or summary judgment
 Issues:

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 o Whether the SLC has the power to cause the present action to be dismissed
when there was no demand made by the derivative action P
 The continuing right of a SH to maintain a derivative action [Grime v.
Donald]
 The corporate power under DE law of an authorized board committee to
cause dismissal of litigation instituted for the benefit of the corporation
[when no demand was made]
 Whether there is a permissible procedure under §141(a) by which a
corporation can rid itself of detrimental litigation
o The role of the court in resolving conflicts between the SH and the SLC
 McKee v. Rogers (McKee rule)
o As a general rule, a SH cannot be permitted to invade the discretionary field
committed to the judgment of the directors and sue in the corporation’s behalf
when the managing body refuses
o BUT, board members will not be allowed to cause a derivative suit to be
dismissed when it would be a breach of their fiduciary duty
 Power of the SLC
o Independent committee possesses the corporate power to seek the termination
of a derivative suit
 §141(c) allows a board to delegate all of its authority to a committee and
§141(a) will give that decision deference by business judgment rule.
 BUT, §141(a) business judgment rule not create authority (it just gets
deference – works as a defense to an attack on the decision’s soundness)
 The board’s managerial decision making power comes from §141(a)
o A committee with properly delegated authority would have the power to move
for dismissal or summary judgment if the entire board did.
 §144 permits disinterested directors to act for the board (even though the
board might be tainted by the self-interest of a majority of its members)
 Rule: When determining whether to grant a special committee’s motion to
dismiss the courts should apply a two step test:
1) I Court should inquire into the independence, good faith, and a reasonable
investigation
o The corporation has the burden of proving independence, good faith, and a
reasonable investigation
o If the Court is not satisfied with Step 1 burden, then the motion will be
denied
2) Court should determine, using their own business judgment, whether the
motion should be granted
o Balance between legitimate corporate claims as expressed in a derivative
SH suit and a corporation’s best interests as expressed by an independent
investigating committee (Court must be persuaded after balancing)
o Here, the Court should give special consideration to matters of law and
public policy in addition to corporation’s best interests, when appropriate.
o Some deference given to the board, but not BJR deference

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  Holding: The court does not give absolute deference to the BJR like other courts
have done. All 10 members of the board were tainted. The court put in place its
own business judgment. They will use BJR in order to determine whether the suit
should be dismissed.

 In re Oracle Corp. Derivative Litigation (SLC Independence; Could Stanford

Profs. Make Tough Decision?)
 Facts: Ps filed derivative suits against 4 members of Oracle’s board of directors
for insider trading (person who possess material information which reasonable
investor would think it is significant, not in the public’s possession, uses the
material information in trading stocks), violating their fiduciary duties –
breaching duty of loyalty
o Ellison: Chairman, CEO, largest shareholder
o Henley: CFO, Executive VP, director
o Lucas: director, chair of executive committee and finance and audit committee
o Boskin: director, chair of compensation committee, member of finance and
audit committees
 Ps’ claims State law claims involving insider trading
o Trading Ds breached their duty of loyalty by misappropriating inside
information and using it as the basis for trading decisions
o Other Ds (other members of the board who did not trade) were alleged a
Caremark violation in the sense that the board’s indifference to the deviation
between the company’s December guidance and reality was so extreme as to
constitute subjective bad faith
o Insider trading (classic definition) The use of material, nonpublic
information in trading the shares of a company by a corporate insider or other
person who owes a fiduciary duty to the company.
o The Supreme Court has also approved a broader definition, known as the
“misappropriation theory”: the deceitful acquisition and misuse of
information that properly belongs to persons to whom one owes a duty.
 The SLC 2 Oracle board members who joined the board after the alleged
wrongdoing (both are tenured professors at Stanford University)
o Paid $250/hour (a rate below that which they could command for other
activities)
o They agreed to give up any SLC-related compensation if their compensation
was deemed by this court to impair their impartiality
o SLC was granted full authority to decide matters without the need for
approval by the other members of the board
o SLC’s extensive investigation and report (pg 240)
 Reviewed paper and electronic records
 Interviewed 70 witnesses and participated in several key interviews
 SLC asked Ps to identify witness the Committee should interview, but
they never did and none of the Ps ever met with the SLC
 SLC met with its counsel extensively and devoted many hours to the
investigation

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  Produced an extremely lengthy report (over 1,000 pages)
o Conclusions: Lengthy report concluding that Oracle should not pursue the Ps’
claims against the trading Ds or any of the other Oracle directors serving
during the 3Q FY 2001
 SLC found that although here were hints of potential weakness in Oracles
revenue growth, there was no reliable information indicating the company
would fall short of the mark, and def. not to the extent it eventually did
 Concluded that even Ellison and Henley – who were obviously the two
Trading Defendants with the most access to inside information – did not
possess material, non-public information
 As to Lucas and Boskin, the SLC noted that they did not receive the
weekly updates of various kinds that allegedly showed a weakening in
Oracle’s performance
 Ellison sold only 2% of his holdings; Henley 7%
 Primary Legal Issue: The independence of the SLC
o P’s argument SLC members had personal ties to the Oracle board Ds (the
trading Ds were graduates and donors of the University)
 D argued the SCL was independent
o Factors supporting independence in the Report:
 The 2 new board members were willing to work unpaid by Oracle (lack of
economic incentives to make decisions)
 The 2 new board members came onto the board after the alleged
wrongdoing
 Absence of any material ties between the new SLC members and Oracle
and the Ds
 Absence of any material ties between the SLC advisors and Oracle and the
Ds
 The 2 new members were tenured at the University who would not be
punished or fired by their decisions
o Noticeably absent from the report: any disclosure of several significant ties
between Oracle/Trading Ds and Stanford University which hires the new SLC
members
 Report failed to mention several significant ties between Oracle/Trading
Ds and Standford Univ.
 The “Stanford” Facts that emerged during discovery
 3 of the 4 Ds have significant connections with Stanford University
(contributed significant value to Stanford, worked together before, ect.)
o The SLC’s argument
 The Stanford facts do not impair the SLC’s independence, placing a great
weight on the fact that
o none of the trading Ds have the practical ability to deprive either
members of the SLC of their current positions at Stanford
o Since both are tenured professors, Stanford itself really does not have
any practical ability to punish them for taking actions adverse to the
trading Ds

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  Much of DE law focuses the bias inquiry on whether there are
economically material ties between the interested party and the director
whose impartiality is questioned
o Director is not independent only if he is dominated and controlled by
an interested party
 Court’s analysis
o DE law not be based on a reductionist view of human nature that simplifies
human motivations on the lines of the least sophisticated notions of the law
and economics movement
o “Homo sapiens is not merely homo economicus.”
 An array of other motivations exist that influence human behavior. In
particular, social nature!
o The contextual nature of the independence inquiry under DE law
 If SLC determines that Oracle should press insider trading claims against
the Ds, that means the possibility of giving Ds of reputational harm as well
as huge monetary damages
o The SLC has not met its burden to demonstrate the absence of a material
dispute of fact about is independence
 Because the ties among the SLC, the trading Ds, and Stanford are so
substantial that they cause reasonable doubt about the SLC’s ability to
impartially consider whether the trading Ds should face suit
 Holding: Denies SLC’s motion SLC could NOT make an unbiased decision
Economic independence is not the only measure of objectivity and the court must
not focus solely on control and dominance. Social factors such as love, envy,
friendships and congeniality must also be considered. SLC failed its burden of
proving independence. The social relationships between SLC and the directors
were too close to assume independence.
 Rule: A director is not independent only if he is not dominated and controlled by
an interested party. The question of independence turns on whether a director is,
for any substantial reason, incapable of making a decision with only the best
interests of the corporation in mind. Focus on impartiality and objectivity.

The Role and Purpose of Corporations

The Role and Purposes of Corporations
Ultra Vires Outside the power of the corporation. §102(A)(3)
The strict ultra vires approach doesn’t apply nowadays, but there are
still limits on corporate philanthropy
Gifts It has to be within reasonable charities and not given to a pet charity.
A.P. Smith v. Barlow
Dividends 1. Directors Declare §170(a)
2. Shareholders Come First (Dodge v. Ford)
3. Boards protected by BJR (Shlensky v. Wrigley)

 Corporate Powers and Ultra Vires Acts

 Ultra vires “beyond the powers” vs. Intra vires “within the powers”

21
  DGC Code §102(A)(3)
o Certificate of incorporation shall set forth the nature of the business or
purposes to be conducted or promoted.
o May simply say “any lawful act or activity”
o May contain restrictions
 DGCL §124
o No act or transfer of property shall be invalid because ultra vires but lack of
capacity or power may be asserted:
 Shareholder suit to enjoin corporation from entering into such act or
transfer of property
 Corporate suit against directors and officers
 Suit by state attorney general
 DGCL §122
o Every corporation shall have the power to … sue and be sued, … acquire real
or personal property and dispose of same, … conduct its business within or
without this state, … appoint officers, …wind up and dissolve, … make
donations for the public welfare or for charitable, scientific or
educational purposes, … make contracts and borrow/lend money, … pay
pensions, … buy insurance for its benefit on life of directors, officers,
employees, or any shareholder …

 Corporate Philanthropy/Charitable Donations

 CA Corporations Code Section 207(3): power to make donations regardless of
specific corporate benefit for the public welfare, or for community fund,
hospital, charitable, educational, scientific, civic or similar purposes
 NY BCL Section 202(a)(12): make donations irrespective of corporate benefit
for the public welfare or for community fund, hospital, charitable, educational,
scientific, civic or similar purposes, and in time of war or other national
emergency in aid thereof
 PA Code Section 102(d): directors may in considering the best interests of the
corporation consider the effects of their actions on any and all groups affected
by such actions, including shareholders, employees, suppliers, customers and
creditors of the corporation, and upon communities in which offices or other
establishments of the corporation are located
 Under Federal income tax law, the deduction for charitable contributions by
corporations is limited to 10% of taxable income (the deduction is not dependent
on the existence of a business purpose for the contribution)
 “Elephant Bumping”
o Warren Buffet gatherings of the rich and powerful
o Buffet’s friend is a chief fundraiser for a philanthropy. When he calls on a
CEOs for donations he likes to take another Big Shot (“elephant”) with his to
encourage them to donate
o Elephants like to go places where other elephants are because it reaffirms for
them that they are important

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 A.P. Smith Mfg. Co. v. Barlow (Princeton Donation, State Law applies to
previous entities)
 P had a history of charitable giving to universities
o The board of directors adopted a resolution, which set forth that it was in the
corporation’s best interests to join with others in the 1951 Annual Giving to
Princeton University
 Barlow (D) and other shareholders of P challenged its authority to make a
charitable donation to Princeton University
o AP Smith then instituted a declaratory judgment action
 D argues that the giving to Princeton University was ultra vires (outside the
bounds of the corporate’s power)
o The company’s certificate of incorporation does not expressly authorize the
contribution and under common-law principles the company does not possess
any implied or incidental power to make it
o The New Jersey statutes which expressly authorize the contribution may not
constitutionally be applied to the P a corporation created long before their
enactment
 1930 NJ Statute (passed after the incorporation of AP Smith)
o Expressly provided that any corporation could cooperate with other
corporations and natural persons in the creation and maintenance of
community funds and charitable, philanthropic or benevolent instrumentalities
conducive to public welfare
 P’s argument Social benefits
o In favor of sustaining the gift, it argues that there is a corporate interest in
giving the gift (such as hiring the future graduates as its employees)  direct
benefit
o Promoting capitalism and democracy which will be good for the corporation
in the end  indirect benefit
 Court’s Reasoning
o Modern conditions require that corporations acknowledge and discharge
social as well as private responsibilities as members of the communities
within which they operate
o 1930 NJ statute
 Donation in excess of 1% of the capital stock required 10 days notice to
stockholders and approval at a stockholders’ meeting if written objections
were made by the holders of more than 25% of the stock
 1949 amendment: 1% of capital and surplus
o NJ Constitution Reserved power for alteration, suspension, and repeal
corporate charters
o Zabriskie doctrine
 Although the reserved power permits alterations in the pubic interests of
the contract between the state and the corporation, it has no effect on the
contractual rights between the corporation and its stockholders and
between stockholders inter se.

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  Other cases after Zabriskie repeatedly recognized that where justified by
the advancement of the public interest, the reserved power may be invoked
to sustain later charter alterations even though they affect contractual
rights between the corporation and its stockholders and between
stockholders inter se
 Court identifies Limitations to Corporate Donations What limitations do
corporations have to be mindful of in order to have the gifts to be sustained by the
court if it is objected by shareholders?
o Must be reasonable in amount, in relationship to the size of the assets of the
corporation (NJ statute)
 DE = court defined the reasonable gift to be up to the amount of
deductions in the income taxes
o Corporate benefits such as reputational advantage
o Don’t give indiscriminately to a pet charity of the corporate directors in
furtherance of personal rather than corporate ends
 Because the pet charity might not be something that the whole board or
company is interested to give
 It will be more self-interests of certain directors rather than of the whole
board
o Must be voluntarily made in the reasonable belief that it would aid the public
welfare and advance the interests of the P as a private corporation and as part
of the community in which it operates
 Holding: Court sustained validity of the donation. The donation was made to a
preeminent institution of higher learning, was modest in amount and well within
the limitations imposed by the statutory enactments and was voluntarily made in
the reasonable belief that it would aid the public welfare and advance the interests
of the plaintiff as a private corporation and as part of the community in which it
operates.
 Rule: CL states that those who manage the corporation could not disburse any
corporate funds for philanthropic or other worthy cause unless the expenditure
would benefit the corporation.

 Dividends
 DGCL §170(a): Directors may declare and pay dividends out of surplus or net
profits, subject to restrictions in certificate of incorporation.
 Recognized in corporate law that there is NO automatic/legal right for
shareholders to receive dividends
 Dodge v. Ford Motor Co. (Rule of Shareholders First- No longer the majority
view)
 Ford Motor Co. was incorporated in 1903 with an investment of $150,000 where
H. Ford was the majority shareholder (58%) and the Dodge brothers were
minority shareholders (10%, not members of the board of directors and not
employed by the company).
 Ford Co. initially gave regular annual dividends plus special dividends
o The company’s profits were far in excess of the amount of these dividends

24
 o 1916: Ford Co. stopped paying the special dividends, and instead, invested
back to the company to expand the operation
 H Ford announced that profits would be reinvested in the business to
expand the operation and the price of the company’s cars would be
reduced
 1913: Dodge brothers had formed an auto company of their own, which competed
with Ford
o Dodge met with H Ford, offering to sell their shares to Ford, but Ford refused
 Ps (Dodge Bros.) then sued the company to compel the special dividends,
attacking both the dividend policy and Ford’s proposed plans to expand the
company’s manufacturing facilities
 P’s argument Bad faith and abuse of discretion
o Bad faith: The board is acting in bad faith in not giving the special dividends
o Abuse of discretion: withholding of the special dividend is arbitrary action of
the directors, abusing its discretion
o Argued that Ford had changed the “purposes” of the business changed the
goal from making profits for the shareholders to a “semi-charitable
institution” (Idea is that corporations are set up to advance shareholder value)
 Proposed expansion of the business out to be enjoined because inimical to
the best interests of the company and its shareholders
 The expansion plan is to continue the corporation henceforth as a semi-
charitable institution and not as a business institution (pointing to H Ford’s
expressions: “My ambition is to employ more men to spread the benefits
of this industrial system…”)
 D’s argument
o Acting in good faith in expanding the operation
o Implied and incidental power that the board has Hire more people, give
them higher wages
o The expansion can affect other people such as consumers who could buy more
cars at cheaper price
 Court’s Reasoning
o Hunter v. Roberts (Michigan SCt): “It is a well recognized principle that
directors alone have power to declare a dividend and determine its amount.
Courts of equity will not interfere in the management of the directors unless…
they are guilty of fraud or misappropriation of the corporate funds, or refuse to
declare a dividend when the corporation has a surplus of net profits…and
when a refusal would amount to abuse of discretion as would constitute fraud
or breach of good faith…”
o The directors of a corporation alone have the power to declare a dividend of
the earnings of the corporation and to determine its amount
 DGCL §170(a): Directors may declare and pay dividends out of surplus
or net profits, subject to restrictions in certificate of incorporation.
o Court of equity will not interfere in the management of the directors UNLESS
 The directors are guilty of fraud or misappropriation of the corporate
funds; or

