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Business Associations

Lecture 1 Chapter 1: Introduction to the Firm

Statutes trump case law

The legislature has the power to make the substantive law.
Qualification: The legislature cant overturn the constitution or a courts interpretation of
By enacting a statute, the legislature can:



reverse any common law doctrine or court opinion regarding a common law
doctrine and


overrule any courts interpretation of a state statute, including the Supreme Courts.

What are Business Association

A. Definition



The contract arrangement among people in a business Aggregate theory


The artificial person the law creates Entity theory

Partnership, Corporation, LLC, LP, Professional Corporation (law firms), Corporation Sole (one
person religious)
Nonprofit association, Nonprofit public benefit corporation, etc.


Three study contexts (by the numbers of investors, not the size of the business)
A. Public Companies (thousands of investors). Corporations

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8,000 public companies in the US

Focus: Decision making about mergers, sales, and "governance"

Small Group (2 to 10 investors). Partnerships, corporations, LLCs

Hundreds of thousands in US
Focus: Contract among the principals


One Person. Corporations, LLCs

Millions in the US
Focus: Formalities, limited liability, veil piercing, entity structures, judgment proofing

III. Basic concepts:

Partnership means an association of two or more person to carry on as co-owners a business for
profit. RUPA 101(6)
Joint venture. A partnership with a limited duration or scope.
Joint venture relates to a single transaction, while partnership relates to a general and
continuing business. 186 F.2d 315.
Co-adventurers. Members of a joint venture.
Fiduciary duties: principally good faith, loyalty, care, information
Important Rules re Fiduciary Duties in RUPA:
404(b) opportunity is [a]n opportunity that [1] is closely related to the entity's existing
A partnership
to the
and the other
is limited
to the and
or prospectiveduty
would competitively
[3] is one
that the partnership has the financial ability, knowledge and experience to pursue. 404 F.3d(derived
by the partner in the conduct . . . of the partnership business) or (derived from a use by the
partner of partnership property), including the appropriation of a partnership opportunity;
(2) . . . .
(3) to refrain
IV. Fiduciary
Duties from competing with the partnership in the conduct of the partnership business
before the dissolution of the partnership.
RUPA 403(c)
Each partner shall furnish to a partner without demand, any information concerning the
partnerships business and affairs reasonably required for the proper exercise of rights and duties.
RUPA 103(b)
The partnership agreement may not: (3) eliminate the duty of loyalty under Section 404(b) . . . but
(i) the partnership agreement may identify specific types or categories of activities that do not
violate the duty of loyalty, if not manifestly unreasonable.
RUPA 202(a)
[T]he association of two or more persons to carry on as co-owners a business for profit forms a
partnership, whether or not the persons intended to form a partnership.
RUPA 202(c)
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In determining whether a partnership is formed, the following rules apply: (3) A person who
receives a share of the profits of a business is presumed to be a partner in the business, unless the
profits were received in payment: (v) of interest or other charge on a loan, even if the amount of
payment varies with the profits of the business. (Exception to the default rule)

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Meinhard v. Salmon (1928) (most famous of Business Associations cases, fiduciary duties under
partnership) compared the corporate opportunity doctrine in Chapter 20 - the 5 elements test
(which results in a very weak corporate opportunity case refer to the slides of Application of Guth
test to Salmon)
Salmon had a joint venture with Meinhard for a lease of 20 years; both contributed half of
investment for a building lease and Salmon managed the building
New owner wants to build a new building in place of the current one
That new owner approaches Salmon with an opportunity to buy the lease
Salmon forms Mid-Point Realty and takes the lease on his own, without telling Meinhard
The deal was a joint venture, so Salmon owed fiduciary duties
Salmon had to disclose the partnership opportunity to his co-adventurer.
[Implicit] Meinhard had no right to share in the deal with Salmon because the joint venture as
complete, only a right to compete but the lease deal related to, arose out of the business
Court grants Meinhard with 49% of the new company (hold as trustee).
Consequence under current law (RUPA 404(b) & 403(c)):

Salmon derives the new lease in the conduct of the partnership business. Gerry (the
new owner) figured to himself beyond a doubt that the man in possession would prove a
likely customer. Salmon must take Meinhard along.


The new lease opportunity is information concerning the partnerships business and
affairs. Salmon approached in his capacity as a partner.


The new lease opportunity information is not reasonably required for the proper exercise of
(Meinhards) rights and duties. Meinhard cannot exercise partnership rights. Salmon
need not furnish the info to Meinhard but must take him along.


It is 1922. We are attorneys for Salmon when Gerry approaches. What is our advice to
A: Tell Meinhard.


Salmon tells Meinhard. We represent Meinhard. What advice?

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A: Meinhard probably cant force Salmon to take him along.


Partnership cant compete for the lease (20 year limit of the first lease), so Meinhard cant
stop Salmon.
A: Meinhard could compete with Salmon for the lease.


We are attorneys for Salmon before he enters into his next real estate deal. What is our
advice to Salmon? Can Salmon disclaim the obligation to tell Meinhard about lease
renewal opportunities?
A: RUPA103(B). Let Salmon disclaim the obligation to tell Meinhard re the new lease


We are attorneys for Salmon before he enters into his next real estate deal. What is our
advice to Salmon?
A: Do not form a partnership and use Meinhards capital as a loan.
Could Salmon borrow the $100,000 from Meinhard and agree to pay Meinhard half the
profits as interest on the loan?
A: RUPA 202(c). The profit received by Meinhard is for payment of loan interests. It is
an exception of presumed partnership stipulated by the law.

Important Rules re Fiduciary Duties in ULLCA:

ULLCA 409(b)
A member's duty of loyalty to a member-managed company and its other members is limited to the
(1) to account to the company and to hold as trustee for it any property, profit, or benefit
derived by the member in the conduct or winding up of the company's business or derived
from a use by the member of the company's property, including the appropriation of a
company's opportunity; [and]
(3) to refrain from competing with the company in the conduct of the company's business
before the dissolution of the company.
ULLCA 103(b)(2)
The operating agreement may not . . . eliminate the duty of loyalty under 409(b) . . . but the
agreement may . . . identify specific types or categories of activities that do not violate the duty of
loyalty, if not manifestly unreasonable . . . .

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McConnell v. Hunt Sports Enterprises (1999) (fiduciary duties under LLC members, whether
members can define their fiduciary duties in the operating agreements)

Hunt, McConnell, others form CHL, apply for franchise from NHL.

Hunt starts negotiating with Nationwide on behalf of CHL. NHL deadline is June 4, 1997.
1.6. Why no deal by May 30?
Answer: Hunt says team will lose millions.


On May 30, McConnell told Nationwide If Hunt wont step up and lease the arena,
therefore get the franchise, I will. 1.7. Affect CHLs negotiating position?
Answer: Undercuts Hunt.


McConnell makes the deal and sets up his own group.


McConnell sues and wins.

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Court: Section 3.3 of the operating agreement of CHL entitles each member (including
McConnell) to compete with the business of the LLC.
Section 3.3: Members may compete. Members shall not in any way be prohibited from
or restricted in engaging or owning an interest in any other business venture of any
nature, including any venture which might be competitive with the business of the
Q: why have Section 3.3 in the operating agreement?
A: Maximize chances of everyone to make a deal, so the city of Columbus can get the
Q: Does Section 3.3 eliminate the duty of loyalty or does it merely approve specific
categories of activities?
A: It approves a specific category that is almost elimination of the loyalty duty. But Section
3.3 survives.
Q: Since Section 3.3 is a specific category agreed by all members, is it manifestly
A: In this public spirit context, it is reasonable to agree that members will bid against one

[Thoughts: The court relied on general contract law to justify LLC members to define their
fiduciary duties. If parties agree to be held to a certain set of conditions, courts try not to disturb
the agreement unless there are statutory or strong public policy concerns.]

Fiduciary duties run...



Fiduciary duties are central in Business



General pattern: they run from labor to capital


Rational-actor model holds that self-interested

action is efficient.


Fiduciary duties require some to act for others.




Partnership, partners


Member-managed LLC

Reasoning: Implicit dependency; unable to

monitor. Is that true?


Manager-managed LLC

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Fiduciary duties limit freedom of contract;

some states do not impose them in LLCs.




Directors, Officers


Major shareholder

Minority shareholder



Sole Proprietorship

RUPA 202(C) Formation of a Partnership

(c) In determining whether a partnership is formed, the following rules apply:
(1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property, or
part ownership does not by itself establish a partnership, even if the co-owners share profits made by
the use of the property.
(2) The sharing of gross returns does not by itself establish a partnership, even if the persons sharing
them have a joint or common right or interest in property from which the returns are derived.
(3) A person who receives a share of the profits of a business is presumed to be a partner in the
business, unless the profits were received in payment:
(i) of a debt by installments or otherwise;
(ii) for services as an independent contractor or of wages or other compensation to an employee;
(iii) of rent;
(iv) of an annuity or other retirement or health benefit to a beneficiary, representative, or designee
of a deceased or retired partner;
(v) of interest or other charge on a loan, even if the amount of payment varies with the profits of
the business, including a direct or indirect present or future ownership of the collateral, or rights
to income, proceeds, or increase in value derived from the collateral; or
(vi) for the sale of the goodwill of a business or other property by installments or otherwise.
Definition: A business owned and operated by one person.
A sole proprietorship is not an entity separate from the person
The proprietor owns the business (and personal) assets and owes the business (and personal)
The sole proprietorship can operate under a fictitious / imaginary name. (e.g., Midtown Office

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Name registration is required.

Sole proprietors can split profits with business associates (but not be considered as a presumed
partnership - RUPA 202(c))
Employee (percentage of profits as bonus)
Lender (percentage of profits in lieu of interest)
Lessor (percentage of profits included in shopping center rents)
Many law firms are sole proprietors sharing office expenses.

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Lecture 2 Chapter2: Corporate Basics (Part 1)

Basic Concepts
Corporate Categories
(1) "Public" vs. "Close"
Principal requirement: maximum of 30 shareholders (DGCL 342)
(2) Tax status
C Corporations (most public corporations)
Taxed on its income
S Corporations (many close corporations)
Sends a notice to each of its owners informing them of their proportionate share
of income in the corporation
Principal requirement: small number of shareholders
Not-for-profit corporation
Qualifies for and elects that status under state law
Has members, not shareholders
Corporate Characteristics
(1) Separate entity - every corporation is a legal entity that is separate from the investors who
provide it with money and the people who manage its business
(2) Perpetual existence - a corporation has an unlimited life
(3) Limited liability - a corporation's shareholders cannot lose more money than they invested
(4) Centralized management - shareholders elect a corporation's directors, who have the
power to manage and oversee the corporation's business
(5) Transferability of ownership interests - shareholders can transfer to others their ownership
interests in a corporation
Corporate Actors

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(1) Shareholders - often described as the "owners" of the corporation

(2) Directors - individuals who are elected by the shareholders to be responsible for managing
or supervising the corporation's business
Directors are in charge, not the shareholders or officers
Although close corporations can elect "shareholder management; they have no
board of directors
Directors are not employees of the corporation, though they can be (in which case they
are an "inside" director)
Important questions: Is the director "disinterested" (i.e. not financially interested in a
particular corporate decision) or "independent" (i.e. not beholden to an interested
(3) Officers - corporate employees, including the CEO, CFO, VPs, Secretary, Treasurer, and
There are no particular officers that a corporation must have
But they must have any officers required by the bylaws or board resolutions
Someone (usually the secretary) must keep track of the minutes (DGCL 142(a))
(4) Stakeholders - everyone with a financial interest in the corporation:
(a) Creditors (including bonds)
NOTE: Creditors are entitled to payment first, before shareholders
(b) Employees
(c) Customers
(d) Suppliers
(e) Taxing authority
(f) The public
(g) Also includes shareholders, directors, and officers
Corporate Securities
(1) Debt securities

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Least risky security and lowest expected return

These payments have priority if the corporation becomes insolvent
Typically yields only fixed payments of interest over time
Bonds or debentures are:
Promises to pay money
Securities because issued in series (each same as the others)
Bonds are typically:
Unsecured debts (no collateral)
Issued in denominations of $1,000, priced as $100
Can be publicly traded
Bonds rarely vote, but can be quasi-stock.
(2) Equity securities
(a) Common shares
Greater risk and return than debt securities
Paid last if corporation becomes insolvent
Have a claim to residual financial rights to corporation's income and assets
Entitled to whatever is left after corporation has paid all of its debts
Can receive payment through "dividends" (at discretion of Board)
(b) Preferred shares
Greater rights to dividends than common shares
If corporation decides not to give dividends to preferred shareholders, it
cannot give dividends to common shareholders
Less risky than common shares, more risky than debt
Lower rate of return than common shares, but greater than debt
Authorized/Issued/Outstanding shares

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Authorized - authorized to be issued by the articles of incorporation

Issued - authorized by the articles of incorporation and in possession of shareholders
Outstanding - authorized by the articles of incorporation, but not currently held by a
Concepts Relating to Corporate Fiduciary Duties
(1) Duty of Care - requires managers to be attentive and prudent in making decisions
(2) Duty of Loyalty - requires managers to put the corporation's interests ahead of their own
(3) Business Judgment Rule - courts defer to the judgment of the board of directors absent
highly unusual circumstances, such as a conflict of interest or gross inattention
(4) Liability to corporation and shareholders - corporate managers who breach their fiduciary
duties can be held liable for any losses they cause the corporation
Derivative suit - action in equity brought by a shareholder on behalf of the corporation
Any recovery belongs to the corporation for whose benefit the suit has been
(5) Duties of shareholders
Almost none, with one exception:
If shareholders exercise control through their share ownership, courts often will
hold that the shareholders owe fiduciary duties to other shareholders
Why Delaware
Current claims:

enabling rather than regulatory

Court of Chancery

Greater predictability

Corporate Law vs. Other Areas of Law

Internal affairs doctrine choice of law rule

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In general, the law of the state of incorporation governs any disputes regarding that
corporations internal affairs (e.g. relationships between owners and managers, litigation
involving the corp.s shareholders and managers may arise)
Internal Affairs: the matters peculiar to the relationship among the corporation and its
officers, directors, and shareholders.
Rationales: certainty on application of choice of law; implied contract
Alternatives to Internal Affairs Doctrine:
General conflicts rule: law of state with the greatest interest applies
Pseudo-Foreign Corporation Doctrine (California Rule):
Real Seat Doctrine: physical location of a corporation determines its charter (generally
accepted in European Union)
Federal incorporation: federal government grants charters.

External affairs are generally governed by the law where the activities occur and by federal
and state regulatory statutes. (For example, a states employment law governs conditions of
employment of all business operations within the state, wherever the business might be
incorporated. When corporations enter into contracts, commit torts, and deal in property, the
internal affairs doctrine does not apply.)
Sometimes corporate activities can be governed by both internal and external rules. (e.g. state
corporation law controls the right to merge and the procedure to be followed, but mergers are
also independently subject to federal antitrust laws and securities laws.)

McDermott Inc. v. Lewis (Del. 1987)

Whether McDermott Delaware, a subsidiary of McDermott International (a Panamanian
corporation), may vote the shares it holds in its parent company in a reorganization of
McDermott Delaware under circumstances which prohibited by Delaware law, but not the law of
Trial court refused to apply Panamanian law as the law governing the internal affairs of
McDermott International.
The appellate court reversed the trial courts judgment, and conceded that the Panamanian law is
the law governing the internal affairs (including the voting rights issue at bar) of McDermott

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DL court upholds the internal affairs doctrine which matters the most in the charter competition.
DL corporation has values only if other jurisdiction applies DL law.

Denial of application of DLGC 160(C): POLICY BASIS directors should not be able to reelect themselves. They could if treasury shares voted. Therefore, treasury shares cannot vote.
RATIONALE: outsiders (shareholders) should control the corporation. Voting treasury shares
interferes with outsider control.
Counter-rationale: non-profit corporation practice, shareholders may sell their shares anyway.

State Regulation of Pseudo-Foreign Corporation (i.e. corporations incorporated outside the

state, but conducting most of their business and having most of their shareholders in the state)
California Corporation Code 2115:
Pseudo-Foreign Corporation Rule:

More than 50% of payroll, property, and sales in state

More than 50% the voting securities held in state

Covers a wide range of corporate internal affairs, but not applicable to public
corporations whose shares are traded on NYSE or Nasdaq National Market.

Views from 2 courts:

California: 2115 is reasonable.
Delaware: 2115 is unconstitutional.

Organizational Choices
4 Basic Types of Entities
(1) Corporation
(2) GP and LLP
(3) LLC

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(4) LP and LLLP

Default Organizational Rules (rules with asterisks cannot be changed)




State charter?***




Legal entity?***




Minimum persons***




Limited liability?




Managed by?


Board of directors


One vote per




Basic changes?


Majority, 2/3s


Pay income tax?

Pass through


Pass through

Get money back?

Yes, 801(1)


Yes, 701(b)

Interest saleable?

Economic only


Economic only

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Profits shared by




Effect of Limited Liability

Limited Liability protects shareholders
corporation's/LLC's/LLP's/LLLP's employees







Two Notable Exceptions:

(1) CA: An attorney, the LLP, and the paralegal can all be liable for the paralegal's negligence
while under the supervision of the attorney
"An attorney who uses the services of a paralegal is liable for any harm caused as the
result of the paralegal's negligence, misconduct, or violation of this chapter." Cal. Bus.
& Prof. Code 6452(b).
(2) NY: An attorney, the LLP, and anyone working under the direct supervision of the
attorney can all be liable for the negligence of the individual working under the attorney's
[E]ach partner, employee or agent of a partnership which is a registered limited liability
partnership shall be personally and fully liable and accountable for any negligent or
wrongful act or mis6 conduct committed by him or her or by any person under his or
her direct supervision and control while rendering professional services on behalf of
such registered limited liability partnership . . . " New York Partnership Law, 26(c)
The parties can change the default rules by contract
RUPA 103(a) (Subject to 103(b)); ULLCA 103(a) (Subject to 103(b)); DGCL sets out
which provisions can be modified section by section
A corporation can choose to be managed by shareholders
Give investors any/no voting rights
Make interests/shares transferrable or not
Give investors the right to withdraw investments or not
Share profits by whatever agreements you choose

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Entity Choice Matters

There are some mandatory rules, especially for corporations
Regulatory law: securities exchange rules; investment regulation
Cost of contracting: suits "off the rack" are cheaper than custom
Drastic modification may cause legal uncertainty
Most business people don't modify
And most lawyers don't modify effectively
Choosing the Right Entity
1. Be aware of industry specific rules
e.g. CA law firms can't be LLCs
2. Copy the choice of others in the industry
3. Choose the entity type with default rules that fit clients most closely
Reason for Default Rules (instead of regulation): competition for fees
Each entity pays about $100/year to the state of incorporation
States compete for this money by offering choices instead of mandatory rules
Pass through tax treatment
NOTE: S vs. C Corporation is a tax election, not an entity type election
Pass through is usually better, but not always
What is better depends on:
(1) expected profitability
(2) plans for use of revenues
(3) tax situations of the investors
Profitable business, all paid to investors - Corporate tax treatment results in partial
double taxation

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Profitable business, none paid to investors - Corporate tax treatment can save money
Losing business - Pass through treatment can save money if the losses can offset the
income (this is a tax question)
Profitable business, all paid, but salary - corporation and pass through cost the same in
Although IRS may seek to characterize the salary as a dividend
Choice of Entity Example
Situation: Investor and Manager work for 6 weeks to establish a restaurant. Investor contributed
$500,000 for capital and Manager contributed his labor. One or both of the parties wants to end
their business relationship. What should be done?
Generalization: A business should repay the value of contributions, split the rest per-person or by
level of involvement.
Almost the default deal for Partnership:
1. $500k goes to investors partnership account, RUPA 401(a), paid first 807(b)
2. Each partner has right to dissolution which forces sale. RUPA 801(1).
3. No priority for labor contributed. Considered a soft investment.
What is the default deal for a Corporation?
Answer: Dissolution only by agreement. All distributions are to the shareholders, pro
rata by shares.
Legal tools for committing to return value of investments:
All entities: debt (soft or hard)
Partnership: capital account
LLC: contribution account
Corporation: preferred stock
Selling Charters
Most artificial entities have only a single owner.
The cost of a California entity is $800 to $12,000 in fees to state.

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Limited liability is the principal advantage over sole proprietorship.

So California makes more than $1 billion a year selling limited liability.
Irony: Government creates vicarious liability; then sells exemptions from vicarious liability.
Increase in LLC Use - Hauserman article
Reality contrasted with theory of LLC / corporation choice across states.
LLC use is increasing rapidly. Fewer than corporations in 1999 to 2.7 times corporations in 2009.
LLCs 25 times LPs by 2004.
LLC use varies widely from state to state
Connecticut, LLCs by 12:1; Ohio 6:1
New York, California, Illinois have fewer LLCs than corporations
Only three statistically significant factors. Choice favors LLCs if:
Formation cost of LLC is lower in relation to corporation
LLC law has a freedom of contract provision
Members can withdraw their investment from an at will LLC
No robust correlation with any other substantive provision
Incorporators are not choosing features; just minimizing costs.
But this cost minimization only occurs at the beginning
It actually becomes more expensive later on
Unintended partnerships
Constructive Intent to Form Partnership
Bender elements for existence of a partnership:
(1) Clear intent to associate as partnership
MacArthur court: this can be constructive intent (i.e. the parties intended the
actions that fulfilled elements 2-4)

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BUT: Professor thinks this is a slippery slope to lender liability and MacArthur is
an expansive view of partnership based on the court's perception of Stein as a
(2) Contribute something that promotes enterprise
(3) Right of mutual control
(4) Share profits of enterprise
MacArthur Company v. Stein
Stein makes a name-sharing contract with Potter and Beebe
Potter and Beebe run up a $39,000 account with MacArthur and abscond
MacArthur sues Stein on a partnership theory
Court: Partnership existed.
Stein intended to contribute something that promoted his enterprise with them
Stein intended to create a right of mutual control for each of the three of them
Stein intended for each of them to share the profits of the enterprise.
Irrelevant whether he intended to form a partnership
Could the bank (MacArthur) have been a partner on the court's theory of partnership?


Steins deal

Banks deal

Contributes something

Name, leads

Loan proceeds

Joint interest, control

Oversight, terminate

Inspection, on demand

Share in profits

3%, 10% of revenues

2% of gross revenues

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Intended to do each?




Stein is a partner

Is bank a partner?

1. Loan to partnership is a slippery slope (lender liability).
2. Stein case is an expansive view of partnership (court thinks Stein is a crook)
Partnership by Estoppel
UPA 16(1) - A person who represents himself, or permits another to represent him, to
anyone as a partner . . . with others not actually partners, is liable to any [representee] who
has, on the faith of the representation, given credit to the actual or apparent partnership. See
Young v. Jones
NOTE: Use of term "partner" has become so loose that courts can't really enforce RUPA
308(a) (successor to UPA 16)
Many advertisements of "partnerships" do not refer to actual legal partnerships
e.g. Google or IBM indicates they are "partners" with a particular entity; they mean that
they are working together in some capacity, not that they have formed a legal
Partnership Accounts - Winding Up
General Rule: absent an agreement, partners share losses as they share gains (equally)
Special Rule: where one partner contributes money against the others labor, neither party is liable
to the other
Kovacik v. Reed (Supplement, p. 66)
Kovacik and Reed go into business remodeling kitchens.
They agreed to share profits equally; no agreement re losses
Reed works for nine months without salary remodeling kitchens.
Business loses $8,680. Kovacik sues Reed for half the losses, $4,340.

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Court: general rule is that, absent an agreement, partners share losses as they share gains
BUT: there is a special rule. Where one partner contributes money against the others
labor, neither party is liable to the other. Reed wins.
Relative Level of Education and Business Sophistication is irrelevant in these types of cases
Professor thinks it should be relevant
Theory of Start-Up Structure
Justin, Kathy and Lorenzo are going into business together; plan to make millions
Justin has expertise, will run JKLs business full time for an estimated three years, then sell it.
Kathy will contribute her going business.
Lorenzo will contribute $150,000 cash.
Deal: The contributions are of equal value; each gets a third of the stock
Three months later, they are squabbling, and the business is dead.
JKL has $100,000 in cash; other assets that liquidate for $50,000.
In a corporation, who gets the $150,000?
Answer: Each gets $50,000 because each owns a one-third interest
In a partnership, who gets the $150,000?
Answer: Each gets $50,000 based on partnership accounts? The deal overrides
401(a), see 103(a ) and 807(b). Is that fair?
Better Approach:
Professor David Herwitz: Business should pay for resources as used.
Each has the right to his/her contribution, plus a third ownership.
1. Justin gets a salary of $50,000 a year, paid or accrued as worked
2. Kathy gets a promissory note secured by the business assets
3. Lorenzo gets a promissory note secured by the cash

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4. $300k assets, $300k liabilities. Stock value is the synergy value

Forming the Corporation

The Incorporation Process
1. Reserve the name. DCGL 103(e) check the availability online but not timely exact.
2. Contract for a resident agent (recorded in AOA). DCGL 132(a) and (b)
3. Incorporator files certificate of incorporation and pays the fees. Corporation now exists. DGCL
4. Purchase a corporate kit (will circulate)
5. Incorporator convenes organizational meeting, DGCL 108(a)
(a) Incorporator adopts bylaws. DGCL 107
(b) Incorporator elects directors. DGCL 107
(c) Directors appoint officers. DGCL 142(b), Facebook bylaws 4.1
(d) Directors adopt corporate seal (optional). DGCL 122(3).
(e) Directors designate a bank account. (commingling)
(f) Directors authorize, and officers issue, shares. DGCL 151(a).
Law of Corporate Names
DGCL 102(a)(1): [T]he name of the corporation . . . shall be such as to distinguish it upon the
records . . . of the Division of Corporations . . . from the names . . . of each other corporation,
partnership, limited partnership, limited liability company . . .
From Delaware Corporation Law and Practice:
1. The corporate designator is an insufficient distinction.
Smith Corp. will not be accepted if there is a Smith, Inc.
2. Differences in punctuation or typography are not sufficient.
A.B.C. Insurance, Inc. preempts use of ABC Insurance, Inc.

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All States Widget Co. preempts Allstates Widget Co.

3. Differences can be as little as one letter
Brown Corp. will not preclude Browne Corp.
Choice of the State of Incorporation
1. Corporations can incorporate anywhere, do business anywhere.
2. Corporate havens offer advantages to corporate insiders.
3. A corporation must (1) pay fees to its state of incorporation, and (2) register as a foreign
corporation in each state where it does business and pay fees to that state.
4. The fees for doing business in a state are generally the same as the fees for incorporating in
the state.
5. A Delaware corporation doing business only in California pays both states fees.


Corporation Fees

LLC Fees Franchise (income) tax




$800 and up after first year








$75 to $180,000




$150 for corporations only

Books and Records

1. A corporation is an artificial being, invisible, intangible, and existing only in
contemplation of law. Dartmouth College Case

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2. Physical manifestations charter, Secretary of States website, the corporate kit

3. Leather binding, metal hinges, gold leaf 100 years
Corporate seal
Application for Employer Identification Number (EIN)
Sample documents Articles to minutes
Difficult-to-reproduce preprinted cardboard separators
Membership certificates, transfer form on back
Membership register (Stock register)
Formation of a Limited Liability Partnership (LLP)
An LLP is a partnership with limited liability (e.g., Kirkland & Ellis, LLP)
To form a partnership requires only on step: a partnership agreement (oral or written)
For a partnership to become an LLP requires three steps:
1. Elect internally to become an LLP, RUPA 1001(b)
2. File a Statement of Qualification, RUPA 1001
Adopt a name that includes LLP or like 1002
Designate an office in the state or appoint a resident agent to receive service of process,
3. File annual reports, RUPA 1003
RUPA 201(b). A limited liability partnership continues to be the same entity that existed before
the filing of a statement of qualification . . . .
Foundational Documents
The contract is in the foundational documents
Corporation: Articles (Certificate) of incorporation; bylaws
Partnership: Partnership agreement
LLC: Articles of organization, Operating agreement

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Foundational documents could say almost anything

They actually use variations on same forms and concepts
Significance of par value: Higher par value restricts corporate action; may render stock
"Shelf" (?) preferred shares: the foundational documents authorize preferred shares but do not
indicate the number of votes each share has so that the board can assign a large number of votes to
preferred shares to avoid being outvoted on something
Attorney-Client Relationship
Lawyers have obligations to clients (primary) and public (secondary)
An attorney-client relation exists whenever an individual seeks and receives legal advice
from an attorney in circumstances in which a reasonable person would rely on such advice,
[or if the client believes] he is consulting with an attorney for the manifest purpose of
obtaining legal advice. Manion v. Nagin.
Duties to Clients
Rule 1.6 (a) A lawyer shall not reveal information relating to the representation of a
client unless the client gives informed consent, the disclosure is impliedly authorized in
order to carry out the representation or the disclosure is permitted by paragraph (b).
Rule 1.4(a) A lawyer . . . shall keep the client reasonably informed about the status of
the matter.
Conflict of Interest
Rule 1.7(a). [A] lawyer shall not represent a client if the representation involves a
concurrent conflict of interest. A concurrent conflict of interest exists if:
(1) the representation of one client will be directly adverse to another client; or
(2) there is a significant risk that the representation of one or more clients will be
materially limited by the lawyer's responsibilities to another client . . . .
Duty to Client in Event of Wrongdoing
Rule 1.13(a). A lawyer . . . retained by an organization represents the organization
acting through its duly authorized constituents.
Rule 1.4(a). A lawyer . . . shall keep the client reasonably informed about the status of
the matter.
Rule 1.13(b). If a lawyer for an organization knows that an officer . . . is engaged in
action . . . that is . . . a violation of law that reasonably might be imputed to the

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organization, and that is likely to result in substantial injury to the organization, then
the lawyer shall proceed as is reasonably necessary in the best interest of the
organization. Unless the lawyer reasonably believes that it is not necessary in the best
interest of the organization to do so, the lawyer shall refer the matter to higher authority
in the organization, including, if warranted by the circumstances to the highest
authority that can act on behalf of the organization as determined by applicable law.
Rule 1.13(c). [I]f (1) despite the lawyer's efforts . . . the highest authority . . . fails to
address in a timely and appropriate manner an action . . . that is clearly a violation of
law, and (2) the lawyer reasonably believes that the violation is reasonably certain to
result in substantial injury to the organization, then the lawyer may reveal information .
. . [despite] Rule 1.6.
NOTE: 5th Circuit case has held that there is a difference between knowing something
and having reason to believe it; only have to act when you know something
Ultra Vires: "Beyond the Powers"
Corporations automatically receive a broad grant of powers
In addition, they can elect any power not contrary to law
DGCL 102(b)(1): The certificate of incorporation may contain: Any . . . provision creating,
defining, limiting and regulating the powers of the corporation . . . if such provisions are not
contrary to the laws of this State.
Corporations can elect to limit their powers (e.g. No derivatives trading)
Acts that exceed the limitations are "ultra vires."
Consequences of Ultra Vires Actions
Ultra vires acts are not invalid. DGCL 124
Powers are public record, but third parties are not expected to discover them
BUT: ultra vires acts can be enjoined or punished
If a corporation is enjoined from performing a contract, the corporation is in
breach and a third party can recover damages.
Example: Investor demands a Certificate of Incorporation prohibition on the corporation owning or
trading in derivatives
The board contracts to purchase derivatives from Goldman Sachs for $10 million. The
contract is ultra vires.
The value of the derivatives contract falls to $3 million.

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Investor does not want the Corporation to perform the contract.

1. The contract is not void and the board cannot avoid it.
2. The investor as shareholder can sue to enjoin performance of the contract, but if the
injunction is granted, Goldman may win damages.
3. The shareholders can sue the directors for damages. Business judgment rule?
4. The shareholders can sue to enjoin / instruct future purchases of derivatives.
Defective Incorporation
Pre-incorporation contracts
Little Importance:
Difficult topic
Not much practical importance because it is so fast and easy to form a corporation now
Illustration: Promoter finds perfect location for a frozen yogurt franchise, but needs three
investors/friends to join
Promoters agenda:
Get friends to agree to invest
Tie up the franchise (advice about location)
Tie up the location (option to lease)
Form the corporation (hire a lawyer)
How the promoter should do it:
Buy options from third parties (e.g. landlord, an option to lease) or
Form the corporation (with almost no assets or money) and contract in its name.
Add Promoter is not liable.
Modify the corporation when the deal is set.
Problem: Promoter contracts before the corporation is formed and contract dont say
whether promoter is liable on them.

