Corporate Law (Corporations) outline.

Corporations Outline

 

Introduction

There are three problems facing profitable enterprises

i)         Tort Problems:  When is the enterprise liable for its employee’s torts?  Who pays if a third party is injured?

ii)       Contract Problems:  When can an employee/partner bind others in the corporation?

iii)      Organizational Control Problems:  How do you make sure that everyone in the organization is acting in the best interests of that corporation?

(1)     Several ways to accomplish this – contract, market forces, law (fiduciary duties).

(2)     Also can be a collective action problem – if ownership is separate from management, and ownership is dispersed, no one individual has the incentive to do anything (will bear 100% of loss, but only a small fraction of return)

 Agency Law
In General

Respondeat Superior

Under the doctrine of respondeat superior, a “master” (employer) is liable for the torts of its “servants” (employees) committed within the scope of employment.

Definitions

Agency is

Mutual consent between 2 parties that agent will act for principal (§1)

Note that an agreement is necessary to create an agency relationship, but that agreement does not have to be a formal contract

An agent is a person

(1)     Who acts on behalf of the principle, and

(2)     Is subject to the principle’s control (§1)

A principal is a person

(1)     For whom the agent acts (§1)

(2)     Who has the right to control the conduct of the agent with respect to matters entrusted to the agent (§14)

Legal consequences of principal/agent relationship

i)         All agents (servant and independent contractors) create contractual liability for principal

ii)       All agents have fiduciary duties to the principal (§13)

iii)      Principles have duties toward their agents

Ex: indemnification

 

Types of agency relationships

Servant Agents

Definition (§ 2(2))

Agents where the principal has control over the agent’s physical conduct

Ex: employees are servant agents

Note that a principal who controls a servant agent is also known as a master (r2a §2(1))

Legal Consequences (r2a §219)

Contract

Principal is liable for contracts entered into by servant agents

Torts

Principal is liable for torts committed by

Independent Contractors – Non Servant Agents

Definition (§2(3))

Agent, not principal, has physical control over own work.

Ex:  brokers and attorneys

Legal Consequences

Contract

Principal is liable for contracts entered into by non-servant agents

Torts

Principal has no liability for torts committed by non-servant agents

Non-Agents

Definition (§1)

Non agents do not represent the principal and cannot bind the principal

Ex:  Parties with whom one conducts arms length business transactions.  Also, independent contractors can be non-agents, If the person they are hired by does not physically control the work they do. (ASK STUDY GROUP ABOUT THIS.  WHY AREN’T ATTORNEY’S NON-AGENTS THEN?)

Legal Consequences

Contract

A principal is not liable for the contracts of non-agents

Torts

Principal has no liability for torts committed by non-agents, except where there is a specific duty to have the act performed with due care (?) (§250)

How to determine whether someone is a servant agent or an independent contractor

Control of principal over party and the parties’ course of dealing determines whether a person is a servant agent or independent contractor. (§ 220(2)). 

Characteristics of control include:

(1)     Extent of control set out in agreement

(2)     Whether the person employed is engaged in distinct occupation

(3)     Kind of occupation employee is engaged in

(4)     Skill required by that occupation

(5)     Who supplies tools and place of work

(6)     Length of relationship

(7)     Method of payment (salary or per job)

(8)     Whether work is part of regular business of employer

(9)     Intent of parties to create master-servant relationship

(10)Whether principal is in business (??SAME BUSINESS AS AGENT?)

Note that intent is a factor but is NOT controlling

Relevant cases

Humble Oil:  Court holds that despite contract repudiating any control of Schneider by Humble, actions show that S was controlled by H so was H’s agent.  So H liable for tort.

(a)     Facts:  Love parked her car at service station managed by Schneider and owned by Humble.  Car rolls of lot, injuring Martin. Now M wants to sue H.  H claims S is an ind. contractor (non-agent).   M says H is an agent.  Case turns on whether H controlled S’s actions to such an extent that S was his agent. 

(b)     The court looked at the following factors:

HOURS:  H controlled work hours

FINANCES:  H paid S’s expenses and was residual claimant.

CONTROL:  S had to report to H, and S has to follow H’s orders

TERMINATION:  H can fire S at any time (court really focuses on this)

(c)     HELD:  H did control S enough to make S his agent.

Sun Oil:  Despite the franchisor/franchisee relationship, no day to day control, so no tort liability.

(a)  Facts:  P injured in fire started by negligence of gas station attendant.   Sun Oil Co. owns station, but asserts that Barone is independent contractor.  Barone is residual claimant

(b)  HELD:  Barone not the agent of Sun Oil, because Sun Oil had no control over details of day to day operation.

See also Murphy, which held that franchisee not agent of franchisor (here, Holiday Inn) because HI did not control day to day aspects of hotel, and HI not the residual claimant.

Note that in both of the above cases, the residual claimant bore liability.  This makes sense, because the residual claimant generally bears risk, receives benefits, and has incentive to be careful and avoid harm.

Legal Consequences of Independent Contractor v. Servant agents

Servant agents carry tort liability, independent contractors don’t

Legal Consequences of Non-Servant Agents v. Non-Agents

Non-servant agents carry fiduciary duties and contract binding ability, non-agents don’ t carry either.

 

Tort Liability

Principals only liable for torts of servants.

(a)  Party is a servant if principal exerts control over daily activities of party. 

(b)  Characteristics of control include (§ 220):

(1)  Extent of control set out in agreement

(2)     Whether the person employed is engaged in distinct occupation

(3)     Kind of occupation employee is engaged in

(4)     Skill required by that occupation

(5)     Who supplies tools and place of work

(6)     Length of relationship

(7)     Method of payment (salary or per job)

(8)     Whether work is part of regular business of employer

(9)     Intent of parties to create master-servant relationship

(10) Whether principal is in business (??SAME BUSINESS AS AGENT?)

Note that intent is a factor but is NOT controlling

Torts must be committed while servant acting within scope of employment.

Activities within scope of employment include (§228):

(1)     acts of the kind the servant is employed to perform

(2)     which occur substantially within the authorized time and space limits, and

(3)     act serves the principal

Policy rationales for holding principals liable for servants torts

Yes, because

(1)     It’s fair.  Master has control

(2)     If residual claimant is responsible, they will take more precautions and increase deterrence.

(3)     They’re in the best position to avoid harm.

(4)     Fair to force master, not 3d party, to bear loss.

No, because

(1)     Fairness too broad a concept to base statute on

(2)     Encourages ignorance of masters (trying to abdicate control to avoid liability)

(3)     Encourages frivolous suits by providing access to deep pockets

(4)     Market forces can force masters to control servants.

(5)     Law should subsidize businesses

(6)     Principal may not have information, and will therefore be unable to take precautionary measures

(i)       Ultimately, control matters because it serves as a proxy for information and liability should flow to the party with information because of fairness, prevention, and control over activity levels.

ii)       Residual claimant should usually bear liability because residual claimant is person who will bargain for control.

iii)      Note that making control central may induce people to give up control more readily

 

Contract Liability

Any agent can contractually bind a principal through:

i)         Actual authority

ii)       Apparent authority

iii)      Inherent agency

iv)     Ratification

See §140

Actual Authority

Definition

An agent has actual authority when the principal expressly or impliedly grants the agent such authority.  (§7)

How created

Actual authority is created by communications between the principal and the agent

Note that a principal impliedly grants an agent any authority necessary for that agent to carry out its express powers.

Ex:  an agent with the express authority to “buy a plane ticket to St. Louis” has the implied authority to choose the airline.

Apparent Authority

Definition

An agent acts with apparent authority when (§8, 27)

(a)     the principal manifests such authority to a third person, and

(b)     that third person reasonably relies on that manifestation. 

How created

created by communications between the principal and the 3d party.

Other issues

Reasonability of reliance

if 3d party knows that the agent is exceeding his actual authority, then there is no apparent authority.  (§27)

Burden of proof

3d party has the burden of proving reliance on indicia of authority and reasonability of that reliance

Cases

(1)     Lind v. Schenly:  court held employer liable for a supervisor’s salary promise to a salesman based on apparent authority.  Employer had argued that supervisor didn’t have the authority to set salaries. But employer had told salesman to speak to supervisor re: compensation and supervisor was direct boss of salesman.  Salesman’s reliance was actual and reasonable.

(2)     370 v. Ampex:  court held Ampex telling 3d party that salesman was “contact” for the company imbued salesman with apparent authority to bind Ampex.  Even though salesman didn’t have actual authority to bind Ampex, Ampex’s actions made it reasonable for 3d party to think salesman had the authority.  Relevant manifestations included:

(a)     ampex telling 3d party during negotiations that salesman was “contact person”

(b)     salesman sending 3d party a contract (at Ampex’s request) with space for signature

(3)     Billops v. Magness:  court reverses summary judgment and holds that franchisor might be liable for franchisee’s torts because there may be enough indices of authority to create apparent authority where:

(a)     Franchisee used franchisor’s name, and “system” (color schemes, etc.)