25
  They refuse to declare a dividend when the corporation has a surplus of
net profits which it can, without detriment to its business, divide among its
stockholders; AND
 A refusal to do so would amount to such an abuse of discretion as would
constitute a fraud, or breach of that good faith
o 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
 The discretion of directors is to be exercised in the choice of means to
attain that end and does not extend to a change in the end itself
o H Ford’s plan for expansion does not call for and is not intended to produce
immediately a more profitable business, but a less profitable one
o H Ford’s decision was influenced by certain sentiments, philanthropic and
altruistic
 Holding: Court finds for Dodge Bros. This was an abusive of discretion by the
board and they must pay the special dividends to the SHs. The court held that the
powers of directors are employed to carry on primarily for the profit of
stockholders. It is not within a board’s lawful powers to conduct the affairs of a
corporation for the merely incidental benefit of the shareholders. Case tells us that
the nature of the corporation: in short run benefit of SHs but in long run there was
a benefit of keeping dividends.
o But, reversed the enjoining the building of the smelting part (business decision
– not for the court to decide)
 Rule: A corporation’s primary purpose is to provide profits for its shareholders.
o This is NOT really the rule anymore
 The Business Judgment Rule
 DGCL §141(a) – The business and affairs of the corporation shall be managed by
or under the direction of the board of directors. It is implied but not specifically
stated in the statute.
 Rebuttable presumption that directors and officers carry out their functions in
good faith, after sufficient investigation and for valid business reasons
Exceptions to the BJR (Schlensky v. Wrigley)
o Fraud
o Misappropriation of funds
o Lack of good faith (or abuse of discretion)
o Illegality
o Conflict of interest
 Breach of fiduciary duty
 Acting in your own best interest
 Schlensky v. Wrigley (A showing that other Boards are doing better not
justification to abandon right)
 Shlensky (P) minority shareholder of Chicago Cubs, DE corporation (w/
Chicago as principal place of business)
 Wrigley super majority of the Cubs (80%)

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  P filed a SH’s derivative suit against the directors for negligence and
mismanagement
 P’s argument BJR should not be applied
o Not installing the lights for night games P sought damages and an order that
D cause the installation of lights in Wrigley Field and the scheduling of night
baseball games
o Wrigley’s personal viewpoints obstruct the company’s interests in profits P
argued D refused to install lights because of his own opinion that baseball is a
“daytime sport” and not because of his interest in the welfare of the
corporation. No interest in whether the Cubs would benefit financially from
the lights
o Such arbitrary and capricious acts constitute mismanagement and waste
of corporate assets
o The directors have been negligent in failing to exercise reasonable care and
prudence in the management of the corporate affairs
 D’s argument
o The courts should not step in and interfere with honest business judgment of
the directors unless there is a showing of fraud, illegality or conflict of interest
o D made a valid, business judgment decision
 Detrimental to the neighborhood, bringing lower property values
 Baseball is a daytime sport
o P must overcome the presumption that the directors acted in good faith in
furthering the interests of the company
 Holding #1: Court upholds decision of directors based on deference (BJR). The
court held that plaintiff’s argument is too conclusory void of any pleading with
facts. The company’s refusal to install lights did not constitute negligence. They
held that evidence of other companies making money is not enough for boards to
give up their own judgment. They were chosen to make their own judgment not
follow others.
o Directors enjoy the benefit of a presumption that their judgment was formed
in good faith and was designed to promote the best interests of the corporation
they serve
o “It is not the court’s function to resolves for corporations questions of policy
and business management. Directors are chose to make such decisions and
their judgment, unless shown to be tainted with fraud, is accepted as final
 Holding #2: Ps also could not establish any exception to the BJR which is a
REQUIREMENT as a matter of law. BJR will protect corporate decision making
unless exception is established
o Exceptions to BJR: Fraud, Illegality, conflict of interest
o Ps also couldn’t establish causation that not installing lights lead to decrease
in revenue
 Rule: A SH’s derivative suit can only be based on conduct by the directors which
borders on fraud, illegality or conflict of interest
 Corporate Social Responsibility
The Berle-Dodd Debate

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 What is the nature and purpose of the modern business corporation?
Berle: Private Property Dodd: Social Institution Current Majority View
 Corps. are set up in  Corps. have a broader  “New” corporate social
order to advance purpose, they are a type responsibility
shareholder interests of social institution and  Shareholder interest is
 Every decision should do have some the primary purpose, but
support the interest of responsibility to the it is permissible for
greater profits for public and not just them to give money to
shareholders shareholders charity/assist the public
(social institution)
 ALI Principles of Corporate Government §2.01
o Corporation’s objective is to conduct business with a view to enhancing corporate
profits and shareholder gain
o Even if corporate profit and shareholder gain are not enhanced, corporation is
obliged to act within bounds of the law, may take into account ethical
considerations appropriate to conduct of business, may devote reasonable amount
of resources to public welfare, humanitarian, educational and philanthropic
purposes
 The “new” corporate social responsibility
o Corporate Social Responsibility companies voluntarily decide to respect and
protect the interests of a broad range of stakeholders and to contribute to a cleaner
environment and better society through active interaction with all
o Corporate social responsibility goes beyond compliance with laws to capture
voluntary initiatives to do more than what is legally required
o Supported by company level, industry level, and international codes of conduct
 Developed by business, civil society, national governments and
intergovernmental organizations
o Areas of coverage
 Core labor standards
 Green environmental standards
 Reject bribery and corruption of government officials to facilitate business
 Respect human rights

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 LIMITED LIABILITY COMPANIES
Characteristics
 “Hybrid” form of business association Can combine limited liability and flow
through tax treatment
o Combines popular features of Corps. and General Partnerships
 Corp. → Limited liability
 Partnership→ flow through tax treatment
 Created under state statutes enacted in all 50 states
 ULLCA (Model Rule we will be using) provides rules for structure, governance, and
operation
 ULLCA §201: LLC is a legal entity distinct from its members- more like a
corporation than a partnership
o Owners are referred to as members
 Corporate Characteristics
o Limited liability
o Free transferability – Don’t need the permission of the other investors to sell
interest.
o Continuity of life – substitute new members for old members
o Centralized management (versus member management) – option. Centralized
designate certain persons to run. Or Member management every investor/member
 Tax treatment:
o Prior to 1997, LLC could only receive flow through tax treatment if it had 2 or
fewer of the above attributes
o IRS 1997 Check the Box regulations simplify tax treatment of LLCs – now is
possible to incorporate more than 2 of the above characteristics.

Formation  Articles of Organization §§202, 203

o Amendments §204
 Must put LLC by name Westec v. Lanham
Operating Agreement  Operating Agreement §103
 Maximum effect of Contract Freedom Elf v. Jaffari
Piercing the “LLC”  In the absence of fraud, a claim to pierce the veil of an LLC
Veil is treated in the same manner as a court would pierce a
corporate veil. Kaycee v. Flahive
Fiduciary Obligations  Fiduciary Duties §409
o Non-Managers owe no duty
 Agents §301
 Can limit competition scope by K McConnell v. Hunt
Dissolution  §801 – Events of dissolution
 §802 – Winding up after dissolution
 §805 - Filing of articles of termination
 §806 – Creditors must be paid! (including Members);
Members entitled to return of contributions
 §807 – Disposing of known claims by giving notice to

29
 creditors – should be paying off debts to the creditors.
 §808 – Disposing of other claims by publishing notice to
creditors in a newspaper
o §808(d)(2) – Member liability to creditors up to amount
received in distribution
 If don’t follow procedure personally liable New Horizons
 Documents Required for Formation
 Contrast to partnerships that don’t require any filings, don’t even need a written
agreement (can be oral)
 Filing of Articles of Organization with state
o Contents are dictated by statute
 Execution by members of Operating Agreement
o Not filed with state and not publicly available
o Are like by-laws for corporations
o Often cover topics such as membership, governance, finance, dissolution
o Flexible structure can be used to revise default rules subject to limits spelled
out in ULLCA §103
 Articles of Organization
 ULLCA §202: One or more persons (“organizers”) may form LLC, consisting of
one or more members, by filing articles with secretary of state
o LLC comes into existence when articles filed with secretary of state
 ULLCA §203: Contents of Articles of Organization
o Name of company
o Address
o Name and address of agent for service of process,
o Name and address of organizer
o Term, if there is one
o Whether manager managed and name and address of managers
 LLC can be managed by managers or by members
 If you don’t specify manager managed, implies that LLC is managed by
everyone who invested in the company
o Liability of members for debts and obligations, if applicable
 ULLCA §204: Amendment of Articles of Organization
o Must be filed with state
 Styles of LLC Management
 ULLCA §404 (a) Member Managed:
1. each member has equal rights in the management & conduct of the company’s
business; and
2. except as otherwise provided in subsection (c), any matter relating to the
business of the company may be decided by majority voting (more like a
partnership)
 ULLCA §404 (b) Manager managed:
1. each manager has equal rights in management/conduct of the business;

30
 2. except as otherwise provided in subsection (c), any matter relating to the
business may be exclusively decided by the manger or, if more than one
manager, majority voting by managers (more like a corporation)
3. Managers must be designated, removed, replaced by a majority consent of
Members
 ULLCA §404 (c) Consent of all Members required for certain important events -
fundamental changes - will affect rights and obligations of every member
(merger, dissolution, new line of business)
 Operating Agreement
 ULLCA §103 Operating Agreement- Executed by members of LLC
 ULLCA §103(a): Members of LLC may enter into Operating Agreement to
regulate conduct of business and relations among members, managers and
company
 May not change provisions of the ULLCA specified in §103(b)
 Unless changed by Operating Agreement, the default rules of the ULLCA apply
 Not filed with state and not publicly available
 Often cover topics such as membership, governance, finance, dissolution
 Flexible structure can be used to revise default rules subject to limits:
o Restrict access to records
o Eliminate the duty of loyalty
o Unreasonably reduce duty of care
o Eliminate obligation of good faith and fair dealing
o Expulsion (see §601(6))
o Vary wind up requirement
o Restrict person’s right to distribution interest.
o Exculpatory Clause: Court will not enforce because the courts do not want
people to screw each other over without impunity. Do not want to use the veil
of the state to get away with murder.

 Westec v. Lanham (Need LLC Next to Your Name)

 Suit for money due for services performed under contract.
 Westec- land development and engineering company
 Lanham and Clark- managers and members of Preferred Income Investors, LLC
o Clark contacts Westec about hiring Westec to perform work in connection
with construction of Taco Cabana
 Cark gave PII business card to Westec
o PII business card did NOT have LLC on it
o Had Clark’s name on it
o Had Lanham’s address on it (also used as address for PII)
 Westec thought they were dealing with Lanham and PII, even though they had no
information about the company
 Westec never got a signed K, but got verbal authorization from Clark to begin
work
 Westec completed the work and sent a bill for $9000 to Lanham
o No payments were made on the bill. Westec sued Clark, Lanham, PII

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 P’s argument Agency law
o Clark was an agent working on behalf of Lanham and the Company
o Under CL of agency law, an agent is liable on a K entered on behalf a PL if
the PL is not fully disclosed
 D’s argument notice provision of LLC act
o “The fact that the articles of organization are on file in the office of the
secretary of state is notice that the limited liability company is a limited
liability company and is notice of all other facts set forth therein which are
required to be set forth in the articles of organization.”
o Filing of the articles of organization serves as constructive notice of the
company’s status as a LLC. Thus, Lanham is not personally liable since
Westec constructively knew that it was dealing with a LLC. Only the LLC
Company is liable to Westec.
 Court’s Reasoning Agency law
o Liability of an agent on a K where principal is not fully disclosed
o “If both the existence and identity of the agent’s principal are fully disclosed
to the other party, the agent does not become a party to any contract which he
negotiates…But where the principal is partially disclosed (i.e. the existence of
a principal is known but his identity is not), it is usually inferred that the agent
is a party to the contract.”
o Whether a PL is partially/completely disclosed is a question of fact.
 Court’s Reasoning Notice Provision of LLC Act
o “The fact that the articles of organization are on file in the office of the
secretary of state is notice that the limited liability company is a limited
liability company and is notice of all other facts set forth therein which are
required to be set forth in the articles of organization.”
o To relieve D of liability, this provision must be read to establish a conclusive
presumption that a 3rd party who deals with the agent of a LLC always has
constructive notice of the existence of the agent’s principal.
o Court = “We are not persuaded that the statute can bear such an
interpretation”
o The LLC statute does not supersede the common law on agency
 The statutory notice provision applies ONLY WHERE a 3rd party seeks to
impose liability on an LLC’s member of managers simply due to their
status as members of managers of the LLC
 When a 3rd party sues a manager or member of an LLC under an agency
theory, the principles of agency law apply NOTWITHSTANDING the
LLC Act’s statutory notice rules.
 Dispositive factor Clark and Lanham did not disclose the full name of the
business entity and what type of the company was (LLC).
o The missing link between the limited disclosure made by Clark and the
protection of the notice statute was the failure to state that “P.I.I.” stood for
“Preferred Income Investors, LLC”
o Therefore, the LLC statute cannot be used in this case.

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  Holding: Because the legislation included a requirement that LLC’s type LLC
next to their names, the court inferred that the legislature did not intend
constructive notice to relieve the agent of a LLC of the duty to disclose its identity
in compliance with CL agency. Lanham is personally liable
 Rule: LLC act provides that the filing of the article of organization serve as a
constructive notice of a company’s status as a LLC. However, the notice does not
replace the common law duty of notice under an agency theory.

Operating Agreement
 ULLCA §103(a): Members of LLC may enter into Operating Agreement to
regulate conduct of business and relations among members, managers and
company
 May not change provisions of the ULLCA specified in §103(b)
 Right to information – can’t unreasonably restrict members right to get business
information
 Cannot completely eliminate the fiduciary duty of loyalty and duty of care; BUT,
 §(2)(i) can identify specific types or categories of activities that do not violate the
duty of loyalty, if not manifestly unreasonable
 §(2)(ii) specify the #/percentage of members or disinterested managers that may
authorize or ratify/ after full disclosure of all material facts,/ a specific act or
transaction that otherwise would violate the duty of loyalty
 Even though you can contract around certain stuff, these are prohibited
 Unless changed by Operating Agreement, the default rules of the ULLCA apply
 There is freedom of K in regards to OA, but there are limitations (Elf)
 Elf Atochem North America v. Jaffari (Operating Agreement: Freedom of K)
 Derivative lawsuit on behalf of a Delaware LLC.
 Who formed Malek LLC?
o Elf Atochem North America→ manufacturing and distributing corporation
o Jafari→ owner of Malek Inc.
o Elf provided capital and marketing assistance, Jafari came up with design for
mask
 Documents executed in connection with formation and operation of LLC
o Certificate of Formation
 Malek, Inc. filed a Certificate of Formation with the DE secretary of State,
forming Malek LLC, a DE limited liability company under the Act
 The certificate does not contain a comprehensive agreement among the
parties, and the statute contemplates that the certificate of formation is to
be complemented by the terms of the Agreement
o Employment Agreement
 Jaffari will be the manager/CEO of the LLC
 Elf contributed $1M in exchange for a 30% interest in the LLC
 Malek, Inc. contributed its rights to the technology in exchange for a 70%
interest in the LLC
o Distributorship Agreement

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  Elf and the LLC entered into an Exclusive Distributorship Agreement
where Elf would be the exclusive, worldwide distributor for Malek LLC
 No forum selection or arbitration clause here.
o Operating Agreement
 Forum Selection Clause→ §13.8: “Any controversy or dispute arising out
of this Agreement, the interpretation of any of the provisions hereof, or the
action or inaction of any Member or Manager hereunder shall be
submitted to arbitration in San Francisco, California”
 Choice of Law Provision→ §13.8: “No action based upon any claim
arising out of or related to this Agreement shall be instituted in any court
by any Member except an action to compel an arbitration or an action to
enforce an arbitral award”
 Jurisdiction Clause→ § 13.7: “All Members consent to the exclusive
jurisdiction of the state and federal courts sitting in California in any
action on a claim arising out of, under or in connection with this
Agreement or the transactions contemplated by this Agreement provided
such claim is not required to be arbitrated pursuant to Section 13.8 and to
personal jurisdiction in California.
 Holding: The court found that “any claim arising out of” and “in connection
with” language subsumed all claims stemming from the agreement including
derivative suits. Elf contracted away its right to the derivative suit in Delaware.
 Rule: Partners to an LLC are given the maximum effect to the principle of
freedom of contract and to the enforceability of LLC agreements and are allowed
to K away certain provisions of the Delaware Limited Liability Act. Only where
the agreement is inconsistent with mandatory statutory provisions will the
members’ agreement be invalidated to protect 3rd parties