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General rule: the promoter is liable. Exceptions:

Parties agree the promoter is not liable.
Contract is under the name of the proposed entity and the third party knows the entity
does not exist. (e.g. A corporation to be formed)
Etc. (refer to slides)
Promoter usually waits to form the corporation because he wants to be sure that
the business plan will succeed before he pays an attorney to form the corporation
Determining Promoter's Liability for Defective Incorporation: Case law supports three
categories of approaches
(1) MBCA 2.04. Promoter is liable if promoter knows there is no corporation.
Comment to 2.04: The section does not foreclose the possibility that persons
who urge defendants to execute contracts in the corporate name knowing that no
steps to incorporate have been taken may be estopped to impose personal liability
on individual defendants.
Hypothetical 1: Promoter and third party both know that P Corp. has not been
formed. They contract that third party agrees to sell 100 widgets to P Corp. for
$100,000. Promoter signs on behalf of P Corp. Is Promoter liable under MBCA
Answer: Yes, absent urging.
Hypothetical 2: Same facts, but signature is P Corp., a corporation to be
formed, by [Promoters name].
Answer: Yes, absent urging. Signature form does not matter.
Hypothetical 3: Promoter and third party do not know that P Corp. has not been
formed. They contract that third party agrees to sell 100 widgets to P Corp. for
$100,000. Promoter signs on behalf of P Corp. Is Promoter liable under MBCA
Answer: No. (Like De Facto Corporation.)
(2) Intention of parties inferred from the form of signature.
See slides 14-17 in Forming the Corporation Part 4
(3) Intention of parties inferred from all the evidence.
Authors suggestion: Promoters good faith predicts outcomes.

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Better to look at both parties good faith

Pharmaceutical Sales and Consulting case:
Sadlon signed knowing that the corporation did not exist. Bad faith.
Sadlon would lose under MBCA 2.04
Delavau tries to use Sadlons bad faith to escape just liability greater bad
Sadlon wins.
Theories of Formation Without Incorporation
(1) De Facto Corporation (Possibly abolished in Delaware)
Doctrine: A corporation may exist even absent incorporation.
This provision may have abolished the doctrine:
DGCL 106. Upon the filing with the Secretary of State of the certificate of
incorporation, executed and acknowledged in accordance with 103 of this title, the
incorporator . . . . shall, from the date of such filing, be and constitute a body corporate
Where De Facto Corporation still exists, the elements are:
(1) a law under which a corporation with the power assumed might be incorporated;
(2) a good faith attempt to incorporate under the law; and
(3) an actual exercise of corporate powers.
NOTE: Pharmaceutical Sales adds that 2 must occur before 3.
(2) Corporation by Estoppel (MORE IMPORTANT)
Much more important doctrine than de facto corporation
Used much more often
(1) A person contracts and deals with an entity as a corporation (thinks it is a
corporation and goes ahead anyway).
(2) The entity acted in good faith.

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(3) The action arises out of the contract or course of dealing.

Effect: The person is estopped to deny the corporate existence in the action. That creates a
corporation for the case.
Rationale: The person is getting what the person bargained for and expected.
1. The promoter will be liable.
2. Hence the third party will be liable too.
Liability of the Corporation
Before Incorporation
No one can bind a corporation prior to incorporation
After Incorporation
After incorporation, the corporation can adopt (ratify) contracts made for it.
Ratification may occur by acceptance of benefit (requires a contract that purports
to be made on the corporations behalf).
Unjust Enrichment
If the corporation receives and retains a benefit, unjust enrichment may apply
(does NOT require a contract that purports to be made on the corporations

Refer to Slides (09152014) Problem 7.40, Suplt, P86

Stock Subscriptions
Promoter wants to raise money prior to the incorporation. Is the offer of issuance of
shares being binding to the potential investor?
Explanation: Illusory contract, revocable

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DGCL 165. Unless otherwise provided by the terms of the subscription, a

subscription for stock of a corporation to be formed shall be irrevocable, except
with the consent of all other subscribers or the corporation, for a period of 6
months from its date.
DGCL 166. A subscription for stock of a corporation, whether made before or
after the formation of a corporation, shall not be enforceable against a subscriber,
unless in writing and signed by the subscriber or by such subscribers agent.

Administrative Dissolution (In DE and CA, known as "forfeiture")

Dissolution of a corporation by the state's administrators
In CA and DE, dissolution refers to voluntary dissolution
General causes:
Failure to file annual report and pay $125 fee
Failure to replace a registered agent who resigned
(1) Corporation now exists only for limited purpose of winding up its affairs
(2) Corporation cannot sue anyone for anything, or defend;
(3) Secretary of State will not accept filings from the corporation (except pay off the fees and
reinstate its Articles)
Reinstatement - Certificate is reinstated if corporation files the late reports, pays the fees and
Delaware: If a Delaware certificate has been forfeited more than five years, the
corporation pays four times the franchise tax in the year of reinstatement

Two Views on Effect of Reinstatement:

(1) The corporation shall be renewed and revived with the same force and effect as if its
certificate of incorporation had not been forfeited...such reinstatement shall validate all
contracts, acts, matters and things made, done and performed within the scope of its
certificate of incorporation by the corporation, its officers and agents during the time
when its certificate of incorporation was forfeited. DGCL 312(e)

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[The Corporation can be sued when it does not pay its filing fees, but cannot initiate

(2) Same, but "subject to the rights of any person who reasonably relied to his prejudice
upon the certificate of dissolution." North Carolina Stat. 55-14-22(c)

The Big Picture
Entities are not real persons, so they cannot act for themselves
Entities can only act through people:
Agents (authority to contract)
Employees (vicarious tort liability)
What human actions does law attribute to the entity?
What human actions does law attribute to another human?
Who is an agent?
Elements of Agency
Restatement Third Agency, 101. Agency is the fiduciary relationship that arises when:
(1) one person (a principal) manifests assent to another person (an agent) that
(2) the agent shall act on the principals behalf and
(3) subject to the principals control, and
(4) the agent manifests assent or otherwise consents so to act.

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BUT: Professor says these elements aren't very helpful because they could apply to waitercustomer relationship

Agency Relationship between non-employee and an employer: Refer to Slides 09152014

(Respondeat Superior) Exceptions to the liabilities for torts

Effect of Disclaimer of Agency: Evidence of lack of agency but not dispositive (Hassur)
Dealing v. Finding
If "dealing" with 3rd party on behalf of principal, agent has fiduciary duties
If merely "finding" or "advising", no fiduciary duties
Douglas v. Steele (Supp. p. 99)
Was Steel the Douglas agent? Does their relationship meet the test?
Answer: Yes, but not clear why.
Competing views:
(1) Steel is Douglas agent, as buyer from Total Hawaii
(2) Steel is Total Hawaiis agent, as seller to Douglas
Why should Steele suffer the Total Hawaii bankruptcy? Douglas chose Total Hawaii.
Answer: Steele had a fiduciary duty to tell Douglas what she knew.
Why did it matter whether Steele was Douglas agent? Why couldnt Douglas sue
Steele for negligence?
Answer: Agency created a fiduciary duty to inform (easy case). The alternative
relationship was buyer-seller. Sellers dont have a duty to disclose information.
Was Steele an agent of The Travel Haus, Inc.? Of Total Hawaii?
Answer: Travel Haus, yes. Total Hawaii, Possibly.
Is a waiter in a restaurant an agent of the customer?
Answer: Probably not, even though the words seem to fit.

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Professor: Language of Restatement, Third, Agency 101 doesn't say very much
and isn't very helpful
When applied to the relationship between a waiter and a customer, the
waiter is the customer's agent
Henderson v. Hassur (Supp. p. 103)
Henderson agreed to seek out Mexican Pizza Hut sites for Hassur.
Hassur agreed to pay $4k commission plus 1% of gross revenues for each site
acquired for me.
Henderson bought Satellite City site for $56,000, sold it to Hassur for $88,000,
without disclosing what he paid.
No fraud.
Site may have been worth $88,000.
Hassur apparently approved that price.
Court: Henderson forfeits $32,000 profit, $16,000 commissions, 1% of gross, $215,000
punitive damages (missing from edit). Harsh?
Hypothetical 1: Assume Henderson and Hassur have not met. Henderson goes to
Mexico, buys site for $56,000. Henderson sells site to Hassur for $88,000,
without disclosing how much Henderson paid. Does Hassur have a cause of
action against Henderson?
Hypothetical 1 Result: No. Buyer-seller is not a fiduciary relationship.
Hypothetical 2: I do not agree to be your agent. But I will go to Mexico, find
sites, and if you buy them you agree to pay me $4k each and 1% of the gross. Is
this disclaimer of agency effective?
Hypothetical 2 Result: Disclaimer of agency is evidence, but not
Sale contracts commonly provide that neither party is the others agent (at
arms length).
Despite that provision, the issue is still whether the relationship meets the
test for agency.

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Hypothetical 3: I do not agree to be your agent. But I will go to Mexico, find

sites, and if you buy them you agree to pay me $4k each and 1% of the gross. Is
this relationship agency? Is Henderson dealing or merely finding?
Restatement 101 comment: [A] relationship of agency always
contemplates three partiesthe principal, the agent, and the third party
with whom the agent is to deal. [A] principal might employ an agent who
acquires information on the principal's behalf but does not deal. [I]f a
service provider simply furnishes advice and does not interact with third
parties as [a] representative . . . the service provider is not acting as an
Hypothetical 3 Answer: Could be either. If merely finding, he isnt
Two types of agency liability
(A) Mainly contract cases
(1) Consent
(2) Agent acts on behalf of principal
(3) Subject control
Principal will be liable for the authorized acts of the agent
Paradigm case:
Principal authorizes agent to make a contract on principals behalf
Agent makes the contract
Principal is liable on the contract
Agent is not liable on the contract
5 Theories for Principal to Third Party Liability
(1) Actual authority
(2) Apparent authority
(3) Inherent agency power
(4) Ratification

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(5) Estoppel
Mainly tort cases (respondeat superior)
Restatement of Agency Third 2.04. An employer is subject to liability for torts committed
by employees while acting within the scope of their employment.
Scope of Employment: Restatement of Agency Third 7.07(2) An employee acts within
the scope of employment when performing work assigned by the employer or engaging in a
course of conduct subject to the employer's control. An employee's act is not within the scope
of employment when it occurs within an independent course of conduct not intended by the
employee to serve any purpose of the employer.
Paradigm case: Employer hires employee to deliver pizzas.
Employer controls or has the right to control how employee drives.
While driving to deliver a pizza, employee negligently causes an accident that injures
third party.
Tort is in scope of employment
Employee is liable (for his/her own negligence)
Employer is liable (respondeat superior)
Employer of an independent contractor is NOT LIABLE EXCEPT:
1. Strict liability for acts of an independent contractor performing ultra-hazardous
activity (non-delegable duty). (Explosives)
2. Respondeat superior liability for torts of an independent contractor performing
inherently dangerous activity. (Wrecking ball)
3. Liability for torts of an incompetent independent contractor. (Drunk)
Agents, employees, and independent contractors
Overlay (See Slide 8 from Agency Part 2) shows two distinctions:
(1) Employees (yellow) from independent contractors (green plus blue)
(2) Agents (green plus yellow) from non-agent independent contractors (blue). E.g., Douglas
v. Steele; Henderson v. Hassur.
Agents may have three types of authority
(1) Actual Authority

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(2) Apparent Authority

Agent's Manifestation of Own Authority
(3) Inherent Authority (Supplement Problem Set 8.a (P107))
Principal gives position to agent, and certain acts are usually authorized for individuals
with that position
Not in Restatement 3rd:
Exists in Restatement 2d but not in Restatement 3d because authors of
Restatement believed that it is just another form of apparent authority
BUT: Professor still thinks it's a helpful concept
Most courts still refer to Restatement 2d in agency cases though
Concept: Restatement 2d 8A. Inherent agency power is a term used in the
restatement . . . to indicate the power of an agent which is derived not from authority,
apparent authority, or estoppel, but solely from the agency relation . . .
Rule: Restatement 2d 161. A general agent . . . subjects his principal to liability for
acts which usually accompany or are incidental to transactions the agent is authorized
to conduct 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
Downward Spiral of Inherent/Apparent Authority
Obscure, secret rules set low public expectations.
Low expectations define what is considered reasonable.
What is considered reasonable limits inherent and apparent authority.

Agents Manifestation of Own Authority

Rule: Only the Ps manifestation matters
BUT Agent can make the Principals manifestation if he is authorized to do so.

All authority has the same effect: the principal is liable

Thus it is rarely necessary to know which type of authority is being exercised

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Clark Resources v. Verizon (Supp. p. 106)

Summary: Be careful when dealing with agents
DeRogatis is Area Sales Vice President for Government and Education in
She meets with Clark
Tells Clark you have a deal.
Verizon says no deal: Rogatis didnt have authority.
Clark sues.
Did Derogatis have Apparent Authority?
Verizon made DeRogatis the contact person. Isnt Clarks belief traceable to that
Ultimately, the Court is mindful of the oft-repeated warning that:
The mere fact that one is dealing with an agent, whether the agency be general or
special, should be a danger signal, and, like a railroad crossing, suggests the duty to
stop, look, and listen, and he who would bind the principal is bound to ascertain, not
only the fact of agency, but the nature and extent of the authority.
If Clark had asked DeRogatis if she had authority to contract and DeRogatis said yes,
would Verizon be bound?
Answer: No. Manifestation must be from principal (Verizon)
If Clark had asked DeRogatis boss if she had authority and boss said yes, would
Verizon be bound?
Answer: Only if boss had authority to say DeRogatis had authority.
Is DeRogatis liable to Clark on the contract?
Answer: No, but she is liable for breach of warranty of authority, Restatement
Liability on the Contract (Default Rules, unless otherwise agreed)

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Principal type



Third Party

Restatement of Agency
















Restatement 6.01. When an agent acting with actual or apparent authority makes a
contract on behalf of a disclosed principal,
(1) the principal and the third party are parties to the contract; and
(2) the agent is not a party to the contract unless the agent and third party agree
Restatement 6.02. When an agent acting with actual or apparent authority makes a
contract on behalf of an unidentified principal,
(1) the principal and the third party are parties to the contract; and
(2) the agent is a party to the contract unless the agent and the third party agree
Restatement 6.03. When an agent acting with actual authority makes a contract on behalf
of an undisclosed principal,
(1) unless excluded by the contract, the principal is a party to the contract;
(2) the agent and the third party are parties to the contract; and
(3) the principal, if a party to the contract, and the third party have the same rights,
liabilities, and defenses against each other as if the principal made the contract
personally . . .
Disclosed Principal
Sears v. Riggs Distiller (Supp. p. 111)

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Riggs is a Baltimore G&E contractor

Riggs wants to look for water mains
Whiteside tells Riggs White Marsh Mall will assume water main liability
Riggs digs, hits water main, floods Sears, sues Whiteside.
Court: Whiteside is not liable because she is an agent of a disclosed principal.
Why did Riggs sue Whiteside instead of White Marsh Mall LLC?
Answer: White Marsh Mall was in the General Growth bankruptcy.
Why is the agent of an unidentified principal personally liable?
Answer: Non-identification indicates the third party intended to rely on the
agent. (Third party doesnt even know who the principal is.)
Why isnt a traceable trade name sufficient disclosure?
Answer: A party who really intends to hold the principal would obtain the
legal name. (Cant judge traceability until you try .)
Why is Patriot Lines a simple misnomer, not a trade name?
Answer: The name is similar to the real name and probably an attempt at
the real name.
A trade name may be completely different from the real name (permissive
subject to required procedures). Example: Black and White Cab, Inc.,
doing business as Yellow Cab.
Undisclosed Principal
Watteau v. Fenwick
Fenwick thinks Humble owns the business; extends credit to Humble
Later Fenwick discovers Watteau and sues on the cigar account.
Court: Watteau is liable; Watteaus secret limitation is ineffective. Rest. 3d 603.

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Fenwick didnt know about Watteau and so could not have relied on Watteaus credit.
Why should he be able to sue Watteau?
Professor's answer: Because Watteau made Humble appear credit-worthy.
Restatement Example
Supplier extends credit to Contractor on a 30 day account.
Contractor incorporates, transfers assets to the corporation
Supplier doesnt know about the corporation.
A year after incorporation, Contractor doesnt pay. Supplier discovers the corporation
and sues for payment of the account.
Who is liable on the account?
Contractor and Contractor, Inc. as undisclosed principal.

Agent's Implied Warranty of Authority

Restatement 3rd 6.10. A person who purports to make a contract . . . on behalf of another
person, lacking power to bind that person, gives an implied warranty of authority to the third
party, and is subject to liability for damages for loss caused by breach of that warranty . . . .
Example: Clark Resources v. Verizon, Supplement 148
Bette DeRogatis tells Clark: You have a deal [with Verizon]
Court holds that Clark doesnt have a deal with Verizon.
DeRogatis is personally liable to Clark.
(Is the agent liable if unaware of her authority?
No exception. She is definitely personal liable for this.)

Restatement 3d 4.01. Ratification is the affirmance of a prior act done by another, whereby
the act is given effect as if done by an agent acting with authority.

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Restatement 3d 4.03. A person may ratify an act [only] if the actor acted or purported to act
as an agent on the persons behalf.
Restatement 3d 4.05. A ratification is not effective unless it precedes the occurrence of
circumstances that would cause the ratification to have adverse and inequitable effects on the
rights of third parties.

Estoppel to Deny Agency

Restatement 3d 2.05. A person [is liable] to a third party who justifiably is induced to make
a detrimental change in position because the transaction is believed to be on the persons
account, if
(1) The person intentionally or carelessly caused such belief, or
(2) Having notice of such belief and that it might induce others to change their
positions, the person did not take reasonable steps to notify them of the facts.
Illustration: Clark Resources v. Verizon
DeRogatis tells Clark that DeRogatis can contract for Verizon / if D is not an employee
of Verizon, and did the same thing, the same results came up.
DeRogatis cant contract, and isnt authorized to say she can.
Verizon knows the facts, but doesnt tell Clark.
If DeRogatis contracts, Verizon may be estopped to deny its authority.

Vicarious Tort Liability

Definition: A license from a trademark or trade name owner allowing another to use the mark
to sell goods or services
Examples: Mobil Mini-Mart, McDonald's, Dunkin Donuts, Pizza Hut, Hilton Hotels, Pwc,
The UPS Store, Charles Schwab, H&R Block
Deal: Franchisor supplies "business formats;" franchisee supplies the capital, runs the
business, and pays "franchise fees"
1. Quick expansion because franchisees supply capital and work independently

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2. Franchisor and franchisee can each own and control its own business
3. Franchisees supply local knowledge and contacts
4. Franchise form may defeat tort liability

Mobil Oil Corporation v. Bransford (p. 113 Supplement)

(1) Right to terminate franchise for failure to follow rules is NOT control.
(2) Franchisors usually are not liable for torts of franchisees because "everyone knows
franchisors don't control franchisees"
Professor: Franchisors should be liable for the torts of their franchisees
Stethem works for a Mobil Oil franchise and has a record of assault
Stethem beats up Bransford when Bransford comes into a Mobil mini-mart
Bransford sues Mobil as Stethem's employer
Legal Theories:
Actual agency: Did Mobil control or have the right to control Stethem's manner?
Majority: Nothing in this contract shall be deemed as creating any right in Mobil
to exercise any control
Dissent: Berman "shall provide qualified attendants" and "render prompt, fair,
courteous...service." Mobil "monitors" the station.
Law: Mobil has the right to terminate Berman's franchise if Berman doesn't run
the business the way Mobil wants. That is not "control."
Holding: No actual agency. Mobil is not an employer.
Concise statement: Monitoring and termination of franchise agreement isn't
Apparent agency:
Mobil did not manifest to Bransford that Mobil controlled the station.

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Florida Supreme Court: In todays world, it is well understood that the mere use
of franchise logos and related advertisements does not necessarily indicate that
the franchisor has . . . control over any substantial aspect of the franchisees
business. Did you understand this?
How much control do you think Mobil has over franchisees operations?
My answer: As much as they want (even as the much control as the
franchisor own the gas station and mart by itself).
Emerson empirical study: Most people think franchises are actually nationally or
dually owned and operated, not locally owned and operated (as they actually are)
Professor Lopucki: Franchisors mislead the public, and courts allow them
to do so.
NOTE: Court used principal/agent language even though this is a tort case, not a contract

Trademark owner / franchisor duty to control: NOT A REAL THREAT B/C NOT
Naked licensing occurs when the licensor fails to exercise adequate quality control over the
licensee. Naked licensing may result in the trademark's ceasing to function as a symbol of
quality and a controlled source. We have previously declared that naked licensing is
inherently deceptive and constitutes abandonment of any rights to the trademark by the
licensor. 9th Circuit case, 2010
To avoid tort liability, the franchisor must not control. To keep its trademark, the franchisor
must control.
But this trademark rule isn't a real threat to companies
Courts pay lip service to it, but do not enforce it

Imputation of Knowledge
[Restatement is not born to be a law unless a court accepts it during its trial, which means the
restatement becomes a case law.]
Refer to the slides [imputation of knowledge summary of general rule and exceptions]
Restatement Third Agency 5.03. [N]otice of a fact that an agent knows or has reason to know is
imputed to the principal if knowledge of the fact is material to the agents duties to the principal,
unless the agent

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(a) acts adversely to the principal as stated in 5.04

(b) is subject to a duty to another not to disclose the fact to the principal
Restatement 3d Agency 5.04. [N]otice . . . is not imputed to the principal if the agent acts
adversely to the principal . . . intending to act solely for the agents own purposes or those of
another person. Nevertheless, notice is imputed
(a) when necessary to protect the rights of a third party who dealt with the principal in good
faith, or
Notice is not imputed under 5.04(a) when 3rd party behaves fraudulently, but maybe
if only negligent (Official Committee v. PriceWaterhouse)
(b) when the principal has ratified . . . the agents action.
Corporation does not "benefit" under 5.04(b) when officers/auditors collude to
misstate finances even if it allows the corporation to continue to exist (Official
Committee v. PriceWaterhouse)

Official Committee v. PriceWaterhouse (Supp. p. 118)

(why sueing PwC instead the officers of AHERF: an entity is much more payable (ability to pay
damages) than individual.)
PwCs task: an audit
AHERFs task: supply information
Collusion: Officers supplied false info; the Auditors ignored falsity.
AHERF files bankruptcy; Creditors Committee, acting for AHERF estate, sues PwC for
negligence, breach of contract
Reason: The creditors are acting on behalf AHERF, for themselves. (It is a bankruptcy
PwCs defense: in pari delicto: both corrupt, leave loss where it falls
Court: Officer misconduct not imputed to AHERF, AHERF is innocent
Reason: PwC acted in bad faith.
Why didn't the creditors sue in their own right?

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States split among three rules regarding auditor liability:

(1) Privity. Only the client can recover.
(2) Foreseeability. Any reasonably foreseeable party who relies on the audit can
(3) Section 552 of the Restatement (Second) of Torts. Only intended
beneficiaries known to the auditor at the time of the audit can recover
The majority of jurisdictions have adopted the Restatement
Example: If AHERF requested an audit to be used to sell bonds, the bondholders could
sue the negligent or corrupt auditor.
Why do auditors collude with audited companies?
Answer: Company hires the auditor; expects loyalty; fires the disloyal. PwC wants
to keep AHERF as a customer.
Who won?
Answer: So far, the Committee. Officer knowledge is not imputed to AHERF.
If the Auditors colluded against PwC, can the Auditors acts be imputed to PwC?
Answer: No, by same reasoning used against AHERF
If the Auditors acts are not imputed to PwC, what result?
Answer: AHERF and PwC are both innocent. AHERF loses.
Assuming collusion by agents, but innocent principals, what should the courts do?
Professor's answer: Grant a remedy to the least guilty. That would encourage the
information function of litigation.
AHERFs officers did the wrongful acts. AHERFs creditors are suing PwC.
the creditors be responsible for the officers wrongdoing?
Answer: The creditors are suing as AHERF, not as creditors.
NOTE: Restatement Third Agency, plus Inherent Authority is the law of this course

Actions Binding the Corporation

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Why should

Default statutory authority to bind, by entity type

Who can bind in Who can make decisions in Who can make
ordinary course?
the ordinary course?
ordinary course?




The CEO, text 184

Majority of directors at a board Majority of directors at a board mee

meeting, DGCL 141(a)
DGCL 141(a)


Any partner

A majority of partners, without Consent of all partners, 401(j)

a meeting, 401(j)



Any member

A majority of members, Majority of members, 404(a)(1), 40

without a meeting, 404(a)(2) unanimous for listed matters, 404(c)


Delegation of Authority - Corporations

The Board of directors: Delegation
Source of board authority: The business and affairs of every corporation . . . shall be
managed by or under the direction of a board of directors. DGCL 141(a)
Delegation. If . . . provision is made in the certificate of incorporation, [then] the powers
and duties conferred . . . upon the board of directors . . . shall be exercised . . . to such extent
and by such persons as shall be provided. DGCL 141(a)
Google delegation. (p.183.) CEO shall . . . subject to control of the Board, have general
supervision, direction, and control of the business and affairs of the corporation and shall
report directly to the Board. refer to the clause of the Bylaws of Walt-Disney to know the
definition of subject to and the report directly stuff.
Hypo. Googles CEO wants to sell you Googles thirty-acre parcel for $1.5 million. Does
the CEO have authority to bind Google?
Answer: Not clear. Ordinary course of business shall be considered. But the delegation
is broad, vague. Courts may interpret it to apply only to ordinary course deals.

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Menard, Inc. v. Dage-MTI, Inc. (p. 181)

Menard makes written offer to buy.
Sterling forwards offer to board
Board rejects offer; instructs Sterling to contract only with board approval
Menard makes second offer
Sterling contracts without board approval.
Dage disputes contract 104 days later; Menard sues
Court: Sterling had inherent authority (2nd Restatement) to sell outside ordinary course
The sale was incidental to transactions Sterling was authorized to conduct, page 189
Menard reasonably believed Sterling authorized
Menard had no notice Sterling was not authorized
We find it reasonable that Menard did not question [Sterlings] statement that he had
authority from his Board of Directors to proceed. P189.
Can Sterling manifest his own authority?
Answer: Only if Dage authorized him to make the manifestation. Dages
manifestations include: (1) making Sterling President and board member, (2)
making him the sole point of contact.
What could Menard have done to question Sterlings statement?
Answer: Asked for resolution copy.
If you were Menards lawyer, would you have advised Menard to ask for the
If Menard had asked for a resolution, what would have happened?
Professor's answer: Worse terms or no deal at all.

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Will you advise Menard to ask for the resolution next time?
Professor's answer: Asking for the resolution is safe for the lawyer.
Lawyers are deal killers. The other approach is to sign the contract and then
negotiate the authority problem.
Proposed rule: If the CEO warrants authority and the third party has no contrary notice, the
corporation is liable.
That is not the law. Should it be?
My answer: Yes. The law over-protects principals.
Actual rule for LLCs
ULLCA 301(c). Unless the articles of organization limit their authority, any member
of a member-managed company or manager of a manager-managed company may sign
and deliver any instrument transferring . . . the companys interest in real property.
Problem Set 8 (p. 88 Supp.)
**View slides 17-21 in powerpoint (Actions Binding the Corporation Part 1)
Actions Binding Partnerships
Stroud v. National Biscuit (Supp. p. 95)
Summary: Partners can bind the partnership when carrying out the ordinary course of
Stroud and Freeman are partners in a Strouds Food Center.
Stroud to National Biscuit: I will not be responsible for bread sold to the store.
Freeman orders bread and National Biscuit sells it.
National Biscuit sues Stroud.
Court: Freeman had actual authority to buy. National Biscuit wins.
Did the court correctly apply RUPA?

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402(f) Each partner has equal rights in the management and conduct of the partnership
(j) A difference . . . may be decided by a majority of the partners.
301(1) Each partner is an agent of the partnership for the purpose of its business. An
act of a partner . . . for apparently carrying on in the ordinary course the partnership
business or business of the kind carried on by the partnership binds the partnership,
unless the partner had no authority to act for the partnership in the particular matter and
the person with whom the partner was dealing knew or had receive a notification that
the partner lacked authority.
Does Stroud have the authority to cancel the bread order?
Yes. Last to speak rules
If there's a split vote on cancellation, does Stroud have authority to cancel?
Yes. There's just no partnership decision.
What could Stroud have done to prevent Freeman from obligating him?
He could have dissociated and given notice to Freeman and National Biscuit.
601(1) A partner is dissociated from a partnership upon . . . the partnerships having
notice of the partners express will to withdraw as a partner . . . .
703(a) A dissociated partner is not liable for a partnership obligation incurred after
dissociation, except as otherwise provided in (b).
(b) A partner who dissociates . . . is liable as a partner . . . only if . . . at the time
of entering into the transaction the other party . . . did not have notice of the
partners dissociation . . . .
704(a) [A] person not a partner is deemed to have notice of the dissociation 90 days
after the statement of dissociation is filed.
Voting power of Partners and LLC Members
RUPA 402(f) / ULLCA 404(a)
RUPA 402(f) Each partner has equal rights in the management and conduct of the
partnership business.
(j) A difference . . . may be decided by a majority of the partners.
ULLCA 404(a). In a member-managed company

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(1) each member has equal rights in the management and conduct of the
companys business; and
(2) . . . any matter relating to the business of the company may be decided by a
majority of the members.
Binding GPs and LLCs in the Ordinary Course of Business
RUPA 301(1) / ULLCA 301(a)(1)
RUPA 301(1) Each partner is an agent of the partnership for the purpose of its
business. An act of a partner . . . for apparently carrying on in the ordinary course the
partnership business or business of the kind carried on by the partnership binds the
partnership, unless the partner had no authority to act for the partnership in the
particular matter and the person with whom the partner was dealing knew or had
received a notification that the partner lacked authority.
ULLCA 301(a)(1). Each member is an agent of the limited liability company for the
purpose of its business, and an act of a member . . . for apparently carrying on in the
ordinary course the companys business or business of the kind carried on by the
company binds the company, unless the member had no authority to act for the
company in the particular matter and the person with whom the member was dealing
knew or had notice that the member lacked authority.
[ULLCA 301(c) re the transfer of real property by LLC members] refer to
slides [Authority of LLC Members]
Formalities for Board Action
Directors have no authority as individuals by virtue of their position on the board
Individual board members have no authority: The legal effect...was to invest the directors...as
a boardthey have no authority to act, [except] at a board meeting. Baldwin v. Canfield.
Powers of the Board of Directors at a Meeting (DGCL 141)
Authority of Board - The board has full authority to manage: DGCL 141(a). The business
and affairs of every corporation...shall be managed by or under the direction of a board of
Board can only act at a meeting - DGCL 141(b). The vote of the majority...present at a
meeting at which a quorum is present...shall be the act of the board of directors
When has a meeting taken place?
Quorum - Majority of total number of directors constitutes a quorum. DGCL 141(b)
However, the corporations bylaws may stipulate otherwise.

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Hearing other members - Board members can participate in a meeting electronically if

they can "hear" each other. DGCL 141(i)
In practice, do get everyones confirmation of hearing each other prior to the meeting)
No Definition - The DGCL does not define a meeting, say who can call one, or specify what
proper notice is.
Bylaws are likely to do these things.
Exceptions to Meeting Requirement
Unanimous Board Approval - meeting would not serve any purpose because there is no need
for opportunity to persuade opposing viewpoints
Emergency (this does not exist in Delaware, but you can incorporate such clause into your
bylaws) DGCL 110(c) - quick decisions to prevent great harm or take advantage of great
Unanimous shareholder approval - not really an exception because DGCL 228(a) gives
shareholders to act in the absence of a meeting with signed consents (which must be
identical) from shareholders of absolute majority of outstanding stock.
BUT: Shareholders can NOT authorize something that can only be done by directors.
Majority Shareholder-Director Approval This exception does not exist at all.
Board Committees: DGCL 141(c)(2)
Appointment: By board
Membership: One or more board members.
Authority: To the extent provided by resolution, "exercise all the powers and authority of the
Exceptions: Three things committees can't do
(1) Change the bylaws
(2) Submit matters (required by the statute reserved to the board) to shareholder vote
(3) Under MBCA only, authorize dividends (no DGCL exception though)
For example, the executive committee of a law firm.
Professor: Almost all the corporate governance work has been transferred to committees

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Reliance protection: Board and committee members are "protected" from liability in relying
on committee work. DGCL 141(e).
Audit Committee Special Rule - Sarbanes-Oxley requires an audit committee composed
entirely of independent directors (sb. Whose decision-making will not be influenced by the
shareholders or directors upon their voting rights, e.g. Bill Gates as the ID of Facebook).
This deals with the recurring problem of auditors who collude with companies (the
AHERF problem)
Securities exchanges require various other committees to resolve specific problems re
the public company.
Legal Opinions
Relevance to Dage:
Menard contracts to buy land from Dage. Much can go wrong:
Dage was never incorporated and doesnt exist.
Sterling, who signed for Dage, wasnt authorized.
The transaction is contrary to the certificate or bylaws.
The transaction is contrary to statutes or regulations
Menard can have a law firm investigate and confirm that there are no problems with the
Purposes of Legal Opinion Letters:
(1) Opportunity to fix problems
(2) Comfort for parties and financiers.
(3) The attorney is liable for negligence (NOT just mistakes) and may reimburse
resulting losses
Common Problem With Legal Opinion Letters (refer to the problems on P90 of the
supplement and P194 of the textbook):
The letter addresses all the buyers legal concerns.
BUT: it contains lots of qualifications and limitations.
After qualifications, is there anything left?
Two Views of Opinion Letters

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(1) The letters are deceptive.

