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Agency, Partnership and Limited Liability Companies

Professor James Feinerman
Semester Fall 2014
Georgetown University Law Center
A. Agency
1. Restatement (Second) of the Law of Agency, 1, 2, 13, 26
Directors and Officers are agents for the shareholders who are the principals, hence the former owe the
latter fiduciary duties such as Care, Loyalty, Disclosure, Honesty, Confidentiality, etc.
How are agencies created?
a. Actual Authority: what the agent reasonably believes from principals conduct
or words that he authorized him to act. Expressed or implied. (incidental
authority: authorized to do acts reasonably or usually necessary to accomplish the
principals desired objectives).
b. Ostensible Authority: Because of the nature of the business relationship,
common sense would want that there is an agency relationship even if there is not
according to the law.
c. Apparent authority: principals manifestation led a third party to conclude
reasonably that the principal authorized the agent to act in a specific manner =
Authority by position.
d. Agency by estoppel: third party believed that one person was the agent of the
principal because of the intentional or careless behavior of the principal, or failure of
the principal to take reasonable steps to notify the third party of the error of such
belief. To be invoked requires detrimental reliance on the part of the third party.
e. Authority by ratification: as if agent possessed actual authority at the time of
relevant acts
f. Inherent authority (Croisant Case): without actual or apparent authority
Actual and reasonable belief of the third party (without any particular
manifestation of the principal). The use of this type of authority is not frequent
and has been eliminated from the 3rd Restatement. This occurs at actions that
"usually" accompany or "are incidental" to the transactions.
2. 23-31 Croisant v. Watrud
Gap between apparent authority that a client (non-sophisticated party) believed
that the partner had and the actual authority had regarding his practices. The
Oregon SC held that, in view of fact that it was reasonable for an accounting firm
client, who dealt exclusively with one partner of the firm, to assume that the added
assignment she delegated to the partner of collecting and disbursing her funds was
an integral part of the proper functions of the partner who kept the accounts
reflecting the income and disbursement of those funds, the accounting partnership
was liable for the partner's breach of trust incident to that employment (the partner
is an agent of the firm), even though those engaged in the practice of accountancy
would regard as unusual the collecting and disbursing of a client's funds by an
accounting firm, as the agent may have an inherent agency power to bind his

principal if, although they are forbidden by the principal, the other party
reasonably believes that the agent is authorized to do them and has no
notice that he is not so authorized.
32-37, Tarnowski v. Resop
Recover money from the lawsuit against sellers + recover money from the bribe
received by the agent because it is qualified as a profit. Action by principal against
agent for damages which resulted when principal had been compelled, by agent's
breach of duties, to sue third parties for rescission of sale on ground of fraud.
Profits made by agent in the course of an agency belong to the principal,
whether they are the fruits of performance or the violation of the agents duty, even
if the principal has suffered no damage or even if the transaction has been
profitable to him.
B. Partnership
Partnership is created when two or more persons agree to carry on business for
profit as co-owners with equal right to manage and share profits (UPA). Exceptions:
payment for debt, wages, rent, goodwill, etc.
Partners are agents and fiduciaries of one another, but differ from agents in that
they are also co-owners and share in profits and losses.
Today, partnership law in many states recognizes a partnership as an independent
entity for some purposes like in suits, marshalling of assets, owning property, etc.
37-42, Martin v. Peyton
Agreement expressed in three documents, whereby securities were loaned to partnership and lenders
acquired supervisory powers with option to enter firm and to accept resignation of any member, held not
to create partnership, but as method of protection against the risk. Where written contract
between parties is complete and expresses in good faith full understanding and obligation of parties, it is
for court to say whether partnership exists, regardless to statement saying no partnership is intended
sharing profits should be considered and given due weight, but it is not decisive.
42-45, National Biscuit Co., Inc. v. Stroud
Purchase of bread by food store operated as going concern by two partners was an
ordinary matter connected with partnership business within statute to effect that
any difference arising as to ordinary matter connected with partnership business
may be decided by majority of partners, and although partner told bread seller he
would not be personally responsible for additional bread sold to store, partner and
partnership were liable for such purchase by copartner because he has a right to
make these decisions (within the scope of the business) unless a majority of the
partners vote to deny him of these rights. One out of two is not majority.
Partners are jointly and severally liable for the actions of the partnership.
45-57, Meinhard v. Salmon
A joint venture with terms embodied in writing. Meinhard was to pay to Salmon half
of the money to reconstruct, alter, manage, and operate the property. Salmon was

to pay to Meinhard 40% of the net profits for the first 5 years of the lease and 50%
for the years thereafter. If there were losses, each party was to bear them equally.
Salmon, however, was to have sole power to 'manage, lease, underlet and operate'
the building. There were to be certain pre-emptive rights for each in the
contingency of death. They were co-adventurers, subject to fiduciary duties akin to
those of partners. Salmon got a new enterprise before the completion of the 20
years involving the same building. Cardozo: The fact that Salomon was in control as
the manager charges him with the duty of disclosure, since only through disclosure
could opportunity be equalized. The opportunity belonged to the enterprise, but
Salmon appropriated it to himself in secrecy and silence. The rule of undivided
loyalty is relentless and supreme. The subject matter of the new lease was an
extension of the subject matter of the old one.
Giles v. Giles Land Company
(1) Irreparable deterioration of relationship between partners proven by family was valid basis for
dissociation. (2) Court found alternative reason for dissociation when it found brother engaged in
wrongful conduct that adversely affected partnership. (dissociation of partner)
C. Limited Liability Corporations
57-68, Elf Atochem North America v. Jaffari and Malek, LLC
(1) Limited liability company was bound by agreement defining its governance and operation, even
though company did not itself execute agreement. (2) Contractual provisions directing that all disputes be
resolved exclusively by arbitration or court proceedings in California were valid under Limited Liability
Company Act and Delaware laws. (3) The derivative suit is a corporate concept grafted onto the limited
liability company form.
D. Fiduciary Obligations
Restatement (Second) of the Law of Agency, 13, 376-396
Unless otherwise agreed, an agent is subject to a duty to his principal to act solely for the benefit of
the principal in all matters connected with his agency. Duty to give info, to keep and render accounts,
to act only as authorized, to obey, duties after termination of authority, to account for profits arising out of
employment, to get principals consent to act as adverse party
E. Piercing the LLC "Veil"
Kaycee Land and Livestock v. Flahive
Attempt to pierce the veil alleging that the LLC had caused environmental damage to the land when
exercising its contractual right to use the surface. The equitable remedy of piercing the veil is an
available remedy under the Limited Liability Company Act. Its a judicially-created remedy for situations
where corporations have not been operated as separate entities as contemplated by statute and, therefore,
are not entitled to be treated as such.
II. Basics of Corporations
A. Choice of Entity 69-76
Sole Proprietorship

S Corporation
C Corporation
Limited Liability Company
Single Member Limited Liability Company
B. A Short History of the Corporation 76-83
C. The Purpose of the Corporation
1. 83-94, Dodge v. Ford Motor Co.
A business corporation is organized primarily for the profit of the stockholders, and the discretion of the
directors is to be exercised in the choice of means to attain that end, and does not extend to the reduction
of profits or the non-distribution of profits among stockholders in order to benefit the public, making the
profits of the stockholders incidental thereto. Courts of equity will not interfere in the management of the
directors unless it is clearly made to appear that 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 which
it can, without detriment to its business, divide among its stockholders, and when a refusal to do so would
amount to such an abuse of discretion as would constitute a fraud, or breach of that good faith which they
are bound to exercise towards the stockholders.' Court: required that directors declare an extra dividend
of $19M. However, the court will not question whether the company is better off with
a higher price per vehicle, or if the expansion is wise, because those decisions are
covered under the BJR.
2. 94-107, A.P. Smith Manufacturing Co. v. Barlow(Delaware SC)
Corporate power to make reasonable charitable contributions exists under modern conditions even apart
from express statutory provisions. Plaintiff can give money to charities providing that the
total does not exceed the statutory maximum of 1% of capital and surplus, and the
institution receiving the money does not own more than 10% of the company stock.
Corporate gift-giving increases the goodwill of the corporation, and public policy
should be to encourage corporations to provide to charities in the same manner as
individuals are encouraged to give. Where justified by advancement of public interest, reserved
power of State to alter corporate charter may be invoked even though they affect contractual rights
between corporations and its stockholders and between stockholders and themselves.
D. Note on Delaware Incorporation 107-111
E. The Players in the Corporation: Shareholders, Directors and Officers
1. 111-130, Campbell v. Loews Inc.
Action by a stockholder against a corporation, where stockholder requested a preliminary injunction
restraining the holding of a stockholders' meeting, or alternatively, restraining the meeting from
considering certain matters, or voting certain proxies. Court: the bylaws dont rule out a call of a
stockholders' meeting by corporate president to fill director vacancies, to amend the bylaws to increase
the number of the board, and remove certain directors and fill such vacancies. This was not action of a
character which impinged upon management power given to board of directors by statute. Well stick to
the bylaws even though such purposes of meetings were not in furtherance of routine business of
corporation, and notwithstanding fact that such matters might have involved policy matters not defined
by the board of directors, and therefore, court would not issue a preliminary injunction enjoining the
holding of such meeting. However, while president can call a shareholder meeting to

