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PRINCIPAL-AGENT RELATIONSHIPS

Gorton v. Doty (1)


It is not essential to the existence of authority that there be a
contract between principal and agent or that the agent promise
to act as such, nor is it essential to the relationship of principal
and agent that they receive compensation

A Gay Jenson Farms v. Cargill (7)


Cargill had many indicators that they had de facto control over
Warren
o Cargill could put Warren into bankruptcy
Warren had a tremendous amount of outstanding
debt they still owed Cargill
o Cargill could have stopped buying grain from Warren
90% of Warrens business was them selling grain to
Cargill

Mill Street Church of Christ v. Hogan (14)


Bill Hogan had implied authority to hire Sam Hogan as his helper
o In the past, the church had allowed Bill to hire his brother
or other persons whenever he needed assistance
o Bill needed an assistant to complete his painting work, it
would be impossible to paint the entire church with just
one person
o Sam believed that Bill had the authority to hire him as he
had done in the past

370 v. Ampex (16)


Issue: whether Kays, acting on behalf of Ampex, had the
authority to enter into a contract with Joyce. Is Kays an agent?
Kays had apparent authority to act for Ampex when he entered
into a contract with Joyce
It is reasonable for third parties to presume that one employer as
a salesman has the authority to bind his employer to sell. And
Ampex did nothing to dispel this reasonable inference.
The other side (Ampex) would argue that they never signed
anything when the purchase order agreement was sent to Joyce
and never signed it when it was returned therefore they never
consented to this agreement
Ampex is the lowest cost avoider all they had to do was put a
small clause into all of their purchase order agreements stating
that only certain officers of Ampex are authorized to enter into
sales contracts

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Principal risk is that EDS fails to pay on the lease

Botticello v. Stefanovicz (24)


Three elements required to show the existence of an agency
relationship include:
o (1) A manifestation by the principal that the agent will act
for him;
o (2) Acceptance by the agent of the undertaking; and
o (3) An understanding between the parties that the principal
will be in control of the undertaking
Ratification
o Defined as the affirmance by a person of a prior act which
did not bind him but which was done or professedly done
on his account
o Requires acceptance of the results of the act with an
intent to ratify, and with full knowledge of all the material
circumstances
No judgment against Mary in order to ratify, there has
to be some knowledge of the agreement

Agency Relationship
Agency is the relationship which results from the
manifestation of consent by one person to another that the other
shall act on his behalf and subject to his control, and consent by
the other to so act
P and D agree that, in determining whether a contract
establishes an agency relationship, the critical test is the nature
and extent of the control agreed upon. Holiday Inn.

Actual Authority
Express Authority
o Where you expressly tell someone that they have the
authority to act on your behalf
o In order for the agent to lose his authority, the principals
revocation of authority must be communicated to the
agent
Implied Authority
o Actual authority circumstantially proven authority that
the principal actually intended the agent possess and
includes such powers as are practically necessary to carry
out the duties actually delegated
o Implied Authority history, job descriptions, circumstances,
or customs

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Apparent Authority
Refers to a situation where a reasonable person would
understand that an agent had authority to act. This means a
principal is bound by the agent's actions, even if the agent had
no actual authority, whether express or implied
o The third person reasonably interpreted manifestation of
consent from the principal that the agent had authority to
act on the principal's behalf
If a person who is not an agent appears to an outsider (a
customer) to have been given authority by the principal, then
the principal is stuck for the acts of anyone he allows to appear
to have authority.
There has to be some action by the principal
Hoddeson v. Koos Bros. (28)
o Open the doors to the public is the action
Amazing thing about apparent authorityit is effective to bind
the principal even when actual authority is lacking
Apparent authority such as where the principal by words,
conduct, or other indicative manifestations has held out the
person to be his agent

Master-servant relationship
1. The servant has agreed to work on behalf of the master, and
2. Has agreed to be subjected to the masters control or right to
control the physical conduct of the servant (that is, the manner
in which the job is performed)
3. A master is subject to liability for the torts of his servants
committed while acting in the scope of their employment

Independent Contractor v. Employee


There is no master-servant relationship when someone is
classified as an independent contractor

Humble Oil & Refining Co. v. Martin (36)


Facts:
o Mrs. Love left her car at the filing station that was operated
by Schneider but owned by Humble. Before any station
employee had touched the car, it rolled off the premises
and traveled across the street where it struck Martin and
his two children.
Humble contends that its station was in effect operated by an
independent contractor
Evidence in favor of master-servant relationship:

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o A provision requires Schneider (employee) to make
reports and perform other duties in connection with the
operation of said station that may be required of him from
time to time by Company.
o Humble pays 75% of the most important operational
expense items
o Humble had a strict system of control and supervision to
make sure its product was delivered to consumers
o Humble furnished all important station location and
equipment, the advertising media, the products and a
substantial part of the current operating costs.
o Hours of operation were controlled by Humble
o Schneiders only title to occupancy of the premise was
terminable at the will of Humble
o The agreement in effect required Schneider to do anything
Humble might tell him to do
Evidence against master-servant relationship
o Neither Humble, Schneider, nor the station employees
considered Humble as an employer or master
o Employees were paid and directed by Schneider
individually as their boss
o A provision of the agreement expressly repudiates any
authority of Humble over the employees
When Humble sells products through Schneider Apparent
authority
Essentially little difference between Schneiders situation and
that of a mere store clerk who happened to be paid a
commission instead of a salary
The court ruled that there was principal-agency relationship and
therefore Humble was liable
Schneider is completely reliant on Humble
o If Humble were to go out of business, Schneider would not
be able to survive

Hoover v. Sun Oil Company (38)


Facts:
o Plaintiff was filling his car at a service station operated by
James Barone. Due to the negligence of John Smilyk who
was an employee of Barones, the plaintiffs car caught on
fire while being filled with gasoline. Plaintiff brought suit
against Barone, Smilyk, and Sun Oil Company that owned
the service station.
Evidence of Suns control
o The station and all of its equipment were owned by Sun

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o Barone was prohibited from selling Sun products unless
they were under the Sunoco label and could not blend in
with products not supplied by Sun
o Advertisements all over for Sun
o Employees wore the Sun logo (however, uniforms were
owned by Barone)
o Barone (upon the urging of a Sun sales rep) attended a
Sun school for service station operations
o Weekly visits of Sun sales representative who inspected
the station, took orders, communicated complaints, and
offered suggestions for improvements
o Sale rep was in contact with Barone to help implement a
competitive allowance system
Evidence against Suns control
o Lease was subject to termination by either party
o Barone was allowed to sell competitive products
o Barone had no obligation to follow the advice of the sales
rep
o Barone made no written reports to Sun
o Barone alone assumed the overall risk of loss or profit
o Barone independently determined his own hours of
operation and the pay scale of employees
Barone was an independent contractor and therefore no master-
servant relationship existed

Franchise Agreement
Independent businesspeople use the brand name of a franchisor
Franchisor provides the franchisee with know-how and brand
identification on a continuing basis
Franchisee enjoys the right to profit and runs the risk of loss
Franchisor controls the distribution of goods/services through a
contract
Franchisor regulates the activities of the franchisee in order to
achieve standardization
What is the legal relationship between franchisor and franchisee?
o Depends, it can sometimes be an agency relationship and
sometimes it is not

Franchisor-Franchisee Relationship
Murphy v Holiday Inns, Inc. (41)
o The fact that an agreement is a franchise contract does not
insulate the contracting parties from an agency
relationship

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o Here, the purpose of the contract provisions was to achieve
system-wide standardization of business identity,
uniformity of commercial service, and optimum public good
will, all for the benefit of both contracting parties
The regulatory provisions did not give D control over
the day-to-day operations
o TAKEAWAY: If a franchise contract so regulates the
activities of the franchisee as to vest the franchisor with
control within the definition of agency, the agency
relationship arise even though the parties expressly deny it

SCOPE OF EMPLOYMENT

Conduct of a servant is within the scope of employment if:


1. Motive to serve the master
a. Court in Bushey says this is indeterminate
b. Manning case follows Massachusetts law
2. Deep Pocket theory
a. From a social policy perspective, this is clearly unfair
b. Judge Friendly does not want to turn this into a strict
liability measure, where employers will be held strictly
liable for the torts of its employees
i. the fact that the D is better able to afford damages
is not alone sufficient to justify legal responsibility
3. Foreseeability test
a. Was the type of harm sustained foreseeable?