They appear to address all the buyer's concerns.
After qualifications and limitations, they address almost none.
(2) The letters are legal opinions, not fact investigation.
The Secretary of the Company is responsible for investigating the facts
The only job of the lawyers is to produce legal opinions based on those facts
Although the facts are the biggest concern, the opinion letter does not purport to
furnish them

Chapter 9: Numeracy for Corporate Lawyers

How Financial Statements (snapshot) are Prepared
For Balance Sheet: Assets = Liabilities + Equity
"Assets" includes:
Current Assets:
Accounts Receivable
Inventory (not reflected of the Market Value)
Prepaid Expenses
Fixed Assets:
Office Equipment
Depreciation (negative value)

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"Liabilities" includes:
Current Liabilities:
Accounts payable
Notes payable
Accrued expenses
Other liabilities
Long-Term Liability
Long-term notes
"Equity" includes:
Paid-in capital
Retained earnings
How Financial Statements be used?
Balance Sheet Analysis - Overview
Liquidity Analysis: Can the Company pay its current debts?
Current Ratio = current assets divided by current liabilities
Debt analysis: Can the Company take on new debt?
Debt-to-equity ratio
Equity analysis: Does the Company have value to its owners?
Book value
Balance Sheet Analysis
The basic technique: business ratios
Look at businesses of a certain type and look at the ratios successful businesses of that type
usually have
e.g. Look at 100 drug stores; how much cash does it usually keep on hand

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(1) Liquidity Analysis: Can the Company pay its current debts?
(the ability to convert the assets to cash, if bankruptcy, the company has problem to
convert its assets to cash, either cannot sell assets or cost excessively to complete the sale)
Current Ratio = current assets divided by current liabilities
Rule of thumb: ratio should be 2.0 or higher
Example: Widget, Inc. has current ratio of 1.29 in year 1 and 1.62 in year 2
That isn't good, but it is getting better. But why is it getting better?
A/R and inventory are up $440k. Sales are up $500.
That could be good or bad. A/R could be up because you're selling more or
because customers aren't paying. Inventory could be up because you need
more to sell or because you haven't been able to sell what you have while
continuing to buy more. Sales aren't up enough to account for the increased
A/R and inventory, so it's likely that there's a buildup of bad inventory or
bad customer debt.
(2) Debt analysis: Can the Company take on new debt?
(Long-term) Debt-to-equity ratio
"Financial leverage" is the ratio of long-term debt to equity
The trend now is to ignore current liabilities and look at long-term debt
Professor says this is fine as long as you're using same approach across different
Ratio of long term debt to equity should be about 1.0 or less
Example: Widget, Inc. has debt-to-equity ratio of 1.79 in year 1 and 1.32 in year 2
Widget's financial leverage is high but declining
(3) Equity analysis: Does the Company have value to its owners?
Book value of owners equity = book value of assets - liabilities
Book value of assets minus book value of liabilities produces book value of
Requires adjustments because assets are listed at cost, not at market value
Sample Adjustments:

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Market value of land, building has increased from cost

Uncollectible Accounts (bad customer debt)
Intangibles not listed as assets
Income statement analysis motion picture
Profitability (Operating Income)
Net Income is usual standard
COGS: cost of goods sold
Net sales: goods that are actually sold excluded those are returned
Investors like to look at something else though: Earnings before Interests (i.e. interests of the
debts) and Taxes (EBIT)
Other option: Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA)
(EBIT + depreciation)
Ignore depreciation deductions on land that make it look like the income is lower
because real estate probably isn't actually depreciating
But this approach is problematic when depreciation is real (e.g. have to replace
machinery that no longer works)
That artificially inflates the company's profitability
Professor is skeptical of this approach
Return on Investment (ROI): How much are the owners earning on their investment?
Ratio of profit (net income) for year to equity at the year of beginning
Example: Widget's ROI is 26% in year 2
Operating Margin: Is the company selling widgets for more than it costs to make them?
Ratio of Operating Income to Net Sales
Operating Income can be measured by:
Net Income
EBIT (operating income)

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Example: Widget's operating margin is 12.3% in year 2

Business Valuation
Difficult to value a business accurately, but it must be done
Requires many assumptions
Calculating Interest
To calculate principal plus 20% interest, multiply by one plus the interest rate. (This is annual
rate, annual compounding)


Start of year value

One plus the interest rate

End of year value


*1.2 =



*1.2 =



*1.2 =



*1.2 =


Discounting is interest backwards. Divide instead of multiply.

Formulas (from different calculating directions):
Accruing interest forward: $482.25*(1+.20)^4 = $999.99
Discounting to present value: $1,000/(1+.20)^4 = $482.25
Discount rates usually are derived from interest rates
Three Methods of Valuing Businesses

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(1) Adjusted Book Value (Assets - Liabilities)

Use real market value for assets
e.g. Market value of land, building has increased from cost
e.g. Portion of A/R is uncollectible; revise downward
e.g. Intangibles not reflected in book value; include those values
(2) Market Comparable - amount for which similar companies are selling
(a) For publicly traded stock: multiply the stock price by the number of shares (market
capitalization) and add the debt. The sum is the value of the assets
(b) For stock not publicly traded: analogize from comparable companies
(i) Isolated stock sale
20% of the stock of a comparable company was sold for $200,000
If 20% is worth $200,000, 100% is worth $1 million (plus debt)
(ii) Comparable company sale ("market multiples")
A company in the industry with EBITDA of $10 million sold for $23
Conclusion: Companies in the industry are worth 2.3 times EBITDA
BUT: "Market multiples" are often arbitrary
They change dramatically over time (subject to the economic
environment, revenue of the company, future profit-making ability of
the company etc.)
Make sure the numbers you're using are from the relevant time
Current ratio averages 18 times earnings, but it was as high as
44 times earnings in 1999
ALSO: Are you making the same adjustments as the comparable company?
e.g. Widget has EBITDA of $1,170,000 * 2.3 = $2,691,000.00
Should we have adjusted EBITDA for insider bonuses or other
costs? Bonuses are more like profits than expenses. But maybe
the comparable company did not adjust for their bonuses.

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NOTE: Comparison basis can be EBIT, net profit, revenues, etc.

(3) Discounted Cash Flow
Concept: A business pays cash to its owner over time, until sold or liquidated. The
present value of the business is the present value of the future cash it will pay.
1. Start with Income Statement
2. Adjust each item to reflect cash flow instead of profitability
3. Do the same for each future year
4. Discount the cash to present value
Example: Estimate Widget's (JKL's) cash flow in Year 2
Initial Estimate
Net income: $390,000 - Starting figure
Depreciation: $250,000 - Deducted form income, but not paid in cash
Accounts Receivable: ($130,000) - Sales count as income, but not
collected yet
Inventory: $80,000 - Cash is tied up in unsold inventory (CGS)
Bonuses: $120,000 - This cash would be ours if we buy
Total: $550,000 - cash flow from year 2 of business
We could assume this cash flow in perpetuity
We require a 30% return
At 30% interest, what would you need to have to produce $550,000 per
$1.83 million
We could assume different amounts of cash in each future year
Discount the separate estimates from each year.

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(i) Emotionless - Ignores people in a business. Are the people good, stable, and
working together?
(ii) Insensitive: Doesn't encourage detailed investigation. Is the product really
better than the competitors' products? How will the market for the product evolve
in the future?
(iii) Arbitrary: Making assumptions for no good reason. Assumes an ability to
predict the future.
What is Widget, Inc. worth?

Valuation method


Adjusted book value


Market comparable 1


Market comparable 2


Discounted cash flow


Conclusion: about


Valuation Problems
(1) You put $5,000 in the bank at 7% annual interest. How much do you have after 10 years?


Start Amount

One plus rate

End amount




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Answer: $9,835.76
(2) You are promised a $80,000 bonus if you stay at the law firm for 5 years. How much is it
worth now? (Bank CDs are paying 8%.)


Start Amount

One plus rate

End Amount
















Answer: Divide the bonus by one plus the implicit interest rate, repeating for each
year. The present value is $54,446.66.
(3) Blockbuster is getting into online movie rentals, just like Netflix. Netflixs price to
earnings ratio is 24 (PE = 24). How much should Blockbusters stock trade for if
Blockbusters earnings per share are $3.50?

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Reasoning: The market says Netflix is worth 24 times earnings, so Blockbuster will
be worth 24 times earnings.
If Blockbusters earnings per share are $3.50, then Blockbuster shares should be worth
24 times $3.50. $84.00.
(4) You buy a vineyard that has annual cash flow of $30,000. Its risk is similar to that of an
apple orchard that was discounted at 15% in another transaction. How much is the vineyard
Reasoning: If the vineyard has the same risk as the orchard, the Market should
discount the vineyards future cash flows at the same rate the Market discounted the
orchards cash flows.
The present value of $30,000 a year in perpetuity, discounted at 15% per year, is the
amount that, if invested at 15% interest, would produce $30,000 a year.
Solution: That amount is $30,000 divided by .15, which is $200,000.
A spreadsheet showing the calculations has been posted to MyLaw.

Chapter 10 - Capital Structure

Definition: The combination of debt and equity by which the corporation is financed
Types of Debt (secured or unsecured, cannot been showed from financial statements):
(1) Term loan (e.g. 5 year loan with regular interest payments)
(2) Revolving line of credit (similar to credit card, however no minimum repayment granted):
withdraw money as soon as the co. needs it and repay them as soon as the co. has available funds
(3) Letters of credit (promise by a bank to make a loan if needed), similar to a bank guarantee
(4) Trade (accounts payable), selling to your customers on credits
(5) Bonds, notes, debentures (securities: issued in a large number under same contract terms)
1000 (quantity) * $1,000 bonds is equivalent to a $1 million loan
Can be convertible to other securities, like preferred/common stock

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Types of Equity:
(1) Preferred (convertible or redeemable): its preference is defined by and strictly subject to the
contract terms. (Preference in dividend, liquidation to the common shareholders)
(2) Common (can be issued in classes and series): the company can define different classes (i.e.
Classes A, B and C) of common shares
Example: Widget, Inc. Sale
Justin, Kathy, and Lorenzo form JKL, Inc. to buy Widget, Inc.
Sale Term Sheet (key terms of a transaction)
Price: $2 million
$1,250,000 in cash at closing
$750,000 by 10-year, interest-only note at 10% interest (at the end of the 10 th year, the
principal will come to due at once) notes to Widget Inc.
Shareholder Agreement ($900,000 cash)
Justin: 40% of the common for $100,000 cash and a $100,000 note secured by stock (like
contribute on credit, he signs a promissory note to the company)
Kathy: 40% of the stock for $200,000 cash
Lorenzo: 20% of the common for $100,000, plus $500,000 preferred for $600,000 cash
Bank Loan Term Sheet
Loan: $500,000
Repayable in 5 annual installments of $100,000 per year
10% interest, payable quarterly
Between Widget Brothers and Bank, who will have priority with respect to repayment?
Whoever gets the first security interest (the Bank it always has the bargaining power.)
Three security interests in this sale:
(1) Bank against the business for $500,000
(2) Widget Inc. against the business for $750,000

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(3) JLK, Inc. against Justin's stock for $100,000

Order of Events for Widget Sale
1. Informal discussion to build trust among each other, the basis of a transaction
2. JKL, Inc. term sheet (present a united front to Widget)
2. Widget sale term sheet; begin due diligence
3. JKL incorporation (avoid promoter liability, client identity issues)
4. Organizational meeting (verify funds of the promoters, authorize someone to sign)
5. Execute sale contract and continue due diligence
6. Apply for bank loan (the collateral is based on the finalized and executed sale contract)
7. Simultaneous closing of sale, bank loan, payment of stock subscriptions
Transaction sometimes conducted by escrow way:
Seller: Stock or asset transfers to escrow agent (a law firms or a bank, someone worth
Purchaser: Payment of funds to escrow
Financing party: Execute notes and security agreements to escrow
8. Record deed (final title check)
9. Disbursement (things go to whoever entitled to it)

Security Interests
Definition: An interest in property contingent on the non-payment of debt
(1) Priority in the collateral - Payment in full before anyone else gets anything
(2) Remedy - After default, (judicial or not) foreclosure sale, proceeds are applied to the debt
(3) Encumbrance - Continues in property notwithstanding sale

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Absolute Priority Rule (APR) - The proceeds of liquidation go to liabilities until paid in full, then
to the preferred liquidation preference, then common.
Capital structure conflicts
Directors' fiduciary duties are stronger for common shareholders than they are for preferred
Equity Linked Investors v. Adams (p. 275)
Genta Inc. is "on the lip of insolvency" and has its bankruptcy petition ready
In liquidation, the absolute priority rule applies
The directors decide not to liquidate, but instead to borrow $3 million secured from
Goal: get money for common stockholders by risking the assets
Strategy: gamble cash on risky investments
Why? Unsecured creditors and preferred stockholders bear risk of loss. Common
stockholders can only benefit.
Paramount bears no risk though because their debt is secured
Court: Business judgment rule applies (directors must act on the best interests of the
corporation). Directors have fiduciary duties to the common shareholders, not the
preferred ones.
There always are transactions bad for the corporation, but good for common
shareholders. Under this circumstances, defining the boards fiduciary duties to the
corporation or the shareholder is the job of the court.
Directors are allowed to decide to borrow $3 million.
Arguments against application of Business Judgment Rule:
(1) Directors were acting for the common stockholders, not for the corporation
(2) The Directors were not "independent" because they were beholden to the
common stockholders (they owned common stock?)
Court's response: "Generally, it will be the duty of the board, where discretionary
judgment is to be exercised, to prefer the interests of the common stock...to the interests
of the preferred stock." p. 276

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What good is a liquidation preference? Won't the directors always refuse to

liquidate until the preference is worthless?
Yes. Preferred shareholders need a control transfer provision.
Example from case: Preferred shareholders had a "trigger." If NASDAQ
delisted Genta stock, Genta must redeem the preferred. Genta wouldn't be
able to redeem the preferred stock and would thus be in default. At that
point, preferred shareholders could sue.
But Genta borrowed the $3 million before NASDAQ delisted them.
Vicinity of Insolvency: Sometimes courts will argue that as a corporation grows closer to
insolvency, the board's fiduciary duties shift to creditors from shareholders
"Leverage" - debt in the capital structure
"High" leverage - debt more than 50% of the capital structure
Effects of leverage are important to business people
Leveraged Buy Out (LBO) means a purchase of the company that results in a lot of
debt in the capital structure. (Purchase the company by using borrowed money)
HLTs - Highly Leveraged Transactions.
If the Operating Income (EBIT) to Assets equals the interest rate, debt and equity get the
same return
If EBIT:Assets > Interest Rate, return on equity increases in proportion to leverage
If EBIT:Assets < Interest Rate, return on equity declines in proportion to leverage

Return of Equity is Net income divided by equity investment.

Outside Leverage
Definition: owners of company borrow money from someone other than themselves
Investors split money with outsiders
Inside Leverage

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Definition: company borrows money from owners

Benefit: reduction in taxes (payments on interest are tax-deductible, and borrowed
money is not considered as income.) under the circumstances of C corporation
Other options: paying salaries to the shareholders, or use the pass-through
structure (S corporation)

If you go too far though, IRS will seek to characterize debt as equity and revoke
tax deductions.
See Deep Rock doctrine equitable subordination (may re-characterize debt as
But still no harm in trying
Usually the worst that can happen is that you lose your deductions (risk of
jail time is only in egregious circumstances)
Other benefit of this approach is a higher bankruptcy priority
Option definition: the right, but not the obligation, to do something
Stock Option definition: The right to buy (call) or sell (put) a specified number of shares at
the exercise (strike) price on or before the expiration (maturity) date.
Example: An option to purchase 100 shares of Facebook for $49 on or before the third
Friday in December
Stock options generally expire on the third Friday of each month and are typically for
up to nine months
If one person has an option, someone else has an obligation to deliver if the option is
exercised. Who?
For executives option, the corporation is the counterparty.
For other options: A stock owner who sells the option, but still owns the stock.
Equity as an Option
This concept is part of finance theory
Stockholders are not liable for the company's debt

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Theory: For shareholders, stock is an option (1) to pay the debt and own the company, or (2)
to walk away from the investment
Professor's view: Analogy of stock to a stock option is usually confusing.
Why came up with this analogy: under the circumstances of insolvency, bank probably is the
real owner of the company, however, the shareholder has an option to pay off the debt and recontrol the company.
Dilution and Preemptive Rights
Authorized Shares: Shares the corporation is authorized to issue
Exist when the AOI say they do
Can authorize more only by amendment to Articles of Incorporation. DGCL 242(b)
Requires majority vote of shareholders
Issued shares: Shares the corporation has issued to investors
Exist when the certificate delivered, or corporation otherwise acknowledges the
shareholder pursuant to Board of Directors' authority. DGCL 152.
Treasury shares: Previously issued shares the corporation now owns (decrease of legal
Outstanding shares: Issued shares that are not treasury shares
No preemptive right to subscribe to an additional issue of stock unless granted in AOI
DGCL 102(b)(3)
MBCA 6.30(a)
The legal capital requirement
Stated capital: The amount of consideration paid for no-par stock that the board determines
to be capital.
DGCL 154
Capital: An amount fixed by the board. It must be at least the total par value of shares
outstanding or the stated capital for no-par shares.

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Also known as legal capital.

Net assets: The amount by which total assets exceed total liabilities. DCGL 154.
Also known as equity.
Surplus: The excess . . . of the net assets of the corporation over the amount . . . determined
to be capital shall be surplus. (Includes retained earnings.)
Also known as additional paid-in capital.
Retained Earnings: Accounting term for past profits that have not been paid out in
Also known as non-capital surplus.
Theory: Legal capital is a cushion for creditors
If the corporation spends one unit of value to buy its own stock, the purchase can be made
from surplus
The cash goes to the seller of stock; the stock is cancelled so the corporation has less total
The corporation can continue to buy stock, but only so long as the capital is not impaired.
Capital is a cushion. Debt is entitled to be paid in full. The corporation cant distribute the
assets necessary to pay debts and cant get too close to doing so.
This is largely a vestige of a prior attempt by legislatures to limit the power of corporations
Professor: the only thing legal capital can do today is to confuse people who don't understand
that it's worthless
DGCL 154 requires "legal capital" in an amount greater than 0.
If par shares, must be at least equal to the aggregate par value of such shares
If no par shares: the amount of the consideration . . . determined to be capital [by the board]
in respect of any shares without par value shall be the stated capital of such shares.
Equity in excess of capital is surplus:
DCGL 154. The excess, if any, at any given time, of the net assets of the corporation
over the amount so determined to be capital shall be surplus.
Why Legal Capital Matters
Legal capital cannot be used to pay dividends:

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DCGL 170(a). The directors . . . may declare and pay dividends upon the shares of
its capital stock . . . out of surplus . . . or . . . out of net profits for the fiscal year and/or
the preceding fiscal year.
DCGL 173. No corporation shall pay dividends except in accordance with this
Directors can have personal liability for violations:
DCGL 174(a). In case of any willful or negligent violation of . . . 173 . . . the
directors . . . shall be jointly and severally liable, at any time within 6 years after paying
such unlawful dividend . . . to the corporation, and to its creditors in the event of its
dissolution or insolvency, to the full amount of the dividend unlawfully paid . . . with
interest . . . .
Legal capital cannot be used to redeem or repurchase stock:
DGCL 160(a). Every corporation may purchase, redeem, ... or otherwise acquire
its ... own shares; provided, however, that no corporation shall:
(1) Purchase or redeem its own shares of capital stock for cash or other property
when the capital of the corporation is impaired or when such purchase or
redemption would cause any impairment of the capital of the corporation . . .
NOTE: Legal capital sets no minimum cash requirement
Methods to Avoid the Legal Capital Requirement
(1) Choose a very small amount for the par value of shares or a small amount for stated value
(2) Create capital surplus by revaluing assets.
Klang v. Smith's Food & Drug Centers (p. 285)
SFD owns Cactus Acquisition
Yucaipa owns Smitty's
Yucaipa intends to become the owner of SFD by acquiring a majority of the public
Then Smitty's will merge with Cactus
SFD buys 6 million shares
SFD issues 3 million new shares

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Smitty's merges into Cactus

SFD borrows and pays back
DGCL 160: SFD can buy using "surplus" only (the net assets minus the capital)
Pro Forma balance sheet indicates SFD has negative equity
But an Investment Banking firm (Houlihan) revalues SFD's assets, creating a
surplus and allowing SFD to move forward with the transaction
The transaction closed: Yucaipa now controls SFD
Plaintiff's argument: the pro forma shows post-transaction capital was impaired
Court: The directors fixed capital impairment by adopting Houlihan's revaluation
What valuation method did Houlihan use?
Answer: Market multiple. SFD is worth the same multiple of earning as
other companies in the industry.
See DGCL 141(e). A member of the board . . . shall . . . be fully
protected in relying in good faith upon . . . such information, opinions,
reports or statements . . . as to matters the member reasonably believes are
within such other persons professional or expert competence . . .
Based on this information in the opinion SFD had (1) a negative net worth and (2) a
deficit to surplus of more than $100 million.
Share purchase would cause an impairment of the capital.
(3) Redeem par value shares; then reduce capital to the new lower par value outstanding. DGCL
(4) Transfer stated capital value to surplus (for no-par, see DGCL 244(a)(4)(iii))
(5) Water the stock. DGCL 152
Example: Sally and Bob each contribute $100,000 in cash to form Corporation.
Each gets 100 shares with a par value of $1,000 per share
Each share is worth $1,000
Example 2: Sally contributes land worth $20,000 but says it's worth $100,000. Bob
contributes $100,000 in cash to form Corporation.
Each gets 1000 shares with a par value of $1,000 per share

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Each share is worth $600

Corporation's stock is "watered"
Remedy under DGCL 163 requires Sally to pay $80,000 to corporation, but modern
laws protect directors who water stock. See DGCL 162
DGCL 153(a). Shares of stock with par value may be issued for such consideration,
having a value not less than the par value thereof, as determined from time to time by
the board of directors.
DGCL 154. When the whole of the consideration payable for shares . . . has not been
paid in, and the assets shall be insufficient to satisfy the claims of its creditors, each . . .
subscriber for such shares shall be bound to pay . . . the sum necessary to complete the
amount of the unpaid balance of the consideration for which such shares were
issued . . . .
Example 3: Justin paid $100,000 cash and delivered a $100,000 personal note. He got JKL
shares with par value $200,000. Kath and Lorenzo paid cash. Absent a written security
agreement, Justin's note is unsecured. Could JKL collect the note from Justin?
Answer: JKL is legally entitled and sued Justin for the repayment, but maybe not able,
to collect. Justin doesn't have $100,000. Unsecured debt is hard to collect.
Professor: It's almost impossible under American law to collect unsecured debts
except from the extremely wealthy.
Thus, is Justin's note worth $100,000 when the Corporation accepts it?
Answer: Probably not. JKL would have to discount it to sell it.
Is the JKL stock watered?
Answer: Yes, but it is conclusively presumed not to be because the directors
valued it at $100,000. DGCL 152 (board resolutions under this circumstances
to confirm the value of this $100,000 note and deem the watered stock as fully
paid and non-assessable stock).
What documents would you need to give an opinion that the stock is non-assessable?
Answer: Resolution authorizing issuance of the stock and valuing the note, board
minutes, receipts for the note and share certificate.

Chapter 10A - Legal Entities (Supplement P131)

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Entity Name
A. Registered Entity Name (DGCL 102)
Entity name shall include: 1) a word of corporateness (exemptions may allowed); and 2)
distinguishing the new name from other corporations registered in the state (a difference in only
the indicator of corporateness is not sufficient to distinguish two corporations; refer to slides
The corporation codes of Delaware and California provide exemptions for corporations
qualified certain requirements regarding the word of corporateness.
Many corporations may not operate at the state of incorporation. The corporation doing
businesses beyond the state of incorporation may be required to register in the state of operation,
but this is merely identify it as a foreign corporation, but register it as a new corporation.

Unregistered Entity Name

Names of partnership, trust or association do not need registrations. Their names may be
specified in the contract or be the ones generally known in the community.


Fictitious (Business) Name (a.k.a. Trade Name in business association laws)

California Business & Professions Code (2012)
Anyone using fictitious business name to transact business in CA for profit shall (1) file a fictitious
business name statement; (2) within 30 days after the filing of such statement, shall cause such
statement be published in a qualified local newspaper; and (3) an affidavit showing the publication of
the statement shall be filed with the county clerk within 30 days after the completion of the
publication of such statement.
However, failure to comply with the above fictitious business name statute may be designated a
misdemeanor, but prosecutions are rare.

III. Corporate Groups

A. Terms
Corporate Group: a corporation and all of the entities controlled by the corporation through (a
major) stock ownership (directly or indirectly).
Business: an individual or organization of individuals that engages in trade. [The scope of
business is usually defined by its accounting system. If a division of a corporation has its own
separate accounting records, such division will probably be considered as a separate business.]
No necessary relationship between entities and businesses.

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Entity Structure: the relationship among two or more legal entities. (A corporate group is one
type of entity structures.)

What is an entity?
The law has two conflicting views of the corporation and switches between them:
(1) An aggregate of individuals - a group of people
The authorized spokesman of a corporation is a human being, who speaks on behalf of
the human beings who have formed that association just as the spokesman of an
unincorporated association speaks on behalf of its members. Citizens United (Supreme
Court 2010)
(2) A person, separate from the individuals
A corporation is an artificial being, invisible, intangible, and existing only in
contemplation of law. Being the mere creature of law, it possesses only those properties
which the charter of its creation confers upon it, either expressly, or as incidental to its
very existence. Dartmouth College (Supreme Court 1819).
Corporations have most of the rights of "persons"
(1) Freedom of speech. Citizens United (Supreme Court, 2010)
Aggregate theory
(2) Freedom of the press. New York Times v. Sullivan (Supreme Court, 1964)
(3) Freedom of Religion. (split of circuits). Aggregate theory. Right to not provide birth control.
(4) Fourteenth Amendment, equal protection of the laws.
The court does not wish to hear argument on the question whether the provision in the
Fourteenth Amendment to the Constitution, which forbids a State to deny to any person
within its jurisdiction the equal protection of the laws, applies to these corporations. We are
all of opinion that it does. Santa Clara County (Supreme Court 1986). Entity theory.
Use and function of artificial entities
(1) Limited liability- Protect owners from respondeat superior
(a) Prevents the entity's creditors from interfering with the owner-controller's affairs
(b) Incorporation confines business liability to the entity (or one of several entities)
Sole proprietor has liability for business contracts and torts by whomever committed.

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(2) Asset Partitioning - Separate assets from owners/others

(a) To prevent the owners and the owners creditors from interfering in the entitys affairs
(except by formal control methods).
(b) To prevent lawsuits in one jurisdiction for wrongful acts in another jurisdiction.
A single entity may operate in several jurisdictions.
Venue: Creditors can sue where the events occurred or where the defendant is present.
Tort creditors of the India operations can sue in the US and win high US jury
Separate incorporations confines India tort creditors to lawsuits against Union
Carbide, India.
Union Carbide India Corp. can only be sued in India, so the tort creditors can
recover only low Indian court awards.
(c) To confine the regulation of a regulated business.
Problem: Regulations ban a corporation engaged in banking from engaging in any other
Solution: Put the bank and the other business in separate entities.
Holding company: A corporation that owns only the stock of subsidiaries (may
not have other businesses (but in some cases, holding company may own assets)).
(d) To package assets for sale (Putnam v. Shoaf).

Fictitious Business Names

Three Situations for Names:
(1) Every registered entity has a name
That name is on the public record
Many are awkward
e.g. Film Studio 17 of Burbank, Inc.
(2) Every human being has a name

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Many variants, uncertainties, and changes

No single controlling public record
(3) Most, but not all, general partnerships have a name
It is usually the name in the partnership agreement
Any of the three may want to use another name for business
e.g. "Mark Liu, doing business as Mark's Pianos"
Fictitious name = trade name
A fictitious name is NOT a trademark (trademarks identify goods or services)
Fictitious business names that must be registered: California Code
Fictitious name filing is available at the county clerk website (for public research).
In the case of an individual: a name that (1) does not include the owners surname or (2)
suggests the existence of additional owners.
A partnership: a name that (1) does not include the surname of each general partner or (2)
suggests the existence of additional owners.
A corporation: a name not the name in its articles of incorporation.
There aren't real penalties for failure to register fictitious names, so most people don't.
Filing Lawsuits
There is a big problem with figuring out who to sue
We live in a world of trademarks (which is what we see), but we sue in a world of entities
Lawsuits can be filed only against entities in their exact legal names
Lawsuits cannot be filed against fictitious names or trademarks
The "misnomer" doctrine may (or may not) permit name correction later
Misnomers can usually be corrected, but service on a wrong entity cannot
A misnomer cannot be amended if the amendment would effect a change of parties; the
misnomer doctrine applies only to correct inconsequential deficiencies or technicalities
in the naming of parties, for example, where the right corporation has been sued by the

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wrong name, and service has been made upon the right party, although by a wrong
name. Miller v. Chapman (Mich. 2007)
FRCP Rule 4(h) sets out requirements of service of process for corporations, partnerships,
and other unincorporated associations
NOTE: It does not apply to sole proprietorships
How do we find out the legal name?
Check with County's registry of fictitious names
Corporate Groups
By owning the shares of other corporations, a corporation can form corporate groups
The owner is a "parent" and the owned corporations are "subsidiaries"
To be a "subsidiary," the parent company must have control (i.e. more than 50%
The groups can include all kinds of entities (e.g. LLCs, Partnerships, etc.)
Groups are NOT entities
They cannot sue, own property, etc.
Multiple Businesses v. One Business
There are wide differences in the nature of groups. The two extremes are:
(1) Each entity has an independent business.
Example: Time Warner owns HBO, CNN, Warner Brothers, DC Comics
(2) The group has only one business. Each entity has a role in that business.
Example: An airline with separate corporations for bagging, finance, intellectual
property, and aircraft leasing.
Corporation statutes apply to each corporation separately
Some Federal regulatory law applies to corporate groups
e.g. Securities regulation, banking, labor, etc.

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Under these laws, corporations may be liable for acts of their affiliates.
Making a Corporate Group Diagram
1. Distinguish assets from entities
An entity name usually contains words of corporateness
Assets distinguish by context: "Fox Sports Net ('FSN'), a national sports programming
2. Drafters pick intuitive names and give convenient short names
Could be Chevron, Chevron International, Chevron Holdings, etc.
3. Put entities in boxes (that's the convention)
4. Put the owner (entity) above the owned entity or asset
5. Draw line down ad indicate percentage of ownership beside line
6. "Indirectly owned" indicates an entity between
7. Include relationships other than ownership: leasing, managing, etc.
These relationships can exist in any combination
You most often see large combinations in hotels
Entities and Liabilities - Consumer Awareness of Nature of Entities
Except when using lawyers, economic participants see only trademarks and not entities.
Do customers need to know what entity they are dealing with?
Not for the product or service, but yes for liability purposes.
Will the market take care of the problem?
What change in the law could enable customers to know what entity they are dealing with?
(1) Require that companies use their real names with the trademark
(2) Enforce the fictitious name statutes (although that knowledge might come too late)

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(3) Warning telling the customer that the trademark holder does not manufacture or operate
the business.
Entity Thinking
Deals can be expressed in "contract" or "entity"*
*Think of "entity" as a language that lawyers speak
Examples of Contract v. Entity Thinking:
Bank lends $500 million to Rockefeller, a human, without recourse.
Bank cannot sue Rockefeller for nonpayment.
Bank lends $500 million to Rockefeller, Inc. (a shell corporation owned by
Bank cannot sue Rockefeller for nonpayment
I transfer all assets of my business to you.
I transfer my stock in Rockefeller, Inc. to you (Rockefeller, Inc. owns all the assets of
my business)
Complex deals often can be stated more simply in entity
e.g. Smith's Food and Drugs
Contract drafting problem 1: A, B, and C will run a supermarket. A and C will run the meat
Solution: Put the supermarket in one corporation and the meat department in another.
A, B, and C are owners and directors of the supermarket corporation. A and C are
owners and directors of the meat department corporation.
Contract drafting problem 2: The bank lenders are to have first priority in the automobile sale
contracts of General Motors.
Solution 1: Lend secured.

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Solution 2: Place the customer contracts in a subsidiary (GMAC). The banks are the
only creditors of that corporation.
"Finance Subsidiary." See Absolute Priority Rule (APR)
Professor: Whether a deal is written in contract or entity can actually determine the outcome
Putnam v. Shoaf (Supp. p. 147)
Charltons and Putnams are partners in the Frog Jump Gin Partnership
Lyle Putnam dies
Carolyn Putnam inherits his interest
A thief steals $68,000
Carolyn sells to the Shoafs
Gin gets the $68,000 back
Carolyn sues Shoafs for $34,000
Court: Putnam loses. She wanted out and out she got.
Judges argument confirms that Putnam did not convey her consent of transfer her interests in the
partnership to Shoaf, but she had to do so.
Lopucki does not agree with this decision. Considering the only exception of restatement of
contract, in the current case, Putnam did not have limited knowledge of the embezzlement, so the lawsuit
sale was voidable for mistake.
Professor: When you start to use entity thinking, it can take you places you would not
otherwise go.