remove directors for cause, and while Harassment/aggressive tactics is

grounds for removing a director for cause, director must have an OPPORTUNITY TO
2. Boilermakers Local 154 Retirement Fund v. Chevron Corporation
Unilateral adoption by a board of directors of a forum selection bylaw that "designates a forum as the
exclusive venue for certain stockholder suits against the corporation, either as an actual or nominal
defendant, and its directors and employees" is both statutorily valid under the Delaware General
Corporation Law ("DGCL") and contractually valid because (i) the boards of both companies were
"empowered in their certificates of incorporation to adopt bylaws under DGCL Section 109(a), which
provides that any "corporation may, in its certificate of incorporation, confer the power to adopt, amend
or repeal bylaws upon the directors.", and (ii) the forum selection bylaws addressed a proper subject
matter under DGCL Section 109(b), which section provides that a bylaw may contain any provision, not
inconsistent with law or with the certificate of incorporation, relating to the business of the corporation,
the conduct of its affairs, and its rights or powers or the rights or powers of its stockholders, directors,
officers or employees."
III. Piercing the Corporate Veil
Non-functioning of other officers and directors
Siphoning of funds
Absence of corporate records
Corporation acts as faade for owners/shareholders
Elements of injustice or fundamental unfairness
General rule: court may disregard the corporate entity if:
1. There is fraud or in order to achieve equity.
2. Alter Ego Doctrine - Unity of Interest: there is such a unity of interest and ownership such that
the separate personalities of the corporation and the individual no longer exist the company is
"a mere instrumentality or alter ego of its owner. Example: co-mingling of assets.
3. Injustice: Allowing shareholder to avoid liability would promote an injustice.
A. State Law
131-141, Minnie B. Berkey v. Third Avenue Railway Corporation
Berkey wanted to sue Third Avenue company (parent of 42 nd street company that
caused him injury). Third Avenue not only owned nearly all the stock of 42nd, the
board of directors and executive officers were also nearly the same. Court: to pierce
the corporate veil it was necessary that the domination of the parent company
over the subsidiary was required to be complete. It was needed that the
subsidiary be merely the alter ego of the parent, or that the subsidiary be thinly
capitalized, so as to perpetrate a fraud on the creditors. Apparently, complete
dominion is insufficient, we have to show that the subsidiary had no corporate ends,
that it was a mere instrument in the hands of its owner with no mind, will, or
existence without him (usually requires proving comingling of assets, thats its a

shell or a faade). The law permits incorporation of a business for very purpose of
escaping personal liability.
Indicia of separate life and operation:
o Own bank account on which it deposits fares collected on its route.
o Wages paid out of that account to employees of the subsidiary.
o Not organized by the defendant at its formation, no evidence the
defendant had an interest in it.
o Functioning as a corporation continuously and actively.
Indicia of inseparate life and operation

Members of the two board of directors were almost the same, each
road had the same executive officers, parent made loans to subsidiary
(however most have been repaid and the rest has been carried out as
debt), parent owned outstanding second mortgage bonds, financial
statement to stockholders exhibited consolidated income.

Defendant was dominant stockholder in many other subsidiaries: buys

the cars which he then leases to subsidiaries.

141-143, Bartle v. Home Owners Cooperative, Inc.
Defendant formed Westerlea to undertake construction to build housing for
Defendants members for the very purpose of escaping liability (although not
without limits). Cant pierce the veil where there had been neither fraud,
misrepresentation nor illegality involved in incorporation of such subsidiary or
its subsequent operation. There was no depletion of assets. The veil is pierced to prevent fraud or to
achieve equity.
143-150, Walkovsky v. Carlton
Defendant was a shareholder of 10 small corporations each has 2 cabs with only
minimum car liability insurance of $10K. The fact that the corporations may have
been one large corporation does not prove that Defendant was controlling the
corporations for his own behalf (which could help pierce the veil because of alter
ego doctrine). Corporate form may not be disregarded merely because the

assets of the corporation are insufficient to assure a recovery (mere

undercapitalization is not sufficient to pierce the corporate veil). In many
areas of the law, like insurance, intervention has to come from the legislature whilst
keeping the separate personality principle unharmed (thats what the principle was
meant for). Defendant would be held liable under the respondeat superior doctrine
(principal-agent theory) if he controlled the corporation for his personal benefit at
the expense of the corporations benefit the corporation would be treated as the
agent of the principal and liability would be imposed on the tort/agency law
doctrine of vicarious liability.


151-160, Morris v. New York Department of Taxation and Finance

Corporate veil could not be pierced so as to hold board member personally liable for compensating use

taxes allegedly incurred by corporation. Attempt to pierce the veil is an assertion of facts and
circumstances which will persuade court to impose corporate obligations on its owners. To pierce the
veil: (1) owners exercised complete domination of corporation (especially when abusing privilege of
doing business in corporate form for personal rather than corporate business no separate mind/ends
from the owner); and (2) such domination was used to commit fraud or wrong or injustice against
plaintiff which resulted in plaintiff's injury (sheer domination is not enough). This wasnt established and
there was no evidence that corporation was sham to avoid taxes, it had a legitimate business purpose.
No definitive authority on the issue of whether a non-shareholder can be personally
liable under a theory of piercing the corporate veil.

B. Federal Law
160-173, United States v. Bestfoods et al.
A parent corporation is not liable for the acts of its subsidiaries. However, the
corporate veil may be pierced and the shareholder may be held derivatively liable if
the corporate form would be misused to accomplish certain wrongful purposes,
notably fraud, on the shareholders behalf. However, a parent corporation may be
directly liable if it actively participated in and exercised control over the operations
of that facility. To determine direct liability, the test is not whether the parent
operates the subsidiary, but rather whether it operates the facility, and that
operation is evidenced by participation in the activities of the facility, not the

IV. State Law on Fiduciary Duty of Directors and Officers

To fulfill fiduciary duty of care, a director has to:
a. Act on an informed basis or due diligence (directors must inform themselves of all information
reasonably available to them and relevant to their decision)
b. In good faith;
c. Independence: In the honest belief that the decision was in the best interest of the company
(loyalty to the company).
The proper standard for determining whether a business judgment was an informed one is gross
negligence. BJR does not protect the directors when they have either abdicated their functions or
failed to act.
A. Nonfeasance
174-186, Francis v. United Jersey Bank
Corporate director was personally liable in negligence for failure to prevent misappropriation of trust
funds by other directors who were also officers and shareholders of the corporation where negligence
was proximate cause of loss. She is jointly and severally liable with all the directors
who breached the duty.
Director should acquire at least a rudimentary understanding of business of corporation and because
directors are bound to exercise ordinary care, they cannot set up as a defense lack of knowledge needed
to exercise the requisite degree of care and if one feels that he has not had sufficient business experience
to qualify him to perform the duties of a director, he should either acquire the knowledge by inquiry, or

refuse to act. A Director is not an ornament, but an essential component of corporate governance;
consequently, a director cannot protect himself behind a paper shield bearing the motto, "dummy
Directors of corporations are under continuing obligation to keep informed about activities of
corporation; otherwise, they may not be able to participate in overall management of corporate affairs
may not shut their eyes to corporate misconduct and then claim that because they did not see the
misconduct, they did not have a duty to look. Shareholders have right to expect that directors will
exercise reasonable supervision and control over policies and practices of a corporation
No need for detailed inspection of day-to-day activities but, rather, a general monitoring of corporate
affairs and policies and accordingly, a director is well advised to attend board meetings regularly.
While directors of corporations are not required to audit corporate books, they should maintain
familiarity with financial status of corporation by regular review of financial statements and, in some
circumstances, directors may be charged with assuring that bookkeeping methods conform to industry
custom and usage.
Usually a corporate director can absolve himself from liability by informing the other directors of
impropriety and voting for proper course of action (In most instances such a director will be absolved
after attempting to persuade fellow directors to follow different course of action). Voting/concurring
liability to the extent of any injuries suffered by such persons, respectively, as a result of such action.