Piercing the LLC Veil

 Limited Liability in LLCs and Piercing the Veil (ULLCA §303)
o Debts, obligations, liabilities of LLC belong solely to the company
o Members or managers are NOT personally liable for debts, obligations and
liabilities of LLC, whether arising in contract, tort or otherwise
o Failure to observe formalities or requirements for exercise of powers or
management are NOT a ground for imposing personal liability
o Members can become LIABLE for debts etc. if they so consent in writing and
include a provision in articles
 ULLCA §303 Liability of Members and Managers- NO piercing absent
consent/provision in articles of organization
(a) Debts, obligations, liabilities of LLC belong solely to the company
o Members or managers are NOT personally liable for debts, obligations and
liabilities of LLC, whether arising in contract, tort or otherwise
(b) Failure to observe formalities or requirements for exercise of powers or
management are NOT a ground for imposing personal liability
(c) Members can become LIABLE for debts etc. if they so consent in writing and
include a provision in articles of organization
(1) a provision to that effect is contained in the articles of organization; AND

34
 (2) a member so liable has consented in writing to the adoption of the provision or
to be bound by the provision
 Must look to state statutes
o Piercing is generally allowed when corporation/LLC fails to respect the corporate
entity OR injustice would result if veil weren’t pierced
o ULLCA is the default rule when there is no state statute
 Differences between corporation and LLC for piercing:
o Observing formalities not relevant for LLC
o No board of directors for LLC
 Kaycee Land and Livestock v. Flahive (No Difference from Corp. Veil)
 P = Kaycee Land and Livestock
 D = Flahive Oil and Gas LLC (WY LLC with no assets at this time)
o Roger Flahive = managing member of Flahive Oil and Gas LLC
 P entered into a K with D allowing D to use the surface of its real property
o P alleges that D caused environmental contamination to its real property in
WY
o P seeks to pierce the LLC veil and disregard LLC entity and hold R
individually liable for the contamination
o No allegation of fraud
 Issue: In the absence of fraud, can the LLC veil be pierced in the same manner as
a court would pierce a corporate veil as an available remedy against a Wyoming
LLC?
 P’s Argument That the legislature intended for the veil to be pierced
 D’s argument Because piercing the veil for LLCs is not specifically mentioned
in the statute, it should not be permitted
o Language that carves out the exception to piercing the corporate veil is
missing
 Comparison of Statutes
o Wyoming Business Corporation Act: “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.”
o Wyoming LLC Act: “Neither the members of an LLC nor the managers of an
LLC…are liable under a judgment, decree or order of a court, or in any other
manner, for a debt, obligation or liability for the LLC”.
 Holding: Piercing is appropriate in the context of an LLC (doesn’t depend on
specific language of statute). The court held that the same manner used to pierce a
corporate veil can be used to pierce the LLC veil, since the legislature did not
clearly intend otherwise and they could find no reason in law and policy to do
otherwise.
 Rule: In the absence of fraud, a claim to pierce the veil of an LLC is treated in the
same manner as a court would pierce a corporate veil.
 Test for LLC PCV

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 o LLC veil piercing is possible when the court thinks that it will be unfair and
unjust for creditors to be damaged – if injustice (something less than
common law fraud) would result
o Injustice Prongs Members and officers of an LLC should not enjoy
immunity from individual liability for the LLC’s acts when:
1. they fail to treat the LLC as a separate entity as contemplated by statute
(i.e. business and personal accounts are not kept separately?); AND
2. the LLC’s acts cause damages to 3rd parties

Fiduciary Obligations
 Fiduciary Obligations of Members & Managers
 These duties can be waived by contract subject to limitations contained in
ULLCA §103(b)
ULLCA §404 Two styles of LLC Management: Member management and Manager
management
 Member Managed: Members have equal rights in management, majority voting
for business decisions
 Manager Managed: Managers have equal rights in management, majority voting
by managers for business decision (by contract)
 Managers must be designated, removed, replaced by a majority of Members
 Consent of all Members required for certain important events (majority voting)
ULLCA §409: General Standards of Member’s and Manager’s Conduct
(Member/Manager choices in LLC contract in operating agreement)
 Member owes duty of loyalty and care to member managed company and its other
members
o Duty of loyalty: 1) accounting for profit from use of property of LLC and
appropriation of corporate opportunity, refrain from acting adversely to the
LLC’s interests, 2) refrain from acting adversely to the LLC’s interests 3)
refrain from competing with the company in the conduct of its business before
dissolution
o Duty of care: do not engage in grossly negligent or reckless conduct,
intentional misconduct, knowing violation of law
 Manager in a manager managed company owes same duties prescribed for
members (§409(h))
o Members who do not manage owe no duties to company or to other members
solely by reason of being a member
o Example: AB Industries LLC has two members, Ann and Barb. It is a
manager managed company with Chris serving as nonmember manager.
Chris may not compete with ABC. Ann and Barb may compete.
 Agency of Members and Managers
 ULLCA §301 - Each Member is an AGENT of LLC for purpose of its business
and acts of Members for apparently carrying on ordinary business of LLC binds
the company, unless there was no authority and 3P knew this
o Acts not for apparently carrying on ordinary business binds only if authorized
by the other members

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 In a manager managed LLC:
o A member is not an agent solely by reason of being a Member
o Each manager is an agent and binds the company if apparently carrying on
ordinary business of LLC, unless the manager had no authority to act on that
matter and 3P had notice of that fact.
o Act of a manager not for apparently carrying on ordinary business binds
company only if authorized as required by ULLCA §404
 §404(b)(2): any matter relating to the business of the company may be
exclusively decided by the manager or by a majority of the manager
 §404(c): matters that require the consent of all of the members
 §404(d): Action requiring the consent of members or managers under this
Act may be taken without a meeting
 §404(e): A member of manager may appoint a proxy to vote or otherwise
act for the member of manager by signing an appointment instrument
(either personally or by the member’s or manager’s attorney-in-fact)
 McConnell v. Hunt Sports Enterprises
 Columbus Hockey Limited, LLC (CHL)
o Formed by several individuals to seek a NHL franchise for Columbus Ohio
o McConnell and Hunt = investors in CHL
o CHL needed an arena and sought public financing through a tax increase
(voter-rejected)
 Nationwide Insurance Enterprise
o Developed interest in building the arena and leasing it to the holder of the
franchise
o McPherson = Nationwide’s chairman and CEO
o McPherson met with Hunt who purported to act for CHL (without consulting
with other CHL investors)
 Columbus Hockey Limited LLC Operating Agreement
o Section 3.3: Members May Compete. Members shall not in any way be
prohibited from or restricted in engaging or owning an interest in any other
business venture of any nature, including any venture which might be
competitive with the business of the Company
o Section 4.1: “No member may take any action on behalf of the company
unless such action is approved by a majority of the units allocated.” (member
managed LLC)
 Issues: 1) Whether an operating agreement of a limited liability company may, in
essence, limit or define the scope of the fiduciary duties imposed upon its
members 2) Whether the Hunt group breached the operating agreement by failing
to obtain the approval of the other CHL members prior to filing, in CHL’s name,
the answer and counterclaim in this suit and the suit in New York
 P’s Argument McConnell alleges breach of obligations of management of the
franchise against Hunt.
o McConnell group did not violate any fiduciary duty (not to compete or
tortious interference)

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  Section 3.3 in the operating agreement allows P to freely compete, even
with the business of CHL (“pro-compete clause”)
o Hunt group violated the CHL operating agreement in failing to ask for and
obtain the authorization of CHL members, other than the Hunt group
members, prior to filing the answer and counterclaim in this action and the
suit in New York
 D’s Argument Hunt alleges breach of fiduciary duty against McConnell.
o Section 3.3 in the operating agreement is ambiguous
 The word “other” means “any business venture that is different from the
business of the company”
 Court this interpretation goes beyond the plain language of the
agreement and adds words/meanings not stated in the provision
o McConnell group violated fiduciary duty by forming and joining COLHOC
(Limited Partnership), by excluding other CHL members (Hunt) from
participating in an NFL franchise, by preparing to compete against CHL and
in not providing addition capital for CHL
 Conflict of interest (especially, “taking the business opportunity”)
McConnell took the business opportunity that belonged to CHL and took
advantage of that opportunity for himself
 Court jury instruction on this matter was proper because the McConnell
group were permitted to compete against CHL for a hockey franchise &
no requirement that CHL members contribute additional capital
o Under the operating agreement, it could only be liable for willful misconduct
 The Hunt group was the “operating member” of CHL and therefore had
full authority to act on CHL’s behalf
 Holding: The court held that the operating agreement could limit the scope of the
fiduciary obligation not to compete with the LLC. Furthermore the court held that
there was no claim for tortuous interference with a business relationship because
McConnell made no secret to compete with the LLC, which was clearly within his
rights in the agreement.
 Rule: Normally the presence of an LLC relationship would preclude direct
competition between members of the company. But that can be contracted away
in the operating agreement.
o Extrinsic evidence will be considered (to give effect to the parties’
intentions) ONLY WHERE the language of a K is unclear or ambiguous or
when the circumstances surrounding the agreement invest the language of the
K with a special meaning
 When a term is ambiguous?
o Common words in a written K will be given their ordinary meaning
unless manifest absurdity results OR unless some other meaning is
clearly evidenced from the face or overall content of the K
o Fiduciary relationship A relationship where special confidence and trust is
reposed in the integrity and fidelity of another, and there is a resulting position
of superiority or influence acquired by virtue of this special trust
 Such fiduciary duty in this case must be considered in the context of
members’ ability, pursuant to operating agreement, to compete with the

38
 company (without this pro-competition clause, the direct competition with
CHL would be a breach of fiduciary duty)
 An operating agreement of a LLC may limit or define the scope of the
fiduciary duties imposed upon its members.
 Hypo Redrafting the section 3.3
o Draft for Mr. Hunt
 Separate sentence that no competition allowed with CHL for the same
business that CHL pursues
o Draft for Mr. McConnell
 Make it broader – take out the word “other”

Dissolution
 Dissolution under the ULLCA
 §801 – Events causing dissolution & winding up of business
 §802 – LLC continues after dissolution / Winding up after dissolution
 §805- Filing of Articles of Termination
(a) File with the Secretary of the State Articles of Termination, stating:
(1) the name of the company;
(2) the date of the dissolution; and
(3) that the company’s business has been wound up and the legal existence
of the company has been terminated
 §807 – Disposing of known claims by giving notice to creditors (US government,
state government for tax are also creditors). A dissolved LLC shall notify its
known claimants in writing of the dissolution.
 §806 – Creditors must be paid! (including Members); Members entitled to return
of contributions (any remainder in equal shares)
 §808 – Disposing of other claims by publishing notice to creditors in a newspaper
o Other claims are barred
o §808 (d)(2) Orderly dissolution according to statutory procedures can limit
liability to amount received in liquidation
 Member liability to creditors up to amount received in distribution (if the
member had followed the steps above, otherwise, personally liable for the
debts)
 New Horizons Supply Cooperative v. Haack (Gas for Truck, Left Unpaid)
 Suit for unpaid debt.
 Haack signed a “Cardtrol Agreement” whereby Patron (Kickapoo LLC) agreed to
be responsible for payment of all fuel purchased with the “Cardtrol Card” issued
under the agreement by a predecessor to New Horizons
 Signed by “Allison Haack” with no designation indicating whether her
signature was given individually or in a representative capacity on behalf
of Kickapoo LLC
 P argues piercing the corporate veil
 D tried to use defense of legal rule of limited liability
 Court denies the defense

39
 o Ultimately they do believe that Allison is liable, but they disagree with the
lower court’s reasoning
 TC’s rationale that Kickapoo’s treatment as a partnership for tax purposes
is NOT conclusive for piercing the veil
 Court states that lower court “erroneously deemed Kickapoo’s treatment
as a partnership for tax purposes to be conclusive”.
o But, this Court affirms the judgment against Haack because Haack failed to
establish that she took appropriate steps to shield herself from liability for the
company’s debts following its dissolution and the distribution of its assets
 Since she did not follow the statutory steps for dissolution, she is not
protected from the liability as LLC.
 Although filing articles of dissolution is option, the order for distributing
the company’s assets following dissolution is fixed by statute, and the
company’s creditors enjoy first priority
 Holding: The court held that evidence that the LLC was treated as a partnership
was not sufficient to pierce the veil. However they still held Haack liable since
she failed to follow the dissolution process properly and had not disposed all of
the company’s assets.
 Rule: A member or manager of an LLC is not personally liable for any debt,
obligation or liability of the LLC. A piercing of LLC veil follows same rules as
piercing corporate veil. Filing of articles of organization is conclusive proof of
organization of an LLC. Upon dissolution of LLC the company’s assets must be
distributed in the following order; creditors get first priority. LLC must dispose of
articles of dissolution and provide written notice to its known creditors.

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 FIDUCIARY DUTIES OF OFFICERS, DIRECTORS &
OTHER INSIDERS
Duty of 2 Prong Test:
Care  1) Duty to exercise due care by being informed and having
documents to support (Van Gorkom)
 2) Duty to oversee (Francis).
Duty of Directors and Burden shifts to the director for personal transactions
Loyalty Mangers on the company’s dime. Bayer v. Beran

Corporate Guth v. Loft Test:

Opportunities 1. Financial ability
2. Same line of business
3. Interest or expectancy
4. Taking opportunity would create conflict
between self-interest and interest of
corporation
Dominant Intrinsic Fairness Test: The test involves both a
Shareholders high degree of fairness and a shift in the burden of
proof. The burden is on the accused to prove, subject
to careful judicial scrutiny, that its transactions were
subjectively fair.
Ratification Interested director/officer transaction not void or
voidable if
1. material fact disclosure and disinterested
director approval; or
2. material fact disclosure and shareholder
approval; or
3. contract is fair (Don’t Want to be here)
§144(a)

The Obligations of Control: Duty of Care

 Kamin v. American Express Company
 Shareholder derivative suit in the name of the corporation, suing the directors of
American Express (AE)
 P= two minority stockholders asking for a declaration that a certain dividend in
kind is a waste of corporate assets

41
 o Directing the defendants not to proceed with the distribution, or
o (in the alternative), for monetary damages (declaratory judgment or damages)
 Individual Ds = directors of the company, moving for an order dismissing the
complaint for failure to state a cause of action, alternatively, for summary
judgment
 1972: AE acquired shares of DLJ at a cost of $29.9 million
o Current market value of those shares = $4 million
o 1975: Board of Directors of AE declared a special dividend to all stockholders
(shares of DJL would be distributed in kind)
 Ps argue that the sale of those shares (instead of distribution) would incur $25
million loss which could be offset against taxable capital gains on other
investments (which would result in $8 million in tax savings)
o Directors were negligent in their actions (distributing the shares in kind rather
than selling them and gaining tax advantages) and it was breach of fiduciary
duties (duty of care)
 Ps demanded (1) directors rescind the previously declared dividend in DLJ shares;
(2) take steps to preserve the capital loss which would result from selling the
shares
o This demand was rejected by the Board of directors
o The Ps never moved for temporary injunctive relief and the dividends were
paid
 P’s argument
o Ds violated their fiduciary duty of care owed to Amex to preserve Amex’s
assets in the same manner as a man of average prudence would care for his
own property
o P’s claim does not contain any claim of fraud, self-dealing, and bad faith or
oppressive conduct
 D’s argument
o The affidavits & exhibits of the Ds show:
 Ps’ objections to the proposed dividend action were carefully considered
and unanimously rejected by the Board at a special meeting called
precisely for that purpose at the Ps’ request
 Ds gave the facts (called to attention; about other options) consideration
and attempted to view the total picture in arriving at their decision
 Court’s Reasoning
o Whether or not a dividend is to be declared or a distribution of some kind
should be made is exclusively a matter of business judgment for the Board
of Directors
 The statute confers upon the directors this power and the minority
stockholders are not in a position to question this right, so long as the
directors are acting in good faith
 The board of directors had rational basis in their business judgment to
distribute the stocks rather than sale of those
 They considered that if they were to sell the stocks at issue, then their
income would go down and their market value of their company stocks

42
 would decrease. That was why they decided to go with distribution rather
than sale
o DGCL §141(e) – In performing their duties, board members may rely in good
faith on records of corporation and on information, opinions, reports,
statements presented to the corporation by corporation’s officers or employees
 Holding: The court found that it is not enough to find that the board made an
imprudent decision or made a mistake of judgment to overcome the BJR. In order
to find that the Board has violated its duties they must be guilty of gross
negligence caused by malfeasance or nonfeasance.
o Nonfeasance The failure to act when a duty to act existed.
o Malfeasance A wrongful or unlawful act; esp. wrongdoing or misconduct
o Simple (ordinary) negligence (such as mere errors of judgment) is not enough
to overcome the presumption of business judgment rule (with rational
decision) because the powers of those entrusted with corporate management
are largely discretionary.
 Rule: Neglect of duties, malfeasance (fraud…), nonfeasance, conflict of interest,
oppression, arbitrary action or breach of trust…must be proven to overcome the
BJR presumption
 Further Analysis: 4 of 20 directors were officers and members of the AE
Executive Incentive Compensation Plan?
o The right claim would be self-dealing (breach of duty of loyalty)
 Claim of self-dealing/self-interest either:
1. Majority of the board is involved in that regard (self-interest); or
2. Domination
o There is no claim or showing that the four company directors dominated and
controlled the sixteen outside members of the Board. Thus, this claim would
fail as well.