Foreseeability Test
Ira S. Bushey & Sons v. United States (52)
Govt says Lanes (seaman) acts were not within the scope of
his employment
Restatement: conduct of a servant is within the scope of his
employment if, but only if it is actuated, at least in part, by a
purpose to serve the master
Judge Friendly uses a foreseeability test to determine whether
the seaman was acting within the scope of employment
o Lanes conduct was not so unforeseeable as to make
it unfair to charge the government with responsibility
o Not the same as negligence foreseeability
o However, the activities of the enterprise do not reach
into areas where the servant does not create risks
different from those attendant on the activities of the
community in general

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i.e. if Lane had set a bar on fire, this would not be
foreseeable in the courts eyes
Here, it was foreseeable that crew members crossing the dry
dock might do damage, negligently or even intentionally
o It is immaterial that Lanes action was not to be
foreseen

Motive to Serve Master Test


Manning v. Grimsley (57)
Plaintiff was attempting to sue the Baltimore Orioles because a
pitcher had intentionally thrown a ball at him while he was in the
stands
In order to prove that an employee was in the scope of his
employment when committing an intentional tort, the plaintiff
must:
o Show that the employees assault was in response to the
plaintiffs conduct which was presently interfering with the
employees ability to perform his duties successfully
o The interference may be in the form of an affirmative
attempt to prevent an employee from carrying out his
assignments

Arguello v Conoco (59)


Agency Relationship?
o To establish an agency relationship, the Ps must
show that Conoco has given consent for the branded
stores to act on its behalf and that the branded
stores are subject to the control of Conoco
o Appellants argument:
Control because the PMA (Agreement) requires the
branded stores to maintain their businesses
according to the standards set forth in the PMA
Conoco controls customer service
Conoco is allowed to conduct by-yearly inspections of
the branded stores
o Courts Holding:
PMA does not establish that Conoco has any
participation in the daily operations of the branded
stores not that Conoco participates in making
personnel decisions
No agency relationship
Essentially, there must be more control over the branded stores
for their to be an agency relationship, and the language of the
Agreement is given great deference

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Some of the factors used when considering whether an
employees acts are within the scope of employment are:
o 1) Time, place, purpose
o 2) Its similarity to acts which the servant is authorized to
perform
o 3) Whether the act is commonly performed by servants
The fact that an employee engages in an intentional
tortious conduct does not require a finding that the
employee was outside the scope of his employment
o 4) The extent of departure from normal methods
o 5) Whether the master would reasonably expect such act
would be performed
Court rejects the presumption that because Smith behaved in an
unacceptable manner that she was obviously outside the scope
of her employment
o Smiths position as a clerk, and her authorization from
Conoco to conduct sales allowed her to interact with
Arguello and Govea, and put Smith in the position to
commit the racially discriminatory acts

PARTNERSHIPS

WHAT IS A PARTNERSHIP? WHO ARE PARTNERS?

Definition: An association of two or more persons to carry on as co-


owners a business for profit
People and entities often times form partnerships without even
realizing or intending to form a partnership
Law will imply unintended partnerships in certain situations
Private Ordering
o Contract partners get to make up their own rules and
guidelines
o Freedom of contract
o Some Issues with this:
May end up with unequal bargaining power one
party imposing its will on the weaker party
Default Rules
o If you did not intend to create a partnership, you will end
up with what the State/Court gives you
o Imposition of what the State thinks is right
RUPA

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o Revised Uniform Partnership Acts
o Groups of experts in a large variety of fields that try to
come up with uniform rules/acts
o This is useless unless State legislatures pass the acts

No settled test for determining the existence of a partnership;


determination is made by reviewing all the attendant
circumstances, including the right to manage and control the
business

Some Legal Consequences of a Partnership:


1. Partners have a fiduciary obligation of the utmost good faith to
each other
2. Partners do not have an automatic right to veto any partnership
transaction
3. Partners have a right to inspect the books of the partnership
4. Partners do not have limited liability for the debts of the
partnership
5. Partners have a right to participate in the partnership business

**Of course, many of the default rules laid out in the UPA can
be altered by an agreement or certain contract provisions

Relevant Factors Courts Look to in Deciding if a Partnership


Exists:
1. Control do parties have a right to control or manage the
business
2. Sharing of Profits receipt of profits is prima facie evidence that
one is a partner in the business (one of the most important
factors)
3. Sharing of Losses very relevant, as parties rarely agree to share
losses in a relationship other than a partnership
4. Intent of Parties looks at how the parties characterized their
relationship both in words and actions
5. Contribution of Capital not required; also must distinguish from
a loan; general rule is that there is no interest paid on capital
contributions, they are a credit to each partners capital account
and not returned until the partnership is dissolved
6. Language of the Agreement what types of provisions are in the
agreement
7. Conduct of parties towards third parties did they hold
themselves out to be a partnership?

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Irrelevant Factors
1. Duration - does not really matter how long the partnership lasts
2. Participation in other businesses while partners have a fiduciary
obligation to not compete with the partnership, absent an
agreement among the parties, partners are allowed to
participate in other businesses

Fenwick v. Unemployment Compensation Commission (79)


Factors that determine if a partnership is created
Here, the agreement between these parties, in legal effect, was
nothing more than one to provide a method of compensating the
girl for the work she had been performing as an employee

Martin v. Peyton (85)


Court held no partnership agreement
o Limit to PPFs profits
o Court found many of the controls that PPF put into place
were proper precautions to safeguard the loan
This seems odd, however, because:
o Joint Control
o Sharing of Profits
o Sharing of Losses

Southex Exhibitions v. RIBA (89)


Sharing of profit
Joint administration
However, we must look at many more different factors:
o 1st, language of the agreement is entitled Agreement
rather than Partnership Agreement
o 2nd, indemnification clause shows that the two parties do
not share in profits
o 3rd, the agreement was for a fixed term
The UPA statute states, The receipt by a person of a share of the
profits of a business is prima facie evidence that he or she is a
partner in the business, but no such inference is drawn if
profits were received in payment:
o (1) As a debt by installments or otherwise;
o (2)
o (3)
o (4)
o (5)
PAGE 89

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FIDUCIARY OBLIGATIONS OF PARTNERS

Fiduciary Duties Owed to Other Partners:


o Duty of the finest loyalty
o Duty of utmost good faith
o One must notify the other of future business opportunities and
allow the other the opportunity to participate in it
o One partner cannot have asymmetrical information and use it to
his advantage
o Meinhard v. Salmon

Decision Making (Partnerships)


Default all partners have equal say
Default Duration is at-will unless otherwise specified
Default must liquidate all assets
o In most cases, partnership agreements should have
clauses outlining how assets will be handled upon
dissolution (i.e. some assets will be distributed amongst
partners, and other assets will be sold)

UPA 404 General Standards of Partners Conduct (pg. 103)


The only fiduciary duties a partner owes to the
partnership and the other partners are the duty of loyalty
and the duty of care set forth in subsection (b) and (c)

Meinhard v. Salmon (97)


Joint Venture created
Outlines what types of fiduciary duties partners owe each other
(see above)
The pre-emptive opportunity (to purchase a new lease on the
same property) was an incident of the enterprise that Salmon (D)
appropriated to himself in secrecy and silence this is a no-no
The trouble about Salmons conduct is that he excluded
his co-adventurer form any chance to compete, from any
chance to enjoy the opportunity for benefit that had come
to him alone by virtue of his agency
Future Business Opportunities:
o Salmon had a duty to disclose
It would be a completely difference question if there were lacking
any nexus of relation between the business conducted by the

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manager and the opportunity brought to him as an incident of
management
o i.e. If Salmon had received form Gerry a proposition to
lease a building at a location far removed, he might have
held for himself the privilege thus acquired
Here, the subject-matter of the new lease was an
extension and enlargement of the subject-matter of the
old one

Sandvick v. LaCrosse (103)


Crucial elements of a partnership are
o (1) An intention to be partners
o (2) Co-ownership of the business, and
o (3) A profit motive
The purchase of the Horn leases was a separate act undertaken
by the parties, not a series of acts
The parties undertaking was very limited and did not coincide
with the definition of a business No partnership was formed
Joint Venture
o Similar to a partnership but is more limited in scope and
duration
o J.V. is for a specific reason, specific amount of time, and
terminates upon completion
o Principles of partnership law apply to the joint venture
relationship
o Four elements must be present:
(1) Contribution by the parties of money, property,
time, or skill in some common undertaking, but the
contributions need not be equal or of the same
nature;
(2) A proprietary interest and right of mutual control
over the engaged property
(3) An express or implied agreement for the sharing
of profits, and usually, but not necessarily, of losses;
and
(4) An express or implied contract showing a joint
venture was formed

Meehan v. Shaughnessy (109)


Courts Holding:
o Meehan and Boyle, through their preparation for obtaining
clients consent, their secrecy concerning which clients
they intended to take, and the substance and method of
their communications with clients, obtained an unfair

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advantage over their former partners in breach of their
fiduciary duties.