B. The Business Judgment Rule

Del. Gen. Corp. Law 141, 251, 271
Fed. R. Civ. P., Derivative Actions by Shareholders
FRCP 23.1 - derivative Action
(a) Prerequisites. This rule applies when one or more shareholders bring a derivative action to
enforce a right that the corporation may properly assert but has failed to enforce. The derivative action
may not be maintained if it appears that the plaintiff does not fairly and adequately represent the interests
of shareholders who are similarly situated in enforcing the right of the corporation or association.
(b) Pleading Requirements (procedures). The complaint must be verified and must:
(1) allege that the plaintiff was a shareholder or member at the time of the transaction complained of, or
that the plaintiff's share or membership later devolved on it by operation of law;
(2) allege that the action is not a collusive one to confer jurisdiction that the court would otherwise lack;
(3) state with particularity: (A) any effort by the plaintiff to obtain the desired action from the directors
or comparable authority and, if necessary, from the shareholders or members; and (B) the reasons for
not obtaining the action or not making the effort.
(c) Settlement, Dismissal, and Compromise. A derivative action may be settled, voluntarily dismissed,
or compromised only with the court's approval. Notice of which must be given to shareholders or
members in the manner that the court orders.
In around 1/3 of states (though not Delaware), a derivative claimant with low
stakes must post security for corporations legal expenses.
Direct Actions

(1) There is a special duty (such as a contract) between the shareholder and the
(2) The shareholder suffers injury separate and distinct from that suffered by
other shareholders.


187-195, Nursing Home Building Corporation v. DeHart

Action brought by corporate nursing home against former sole shareholders of corporation for alleged
fraudulent misappropriation of corporate funds. Since former sole shareholders were experienced in
operation of various types of businesses including nursing homes and were involved in day to day
management of corporate nursing home on full time or greater basis, the challenged expenditures were
deemed to have been made within scope of proper exercise of their business judgment. Because
disbursements were ratified by all shareholders former sole shareholders were not liable to
corporation for such installment payments.
BJR immunizes management from liability in corporate transaction undertaken within both power of
corporation and authority of management where there is reasonable basis to indicate that transaction
was made in good faith.

C. Nonfeasance or the Business Judgment Rule?

195-228, Smith v. Van Gorkom
(1) The business judgment standard for determining whether the judgment was
informed is gross negligence.
(2) The Board has a duty to give an informed decision on an important decision
such as a merger and cant escape the responsibility by claiming that the
shareholders also approved the merger (not to blindly rely on VG without further
inquiry). Because the Board did not disclose all information to the shareholders that
they knew or should have known, the Board breached their fiduciary duty to
disclose all germane facts.
(3) Good faith is irrelevant for determining informed business judgment (fulfillment
of fiduciary role requires more than the mere absence of bad faith or fraud). The
directors are protected if they relied in good faith on reports submitted by officers,
but there was no report that would qualify as a report under the statute. The
directors cannot rely upon the share price/premium as it contrasted with the market
(4) When breaching duty of care, directors can fend for themselves based on:
Transaction was entirely fair to corporation. or
Fully-informed shareholders voted to approve boards action.
(5) Process challenges may have lower threshold (e.g., ordinary negligence) for
banks or financial intermediaries.
* Following that case, 102(b)7 rule was passed to absolve directors from being

held personally liable for breach of duty of care unless there was lack of good faith,
etc. still liable for breaching duty of loyalty.


Note on Settlements and Attorney's Fees (look into it)



Lawyers paid on contingent fee basis (no award for plaintiff no fee to
attorney). This provides an incentive for attorneys to settle for big amount.


Strike suits: have little prospect of success on the merits, but could impose
litigation costs forcing defendants to settle.


Why would s/holders bother to bring derivative claim when there is nothing
personally in it for them?


If you get a judgment or settlement of that action, the law firms have a quasi
contractual right to be compensated by the s/holders from the amount
created by the judgment.


No case can be settled unless a judge determines that the settlement is fair
to the corp. & its s/holders.


Courts are split as to which method of compensation is appropriate:


Lodestar approach: ask how many hours went into litigation multiplied by
reasonable hourly rate, then adjust up or down to reflect quality of work.
Judge makes independent evaluation after settlement as to what efforts were
worthwhile - holistic, subjective approach.


Percentage of recovery: instead of quantifying effort, just say 30% should

go to lawyers (usually 20-30);


Incentives for lawyers: lawyers might behave strategically based on which

rule is adopted. I.e., if you bring strike suit litigation or nuisance litigation
you try to get them to settle even if you think you can win.


Class Actions & Their Abuse


Class actions were conceived as an expeditious way for people w/ similar

grievances to join in a common suit & get compensated for injuries, however,
they have become a tool for trial lawyers to launch litigations against large
bus-es. Plaintiffs sometimes dont even know they are on trial.


Despite of lacking cause of action, these bus-es forced to settle rather go for
expensive trials as they may face K/M of plaintiffs.


Mostly only trial lawyer benefit (an aver. fee is $1K/hour). Plaintiffs get tiny
awards. E.g. in insur. sum-up case in TX, lawyers got $11m; plaintiffs only


Market in Securities


Lawyers even sue when there is a drop in a corp.s stock priceoften w/o any
proof of corp.s wrong. Corp. forced to settle, 1/3 of sett-t goes to lawyers.


The figures show that securities class actions dont prevent corp. wrong.


Securities class action filings rose 31% in 2002. In a recent sett-t a law firm
negotiated $300m in fees.


Magnet Courts


Class actions tend to involve plaintiffs from multiple jurisdictions. Thus, trial
lawyers are able to make a forum shopping. The best forum should be
known for favor of class action (magnet courts).


E.g. Madison County, Illinois made a $10.1b verdict against Philip Morris in
a light cigarettes are safer case. After that the # of class actions filled
there increased over 1,800%.


Oversight of Class Action Settlements


The Sup. C. in Campbell v. State Farm case ltd jurys ability to set
punitive/exemplary damages at an extreme multiple of actual damages. NY
judge Nicholas Figueroa recently threw out as an excessive a $1.3B claim by
the Castano group for work on the California tobacco settlement.

D. Duty of Loyalty and Derivative Actions: The Demand Requirement

Duty of Loyalty: merely a financial interest conflict of interest. Three Alternative ways to cleanse (144
1. Disclosure to Board of Directors & approval
No quorum requirement; but majority of minority requirement
2. Disclosure to Shareholders & approval
No apparent Quorum requirement but good fiath.
3. Transaction fair at time of approval
By BoD, Committee, or Sh. Burden of Proof?
Aronson test (Delaware)
Demand requirement waived if there is a reasonable doubt that:
(1) Director are disinterested + independent.
(2) The transaction being challenged was the product of the valid exercise of BJ (good faith + informed).

Directors are shielded by BJR if:

1. Directors are disinterested as to any decision in question.
2. The directors have not been grossly negligent with respect to their duty to inform themselves regarding
the decisions.
Approaches to demand futility:
1. Model Business Corporation Act: Absent a showing of irreparable harm if demand is required, a
demand must always be made before a derivative action can be pursued. Universal Demand.
2. New York: Demand required unless plaintiff shows:
1. Majority of board are not disinterested as to the transaction
2. Board did not inform themselves as to the transaction; or
3. Failure of BJR: Transaction is so egregious that could not have resulted from sound
business judgment.
Independent Litigation Committee
Board votes to create independent SLC, expands itself to add members to be the SLC, corporation seeks
Stay of the derivative suit, SLC investigates and reports back to board.
Self dealing: There is a direct relationship between the fiduciary and the
corporation such as the director is also an employee.
o Parent/Sub: a parent corporation can breach its duty to the minority
shareholders of a partially owned subsidiary if the parent prefers itself at
the expense of the sub, e.g. squeezes out the minority (in a merger or other
transaction) and forces the minority to accept unfair consideration for their

Interlocking directories: when two corporations share some common

directors and when they deal with each other.
Note: Neither of these situations is illegal or unethical. The only problem is
that there is a conflict of interest and that raises some concerns.
Remedies: rescission, which returns the parties to their position before the

Corporate opportunity doctrine: there is no direct connection between fiduciary

and the corporation, but directors/officers/SHs are going after an opportunity that
is for the corporation.
Executive compensation and the problem of waste.
False/deceptive information to SH corporate officials who provide SH with
false info, on which SH rely to their detriment duties of disclosure result when
directors seek a SH vote and when corporate officials communicate to stock
trading markets.


