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Prof. John Barrett

Room 2014D
Phone 530-2131(W) ; 530-4311(H)

May 27 & 29 Assignment

Basic Business Forms
Sole Proprietorship
Limited Liability Company
Closely Held
(A) Decision Making Issue: Harder to get heads together
(B) Control: Easier to control the company. (51% is easier to
Get – more potential for abuse)
(C) Potential for conflict and disagreement on a personal
level is more likely (personal dislike)
(D) Concern: How do you get along?
Publicly Held
(A) Decision Making Issue: Easier time of decisions making
centralized management
(B) Control: Harder to have control of company (20% could
control the company)
(C) Less likely for potential conflict and disagreement
(D) Concern: How to keep control over the managers?
Unincorporated Businesses: These are on the rise. Only LLC and Corps
need to file something.
(A) Move away from Corporation because of tax advantage.

Corporation: 2 Theories are

(A) Similar to an entity (corporation can do almost anything
that a person can do); it can last forever; can be
controlled by someone else; does not exist
independently; created by the state (even though a
corporation can commit a crime, can’t be sent to jail – so
some managers or owners can)
(B) Nexus of Contracts Approach: Says not an entity, but
just a whole bunch of contracts (i.e. managers and
owners, creditor and suppliers and managers and
owners; managers and workers) Can’t contract yourself
into limited liability – state limits your ability to contract.
I) Introduction (pp. 1-16)
1. Subject in General: Involves the study of the means and devices
by which business is conducted either by a single person or
cooperatively by a few or many people.
Business means all kinds of profit making activity.
2. The Statutes
3. The Basic Business Form
The Subject of business forms can be broken down into:
1) Unincorporated Associations: i.e. agency, partnership, etc.
2) Closely Held Businesses: (Ones with a few owners)
3) Publicly Held Businesses: (with 100s or 1000s of owners)

Restatement (Second) of Agency

4. Role of the Law of Agency in Business Associations
1) Example: A and B go into a small business together, with A putting up the
money and B providing the management. A wants to avoid being asked to
invest more money and wants veto power over the important decisions
affecting the business. Profits are to be divided equally after B is paid a
salary. If A and B enter an oral agreement and B starts in, what form of
business organization has been formed?
(a) This is not a good partnership, because A does not want to be liable for
the organization being formed. Unlimited liability. B was getting $1,500 a
month for being in the business, w/o a writing that modifies the UPA, then
B cannot be a partner.
(b) Limited Partnership? A LLC must be filed, but it wasn’t. If it were filed then
the veto right may constitute too much control by the limited partner.
(Participating in the control includes proposing, approving, voting any of
the following: dissolution, sale of the assets, adding a partner, etc. These
aren’t a veto – voting on things not enumerated but says that an
agreement is subject to the approval or disapproval of the limited
partners.) You could maybe make this an LLC if it is done properly
(c) Corporation: Nothing has been filed. We could be a corporation. We
have the basis for the corporations.
Owners (A and B Shareholders)

Board of Directors (A is President)

Officers (B is an officer)

Employees (B is an employee)
Could be setup as an S corporation, (type that is not taxed twice).
(d) Limited Liability Company? Isn’t because you have to file. But if you set
it up properly, then this has the most flexibility than any other (look and act
like a partnership, but have benefits of corporation)
(e) Partnership: If a driver is added to this hypo, then an employee is added
and he is a servant to the partnership. The employee can be held liable
for what the servant does, within the scope of his duties. (i.e. driving a
truck and causing an accident – partnership would be liable for
negligence). Apparent or actual authority is the question. The share of
profit and loss are 50-50 (no matter what you contribute) unless you agree
otherwise. What is a fair split? Losses, the business loses money, then
the partners are all jointly and severally liable for obligations of the
partnership. If one partner pays for all liability, the partnership is still liable,
so the partnership must indemnify partners, for costs and losses incurred
during the business. The problem is the partnership is broke. The assets
of the partnership include contributions that the partners must make to pay
off the partnership debts. Therefore, the partnership owes one of the
partners for the losses paid for by the partner minus his % of that debt.
Class Example: A owns 20% of the profits and losses in a partnership, B is 20%
and C is 60%. The partnership owes $8,000. A is bankrupt. You must split ¼
(B) and ¾ (C) of the $8,000. The whole amount must be covered.
A contract that agrees to cover liability between partners, this only
includes the partners. Partners are still servally and jointly liable,
therefore, 3rd persons can sue no matter what the partner’s agreement is.
(f) Limited Liability Partnership: Many states don’t allow professionals to be
in partnerships. Most law firms are partnerships. Therefore law partners
up to this point each partner was severally and jointly liable. To avoid this
Texas set up partnerships with the difference that says: Partners are not
liable for tort claims against the partnership. Everyone is liable for their
own torts (malpractice). Partners therefore are not jointly and severally
liable. 30 states have allowed this. Some states have added contractual
claims as well. People are liable for their own wrong doings. A
partnership is liable for its own assets, then the wrong doing partner
comes next.

2) Agency Law
(a) Principal-agent: An agency is a fiduciary relationship that results from
consent between the principal and agent that the agent shall act on the
principal’s behalf and subject to her control (Rest. 2nd of Agency §§1, 2)
(b) Master-servant: A master is a principal who employs an agent to perform
service in her affairs and who controls or has the right to control the
physical conduct of the other in the performance of the service
(c) Independent contractor: is a person who contracts with another to do
something for her, but who is not controlled by the other’s right to control
with respect to his physical conduct in the performance of the undertaking.
The independent contractor may or may not be an agent.
(d) Questions: In the above situation, has a principal-agent relationship been
established? An employer-employee relationship? An independent
contractor relationship? Alternatively, are A and B partners? Is A a limited
partner? Can A get what she wants if she organizes as a corporation?
5. The Corporation as a “Person”

6. Other Theories of Corporateness: the “Nexus of Contracts”


II) The Partnership (pp. 17-19; pp. 29-118): A partnership is an association

of 2 or more persons to carry on a business as co-owners for profit.
Uniform Partnership Act (UPA) §6]. A lawful partnership cannot be
formed for nonprofit purposes.

Comparison w/ other forms of doing business:

(a) Agency: A partnership is a more complex form of organization than a sole
proprietorship –it is really an extension of the sole proprietorship, which
incorporates many of the principles of agency law in structuring how the
partnership will function.
(1) Each partner is the agent of her copartners, and when any partner acts w/I
the scope of the partnership, her acts will bind the other partners.
(b) Joint Venture: A joint venture is an association of 2 or ore members, agreeing
to share profits. However, a joint venture is usually more limited than a
partnership; i.e. it is formed for a single transaction and usually is not the
complete business of it’s individual associated members. However, the rights
and liabilities of partners and joint venturers are usually the same, and the
courts usually apply the provisions of the UPA to joint ventures.
(c) Other unincorporated associations: There are other types of unincorporated
associations (such as the business trust) that are not partnerships.
(d) Uniform Partnership Act: The UPA has been adopted by most states, so that
the provisions governing partnerships are usually a part of state statutory law,
rather than the common law.
A) The Need for a Written Agreement: Since a partnership is a voluntary
association, there must be an express or implied agreement in order to form a
(1) Formalities: If the partnership is to continue beyond one year, the
agreement must be in writing since it comes w/I the Statute of Frauds.
(2) Duration: If no term is specified, then the partnership is terminable at the
will of any partner.
(3) Capacity to become a partner: Persons must have the capacity to
contract. Some states hold that corporations cannot be partners.
(4) Intent of the parties: Where there is any question, the intent of the parties
involved is determined from all of the circumstances.
(5) Writing are best: help to overcome disputes later; spells out the rules of he
B) Sharing of Profits and Losses: UPA Section 7 lists the factors to
determine intent, including the sharing of profits of the business.
Richert v. Handly (1957) (p. 30)
Issue: May a court determine the respective rights and duties of partners or joint
venturers without 1st ascertaining the terms upon which the parties have agreed
to cooperate with one another?
Rule: The respective rights and duties of partners or joint venturers cannot be
determined until the terms of all agreements between them have been

Richert v. Handly (1958) (p. 33)

Issue: Is the court precluded from determining the respective rights of partners
who have made no agreement concerning the proportion in which partnership
losses are to be borne?
Rule: In the absence of a n express agreement to the contrary, each partner is
liable for a partnership’s losses in an amount proportionate to his share of the
Comment:: Richert v. Handly illustrates the need for parties to a partnership
agreement to included a provision for allocation of losses. At the inception of a
partnership, its members (particularly if they are superstitious) may be reluctant
to acknowledge the possibility that their venture will produce a net loss.
Experience has shown that partnerships, like other business arrangements,
occasionally prove unprofitable. It is in recognition of this fat that §18 of the
Uniform Partnership Act has provided a standard to be used in allocating losses
when partners have made no agreement concerning loss sharing.

A) Limited Liability Partnerships (LLPs): Creates one general partners who is

liable, but this partner gets to make decisions. The limited partner, only has
the money on the line, and didn’t have any decision making capacity.
B) General Partnership Liability:
(1) Liability of alleged partners: One who holds herself out to be a partner, or
who expressly or impliedly consents to representations that she is such a
partner, is liable to any 3rd person who extends credit in good-faith reliance
on such representations (UPA §16)
(2) Liability of partners who represent others to be partners: (i.e. A
represents to C that she has a wealthy partner, B, in order to obtain credit.
B knows of the representation and does nothing to inform C that he s not
a partner. ) In this example, if A were part of an actual partnership, then
she would make B an agent of the partnership by her representation that
B was also a partner. As such B could bind A as though they were in fact
partners (but only those other partners of A who made or consented to A’s
representation would be bound).
May 29, 1998 Class Notes

Continuum of Business
Sole Proprietorship/Partnership Corporations
Joint & Several Liability Limited Liability
No Tax (except personal) (Corp. and personal tax)

Four Characteristics of Companies:

When these are mixed , depending on the mix the entitity will be a partnership or

1) Limited liability
2) No tax
Rules for Partnership
Look to the Rules of Agency
C) Management: All partners have equal rights in management (even if sharing
of profits is unequal)
(a) Partner is an agent of the partnership: Gives them the power to act on
the behalf of another (this is a limited authority)
(b) Determination of agency
(1) Actual authority: Explicitly given
(2) Apparent authority: When you are acting outside the authority
given. (create impression that authority is there). This is done
(i) Custom (even no actual authority the impression is you have it)
Was this reliance unreasonable? If no, can the 3rd party go after
the partnership.
(ii) Course of dealings: This creates the impression of authority
To avoid apparent authority problems, then put the suppliers on notice, that there
is no authority.

National Biscuit Co. v. Stroud (1959) (p. 41)

Issue: May a partner escape liability for debts incurred by a copartner merely by
advising the creditor, in advance, that he will not be responsible for those debts?
Rule: The acts of a partner, if performed on behalf of the partnership and within
the scope of its business, are binding upon all copartners.
Comment:: The rule adopted by the Uniform Partnership Act is consistent with
traditional principles of agency law. In the absence of a contrary provision in the
parties’ partnership agreement, each partner acts as the agent of the partnership
and of each other partner. Only acts which are performed on behalf of the
partnership and are consistent with its purpose are binding on other partners.
Even an act which was outside the scope of a partner’s duties may bind his
copartners if they ratify it.

Smith v. Dixon (1965) (p. 42)

Issue: Is a partnership bound by acts performed by one of the partners?
Rule: The acts of a partner are binding upon the partnership if he acted within
the scope, or apparent scope, of his authority.
Comment: A partner’s acts are binding on the partnership if he acts within his
actual or apparent authority. The concept of apparent authority is from Agency
law. The Restatement of Agency 2nd, §8 defines the term as:
“Apparent Authority: is the power to affect, the legal relations
of another person by transactions with 3rd persons, professedly as
agent for the other, arising from and In accordance with the other’s
manifestations to such 3rd persons.”
The existence of apparent authority is ordinarily established according to an
objective test; i.e. the 3rd party’s belief that the agent has authority to act must be
a reasonable one if the principal is to be bound.
• Industry Practice should also be reviewed.
• What is the 3rd party’s reasonable expectations (Does it look like you are
doing it in the ordinary course of business – there would probably be apparent

Rouse v. Pollard (1941) (p. 46)

Issue: May members of a partnership always be held liable for one another’s’
Rule: Partners are liable for the acts of their copartners only if those acts are
within the scope of the partnership’s business.
Comment:: The rule of Rouse v. Pollard is consistent with the weight of
authority. A partner is, in effect, the agent of the partnership and of the other
partners. The rule of this case is a logical corollary to the proposition that a
principal is liable for all acts of his agent if performed within the scope of his
agency. Note that a partner may even be liable for a transaction in which a
copartner committed fraud. This does not mean, of course, that each partner is
himself guilty of fraud. He is not excused from financial liability to the aggrieved
3rd party merely by reason of the fact that his copartner’s conduct was fraudulent.
An agent cannot create their own apparent authority. This is created by the
partnership. DURBIN

Roach v. Mead (1986) (p. 49) CREATIVE LAWYERING

Issue: Is one partner responsible to 3rd parties for the acts of the other partner
where the 3rd party reasonably believes that those acts were within the
partnership business?
Rule: Each partner is responsible to 3rd parties for the acts of the other partner
where the 3rd party could reasonably believes that those acts were within the
purpose of the partnership. Court ignores the agency principle and looks to the
partner giving legal advice (you should seek independent counsel before entering
into a deal with a lawyer). The partnership was therefore liable for malpractice,
and not for embezzlement.
Comment:: The case rests on the fact determination as to whether or not
particular acts fall within the business purpose of a partnership. Each case
should be determined on its individual merits, and each factual situation may
change the result. The court found as a matter of fact that Roach (P) acted
reasonably in believing that Mead (D) was acting as his attorney when he
borrowed the money. Because the stated purpose of the partnership was a law
partnership, when Mead (P) acted as an attorney, Berentson (D) was fully
responsible for such actions.



FANARAS ENTERPRISES, INC. v. DOANE (423 Mass. 121)(1996)( (p. 52)

D) Duties of Partners to Each Other: The duty of one partner to all others is
based on a fiduciary relationship.

Meinhard v. Salmon (1928) (p. 54) FIDUCIARY DUTY

Issue: Do joint adventurers owe to one another, while their enterprise continues,
the duty of loyalty?
Rule: Joint adventurers owe to one another, while their enterprise continues, the
duty of finest loyalty, a standard of behavior most sensitive. Joint venture will
affect the scope of fiduciary duties (which can be modified by K); and the amount
of authority.
Dissent:: This was not a general partnership. Rather, Meinhard (P) and Salmon
(D) entered into a venture for a limited purpose. The interest terminated when
the joint adventure expired. There was no intent to renew the joint adventure
after its expiration.
Comment:: One of the most important aspects of the partnership relation is the
broad fiduciary duty between partners. “The unique feature is their symmetry;
each partner is, roughly speaking, both a principal and an agent, both a trustee
and a beneficiary for he has the property, authority and confidence of his co-
partners, as they do of him. He shares their profits and losses, and is bound by
their actions. Without this protection of fiduciary duties, each is at the others’
mercy.” J. Crane

Entity and Aggregate Characteristics of a Partnership

(a) Both characteristics: A partnership is treated both as a separate entity form its
partners (for some purposes) and as though there is no separate entity but
merely an aggregate of separate, individual partners.
(b) Aggregate theory: The partners are jointly and severally liable for the
obligations of the partnership (UPA §15). For federal income taxes, the
income or losses of the partnership are attributed to the individual partners;
the partnership itself does not pay taxes (although it does file an information
(c) Entity characteristics: For other purposes, a partnership is treated as a
separate entity apart from its individual partners.
(1) Capacity to sue or be sued: The jurisdictions vary as to whether a
partnership can be sued and/or sue in its own name. For example, if a
“federal question” is involved, then a partnership can sue or be sued in its
own name in the federal courts (FRCP 17(b)).
Ownership of property: A partnership can own and convey title to real or
personal property in its own name, w/o ll of the partners joining in the
conveyance (UPA §18)
E) Partnership Property: A frequent issue involves whether property is
partnership property or the individual property of a partner.
(a) Definition: All property originally brought into the partnership or
subsequently acquired by purchase or otherwise, for the partnership, is
partnership property. (UPA §8(1))
(b) Individual partner’s interest in the partnership: The property rights of
an individual partner in the partnership property are:
(i) his rights in specific partnership property,
(ii) his interest in the partnership, and
(iii) his right to participate in the management of the partnership. (UPA
(1) Rights in specific partnership property: Each partner is a tenant-
in-partnership w/ his copartners as to each asset of the
partnership (UPA §25(1)). The incidents of this tenancy are as
(i) each partner has an equal right to possession for
partnership purposes;
(ii) the right to possession is not assignable, except when
done by all of the partners individually or by the
partnership as an entity;
(iii) the right is not subject to attachment or execution except
on a claim against the partnership (the entity theory);
(iv) the right is not community property, hence it is not subject
to family allowances, dower, etc.
(v) on the death of a partner, the right vests in the surviving
partners (or in the executor or administrator of the last
surviving partner). The partnship property is not part of the
estate of a deceased partner but vests in the surviving
partner, who is under a duty to account to the deceased
partner’s estate for the value of the decedent’s interest in
the partnership.
(2) Partner’s interest in the partnership: A partner’s interest in the
partnership is his share of the profits and surplus, which is
personal property (UPA §26)
(i) Consequences of classification as personal property: A
partner’s interest is personal property, even where the firm
owns real property. The partner’s rights to any individual
property held by the partnership are equitable (the
partnership holds title), and this equitable interest is
“converted” into personal property interest. This can be
important in inheritance situations where real property may
be given to one heir and personal property to another.
(ii) Assignments: A partner may assign his interest in the
partnership (unless there is a provision in the partnership
agreement to the contrary), and unless the agreement
provides otherwise, such an assignment will not dissolve
the partnership. (UPA §27(1)).
• The assignee has no rights to participate in the
management of the partnership ( he is not a partner – he
only has rights to the assigning partner’s share of
profits and capital)
• The assignee is liable for all partnership obligations.
(iii) Rights of partner’s creditor: A creditor of an individual
partner may not attach partnership assets. He must get a
judgement against the partner and then proceed against
the individual partner’s interest (by an assignment of future
distributions, a sale of the interest for proceeds, etc.)
(3) Liability to partnership creditors:
(i) On contracts: All partners, including silent ones, are jointly
liable on all partnerhip debts and contracts (UPA §15(b))
(ii) Tort Liability: Each partner is liable for any tortious act
committed by a copartner w/I the scope of the partnership
business or w/I his authority as a copartner. Liability is both
joint and several. Where the tort involves a showing of malice
or intentional conduct, then it must appear that each partner
sought to be held liable possessed such intent.
F) Partnership Accounting: a partner may obtain an accounting from his
partners as to affairs of the partnership whenever the circumstances render it
just and reasonable.

Formula for Partners Accounts
When a partnership is dissolved, all partner accounts must equal zero

Balance Sheets: Assets Liab. & Equity

Equity = Assets-Liabilities Cash = 8K Equity = 10K
Assets = Equity + Liabilities Truck =3K Liab. = 1K
P&L Statement
Income = Revenues - Expenses

Income Statement

Default settings of Partnerships

2 or more people in business for profit, voluntary, dissolves when you choose not
to be in it, or one partner is no longer in for technical reasons (death, bankruptcy,
insanity, etc.)

G) Partnership Dissolution: does not immediately terminate the partnership.

The partnership continues until all of its affairs are wound up (UPA §30).
Unless otherwise provided for in the partnership agreement, the following
may result in a dissolution:
Expiration of the partnership term:
(i) Fixed term: Even where the partnership is to last for a fixed term,
partners can still terminate at will (but it will be a breach of the
agreement by the terminating partner)
(ii) Extension of term: Partners can extend the partnership by creating
a partnership at will on the same terms.
Express Choice of partner: Any partner can terminate the partnership at will
(since a partnership is a personal relationship that no one can be forced to
continue in). Even where it is a partnership at will, if dissolution is motivated by
bad faith, then dissolution may be a breach of the agreement.

Collins v. Lewis (1955) (p. 75)

Facts: After entering into a long-term lease of space in a building then under
construction, Collins (P) and Lewis (D) established a partnership. Collins (P)
agreed to advance money to equip a cafeteria which Lewis (D) agree to manage
Collins’ (P) investment to be repaid out of the profits of the business. Delays and
rising costs required a larger initial investment than the parties had anticipated,
and Collins (P) eventually threatened to discontinue his funding of the venture
unless it began to generate a profit. Eventually Collins (P) sued Lewis (D),
seeking dissolution of the partnership, the appointment of a receiver, and
foreclosure of a mortgage upon Lewis’ (D) interest in the partnership’s assets.
Lewis (D) filed a cross-action in which he alleged that Collins (P) had breached
his contractual obligation to provide funding for the enterprise. The trial court
denied Collins’ (P) petition for appointment of a receiver, and a jury, after finding
that the partnership’s lack of success was attributable to Collins’ (P) conduct,
returned a verdict denying the other relief sought by Collins (P). From the
judgment entered pursuant to that verdict, Collins (P) appealed.
Issue: Does a partner always have the right to obtain dissolution of the
Rule: A partner who has not fully performed the obligations imposed on him by
the partnership agreement may not obtain an order dissolving the partnership.
Analysis: In this case, the jury specifically found that Collins’ (P) conduct
prevented the cafeteria venture from succeeding. It was because Collins (P)
withheld the funds which were needed to cover the expenses incurred by the
business, thus requiring Lewis (D) to expend the cafeteria’s receipts in order to
meet those expenses, that the business showed no profit. In refusing to pay
these costs, Collins (P) breached his contractual obligations, and he is therefore
precluded from obtaining either dissolution or foreclosure. If Collins (P) is
adamant in his desire to be released from the partnership, his only recourse is to
take unilateral action to end the relationship, thus subjecting himself to a suit for
the recovery of whatever damages Lewis (D) may sustain.
Comment:: Sometimes partnerships are created for a specific period of time;
e.g. 15 years. Or, they maybe established for an indefinite but determinable
period of time, as is the case with partnerships that are to continue until the death
of one of the partners. For good cause, partnerships may also be dissolved by
judicial decree. This last method of termination is comparatively rare, however.
Even partners who are locked in an irreconcilable dispute usually manage to
agree to some plan which enables one or all of them to exit gracefully, because
whatever settlement the feuding individuals can work out is likely to prove more
economical than court ordered dissolution, a procedure which typically results in
the partnership property being disposed of for considerably less than it actual

Assignment: Not that an assignment is not an automatic dissolution, nor is the

levy of a creditor’s charging order against a partner’s interest. But the assignee
or the creditor can get a dissolution decree on expiration of the partnership term
or at any time in a partnership at will (UPA §30-32)

Death of a partner: On the death of a partner, the surviving partners are entitled
to possession of the partnership assets and are charged with winding up the
partnership affairs w/o delay. (UPA §37). The surviving partners are charged
with a fiduciary duty in liquidating the partnership and must account to the estate
of the deceased partner for the value of the decedent’s interest.
Cauble v. Handler (1973) (p. 78)
Facts: Cauble and Handler (D) were equal partners in a retail furniture and
appliance business. Cauble eventually died, and the administratrix (P) of his
estate sued Handler (D) for an accounting of the partnership’s assets. After
receiving the report of a court appointed auditor, the trial judge awarded Cauble’s
administratrix (P) $20.95 and some interest. He then taxed the entire $1800 in
auditor’s fees to the administratrix (P). She appealed, claiming that the court
should have used market value rather than cost in appraising the existing
partnership assets and that the court should have awarded her half of the more
than $40,000 that Handler (D) had earned in profits by continuing to operate the
partnership’s business after Cauble’s death.
Issue: Does the non-continuing partner have a right to share in the profits
earned by a partnership after the date of its formal dissolution?
Rule: If a partnership continues to do business after it has been formally
dissolved, the non-continuing partner or his representative may elect to receive
his share of the profits earned by the firm after the date of its dissolution.
Analysis: The trial court did err in computing the worth o the partnership assets
by their book value rather than their market value. But, of far greater moment
was the court’s erroneous refusal to award ½ of the profits which Handler (D)
earned after the partnership was dissolved by Cauble’s death. When Handler
(D) continued to operate the business after Cauble died, the administratrix (P)
had several choices. She could have insisted on liquidation, which would have
entitled her to 50% of the proceeds of the sale of all partnership property.
Instead, she permitted the business to continue. She thus became eligible to
receive the value of Cauble’s interest as of the date of dissolution. And
according to § 42 of the Uniform Partnership Act, she also had the right to elect
to receive a share of the profits from the continuing business. There is no
question but that she exercised that right at or before trial. The judgment must
be reversed and a new trial held, at which the court might also reconsider the
decision to charge the entire auditor’s fee to the administratrix (P).
Comment:: Cauble v. Handler describes in detail the options which are available
to a non-continuing partner or his personal representative upon the dissolution of
partnership. The various rights which may be exercised if the partnership
continues in operation after the dissolution are of increasing importance. This is
because dissolutions today only rarely result in the cessation of business.