(b)     3d party reasonably believed that hotel offered franchisor’s ‘quality’

Theoretical issues in apparent authority

Pros and Cons of Apparent Authority

Pros

(i)      Cuts down investigative costs for 3d parties

(ii)    Limits temptation of principal to destroy evidence of actual authority to avoid liability

(iii)Uncertainty without apparent authority would be too cumbersome

Cons

(i)      Unfair to principal

(ii)    Could adjust contract price to include this risk

Billops approach v. Murphy approach

(a)     note also that this case is inconsistent with Murphy, where court affirmed summary judgment because of failure to find day to day control.  If anything, there’s even less control in Billops.  What does this say about the efficacy of the day to day control test?

(b)     note that this case is really a stretch, in that it suggests that tort liability may flow from apparent authority (this runs counter to §219, which makes clear that principals only liable for torts of servant agents).  This is worrisome because the policy reasons for extending contract liability to principals is different than the reasons for extending tort liability to principals.

Different justifications for extending tort and contract liability

Tort liability

Extend because:

1.       Compensation for victim

2.       Fairness

3.       Principal can take precautions

4.       Principal can control activity level

Limit because:

1.       What if Principal doesn’t have much control?

2.       Encourages frivolous lawsuits

3.       Subsidizes businesses – good for economy

Contract liability

Extend because:

Couldn’t do business without it.  Too costly for 3d parties to investigate and ensure that people they do business with have authority to do business

Limit because

1.       Unfair to principal

2.       3d party can take risk into account when making contract

Inherent Agency

Definition (§8(a), 194, 195)

An agent has inherent authority when its acts are

(a)     Done on the principal’s account

(b)     Are usual and necessary - even if contrary to actual authority

(c)     Third party reasonably believes that the agent is authorized to do the act.

How created

Inherent agency is derived solely from the agency relation.  It doesn’t depend on communication at all.

Other issues

Undisclosed principal liable for inherent agent (§195)

Watteau v. Fenwick:  principal (brewery) liable for manager buying cigars for pub in contravention of authority.  Court held that because pub appeared to be under manager’s control (owner was ‘silent partner’), and buying cigars part of usual acts of authority of manager, inherent agency existed and principal was liable

Cases

(1)     Kidd v. Edison:  agent told by boss not to guarantee performances, but agent did anyway and booked singers for tours that never materialized.  Court held that no singer could anticipate that a booker couldn’t actually book shows, so inherent authority existed.

(2)     Nogales v. ARCO:  gas co. agent promised Nogales a 1% discount on gas.  Nogales took out loan in reliance on discount, which never materialized.  Court held that agent had inherent authority to give discounts.

 

Ratification

Definition (§ 143)

Where principal either expressly or impliedly ratifies the agent’s actions, the principal is estopped from asserting no agency relationship exists.

 

 

Theory Issues of Agency Law

Problems addressed by agency law

Organizational Control:  once more than one person in a productive enterprise, have to worry about individual interests conflicting with interests of organization.

Agency law addresses this by imposing fiduciary duties on all agents

Contract issues:  Where people inside the organization make contracts with 3d parties, to what extent should the contract bind the organization?

Agents can bind principals under contract

Tort responsibilities to third parties:  should organization be liable for torts committed against third parties?

Principal liable for agent’s torts if committed within the scope of employment.

 

Fiduciary Duties

In General

Agents have the following duties toward the principal

(1)     Fulfil the Contract:  An agent is subject to a duty to act in accordance with the terms of his contract (§377)

(2)     Duty of Care:  Unless otherwise agreed, an agent must act with standard care and skill expected from people in similar positions (§379)

(3)     Duty of Loyalty: Unless otherwise agreed, an agent must act solely for the benefit of the principal in all matters connected to the agency relationship.  (§387)  An agent cannot:

no secret profits (§388)

General Automotive v. Singer: Singer took certain orders placed for his employer and sent them to another company (he got commission).  Even though Singer believed that his employer couldn’t handle the orders, court held that Singer had a duty to disclose information about orders to employer and allow employer to decide whether or not it could fill them before making a commission profit on them.

no acting adversely to principal (§389)

Bancroft-Whitney v. Bender: employee setting up new company violated DOL to old company when employee: (1) denied a raid was taking place, (2) used confidential info about salaries to make attractive offers, (3) used knowledge of “best employees” for hiring, (4) gave ‘strategic’ advice about how to approach employees, (5) delayed raises at old company to make new company salaries look better, and (6) solicited editors working under him.

Note that employees leaving a company can recruit peers but not employees working under them. (fn. 10)

no competing with principal (§393), or

no using confidential information obtained from agency relationship (§395-396).

Town & Country v. Newberry: former employees start own business and solicit customers of former employer.  Court says customer list is trade secret because former employer had to put a lot of energy into creating it, so employee’s use of it was a violation of duty of loyalty

1.       Note that DOL terminates at end of agency relationship, except that confidential information from agency relationship can never be used.

2.       Note that non-agents have no FD’s

Actions that violate fiduciary duty

i)         Disclosure of bad acts don’t keep acts from violating FD (Bancroft-Whitney)

ii)       Can’t solicit lower level employees (B-W)

iii)      Can’t use customer list that former employer had to expend time and energy generating (Town & Country)

Actions that don’t violate fiduciary duty

i)         can make preparations to compete without violating FD

(1)     Can set up office space, etc (????)

ii)       Can solicit peer employees (B-W)

Fiduciary Duty Theory

Many people see FD’s as substitutes for contractual terms. 

(1)     Default terms are imposed because it’s assumed that most people would want them, so it saves transactional costs to impose them on everyone.  FD’s should reflect terms that are reasonable to most people had they thought about them.

(2)     If you see FD as substitute for K, how to determine where FD line should be?

Ask where parties would have drawn FD line if they had contracted for terms.

(3)     Note that fiduciary duties aren’t free.  The more restrictions on an agent’s actions, the more you will have to pay them

Why are fiduciary duties set where they are?

Purpose is to maintain organizational control.  Fiduciary duties are set where they are to maintain such control without overly restricting the acts of an agent.

Rationale behind default fiduciary duty terms

Fiduciary duties address the problem of organizational control.  By requiring agents to act in accordance with these duties, we make sure they will act in best interests of organization

Arguments for mandatory terms

(a)     Economy of scale/eliminating uncertainty in terms

Because if you have default terms, everyone knows what those terms mean

(b)     Helps unsophisticated parties and parties with unequal bargaining power (if you assume most would want terms)

(c)     Efficient – reduces transaction costs

Because people would come up with the same terms anyway if forced to bargain about them

Arguments against mandatory terms

(a)     Could use boilerplate terms to eliminate uncertainty

(b)     Parties should have freedom to contract

But note that they really do, since default terms can be modified through contract

(c)     Reduces flexibility

(i)      Different terms may serve different needs better

(ii)    Not everyone may want default terms

(d)     Traps the unwary because if terms aren’t explicitly in contract, party may not know they are agreeing to them.

Note that this is more likely to hurt agents than principals, who are more likely to be repeat players

(e)     There are other ways (market forces, contract) to impose fiduciary duties

Alternative solutions

Contract

Could take the place of fiduciary duties by requiring everyone to bargain for them, but this is inefficient and costly

Market forces

Could provide other, non-legal incentives to work hard.

How to determine what fiduciary duties are in a particular context

Look at black letter law (restatement of agency and case law)

Figure out theory behind fiduciary duties and work from there

 

 

Partnership Law – Governed by Revised Uniform Partnership Act (RUPA)

Law relies on people to choose which framework (agency relationship, partnership, corporation) best suits their situation.

Basic Rules of Partnership Law

a)Organizational Problems – Fiduciary duty is owed by each partner to each other partner

b)       Contract liability – Each partner can bind the partnership in contract

c)       Tort Liability – Liability extends to the partnership, and therefore to each individual partner

In General

Characteristics of a Partnership

Generally small

Because default rules extending liability to individuals work best with small entities

Equal ownership and management power (RUPA §401(f))

Partners generally share equally in ownership and management.  They tend to participate in all aspects of business and have high levels of confidence and trust in other partners

Note that equal management rights is a default rule (UPA §18(e) and can be modified by contract

Equal sharing of profits and losses (RUPA §401(b))

Limited Transferability (RUPA §401(i))

Partnership shares have limited transferability, because you can only initiate a new partner with the consent of all the other partners

Unlimited Personal Liability (RUPA §305(a), 306(a))

Partners are personally liable for torts and contracts of the partnership.  Each partner is jointly and severally liable.

Note: this liability can’t be modified by contract

Fiduciary Duties (RUPA §404, 103(b))

Partners have duties to the partnership and to other partners.

Flexible and Adaptable (RUPA §103(a))

Partnerships are easier to dissolve than corporations

You can modify almost all default partnership terms by contract.

But you CAN’T modify RUPA “series 300” rules having to do with liability to 3d parties.

Forming a Partnership

Partnership Defined

A partnership exists when (RUPA §202)

(a)     Two or more persons

(b)     Are engaged as co-owners

(c)     In a for-profit business

Unless some other form of relationship is chosen

Existence of Partnership depends on characteristics of the relationship

Intent to form or not form a partnership is not sufficient

(a)     See Fenwick v. Unemployment Comp. Comm’n: Fenwick and cashier did not form a partnership, notwithstanding the existence of a partnership agreement and clear intent to form partnership.  Court says no partnership because:

(i)      Fenwick got 100% of  assets upon dissolution

(ii)    Fenwick had 100%  control

Note that this is a slippery concept.  Employee ‘controlled’ reception area, but not enough control to create partnership

(iii)Fenwick bore all losses

(iv)Profit sharing agreement unequal (80%/20%)

(v)Company holds itself out to the world as Fenwick business

(vi)Court looks at intent in fact, not just in words

Court finds that real intent was not to be partners, just to increase employee compensation

(b)     Note that here, court may have been more willing to deny partnership because employer is trying to avoid having to pay unemployment insurance.