Whenever a conflict of interest is identified, the affected directors have the burden
of proving that the transaction meets an intrinsic fairness test
Deal was substantively fair: good price, etc.
Deal was procedurally fair: i.e., enough independent (not conflicted) directors
or disinterested shareholders considered and approved the transaction so as
to cleanse the transaction.
Where a conflict of interests arises, directors can make the transaction non-voidable
Full disclosure and approval by disinterested Directors , i.e. get
majority vote of disinterested directors (or shareholders) to approve
The fine line b/w interested and disinterested members is a question of fact, so
the jury will to determine.


228-248, Holden v. Construction Machinery Co.

Equity holds officers and directors of corporate entity, particularly management-controlling directors of
closely held corporations, strictly accountable as trustees.
Majority shareholder of corporation who was also president and general manager was strictly
accountable to corporation for another company's stock purchased with check from corporation, or for
fair market value of such stock, and for all increases, income, proceeds or dividends realized. This suit is
derivative in nature. So as the freeze out issue is basically of a derivative nature
because it have had an adverse effect on all corporate personnel with an attendant
negative reflection upon CMCs general business complexion.
Although actual damage must be established as a condition precedent to an
allowance of punitive/exemplary damages, in shareholder's derivative action,
equity court may, in its discretion, award exemplary damages upon showing that
some legally protected right has been invaded, such as by intentional act of
fraud or other wrongful conduct (personally engineered every phase of deal by which stock in another
company was acquired with check from corporation, appropriated to his own use all dividends issued
upon such stock, directed falsification of corporate records and other documents, and subsequently
endeavored to impress upon whole transaction a coloration of honesty and also did all in his power to
isolate minority holder of 49.976% of outstanding stock from any rights or privileges pertaining to


Eisenberg v. Flying Tiger Line, Inc.

Action by stockholder, on behalf of himself and all other stockholders of corporation similarly situated,
to enjoin effectuation of plan of reorganization and merger the effects of which was that business
operations were confined to a wholly owned subsidiary of holding company whose stockholders were the
former stockholders of defendant corporation.

Court: this is a "personal action" and not "derivative" no need for security requirement. the injury is
one to the plaintiff as a stockholder [Deprivation of voting rights] and to him individually and not to the


Marx v. Akers (NY)

Complaint that the board of directors wasted corporate assets by awarding excessive compensation to the
outside directors.
Court: Directors are always self-interested for the purpose of demand excuse in
a challenged transaction where they received a direct financial benefit (like voting
for a raise in their compensation) which is different from the benefit to
shareholders. But this alone will not give rise to a cause of action in the merits of
the suit, as directors are statutorily entitled to set those levels. Hence a plaintif
has to demonstrate with particularity that the compensation is excessive
on its face or other facts which call into question (1) whether compensation was
fair to the corporation when approved (disinterested?), (2) the good faith of the
directors setting those rates, or (3) that the decision could not have been a product
of valid business judgment.
In the case, there are no factually based allegations of wrongdoing or waste which
would, if true, sustain a verdict in plaintiff's favor. Plaintiff's bare allegations that
the compensation set lacked a relationship to duties performed or to the cost of
living are insufficient as a matter of law to state a cause of action.
Demand was excused because a majority of the board was self-interested in setting
the compensation of outside directors because they comprised a majority of the
board (Aronson test).

E. Note on The Duty to Act in Good Faith

248-252 The Disney Case (Brehm v. Eisner) (Delaware)
Complaint against Walt Disney Company and its Board of Directors, claiming that
the directors breached their fiduciary duty and committed waste by approving the
employment agreement without properly informing itself of the cost of the non-fault
termination provision and in failing to determine a cause to fire Ovitz and avoid this
Under the exception of demand futility, the demand requirement has been
excused when demand would have been "futile," "useless," or "unavailing". In
order to determine demand futility, there must be reasonable doubt that
(1) majority of directors are disinterested or independent, or (2) the
transaction was the product of valid business judgment (Aronson test).
Court: No breach of fiduciary duty. The committee had not acted in bad faith,
which it defined as:

1. Subjective bad faith: fiduciary conduct motivated by an actual intent to do

harm to the corp. or its s/holders, referred as quintessential bad faith.
2. Intentional dereliction of duty, a conscious disregard for ones responsibilities.
The shareholders appealed, arguing that the Court of Chancery applied an
incorrect definition of bad faith, that the committee was grossly negligent in
approving the no-fault termination terms because it failed to inform itself of
material facts, and that the payment of severance to Ovitz constituted waste.
Court: Plaintiffs did not allege facts that would put into question the Boards
independence. Moreover, there was a compensation expert who endorsed the
Plaintiffs would have to prove that the Board (1) did not in fact rely on the
expert, (2) their reliance was not in good faith, or (3) that the expert was not
The allegation of waste (= gross negligence, difficult to prove) when a
shareholder in a derivative action against the corporation's directors fails to rebut
the presumption of the BJR, she is not entitled to any remedy, unless the
transaction constitutes waste Only if guilty of fraud or misappropriation.
Because the shareholders failed to show that the approval of terms of agreement
was not a rational business decision, their corporate waste claim failed BJR.
Plaintiffs did not set out with particularity facts that would show that no reasonable
business person would do so.
The court is comfortable with this because they feel there are other alternatives for
a remedy (shareholders vote out the Board, or sell their stock)
Duty to act in good faith is between duty of care (gross negligence) and the duty of
loyalty (self interest).

F. Directive Actions: The Role of the Special Committee

Auerbach v. Bennett (NY)
Board of Directors were involved in the payment of bribes and kickbacks to foreign
A board may act as a whole in reviewing a shareholder's demand or it may
choose to appoint a committee to investigate the facts underlying a demand
and make a report and recommendation.
Auerbach Test for demand-excused cases in which an SLC has recommended
dismissal of demand:
1. Did SLC act independently (honest belief that the action taken was in the best
interest of the company), in good faith, and with a reasonable
investigation/informed (due care)? If yes BJR. The burden is on the SLC to
prove the abovementioned. After that the court itself applies the BJR (Zapata). (In
NY, they do the same without the court applying BJR).

2. Is BJR violated?
If SLC is not independent, its recommendations are meaningless:
Independence Factors: Non-defendants; no nomination by named directors; full
delegation of authority to SLC.
If SLC is independent ( BJR):
1. Procedures used by SLC scrutinized under gross negligence standard.
2. Substantive Decision of SLC gets protection of the Business Judgment Rule.
Note: Decision not clear about who bears burden here. Once above factors
established plaintiff bears burden of proof that BoD didnt act in a good faith.


In Re Oracle Corp. Derivative Litigation

Independence of SLC: whether a director is, for any substantial reason, incapable of
making a decision with only the best interests of the corporation in mind. To prevail,
SLC has to prove the Auerbach test.
Members of SLC could lose independence without being essentially subservient to
officers and directors under investigation for insider trading; whether the members
of SLC were under the domination and control of the interested parties was not
the central inquiry in the independence determination necessary for ruling on SLC's
motion to terminate shareholder derivative action.
A director may be compromised and lose independence, if he is beholden to an
interested person; "beholden" does not mean just owing in the financial sense, and
it can also flow out of personal or other relationships to the interested party.
When evaluating whether a director is "disinterested" you have to look as broadly
as possible for ties among SLC members: university where they were tenured
professors, and CEO had really good ties with them and the universtiy reasonable
doubt about the members' independence and impartiality; CEO was very wealthy,
was publicly considering extremely large contributions to university when members
were being added to board and sourced $10 million in funding to university.
University's rejection of CEO's child for admission did not keep CEO from making
public statements about consideration of huge donation, and although members
claimed ignorance, an inquiry into CEO's connections with university should have
been conducted before the SLC was finally formed and, at the very least, should
have been undertaken in connection with its report.