Withdrawal or admissions of a partner: Most partnership agreements provide

that admitting or losing a partner will not result in dissolution. New partners may
become parties to the preexisting agreement by signing it at the time of
admission to the partnership.
Adams v. Jarvis (1964) (p. 82)
Facts: Adams (P), Jarvis (D), and a 3rd Dr. (D) entered into a medical
partnership. They executed a partnership agreement which provided, among
other things, that the firm would continue to operate as a partnership eve if one of
the Drs. withdrew. The agreement also provided that a withdrawing partner was
entitled to share in the profits earned for any partial year that he remained a
member of the partnership but that all accounts receivable were to remain the
property of the continuing partners. On 6/1/61, Adams (P) withdrew from the
partnership. Adams (P) later sued for a declaration that he was entitled to share
in the assets of the partnership, including its accounts receivable. The trial court
concluded that Adams’ (P) withdrawal had worked a dissolution of the
partnership, that the provisions of the partnership agreement were not controlling
since a statutory dissolution had been ordered, and that Adams (P) was entitled
to recover 1/3 of the value of the partnership’s assets, including the accounts
receivable. From this judgement, the surviving partners (D) appealed,
contending that the trial court should have given effect to the provisions of the
partnership agreement.
Issue: Should a court enforce the provisions of a duly executed partnership
Rule: A partnership agreement which provides for the continuation of the firm’s
business despite the withdrawal of one partner and which specifies the formula
according to which partnership assets are to be distributed to the retiring partner
is valid and enforceable.
Analysis: In this case, the parties unambiguously agreed that their partnership
would not terminate when one of the Drs. withdrew from the firm. There are
obvious reasons why they would have made provision for the continuance of the
partnership, and where an express agreement has been reached, to that effect,
there is no reason why statutory rules relating to withdrawal should operate to
effect a dissolution. The Drs. also agreed that a withdrawing partner would have
no right to share in the firm’s accounts receivable, and this provision is also
enforceable, despite Adam’s (P) contention that it is contrary to public policy. It is
altogether reasonable that the remaining partners should be able to reserve
exclusive control over the accounts of an ongoing firm’s active customers. Of
course, some of the accounts receivable were ultimately collected during the
year of Adam’s (P) withdrawal and thus constitute profits in which he is entitled to
share. Since the court below failed to give effect to the provisions of the parties’
partnership agreement, it is necessary that its judgment be reversed, with
directions to conduct supplementary proceedings at which Adams’ (P) proper
distributive share of the partnership assets may be ascertained.
Comment:: In most jurisdictions, matters pertaining to the distribution of
partnership assets and continuation of the firm following one partner’s withdrawal
are regulated by statute. Partners usually prefer to reach agreement among
themselves concerning these matters since a statute designed to apply to an
infinite variety of situations will rarely achieve a problem-free result when applied
to a particular firm. If such an agreement is struck at the beginning stages of the
partnership, both withdrawing and continuing partners are likely to be dealt with
fairly, because no individual is apt to know at the outset whether he is destined to
be a surviving partner or a withdrawing one.

Meehan v. Shaughnessy (1989) (p. 88)

Facts: Meehan (D) and Shaughnessy (P), and others were partners in the law
firm of Parker, Coulter Daily & white. Meehan (D), Boyle (D), and Cohen (D)
decided to from their own law firm and take certain clients with them. In the
planning process for the new firm, they contacted such clients by letter on
Parker, Coulter letterhead and asked whether or not they would come with them
to the new firm. On at least 3 occasions, they failed to honestly respond to their
partners’ inquiries as to whether or not they were leaving the firm. They met with
certain clients to determine whether or not such clients would continue to request
their particular legal services when the new firm was chosen. Some clients
signed authorizations forms allowing for the case files to be transferred to the
new firm. When Meehan (D) and the other eventually left the firm, Shaughnessy
(P), on behalf of the old firm, sued, contending that this solicitation of current
Parker, Coulter clients in anticipation of forming a new firm was a breach of
fiduciary duty. The trial judge found that Meehan (D), Boyle (D), and Cohen (D)
did not continuously interfere with Parker, Coulter’s relations with clients.
Shaughnessy (P), on behalf of Parker, Coulter, appealed, contending the trial
court had erred in this regard.
Issue: Do partners owe a partnership a fiduciary duty not to act for their personal
Rule: Partners owe the partnership a fiduciary duty of utmost good faith and
loyalty and may not act or fail to act for purely private gain.
Analysis: The secrecy and dishonesty displayed by Meehan (D) clearly
breached the fiduciary duty to the existing partnership, rendering the solicitation
of clients actionable. As a result, Parker, Coulter is entitled to recover damages
directly stemming from this interference with client relations. Even though the
partnership agreement was breached by Meehan (D), by such conduct he does
not forfeit his rights to his capital contributions to the partnership. Only those
client’s fees which were directly related to this interference may be recovered by
Parker, Coulter. Reversed; case remanded.
Comment:: The court rejected 2 of Parker, Coulter’s allegations against the new
firm while accepting the claim of interference with client relations. The other 2
allegations were that Meehan and others breached fiduciary duties by improperly
handling cases for their own and not the partnership’s benefit, and by secretly
competing with the partnership. The trial court found as a matter of fact that the
departing partners did not mismanage their cases while still at Parker, Coulter
and in fact handled their files consistently with their partnership duties. As a
result, no recovery was granted on this basis

Illegality: Dissolution results from any event making it unlawful for the partnership
to continue in business.

Death or bankruptcy: W/o an agreement to the contrary, the partnership is

dissolved on the death or bankruptcy of any partner. (UPA §31(4), (5))

Dissolution by court decree: courts, in its discretion, may in certain circumstance,

dissolve a partnership. These circumstances include insanity or a partner,
incapacity, improper conduct, inevitable loss, and/or wherever it is equitable
(UPA §32)
Gelder Medical Group v. Webber (1977)(p. 103)
Facts: Webber (D) joined an existing medical partnership, agreeing to the
partnership agreement which provided for expulsion without cause and, upon
expulsion or resignation, a covenant not to compete. He other partners expelled
him for alienating the patients, and he was paid off according to the terms of the
partnership agreement. He thereafter engaged in practice, and the partnership,
Gelder Medical Group (P), sued to enjoin his practice through enforcement of the
covenant not to compete. Webber (D) cross-complained for declaratory relief
and breach of contract, contending he could not be expelled without cause and
that the covenant not to compete was unenforceable. The trial court granted
Gelder’s (P) motion for summary judgment and denied recovery on the cross-
claim. Webber (D) appealed, yet the appellate court affirmed. The court of
appeals granted certiorari.
Issue: May a partner who has been forced out of a partnership be held to a
covenant not to compete?
Rule: A partner who has been forced out of a partnership as permitted by the
partnership as permitted by the partnership agreement may be held to his
covenant not to compete.
Analysis: Partnership agreements may validly allow expulsion with or without
cause. A partner agreeing to such must abide by the agreement. As the
restrictive covenant was reasonable in its scope, it was enforceable. Affirmed.
Comment:: The court rejected the argument that a partner could only be
expelled when the remaining partners felt in good faith there was cause for such
exclusion. The court further rejected the suggestion that even if such good faith
were required, the ousted partner was not relieved of his burden to establish a
lack of good faith.
Distribution of Assets:
(1) Partnership Debts: must be paid first.
(2) Captial Accounts: Then amounts are applied to pay the partners their
capital accounts (capital contribution + accumulated earnings –
accumulated losses)
(3) Current Earnings: If there is anything left over, the partners receive
their agreed share of current partnership earnings. (UPA §40)
(4) Distributions in kind: Where there are no partnership debts, or where
the debts can be handled from the cash account, partnership assets
may not be sold, but they may be distributed in kind to the partners.
(5) Partnership Losses: Where liabilities exceed assets, the partners must
contribute their agreed shares to make up the difference. (UPA §18(a))
Rights of Partners:
(1) No violation of agreement: If the dissolution does not violate the
partnership agreement, the partnership assets are distributed as set
forth above, and no partner has any cause of action against any other
(2) Dissolution violates agreement: Where dissolution violates the
partnership agreement, the innocent partners have rights to those
listed above.
(a) Rights to Damages: Innocent partners have a right to damages (i.e.
lost profits due to dissolution, etc.) against the offending partner.
(UPA §38(2))
(b) Right to continue the business: The innocent partners also have
the right to continue the partnership business (i.e. not sell off and
distribute the assets) by purchasing the offending partner’s interest
in the partnership. (UPA §38(2)(b) – provision for posting bond
and beginning court proceedings). Alternatively, the innocent
partners may simply dissolve and wind up the business, paying the
offending partner his share (less damages).
Effects of Dissolution:
(1) Liability of partners for existing partnership debts remains until they are
(2) New partnership remains liable for old debts:
(3) Retiring partner’s liability for debt incurred by partners continuing in the
• A retiring partner must make sure that prescribed
procedures are followed to terminate any possible liability for
partnership obligations. The UPA provides that notice of
withdrawal or dissolution may be published in a newspaper
of general circulation (UPA §35(1).

H) Inadvertent Partnerships: A partnership may be formed inadvertently (i.e.

not by express mutual consent, but by implication)
Martin v. Peyton (1927) (p. 110)
Facts: The partnership of Knauth (D), Nachod (D), and Kuhne (D) was in
financial difficulty. Hall (D), one of the partners, arranged a loan from Peyton (D)
and other friends (D). In exchange for the loan of $2,500,000 in liquid securities,
Peyton (D) and the others (D) were to receive a percentage of the profits until the
loan was repaid. The relevant loan provisions and conditions were:
1) Peyton (D) was to have a veto over speculative investments;
2) An insurance policy was to be taken out on Hall’s (D) life;
3) The securities could be pledged as a loan;
4) And Peyton (D) and the others 9d0 were to receive dividends from the
Peyton (D) could not bind the partnership, nor could he initiate any action on his
own. The agreement specifically stated that it was a load and not a partnership
arrangement. It stated that no liability was to accrue to Peyton (D) and the others
(D) for the partnership debts. Martin (P), a creditor of the partnership, brought
suit against it plus Peyton (D) and the others (D). Martin (P) alleged that a
partnership interest had been formed by the agreement. The court found for
Peyton (D).
Issue: Where the only control exerted or sharing of profits occurs to protect and
pay off a loan, will a partnership arrangement by found?
Rule: While words are not determinative, where a transaction bears all of the
aspects of a loan, no partnership arrangement will be found.
Analysis: If the words, cats, and agreements establish the existence of a
partnership arrangement; the parties will be liable as partners. Nothing in
Peyton’s (D) words or actions establishes a partnership. Therefore, the court
must look to the contract alone. Nothing in it is other than what were necessary
precautions to protect the loan. Any control was negative in nature and was to
prevent any misuse of the funds. Peyton (D) had no right to control or initiate
policy or to bind the contract. This was a loan, and Peyton (D) and the others (D)
are not liable. Judgement affirmed.
Comment:: A partnership results from either express or implied contracts. An
arrangement for the sharing of profits is often an important factor in determining
the existence of a partnership. Of equal importance is the right to share n the
decision making function of the partnership and/or to bind the partnership to
contractual obligations.

Smith v. Kelley (1971) (p.114)

Facts: Kelley (D) and Galloway (D) were partners in an accounting firm for which
Smith (P) went to work aas a salaried employee. Smith (P) contributed no assets
to the firm, had no authority to hire or fire personnel or to make purchases, had
no managerial authority, executed no promissory notes on behalf of the firm, and
was not obligated to bear any losses of the firm. Kelly (D), Galloway (D), and
another employee all concurred in the fact that there had never been any
agreement that Smith (P) would be a partner or would share in the firm’s profits.
Smith (P) was held out to members of the public as a partner and was
designated as a partner on the firm’s tax returns and a statement filed with a
state agency. Smith (P) was also listed as a partner in connection with a contract
entered into by the firm and in connection with a lawsuit the firm filed. After
resigning from the firm after 3 ½ years tenure, Smith (P) claimed to have been a
partner and argued that he was entitled to 20% of the firm’s profits. When Kelley
(D) and Galloway (D) disputed his right to share in the firm’s profits, Smith (P)
sued for an accounting. The Chancellor concluded that no partnership had
existed and therefore dismissed the action. Smith (P) appealed.
Issue: May the existence of a partnership arrangement be established despite
proof that there was never any intention to create one?
Rule: Unless the rights of 3rd parties are involved, a partnership cannot exist in
the absence of an intention to create it.
Analysis: A partnership is a contractual relationship, and the Chancellor, after
evaluating the testimony of all the witnesses, found that there was never any
agreement that Smith (P) would be a party or would share in the firm’s profits. In
an action by an outsider, the parties’ conduct might estop them from denying that
Smith (P) was a partner in the firm. But, for purposes of an action for an
accounting, actual intent that a party be accorded the status of a partner must be
established. Since the evidence presented justified the conclusion that Smith (P)
was not intended to enjoy the status of a partner, the Chancellor properly
dismissed his action.
Comment:: The rule announced by Smith v. Kelley court is not applied
uncompromising. In fact, certain factors are frequently deemed sufficient to
establish a partnership even where no such arrangement was intended. For
example, an agreement to share profits was, at common law, often considered
sufficient to prove a partnership. Under the Uniform Partnership Act, such an
agreement is deemed prima facie evidence of the existence of a partnership
arrangement. Of course, as was acknowledged by the Smith v. Kelley court, 3rd
parties may find it easier to establish a partnership than might a would-be

Young v. Jones (1992) (p.115) PARTNERSHIP BY ESTOPPEL

Facts: On the basis of an audit letter issued by the Bahamian general
partnership of Price Waterhouse (D) (PW-Bahamas) regarding the financial
statement of Swiss American Fidelity and Insurance Guaranty (SAFIG), Young
(P) deposited more than ½ million dollars in a South Carolina bank, which was
then sent by others from the bank to SAFIG. SAFIG’s financial statement had
been falsified. When young’s (P) funds disappeared, he filed suit against both
PW-Bahamas (D) and PW-United States (D). Young (P) asserted that PW-
Bahamas (D) and PW-US (D) operated as a partnership for profit. Young (P)
alternatively contended that if the 2 were not actually operating as partners, they
were operating as partners by estoppel. PW-US (D), denying that a partnership
existed between itself and PW-Bahamas (D), moved to dismiss the action.
Issue: Is a person who represents himself to anyone as a partner in an existing
partnership liable to any such person who has, on the faith of the representation,
given credit to the actual or apparent partnership?
Rule: A person who represents himself to anyone as a partner in an existing
partnership is liable to any such person who has, on the faith of the
representation, given credit to the actual or apparent partnership.
Analysis: In this case, Young (P) asserted that a PW (D) brochure cast PW (D)
as an established international accounting firm and that the image was designed
to gain public confidence in the firm’s stability and expertise. However, Young
(P) did not contend that the brochure was seen by him or relied on by him in
making the decision to invest. In fact, there was no evidence that Young (P)
relied on any act or statement by any PW-US (D) partner that indicated the
existence of a partnership with PW-Bahamas (D). The motion to dismiss is
Comment:: Under §7 of the Uniform Partnership Act (UPA) persons who are not
partners as to each other are not partners as to 3rd persons. However, §16 of the
UPA, the rules applied by the court in this case, constitutes an exception to the
general rule. However, since there was no evidence that credit was given by
Young (P) to any actual or apparent partnership, the requirements of the
exception were not satisfied.

June 1 Assignment
4 things that the IRS looked at
Corporation: If you have 3 or 4 you are seen as a corporation
Partnership: 2 or less

(a) Limited liability (YES – you look like a corporation)

(b) Continuity of life (YES – you look like a corporation, even with stated ending
(c) Centralized management?: (YES – Corporation, shareholders can’t enter into
Ks for the company, only authorized management can – power is limited to a
handful of people)
(d) Transferability: (YES – Corporation anyone can sell their shares of stock)

III) Other Unincorporated Business Forms (pp. 119-165)

A) In General
(a) Proprietorship: Liability, Single tax paid by individual
(b) General Partnership: Liability, fill out tax form, tax paid by individuals:
(c) Limited Partnership : One person has unlimited liability,
 LLP w/ one or more individuals as general partners:
 LLP w/ corporation or other limited liability entity as general partner:
Corporation has unlimited liability)
 LLP which elects to be a limited liability partnership:
 LLP Member managed limited liability company:
(d) Limited Liability Company:
 Member managed:
 Manager managed:
(e) Corporation (Incorporated Business Forms)
 S Corporation: Files for under subchapter S tax code
 C Corporation: Normal taxing (2 levels of tax, limited liability shield)

B) The Limited Partnership: Limited partnerships are entities created by

modern statutes. They were developed to facilitate commercial investments
by those who want a financial interest in a business but do not want all the
responsibilities and liabilities of partners.
(1) Definition: A limited partnership is a partnership formed by 2 or more
persons and having as its members one or more general partners and one
or more limited partners.
(a) General Partner: Assumes management responsibilities and full
personal liability for the debts of the partnership
(b) Limited Partner: makes a contribution of case, other property, or
services rendered to the partnership and obtains an interest in the
partnership in return – but is not active in management and has limited
liability for partnership debts.
(c) A person may be both a general and a limited partner in the same
partnership at the same time. In such a case, the partner has, in
respect to his contribution as a limited partner, all the rights which she
would have if she were not also a general partner.
(2) Purpose: A limited partnership may carry on any business that a
partnership could carry on.
(3) Liability: The general partner is personally liable for all obligations of the
partnership. A limited partner, has no personal liability for partnership
debts, and his maximum loss is the amount of his investment in the limited
(a) Exception: Where a limited partner takes part in the management and
control of the business, he becomes liable as a general partner.
(4) Rights of Limited Partners: The rights of a limited partner are substantially
the same as those or a partner in an ordinary partnership, except that he
has no rights in regard to management. He has rights of access to the
partnership books, to an accounting as to the partnership business, and to
a dissolution and winding up by decree of court.
(a) Limited partner may lend money to, or transact business with the
(b) A limited partner’s interest is assignable, unless the agreement
provides otherwise. The assignment vests in the assignee all rights to
income or distribution or assets of the partnership, but unless and until
the certificate of limited partnership is amended with the consent of all
other partners, the assignee is not entitled to inspect partnership
books, obtain an accounting, etc.

Formation of limited partnership: While formalities are usually not required to

create a partnership, there are certain requirements for the formation of limited
(1) The partners must execute a certificate setting forth the name of the
partnership, the character of the business and the location of the principal
office, the name and address of each of the partners and their capital
contributions, a designation of which partners are “general” and which are
“limited”, and the respective right and priorities (if any) of the partners.
(2) A copy of the certificate must be recorded in the county of principal place of
business. The certificate may be amended or cancelled by following similar
(a) If the certificate contains false statements, anyone who suffers a loss by
reliance thereon can hold all of the partners (general and limited) liable.
(b) The purpose of the certificate is to give all potential creditors notice of the
limited liability of the limited partners.
(3) The ULPA requires at least “substantial compliance in good faith” with these
requirements. Where there has been no substantial compliance, the
purported limited partner may be held liable as a general partner.
(a) A purported limited partner can escape liability as a general partner if –
upon ascertaining the mistake – he “promptly renounces his interest in the
profits of the business or other compensation by way of income.

Continental Waste System, Inc. v. Zoso Partners (1989)(p. 121)

Issue: If a limited partnerships filings were defective according to statute, does
this preclude the formation of a limited partnership?
(1) Any contract entered into prior to the date on which the limited partnership
certificate was filed and made of record, would be contracts entered into by a
general partnership and all partners involved would be liable as general
(2) If one of the limited partners participated in the management of the enterprise
the partnership is a general partnership and that general partner is personally
Comment:: A purported limited partner can escape liability as a general partner if
– upon ascertaining the mistake – he “promptly renounces his interest in the
profits of the business or other compensation by way of income. The modern act
requires reliance (majority) . Courts balance on whether the creditor was relying
on the limited partnership (majority), versus what is fair. The people in control
should be liable (majority). If there is no actual notice and creditors think you are
a general partner and rely on this, the limited partner is liable.

Hypo #1: Corporation is General Partner of limited partnerships. Who does the
Board of Directors have a fiduciary responsibility to? The Shareholders of the
Corporation or the Limited Partners of the Partnership?

In re: USACafes, L.P. Litigation (1991)(p. 130)

Issue: Whether the board of directors of a corporate general partner owes
fiduciary duties to the partnership and its limited partners?
Rule: The principle of fiduciary duty, is that one who controls property of another
may not, w/o implied or express agreement, intentionally use that property in a
way that benefits the holder of the control to the detriment of the property or its
beneficial owner. A fiduciary cannot use his/her position to help yourself at the
expense of another.
Comment:: Any officer who knowingly causes the corporation to commit a
breach of trust causing loss is personally liable to the beneficiary of the trust. The
corporate duty is there, but so is the duty to the limited partnership. There is no
liability shield for personal acts.

C) The Limited Liability Company: Between 1988 and 1997, every state
adopted LLC statutes that authorizes the creation of a new business form, the
“limited liability company” LLC.
(1) LLC is an unincorporated business organization that contains dissolution,
management and transferability provisions similar to those of a general
partnership but that can easily be altered to resemble the limited
partnership or to approach the corporate model.
(2) By combining the best of both worlds the tax advantages of a partnership
with limited liability protection for all members (usually associated with
corporations) the LLC can be seen as tax driven.
(3) LLC members unlike general partners, can adopt a management
structure resembling those of corporations or LLPs by appointing
managers. LLC managers, hold the power to make important policy
decisions and to bind the LLC in day to day business transactions This
takes on the role of general partners and corporate directors and officers)
(a) Scope of liability:
(b) 2 member requirement:
(c) Piercing the veil:
Poore v. Fox Hollow Enterprises (1994) (p. 140)
Issue: LLC is not a corporation, does a licensed attorney have to represent the
LLC in court?
Rule: The underlying purpose of the rule prohibiting the appearance of a
corporation by anyone other than a member of the Delaware Bar also apples to
the representation of LLCs.
Comment:: LLC is an artificial entity, like a corporation, and therefore an agent
must represent it. With this in mind the statute states that a member of the
Delaware Bar must represent the LLC

Meyer v. Oklahoma Alcoholic Beverage Laws Enforcement Commission (1995)

(p. 141)
Issue: Can an LLC hold a liquor license?
Rule: Statute says that corporations cannot hold a liquor license, the court said
that the LLC is more like a corporation, therefore LLC cannot be licensed.
Comment:: The only entities that can hold the liquor license are partnerships and
individuals. The Uniform partnership act defines a partnership and the LLC does
not fall in this class. The difference is that a partnership ahs liability, and an LLC
does not. The Court reasoned that to have a liquor license there has to be some
personal responsibility and if the form of the business does not give you that then
it is excluded from holding a liquor license.

D) Federal Income Taxation of Business Forms: Herein of “Check-the-box”

Income = Receipts – Expenses _
Effective Tax Rate: What are you paying net in taxes? Average Tax Rate = X rate
Marginal Tax Rate: Last $$ rate

Types of Taxation
(a) Corporate Tax Rates (p. 145) (Top effective rate is 35%)
(1) C Corporation: Taxed once, and if they keep the money no more tax.
However if dividends are paid, individuals must pay tax on the dividend
only on the amount that is distributed.
(2) S Corporation:
(3) Personal Services Corporations: Taxed at a flat 35%.
(b) Individual Tax Rates (p. 146) (Top effective rate is 39%) Tax on what you
earn. (Proprietorship, Partnership (problem is that the partnership can
keep the money, but income tax must be paid no matter what was
distributed to you)

Progressive Tax System: Higher taxes with higher income.