Procedural Duty of Care

 Merger Procedures
 DGCL §251(b) – BOARD APPROVAL
o Board of each merging corporation shall adopt a resolution approving an
agreement of merger and declaring its advisability
 DGCL §251(C) – STOCKHOLDER APPROVAL
o Merger agreement shall be submitted to stockholders for approval
o Majority of shares entitled to vote must approve
o If approved by stockholders, merger agreement (or certificate of merger)
is then filed and becomes effective
 Management by Board of Directors
 DGCL §141(a) - BOARD AUTHORITY
o Business and affairs of corporation shall be managed by or under the
direction of a board of directors
 DGCL §141(b) – BOARD COMPOSITION & ACTION
o Composed of one or more members (fixed in bylaws or certificate)

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 o Majority of total # = QUORUM (can reduce to 1/3 in bylaws unless
certificate provides otherwise)
o VALID BOARD ACTION = vote of a majority of directors present at a
meeting with a quorum present (can require supermajority (=over 50%)
in certificate or bylaws)
 Shareholder Voting
 DGCL §216 SHAREHOLDER VOTING
o Majority of shares entitled to vote shall constitute a quorum at a
stockholder meeting (can reduce to 1/3 in certificate or bylaws)
o Vote of majority of those present or represented by proxy shall be the act
of the stockholders (except for election of directors)
o Directors elected by plurality
 Smith v. Van Gorkem (Cash out merger)
 A cash-out merger under DE corporate law
o A merger in which shareholders of the target company must accept cash for
their shares.
o One type of corporate combination
o Acquiring company pays shareholders of target company the value of their
shares
o Target company is merged out of existence and shareholders have no interest
in any company that results from the merger
o Shareholders’ interests are protected by fiduciary duties of directors
o Requires BOTH board approval and stockholder approval
o Must approve the agreement and plan of merger
 Chronology of case
o 8/27/80 & 9/5/80 – Sr. Mgmt. & Van Gorkom discuss sale/leveraged buy out
(LBO) of TransUnion; CFO & COO ran the numbers at $50 & $60/share
o 9/13/80 – Van Gorkom meets w/ Pritzker & offers him TransUnion at
$55/share
o 9/15/80-9/19/80 – Pritzker expresses interest; subject to financing, lock-up
option & board approval within 3 days
o 9/20/80 – Van Gorkom convened meeting of senior management at 11 AM
followed by board meeting at noon
 no documentation or valuation study presented to board
 board approved after 2 hour meeting subject to conditions:
o Reserve right to accept better offer during market test period
o Share proprietary information with other potential bidders
o 10/8/80 – Board meeting convened and approved proposed amendments to
Merger Agreement sight unseen; Salomon Bros. Retained to solicit offers for
3 month market test period
o 2/10/81 – Shareholders approve Pritzker merger proposal
o Shareholders sue for rescission and damages against directors
o After trial, court grants judgment for defendant directors
 Court’s Reasoning
o Business Judgment Rule under DGCL § 141(a)

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  Ps up against the BJR when challenging the decision of the board
 Connie→ “it is a rare day in hell when you are able to overcome the
business judgment rule”
 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 interests of the company
 The party attacking a board decision as uninformed must REBUT the
presumption that its business judgment was an informed one
 How to evaluate whether a business judgment is an informed one
o Whether the directors have informed themselves prior to making a
business decision, of all material information reasonably available to
them
o Gross negligence is the proper standard for determining whether a
business judgment reached by a board of directors was an informed
one
 No protection for directors who have made “an unintelligent or unadvised
judgment”
o Merger and Director’s Duty A proposed merger of domestic corporations
 Standard for Fid. Duty of Care DGCL 251(b): a director has a duty,
along with his fellow directors, to act in an informed and deliberate
manner in determining whether to approve an agreement of merger before
submitting the proposal to the stockholders
o Good Faith Reliance on Records and Reports
 DGCL §141(e) – In performing their duties, board members may rely in
good faith on records of corporation and on information, opinions, reports,
statements presented to the corporation by corporation’s officers or
employees
 Court says in this case §141(e) does not apply→ must be concrete facts,
cant rely on random speculation
o At a minimum for a report to enjoy the status conferred by this
provision, 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 (usually must come from outside experts)
o No report as defined under §141(e) concerning the merger proposal
was presented to the Board on the Sept. 20 meeting
 Holding: The directors were held personally liable for the damages
o The directors breached their fiduciary duty to their stockholders
1. by their failure to inform themselves of all information reasonably
available to them and relevant to their decision to recommend the Pritzker
merger; and
2. by their failure to disclose all material information such as a reasonable
stockholder would consider important in deciding whether to approve the
Pritzker offer
 Rule: (Proper Decision) Whether a business judgment is an informed one turns
on whether the directors have informed themselves “prior to making a business
decision, of all material information reasonably available to them. No protection

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 for directors who have made an unintelligent or unadvised judgment. Gross
negligence is the proper standard.
 Limits on Director Liability
 After Smith, DE laws were amended
 DGCL§102(b)(7)- Certificate of incorporation may contain provision eliminating
or limiting personal liability of director for monetary damages for breach of
fiduciary duty
 EXCEPTIONS
o Duty of loyalty
o Lack of good faith, intentional misconduct, knowing violation of law
o Violation of Section 174 on dividends
o Transactions in which director derived improper personal benefit
 Francis v. United Jersey Bank (Alcoholic Mom Who Let Sons Go Wild)
 Pritchard & Baird was a reinsurance broker
o Reinsurance  business of spreading insurance risk
 Ceding company that has insured a risk assigns some or all of that risk to
reinsurer along with share of the premiums to the reinsurer
 Reinsurance broker acts as intermediary and receives funds from ceding
company that are to be paid to reinsurer
 Pritchard & Baird became bankrupt
o Lawsuit brought by trustee in bankruptcy on behalf of creditors of Pritchard &
Baird seeking to recover money that had been misappropriated by two if its
directors (Charles Pritchard Jr. and William Jr.) against the estate of another
director, Mrs. Pritchard
 Applicable standard of care for someone in Mrs. Pritchard’s position:
o New Jersey law requires good faith and due care
o What diligence would an ordinarily prudent director exercise in the conduct of
their business
o Nature and extent of due care depend on nature of business, size of business
and financial resources
 Bank directors are held to a heightened standard of care
 What should Pritchard have done to discharge her duty to corporation?
o Must acquire rudimentary understanding of business of corporation
o Must keep informed and stay current with corporate activities
o Must not shut eyes to corporate misconduct (general monitoring not detailed
inspection)
o Must maintain familiarity with financial status of corporation
 How did her behavior fall short?
o She didn’t know the nature of the business or what was going on
o Didn’t keep an eye on her sons or the loans they took out
o Didn’t look at financial statements
 Generally, corporate directors may usually rely on lawyers and accountants BUT
o Must inquire further if financial statements disclosed problems on their face
o Must object and take corrective action

46
 o May have to resign to avoid liability if misconduct continues
 Holding: The court held that Pritchard had a duty to the clients, she breached that
duty and it was the proximate cause of their losses. Directors should acquire at
least a rudimentary understanding of the business of the corporation. Accordingly,
a director should become familiar with the fundamentals of the business in which
the corporation is engaged. Therefore they cannot use the defense of lack of
knowledge. If they cannot perform duties they should either acquire the
knowledge by inquiry, or refuse to act.
 Rule: (Oversight) Determination of the liability of Mrs. Pritchard requires
findings that she 1) had a duty to the clients of Pritchard & Baird, 2) that she
breached that duty and 3) her breach was a proximate cause of their losses.
 In re Caremark Derivative Litigation
 Two Settlements
1) U.S. suit
o Government initiated action
o Basis for violations of Anti-Payments Referral Law Prohibits a
company in the business of providing health care services from getting
kick backs for Medicare referrals
o Govt. investigating whether or not contracts between Caremark and
doctors were disguised kick backs
2) Shareholder suit
o Breach of duty of care for failing to monitor and detect violation of APRL
o Ps claim failure to exercise due care and appropriate oversight/failing to
monitor employee conduct
o Plaintiffs initiated this suit alleging that the Board of Directors did not
exercise the appropriate attention to this problem.
 Big problem occurred in MN
 Directors claim they did not know what was going on → decentralized
management
 Steps taken by Board to comply with APRL → attempt to comply with federal
law (COMPLIANCE PROGRAM)
o Discontinue management fees to doctors for services to Medicare and
Medicaid payments
o Internal audit plan & external audit reviewed by Board Ethics Committee
o Board Ethics committee also implemented standards that employees and
directors would be held to
o Employee ethics handbook
o Ethics hotline
o Local branch managers needed home office approval for disbursements with
health care providers
o CFO became compliance officer
 Two lines of cases for duty of care
1) Liability for directorial decisions (Kamin, Smith v. Van Gorkem)
o focused on the process

47
 o a board decision that results in a loss because that decision was ill advised
or negligent
o these cases are subject to review under the BJR, assuming that the
decision was made was the product of a process that was either
deliberately considered in good faith or was otherwise rational
2) Duty to monitor
o A loss eventuates not from a decision but from unconsidered inaction
(“failure to monitor”)
o Federal sentencing guidelines
 Criminal indictment of corporations even though the complaint itself
might be civil (establishes benchmarks, more responsibilities on the
shoulders of the board members). Thus, the Board needs to be on
heightened alert
 The Guidelines offer powerful incentives for corporations to have in
place compliance programs to detect violations of law
o Corporate boards have affirmative duty to put corporation information and
reporting system in place to assure compliance with laws =
COMPLIANCE PROGRAM
 Failure to do so under some circumstances may render a director liable
for losses caused by non-compliance with applicable legal standards
 Terms of the settlement:
o Caremark will not pay compensation to 3P or split fees with physicians in
exchange for referral of Medicare/Medicaid patients
o Board will discuss material changes in govt. health care regulations
semiannually
o Caremark will remove personnel placed in medical facilities for purpose of
providing remuneration in exchange for patient referral involving M/M
o Patients will receive written disclosure of financial relationship between
Caremark and health care provider
o Establish Compliance & Ethics committee of Board
o Managers for each business unit must serve as compliance officers and report
to Compliance & Ethics Committee; review and approval of contracts
 Standard of Review of the Settlement Agreement
o Court says settlement must be fair and reasonable
 Court will look at the strengths and weaknesses of the claims on each side

o Here, settlement is an enhancement of a pre-existing compliance program

 Holding: Court approved settlement the proposed settlement is adequate,
reasonable, and beneficial outcome for all of the parties

Duty of Loyalty
 Conflict of Interest
 Taking business opportunities
 Using business assets
Directors and Managers

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  Conflict of Interest Transactions
 NYBCL §713 – Covers contracts between 1) corporation and 2) director or
corporation in which director has substantial financial interest or is a director
or officer
 NYBCL §713 – No contract involving an interested director (definition) is
void or voidable because director was present/voted in favor if:
o Disclosure and valid board approval without counting vote of interested
director
o Disclosure and contract approved by shareholders
o In other cases, must show fair and reasonable (most difficult because you
will need business experts, more money involved).
 Bayer v. Beran (Rayon Company with Wife that Needed Radio Ads)
 Celanese Corporation (D) chose to advertise through radio programs to
distinguish their products from other rayon products
o Hired a female singer who happened to be the wife of the president of the
company
 P’s argument
o The advertising cause of action charges the directors with negligence, waste,
and improvidence in embarking the corporation upon a radio advertising
program, costing about $1,000,000 a year
 Motivated by non-corporate purpose (conflict of interest claim)
o Negligence in selecting the type of program and in renewing
 The procedure to approve and renew the advertising campaign was too
informal
o The directors were motivated by a non corporate purpose in causing the radio
program to be undertaken and in expending large sums of money therefor →
benefit for the singer
 BJR does not protect from judicial scrutiny in this case
o There is an alleged conflict of interest which means that the court must apply
more rigorous scrutiny
o Actual conflict of interest belongs to Mr. Dreyfus the president→ one
individual cant take action for the entire board
 Assumption is that by employing him wife, he is disadvantaging the
business
 Standard of Review
o Because there is an alleged conflict of interest, Court will apply “strict
scrutiny” standard of review
 The court will scrutinize the business judgment (will second guess the
business decisions)
 When challenged (since such transactions may tend to produce a conflict
between self-interest and fiduciary obligation), such transactions will be
voided if there is any evidence of improvidence or oppression, any
indication of unfairness or undue advantage
o The burden shifts to the board of directors
 To prove the good faith of the transaction; and

49
  To show its inherent fairness from the viewpoint of the corporation and
those interested therein
 Holding: The court found that the directors acted in the free exercise of their
honest business judgment and their conduct in the transactions challenged did not
constitute negligence, waste or improvidence. . (it is not the existence of the
conflict of interest that does not lead to the breach of the duty of loyalty, it is the
way that the conflict is resolved.)
o The evidence fails to show that the program was designed to foster or
subsidize the career of Miss Tennyson as an artist or to furnish a vehicle for
her talents
o No ground for directors’ liability since the advertising served a legitimate and
a useful corporate purpose and the company received the full benefit thereof
 Rule: (Burden Shift) Alleged Conflict of Interest = No BJR, Strict Scrutiny
o Personal transactions by directors are subjected to rigorous scrutiny and where
any of their contracts or engagements with the corporation are challenged, the
burden is on the director not only to prove the good faith of the transaction but
also to show its inherent fairness from the viewpoint of the corporation and
those interested therein.
 *Note→ Freedom of K
o In the late 19th cent. courts held that a corporation could freely void any K
between it and one of its directors or officers
o By the 20th cent. courts hesitated to let firms void their Ks so easily→ began
to move away form those kinds of strict legal rules
o New rule→ if a disinterested majority of directors has ratified a K and if the
complaining party could not prove it UNFAIR, the courts generally help the K
valid
o Bayer takes the rule one step further→ because the K is fair, it is valid even
though disinterested directors have not formally ratified it

Corporate Opportunities Doctrine

 Involves taking a business opportunity from the company for yourself
 Sub-branch of the duty of loyalty
 Some say you could decide these cases using a duty of loyalty analysis. But courts
have not gone in this direction→ apply a separate test
 Ratification
 DGCL, §144(a): Interested director/officer transaction not void or voidable if
1. material fact disclosure and disinterested director approval; or
2. material fact disclosure and shareholder approval; or
3. contract is fair. (Fairness is not where you want to be).
 Delaware Test (Guth V. Loft)
 Factors:
1. Financial ability
2. Same line of business
3. Interest or expectancy

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 4. Taking opportunity would create conflict between self-interest and interest of
corporation
 *Conjunctive test→ elements must be present for there to be a corporate
opportunity
 Persons covered by doctrine→ corporate officer or director
 Formal presentation to the board & rejection
o Not legally required before individual can take opportunity
o But may act as a safe harbor
 Broz v. Cellular Information Systems, Inc. (Michigan Cellular Area Licenses)
 Robert F. Broz
o President/sole SH of RFBC
o Board member of CIS
 RFB Cellular Inc. (RFBC)
o owned Michigan 4 cellular license
 Mackinac Cellular Corp. (Mackinac)
o Sought to divest Michigan 2 cellular license
 Daniels & Associates/Rhodes – broker
o Contacted RFBC about Michigan 2 license acquisition
 Cellular Information Systems Inc. (CIS)
o Treibick, Bloch, Schiff rejected Michigan 2 cellular license
 Pricellular: launched tender offer for CIS
 Rule: Delaware Test (Guth v. Loft)
1. Financial ability (they could not financially)
2. Same line of business (both in cellular business)
3. Interest or expectancy (evidence that they are selling of cell licenses so not
expectation to buy Michigan 2)
4. Taking opportunity would create conflict between self-interest and interest of
corporation (As a director is suppose to be taking care of CIS’s interests and
the interests of their SHs but he is also a director for RFBC. However he did
not “formally” present to board. He talked to other managers of CIS that
refused it non-formally which is sufficient. (Safe Harbor) Formally is
preferable but not necessary.)
o Only need to look at the current situation of the company when considering
the taking business opportunity doctrine
 In this case, the only prong that satisfied the test was the same line of
business, the other prongs pointed away from the corporate opportunity,
thus no corporate opportunity
 Holding: The court found that the corporate opportunity doctrine is implicated
only in cases where the fiduciary’s (Officer or Director) 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. Since
CIS declined there was not conflict and Broz was free to take advantage of the
opportunity.
 What if there is no corporate opportunity?