Chapter 11 - Piercing the Corporate Veil

Piercing generally (i.e. taking away limited liability)

Sole Proprietorship: no limited liability
Limited Liability defined
Equity investors are not liable for the entitys obligations

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Equity investors are liable for their own obligations.

Equity investors include:
Shareholders of a corporation
Members of an LLC
Partners in an LLP
NO limited liability for:
Partners in a general partnership
The owner of a sole proprietorship
Policy rationales for limited liability
Moderate version: Limited liability encourages investment
Extreme version: Wealthy won't buy stock in corporations if mere ownership could cost their
entire fortune.
e.g. Rich buys 100 shares of Golden Sachs. Goldman loses $100 billion trading
derivatives, so Rich "loses his entire fortune."
Reasons respondeat superior actually should extend to Rich
(1) Professor: Loss would be spread pro-rata over thousands of Goldman
investors, so no one would lose much.
(2) Individual debtors are already protected by exemption laws.
(3) Limited liability doesn't prevent losses, it just shifts the loss to someone else
(Goldman's creditors and employees)
(4) Limited liability encourages Goldman to operate recklessly because Goldman
has a limit on its losses.
(5) Limited liability is a government handout to businesses.
Short history of limited liability
Traced to the 15th century
General incorporation laws New York 1811 (several say it was first).
Corporate limited liability: Active political issue in mid-19 th Century

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New York, limited liability

Massachusetts, expressly unlimited liability (policy, fairness, not state competition)
American Express had unlimited liability into the 1960s.
Law firms had unlimited liability into the 1990s in many states (basically b/c the law does not
permit limited liability)
Avalanche of liability-limiting laws in 1990s
Arguments against limited liability
(1) Externalization of risks/costs: Shifts business activity costs to people who shouldn't bear
(2) Strategy can turn limited liability into no liability: the Exxon example in the slides
American entities are largely divided into two groups: entities that do things but don't
own anything and entities that own things but don't do anything. The entities that do
things incur the liability but cannot pay for it because they dont own anything. The
entities that own things never incur liability because they don't do anything.
(3) Discourages insurance (Walkovsky)
(4) Complexity and deception (strategic use, Mobil Mini-Mart)
Arguments for limited liability:
(1) Ones entire fortune should not be at risk
(2) Tort liability is excessive and out of control
(3) Investors will go elsewhere (jurisdictional competition)
(4) Authors: Democracy, urbanization, monitoring, and "protecting the little guy"
(5) Cant get rid of it (jurisdictional competition)
Joseph Grundfest: US cannot avoid limited liability
Other nations still have limited liability
If US adopted unlimited liability, (domestic and foreign) investors would invest
in foreign shell corporations which invested that money in US corporations
Courts could only reach the shell corporation and not the rich investors,
effectively giving limited liability to the investors in the shell corporations

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Law of Corporate Veil Piercing

Casebook authors: None of what courts say is helpful
Professor: Some (legal rules and standards) of it is helpful
Dominant two-prong test for Veil Piercing (Folger v. Cottle (Cal. App. 2002)):
(1) There is such a unity of interest and ownership between the corporation and the individual
or organization controlling it that their separate personalities no longer exist; and
Do entities have "personalities"? How would a court know if one did?
Formalities: are there meetings, minutes, and other necessary paperwork?
Most courts do not require a business, but only compliance with formalities
BUT: OTR Associates v. IBC Services, Inc. (p. 328) held against IBC
Services because it was a subsidiary without a business (Professor said
court in that case didn't understand how U.S. subsidiaries work though)
Commingling: funds or assets being put together, and cannot be separated (by
FYI: law firm shall at least have two bank accounts: operating account for the
law firm, and a trust account for putting clients funds (professional conduct rules
request the law firm shall not commingle their funds with their clients.)
Are there separate bank accounts that are used for distinct purposes?
Fletcher v. Atex, Inc.
Atex, Inc. sells a defective keyboard that injures Fletcher
Fletcher sues Kodak; seeks to pierce corporate veil
Was Kodak's cash management system a "commingling" of funds?
Depends on which definition of "commingling" is used:
(1) mixing of funds in the same account (which occurred) or
(2) mixing of funds so they cant be separated (didnt occur).
Fletcher's evidence:
Cash management system

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Each entity operates a business, earns cash and pays bills

All cash is deposited to Parent's account
All bills are paid from Parent's account
Kodak approval required for leases, capital expenditures, asset
A number of Kodak employees sat on Atexs board of
Atex use of Kodak logo, misleading merger, division
Court: No piercing.
Your corporation exists when you act like you believe it exists.
(2) Failure to disregard the corporate entity would sanction a fraud or promote injustice
NOTE: "Domination," "alter ego" are not part of the test, but are part of the rhetoric used
when talking about veil piercing (e.g. in NetJets)
Undercapitalization alone is not enough (i.e. no minimum capital)
Agency rules are applied consistently
In UK and other countries, trading while insolvent is wrongful; directors are personally liable.
Corporate poverty is voluntary (the owner chooses not to put money in), and piercing only
matters when the owners have money.
Internal Affairs Doctrine
The law of the state of incorporation governs the "internal affairs" of a corporation
"Internal affairs" - the relations between the shareholders, officers, and directors
Policy justification: They consented to the state of incorporation.
Whether to pierce the veil is an internal affair, so it is governed by the law of the state
of incorporation
[California partly rejected such internal affairs doctrine.]
Professor: this is unfair because Delaware can determine whether a plaintiff injured in
California will be able to recover anything against a tortfeasor corporation

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Delaware has a conflict of interest

Inadequate Capitalization
Inadequate capitalization is a factor, but not dispositive
An important factor considered in veil piercing, but not enough on its own to pierce the
Professor: it should be enough though. If parent doesn't give subsidiary enough
money, the subsidiary isn't real.
Adequacy of capitalization is considered as of the time of:
(1) Formation; and
(2) Substantial expansion of size or nature of business
Professor thinks it should be tested at the time of the tort
Insolvent companies should not have limited liability
It is wrong to trade while insolvent in the U.K.
Comparing insolvent corporations to insolvent individuals is wrong
Corporations are voluntarily insolvent; individuals are not
Thus it is fair to allow individuals to conduct business and drive cars
while insolvent, but wrong to allow corporations to do so
Insurance and Capitalization
Professor: purchasing minimum required (by statute) insurance should not be sufficient
to have adequate capitalization because legislatures assume corporations will have
other assets when setting the minimum
Minimum Capitalization v. Inadequate Capitalization
Minimum capitalization requirement: Statutory requirement that shareholders
contribute some minimum amount of capital.
Example. The initial paid in capital shall not be less than $1,000.
Such statutes no longer exist for corporations, LLCs, or limited partnerships in
Statutes and regulations still exist for banks, insurance companies, and other
regulated businesses.

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Inadequate capitalization: A factor to be considered by the court in deciding whether

to pierce the corporate veil. What amount is adequate depends on the particular
business. Adequacy is measured at the incorporation and change of business scope.
"Everybody knows" that the names in which business is done are not the names of the entities
with liability.
Thus, fraud that leads consumers to believe that the names in which business is done ARE the
names of the entities with liability is acceptable
See Gardemal v. Westin Hotel Co., where Gardemal stayed at a Westin Hotel owned by a
Mexican corporation but believed based on the website on which he booked the trip and his
interaction with the hotel staff that it was owned by Westin Hotel Co., but no fraud occurred.
Empirical studies - Piercing is more likely if:
Corporation has fewer shareholders or employees (as expected)
Contract (not tort) creditor sues (opposite of expected)
Judge is conservative (opposite of expected)
Plaintiff made undercapitalization allegations (as expected)
One-Person Corporations
Courts are no more likely to pierce to hold a corporate owner than to hold an individual
One person corporations are authorized by law and should not lightly be labeled sham.
Nelson v. Adams USA, 529 U.S. 471 (2000).
How can a one-person corporation NOT be completely dominated by its owner and a mere
instrumentality or alter ego"?
Answer: It cannot. Those judicial statements are nonsense.
Veil Piercing: Are LLCs harder to pierce?
LLCs are not harder to pierce because:
(1) Every state that has enacted LLC piercing legislation has chosen to follow corporate
law standards and not develop a separate LLC standard. Netjets (Supplement, p. 165)
LLCs are harder to pierce because:

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(1) ULLCA imposes no meeting or minutes requirements, so an LLC can't fail to

comply with formalities
ULLCA 303(b). The failure of a limited liability company to observe the usual
company formalities or requirements relating to the exercise of its company
powers or management of its business is not a ground for imposing personal
liability on the members or managers for liabilities of the company.
Unclear what this statute means
Could be completely meaningless or could eliminate veil piercing entirely
(2) Boyd & Hoffman empirical finding: LLCs owned by entities were less likely to be
pierced than corporations owned by entities.

Contrasting Perspectives on Permissibility of Entity Contracting: OTR Associates and RJ

OTR Associates v. IBC Services, Inc. (p. 328)
OTR leases sandwich shop premises to IBC, a judgment-proof shell.
IBC subleases to Samyrna. Samyrna pays rent directly to OTR
Why is IBC in this transaction?
Answer: Assisting franchisees in negotiating leases.
$150,000 in rent arrearage. Why didnt Blimpie pay?
Answer: IBC was liable, but judgment proof. Blimpie thinks this is Samyrnas debt.
(Some companies pay subs debts; others dont.)
Court: OTR can pierce IBCs veil and collect from Blimpie.
First prong: IBC had no separate existence. IBC had no business premises;
exclusively preform services to the parent, no income, no employees was not
seeking a profit.
BUT: IBC had its own officers and directors, filed annual reports kept
minutes, held meetings, had a bank account. (Formalities)
Most courts do not require a business, but only compliance with formalities
Second prong: IBC was used to perpetrate a fraud or injustice.
IBC Services Inc. having an address at c/o International Blimpie Corporation

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Court: IBC was either the corporate name or a trading-as name and that
International Blimpie Corporation was the other of these two possibilities.
"No independent business of its own; exclusively performed a service for the parent."
Professor: the court misunderstands the way that subsidiaries function in the U.S.
Most courts do not require a business, but only compliance with formalities
11.10. The court said IBC affirmatively, intentionally and calculatedly led OTR to believe
[IBC] was Blimpie. What is the evidence?
Answer: [T]wo men in Blimpie uniforms who announced that they wanted to open a
Blimpie sandwich shop. (Mobil/Westin did this.)
The lease description (previously discussed)
IBCs use of Blimpie logo letterhead (PwC Bahamas did this.)
IBCs reference to Samyrna as our franchisee.
Court considers logos used by judgment proof entities misleading.
Geigo Properties, LLP v. RJ Gators (Supp. p. 165)
Professor: This is in the reading to offset OTR Associates v. IBC Services, Inc.
RJ Gators is a shell and has no bank account.
RJ Gators signs the lease, makes the initial payment, and never moves in
Court: Mere shell use and subsequent breach is not enough to pierce the veil
Contract drafting possibilities:
Direct contracting: A solvent entity (Timoteo) signs, but the contract says Timoteo is
not liable
Entity contracting: An insolvent entity signs and agrees to be liable.
11.11. Should entity contracting be permitted?
OTR Associates v. IBC Services: Yes (courts decision)
Geigo Properties v. RJ Gators: No (courts decision)
Professor's Answer: Yes, but only with proof the counter-party understood the
provision. Shell owner should have a duty to speak.

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But cases are split on whether shell owners have a duty to speak:
No. Some courts presume that a party dealing with a corporation did
assume the risk of grossly inadequate capitalization. . . . Parties
generally entitled to rely upon certain assumptions . . . including
presumption that the corporation is more than a mere shellthat it
substance as well as form. Fletcher, Cyclopedia of Corporations.


Yes. Under the doctrines of waiver and equitable estoppel, a corporate

creditor may be precluded, by continuing to extend credit and by failing to
take advantage of the opportunity to investigate the corporation's capital
foundation, from claiming the inadequacy of the corporation's
capitalization as the basis to pierce its veil. Fletcher.

Tort cases
Walkovsky v. Carlton (p. 306)
Carlton owns ten corporations
Each corporation owns one or two cabs
Seon cab injures Walkovsky
Walkovsky sues Carlton and each of the corporations as one entity
Reachable money:
$10,000 insurance
Each corporation held only $10,000 insurance policies, the minimum amount
required by the Legislature
Unreachable money:
15 taxis at $5,000 each = $75,000
15 medallions at $10,000 each = $150,000 (held by Carlton)
Garage real estate: unknown
Cash flow from the business: Unknown
Carlton's other wealth: Unknown
Carlton set the corporations up this way knowing the business would injure customers and
Court: complaint is dismissed

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Fletcher v. Atex (see above)

Gardemal v. Westin Hotel Co. (p. 312)
Gardemals vacation at the Westin Mexico
Concierge at Westin Mexico recommends Lover's Beach but doesn't mention the strong
Dr. Gardemal is swept up by a rogue wave and dies
Mrs. Gardemal sues Westin Hotel in U.S. for negligence of Westin Mexico's concierge
Plaintiff's theories:
(1) Veil Piercing: "Alter ego," "mere tool or business conduit"
Supporting evidence:
Parent owns most of stock
Common officers
Manuals and contracts
Opposing evidence:
Separate banking, assets, staff, insurance
Follows formalities
Adequately capitalized
(2) Single Business Enterprise Doctrine: when corporation are not operated as
separated entities, but integrate their resources to achieve a common business purpose,
each constituent corporation may be held liable for the debts incurred in pursuit of that
business purpose.
This doctrine is an equitable remedy which applies when the corporate form is used as
part of an unfair device to achieve an inequitable result.
Supporting evidence:
Shared trademarks
Shared reservation system
Opposing evidence:

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No "blending of corporate identities"

Test for Single Business Enterprise:
1. identity of ownership (actual working control)
2. common directors or officers
3. unified administrative control
4. directors, officers of one corporation act in its interests
5. one entity finances others
6. inadequate capitalization
7. incorporated its affiliates
8. one pays salaries, expenses of the others
9. receives business only from affiliates
10. uses the property of another corporation as its own
11. formalities noncompliance
12. common employees
13. employees of one corporation render services for another
14. common offices
15. centralized accounting
16. undocumented fund transfers
17. unclear allocation of profits
18. excessive fragmentation of an enterprise among entities.
Court: Summary judgment for Westin.
Nothing more than a typical corporate relationship between a parent and subsidiary.
Note: Majority rule is that law of state of incorporation applies with respect to veil piercing,
but the court applied Texas law to a Mexico corporation [conflict with the internal affairs
doctrine adopted in the Fletcher case (California law v. Delaware laws)]

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The court using the U.S. law b/c the issue / case is between U.S. nationals.

Contract Cases
NetJets Aviation v. LHC Communications
Summary: Court mistakenly pierces veil of one-person corporation because it thinks the
owner is scum. Owner won in subsequent proceedings even though he withdrew funds at
will, changed his story on capital contribution, and used LLC funds to pay for personal living
expenses because he accounted for all the transfers and thus did not operate as a "single
economic entity".
LHC (an LLC) uses $341,000 of private jet rental time and doesn't pay for it
NetJets sues Zimmerman personally, seeking to pierce the LLC veil
Court applies two prong test:
(1) The LLC and owner "operated as a single economic entity"
(2) An "overall element of injustice or unfairness is present"
NetJets's evidence:
Domination: No decision was made without Zimmerman's approval
LLC funds were used to pay personal living expenses (and recorded as "loan
receivable" in the bookkeeping)
Money went in an out based on need, at the eleventh hour
$350,000 for Bentley in year he didnt pay $340,000 to NetJets
Court is willing to pierce the veil (overturns lower court's SJ in favor of LHC)
The court got this decision wrong (see 11.5)

Dual Agency
Parent liability for group action
MBCA 6.22(b): . . . . [A] shareholder of a corporation is not personally liable for the acts
or debts of the corporation except that he may become personally liable by reason of his own
acts or conduct.
The rule applies to shareholders that are corporations.

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If the parent does the wrongful act, the parent is liable.

If the sub does the wrongful act, the sub is liable.
Most acts are done by people; they may work for both corporations.
When those people act, how do we know which corporation acted?
Bestfoods Rule: When directors and officers claim to act for a subsidiary, the court presumes they
act only for the subsidiary
BUT: Presumption wanes as action by dual officer appears to be plainly contrary to the
interests of the subsidiary yet is advantageous to the parent
PROBLEM: This test can never be met
The test could be met if the purpose of the corporation is not to maximize its value, but
to serve social interests c. Externalization of risk is contrary to the subsidiary's
What are the best interests of a corporation? What do corporations want?
Professor's answer: This language has no meaning. It leaves judges free
to do whatever they want.
Others answers: Corporations want to maximize their net assets;
maximize their aggregate share value; maximize their aggregate share
value after meeting their social responbililities; or do the right thing.
United States v. Bestfoods
Ott operates a factory that pollutes (a.k.a. Ott Chemical Co., Ott I)
CPC bought the assets of Ott and formed a new corporation with the same name
("Ott II")
CPC and Ott II have the same directors and officers
CPC then sold the company to Story Chemical Company, then the company
bankrupt in 1977
Aerojet-General Corp. took over the company by using its California subsidiary
Cordova Chemical Company and established a wholly owned Michigan company
- Cordova Chemical Company of Michigan.
Government sues CPC, Aerojet, Cordova California, Cordova Michigan and
Arnold Ott for their pollution. Any "operators" of the facility are liable under a

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federal pollution statute (CERCLA). Under the statute, an operator must manage,
direct, or conduct operations specifically related to pollution, that is, operations
having to do with the leakage or disposal of hazardous waste, or decisions about
compliance with environmental regulations.
Ott II settles
CPC claims that it does not have liability because it was not involved in the
CPC and Ott II had common officers and directors. They operated the facility.
Issue: Did they operate on behalf of CPC or Ott II?
One CPC employee ("Williams") who was not connected in any way with
Ott II may have "operated" the facility
Court: CPC is not liable on the basis of sharing directors and officers with Ott II as long
as those directors and officers were acting only for Ott II and not for CPC while they
operated the facility. Williams, CPC employee not employed by Ott II may have
operated the facility. Remanded for retrial.
Test for Overcoming Presumption that Officers/Directors Act for Whom they Claim to
Act: The presumption . . . an act is taken on behalf of [a subsidiary] wanes as the
distance from [the norms of corporate behavior] approaches the point of action by a
dual officer plainly contrary to the interests of the subsidiary yet nonetheless
advantageous to the parent.

CHAPTER 11A - Other Entity Disregard Theories

Rm 1420 Oct 20 (Tue), same time instead of Oct 21 (Wed)
List of Entity Disregard Theories
I. Veil Piercing
1. Veil piercing (alter-ego, mere agent or instrumentality)
Entities (i) operated as a single economic entity" and (ii) an overall element of injustice
or unfairness is present
2. Reverse veil piercing
(i) Creditor is entitled to payment from the owner of an interest in and entity; and
(ii) Elements of veil piercing have been met with respect to the entity

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3. Equitable ownership
(i) Control by a person who is not the legal owner of an interest in the entities; and
(ii) Elements of veil piercing have been met
II. Agency
4. Agency
(i) Manifestation by the principal that the agent shall act for him
(ii) Agent's acceptance of the undertaking
(iii) Understanding between the parties that the principal is to be in control of the
(iv) Injury inflicted by the subsidiary was within the scope of the subsidiary's authority
as an agent
Consequence: P is liable to As authorized act.
5. Ratification
Knowing acceptance by the principal of an agent's act after the act occurs
Can be shown by:
Defending the action of the agent
Covering up the action of the agent
6. Aiding and abetting
(i) the party whom the defendant aids must perform a wrongful act which causes an
(ii) the defendant must be generally aware of his role as part of the overall or tortious
activity at the time that he provides the assistance; and
(iii) the defendant must knowingly and substantially assist the principal violation.
III. Enterprise Liability
7. Enterprise liability (single enterprise, integrated, plain)
Same elements as veil piercing, except that entities are sisters, not parent-subsidiary

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NOTE: Only California allows enterprise liability, and it's not really clear if even
California actually allows it
IV. Substantive Consolidation
8. Substantive consolidation (only in bankruptcy)
(i) creditors dealt with the entities as a single economic unit and did not rely on
their separate identity in extending credit; or
(ii) the affairs of the debtor are so entangled that consolidation will benefit all
How can consolidation benefit all creditors? If some get more, dont others
get less?
Answer: No. Correction of the accounting could consume the entire
bankruptcy estate.
Restatement 3rd Agency 101. Agency is the fiduciary relationship that arises when:
(1) one person (a principal) manifests assent to another person (an agent) that
(2) the agent shall act on the principals behalf and
(3) subject to the principals control, and
(4) the agent manifests assent or otherwise consents so to act.
The parent-subsidiary relationship may be a principal-agent relationship
Consequence: The parent is liable for a subsidiary's authorized acts
Supervision v. Domination
Parent can supervise subsidiary without incurring liability, but can be liable if they dominate
Supervision requests coercively, but generally; domination orders specific action.
Spectrum from supervision to domination (from Bowoto v. ChevronTexaco):
CVX: This publicity is a problem. Solve it or well vote you out.
CVX: I want the demonstrators off the platform by morning.

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CVX: Take the soldiers to the platform on our helicopters.

Scope of Authority
The parent is only liable for damages caused by the agent's acts within the scope of the
agent's authority
Purpose of Limited Liability for Subsidiary's Actions
Protection of passive investors?
There are none (the offshore parent company is not a passive investor)
Protection of corporation from responsibility for acts beyond its control?
Acts of wholly owned subsidiaries are not beyond the parent' s control
Professor's Answer: They shouldn't have limited liability. Liability seeks to alter behavior. If
it doesn't extend to the deep pocket, it won't alter behavior.
The continuing puzzle is why courts remain so willing to provide limited liability to
parent corporations in tort cases. The various arguments for limited liability do not
have much impact in the parent-subsidiary situation. Robert Thompson, Unpacking
Limited Liability, 47 Vand. L. Rev. 1 (1994)
BUT: Delaware will never get rid of limited liability for subsidiary's actions
If they did, corporations would no longer choose Delaware and they would lose a large
source of revenue.
Bowoto v. ChevronTexaco (p. 176, Supplement)
CNL cracks down on demonstrators, resulting in two deaths
Plaintiffs sue the US parents in San Francisco.
Court remanded for consideration of whether CNL acted as an agent of CVX or whether
CVX ratified the actions of CNL by defending CNL's actions or by covering them up
The parents and subsidiaries may . . . have entered into a limited agency relationship for a
specific transaction. Facts suggesting agency:
(i) Representations made about Nigerian oil production as a percentage of overall
(ii) Revolving door of managers and directors between the parent and subsidiary
(iii) Hiring process which involved selection of CNL officers by U.S. Defendant's
Personnel Development Committees

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(iv) Daily communications between CNL and Defendants, especially sharp rise in
communications during attacks
(v) Corporate security committee which monitored and planned security operations for
the subsidiaries
Enterprise Liability
Definition: Liability for a business's actions is imposed on all entities that are part of the business.
Limited liability within the corporate group is abolished.
This is what Plaintiff hoped to do in Bowoto v. ChevronTexaco
Requires actual ownership to be imposed
NOT ENOUGH: operations that could have been one business
Other concepts referred to as "enterprise liability": (rational behind: business shall be liable
instead of entity)
(1) Industry wide liability - Liability on all members of an industry for manufacturing a
harmful or defective product, allotted by market share. Asbestos.
(2) Joint enterprise liability - Liability on members of a group that act together. Similar to
partnership liability.
(3) Single business enterprise - Liability on entities for acts of other entities that are mere
business conduits. Gardemal.
Only in Texas, Louisiana, and North Carolina. Has an 18-factor test. See Gardemal.
(4) Single employer doctrine - Labor-related liability on related entities that do not act at
arms length. Integrated enterprise theory. Bowoto.
Problem with enterprise liability: you have to figure out the scope of the enterprise.
e.g. Continental Airlines has several subsidiaries: Finance; Operations; Baggage; and
Texas Air bought Continental Airlines, which continued to operate on its own, and
Eastern Airlines, which eventually filed for bankruptcy.
Texas Air was owned by a holding company which was owned by Frank Lorenzo.
Are there three businesses (Continental, Eastern, and Texas)?
Or just one (holding company that owns Texas Air)?
What makes a business separate?

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Separately managed operations: different directors, officers, employees

Separate profit center and investors
Separate accounting system
NOT separate trademarks (e.g. Salant has 160 different clothing brands)
The argument for enterprise liability:
(1) Vicarious liability: Employers should be liable because:
(a) the employer's business is being done
(b) the employer has power to make changes
(c) the employer can pay
(2) In reality, the business, not the entity, is the employer and has the power to make changes.
(3) Limiting liability to the employer entity invites strategic evasion: the employer entities
dont own assets and so cant be forced to pay.
The argument against enterprise liability:
(1) Uncertainty
Business boundaries are not distinct, so actors would not know the scope of their
liability in advance.
Business boundaries change through integration and disintegration, so the scope of
liability would be constantly changing.
(2) Vicarious liability was a mistake. Law should act only against wrongdoers, not employers.
Equitable Owner Liability
Swenson v. Bushman (Handout)
Bushman wins a judgment against DBSI-E470 East and pierces the corporate veil.
The arbitrator finds David and Jeremy "were part of an 'insider' group that controlled
the DBSI entities."
The arbitrator finds David and Jeremy liable as equitable owners.

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Court: To pierce the corporate veil, "it must be shown that there is such a unity of interest and
ownership that the individuality of such corporation and such person has ceased . . . .
Equitable ownership in a corporation, demonstrated by control exercised by an individual
sought to be held liable for corporate debts, may satisfy the unity of interest and ownership
element . . .
The "equitable ownership" doctrine only applies in some states
Substantive Consolidation
Grounds for Substantive Consolidation: "Substantive consolidation is appropriate if:
(1) creditors did not rely on the separate existence of the debtors in extending credit; or
(2) the debtors' financial affairs are hopelessly entangled." In re Augie/Restivo Baking Co.,
860 F.2d 515 (2d Cir. 1988)
Level of Use
The estates are substantively consolidated in approximately 50% of all large public company
This is entity disregard on a massive scale
Effect of Substantive Consolidation:
"Intercompany" stockholdings and claims are ignored
Cash management system loans are not repaid
In re LLS America (Supplement p. 194)
Doris has a small loan business in Canada
Doris starts a small loan business in the U.S.
Doris sets up a business to supply them
Her husband Dennis buys a building and the business rents it
Doris creates a new Note LLC for each lender she borrows from
The Note LLCs allow use of the funds by any of the entities
Doris commingles all the money (she has consent to mix it) to the extent that it cannot
be determined which money has gone where

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LLS America and D&D file bankruptcy

Court substantively consolidates all the artificial entities, but not Doris
Bonham test: Substantive consolidation is appropriate if:
(1) creditors dealt with the entities as a single economic unit and did not rely on
their separate identity in extending credit; or
(2) the affairs of the debtor are so entangled that consolidation will benefit all
Bankruptcy Consolidations
(1) Large, public companies are nearly always groups
Some or all group members may file bankruptcy: one entity or 2,000 (e.g. Footstar paid
$2 million in filing fees because they incorporated every one of their stores separately)
(2) Administrative consolidation: Cases of filing group members are administered together.
(Done in nearly all cases)
Court enters order designating one case as "lead"
All later documents are filed in that court file
One reorganization plan, disclosure statement, and confirmation order
But separate estates for each corporation
(3) Substantive consolidation (done in about half of all cases):
The assets of all group members are combined in a single estate.
All creditors share pro rata in the estate (like enterprise liability)
Thus we effectively have enterprise liability

Chapter 14 - Shareholder Voting Rights (Textbook)

Voting Procedures
Shareholders CANNOT vote on managerial matters; the directors do that

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Shareholders do not own the corporation; they own their shares

Shareholders CAN vote on the following issues:
(1) election of directors
(2) Removal and replacement of directors
(3) Fundamental transactions
Sale of all or substantially all assets
Certificate of Incorporation amendments
(4) Some Bylaws
(5) Shareholder proposals (mostly recommendations)
e.g. Recommend that Directors don't open a plant in South America.
CANNOT propose not to open plant because that is managerial.
Voting Procedure (public companies context)
(1) Person(s) with authority call a shareholders meeting
(2) The board sets a "record date." DGCL 213(a). Ten to sixty days before the meeting.
(3) An officer prepares a list of stockholders as of the record date.
(4) During at least the last ten days before the meeting, any stockholder may examine the list
for a purpose germane to the meeting. DGCL 219(a)
(5) The corporation files a proxy statement with the SEC.
(6) At corporate expense, the corporation mails meeting notice, proxy statement and ballot to
shareholders. DGCL 222(a), (b)
(7) At their own expense, others may solicit proxies.
(8) At the meeting, shareholders vote by written ballot or proxy.
(9) A corporation-appointed inspector counts the votes and certifies the outcome. DGCL
231(a) and (b).

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When do shareholders meet? DGCL 211(b).

[A]n annual meeting of stockholders shall be held for the election of directors on a date and
at a time designated by or in the manner provided in the bylaws.
Often bylaws do not set a specific time for annual meetings for strategic reasons (e.g.
combatting hostile takeovers)
What type of business can be considered at the annual meeting in addition to election of directors?
DGCL 211(b). Any other proper business may be transacted at the annual meeting.
Ratification of board actions is common.
For example, Dodd-Frank requires an advisory shareholder vote to approve past
management compensation.
What is the remedy when the annual meeting is not held and who causes it?
DCGL 211(c). [T]he directors shall cause the meeting to be held as soon as is convenient.
DCGL 211(c). If there be a failure to hold the annual meeting . . . for a period of 30 days
after the date designated for the annual meeting, or if no date has been designated, for a
period of 13 months after . . . [the] last annual meeting, the Court of Chancery may
summarily order a meeting to be held upon the application of any stockholder or director.
How would the issue get to court? Who sues? Why?
Answer: Probably a shareholder in a takeover attempt.
Shareholder action without a meeting. DGCL 211(b), 228(a).
DGCL 228(a). Any action which may be taken at any annual or special meeting of
stockholders of a corporation if written consents setting forth the action are signed by holders
of the necessary number of votes (assuming all shareholders are voting)
DGCL 211(b). Stockholders may, unless the certificate of incorporation otherwise
provides, act by written consent to elect directors . . . .
Signed Consents v. Proxy Voting
If an absolute majority deliver identical consents, these actions have been taken, DGCL
What is the difference between signed consents and proxy voting at a meeting?
Signed consents don't require a meeting
Consent requires an absolute majority

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Proxy solicitation rules apply to consent solicitation. Rule 14a-1.

Necessary Notice for the Meeting
DCGL 222(b). [T]he written notice of any meeting shall be given not less than 10 nor more
than 60 days before the date of the meeting to each stockholder entitled to vote at such
meeting as of the record date . . . .
Record Date and Shareholders Entitled to Vote
DGCL 213(a). [T]he board of directors may fix a record date . . . which record date shall
not be more than 60 nor less than 10 days before the date of such meeting. If the board of
directors so fixes a date, such date shall . . . be the record date for determining the
stockholders entitled to vote at such meeting . . . .
i.e. If A sells his shares to B the day before the meeting, A would still be entitled to vote at the
Quorum Requirement
DGCL 216(1). The holders of a majority of the shares entitled to vote must attend in person
or by proxy.
Purpose: To prevent a small minority from taking action contrary to the will of the majority.
Voting When Absent (Proxy Voting)
DGCL 212(b). Each stockholder entitled to vote at a meeting of stockholders . . . may
authorize another person or persons to act for such stockholder by proxy . . .
The proxy remains valid for three years after its date unless the proxy provides for a longer
Shareholder Rights in Fundamental Transactions
Appraisal right under the DGCL:
To the shareholders of the seller: if they are entitled to vote on the merger, they can dissent and
seek an appraisal unless Delawares market out exception applies. Shareholders of the seller
who are required to take cash are entitled to appraisal rights, but those shareholders who have a
choice of among cash, shares, or other consolidation are not.
(The market out exception assumes shareholders dissatisfied with the terms of a merger do not
need a judicial valuation remedy if there is a public market for their stock.)
To the shareholders of the buyer: if the merger is significant enough to require their approval,
they have the appraisal right.
Mergers and Acquisitions

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There are seven kinds of transactions, but only two types of moves:
(1) Merger: two corporations become one, and the shareholders of both own it (the
surviving entity may have either of the former companies names or neither, whatever
kind of shares they want)
(2) Acquisition: The shareholders own one corporation and that corporation owns the
(1) Statutory merger (a combination effected pursuant to a corporate statutes merger
provisions). Direct Combination: Shareholders of both must approve; dissenters of
both shareholders get appraised value of their shares.
Objective: Two corporations combine into one.
1. Both boards adopt a plan of merger by majority vote. 251(b)
2. Both shareholder groups approve by absolute majority. 251(c)
3. File certificate of merger (with Secretary of the State of Delaware).
4. Dissenting shareholders have appraisal rights. 262(b)
5. Creditors do not vote.
Effect on Surviving Corporation:
1. Owns the assets of both corporations
2. Owes the obligations of both corporations
3. Buys the appraised shares for cash, but market out 262(b)(1)
4. Issues its shares in exchange for non-dissenting Green shares.
5. Files the plan of merger with the secretary of state.
Effect on Creditors
Each retains its claim, but against more assets, with more creditors
competing. Collection may be more or less difficult.
Creditors contract may make debt due on merger.