Regressive Tax System: (Sales taxes are naturally regressive) Tax affects those
with a lower income more. (Flat tax on all types of income is not that way)

June 3 Class Discussion

Taxation of Capital Gains or Losses (p. 147)
(1) Who pays taxes
(2) Are they paid 2x (is corporation taxed as a separate entity)
Mexico: If a corporation pays taxes, then dividends are not paid by you again
(Integrated tax system): US Investors would still pay tax on the distribution
(3) What are capital asset taxes
 Capital Asset: Definition
 Basis: What the stock was worth when you purchased
Exception: If stock is inherited the basis is the FMV at time of death
Adjustments: Non on stock
Home improvements, legal fees for transaction,
depreciation of value of capital asset (MACRS)
 Amount Realized - Basis = Income
 Tax Treatment on Capital Gains: v. Partnerships, Sole proprietorships,
personal income tax: Only pay the tax on the Capital Asset when the gain is
realized (paid out)
 Dividends: tax must be paid the year the dividend is paid out.
 Current Approach:
If held less than 12 months taxed at normal income rate
If held for more than 12 months and less than 18 months: tax is
If Capital Asset is owned over 18 months, the maximum tax is 20%.

Flat Tax: All income taxed the same instead of by tables.

What is income to this?

Taxation of Partnerships and Corporations (p. 149)

Tax planning strategies (p. 153) Tax is the biggest areas to determine a
business form
(1) Don’t pay dividends if you are a C-Corporation: This way the corporation only
pays taxes, not double taxation on the dividends. When company reaches a
certain size, sell the stock; get capital gain and pay capital gain tax 1x.
Downside is more shareholders come in. instead:
(2) Corporation can buy stock back from you (Corporation redeems stock), and
the same takes place.
(3) Avoid corporation: Form an LLC
(4) Zero out: Make the corporation not have any income. Revenues – Expense
= Zero. Increase expenses to do this. Most popular expense to increase is
salaries (Big Bonus). Eat up a lot of profits. Individual taxes are paid, and
avoid corporate taxes. (e.g. rent to corp. land, take a loan from corp.) This is
OK as long as it is reasonable for that type of business. This is OK if
(5) Losses: If they are expected, it is common to start out with an entity which is
not taxed immediately, then convert to a corporation, which has the tax
barrier. There are now more restrictions on losses taken.
Sub Chapter S Corporation: Just like a normal corporation, but the exceptions
(1) Make a special filing to the IRS that you want to be treated like an S Corp
(2) Essential the individual is taxed, not the corporation
(3) Technically taxed slightly different
(4) Everyone does not choose this because
(a) You are limited to 75 shareholders
(b) Can’t have any non resident aliens as shareholders
(c) Couldn’t have a corporation or other entities as a shareholder (until 1997).
(d) Can only have one class of stock..
(e) Cannot own a controlling interest in another corporation and most other
types of entities.
S-Corp v. LLC: LLC gives pass through tax treatment and limited liability.
(1) Continuity of life
(2) Centralized management*
(3) Limited liability*
(4) Flow through treatment of a partnership (tax treatment)*
 Create an entity with limited liability, with 2 other of the 4 criteria the IRS
came up, and create a new entity taxed as a partnership. This gives the best
of both worlds. There is uncertainty with LLC’s.
 Some people take S-Corp because creating it is very simple, formal, well
defined, and there is plenty of case law.
 LLC will probably grow to be the entity of choice.
 LLC kills the 4 criteria test of whether you are a partnership v. a corporation.
 1/1/97 new regulations

Publicly held Limited Partnerships (p. 156)

Duties of partners v. shareholders
 Higher standard for partners
 LPs have become publicly traded entities. So the IRS and Congress said that
they are no longer looking at the 4 prong test

Check-the-Box: The End of the Kintner Regulations (p. 158)

Rules for how do you want to be taxed are: (Check the box as how you want to
be treated for tax treatment)
 If you call yourself a corporation, body politic, etc. you are a corporation by
the IRS
You still have the choice of C Corp or S Corp.
 If you don’t you any o the above words in your name, and have 2 or more
members, you can be either a corporation or partnership as far as the IRS is
concerned. The IRS does not care about limited liability.
 If you don’t choose, by default you are treated as a partnership.
 If one person is involved you can elect to be a corporation or you are by
default a sole proprietorship
 If you make an election and decide to change it, you have to stick with the
change for 5 years.
 If you are a publicly traded entity you are taxed as a corporation.
Concluding Thoughts on Limited Liability (p. 162)
Professional Corporation: Created because historically you were prohibited
from forming a corporation. The advantages of a professional corporation were
(1) you are not liable for everyone else liability, only your own;
(2) Profits cannot be shared with non-professionals in the professional
corporation (Lawyer cannot profit share w/ a non-lawyer
(3) Tax benefits: Life insurance could be paid with pretax money (but this has all
Most Professional organizations now have gone to LLCs

Limited Liability Company: These entities existed before check the box. Each
state handled this a little different. Model either on corporate or partnership
statutes. LLCs can be any where in between. Tremendous flexibility.
Terminology used
 Members: These are the same as shareholders in Corporations and partners
in partnerships.
 Agency type authority is given to members (any member can bind the entity).
This can be changed according to statutes, or if modified in the agreement.
 Governing structure is more like a partnership (do a head count vote) You
don’t vote as % of ownership or number of shares unless you modifiy you
articles of association. (Some states look at profit pd to each member)
 Manager managed: Usually authority comes from a hierarchy of manager
managed v. member managed. This is a hierarchy similar to t Board of
 Members are not liable for the wrongful acts of other members, only your own
acts. Limited liability for business debts, but excessive distribution must be
paid back by individual members.
 Most states require 2 members
 Default is that unanimous vote by all members to bring in a new member,
unless the power is delegated to the managers.
 Must say in the name of the LLC that they are an LLC (Notice concept)
 Ultimate governing document in a corporation is the articles of corporation
and then the By-laws. If there is a conflict the Articles are controlling.
 LLCs have Articles of organization. Operating agreement (like the By-laws)
The operating agreement is controlling in an LLC.
 Some states discourage LLCs by charging higher fees for formation and
having franchise taxes imposed on them.

2 questions on corporate law
1 question on think piece (Business Planning) MOST OF THIS HAS BEEN
Show the understanding of pros and cons of business planning
IV) Formation of a Closely Held Corporation (pp. 194-249)
A) Where to Incorporate
(1) What does it cost to incorporate
 How much does it cost to keep the corporation in that state?
 Where will you be doing business? You have to be registered in
that state that you do business regularly. You pay a fee for this as well.
 Looking at costs, Delaware has been a major choice, and look at
your home state.
 If you incorporate in Delaware and do business in Ohio you will
probably have to pay fees in both states
(2) Where are the state laws favorable for the corporation?
 Belief is that the advantage is in Delaware
 Look at the practical considerations to compare
 Publicly traded v. closely held: Most closely held are incorporated
in the state they operate
(3) Delaware
 More expensive, hire attorneys
 Taxes in Delaware and where you do business
B) How to Incorporate
(1) What do you need to do?
 Reserve your name (before you setup the corporation)
 File Articles of Incorporation (some states have an actual form to
use. This basically says
(a) Name of corporation
(b) # of authorized shares (if you change this you must amend the articles)
(c) Appointment of agent (so process can be served) & a registered office
(this is usually done by a special organization or attorney)
(d) Name and address of the incorporators (not necessarily the Board of
(e) Must be signed by the incorporator and the initial directors (indicate
your capacity)

June 8, 1998 CLASS

Learn the rules
Apply the rules
Examination: Don’t list a rule, point out the problematic areas of the rule and the
Partnership is a default setting, at the same time, if the plan is to set up a
corporation, you aren’t anything until you do business
Leave messages to regarding suggestions
Setting up a Corporation
1) Reserving a name (not necessary, but if you don’t someone else may take
the name from you.
(a) Registering a name: This is different. When you are a company in another
state and using it, you then register that name in a new state
2) Articles of Incorporation: Must file these w/ state before you are considered a
corporation. This is a Public Document and must look at the state statute
where you are incorporating in to see what is required. (Don’t put any more
than you have to on it) What is required in Articles of Incorporation:
(a) Needs a name: Can’t be deceptively similar to another company and
must have either, Corp, Incorp. or corporation)
(b) # of authorized shares (how many shares of ownership interest the
company can sell) This can be changed (but is done by amending the
articles with more than a majority vote) ( a quorum is needed for a vote: A
quorum is usually a majority of the outstanding # of shares outstanding)
Need a majority of those shares actually attending the meeting)
(c) Street Address of the Corporation’s registered office: What is the address
for the service of process?
(1) and the registered agent: Who should service to given to?
(d) Name and address of the incorporator: The incorporator is not responsible
for actions of the corporations
(e) Signed by the orignal incorporator or the the
(f) Optional:
(1) Duration of the corporation (if this is not stipulated it is set up in
(2) How the by-law can be altered: This affects how you will conduct
business (Most states allow this in the b-laws now)
(3) List of initial directors of the Company: Usually need 3 directors , but if
fewer than 3 shareholders then you can have as many directors as
shareholders (if there is only one person as a shareholder then only
one director is needed)
(4) Purposes of the Company: People don’t use this any more. People
usually say “to conduct all legal businesses.” That way they are not
 May do this because the corporation was setup for a specific
purpose (i.e. 2 competitors, jointly agree to undertake a special project;
also investors get a higher comfort level as to what they are all about)
 Usually non-profits list what their limited purpose is to be a non-
profit organization re: to IRS
(5) Power: This is what can be done to pursue the business (buy/sell
property; borrow/lend money; etc. ) Usually not listed, because you can
be excluded. If you list make sure that you put a caveat in the list “this
list is not exhaustive.”
(6) Par Value: This is for initial capitalization. (Not usually listed) Listing
this is saying that this is the minimum amount that stock is sold for.
(7) Anything in By laws can be included (not common)
(8) Anything that investors would be liable for
(9) Limit or eliminate the liability of the Board of Directors (The Officers are
not necessarily a member of the Board.) Shareholders appoint Board,
Board appoints the Officers. (this is fairly new – and the liability cannot
be totally eliminated)
3) By Laws: These are the detailed rules of how the company is run. How is the
board appointed, how much they make. Typically in the by laws
(1) Where the offices are
(2) What type of voted is needed
(3) What is a quorum
(4) Can you have a meeting by telephone
(5) Provisions that allow you to avoid having a meeting (p. 212) Allows to
do business w/o having a meeting. This must be unanimous written
consent because all the shareholders must agree. (This is allowed
because of the shareholders don’t have the opportunity for discussion).
A written consent is used in lieu of an organizational meeting.
(6) Powers, size, removal, vacancies, pay, committees, how many,
qualifications, of the Board
(7) Powers, size, removal, vacancies, pay, committees, how many,
qualifications, of the officers, what is the officers authorized authority
(8) Shares, types (what classes)
(9) Indemnity provisions of officers and directors
(10) Record keeping
(11) Fiscal year of the corporation (business year for reporting income to
the IRS
4) Organizational Meeting or Organizational Consent (p. 206)
(1) Adopt a minute book (how will records be kept)
(2) Show the by laws
(3) Adopt the form of the stock certificate
(4) Corporate seal (This is an evidentiary issue, but not required in US)
(5) Election of the officers
(6) Salaries
(7) Accept subscriptions of the shareholders (agreement to buy shares of
stock) Subscription agreement is a contract.
(8) List expenses (of business before set up) Vote on reimbursing
(9) Choose a bank
5) Register a trademark (this is not necessary but suggested)
6) Doing business in more than one state, register to do business in foreign
7) Need a minute book (3 ring binder OK, share certificate, stock and transfer
book; and seal (optional), Federal Tax ID #; Bank account (when opening one
the signature card must have the person authorized by at the organizational
meeting and subsequent meetings who can do this); shareholders agreement
(how and who you can sell stock shares to. (p. 732); employment contract;
special permits needed to do business;
Where to File
1) Secretary of State gets this (administrative) They only look to see if you
comply with the technical aspects
2) 2 copies are files with a fee
3) Filing may need to be acknowledged (Notarized – This acknowledges that
this is your signature and that they watched the signature and you presented
yourself as the identity of the persons signature you signed
4) Some states require a filing in the county.
5) Publish notice in the paper

Who does this?

1) The attorney
2) CT corporation or like service can do this for you.
3) Shelf corporation is a company that already exists and does no business (you
can buy this corporation that is already set up)


C) The Decline of the Doctrine of Ultra Vires

Ultra Vires Acts: literally means “beyond the powers.” When a corporation does
an act or enters into a contract beyond the scope of its charter, it is not
necessarily illegal and it is not necessarily void. Rather, it is voidable. The
doctrine of ultra vires is declining in importance and should not be applied to
purposes clauses of articles of incorporation. When you limit your purposes or
powers this act comes in to play.
English case: Ashbury Railway Cartage & Iron Co. v. Riche (1875), the
discussion surrounded the question of a contract’s being void from the beginning
because the object of the contract was beyond the powers of the corporation.
The corporation was allowed to repudiate a contract on the ground of ultra vires
after it had partially performed
Arguments for Ultra Vires: The limits of power are public record, caveat emptor.

Arguments against Ultra Vires: A corporation can injure others without any
repercussions. 20th Century courts did not like this so they made arguments of
estoppel, unjust enrichment, waiver, etc.

711 Kings Highway Corp. v. F.I.M.’s Marine Repair Serv., Inc. (1966)(p. 215)
Facts: 711 (P) leased premises to F.I.M. (D) for use as a move theater for 15
years. F.I.M. (D) paid a $5,000 security deposit. 711 (P) then tried to get a
declaratory judgment declaring the lease to be invalid or, in the alternative,
rescission on the grounds that the intended use was outside the scope of
permissible business activities under F.I.M.’s (D) charter. F.I.M. (D) moved to
dismiss arguing that only a shareholder could assert the claim brought by 711
Issue: Should a no act of a corporation and no transfer of property to or by a
corporation, otherwise lawful, be held by reason that the corporation was w/o
capacity or power to do such act or engage in such transfer except in an action
brought by a shareholder?
Rule: Yes. No act of a corporation and no transfer of property to or by a
corporation, otherwise lawful, shall be held invalid by reason that the corporation
was w/o capacity or power to do such act or engage in such transfer except in an
action brought by a shareholder.
Analysis: This also includes actions taken by or in the right of a corporation
against an incumbent or former officer or director. Clearly, under this rule, there
was no substance to 711’s (P) argument as 711 (P) did not fall under either
exception. Nor could 711 (P) escape application of the rule by claiming that it did
not apply to executory contracts. Complaint dismissed.
Comment:: Ultra Vires literally means “beyond the powers.” When a corporation
does an act or enters into a contract beyond the scope of its charter, it is not
necessarily illegal and it is not necessarily void. Rather, it is voidable. However,
under the English case: Ashbury Railway Cartage & Iron Co. v. Riche (1875),
the discussion surrounded the question of a contract’s being void from the
beginning because the object of the contract was beyond the powers of the
corporation. The corporation was allowed to repudiate a contract on the ground
of ultra vires after it had partially performed. However, the doctrine of ultra vires
is declining in importance and should not be applied to purposes clauses of
articles of incorporation.

Derivative Suits: Shareholders suing on behalf of the company. Someone did

something to harm the company, and it has a cause of action. The corporation
decided not to pursue a cause of action, but a shareholder decides to sue.
(1) Shareholder can sue an company (injunction, etc.) Are you an innocent
(2) A shareholder suing derivatively (in the name of the company)can sue an
officer, or director.
(3) Attorney General can sue if the corporation is acting outside the power or
purpose. (depending on the state law applied, and what state is being claimed
in, then this will help decide which Attorney General sues – state of
incorporation or state of action)

Theodora Holding Corp. v. Henderson (1969) (p. 217)

Facts: In 1955 Girard Henderson (D) and his wife, Theodora entered into a
separation agreement whereby Girard (D) gave her 11,000 shares of common
stock of ADI (D) and a number of shares of preferred. However, Girard (D)
retained voting control of ADI (D) through majority holdings amounting to
$150,000. Theodora continued thereafter to earn large dividends from this stock.
In 5/67, Theodora form Theodora Holding Co. (P) and transferred her 11,000
shares of ADI (D) common to Theodora Holding (P). ADI (D) common had a fair
market value at the time of $15,675,000. On 12/8/67, Girard (D) through his
voting control of ADI (D), reduced the board of directors from 8 members to 3 –
himself, Ljunggren, and Mrs. Ives, his daughter. Girard (D) then caused the
board to contribute ADI (D) stock valued at $550,000 to the Alexander Dawson
Foundation. Among other contributions was a tract of Colorado land worth
$467,750. The Dawson Foundation was a charitable trust controlled by Girard
Henderson (D), and he caused contributions to it to be made from 1957 to 1967.
These contributions received stockholders approval, including that of Theodora
Henderson while she was still a member of the board of ADI (D). This suit was
brought by the Theodora Holding Co. (P), attacking one contribution to the
Dawson Foundation of an ADI (D) share worth $528,000, asking for an
accounting by the individual defendants and Girard (D) and appointment of a
liquidating receiver for ADI (D).
Issue: May a majority shareholder cause a charitable contribution to be made out
of corporate funds over the protests of minority shareholders where such
contributions diminished the equity and dividends of those minority shareholders’
stock interest?
Rule: A majority shareholder may cause a charitable contribution to be made out
of corporate funds if such charitable gift is within reasonable limits as to amount
and purpose.
Analysis: The test applied in passing on the validity of any corporate gift is that
of reasonableness. Such test is based on the provisions of the IRS Code
permitting charitable gifts by corporations within 5% or annual income to be
deductible. Here, the $528,000 gift was made during a year (1967) in which
ADI’s (D) total income was $19,144,229, well within the allowable 5% figure.
Delaware statutes (Del. C. §122) provide that every corporation has the power to
make donations for the public welfare or for charitable, scientific, or educational
purposes. Indeed, courts encourage such philanthropic activity as an obligation
of corporations. In the present case, the $528,000 gift to the Dawson Foundation
was for consummating the purpose behind the 1966 purchase of the Colorado
land tract, namely to convert it into a western camp for underprivileged children.
The relatively small loss of immediate income to the Theodora Holding Co. (P) is
far outweighed by the benefits from the gift in supporting philanthropic or
educational activities via the children’s camp. Besides it is admitted by Theodora
Holding (P) that any loss in equity or dividends from the gift is softened by the
favorable tax consequences.
Comment:: Where a corporation makes a gift of corporate property or funds,
such transaction raises an Ultra Vires issue. Some courts do not allow gifts to a
director’s or majority shareholder’s pet charity. The question is whether the gift is
‘reasonably necessary’ to furthering a valid corporate objective. In California,
corporations are allowed to have the power to make unlimited gifts to charity.
However, for federal tax reasons corporations generally limit such charitable gifts
to within 5% of current annual profits.

Ultra Vires is dead, Charitable giving is OK. Charitable giving was raised to 10%
by Reagan. Most corporations give 1%.
June 10, 1998 Class Starts Here

D) Premature Commencement of Business

1) Promoters: includes a person who, acting alone or in conjunction with one or
more other persons, directly or indirectly takes initiative in founding and
organizing the business or enterprise of an issuer. A promoter is also know
as a founder or organizer under the SEC. Promoter owes fiduciary duties to
the participants in the venture as well as corporation itself. (i.e. the promoter
buys property for the corporation – he is not allowed to make a large
undisclosed profit on the sale.) (EXAM NOTE: PRICES ARE WAY OUT OF
Securities Exchange Act of 1933: Deals w/ formation and issue of shares.
Requires filing with the SEC of the names and any interaction between the
company and promoters
Securities Exchange Act of 1934: Deals with trading and ongoing business

Novation: Specific agreement between corporation, promoter, and 3rd party to

release the promoter from personal liability.

1. Pre-incorporation Promotion
a) General rule: a person signing for a nonexistent corporation is
personally liable unless there is clear intent expressed to the
contrary: (Do the parties know it’s pre-incorporation or think the
corporation is already set up)
(1) Thus, when person signs contract for architectural services
as “agent for a corporation to be formed who will be the
obligor,” that person is liable if the corporation is never
formed. (Stanley J. How & Assoc. v. Boss)
Promoters are personally liable, unless one of the following are agreed to by the
other party:
(a) Contract w/ promoter and other company if corporation
accepts promoter and corporation on the hook.
(b) Revocable offer  Future Corporation (if corporation
formed and accepts K)
(c) Irrevocable offer  consideration is that promoter
formed the K corporation accepts with liability being
released to corporation (when formed)
(2) The upshot is that you must make it expressly clear that the
individual isn’t to be liable
b) Cover Your Ass (CYA)! – get copies of the stamped, filed
incorporation document before closing anything!
c) Restatement (2d) of Agency §326, comment b: Intent can be
shown by a revocable offer, offer made irrevocable for a limited
time with promoter’s implied promise to use best efforts to
incorporate, etc.
d) At the end of the day, though, any ambiguity is held against
the agent
e) Clarity in signature of contract: Who are you, President of the
Corporation or an individual
Correct Signature: ABC Corp, by DBMcDonagh, President
Incorrect Signature:
ABC Corp.,
signature and corporate seal (you’ll be liable) or
ABC Corp,
By DBMcDonagh, President,
DBMcdonagh (w or w/o President) This shows that you intended to be liable
ABC Corp,
signature, Authorized
signature. (corp probably not bound and personally bound)

Stanley J. How & Assoc., Inc. v. Boss (1963) (p. 225)

Facts: Boss (D), a corporate promoter entered into a contract w/ How & Assoc.
(P) for architectural services. How & Assoc. (P) were to design a building for a
corporation Boss (D) was forming. Boss (D) signed the contract as agent for the
corporation to be formed which was to be the obligor. The corporation was never
formed, and the building designed by how & Assoc. (P) was never constructed.
How & Assoc. (P) sued for the contract price, alleging that Boss (D) was liable as
the corporate promoter.
Issue: Is a corporate promoter liable for contracts signed by him as an agent for
a corporation yet to be formed?
Rule: A promoter will be liable on a contract he entered into on behalf of a
corporation yet to be formed unless the other party agreed to look to some other
person or fund for payment.
Analysis: There are 3 exceptions to this rule:
(1) the contract is treated as an option which can be accepted by the corporation
when it is formed, and the promoter agrees to form the corporation, give it the
opportunity to pay;
(2) a novation with the corporation assuming the promoter’s liability and
replacing him in the contract;
(3) the promoter remains liable even after formation but only as a surety.
Boss (D) argued that his signature “as agent for the corporation to be formed
which is to be obligor” makes the corporation, only, liable for the debt. In
deciding on the meaning of ambiguous phrases, it is necessary to look at them in
light of the entire contract. Much of the performance due would have been
completed prior to the formation of the new contract. As a general rule, where
work is to be performed prior to incorporation, the promoter will be personally
liable unless another person or fund is made so under the contract. Since this
was not the case, no novation clause was contained in the contract and How &
Assoc. (P) stated that they thought Boss (D) was to be liable, we must follow the
general presumption that the promoter will be liable. Since Boss (D) did not
plead novation, his only defense is that the contract was really a continuing offer
and was not valid until accepted by he new corporation. There is no showing of
this. Judgement for How & Assoc. (P).
Comment: Statutory authority aside, this decision is a matter of policy. The law
normally excuses an agent from liability for contracts he entered into in an
agency capacity. The principal’s reputation and resources are the ones which
induced the other party to enter into an agreement. When the principal is not yet
in existence. The agent’s reputation and assets must be assumed to have
induced the other party to enter the contract.