(c)     Court is really determining whether it would be “fair” to hold this person liable for actions of another. 

Profit sharing arrangements are assumed to be partnerships (RUPA §202)

Distinct Entity

Partnerships are a distinct entity from partners (RUPA §201)

Policy Considerations in Forming Partnerships

Why shouldn’t partnership agreement/intent determine formation of partnership?

(a)     Because this may protect unsophisticated parties like the cashier in Fenwick, who signed partnership agreement, but probably wouldn’t want to bear unlimited personal liability (which is not waivable)

(b)     Note that the legal consequences of partnership means getting out of employer / employee obligations (unemployment insurance, workers comp., taxes, etc.)

Operation of a Partnership

Governed by partnership agreements (RUPA §103(a)).  

Fiduciary duties exist, but are superseded by terms in partnership agreement.

See Frank v. Pickens:  under partnership agreement, Pickens had exclusive control over admission and expulsion of partners, so Pickens could buy out Frank’s shares, even if later, Frank didn’t want to sell.  Court holds that to the extent you make a partnership agreement, you are stuck with the terms of that agreement.  Can’t go back later and argue that the terms of the agreement are unfair.

Subject, of course, to RUPA §103 restrictions on unreasonably altering DOC and DOL terms.

See Day v. Sidley & Austin: court held that merger that resulted in partner becoming co-chair (instead of sole chair) of office not a breach of FD, because partner had no right to be sole chair – nothing in partnership agreement gave him this right.

All partners have equal management rights (RUPA §401(j))

Ordinary business decisions can be made by a majority of the partners.  These decisions bind all partners

National Biscuit Co.: If partnership made up of only 2 people, either one can make binding management decisions, even if the other partner disagrees.

Extraordinary decisions require unanimous consent

Such decisions include adding new partners, modifying the partnership agreement, or making decisions outside the normal business of the partnership.

 

Fiduciary Duties of Partners

Partners have FD’s to each other and to the partnership

In general

The partnership agreement is paramount with respect to the duties among and between partners, except that certain duties are not waivable (RUPA §103(b)).

Duty of Care  (RUPA 404(c))

Partner has duty to refrain from gross negligence.

Defined as acts which are reckless, intentional wrongdoing, or knowingly violating the law

Partially waivable

Duty of care can be modified, but can’t be “unreasonably reduced” (RUPA §103(b)(4))

Duty of Loyalty  (RUPA §404(b))

Accounting for benefits/profits

Partners must account to the partnership for any property, profits, or benefits derived by partner from the partnership.

Undivided Loyalty: In Meinhard, Cardozo says that partners have a duty of undivided loyalty to one another, which was violated by failure to disclose opportunity to renew lease with partner.  But note that this concept has gotten way more lax.

See Lawlis, where court holds that the duty of loyalty between partners is limited to not wrongfully withholding money or property from a partner.

Ratification:  A partner can realize a profit from the partnership so long as the partners consent either ex ante in partnership agreement or ex post by ratification.  If there is no consent, however, it is a DOL violation.

See Bassan, where court found that even though partnership consented to one partner profiting from land sale, the partnership had rights to the profit because partnership did not ratify the realized profit.

No adverse interests

Partners cannot have interests adverse to the interests of the corporation

See

No competition

Partners can’t compete with the partnership until after the dissolution of the partnership

But in Meehan, court holds that making preparations to compete does not violate the DOL.  Permissible preparations include:

No secrets

Partners must furnish without demand any information concerning partnership business that is reasonably required for other partners to exercise their rights. (§403)

Modifying the DOL

DOL is mandatory, but may be modified

Ex ante agreement

Partnership agreement can identify particular types of activities that do not violate the duty of loyalty, so long as the modification is “not manifestly unreasonable”

Ex post ratification

Partners can, after being informed of all material facts, ratify a particular act or transaction that would otherwise violate the DOL.

Partially waivable

DOL can be modified, so long as waiver is “not manifestly unreasonable”

Unlimited liability to third party creditors

Partners are agents of the partnership, so partnership is liable for the contract and tort liability of individual partners (§301, 305(a))

Contract (§301)

Partnership is liable for actions “within the ordinary course of partnership business”

National Biscuit:  partnership liable to creditor when one partner purchased bread against wishes of other partner.

EXCEPTION:  Partnership is not liable for actions within the ordinary course of business where:

1.       partner has no actual authority to make the decision, and

2.       The third party was aware of this lack of authority

Partner action that is outside the ordinary course of partnership business do not bind the partnership (§301(2))

UNLESS the partners authorize or ratify the act.

Tort (§305)

Partnership is liable for any tort committed by a partner in the ordinary partnership business or any act within the partner’s authority

Partners are jointly and severally liable for liabilities of partnership (RUPA §306(a))

Underlying rationale determines what should be a fiduciary duty

i)         If you accept that fiduciary duties are simply a default for what parties would contract for, there is no justification for limiting parties’ ability to modify them through contract.

ii)       If you believe that fiduciary duties reflect ‘fundamental rights’ that should be protected, you may decide that some rights should not be able to be contracted away.

 

Termination of Partnerships

Terms:

i)        Dissociation: a single partner leaves the partnership

ii)      Dissolution:  whole partnership ends for all partners

Dissociation

i)        A partner has the power to dissociate at any time.  This dissociation may be rightful or wrongful.

ii)      Events causing dissociation

§601(1):  partner’s express will

ok if not term breach

§601(2):  event in partnership agreement

depends on terms of agreement(?)

§601(3):  expulsion pursuant to partnership agreement

depends on terms of agreement, probably wrongful(?)

§601(4):  unanimous vote by other partners

ok

§601(5):  judicial dissociation.  Granted where a partner:

(a)     Engages in wrongful conduct that adversely and materially affects partnership business

(b)     Willfully or persistently commits a material breach of the partnership agreement or violates fiduciary duties

(c)     Engages in conduct relating to the partnership business that makes it not reasonably practicable to carry on the partnership

If granted, it is a wrongful dissociation

§602:  Dissociation is wrongful only if:

(1)     It breaches the partnership agreement

(2)     Partnership agreement is for a specified term or undertaking and

(a)     Partner dissociates before term or undertaking is complete, or

(b)     Partner is expelled by judicial dissociation

(WHAT ABOUT WHERE IT’S AN AT WILL PARTNERSHIP, BUT OTHER PARTNERS GET A JUDICIAL DISSOCIATION?  WRONGFUL?)

Liabilities and duties after wrongful dissociation

(1)     Partner is liable for damages caused by dissociation

(2)     Partner loses any right to manage or control partnership

(3)     Partner still must account for profits and refrain from conflicts of interest regarding matters that occurred before dissociation

(4)     BUT Partner can compete with the partnership after dissociation. 

(EVEN IF PARTNERSHIP DOESN’T DISSOLVE?)

What happens to partnership after a partner dissociates

(1)     Partnership can choose to continue partnership without that partner or can choose to dissolve partnership

(2)     Continuing the partnership

(a)     Must buy out shares of dissociated partner

(i)      Shares valued at sale or liquidation price (§701(b))

(ii)    Note that if it’s a term/undertaking partnership, the partnership doesn’t have to buy out the wrongfully dissociated partner’s shares until the end of the term or undertaking.

(b)     Can collect damages for wrongful dissociation (§602(c))

Dissolution (RUPA §801)

Events causing dissolution

§801(1): A partner withdraws from an at will partnership

§801(2):  For term partnership

§801(3):  event agreed to in partnership agreement resulting in dissolution

§801(5):  Judicial dissolution

granted where economic purpose of partnership is frustrated

Dissolution of at will partnership occurs when:

§801(1):  partner gives notice to the partnership that they want to withdraw

(THIS DOESN’T MAKE SENSE TO ME.  WHY CAN’T PARTNERSHIP CONTINUE WITHOUT HIM PURSUANT TO §601?)

Dissolution of term partnership occurs when:

§801(2)(i): at least half of remaining partners vote to dissolve after a partner wrongfully dissociates

§801(2)(ii): express will of all partners is to dissolve

§801(2)(iii): term or undertaking of partnership is completed

§801(2)(iv): event in partnership agreement resulting in dissolution takes place

Judicial dissolution occurs when partners go to court and prove: (§801(5))

(1)     The economic purpose of the partnership is likely to be frustrated

(2)     A partner’s conduct makes it not reasonably practicable to carry on the partnership business

(3)     It is, for other reasons, not reasonably practicable to carry on the partnership

Generally, judicial dissolution is easy to get. 

See Owen v. Cohen, where court granted dissolution on the grounds that disharmony between the parties frustrated the economic purpose of the partnership.  Court notes that disharmony could be one big wrong act, or compilation of many smaller acts.

But you can’t get dissolution where your own wrongdoing frustrates economic purpose of partnership. 

See Collins v. Lewis:  Collins sought dissolution when cafeteria exceeded its budget and other partner failed to promptly repay loan.  But court denied dissolution on the grounds that Lewis’ failure to repay loan was caused by Collins’ failure to provide financing, which he had a duty to do.