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Effect on Shareholders
Each has a smaller percentage of the shares of a larger corporation.
Shareholders contract may make shares redeemable on merger.
(2) Whale-minnow merger. If Green (Seller) is less than one fifth the size of Blue
(Buyer), Blue shareholders dont vote or have appraisal rights.
Definition: Statutory merger in which Blue and its stock remain the same, and
Blue buys Green for newly issued Blue stock not more than 20% of previously
issued Blue stock. The shareholders of Blue do not need to vote.
Statutory Authorization: DGCL 251(f). Unless required by its certificate of
incorporation, no vote of stockholders of a constituent corporation surviving a
merger shall be necessary to authorize a merger if
(1) the agreement of merger does not amend in any respect the certificate
of incorporation of such constituent corporation,
(2) each share of stock of such constituent corporation outstanding
immediately prior to . . . the merger is to be an identical outstanding . . .
share . . . after the . . . merger, and
(3) the . . . shares of common stock . . . to be issued . . . under the plan of
merger . . . do not exceed 20% of the shares of common stock of such
constituent corporation outstanding immediately prior to the effective date
of the merger.
Effect on Shareholders
Buyer grew by up to 20% in size. Shareholders of Buyer had shares
diluted by up to 20%.
Each shareholder of Seller chose between (1) a smaller interest in a larger
business and (2) the appraised value of their shares.
(3) Short-form merger (Absorb 90%-owned subsidiary). If Blue owns at least 90%
of Green, Blue can absorb Green. Both the shareholders of Blue and Green dont vote,
but the shareholders of Green have appraisal rights.
Starting point. Blue owns 90% of Greens shares.
Step 1. Blue sets a price for Greens shares and merges Green into Blue.
Step 2. Green shareholders choose between the price offered and appraisal

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Parent can absorb a 90%-owned sub, just by filing a certificate.

Parent can force a 10% minority to sell for appraised value. (Like eminent
domain: governmental activity taking such shares.)
Statutory Authorization: DGCL 253(a). In any case in which at least 90% of
the outstanding shares of each [voting] class of the stock of a corporation . . . is
owned by another corporation . . . the corporation having such stock ownership
may either merge the other corporation . . . into itself . . . or merge itself . . . into
1 of the other corporations by executing, acknowledging and filing . . . a
certificate . . .provided, however, that in case the parent corporation shall not
own all the outstanding stock of . . . the subsidiary . . . the parent corporation
shall state the terms and conditions of the merger, including the securities, cash,
property, or rights to be issued, paid, delivered or granted . . . upon surrender of
each share of the subsidiary corporation . . . or the cancellation of . . . such
(4) Sale of assets. Green Corporation sells its assets to Blue. Green shareholders vote
(for selling assets); Blue shareholders do not (b/c they are buying assets). No appraisal
rights to both shareholders under DGCL.
A corporation can sell its assets. If it sells them all at once, shareholders are
entitled to vote. In case of sale of substantial assets, shareholders of seller may
need to vote depending by the court.
Green agrees to sell its assets to Blue in return for 50% of Blue shares.
The shareholders of Green (seller) vote; the shareholders of Blue (buyer)
do not vote. Nobody has appraisal rights.
At closing, the parties exchange assets for stock. Blue shares are diluted.
Green holds Blue 50% of shares.
Green must pay its creditors.
Green distributes the Blue shares as a dividend.
Green dissolves.
Statutory Authorization: DGCL 271(a). Every corporation may at any
meeting of its board of directors or governing body sell, lease or exchange all or
substantially all of its property and assets . . . upon such terms and conditions and
for such consideration, which may consist in whole or in part of money or other
property, including shares of stock in, and/or other securities of, any other
corporation or corporations, as its board of directors or governing body deems
expedient and for the best interests of the corporation, when and as authorized by
a resolution adopted by the holders of a majority of the outstanding stock of the

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corporation entitled to vote thereon . . . at a meeting duly called upon at least 20

days notice.
Effect CAN BE Same as Statutory Merger
If Green sells its assets to Blue for Blue stock, the result is the same as a
statutory merger, but Blue shareholders dont vote.
Same start and end points as a statutory merger, but Blue shareholders had
no vote or appraisal rights, regardless of size.
De Facto Merger Doctrine: A sale of assets that reaches the same result as a
statutory merger is a statutory merger. Shareholders have the voting and
appraisal rights they would have had in a statutory merger.
De Facto Merger Doctrine is rejected by Delaware: each merger form has
"independent legal significance"
Farris v. Glen Alden (1958)
Implications of Delaware's view:
1. Sale of assets can reach the same result as merger.
2. Sale of assets does not require a vote of the buyers
3. Which corporation is buyer does not matter.
4. Therefore, merger by sale of assets can be accomplished
with vote of either corporation and without appraisal rights.
5. Limitation: Sale of assets requires asset transfers
This results in a tax bill on the transfer
(Transfer of assets is a tax event)
(5) Tender offer. Blue Corporation buys enough Green shares to control Green. No
voting or appraisal.
Blues tender offer to Green shareholders: I will purchase 51% of Greens shares
for $38 a share.
Blues objective: Obtain control of Green Corp.
Holders of 67% of Greens shares accept.
Blue pays cash for 51% (pro rata among the acceptors).

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Result: Green is a 51%-owned subsidiary of Blue

Nobody voted, no appraisal rights.
(6) Triangular merger. Blue creates a subsidiary to merge with Green. Green
shareholders vote. Blue shareholders dont vote. Blue does (the board of directors of
Blue votes indeed).
Definition: Statutory merger of Green into a shell Blue subsidiary.
1. Operate Green as a subsidiary.
2. To protect Blue assets from Green creditors. (e.g. CPC / Ott II)
Step 1. Blue incorporates Green Acquisition sub, exchanges Blue stock for
Green Acquisition stock (serves as the consideration of the following
transaction, and distribute Blue shares to the shareholders of Green as
Step 2: Green Corp. and Green Acquisition do a Statutory Merger.
Green shareholders and Green Acquisition shareholders vote.
Step 3 (optional). Green Acquisition incrementally sells assets to Blue
Corp. Greens creditors are left behind; cant reach Blues assets.
(7) Share exchange. (Not permitted in Delaware) By vote, Green shareholders agree
to accept Blue shares in place of their Green shares. Green appraisal rights.
Share Exchange Plan: Each share of Green Corp. shall be exchanged for one
share of Blue Corp.
Effects of the share exchange:
Blue Corp. acquired Green Corp.
Same as a triangular merger.
MBCA 11.03(a)(1). [A] corporation may acquire all of the shares of one or
more classes or series of shares of another . . . corporation . . . . pursuant to a plan
of share exchange.
(b) A foreign corporation . . . may be a party to a share exchange only if the share
exchange is permitted by the organic law of the corporation . . . .

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11.04(a). [T]he plan of . . . share exchange must be adopted by [each] board of

(b) Except as provided in subsection (h) (Blue dilution less than 20%) . . . the
board of directors must submit the plan to the shareholders for their approval.
A majority can force minority shareholders to sell their shares
Not available in Delaware
Professor: There are already a number of ways to take people's shares away
in Delaware. They don't need this method
Summary: Delaware Voting and Appraisal of Shareholders

Blue vote

Blue appraisal

Green vote

Green appraisal

1. Statutory merger





2.Whale-minnow merger





3. Short form merger





4. Sale of assets





5. Tender offer





6. Triangular merger




7. Share exchange

Does not exist in Delaware

(board Corp has

Appraisal Rights

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Who has appraisal rights - substance

DGCL 262(b). Appraisal rights shall be available for the shares of any class or series of
stock of a constituent corporation in a merger or consolidation to be effected pursuant to 251
(other than a merger effected pursuant to 251(g) of this title), 252, 254, 255, 256, 257,
258, 263 or 264 of this title.
(1) Provided, however, that no appraisal rights under this section shall be available for the
shares of any class or series of stock, which . . . were either
(i) listed on a national securities exchange or
(ii) held of record by more than 2,000 holders;
(3) In the event all of the stock of a subsidiary Delaware corporation party to a merger
effected under 253 [short form] . . . is not owned by the parent immediately prior to the
merger, appraisal rights shall be available for the shares of the subsidiary Delaware
Who has appraisal rights - procedure
DGCL 262(a). Shareholders have appraisal rights described in subsections (b) and (c) if
(i) hold shares of stock on the date of the making of a demand pursuant to subsection
(d) of this section with respect to such shares;
DGCL 262(d). Each stockholder electing to demand . . . appraisal . . . shall
deliver to the corporation, before the taking of the vote on the merger or
consolidation, a written demand for appraisal . . . .
(ii) continuously hold such shares through the effective date of the merger or
(iii) otherwise complied with subsection (d) of this section; and
(iv) neither voted in favor of the merger or consolidation nor consented thereto in
(who will eventually buy the stocks of the target company at the fair market price? The
Shares Valued EXCLUSIVE of Merger
DGCL 262(h). [T]he Court shall determine the fair value of the shares exclusive of any
element of value arising from the accomplishment or expectation of the merger . . . .
e.g. If merger is announced and value of shares drops from $12 to $10, shareholder who
exercises appraisal rights receives $12.

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Example of Protection of Appraisal Rights: Blue, Green, and survivors shares are each worth
$100. The terms of merger favor Green shareholders by giving them 1.07 survivor shares per Green
share while giving Blue shareholders .90 shares per Blue share. How much money do Blue
shareholders get?
DGCL 262(h). [T]he Court shall determine the fair value of the shares exclusive of any
element of value arising from the accomplishment or expectation of the merger or
consolidation, together with interest, if any, to be paid upon the amount determined to be the
fair value.
Answer: Blue shareholders opt for appraisal, so they get $100 a share. Appraisal protects
them against merger that is a bad deal.
Market-out exception - No appraisal rights if your shares are listed on a national securities
exchange DGCL 262(b)(1).
FLAW: the exception assumes that the market is more knowledgeable about the stock's value
than a judge would be.
By the time shareholders learn the terms of the merger, the market may already reflect
price depreciation in anticipation of the merger.
From 1991 to 2001, acquiring firms' shareholders lost an aggregate $216 billion
Response of MBCA / Efficient Capital Markets Hypothesis: The market protects Blue
shareholders by not doing bad mergers.
MBCA 13.02, Cmt. 2. Where an efficient market exists, the market price will be an
adequate proxy for the fair value of the corporations shares. After [a merger
announcement] the market operates at maximum efficiency . . . because interested
parties and market professionals evaluate the proposal and competing proposals may be
generated if the original proposal is deemed inadequate.
Professor: this exception is a mistake. It just punishes people who have publicly traded
shares and does not substitute for appraisal rights.
Shareholder Power to Initiate Action
Bylaws (A rule or administrative provision adopted by an organization for its internal governance
and its external dealings)
Who makes them?
(i) Shareholders have inalienable right to adopt, amend, and repeal. DGCL 109(a)
(ii) Directors can make bylaws if so provided in the certificate. DGCL 109(a)
What can be in them?

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(1) Anything consistent with law and the certificate of incorporation that relates to:
(a) The business of the corporation;
(b) The conduct of the corporation's affairs;
(c) The corporation's rights or powers; or
(d) The rights or powers of the corporation's stockholders, directors, officers or
employees. DGCL 109(b).
In short, any not in violation of the law and the certificate of incorporation can be
in the bylaw.
(2) Can specify procedure, but cannot commit board to a course of action:
DGCL 141(a). The business and affairs of every corporation organized under
this chapter shall be managed by or under the direction of a board of directors,
except as may be otherwise provided in this chapter or in its certificate of
REMEMBER: Powers of Board that cannot be restricted in bylaws can be
restricted in articles of incorporation.
Reimbursement Bylaws and the "Fiduciary out"
CA, Inc. v. AFSCME held that reimbursement bylaws must provide a
"fiduciary out" for directors
Bylaws can specify the procedure by which directors manage, but
cannot commit the board of directors to a course of action that
would preclude them from fully discharging their fiduciary duties [to
manage]. CA, Inc. v. AFSCME (See below)
BUT: Delaware responded with DGCL 113(a), which appears to allow
reimbursement bylaws without the "fiduciary out"
The bylaws may provide for the reimbursement . . . of expenses
incurred by a stockholder in soliciting proxies in connection with an
election of directors, subject to such procedures and conditions as the
bylaws may prescribe, including [specified conditions and] . . . any
other lawful condition.
UNCERTAINTY: Professor thinks 113 overturns CA, Inc., but many
experts say it is unclear whether courts will read a "fiduciary out"
exception into bylaws passed under 113.
Examples of valid shareholder bylaws procedural things:

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(1) Fixing the numbers of directors and the quorum requirement.

(2) Requiring unanimous board attendance and unanimous approval of board
(3) Recommending director action on any matter. Auer v. Dressel.
Examples of invalid shareholder bylaws:
(1) Requiring no-shop provisions in contracts for sale of the company
(preventing directors from communicating with competing bidders to get a higher
price for the company).
(2) Prohibiting poison pill redemption for six months (ties future board's hands)
(3) Requiring reimbursement of election expenses (prevents directors from
denying compensation to mischievous candidates)
Professor: the distinctions between valid and invalid shareholder bylaws above are
CA, Inc. v. AFSCME Employees Pension Plan (p. 209 supp.)
NOTE: May have been overturned by DGCL 113. (See above)
Problem: CA finances only management-nominated directors in original bylaw
Shareholder proposes a bylaw that would require reimbursement of reasonable
expenses incurred in nominating directors if:
(a) Fewer than 50% of the directors to be elected are contested;
(b) One or more of the nominator's nominees are elected;
(c) Stockholders are not permitted to cumulate their votes; and
(d) the election occurs after the bylaw's adoption.
CA notifies the SEC it will exclude the bylaw from its proxy materials
SEC certifies to Delaware Supreme Court: Would the AFSCME proposal, if
adopted, cause CA to violate any Delaware law?
Court: The proposal would violate Delaware law.
[T]he Bylaw [does not] reserve to CAs directors their full power . . . to
decide whether or not it would be appropriate, in a specific case, to award
reimbursement at all.

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14.19.b VentCap wants to use a computer algorithm to weight shareholder votes. Can
VentCap do that? How?
DGCL 151(a). Every corporation may issue . . . stock . . . [with] such voting
powers, full or limited, or no voting powers . . . as shall be stated . . . in the
certificate of incorporation . . . or in the . . . resolutions providing for the issue of
such stock . . . .
Any of the voting powers . . . may be made dependent upon facts ascertainable
outside the certificate of incorporation . . . or . . . resolutions . . . provided that the
manner in which such facts shall operate upon the voting powers . . . is clearly
and expressly set forth in the certificate of incorporation or in the . . . resolutions .
Answer: Yes.

The algorithm must be set forth in the certificate or the

Removal and Replacement of Directors

Directors: Who can remove them?
The basic principle: the shareholders who can elect can remove.
In straight voting systems: DGCL 141(k). Any director or the entire board...may be
removed, with or without cause, by the holders of a majority of the shares then entitled to
vote at an election of directors
In class voting systems: DGCL 141(k)(1) . . . [I]n the case of a corporation whose board is
classified . . . stockholders may effect such removal only for cause; (k) [The class that
elected the director may remove without cause.]
If Class A shares have the right to elect one director:
Class A stockholders can remove that director without cause
All stockholders can remove that director, but only for cause and Class A
stockholders will elect the replacement. (Class A always owns such board seat.)
In cumulative voting systems: DGCL 141(k)(2). If less than the entire board is to be
removed, no director may be removed without cause if the votes cast against such directors
removal would be sufficient to elect such director.
To remove entire board requires only majority vote
To remove less than the entire board requires enough votes such that the votes against
removal would not have been enough to elect the directors being removed
Example: Stockholder One has enough votes (100) to elect two of a seven member

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1. Stockholder Two moves to remove Pat and Mike, without cause. Stockholder
One casts 100 votes against removal.
Pat and Mike are not removed.
2. Stockholder Two moves to remove the entire board. Stockholder One casts
100 votes against removal; a majority vote for removal.
The entire board is removed.
Stockholder One can then re-elect Pat and Mike.
The majority of shareholder can call for a re-vote whenever they want.
Notice and Opportunity to Defend: If cause is necessary to replace a director, notice and an
opportunity to defend are required. Auer v. Dressel
Cause is not required by the DGCL, but may be provided in the COI of certain companies. So
under such circumstances, notice and opportunity to defend shall be required.
Removing Directors - Process and Strategy
14.20. Can Zuckerberg, as CEO, Chairman, and holder of a majority of the voting
power remove dissident director Hanson?
DGCL 141(k). Any director or the entire board of directors may be removed,
with or without cause, by the holders of a majority of the shares then entitled to
vote at an election of directors . . .
Answer: Yes.
What is the quickest way to remove Hanson?
DGCL 228. Unless otherwise provided in the certificate of incorporation .
. . any action which may be taken at any annual or special meeting . . . may
be taken without a meeting . . . if a consent . . . in writing . . . shall be
signed by the holders of . . . the minimum number of votes . . . necessary . .
. take such action at a meeting . . . and shall be delivered to . . . an . . . agent
. . . having custody of the book in which proceedings of meetings of
stockholders are recorded.
Answer: Deliver a written consent to the Secretary removing him.
What is the best way to remove Hanson?
DGCL 223(a)(1). Vacancies . . . may be filled by a majority of the
directors then in office, although less than a quorum . . .

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DGCL 211(b). Stockholders may . . . act by written consent to elect

directors; provided, however, that, if such consent is less than unanimous,
such action . . . may be in lieu of holding an annual meeting only if all of
the directorships to which directors could be elected at an annual meeting
held at the effective time of such action are vacant and are filled by such
DGCL 141(f). [A]ny action . . . permitted to be taken at any meeting of
the board of directors . . . may be taken without a meeting if all members of
the board . . . consent thereto in writing . . . and the . . . writings . . . are
filed with the minutes . . .
Answer: Stockholder consent that removes all and replaces all but Hanson.
Director action risks dissent.
Division of power between shareholders and directors
DGCL 223(a)

Unless otherwise provided in the certificate of incorporation or

(1) Vacancies . . . may be filled by a majority of the directors then in office, although
less than a quorum . . .
(c) If, at the time of filling any vacancy or any newly created directorship, the directors
then in office shall constitute less than a majority of the whole board . . .the Court of
Chancery may, upon the application of stockholders holding at least 10% . . . order an
DGCL 211(b). Stockholders may . . . act by written consent to elect directors . . . .
Bylaws can give stockholders the power to fill vacant directorships. They have inherent
power to fill the new ones. Campbell v. Loew's, Inc.
Board Responses to Shareholder Initiatives
Without compelling justification, the Board cannot act for the primary purpose of thwarting the
exercise of a shareholder vote. (Breaches Duty of Loyalty)
No compelling justification in Blasius v. Atlas because:
Not faced with a coercive action taken by a powerful shareholder against the interests
of a distinct shareholder constituency
Board knew it had time to inform shareholders of its views on the merits of the
proposal subject to the shareholder vote
Not enough to say "Board knows best" when the issue is who should comprise the

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What would be compelling justification?

Blasius has nearly enough consent to take over the Board. Atlass business is currently
succeeding. Should Atlas adopt a bylaw expanding the board just like Atlas did
before Blasius?
Answer: Yes. We have different, more compelling facts. The court may award
damages, but probably just attorneys fees. Blasius may change course and
destroy the company. (And Blasius will fire us anyway.)
Blasius Industries v. Atlas Corp. p. 399
Atlas certificate provides for a board of up to 15 members.
Atlas bylaws provide for a board of 7 members, all of which are filled.
Blasius (9.1%) delivers written consent to bylaw expanding the board to 15, and
filling the new seats with 8 sympathetic to the Blasius proposal.
Board creates two new seats and fills them with Weaver directors, defeating
Blasius plan.
Board breached Duty of Loyalty by acting for the primary purpose of thwarting
the exercise of a shareholder vote (even though it acted in good faith) because it
had no compelling justification to do so.
[T]hat the board knows better . . . is irrelevant . . . when the question is
who should comprise the board. page 402
CONTRA: CA, Inc. v. AFSCME: That director action to foreclose
effective shareholder action didnt violate the directors duty of loyalty.
If additional 41% had delivered identical consents, these actions have been taken shareholders written consents (requiring an absolute majority)

LoPucki: Board members are rarely independent. They are loyal to the persons who
elected them. Courts usually maintain the legal fiction that they are independent.
Structural Bias
A minority of courts acknowledge Structural Bias in extreme cases. Clark v. Lomas &
Nettleton Fin. Corp. (1980)
Board responses to shareholder initiatives: Quickturn

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Poison Pill (a.k.a. Rights Plan)

A poison pill is a legal device used by directors to discourage hostile takeovers of the
directors companies. (designed to make a hostile acquisition financially prohibitive
unless the targets board approves the deal; essentially, the poison pill gives rights to
the shareholders other than the acquirer, which dilute the acquirers stake in the
corporations rights)
Process of Poison Pill re Netflix:
Step 1. The dividend. The board declares a dividend of rights. The rights are
options to buy stock at a very high price.
The Board of Directors . . . declared a dividend distribution of one right (a
Right) for each outstanding share of the common stock . . .
Each Right entitles the registered shareholder to purchase from the Company one
one-thousandth of a share of the Series A Participating Preferred Stock . . . at an
exercise price of $350 per one one-thousandth of a Preferred Share . . . (the
Exercise Price). ($350 per 0.001 share)
The threat to anyone buying 10% of Netflix:
[After trigger] all Rights that . . . were beneficially owned by an Acquiring
Person . . . will be null and void. (Bottom P 212 of Supplement)
The Rights . . . may be amended . . . prior to the Distribution date.
Step 2. Public Announcement. A person or group [Carl Icahn] announces a
tender . . . offer that would result in ownership by a person or group of 10% . . . or more
of the Common Shares. [Call]
Step 3. The ten day period. The rights remain redeemable and amendable for 10
days after the public announcement. The board can extend the period. [Negotiation
period: Carl Icahn and the board are negotiating the purchase price for the shares; but
failed to make a deal between two parties.]
Purpose of 10-day period is to give the Board time to talk to the Acquiring
Possibly negotiate terms of a merger
Possibly make threat more explicit or more serious
Step 4. Distribution date (means the Rights are separated from the common shares
and becomes exercisable). The 11th day after the public announcement. The board can

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no longer redeem and amendment is limited. Netflix issues certificates (which is

tranferrable). [Now its war.]
Step 5. Trigger. If Icahn (the acquirer) goes ahead, his rights are void and everyone
elses right is buy a common share, get one free or get one free (exchange the right
with one common share by the company). [under this circumstance, the exercise price
is very low]
Two possibilities for the trigger:
(1) If a person or group . . . obtains beneficial ownership of 10% . . . or
more of the Common Shares, then each Right will entitle the holder thereof
to purchase, for the Exercise Price . . . Common Shares . . . having a thencurrent market value of twice the Exercise Price. [A]ll Rights that are . . .
or were beneficially owned by an Acquiring Person or certain of its
transferees will be null and void. p. 222 (buy one get one free)
(2) Prior to the acquisition by the Acquiring Person of 50% of the Common
Shares, the Board may exchange the Rights (except for rights that have
previously been voided) . . . for Common Shares at an exchange ratio of
one Common Share per Right. p. 222-23 (get a free share by redeem one
Step 6. Exercise. Right holders pay the exercise price and receive shares. Exercise
dilutes Icahns shares.
Competing Views Over Poison Pills
Corporation: The Board adopted the Rights Agreement to protect stockholders from
coercive or otherwise unfair takeover tactics.
The Rights Agreement does that by giving the board the power to punish anyone
who attempts a takeover.
Tender Offeror: Any poison pill without a shareholder vote is an example of poor
corporate governance.
The shareholders should decide whether to allow a takeover. The board members
have a conflict of interest.
Why not require shareholder post-approval for a poison pill?
Professor: The law should. The board can argue to the shareholders that
the pill is for their benefit.
The law's approach to Poison Pill indicates a distrust of the market and a trust of
the directors

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Assumes the directors will operate in the best interest of the shareholders (and
aren't just operating in their own interest)
Also assumes that the market is not correctly valuing shares in these situations
Netflix shares were trading at $77
Icahn offered a higher amount for the shares (may have been $90-100)
The law allows the directors to block Icahn's offer because the shares may
actually be worth an even larger amount than what Icahn has offered for
Interpretation of 102(a)(4) and 157(a) Enables Use of Poison Pill
Because of an interpretation of DGCL 102(a)(4) and DGCL 157(a), Rights are not
stock that must be authorized by a provision in the certificate of incorporation . This
interpretation enables the use of the Poison Pill.
DGCL 102(a)(4). The certificate of incorporation shall . . . set forth . . . the
designations and the powers, preferences and rights, and the qualifications,
limitations or restrictions [of each class of stock] . . . and an express grant of . . .
authority . . . to fix [the same] by resolution [if] desired but . . . not . . . fixed by
the certificate of incorporation.
DGCL 157(a). [E]very corporation may create and issue . . . rights or options
entitling the holders thereof to acquire from the corporation any shares of its
capital stock of any class or classes . . .
When the corporation does not have enough authorized share, the board cannot give share
to the shareholders who exercised their rights. What can they do?
The court said the corporation can issue debt to the shareholders instead. Other
shareholder then own debt to the corporation; and the board may call on an interim
shareholders meeting to authorize more shares; then no debt to decrease the value the
company but more shares to dilute the Acquiring Person.

Poison Pill Does Not Discriminate

Every shareholder gets identical Rights
By acquiring a certain percentage of shares, the tender offeror chooses not to have the
Every other shareholder can make that same choice by acquiring the certain
percentage of shares.

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Thus, everyone is treated equally.

Math Behind Netflix's Poison Pill

Before Dilution


After Dilution

Shares out








Market Cap




Icahn shares



Icahn percent




Icahn value




Other shares




Other percent




Other value




Icahns shares have lost $100 million in value, and he now owns only 5.25%
Special Rule for Takeover Context: The Board cannot prevent future boards from managing the
corporation (under 141(a)) and fulfilling their fiduciary duties.
Quickturn Design Systems, Inc. v. Shapiro (p. 404)

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Quickturn has a patent injunction barring Mentor from the US emulation market
Mentor makes a cash tender offer for Quickturn; 50% over the pre-offer price;
Mentor solicits proxies for a shareholder-called special meeting to oust the
The Quickturn board recommends that shareholders reject the offer
The Board amends Quickturn's bylaws to let the board control the time of the
special meeting. Board could delay three months
The Board amends its poison pill to prevent the acquirers board from redeeming
for six months. Delayed Redemption Period (DRP)
Court: the bylaw amendment is valid, but the DRP is invalid.
The DRP is invalid because it prevents future board from managing the
corporation (under 141(a)) and so fulfilling its fiduciary duties.
Future shareholders (Mentor) are not protected.
Future boards (Mentor-elected) are protected.
Professor: Bylaw was allowed because Blasius refused to establish a per se rule, so the
court must have thought the Board had compelling justification for its action.
Because the Quickturn rule applies only in the takeover context, the following are NOT
invalid limitations on the board's right to manage:
A contract to buy from a major supplier for three years
A contract to construct and occupy a factory for five-years
The same contract if Mentor is objecting before it is signed
Delaware Supreme Court: [T]o the extent that a contract, or a provision thereof, purports
to require a board to act or not act in such a fashion as to limit the exercise of fiduciary
duties, it is invalid and unenforceable.
Paramount v. QVC: No-shop provision (prohibiting the directors from contacting other
buyers for higher prices) in merger agreement invalid, because it prevented directors from
talking to a potential buyer.

Planning in the Close Corporation

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Part 1 - Voting Substance (move to chapter 14 together with the voting procedures)
Three Voting Systems:
(1) Straight Voting
Default rule. DGCL 212(a)
A resolution is made to elect a person or a slate of people
Votes are recorded for and against
Holder of a majority of the voting power always wins
(2) Class Voting. DGCL 151
The certificate divides shares into classes and gives each class the right to elect some
number of directors. (Each class has equal right on electing directors.)
Shareholder A owns Class A shares; Class A has the right to elect four directors.
Motion is to elect, and votes are recorded for and against.
The holder of a majority of the voting power in each class will win all votes in the class
and so elect all board members electable by the class.
Voting control can be substantially separated from share control
(3) Cumulative Voting
Mandatory / Required in California (California Corporation Code 708(a)); option
everywhere else (choice in other states, e.g. Delaware)DGCL 214
Most complex of the three systems
Ensures minority board representation
DGCL 214. The certificate of incorporation . . . may provide that . . . each holder of
stock . . . shall be entitled to as many votes as shall equal the number of votes . . . such
holder would be entitled to cast for the election of directors . . . multiplied by the
number of directors to be elected . . . and that such holder may cast all . . . for a single
director or may distribute them among the number to be voted for . . . .

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X = number of shares required to elect number of directors desired
s = number of shares voting
d = number of directors desired
D = number of directors to be elected

Intuitive Method in Cumulative Voting: refer to the slides dated 10202014

In event of deadlock and appropriate application for relief, Delaware Court of Chancery will
appoint a custodian or a provisional director REGARDLESS of contrary provision in Articles
or Bylaws (DGCL 353)
DGCL 226(a) requires application of any stockholder
DGCL 353(a), for close corporations, has more particular application requirements,
Application by half of directors
Application by holders of one-third of stock entitled to vote on directors
Application by holders of two-thirds of one of the classes of stock
Custodian or provisional director is expensive and intrusive.
Shareholder Agreement - DGCL 218(c)
Remedy for Breach of Shareholder Agreement: Damages, possibly plus an injunction and
change of the vote (this is a breach of contract action)
Ringling Bros: disallowed breachers' wrongful votes, but didnt deem them cast as

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Voting Trust - DGCL 218(a)

Procedure: Name a person, institution, or attorney who represents all three as trustee, with
instruction to elect the four.
Remedy for Breach of Voting Trust: Same as remedy for breach of Shareholder Agreement.
Proxy - DGCL 212(b)
DGCL 212(b). Each stockholder entitled to vote . . . may authorize another person or
persons to act for such stockholder by proxy, but no such proxy shall be voted or acted upon
after 3 years from its date, unless the proxy provides for a longer period.
Procedure: Name a person to appear at the meeting and vote the shares.
Advantage Over Trust: The trust problem is reduced because the proxy has no authority to
vote the shares differently. The proxy can be for four hundred years, but probably not
Can Be Irrevocable
DGCL 212(e). A duly executed proxy shall be irrevocable if it states that it is
irrevocable and if, and only as long as, it is coupled with an interest sufficient in law to
support an irrevocable power. A proxy may be made irrevocable regardless of whether
the interest with which it is coupled is an interest in the stock itself or an interest in the
corporation generally.
Shareholder Management
Close corporations can be managed by shareholders if certificate of incorporation provides
for it
DGCL 351 The certificate of incorporation . . . may provide that the business . . . shall
be managed by the stockholders . . . rather than by a board of directors. . . . Unless the
context clearly requires otherwise, the stockholders of the corporation shall be deemed
to be directors for purposes of applying provisions of this chapter.
DGCL 141(b). The vote of the majority of the directors present at a meeting . . . shall
be the act of the board of directors . . . .

Voting Device (Voting Agreements) Comparison

Voting Trust

Irrevocable Proxy

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Pooling Agreement

Who owns the shares?




Who votes the shares?




Degree of publicity?

Stock record

Voting record


Time limit?

None in
(usu. 10



Are transferees bound?


If on certificate

If on certificate

Is there a validity issue?


Coupled with an






It is the law permitted business people to do whatever they want to, so there are 3 options though
they are confusing.

Vote Counting
Votes per share:
Default Rule is that each share has one vote.
If so provided, shares can have no votes or multiple votes.
Types of majorities:

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Director elections: Default rule requires a plurality of shares present or represented.

Fundamental transaction votes: Mandatory rule requires an absolute majority
(counting all shares entitled to vote and the majority of such shares). 242(b)(1),
275(b), etc.
Other votes: Default rule requires a simple majority of shares present or represented.