Fact based inquiry, based on intent, be very clear if the entity is not formed (that
they will not go after the promoter if the corporation is not formed)

Quaker Hill v. Parr (1961) (p. 231)

Facts: In May 1958, Parr (D) and others formed and incorporated Denver
Memorial Gardens, a cemetery corporation not a party to this action.
Subsequently, and (as was found by the trial court) at the insistence of Quaker
Hill Inc. (P), Parr (D) and others agreed to form a corporation to be called Denver
Memorial Nurseries, for the purpose of executing a contract between that
corporation and Quaker Hill (P) for the purchase of certain nursery stock. On
May 16, the contract was executed by Quaker Hill (P) and “Denver Memorial
Nursery Inc., E.D. Parr, President; James P. Presba, Secretary-Treasurer,” with
Parr (D) paying $1,000 down, the balance due under a promissory note. The
shipment of stock arrived on May 26. On May 27, Parr (D) incorporated
“Mountain View Nurseries,” with Quaker Hill P) accepting that name and
executing a new promissory note. Prior to the due date of the note, however, all
the purchased stock died. Quaker Hill (P) now sued Parr (D) to hold him
personally liable for the promissory note he executed for the Nurseries. From a
judgment for Parr (D) Quaker Hill (P) appeals, contending that promoters should
be held liable for contracts which they enter into on behalf of corporations “to be
Issue: Will a party acting as a promoter for a proposed corporation always be
held personally liable for agreements entered into in that capacity?
Rule: No. While promoters are personally liable on contracts made on behalf of a
corporation “to be formed,” if (1) a contract is made on behalf of such a
corporation, and (2) the other party agrees to look to the corporation and not the
promoters for payment, the promoters incur no personal liability.
Analysis: This is a well recognized exception to the general rule asserted by
Quaker Hill (P). Here, Quaker Hill (P) was well aware that the corporation had
not been formed and nevertheless urged it be made in its name. There is little
evidence that they ever intended to look to Parr (D) for payment. Rather, it was
clear from the start that they contemplated that the corporation be the other
contacting party. Personal liability does not arise under such circumstances.
The judgment was affirmed.
Comment:: This case points out the primary exception to the general rule that
promoters are to be held personally liable on contracts made on behalf of a
corporation “to be formed.” Similar to the doctrine of estoppel involved in
Cranston, a party will not be permitted to reach the individual contracting for the
corporation where that party has somehow evinced an intention to look to the
corporation, not the promoter for payment. Many things may be evidenced of
intending to treat the proposed corporation as an actual corporation. The most
common is evidence of reliance on the credit of the proposed corporation as
opposed to the credit of the individual promoter. Where the promoter is held to
be personally liable under a contract, the general rule Is that he may also be
permitted to personally enforce the contract against the other party.


Corporation has no liabilities that it does not agree to. The new corporation must
accept all contracts.
Corporation will almost always be found to have accepted the contract made by a
promoter before the new corporation became an entity. (Ascent of agreeing to
shift the contract from promoter to corporation is usually built into the K. The
corporation must agree)
McArthur v. Times Printing Co. (1892) (p. 235)
Facts: In Sept. 1889, promoters were active in procuring the organization of
Times Printing Co. (D) to publish a newspaper. On or about Sept. 12, one of
these promoters (Nimocks) made a contract with McArthur (P) on behalf of the
contemplated company for his services as advertising solicitor for period of 1
year from and after Oct. 1, the date at which it was expected the company would
be organized. The company was not organized until Oct. 16, but the publication
of the newspaper began. McArthur (P) began the discharge of his duties and
after the organization of the company, continued in his duties until discharged in
April. No formal action was ever taken regarding the contract, but all of the
stockholders, directors, and officers of the corporation knew of it and none
rejected it. The lower court ruled for McArthur.
Issue: Can a corporation be held liable for contracts made on its behalf by
promoters before incorporation?
Rule: Yes. Formal adoption or acceptance of a contract by a corporation is not a
part of the corporation or its authorized agents.
Analysis: A corporation may not be bound by engagements made on its behalf
by its promoters before its organization, but it may, after its organization, make
such engagements its own contracts. Formal action of the board would be
necessary only where it would be required in the case of an original contract..
Adoption or acceptance may be inferred from acts or acquiescence on part of the
corporation or its authorized agents, as any similar contract might be shown.
The agreement must be one which the corporation itself could make and one
which the usual agents of the company have express or implied authority to
make. The contract in this case is of that very kind, and the acts and
acquiescence of the corporate officers, after the organization of the company,
fully justified the jury in finding that it had adopted it as its own.
Comment:: The corporation must accept the benefits of the contract with the
knowledge of the contract. Knowledge is usually the issue when the contract is
breached or repudiated. Traditional agency theory inputting the knowledge of the
promoters and/or officers to the corporation is usually applied. However, this
requires a showing that the promoters were acting on behalf of the corporation
and not for themselves. Where the corporation is found to have knowledge of
only part of the contract, it is held to that part only.

Accepting the product or service that was contracted for by the promoter,
is acquiescence to the contract.

2) Defective Incorporations
De Jure corporations is one which as been created and recognized in
compliance with the general incorporation law of the particular state (few
corporations are chartered by Congress and only in extraordinary circumstances
such as the Red Cross). This usually means literal compliance with all mandatory
incorporation requirements and substantial compliance with all directory (where
court has discretion) requirements.
De Facto corporation (Good Faith attempt to incorporate) is one where
sufficient steps have been taken toward incorporation for a court to be justified in
finding that the association involved was “in fact” operating as a corporation.
Such a finding raises the association’s status to that of a de jure corporation
against all persons except the state (who may have the corporation declared
invalid in a so-called quo warranto proceeding).
(A) Thus, where a corporation has filed, paid taxes, but had a few errors in its
incorporation process, it is a corporation for purposes of determining the
order of payment to creditors. (Matter of Whatley) Court sets out three
factors for a de facto corporation:
(a) Existence of a valid law under which it could incorporate
(b) Bona fide attempt to incorporate
(c) Actual use of corporate powers
Incorporation by Estoppel is an equitable theory invoked by courts to avoid
injury due to detrimental reliance upon someone’s representations, etc.
(A) Sometimes, a court will treat a corporation as formed even though there are
technical defects.

Robertson v. Levy (1964) (p. 236)

Facts: Levy (D) attempted to form a corporation. Its Articles were rejected by the
Corporations Commissioner. Prior to the acceptance of the corrected Articles,
Levy (D) entered into a contract with Robertson (P) to purchase his business for
the corporation. Levy signed as corporate president. The Articles were later
accepted and the corporation was validly formed. One payment was made on
the note to Robertson (P), and the corporation later became insolvent.
Robertson (P) sued Levy (D) on the note, claiming he was personally liable since
the contract had been signed before incorporation. The Trial Court found that
Robertson (P) was estopped from asserting proper formation because he knew
that the corporation had not been validly formed at the time of the contract and
he also had accepted a payment on the note from the corporation.
Issue: Will knowledge of the lack of corporate status plus receipt of payments
from the corporation estop a creditor from denying corporate form?
Rule: No. Officers and directors who attempt to act for a defectively formed
corporation, or prior to its formation are jointly and severally liable for those acts.
Analysis: The pertinent statute states the corporation’s existence does not begin
until the certificate of incorporation has been issued. It further states that all
persons attempting to act as a corporation w/o authority to do so shall be jointly
and severally liable for debts and liabilities resulting from these acts. The thrust
of this legislation is to destroy the common-law concepts of de factor
corporations by estoppel. Equity can no longer provide relief for lack of or
defective formation. A creditor, even with knowledge of the defective formation,
is not estopped from looking to those who incurred the liability for payment. Part
payment or part performance is immaterial. Levy (D) is liable on the contract
between the corporation and Robertson (P). The decision of the trial court is
Comment:: Corporate form and protection is a matter of legislative grace. To
qualify, certain formalities must be met. Failure to comply subjects the
incorporators to personal liability. It is not a matter of protecting innocent
creditors. Since the corporation was not in existence, Levy (D) was acting in his
individual capacity. It is the same situation as where the promoter enters into a
contract as agent for a corporation to be formed. Unless the creditor agrees to a
novation when the corporation is formed or specifically agrees that the promoter
shall not be liable, he cannot escape contractual liability (i.e. Stanley J. How &
Assoc. v. Boss)

Cantor v. Sunshine Greenery, Inc. (1979) (p. 241)

Facts: When Cantor (P) leased his building to Sunshine Greenery (D), William
Brunetti (D) signed the document as president of Sunshine (D). At the time
Sunshine Greenery (D) was not a de jure corporation inasmuch as the certificate
of incorporation that had been forwarded to the Secretary of State was not
officially filed until 2 days after the lease was executed. Counsel for Sunshine
Greenery (D) thereafter repudiated the lease agreement, and Brunetti (D) put a
stop payment on the check supposedly covering the 1st month’s rent and security
deposit. Cantor (P sued both Sunshine Greenery (D) and Brunetti (D). In
appealing the personal judgment rendered against him, Brunetti (D) argued that
a de facto corporation was in existence when the lease was signed, that Cantor
(P) dealt with the corporation as such, and that he was thus estopped to deny its
corporate existence so as to hold Brunetti (D) personally liable.
Issue: If one contracts with a de facto corporation as such, can he thereafter
deny its corporate existence so as to hold those with whom he dealt personally
liable on the contract?
Rule: No. One who deals with a de facto corporation as a corporation is
estopped to deny its existence in an attempt to hold those with whom he dealt
personally liable on the contract.
Analysis: In this case, a de facto corporation clearly existed because the 3
necessary elements were present:
(1) the existence of a law authorizing incorporation;
(2) actual exercise of corporate powers; and
(3) a bona fide (good faith) effort to satisfy all conditions precedent to
incorporation under the existing law.
Since Cantor (P) dealt with Sunshine Greenery (D) as if it were in fact a
corporation, he is now estopped from denying its corporate existence so that he
might hold Brunetti (D) personally liable on the lease contract. Reversed.
Comment:: Although “corporate” officers can escape personal liability by use of
both theories, there is a difference between corporation by estoppel and
corporation de facto.
A de facto corporation is considered a corporation as against all parties except
the state (in a quo warranto proceeding to declare the corporation invalid.)
A corporation by estoppel is given corporate status only as against the particular
person in the particular proceeding before the court.

(B) Also, where attorney botches incorporation, individual s/h still retain limited
liability so long as
(1) creditor thought it was a corporation at time of contract and
(2) investor in good faith thought a corporation had been formed
(i.e., reasonable reliance on the attorney) (Cranson v. IBM)
Effect of this: so long as investor had good-faith reliance, there is no liability for
transactions (but liability remains for torts)

Cranson v. International Business Machines Corp. (1964) (p. 246)

Facts: Cranson (D) and other s met with an attorney to form the Real Estate
Service Bureau as a corporation under the laws of the state of Maryland. After
being advised by the attorney that the corporation had been formed, Cranson (D)
received stock in the corporation, and was shown the corporate seal and minute
book. The association was conducted as if it were a corporation (corporate bank
account, etc.) and Cranson (D) was elected president. As president, between
May 17 and Nov. 8, 1961, Cranson (D) purchased 8 typewriters for the
corporation from IBM (P). Subsequently, he discovered that the attorney had not
filed a certificate of incorporation with the Secretary of State (as is required by
law) until Nov 24. IBM (P) sued Cranson (D) as personally liable for the balance
due on the typewriters. From Judgment for IBM (P), Cranson (D) appealed.
Issue: May the officers of a defectively formed corporation escape personal
liability for agreements he enters into on behalf of the association?
Rule: Yes. 2 doctrines have been used by the courts to clothe an officer of a
defectively incorporated association with the corporate attribute of limited liability:
(1) The doctrine of de facto corporations, where there is evidence showing:
(a) the existence of law authorizing incorporation,
(b) an effort in good faith to incorporate under that existing law, and
(c) actual exercise of corporate powers, and
(2) The doctrine of estoppel where the person seeking to hold the officer
personally liable has contracted or otherwise dealt with the association “as a
corporation. “
Analysis: Though there is a tendency to merger these 2 theories into one, there
is clearly a distinct difference between finding a corporation to be created “de
facto,” and merely estopping a party due to his conduct from asserting defective
incorporation to reach an officer personally. Where a de facto corporation is
found form the 3 above elements, the association becomes a corporation de jure
against all person but the state. On the other hand, estoppel depends on and is
limited to the facts of each particular case. Here, IBM (P) clearly dealt with
Cranson (D) as a corporate officer and relied on its credit, not Cranson’s (D) in
selling the typewriters. This is a case where estoppel applies. Nothing more
need be found. The judgement was reversed.
Comment:: This case points out 2 general principals of corporate officer liability
law: De Facto incorporation and estoppel.
De Jure corporations is one which as been created and recognized in
compliance with the general incorporation law of the particular state (few
corporations are chartered by Congress and only in extraordinary circumstances
such as the Red Cross). This usually means literal compliance with all mandatory
incorporation requirements and substantial compliance with all directory (where
court has discretion) requirements.
De Facto corporation is one where sufficient steps have been taken toward
incorporation for a court to be justified in finding that the association involved was
“in fact” operating as a corporation. Such a finding raises the association’s status
to that of a de jure corporation against all persons except the state (who may
have the corporation declared invalid in a so-called quo warranto proceeding).
Estoppel is an equitable theory invoked by courts to avoid injury due to
detrimental reliance upon someone’s representations, etc.
In the above case the detrimental reliance of Cranson (D) was really upon his
attorney’s representations, not upon IBM’s (P). The court finds that IBM’s (P)
dealing with Cranson’s (D) association “as a corporation” is an implicitly
representation upon which Cranson (D) relied.
Acts of Pre-incorporation

Everyone knows not incorporated Acting like incorporated, but not

1) Has fiduciary duty to corp. and 1) Levy liable cause, no de jure
Shareholders (liable for investment)
2) Promoter is not liable unless corp. 2) Not liable due to de facto (need good
Is formed and accepts the contract faith and attempt to form
3) Not liable based on estoppel
(everyone thinks corp)

We have limited liability for 3 reasons:

1) Every other state offers it
2) Attracts investors
Piercing is allowed basically because of misbehavior and fairness.


June 8, 1998 Class Assignment
DISREGARD of the CORPORATE ENTITY (pp. 250-298) (“Piercing the Veil”)
B. The basic question: when will a court ignore the existence of the
corporation and extend liability to the investors personally?
1. Carson: Piercing in any situation is very rare.
C. Piercing and Contract Breaches
1. Generally, courts are very reluctant to pierce in the context of
contracts; after all, if the corporation is thinly capitalized, why doesn’t
the contracting party get a personal guarantee from the s/hs?


Bartle v. Home Owners Coop. (1955)(p. 250)

Summary: Where a corporation forms a subsidiary to build housing, and
subsidiary goes bankrupt, the subsidiary’s creditor’s cannot pursue the parent
corporation for the remaining debt.
Facts: Home Owners Coop. (D) a cooperative association of mostly veterans,
unable to secure a contractor to build low cost housing for its members,
organized Westerlea Builders, Inc. for that purpose. When Westerlea ran into
financial difficulties, its creditors, pursuant to an extension agreement, took over
the construction responsibilities. 4 years later, even though Home Owners (D)
contributed some $50, 000 in original capital and additional sums, Westerlea
went bankrupt. Westerlea’s trustees in bankruptcy (P) sued Home Owners (D)
for the contract debts of Westerlea. The trial court, in deciding for Home Owners
(D) found that while Home Owners (D) controlled Westerlea’s affairs, it
maintained separate outward indicia at all times that credit was extended, did not
mislead or defraud Westerlea’s creditors, and performed no act injurious to them
by depletion of assets or otherwise. The trial court also ruled that the trustees
(P) were estopped by the extension agreement from denying the separate
identities of the 2 corporations.
Issue: Should the trial court have “pierced the corporate veil” of Westerlea’s
corporate existence to see Home Owners (D) lurking in the background?
Rule: No. Where there has been neither fraud, misrepresentation, nor illegality,
the doctrine of “piercing the corporate veil” will not be invoked to hold a
corporation liable for the debts of a wholly owned subsidiary.
Analysis: Since the law permits the incorporation of a business for the very
purpose of escaping personal liability, the doctrine of “piercing the corporate veil”
is invoked only in instances of preventing fraud, or to achieve equity. Home
Owners (D) purpose in placing its construction operation into a separate
corporation was within the limits of public policy.
(A) Westerlea is a wholly owned subsidiary of Home Owners (D), having the
same directors and management,
(B) Business was done on such a basis that Westerlea could not make a profit
(no allowance was made for profit by Westerlea).
The benefit to the stockholders of Home Owners (D) from this arrangement is
analogous to dividends. Westerlea, consequently, was no more than an agent of
Home Owners (D).
Comment:: “Piercing the corporate veil” can take one of 2 routes:
(A) The corporation is the “alter ego” of its shareholders – it is so dominated and
used by them, that, in reality, no separate entity is in existence. This is
usually the case where the shareholders treat the corporation’s assets as
their own, drawing on company funds for their personal use at will.
(B) Recognizing the corporation, as a legal entity would be to sanction a fraud or
injustice. In these instances, where this approach is used, the purpose of
incorporating was to prevent creditors from reaching personal debts, to run up
debts in excess of assets, or, as charged in this case, to minimized expected
tort liabilities.
(C) Possibly different result if fraud had been involved
1) Ex.: Where construction corporation (WCC) purchases bowling lanes and
equipment from Brunswick and then breaches, Brunswick cannot hold the
construction corporation’s officers liable (Brunswick Corp. v. Waxman)
(A) Plaintiff here advances several arguments, including instrumentality rule
(complete domination by s/h, use of that domination to commit a
fraud or other wrong, and injury caused by that act) and the straw
corporation theory (pierce if corporation is a dummy for purely
personal ends)
(B) Court rejects both in this case – since Brunswick knew that WCC was
undercapitalized, it shouldn’t be allowed to avoid the consequences now.
Caveat emptor.
(C) Compare Dewitt Truck Brokers v. W. Ray Fleming Fruit Co., where
corporation was run with complete disregard for corporate
formalities, it was undercapitalized, president had withdrawn funds
due to plaintiff, president made statements to effect that he would be
liable (statute of frauds prevents enforcement). Here, court pierces
veil via application of the instrumentality rule (see above)
• Why the different result? There’s still no fraud, but here
there is a fundamental unfairness: here the breach of
the contract goes against the good-faith assumptions of
the contracting party.
• Instrumentality doctrine used to pierce when
corporation is used as an instrument to cause a wrong –
not just because it’s an instrument

Reviewing piercing the corporate veil, the factors to look at in determining
this are:
1) Corporation Formalities (Were meetings, etc setup)
2) Control / Domination of the Company (Was there control of the
company by the shareholders?)
3) Under-capitalization (was there enough money in the corporation to
operate?) This should be the philosophical reason to pierce, however
most courts look at lack of corporate formalities)
4) Alter Ego/Instrumentality: Was this an alter ego of the shareholders or
an instrumentality of some other entity to completely avoid liability.

More likely to pierce in a Tort v. Contract

(A) Parents (in a publicly traded company) has probably never been
(B) Parents should be pierced because the parent is more likely to
dominate the subsidiary. (Parent appoints the board)
(C) Having the same people on the board is the interlocutory board. This is
pretty dominated.

Dewitt Truck Brokers v. W. Ray Flemming Fruit Co. (1976)(p. 252)

Summary: Corporation was run with complete disregard for corporate
formalities, it was undercapitalized, president had withdrawn funds due to
plaintiff, president made statements to effect that he would be liable (statute of
frauds prevents enforcement). Here, court pierces veil via application of the
instrumentality rule. There’s no fraud, but here there is a fundamental unfairness.
Here the breach of the contract goes against the good-faith assumptions of the
contracting party.
Instrumentality doctrine used to pierce when corporation is used as an
instrument to cause a wrong – not just because it’s an instrument
Alter ego doctrine: of its shareholders – it is so dominated and used by them,
that, in reality, no separate entity is in existence. This is usually the case where
the shareholders treat the corporation’s assets as their own, drawing on
company funds for their personal use at will.
Facts: Flemming (D) was president of and ran a close, one-man corporation,
Ray Flemming Fruit (D), which acted as a commission-paid agent selling produce
for growers. Corporate formalities were not observed, the corporation was
undercapitalized, and no other stockholder or officer other than Flemming (D)
ever received a salary or dividend. DeWitt (P) brought an action to collect
moneys due it for providing transportation. It sought to hold Flemming (D)
personally liable on the debt, noting he had withdrawn funds from the corporation
that could have been used to pay the debt. The lower court pierced the
corporate veil and imposed persona liability on Flemming (D) who appealed.
Issue: Will the corporate veil be pierced where recognition of the corporate form
would extend the principle of incorporation beyond its legitimate purposes and
produce injustice or inequality?
Rule: Yes. A court will pierce the corporate veil when recognition of the corporate
form would extend the principle of incorporation beyond its legitimate purposes
and would produce injustices or inequitable consequences.
Analysis: The concept that a corporation is an entity, separate and distinct from
its officers and stockholders, is merely a legal theory introduced to serve the
ends of justice and for convenience. As such, the courts will refuse to
recognized it and will pierce the corporate veil, where, as in this case, recognition
of the corporate form would extend the principle of incorporation beyond its
legitimate purposes and would produce injustices or inequitable consequences.
One fact significant to such an inquiry, particularly so in the case of a one-man or
closely held corporation, is whether the corporation was grossly undercapitalized
for the purposes of the corporate undertaking. Here, undercapitalization of this
one-man corporation and the presence of other factors, such as lack of corporate
formalities, lead to the conclusion that the finding below that the corporate entity
should be disregarded was not clearly erroneous. Affirmed.
Comment:: Although courts are willing to pierce the corporate veil to hold an
individual responsible for corporate debt, they are even more willing to pierce the
corporate veil to hold a parent corporation responsible for the debt of a subsidiary
whose stock it holds. Intermingling of the business affairs of parent and
subsidiary, i.e., not delineating between their operations, has proven to be an
almost certain way to ensure the veil will be pierced.

2. Other policy reasons may also trump piercing (Cargill v. Hedge,

denying “reverse piercing” in order to protect homestead policy –
creditors should have secured the loan)

Piercing and Tort Claims

Baatz v. Arrow Bar (1990)(p. 260)

Facts: Kenny and Peggy Baatz (P) were seriously injured when McBride who
had been drinking at the Arrow Bar (D) struck them while they were riding their
motorcycle. McBride was uninsured and is judgement proof. The Tort action in
1984 claimed that The Arrow Bar was negligent in serving alcoholic beverages to
McBride and this contributed to the injuries of the Baatz (P). The Neuroth’s
formed the Arrow Bar, Inc. in 1980 with substantial money contributions. On
advice of their attorney, because of South Dakota legislation they did not
maintain dram shop liability insurance at the time of the accident. The 1987 trial
entered a summary judgement in favor of Arrow Bar and the Neuroths as
individual defendants.
Issue: In a tort action, should the corporate veil be pierced leaving the
shareholders of the corporation individually liable?
A) A trial court may grant summary judgement only when there are no genuine
issues of material fact.
B) When continue recognition of a corporation as a separate legal entity would
“produce injustice and inequitable consequences ”then a court has sufficient
reason to pierce the corporate veil.
A) Baatz claims the Arrow Bar owners personally guaranteed corporate loans,
and they should also be liable for other corporate liabilities, because the
company is undercapitalized. The court said they are capitalized for their
normal operations
B) Baatz says the Arrow Bar is an alter ego of the owners. The court says that
there is no evidence presented showing this or that the owners used the
Arrow Bar as an instrumentality for which they conducted personal business
C) Baatz said that corporate formalities were not followed, because it did not say
Arrow Bar, Inc. on the sign. The mere failure on certain occasions to use
these formalities like this as well as meetings and records followed are OK. A
little informality does not kill corporate formality.
Did not find the owners personally liable.
Dissent:: The dissent said that the corporation was an instrumentality, and the
shareholders set themselves up to be liability proof. This is considered a fraud
on the public.