Lawlis v. Kightlinger & Gray (116)


When a partner is involuntarily expelled from a business, his
expulsion must have been bona fide or in good faith for a
dissolution to occur without violation of the partnership
agreement
o If the power to involuntarily expel partners granted by a
partnership agreement is exercised in bad faith or for a
predatory purpose, as Lawlis phrases it, the partnership
agreement is violated, giving rise to an action for damages
the affected partner has suffered as a result of his
expulsion
Third, Lawlis argues the firms act of expelling him was
constructively fraudulent because it constituted a breach of the
fiduciary duty owed between partners which requires each to
exercise good faith and fair dealing in partnership transactions
and toward co-partners
o Court rejects this argument
o At the time the partners negotiated their contract, it is
apparent they believed that the guillotine method of
involuntary severance would be in the best interests of the
partnership
o Their intent was to provide a simple, practical, and above
all, a speedy method of separating a partner from the firm,
if that ever became necessary for any reason
Court finds no fault with that approach to severance
o Also, parties were both experienced lawyers who knew
what they were doing when negotiating the original
agreement

RIGHTS OF PARTNERS IN MANAGEMENT

The Rights of Partners in Management


UPA provides that in the absence of an agreement to the
contrary, all partners have equal rights in the management and
conduct of the partnership business, and
Any difference arising as to ordinary matters connected with the
partnership business may be decided by a majority of the
partners"
If there are only two partners, there can be no majority vote that
will be effective to deprive either partner of authority to act for
the partnership

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National Biscuit Company v. Stroud (127)
If one partner goes to a third person to buy an article on time for
the partnership, the other partner cannot prevent it by writing to
the third person not to sell to him on time
o What either partner does with a third person is binding on
the partnership
Stroud, Freemans co-partner, could not restrict the power and
authority of Freeman to buy bread for the partnership as a going
concern, for such a purchase was an ordinary matter connected
with the partnership business

Summer v. Dooley (129)


In the case at bar one of the partners continually voiced
objection to the hiring of the third man
It is manifestly unjust to permit recovery of an expense which
was incurred individually and not for the benefit of the
partnership but rather for the benefit of one partner

Difference between Stroud and Summer


In Stroud, the status quo was to order bread, and it was
something the company did on a continual basis
o Therefore, the court held that the decision of a partner to
order bread was binding on the partnership
In Summer, the status quo was not to hire any other employees,
the work was normally done by the two partners, and if one was
out, a replacement would only work on a temporary basis
o Therefore, the court held that the decision of a partner to
hire a third employee and pay him was not binding on the
other partner
In Stroud case, the partner who entered into the bread
agreement went behind the other partners back.
In Summers case, the partner who hired the third employee did
so even though the other partner continually objected to the idea
o In Stroud case, the decision to order more bread was for
the benefit of the entire partnership
o In Summers case, the decision to hire a third employee
was for the sole benefit of Summers
In Stroud case, the decision was a normal business
decision and not out of the ordinary

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In Summers case, the decision was contrary to the
status quo

Fiduciary Duties
If you are a minority shareholder in a partnership, corporation,
etc. Usually the majority shareholders have fiduciary duties not
to screw over the minority shareholders

Day v. Sidley & Austin (131)


The essence of a breach of fiduciary duty between partners is
that one partner has advantaged himself at the expense of the
firmthe basic fiduciary duties are:
o 1) A partner must account for any profit acquired in a
manner injurious to the interests of the partnership, such
as commissions or purchases on the sale of partnership
property;
o 2) A partner cannot without the consent of the other
partners, acquire for himself a partnership asset, nor may
he divert to his own use a partnership opportunity; and
o 3) He must not compete with the partnership within the
scope of the business
Here, failure to reveal information regarding changes in the
internal structure of the firm is not breach of fiduciary duties
o There was no financial gain for defendants
o Remaining partners did not acquire any more power within
the firm as a result of the alleged withholding of
information from plaintiff

PARTNERSHIP DISSOLUTION

Owen v. Cohen (137)


A partner may move for a dissolution of the business when
another partners conduct negatively affects the business or
another partner willfully or repeatedly breaches the partnership
agreement
UPA
o (1) On application by or for a partner the court shall decree
a dissolution whenever:
(c) A partner has been guilty of such conduct as
tends to affect prejudicially the carrying on the
business,
(d) A partner willfully or persistently commits a
breach of the partnership agreement

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Dissolution:
Partnership DEFAULT rule is that it lasts for duration at-will unless
otherwise specified
You also dont want a discontinuance at-will
DEFAULT is to liquidate assets to pay people out, BUT liquidating
everything is NOT the best option
Probably want to negotiate and contract out ways to dissolve the
business where liquidation is the LAST option instead of the first

CORPORATIONS
Corporation
Perpetual life
Has individual constitutional rights
o Freedom of speech in connection with ability to make
campaign contributions
o Freedom of religion (Hobby Lobby Supreme Court case)
Ability to make contracts
Ability to be sued
Ability to own property
A creature of the state
o Usually have to file papers with the secretary of the state
and pay certain fees
Anybody can create a corporation
o You can be one shareholder
o You do not have to have any assets to create a corporation
Officers of the Corporation are typically a President, Treasurer,
and Secretary
Limited Liability
Two Main Documents:
o (1) Certificate of Incorporation
o (2) By-laws (governing documents)
Instructions on how the corporation will operate
Tells us about:
Annual meetings (both special and for
shareholders)
Voting
Books & Records
o Inspection procedures
How by-laws will be amended
o Super majority?
o Majority?

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Dissolution of the corporation
Where corporate offices will be located
What big decisions the Board of Directors
(chairman and board members) will make:
o Merge with another company
o Issue dividends
o Settle large lawsuits
o File bankruptcy
o Go into a different product line
o Build new factory/facility
How many people will be on the Board of
Directors
How Board members will be elected
o Shareholders usually vote for board
members
o Board appoints officers and senior
managers
Indemnification and Insurance of Corporate
Agents
o Board is indemnified by lawsuits from
shareholders
Basic capital structure
o What kind of stock there will be
Common stock voting rights
i.e. 1 share = 1 vote
i.e. only shareholders who
meet a certain threshold will
be able to vote
Collective Action Problem
Its hard for small
shareholders to get together
to do things and vote on
specific things
How to fix this problem 1
vote per shareholder (does
not matter if you own 1 share
or 1000 shares, you only get
1 vote)
o This empowers small
shareholders
Preferred stock generally no
voting rights
Preference in cases of
bankruptcy

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Paid dividends before
common stockholders
o How shares are distributed
Board of Directors itself will be required only to authorize the
most significant corporate acts or transactions: mergers,
changes in capital structure, fundamental changes in business,
appointment and compensation of the CEO, etc.
Section 952 of Dodd-Frank mandates that the compensation
committees of the board of directors of public companies must
be fully independent and that those committees be given
responsibility for setting CEO pay

THE CORPORATE ENTITY AND LIMITED LIABILITY

Piercing the Corporate Veil


Courts will Pierce the Corporate Veil whenever necessary to
prevent fraud or to achieve equity
o In other words, whenever anyone uses control of the
corporation to further his own rather than the corporations
business, he will be liable for the corporations acts
If a stockholder is conducting the business in his individual
capacity, he will be personally liable
o Is he treating the corporation solely as his? Or is he
treating the corporation as a separate entity?
o Is the corporation simply an alter ego of the individual?
o Are assets intermingled?
o Is the corporation undercapitalized?
o Are there adequate books and records?

Walkovszky v. Carlton (176)


o Two Main Takeaways
1. Undercapitalization of one corp. is not itself
enough to pierce the corporate veil
2. The reason we have limited liability protection
for corporations is because we dont want
shareholders to be liable for undercapitalized
corporations

Moral Hazard

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Corporations (or the people who run them/own them) know they
will not be personally liable, so they have more incentive to act
risky
Limited Liability can create incentive to take risky actions

Sea-Land Services v. Pepper Source (181)


Van Dorn Test for Corporate Veil-Piercing
o A corporate entity will be disregarded and the veil of
limited liability pierced when two requirements are met:
First, there must be such unity of interest and
ownership that the separate personalities of the
corporation and the individual [or other corporation]
no longer exist;
Second, circumstances must be such that adherence
to the fiction of separate corporate existence would
sanction a fraud or promote injustice
What constitutes promote injustice in the second-step of the
Van Dorn test?
o Some element of unfairness, something akin to fraud or
deception or the existence of a compelling public interest
must be present in order to disregard the corporate fiction
o Courts that properly have pierced corporate veils to avoid
promoting injustice have found that, unless it did so,
some wrong beyond a creditors inability to collect would
result
o In most cases the court will look for something that fringes
upon fraud
Whether a corporation is so controlled by another to justify
disregarding their separate identities, the Illinois casesfocus on
four factors:
o (1) The failure to maintain adequate corporate records or
to comply with corporate formalities,
o (2) The commingling of funds or assets,
o (3) Undercapitalization, and
o (4) One corporation treating the assets of another
corporation as its own
Here, factors for finding a piercing of the corporate veil:
o None of the corporations ever held a single corporate
meeting
o Marchese (D) did not remember any of these corporations
ever passing articles of incorporation, by-laws, or other
agreements
o Marchese (D) runs all corporations out of a single office,
with the same phone line, and the same expense accounts