Part 2 - Restrictions on Board Discretion

Shareholder Restrictions of Board Discretion: Non-unanimous Agreements
1. Shareholders may contract to vote their shares together on any issue, including election of
directors. N.Y. Bus. Corp. Law 620(a)
BUT: Shareholders cannot vote on how to manage (CA, Inc. v. AFSCME)
2. Shareholders may not contract to restrict director decision making.
May not sterilize the board.
Rationale: Management is the directors prerogative, DGCL 141(a)
3. Close Corporation ONLY: Majority stockholders may contract in a way that restricts the
discretion of the board. DGCL 350
DGCL 350. A written agreement among the stockholders of a close corporation
holding a majority of the outstanding stock entitled to vote, whether solely among
themselves or with a party not a stockholder, is not invalid, as between the parties to the
agreement, on the ground that it so relates to the conduct of the business and affairs of
the corporation as to restrict or interfere with the discretion or powers of the board of
directors. The effect of any such agreement shall be to relieve the directors and impose
upon the stockholders who are parties to the agreement the liability for
managerial acts or omissions which is imposed on directors to the extent and so long
as the discretion or powers of the board in its management of corporate affairs is
controlled by such agreement.
4. A contract to elect particular persons (valid) and restrict their discretion (invalid) is entirely
invalid (provisions are not severable).
Examples of invalid restrictions:
Particular persons to be officers or employees
Particular salaries to be paid

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Shareholder Restrictions of Board Discretion: Unanimous or in-the-Certificate Agreements

1. Shareholders may contract to restrict director decision making if the restriction is slight.
2. Shareholders may contract to restrict director decision making if the restriction is:
a. Unanimous AND in the certificate, N.Y. Bus. Corp. Law 620(a).
NY Bus. Corp. Law 620(b). A provision in the certificate of incorporation
otherwise prohibited by law because it improperly restricts the board in its
management of the business of the corporation, or improperly transfers to one or
more shareholders or to one or more persons or corporations . . . management
otherwise within the authority of the board . . . shall nevertheless be valid . . . . if
all . . . holders . . . have authorized such provision . . . .
b. In the certificate, DGCL 141(a).
DGCL 141(a). The business . . . shall be managed by or under the direction of a
board of directors, except as may be otherwise provided . . . in its certificate of
incorporation. If any such provision is made in the certificate of incorporation,
the powers and duties conferred or imposed upon the board of directors by this
chapter shall be exercised or performed . . . by such person or persons as shall be
provided in the certificate of incorporation.
3. A unanimous agreement may be valid even if not in the certificate. Zion v. Kurtz (New
York 1980).
4. Anyone who (1) restricts directors or (2) manages by delegation has the fiduciary and other
duties of a director. DGCL 141(a); N.Y. Bus. Corp. Law 620(f).
Smith v. Atlantic Properties
Summary: Certificate provision requiring 80% of shareholder vote for director action is
allowed. Shareholders with ad hoc controlling interests have fiduciary duties of directors.
NOTE: In absence of controlling interest, shareholders do not owe fiduciary duties to
other shareholders.
Four shareholders, each has 25% of votes.
Certificate provision: Director actions are valid only if ratified by 80% shareholder
Wolfson vetos all dividends, resulting in tax penalties on corporation.

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Court: The agreement is valid, but Wolfson must pay dividends to the shareholders because,
as a controlling interest, he owed fiduciary duties to the other shareholders and refusing to
pay dividends was a violation of those fiduciary duties.
Court's argument is actually that Wolfson owed fiduciary duties to the shareholders because
he was an ad hoc controlling interest.
LoPucki: Controlling shareholders in a close corp. own fiduciary duties to other shareholders.
Part 3 - Contractual Transfer Provisions - DGCL 202
Stock transfer restrictions: use context when creating
Default rule: Investors cannot withdraw their investment whenever they want and the majority
determines when distributions are made. Capital lock-in.
Typical Restrictions:
Consent: sale only with consent of the directors or shareholders
Rights of first refusal: Shareholder can sell the shares, but only after offering them to the
corporation and other shareholders.
Prohibition: prohibits sale to designated persons or classes of persons if not manifestly
unreasonable (DGCL202(c)(5))
Mandatory redemption. The corporation must redeem the shares for a fixed amount or for their
appraised value.
Mandatory buyout. Other shareholders must buy the shares for a fixed amount or for their
appraised value.

Stock transfer restrictions: Legality

By contract, the corporation or the shareholders may impose virtually any restrictions on
share transfer.
DGCL 202(a). A written restriction or restrictions on the transfer or registration of
transfer of a security of a corporation, or on the amount of the corporations securities
that may be owned by any person or group of persons, if permitted by this section . . .
may be enforced against the holder of the restricted security . . . or any successor . . . .
DGCL 202(e). Any other lawful restriction on transfer or registration of transfer of
securities, or on the amount of securities that may be owned by any person or group of
persons, is permitted by this section.
"Not Manifestly Unreasonable" DGCL 202(c)(5)

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Restriction in DGCL 202(c)(5) must be "not manifestly unreasonable"

Exclusion of that provision from 202(c)(1)-(4) indicates those restrictions probably
do not have a reasonableness requirement
Stock transfer restrictions: notice
Restrictions bind transferees ONLY if noted conspicuously on the certificate or known to the
transferee prior to purchase.
DGCL 202(a). Unless noted conspicuously on the certificate or certificates
representing the security or securities so restricted . . . a restriction, even though
permitted by this section, is ineffective except against a person with actual knowledge
of the restriction.
Harlamert v. World Finer Foods (6th Cir. 2007): Harlamert purchased stock from his
employer, World Finer Foods.
It's not enough for a corporation to show that it always has purchasers sign
transfer restrictions; the corporation must show that the particular stockholder
signed the transfer restrictions
Stock certificate: These securities may be transferred only through the company
and only in compliance with the agreement between this share holder and the
After Harlamerts death 22 years later, the company tried to enforce its standard
buy-back agreement against his estate.
Court: Harlamert was not bound because the company could not
Harlamert signed the buy-back agreement.


Concord Auto Auction v. Rustin, p. 955

Cox, Powell and Tomas are the shareholders of Concord Auto Auction, Inc. and
E.L. Cox Associates, Inc., whom agreed to a buyout on death by each company
from the estate of the deceased for a stock value set annually. Three of them
failed to call on shareholders meeting to reset the stock price, and the price of
the stock was firstly set in the original agreement.
Agreement said The purchase price shall remain . . . in effect . . . until changed.
At Coxs death, stock was worth twice the previous value set in the agreement.
Defendant asserted that (1) three shareholders intended to review the stock price
annually; but failed to do so; which may excuse his delay of stock tendering; and

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(2) failure of revaluation resulted in unclean hands which breached the

fiduciary duties, hence his tender of stock shall be exempted.
Court: The agreement has no ambiguity. The agreement stated that the purchase price
shall remain in full force and effect unless and until so changed. Since no revaluation
occurred, Coxs estate must sell for the previous value originally set.
Even great disparity between the price specified in a buy-sell agreement and the
actual value of the stock is not sufficient to invalidate the agreement.
Bad Rule?
Professor: The court's rule is not a good one. If intend to make a gift, it is a good
Planning Insured Buyouts for Inattentive Parties
If the parties were inattentive, but wanted an insured buyout at full market value on death,
Professor recommends the following provisions as options to achieve that:
1. If the parties dont review and decide, the insurance agent can review and decide.
2. If the parties dont review and decide, any party can review and decide after ten days
notice to the other parties.
3. If the shares are worth at least 50% more than the buyout price, the buyout
agreement is void.
4. If the shares are worth at least 50% more than the buyout price, the buyout shall be at
the actual value, but the corporation may pay the excess over insurance, with interest,
in 120 equal monthly payments.
Buyout Arrangements
Attorney: What should happen if you cant work together?
The answer can generate centripetal force
No buyout, rights of first refusal.
Parties are stuck in a bad arrangement.
The answer can generate centrifugal force
Anyone can elect a cash buyout at an appraised price.
Parties may leave just because the deal is so good
Ideal: Modest centripetal force.

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Differs with wealthy, liquidity, and interests of the parties

Methods of Setting Buyout Price
(1) Book value: Generates arbitrary prices likely to be too low; requires complex
(2) Auction Sale: what about somebody other shareholders do not want
(3) Capitalized earnings (earnings multiple): Control parties can manipulate
earnings; best multiple is difficult to estimate, changing
(4) Right of first refusal. Usually renders stock unsalable. Arms-length buyers wont
(5) Appraisal. Expensive, somewhat arbitrary, may require arbitration
Professor: I don't trust arbitration
(6) Annual agreements. Time and resource consuming; parties are unlikely to do it.
(7) Texas offer. Any party may fix a company value at which the party agrees to buy
or sell. The others must by or sell at that value.
Differences in wealth or liquidity confer advantages.
Corporate debt enforcement
Legal remedy (to an unpaid, unsecured creditor):
(1) Creditor sues, obtains judgment; and the creditor becomes judgment creditor.
(2) Sheriff, standing in debtor's shoes, sells debtor's property at auction. (Garnishment)
(3) Sheriff pays the proceeds of sale to the judgment creditor.
(4) Judgment is reduced by the amount paid.
(5) Enforcement continues until judgment is paid in full.
(the above are procedures in case that a debtor is corporation.)
(6) If the shareholder is the debtor, the sheriff may seize the stock
(7) The stock buyer becomes the shareholder and controls the company
(8) If the debtor owns a minority interest, sheriff sells the minority part

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(9) The buyer becomes the shareholder and can vote.

The stock purchaser's interest in the corporation depends on the portion of shares that
the debtor held
In re Popkin & Stern (Supp. p. 264)
Blackwell has $1.1 million judgment against Lurie
Blackwell garnishes Lurie's shares
Dierdorf and Hart intervene and claim the right to buy the shares
Buyout Agreement: If one shareholder sells, others have the right of first refusal.
The price is to be the lesser of: (1) bona fide offer to buy; and (2) 1.5 times net
Earnings are $34,215. Businesses generally sell for three ($102,646) to ten
($342,153) times earnings.
Court: Dierdorf and Hart can buy the stock for $51,323.
29.13. Could the agreement have been enforced under DGCL 202?
DCGL 202(c). A restriction on the transfer . . . of securities of a corporation . . .
is permitted by this section if it:
(1) Obligates the holder of the restricted securities to offer . . . to any other
holders of securities . . . a prior opportunity, to be exercised within a
reasonable time, to acquire the restricted securities . . . .
Answer: Yes
29.14. Does it matter whether the agreement is reasonable? Sell for $1.
Answer: No. Not manifestly unreasonable is an express requirement of
DCGL 202(c)(5), but omitted from DCGL 202(c)(1).

Chapter 15 - Shareholder Information Rights

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Shareholders' need for information

(1) Copies of the foundational documents to know their rights
(2) Information about the business to:
(a) trade in shares
(b) cast informed votes
(c) sue for wrongdoing
(3) The identities of other shareholders to:
(a) campaign for votes
(b) make tender offer
(c) make shareholder agreements
Shareholders' rights to information
(1) In public companies only:
(a) proxy statements (for voting)
(b) financial statements (annual report, Form 10-K, 10-Q); and
(c) other SEC filings
(2) In all companies:
(a) DGCL 219. List of stockholders entitled to vote.
(b) DGCL 220. Inspection of books and records.

DGCL 219

DGCL 220

Who has access? Stockholder of record (on stock ledger)

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Stockholder of record or
beneficial owner of stock

Access to what?

List of stockholders entitled to vote (a.k.a. stock

holder list)

Stock ledger, stockholder list,

other books & records

Nature of

"examination", but Professor says case law

indicates you are entitled to basically the same
nature of access as under 220

Inspect, makes copies and


Purpose needed? Any purpose germane to the meeting

Proper purpose

Burden of proof
re purpose?

On company (company proving no purpose

germane to the meeting)

On stockholder except for list

or ledger (stockholder proving
the proper purpose)

Remedy for

Order compelling disclosure; postpone or void

results of meeting

Order compelling disclosure;

"other or further relief"

Stock ledger: a list of all transactions in shares by, or known to, the corporation:
1. Initial issuance of shares
2. Transfer of shares.
Refer to the slides re uncertificated securities, securities intermediaries, Depository Trust & Clearing
Corp. etc.
DTTC will generate a list of shareholders based on the shareholders securities accounts with DTCC
(the CEDE List).
List of Stockholders Entitled to Vote (DGCL 219(a))
DGCL 219(a) The officer who has charge of the stock ledger . . . shall prepare and make, at least
10 days before every meeting of stockholders, a complete list of the stockholders entitled to vote at
the meeting . . . . Such list shall be open to the examination of any stockholder for any purpose
germane to the meeting.
Who is on the list?

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1. Shareholders on the stock ledger

2. Shareholders on the CEDE breakdown (Most stock brokerage firms and financial
institutions first tier nominees are members of Depositary Trust Company, which holds
the customers stock. Depositary Trust registers all of its members stock in one name,
CEDE & Co., which allows it to simplify stock transfer among its members. This list
does not identify which brokerage firms and institutions hold their stock or who the beneficial
owners are. The corporation can ask Depositary Trust to prepare a CEDE Breakdown
a list of all brokerage firms and institutions holding stock in the name of CEDE & Co.
Then the corporation individually contact the brokerage firms and institutions to determine
the number of beneficial owners each represents, so as to facilitate distribution of corporate
documents. Such firms do not volunteer the name of beneficial owners to the corporation.
BUT SEC rule requests them maintain a NOBO list and make it available to requesting
corporations within 7 days.)
Review Shareholder Information Rights Powerpoint Slides 25-37 re CEDE breakdown
3. Shareholders on the non-objecting beneficial owners (NOBO) list (shareholders who
agree / do not object to having their name and addresses revealed to the company can be
found on such list.)
Inspection of Books and Records (DGCL 220)
DGCL 220(a). As used in this section:
(1) Stockholder means a holder of record . . . or a person who is the beneficial owner of
shares of such stock held either in a voting trust or by a nominee on behalf of such person.
(b) Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath
stating the purpose thereof, have the right during the usual hours for business to inspect for any
proper purpose, and to make copies and extracts from:
(1) The corporations stock ledger, a list of its stockholders, and its other books and records;
(2) A subsidiarys books and records [if the corporation has possession or could obtain
possession the corporation makes a request to the board of the subsidiary based on 220
(like what the shareholders of the corporation did)]
A proper purpose shall mean a purpose reasonably related to such persons interest as a
Other Books and Records (mentioned in 220) open to inspection:
Corporate kit: Certificate, bylaws, minutes, resolutions, stock ledger.
Accounting records, including financial advisors reports and correspondence.
Documents useful in investigation of wrongdoing (Saito).

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Books and records of subsidiaries (220(b)(2))

Source of the documents and time at which corporation acquired the documents do not matter
Entitled to any documents the corporation holds, not just those documents created by the
Privileged and protected work product records are not open to inspection.

Saito v. McKesson HBOC, Inc. (Del. 2002)

Limitation on a stockholders statutory rights to inspect corporate books and records.
To obtain information for litigation against company or managers
Ferret out (a.k.a. dig into) possible wrongdoing
Oct-17-1998: Stock-for-stock merger agreement.
Oct-20-1998: Saito buys shares of McKesson.
April-July 1999: McKesson revises three years of financials.
July 1999: Merger consummated (HBOC as a subsidiary of McKesson HBOC
the surviving entity after the merger). Saito sues McKesson.
Trial courts holding:
(1) Saitos proper purpose only extended to potential wrongdoing after the date
on which Saito acquired McKessons stock.
(2) Saito did not have a proper purpose to inspect documents relating to potential
claims to third party advisors who counseled the boards regarding the merger.
(3) Saito was not entitled to HBOCs documents since he was not a shareholder
of HBOC (either pre- or post-merger). Reversed by the legislature
Appellate court holding:
Saito can inspect pre-share-purchase documents. (In sum, the date on which a
stockholder first acquired the companys stock does not control the scope of records
available under 220.)

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Saito can inspect documents received from third parties. (generally, the
source of documents in a corporations possession should not control a
stockholders right to inspection under 220. The issue is whether the documents
are necessary and essential to satisfy the stockholders proper purpose.)
Saito cant inspect wholly owned subsidiary HBOCs documents because Saito
never owned HBOC stock. (Stockholder of a parent company are not entitled to
inspect a subsidiarys books and records in the absent of a fraud or that a
subsidiary is in fact the mere alter ego of the parent.)

Did McKesson have the right to inspect HBOCs documents?

Answer: Yes. McKesson is a shareholder, DGCL 220(b).
DGCL 220(b). Any stockholder . . . shall . . . have the right . . . to
inspect . . . a subsidiarys books and records, to the extent that . . . the
corporation could obtain such records through the exercise of control over
such subsidiary . . . .
Was McKesson obligated to exercise its right on behalf of Saito?
Answer: Yes.
Therefore Saito was wrong about HBOC's documents
Must not be privileged or protected work product
Can't go on "fishing expedition"
Proper Purpose - "a purpose reasonably related to such person's interest as a stockholder." DGCL
To solicit proxies (but Pillsbury lost)
To value the shares (but Seinfeld lost)
To take over the company
To obtain information for a derivative suit against company or managers; to ferret out
possible wrongdoings
But only shareholders already have creditable-basis-from-some-evidence (Seinfeld)
An additional, improper purpose is not disqualifying
Not curiosity, speculation, or vexation purpose (Pillsbury)

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Pillsbury v. Honeywell (Minnesota, 1971) (TB Page400)

Defendant Honeywell concedes that "Proper purpose" contemplates "concern with
investment return;" seeking "economic benefit to himself or Honeywell"
Plaintiff (petitioner) argued that a stockholder who disagrees with the management has
an absolute right to inspect corporate records for purposes of soliciting proxies.
Pillsbury buys 100 shares for the sole purpose of gaining voice, and then
requests a shareholders list in order to solicit proxies to elect new directors so
that he can stop the production of anti-personnel fragmentation bombs used in
But for his (Plaintiffs) opposition to Honeywells policy, petitioner probably
would not have bought Honeywell stock, would not be interested in Honeywells
profits and would not desire to communicate with Honeywells shareholders.
P401 Textbook
Court: Such a motivation can hardly be deemed a proper purpose germane to his
economic interests as a shareholder. P401 Textbook
Usually a plan to elect one or directors would be a proper purpose, but also shall
be germane to the companys economic interests. (In the instant case, the plan
was designed to further plaintiffs political and social beliefs.)
List denied, because he sought no economic benefit to himself or Honeywell.
requisite propriety of purpose germane to his or Honeywells economic interest is not
BUT: This case decision is wrong under current Delaware law.
Pillsbury sought the list to solicit proxies for the election of new directors.
Soliciting proxies is a purpose germane to the meeting.
Proper purpose is irrelevant under DGCL 219.
Disclosure for Voting
State law requires: only purpose of meeting (in notice of meeting)
Federal law requires:
(1) extensive information for publicly held; or

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(2) no information / disclosure for private corporations (e.g. Chrysler with 400 shareholders);
Disclosure Process:
(1) Corporation determines the issues; drafts a proxy statement (a detailed disclosure
document describing board directors and the matters on which shareholders will vote)
(2) If non-routine, corporation files with the SEC (proxy statement)
(2)(b) SEC comments on the proxy statement.
(3) For all votes, corporation sends definitive proxy statement to shareholder list
(shareholders of record, NOBOs and intermediaries)
(4) Shareholders send proxy cards to management
(5) Management votes the shares in accordance with the proxy statement
Short Selling and Encumbered Shares
Encumbered Shares
Shareholders with encumbered shares have the same right to inspect corporate records as a
regular shareholder
Why? It is usually too difficult to figure out any given shareholder's net position in a
Deephaven v. United Global (Del. Chancery 2005): On a request for inspection, the court will
not inquire into Plaintiffs net stock holdings.
Two Votes, One Share: Three individuals all think they have shares even though only two
shares exist because of the effect of short selling. Who can vote?
Answer: The bizarre solution to this problem is that brokers allow both shareholders
to vote, and simply reallocate the votes from shareholders who have not submitted
proxies. . . . In essence, a single share can generate multiple votes. Martin & Partnoy
DTCC Stock Borrow Program (Short Sale)
The shares the firm borrows can come from:
(1) the brokerage firm's own inventory (not in any customers account);
(2) the margin account of one of the firm's clients; or
(3) another brokerage firm

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Naked short selling is selling stock you dont own, but borrowing it and making no attempt to
do so
Delaware Court of Chancery held that an investor that held both long and short positions was
entitled to exercise inspection rights based on its long positions - that is, beneficial
ownership determines shareholder rights, not the investors net financial position.
Whistler alleges that at times fails-to-deliver are not cured for long periods (naked short sale),
which creates more electronic shares in the marketplace than are reflected in the paper share
certificates held by DTC. Whistler argues that Defendants are liable under state law because
this defect in the Stock Borrow Program depressed [Whistler stock value]. Whistler
Investments, Inc. v. Depository Trust & Clearing Corp., 539 F.3d 1159, 1164 (9th Cir. 2008)

Chapter 17 - Shareholder Litigation

Shareholder Action Types:
(1) Shareholder derivative action: Shareholder sues corporation to compel the corporation to sue
a third party. [Shareholder sues on behalf of the corporation, but the corporation is the nominal
If the managers wont sue themselves, the shareholders can bring a derivative action to force
the suit.
Derivative action can be brought by a shareholder against any party who has harmed the
corporation, whether insider or outsider. In practice, nearly all derivative actions are brought
against directors or controlling shareholders who have breached duties to the corporation.
(2) Shareholder direct action [shareholders sue on their own behalf]:
(a) Individual: Shareholder sues corporation for a wrong done to the shareholder
If managers wrongfully injure the corporation, it owns the cause of action.
(b) Class representatives: Shareholder sues corporation for a wrong done to a shareholder
If managers wrongfully injure shareholders, shareholders can bring a class action.

Shareholder action types



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Derivative v. Direct Actions

Derivative actions typically are based on the law of the state of incorporation.
Real test for Derivative v. Direct: Has the plaintiff demonstrated that he or she can prevail without
showing an injury to the corporation?
(The stockholders claimed direct injury must be independent of any alleged injury to the
corporation. The stockholder must demonstrate that the duty breached was owned to the
stockholder and that he or she can prevail without showing an injury to the corporation.)
Professor: this test is more helpful than memorizing many different classes of cases, which
can still lead you astray
Tooley v. Donaldson, Lufkin & Jenrette (p. 505)
Credit Suisse is buying AXA shares for Credit Suisse shares, minority shares for
The DLJ directors agree to a 22-day delay. Minority lost time value of the cash.
Minority sues DLJ, the corporation, for damages.
Trial court used the special injury test, which is abandoned by the appellate court.
Appellate court concedes that:
[W]hether a stockholders claim is derivative or direct . . . must turn solely on the
following questions:
(1) who suffered the alleged harm (the corporation or the suing stockholders,
individually); and
(2) who would receive the benefit of any recovery or other remedy (the
corporation or the stockholders, individually)
In many cases, the corporation and stockholders suffered harm, so . . .

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[T]his approach is helpful in analyzing the first prong of the analysis:

[H]as the plaintiff demonstrated that he or she can prevail without showing
an injury to the corporation?
Professor: This part is the real test
Derivative Action: in case of derivative action, the plaintiff is required to comply with the
requirement of Court of Chancery Rule, the shareholder: (a) retain ownership of the shares
throughout the litigation; (b) make pre-suit demand on the board; and (c) obtain court approval of
any settlement. Further, the recovery, if any, flows only to the corporation.
During derivative action, the successful plaintiff is entitled to an award of attorneys fees in a
derivative action directly from the corporation, but in a direct action the plaintiff must generally
look to the fund, if any, created by the action.

Hypotheticals: Derivative or Direct?

17.1.a. An action against the directors for breach of fiduciary duty (Excessive compensation
to a retiring executive).
Answer: Derivative. (facts of Lewis v. Aronson)
17.1.b. An action seeking inspection of corporate records.
Answer: Direct.
17.1.c. An action challenging the board-set price for a company's sale.
Answer: Smith v. Van Gorkom allowed this action for breach of fiduciary duty to
proceed as direct. But by the rule in Tooley, this action is derivative.
17.1.d. An action challenging the price at which shares were issued.
Answer: Derivative (money the corporation could have had)
17.1.e. A claim that a new bylaw interferes with shareholder voting.
Answer: Could be direct. Some or all of the shareholders might be injured even though
the corporation is not injured.
17.1.f. An action to recover $68,000 the bookkeeper embezzled.
Answer: Derivative. Putnam v. Shoaf (not what we read that for, but the court relied on
17.1.g. An action alleging that share prices are depressed because the majority shareholder is
paying himself a high salary.

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Answer: Derivative.
17.2. Who gets the recovery in 17.1.g.?
Answer: Logically, the corporation controlled by the defendant. How do we handle that
Derivative v. Direct in Close Corporations - Avoiding Recovery by Defendant
Possible Problem in Close Corporations:
Holder A has 40% and Holder B has 60%
Holder B embezzles $1 million from the corporation.
Holder A's action is derivative.
Holder A wins the claim
The corporation, controlled by Holder B, gets the recovery.
Two solutions:
(1) Action is derivative, but A recovers
(2) Action is direct, so A recovers
ALI Principles: In the case of a closely held corporation, the court . . . may treat
an action raising derivative claims as a direct action and order a direct recovery if
[that] will not (1) unfairly expose the corporation or defendants to a multiplicity
of actions, (2) prejudice creditors, or (3) interfere with a fair distribution of the
recovery . . .
The Demand Requirement (Relative to Derivative Claims)
The board of directors manages the corporation and is protected by the business judgment rule.
Manage includes deciding whether the corporation should sue (which is protected by BJR).
The shareholders can demand that the corporation sue.
If the board is suing the board members, conflicts of interest may prevent a decision.
When conflicts do, demand is excused and the shareholders can sue on the corporations
Ordinarily, it is only when demand is excused that the shareholder enjoys the right to initiate suit on
behalf of his corporation in disregard of the directors' wishes. Kamen v. Kemper Fin. Servs., Inc.,
500 U.S. 90 (1991)

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Purpose of Derivative Claims is to allow shareholders to litigate on corporation's behalf when

Board of Directors has a conflict of interest
Delaware Demand Requirement: Plaintiff must (1) make a demand before filing suit
(shareholders rarely do this) OR (2) prove that such a demand would have been futile.
The shareholder [must] demonstrate that the corporation itself had refused to proceed after
suitable demand, unless excused by extraordinary conditions. Kamen v. Kemper Fin. Servs.,
Inc., 500 U.S. 90 (1991)
Whether to Make Demand
Shareholders very rarely make demands because there is a high risk that it will preclude
them from suing, a high risk that the Board will reject the demand, and a low reward
even if the Board accepts the demand
In these situations, the Board will always claim that they are protected by the
Business Judgment Rule
The Board will also raise this argument when the shareholder does make a
demand but is rejected by the Board
But if the shareholder makes a demand, Spiegel v. Buntrock states that the
shareholder "tacitly acknowledges the absence of facts to support a finding of
Even if the Board accepts the demand, it will sue or settle for likely a nominal
Must Allege Facts with Particularity
FRCP, Rule 23.1(b) The complaint must be verified and must:
(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.
Aronson v. Lewis: Must allege particularized facts manifesting a direction of corporate
conduct in such a way as to comport with the wishes or interests of the corporation (or
persons) doing the controlling
Test for Futility:
Aronson v. Lewis Test: Demand is futile if a reasonable doubt is created that:

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(1) The directors are disinterested and independent; OR

Insufficient Allegations:
Suit will be against corporation's controlling shareholders
Suit will be against the individual who chose these directors
(structural bias)
Suit will be against the directors themselves
Professor's Note: These allegations do create a reasonable doubt, but
the law ignores them because they are ubiquitous
Sufficient Allegation:
Directors "stood on both sides of the transaction
(2) The challenged transaction was otherwise the product of a valid exercise of
business judgment
Sufficient Allegation:
Generally: Gross Negligence or higher
Failed to act without consciously deciding to do so
Aronson v. Lewis (p. 510)
This is the leading case on the demand/futility requirement
Fink dominates Meyers and has a sweetheart deal: lots of money for no work
Lewis sues, alleges demand is futile
Demand is not futile if these directors are able to exercise their business judgment.
Court's Test: Demand is futile if a reasonable doubt is created that:
(1) The directors are disinterested and independent; and
(2) The challenged transaction was otherwise the product of a valid exercise of business
Court: These allegations are insufficient to create a reasonable doubt:

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Suit will be against Fink who controls the corporation

Suit will be against Fink who chose these directors (structural bias)
Suit will be against the directors themselves
MBCA 7.42 has a universal demand requirement (not excuse)
Special Litigation Committees (Derivative)
Refer to the slides Whether to make a demand (derivative) the flowchart
In response to a derivative action, a special litigation committee often formed by the corporation.
SLC typically is formed by independent directors and hires independent lawyers. SLC investigates
the claims in the complaint, and then acts for the corporation to recommend to the court whether to
allow the action to proceed.
Early cases held that the business judgment rule precluded judicial review of the substance of a
recommendation by SLC that a derivative suit be dismissed. Recently the court judges the decisions
made by SLC mainly by analyzing the independence of the committee or interest of individual
directors. Many cases address structural bias, the notion that even members of independent
committees can be subject to influence of other directors.
BJR deference / respect: Auerbach v. Bennet (1979): To permit judicial probing of such issues
would be emasculate the business judgment doctrine as applied to actions and determinations of
Two-tiered judicial scrutiny: Zapata Corp. v. Maldonado (1981): whether to file a pretrial
motion to dismiss the derivative action, which shall be decided by SLC, shall have the basis of
motion is the best interests of the corporation, as determined by the committee. Two-step test is
(1) the court shall inquire into the independence and good faith of SLC and the bases supporting
its conclusions (whereby the corporation has the burn of proving independence, good faith and a
reasonable investigation) if the corporation passes the step 1 test, then goes to the step 2 test;
otherwise, the court shall deny the corporations motion; (2) the essential key in striking the
balance between legitimate corporate claims as expressed in a derivative stockholder suit and a
corporations best interests as expressed by SLC (the court shall determine by applying its own
independent business judgment).
If a reasonable doubt exists that the directors are independent and disinterested (first prong of
demand futility test), the boards decision on litigation is not protected by the business judgment
When the decision would not be protected by the BJR, the board can refer the litigation to a board
DGCL 141(c)(1): The board of directors may, by resolution passed by a majority of the
whole board, designate 1 or more committees, each committee to consist of 1 or more of the
directors of the corporation.

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Any such committee, to the extent provided in the resolution of the board of directors, or in
the bylaws of the corporation, shall have and may exercise all the powers and authority of the
board of directors in the management of the business and affairs of the corporation . . . .
Zapata v. Maldonado (Del 1981): [A]n independent committee possesses the corporate power
to seek the termination of a derivative suit.
Must be made up of 1 or more of the directors. DGCL 141(c)(1).
Test for Review of Special Litigation Committee Decisions:
(1) The court should inquire into the independence and good faith of the committee and the
bases supporting its conclusions
(2) the Court should determine, applying its own business judgment, whether the motion
should be granted.
Zapata Corp. v. Maldonado (Del. 1981)
This is the unquestioned law of Delaware today
Plaintiff files complaint alleging demand futility
Four years later, corporation appoints a two-member committee
The committee investigates, and then moves to dismiss
Court's two-part test:
(1) The court should inquire into the independence and good faith of the
committee and the bases supporting its conclusions
(2) the Court should determine, applying its own business judgment, whether the
motion should be granted.
Reasoning: Dismissal is analogous to settlement:
In determining whether or not to approve a proposed settlement of a derivative . .
. action [when directors are on both sides of the transaction], the Court of
Chancery is called upon to exercise its own business judgment." Neponsit
Investment v. Abramson (Del. 1979)
Professor: Courts say they won't substitute their business judgment for the business
judgment of the directors, but that's exactly what they're doing in this case
Maybe they're suggesting that litigation decisions aren't business judgment?

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Other jurisdictions have generally rejected Zapata on basis that courts should not
substitute their business judgment for that of the directors
e.g. Tennessee, Connecticut
Einhorn v. Culea (Wis. 2000). [T]he court is bound by the substantive decision of a properly
constituted and acting committee.
Einhorn independence test: The test is whether a member . . . has a relationship with an
individual defendant or the corporation that would reasonably be expected to affect the
members judgment with respect to the litigation in issue.
Independence test factors:
1. Is the member a defendant?
2. Did the member participate in or approve the alleged wrong?
3. Members business dealings with any defendant
4. Members personal relationships with any defendant
5. Members business relationships with the corporation
6. Number of committee members (more is better)
7. Does the committee have independent counsel?
Refer to the slide re the M& F Worldwide case.

Qualification as plaintiff
For class actions (Largest Financial Interest)
FRCP Rule 23(a)(4). One or more members of a class may sue or be sued as
representative parties on behalf of all members only if . . . the representative parties
will fairly and adequately protect the interests of the class.
Who best qualifies as plaintiff?
Most capable of adequately representing the interests of class members
15 U.S.C 78u-4(a)(3). [T]he court . . . shall appoint as lead plaintiff the [class]
members . . . the court determines to be most capable of adequately representing
the interests of class members.