51
 o Then, you are free to take the corporate opportunity (with specific procedures
to follow)
o 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
o There is no requirement for formal presentation and formal rejection under
circumstances where the corporation does NOT have an interest, expectancy
or financial ability. But may act as a safe harbor
 In re eBay, Inc. Shareholders Litigation (Giving Securities not Same as Advice for
Wealthy Individuals)
 Shareholders of eBay filed derivative suits against directors and officers for
usurping corporate opportunities
 Demand was excused as futile The same people who were sued for illegal
conduct were those on the board of directors
 Business relationship between eBay and the Goldman Sachs
o eBay retained GS to underwrite an initial public offering (IPO) of common
stock as the lead underwriter ($18/share, GS purchased 1.2M shares) and a
secondary offering (issuing 6.5M shares at $170/share)
o eBay also asked GS to serve as its financial advisor in connection with an
acquisition by eBay of PayPal, Inc.
 Alleged corporate opportunity
o GS rewarded the individual Ds by allocating to them thousands of IPO shares
(other companies’ IPO shares), managed by GS, at the initial offering price.
o These individual Ds were able to flip these investments into instant profit by
selling the equities instantly
o GS provided these IPO share allocations to the individual defendants to show
appreciation for eBay’s business and to enhance GS’s chance of obtaining
future eBay business. (practice of “spinning” – which is currently prohibited)
o Corporate opportunity here = Opportunity to buy IPO shares
 Rule: Guth Factors (No one disputed that ebay was financially able to exploit
the opportunities. Ebay was in the business of investing in securities. Third the
complaint showed that investing was integral to their cash management strategy
so it was expected that they would be interested in the securities.)
 Alternative theory of liability
o Agency theory (breach of fiduciary duty of loyalty) – accounting for profits
acquired by using the principal’s assets
o Agent is under a duty to account for profits obtained personally in connection
with transactions related to his or her company
o The complaint gives rise to a reasonable inference that the insider directors
accepted a commission or gratuity that rightfully belonged to eBay but was
improperly diverted to them
 Holding: D’s motion to dismiss is denied. The court held that even if the claims
do not breach corporate opportunity it can still breach the fiduciary duty to

52
 loyalty. The defendants were not free to accept the lucrative IPOs as consideration
in exchange for their business to GS.

 Dominant Shareholders
 Sinclair Oil Corp. v. Levien (Strong Control SH, Can Bypass Board)
 D = Sinclair Oil Corporation (Sinclair)
o Holding company
 Sinclair Venezuelan Oil Company (Sinven)
o 97% owned by Sinclair
o 3% owned by minority shareholders
o Among the 3%, Ps owned 2.5% of the 3%.
 Sinclair International Oil Company (International)
o 100% owned by Sinclair
 Alleged wrongful acts of Sinclair (D) in a derivative action for damages sustained
by its subsidiary, Sinven (derivative action brought by minority shareholders of
Sinven)
o D caused Sinven to pay out excessive dividends
o Denial of business opportunities (industrial development) Taking of the
business opportunities claim
o Breach of K between Sinven and International
 Sinven’s board of directors
o All nominated by Sinclair
o The directors were not independent of Sinclair
 They were officers, directors, or employees of corporations in the Sinclair
complex (overwhelming influence over Sinven by Sinclair)
 By reason of Sinclair’s dominance, it is clear that Sinclair owed
Sinven a fiduciary duty
 Test Used by Court
o Intrinsic Fairness Test: The test involves both a high degree of fairness and a
shift in the burden of proof. The burden is on the accused to prove, subject to
careful judicial scrutiny, that its transactions with Sinven were subjectively
fair.
o When a parent and a subsidiary are involved with the parent controlling the
transaction and fixing the terms of the transaction, the TEST is that of intrinsic
fairness + burden shifting
 Basic situation (triggering event) = when the parent has received a benefit
to the exclusion and at the expense of the subsidiary
o A parent owes a fiduciary duty to its subsidiary when there are parent-
subsidiary dealings
 The intrinsic fairness standard will be applied ONLY when the fiduciary
duty is accompanied by self-dealing – situation when a parent is on both
sides of a transaction with its subsidiary
o Self-dealing Show this first
 By virtue of its domination of the subsidiary, the parent causes the
subsidiary to act in such a way that the parent receives something from the

53
 subsidiary to the exclusion of, and detriment to, the minority stockholders
of the subsidiary
 If there is no self-dealing, BJR will be applied
 Rule: Intrinsic Fairness Test When a strong controlling parent has received a
benefit (1st show Self Dealing) to the exclusion and at the expense of the
subsidiary the intrinsic fairness test will be applied.
o A dividend declaration by a dominated board does not always demand the
application of the intrinsic fairness standard
o If such a dividend is in essence self-dealing by the parent, then the intrinsic
fairness standard is the proper standard
 Holding: Reverse the dividends part (no intrinsic fairness standard, but BJR, thus
no breach of fiduciary duty) and affirm the breach of K claim (Yes intrinsic
fairness standard and Sinclair failed to meet its burden, thus Ps win and D must
pay for the damages)
o The court found that 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. Which P failed to do since all
their business came from Sinclair.
o However the court did find that Sinclair did not show enough evidence to
overcome the intrinsic fairness standard for the breach of K. They did not
have to K with their subsidiary and since they did they owe a duty

 Ratification
 Procedure that occurs after the officer has found a corporate opportunity and has
presented it to the corporation to accept or deny the opportunity before the officer
takes it for his own. (Safe Harbor)
 DGCL, §144(a): Interested director/officer transaction not void or voidable if (1)
material fact disclosure and disinterested director approval; or (2) material fact
disclosure and shareholder approval; or (3) contract is fair
 Fliegler v. Lawrence
 Shareholder derivative lawsuit brought by on behalf of Agau against the officers
and directors of Agau
 P: Agau Mines Inc. (Agau) DE corporation
o President Lawrence acquired antimony properties
o Lawrence offered to transfer properties to Agau, but board decided Agau
could not acquire due to legal and financial problems
 Ds: Agau, officers and directors of Agau, United States Antimony Corporation
(USAC)
o USAC was formed to acquire antimony properties from Lawrence and
majority stock held by defendants
o Developed properties and sold to Agau under Option Agreement
o Same people were directors, officers & shareholders of Agau and USAC
 Option Agreement between Agau & USAC

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 o Upon shareholder approval, Agau to deliver 800,000 shares of its own stock
(consideration, payments for the property) in exchange for all shares of USAC
o Exchange calculated on basis of reimbursement to USAC shareholders for the
costs of developing properties (original acquisition + developing)
o Agau board resolved to exercise the option and a majority of Agau
shareholders approved
 P filed derivative lawsuit to recover the 800,000 shares and accounting for
damages
 Issues: 1) Whether the directors and officers wrongfully usurped a corporate
opportunity belonging to Agau 2) Whether all Ds wrongfully profited by causing
Agau to exercise an option to purchase that opportunity
 P’s argument Taking of the business opportunities
o Individual defendants, in their capacity as directors and officers of both
corporations, wrongfully usurped a cooperate opportunity belonging to Agau
 D’s argument
o Ds argue that they have been relieved of the burden of proving fairness by
reason of shareholder ratification of the Board’s decision to exercise the
option
o Ds argue that the transaction here is protected by §144(a)(2) because Agau’s
decision to exercise the option to buy USAC was ratified by the stockholder
approval
 Court’s Reasoning
o Corporate waste the transaction in question must be so one sided that no
reasonable business would take on
o Gottlieb Standard
 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
 “The entire atmosphere is freshened and a new set of rules invoked where
formal approval has been given by a majority of independent, fully
informed shareholders”
 Rule: Gottleib Standard Ratification of an interested transaction by a majority of
informed shareholders shifts the burden of proof to an objecting SH to demonstrate
that the terms are so unequal as to amount to a gift or waste of corporate assets.
 Holding: Ds win. The court found that ratification did not apply where the majority
of SHs were the defendants. Only 1/3 of the disinterested SHs voted. However the
court did find that there was value in the property transaction to the company so
proved intrinsic fairness of the transaction.
o §144(a)(1) and (2) cannot be applied (because the shareholders (majority) were
interested parties (Ds themselves) and only 1/3 of the disinterested shareholders
voted in approving the option exercise) → Ds did not establish factually a basis
for applying Gottlieb
 “ We cannot assume that such non-voting shareholders either approved or
disapproved”

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  Thus, we cannot say that “the entire atmosphere has been freshened” and that
departure from the objective fairness test is permissible
o §144(a)(3) applies and Ds met its burden of showing (3) K is fair
 Ds have proven the intrinsic fairness of the transaction, thus, BJR will be
applied
 Agau received properties which by themselves were clearly of substantial
value, a promising (potentially self-financing and profit generating) enterprise
which would benefit Agau
 Interest given to the USAC shareholders was a fair price to pay

56
 FEDERAL SECURITIES REGULATION, STATE PROXY
REGULATION, SHARHEEHOLDER INSPECTION RIGHTS
Regulatory Schemes
One of the duties of officers/directors is to understand the laws that apply to you company/corporation
and how to comply with those laws
Federal  Policy: protection of investors and integrity of markets
Securities o Trying to protect people who make corporate investments in stocks and bonds
Laws o Protecting the integrity of markets
Securities Act of 1933: primary market
Securities Exchange Act of 1934: secondary market
 Scope of Laws 2 Main Focuses:
1. Disclosure provisions→ companies have the burden of producing a lot
of information to their investors if they are they required (Doran)
o Information must be true, fair and accurate
o Rational→ investors cannot make best decisions about what to invest in
with out all the necessary information
2. Anti-fraud provisions (Escott)
 3rd Focus→ Regulation of markets and market professionals.
o People who are involved on a day to day basis in the secondary market
o Not studied in this class
Securities and  Federal regulator that handles capital market issues
Exchange o Federal executive agency of government
Commission o Delegated authority by congress to administer laws and to enforce all provisions of statutes
 Executive agency charged with administration & enforcement of statutes
(SEC)
 Delegated authority by Congress to make rules and adjudicate matters arising under the statute
 Headquartered in Washington DC with regional offices
State  Some overlap between federal and state laws
Regulation o More and more federal preemption happening
(Common Law) “Blue-Sky” Laws
o State level regulation of securities that predates federal securities laws
o Regulated entities must comply with both federal and state law
o Some overlap between the two regulatory schemes subject to federal preemption
o Represent attempt by the states to also regulate
Missouri Laws
o Missouri securities regulation authority is in the Office of the Secretary of State
o Regulates sales of securities and operations of broker-dealers & investment advisers and
prosecutes securities fraud

Securities Act of 1933

Primary  The primary market is the part of the capital market that deals with issuing of new
Market securities.
 Issuer of securities (i.e. the company that created the securities) sells them to
investors
 Companies, governments or public sector institutions can obtain funds through the
sale of a new stock or bond issues through primary market.
 This is typically done through an investment bank or finance syndicate of
securities dealers.

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2 Goals  Mandating disclosure of material information to investors and
 Prevention of fraud
§2(a)(1) Threshold Question #1: Is this a security?
 Specific Instruments - including stock, notes and bonds.
o Economic realities test – Cts are not bound by how people label terms. SC
created factors in Landreth Timber:
 Right to Dividends/Profits
 Negotiability
 Can Be Pledged or Hypothecated
 Voting Rights
 Capital Appreciation
 General Catch-all-Phrases - such as evidence of indebtedness, investment Ks
and most general “any instrument commonly known as a security”. (LLC was not
included because they did not exist in 1933)
o Investment contract – SC in Howey has defined as a K, transaction or
scheme whereby a person:
 Investment of Money
 In a Common Enterprise
 With an Expectation of Profits
 Solely from the efforts of others.
 (Nominal Power) However agreements that retain nominal power for
investors unable to exercise them do not annul securities law.
§4 (2) –  Private Offerings shall not apply to §5. The provisions of Section 5 shall not apply
Exemptions to transactions by an issuer not involving a public offering (Congress did not
from define so courts had to see Purina below Registration Process).
Registration
Exemptions from Registration
 Certain Types of Securities– In general, an exempt security need never be
registered, either when initially sold by the issuer or in any subsequent
transaction.
o Example: U.S. government securities (treasury bonds, bills ect.)
 Certain Types of Transactions – in contrast are onetime exemptions.
o Example: Private Placement
 Private Offering
o Purina test (SC): Did the offerees need the protection of the registration
provisions of the 1933 Act or were they able to fend for themselves?
o Factors (5th Circuit):
1) the # of offerees (not # of purchasers) and their relationship to each
other and the issuer
o The role of investment sophistication
o The requirement of available information
2) the number of units offered
3) the size of the offering and
4) the manner of the offering. Doran

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§5  File Registration Statement - a security may not be offered for sale through the
Registration mails or by use of other means of interstate commerce unless a registration
statement has been filed with the SEC;
 Until Effective - securities may not be sold until the registration statement has
become effective; and
 Prospectus Requirement - the prospectus (disclosure statement) must be
delivered to the purchaser before the sale.
 Remedy for selling unregistered securities is recission
§11 Fraud  Threshold Question #2: Materiality
in Regist.  Material misstatement or omission in a registration statement is actionable fraud.
Statement No reliance or scienter required.
o Person acquiring such security has express private right of action against any
person:
 who signed registration statement,
 any director,
 any expert (accountant, engineer, appraiser, but not lawyer) who prepared
or certified part of registration statement,
 underwriters
o Subject to defenses of loss causation and due diligence
o Remedy = damages
 Due Diligence Defense – Expert v. Non-expert
§12  Serves Deterrence Function
Liability  Reaches material misstatements or omissions outside of a registration statement
 Section 11 and 12 create express private rights of action

What is a Security?
 1st Question to ask for your client: Whether or not the investment scheme at issue is
subject to the definition of security and the Security Acts
 Statutory definition of a security in the Securities Act of 1933 § 2(1)
1) a list of specific instruments = stock, notes, bonds
2) a list of general catch-all phrases
 “evidence of indebtedness”
 “investment contracts”
 “Any instrument commonly known as a ‘security’”
o “~unless the context otherwise requires” = escape hatch
 Threshold issues (which would require federal registration)
o Economic reality test (for the 4th factor in Howey’s test)
 When the SEC or a private P sues your Client for failing to register securities
1) Argue what the CT sold is not a security; or
2) Argue that one of the exemptions from registration is available
 Robinson v. Glynn (Threshold Issue: Is this an Investment K that falls under
Security?)
 P: James Robinson
o Businessman with no prior telecommunication experience but promised to
provide capital for GeoPhone