Liabilities and duties after dissolution

A wrongfully dissociated partner is not liable for damages to the partnership when the partnership dissolves after the dissociation.

Partnership agreements can include list of circumstances that will lead to expulsion or withdrawal of a partner.

Partnership agreement is generally paramount.  Where you have a partnership agreement, fiduciary duty arguments have very little weight.  No independent duty to be “fair” beyond terms of partnership agreement.

See Lawlis:  Partnership agreement said any partner could be expelled with 2/3 vote.  Lawlis was expelled by other partners at law firm after repeated relapses.  He argued that the expulsion was violation of other partners’ duty of loyalty to him, but court said that expulsion was consistent with partnership agreement, so no duty of loyalty violation.   

 

 

Corporate Law

 

Characteristics of a Corporation

Separate entity

Corporations are their own legal entities.  They can take out loans, own property, etc.

Perpetual existence

Its very difficult to end the life of a corporation

Corporate ownership is freely transferable

Shareholders enjoy free transferability of their assets

But this can be modified/limited

Ex: closely held corporations

Note: very different from partnerships, where transfer of assets requires consent of other partners

Management structure separates directors, managers, and shareholders

Shareholders

(1)     Typically own stock, have dividend rights, and liquidation rights.  Also have right to approve Board of Directors.

(2)     They don’t make management decisions for corp., but can vote to (1) elect directors, and (2) ratify big decisions like mergers. 

Directors

(1)     Have the authority to make management decisions, but usually aren’t residual claimants.  They act as a collective body.

(2)     They make big decisions, like when to pay dividends, who to elect as managers, and whether to approve mergers (??WHO VOTES ON MERGERS – SH OR D?)

Managers

People who have daily control of the corp.  but they don’t have absolute control, because they are overseen by Directors, who can fire them.

This set up is supposed to help org. control problem.  Directors watch managers, but who watches directors?  Several Possibilities:

(i)      Courts

(ii)    Market Forces (takeovers)

(iii)Labor Market (Directors want employment mobility, so want to do a good job)

(iv)Product market (the more efficient the corp. is, the lower the cost of the product they sell)

(v)Big Block SH (they have a huge stake in corp., so more incentive to keep an eye on directors

Limited liability

Generally, SH are only liable up to the amount they invest in the corporation

Differences between Corporations and Partnerships

i)         Difficult to end life of corp., easy to end partnership

ii)       Org. structure of corp. is divided, isn’t divided in partnership

iii)      SH in corp. enjoy limited liability, partners liability for partnership debts/torts is unlimited

iv)     Different types of stock in corp. allows SH to tailor interest in corp. to specific needs.  Not so with partnerships

Corporate formalities

Corporate law is driven by formalism.  In order to create a corporation, you must file articles of incorporation, and follow required corporate formalities (these include holding annual meetings of Directors, keeping minutes, electing officers)

Land sale hypo

(1)     A and S are strangers.  A sells S land for 200k.  A’s profit is 75k.  A has no fiduciary duties towards S.

(2)     A is agent of S.  S tells A to find her some land.  A sells S land for 200k (75k profit).  S is entitled to profits, because agents have duty not to act adversely to principal’s best interests, and no secret profits are allowed.

(3)     A is agent of X-corp.  S is president of X-corp.  Here, A has same duty not to act adversely to principal.  Only difference is that x-corp. would bring claim against A, not S.  this is because S has no right to profits here, only x-corp. does, because A is agent of x-corp., not S.

(4)     A wants land to end up in corp. hands.  So A sets up A-Corp.  Then, S buys all the shares in A-Corp.  Then, A sells his land to A-Corp.  Here, A has a FD to the corporation as the promoter, so A-corp. would get profits.

Note that promoter FDs extend through the plan for which the corp. was created.   So if corp. was created to buy this land, FD still exist, even after S becomes sole SH.

(5)     P sets up P-corp.  A sells land to P-corp.  A keeps profits

Note that last 2 examples end the same way (P sole SH in corp. that owns land) but who ends up with profits is different.  The path taken in each is different, so profit result is different.

Where can formalism requirement be overridden?

No clear or consistent doctrine, but some courts have held that when party contracts with an entity and treats that entity AS a corporation, the party is estopped from denying the entity’s corporate existence at a later time.

Southern-Gulf Marine: Court held that even though boat buyer wasn’t officially a corporation (hadn’t filed articles of incorp.), boat builder had treated boat buyer as a corporation in contract, so bound to contract.

 

Forming a Corporation

How to form a corporation

§101(a):  any person can incorporate by filing article of incorporation with secretary of state in incorporating state

§106:  when article of incorporation filed, corporation is created

next, you need to appoint directors

§109: write up some bylaws

bylaws set out ‘nuts and bolts’ of corporation

when annual meetings will be

duties of officers

types of stock

bylaws can be unilaterally modified by directors

§153:  then issue some stock

PRESTO!  You are a corporation

Issuance of shares

Different types of stock gives you different rights

(1) Common Stock – most control, weakest financial

(a)     Full voting

(b)     weak dividend (only if directors authorize)

(c)     weak liquidation rights (last in line).

(2)     Preferred stock – weak control, medium financial

(a)     Weak/no voting rights

(b)     Medium dividend rights (still dependent on directors, but ahead of common stockholders

(c)     Medium liquidation rights (ahead of common SH, but behind creditors

(3)     Bonds – no control, financial only

(a)     No voting rights

(b)     No dividends (gets fixed, guaranteed interest instead)

(c)     Highest liquidation rights (treated like creditors)

Note that you can’t just sell voting rights alone, they have to be tied to dividends or liquidation rights (to avoid total disconnect between residual claimant and voters)

Dividends

§170.  Dividends can be issued in two situations

(a)     When there is a capital surplus

(i)      §154 defines capital surplus as actual capital (from profits or sale of stock) minus stated capital (par value times number of shares)

(ii)    §244 gives directors ability to set par value and to change par value, if they want to free up more capital

Note that Del §170 allows issuance of dividends when assets are greater than liabilities, but CA requires assets to be 125% of liabilities

(b)     Out of net profits for that fiscal year (even if no capital surplus)

Justification for dividend restriction

(a)     Designed to protect creditors

(b)     Substitute for limited liability in places where corporation doesn’t have enough assets to pay.(?)

(c)     Restricting when dividends can be issued acts as an alternative/preventative measure to PCV by, hopefully, keeping the corp. from becoming underfunded.

Judicial review of decision to issue dividends

(a)     Reviewed under BJR.  Won’t often fail BJR, even if it causes big losses to the company (See Ford)

(b)     But note that directors may be forced to declare dividends where

(i)       Surplus of net profits

(ii)     Issuing dividend will not harm corporation

(iii)    Failure to issue is so egregious (like threat to never issue) that it violates the directors duty to act in good faith toward SH.

Purpose of Corporations

a)       Main goal is to maximize SH profits and welfare

b)       How are charitable donations reviewed?

A.P. Smith Test: Ok to give to charity so long as:

(1)     Money expended is reasonable or modest amount

(2)     Can’t be a personal or pet charity of a director

(3)     Must help either society or corporation

In A. P. Smith, court upheld charitable contributions to Princeton because found that donation increased goodwill for corp. so was in SH and corp. best interest.

But See Ford: Must serve stockholder interests before interests of general public

Dodge v. Ford:  Ford stops paying dividends and puts all profits into new manufacturing plant which he opened for humanitarian reasons.  Court says that corp. does not exist to be charitable org, but to maximize SH wealth, so corp. must give dividends sometimes. 

Different result from AP Smith could be because Ford wasn’t giving ANY dividends, so wouldn’t have been a reasonable amount even if AP Smith had been applied

Del. §122

Allows charitable donations that sere the interest of the corp. (to maximize profit).  Courts will apply BJR and defer to managers about donations.

Note that NY and CA allow charitable contributions regardless of a showing that the corporation benefited. 

Other limitations on charitable giving

In practice, the threat of SH lawsuits and market forces keep charitable giving to reasonable levels

Justification for allowing corps to make charitable donations

Pro

(a)     Corps have lots of money, so good for them to help society

(b)     Helps corp. because increases goodwill

(c)     Government is a bad spender of money, better from private folks

(d)     Corps get lots of benefits from society so should give back

Con

(a)     Corps don’t have money, all the cash really belongs to individual SH, who can choose to give individually

(b)     If you think corps should have a duty to help society, should just tax them higher

(c)     Could be deemed waste (taking SH $ and giving it away)

(d)     SH might not invest because of charity gifts.

(e)     Allowing goals other than profit maximization makes it too easy for managers to justify anything

Director discretion respected unless fraud, illegality, or conflict of interest

Schlensky v. Wrigley:  Wrigley hates night baseball, so refuses to install lights at Wrigley Field.  Court uses BJR, and finds that DOC and DOL met and no waste.

Role of the courts

Note that courts don’t really know what’s good for a corp. and what’s not (see Ford, where new ‘humanitarian’ plant led to huge sales and profits)

Limited Liability

Default Rule (§102(b)(6))

Shareholders have limited liability.  They are liable only up to the amount of money they have invested into the corporation

Alternatives could be enterprise liability or unlimited liability like partnerships

Justifications for Limited Liability

Pro

(1)     Corporations are good for the economy, so law should subsidize and encourage them.