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o Marchese (D) borrows substantial sums of money from
these corporationsinterest free, of course
o These corporations also borrow money from each other
when need be
o Marchese (D) uses the bank accounts of these corporations
to pay all kinds of personal expenses

In re Silicone Gel Breast Implants Products Liability Litigation (238)


Court looks at the totality of circumstances to determine
whether a subsidiary may be found to be the alter ego or mere
instrumentality of the parent corporation
o Page 195 gives long list of factors
Bristol contends that a finding of fraud or like misconduct is
necessary to pierce the corporate veil
o Delaware Courts do not necessarily require a showing of
fraud if a subsidiary is found to be the mere instrumentality
or alter ego of its sole shareholder
o Even in jurisdictions that require a finding of fraud,
inequity, or injustice, there is enough evidence to preclude
Bristol from obtaining summary judgment
Bristol permitted its name to appear on
advertisements, packages, and products to improve
sales by giving the product additional credibility +
potentially insufficient assets it would be
inequitable and unjust to allow Bristol now to avoid
liability to those induced to believe Bristol was
vouching for this product
Court does not pierce the corporate veil
o It just denies summary judgment
o Because the evidence available at a trial could support if
not perhaps mandate a finding that the corporate veil
should be pierced, Bristol is not entitled through summary
judgment to dismissal of the claims against it

How do I make sure I set up a corporation that is separate from


myself?
Set up a separate bank account for the corporation
o Do not keep putting your own money into the corporation
(this could be seen as a comingling of assets/funds)
o If you do put money into the corporation, document it as a
loan or as purchasing stock
You cannot just take money out of the corporation bank account
when profits are high

20
o You must give the withdrawal some sort of title or
documentation
Dividend payments
Repayment of loans
Get all the necessary corporate documents in order
Passy by-laws and regulations that the corporation must adhere
too
Keep adequate and separate books & records for the corporation

THE ROLE AND PURPOSES OF CORPORATIONS

Primary Purpose of Corporations


Maximize profits
Take actions and make decisions that are in the best interest of
the shareholders

ALI Principles of Corporate Governance: Analysis and


Recommendations
(a) Subject to the provisions of Subsection (b), a corporation should
have as its objective the conduct of business activities with a
view to enhancing corporate profit and shareholder gain
(b)Even if corporate profit and shareholder gain are not thereby
enhanced, the corporation, in the conduct of its business:
a. (1) Is obliged, to the same extent as a natural person, to
act within the boundaries set by law;
b. (2) May take into account ethical considerations that are
reasonably regarded as appropriate to the responsible
conduct of business; and
c. (3) May devote a reasonable amount of resource to public
welfare, humanitarian, educational, and philanthropic
purposes

Board of Directors
Usually given a lot of discretion on what actions to take and what
decisions they can make
If shareholders really dont like what is going on, they can sell
their shares

A.P. Smith v. Barlow (251)


FACTS:

21
o Corporation wanted to donate money to Princeton
University. Shareholders sued board of directors claiming
they could not make the donation because: (1) the
certificate of incorporation does not expressly authorize
the contribution and under common-law principles the
company does not possess any implied or incidental power
to make it, and (2) the NJ statutes which expressly
authorize the contribution may not constitutionally be
applied to the plaintiff, a corporation created long before
their enactment.
Ultra Vires outside the power (corp. was not authorized to
perform something)
Court holds that the donation is valid
o Corporation has an interest in the community
o Corporation has an interest in donating to liberal arts
institutions of higher learning
o Statute allows for the donation
o Donation was modest compared to overall earnings
o Voluntarily made in the reasonable belief that it would aid
the public welfare and advance the interests of the plaintiff
as a private corporation and as party of the community in
which it operates
o This is in the best interest of the corporation itself
Creates goodwill
This case was decided at the heart of the cold war
Private institutions need to be built up
Must maintain the capitalist nature of the
United States
Private lending to private institutions should be
encouraged

Dodge v. Ford (257)


A business corporation is organized and carried on primarily for
the profit of the stockholders
o The powers of the directors are to be employed for that
end.
o The discretion of directors is to be exercised in the choice
of means to attain that end, and does not extend to a
change in the end itself, to the reduction of profits, or to
the non-distribution of profits among stockholders in order
to devote them to other purposes...
It is not within the lawful powers of a board of directors to shape
and conduct the affairs of a corporation for the merely incidental

22
benefit of shareholders and for the primary purpose of benefiting
others
o Ford was not concerned with benefiting his fellow
shareholders
o He wanted to benefit the community
Expand operations create more jobs
Lower price of automobiles more affordable to the
average working man

Shlensky v. Wrigley (262)


It is clear that the Dodge court felt that there must be fraud or a
breach of that good faith which directors are bound to exercise
toward the stockholders in order to justify the courts entering
into the internal affairs of corporations
Directors are elected for their business capabilities and judgment
and the courts cannot require them to forego their judgment
because of the decisions of directors of other companies
o Here, just b/c other teams had chosen to install lights does
not mean the Cubs have to
Plaintiff is alleging the following:
o Directors are acting for a reason or reasons contrary and
wholly unrelated to the business interests of the
corporation
The President was acting in his own interests and in
the interest of the public, not in the interests of the
shareholders
o Such arbitrary and capricious acts constitute
mismanagement and waste of corporate assets
By refusing to install lights and schedule night games
at Wrigley Field
o The directors have been negligent in failing to exercise
reasonable care and prudence in the management of the
corporate affairs
Court Holding:
o We are going to accept the decisions made by the Board,
unless there is found to be:
Fraud
Bad faith
Illegality
Conflict of interest
o The decision by the Board must be arrived at with
knowledge
o Start of the Business Judgment Rule

23
DUTIES OF OFFICERS, DIRECTORS, AND OTHER
INSIDERS
THE OBLIGATIONS OF CONTROL: DUTY OF CARE

Fiduciary Duties in Modern Public Corporations


In public corporations, management has three principal
functions:
1. Directors and senior executives make enterprise
decisions concerning operational and business matters
such as where to locate a new facility or where to
discontinue a product line
2. Directors act on ownership issuessuch as initiating a
merger with another company or constructing takeover
defenses
3. Directors are responsible for oversight of the corporation
such as reviewing senior executives performance and
ensuring corporate compliance with legal norms

Kamin v. American Express Company (308)


A Complaint which alleges merely that some course of action
other than that pursued by the Board of Directors would have
been more advantageous gives rise to no cognizable cause of
action
o The directors room is the appropriate forum for thrashing
out purely business questions which have an impact on
profit, market prices, competitive situations, or tax
advantages
Essentially this is just a disagreement between two minority
shareholders and a unanimous Board of Directors as to the best
way to handle a loss already incurred on an investment
American Expresss argument for why they decided to distribute
the DLJ shares to stockholders
o Realizing a capital loss of $25 million would have a great
effect on the net income figures in their financial
statements
o Such a reduction in net income figures would have a
serious effect on the market value of the publicly traded
AMEX stock
Therefore, it is in the shareholders best interest to
keep the stock price as high as possible

24
The court will not overrule a business decision of the directors of
a company unless there is evidence of fraud or some other
dishonest dealing
o The only accusation of dishonest dealing was a general
assertion that four of the twenty directors had a financial
interest in the outcome. This was clearly not enough
Mere errors of judgment are not sufficient for there to be
a breach of a fiduciary duty
o As long as the BOD is making its decision in good
faith and it is not negligent, the decision will be
protected by the Business Judgment Rule

Smith v. Van Gorkom (312)


Case involving the Leveraged Buyout of Trans Union
Breach of duty of care
o The BOD made its decision to sell to Pritzker after
deliberating for only two hours
Van Gorkom gave a 20 minute presentation
Board members never had documentation in front of
them
o Did not review any documents in coming to its decision to
sell at $55 a share
o BOD had no idea what the intrinsic value of the company
was
A BOD when making decisions should be reasonably informed
If a BOD engaged in gross negligence, it will constitute a breach
of a duty of care
Business Judgment Rule: 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.
o 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
Defense argued that they put the company on the open market
and this showed the price was fair and that they relied on
(statute) good faith reports made by Van Gorkom
o Also argued that $55 was a very fair price considering the
stock was trading at $38