Key difference between this and contracts: the injured party here is not a willing
1. The veil will not be pierced just because the plaintiff cannot recover
solely from the corporation – must prove control and bad conduct
a) Thus, in Walkovszky v. Carlton, 2-cab corporation will not be
pierced even where sole s/h owns 9 other 2-cab corporations
just like it. Why? Because the corporation was incorporated in
perfectly legal fashion, and the fact that there are multiple
entities does not constitute a fraud.
(1) Also note dicta saying that undercapitalization argument fails
as well – the cabs carried the requisite amount of insurance
mandated by law ($10,000); since the legislature says that
amount is sufficient, the courts presume it is not
(2) To even state a cause of action that can be heard, plaintiff
must allege the business was run in a “personal capacity”
b) Also see Radaszewski v. Telecom Corp., where piercing was
denied where corporation was thinly capitalized and went
bankrupt but nonetheless carried adequate liability insurance
coverage. The court says no socially irresponsible behavior
(1) Court sets following test for piercing:
(a) Complete shareholder control of corporate policy with
respect to the issue at hand
(b) Used to commit a fraud or wrong (i.e., breach of duty –
no such breach here because of adequate insurance)
(c) Injury to plaintiff
(2) Dissent: insurance isn’t per se adequate capitalization;
question should be submitted to a jury

Radaszewski v. Telecom Corp. (1992)(p. 266)

Summary: piercing was denied where corporation was thinly capitalized and
went bankrupt but nonetheless carried adequate liability insurance coverage.
The court says no socially irresponsible behavior here. Court sets following test
for piercing:
 Complete shareholder control of corporate policy with respect to the issue at
 Used to commit a fraud or wrong (i.e., breach of duty – no such breach here
because of adequate insurance)
 Injury to plaintiff
Dissent: insurance isn’t per se adequate capitalization; question should be
submitted to a jury
Facts: After Radaszewski (P) was seriously injured when the motorcycle he was
riding was struck by a truck driven by an employee of Contrux, Inc., a wholly
owned subsidiary of Telecom (D), Radaszewski (P) filed this suit to recover
damages for his injuries. He sought to hold Telecom (D) liable for his injuries by
piercing the corporate veil to reach its assets since Contrux was
undercapitalized. Contrux initially had had basic and excess liability coverage,
which would have covered Radaszewski (P) damages. Unfortunately, 2 years
after the accident, the excess liability insurance carrier became insolvent and
went into receivership. The district court dismissed the complaint against
Telecom (D), holding that the court lacked jurisdiction. Radaszewski (P)
Issue: To pierce the corporate veil, must one show control amounting to
complete domination, use of that control for an improper motive which breaches
a duty owed, and injury proximately caused by that breach?
Rule: Yes. To pierce the corporate veil, one must show control amounting to
complete domination, use of that control for an improper motive which breaches
a duty owed, and injury proximately caused by that breach.
Analysis: Undercapitalizing a subsidiary is a sort of proxy for the second.
Operating a corporation without sufficient funds to meet its obligations shows
either an improper purpose or reckless disregard of the rights of others. Here
Contrux was undercapitalized in the accounting sense. However, it did carry $11
Million worth or liability insurance. Insurance meets the policy behind the proper
capitalization requirement just as well as a healthy balance sheet. There is no
evidence that Telecom (D) or Contrux knew that the insurance company was
going to become insolvent. The doctrine of limited liability would largely be
destroyed if a parent corporation could be held liable simply on the basis of
errors in business judgement. Affirmed.
Dissent: The record is more than sufficient to support a prima facie showing that
personal jurisdiction over Telecom (D) exists. Contrux had neither the working
capital nor the unencumbered assets to permit it to make decisions on its own.
On the basis of the record, Contrux was nothing but a shell corporation
established to permit Telecom (D) to operate as a nonunion carrier without
regard to the consequences that might occur to those who might be affected by
its actions.
Comment:: State courts have developed a variety of tests designed to guide
courts in determining when the corporate veil should be pierced. All, however,
tend to embody some sort of domination or abuse requirement and require proof
of injustice that, over the past forty years, courts have chosen to pierce the
corporate veil in 40% of reported cases.

A) However, can’t defend yourself on the grounds that you were a ‘temporary’
director (Minton v. Cavaney)
B) Mere opportunity to control isn’t enough – must be actual utilization of control
(American Trading and Production Corp. v. Fishbach & Moore)
C) However, a family-owned corporation with subsidiaries where the parent
corporation totally dominates the subsidiaries to the extent that it’s unclear to
a neutral observer that they are separate entities can result in piercing. (My
Bread Baking Co. v. Cumberland Farms, where it was shown that president
directly ordered subsidiary to not return bread racks)
 In other words, a jury could reasonably find the subsidiary was a
mere instrumentality of the parent – so the issue of control should reach a

Fletcher v. Atex, Inc. (1995)(p. 273)

Facts: Fletcher (P) filed a suit against Atex (D) and its parent Kodak (D) to
recover for repetitive stress injuries that he claimed were caused by the use of a
computer keyboard, mfg. By Atex (D). Summary judgement dismissed Kodak as
a D and Fletcher (P) appealed.
Rule: Under an alter ego theory of law, there is no requirement of showing fraud
(as is the rule) in a liability case.
Analysis:: The P must show (under Delaware law – because this is the state of
incorporation of Atex.) (1) that the parent and the subsidiary “operated as a
single economic entity” and (2) that an “overall element of injustice or unfairness
is present. Kodak has shown that Atex followed corporate formalities, and the Ps
have shown no evidence to the contrary. The district court was correct in hold
that “Atex (D) participation in Kodak’s cash management system is consistent
with sound business practice and does not show undue domination or control.”
The district court was held:
1) that Atex’s participation inn Kodak’s cash management system is consistent
w/ sound business practice and does not show domination or control.
2) District court concluded that it could find no domination based on the P’s
evidence that Kodak approved Atex’s real estate leases, capital expenditures,
negotiations of sale of minority stock ownership to IBM, or that Kodak played
a significant role in the ultimate sale of Atex’s assets to a 3rd party.
Comment: Things that blur the distinction between entities are common
retirement plan, common resources, etc. (see notes on p. 277)

Other Veil-Piercing Issues: Courts try to balance common-law theories with

federal laws holding intra-corporate actors liable; where there is a statute, courts
will apply it

United States v. Kayser-Roth Corporation (1989)(p. 284) STATUTES

Facts: Stamina Mills Inc. a defunct corporation, was charged with dumping
hazardous waste in the waters adjacent to the village of Forestdale, Rhode
Island. The Government (P) sought to recover the costs of cleanup from Kayser-
Roth Corporation (D), the parent corporation of Stamina Mills. The Government
(P) asserted that liability existed under the Comprehensive Environmental
Response Compensation and Liability Act (CERCLA). Prior to Stamina Mills’
dissolution, Kayser-Roth (D) exerted practically total influence and control over
the operations. Kayser-Roth (D) approved all actions of Stamina Mills and was
intimately involved in the selection of corporate officers and the day-to-day
operation of the company. The Government (P) contended that Kayser-Roth (D),
as the operator of Stamina Mills, was therefore liable under the Act.
Issue: May a parent corporation be responsible for the actions of a subsidiary
under federal law?
Rule: Yes. A parent corporation may be held responsible for the acts of its
subsidiary under federal law.
Analysis: In this case, the federal statute allows for vicarious responsibility of the
parent corporation for hazardous waste cleanup. The parent in this case was
clearly an operator in that it was intimately involved in the day-to day operations
of Stamina Mills. Here, because of the very close relationship between the
parent and subsidiary, responsibility under the Act exists in 2 forms: parent-
operator liability and piercing-the-corporate-veil theory. As a result, Kayser-Roth
(D) is responsible for the amount of the cleanup. Judgment for the Government
Comment:: Some commentators have noted that given the rather precise
definition of “operator” under the Comprehensive Environmental Response and
Liability Act, the court in this case did not need to get into the discussion of
piercing the corporate veil. It is clear from Kayser-Roth’s (D) close operating
business at the time, and therefore no need to analyze the case in terms of an
alter ego theory was shown. However, in cases where such a relationship is not
as clear, such an analysis could prove beneficial.

In some situations (notably bankruptcy) courts may hold a fiduciary duty

exists to creditors

Stark v. Flemming (1960)(p. 289)

Facts: Stark (P) placed her assets in a newly formed corporation. She operated
her farm and duplex for it and paid herself a $400 a month salary. This was done
so as to quality her to social security. Flemming (D), the Secretary of HEW,
denied Stark (P) her claimed benefits on the theory that the corporation was a
mere sham. The district court found for Flemming on this basis. It concluded
that Stark’s (P) only purpose in incorporating was to qualify for social security
Issue: Where not provided for by statute, may the government withhold benefits
because a corporation was formed merely to qualify for them?
Rule: No. Where corporate formalities have been observed, the form cannot be
disregarded unless authorized by statute.
Analysis: If Congress has not specified that benefits are to be withheld in these
cases, the Secretary of HEW (D) is not permitted to deny them. All corporate
formalities were complied with by Stark (P), and regardless of her motive it must
be related as a legitimate entity. Flemming (D) is permitted to make an
independent appraisal of the salary paid o Stark (P) in order to determine if it is
excessive. He may compare salaries paid to others in similar situations and
commensurate with her responsibilities and the capital contribution to the
business. The decision of the district court is vacated and remanded for further
Comment:: Stark stands for the principle that corporate form cannot be ignored.
The motive of the incorporator is immaterial. Therefore, incorporation cannot be
attacked because the incorporator’s sole motive was to save taxes or to avoid
personal liability. No legitimate business purpose is required. A person is free to
adopt whatever form he desires, so long as he observes the formalities
associated with his choice. There must be a compelling policy reason for
piercing the form if statutory authority to do so is not granted.

Roccograndi v. Unemployment Comp. Bd. Of Review (1962). 290)

Facts: Roccograndi (P) and 2 other applicants filed for unemployment
compensation benefits when they were “laid off.” All were members and
shareholders of a family business which, during slow periods, laid off various
family members so as to qualify for these benefits. The Unemployment
Compensation Board denied the claim based on the fact that the applicants were
really self-employed. A referee reversed. The Board of Review (D) reversed the
Issue: May corporate form be disregarded for the purpose of unemployment
benefits where the applicants exert sufficient control over the corporation to lay
themselves off and/or rehire themselves?
Rule: Yes. The corporate form may be ignored where applicants for
unemployment compensation benefits exert sufficient control over the
corporation to lay themselves off or rehire themselves at will and are considered
Analysis:: Where the applicants can exert sufficient control over a corporate
entity to lay themselves off when business is bad, they are really self-employed.
The Unemployment Compensation Act provides that no benefits shall be given
the self-employed. Case law on the Act has held that in cases of close family
corporations, such as Roccograndi’s (P), the corporate form may be disregarded.
The decision of the Unemployment Review Board (D) is sustained.
Comment:: To qualify for benefits from the State, an applicant must be able to
bring himself within the class sought to be benefited. The self-employed are
excluded. The courts have defined self-employed as members of a close
corporation in which they retain a substantial amount of control after being laid
off. This is a public policy decision that said parties are not within the class
sought to be benefited by the legislation.


Cargill Inc. v. Hedge (1985)(p. 291)
Summary: policy reasons may trump piercing. In this case the court denied
“reverse piercing” in order to protect homestead policy – creditors should have
secured the loan.
Facts: After purchasing a 160 acre farm, the Hedges (D) incorporated as a family
farm corporation, Hedges Farm, Inc. (D). While the Hedges (D) maintained
some of the corporate formalities, they operated the farm as their own. Annette
Hedge (D) owned all the stock. All the corporate directors and officers were
family members, with none of the officers receiving any salary. Sam Hedge (D)
purchased farm supplies and services on account from Cargill (P). Cargill (P)
filed suit to collect on the account, and judgement was entered in its favor.
Shortly before the expiration of the redemption period, Annette (D) was allowed
to join the proceedings as an intervenor. The trial court subsequently ruled that
the Hedges (D) had a right to exempt from the execution ½ the acreage of the
farm as their homestead. The court of appeals affirmed. This appeal followed.
Issue: To apply a reverse pierce of the corporate veil, is it necessary to examine
the extent to which the corporation is an alter ego and whether creditors or other
shareholders would be harmed by a pierce?
Rule: Yes. To apply a reverse pierce of the corporate veil, it is necessary to
examine the extent to which the corporation is an alter ego and whether creditors
or other shareholders would be harmed by a pierce.
Analysis: Here, there is a close identity between the Hedges (D) and their
corporation. Realistically, they operated the farm as their own. They had no
lease with the corporation and paid no rent. The farmhouse was their family
home. The corporation was therefore an alter ego of the Hedges (D). While a
reverse pierce should be permitted in only the most carefully limited
circumstances, this is such a case. Thus, the creditors’ execution sale of the
exempted acreage is void. Affirmed.
Comment:: The court cited its prior decision in Roepke v. Western National
Mutual Insurance Co. (1981) to support its analysis here. In Roepke, the court
disregarded the corporate entity to further the purposes of the No-Fault
Insurance Act; otherwise, a deceased business owner would have been deprived
of no-fault coverage he would have had if he had operated as a sole
proprietorship. The policy reasons for a reverse pierce were much stronger in
this case than in Roepke – namely, furtherance of the purpose of the homestead

Pepper v. Litton (1939)( p. 294)

Summary: Dominant s/h with advance knowledge of impending bankruptcy
secured a judgment for back salary (which was paid ahead of creditors, unlike
s/h claims); court denied collection in favor of creditor on basis of fiduciary duty to
Facts: Litton (P) was the sole owner of a small corporation. When the
corporation became insolvent, Litton (P) brought suit and recovered a judgement
against it for “wage” claims. When bankruptcy was declared, Litton (P) filed a
priority claim for wages with Pepper (D), the trustee. Pepper (D) disallowed the
claim. Litton (P) brought suit in district court. The court found that Litton (P) had
engaged in a scheme to defraud creditors and dismissed Litton’s (P) claim under
its broad equity powers. If found that Litton (P) totally controlled the corporation
and had dealt unfairly with it. Finally, allowing Litton (P) to enforce his claim
would be unfair to other creditors.
Issue: May the bankruptcy court disallow a claim by a party who dominated and
controlled the bankrupt corporation?
Rule: Yes. Where a claimant in bankruptcy has dominated and controlled a
corporation, is claim may be subordinated or even disallowed upon a showing
that enforcement of the claim would be unfair to other creditors.
Analysis: The parties to be protected in a bankruptcy proceeding are the
corporation’s innocent creditors. Therefore, a party owning and controlling the
corporation who files a claim must be carefully scrutinized. Where he has dealt
with the corporation unfairly and has attempted to defraud creditors, or where the
corporate form may be disregarded, his claim should be subordinated or even
disallowed. To hold otherwise would work an injustice upon those who innocently
bestowed credit to the bankrupt corporation. In one-man or family corporations,
claims will normally be subordinated. Here, the court found that Litton (P) had
initiated a plan to defraud creditors. The fact that his claim has been reduced to
judgement is immaterial. The bankruptcy court has broad equity powers to
disallow claims which would be unfair to innocent creditors. The decision of the
district court is affirmed.
Comment:: By way of explanation, wage claims take precedent over creditor
claims in bankruptcy. By filing a wage claim, Litton (P) tried to put himself ahead
of the corporation’s creditors. This is known as the “Deep Rock doctrine.” The
doctrine also applies to dominant or controlling stockholder or group of
stockholders. Southern Pacific Company v. Bogert

a) Note fraud in this instance need not be shown – only inequity in

a situation where a duty exists (also note this isn’t really a
piercing case, but an order-of-payment case)
3. Sophistication of the parties is often an issue, as is the voluntary
nature of their participation (i.e., why tort victims are more likely to
pierce than parties to a contract). It’s also more likely that a parent
corporation will be held liable than an individual investor – investors
in parent have put their money at risk; there’s no “nest egg” at stake.
4. In Texas, issue of piercing the veil is a jury issue (Castle v.
D. Summary of approach to veil-piercing problems:
1. Contract issues: show some kind of injustice. Could other party
have foreseen this result? Could they have taken steps to prevent
it? Was corporation used as an instrument to commit a wrong?
2. Tort issues: look for thin capitalization. Also total domination.

June 10 -12, 1998 Class Assignment

400) Usually there are 3 sources of assets for the beginning corporation:
1) Equity (ownership interest) STOCKS
a. Contributions in exchange for stock in the corporation
2) Debt (Interest rate, right to be repaid, no upside) BOND & DEBENTURE
a. Loans by the shareholders and loans from other sources (like banks).
b. Bonds (secured), debenture (unsecured) loans by the general public.
A) Debt and Equity Capital (p. 299) A shareholder is one who owns an “equity”
security (that is, he is an owner of the corporation as opposed to a creditor).
In addition, the equity securities issued to owners, the corporation issues debt
securities to creditors.
B) Types of Equity Securities (p. 300) Typically the rights of shareholders are
created (as a matter of contract) in the articles of incorporation. In addition,
state corporation law provides shareholders with certain rights (such as the
right to obtain a shareholders list, etc.), and the board (where permitted by
law) may set certain terms and conditions in issuing equity securities.
 Federal laws (Securities Act of 1933) and state laws (Blue Sky
Laws) require disclosure. This is usually done via prospectus of the
company. As of 10/98 prospectuses are required to be in plain
A. MBCA §§6.01-04 regulates issuance of shares; liquidation usually is face
value of stock plus dividends in arrears.
B. §6.01(b) – at least one class must have voting rights and rights to assets
on dissolution
C. Par value optional in most states – but not Texas (used to be corporations
had to keep assets equal to par value)
(A) Common Shares (p. 300) – Confers voting rights, but dividends
come only after preferred shareholders; owns residual value of
corporation. These have the rights to inspect the minute book of the
company, right to vote, right to sue in the name of the corporation for
wrongs done to the corporation (derivative suits), a right to the financial
information of the company, and share in assets via dividends and
liquidation payments.
1. Classes of Common (p. 305) – Various classes of common stock
may be issued, each with their own unique rights (i.e. different
number of votes per share, rights to different amount of dividend,
PARTNERSHIP. (This is because the right is tied to the # of shares
(B) Preferred Shares (p. 302)– Usually no voting rights, but get
dividends first; can usually be redeemed at corporation’s discretion at a
premium; sometimes convertible into common shares; priority in
dissolution over common (but not over creditors) Payment preference
is the key to this. (i.e. $4.00 preferred shares get $4.00 paid first,
before the other shareholders (common) are paid anything.
1. Reasons for issuing preferred stock
(A) Contingent voting rights: (i.e. voting rights accrue only when
dividends are not paid or on major corporate transactions, such as
sale of all corporate assets) This means that preferred stock does
not dilute the voting control that resides in the common
(B) No required, fixed repayment: of principal (some do require
repayments, and the corporation must set up a sinking fund to
periodically pay off part of the principal invested by preferred
shareholders) Nearly all do permit management to “call” the
preferred stock (redeem it) at its discretion.
(C) Fixed % annual dividends: these are not tax deductible to the
corporation. Since the risk to the preferred shareholders is greater
(won’t receive dividends) than to the holder of debt securities
(which carry a prior right to interest payments), the rate of interest
that must be paid on preferred stock is normally higher than on
most forms of debt securities.
2. Implied preferences: At common law, the courts would sometimes
imply terms in preferred stocks (i.e. if the stock was called preferred,
then the courts would imply certain preferences). Now most state law
provides that all terms and conditions of classes of stock must be
specifically stated in the articles of incorporation. However, there are
also series of stocks, which are not called out in the statutes. This
allows the board of directors (if the power is given to them in the
articles of incorporation and by laws) to decide the rights and powers
of each series on their own. If you want to issue a different class, you
have to amend the articles by getting a vote from the shareholders.
3. Specific preferences
Dividends: are normally paid to preferred class of stocks before other
classes of stocks.
(A) Noncumulative preferred: dividends are paid only if declared by the
board, and if not paid in one year, the amount does not accumulate
to future years.
(B) Cumulative: if dividends are not in one year, they are accumulated
for payment in future years
Partially cumulative: the only part that is carried over is the
amount that was available at the time the dividend should
have been paid but didn’t.
(C) Participating preferred: to participate in dividends paid after the
preferred and the common shares have received a certain
percentage dividend. (Both common and preferred holders
participate in remaining money available for dividends after the
contracted dividends have been paid. This depends a lot on state
Liquidation rights: Normally preferred shares have priority (after corporate
creditors) to the assets of the corporation in liquidation. Typically
preferred shares receive par value (plus accumulated dividends), the
common receive par, and then the preferred and common share the
Conversion Rights: are the rights to convert preferred stock into common
stock with a certain ratio set. The most common reason to convert is that
companies match conversion rights with redemption rights (i.e. a call is
made on the stock and the preferred shareholder has the right to take
common stock in lieu of cash.) Not usually worth converting unless the
stock goes up substantially in value.
Protective Provisions: Each share goes up in value proportionate with the
issuance of new stock (i.e. if stock split in common stock 100 to 200
shares and the value is $100 for old and new stock, the preferred stock
splits with it or there is a dividend paid, or % shares are given in dividend.
Basically this prevents dilution of the stock. There are a multitude of ways
to protect. Sinking funds are used by companies to buy out shares over
Treasury Share: is a redeemed share. A share bought back by the
company. These are like authorized shares, things bought back don’t get
a dividend paid to them. Only outstanding shares are paid the dividend.
The differences is that authorized shares cannot be sold for less than par
value, but treasury shares can be sold for what ever can be gotten for
them (less than par value).
Preferences set by board: The articles may give authority to the board to
issue the preferred shares in different series and to set certain terms with
respect to each series (such as the dividend rate, redemption rights
(forces the sale of the shares back to the corporation – this is a call that is
set usually by a time limit and a price that is higher than any liquidation
preference), and liquidation amounts and priorities).

A) Issuance of Shares: Herein of Subscriptions, Par Value and Watered Stock

(p. 307)
1) Historically, unperformed services, promissory notes (unsecured), or
intangible property (i.e. good will, name, etc.) were not OK to buy stock
2) §6.21 – BoD has default power to issue; consideration for shares is not
limited to cash (i.e., can be for services rendered, intangibles, etc. – future
services still aren’t OK, but a promissory note, may or may not be OK)
3) Watered Stock: Property less than shares worth Other Watered stocks are
A)`Discount shares: not paying the full cash account
B) Bonus shares: not paying for the stocks at all.
To get around watered stock issues par was set very low (i.e. $1.00 or $0.01)
Issue comes up that shares must be sold for the same minimum par.
4) But only for authorized number of shares in the articles of incorporation –
thus making number of authorized shares an important s/h issue
5) Share Subscriptions and Agreements to Purchase Securities (p. 307)
6) Authorization & Issuance of Common Shares Under the Model Act (p.


Hanewald v. Bryan’s Inc. (1988)(p. 312)

Facts: After the Bryans (D) incorporated Bryan’s Inc. (D) to operate a general
retail clothing store, they issued stock to themselves, lent the corporation some
cash, and personally guaranteed a bank loan. However, they failed to pay the
corporation for the stock that was issued. Bryan’s Inc. (D) then purchased
Hanewald’s (P) inventory and assets in a dry good store for cash and for a
corporate promissory note. It also signed a lease on Hanewald’s (P) store.
When Bryan’s Inc. (D) closed after a few months, it paid off all its creditors except
Hanewald (P), sending him a notice of rescission in an attempt to avoid the
lease. Hanewald (P) sued Bryan’s Inc. (D) and Bryans (D) for breach of the
lease agreement and the promissory note, seeking to hold the Bryans (D)
personally liable. The trial court ruled against Bryan’s Inc. (D) but refused to hold
the Bryans (D) personally liable. Hanewald (P) appealed.
Issue: Is a shareholder liable to corporate creditors to the extent his stock has
not been paid for?
Rule: Yes. A shareholder is liable to corporate creditors to the extent his stock
has not been paid for, up to the unpaid par.
Analysis: A corporation that issues its stock as a gratuity commits a fraud upon
creditors who deal with it on the faith of its capital stock. Where, as here, a loan
was repaid by the corporation to the shareholders before its operations were
abandoned, the loan cannot be considered a capital contribution. The Bryans
(D) had a statutory duty to pay for shares that were issued to them by Bryan’s
Inc. (D). However, Bryan’s Inc. (D) did not receive any payment, either in labor,
services, money, or property, for the stock issued to Keith and Joan Bryan (D).
The Bryans (D) have not challenged this finding of fact on appeal. Thus, the trial
court erred as a matter of law in refusing to hold the Bryans (D) personally liable
for the corporation’s debt to Hanewald (P). Affirmed in part, reversed in part and
Comment:: The Bryan’s (D) failure to pay for their shares in the corporation
made them personally liable under the court’s application of § 25 of the Model
Business Corporation Act (MBCA). The court also applied Article Xii, §9 of the
state’s constitution, stating that no corporation shall issue stock or bonds except
for money, labor done, or money or property actually received. The purpose of
the constitutional and statutory provisions is to protect the public and those
dealing with the corporation.