This mostly helps entrepreneurs, big corps don’t need subsidy.  If it’s mostly for entrepreneurs, though, why does corp. definition hinge on corp. formalities, which entrepreneurs are less likely to follow?

(2)     Contracting parties could take risk into account when pricing contract

Cons

Full liability would increase deterrence for torts in 2 ways

(a)     Would give SH more incentive to be careful

(b)     Would give SH incentive to limit activities that are risky, which would minimize injury

Piercing the Corporate Veil

Definition

Piercing the corporate veil eliminates limited liability and makes SH personally liable for corporation’s torts and contracts.

This only becomes an issue where corp. is facing contract or tort liabilities it can’t pay.

General rule:  you can PCV where:

(1)     There is unity of interest and ownership between the individual and the corporation

(a)     Failure to observe corporate formalities

Was the corporation actually incorporated?

Were regular meetings of directors held?

Were minutes taken at those meetings?

(b)     Commingling of funds or assets

(c)     Undercapitalization of corporation

(d)     Appropriation of one corporation’s property by individual

Note that unity of interest doesn’t mean that the individual is only in business to make money – this is true for all individuals.  It means that corp. is really a “shell” to hide assets.

Sea-Land v. Pepper Source:  court held that corp was a shell because didn’t meet corporate formalities and commingled personal and corporate assets

(2)     AND adherence to separate corporate existence would sanction a fraud or promote injustice

(a)     Creating loopholes regarding monetary obligations

(b)     Permitting unjust enrichment

(i)      Sea Land v. Pepper Source: 

(ii)    Note that in In Re Silicon, the court only applied the first prong.  It PCV’d without discussing the “promote injustice” prong.

(c)  note that unjust enrichment isn’t proven by unpaid debts alone.  If it was, all cases would fulfil requirement.  It’s more than that, but something less than fraud.

Other PCV Tests

Kinney Test (W. Virginia): in contract case, PCV ok where:

(a)     Unity of interest

(b)     Inequitable result

But this test allows defendant to argue that plaintiff assumed the risk where undercapitalization so stark that contractor should have known about risk

Perpetual Real Estate Test:  In contract case, PCV ok only where

(a)     SH exercised undue domination or control, and

(b)     Corporation is a device or sham used to disguise wrongs, obscure fraud, or conceal a crime.

In this case, no PCV allowed by sophisticated contract creditor who entered into partnership with the defendant corp, which had no money to pay contract liabilities.  Court said that even though corporate formalities not followed in defendant corp., plaintiff had full knowledge of nature and undercapitalization of defendant corp., so no disguising of a wrong or anything.  Assumed risk.

Earmarks of ‘shell’ corporations

(1)     Not maintaining separate corporate and personal bank accounts

(2)     Disregarding formalities like shareholder meetings

Cases where PCV not allowed

(1)     Where corporate formalities were followed

Walkovsky v. Carlton, where Defendant owned 10 cab corps with 1 cab each.  When P was injured by a cab, found that that corp was underfunded.  P argued that all 10 corps should be treated as one corp, but court says that the splitting up of the corp into 10 corps does not per se show fraud.  P also tried to PCV to D’s assets, but court found that corp formalities had been followed, so refused to PCV.

(2)     Where sophisticated contract creditor knew that defendant’s corporation was underfunded before entering into agreement

Perpetual real estate   court denied PCV even though no corporate formalities were followed.  This is consistent with the idea that corporate formalities are really a proxy for ‘notice/presumption that corp isn’t underfunded.’

Cases where PCV allowed

(1)     Sealand v. Pepper Source (K case):  P shipped peppers for D corp.  M=sole SH of corp and sole SH of some other corps and 50% SH of  Tie-Net corp.  D corp owes money to P, but has no money.  That corp dissolves, but P wants to PCV to M personally AND to other corps M owns.  Court allows this (known as “reverse piercing”) after finding

(a)     Unity of interest:  funds commingled, no meetings, no minutes, no article of incorporation, no bylaws, same office for all corps, inadequate capitalization

(b)     Injustice: M personally benefits & court finds tax fraud.

(2)     Kinney (K case):  Kinney leases building to D corp who leases 50% of it to ABC corp.  Mr. X is 100% SH of both D corp and ABC corp.  No money in D corp.  Court allows reverse piercing to ABC corp, after finding that D corp was grossly undercapitalized and did not follow corporate formalities.

(3)     In Re Silicone (tort case):  Tort creditors, corporate SH.  Test is only whether the subsidiary has a unity of interest or is the alter ego of the parent corp.(no injustice requirement)  Court found PCV may be justified where parent and sub. Share common directors, common departments, consolidated tax returns, and commingled resources.

Alternative theories of parent liability

Direct liability

Apparent authority (like Billops)

PCV in parent corp. / subsidiary corp. context

(1)     If there is a unity of interest, can pierce veil of subsidiary.  Unity of interest exists where parent so controls the subsidiary that the subsidiary is the mere “alter ego” or instrumentality of parent.

(2)     Factors to determine whether unity of interest exists include:

(a)     Whether parent and subsidiary have common directors and officers

(b)     Whether parent and subsidiary have consolidated statements and officers

(c)     Whether parent finances the subsidiary

(d)     Whether parent caused the incorporation of the subsidiary

(e)     Whether the subsidiary is grossly undercapitalized

(f)      Whether subsidiary receives only the parent’s business

(g)     Whether the parent uses the subsidiary’s property as its own

(h)     Whether the daily operations are kept separate

(i)       Whether both corporations have kept corporate formalities

(3)  Cases

(a)     In Re Silicon:  court denied D SJ and held parent and sub. May have unity of interest because common directors, common departments, consolidated tax returns, and commingled resources

(b)     Sinclair Oil:  similar factors considered

Justifications for PCV

Pros

(a)     Ensures that managers use care in running corp.

(b)     Requires corps to take account of activity level costs

(c)     Fair, because SH are residual claimants who receive benefits of the corp.

(d)     Failure to maintain formalities removes ability of creditors to protect themselves ex ante

(e)     Only protection for tort victims, who can’t bargain to protect themselves like creditors.

Cons

(a)     Too much personal liability will deter investment and increase cost of investing

(b)     Limited liability encourages entrepreneurs

(c)     Contract creditors can bargain for liability terms

(d)     If there are lots of SH, each individual SH could be jointly and severally liable for both the company and all other SH.

Distinguishing PCV standard for contract and tort creditors: Facially, the PCV rule is the same for tort creditors or contract creditors.  But the differences between contract and tort creditors, and the underlying rationales of limited liability suggest that different tests might be appropriate

Contract Creditors

A court should PCV only when there is a failure to observe corporate formalities (i.e. when you find a unity of interest between corp and ind.) or when SH commits fraud against creditors

(i)      When formalities are observed, contract creditors have enough information available to them that they can contract for particularized terms and take account of risks.  So it makes sense to have PCV hinge on this, because if formalities are met, we can assume contract creditors had the ability to assess risk.

(ii)    Removing “squishy injustice requirement” will give business people certainty that, so long as formalities are maintained and fraud is not committed (minimal requirements), they will not be personally liable

(iii)  Formality/fraud rule is easy for public and unsophisticated parties to understand.

(iv)   Formality/fraud rule is sufficient incentive for managers to use care in managing corporation

(v)     Only using prong one of PCV test (“unity of interest”) increases efficiency because contractors will have to make business decisions about whether their concern over liability is great enough to bargain for specifics.  Contractors who are not concerned will assume the risk

Tort Creditors

A court should only PCV where

(i)      The corporation is undercapitalized, so that it can not meet ordinary liabilities, and

(ii)    The SH have sufficient information and control to prevent corp’s undercapitalization.  A failure to maintain corporate formalities creates a presumption that the SH is responsible for undercapitalization.

Justifications for this proposed approach

(i)      Creates an incentive for managers and SH to capitalize corp. in sufficient amounts to account for tort creditors.

(ii)    Creates an incentive for managers to use care in ensuring corp. is sufficiently capitalized

(iii)  Serves equity by making corporations responsible for damages caused by tortious activities – activities that the corporation receives benefits from

(iv)   Removes the unnecessary “unity of interest” requirement in tort contexts.  It’s not relevant there because a tort creditor can’t bargain for protection or assess risks ex ante (?)

(v)     Presumption makes courts job easier in determining whether SH are responsible for undercapitalization, while also maintaining corporate formalities as a minimal requirement that is easy for directors to meet

(vi)   Determining unreasonable undercapitalization is easier and more certain than determining what “promotes injustice”.   So the rule would give courts more guidance about when to PCV, and investors more certainty of the risk of PCV.

(vii) Continues to encourage entrepreneurs, but balances the costs imposed on tort victims and the public generally

(viii)                       Closely held corporations most likely to have undercapitalization problems, but their SH are also more likely to have control and information.  This rule would create a strong incentive for SH with control to ensure adequate capitalization.  Furthermore, this is fair since the same SH benefit from the undercapitalization of the corporation.

 

Duties of Directors and Managers

Business Judgment Rule

General Rule:  The court will not review a business decision if the decision maker

(1)     Met the duty of care

(2)     Met the duty of loyalty, and

(3)     The decision did not cause waste

(a)     Note that the court will not analyze the underlying substance of the decision if the above three duties are met

Mostly procedural

In practice, the BJR basically means that a director just has to follow the proper procedures in making a decision to protect that decision from judicial review.