25
State Legislation that limits Liability of the BOD
A corporation can include in its certificate of incorporation: a
provision that eliminates or limits the personal liability of a
director to the corporation or its shareholders for monetary
damages for breach of fiduciary duty as a director, provided that
such provisions shall not eliminate or limit the liability:
o For acts or omission which were not in good faith or which
involve intentional misconduct or a knowing violation of
law
o For any transaction from which the director derived an
improper personal benefit
o For any breach of the directors duty of loyalty
You cannot eliminate a breach of the duty of loyalty
Only the duty of care can you get rid of

BUSINESS JUDGMENT RULE


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.
o Those presumptions can be rebutted if the plaintiff shows
that the directors breached their fiduciary duty of care or of
loyalty or acted in bad faith
o If that is shown, the burden shifts to the director
defendant(s) to demonstrate that the challenged act or
transaction was entirely fair to the corporation and it
shareholders
o In order to get to the Business Judgment Rule, there must
be good faith. So if there is not good faith, you dont even
get to the Business Judgment Rule, you instead use the
Inherent Fairness Rule
Unless this presumption is overcome, courts abstain from
second-guessing well-meaning business decisions even when
they are flops this is a risk that shareholders take when they
make a corporate investment
This rule insulates Board decisions from judicial review
Business Judgment Rule presumes directors do not breach their
duty of care

Elements of the Business Judgment Rule


1. There must be a business decision;
a. Does not protect decisions that involve illegal actions

26
2. The decision must be made by the directors in the good faith
belief that it is in the best interest of the corporation and its
shareholders;
a. What is bad faith?
i. Directors actions primarily motivated by the desire to
remain entrenched in their positions of control
ii. BODs decision to mislead its shareholders by
intentionally withholding material information from
them
iii. Gross disparity between the price paid for assets and
their fair market value
3. The decision must be made with due care
a. Failure to satisfy due care is gross negligence
4. Must be made on an informed basis
a. Corporate directors must have informed themselves of all
reasonably available, material information about a
proposed business decision before making that decision
b. Dont need to personally investigate every possible source
of information concerns the decision
c. Corporate directors may rely on the corporation's records,
including financial statements, and on the reports, opinions
and statements of the corporation's executives and other
employees, as long as the directors' reliance on those
sources is itself reasonable
d. ALWAYS HIRE OUTSIDE EXPERTS TO CONDUCT AN
INVESTIGATION/RESEARCH AND GET AN OPINION FROM
THEM

Justification of the Business Judgment Rule


Encourages risk-taking shareholders expect the board to take
business risks
Avoids judicial meddling judges are not business experts
Encourages directors to serve business people detest liability
exposure

DUTY OF CARE
Addresses the attentiveness and prudence of managers in
performing their decision-making and oversight functions
Judicial review of the BODs decision-making and oversight is
governed by the duty of care, which in turn is confined by the
Business Judgment Rule
A party challenging a business decision must show that directors
failed to act:
o (1) In good faith,

27
o (2) In the honesty belief that the action taken was in the
best interest of the company, or
o (3) On an informed basis
Facets of the Duty of Care: good faith, reasonable belief,
reasonable care
Directors must rely on information from others, but to claim
reliance, directors must have become familiar with the
information or advice, and must reasonably have believed that it
merited confidence
Directors, however, cannot hide their heads in the sand and
claim reliance if they have knowledge or suspicions that make
reliance unwarranted

Overcoming Business Judgment Presumption


When a board decision is challenged, courts place the burden on
the challenger to overcome the business judgment presumption
by proving either
o (1) Fraud, bad faith, illegality or a conflict of interest (lack
of good faith);
o (2) The lack of a rational business purpose (waste);
Even board decisions that in hindsight seem patently
unwise or imprudent are protected from review
Only where the board approves a transaction in
which the corporation receives no benefit have
courts found corporate waste
o (3) Failure to become informed in decision-making (gross
negligence); or
o (4) Failure to oversee the corporations activities
(inattention)

DUTY OF LOYALTY

DUTY OF LOYALTY
Addresses fiduciaries conflicts of interest and requires fiduciaries
to put the corporations interests ahead of their ownthat is,
fiduciaries cannot serve two masters
Corporate fiduciaries breach their duty of loyalty when they
divert corporate assets, business opportunities, or proprietary
information for personal gain
EXAMPLES:
o Self-Dealing

28
o Usurping Corporate Opportunity when a fiduciary seizes
for herself a desirable business opportunity that the
corporation may have taken and profited from

Self-Dealing
Direct Interest
o It its classic form, self-dealing occurs when the corporation
and the director herself are parties to the same transaction
Sales and purchases of property
Loans to and from the corporation
The furnishing of services by a non-management
director (such as when the corporations outside
attorney sits on the board)
Indirect Interest
o Self-dealing also occurs when the corporate transaction is
with another person or entity in which the director has a
strong personal or financial interest
Corporate transactions with the directors close
relatives
Corporate transactions with an entity in which the
director has a significant interest (another eneity in
which the director is a director, partner, agent, or
employee)
Corporate transactions between companies with
interlocking directors
Inherent Fairness Test
o Objective Test: the self-dealing transaction must replicate
an arms length market transaction by falling into a range
of reasonableness.
o Value to corporation: the transaction must be of particular
value to the corporation, as judged by the corporations
needs and the scope of its business
Procedural Fairness
o Courts also inquire into the process of board approval,
showing various levels of deference if the transaction is
approved by informed, disinterested, and independent
directors
o In reviewing the process by which directors vote, courts
have focused on three procedural elements:
(1) Disclosure to the board,
some courts have said that full disclosure is a
factor bearing on the transactions fairness

29
some courts have require that there be
disclosure only of the conflict of interest to put
the board on guard
some courts have required full disclosure of all
material info including the profit the interested
director stood to make in the transaction
(2) Composition of the board (or committee)
that approved the transaction, AND
The directors who approve the transaction
must be both disinterested and
independent
o He is disinterested if he has no direct
or indirect financial interest in the
transaction
o He is independent if he is neither
beholden to nor dominated by the
interest director
(3) The role of the interested director in the
transactions initiation, negotiation, and
approval
An interested directors negotiation or
participation may evidence that the interested
director dominated the other directors,
undermining the advantage of disinterested
approval

Bayer v. Beran (334)


Duty of loyalty issue
BOD chose to invest $1 million into radio advertising on an opera
radio station; The CEOs wife was an opera singer who would be
frequently played on that station
Court looked at: wife received less pay than other performers;
directors did not know wife was involved when they voted; wifes
competency as a singer; contract itself was renewable and short
term (13 weeks)
To avoid future liability
o Have only disinterested BOD members votes on issues

Benihana of Tokyo v. Benihana (339)


Aoki argued that the directors had breached their fiduciary duties
by allowing Abdo to negotiate the deal from both sides.
o That would be self-dealing which is a breach of the duty of
loyalty.

30
Delaware statute 144(a)(1) provides a safe harbor for
interested transactions like this one
o Statute says if the material facts as to the directors
relationship or interest and as to the contract or
transaction are disclosed or are known to the BODand
the boardin good faith authorizes the contract or
transaction by the affirmative votes of a majority of the
disinterested directors after approval by disinterested
directors, courts review the interested transaction under
the business judgment rule
Delaware law allows disinterested directors to vote on a decision
if they know there is a conflict of interest, and the business
judgment rule will apply to the decision
What Benihana should have done to avoid litigation:
o Be informed, make the decision in good faith, disclose the
conflict upfront, only let disinterested parties vote on the
decision
Dilution of Shares argument
o It is settled law that corporate actionmay not be taken
for the sole or primary purpose of entrenchment

Broz v. Cellular Information Systems (345)


The Doctrine of corporate opportunity represents but one species
of the broad fiduciary duties assumed by a corporate director or
officer.
A corporate fiduciary agrees to place the interests of the
corporation before his or her own in appropriate circumstances
Corporate Opportunity:
o Corporation must be financially able to undertake the
opportunity
o From the corporations nature, the opportunity must be in
the line of the corporations business and is of practical
advantage to it
o Must be an opportunity where the corporation has an
interest or reasonable expectancy in
o Self-interest of the officer or director cannot be brought
into conflict with that of the corporation
Safe harbor laws in Delaware
o Says that if you do x, y, and z, then you are protected by
the law
o However, it does not say that you HAVE to do x, y, and z to
be protected, but it is in your best interest to do them

31
Broz could have presented to entire CIS Board and gotten himself
the safe harbor rule in Delaware by disclosing info to entire
Board and in voting not to go for it BUT this is NOT required
Directors only owe a duty to their CURRENT corporation and
CURRENT shareholders

In re eBay, Inc. Shareholders Litigation (350)


"An opportunity is within a corporation's line of business . . . if it
is an activity as to which the corporation has fundamental
knowledge, practical experience and ability to pursue."
Investing in various securities was held to be in a line of business
of eBay despite the fact that eBay's primary purpose is to
provide an online auction platform.
o Investing was in a line of business of eBay because eBay
"consistently invested a portion of its cash on hand in
marketable securities."
o A corporation has an interest or expectancy in a business
opportunity if the opportunity would further an established
business policy of the corporation.
o One can realistically characterize these IPO allocations as a
form of commercial discount or rebate for past or future
investment banking services

A business opportunity is a corporate opportunity if the corporation


is:
1. Financially able to undertake the opportunity,
2. The opportunity is within the corporation's line of business,
a. an activity as to which the corporation has fundamental
knowledge, practical experience and ability to pursue
3. The corporation has an interest or expectancy in the opportunity,
AND
a. This is a balancing test
4. Arose out of the partnership/corporations dealings

A Director or Officer may take a Corporate Opportunity if:


1. The opportunity is presented to the director or officer in his
individual and not his corporate capacity;
2. The opportunity is not essential to the corporation;
3. The corporation holds no interest or expectancy in the
opportunity; AND
4. The director or officer has not wrongfully employed the resources
of the corporation in pursuing or exploiting the opportunity.