1) Eligible and Ineligible Consideration for Shares (p. 316)

2) Par Value in Modern Practice (p. 318)
Par value: This is the stated value of the equity shares when they are issued
in exchange for cash or property. The shares must be sold for at least this
value unless the BoD finds in good faith that they cannot be sold for par
Stated Value: Corporation shares are no par, they can be sold for a
reasonable value set by the board. This value is called the stated value.
What is “reasonable” depends on the company’s worth, its earnings per
share, etc. The board’s determination is upheld as long as there is good faith.
Dillution: this is technically OK. This is where stock is sold for more or less
than par. If someone buys for more, it is acceptable to do this as long as
there is no fraud.
Model Act: eliminates the idea of par value. (i.e. if stated par is $0.01 and
stock is sold for 1.00 is Capital Surplus; and Earned Surplus is what is earned
from sales of products or services. ) Some states require a minimum
capitalization (20) the rest say you don’t have to. Most corporations usually
choose to go with a par.
Limiting Authorized Shares: Usually protects the minority share holder from
diluting their power.
If no par: No state allows dividends out of Stated Capital (i.e. par value) That
is why many companies make the par value of stock very low.Capital surplus
and earned surplus are not counted for determining issuance of dividends. If
this is the case, some cases allow dividends out of earned surplus only, and
not capital surplus.
In contribution of property: a question could be raised re: value of contributed
value. Could open litigation later.
Creditors: With no par, they usually want security re: loans, (i.e. see the
books, what property, limit on the ability to make dividends., financial
covenants, etc.)
Put: A shareholder makes someone buy their shares of stock. The problem
with these are that the company does not have the money to do this.
Calls: A company can call a share in, to buy it.
Reviewed reading the common stock information.

Accounting for Business Lawyers (p. 321)

C) Debt Financing (p. 322)
1) Terminology
(a) basically is a fixed obligation
(b) Debenture – an unsecured obligation (usually short
(c) Bond – obligation secured by a lien (though commonly
used to refer to both) (usually long term)
(d) Zero-coupon bond – no interest, sold at a discount. The
lower the price paid for the bond, the higher the effective
(e) Junk bond – a below-investment grade debt: “High yield-
debt market.” High risk, high yield. Junk bonds are
issued in connection with: Mergers; Leverage buyouts;
companies w/ heavy debts to repay; stock buyback by
2) Leverage: involves the use of debt in financing assets of a firm. The use
of fixed cost financing affects the EPS available to the stockholders,
magnifying both gains and losses. Because of the risk of default, and
therefore the possibility of bankruptcy, arising form the use of debt,
variability in a company’s returns should increase with the use of financial
leverage. (p. 324)
3) Concept of Leverage (p. 323) Leverage can greatly increase the return on
equity, maintain control of a corporation, and has tax advantages (i.e.,
interest is deductible); the downside is that it is risky and an adversely
affect financial ratios.
4) Tax Treatment of Debt (p. 325): There are usually tax advantages in C-
Corp shareholders. Interest payments on debt are deductible by the
borrower whereas dividend payments on equity securities are not. A loan
by a shareholder to his corporation therefore reduces the double tax
problem of a C corporation. This offsets the benefit of the S-Corporation
5) Debt as a Planning Device (p. 327):
a) sometimes “debt” will be treated as “equity” if it looks like a sham
For example, see Slappey Drive Industrial Park v. US, where IRS
considered notes held by s/h to be equity since they didn’t require the
corporation to make timely interest payments; IRS denied deduction for
“interest.” (IRS tried to say for every $1 of equity and anything of $10
with outsiders was not considered debt, but there is no bright line rule.
But it is safe to say that 10:1 debt to equity with outsiders and 4:1 with
insiders the IRS will come after you.)
b) Also beware of under-capitalization, especially if debt is held by co-
owners – ‘deep rock’ doctrine of Pepper v. Litton (supra) could bite you
(see also Obre v. Alban Tractor Co.(p. 327), saying capital structure
was permissible)
D) Planning the Capital Structure for the Closely Held Corporation (p. 328)
1) Will the structure “work” i.e. will it stand up in the event of later
disagreement and possible legal attacks?
a) How to resolve disputes? (can you elect a new board?)
2) Will the structure actually provide the desired results?
a) will profits be shared the way they want
b) will it get property tax treatment
3) What will happen when unexpected liabilities arise?
4) Will the desired tax treatment be available, or more likely, is the structure
created one that makes the desired tax treatment probable if not certain?
5) Are the clients’ financial contributions reasonably protected and
reasonably fairly treated in the event of unexpected or disastrous
occurrences causing the sudden and premature termination of the
Issues in Capital Structure of a Closely Held Corporation
Disproportionate Stock
Watered down stock
S-Corp treatment ?
Different classes of stock for different rights. Have it setup so that overtime
different classes become similar.
Mix debt and equity: Have more comparable amounts of money. $50K debt,
$50K equity. To get money needed. Mandatory conversion.

Think about possibilities of structuring deals of partners in a corporation.

Corporate planning is really tough to meet the clients needs (i.e. deal with
country that only works with corporation, setup to go public, need for a license
that is only available for corporation)
E) Public Offerings (p. 331): Help to raise money for the corporation. There are
a lot of securities regulations state (Blue Sky laws) and federal.
The Law of Securities Regulations (p. 331)
1. Securities Act of 1933: Deals with initial sale of securities by the initial issuer.
Covers all sales of securities using the instrumentality of interstate commerce.
The idea is that you have to register all initial offerings, and file it with full
disclosure. They don’t care about merit. This is not the same as Blue Sky
laws) IPO s
a) Is it a security (Stock, bond or debenture)
b) Was an instrumentality of interstate commerce used (i.e. th
phone, road, internet)?
2. Securities and Exchange Act of 1934 (created the SEC) This covers all trading
after the IPO.
3. Must comply with federal and state laws. The exceptions to this are only in
closely held companies
4. 1996 National Securities Market Improvement Act: If you register for the full
registration and comply with the federal law, the blue sky laws are preempted.
5. SEC requires information re: the corporation, provide certified financial
statements, prospectus, file a registration statement under the ’33 act.

Securities Exchange Comm’n v. Ralston Purina (1953)(p. 335)

Is this offering exempt from the 1933 Act?
Issue: Does an offer of stock by a company to a limited number of its employees
automatically qualify for the exemption for transactions not involving any public
Rule: No. The exemption in § 4(1) of the Securities Act of 1933, which exempt
transaction by an issuer not involving any public offering from the registration
requirement, applies only when all the offerees have access to the same kind of
information that the act would make available if registration were required.
Analysis: The Securities Act does not define what is a private offering and what
is a public offering. The court looked at the intent of the Securities Act, which is to
protect investors by promoting full disclosure of information thought to be
necessary for informed investment decisions. When the Act grants an
exemption, the class of people involve were not considered as needing the
disclosure that the Act normally requires. When an offering is made to people
who can fend for themselves, the transaction is considered to be one not
involving a public offering. Most of the employees purchasing the stock from
Ralston Purina (D) were not in a position to know or have access to the kind of
information which registration under the Act would disclose and, therefore, were
in need of the protection of the Act. Stock offers made to employees may qualify
for the exemption if the employees are executive personnel who, because of their
position, have access to the same kind of information that the Act would make
available in the form of a registration statement. Absent such a showing of
special circumstances, employees are just as much members of the investing
public as nay of their neighbors in the community. The burden of proof is on the
issuer of the stock, who is claiming an exemption to show that he qualifies for the
exemption. Also, since the right to an depends on the knowledge of the offerees,
the issuer’s motives are irrelevant. It didn’t matter that Ralston Purina’s (D)
motives may have been good, because they didn’t show that their employees
had the requisite information. Therefore, judgement reversed.
Comment:: The exemption discussed above is now found §4(2) instead of §4(1).
This case is considered to be the leading case in this area. The test established
in this case is still used in determining whether an offering qualifies for the
nonpublic offering exemption of § 4(2). Some of the factors used in determining
whether the offerees have sufficient access to information concerning the stock is
1) the number of offerees,
2) the size of the offering,
3) the relationship of the offerees,
4) the manner of the solicitation of the offerees, and
5) the amount of investment experience of the offerees.
Generally there is a 2 year rule that officers must hold (unregistered) stock for 2
years, before they can sell the stock. Otherwise they would be considered a
public offering.

June 22, 1998 Class Starts Here

July 24th is tentatively the review session date.

EXAM: 4 Questions
1) 1 Question: be a business planning question and you need to advise
them as to the type of entity of what they use and the pros and cons of
all the entities that could be used) 25 Points
2) 2 Heavy fact pattern questions: will be geared around liability and
anytime something wrong occurs and what will 65 points: Not looking
for a great essay, look for the issues and discuss briefly and with
default setting, problem, and what the situation really is. (i.e. Rule,
violation, move on, good faith effort to comply, what is the minority rule.
3) 1 Question: a think piece, (i.e. Should the sole duty of directors be to the
shareholders?) discuss all valid points in this area (15 points)
(a) 4 hours: can be taken anytime and can be checked out at the
registrar desk and make arrangements to turn it back in.
(b) Grading: Check for technical compliance (over time ?)
Was the exam initialed, typed or in pen?
Grade Question by Question
(c) Will grade at the end of the exam time.
4) He will administer exam the night it is scheduled for.
5) You can use word processor, do not download pages out of outline;
(a) Positive points for every problem found.
(b) Negative points for problems that are not really there.
6) Consult anything other than a person. Do not discuss the exam with
7) Double space, don’t scribble.
8) Will schedule a night during the reading period, where he will go
through the exam he used previously.
9) Pre-take the exam.

6. Preemptive Rights and Dilution (Issuance of Shares)

a) Preemptive rights basically refers to an existing s/h’s right to not
have his shares diluted by a new offering; he must have “first
crack” at buying the shares.
(1) However, this right does not entitle an existing s/h the right
to buy at lower than the market price. (Stokes v. Continental
Trust – holding damages limited to price increase after
(2) This is now an opt-in provision of the MBCA (§6.30) –
Preemptive rights are optional; however, some states have it
as an opt-in provision (making preemption the default rule)
b) There is also a fiduciary duty to not issue shares at a lowball
price in an effort to dilute the shares of a s/h you don’t like, even
if preemptive rights are protected (i.e., must have a business
justification for the issue) (Katowitz v. Sidler)


Securities Act Release No. 33-5450 (p. 339) (§ 3 (a)(11)): Allows a localized
offering without registration. The theory is that those in a close proximity of the
business in the community and the reputation would be known. The offering and
the issuer has to be entirely in the state they do business. The requirements are
1) The company has to be incorporated in the state,
2) the buyers all have to be from the state,
3) and offer has to be in the state.
Without this exemption to avoid a public offering you’d have to avoid the
instrumentalities of interstate commerce (e-mail, phone, mail, etc.)
1) It is hard to do expand the ability of small business to expand so the following
was created
Securities Act Release No. 336389 (p. 341) (Regulation D): This allows an
offering limited in scope, without a public offering
1) There can be no general advertising
2) No resale of the shares without an exemption (limited liquidity to investors)
3) Issuer must take reasonable care to insure that the shares are not purchased
for resale. (Issuer must check with the buyer to see why he is buying. The
issuer can take many ways to take reasonable care. The safe harbor rules of
the SEC are:
(a) Inquire of the purchaser
(b) Disclose that the shares are not registered and that
there is no resale without an exemption
(c) The shares must have a legend on them that says the
shares are not registered and are not for resale w/o
4) If the aggregate offer is less than $1MM in a (rolling) 12 month period (all
offers in 1 year are seen as a single offering): there is no limit on the number
of investors (Must always comply with state law)
5) If the aggregate offer is less than $5MM in a (rolling) 12 month period you
can have a maximum of 35 unaccredited investors.
6) If the aggregate offer is over $5MM in a (rolling) 12 month period you can
have 35 unaccredited investors and they all must have knowledge or
expertise necessary to evaluate the merits and risks of the investment. (Test
of business sophistication)
EXCEPTIONS: We do not count anyone who is known as an accredited investor
in the 35 person limits. The accredited investors are defined in this Act as:
1) Banks
2) Organization or Trust (LLC, Corporation, etc.) with assets over $5MM
If formed only for this investment does not count.
3) Directors or officers of the company
4) An individual with a personal net worth over $1MM
5) An individual with a net worth less than $1MM, and their income level (as an
individual) of $200K/yr. over the last 2 years or the combined income of
spouses of $300K/yr. over the last 2 years.

Regulation D – Rules Governing the Limited Offer and Sale of Securities without
Registration Under the Securities Act of 1933 (17 CFR §230.501)(1997)(p. 342)

Smith v. Gross (1979)(p. 349)

Facts: The Smith’s (P) responded to a newsletter in which Gross (D) solicited
buyer-investors to raise earthworms, promising they would double ever 60 days
and he would buy back all the worms produced at $2.25 per pound. He told the
Smiths (P) that little work was required, success was guaranteed by the
repurchase agreement, etc. A suit the Smith’s (P) filed charging Gross (D) with
violation of the federal securities laws was dismissed on the ground that no
“security” was involved. On appeal, the Smith’s (P)argued that there had been
an investment contract type security involved. They claimed the worms did not
multiply at the promised rate and that a profit could be made only if the promised
multiplication rate were reached and if Gross (D) bought back the entire
production at the higher than market price of $2.25 he had promised. As it
turned out, he could pay the price only by selling worms to new worm farmers at
inflated prices. Gross said this was a franchise, not an investment contract.
Issue: Does an investment contract exist when a scheme:
(1) involved an investment of money
(2) in a common enterprise
(3) with profits to come solely from the efforts of others?
Rule: Yes An investment contract exits when a scheme:
(1) involved an investment of money
(2) in a common enterprise
(3) with profits to come solely from the efforts of others.
(meaning the efforts made by those other than the investor
are the undeniably significant ones.)
Analysis: Those essential managerial efforts which affect the failure or success
of the enterprise are what is meant by efforts of others. In this case, these 3
criteria were met. A security therefore was involved. Reversed.
Comment:: The definition of “security” that has been adopted in this line of
cases is quite broad. The result has been to permit investors suckered into a
number of ingenious investment schemes to utilize the protection of the
securities laws. In International Brotherhood of Teamsters v. Daniel (1979), the
Supreme Court refused to characterize a noncontributory pension plan as a

TEST FOR A SECURITY: Essential managerial efforts which affect the failure or
success of the enterprise are what is meant by efforts of others. A security exists
(A) An investment is involved;
(B) in a common enterprise; (in this case they said there was a
symbiotic relationship between the companies)
(C) with profits to come solely from the efforts of others.
(meaning the efforts made by those other than the investor are the
undeniably significant ones.) (In the above case the profit would
come solely from the brilliant efforts of Gross).

F) Issuance of Shares by a Going Concern: Preemptive Rights and Dilution (p.

Preemptive Rights: is a right of a shareholder to subscribe to a pro rata or
proportionate share of any new issuance of shares that might operate to
decrease his percentage ownership in the corporation. (i.e. 1000 shares are
outstanding and a shareholder owns 100 shares. The corporation plans to
issue another 1000 shares, the shareholder has a preemptive right to
subscribe to an additional 100 shares.
Common Law: the shareholders were deemed to have an inherent
right to
preempt new stock offerings.
(1) Some states provide that there are no preemptive rights unless
such rights are provided for in the articles.
(2) Other states indicate that there are preemptive rights unless they
expressly denied in the articles.
Problem w/ preemptive rights: (As far as the corporation is concerned) is
that it limits the financing opportunities of the corporation. Because of this
the preemptive rights usually are only used in closed corporations.


(i.e 20K new shares and 5MM existing shares)
3) ORDINARY SHAREHOLDER: Doesn’t know the articles of incorporation
say, what can they do to protect themselves (opting out helps – opting
in states help shareholders know there is a protection for smaller
4) MBCA Approach: Most larger companies will have an opt out language
therefore no need for them.
5) If not taken (in opt in) the shares can be sold for the same price to
another for 1 year if the rights are not exercised as long as the price is
at least as high as the price that the option was for.
6) In many states the preemptive right does not include shares that are
given for something other than money (ie. Intellectual properties, land,
7) Compensation of shares to officers or directors (Preemptive rights do
not apply)
8) Preemptive rights don’t apply for the 1st 6 months of the corporations
9) If different class shares have been issue, and only one class of shares
will be issued , only those who own shares in that class participate in
the preemptive rights.

Remedies: available to protect a shareholder’s preemptive rights.

Damages: are calculated on the basis of the difference between the
offering price of the new shares and the cost of acquiring the shares in the
market (market value)
Equitable remedies: If the shares are not available in the market, the
shareholder with preemptive rights may sue for specific performance (to
compel the corporation to issue the additional shares necessary for the
shareholder to retain his proportionate interest.) Where the shares have
not been issued (but are about to be) the shareholder may get an
injunction against issuance of the shares in violation of his preemptive

Stokes v. Continental Trust Co. of City of New York (1906)(p. 353)

Facts: Continental Trust Co. (D) had 5,000 shares of outstanding stock of which
Stokes (P) owned 221 shares. The par value of the stock was $100, but the
book value was $309.69. Blair and Company offered to buy 5,000 newly issued
shares of Continental Trust (D) at $450, if those shares were issued. Continental
(D) held a shareholders’ meeting and the new issue was voted. Stokes (P)
demanded that he be sold enough of the new shares to keep his percentage of
stock ownership the same before and after the new issue. He also demanded
that he be sold these shares at par value; however, these demands were turned
Issue: Is a stockholder entitled to purchase enough shares of newly issued stock
to insure that his proportionate share of ownership will remain constant?
Rule: A corporation must allow a shareholder to purchase newly issued stock at
the fixed price to allow him to keep his proportionate share of the stock if he so
A) The existing shareholders have an inherent right to a proportionate share of
new stock issued for cash.
B) Such a right can be waived, but it was not waived here. P protested and
offered to buy his proportionate interest prior to the sale to the brokerage firm.
C) The price to exercise preemptive rights is not to par value but the price fixed
for issuing the shares by the board. Here, it was $50 per share. The
damages should be measured by the difference between the market price of
the shares at the date of the sale and the price P would have had to pay for
the shares at that time ($450).
Dissent:: By demanding to buy at par, there was no evidence that he would have
been willing to pay the stated price.
Comment:: This case represents the common-law view of preemptive rights, or
the right of first refusal of new issues of stock. The prevailing view is that these
rights apply only to common stock.

Equitable limitations on the issuance of shares

1) Fiduciary’s objective of gaining control: As a general rule, it is improper for
directors or majority shareholders to issue shares to themselves for the
purpose of perpetuating their control
2) Duty to issue shares for adequate consideration: There are equitable
considerations other than whether shares have been issue for property or
services equal in value of the shares (i.e. stock watering). The fiduciaries of
the corporation (i.e. directors) have th duty to issue stock for an adequate
price. The factual situations must be closely examined to see whether there
is any injury involved where shares are issued for at least their par value but
for less than their going value.
B. Initial issuance: The shares must be issue for at least their par value.
Beyond this creditors cannot complain, and the shareholders do not care
about the price per share (as long as they each pay the same amount)
C. Later issue: It makes no difference to creditors if shares are issued for less
than they might be worth (since their interests are not affected), but if
stock is reasonably worth $10 / share and is issue for $5, then the
percentage interest of existing shareholders is diluted. But where all
existing shareholders buy their pro rata interest in the new shares, it
makes no difference (since their interests are not diluted). However,
where new shares are to be issued to new shareholders (or to only some
of the existing shareholders), all existing shareholders have an interest in
seeing that the new shares are issued for an adequate price.

Katzowitz v. Sidler (1969)(p. 358)

Inadequate Consideration
Facts: Katzowitz (P), Sidler (D) and Lasker (D) were the sole shareholders and
directors in the Sulburn Corporation. Sidler (D) and Lasker (D) had joined forces
in an attempt to oust Katzowitz (P) form his position in the corporation, and by
stipulation Katzowitz (P) agreed to withdrew from active participation. At the time
of Katzowitz’s (P) withdrawal, the corporation owned each of the directors
$2,500, and Sidler (D) and Lasker (D) proposed a new issuance of stock to
ameliorate (reduce) the debt. Over Katzowitz’s (P) objections, they passed a
resolution whereby each of the three could purchase 25 shares at $100 per
share when the stock was actually worth $1,800 per share (1/18th of book value).
Katzowitz (P) did not opt to purchase, and when the company was dissolved he
received $3,247.59 to Sidler’s (D) and Lasker’s(D) $18,885.52. Katzowitz (P)
brought this action to set aside the distribution, to allow Sidler (D) and Lasker (D)
the return of their purchase price of the 25 shares and to compel an equal
distribution of the remaining assets.
Issue: Can a shareholder who did not purchase from a new issuance as
fraudulent where the new shares are offered in a closed corporation at a totally
inadequate price causing dilution of the shareholder’s interest in the corporation?
Rule: Yes. Where new shares are offered in a closed corporation, existing
shareholders who do not want to or are unable to purchase their share of the
issuance are not estopped from bringing an action based on a fraudulent dilution
of their interest where the price for the shares was inadequate.
Analysis: The concept of preemptive rights was fashioned by the courts to
protect against dilution of shareholders’ interest and is particularly applicable to
the situation of a closed corporation. Although the courts and the legislature are
reluctant to regulate the price at which shares can be offered, if issuing stock for
less than fair value results in a fraudulent dilution of the shareholders’ interests, it
will be set aside. Here Sidler (D) and Lasker (D) issued stock at $100 per share
when the true value of the stock was over $1,800 per share, knowing that
Katzowitz (P) would not elect to purchase his proportionate share and thereby
diluting his interest. The issuance was fraudulent, and after allowing Sidler (D)
and Lasker (D) the amount they paid for the additional shares of stock, the
remaining assets of the corporation will be divided among the shareholders in
proportion to their interests held before the issuance.
Comment:: Although the courts are reluctant to fix prices at which corporate
stock can be issued, they can find little justification for issuing stock far below its
fair value. Generally, the only time stock can be issued far below its book value
is when book value is not reflective of the actual worth of the corporation of
where a publicly held corporation experience difficulties floating a new issue.
The Model Corporations Act §26, provides that preemptive rights only exist to the
extent that such rights are provided, if at all, in the articles of incorporation.

FREEZEOUT: Any attempt to push anyone out of a corporation (This is

what took place in the above case)
Generally speaking freeze-outs are OK, as long as the price is OK, and the
preemptive rights have not been violated.
Trend in most states is that the majority cannot dilute the equity of the minority’s
equity without a good business reason.
June 24, 1998 Class Starts Here
Distribution by a Closely Held Corporation (p. 363)
1. Distributions: A dividend is any distribution of cash, property, or
additional shares (a stock dividend) paid to present shareholders asa
result of their stock ownership.
a) No remedy for minority s/hs where majority s/hs pay themselves
salaries and bonuses but issue nothing but nominal dividends
(Gottfried v. Gottfried) (note: rule changes for small corporations
– see Davis v. Sheerin, infra)
b) However, if it’s clear that management isn’t working for profit
maximization for the s/hs, a court can force a dividend payment
(Dodge v. Ford Motor Co.)
(1) Note result above is probably more due to Ford’s
brazenness than anything else; also note that IRS can nail you with
penalties (IRC §§ 501, 502) for holding excessive surpluses

Balance Sheet Test: dividends may only be paid when (after the payment of the
dividend) the assets exceed both the liabilities and the capital stock accounts.
Earned Surplus Test: Indicates that dividends can only be paid out of the
earned surplus (including current profits) of the corporation.
Solvency Test: The corporation cannot pay a dividend if it is insolvent or the
dividend would make it insolvent. Definition of insolvency include:
(a) Liabilities exceed assets.
(b) The company cannot meet its debts as they fall due
(regardless whether the value of the assets exceeds the

Gottfried v. Gottfried (1947)(p. 363)

Bad Faith
Summary: No remedy for minority s/hs where majority s/hs pay themselves
salaries and bonuses but issue nothing but nominal dividends (note: rule
changes for small corporations – see Davis v. Sheerin, infra)
Facts: Minority stockholders (P) brought a suit against the board of directors (D)
of a closely held family corporation to compel it to declare dividends on the
common stock. No dividends were paid on the common stock for 14 years until
immediately before commencement of this action, the purpose of which was now
to compel payment in such amount as would be fair and adequate. The minority
stockholders (P) contended that the directors (D), who owned the controlling
stock, had bitter animosity toward the minority (P) and sought to coerce them into
selling their stock to the directors (D) at a grossly inadequate price.
Issue: If an adequate corporate surplus is available for the purpose, may
directors withhold a declaration of dividends in bad faith?
Rule: No. If an adequate corporate surplus is available for the purpose, directors
may not withhold a declaration of dividends in bad faith.
Analysis: The essential test of bad faith is to determine whether the policy of the
directors is dictated by their personal interests rather than the corporate welfare.
Facts relevant to the issue of bad faith include:
1) intense hostility of the controlling factions against the minority;
2) exclusion of the minority from employment by the corporation;
3) high salaries, or bonuses, or corporate loans made to the officers in control;
4) the fact that the majority may be subject to high personal income taxes if
substantial dividends are paid;
5) and the existence of a desire by the controlling directors to acquire the
minority stock interests as cheaply as possible.
Here, it appears that the directors (D) had legitimate business reasons for not
declaring dividends, and hence, no bad faith was involved. Complaint was
Comment:: Closely held corporations are easily subject to abuse on the part of
the dominant shareholders, particularly in the direction of action to compel
minority stockholders to sell their stock at a sacrifice. Even in the absence of bad
faith, the impact of dissension and hostility among shareholders usually falls with
heavier force in a closely held corporation. In many such cases, a large part of a
stockholders’ assets may be tied up in the corporation. It is frequently
contemplated by the parties, moreover, that the respective stockholders receive
their major livelihood in the form of salaries as employees of the corporation. But
the fact that the corporation is closely held will not cause the courts to give
greater scrutiny to the validity of the majority’s actions.