Error in judgment not actionable

Kamin v. AmEx:  Amex chose to give dividends, which cost them $8mil in tax credits.  Court just says no self dealing or fraud.  Even though not giving dividends would have been financially better, doesn’t rise to the level of waste.

If Decision Flunks BJR

Ask if there was shareholder ratification

SH ratification requires full disclosure of material facts and ratification (usually through a vote) of informed, disinterested shareholders.  Directors disclosure of material facts must include an explanation of how their previous decision violated the duty of care.  This makes SH ratification unlikely

See VanGorkam, where SH ratification voided because found not to be informed

If decision is ratified

And BJR failure was based on DOC violation, then decision is upheld and DOC claim is extinguished

See VanGorkum

Wheelabrator

If BJR failure based on DOL violation by a director, DOL claim is converted to a waste claim, and the BJR is applied to the decision

Plaintiff has burden of proving waste

See §144

Lewis

If BJR failure was based on DOL violation by a SH, DOL claim is not extinguished.  Rather, decision will be reviewed based on entire fairness doctrine, but burden shifts.

Note that a majority of the minority shareholders must ratify

Plaintiff has burden of proving unfairness

If BJR failure was based on a finding of waste, claim is only distinguished if ALL SH unanimously voted to ratify decision.

If decision not ratified (or is DOL violation by SH), court will look at entire fairness of decision

To determine the fairness of a transaction, look at timing, initiation, negotiation, and structure of transaction, disclosure and ratification by directors, and disclosure and ratification by SH.

Note that D has burden of proving fairness

Entire Fairness Cases

VanGorkam: court held directors liable and found unfairness because suggested stock price was motivated by conflict of interest, and SH ratification wasn’t informed.

 

TYPE OF CLAIM DOC violation	IF RATIFICATION claim extinguished (VanGorkum)	IF NO RATIFICATION Entire fairness doctrine (BOP D)
DOL violation by director	converts to waste claim.  BOP on P (§144)	Entire fairness doctrine (BOP D)
DOL violation by maj. SH	converts to entire fairness doctrine, with BOP on P (Wheelabrator)	Entire fairness doctrine (BOP D)
Waste	If UNANIMOUS ratification, claim extinguished	Entire fairness doctrine (BOP D)

 

 

Justifications for BJR

Pro

(1)     Court lacks expertise to second guess business decisions

(2)     Judicial review would make business decisions too risk averse

(3)     Judicial deference to business decisions limits frivolous suits and cuts down on expensive litigation

(4)     Hindsight bias – what seemed like a good idea at the time might look moronic later

(5)     There are alternative mechanisms (efficiency, fear of takeovers) to ensure good business decisions

Con

(1)     Courts make complex factual determinations all the time

(2)     Shareholders might be scared to invest because courts are so deferential to business decisions.

(3)     Managers might go wild if no judicial review

(4)     Alternative mechanisms weak

 

Duty of Care

RMBCA §8.30: General Rule. 

Duty of care will be fulfilled if directors act:

(a)     In good faith

(b)     Using ordinary care

(c)     With the reasonable belief that act is in best interests of corp.

Cal. Corp. Code §309:  Another General rule

Duty of care fulfilled where director acts:

(a)     In good faith

(b)     In the best interests of the corporation, and

(c)     Acts with such care as an ordinarily prudent person in a like position would use under similar circumstances

Del. §102(b)(7):  DOC is partially waivable

Ordinary Care

Del. §141(e): Directors can rely on managers and employees in good faith and if director has

(a)     a reasonable belief in competence of mgr or e’ee, AND

(b)     selected the mgr or e’ee with reasonable care

Directors duty of care also includes:

(a)     Rudimentary knowledge of business

(b)     Obligation to keep informed of business

(c)     Not ignoring corporate misconduct

(i)      But no duty to investigate unless put on notice that misconduct may be taking place. (Allis Chalmers)

(d)     General monitoring of corporate affairs

(e)     Familiarity with financial status of corp.

Court laid out these basic duties in Francis, where Mrs. Prichard, CEO, had no clue about business, which allowed her thieving sons to embezzle everything.

Breach of duty turns on whether directors made an informed decision

Characteristics of uninformed decisions

(a)     No notice

(b)     No written documents

(c)     No counsel by experts

(d)     Time pressure

(e)     Oral representations

(f)      No critical evaluations of terms and prices

Director Defenses

(a)     Offered a premium over stock price

(b)     Existence of market test

(c)     SH ratification

(d)     Directors are experts

DOC for Mergers

In order to go forward with a merger, need to have

(a)     Majority of directors vote for the merger

(b)     Majority of shareholders ratify the merger

Both the director vote and the shareholder ratification have to be informed and made by disinterested parties.

VanGorkum: 

(a)     SH suit.  SH sold stock in friendly merger by another company.  SH alleges the shares were worth more than price imposed by directors, and say they would have gotten a better price if directors had acted with greater care.

(b)     Court held that directors breached DOC because they failed to inform themselves of all reasonably available info regarding stock price for merger.  Failed to disclose material info. Re: method of computing sale price to both managers and SH. 

(c)     SH ratification didn’t cure DOC violation because SH not adequately informed by proxy statement

(d)     Court focused on lack of notice, reliance on oral representations, lack of written documentation, absence of independent valuation.

(e)     Case was remanded for entire fairness review

§102(b)(7): Can limit/eliminate personal liability for directors, but:

(1)     can’t completely eliminate DOL

(2)     can’t limit or eliminate liability for intentional misconduct, knowing violations of the law, or acts where directors improperly benefit personally.

This was passed as a response to VanGorkum

Ignorance is not a defense and can itself be DOC violation

(1)     Joy v. North:  P alleged that D violated DOC by allowing corp. to loan money to Katz (son of CEO).  Court held that ignorance about an issue that is a director’s responsibility is an abdication of that responsibility, and a violation of the duty of care.

(2)     Francis:  P CREDITOR (not SH) alleges that CEO’s sons embezzled all the money.  Court holds that corps do have FD’s to creditors.  CEO says she didn’t know about embezzlement, but court finds that if she had stayed reasonably informed about the business, she would have known, so it’s a DOC violation.

But no duty to ferret out corp. misconduct unless on notice

Allis-Chalmers:   Corp divided into lots of divisions.  Derivative suit brought after corp. loses money due to price fixing by managers in one division.  SH says directors had duty to find out about price fixing.  Court held that corp. doesn’t have to continually monitor directors for misconduct without notice that misconduct is occurring.

In the event DOC is violated

(1)     Was decision ratified by SH?

(2)     Was ratification informed?

If yes to both, no liability

(3)     If no ratification, will decision pass entire fairness doctrine?

Justification for DOC

Another middling rule.  If too high, breaches will occur a lot and no one will want to be a director, will make people too risk averse, hindsight bias trouble.  But if too low, screws the creditors

 

Duty of Loyalty for Directors and Managers

Minimum mandatory requirement:  Directors and managers owe undivided loyalty to the corporation.  Cannot have conflicting personal interests at stake in any business transaction or decision.

Particularly concerned with “self dealing” – when a director or officer deals with a company for their own personal interest.

Test

(1)     Was there a conflict of interest?

(a)     What constitutes a conflict?

(i)       RMBCA §8.31(b)(1) and Cal. Corp. Code §310: when director has  a material financial interest

(ii)     RMBCA 8.31(b)(2): Director is a director, officer, or trustee of an entity that is a party to the transaction

(b)     If no conflict of interest, no DOL violation

(2)     If yes, was there ratification by disinterested SH?

(a)     If ratification

DOL claim converts to waste claim, which is reviewed under BJR.  Plaintiff has burden of proving waste.

(b)     If no ratification

DOL violation

Cases

Bayer v. Beran:  Corp sponsors radio program and hires CEO’s wife to sing on program

Is there a conflict?  Yes.

CEO will personally benefit from decision to hire wife because he’ll enjoy her salary too.

Decision violates DOL so flunks BJR. 

No ratification, so look at decision under entire fairness doctrine, where court uses rigorous scrutiny to review the entire transaction, and shifts burden of proof to D to prove entire fairness test.

Court finds decision fair under entire fairness doctrine

Lewis v. SL&E:  Both P and D have same directors, except D has a few more.  P leases land from D at below market price.

Is there a conflict?  Yes.

D’s directors personally benefit from close relation with P.  P’s SH getting a raw deal, because the directors that are only on P’s board don’t get benefit, only directors on both boards get benefit.

Decision violates DOL so flunks BJR.  Look at SH ratification

No SH ratification here, because SH have to be disinterested to ratify, and here, interested SH owned 66% of stock.

If no ratification, court uses ‘entire fairness’ test and shifts burden of proof to D to prove entire fairness of transaction.

Here, defendants fail to show that the decision was in the best interests of corp, so it’s a violation.

 

Corporate Opportunities

General Rule

If you become aware of a corporate opportunity while you are working for a corporation, you must offer it to the corporation first.

Note that a failure to do so is a DOL violation

ALI 5.05:  Something is a corporate opportunity if it is:

(a)     An opportunity in the same line of business as the corp, OR

(b)     Something you learn about through working with the corp.

old rule defined corp. opp. more narrowly.  Only barred (1) stealing business away, (2) required that corp get first shot, and (3) defined corp. opp. as something necessary to business.