Illegal Bribe

32
Where there is a quid pro quo between the investment bank and
the recipient of the share allocation, whereby the recipient
directs business to the bank in return for the allocation, the
transaction may be an illegal bribe

Sinclair v. Levien (355)


A majority shareholder may have some fiduciary duties to the
minority shareholders
Self-dealing, coupled with a parent corporations
fiduciary duty, will make intrinsic fairness the proper
standard
Here, Sinclair received nothing from Sinven to the exclusion of its
minority shareholders. As such, these dividends were not self-
dealing
o Therefore, the intrinsic fairness test does not apply to the
dividend payments and the Business Judgment Rule should
be applied.

Corporate Jets
If a CEO uses the corporate jet for a weekend vacation to go
skiing, is he breaching his fiduciary duty to shareholders?
o No, but only under certain circumstances
o If there are corporate jets that have been bought for
business purposes, then CEOs can use the jet provided
that they pay the expenses for the trip (fuel, pilot costs,
etc.) AND provided that the jet is free to use that weekend
A decision to buy a corporate jet would most likely fall under a
business judgment rule

Zahn v. Transamerica Corporation (359)


Big breach of duty in this case:
o The BOD knew and failed to disclose that the price of
tobacco had rocketed up
o Price of its principal tobacco leaf went from $6 million to
$20 million in less than a year; BOD did not disclose this
information to shareholders
o Asymmetrical information
If the shareholders of Class A stock had known the real value of
the tobacco, then they would have immediately converted to
Class B shares
o This way, their shares could not be called, and they would
get paid a significant amount in liquidation

33
o Otherwise, their Class A stock would have been called by
the company and they would not have been paid in
liquidation
In Todays world, this would be considered a type of Insider
Trading (breach of loyalty)

THE OBLIGATION OF GOOD FAITH

In re The Walt Disney Co. Derivative Litigation (374)


Three categories of Fiduciary Behavior are candidates for the
bad faith pejorative label:
o (1) Subjective Bad Faith
Fiduciary conduct motivated by an actual intent to do
harm
o (2) Lack of due care
Fiduciary action taken solely by reason of gross
negligence and without any malevolent intent
This court says that gross negligence, without more,
cannot constitute bad faith
o (3) Intentional dereliction of duty, a conscious disregard for
ones responsibilities
To protect the interest of the corporation and its shareholders,
fiduciary conduct of this kind, which does not involve disloyalty
but is qualitatively more culpable than gross negligence, should
be proscribed
Three Examples of Bad Faith
o (1) Where the fiduciary intentionally acts with a purpose
other than that of advancing the best interests of the
corporation,
o (2) Where the fiduciary acts with the intent to violate
applicable positive law, or
o (3) Where the fiduciary intentionally fails to act in the face
of a known duty to act
There was some deliberation, a report from an outside expert,
and spreadsheets that were prepared for the compensation
committee meetings evidence that the BOD was informed in
making its decision

34
Corporate Waste Claim
Rooted in the doctrine that a plaintiff who fails to rebut the
business judgment rule presumptions is not entitled to any
remedy unless the transaction constitutes waste
To recover on a claim of corporate waste, the Ps must shoulder
the burden of proving that the exchange was so one sided that
no business person of ordinary, sound judgment could conclude
that the corporation has received adequate consideration
o A claim of waste will arise only in the rare, unconscionable
case where directors irrationally squander or give away
corporate assets

More on the Duty of Good Faith:


An illegal act may not violate a directors duty of care, but it
would most certainly violate the directors duty of good faith
In order to get to the Business Judgment Rule, there must be
good faith. So if there is not good faith, you dont even get to
the Business Judgment Rule, you instead use the Inherent
Fairness Rule
The doctrine surrounding Good Faith is pretty incoherent. Some
courts see it as a separate standard, and some courts see it as a
part of the duty of care or duty of loyalty
LOOK TO PAGE 384 FOR A DEFINTION OF BAD FATH

DUTY TO MONITOR

In re Caremark
The core element of any corporate law duty of care
inquiry: whether there was good faith effort to be
informed and exercise judgment.
Thus, I am of the view that a director's obligation includes a duty
to attempt in good faith to assure that a corporate information
and reporting system, which the board concludes is adequate,
exists, and that failure to do so under some circumstances may,
in theory at least, render a director liable for losses caused by
non-compliance with applicable legal standards
In order to Show that the Caremark directors breached their duty
of care by failing adequately to control Caremark's employees,
plaintiffs would have to show either (1) that the directors knew or
(2) should have known that violations of law were occurring and,
in either event, (3) that the directors took no steps in a good
faith effort to prevent or remedy that situation, and (4) that such
failure proximately resulted in the losses complained of

35
A board has a duty to attempt in good faith to assure that a
corporations information and reporting system, which the board
concludes is adequate, exists, and that failure to do so under
some circumstances may, in theory at least, render a director
liable for losses caused by non- compliance with applicable legal
standards

o Finding a violation of this duty requires:


The Board must have failed to provide
reasonable oversight in a sustained or
systematic fashion, AND
The information reporting system on which the
Board relied must have been an utter failure
Failure to Monitor
o Part of your duty to monitor requires that you have in place
adequate systems to monitor
Federal Sentencing Guidelines:
o Meant to establish standardization in the federal courts
o Does not say you need a perfect program
If criminal activity has occurred or some things have
fallen through the cracks, this is not detrimental to a
duty to monitor
As long as there is an effective system in place
o Must take reasonable steps to prevent criminal and
unethical activities
Under a good faith standard, a BOD has the responsibility to
have a monitoring system in place, and that monitoring system
is meant to be a reasonable and effective system

Federal Sentencing Guidelines


Apply to businesses starting in 1990 and were trying to make
standard penalties across federal courts
Citigroup
Citigroups Board decided that more of the firms capital should
be invested in securities and derivative promising higher returns
o These turned out to be bad investments and Citibank was
taking on enormous risk
o Citibank ended up incurring loses of over $65 billion on
these toxic investments
o In late 2008, the firm had to submit to two government
rescue packages, and its shareholders bore heavy losses
The Delaware Court dismissed an attempt to hold the Citigroup
board liable for the firms losses, finding that the board did not
breach any of its fiduciary obligations

36
Caremark had to do with activities that violated the law (paying
physicians for patient referrals)
Citigroup did not involve any illegal acts, it just involved the bank
taking on too much risk in mortgage-backed securities

Volker Rule included in the Dodd-Frank Act prohibits banks from


proprietary trading and restricts investment in hedge funds and private
equity by commercial banks and their affiliates
Volcker argued vigorously that since a functioning commercial
banking system is essential to the stability of the entire financial
system, for banks to engage in high-risk speculation created an
unacceptable level of systemic risk
He also argued that the vast increase in the use of derivatives,
designed to mitigate risk in the system, had produced exactly
the opposite effect

DERIVATIVE LAWSUITS
Derivative Suits
Shareholders sue on behalf of the corporation to enforce
corporate rights that affect them only indirectly
This means any recovery in derivative litigation generally runs to
the corporation
Derivative suits generally enforce fiduciary duties of directors,
officers, or controlling shareholdersduties owed to the
corporation
It is the BOD who should be suing themselves, because they are
they ones representing the Company
Shareholder sues the company on behalf of all the shareholders
o However, a shareholder can sue directly on behalf of
himself
EXAMPLES:
o Typically breach of fiduciary duties
o Corporate waste

37
Demand
Shareholders are required to make demand upon the BOD
before they can commence a derivative suit on the
corporations behalf against either the corporations
officers, its directors or a third party
o Demand upon the BOD is required because the directors of
a corporation (not its shareholders) are charged with
primary responsibility for managing the corporations
business and affairs (including the business decision
whether to pursue a particular corporate COA)
Before you can sue a BOD you have to make a demand
o Usually the demand is about an issue of corporate injury
o The corporation will with no doubt say no, we are not going
to sue ourselves
o The decision by the BOD is protected by the business
judgment rule
Insulates the BOD
Incentives risk
Reasons a BOD might decline a shareholders demand even if a
COA strongly favors the corporation:
o Substantial expense of litigation
o Negative publicity such a suit might generate
o Distraction to employees and diversion of corporate
resources while the lawsuit proceeds to its resolution
Limited Liability and the Business Judgment Rule are substantive
rules that incentive risk

Why have a Demand Rule?