Dodge v. Ford Motor Company (1919)(p. 367)

Accumulation of Surplus
Summary: If it’s clear that management isn’t working for profit maximization for
the s/hs, a court can force a dividend payment
Facts: In the 1916 sales year, FMC (D) looked forward to a $60 million profit,
$132 million in assets, $54 million in cash and municipal bonds, and $122 million
surplus – all set against a mere $20 million in liabilities. Despite this President
and Board Chairman, Henry Ford announced that he was forthwith discontinuing
the payment of dividends to stockholders. 2 general reasons were given.
1) He anticipated an $11.3 million construction program to go into effect in order
to erect a smelter for the company
2) And, he had determined to dedicate the company to the welfare of the
general public by increasing jobs and lowering the price of cars annually.
The Dodge Brothers (P), shareholders in FMC (D) objected to the latter reason
for not declaring dividends so they filed this action to compel repayment. From
decree for Dodge (P), this appeal followed.
Issue: May the courts intervene to require payment of a corporate dividend
where the avowed motive of the directors for not paying it is to benefit the
interests of third parties not participating in the ownership of the corporation?
Rule: Yes. Ordinarily, the directors of a corporation alone have the power to
declare a dividend, but the courts will intervene to require that a dividend be paid
if it is discovered that the refusal of the directors to do so is based in fraud or an
intention to conduct the affairs of the corporation not for the shareholders but
rather for 3rd parties who do not participate in the ownership of the corporation.
Analysis: It is manifestly improper for the directors of a corporation to refuse to
exercise their powers for the benefit of the shareholders. In following Chairman
Ford’s reasoning, here, however, the directors have done just that. As such,
FMC (D) was directed to pay a dividend to its stockholders this year in an amount
consistent only with the legitimate expansion and business interests o the
corporation. Reversed.
Concurrence: The very fact here of the extraordinary accumulation of surplus
should, by itself, be enough to establish a sufficient abuse of discretion to justify
the intervention of equity.
Comment:: Though many public interest groups have urged changes in it , the
general rule still is that a corporation may not legally put the public interest above
the interests of its shareholders. As a general rule, there is no right to a dividend
for any shareholder (except in those cases in which dividends are made
mandatory for preferred shareholders, by the Articles of Incorporation, in cases in
which proper sources are available). Note finally that Dodge is one of the very
few cases in which equity has ever considered a refusal to pay a dividend so
improper and/or in such bad faith as to justify interference with the normal
corporate decisions process. Of course, since Henry Ford dominated the
process in the FMC (D), it was ineffective to protect the (soon to depart) minority
interest of the Dodges (P).

Wilderman v. Wilderman (1974)(p. 370)

Unauthorized Salaries to Officers
Facts: Eleanor Wilderman (P) and her husband Joseph (D) founded, and later
incorporated, the Marble Craft Company (D). The business was engaged in the
installation of ceramic tile and marble facings. Both Eleanor (P) and Joseph (D)
had some knowledge of the craft, but from the start of the company (D), Joseph
(D) performed most of the duties of the business, while Eleanor (P), as the
company’s (D) only stockholders, elected themselves as directors and chose
Joseph (D) as president, while Eleanor (P) was designated vice president,
secretary, and treasurer. Both Joseph (D) and Eleanor (P) received salaries
which had been fixed by agreement, although they elected not to pay themselves
dividends because that practice would have subjected them to double taxation.
Although the company (D) became extremely successful, the Wildermans’
marital relationship ultimately proved unsatisfactory. They separated and later
divorced, and Joseph (D) increased the amount of compensation which he paid
to himself. Although Joseph (D) had been authorized to receive an annual salary
of only $20,800, he paid himself more than $90,000 in salary and bonuses in
1971, received $35,000 in 1972, and accepted a total compensation of nearly
$87,000 in 1973. Eleanor’s (P) salary from 1971 to 1973 was $7,800 per year.
During this period, the court appointed a custodian to assist in the management
of the company (D), and he succeeded in having a $20,000 dividend declared,
Eleanor (P) and Joseph (D) dividing the amount equally. But when the
custodian’s intervention failed to eliminate or reduce the disparity in salaries.
Eleanor (P) filed suit against both Joseph (D) and the company (D). Suing both
as an individual and in her capacity as a shareholder, Eleanor (P) sought the
return of excessive amounts paid to Joseph (D), an injunction against additional
unauthorized disbursements, and an order directing that the company’s (D)
management continue to be subjected to the supervision of the custodian.
Eleanor (P) also sought an order compelling the company (D) to pay dividends
and asked that the corporate pension plan be adjusted to reflect the fact that the
excessive compensation paid to Joseph (D) had bee declared improper.
Issue: May the president of a corporation arbitrarily pay himself more
compensation than the company’s board of directors has authorized?
Rule: No. In the absence of a specific authorization b the company’s board of
directors, a corporate executive may receive only that amount of compensation
which is reasonably commensurate with his function and duties.
Analysis: Joseph Wilderman (D) was authorized to receive a salary of only
$20,800 per year. Any agreement pursuant to which he may have been entitled
to more compensation had been rescinded prior to 1971. The excessive
amounts which he received in 1971, 1972, and 1973 may be justified, if at all,
only the application of the quantum meruit theory. On thee basis of the evidence
presented, it does not appear that the compensation to which Joseph (D)
unilaterally and arbitrarily declared himself entitled was reasonable in light of the
services he performed for the company (D). An expert witness testified that
$35,000 per year was the highest salary which should reasonably have been
paid to Joseph (D). Moreover, the IRS permitted Marble Craft (D) to deduct only
$53,000 of the more than $92,000 which Joseph (D) received in 1971. Since
Joseph (D) has produced no evidence which would justify his receipt of
compensation as generous as that which he paid himself, it is appropriate to
require the return of any excess over $45,000 received in any of the years in
question. Appropriate adjustments in the corporate pension fund must also be
made, and dividends may be declared at the instance of the company’s (D)
board of directors or, in the event of a deadlock, the custodian.
Comment:: The salaries of corporate executives are ordinarily fixed by the
company’s board of directors and are incorporated into each executive’s
employment contract, whether it be oral or written. Any person who renders
services for another has some chance of recovering compensation. It he brings
an action based on quantum meruit. Only rarely would such a suit prove
beneficial to a corporate executive since, in order to recover, he would have to
prove that his services were performed on behalf of the company but were in
addition to the duties which were required of him in the usual conduct of his

Unincorporated Businesses & Closely held Corporations (p. 375)

Donahue v. Rodd Electrotype (1975)(p. 378) Offer to all shareholders

Facts: as a controlling stockholder of Rodd (D) a close corporation, Harry Rodd
(D) caused the corporation to reacquire 45 shares for $800 each ($36,000 total).
He then divested the rest of his holding by making gifts and sales to his children.
Donahue (P) a minority stockholder who had refused to ratify this action, offered
to sell her shares on the same terms but was refused. A suit followed in which
Donahue (P) sought to rescind the purchase of Harry Rodd’s (D) stock and make
him repay to Rodd (D) the $36,000 purchase price with interest. Finding the
purchase had been w/o prejudice to Donahue (P), the trial court dismissed the
bill and the appellate court affirmed.
Issue: Must a controlling stockholder in a close corporation who has caused the
corporation to purchase some of his shares see to it that an equal offer is made
to the other stockholders?
Rule: Yes. A controlling stockholder (or group) in a close corporation who causes
the corporation to purchase his stock breaches his fiduciary duty to the minority
stockholders if he does not cause the corporation to offer each stockholder an
equal opportunity to sell a ratable number of shares to the corporation at an
identical price.
Analysis: Stemming from the fiduciary duty owed by a controlling stockholder of
a close corporation to the minority stockholders, a controlling stockholder who
causes such a corporation to purchase some of his shares must cause the
corporation to offer each stockholder an equal opportunity to sell a ratable
number of shares to the corporation at an identical price. Close corporations are
somewhat different in that thy are very much like partnerships and require the
utmost trust, confidence, and loyalty among the members for success. This
means a partnership-type fiduciary duty arises between stockholders, it is the
basis for the rule herein announced, under which Donahue (P) must be given an
equal op0portunity to sell her shares. Reversed and remanded.
Concurrence: I do not join in nay implication that this rule applies to other
activities of the corporation, like salaries and dividend policy, as they affect
minority stockholders.
Comment:: A problem which exists with close corporations is that there is no
ready market to which a minority stockholder can turn when he wishes to
liquidate his holdings. Knowing that fact, the controlling stockholder has a very
powerful weapon which he would not have in a regular corporate setup. This is
one of the reasons he is held to a higher degree of fiduciary duty in this case.

D) Legal Restrictions on Distributions (p. 391) IRS can reclassify a salary as a

dividend if it is deemed unreasonable
(A) See Herbert G. Hatt, where excessive salary, boat, and plane are all
deemed to be dividends for tax purposes
(B) Note: if s/h wants to sue director for taking action that increases taxes
unnecessarily, the standard is unreasonableness
1) “Earned Surplus” Dividend Statutes (p. 392)
2) “Impairment of Capital” Dividend Statutes (p. 393)
3) Distribution of Capital under “Earned Surplus” Statutes (p. 394)
4) Insolvency:
b) General Rule: No repurchase or redemption is permitted where
the corporation is insolvent or would be rendered insolvent by
the purchase distribution.
c) Definition of insolvency: is different in various jurisdictions.
(Financial condition such that the corporations’ debts are greater
than aggregate of such debtor’s property at a fair valuation. ( A
condition where if all of the entity’s assets and liabilities were
made immediately available and due, they would not balance
each other.
d) Subsequent insolvency: There are instances where the
corporation enters into a contract (at a time when it is solvent) to
purchase shares, and at the time that the contract is to be
executed, the corporation is insolvent. For example, the
corporation may agree to buy a shareholder’s stock on an
installment basis, and when one of the installments falls due, not
have the lawful source for the purchase.
5) The Model Business Corporation Act (p. 395)
Official Comment to §6.40) (p. 395) MBCA §6.40 – A corporation cannot
make a distribution if it meets two tests:
(2) Equity Insolvency Test (p. 395) (§6.40(c)(1)): can’t pay its
liabilities as they come due (absence of auditor’s
qualification on audit report meets this test; otherwise, a
judgment call), and
(4) Balance Sheet Test (p. 396) (§6.40(c)(2)): the distribution
would reduce assets to less than liabilities + distribution
preferences (Must use ‘reasonable’ accounting method, but
GAAP isn’t mandated – §6.40(d))
(a) GAAP (p. 397)
(b) Other principles (p. 397)
(5) Preferential Dissolution Rights & the Balance Sheet Test (p. 398)
(8) Application to Reacquisition of Shares (p. 398)
(a) Time of measurement (p. 398)
(b) When tests are applied to redemption-related debt (p. 398)
(c) Priority of debt (p. 399)
(9) Treatment of certain indebtedness (p. 399)

JUNE 29, 1998 Class Starts Here

June 22 & 24, 1998 Class Assignments (pp. 401-524)
Management and Control of the Closely Held Corporation
A) Traditional Roles of Shareholders and Directors (p. 401)
McQuade v. Stoneham (1934)(p. 401)
Facts: Stoneham (D) was the majority stockholder in the National Exhibition
Company (New York Giants Baseball Club) and held 1,306 shares. McQuade
(P) and McGraw (D) were the only other stockholders. Each held 70 shares for
which each paid Stoneham (D) $50,338.10. The 3 entered into an agreement by
which they promised to use their “best endeavors” for the purpose of continuing
themselves as directors and officers of the club, with Stoneham D) as president
at $45,000 per year, McGraw (D) as vice president at $7,500 per year, and
McQuade (P) as treasurer at $7,500 per year. The agreement could not be
changed w/o unanimous consent of the parties. The board of directors had 4
other members controlled by Stoneham (D). McQuade (P), who also happened
to be a New York city magistrate, served as treasurer for 7 years when Bondy
was elected to succeed him. At the meeting, Stoneham (D) and McGraw (D
abstained from voting. McQuade (P) voted for himself, and the other 4 directors
voted for Bondy. Stoneham (D) and McGraw (D) acquiesced in this election and
in the failure to reelect McQuade (P) as a director at the following shareholder
meeting. The trial court would not reinstate McQuade (P) in his action to compel
specific performance but gave him damages for wrongful discharge. Stoneham
(D) and McGraw (D) appealed.
Issue: Is a contract illegal and void so far as it precludes the board of directors,
at the risk of incurring legal liability, from changing officers, salaries, or policies or
retaining individuals in office, except by consent of the contracting parties?
Rule: Yes. A contract is illegal and void so far as it precludes the board of
directors, at the risk of incurring legal liability, from changing officers, salaries, or
policies or retaining individuals in office, except by consent of the contracting
Analysis: While McQuade (P) argued that the agreement should be enforceable
so long as the officer is loyal to the interests of the corporation, holding such
agreements unenforceable is preferable to one where the courts would have to
pass on the motives of directors in the lawful exercise of their trust. The decision
should also be reversed because, by statute, no city magistrate shall engage in
any business other than the duties of his office. McQuade’s (P) employment with
the club was more than an occasional business transaction or voluntary
assistance. He was receiving a substantial salary. Reversed and dismissed.
Dissent in Part: Reversal was required on grounds of the violation of the
magistrate’s duties statute only. As for the contract, it appears to be legal. A
contract which merely provides that stockholders shall in combination, use their
power to achieve a legitimate purpose is not illegal. There was no evidence that
the contract here was a corrupt bargain intended to despoil the corporation.
Comments: Generally, an agreement made by a person who is director or
expects to become one which requires that he vote in a certain way or puts him
under pressure to do so is illegal and void, except in some cases where all the
shareholders are parties. Also, an agreement which places restrictions on a
shareholder which wholly deprive him of any functions as a shareholder or as a
director, if he were to become one, is illegal. Such an agreement would, under
Delaware law, insofar as it concerns a close corporation and stockholders
holding a majority of the outstanding voting shares, be valid. Employment
agreements OK, separate class of share OK, generally shareholders appoint
directors, and directors appoint management.


Clark v. Dodge: Closed Corporation: They all agree to appoint each other.
Galler v. Galler (1964)(p. 407) IMPORTANT CASE
Facts: 2 brothers, Isadore (D) and Benjamin, incorporated their partnership in
1924 and operated as such for over 30 years. In 1955, the 2 brothers drew up a
shareholders’ agreement to provide for the financial security of their respective
families in the event of either brother’s death. The agreement provided for salary
continuation payments to the surviving widow. It further allowed the surviving
widow to remain on the board of directors and to name a successor to her
husband. Specific dollar amounts of dividends were mandated by the
agreement. However, these payments were qualified so as not to impair the
capital of the corporation. After Benjamin’s death, his wife Emma (P) sought
enforcement of the agreement. Isadore (D) repudiated the agreement, claiming it
violated the corporation code of Illinois and the public policy of that state.
Issue: Can shareholder agreements pertaining to dividend policy and selection of
directors be enforced in the case of a close corporation when such agreements
would not be permissible in a publicly held corporation?
Rule: Yes. Close corporations will not be held to the same standard of corporate
conduct as publicly held corporations in the absence of a showing of fraud or
prejudice toward minority shareholders or creditors.
Analysis: The unique nature of close corporations – close relationship of
shareholders; lack of marketability of shares; and overlapping of shareholders
and officers – creates a situation which should allow “slight deviations from
corporate norms.” These deviations should be permitted so long as they do not
operate to defraud or prejudice the interests of minority shareholders or
creditors. Since the principals in a close corporation usually have a close
relationship, their agreements should be enforced where no clear statutory
prohibitions are violated. Since the agreement did not imperil creditors and there
were no minority shareholders’ interests involved in this instance, the agreement
was valid and enforceable.
Comments: This case is representative of the growing acceptance by most
jurisdictions of the basic differences between publicly held and closely held
(close) corporations. There is recognition that the parties in a close corporation
regard themselves, in fact, as partners. This view allows for a latitude in
enforcing shareholders’ agreements that would be unacceptable in publicly held
corporations. Many statutes regulating corporations are intended to protect the
interests of the shareholders and creditors. Where the shareholders are few in
number and operating, in essence, as partners, the need for such rigid protection
is absent. As long as the rights of minority shareholders and creditors are not
infringed, the close corporation can be given a relatively free reign as regards
internal structure and operation.

Closed Corporation Statutes: In about 30 states it is allowed to carve out

traditional directors powers and allow them to act as shareholders. 2 states don’t
distinguish between directors and shareholders in closed corporations, since
they are usually the same people.
17 states you can elect to be a closed corporation at the time of incorporation.
(must opt in)

In some states, amending the by laws is allowed by the board. Most state
statutes said this specifically, but the modern approach lets the Board or the
Shareholders amend by laws unless the Articles of Incorporation gives this only
to one group (not usual)

Zion v. Kurtz (1980)(p. 417)

Facts: Kurtz (D) was the principal shareholder of a corporation in which Zion (P)
was a minority shareholder. They executed an agreement which precluded the
corporation from entering into any business transactions without Zion’s (P)
consent. The corporation subsequently breached the agreement, and Zion (P)
sued to enforce it. The trial court granted summary judgement for Zion (P), and
Kurtz (D) appealed, contending the agreement violated state law by delegating
the control over corporate actions from the board of directors to a minority
shareholder. The appellate court reversed, and the court of appeals granted
Issue: Is a shareholder’s agreement requiring minority shareholder approval of
corporate activities enforceable between the original parties to it?
Rule: Yes. A shareholder’s agreement requiring minority shareholder approval of
corporate activities is enforceable between the original parties to it
Analysis: Reasonable restrictions on director discretion are not against public
policy and are not precluded by statute. Since all stockholders assented to the
agreement and it is not prohibited by statute or public policy, it is enforceable.
Comments: Agreements of the type discussed in this case are usually found in
closely held corporations. Although the corporation in this case was not formed
as a close corporation, the court found this inconsequential. It reasoned that
because the articles of incorporation granted the board power to take all steps
necessary to enforce the terms of the articles, the corporation could easily gain
close status in order to render the shareholder agreement valid.

The above case shot down McQuade if you are a closed corporation.
If you don’t act unanimously at the outset or you are not a closed corporation,
you can’t get rid of the powers of the directors v. shareholders.
McQuade is good law for
1) Large Public corporation
2) In state where you have to action to be known as a closed corporation.
3) May apply where you try to cram something down a minority’s throat

Matter of Auer v. Dressel (1954)(p. 424) PUBLICLY TRADED SHARES

Facts: Stockholders of Hoe & Co. Inc. (P) sought to compel Hoe’s president (D)
to call a special stockholders’ meeting after stockholders of more than the
required 50% of the voting class A stock requested such meeting which the
president (D) refused call. He claimed that he did not have information sufficient
to confirm the adequacy of the number of shares backing the request. He also
claimed that none of the four stated purposes for the meeting was proper. Those
purposes were as follows:
(A) to recommend reinstatement of the former president (Auer) who had been
ousted by the directors;
(B) to amend the bylaws so that any vacancy on the board be filled by a vote of
only those stockholders whom the director represents;
(C) to vote upon charges against for particular directors; and
(D) to amend the bylaws regarding the number of directors necessary for a
The court summarily ordered the president (D) to call the requested meeting, and
he appealed.
Issue: Must corporate management call a special meeting when the necessary
number of voting shares back such a request and when no purpose for the
meeting is improper?
Rule: Yes. Corporate management must call a special stockholders’ meeting
when the necessary number of voting shares back such a request and when no
purpose for the meeting is improper.
Analysis: Here, there was no reason why the stockholders could not show their
approval (make a recommendation) of their former president. As for purpose “B”
stockholders who are empowered to elect directors have the inherent power to
remove them for cause. Furthermore, stockholders of one class can exclude
those of another from filling vacancies when the director only represents a
particular class. The important right of stockholders to have such meetings
called will be of little practical value if corporate management can ignore the
requests, force the stockholders to commence legal proceedings, and then, by
purely formal denials, put the stockholders to lengthy and extensive litigation to
establish facts as to stockholdings which are peculiarly within the knowledge of
the corporate officers. Affirmed.
Dissent: The president (D) was justified in not calling a meeting no matter how
many shares supported the request if none of the proposals could be acted upon
by the stockholders. It would have been an idle gesture for the shareholders to
show their support for the former president because the management of the
corporation is vested in its board of directors. As for only allowing class A
stockholders to fill class A directorships, class A stockholders could not exclude
other shareholders from voting on a proposal which would prevent them from
voting on certain directorships in the future. Further, while stockholders can
recall directors before their terms have expired simply to change corporate
Comments: One aspect of the case barely discussed by the majority was the
alleged impracticability and unfairness of constituting the numerous stockholders
as a tribunal to hear charges made by themselves and the incongruity of letting
the stockholders hear and pass on those charges by proxy. The dissent feared
that “the consequence is that these directors are to be adjudged guilty of fraud or
breach of faith in abstentia by shareholders who have neither heard nor ever will
hear the evidence against them or in their behalf.” The majority simply stated
that this question was not before the court on the appeal and that any director
who believed he was illegally removed could seek his remedy in the courts.

Shareholders vote to
1) elect and remove directors.
2) amend by-laws.
3) Approve mergers and assets sales not in the normal course of business
(i.e. mergers, dissolutions, conflict of interest transactions – member of the
board is dealing with the company and may be doing things for his personal
gains; indemnification of director or officer; make recommendations i.e.
authorize dividends; and appoint the auditors.