If it’s a corporate opportunity

Directors and managers not banned from taking advantage of opportunity, but before they do:

1.       Must inform the corporation about opportunity

2.       Corporation must refuse to take advantage of it

3.       Taking the opportunity must be:

(a)  Fair

(b)  Ratified by directors or SH before taking opportunity

(c)     Ratified by SH after taking opportunity

Refusal to deal must be disclosed by officer

Porter:  employee setting up K on behalf of e’r with 3d party is told by 3d party that they are refusing to deal with e’r, and aren’t going to grant them the K. So e’ee decides to go for K himself, without telling e’r.  Issue: whether e’r can use 3d party’s refusal to deal as defense against taking corp. opp. without presenting it to e’r first.  Court holds that can’t use 3d party’s refusal to deal as defense to e’ee’s failing to disclose, because if he had disclosed, maybe e’r could have done something to change 3d party’s mind.

Duty of Loyalty for Dominant Shareholders

i)     General Rule:  dominant SH owe a DOL to corp AND to minority SH

ii)       Test:

(1)     Is there self-dealing by dominant SH?

(2)     If yes, did a disinterested [majority of the minority] SH, after being fully informed, ratify the action?

(a)     If no ratification,

(i)       court uses rigorous scrutiny to look at entire fairness of whole transaction

(ii)     BOP is on D to show fairness

(b)     If ratification

(i)       Court uses rigorous scrutiny to look at entire fairness of whole transaction

(ii)     BOP is on P to show transaction not fair

iii)    Maj. SH DOL to Corp

Sinclair Oil: Sinclair is parent corp. and owns 97% of SinVen [subsidiary] and 100% of SinInt [subsidiary].  Min. SH of SinVen alleges (1) excessive dividends paid to Sinclair, (2) stealing of corp. opp., and (3) breach of K by SinInt.  Court finds that Sinclair owes DOL to SinVen and its min. SH.

Excessive dividends

Court uses BJR and finds no self dealing because same benefits went to all

Corporate opportunity

SinVen says it, not SinInt, should have gotten to develop new oil reserves, but court says that Sinclair followed internal rule to go by geography, so opp. never belonged to SinVen. (court sort of sidesteps)

K claim

Court applies intrinsic fairness test.  Puts burden on D.  Finds a violation because benefits not given in equal proportions.

Maj SH sued by min SH

Zahn v. Transamerica:  TA is maj SH.  Corp has 2 types of stock.  TA owns 60% of A stock and 90% of B stock.  Corp has right to redeem A stock for $60 per share, but if A SH had been given notice, would have converted to B stock.  TA forced corp to redeem A stock, which reduces value of A stock and increases value of B stock.

(a)     Note that here, redemption is bad for A SH and conversion is bad for B SH.  One class of SH will have to lose out, because case is about how to divide up a finite amount of money.

(b)     But this is tricky for court, who is supposed to determine what would be best for corp. as a whole, not just look out for ‘losing side’ of equation.  (in other words, board is supposed to look out for SH, but which SH?)  No clear answer about how to do this.

 

Ratification

General Rule

Informed ratification by disinterested SH will extinguish, convert, or shift the BOP on DOC/DOL claims.

Cases

Wheelabrator:  Board sends info about merger to SH, which approve the merger.  SH sue later with three claims: 

(1)     state law requires duty to disclose all relevant info, which directors didn’t

court says that the fact that mtg. was only 3 hrs long and didn’t include experts proves nothing.  Didn’t need experts because directors were bankers and knew about mergers

(2)     DOC violation because directors not careful in discussing/explaining merger to SH

claim is extinguished by SH ratification

(3)     DOL claim because directors had personal interest in merger because they owned the company Wheelabrator was merging with.

Court throws out votes of interested SH (those that also held stock in other corp).  only disinterested SH can ratify

 

Shareholder Suits

Two types of suits a shareholder can bring for director/manager violation of fiduciary duties

Shareholder suit

i)         Suit to enforce rights that the corporation owes to shareholder (voting, dividend, or liquidation, maybe right to disclosure)

Note: lower stock prices CANNOT be basis for SH suit.

ii)       Characteristics of shareholder suit

(1)     Recovery goes directly to SH

(2)     SH have standing without additional procedural requirements

Note that these suits are the best for SH, because no procedural Requirements and SH get direct renumeration.

 Derivative suits

Definition

Suit to enforce rights that directors and managers owe to the corporation alleging an injury to the corporation

Characteristics of derivative suit

(1)     Plaintiff is the corporation

(2)     Recovery goes to corporation

(3)     More often settled than SH suits

Procedure for Derivative Suit

(1)     Demand Requirement (tough to get past)

(a)     SH must make demand to BOD asking them to institute suit against maj. SH or directors themselves

(i)      If SH demands that BOD sue and is turned down, she waives her right to later argue demand futility

(ii)    In practice, BOD always refuses to sue themselves

(b)     Demand Futility

2 prongs to demand futility test (from Heinman)

1.       show that there is reasonable doubt that directors making decision not to sue were disinterested and independent.

a.       this isn’t about the original decision underlying the suit, but about decision not to pursue suit.

b.       You can automatically satisfy this prong by suing all the directors, so they aren’t disinterested

2.       Show reasonable doubt that underlying decision was not the result of reasonable business judgment

(2)     If demand requirement is met (or demand futility proven) derivative suit is instituted

(a)     Corporation, not original SH, controls the suit.

If SH files derivative suit, Directors can create a Special Litigation Committee, which will decide whether suit should go forward. This committee is made up of directors not involved in the underlying transaction.

(b)     If no SLC, suit proceeds to merits

(c)     If SLC is formed, and declines to pursue case: 2 possibilities

(i)      Auerbach (NY):  SLC declines to pursue cases after demand futility proven.

1.       Court reviews SLC’s decision not to pursue suit under BJR, and will defer if BJR is met.

a.       Here, BOP on P to show violation of DOC, DOL, or waste

2.       This basically guts the demand futility requirement, because SLC can still choose not to sue, and decision will be upheld if passes low threshold of BJR.

a.       The only benefit is perhaps judicial review will put pressure on directors to pursue meritorious cases.

b.       Only other benefit to demand futility is that it might give SH a little extra time for discovery (since dir’s have to take time for decision to prove DOC).

(ii)    Zapata (Del):  demand futility proven (b/c all directors named defendants). After demand futility proven, SLC decides not to pursue suit.

1.       SLC must show that they are independent and acted in good faith  (looks like BJR)

a.       BOP on SLC to show that their decision not to pursue was made in good faith and with due care.

b.       SLC can prove this by showing that the directors who make up the SLC were appointed after the events underlying suit.

2.       Even if 1^st prong met, court can still reverse decision using its own business judgment that suit should go forward.

Modified Zapata (Alford v. Shaw):  Committee decision a factor, but not binding.

(3)     Result of Refusal to Pursue Suit

SH can sue BOD, and their decision not to sue will be reviewed using the BJR (so decision will be upheld unless DOC or DOL shown)

Policy behind Demand requirement

Pro

(a)     Will cut down on frivolous lawsuits

(b)     Board has best expertise to determine whether suit in best interests of corp

(c)     Market forces will contain directors from wrongful acts

Con

(a)     Even meritorious suits will have hard time passing test

(b)     Increases costs for meritorious suits

(c)     Board has huge conflict, even if found to be disinterested [no direct involvement in underlying transaction], they never want themselves or other directors to get sued

(d)     Frivolous suits can easily get by 1^st prong by naming all directors in lawsuit

(e)     Market incentives against wrongful acts are weak.

Distinction between SH suit and derivative suit

Eisenberg:  SH sought injunction to stop merger, claiming merger would dilute his voting rights.  Court says it’s a SH suit, since Eisenberg’s rights as SH (voting) are at issue.  Note that he was only a min. SH to begin with, so maybe no real ‘loss’ of voting power (never had maj. power) but suit is about SH rights so is SH suit

 

Indemnification

Del. §145(a):  indemnification for non-corporate actions (usually tort cases)

 A corporation shall have the power to indemnify any [director, officer, employee, or agent who is being sued]… against expenses, judgments, fines, and settlements incurred by such person.

Here, indemnification covers fees and costs

Del. §145(b):  indemnification for derivative suits

A corporation can indemnify directors against derivative suits if such person acted in good faith and in a manner such person reasonably believed to be in the best interests of the corporation

Here, indemnification only covers fees (not costs)

§145(c):  Corporation must reimburse directors if directors win in court (but no reimbursement if director is not found guilty at trial.

This provides huge incentive to settle cases, so indemnification is ensured.  But note that this will also increase # of frivolous suits and therefore increase cost to good managers.

§145(f):  bylaws can indemnify in other situations

but not clear if corp. can choose to indemnify beyond limits in §145(b) (i.e. can they indemnify for bad faith?)