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 o Argues that he was misled about the nature of the company and investment
 D: Thomas Glynn
o chairman of GeoPhone
o GeoPhone Company LLC (D)
 Started out as a corporation, but then converted into a LLC later
 Robinson filed suit against other parties alleging that Glynn committed def. sec.
fraud when he sold Robison a partial interest in GeoPhone Co.
 Issue: Whether P’s purchase of membership interests in GeoPhone amounts to
security
 Letter of Intent dated August 1995
o After P invested $1M as a loan to GeoPhone, P pledged to invest up to $25M
in GeoPhone, LLC if the field test indicated that CAMA (signal processing
technology) worked in the GeoPhone system
o Case of outsider buying into the business and making a pledge to contribute
funds
 Contingency in letter of intent that the technology be used by the company
 Feature of investment that was very important to Robinson
 October 1995 field test
o Engineers hired by D performed the field test, but did not use CAMA in the
test.
o D still told P that the field test had been a success
 Agreement to Purchase membership Interests in GeoPhone (APMIG)
 Amended and Restated GeoPhone Operating Agreement (ARGOA)
o Detailed the capital contribution, share ownership, and management structure
of Geophone
o 2 of the 7 managers were to be appointed by Robinson
o Vested management of Geophone in Robinson and Glynn
o Named Robinson as the company’s treasurer
 Share certificates with restrictive legend
o Pursuant to ARGOA, Robinson received 33,333 of Geophone’s 133,333
shares
o Share certificates with restrictive legend (on the back) referring to the
certificates as “shares” and “securities”
 Restrictive legend = applies when someone sells a stock which is not
freely transferrable probably because it was not federally registered
 The legend specified that the certificates were exempt from registration
under the 1933 Act
 Alleged wrongful conduct→ Law suit alleging fraud
o Violation of the federal securities laws (Glynn committed federal securities
fraud when he sold Robinson a partial interest in Geophone Company)
o Section 10(b) of the Securities Exchange Act of 1934: “It shall be unlawful
for any person… to use or employ, in connection with the purchase or sale of
any security…any manipulative or deceptive device or contrivance in
contravention of [rules and regulations of the Securities and Exchange
Commission”

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 o Rule 10b-5: “It shall be unlawful for any person…(a) to employ any device,
scheme or artifice to defraud, (b) to make any untrue statement of a material
fact or [material omission], or (c) to engage in any act, practice, or course of
business…which operates as a fraud or deceit upon any person”
 when you plead a case under this rule, you have to choose which of the 3
subsections you are relying on
 *Important distinction between statute and regulation→ difference is in the
SOURCE of the law
o statue is law passed by congress through legislative process
o regulation is rule passed by relevant regulator
o Congress passed to SEC the power to regulate
o Power is derivative from Congress’s power under the constitution
o There are rules and procedures these rule making bodies have to follow
o BUT once a rule is made according to the procedural rules, it is as binding as
a law passed by congress
o Rules passed by bodies such as the SEC can be challenged (constitutionality,
ect.)
 P’s Argument Threshold Issue
o P claims that his membership interests in GeoPhone qualifies, under the
Securities Acts, as either
 “investment contract” or
 “stock”
o Tries to argue under the vague language of the Securities Act
o Robinson cannot point to the law and say the language protects my investment
agreement in an LLC
 Securities Act of 1933, §2(a)(1)- “Security” means, unless the context
otherwise requires, any note, stock, treasury stock, bond, debenture,
evidence of indebtedness, …investment contract…or in general any
interest or instrument commonly known as a security
o Implications of calling an investment opportunity a “security”
 Disclosure and antifraud provisions apply, including 1934 Act §10(b) and
SEC Rule 10b-5
o Broad/ambiguous language
 “Investment K” is very broad language. Not an explicit definition, gray
area
 it is these gray areas that often lead to the most litigation
 Court’s Reasoning Investment K
o Gray area→ nothing in the real world you can point to and say this is an
investment K
o This is NOT a security because it is NOT an investment K→ doesn’t meet the
threshold requirement
o Investment K Characteristics (Howey) (SCOTUS 1946)
1) Investment of money
2) In a common enterprise
3) With the expectation of profits

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 4) To come solely from the efforts of others
o What element is at issue in this case?
 Element 4→ Robinson did not solely rely on Glynn and others
 “to come from the efforts of others” = economic reality
 This prong is satisfied when an investor (as a result of the investment
agreement itself or the factual circumstances that surround it) is left unable
to exercise meaningful control over his investment (=passive investor
relying on the efforts of others)
 Economic Reality P was NOT a passive investor, he was an ACTIVE
investor
o P was no passive investor heavily dependent on the efforts of others
like Glynn
o P resided in a board of managers
o P had power to appoint two of the board members
o P was the board’s vice-chairman
o P served as GeoPhone’s Treasurer
o P exercised his management rights despite his lack of technical
expertise
 Court’s Reasoning Stock Issue
o Why can an item called “stock” be excluded from the definition of a security?
o Economic realities test→ Courts are not bound by how people label terms
o Characteristics of Stock (Landreth Timber) (SCOTUS 1985)
1) Dividends
2) Negotiability
3) Can Be Pledged or Hypothecated
4) Voting Rights
5) Capital Appreciation
o Court says this is NOT a stock
 Holding: LLC The court found according to the Howey test for investment Ks
that Robinson demonstrated enough control to eliminate from the Investment
contract factor. Also the court held that although the instruments Robinson
purchase were called stock it did not fit the legal definition so he could not get
relief there either.
 Rule: In order to commit securities fraud the plaintiff must first prove the
threshold issue that the instrument is a security. If not the Court will not address
the substance of the case.
 Hypo What result in this case if Geophone had been organized as:
o A close corporation
 Landreth Timber analysis would apply
 It would be considered a stock
o A general partnership
 Investment Contract analysis:
o Especially, the dependence factor would be very relevant

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 o Everybody manages equally (default), thus, it will be hard to argue
that your expectation of profits came solely from the efforts of others
(you are actively participating in the management of the company)
 Not an investment K because of 4th prong
 Similar to issue with LLCs, not usually considered to be investment Ks
o A limited partnership
 Looking at the document that set up the limited partnership
 This would fall under the investment K rule and deemed to be securities
 Investment Contract analysis
o Limited partners do not have control over the business (passive
investors)
o Thus, limited partners will be able to satisfy the fourth prong of
passive investors
o Thus, limited partners would be perceived as passive investors thus,
perceived as purchasing securities, passing the threshold issue

The Registration Process

 Registration requirement under the 1933 Securities Act § 5 [3 basic rules]
1. a security may not be offered for sale through the mails or by use of other means
of interstate commerce unless a registration statement has been filed with the
SEC;
2. securities may not be sold until the registration statement has become effective;
and
3. the prospectus (a disclosure document) must be delivered to the purchaser before
a sale
 Registration Statement
o A document containing detailed information required by the SEC for the public
sale of corporate securities.
o The statement includes the prospectus to be supplied to prospective buyers
 Prospectus
o A printed document that describes the main features of an enterprise (esp. a
corporation's business) and that is distributed to prospective buyers or investors;
esp., a written description of a securities offering.
o Under SEC regulations, a publicly traded corporation must provide a prospectus
before offering to sell stock in the corporation
 Registration exemptions
o Exempt securities An exempt security need never be registered
o Exempt transaction Exempt transactions are one time exemptions.
 Doran v. Petroleum Management Corp. (Exemption Defense, Privacy)
 2 Important Issues
o registration requirements
o exemptions from registration
 Case of sophisticated investor who wanted to rescind

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 Doran (P) was solicited to become a member as limited partner and invested
some cash. Got a loan from Mid-Continent to invest in D (Petroleum
Management Corp.)
 Alleged wrongful conduct
o The wells that D were developing were deliberately overproduced in violation
of the production allowance established by the Wyoming Oil and Gas
Conservation Commission
o D’s wells were sealed for a period of 338 days
o P sued D seeking damages for breach of K, rescission of the K based on
violations of the Securities Acts of 1933 and 1934, and a judgment declaring
the D liable for payment of the state judgment obtained by Mid-Continent
 Issue: Whether the sale was part of a private offering exempted by S.4(2) of the
1933 Act, from the registration requirements
 P’s argument Registration Provision
o Securities Act of 1933, §5 Registration Provision
 Unlawful to sell or offer for sale securities in interstate commerce unless
securities are registered with the SEC
 Issuer must provide disclosure in a prospectus
 Remedy for selling unregistered securities is rescission
o D violated the section 5 of the Securities Acts of 1933 and 1934 by not
registering the limited partnerships as securities. Thus, the remedy under this
section is rescission
 D’s argument→ Affirmative defense
o Says this was an exempt transaction
o This was a private offering, thus exempt from the registration requirements of
the section 5 under §4(2)
 Burden of Proof is on party claiming exemption (D)
o D must prove that this was a private offering to establish defense
o Ralston Purina test: Did the offerees need the protection of the registration
provisions of the 1933 Act or were they able to fend for themselves?
 Private placement exemption test
 Turns on access to information
o Whether they would have had same degree/type of information that
would have been available if it were a public offering offered to the
general public investors
o Give offering memorandum (what would be provided at public
offering)
o Or let them ask questions
o 5th Circuit Four Factor Test for Private Offering
1. Number of offerees and relationship to each other and issuer
2. Number of units offered
3. Size of the offering
4. Manner of the offering
o Ds did not meet the burden
 Tried to argue that there was a sophisticated investor

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  Court says it doesn’t matter if an investor is sophisticated if he isn’t given
adequate information
 Rule: Privacy – Even where an offering is relatively small and offered informally
to sophisticated investors it will not automatically be labeled a private offering,
absent proof that each offeree had been furnished, or had access to, such
information about the issuer that a registration statement would have disclosed.

Fraud in Registration Statement (Anti-Fraud Provs. §11, 12)

 Sec. 11 of 1933 Act: Fraud in Regist. Statement
o Material misstatement or omission in a registration statement is actionable fraud
 Person acquiring such security has express private right of action against any
person who signed registration statement, any director, any expert
(accountant, engineer, appraiser, but not lawyer) who prepared or certified
part of registration statement, underwriters
 Lawyer can be sued if they serve some other function like the person who
singed the paperwork, director of company, ect.
o Subject to defenses of 1) loss causation and 2) due diligence
 Loss causation→ reason the stock went down in value because of general
market decline, not misstatement in registration
 Due diligence → can either eliminate liability or limit liability in comparison
to other defendants
o DON’T have to show reliance or that you were damaged by the loss (decline in
stock)
o Remedy = damages
o Have to have someone who purchased under the registration statement
 Purchased directly from the issuer in the primary offering stage
 Or bought from someone who purchased during the primary offering
 Have to show LINK to the registration statement
o Along with individuals, corporation is also ALWAYS sued as a defendant→
CORPORATE DEFENDANT
 Will be strictly liable, have no chance to make a due diligence defense
 Sec. 12 of the 1933 Act: Material misstatement or omission
o Serves as DETERRENCE function
o Section 11 reaches material misstatements or omissions IN registration statement
o Section 12 reaches material misstatements or omissions outside of a registration
statement
o Section 11 and 12 create express private rights of action

 Due Diligence Defense

 The diligence reasonably expected from, and ordinarily exercised by, a person
who seeks to satisfy a legal requirement or to discharge an obligation. A failure to
exercise due diligence may sometimes result in liability, as when a broker
recommends a security without first investigating it adequately.

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  Relied on authority of expert, reasonable investigation found no omission of
material fact.
 Reasonable investigation: the standard required is that of a prudent man in the
management of his own property
 Doesn’t matter that there was a material misstatement/omission

 Due Diligence Defense Under §11(b)

Expertised Portion (*part of statement Nonexpertised Portion (Narrative)
prepared by experts) 

 EXPERT: Reasonably believes, after  EXPERT: No liability

reasonable investigation, info is true

 NON-EXPERT: No reason to believe  NON-EXPERT: Reasonably believes,

information false after reasonable investigation, info is
true

 Threshold Issue Materiality

 Definition: information that an average prudent investor ought reasonably to be
informed about before purchasing the registered security
 The first threshold issue was whether there was any security involved
 Next threshold issue→ whether material information was omitted or misstated
 Reasonable investor standard
o Have all the information necessary to make an informed investment decisions
so that they could have a good return and prevent a loss
 Covers an array of issues within a corporation
o Financial statement parts→ Balance sheets, incomes, projections by company
o Narrative portion→ management, business, risks associated business
 Escott v. BarChris Construction Corp. (Bowling Alley, Due Diligence)
 Escott (Ps)
o Ps purchased investments in construction company that engaged in building
bowling alleys
o Were sold a deventure→ type of corporate debt (IOU)
o purchasers of 5½ per cent convertible subordinated fifteen year debentures
(debt instrument – agreement to pay overtime with interest) of BarChris
 BarChris et al. (Ds)
o The persons who signed the registration statement
 BarChris itself, 9 directors of BarChris + its controller
o The underwriters, consisting of 8 investment banking firms led by Drexel
o BarChris’s auditors (Peat, Marwick)
 P claims there was misinformation in the registration statement

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 o Material misstatement (affirmative lie) or material omission (failure to state
necessary/required information)
 Threshold Issue of Materiality Were there material misstatements or omissions
in the registration statement?
o Yes. Some of them were trivial but some of them were material, thus liability
for D
 The overstatement of sales and gross profit for the 1st quarter
 Understatement of contingent liabilities
 Failure to disclose the true facts re: officers’ loans, customers
delinquencies, application of proceeds, the prospective operation of
several alleys
o Balance sheet errors → this is material error
 Assets: liabilities = 1.9:1
 True ratio was 1.6:1
 Due Diligence Defense under Section 11(b)
o Expertised Portion
 EXPERT: Must establish that they reasonably believed, after reasonable
investigation, info is true
o Here, Peat, Marwick as an expert (accountant who audited the
financial statement)
 NON-EXPERT: As long as there is no reason to believe information false
o Here, all the other parts (narrative portion), everybody else (people
who signed the registration statement – CEO, president, CFO ,
directors, underwriters, lawyers)
o Non-Expertised Portion
 EXPERT: No liability
 NON-EXPERT: Reasonably believes, after reasonable investigation, info
is true
o They have to reasonably investigate the non-expertised portion
o *Look at notes for DD Defense evaluations
 Rule: In order to be a violation under §11 the false or misleading omission must
be material. Material is defined as matters as to which an average prudent investor
ought reasonably to be informed before purchasing the security registered. They
are matters which such an investor needs to know before he can make an
intelligent, informed decision whether or not to buy the security.
o Due Diligence Defense: relied on authority of expert, reasonable investigation
found no omission of material fact. Reasonable investigation: the standard
required is that of a prudent man in the management of his own property. (See
graph above)

Securities Exchange Act of 1934

Secondary  Investors trade securities among themselves without any significant
Market participation by the original issuer
 Example: trading between investors on the floor of the NY stock
exchange
Section 10(b) &  “A judicial oak which has grown from little more than a legislative

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Rule 10b-5 acorn”
 Most widely used anti-fraud provision in the federal securities law
Section 10(b): “It shall be unlawful for any person..to use or employ, in
connection with the purchase or sale of any security…any manipulative
or deceptive device or contrivance in contravention of [rules and
regulations of the Securities and Exchange Commission”
 Focus on what is manipulation of deception this has been
expanded by the courts
Rule 10(b)-5: “It shall be unlawful for any person…(a) to employ any
device, scheme or artifice to defraud, (b) to make any untrue statement
of a material fact or [material omission], or (c) to engage in any act,
practice, or course of business…which operates as a fraud or deceit upon
any person”
 Types of Cases:
o defective corporate disclosure
o insider trading
o fraud in dealings between broker-dealer & their customers
 Elements of Private Right of Action (implied right of action that is well
established, not explicitly stated in Rule):
1. Material misrepresentation or omission,
2. Scienter (knowing. state of mind)
o A degree of knowledge that makes a person legally responsible
for the consequences of his or her act or omission; the fact of an
act's having been done knowingly, esp. as a ground for civil
damages or criminal punishment
o A mental state consisting in an intent to deceive, manipulate, or
defraud.
o In this sense, the term is used most often in the context of
securities fraud. The Supreme Court has held that to establish a
claim for damages under Rule 10b–5, a plaintiff must prove that
the defendant acted with scienter.
3. Reliance,
4. Causation,
5. Damages
 Deceptive Device – Trading on insider knowledge is deceptive to public.