In Re China Agritech, Inc. Shareholder Derivative Litigation

Fraudulent Financial Reporting 19871997 and a series of corporate governance

issues such as weak independence, unusual and self-interested transactions at the
end of accounting periods.
The board formed a Special Investigation Committee to investigate Ernst & Youngs

reports. The members of the board were not independent and were investigating
their own actions.
The Complaint contends that China Agritech is a fraud. Aspects of the fraud include:
1. failing to use the proceeds of the IPO for its stated purpose;
2. not being able to produce basic documents essential to the Companys
business, such as the original Chinese language contract with the primary
customer or a license to produce one of the primary products; and
3. repeated failures to maintain effective internal controls that prevented the
Company from making public filings with the SEC and ultimately resulted in
the delisting of the Company.
On the demand requirement - It would have been futile for plaintiff to make a
litigation demand.
o 5 of the 7 board members were directors at the time the contested
decisions were made court applies the Aronson standard (see above).
o For the 2 remaining directors Rales v. Blasband standard (used when
there is no BJ) plaintiff has to plead sufficiently particularized facts that
create a reasonable doubt that the board of directors could have
exercised its independent and disinterested business judgment in
responding to demand. Applicable in 3 types of scenarios:
where a business decision was made by the board of a company,
but a majority of the directors making the decision have been
where the subject of the derivative suit is not a business decision
of the board.
where the business decision was made by a board of another
Plaintiff provided facts sufficient to raise a reasonable doubt when directors resign
under highly suspicious circumstances, their ability to consider a demand on the
board comes into question (Rich v. Chong).
On the breach of the Caremark duty:
o Caremark duty: establish reporting and monitoring systems designed to
provide the necessary information required for the board to stay informed
concerning the corporations compliance with law and business
performance. High standard, requires a sustained or systemic failure of
the board to exercise oversight. Plaintiff must prove either:
Failure by directors to implement any reporting or information
systems of controls, or
Failure to monitor or oversee companys operations in spite of
existence of those controls.
Plaintiff allegations supported a reasonable inference of a failure to monitor:
Audit committee failed to meet in over 2 years.
Profit reports diverged drastically depending on whether the
filing was with the SEC or with Chinas regulator.

Auditor resigned (E&Y) and sent a letter to the company under

his obligation to report a belief that the companys financial
statements are materially affected by an illegal act and
management has not taken timely and appropriate remedial
Because of this ongoing failure of the board to provide oversight (duty of oversight
under Caremark), demand futility is established to the five participating directors.

Derivative actions:
Board will be divested of its authority to address misconduct when:
o Demand excusal: directors incapable of making an impartial decision
regarding the litigation in question.
o Wrongful refusal: stockholder has demanded that directors pursue the
corporate claim and they wrongfully refused.
Court sharply notes that it has no interest in supporting reverse mergers that
contravene Delaware public policy by merging foreign corporations with dormant
but publicly registered shell companies for the purpose of circumventing the federal
securities regulatory regime.
Since the Complaint raised questions invoking the duty of loyalty and good faith,
rather than the duty of care, the Court held that the exculpatory provision in the
certificate did not exculpate the directors.

G. Dominant Shareholders Problems and a Primer on Corporate Finance

Sinclair Oil Corp. v. Levien
Duty of loyalty arises when:
1. Controlling shareholder exercises its control over the corporation, must be
advantageous for all the shareholders and not only our self.
2. In self-dealing transaction, prove that the transaction advantage the
corporation. Self-dealing is wrong, but if the test of intrinsic fairness is ok,
then its acceptable.
3. Sells control.
The Court held that the issue involving the excessive dividends & limiting business
opportunities should be evaluated under Business Judgment Rule. Thus, defendant
did not engage in self-dealing by issuing large dividends because it was pro-rata
(passes the intrinsic fairness test) and Defendants motives are not a factor when
all shareholders benefit from the transaction.
However, refusal to enforce the contract claim should be evaluated under intrinsic
fairness test. Defendant did engage in self-dealing when they breached the
agreement because the contract breach was to the detriment of Sinven and its
minority shareholders with the positive effect being exclusive to defendant, so the
breach is self-dealing.

Majority vs. D&O

Majority exercising its control has a duty to disclose material facts of the
transaction and plaintiff has to prove that the majority enjoyed an exclusive
benefit to the detriment of the minority (self-dealing) before the burden is
shifted to the defendants.
A transaction where a director or an officer has a conflict of interest is
voidable unless it is proven to be fair.

Both Parent and its BoD have a fiduciary duty to the subsidiary.

Intrinsic Fairness
Intrinsic fairness: Fiduciary duty + self-dealing (both sides of a trans) intrinsic
fairness standard.
Self-dealing: parent causes the subsidiary to act in such a way that the parent
receives something from the subsidiary to the exclusion and detriment of
the minority stockholders of the subsidiary.
If theres no self-dealing Waste claim: The motives for causing the
declaration of dividends are immaterial unless the plaintiff can show that the
dividend payments resulted from improper motives and amounted to
Definition of waste: an exchange of corporate assets for consideration so
disproportionately small as to lie beyond the range at which any reasonable
person might be willing to trade.
If Waste = Fraud then shareholders cannot approve the transaction and it is
not protected by the Business Judgment Rule.
Burden of proof: Once the plaintiff shows dominance and raises unfairness (selfdealing or exclusive benefit to the detriment of the minority), the burden is on
the defendant to prove intrinsic fairness. The defendant can shift the burden
to plaintif if the transaction was approved by informed independent,
disinterested special committee (intrinsic fairness).


Zahn v. Transamerica Corp.

Court: distinction between a decision made by a shareholder and one made by a

Indeed, as a shareholder, the defendant is entitled to vote in their interests, but
their capacity as director (if the directors are acting as an extension of the majority
shareholders) is limited because they owe a fiduciary duty to every shareholder.
Court: the Plaintiff was entitled to equitable relief if the directors were acting on
Defendants behalf when they decided to redeem Class A shares.
Court: the company had the legal power to cash out Class A shareholders, but
before doing so, they had duty to inform the shareholders of the value of the
tobacco, so theyll have the option to convert their shares to Class B (not cashed

The majority has the right to ctrl, but when it does so, it occupies a fiduciary
relation toward the minority, as much so as the corporation itself or its officers &
A dominant/controlling shareholder owes fiduciary duty to the other shareholders. A
shareholder can be dominant with <50% of shares. Courts usually presume
dominance at 25%. Suits against these dominants are based on duty of loyalty. Its
enough for plaintiff to show that directors were interested and burden of proof
shifts towards defendant to cleanse himself.
Proof of Self-dealing + control = duty to prove intrinsic fairness to minority
Informed vote = full disclosure.
Intrinsic Fairness Test:
(1)Fair dealing (procedural aspects) How the transaction was timed, initiated,
structured, negotiated, disclosed and approved? Was it rushed by the controlling
(2) Fair Price? Considering the circumstances.

H. Ratification
Flieger v. Lawrence
One of the Defendant directors, acting in his individual capacity, purchased a lease
option for antimony (metal) rights. He offered the rights to Agau but the directors
agreed that Agaus financial position would not allow the purchase.
Where defendant officers, directors, and shareholders of the first corporation had
held a significant interest in the second corporation which was acquired by the first
corporation, burden was on those defendants to show the intrinsic fairness of the
transaction. (self-dealing intrinsic fairness)
Since a majority of the shareholders voted in favor of exercising option to purchase
a second corporation were alleged to have acted detrimentally to the first
corporation for their own gain (self-dealing), ratification of the option by the
shareholders did not affect the burden of showing that the transaction was
intrinsically fair because they were interested. (ratification intrinsically fair).
However, ratification by majority of minority votes is capable of shifting the
burden of proof.


In re Wheelabrator Technologies, Inc. Shareholders Litigation

Two companies decided to merge self-dealing (one held 30% of the other).
Shareholders ratified the decision.
Duty of Care
Shareholders ratification extinguished duty of care claim (Holden).
Duty of Loyalty

Delaware law imposes upon board of directors a fiduciary duty to disclose fully and
fairly all material facts within its control that would have significant effect upon
stockholder vote.
"Self-Interested" transactions with no control (between corporation and its
directors, or between corporation and entity in which corporation's directors are
also directors or have financial interest) + good faith + fully informed +
disinterested shareholders not be voidable but rather invokes business
judgment rule and limits judicial review to issues of gift or waste with burden of
proof upon party attacking transaction.
In a corporation and a controlling shareholder (parent-subsidiary merger)
entire/intrinsic fairness + burden of proof on directors/shareholders.
In a corporation and a controlling shareholder (parent-subsidiary merger) +
approved by majority of minority of shareholders entire/intrinsic fairness +
burden of proof on the plaintiff.
* In cases of M&As, we use the entire fairness test that requires majority of
Entire Fairness:
(1)Fair dealing (procedural aspects) - How the transaction was timed, initiated,
structured, negotiated, disclosed and approved? Was it rushed by the controlling
(2) Fair Price? Considering the circumstances.

V. Federal Law Regarding Duties to Shareholders

A. Regulation by the Securities and Exchange Commission
Note on Definition of a Security

Investments using money or other considerations

Common enterprise
Investor expecting a profit
Profit derived primarily through the efforts of others


Note on SEC Registration Process

Note on Other Exemptions [under the Securities Act of 1933]
Note on Securities Act Civil Liabilities

10(b) and Rule 10b-5: The breadth and utility of section 10(b) and Rule 10b-5 in the pursuit of securities
litigation are significant. Rule 10b-5 has been employed to cover insider trading cases, but has also been
used against companies for price fixing (artificially inflating or depressing stock prices through stock
manipulation), bogus company sales to increase stock price, and even a company's failure to
communicate relevant information to investors. Many plaintiffs in the securities litigation field plead
violations of section 10(b) and Rule 10b-5 as a "catchall" allegation, in addition to violations of the more
specific antifraud provisions in the '34 Act.