First, by requiring exhaustion of intracorporate remedies, the
demand requirement invokes a species of ADR procedure which
might avoid litigation altogether
Second, if litigation is beneficial, the corp. can control the
proceedings
Third, if demand is excused or wrongfully refused, the
stockholder will normally control the proceedings

Way to get out of making a Demand


o You can say that making a demand is so futile that you
cannot even make it

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o The BOD is so conflicted, that there is no way they would
allow for a lawsuit
A demand is futile if:
o (1) A majority of the board has a material financial or
familial interest (not disinterested);
o (2) A majority of the board is incapable of acting
independently for some other reason such as domination
or control (not independent); OR
o (3) The underlying transaction, that is the subject of the
lawsuit, is not the product of a valid exercise of business
judgment
Put another way: the P shareholder must be able to allege
particular facts that, if true, raise a reasonable doubt as to the
Boards ability to reach a sound business decision with regard to
whether or not the derivative action should be dismissed
If the corporation is able to put together a Special Litigation
Committee, the SLC will have the authority whether to accept
the demand or not

Direct suit
Shareholders sue in their own capacity to enforce their rights as
shareholders
Direct suits generally vindicate individual shareholders
structural, financial, liquidity, and voting rights
Shareholders have been harmed in the rights that they possess
as shareholders not something that the corporation possessed
Suits involving dividends
Suits involving voting rights
Actions that are done to a particular class of shareholders
Generally when there is a claim of dilution of stock, it will be a
direct suit

Grimes v. Donald (210)


P makes demand, BOD says no, and now they want to argue that
demand should have been excused and court rejects this
Once you have made a demand, you cannot go back and argue
that the demand should have been excused or that a demand
was futile

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You must, at the very beginning of your case, argue that demand
would have been futile
o So, once you have chosen to make a demand, you cannot
go back and argue futility
However, you can argue wrongful excusal
o If a demand is made and rejected, the board
rejecting the demand is entitled to the presumption
of the business judgment rule unless the stockholder
can allege facts with particularity creating a reasonable
doubt that the board is entitled to the benefit of the
presumption.
o If there is reason to doubt that the board acted
independently or with due care in responding to the
demand, the stockholder may have the basis ex post to
claim wrongful refusal.
As a plaintiffs lawyer, you do not want to make that demand.
o You just want to make the claim that the demand would be
futile

In re Oracle Corp. Derivative Litigation (238)


Oracle is being sued by its shareholders
o Senior officers sold stock about a month before the
companys third quarter results showed that the
companys revenue growth was 20% lower than what the
company projected. As a result, the stock dropped by 21%
in one day.
Insider trading case
The information that Oracle was not going to meet its figures, is
information that belonged to the corporation BOD has
fiduciary duties to the corporation to inform the shareholders.
The members instead used this information to appropriate funds
for themselves personally.
It sets up a Special Litigation Committee to counter the plaintiffs
claim that it is excused from demanding the corporation to file a
lawsuit (demand would be futile)
o Turns out, the Special Litigation Committee hired by Oracle
has conflicting interests with the BOD
Insider Trading Penalties:
o Criminal charges
o Sued by SEC (civilly)
o Sued by shareholders (civilly)

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HOSTILE TAKEOVER/ACQUISITION

Acquisition of Another Corporation


Van Gorkam
Shareholders are upset about the price that they got from their
shares
Sometimes these acquisitions are called tender offers
o Shareholder is tendering (giving) their shares for money,
new shares, or money + new shares

Hostile Takeover
Almost like the opposite of Van Gorkam
It is when we have a corporation that is sitting happy, and out of
nowhere another corporation comes in and says we want to
take you over
Why would a corporation do this?
o Competitor
o Liquidating
o Underlying assets that are very valuable
o Company could be worth a lot of money and the stock
could go way up, but the problem is the current
management
How does a takeover happen?
o Start buying the shares (if it is a publicly traded company
on the open market)
It might be tough to buy a majority of the shares
o Make a Tender Offer
To all shareholders saying we want to buy the stock
you own for market price + a premium
The current BOD will tell shareholder dont sell, and
this could potentially be a breach of the BODs
fiduciary duties the BOD is only saying this
because they want to retain control of the
corporation
What are some good defenses to a hostile takeover?
o Have something in the by-laws that says In the event that
a hostile takeover is occurring, we are able to call stock at
$X price Buy back provision
Must be careful, because if the corporation is buying
back stock at a price less than the tender offer, this
could be a breach of fiduciary duties

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Also, if the buyback price is too high, a shareholder
could sue for corporate waste wasting the
corporations money
So this is NOT a good idea
o Poison Pill
If somebody tries to takeover this corporation, what
immediately goes into effect is a warrant so that
every shareholder has a warrant that is worth $X
This raises the price of the corporation so high, that
the offer to takeover no longer looks attractive
Set forth in the by-laws of the corporation
BOD has the right to waive the provision
i.e. if the BOD likes the takeover offer
However, if the BOD chooses to enforce this poison
pull there is still potential for liability for breach of
fiduciary duties because the shareholders were
denied the chance to sell shares for market price +
premium
In order to shield itself from liability, the BOD should:
Hire an outside consultant or investment bank
to value the company and its stock at the time
of the proposed takeover
o Want this outside consultant to say
whether the tender offer price was a
good price, excellent price, not a
very good price, etc.
Figure out if this corporation has any long-term
growth
Figure out if the current employees will get laid
off or not
Whether this corporation engages in activities
of social value
The fabric of the community in which the
corporation operates
Paramount Case
Only one bidder in this case
Court says that a BOD should primarily take
into account the shareholders interests, but
other outside interests might be valid as well.
But outside interests cannot be the top
interest.
Revlon Case
In a Paramount type of situation, in which you
are going against one other bidder, you can

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take outside considerations into account. But
in a situation where it is clear that the
corporation is going to be acquired one way or
another (multiple bidders have come in) then it
is okay to get the highest bid.
o A White Knight
Somebody, who you like, is going to come in and
acquire the corporation instead of the evil acquirer
BOD will remove the poison pill, but it will only
remove it for the White Knight
Courts usually hold that in the situation of a White
Knight, if the evil acquirer offers more money for
shares, then the corporation must go with the evil
acquirer or else subject itself to liability (shareholder
suits)
o Management Buyouts
Management takes over by buying the majority of
the shares
This presents more complications in regards to
breach of fiduciary duties

CLOSELY HELD CORPORATIONS


Closely Held Corporations
Characteristics:
o Typically small, tightly knot group of participants (generally
less than 30-75)
Often family members or former partners
o Active, often informal management by non-specialized
investors/owners
o Undiversified participants who often look to the corporation
for livelihood through payment of salaries or dividends
o No ready market for shareholders to dispose of their shares
also sometimes there are contractual limits on
transferability
Many states now have special statutory provisions for closely
held corporations
Delaware General Corporation Law states The certificate of
incorporation of a close corporation may provide that the
business of the corporation shall be managed by the
stockholders of the corporation rather than by a BOD
One advantage of close corporation status is avoidance of any
need to provide for certain corporate formalities (where

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otherwise the failure to do so might give rise to personal liability
of shareholders for corporate debts)
Delaware Law: close corporation status may be elected by
corporations with not more than 30 shareholders

McQuade v. Stoneham (589)


An agreement among stockholders whereby it is attempted to
divest the directors of their power to discharge an unfaithful
employee of the corporation is illegal as against public policy
o It must equally be true that stockholders may not, by
agreement among themselves, control the directors in the
exercise of the judgment vested in them by virtue of their
officer to elect officers and fix salaries
Directors may not by agreements entered into as
stockholders abrogate their independent judgment
Stockholders may of course combine to elect directors
o The power to unite is limited to the election of
directors
o It is NOT extended to limit the power of directors to
manage the business of the corporation

Clark v. Dodge (594)


The business of a corporation shall be managed by its board of
directors
If the enforcement of a particular contract damages nobody one
sees no reason for holding it illegal, even though it impinges
slightly upon the board provision of section 27
Damage suffered or threatened is a logical and practical
test, and is one generally adopted by the courts
o Where the directors are the sole stockholders, there
seems to be no objection to enforcing an agreement
among them to vote for certain people as officers
Here, even though the stockholder agreement seems to violate
the McQuade case, the agreement was only between the only
two shareholders of the corporation, and there certainly was no
damage suffered by or threatened to anybody
McQuade only gave broad statements
META THEME: Freedom of contract