Insider Trading Prohibition

 Theories of Liability
1) Disclose or Abstain Rule: Classic Rule Against Insider Trading
 Securities and Exchange Commission v. Texas Gulf
Sulphur Co
2) Tipper – Tippee Liability: A tippee will be held liable for
openly disclosing nonpublic information received from an
insider, if the tippee knows or should know that the insider will
benefit ($) in some fashion from disclosing the information to
the tippee.
 Two Part test (Dirks v. SEC)
3) Misappropriation Theory – Holds that a person commits fraud
in connection with a securities transaction, and thereby violates
§10(b) and Rule 10(b)-5 when he misappropriates confidential

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 information for securities trading purposes, in breach of a
fiduciary duty owed to the source of the information.
 United States v. O’Hagan
o Other Precedent on §10(b) Insider Trading Prohibition
 In re Cady Roberts Co
 Chiarella v. United States
§16(b) Short  “Prophylatic Rule”→ preventative measure
Swing Profits  Note that Section 16(a) requires insider reporting of transactions in
equity securities
 Section 6(b) was intended to prevent insider trading, covers public
companies
 Who is covered by the rule?
o Applies to 3 types of people
1. director
2. officer
3. beneficial owner→ owns more than 10% of stock
o Insiders: Controlling SH 10%, directors, officer Dirks v. SEC
 What activity is covered?
o Short term trading Buying or selling within 6 month period.
o Purchased and sold OR sold and purchased shares of company with
in a 6 month time frame that resulted in profits
o Match purchase and sale with in a 6 month time frame + making of
profits
 Remedy: Disengorgement of Profits
o Any profit that you get on that transaction is recoverable by the
corporation. The presumption is that you buy/sell within 6 month
period you did so because you had nonpublic information, this was
the assumption. So purpose was to take profit out of transaction.
 If you are required to register you stock under 1934 you are subject to
this rule (Assets level $10 Million, 500+ SHs, trade nationally on NY
Stock Exchange).
 Can avoid rule by selling in parts (Reliance Co. v. Emerson Electric Co.)
§14(e) & SEC Insider Trading Prohibition in Tender Offers
Rule 14e-3(a)  §14(e): In connection with a tender offer, it shall be unlawful to make
material misstatements or omission or to engage in fraud, deception or
manipulation
 Rule 14e-3(a): If a tender offer has been commenced, it is unlawful to
purchase or sell securities on the basis of material inside information if
trader knows info obtained from offeror, issuer or any officer, director,
partner, or employee to either offeror or issuer
§14(a) & SEC Proxy Regulation
Rule 14a-8  §14(a) Requires proxy solicitations for reporting companies to comply
with SEC rules
o SEC rules requiring disclosure to accompany proxy solicitation,
specify form of proxy card, require prior filing and review of proxy
statement and proxy card, prohibit false and misleading proxy
solicitations.
 Look to state statutes on Shareholder Inspection Rights for access to SH
list

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  SEC Rule 14a-8: Shareholder Proposals
o Recommendation or requirement that company and/or board take action
which you intend to present at meeting of shareholders
o Company must include information in proxy statement and identify it in
form of proxy subject to procedural limitations and the right to exclude
o Becoming increasingly common
o Procedural limitations
 Must own $2000 or 1%
 May submit one proposal not to exceed 500 words
o Management must include unless it can meet burden of showing proposal
may be excluded
 Must notify shareholder and give opportunity to correct
 Must file reasons with SEC

Insider Trading
 Who is an Insider?
 An insider is anyone who:
o Learns of material, non-public information about the corporation as a
consequence of his corporate position, or
o Has a fiduciary relationship to the corporation or the P
 Insiders typically include officers, directors, controlling SHs, or employees of the
corporation
o A confidential relationship also exists with temporary insiders- outside
counsel, accounts, bankers ect. (Dirks)
 Theories of Insider Trading Liability
1) Classic rule against insider trading→ disclose or abstain (Texas Gulf Sulphur)
2) Tipper-Tippee Liability Rule (Dirks)
3) Misappropriation Theory (O’Hagan)
 Other Precedent on Section 10(b) Insider Trading Prohibition
 In re Cady Roberts Co. (SEC 1961)
 SEC recognized common law duty of corporate insiders (inc. officers
directors control SH) to disclose inside information when dealing in securities
 Chiarella v. U.S. (SCT 1980)
 Corporate insider must abstain from trading in the shares of his corporation
unless he has first disclosed all material inside information known to him
 Duty to abstain arises from this relationship of trust between a corporation’s
shareholders and its employees; duty does not arise from mere possession of
material inside information
 Tender offer→ one company offering to buy majority stock or shares of
another
o A public offer to buy a minimum number of shares directly from a
corporation's shareholders at a fixed price, usu. at a substantial premium
over the market price, in an effort to take control of the corporation
o Attempt to gain corporate control of a business
 Holding: No liability because Chiarella did not have a relationship of trust
with shareholders of company in whose stock he traded

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 o Only liable for insider trading fraud if there is a breach of a fiduciary duty
and D was not in a position of trust or confidence, he worked for a
separate company
o Court is limiting the scope of people who can be held responsible

 Securities and Exchange Commission v. Texas Gulf Sulphur Co. (Classic Rule of
Insider Trading Liability)
 P = SEC
 Ds = TGS President, TGS Vice President, a mining engineer, an electrical
engineer, TGS director, TGS secretary
 Transactions that gave rise to lawsuit
o After an exploratory drilling in Canada (10/29,30/1963), TGS President
ordered company employees to keep drilling results secret
o On-site officials began to send daily reports to TGS President and Vice
President
o March 27/1964- TGS had bought enough of the land
o From 11/12/1963 ~ 03/31/1964: several TGS employees and their tippees
bought TGS stock and calls on stock o
 Any employee who has inside information and misuses it can be sued,
don’t have to be high ranking
o Between the time the first press release of the actual report was issued on
April 12 and the dissemination of the TGS official announcement on the
morning of April 16, Clayton, Crawford and TGS director Coates engaged in
market activity
 Alleged Fraud:
1) Employees misusing information→ insider trading
o Before the information that TGS made exploratory drillings discovered a
land with a lot of ores was made public, some insiders started buying up
the stocks of TGS
2) Press release and April 12 → security fraud nondisclosure issue
o Designed to quell the “rumors” of a substantial copper discovery because
TGS wanted to buy the land without driving up prices
o “…These reports exaggerate the scale of operations … originated by
speculation of people not connected with TGS…The work done to date
has not been sufficient to reach definite conclusions …”
 Issues: 1) Insider trading prohibition 2) Materiality of information 3)
Interpretation of statutory language (“In connection with the purchase or sale of a
security”)
 P’s argument
o SEC argued that the release of April 12 painted a misleading and deceptive
picture of the drilling progress at the time of its issuance, and hence, violated
Rule 10b-5(2)
 D’s argument:
o The issuance of the release produced no unusual market action and in the
absence of showing that the purpose of the April 12 press release was to affect

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 the market price of TGS stock to the advantage of TGS or its insiders, the
issuance of the press release did not constitute a violation of Section 10(b) or
Rule 10b-5 since it was not issued in connection with the purchase or sale of
any security
o Even if it was connected, the SEC failed to demonstrate that it was false,
misleading, or deceptive
 Issue #1: Insider trading prohibition Section 10(b) – Insider trading issue
o What is the “disclose or abstain rule” and who does it apply to?
 Disclose or abstain rule (classic theory of Liability)→ anyone in
possession of material information must either disclose to the investing
public OR if he is disabled from disclosing/chooses not to disclose he
must abstain from market activity
o applies to anyone with access to information
o need to demonstrate that it is material information
 Insider – anyone who has access to nonpublic information
o One possessing the information who may not be strictly termed an
“insider” within the meaning of Sec. 16(b) of the Act. [In re Cady
Roberts]
o Anyone in possession of material inside information must either
disclose it to the investing public or must abstain from trading in or
recommending the securities concerned while such inside information
remains undisclosed
o Disclose or Abstain rule applies here
 Here, the Ds are liable (they should have waited to buy the stocks until the
material information is disclosed to the public)
 Want to establish the proper purpose for the information and why it was
misused
o Help employees make best business decisions (possibly buying land)
to serve the business purposes
o The engineers would want to supervise the project and assess the core
drilling sample
o Misuse→ were using the information for personal gain, this is
defrauding the company who gave them access to the information.
Made secret profits at the expense of the trading public
 Issue #2: standard of materiality – Insider trading issue
o An insider’s duty to disclose information or his duty to abstain from dealing in
his company’s securities arises 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 Reasonable Man Test (Escott): Whether a reasonable investor would attach
importance in determining his choice of action in the transaction in question.
What reasonable investor would want to know in making investment decision
 Encompasses any fact which in reasonable and objective contemplation
might affect the value of the corporation’s stock or securities

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  Material facts include 1) info disclosing the earnings and distributions of a
company, 2) facts which affect the probable future of the company and, 3)
facts which may affect the desire of investors to buy, sell or hold the
companies securities
 Here, the knowledge of the results of the discovery hole would have been
important to a reasonable investor and might have affected the price of the
stock
o Court refines this definition further because kind of info in this case is
speculative information because at the time of the trading, it was not known
for certain that the company would hit an ore strike
 Speculative info adds 2nd level of analysis→ probability magnitude test
o Probability magnitude test of materiality: Dealing with speculative
information, the materiality has not yet been realized
 Material facts include not only information disclosing the earnings and
distributions of a company but also those facts which affect the probable
future of the company and those which may affect the desire of investors
to buy, sell, or hold the company’s securities (speculative information)
 Weigh the probability of something happening with the magnitude of that
event (impact on the company)
 Probably of ore strike was relatively high and magnitude of impact on
company would be very large because this was their main line of business
o The info in this case was material→ everyone is liable
 Issue #3: How does the Court’s interpretation of the “in connection with”
requirement expand the category of lawsuits that may be brought under Section
10(b)? – Corporate disclosure issue
o D’s arguments Not corporate fraud because TGS was not involved in
selling any of their stocks to the public at that time.
o Court’s interpretation This requirement expands to situations where the
issuer makes a statement to the public which would affect their desire to buy,
sell, or hold the company’s stocks (reliance)
 Press releases are voluntary disclosures, but you can still get in trouble if
you don’t disclose truthful information to the public
 Can be liable if the investor can show that you knew what you were
putting out was not correct and that investors would rely on it
 Rule: Disclose or Abstain (Classic Rule of Insider Trading) – Anyone in
possession of material inside information must either
o Disclose: it to the investing public or
o Abstain: if he is disabled from disclosing it in order to protect a corporate
confidence, or he chooses not to do so, must abstain from trading in or
recommending the securities concerned while such inside information remains
disclosed.
 Holding: The court held that anyone in possession of material nonpublic
information cannot properly trade on the information even if he is forbidden by
the company from disclosing it must wait till it has been publicly disseminated.

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 o Also the court held that the discovery would be important to the reasonable
investor. Court held that although the corporation itself did not trade, a suit
can be brought via the statement (press release) if it mislead investors.
 Dirks v. SEC (Tipper/Tippee Liability, Need Personal Benefit)
 P: Mr. Dirks (Tippee)
o An officer (broker-dealer) of a NY broker-dealer firm who was an insurance
industry analyst
 Mr. Secrist→ whistle blower, insider (Tipper)
 On March 6, Dirks received info from Secrist, a former officer of Equity Funding
of America
o That Equity Funding vastly overstated its assets
o That various regulatory agencies had failed to act on similar charges made by
its employees
o Secrist urged Dirks to verify the fraud and disclose it publicly
 Dirks decided to investigate the allegations
o Neither Dirks nor his firm owned or traded any Equity Funding stock
o Dirks openly discussed the information he had obtained with a number of
clients and investors
o Tries to warn investing public→ Asked Wall Street Journal to publish this
fraud, but they didn’t want to
 Why did the SEC start an enforcement proceeding against Dirks?
o Dirks did pass on the information to some of his customers who used it to
trade on the market and sell stocks
 Dirks→ tippee
 His customers who got the info→ sub-tippees
o SEC tries to argue that because insider Dirks got info from insider Secrist, he
should either have to disclose or abstain
 Classic rule is if someone who is employed by the company uses
information for their own personal gain
 Dirks is not subject to the classic rule because he is not an employee of
Equity Funding
 SEC wants to extend reach of insider trading prohibition to tippees who
use information from an insider
o Court disagrees with this. Already ruled against this theory in Chiarella
 Court establishes new rule→ rule of tippee liability
 Tippee Liability Rule (2 part test)
1) Tipper must have breached a fiduciary duty
o Mere possession of material inside information does not give rise to a
duty to disclose
o Existence of breach turns on receipt of direct personal benefit by tipper
o Temporary insider Footnote 14: Underwriter, accountant, lawyer or
consultant may become fiduciaries of shareholders
2) Tippee knew or should have known of breach
 Holding: Dirks not liable, did not owe a duty to abstain from use of insider
information he obtained

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 o Secrist did not breach a fiduciary duty
o Dirks didn’t get any personal gain from sharing information (no monetary
benefit)
 Rule: A tippee will be held liable for openly disclosing nonpublic information
received from an insider, if the tippee knows or should know that the insider will
benefit in some fashion from disclosing the information to the tippee (improperly
breaches fiduciary duty).
o Underwriter, accountant, lawyer or consultant may become fiduciaries of
shareholders
 United States v. O’Hagan (Misappropriation Theory)
 Section 10(b) Outsider Trading Prohibition
 US (instead of SEC) means it is a criminal case SEC has civil enforcement
authority, it doesn’t have criminal enforcement authority
 O’Hagan→ partner/corporate lawyer in law firm Dorsey & Whitney
o Firm represented Grand Met, who wanted to acquire Pillsbury
o Tender offer→ A public offer to buy a minimum number of shares directly
from a corporation's shareholders at a fixed price, usu. at a substantial
premium over the market price, in an effort to take control of the corporation
 Main goal is to gain control of company
 O’Hagan buying shares and call options of Pillsbury stock before tender offer was
made public
o Made a profit of more than $4.3M
o Using the money to cover up money he embezzled from unrelated clients of
firm
 Court endorses a third theory of liability→ Misappropriation Theory
o Classic theory didn’t apply to O’Hagan because he was not an insider or a
temporary insider for Pillsbury (Dirks FN14)
 He was working for Grand Met, not for Pillsbury
o There was no insider tipper in this case→ he got the info through D&W and
Grand Met
 Misappropriation Theory Of Liability
o Outsider violates 10b/10b-5 when he trades on material non-public
information in breach of a duty owed to the source of such information
o Disclosure to source of information absolves breach
o Purpose: protect integrity of markets against abuses by outsiders who have
access to confidential info that will affect a company’s stock price but who
owe no fiduciary duty to corporation’s shareholders
o There has to be fraud, fraud is breach of fiduciary duty
o Here, D got info from D&W and Grand Met, they did not expect that he
would use it for his personal advantage
 He should have engaged in disclosure to people he owed fiduciary
duty to (D&W and Grand Met), which cures potential breach of duty
o Disclosure to source of information absolves breach
 If the fiduciary discloses to the source that he plans to trade on the
nonpublic information, there is no “deceptive device” and thus no §10(b)

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 violation – although the fiduciary-turned-trader may remain liable under
state law for breach of a duty of loyalty
 Must disclose to both the law-firm and the client (otherwise, still liable
under §10(b))
 Court also Discusses §14(e) of 1934 Act & SEC Rule 14e-3(a): Insider Trading
Prohibition in Tender Offers
o §14(e): In connection with a tender offer, it shall be unlawful to make
material misstatements or omission or to engage in fraud, deception or
manipulation
o Rule 14e-3(a): If a tender offer has been commenced, it is unlawful to
purchase or sell securities on the basis of material inside information if trader
knows info obtained from offeror, issuer or any officer, director, partner, or
employee to either offeror or issuer
 Made by the SEC to address issue of insider trading when there is no
breach of fiduciary duty
 No breach of duty requirement
o D argues the Commission exceeded its rulemaking authority under these rules
without requiring a showing that the trading at issue entailed a breach of
fiduciary duty. Court rejects this argument
 Valid rule because Rule 14e-3(a) qualifies under §14(e) of the Act,
providing that “…SEC shall …prescribe means reasonably designed to
prevent such acts and practices as are fraudulent, deceptive, or
manipulative.”
 It is a fair assumption that trading on the basis of material, nonpublic
information will often involve a breach of a duty of confidentiality to the
bidder or target company or their representatives
 *Chevron Doctrine→ we give deference to rules that are made by
administrative organizations of government (reasonable basis for the rule)
 Holding: The fiduciary’s fraud is consummated, not when the fiduciary gains the
confidential information, but when, w/o disclosure to his principal, he uses the
information to purchase or sell securities. Although O’Hagan did not owe a FD to
Pillsbury he did owe a duty to his firm therefore a deception occurred necessary
for a 10(b) violation.
 Rule: Misappropriation Theory – Holds that a person commits fraud in
connection with a securities transaction, and thereby violates §10(b) and Rule
10(b)-5 when he misappropriates confidential information for securities trading
purposes, in breach of a fiduciary duty owed to the source of the information.
Self-serving use defrauds the principal of the exclusive use of the information