10(b): It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce or of the mails, or of any facility of any national
securities exchange To use or employ, in connection with the purchase or sale of any
security registered on a national securities exchange or any security not so registered, or
any securities based swap agreement [32] any manipulative or deceptive device or
contrivance in contravention of such rules and regulations as the Commission may
prescribe as necessary or appropriate in the public interest or for the protection of

Rule 10b-5: It shall be unlawful for any person, directly or indirectly, by the use of
any means or instrumentality of interstate commerce, or of the mails or of any
facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state
a material fact necessary in order to make the statements made, in the light of the
circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would
operate as a fraud or deceit upon any person, in connection with the purchase or
sale of any security.
Material info: a substantial likelihood that a reasonable investor would find its disclosure significant.

B. Insider Trading

SEC v. Texas Gulf Sulphur

Defendants bought shares of Texas Gulf while they secretly had positive information
regarding mining activities carried out by the company, namely the discover of an
area, called Kidd 55, extremely rich in minerals. When rumors came out,
defendants sent out a misleading press release to calm the speculation.
Insiders cannot act on material information (information that a reasonable man
would deem important to the value of the stock) until the information is reasonably,
publicly disseminated (reasonable opportunity to act on the information).
It did not matter that there was still an element of uncertainty in the eventual
mineral mining.
Not only all officers, senior officers and directors, but anyone in possession of
material inside information is an insider.
Duty of insider to disclose information or duty to abstain from dealing in
corporation's securities arises only in those situations which are essentially
extraordinary in nature and which are reasonably certain to have substantial effect
on market price of security if extraordinary situation is disclosed.


253-270, United States v. OHagan

OHagan was working as a partner in a law firm which was representing a company
and heard about a tender offer and went and traded on that info.

An outsider who misappropriates confidential information to personally benefit

violates Section:10(b) because there is deception in connection with the
purchase or sale of a security.
Rule of Law
Relating to 10(b): Criminal liability under 10(b) of the Exchange Act
may be predicated on the misappropriation theory.
Relating to 14(e) and SEC Rule 14e-3(a): The Commission, in this
regard, did not exceed its authority.
"Misappropriation theory" holds that person commits fraud "in connection with"
securities transaction, and thereby violates 10(b) of Exchange Act and Rule 10b-5,
when he misappropriates confidential information for securities trading purposes, in
breach of duty owed to source of information.
The security-trader knowingly abuses the duty owed toward the source of
information, whether the source is the company he works at or not. He did not
necessarily have to deceive the seller in order to violate the Rule.
Under misappropriation theory of securities fraud liability, fiduciary's undisclosed,
self-serving use of principal's information to purchase or sell securities, in breach of
duty of loyalty and confidentiality, defrauds principal of exclusive use of that
Company's confidential information qualifies as property to which company
has right of exclusive use, Undisclosed misappropriation of such information, in
violation of fiduciary duty, constitutes fraud akin to embezzlement, or fraudulent
appropriation to one's own use of money or goods entrusted to one's care by

C. Rule 10b-5

Basic Inc. v. Levinson

Petitioner publicly refuted the rumors of a merger, and then, shortly thereafter
requested to suspend trading because of merger talks. Respondents sold their
shares before the suspension but after the public denials of merger discussions and
lost money.
According to the Court, a merger has a high magnitude on investor decisions
material info.
The court held that an omitted fact is material if a reasonable s/holder would
consider it important in making their vote, & this standard should be applied to all
Sec 10(b) & Rule 10b-5 actions. Materiality requires a case by case review of the
facts, & a presumption exists that s/holders relied on available info when buying or
selling securities (fraud on the market theory) Misleading statements will
therefore defraud purchasers of stock even if the purchasers do not directly rely on
the misstatements.

Probability/magnitude TEST: Assessment of the probability of the merger based

on the indicia of interest in the transaction at high corporate levels balanced with
the magnitude of the event.

Note on Judicial Limitations on Actions Under Rule 10b-5
D. The Federal Proxy Rules
Written authorization empowering another person to act for the signer at shareholders meetings.
Proxy votes are similar to absentee ballots. Proxy fights occur when minority owners are trying to get
enough votes to obtain seats on the Board or affect other important issues that are coming up for the vote.


Note on Proxy Fights

Sample of a Proxy Card
SEC Rule 14a-9, False or Misleading Statements [in Proxy Materials]
270-274, Gaudiosi v. Mellon

In action for equitable relief RE: proxy contest, evidence sustained finding that one
of plaintiffs had "unclean hands" by reason of his attempts to intimidate s/holders.
One who comes into equity must come w/ clean hands & keep those hands clean
throughout pendency of litigation, even to time of ultimate disposition by appellate
In applying unclean hands doctrine, courts act for their own protection and not as a
matter of "defense" to defendant.
Candidate-stockholder's unclean hands would require denial of equitable relief in
connection with proxy contest even though other stockholder-plaintiffs had not
participated in his acts.
In action for declaratory and injunctive relief relative to proxy contest, wherein plaintiffs
pleaded a class action in one count of complaint and asserted a derivative claim that defendant directors
were liable to corporation for improper expenditure of corporate funds to promote candidacies of
management's nominees for director, district court did not abuse its discretion in (1) reserving class
action claim for separate trial, (2) in fixing security for expenses at $3,000, or (3) in rejecting, for noncompliance with order, 'costs' bond which bore signature of surety company only.


274-291, J.I. Case Co. v. Borak

US SC: the Exchange Act authorizes a federal cause for rescission or damages to a corporate stockholder
with respect to a consummated merger which was authorized pursuant to the use of a proxy statement
alleged to contain false and misleading statements violating the Act.
Private parties have right under Securities Exchange Act provision to bring suit for violation of Act
making it unlawful to solicit any proxy or consent authorization (usually by management) in violation
of regulations prescribed by the SEC (deceptive and inadequate of proxy solicitation). And the remedies
for this are not limited to prospective relief. This right exists both as to direct and derivative causes.

Corporate suffrage (voting) right is important and should be attached to every public stock. This
provision was intended to control conditions under which proxies may be solicited with view to
preventing recurrence of abuses which frustrated free exercise of voting rights of stockholders.
It is for federal courts to adjust their remedies so as to grant necessary relief where federally secured
rights are invaded, and when federal statute provides for general right to sue for such invasion, federal
courts may use any available remedy to make good wrong done.
Overriding federal law would, where facts required, control appropriateness of relief sought by
shareholder attacking consummated merger as allegedly achieved by proxy statement containing false
and misleading statements in violation of Exchange Act, despite provisions of state corporation law. Fact
that questions of state law had to be decided in this suit did not change character of right; it remained

E. State Law Regarding Inspection of Books and Records

291-302, Thomas & Betts Corp. v. Leviton Mfg. Co., Inc.

Minority shareholder, which had purchased its interest in closely held corporation with the goal of
ultimately acquiring the entire company, requested inspection of corporation's books and records. The
Court of Chancery granted limited inspection so that he could value his shares, but he appealed.
(1) shareholder failed to satisfy appropriate standard for inspection of books and records with regard to
claim of waste and mismanagement;
(2) facilitating its own use of equity method of accounting for its investment was not proper purpose for
shareholder's requested inspection; and
(3) trial court has wide latitude, it did not abuse its discretion in limiting scope of inspection to those
documents which were essential and sufficient to shareholder's purpose of valuing its shares.
Investigation of waste and mismanagement is proper purpose for shareholder to seek inspection of
corporation's books and records, but must demonstrate that his purpose is proper; in order to meet that
burden of proof, stockholder must present some credible basis from which court can infer that waste or
mismanagement may have occurred. Stockholder does not bear "greater-than-normal evidentiary
burden," but rather has a normal burden.
Shareholder's need to account for its investment by particular method stemmed from its relationship with
its own stockholders and bore no relationship to its status as shareholder; even if shareholder's
accounting purpose was proper, shareholder failed to meet its evidentiary burden, since it was
questionable whether it could justify use of equity accounting, given its lack of control over the company.
Even where no improper purpose has been attributed to inspecting shareholder, burden of proof is always
on party seeking inspection of corporation's books and records to establish that each category requested
is essential and is sufficient to stockholder's stated purpose.
As a result, when corporate financial records are made available and those records provide an adequate

basis upon which to value the shareholder's stock, courts have justifiably denied shareholder requests for
additional corporate information.