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[T]he court shall adopt a presumption that the most adequate plaintiff . . . is
the person or group . . . that
(aa) has either filed the complaint or made a motion . . . ;
(bb) in the determination of the court, has the largest financial
interest in the relief sought by the class; and
(cc) otherwise satisfies the requirements of Rule 23 . . . .
Most Capable = Largest Financial Interest (shareholders have the largest
shareholding ratio, literally)
Professor: Shouldnt the presumption be in favor of the plaintiff that
1. Has the attorney best able to represent?
2. Has the largest ratio of stake to total wealth?
3. By virtue of knowledge, education, or profession is most capable of
making decisions?
For derivative actions (Don't have to know anything as long as you have a competent
F.R.C.P. Rule 23.1(a). The derivative action may not be maintained if it appears that
the plaintiff does not fairly and adequately represent the interests of shareholders or
members who are similarly situated in enforcing the right of the corporation or
Surowitz v. Hilton Hotels Corp. (U.S. 1966)
A person with limited grasp of English and almost no under-standing of the
complaint held adequate (helped by son-in-law)
In re Fuqua Industries, Inc. (Del Ch. 1999)
Ill shareholder, confused about her lawsuit adequate (helped by husband)
Multiple plaintiff who barely understands the basic nature of the
derivative claims adequate (he has no interests antagonistic / adverse /
Lawyers take a dominant role in prosecuting litigation. In re Fuqua
Qualification as plaintiff's counsel
For class actions

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F.R.C.P. Rule 23(g)(1) Appointing Class Counsel. Unless a statute provides otherwise,
a court that certifies a class must appoint class counsel. In appointing class counsel, the
court . . . may consider any other matter pertinent to counsel's ability to fairly and
adequately represent the interests of the class . . .
(2) Standard for Appointing Class Counsel. When one applicant seeks appointment . . .
the court may appoint that applicant only if the applicant is adequate . . . . If more than
one adequate applicant seeks appointment, the court must appoint the applicant best
able to represent the interests of the class.
For derivative actions
FRCP Rule 23.1 imposes no requirement
BUT: a plaintiff can't be adequate if counsel is incompetent or inexperienced. Fuqua
Industries, p. 529
Creditor standing
Since derivative actions seek to enforce a right in the name of the corporation, standing generally
has been limited to those with an equity interest in the corporation.
Generally a shareholder of record or a beneficial owner of stock satisfies the nature of the plaintiffs
Creditors generally are not allowed to maintain a derivative suit, but when the corporation becomes
bankrupt / insolvent, the creditors may have standing.
Derivative Actions
Creditors do have standing in derivative actions
NACEPF v. Gheewalla 930 A.2d 92, 101 (Del. 2007):
"It is well settled that directors owe fiduciary duties to the corporation.
When a corporation is solvent, those duties may be enforced by its shareholders,
who have standing to bring derivative actions on behalf of the corporation . . . .
When a corporation is insolvent, however, its creditors take the place of
shareholders as the residual beneficiaries of any increase in value.
Consequently, the creditors of an insolvent corporation have standing to maintain
derivative claims against directors on behalf of the corporation for breaches of
fiduciary duties."
Class Actions
Creditors also have standing to file class actions

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F.R.C.P. Rule 23(a): One or more members of a class may sue or be sued as
representative parties on behalf of all members only if:
(1) the class is so numerous that joinder of all members is impracticable;
(2) there are questions of law or fact common to the class;
(3) the claims or defenses of the representative parties are typical of the claims or
defenses of the class; and
(4) the representative parties will fairly and adequately protect the interests of the
Creditors recovered in only 3.9% of securities class actions 1996-2005.
BUT: Creditors recovered in the largest securities class action.
Standing Timing refer to the slide Standing Timing re the flowchart
When must an individual be a shareholder to have standing?
Three stages:
(1) Wrongful Act
(2) Wrong Disclosed
(3) Litigation
The "contemporaneous ownership" requirement
Class Actions: Plaintiff must own shares at the time of the wrongful act (Stage 1 only)
Derivative Action: Plaintiff must own shares at the time of the wrong and hold through
the litigation (Stages 1, 2, and 3)
DGCL 327. In any derivative suit instituted by a stockholder . . . it shall be
averred . . . that the plaintiff was a stockholder . . . at the time of the
transaction . . . or that such stockholders stock thereafter devolved upon such
stockholder by operation of law.
Purpose: Shareholder litigation is bad and this rule minimizes it
Derivative Action in California: Plaintiff must be a shareholder before disclosure of the
wrong and hold through the litigation (Stages 2 and 3)
Professor likes this rule better
Settlement Approval

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Derivative Actions
F.R.C.P. Rule 23.1(c) A derivative action may be settled, voluntarily dismissed,
or compromised only with the court's approval. Notice of a proposed settlement,
voluntary dismissal, or compromise must be given to shareholders or members in
the manner that the court orders.
The Delaware settlement test is the Court's business judgment:
In determining whether or not to approve a proposed settlement of a derivative . .
. action [when directors are on both sides of the transaction], the Court of
Chancery is called upon to exercise its own business judgment." Neponsit
Investment v. Abramson ( Del. 1979)
Class Actions
F.R.C.P. Rule 23(e) The claims, issues, or defenses of a certified class may be settled,
voluntarily dismissed, or compromised only with the court's approval.
(1) The court must direct notice . . . to all class members.
(2) . . . the court may approve [the settlement] only after a hearing and on
finding that it is fair, reasonable, and adequate.
(3) The parties must [identify] any agreement made . . . .
(5) Any class member may object . . . .
Derivative and Class Action settlement standards are similar:
(1) Derivative: Chancellors business judgment, considering law and public policy in
addition to the corporations best interests. Zapata.
(2) Class action: Fair, reasonable, and adequate
The two different standards mean basically the same thing: the court can do whatever it
Attorney Fee Awards
Problem: In suing directors, shareholders have a collective action problem
Solution: courts award attorneys' fees from the recovery
Derivative action: Plaintiff is entitled attorney fees award if

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(1) The action is successful and

(2) The action confers a substantial benefit on the corporation Amalgamated v. WalMart Stores, (2d Cir. 1995), text at 539
Class action: Plaintiff is entitled to an attorneys fee award under the common fund
doctrine. Alyeska Pipeline v. Wilderness Soc'y, 421 U.S. 240 (1975), text at 539
Class actions that generate no funds, generate no fees.
Example: Directors denial of voting rights.
Class and derivative actions: Fee award is part of the settlement. Courts must approve the
settlements, including the awards.
Policy Implications
Critique of Derivative Actions: Circularity
Nearly all derivative actions are dismissed or settled.
Directors rarely contribute to settlements. The corporations pay as indemnification or
Thus the money goes in a circle. Transactions costs are large. Is this worth doing?
(1) Deterrence:
Litigation investigates and discloses wrongdoing
Fear of disclosure deters
(2) Process improves governance (oversight, etc.)
Critique of Class Actions: Pointless Transfer
Nearly all class actions are settled or dismissed.
The corporations pay the shareholders at the time of the wrong.
Payment reduces corporate value and current share value.
Transactions costs are large. Is this worth doing?

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(1) Deterrence:
Litigation investigates and discloses wrongdoing
Fear of disclosure deters
(2) Incentive for later shareholders to investigate before buying
Professor: This system would work better if directors had to pay
Is Delaware Losing its Cases?
Armour, Black & Cheffins, 9 J. Empirical Legal Studies 605 (2012)
Sample: 25 largest M&A deals each year since 1995
Main findings:
Proportion of deals challenged by litigation is approaching 100%
Proportion challenged by more than one lawsuit is rising sharply
Proportion of shareholder litigation in Delaware is declining
Suing only in Delaware is becoming rare.
What happened in 2001-2002 to cause the decline in shareholder litigation in Delaware?
Pre-2001: [Delaware Chancery Court] usually endorsed the full amount of agreed
attorney fees in class action and derivative suits.
2001: Delaware Chancery Court reduced a $25 million fee to $12 million in Digex.
Other fee cuts followed.
Chancellor Strine: [O]ur judiciary must be vigilant to make sure that the incentives
we create promote integrity and that we do not . . . generate the need for defendants
[who did nothing wrong] to settle.
If you are a plaintiffs lawyer, what do you think?
Finding: the anti-Delaware trend strengthened around the time of the Digex fee-cut
Finding: Delaware abandonment of first to file is class counsel encouraged fastfilers to file outside Delaware.
Delaware is favoring managers over shareholder litigation lawyers.
Two main changes:

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(1) Delaware began reducing attorneys fees in class action and derivative suits
(2) Delaware abandoned the "first to file is class counsel" rule, so fast-filers filed
Delaware's Conflict re Shareholder Litigation
(1) Delaware wants to attract incorporations. Incorporators want:
Fewer actions to succeed against Delaware managers
Smaller recoveries with lower fee awards
(2) Delaware wants to attract legal work for Delaware lawyers and judges. Glossy brochures:
advertising that Delaware is a good place to litigate. The plaintiffs lawyers who place these
cases want:
More actions succeeding against Delaware managers
Bigger recoveries with higher fee awards
Delawares solution:
Force the plaintiffs to file their lawsuits in Delaware
Corporations can do this with forum-selection bylaws
Boilermakers Local 154 Retirement Fund v. Chevron Corp., 2013 WL 3191981 (Del. Ch. 2013).
Chevron (and FedEx) enacts a forum-selection bylaw that requires certain suits to be
brought in Delaware. The bylaw:
[T]he Court of Chancery of the State of Delaware shall be the sole and exclusive
forum for
(i) any derivative action . . . brought on behalf of the Corporation,
(ii) any action asserting a claim of breach of a fiduciary duty owed by any
director, officer or other employee of the Corporation or the Corporations
(iii) any action asserting a claim arising pursuant to any provision of the
Delaware General Corporation Law, or
(iv) any action asserting a claim governed by the internal affairs doctrine.

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Any person or entity purchasing or otherwise acquiring any interest in shares of

capital stock of the Corporation shall be deemed to have notice of and consented
to the provisions of this [bylaw].
Shareholders claimed that Chevron changed their rights after they purchased their
Court: Shareholder contract with the corporation when they buy share in the corporation. The
board can change the shareholders rights after purchase because contract is flexible. The
bylaw is valid.
DGCL 109(b). The bylaws may contain any provision, not inconsistent with law or
with the certificate of incorporation, relating to the business of the corporation, the
conduct of its affairs, and its rights or powers or the rights or powers of its
stockholders, directors, officers or employees.
Court says that the bylaw only applies to internal affairs doctrine suits, but the bylaw doesn't
say that. Is the court saying that it won't enforce the bylaw as written?
17.7. Is it true that: [A]ll investors who bought stock in the corporations whose forum
selection bylaws are at stake knew that (i) the DGCL allows for bylaws to address the
subjects identified in 8 Del. C. 109(b), (ii) the DGCL permits the certificate of
incorporation to contain a provision allowing directors to adopt bylaws unilaterally, and (iii)
the certificates of incorporation of Chevron and FedEx contained a provision conferring this
power on the boards?
Answer: No.
Why does the court say it is true?
Answer: Items (i) and (ii), all persons are presumed to know the law. Item
(iii): Unclear. Boilermakers statement is closest :
[B]ylaws, together with the certificate of incorporation and the . . . DGCL,
form part of a flexible contract between corporations and stock-holders . . .
[S]tockholders assent to be bound . . . when they buy stock.
17.8.b. Why did Chevron choose Delaware over California?
Professor's answers: (1) The Delaware court will favor Chevron management in the
litigation (2) Delaware has specialized court (including no juries)
Procedure to Change a Bylaw
Propose a new bylaw and
1. persuade an absolute majority of the voting power deliver shareholder consent
to the new bylaw, or

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2. Win a proxy fight.

For shareholders in public corporations without access to the proxy machinery, this
power [to propose and adopt resolutions] is illusory. Text at page 479.
To amend using the companys proxy machinery, the shareholder must:
(1) own $2,000 of Chevron stock for one year
(2) submit the proposal and 500-word supporting statement at least 120
days before the proxy statement date
(3) if the company excludes it, sue for inclusion
(4) win the vote

Chapter 18 - Board Decision Making

Directors Fiduciary Duties:
(Officers own the same fiduciary duties to the corporation too)

Duty of Care: as a duty to act honestly, in good faith, and in an informed manner.
Directors, who behaved unreasonably, or in grossly negligent manner, violated their duty
of care.
Directors should reasonably believe they were acting in the best interest of the
Best interest of a corporation shall be considered under the property / entity dichotomy.
1. Whether the company is a device for the maximization of shareholder
profits (a property perspective), or
2. Whether the corporation is a social institution with responsibilities to its
many constituents (an entity perspective)

Duty of Loyalty: as a duty to avoid self-dealing,

Duty of loyalty applied when a director wore two hats because s/he had a personal
stake in a corporate decision, or a conflict of interest.

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Applying the duty of loyalty, judges scrutinized director involvement in conflicted

decisions, and applied various tests and remedies to ensure that those directors were fair
to the corporation and its shareholders.

Directors have 4 lines of defense against liability:

(1) The Business Judgment Rule
(2) Exculpation (free from blame or accusation)
(3) Indemnification
(4) Insurance
The Business Judgment Rule: if BJR applies, courts do not interfere with or second-guess directors
decisions. If BJR does not apply, courts may scrutinize the decision as to its fairness to the corporation
and its shareholders.
The BJR shields stupid board decisions
Kamin v. American Express (p. 292)
American Express (AmEx) bought DLJ stock for $30 million
The stock is now worth $4 million
Board wants to give stock to the shareholders ($4 million) (accounting fiction: by
pass income statement, directly reduce the retained earnings by the face value)
No tax benefit to AmEx. None to the shareholders (Professor Oh).
The loss wont appear on AmExs income statement (Kamin disputes)
Kamin want AmEx to sell the stock, take a $26 million capital loss, save $8
million in taxes, and give shareholders $12 million cash
Which alternative is better?
Answer: $12 million is better than $4 million
But the court applies the business judgment rule. The board wins.
Shlensky v. Wrigley (1968) (TB p562)

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Stockholder derivative action against directors for negligence (in failing to exercise
reasonable care and prudence in the management of the corporate affairs),
President / director / major shareholder refused to install lights in the baseball field and
schedule night baseball games, because his personal opinions that baseball is a
daytime sport and his concern for the neighborhood.
All other major league teams play their weekday games at night.
The Cubs dont play at night due to Wrigleys personal views that
(a) baseball is a daytime sport and
(b) night games would harm the neighborhood.
Do you think the directors were negligent?
Professor's answer: Yes if the objective is to make money for shareholders. No
if boards can consider other constituencies.
Court: Because there is no fraud, illegality or conflict of interest, the decision is one
properly before the directors and beyond our jurisdiction and ability. Dismissal
affirmed. BJR shields Wrigley
Professor: The business judgment rule is bad policy.
Doctors should make medical decisions. Boards should make business decisions.
Both should be liable for negligence.
Courts would decide based on the testimony of expert witnesses
Wheeler v. Pullman Iron and Steel Company court holds that court of equity will not
undertake to control the policy or business methods of a corporation, although it may be seen that a
wiser policy might be adopted and the business more successful if other methods were pursued. The
majority of shares of its stock, or the agents by the holders thereof lawfully chosen, must be
permitted to control the business of the corporation in their discretion, when not in the violation of
its charter or some public law, or corruptly and fraudulently subversive of the rights and interests of
the corporation or of a shareholder. majority shareholder can have its own little business empire.
The BJR as Shapeshifter
Authors: "Although the basic idea behind the BJR seems simple, it is hard to express the
boundaries of the rule using words." p. 543
Six Basic Prongs to decide BJR:

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(1) The decision is an exercise of business judgment

(2) The decision is not entirely irrational (waste)
(3) The directors are trying to serve the interests of the corporation
(4) No bad faith or disabling conflicts of interest (the directors do not have other
interest in this transaction, other than the best interest of the corp.)
(5) Informed to the extent director reasonably believes necessary
(6) The rule is a presumption in favor of management.
Summary of the express provisions:
(1) 4 of 5 (80%) expressly limit the decisions to business judgments
(2) 2 of 5 (40%) expressly require that the decision be rational
(3) 5 of 5 (100%) expressly require that the director be attempting to serve the interests
of the corporation
(4) 5 of 5 (100%) expressly require that the decision be in good faith and 4 of 5 (80%)
not motivated by conflicts of interest
(5) 3 of 5 (60%) expressly require that the director be informed to the degree the
director reasonably believes necessary
(6) 2 of 5 (40%) expressly says the rule is a presumption
Five Statements of the Business Judgment Rule
(1) White v. Barnes, New Mexico Supreme Court
If . . . directors arrive at a decision within . . . their authority, for which there is a
reasonable basis, and they act in good faith, as the result of their independent
discretion and judgment, and uninfluenced by any consideration other than what
they honestly believe to be the best interests of the corporation, a court will not . .
. substitute its judgment for that of the directors . . . .
(2) ALI Principles of Corporate Governance, 4.01(c)
A director or officer who makes a business judgment in good faith fulfills [the
duty of care] if
(1) he is not interested in the subject of his business judgment;

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(2) he is informed with respect to the subject of his business judgment to

the extent he reasonably believes to be appropriate under the
circumstances; and
(3) he rationally believes that his business judgment is in the best interests
of the corporation.
(3) Smith v. Van Gorkom, Delaware Supreme Court (TB p534)
The rule itself is a presumption that in making a business decision, the directors
of a corporation acted on an informed basis, in good faith, and in the honest
belief that the action taken was in the best interests of the company. Thus, the
party attacking a board decision as uninformed must rebut the presumption that
its business judgment was an informed one.
The determination of whether a business judgment is an informed one turns
on whether the directors have informed themselves prior to making a business
decision, of all material information reasonably available to them.
(4) Shlensky v. Wrigley, quoting Illinois Supreme Court (TB p527)
The majority of shares of its stock, or the agents by the holders thereof lawfully
chosen, must be permitted to control the business of the corporation in their
discretion, when not in violation of its charter or some public law, or corruptly
and fraudulently subversive of the rights and interests of the corporation or of a
(5) Model Business Corporation Act
MBCA 8.31 A director shall not be liable . . . for any decision to take or not
take action, or any failure to take action . . . unless the party asserting liability . . .
establishes that:
(2) The challenged conduct consisted or was the result of:
(i) action not in good faith; or
(ii) a decision
(A) which the director did not reasonably believe to be in the
interests of the corporation, or
(B) as to which the director was not informed to an extent the
director reasonably believed appropriate . . .
(iii) a lack of objectivity due to [conflict of interest]
Relationship between fiduciary duty and the BJR refer to the flow chart re their relationship

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The BJR limits the Duty of Care

Duty of Care under the BJR in Delaware

Misconduct Level


Becoming Informed

Bad Faith



Gross Negligence




No Liability No Liability


No Liability No Liability

DGCL provided exculpation clause to these two liabilities. Refer to the slide

Duty of Care under the BJR in MBCA

Misconduct Level


Becoming Informed

Bad Faith



Gross Negligence




No Liability Liability


No Liability No Liability

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MBCA 202(b)(4) also provides exculpation clause to both kinds of liabilities.

Good faith and the Duty of Loyalty limit the BJR

Smith v. Van Gorkom (Del. 1985)
Trans Union owns and leases rail cars
Trans Union is generating investment tax credits, but cant use them because it
has insufficient income.
The solution is (1) to get income by acquiring a company that has income, or (2)
to sell the business to a company that has income.
On Thursday Pritzker demands an answer by Sunday.
September 20 Meeting (Saturday):
Offer to buy the company for $690 million -- $55 per share. This is a 50%
premium over the current trading price of $38.75.
And it's 62% better than the average of our high and low prices this
We have until tomorrow evening to say yes or no.
I negotiated Jay down on a stock lock-up he wanted 1.75 million
shares, I gave him 1 million stock option associated with the stock
sale, which can be calculated in accordance with a Blackhole
formula (Prof. LoPucki this is crazy).
Board discusses for two hours; says ok if (1) they can shop and (2) give
buyers nonpublic information.
Board accepts, subject to a 90 day market test
Nobody else makes an offer. (Van Gorkom talks a manager out of it.)
Shareholders approve the sale and the sale closes
Smith brings direct class action
Court: Directors breached their fiduciary duties by grossly negligent failure to inform
themselves and failure to disclose to the shareholders.

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we hold that the directors of Trans Union breached their fiduciary duty to their
shareholders (1) by their failure to inform themselves of all information reasonably
available to them and relevant to their decision to recommend the Pritzker merger; and
(2) by their failure to disclose to recommend such as reasonable stockholder would
consider importance in deciding whether to approve the Pritzker offer.
Do you think the directors were grossly negligent?
Professor: This was ordinary negligence if any.
The court is substituting its business judgment for the board's, but that is
inherent in the gross negligence standard.
The board should have formally valued the company and discussed
bumping the price up.
Delaware Takes Care of Its Guests
Managers (Delawares customers/houseguests) are distressed about:
1. Liability for gross negligence
Delaware's response: DGCL 102(b). [T]he certificate of incorporation
may also contain . . . (7) A provision eliminating or limiting the personal
liability of a director . . . for monetary damages for breach of fiduciary duty
[of care]
2. Inability to rely on officers, directors, and professionals.
Delaware's response: New 141(e): A [board member] shall . . . be fully
protected in relying in good faith upon the records of the corporation and
upon such information, opinions, reports or statements presented to the
corporation by any of the corporations officers or employees, or
committees of the board of directors, or by any other person as to matters
the member reasonably believes are within such other persons professional
or expert competence and who has been selected with reasonable care by or
on behalf of the corporation.
Van Gorkom interpreted the prior version of 141(e), which covered
"reports", to exclude officers' oral statements; now the case changed in
favor of the management.

Avoiding Directors Liability - 3 ways that director can avoid liability: exculpation, indemnification, and

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Response to Van Gorkom

Directors can be exculpated for anything but 4 exceptions: DGCL 102(b) Contents of
COI: [T]he certificate of incorporation may also contain: (7) A provision eliminating or
limiting the personal liability of a director to the corporation or its stockholders for monetary
damages for breach of fiduciary duty as a director, provided that such provision shall not
eliminate or limit the liability of a director:
(i) For any breach of the directors duty of loyalty to the corporation or its
(ii) for acts or omissions not in good faith or which involve intentional misconduct or a
knowing violation of law;
(iii) under 174 of this title [for unlawful dividends]; or
(iv) for any transaction from which the director derived an improper personal benefit.
NOTE: Exculpation is only for directors, not officers
Problem Set 18
Facebook Certificate of Incorporation, Article VII, 1:
To the fullest extent permitted by law, no director of the corporation shall be personally liable
to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a
Purpose: To compensate for loss or damage
Three types of director/officer-indemnification laws
(1) Mandatory no contracting out (DGCL 145(c))
(2) Prohibited no contracting for indemnification (DGCL 145(b))
(3) Permissive (DGCL 145(a),(b),(e), and (f))
Includes nearly all that is not mandatory or prohibited
Adjudication is rare, so nearly all indemnification is permissive
Much of the language in DGCL 145(a) and (b) is similar
DGCL 145(a) covers actions brought by third parties and thus covers a
broader range of actions and expenses

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DGCL 145 (b) covers actions brought by the corporation (i.e. derivative
actions or direct actions by corporation) and thus covers a smaller range of
actions and expenses
Both sections require good faith and reasonable belief.
Permissive Wildcard: DGCL 145(f)
Professor: 145(e) should be interpreted narrowly (i.e. purpose is only to
authorize early payment of certain expenses) whereas 145(f) can only be
interpreted in a way that effectively eats 145(a) and (b)
Subsection f could conflict with a and b, but the Delaware courts have yet
to weigh in on this
Restatement Approach:
Restatement 3rd Agency 8.14.
A principal has a duty to indemnify an agent
(1) in accordance with the terms of any contract between them; and
(2) unless otherwise agreed,
(a) when the agent makes a payment
(i) within the scope of the agent's actual authority, or
(ii) that is beneficial to the principal, unless the agent acts officiously
in making the payment; or
(b) when the agent suffers a loss that fairly should be borne by the principal
in light of their relationship.
This provision covers officers, but directors are not agents
This provision is permissive
Permissive Indemnification refer to the slides
145(a) indemnification to other partys actions (somebody Other than the corporation)
145(b) indemnification to actions brought by the corporation
Scope of indemnification is different: 145(a) is much broader; 145(b) excluded
the cost of settlement
145(f) wild card section: not applied to the 145(b) prohibited indemnification

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Mandatory Indemnification

Prohibited Indemnification

Corporations can buy whatever insurance a company will sell for their directors and officers
CONTRA indemnification, which is subject to prohibitions in 145(b)
DGCL 145(g). A corporation shall have power to purchase and maintain insurance on behalf of
any person who is or was a director, officer, employee or agent of the corporation, . . . against any
liability asserted against such person and incurred by such person in any such capacity, or arising
out of such persons status as such, whether or not the corporation would have the power to
indemnify such person against such liability under this section.
Two types of coverage:
(1) Coverage for Directors and Officers when indemnification is unavailable
(2) Coverage for corporations for their indemnification obligations
Exclusions from a SAMPLE insurance policy:
(1) Any civil or criminal fines or penalties
(2) Claims arising out of, based upon or attributable to the committing of any deliberate
criminal or deliberate fraudulent act by insured person, as evidenced by a judgment, ruling or
other finding of fact in the underlying action or in a separate action . . . or other proceeding
BUT Policy specifically covers:
(i) punitive, exemplary and multiple damages and
(ii) civil penalties assessed . . . pursuant to 2(g)(2)(C) of the Foreign Corrupt Practices
Ralph Nader claims that directors should not be able to evade criminal fines. Can they evade them
at all?
DGCL 145(a) authorizes corporations to indemnify directors against fines if the directors
acted "in good faith". But who determines whether they acted in good faith? The corp. should
judge their conducts.

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DGCL 145(d) states that the corporation determines whether the director met the
applicable standard of conduct.
Though directors cannot be insured against criminal fines, they can be indemnified by the
corporation against them as long as the corporation decides they have met the applicable
standard of conduct.
Cumulative Coverage: Indemnification and Insurance

How Much Do Directors Pay?

Short version: very little, if any
Sherman & Sterling, 2005: It has been reported that the Enron directors $13 million contribution
represents 10% of their alleged profits from trading in Enron in the months leading up to . . .
Black Cheffins Klausner. Empirical study finding only 13 shareholder litigation cases from 1980
through 2005 in which directors paid any part of the recovery from personal funds.
Should the law require directors to pay?
Conventional wisdom: capable directors would be overly cautious or refuse to serve as
directors in the absence of indemnification provisions
BUT: Berkshire Hathaway does not indemnify, insure, or exculpate directors and provides
very little compensation but still obtains excellent directors who manage the company well
(1) Business Judgment Rule - Directors are not liable for negligent decision making
Only for grossly negligent, conflicted, or bad faith decision making
(2) Exculpation - The corporation can exclude gross negligence
(3) Indemnification - The corporation can indemnify them against third party actions and litigation
(4) Insurance - The corporation can insure them against everything else except deliberately
criminal or deliberately fraudulent acts.
Directors who engaged in criminal or fraudulent acts can still be reimbursed in settlements

Refer to the table in the slide cumulative coverage: indemnification and insurance
Derivative Actions move money in a circle
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Justification re derivative actions, indemnification, and likely stuff

o Process improves governance (shareholder provide oversight)
o Deterrence litigation investigates and disclosed wrongdoing / fear of disclosure
Professors proposal for shareholder litigation reform (reference to slides 8 proposals)
1. How would corporation and directors react to the reform panic
2. Would the new system make better or worse business decision unaffected decisionmaking process (Prof.s view)

Chapter 19 - Board Oversight

State law distinguishes three kinds of director liability:
(1) Decision making: liability for gross negligence (Delaware) OR only for bad faith
(2) Becoming informed: liability for gross negligence (Delaware) OR for ordinary
negligence (MBCA)
(3) Oversight: liability only for bad faith
Federal law (The Public Company Accounting Reform and Investor Protection Act of 2002, also
known as Sarbanes-Oxley Act) requires "internal control structure and procedures for financial
reporting" (but not for criminal activity)
Good Faith
"Good Faith is NOT an independent fiduciary duty, breach of which may directly result in liability."
[T]he fiduciary duty of loyalty is not limited to cases involving a . . . fiduciary conflict of interest.
It also encompasses cases where a fiduciary fails to act in good faith. Stone v. Ritter

The Fiduciary Duty of Care

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Misconduct degrees

Becoming informed



Intentional wrong

Bad faith

Bad faith

Bad faith

Gross negligence



No liability


No liability

No liability


A failure to act in good faith requires conduct that is qualitatively different from, and more
culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e. gross
Takeaway: Directors are only liable for lack of oversight if they commit intentional wrongs.
They are not liable for gross negligence in their oversight.
Three Oversight Rules:
(1) Corporations must have a reasonable internal control system
(2) Any board effort to accomplish (1) is sufficient
(3) Board must respond to "red flags" (i.e. only respond to problems once they have occurred)
(a) Can assume the integrity and honesty of employees as long as no red flags have been
(b) Protected in relying on information from control system by DGCL 141(e).
"A member of the board . . . shall be fully protected in relying in good faith upon . . .
opinions . . . presented . . . by any other person as to matters the member reasonably
believes are within such other persons professional or expert competence." DGCL
In re Caremark International, Inc.

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1989 Caremark Guides stated policy of no payments for referrals.

1991 US Office of the Inspector General began investigating Caremark for violations
of Anti-Referral Payments Law (ARPL) by paying kickbacks.
1993 Price Waterhouse reported no material weaknesses in Caremarks control
structure and not aware of illegal acts in relation to the Inspector General
1994 Caremark is indicted in Minnesota and Ohio.
1994 Caremark pleads guilty to one felony count and makes $250 million in payments
to resolve the matter.
Caremark settled a derivative action at a very cheap amount later on, and the court
approved such amount since they are not in bad faith.
Court: Low probability that . . . directors . . . breached any duty.
Good Faith Duty of Oversight: ensure that an information gathering and reporting
system is in place
Standard for Breach: Sustained or systemic failure to exercise oversight (e.g. not
ensuring the information system is in place)
Directors can assume the integrity and honesty of their employees as long as no
red flags have been raised
Stone v. Ritter
AmSouth operated 600 branch banks, 11,600 employees
Bank employees failed to file Suspicious Activity Reports.
AmSouth paid $50 million in fines and penalties.
Stone brings a derivative action.
Professor: Stone does not require adequate oversight; it only requires an attempt at oversight.
Court: no red flag raised to the directors / KPMG report showed that the board received and
approved relevant policies and procedure, delegating to certain employees the responsibility
for filing SARs and monitoring compliance, and exercised oversight by relying on periodic
reports from them - only a sustained or systematic failure of the board to exercise oversight
such as an utter failure to attempt to assure a reasonable information and reporting system
exists will establish the lack of good faith that is a necessary condition to liability.
Caremark Decision

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Lack of good faith is a necessary condition to liability

A failure to act in good faith may be shown (definition of BAD FAITH), for instance,
(1) where the fiduciary intentionally acts with a purpose other than that of
advancing the best interests of the corporation,
(2) where the fiduciary acts with the intent to violate applicable positive law, or
(3) where the fiduciary intentionally fails to act in the face of a known duty to
act, demonstrating a conscious disregard for his duties. . .
In re Citigroup, Inc.
Citigroup acquired securitized home mortgages, which would have bankrupted
company absent bailout
Shareholders filed a derivative action.
Claim: Failure to monitor excessive risk
Court: Directors are not liable.
Citigroup had an Audit and Risk Management Committee (indicate controls on the
Plaintiffs made no specific allegations of bad faith; business judgment rule applies to
risk taking.
In what realistic circumstance could a director have oversight liability? Francis v. United Jersey Bank?
Answer: Director knows of illegal activity, but deliberately allows it to continue. (Even Francis
might not qualify.)
"A director is not an ornament." - Harsh Oversight Standard
Francis v. United Jersey Bank (p. 566)
Two Board members of Pritchard & Baird, Charles and William, borrow $12 million
of trust funds.
Lillian, their mother who is also on the Board of Directors, fails to notice.
Pritchard & Baird is bankrupt.

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Trustee sues Lillian.

Court: Lillian is liable. "A director is not an ornament"
A board member has the following duties:
Keep informed about corporate activities
Regularly review financial statements
Object, and if the corporation persists, resign. (What good would that have
Answer: None. Puda Coal.
All reasonable action to stop the continuing conversion
NOTE re Exculpation Clauses: Although 102(b)(7) does not mention creditors, it allows
creditors to bring any claims belonging to the corporation itself

Puda Coal Case (On-going Case)

IPO - $116 million
Chinese director took all assets 19 months ago; short sellers tip bloggers
Shareholders sue the US directors
US directors move to dismiss the lawsuit, then they resign; and the last director wrongdoer kept his
Strines answer: He entered a default judgment against Puda Coal and allowed the case to go forward
against the US directors
Is this an oversight case? Are the US directors liable?
Prof.s Answer: It is an oversight case, but the US directors are not in bad faith (no red flags raised to the
directors), instead they are under real and real negligence, or gross negligence. The legislature allows
exculpation of all negligence.