NOTE ON SHAREHOLDER AGREEMENTS


Board Directors
o Agreements by which the shareholders simply commit to
electing themselves, or their representatives, as directors,

44
are generally considered unobjectionable, and are now
expressly validated in many jurisdictions
Officers & Employees
o The courts have had more difficulty with shareholder
agreements requiring the appointment of particular
individuals as officers or employees of the corporation,
since such agreements do deprive the directors of one of
their most important functions
Such agreements are enforceable, at least for closely
held corporations, as long as they are signed by all
shareholders

Galler v. Galler (601)


Several shareholder-director agreements that have technically
violated the letter of the Business Corporation Act have
nevertheless been upheld in the light of the existing practical
circumstances
o i.e. no apparent public injury, the absence of a complaining
minority interest, and no apparent prejudice to creditors
Generally, so long as there is not detriment to public interest,
creditors, or outsiders, the court will uphold these agreements
Consider the validity of payments to the widow of an officer and
shareholder in a corporation
o Treated as a gift of corporate property that is in violation of
the rights of its shareholders
Here, there are no shareholders other than the parties to the
contract, so the above argument does not apply is upheld as
enforceable

Take-aways from these 3 cases:


Separation between the shareholders who have every right to
elect the BOD, but it is the BODs responsibility to elect officers
and employees.
Courts will allow shareholders agreements to appoint officers and
even allow dividends as long as the dividends are not too
excessive (i.e. as to hurt creditors)
o Usually all shareholders must agree to the agreement
o Cannot be a pissed off minority

Ramos v. Estrada (606)


The members of the Broadcast group entered into an agreement
to vote all of their shares of Television in a manner determined
by a majority of them

45
o The terms of this agreement expressly state that failure to
adhere to the agreement constitutes an election by the
shareholder to sell his or her shares
The agreement has the characteristics of a shareholders voting
agreement expressly authorized by section 706, subdivision (a)
for close corporations
o Although the articles of incorporation do not expressly call
this corporation a close corporation, the arrangements of
this corporation, and in particular this voting agreement,
are strikingly similar to ones authorized by the Code for
close corporations
CONTRACT LAW:
o As long as the shareholders agreement does not violate
contract law, usually it will be upheld in close corporations

FREEZE OUTS
Isolate minority shareholders from corporation participation,
forcing the minority to sell to (or buy from) the majority on
unfavorable terms
o EXAMPLES:
Refuse to declare dividends
Drain off the corporations earnings in the form of
exorbitant salaries and bonuses to the majority
shareholder-officers and perhaps relatives
In the form of high rent by the corporation for
property leased from majority shareholders
Deprive minority shareholders of corporate offices
and of employment by the company
Cause the corp. to sell its assets at an adequate price
to the majority shareholders
The minority shareholders in a close corporation will bring suit
against the majority alleging a breach of the strict good faith
duty owed to them by the majority
Must be analyzed on a case-by-case basis
Two cases give us two different tests (Wilkes & Bordie):
Balancing Test Employed
o If the majority shows a legitimate business purpose for
its action and the minority shows the objective could have
been accomplished in a way less harmful to the minoritys
interest, THEN
o The court must balance the legitimate objective against
the practicability of the alternative
Reasonable Expectations Test

46
o Look to shareholders reasonable expectation in
determining whether to grant relief to an aggrieved
minority shareholder in a close corporation
Remedies for a Freeze Out
o Brodie v. Jordan
The remedy in a corporate freeze out must match
the reasonable expectations that have been
frustrated

Wilkes v Springside Nursing Home (613)


No shareholders agreement in this case, therefore no breach of
contract
Court comes up with a balancing test for finding a freeze out
Stockholders in the close corporation owe one another
substantially the same fiduciary duty in the operation of
the enterprise that partners owe to one another
o The standard of utmost good faith and loyalty
o Stockholders in close corporations must discharge their
management and stockholder responsibilities in conformity
with this strict good faith standard
o They may not act out of avarice, expediency or self-interest
in derogation of their duty of loyalty to the other
stockholders and to the corporation
Majority owners still have certain rights to what has been known
as selfish ownership in the corporation which should be
balanced against the concept of their fiduciary obligation to the
minority
Stockholders in close corporations must discharge their
management and stockholder responsibilities in conformity with
this strict good faith standard

Ingle v Glamore Motor Sales (620)


Here, fair principles of well-settled law, affecting employment
and contractual relationships between private parties, govern
and are entitled to respect and efficacy from this court
Court treats the plaintiffs complaints as a claimed breach of a
hiring contract by the employer rather than an unfair squeeze-
out of a minority shareholder in a close corporation
o His status as an employee at-will trumps fiduciary duties
he is owed as a minority shareholder

Brodie v. Jordan (625)

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The proper remedy for a freeze-out is to restore the minority
shareholder as nearly as possible to the position she
would have been in had there been no wrongdoing
o The remedy should restore to the minority shareholder
those benefits which she reasonably expected, but has not
received because of the fiduciary breach
If, for example a minority shareholder has a
reasonable expectation of employment by the corp.
and was terminated wrongfully, the remedy may be
reinstatement, back pay, or both
Here, the court ordered the D to buy out the P at the price of an
experts estimate of her share of the corp.
o Wrong remedy it had the perverse effect of placing the P
in a position superior to that which she would have enjoyed
had there been no wrongdoing

What would be a good Shareholders Agreement that ensures


that our client (minority shareholder) does not get frozen
out?
1. Clause: Shareholders are to elect each other to the BOD
2. Clause: Shareholders are to elect each other as officers
3. Clause: Provision outlining clients salary or dividends owed to
client
4. Clause: Provision prohibiting dilution of stock
5. Clause: Provision outlining the various fiduciary duties each
shareholder owes one another

Should there also be Employment Contracts?


An employee owes fiduciary duty to employer but NOT vice versa
Employment agreement is person and cannot be implied
In many cases, it is good to have both, but an employment
agreement is much more optional then a shareholder
agreement (which should be required)

LIMITED LIABILITY COMPANIES


LIMITED LIABILITY COMPANY:
LLC statutes are horribly drafted by legislatures

48
To form an LLC requires an affirmative action of going to the
Secretary of States office to fill out the necessary forms
o Not like a partnership where it can be implied
Default rules of fiduciary duties
o Duty of loyalty and duty of utmost good faith
o Same as partnership
o These can change if you contract your own fiduciary duties
You can pretty much contract out of most of your duty of loyalty
o i.e. agreements that members to an agreement for an LLC
are allowed to compete with one another

Elf v Jaffari (274)


The policy of freedom of contract underlies both the
Delaware LLC Act and the LP Act
It is the policy of the Act to give the maximum effect to
the principle of freedom of contract and to the
enforceability of limited liability company agreements.
How you draft agreements will be crucial to the life of the LLC
and the equity owners
LLC land is contract land and they enter into two contracts:
o One between the three entities (Elf, Malek Inc., and Jaffari)
is an operating agreement (LLC is not executing this one)
o Between Malek LLC and Elf there is an exclusive
distributorship agreement (missing a forum selection
clause and an arbitration provision)
Documents are NOT consistent with one another! Agreements
need to conform to one another!
TAKEAWAY: drafting of the contract becomes crucial where you
have private orderings

Fisk Ventures v. Segal (280)


P argues that Fisk, Rose, and Freund breached the implied
covenant of good faith and fair dealing by frustrating or blocking
the financing opportunities proposed by Segal
o However, neither the LLC Agreement nor any other
contract endowed him with the right to unilaterally decide
what fundraising or financing opportunities that the
Company should pursue, and his argument is another in a
long line of cases in which a plaintiff has tried,
unsuccessfully, to argue that the implied covenant grants
him a substantive right that he did not extract during
negotiation

McConnell v. Hunt (292)

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LLC agreement made clear that members were not prohibited
from in engaging in a venture that was competitive with CHLs
investing in and operating an NHL franchise
An LLC, like a partnership, involves a fiduciary relationship
o Normally, the presence of such relationship would preclude
direct competition between members of the company
o However, here we have an operating agreement that by its
very terms allows members to compete with the business
of the company
An operating agreement of an LLC may limit or define the
scope of the fiduciary duties imposed upon its members
Also no tortious interference with a business relationship

Breach of Implied Covenant of Good Faith and Fair Dealing


Every contract contains an implied covenant of good faith and
fair dealing that requires a party in a contractual relationship to
refrain from arbitrary or unreasonable conduct which ahs the
effect of preventing the other party to the contract from
receiving the fruits of the bargain
PAGE 285

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