F. Sarbanes-Oxley
302-307, Note on Sarbanes-Oxley
Welch v. Cardinal Bankshares Corp.
Welch was employed as the Chief Financial Officer of Cardinal and was terminated.
He claimed that he was terminated in retaliation for engaging in activities protected
by Sarbannes Oxley Act.
An administrative proceeding started and after multiple filing and appeals, Welch
filed petition seeking enforcement of an ALJ's order of reinstatement. Employer filed
motion to dismiss.
Whether or not court can enforce a preliminary order of ALJ?
(1) ALJ's order was a preliminary order, &
(2) court did not have subject matter jurisdiction to enforce ALJ's preliminary order.

Due to the jurisdiction-conferring nature of

statute governing enforcement of Department of Labor rulings, inconsistent
agency interpretations could not inform the court's interpretation of the


Filing of an enforcement action w/ the district

court under Sarbanes-Oxley Act's whistleblower protection provision vests
jurisdiction in the district court.

The Court held that the enforcement powers concerns exclusively a "final orders" of
the Secretary of Labor, which the court found to include orders by the board but not
preliminary orders by an ALJ.
It is not for the court to fashion a remedy, even in those circumstances in which
principles of fairness might counsel intervention, when Congress has chosen not to
provide for the form of redress sought by the plaintiff.

VI. Close Corporations

A. Fiduciary Obligations in the Close Corporation
1.MBCA 7.22, 7.30, 7.31, 7.32
2 .308-321 , Euphemia Donahue v. Rodd Electrotype Company of New England, Inc.

The stockholders in close corporation owed one another the same fiduciary duty as that owed by one
partner to another in a partnership (trust, confidence and absolute loyalty.
In close corps, action of controlling stockholders in authorizing purchase of his shares by corporation
without granting an equal opportunity to minority shareholder to sell shares for same price constituted a
breach of fiduciary duty, unless minority gives advance consent through acceptance of appropriate
provision in the articles of organization, the corporate bylaws, or a stockholder's agreement; similarly all
other stockholders may ratify purchase. Agreement to reacquire stock is enforceable subject at least to the
limitation that the purchase must be made in utmost good faith, loyalty, and without prejudice to
creditors and stockholders.
Corporate directors are held to good faith and inherent fairness standards of conduct and are not
permitted to serve two masters whose interests are antagonistic, and since their paramount duty is to the
corporation and their pecuniary interests are subordinate to that duty.
In close corps, stockholders must discharge their management and stockholder responsibilities in
conformity with strict good faith standard (that is more stringent than that in regular corporations) and
may not act out of avarice, expediency or self-interest in derogation of their loyalty to other stockholders
and to the corporation.
The close corporation provides an opportunity for majority stockholders to oppress or disadvantage
minority stockholders who are subject to a variety of oppressive devices termed "freeze-outs" which
majority may employ.
To secure dissolution of ordinary close corporation subject to G. L. c. 156B, stockholder in
absence of corporate deadlock, must own at least 50% of the shares or have advantage of favorable
position in articles of organization.

B. Shareholder Agreements in the Close Corporation

Note on Shareholder Agreements, Voting Trusts, Statutory Close
Corporations, & Involuntary Dissolution.
321-333, Galler v. Galler
Where the agreement was not a voting trust but a straight contractual voting control agreement which did
not divorce voting rights from ownership of stock in a close corporation, the duration of the agreement,
which was interpreted as continuing so long as one of the two majority stockholders lived, did not offend
public policy and did not render the agreement unenforceable. And intention of that indefinite longevity
was ascertainable from agreement as a whole.
Unless agreement is part of corrupt scheme, agreements between stockholders dealing on equal terms
should be invalidated on grounds of public policy only where corrupt or dangerous tendency clearly and
unequivocally appears on face of agreement or is necessary inference from matters expressed.
For purpose of determining whether public policy requires invalidation of shareholders' agreement, a

"close corporation" is one in which stock is held in a few hands, or in few families, and wherein it is not
at all, or only rarely, dealt in by buying or selling.
Clause of stockholders' agreement providing for election of certain persons to specified offices for period
of years did not require invalidation.
Stated purpose of stockholders' agreement to provide income for support and maintenance of
stockholders' immediate families did not invalidate agreement, nor did fact that subject property was
corporate stock, where corporation was close corporation and there existed no detriment to minority
stock interests, creditors or other public injury.
Where agreement required minimum annual dividend of $50,000, but only if earned surplus of $500,000,
was maintained, such contractual requirements as restricted were not invalid.
Where agreement for continuation of salary to widow of deceased shareholder was contingent on
deductibility for corporate income tax purposes and no complaining minority interests appeared, such
salary continuation agreement was not invalid.
Where shareholders' agreement relating to directorships, salary continuation and dividends was not
invalid, defendant director-shareholders were properly ordered, on petition seeking such relief, to
account for all moneys received by them from corporation from time that such defendants took control.

C. Oppression in the Close Corporation

333-346, Baker v. Commercial Body Builders, Inc.
Owners of 49% of stock in a 'close corporation' filed action under ORS 57.595 against owners of
remaining stock and directors of corporation to compel dissolution of corporation for
alleged illegal, oppressive and fraudulent conduct of defendants and misapplication and
waste of assets.
Oregon SC: though some of defendants' conduct, including preventing plaintiffs from examining
corporate records and failing to notify plaintiffs of certain corporate meetings, was 'oppressive' conduct
within ORS 57.595 , such conduct was not so serious as to require dissolution of corporation or any
other equitable relief in view of fact that most of conduct complained of occurred during one year and did
not continue after that year.
Conduct of corporate directors or others in control of corporation need not be fraudulent or illegal to be
Though showing of "imminent disaster" is not required to authorize liquidation of assets and business of
a corporation pursuant to ORS 57.595 under illegal, oppressive, and fraudulent conduct or
misapplication and waste of corporate assets, liquidation is not available upon showing of mere vague
apprehensions of possible future mischief or injury or to extricate minority stockholders from an
investment that turns out to be a bad bargain.

While showing "oppressive" conduct by directors/others or proof of a deadlock among shareholders

may be sufficient to confer jurisdiction of minority stockholder's action to liquidate corporation under
ORS 57.595 , such showing does not require circuit court to exercise power conferred upon it by
statute and does not require either dissolution of corporation or any other alternative equitable remedy.
But may, as an alternative, consider other specified appropriate equitable relief.
For purposes of dissolution (as opposed to fiduciary), a "close corporation" is not like a partnership and
a minority stockholder does not have the right to demand dissolution of a corporation upon substantially
the same showing as might be sufficient for dissolution of a partnership.

D. Special Statutory Treatment of the Close Corporation

346-355, Delaware Statute and Notes and Questions
VII. Control of Publicly Traded Corporations
A. Shareholder Proposals
SEC Rule 14a-8, Shareholder Proposals (read the note)
Lovenheim v. Iroquois Brand, Ltd.
On shareholder's motion for preliminary injunction, the District Court held that shareholder
demonstrated likelihood of prevailing on merits with regard to issue of whether his proposed addition to
proxy materials being sent to all shareholders in preparation for an upcoming shareholder meeting was
"otherwise significantly related" to corporation's business within meaning of shareholder proposal rule,
thus entitling shareholder to a preliminary injunction to bar corporation from excluding from proxy
materials his proposed resolution related to procedure used to force-feed geese for production of pt de
foie gras" in France, a type of pt imported by corporation, despite fact that none of corporation's net
earnings and less than .05% of its assets were implicated by proposal; ethical and social significance of
shareholder's proposal warranted inclusion in materials. Motion granted.
In addition to considering likelihood of prevailing on the merits, the courts consideration of plaintiff's
motion for preliminary injunction requires a determination as to whether plaintiff will suffer irreparable
injury without such relief and whether issuance of requested relief will substantially harm other
parties, as well as consideration of public interest.
The court holds that it should not matter that shareholder's resolution was likely to fail at the
shareholder meeting in determining irreparable harm if corporation were permitted to exclude his
resolution from proxy materials being prepared for meeting.