Short Swing Profits

 The short swing profit rule was made by Congress so that insider trading is
prohibited→ some sort of insider trading based on insider information is necessary as
well.
 §16(b) of 1934 Act (Original Federal Insider Trading Provision)
o Section 16(b) was intended to prevent insider trading
o Insiders: Controlling SH 10%, directors, officer

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 o Buying or selling within 6 month period.
o Remedy: any profit that you get on that transaction is recoverable by the
corporation. The presumption is that you buy/sell within 6 month period you did
so because you had nonpublic information, this was the assumption. So purpose
was to take profit out of transaction.
o If you are required to register you stock under 1934 (Assets level $10 Million,
500+ SHs, trade nationally on NY Stock Exchange), then subject to this rule.
o Violation of §16(b) is a strict liability offense
 Intent is irrelevant
 Don’t need to show D knew of and acted on material insider info
 Reliance Co. v. Emerson Electric Co. (You can sell in parts to avoid rule)
 Purchase of shares: Emerson purchased 13.2% of Dodge in a tender offer
 Tender offer did not result in a takeover; Dodge subsequently merged into
Reliance
 Sale of shares:
o Sale #1: Emerson sold 3.24%
o Sale #2: Emerson sold remaining 9.96%
 Since Emerson is 10% or more shareholder, they are subject to §16(b) and
disgorgement of profit rule. If they sell all of their shares at once, they have to
give all the profits to Reliance.
o “objective standards” = 10% or more shareholder both at the time of purchase
and sale of the security involved
 Issue: Is Emerson liable for profits on sale #1? On sale #2?
o DON’T have to pay back to the company if you are not a covered person→ in
this case, a beneficial owner
o Sale #1 The 3.24% sale is subject to §16(b) because at this transaction they
were 10% or more shareholder
 Were subject to disgorgement of profits, but not for their whole 13.2%,
only the 3.24% that they sold
o Sale #2 they were not 10% owner anymore at this time. Thus, the statute
would not apply on sale #2
 This is an acceptable practice; this is just working around the legal rule.
Not illegal.
 The two sales were not related to each other As long as sales are not
legally tied, this work around is legal for the purposes of §16(b)
o Court does very literal reading of the statute→ say it is a flat rule
 Only applies if you are a covered person
 As long as two sales are not legally tied, this work around is legal for the
purpose of §16(b)
o Problem with the rule is that it is both over inclusive and under inclusive
 No state of mind inquiry
 Short Swing Profit Hypo
 Bill is chief executive officer of SC Law, Inc. (SCLI), a chain of proprietary law
schools in southern California. SCLI stock is registered under the 1934 Act, and

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 1,000,000 shares are outstanding. On January 1, Bill purchased 200,000 shares of
SCLI common stock for $10 per share.
 Determine his liability, if any, under § 16(b):
1) If he sells all 200,000 shares on May 1 for $50 per share?
o Yes he is liable under rule §16(a)
o He is covered person by virtue of being an officer in the company
o This is a covered transaction
 It is within the 6 month period. Thus, purchase and sale matches.
 He is making a profit $40 profit per share.
o Will have to disgorge the property he made
o Difference in the stock price times the amount of shares and this is how
much he has to give up.
2) If he sells all 110,000 shares on May 1 for $50 per share, and the remainder on
May 2 at the same price?
o Still liable, has to disgorge profits
o He is still a covered person as an officer (not as a 10% shareholder)
o Still a covered transaction because its within 6 months and he makes a
profit
3) If he sells 110,000 shares on May 1 for $50 per share, resigns from SCLI, and
sells the remainder on May 2 at the same price?
o He is liable for the whole thing (sale 1 and 2) since officer is liable if they
were an officer at the time of either the sale or purchase.
 10b-5 Cause of Action vs. 16(b) Cause of Action
Rule 105-5 Section 16(b)
Applies to all corporations Applies only to publicly traded companies
Applies to all purchases and sellers Applies only to directors, officers, and 10%
beneficial owners
Requires a purchase or sale Requires a purchase and sale
Requires intent to deceive No intent required; strict liability
Direct and derivative actions; SEC action Derivative action

Proxies
 Proxy→ One who is authorized to act as a substitute for another; esp., in corporate
law, a person who is authorized to vote another's stock shares
 Proxy card→ The document granting this authority
 Proxy solicitation→ A request that a corporate shareholder authorize another person
to cast the shareholder's vote at a corporate meeting.
 Uses:
1) Used in large, publicly held corporations to solicit shareholder votes needed to
hold meetings and take valid shareholder action
2) Proxy fights to gain corporate control
 Regulation
 State law
o Statutory: DGCL §212(b) permits use of proxies; remember that §211(b)
requires annual meetings of shareholders for election of directors

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 o Case law on strategic use of proxies and cost reimbursement in proxy contests
 Federal law
o §14(a) of 1934 Act requires proxy solicitations for reporting companies to
comply with SEC rules
o SEC rules require disclosure to accompany proxy solicitation, specify form of
proxy card, require prior filing and review of proxy statement and proxy card,
prohibit false and misleading proxy solicitations
 Problems of Control- Proxy Fights
 Because few shareholders of public corps attend annual meetings, the outcome
generally depends on the group which has collected the most proxies c
o Corporate law→ shareholders can appoint agent to attend meeting and vote on
their behalf
 Proxy fight→ way to take over the business
o Results when an insurgent group tries to out incumbent management by
soliciting proxies and electing its own representatives to the board
 Proxy fights are subject to the 1934 Securities Exchange Act and state corporate
statutes
 Levin v. MGM
 Ds: The O’Brien Group
o Party sitting in controlling seats who want to maintain their control→
incumbents
 Ps: The Levin Group
o Party who wants to take control from the incumbents→ insurgents
o Complaining that the incumbent group wrongfully used corporate funds to
hire/use a proxy solicitation firm
 Don’t like the manner, means and method of proxy solicitation by the Ds
 Expenditure of corporate money
 P is seeking injunctive relief AND money damages on behalf of MGM
 Controlling question: whether illegal or unfair means of communication that
demand judicial intervention are being employed by the present management
 Outcome of Case: Who wins and why?
o P incumbents win
o Court says P was fully justified in their actions Incumbent boards have right
to expend corporate money to defend their position against and insurgent
group, with
o No illegal or unfair means or methods of communication
 What limitations does the court impose on costs incurred for proxy contests?
o Must be a fight over business policy as opposed to just wanting to maintain
control/management
 Court says there are definite business policies advanced by each group so
divergent that reconciliation doesn’t seem possible
 pg 519, n. 7→ court discusses fundamental policy differences between the
groups
o Amounts cant be excessive
 Analyzed on case by case basis

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 o Methodology cant be illegal
 Not giving full and fair disclosure
 Fraudulent disclosure
 No violation of federal/SEC rule
 Holding: The court held that the proxy statement was information in that in
named the firms and agencies it was working with, that it would bear the costs
etc. Therefore the MGM method was not unfair or illegal.
 Rule: The decision as to the continuance of the present management rests entirely
with the SHs. A court may not override or dictate on a matter of this nature of
SHs. it is the concern of the law and of the Court that they be fully and truthfully
informed as to the merits of the contentions of those soliciting their proxy. The
right of the SH to be fully informed is of supreme importance.
 Rosenfeld v. Fairchild Engine & Airplane Corp.
 Case is a stockholder derivative action
o Not someone involved in the original proxy fight, a shareholder who wants
corporation to be reimbursed
o Over $260,000 from corporate treasuring used to reimburse both sides after
proxy contest
 Outcome of Case: Who wins and why?
o The company wins
o Incumbents have the right to reimburse themselves
 This was a fight about policy (permissible reimbursement) as opposed to
corporate control
 Expenses were reasonable and methods were legal
o Test: when directors act in good faith in a contest over policy, they have the
right to incur reasonable and proper expenses for solicitation of proxies and in
defense of their corporate policies
 Don’t have to sit idly by while someone else tries to remove them from
power
o The insurgents won the proxy fight and reimbursed themselves also
 Because there was shareholder ratification, insurgents were permitted to
reimburse themselves
 Rule: Who can be reimbursed for proxy contest expenses?
o Incumbents
o Insurgents if they win proxy fight and shareholders approve reimbursement
 Rule: What are the limits for reimbursement?
o Cant be reimbursed for expenditures:
 For personal power, individual gain, or private advantage
 Not in the belief that such expenditures are in the best interests of the
stockholders and the corporation
 Where fairness and reasonableness of the amount allegedly expended are
duly and successfully challenged
 Holding: The court held that in a contest over policy as compared to a purely
personal power contest, corporate directors have the right to make reasonable and
proper expenditures, subject to the scrutiny of the courts when duly challenged,

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 from the corporate treasury for the purpose of persuading the SHs of the
correctness of their position and soliciting their support for policies which the
directors believe, in all good faith, are in the best interests of the corporation. The
SHs, can reimburse successful parties.
 Rule: When the directors act in good faith in a contest over policy, they have the
right to incur reasonable and proper expenses for solicitation of proxies and in
defense of their corporate policies, and are not obliged to sit idly by.
 Proxies Regulation
 State law on cost reimbursement
o Annual meeting of shareholders with uncontested board election: Incumbents
may charge the firm for proxy costs
o Limits imposed by courts
 Proxy contest: Incumbents may charge firms for proxy costs; Insurgents may be
reimbursed if they win AND shareholders ratify
 Federal Law (see chart above)
o §14(a) of 1934 Act
o SEC Rule 14a-8: Shareholder Proposals

Shareholder Inspection Rights

 Definition: Ability of shareholders to obtain shareholder list or other corporate
records regulated by state law
 Information covered by statutes
1) Shareholder list
o Fought over under state laws
2) Books and records
 Right of shareholder to this information is NOT automatic
 There is nothing in the federal proxy rules requiring the corporation to give you
the SH list, but the federal rules do not impair any rights you may have under
state law. Thus, need to look at state law for burden of proof, procedural access,
type of shareholder, type of records.
 Crane Co. v. Anaconda Co (Anaconda don’t want none)
 Exchange offer→ variation of a tender offer
o Company that is trying to gain control is giving away shares of stock
 Crane wants to take over control of Anaconda
o Crane→ acquiring corporation
o Anaconda→ target corporation
o Unfriendly/hostile offer→ Anaconda wants nothing to do with Crane
 Records P was seeking and why?
o P wants shareholder list so they can do a mailing of the information about the
transaction→ “direct approach”
o D says they can mail it for them, but P wants to do it themselves
 Looking at NY law→ NYBCL §1315
o To get lists and records
 Must be a SH of Record for at least 6 months preceding demand
 Must be a shareholder with at least 5% of any class of outstanding shares

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  Must give 5 days notice in writing about shareholder list
 Must not have been involved in the sale of stock lists with in the last 5
years
 D claims that P’s request doesn’t have a proper business purpose
o NYBCL §1315 access must be permitted to qualified SHs on written
demand with affidavit that “inspection is not for a desired purpose… other
than the business” of the corporation
o Court disagrees
 Although everything affecting the SHs will not affect the corporation, the
converse is not true
 SHs are necessarily affected and the business of the corporation is
involved within the scope of §1315
 Statute should be liberally construed in favor of the SH whose welfare as a
SH or the corporation’s welfare may be affected
 Holding: The court found that since a tender offer affects the future of the
company and continued vitality of the SH’s investment it was a purpose related to
business. Therefore Anaconda did not sustain its burden of improperness and
hence the court compelled the inspection. Anaconda agreed to mail information to
SHs but Crane wanted to do it their way which is permitted by state law.
 Rule: A SH desiring to discuss relevant aspects of a tender offer should be
granted access to the SH list unless it is sought for a purpose inimical to the
corporation or its SHs and the manner of communication selected should be
within the judgment of the SH. Statute list state requirements
 State Ex Rel. Pillsbury v. Honeywell (Vietnam gun protest)
 P: Pillsbury
o Member of “Honeywell Project” Believed that involvement in Vietnam war
was wrong and knew that a substantial portion of Honeywell’s production
consisted of munitions used in that war, and thought they should stop
 D: Honeywell Inc.
o Had large govt. K to produce anti-personnel fragmentation bombs
 State Law applied DGCL §220
 What records were sought?
o P wanted writ of mandamus to compel D to produce its original SH ledger,
current SH ledger, and all corporate records dealing with weapons and
munitions
 Shareholder list AND files of the business (books and records)
 This makes it a more sensitive case
 Burden of Proof for Proper Purpose
o DGCL §220 Proper Purpose: a purpose reasonably related to such
person’s interest as a SH
o Difference between burden for SH list and books and records
 Higher burden for books and record Burden on shareholder to
affirmatively establish proper purpose
 Burden on corporation to show improper purpose for SH list
o Court said this case did not have a proper purpose

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  Request was not economic in nature, its purpose was political
 Holding: Court denied request. Because the power to inspect may be the power to
destroy, it is important that only those with bona fide interest in the corporation
enjoy that power. Because the purpose of his request was to persuade the other
SHs to adopt his political view it was not germane to his economic interest the
petitioner’s request must be denied.
 Rule: The SH must prove a proper purpose related to economic interests in order
to inspect corporate records and SH lists. (Delaware has a wider requirement “any
SH” and broader)
 Compare NYBCL §1315 and DGCL §220
NYBCL §1315 DGCL §220
(generally broader than NY Statute)
Type of SH  Must be a SH of Record for at least 6  Any SH
months preceding demand
 Must be a shareholder with at least
5% of any class of outstanding shares
Type of  May request SH list  May request SH list, stock records,
Records other books and records
 Allowed to make copies
Conditions to  5 days written notice  Written demand
Access  Must have a valid business purpose  Inspection during regular business
 Must not have requested shareholder hours
list of this company or any other  Proper purpose
company within the last 5 yrs
OFFICER & DIRECTOR INDEMNIFICATION AND
INSURANCE
Indemnification & Insurance
DGCL §145
 Delaware corporations have power to indemnify, grant advances and insure covered
persons as specified.
 Covered persons – any person who becomes a party to lawsuit by reason of service as
director, officer, employee or agent. Indemnification permitted – In statute because
people could say that it was misuse of corporate funds. If you are a covered person
you can recover for:
a) Third party suits expenses and judgments; good faith (sometimes judgment
against you).
b) Derivative suits expenses; good faith
c) Indemnification required for expenses if successful on the merits
d) Advances of expenses to D & Os. Corporation may grant advances with written
undertaking to repay if not entitled to indemnification
e) Additional rights may be granted by contract
f) Insurance – Corporation may shift its risk to insurance company. May insure
covered persons against liability (D&O insurance)

 Waltuch v. Conticommodity [Settlements count and you can’t abrogate (a)]

 Suit for indemnification of legal expenses

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 Crash in the silver market and some people who were speculators and trying to
make money in commodity exchange took big losses and brought private law
suits against Waltuch and Conti claiming fraud and market manipulation
o The lawsuits were settled by Conti and Waltuch
 As an individual, P Waltuch, suffered personal expenses even though he was
settled out because he had to higher attorneys to defend himself.
o He incurred 1.2 million in legal fees for his defense
o In addition to the private lawsuits there were also enforcement proceedings
brought against him by CFTC
 He also had to defend himself in that action, the CFTC fined him and he
was also banned from trading in commodities for 6 months
 He again had to pay $1 million dollars in legal fees towards that hearing
o P is trying to get reimbursed by his prior employer for his legal fees on the
theory that he was sued because he was working for them so he is entitled to
indemnification
 Conti Article of Incorporation Article Ninth
o “The Corporation shall indemnify and hold harmless each of its incumbent or
former directors, officers, employees or agents…against expenses actually and
necessarily incurred by him in connection with the defense of any action, suit
or proceeding…”
o No requirement of good faith.
 Holding: The court held that the “good faith” requirement in §145(a) was a
substantive provision that could not be overcome through a corporation’s article
of incorporation. Furthermore the court held, in accordance with Merrit, that the
only question important for a (c) analysis is what the result was, not why it was.
Therefore the morality argument failed and all that matters is success or
vindication which Waltuch accomplished with his settlement.
 Rule: A corporation’s grant of indemnification rights cannot be inconsistent with
the substantive statutory provisions of §145(a) (good faith), notwithstanding
§145(f). The Delaware SC in Hibbert held that substantively Subsection (a) does
not allow a distinction between plaintiff and defendant. Furthermore §145(c)
requires corporations to indemnify its officers and directors for the successful
defense of certain claims…successful on the merits or otherwise defense of any
action, suit or proceeding referred to in subsections (a) and (b).

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