Insurance

Del. §145(g): Insurance

A corporation can get insurance for directors against derivative lawsuits

This seems to create a loophole where you can get insurance for whatever acts aren’t indemnified under §145(b).  But in reality, insurance co’s are market driven, and will simply refuse to insure for acts in bad faith or unreasonable acts (b/c so cost-prohibitive)

Policy behind indemnification and insurance

i)         May protect managers who are acting in SH best interests, but who make a mistake.  This will help protect good managers, but will also attract bad managers.  The more the court steps in to allow SH to sue bad mangers, the higher the cost to good managers

ii)       But rules also limit indemnification.  With full indemnification, directors would have huge incentives to steal.  This would be worse than eliminating FD’s completely.

Alternatives to indemnification/insurance

Get rid of fidiuciary duties altogether and create market-driven incentives

(1)     Give directors stock options, to align interests with corp.

(2)     Incentive K’s/profit sharing

(3)     Takeover threat – if corp sucks, stock price will drop and takeover will be easier

(4)     Labor market – directors want mobility, so will want to build good rep

(5)     Product market – the more efficient the corp is, the lower the product price, the more you’ll sell, the greater the profits

 

Closely Held Corporations

Characteristics

i)         Fewer than 30 SH

ii)       SH generally involved in running corp (like partners)

SH Voting Problems in Closely Held Corporations

Because there are only a few SH, once a SH gets a majority, they can control all decisions, and min. SH gets screwed.

The shareholder voting issues discussed below apply to all corps, but are most interesting with closely held corps

 

Shareholder Voting

In General

Shareholders vote on:

(1)     Election of directors (§211)

(2)     Substantial changes in corporate form (mergers, etc.)

Shareholders DON’T vote on ordinary business decisions

These are made by managers, who are overseen by directors.

Del Default Terms About SH Voting

§212: one vote per share

note that this can be altered by corporation

Providence: court upheld structure that allowed one share/vote for 1^st 50 shares, but only allowed 1 vote per every 20 shares over 50.

§211: voting at annual meeting

§212:  allowed proxies who can vote shares of SH unable to attend mtg.

(1)     Proxy:  someone can vote your share, but you still own your share

(2)     Voting trust:  giving your vote to management to vote for you

These are revocable proxies, SH can take voting power back

(3)     212(e): irrevocable proxies only allowed if dividend or liquidation right transferred to proxy along with voting right

the concern here is that don’t want people buying up all the votes, and don’t want SH to sell votes w/o thinking

§216: quorum required for most decisions

(1)     quorum defined as at least 1/3 of those entitled to vote

(2)     Plurality to elect directors

(3)     Majority for other decisions

(4)     Corps allowed to alter their voting structures

 

§218(a):  Voting Trusts

agreements where a SH ‘gives’ his votes to a trustee to vote for him.

(1)     must be written

(2)     must be filed with secretary of state and be open for inspection

this lessens vote buying concern b/c no secrecy)

(3)     self-enforcing.  Trustee is vested with voting power, which can be taken back if they fail to vote properly

but there’s a risk in voting trusts, because they separate the vote from the residual claimant 

§218(c):  Vote Pooling Agreements

agreements between SH to control voting

(1)     also has to be written

(2)     doesn’t have to be filed anywhere

(3)     not self executing.  If agreement is breached, have to go to court for remedy.

Most VPA’s provide for specific performance in case of breach

Court treats these agreements as regular contracts.  Where breached, the breaching parties votes are voided or specific performance ordered.

See Ringling

Why not just have voting trusts?

One arg. is that people can pool their votes at any time, so why not let them do it in writing

Opposing side is that VPA’s aren’t open for inspection, so SH that don’t know about arrangement can have their voting power ‘taken’ from them, if results of an election already decided per VPA.

VPA’s are insurance against ‘fallings out’ between SH who had earlier agreed to work together

Difference between VPA’s and irrevocable proxies

(1)     VPA’s cannot be subsequently transferred from trustee to another.  Irrevocable proxies can be.

(2)     Voting agreements can be used when electing directors.  But cannot be used to control director’s exercise of judgment.

Rule is good, because it doesn’t allow directors to trade control to maj. SH in return for votes.  Meant to protect min. SH.

(i)      McQuade: A is maj. SH.  B and C are min. SH.  All are directors or officers.  They all enter into agreement to do their best to keep all 3 in their positions, but A and C breach this when they, in director capacity, fire B as manager for antagonizing A.  B sues, but court refuses to give him his job back.  Says SH may not make an agreement that controls director’s exercise of judgment (like when to hire/fire managers).

(ii)    But see Clark:  same facts, but all SH agree to do their best to keep directors in their positions.  Upheld

Clark comes out differently, because there aren’t min. SH getting screwed (all SH agreed to agreement)

 

Organizational Control Problems between Maj and Min SH

Org. Control Problems Theoretically Solved by Shareholders

i)         SH are residual claimants

ii)       They can watch over directors and vote out those not acting in their best interests.

Different Org. Control Problems in big corps and closely held corps

i)        Big corps

SH won’t keep directors in line, because shares are dispersed and each SH owns only a few shares.  So collective action problem:  people’s individual stake in the company not big enough to warrant time and energy required to oversee directors.  Plus, their vote alone won’t make a difference.

ii)      Closely Held Corps

(1)     Fear of maj. SH “freeze out” – domination of corp. 

This is main reason voting pools and trusts are allowed, to protect against prolonged domination by one SH.

(2)     Fear of min. SH “hold ups”  -- if min. SH given too much protection against domination

 

Majority SH freeze-outs

maj. SH could freeze out min. SH by:

making shares valueless (like refusing to pay dividends or firing min. SH) so maj. SH can buy them back cheaply)

if you take away min. SH salary, its more than just an at-will firing, because salary reflects both that SH work and their return on their investment.  So if fired, investment in corp becomes worthless

compounded by the fact that in closely held corps, there’s no public market on which to sell shares

Possible protections against freeze outs

Require maj. SH to have fiduciary duties to min. SH

Sinclair

§216:  Supermajority

Gives min. SH veto power over maj. decisions

But criticism is that this leads to hold-up

§214:  Cumulative Voting

elections for all directors occur at once.  SH can put all votes toward one director (thereby insuring their election, so min. SH are represented)

Use contracts to bind directors

(a)     Min. SH can have buy-out on demand, so if they have no power, they can get out of corp.

(b)     Clause requiring directors to issue dividends

(c)     Employment contracts, requiring corp to only fire with cause, etc.

(d)     Dissolution Contracts

(e)     Forcing an IPO, so min. SH can get something for their shares if frozen out

ii)      Cases

When is firing a min. SH a breach of maj. SH fiduciary duties?

Wilkes test:  2 parts

(i)       Maj. SH must show a legitimate business purpose for firing.

(ii)     If that’s proven, min. SH can prevail by showing a less restrictive way of accomplishing that business purpose.

Applying the test

Wilkes:  4 directors in nursing home.  3 directors fire Wilkes, who is still a SH, but no longer receives salary like other directors.  court says maj. SH owe duty of “utmost good faith and loyalty” to min. SH. Court finds violation because although other 3 directors say that they fired him to hire someone cheaper, they get salary that’s way above market, so explanation is pretext.

Maj. SH can contract out of duties to min. SH if done right

Firing ok where employment K is at will

Ingle:  ingle fired, and corp activates buy-back provision in empl. K.  Ingle claims FD breach, but court says that as long as empl. K is at will, it won’ t analyze circs. of firing.  So here, K trumps FD.

Dissent criticizes maj. failure to see that Ingle was wearing 2 hats, and should get return for investment.

Non-firing freeze-outs

Sugarman Test: 2 part test:

(i)       min SH must show that a freeze-out is actually occurring, AND

(ii)     have to show that the maj. SH made an offer to buy min. shares at below-market price.

Test requires a below-market offer to ensure that suits will have at least some evidence of a freeze-out.  Otherwise, freeze-out suits could be used by min. SH to hold-up maj.

Application of the test

Sugarman:  Maj SH (who is also a manager) pays himself huge salary.  Min SH bring SH suit, alleging that his mega-salary is infringing on their dividend rights.  maj SH says his salary is for work and is not a dividend.  Passes first prong of test (mega-salary, no dividends issued for others) but fails 2^nd prong (no offer).

Criticism of Sugarman Test

If a maj. SH knows the law, they can avoid ever getting nailed for a non-firing freeze out by never making a buyout offer.

Minority SH Hold-Up – Recklessly Vetoing Dividends

Min. SH have a fiduciary duty to corp/maj SH to act reasonably

Smith v. Atlantic:  W and 3 others own corp.  different opinions about what to do with money.  Others want dividends, but W wants to keep in corp (to avoid getting taxed on it).  SH agreement requires 80% vote on dividends, so any one can veto.  Court finds W breached FD to other SH.

Note: this is the 1^st time a court imposes a FD on min. SH.

Can min. SH contract out of this fiduciary duty?  Maybe, but it’s tough.

Not clear.  Court in Smith said you could contract out of FD, but you must act reasonably in exercising rights under a K.  not clear why W veto found to be unreasonable exercise of K right.

To what extent does market or contract override FD?

Jordan v. Duff:  J is at-will e’ee and SH.  SH agreement provides for buyback of shares if J leaves corp.  Corp about to merge, and share price will skyrocket, so fires J, buys back shares at buyout price, and reaps profits from those shares once merger happens.  Ct holds that if K states that J could be fired at any time, then J. could be fired at any time, even if only fired to strip him of his stocks.

Concurring judge says that K includes implied clause to act in good faith, so would have found a duty to disclose info about merger to J.