MF Global Holdings, Ltd. - Weak Internal Controls, But Probably No Oversight Liability
The CEO submitted and signed the Global Annual Report required by Sarbanes-Oxley 404(a)

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Sarbanes Oxley 404(a) RULES REQUIRED.The Commission shall prescribe rules

requiring each annual report . . . to contain an internal control report, which shall
(1) state the responsibility of management for establishing and maintaining an adequate
internal control structure and procedures for financial reporting; and
(2) contain an assessment, as of the end of the most recent fiscal year of the issuer, of
the effectiveness of the internal control structure and procedures of the issuer for
financial reporting.
internal control assessment required by subsection (a), each registered public accounting firm
that prepares or issues the audit report for the issuer shall attest to, and report on, the
assessment made by the management of the issuer.
MF Global Holdings, Ltd.'s report:
We maintain "disclosure controls and procedures"
There can be no assurance that any design will achieve its stated goal
Management has evaluated our disclosure controls and procedures and is satisfied that the
controls are effective to ensure that necessary information is recorded, processed, and acted
upon in a timely manner,

They dont tell what the internal controls system is.

In late October 2011, MF Global suffered severe trading losses.

October 27, 2011, regulators asked MF Global how much cash it had and MF Global couldnt
answer. WSJ: Officials had been trying to fix the problem for months.
October 31, 2011, Edith OBrien, an assistant treasurer, met MF Globals losses by transferring over
$891 million dollars from customer accounts to a MF broker-dealer account.
WSJ: Midlevel employees had wide leeway when handling requests from elsewhere in the
company to move hundreds of millions of dollars at a time.
MF Global was placed in receivership, and a trustee was sent looking for the missing money.
CFTC is suing Corzine
Does Corzine have liability under Delaware law?
Answer: No. No evidence he acted in bad faith.

Internal Controls

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Definition: Systematic measures (such as reviews, checks and balances, methods and
procedures) instituted by an organization to:
(1) conduct its business in an orderly and efficient manner,
(2) safeguard its assets and resources,
(3) deter and detect errors, fraud, and theft,
(4) ensure accuracy and completeness of its accounting data,
(5) produce reliable and timely financial and management information, and
(6) ensure adherence to its policies and plans.
COSO: Internal control is broadly defined as a process, effected by an entitys board of
directors, management, and other personnel, designed to provide reasonable assurance
regarding the achievement of objectives in the following categories:
(1) Effectiveness and efficiency of operations
(2) Reliability of financial reporting
(3) Compliance with applicable laws and regulations.
Public Company Accounting Oversight Board (quasi governmental):
Reasonable is a high level of assurance, the understanding that there is a remote
External auditors typically use a range of 5% to 10% for remote likelihood.
Thus if theres less than a 5% to 10% chance of illegal activity, the corporation can
ignore it!

Chapter 20 - Director Conflicts

Director Conflicts
Director has a conflict of interest when he:
(1) transacts with the corporation;

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(2) has an interest in a transaction with the corporation;

(3) has an interest in a party that transacts with the corporation; OR
(4) is a director or officer of a party that transacts with the corporation
The issue typically arises because sometimes a shareholder sues
Applicable Rules:
(1) Statutory Safe Harbor (Benihana of Tokyo): DGCL 144(a)
Action taken involving conflicted director is valid if:
(i) The disinterested directors approve by a majority vote
(ii) The disinterested shareholders approve by a majority vote, or
(iii) The transaction is fair to the corporation. (Conflicts never prevent deals that
are in the corporations interests.)
Professor: The statutory safe harbor interpretation requires a negative implication from
the statute. That's how Benihana of Tokyo interpreted the statute. With that
interpretation, there is no need to show the "intrinsic fairness" of the transaction.
Three parts to DGCL 144(a):
(a) What conflicts exist and are excused
(i) director or officer transacts with the corporation
(ii) director or officer has a financial interest in a transaction with the
(iii) director of officer has a financial interest in a party to the transaction
with the corporation
(iv) director or officer is a director or officer of a party that transacts with
the corporation (interlocking directorates)
(b) What aspect is excused (invalidity, voting, quorum)
(i) existence of the conflict
(ii) conflicted director or officers presence at, and participation in, the
(iii) counting of the conflicted officers or directors votes

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(c) The conditions of excusal (disinterested approval or fairness)

(i) Disinterested director approval;
"disinterested" has been read into 144 by the courts
(ii) Disinterested stockholder approval; OR
"disinterested" has been read into 144 by the courts
(iii) The contract is fair to the corporation.
Procedural and Substantive Fairness
Procedural fairness:
Was approval by fair procedures?
Substantive fairness:
(a) Was the price within the range an unrelated party might have been
willing to pay or accept?
(b) Did the transaction provide benefit to the corporation? Need for the
property, detriment, gain siphoned off, etc.
(2) Conflicted directors must show transaction's "intrinsic fairness"
Professor: not clear whether this is still applicable
Existed prior to 144
144 already has a fairness element
Benihana of Tokyo, Inc. v. Benihana, Inc. (p. 641)
BOT owns a controlling interest in Benihana
Benihana board issues voting preferred, dilution.
NOTE: Board can determine the powers/rights of shares they issue if those
powers/rights have not already been determined by the Articles of
Incorporation (assuming the Articles have authorized them to do so).
DGCL 151(g)

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NOTE: Issuance of the preferred stock isn't a breach of the duty of loyalty
even though BOT elected them and they are diluting BOT. This is because
the directors' duty of loyalty is to Benihana, not BOT. The directors weren't
beholden to BOT.
John Abdo is on both sides of the transaction.
Benihana director uses confidential Benihana information to negotiate against
Why isnt that a breach of duty of loyalty John Abdo?
Abdo did not breach his duty of loyalty because there is no evidence Abdo used
confidential information in his negotiation from the other side. Abdo knew the
terms a buyer could expect in a deal like this.
Abdo had a conflict of interest.
The conflict was excused because a majority of the disinterested directors
144 is a safe harbor so the intrinsic fairness rule no longer applies. ( Fliegler
no longer law?)
Business judgment rule applies.
Distinguishing Among Conflicts refer to the slides
Solution to Membership of a Competitor's Director on Your Board
Should we allow Drake, a member of a competitors board, to serve on our board? How do
we keep our secrets?
Answer: Use committees to exclude Drake from sensitive discussions. Cox and Hazen
10:11 (2012) The duty of loyalty places directors under a duty of confidentiality.
Example of Two-Tiered Analysis
Uncertain whether this actually needs to occur
Fliegler v. Lawrence (p. 639)
Lawrence controls Agau and USAC
Lawrence causes Agau to acquire USAC

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As majority shareholder of Agau, Lawrence approves.

Fliegler brings a derivative action
1. Shareholder approval under 144(a)(2)must be by a disinterested majority
(same misreading as California!)
Only a third of disinterested minority voted; their vote is unknown
2. Two-tiered analysis: application of section 144 coupled with an intrinsic
fairness test.
Professor: court's reading of "disinterested" into 144(a)(2) was wise. The rule makes
more sense that way
Approach to Conflicts - Why is a serious problem so easy to cure?
Answer: Conflicts were bad when the disinterested couldnt or didnt assume control.
Conflicts are okay when the disinterested assume control or the director doesnt act on
the conflict.
Waste and the Business Judgment Rule
Waste definition: an exchange was so one-sided that no business person of ordinary, sound
judgment would conclude that the corporation has received adequate consideration. Claim of
waste will only arise in rare, unconscionable cases where directors irrationally squander or
give away corporate assets. Board's decision is upheld unless it cannot be attributed to any
rational purpose.
Professor: Very difficult to show that a board decision is irrational. Most judges don't
like waste doctrine so they limit it in this way, but a few plaintiffs are able to get past
this standard.
For the lucky few, waste allegations get the plaintiff past a motion to dismiss and
into discovery
At that point (discovery), the defendant settles because they don't want to reveal
their secrets
NOTE: Conflicts and waste are exceptions to the BJR
Conflicts can be excused
Waste cannot be ratified except by all of the shareholders acting together
Freedman v. Adams (2013)

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Rational v. reasonable standard, rational is a lower standard adopted by Del court.

Waste allegations get the P past a motion dismissed and obtained a deposition.
Conflicts and Fair Treatment of Other Directors
20.4. Kathy and Lorenzo are voting to issue additional shares to themselves for $250 a share.
Is Justin being treated fairly?
Delaware answer: Yes. Justin didnt bargain for preemptive rights.
[The Delaware] Supreme Court has long noted that bylaws, together with the
certificate of incorporation and the broader DGCL, form part of a flexible
contract between corporations and stockholders . . . and that stockholders who
invest in such corporations assent to be bound by board-adopted bylaws when
they buy stock in those corporations. Boilermakers v. Chevron (Del. 2013)
Do Kathy and Lorenzo have a conflict of interest?
Answer: Yes. They are on both sides of the stock issuance.
Is the conflict excused under DGCL 144(a) as fair to the corporation?
Professor's answer: No, because the corporation could have sold the stock for
more than $250 a share.
Corporate Opportunity
Classic statement of the doctrine (Guth v. Loft, Inc.):
Established a broader line of business test in addition to a narrower interest or expectancy test
(5 elements test) [which may be used in the partnership and LLC opportunity cases as well]:
1. [I]f there is presented to a corporate officer or director a business opportunity which
the corporation
2. is financially able to undertake,
3. is, from its nature, in the line of the corporation's business and is of practical
advantage to it,
Not enough if the corporation has never contemplated the opportunity and had no
plan to get into that line of business, but the opportunity was too good to pass up
4. is one in which the corporation has an interest or a reasonable expectancy, and,
Something short of ownership (which is why the director was able to take it in
the first place)

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Some sort of a pre-existing relationship

5. by embracing the opportunity, the self-interest of the officer or director will be
brought into conflict with that of his corporation,
the law will not permit him to seize the opportunity for himself.
Unclear whether these are elements or factors
Some courts require all (elements), but others are willing to hold a corporate opportunity
existed when only some are present (factors) - balance during the determination
Remedy: Constructive trust placed on all of the benefits of the transaction itself (property, interests,
and profits) in case of determination of corporate opportunity
Officer and Director Opportunities:
The opportunity belongs to the officer or director when a business opportunity comes to
a corporate officer or director in his individual capacity rather than in his official capacity,
and the opportunity is one which, because of the nature of the enterprise, is not essential to
his corporation, and is one in which it has no interest or expectancy Guth v. Loft, Inc.
Individual capacity + not essential to the corp. individual opportunity
Broz v. Cellular Information Systems
Broz owns RFBC and is the director of CIS
CIS and RFBC are competitors
Opportunity: Michigan-2 area cellular license.
Offered to Broz, not CIS (CIS was in financial trouble, it is selling licenses)
Broz asks CIS CEO, buys the license; CIS later on acquired by other co, then sues
Guth test:
(1) Opportunity presented to director in his corporate capacity? No. In his personal
(2) CIS financially able to undertake? No. CIS was near bankruptcy
(3) In line of CIS's business? Yes. Michigan cellular license.
(4) Interest or a reasonable expectancy? No. Not in CIS business plan.

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(5) Would RFBC purchase bring Brozs interests in conflict with CIS? No. No
duties . . . inimical to his obligations to CIS. Not competitors.
Court: Presenting to the board is a safe harbor, but not always necessary. Broz wins not a
corporate opportunity.
Farber v. Servan Land Co. (5th Cir. 1981)
Serianni and Savin are majority shareholders and principal officers.
Forman (director) tells annual shareholder meeting that Farquhar is willing to sell
another 160 acres. Feasible, should be investigated. transaction pending
Serianni and Savin purchase the 160 acres.
1969. No discussion at annual meeting.
1970. Farber discovers purchase; asks at meeting; court reporter conflicts with minutes
re ratification.
1973. Joint sale of properties, generous allocation by major shareholders
1973 Farber brings derivative action.
Trial Court: This is a corporate opportunity since the corp. does not declined, not ratified;
not cured; so corporation gets all profits. The property bore no substantial relationship to
Servans primary purpose of operating a golf course. Hence the purchase was not
antagonistic to any significant corporate purpose.
Appellate Court: it vacated and remanded the lower court for clarification.
NOTE re Minutes from Case:
Why would a court accept official minutes over a court reporters transcript?
Answer: Because people dealing with the corporation rely on the official
minutes. E.g., Big Machines.
Corporate Opportunity Doctrine
Guvertz: every case involves three relationship, aggreagate closeness should or does determine the
Close agent is CEO, Intermediate a director, Weak an employee
Close corporae tenants opportunity to buy a leased property, intermediate develop adjacent and
premises (Salmon), Weak develop the adjacent property (Farber)

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Refer to the flow chart in the slide

Johnston v. Greene (p. 653)
Airfleets has $3.5 million, is looking for investments
Hutson knew Odlum as president of Atlas and in several businesses
The investment came to Odlum in his individual capacity.
For tax reasons, Odlum gave stock to Airfleets and patents to others.
Odlum dominated the other Airfleets directors (finding of fact).
The opportunity has no close relationship to Airfleets business and was not essential to
it; Airfleets has no interest or expectancy.
Court: The opportunity belonged to Odlum and not to his companies.
Otherwise, Odlum would have had conflicting duties.
The business opportunity is Odlum's because (citing Guth v. Loft):
(1) the opportunity came to him in his personal capacity;
(2) the opportunity is not essential to the business enterprise because of its
nature; and
(3) the corporation had no interest or expectancy in the opportunity
Renunciation of Corporate Opportunities
DGCL 122. Every corporation created under this chapter shall have power to:
(17) Renounce, in its certificate of incorporation or by action of its board of directors, any
interest or expectancy of the corporation in, or in being offered an opportunity to participate
in, specified business opportunities or specified classes or categories of business
opportunities that are presented to the corporation or 1 or more of its officers, directors or
Renunciation can be:
(1) categorical in advance
(2) one by one as opportunities arise

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NOTE: Same for Partnerships (404(b) & 103(b)(2)) and LLCs

Opportunity Doctrine for Partnerships and LLCs
UPA 404(b). A partner's duty of loyalty to the partnership and the other partners is
limited to the following:
to account to the partnership and hold as trustee for it any property, profit, or
benefit derived by the partner in the conduct . . . of the partnership business or
derived from a use by the partner of partnership property, including the
appropriation of a partnership opportunity . . . .
Renunciation of Partnership Opportunities
RUPA 404(b)
A partner's duty of loyalty to the partnership and the other partners is
limited to the following:
(1) to account to the partnership and hold as trustee for it . . . a
partnership opportunity . . . .
RUPA 103(b)(2)
The partnership agreement may not . . . eliminate the duty of loyalty under
404(b) . . . but:
(i) the partnership agreement may identify specific types or
categories of activities that do not violate the duty of loyalty, if not
manifestly unreasonable; or
(ii) all of the partners or a number or percentage specified in the
partnership agreement may authorize or ratify, after full disclosure of
all material facts, a specific act or transaction that otherwise would
violate the duty of loyalty . . .
ULLCA 409(b). A member's duty of loyalty to a member-managed company and its
other members is limited to the following:
(1) to account to the company and to hold as trustee for it any property, profit, or
benefit derived by the member in the conduct . . . of the company's business or
derived from a use by the member of the company's property, including the
appropriation of a company's opportunity . . . .
Renunciation of LLC Opportunities

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ULLCA 409(b)
A member's duty of loyalty to a member-managed company and its other
members is limited to the following:
(1) to account to the company and to hold as trustee for it . . . a
company's opportunity . . . .
ULLCA 103(b)(2)
The operating agreement may not . . . eliminate the duty of loyalty under
409(b) . . . but the agreement may . . .
(i) identify specific types or categories of activities that do not
violate the duty of loyalty, if not manifestly unreasonable . . . .
(ii) specify the number or percentage of members or disinterested
managers that may authorize or ratify, after full disclosure of all
material facts, a specific act or transaction that otherwise would
violate the duty of loyalty.
Review Problem (Supplement p. 263)
Hypo is insolvent
$1.3 million foreclosure is pending; will become final in two days.
Dan is a Hypo director who owns 7% of shares.
Dan will lend $1.3 million secured to redeem
We represent Dan. Objective: a mortgage authorized by Hypo.
Hypo has about 14 shareholders; 57% of the shares favor the loan; 23% oppose it; the
remainder are unavailable/uninterested.
Certificate of Incorporation: the board shall consist of nine members
The bylaws provide that the board chairman (Dan) may call a special meeting on ten days
notice to all board members.
20.6.a. Can shareholders authorize the security interest? 141(a), 228(a)
Answer: No. The board manages the business.
20.6.b. How many board members are there?

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Answer: Eight. Frans resignation is invalid because not upon notice given in writing. Al is
no longer a natural person.
20.6.c. Can Dan call a special board meeting on 24 hours notice?
Answer: No, the bylaws require ten days.
20.6.d. Could a shareholder resolution cure the problems with the board? If so, what should it say?
Answer: A resolution could
(1) change the board meeting notice requirement to 24 hours, or
(2) remove the current board and appoint a new board.
It cant reduce board size because that is in the certificate.
20.6.e. If we could call a board meeting, do we have the votes?
Answer: Probably not. No quorum would exist if Wayne boycotted the meeting.
20.6.f. How many of these new board members are disinterested?
A plaintiff may also challenge a director's independence by alleging facts illustrating that a
given director is dominated through a close personal or familial relationship or through force
of will, or is so beholden to an interested director that his or her discretion would be
sterilized. In re Tyson Foods, Inc., (Del. Ch. 2007)
(1) Virginia, Dans full time assistant.
(2) Edra, spouse of Dan (the lender/board chairman).
(3) Marilyn, spouse of a board member who is employed by Dan.
(4) Mark, board chairmans close friend.
(5) Walter, spouse of another board member.
Answer: Virginia and Marilyn are probably dominated. But more information is necessary to
determine domination
20.6.g. How many of these new board members are legally qualified to be directors?
(1) Edra, college degree, no business experience, no knowledge of Hypo.
(2) Marilyn, homemaker, mother, high school education.
(3) Virginia, executive assistant, college degree, familiar with business

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(4) Mark, no prior relationship to Hypo.

(5) Walter, same as Edra.
Answer: All are qualified to be directors. There are no minimum requirements, e.g., Francis
v. United Jersey Bank.
20.6.h. Can you opine that this board can take valid action? Would you bet your $1.3 million?
1. Dan, board chairman and proposed lender.
2-4. Jill, Mike, Aron. Current board members with no conflicts.
5. Edra, spouse of the lender/board chairman.
6. Marilyn, spouse of board member employed by Dan.
7. Virginia, board chairmans full time assistant.
8. Mark, board chairmans close friend.
9. Walter, spouse of another board member.
Answer: Yes. Board can approve the transaction unanimously.
Three or four disinterested directors can ratify
The transaction is fair to the corporation (highly beneficial!).
Dwaynes 23% may prevent disinterested shareholder ratification.

Chapter 29A - Buyouts in Partnerships and LLCs (Supplement)

Basic Concepts
Dissociation: Withdrawal from association (with partnership or LLC).
RUPA 601. A partner is dissociated from a partnership upon the occurrence of any of the
following events:
(1) The partnerships having notice of the partners express will to withdraw.
ULLCA 601 A member is dissociated from a limited liability company upon the occurrence
of any of the following events:

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(1) The companys having notice of the members express will to withdraw . . . .
Different Effect of Prohibition on Dissociation in Partnerships and LLCs
Partnership: If dissociation is prohibited by Partnership Agreement, Partner can
dissociate but may be liable for "wrongful dissociation."
LLC: If dissociation is prohibited by Operating Agreement, Member cannot dissociate.
Member can also have liability for "wrongful dissociation."
Dissolution: Termination of an entitys existence
Liquidation: Sale of the entitys assets for cash.
Winding up: Continuation of business operations during liquidation to increase the liquidation
proceeds. (during the winding-up, owner may operate while advertising for sale)
Distribution: Transfer of money or property from an entity to its investors.
Dividend: A distribution from a corporation
Transferrable interest: a partners right to receive distributions from the partnership
Distributional interest: a members right to receive distributions from the LLC
NOTE: Transferable Interest and Distributional Interest are the same concept but applied to
Partnerships and LLCs (respectively)
Buyout Rules
Default Rights of a Minority Investor to Withdraw (w/t otherwise agreed in the COI /
partnership agreement / operating agreement)



LLC (same as
partnership results)

Dissolve the entity?

No, DGCL 275

Yes, 801(1)

No, 801

Mandatory buyout

No, b/c lock-in

Yes, 701(a) (indirectly, Yes, 701(a)

by choice)

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Sale of rights to a Distribution and

third party
control rights,
DGCL 159

Distribution rights only,

Distribution rights
no controlling right of the only, 502
business is transferrable
to 3rd party 502

Default Buyout Rules

1. If partners want out, the entity must buy their interests.
701(a) If a partner is dissociated from a partnership without resulting in a
dissolution and winding up . . . the partnership shall cause the dissociated
partners interest . . . to be purchased for a buyout price determined pursuant to
subsection (b).
2. The price is fair value, determined by the court using standard methods of valuation.
701(b) The buyout price . . . is the amount that would have been
distributable . . . if, on the date of dissociation, the assets of the partnership were
sold at a price equal to the greater of the liquidation value or the value based on a
sale of the entire business as a going concern without the dissociated partner . . . .
3. The entity has a grace period in which to pay. After that period, the withdrawing
member can sue for the price.
120 days to suit
Obligation to pay admitted value within the same 120 days
Dissociating partner may have to wait a long time for his money
RUPA 701(e). If no agreement . . . is reached within 120 days after a written
demand for payment, the partnership shall pay . . . in cash to the dissociated
partner the amount the partnership estimates to be the buyout price . . .
4. Any partner has the right to force the partnership to dissolve. 801
Can also force the partnership to buy him out OR dissolve. 701
5. Events causing Partner's dissociation. 601
6. Settlement of Accounts and Contributions Among Partners. 807
7. Court can order judicial supervision of dissolution upon application of any partner.

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Court can do anything that is a valid exercise of its discretion as long as it can
assign a reason. (e.g. can order sale of assets by Partner A to Partner B if A
cannot pay for the assets)
Problem with Auctions: when the partners do not have enough to make a decent bid,
the assets can be bought for much less than their value.
Solution: Allow the purchaser to pay part of the bid price by note and mortgage.
Creel v. Lilly (Supp. p. 269)
Lilly, Altizer, and Creel are partners in Joes Racing.
Creel dies, and his widow was appointed as personal representative of his
Lilly and Altizer winded up the partnership, and started a new business
without taking the widow.
Estate sues; Mrs. Creel wants the business sold.
Court: Sale is not required, but the partnership should have paid 52% interests in
the partnership to the widow.
Holding: the default rule is that when a partner died, the partnership
automatically dissolved if the partners did not otherwise agreed.
McCormick v. Brevig (Supp. p. 284)
Joan and Clark, brother and sister, are disputing their partnership interests.
The trial court dissolves the partnership, RUPA 801(5), and allows Clark
to buy Joans interest.
Court: reverses, holds that the ranch must be sold for cash and the cash
RUPA 807(a) Any [sale] surplus must be applied to pay in cash the net
amount distributable to partners in accordance with . . . (b).
(b) In settling accounts among partners, profits and losses that result from
the liquidation of the partnership assets must be credited . . . to the
partners accounts.

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1. If members want out, the entity must buy their interests.

701(a) A limited liability company shall purchase a distributional interest of
a . . . member of an at-will company for its fair value determined as of the date of
. . . dissociation if . . . dissociation does not result in a dissolution and winding
up . . . .
2. The price is fair value, determined by the court using standard methods of valuation.
702(a) [T]he court shall . . . determine the fair value of the interest, considering
. . . the going concern value of the company, any agreement . . . [and] the
recommendations of any appraiser appointed by the court . . . [and] specify the
terms of the purchase.
3. The entity has a grace period (120 days) in which to pay. After that period, the
withdrawing member can sue for the price.
240 days to suit
No obligation to pay admitted value
Dissociating member may have to wait a long time for his money
701(b) A limited liability company must deliver a purchase offer to the
dissociated member . . . not later than 30 days after [dissociation].
(d) If an agreement to purchase . . . is not made within 120 days after [the
withdrawal date] the dissociated member, within another 120 days, may [sue].
Common Contracts Allowing Minority Investors to Withdraw
(1) Stated term: Investors may not withdraw their investments for an agreed period of time.
(term versus at-will)
(2) Auction: business is sold to the highest bidder. (dissolution)
(3) Right of first refusal: Investor must offer the interest to the entity and other investors
before selling to an outsider.
(4) Texas offer: Any investor can set a price for buyout, the other choses whether to buy or
sell at that price.
Procedure for Dissolution
Step 1. Decision to dissolve.
Step 2. Liquidation and winding up. Entity converts all assets to cash.
Step 3. Distribution.

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Step 4. Public filing. (This is Step 2 for a corporation.)




Who decides to

Board and share-holders,

DGCL 275

Any partner, 801

Unanimous members

Who winds up?

The corporation, DGCL


Members not wrongfully

dissociated, 803

Members not wrongfull


Public filing?

Certificate of dissolution,

Statement of dissolution, 805

Articles of termination

Partnership Dissolution Procedure

Step 1. Dissolution. A dissolution event occurs. RUPA 801
Step 2. Winding up. The not-wrongfully-dissociated partners may participate. RUPA
Partnership continues only for that purpose. RUPA 802.
Partners may preserve the business or property as a going concern for a reasonable
time. RUPA 803.
The assets must be liquidated. RUPA 807(b).
Step 3. Settlement. The partnership pays creditors and settles all partnership accounts.
Step 4. Statement of dissolution. A non-wrongfully dissociated partner may file.
Enables the dissociated partner to avoid liability for being an apparent partner
No other purpose
Sale to a Third Party
Interests are partnership and LLC, equivalents of corporation shares. (what the investor
received resulting from their investment in different entities)

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Each interest consists of control rights and distribution rights.

Distribution rights are freely transferable, control rights are not. RUPA 503.
Transfer entitles transferree to transferrors distributions.
Partner-transferor retains partner rights and duties, RUPA 503(d).
Distribution rights are freely transferable, control rights are not. ULLCA 503.
Transfer entitles transferree to transferrors distributions.
Member-transferor retains member rights and duties, ULLCA 503(d).
Member-transferor is not released from liability, ULLCA 503(c).
Judgment Proofing
Competition among entity types to protect businesses from the owner's creditors
Similar to jurisdictional competition among the states for franchise taxes
Common belief: If a business is sound, a creditor of the owner should not be able to interfere
with it
The creditor should not be able to send the sheriff to execute and sell assets of the
The creditor should not be able to participate in governance
NOTE: they can participate in corporate governance, but not in GPs and LLCs
The creditor should receive a charging order and wait for the business to distribute the
These principles seem reasonable but enable judgment proofing
Comparison: Creditor's Rights in Shareholders' Interests
Creditor has a judgment against Shareholder. How can it collect?
Sheriff seizes the stock (levy under a writ of execution).
Sheriff sells the stock to highest bidder for cash (creditor can bid).

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Sheriff pays sale proceeds to the creditor. Payment reduces the debt.
By bidding the amount of the debt, creditor can always (1) be paid in full or (2) own the
Execution and sale is available against nearly all kinds of property.
Creditor's Rights in Partners' Interests
Creditors Collecting Judgments Against Partners: Obtain a Charging Order and
RUPA 504(a). A court having jurisdiction may charge the transferable interest of the
judgment debtor to satisfy the judgment. (charging order)
(b) The court may order a foreclosure of the interest subject to the charging order at
any time.
(e) This section provides the exclusive remedy (only available remedy) by which a
judgment creditor of a partner . . . may satisfy a judgment out of the judgment debtors
transferable interest in the partnership.
PB Real Estate v. DEM II Properties (Supp. p. 290)
Botwick and Kurzawa practice law through an LLC
PB Real Estate wins judgments against Botwick and Kurzawa.
PB Real Estate obtains a charging order against Botwick & Kurzawas law firm:
Pay Botwick and Kurzawa distributions to PB Real Estate.
The LLC pays $28,000 to Botwick and $28,000 to Kurzawa.
Court: enters judgment against the LLC for $56,000.
Charging Liens and Foreclosure
Step 1. Creditor obtains a judgment against the Partner.
Step 2. Creditor obtains a charging order against the Partnership.
504(b) A charging order constitutes a lien on the judgment debtors transferable
interest in the partnership.
Step 3. Creditor forecloses on the Partners transferrable interest.

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504(b) The court may order a foreclosure of the interest subject to the charging order
at any time. The purchaser at the foreclosure sale has the rights of a transferee.
Step 4. Creditor buys the Partners transferrable interest at the sale (via credit bid).
This is only the right of a transferee. 504(b)
No right as a member unless consent is given. 503(a)
No participation in management. 503(d).
Step 5. Can the creditor force dissolution of the partnership?
801 A partnership is dissolved, and its business must be wound up, only upon the
occurrence of any of the following events:
(6) on application by a transferee of a partners transferable interest, a judicial
determination that it is equitable to wind up the partnership business:
(ii) at any time, if the partnership was a partnership at will at the time of
the transfer or entry of the charging order . . . .
Answer: Maybe, depending on the situation and judges attitude (by evaluating the
business of the partnership, whether it is doing well or just holding the money from
The provisions and analysis for an LLC are the same as for a partnership.
Charging orders do not reach payments made as salaries (those are paid in partners'
employee capacities)
504(a) [A] court . . . may charge the distributional interest of the judgment debtor to
satisfy the judgment.
101(5) Distribution means a transfer of money, property, or other benefit form a
limited liability company to a member in the members capacity as a member . . . .
Term of Years: If LLC is term company, court cannot dissolve it until end of term. 801(a)
Problem: LLC can change to term company at any time before foreclosure sale and
court will respect it. This gives LLC plenty time to make change before creditor can
take action.
Different rules apply in Limited Partnership.
802 not reasonable practicable to carry on the activities of the limited partnership [by
application of a PARTNER].

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The Desert Ranch Judgment-Proofing Structure

Professor: Corporate law has evolved around idea that majorities can oppress minorities.
Where that is happening, courts are willing to step in and dissolve the corporation. That
doesn't happen with GPs and LLCs
We represent YCLT, seeking to collect $40 million judgment.
29a.12.a. What does Blixseth own? What is it worth?
Answer: A limited partnership interest worth 98% of $209 million.
b. What is YCLTs remedy? (Same as LLC or LLP).
Answer: A charging order and foreclosure.
29a.12.b. Our charging order will reach distributions. Will any occur?
ULPA 102(5). Distribution means a transfer . . . from a limited part-nership to a
partner in the partners capacity as a partner or to a trans-feree on account of a
transferable interest owned by the transferee.
Answer: No. LLLP will not pay Blixseth in his capacity . . . as a member.
29a.12.c. How can Blixseth enjoy the money without distributions?
ULPA 102(5). Distribution means a transfer . . . from a limited part-nership to a
partner in the partners capacity as a partner or to a trans-feree on account of a
transferable interest owned by the transferee.
Answer: Entities will pay him fees and salaries. Payments will be directly to credit
card companies, etc.
29a.12.d. Could YCLT get control rights through foreclosure?
ULPA 702. A transfer, whole or in part, of a partners transferrable interest, does not .
. . entitle the transferee to participate in the management or conduct of the limited
partnerships activities . . .
Answer: No
29a.12.e. Could a court order the LLLP to distribute excess cash?
ULPA 703(a) [T]he court may charge the transferable interest of the judgment debtor
with payment of the unsatisfied amount.
(e) This section provides the exclusive remedy by which a judgment creditor of a
partner or transferee . . . may satisfy a judgment out of the judgment debtors
transferable interest.

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Answer: No
29a.12.f. Could a court order Blixseth to cause a distribution?
Answer: No. Blixseth lacks the power to cause a distribution.
Management LLC is the manager. Blixseth has only a 40% interest.

Desert Ranch

29a.12.g. If LLLP were a corporation, would dissolution be a remedy?

MBCA 14.30(a)(2)(ii) The [court] may dissolve a corporation . . . in a proceeding by
a shareholder if it is established that . . . the directors or those in control of the
corporation have acted, are acting, or will act in a manner that is illegal, oppressive, or
Answer: Yes, if YCLT levied on the stock and bought it at the sale.
29a.12.h. Can a court dissolve an LLLP for oppression?
ULPA 802. On application by or for a partner the district court may decree
dissolution of a limited partnership whenever it is not reasonably practicable to carry
on the business in conformity with the partnership agreement.
Answer: No. Oppression is not a ground for dissolution.
29a.12.i. If YCLT owned Blixseths transferrable interest and the court dissolved the
partnership, what would the receiver get?
ULPA 803. In winding up its activities, the limited partnership . . . shall discharge
the limited partnerships liabilities . . . and marshal and distribute the assets of the
Answer: Interests in other LLLPs.
29a.12.j. Was Blixseths transfer to the LLLP fraudulent? How prove it?
UFTA 4(a). A transfer made . . . by a debtor is fraudulent as to a creditor . . . if the
debtor made the transfer . . . with actual intent to hinder, delay, or defraud any creditor
of the debtor . . . .
Professor's answer: Yes. Expert testimony showing the transaction (1) judgmentproofed Blixseth and (2) had no other plausible purpose.
Will YCLT be able to recover from Blixith?
Professor's answer: I dont know.

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