B. Separating Economic Rights from Voting Rights

Stroh v. Blackhawk Holding Corp. (Illinois)
Action by class A shareholders' protective association for decree cancelling class B stock certificates and
restraining holders thereof from voting them at any shareholders' meeting. They claimed that class B
stocks were not valid shares of corporate capital stock in that their principal attribute consisted solely of
the right to vote.
SC Court: corporation's class B stock, holders of which were entitled to vote, were valid shares of stock

notwithstanding stock was not entitled to any dividends on voluntary or involuntary liquidation or
otherwise, and right to vote which they possessed was not separation of voting rights from ownership of
corporate shares.
The Illinois constitution requires only that the right to vote be proportionate to the number of shares
owned and did not require shares to be an investment in a corporation. It has long
been the common practice in Illinois to classify shares of stock so that one may invest less than another
in a corporation, and yet have control. The court concluded that a shareholder could be
deprived of an economic interest in the corporation but could not be deprived of his
voice in management.
In this case the parties went one step further than is customary. The stock which could be bought cheaper,
and yet carry the same voting power per share, was not permitted to share at all in the dividends or
assets of the corporation. However, this additional step did not invalidate the stock.
Rights conferred by the ownership of stock could consist of one or more of the
rights to participate in the control of the corporation, but did not require that the
shares possess an economic interest in the corporation.

C. Duties related to Transfer of Control

Zeitlin v. Hanson Holdings, Inc.
(1) absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad
faith, a controlling stockholder is free to sell and the purchaser is free to buy that controlling interest at a
premium price without the purchaser being obliged to extending a tender offer to all shareholders, and
(2) adoption of rule that a controlling interest may be transferred only by means of a tender offer (offer to
all stockholders) by the purchaser would be contrary to existing law and so radical a change that it
would be best effectuated by the legislature.
Although minority shareholders are entitled to protection against abuse by controlling shareholders, they
are not entitled to inhibit the legitimate interests of the other stockholders (compare to close corps).

D. The Discretion of the Board in an Endgame Situation - Hostile Takeover Attempts

and Management Defensive Tactics
1. 356-372, Paramount Communications, Inc. v. Time, Inc.(Delaware)
Directors are not required to favor a short-term shareholder profit over an ongoing long-term corporate
plan as long as there is a reasonable basis to maintain the corporate plan.
The Delaware Supreme Court affirmed the lower courts holding in Defendants favor. The court
distinguished the Revlon decision as concerning a company that already was determined to sell itself off
to the highest bidder, and therefore the only duty owed at that point was to the shareholders. However, in
this case, Time only looked as if it were for sale as it moved forward on a long-term expansion plan
(Revlon wasnt triggered). Various facts, such as Times insistence on ensuring the journalistic
independence and its temporary holding of the CEO position, illustrated that the directors were not
simply selling off assets. Once it was determined that the directors decision passed the Revlon test, the
Unocal test was applied. The directors also passed the higher standard called for in Unocal to directors
who are rebuffing a potential buyer. The directors reasonably believed, after researching several
companies, that a merger with Warner made the most sense as far as future opportunities and
maintaining their journalistic credibility. BoD got to decide but not BJR.

Revlon rule: The legal requirement that a BoD make a reasonable effort to obtain
the highest value (short-term) for a company when a hostile takeover is imminent
(not necessarily an auction). Boards fiduciary duty is limited to protecting a
company from external threats: under normal conditions a director is not required
to negotiate with any hostile bidder. But of course BoD cant favor a bidder with
whom they have interest. If yes entire fairness (not BJR).
Unocal standard: the Court held that a BoD may only try to prevent a take-over
where it can be shown that there was a threat to corporate policy and the defensive
measure adopted was proportional and reasonable given the nature of the threat.
Take-over defenses are appropriate.

2. 372-397, Paramount Communications, Inc. v. QVC Network, Inc.

A merger agreement between a target company and an acquiring company that restricts (by way of
merger defensive provisions) the target companys directors from upholding their fiduciary duties owed to
their shareholders is invalid.
QVC offered more than Viacom to buy out Paramount, but Viacom put defensive measures (no-shop,
break-up fees) to thwart any other bidder.
The Delaware SC held that the merger between Paramount and Viacom should be enjoined, and that the
merger agreement (that included the defensive measures) was invalid. Defendants argued that they were
under no obligation to seek the maximum value for shareholders under the Revlon rule because there was
no breakup of the company, but the court determined that the company was shifting its control to another
entity and therefore the sale of Paramount reached the point to where the prime concern for the
Paramount directors was to maximize shareholder value. Paramount was under no contractual
obligation to avoid discussions with QVC because the merger agreement between Viacom and Paramount
was invalid. Court (applied Revlon): Shareholders should get Control Premium keeping in mind the
fact that there was a competing (QVC) Offer. Corporate law does not operate on the theory that
directors, in exercising their powers to manage the firm, are obligated to follow the wishes of a majority
of the shares.
If court rules out defensive measures/agreement shareholders decide (Revlon) and BoD are out.
The more defendants can show procedural fairness, the less likely it is that a court will overturn the
directors determination as to the economic fairness of a transaction. On the other hand, the court paid
attention that shareholders will lose complete control (Break-up Revlon), hence raised its standard
against the BoD.

Moran v. Household (poison pills are allowed)

The pill changed everything. Instead of 20 business days, boards now often had months to consider,
respond to and craft alternatives to unsolicited bids. And, contrary to the arguments of the plaintiffs in
Household, the pill actually revived the importance of proxy contests as a means of determining a
corporations future.
Secure in their ability to resist hostile bids, directors have used this authority to enhance shareholder
value. And directors can use this same power to resist a transaction they reasonably believe to be
insufficient or unduly speculative a power of no mean significance, protective of the interests of
shareholders and, indeed, every corporate constituency.

E. Valuation
397-405, Piemonte v. New Boston Garden Corporation
The judge weighted the three valuations as follows: 10% Market Value; 40%
Earnings Value; 50% Net Asset Value.
Yes, the 10% was appropriate because of the lack of trading volume of the stock.
He was entitled to reconstruct and not to pure market value. Fair market value is
better for highly traded stocks on high value exchanges. Where there isnt an
established market for such a stock, fair market value isnt possible and a judge
usually reconstructs the value on his own, but doesnt need to do so. The stock at
issue was rarely traded on the Boston stock exchange.
Valuation based on earnings Judge used last five years worth of earnings to
project $52/share, excluded extraordinary gains and losses, and then allows the
appraiser to select a multiplier that suits the industry. The judge didnt use a
specific multiplier for the industry, and instead made his own based on the
favorable financial prospects of the company. He then factored in particular risks to
the company as well and arrived at 10X multiplier. The judge in this case did not
abuse his authority in excluding a year with significant expansion income.
Valuation based on Net Asset Value The judge valued each entity separate and
arrived at a total valuation of $23.2M.
Ds argue there is double counting of assets in this manner. They also argue that the
judge shouldnt have refused to deduct $1M, which represented the good will of
the Bruins. Court says the judge wasnt plainly wrong. Ps argue judge didnt
explicitly value the Boston Garden. The judge did not give reason for including it in
the 9.4M book value. Court says judge should do so on remand.
The judge stated he was constrained to accept the Ds experts valuation of the
Bruins franchise. Court says this is wrong and that judge should make his own
determination on remand, which he is free to do. Court also says he was wrong in
bluntly accepting the Ps expert testimony on the value of concessions, where the
Ds didnt submit any opinion. They remand for the judge to make his own

F. Freeze-Out Mergers
Del. Gen. Corp. Law 262 (merger procedures)
405-421, Weinberger v. UOP, Inc.
A majority shareholder owes a fiduciary duty to minority shareholders to provide all relevant
information that would pertain to a proposed cash-out merger.
The Supreme Court of Delaware held that the shareholder vote was not an informed vote and
that Signal breached their duty as a majority shareholder of UOP to the minority shareholders of
UOP. Therefore the minority shareholders are entitled to a greater value (to be determined by
weighing all relevant factors such as the Arledge-Chitiea study value). The evidence indicated a

lack of fair dealing by the majority, such as withholding the Arledge-Chitiea report from the
UOP board and the shareholders. The only information the outside directors of UOP had at their
disposal was a hurried fairness opinion by an arguably interested party. The board members that
served with Signal and UOP breached their duty as UOP directors as well by not providing
Arledge-Chitiea study. They are not exempt from their duties because the entities are a parent
and a subsidiary (every BoD owes duty to his company regardless of other positions).
In re MFW Shareholders Litigation (not on the exam)
This case provides controlling shareholders a clear outline of how to avoid entire fairness review
in favor of more advantageous business judgment deference. Under In re MFW, controlling
shareholder transactions would be judged under the business judgment rule if:
(1) the transaction is approved by both a special committee and a majority-of-theminority vote;
(2) the special committee is independent of the controlling shareholder;
(3) the special committee has power to reject the proposal and is free to retain
independent legal and financial advisors;
(4) the special committee meets its duty of care; and
(5) the minority vote is non-waivable, fully informed, and uncoerced.
G. A Note on the Williams Act and State Statutes
422-424, Note