B) Shareholder Voting and Shareholders’ Agreement (p. 431)


A. General Concepts: S/holdrs can only act at reg. mtg (OHIO unanimous
written consent)
-> Must have annual mtg; special s/holdrs mtgs can be called by dir.,
Pres. or usually 25% s/holdrs (ltd to items in mtg notice); quorum is
maj. of authorized & issued record s/holdrs entitled to vote

B. Voting by Proxy (designate someone vote your shares)

1. Proxy is special form of agency; must be in writing; valid 11 mo.
unless says otherwise & valid if giver dies unless corp. notified b/4
vote taken
2. Proxy is REVOCABLE unless appt coupled w/ financial interest in
the shares (shares to bank for loan security)

C. Voting Agreements: s/holdrs pool shares & K'lly bind themselves to

vote in certain way (keep physical shares)
1. Some states say if agreement for valid purpose (getting control of
corp. is valid purpose) then IRREVOCABLE by statute (NOT OHIO) and
specifically enforced
2. W/O statute, proxies w/in the agreement are REVOCABLE
-> Can't then demand specific perf., only $ damages

D. Voting Trusts: agreement in writing where s/holdrs transfer title of

shares to trustee & get cert. of benef'l ownership
1. Valid if for proper purpose; trustee owner on books & gets to vote
the shares (less chance of rebelling)
2. OHIO: requires writing, not longer 10 yrs unless voting rights are
couple w/ an interest in the shares (maj. can vote to extend); copy must
be filed with corp.
3. PROBLEMS: agreement public & don't like giving up title

Shareholder Meetings
A) Annual Meeting
1) Shareholders vote on various items affecting the corporation
B) Notice varies from state to state, 10 days to 50 days. If notice is not sent and
any one objects the meeting cannot proceed. If waived then meeting can
C) The more common way of a meeting to happening is that if you showed up to
the meeting and didn’t complain about getting notice then you have
acquiesced to the meeting.
D) Quorum: is needed, and this is decided by the by laws. Normally it is a
majority of issued shares. What happens if at a meeting there are 500 shares
in a company and 251 shares show up and I own 3 shares. If the person with
3 shares walks out of the room, the meeting keeps going. You cannot walk
out of a meeting to break a quorum.
E) The number of votes needed to pass corporate activities are listed in the
Articles of Incorporations is typically a majority of shares at the meeting.
Traditionally you count abstentia votes as a no. Under the MBCA you don’t
count abstentias. (so only those actually vote count).
F) We don’t want to have a meeting we can sign an unanimous letter (everyone
must sign) so that no meeting need to be held. (this is in some states, other
states say that you need a majority to pass a resolution.)
G) The company, in the notice, states a record date in the notice that is when
they are going to look in the corporate books to see who the shareholders
are. This determines who can vote.
H) Beneficial ownership (has the right to dividends and the right to vote) is the
stock issued to Cede & Company ( a nominee who is the record holder on the
books) This company has to notify the (beneficial owner who can vote (in
some case, if you don’t vote the record holder may be able to vote in your
place.) Dividends are paid to Cede & Co. who then pays the dividends to the
beneficial owner.
I) The record owner has an obligation to notify the beneficial owners on all
activity of the stock. Most public companies contact the record holder.
J) When the meeting is held, the record holder is sent a proxy, who forwards
the proxy to the beneficial owner, with the notice of the meeting and
beneficial owner sends it back to them with how they want to vote (in some
cases the record holder may have the right to vote).

Salgo v. Matthews (1973)(p. 431)

Facts: Matthews (P) headed a group of stockholders who desired to wrest
control of General Electrodynamics Corp. from Salgo (D), the president of the
corporation. Matthews (P) faction, intended to accomplish its objective by
waging a successful proxy fight. A special stockholders’ meeting was convened,
and Salgo (D) appointed Meer (D) to serve as election inspector. Numerous
proxies were submitted to Meer (D) by Matthews (P), but Meer (D) refused to
accept certain of these, including some that had been executed in Matthews’ (P)
favor by Pioneer Casualty Company, registered owner of nearly 30,000 shares of
General Electrodynamics stock. Pioneer was in receivership, and beneficial title
to its shares had been transferred to Shepherd, who was himself bankrupt. A
court order had authorized Pioneer’s receiver to give Shepherd a proxy vote
executed by Shepherd. Meer (D) took the position that only Shepherd’s
bankruptcy trustee, as beneficial owner of the General Electrodynamics stock,
had a right to vote the shares. Matthews (P) filed suit against Salgo (D) and
Meer (D), and the trial court issued an order requiring Salgo (D) to reconvene the
shareholders’ meeting for the purpose of declaring Matthews (P) and his slate as
winners of the company election. Salgo (D) did so but then appealed from the
court’s order.
Issues: May a corporation require that shares of its stock be voted only by their
beneficial owner?
Rules: No. Shares of stock may be voted only by an authorized representative of
the party designated in the corporate records as legal owner of the shares.
Analysis: General Electrodynamics’ corporate records show that nearly 30,000
shares of its stock are owned by Pioneer, and Meer (D) had no right to insist that
those shares of its stock are owned by Pioneer, was entitled to vote the shares,
and, because of Pioneer’s insolvency, its receiver was the only representative
authorized to act on the company’s behalf. The receiver did, in fact, act, and the
fact that he chose to do so through Shepherd does not change the fact that the
receiver was acting on behalf of the duly registered owner of the stock. As
election inspector, Meer (D) was entitled to use his discretion in assessing the
validity of disputed proxies, but he had no right to go beyond the corporate
records to determine the identities of those shareholders entitled to vote.
However, although Meer (D) exceeded his authority, the proper remedy for his
abuse of discretion was a proceeding quo warranto. Since Matthews (P) should
have availed himself of that statutory remedy, the court had no right to grant the
mandatory relief which it decreed.
Comment:: The individuals listed in a corporation’s stock book are designated
its “shareholders of record.” Only those persons who were shareholder of record
on a specified date may vote in corporate elections. Ordinarily, a list of all
shareholders is maintained and kept current, and interested parties are entitled
to inspect the list if certain statutory requisites are met. Shareholders of record
enjoy various other privileges as well, including the right to bring derivative suits
against the corporation and the right to receive such dividends as may from time
to time be declared.

Election of Directors and Cumulative

1) Elect directors for a year
2) Staggered /Classified Board of Directors (i.e. every 3 years new directors are
3) Classification of Shares to vote:
4) Cumulative Voting v. Straight voting
a) Cum voting can be eliminated by amendment to Art. 90 day after
corptn formed; must give 48 hr notice b/4 mtg; can classify dir.
in Ohio for staggered terms
b) Dir. run at large; Non-cumulative 51% elects entire bd; Cum = #
shares x # dir. electing; Cumulative can pool votes
c) Look to see if w/ minority s/holdrs pooled altogether, maj. can
still defeat. Requires: 1/#dir be'g elected+1 + 1=shares to WIN
When cummulative voting oust a director, then
Most states allow you to have cummulative voting or not. Do you opt in or opt
out. This is only for directors.
Review pages 435-436 re: Cumulative voting
JULY 1, 1998 Class Starts Here
3. Ties don’t count
4. See note on page 436 (case Note #1)
5. Opt in or opt out (or given by statute) does not it will automatically
happen at the meeting. If no shareholder requires cummulative
voting then it won’t happen. Notice must be given if a shareholder
wants cummulative voting

Review of Cummulative Voting

Minority has 75 votes and the majority stockholder has 225 votes
3 people are running
the minority will never take one director slot
73 1 1 (minority)

5 person board
125 Total Votes 121 1 1 1 1 (minority) would get one spot
375 Total Votes 75 75 75 75 75

Humphrys v. Winous Co. (1956)(p. 437)

Facts: The board of directors of Winous Co. (D) consisted of 3 members. The
company (D) created separate classifications for each of the 3 directors so that
no 2 would be required to stand for reelection at the same time. Humphrys (P)
filed suit against the company (D), contending that its classification scheme
nullified the effectiveness of cumulative voting. A state statute expressly
conferred the right to vote cumulatively and prohibited the restriction or
qualification of that right. The trial court rejected Humphrys’ (P) argument, but
the appellate court reversed. Winous Co. (D) then appealed.
Issues: Does a statute which prohibits interference with the exercise of
cumulative voting rights ensure that minority stockholders will be represented on
a company’s board of directors (on a classified board)?
Rules: No. A statute prohibiting restrictions upon the exercise of cumulative
voting rights should not be construed as guaranteeing minority stockholders
representation on a company’s board of directors.
Analysis: The value of cumulative voting as a restraint upon a potentially
oppressive majority was first recognized by the bar association of this state. And
cases in other jurisdictions have held that cumulative voting may not be negated
by charter amendments, by removing minority directors without cause, or by
reducing the membership of a board of directors. But the Ohio cumulative voting
statute, while it precludes interference with the right to vote cumulatively, cannot
be interpreted as ensuring minority representation. Any scheme for classifying
directors necessarily diminishes the potential effectiveness of cumulative voting.
But, since the legislature has chosen to permit the classification of directors, it
seems illogical to contend that classification should not be permitted merely
because it may tend to nullify the potential success of cumulative voting.
Therefore, the appellate court erred in deciding that the Winous Co. (D)
classification scheme violated the cumulative voting statute, although the scheme
would be void today because of a code revision prohibiting the creation of
classes consisting of fewer than 3 directors.
Dissent:: In authorizing classification of directors, the legislature could not have
intended that practice to be used to defeat cumulative voting. This is evidenced
by the fact that the same act as permitted classification of directors also induced
the provision prohibiting restriction or qualification of the right to vote
Comment:: Cumulative voting is designed to enable minority shareholders to
secure some representation on a corporation’s board of directors. It permits a
shareholder to cast his total number of votes (the number of share he owns x the
number of slots to be filled) for one director, instead of casting one vote per
share for each vacancy. A simple formula may be used to determine the number
of shares needed to elect a given number of directors. Where S equals the total
number of shares voting, D equals the number of slots to be filled, and n equals
the number of directors the minority hopes to be able to elect, the following
equation will reveal the number of shares needed to elect the desired number of
number of shares minority shareholders needed in order to elect a director.


Voting Trust: is given the right to vote, and is given instructions on how to vote
(i.e. vote as the majority wishes, or do whatever a particular person does, etc.)
This is enforceable. There is a trustee over the trust (with a limited time usually
10 years)
Voting Agreement: This is just a standard contract between several
shareholders, and this is an agreement to vote together, and if they can’t agree
on how to vote, the arbitrator will decide and we are bound by the decision.
a) If the arbitrators decision is not followed then (the arbitrator did
not have the power to vote) It is permissible to vote the same,
and does not violate the rules for voting trusts. Shareholders
have flexibility on binding themselves.
b) If the contract is violated, it must be enforced. The court can sue
for damages, or force an injunction, or have a re-vote, or not
count the votes of the person who did not follow it.
c) In Ringling the court did not provide for specific performance, (in
a voting trust the arbitrator would have been given the right to
vote on behalf of the shareholders)
Ringling Bros.-Barnum & Bailey Combined Shows v. Ringling (1947)(p. 444)
Facts: 2 of the stockholders of Ringling Bros. (D), Ringling (P) and Haley (D),
entered into an agreement by which they always would vote their shares
together, but if they could not agree, they would vote in accordance with the
decision of an arbitrator, one Loos. They made this agreement because together
they would have enough votes to elect 5 of the 7 directors, while North, the 3rd
stockholder, could only elect 2. In 1946, Ringling (P) and Haley (D) agreed to
elect themselves, Ringling’s (P) son, and Haley’s (D) husband, but they could not
agree on a 5th director. Ringling (P) demanded arbitration, and Loos decided that
Ringling’s (P) proposed director, Dunn, should receive the votes of Haley (D).
Haley (D) refused to vote for Dunn and voted for just herself and her husband. If
the vote was figured according to Loos’ direction, Dunn was elected, but if not,
one of North’s candidates, Griffin, was chosen. Ringling (P) brought suit to
enforce the arbitrator’s decision, while Haley (D) argued that their voting
agreement was illegal. The agreement was upheld and a new election directed
in accordance with the agreement. Haley (D) appealed.
Issues: May a group of shareholders lawfully contract with each other to vote in
the future in such a way as they, or a majority of their group, from time to time
Rules: Yes. A group of shareholders may without impropriety lawfully contract
with each other to vote in the future in such a way as they, or a majority of their
group, from time to time determine.
1) The agreement in question did not give Loos the power to enforce his
decision. His decision could only be enforced if one of the parties attempted
to enforce it.
2) The agreement was not illegal. The law does not purport to deal with
agreements whereby shareholders attempt to bind each other as to how they
shall vote their shares. Various forms of pooling agreements have been held
valid and have been distinguished from voting trusts. The provision for
submission to an arbitrator was clearly for the purpose of breaking deadlocks.
3) The agreement did not allow the parties to take unlawful advantage of each
other or any other person. As for a remedy, only the votes of Ringling (P) and
North should have been counted. While that would leave one board vacancy,
because the next board meeting follows closely, the board can fill the vacancy
itself. As modified, Affirmed.
Comment:: Generally, a stockholder may exercise wide liberality of judgement
in the matter of voting of his shares. It is not objectionable that his motives may
be for personal profit, or determined by whims or caprice, so long as he violates
no duty owned to his fellow shareholders. The remedy in the above case was
made possible by Delaware law which permits the chancery court., when
reviewing an election, to reject the votes of a registered stockholder where his
voting of them is found to be in violation of the rights of another person.

New York – McKinney’s Bus. Corp. Law (p. 451)

PROXIES: are the instrument that grants someone the right to vote in the place
of the shareholder. (i.e. agency). The beneficial holder has the right to vote and
gets the proxy from the record holder. Either of these groups can give the proxy
to a stranger.
Rules of proxies are:
1) Proxy is good for 11 months unless it is stated for another term
2) Proxy is revocable (the person who gets the latest proxy is the one who has
the right to vote.)
3) Don’t need to give notice to the previous proxy holder that his right has been
4) Not revoked by death or insanity of the proxy holder unless the proxy holder
is on notice of the
5) Cannot sell your vote (common provision, but not in all states)
6) Proxy is irrevocable if it is coupled to an interest (i.e. borrow money and as
part of the loan the bank wants a right to the shares – including voting rights –
the bank has a financial interest in the proxy or purchase agreement to buy
the shares, this could have a purchase agreement)

Schreiber v. Carney (1982)(p. 454) Note #3

Court allowed sale of vote, but since this could be abused, if the sale of vote is
intrinsically fair, it is OK. If it isn’t fair court won’t allow it.

Brown v. McLanahan (1945)(p. 457)

Facts: The directors and trustees (Ds) of a 10 year voting trust of all the voting
shares (preferred and common stock) passed an amendment to the articles of
incorporation of the company near the end of the trust’s term. The amendment
allowed the debenture holders (which included Ds) to vote; previously, only
preferred and common stock holders had that right. When the company went
bankrupt, was reorganized, and the 10 year voting trust was created, the
debentures and preferred stock were issued to the holders of the corporation’s 1st
lien bonds; hence, the debenture holders and the preferred stock had been
traded during the term of the trust, so that Ds, who held a substantial amount of
debentures, were seeking to preserve their voting control over the corporation
and to dilute the power of the preferred stockholders by allowing debenture
holders to vote. Brown (P) who held trust certificates representing 500 preferred
shares, sued in a class action, alleging that passing the amendment allowing
debenture holders to vote was a violation of Ds’ duties as trustees. The district
court granted Ds’ motion to dismiss, and P appeals.
Issues: Was the passage of the amendment that diluted the voting power of the
preferred stock held in a voting trust for which Ds served as trustees a violation
of Ds’ duties as trustees?
Rules: Yes. Reversed.
1) A trustee may not exercise his powers in a way that is detrimental to the
cestius que trustent” (in this case, the actual owners of the preferred shares
held in trust.). Since the amendment granting the debenture holders the right
to vote diluted the value of the preferred stockholders’ right to vote, it was a
violation of Ds’ duties as trustees.

Lehrman v. Cohen (1966)(p. 463)

Facts: A corporation had two classes of voting stock, equally divided among two
families. To break deadlocks, they created one share of a third class of voting
stock, which had no right to dividends and a value of only $10 par, and issued it
to their corporate counsel. The corporate counsel proceeded to consistently vote
against the wishes of one of the families.
Procedural Posture: The minority family brought this action to declare the
deadlock-breaking class of stock invalid as a voting trust. The lower court found
that the stock was valid.
Issue: Whether the third class of voting stock created here was valid.
Holding: Yes.
Reasoning: There are three tests that must be satisfied to establish that an
arrangement is a voting trust:
1) the voting rights are separated from the beneficial ownership of the
2) the voting rights are irrevocable for a fixed period of time, and
3) the principle purpose is to acquire voting control of the corporation.
Here, the voting rights were not separated from the beneficial ownership.
Although the creation of the third class of stock diluted the voting power of the
other two classes, the other two classes still retained complete control of the
voting power of their own stock. Furthermore, since even non-voting stock is
allowed by Del §151(a), it is not against public policy to separate voting rights
from beneficial stock ownership.
Note 3(a): Page 370: The more stock you own the less votes you have. (i.e. 1
share = 1vote; 50 shares = 25 votes) You can maintain power in this scheme)

Ling and Co. v. Trinity Sav. and Loan Ass’n (1972)(p. 470)
Facts: be obtained from the New York Stock Exchange before any sale. The
limitation requiring an offering to other shareholders of the same class appeared
on the stock certificate but was not in bold type or otherwise conspicuous. The
lower court entered summary judgement for P, and the state circuit court of
appeals affirmed.
Issues: Were the restrictions on the transfer of the stock valid?
Rules: Yes. Reversed.
1) Although the state law of forum generally requires restriction to be
conspicuously noted on the certificate, if P is aware of the restrictions
conspicuous notice on the certificate is not required. Summary judgement for
P should not be granted w/o conclusive proof that P lacked notice of the
restrictions on transfer.
2) Both restrictions are reasonable since allowing shareholders of the same
class to purchase before a public sale has not been shown to be unduly
burdensome, and the approval of the New York Stock Exchange was required
by the exchange while Ling was a member.
Rule of construction: relating to restraint is that they are construed narrowly so
as to give maximum scope to the ability of the shareholder to transfer the shares.

Rodney J. Waldbaum, Buy-Sell Agreements (p. 475)

C) Deadlocks (p. 480)

A. Voluntary Dissolution
1. Corp adjudged bankrupt or gen'l assignmt for credtr benefit
2. Leave of ct when receiver has been apptd in gen'l credtr suit or in any suit to
wind up affairs
3. All assets sold at judicial sale
4. Art. cancelled for no annual franchise or excise taxes
5. Period corporate existence has ended
6. 2/3 s/holdrs (or what Art. require) approve Resolutn dissolving
-> 1-5 Bd adopts resolution of dissolution & sells all assets; 6 Bd
though no resolution still sells assets; s/holdrs don't sell the assets

B. Judicial Dissolution
1. S.Ct. or Ct. App. order to wind up corporate affairs for misuse or
nonuse of corporate powers
2. Common Pleas order to dissolve after s/holdrs entitled to dissolve
voluntarily establish:
a. Art. were cancelled or corporate existence period up &
dissolution necessary to protect s/holdrs
b. corp. insolvent/unstable & necessary to dissolve to protect
creditors, or
c. corporate objectvs have failed, been abandoned or are
impracticable to accomplish
3. By Common Pleas order if bet. MAJ & 2/3 (if 2/3 could voluntarily
dissolve) show beneficial to s/holdrs to dissolve
4. By Common Pleas order after either 1/2 Dir. or s/holdrs 1/2 of
voting power show dir. even #, hopelessly deadlocked in mgmt of corptn &
s/holdrs can't break deadlock so dissolutn only answer OR dir. uneven #
but s/holdrs hopelessly deadlocked in electg directors (DISSOLUTION HERE
5. By Common Pleas order after prosecutor shows corp. organized and
used to further criminal purposes

Gearing v. Kelly (1962)(p. 480)

Facts: The bylaws of Radium Chemical Co. provided for a board of 4 members,
a majority constituting a quorum. Gearing (P) and her mother owned 50% of the
stock, but only P was no the board. The 2 defendants owned 50% of the stock
and were on the board. A board meeting was called, P refused to attend, the 4th
director resigned at the meeting, and Ds elected a new 4th director. P had
refused to attend since she knew that she would be out voted in electing a new
director and that control of the corporation would pass to Ds. P sued to set aside
the election.
Issues: Where a director-shareholder intentionally refuses to attend a board
meeting in order to prevent a quorum, may the court deny the director’s equitable
suit to nullify a director’s election where the requisite quorum was not present at
the meeting?
Rules: Yes. New election denied.
1) Justice does not require that there be a new election in these circumstances.
Control had already passed from P and her mother when they earlier had
allowed a 4th director supporting Ds to be elected.
2) If there were to be new election, Ds would outnumber P and the result would
be the same as it is now.
Dissent:: The election is void since there was not a quorum. In disputes for
control of a close corporation, where both sides own equal amounts of stock, the
court should not assist either side. It is proper for P not to attend the meeting
where she is outnumbered and to seek a solution of the deadlock through other

In re: Radom & Neidorff, Inc. (1954)(p. 483)

Facts: Radom and Neidorff each owned 50% of the corporate stock; Neidorff
died and his wife inherited the stock. Radom and Mrs. Neidorff (brother and
sister) did not get along, and although the corporation was very successful,
Radom petitioned under § 103 of the General Corporation Law for dissolution.
The petition cited that the directors, and Mrs. Neidorff would not sign Radon’s
salary checks although he was running the business. Mrs. Neidorff had also
sued Radom in a derivative action over misappropriation of corporate funds.
Profits had averaged $71,000 per year, and there was $300,000 cash on hand.
Radom had offered 3 years ago to buy Mrs. Neidorff out for $75,000. Mrs.
Neidorff claimed that she did not interfere in running the business, that she would
allow a 3rd director to be appointed by an independent body, and that the refusal
to sign salary checks was a result of the pending derivative suit. The lower court
dismissed w/o a hearing.
Issues: Where the court has discretion, should it allow dissolution where the 2
sole shareholders are feuding but the corporation is successful?
Rules: No. Decision affirmed.
1) The statue grants the court discretion to dismiss where the petition is brought
by 50% of the ownership and the directors are evenly divided and deadlocked
and new directors cannot be elected.
2) The court usually grants dissolution where the corporate purposes cannot be
obtained, efficient management is impossible, and the dissolution will be
beneficial to the shareholders and not harm creditors or the public. Here, the
business is successful and able to operate; Mrs. Neidorff will allow an
additional director to be appointed.
Dissent:: The state law provides that where certain conditions exist, a petition for
dissolution may be made to the court. The court cannot dismiss without holding
a hearing. The lower court did not do this. In this situation, dissolution should be
ordered. The shareholders are feuding, there is no likelihood that this will
change, the board and shareholders are deadlocked, and there is no other
alternative remedy.
Comment: Probably what the court is doing is preventing Radom, who is able to
control the business because of his expertise, from taking over the business for
much less than what it is worth. In effect, what the court is saying is, buy out
Mrs. Neidorff for a fair price.


Last class described deadlock at a board level
In dealing with a deadlock
You can by statute
a) dissolve the company if in the best interest of the shareholders.

D) Where dissolution will be allowed: Modern Remedies for Oppression,

Dissention or Deadlock (p. 489)
What constitutes oppressive conduct and what remedy can the court give?
a) order one side to buyout the other side
b) also by bringing in someone to run the company
Davis v. Sheerin (1988)(p. 489)
Facts: Davis (D) and Sheerin (P) formed a corporation in 1955, with D owning
55% and P owning 45%. D was an employee (and president), responsible for
managing the corporation. In 1985 D refused P’s request to inspect the books of
the corporation, claiming that P no longer owned any stock (supposedly having
gifted the stock to D in the late 1960s). P sued after a jury trial, the jury found P
owned 45% and a “buyout” of 45% interest by D was ordered for $550,000. D
challenged the buyout requirement.
Issues: Is a court-enforced buyout an appropriate remedy in these
Rules: Yes. Lower court opinion affirmed.
1) Texas law does not explicitly provide for a buyout remedy for aggrieved
minority shareholders of a corporation.
2) Texas law does provide, that in certain circumstances (including the one
where those in control of a corporation engage in illegal, oppressive, or
fraudulent conduct) a receiver may be appointed to liquidate the corporation.
3) Texas courts have not held that a buyout is an appropriate remedy but the
courts of other states have, since it is a less extreme remedy than a
4) Even though Texas statutory law does not provide for such a remedy, we feel
that the remedy is an appropriate one.
5) The issue here is whether it is appropriate in this case. In general, it is
appropriate where the majority is attempting to squeeze out the minority
(who do not have a ready market for their shares but are at the mercy of
the majority). Oppressive conduct may include many different kinds of acts;
broadly speaking, it means conduct that reasonably can be said to
frustrate the legitimate expectations of the minority, particularly when
the expectations being frustrated are those that were the basic reason
the minority invested in the corporation in the first place.
6) Oppression does not have to mean fraud, illegality, nor deadlock. It is
just burdensome, harsh, unfair conduct in dealing with the affairs of the
7) Here, conspiring to deprive P of his ownership of stock in the corporation,
especially when the corporate records clearly indicate such ownership,
qualifies as oppression. Oppression can occur when an officer or director
substantially is against the reasonable expectations of a minority
8) There are no other lesser remedies that could adequately remedy the
situation. Damages and certain injunctions could remedy breach of fiduciary
duties (paying excessive legal fees, etc.) that have been occurring, but not
the problem of trying to deprive P of his ownership interest.
Broadening of the deadlock and dissolution to the buyout realm. Oppression is
defined in this case. The buyout remedy has been pretty much followed.
Look at note #1 (p. 493) This usually takes place in closely held corporations.
Some states you have to elect to be a closed corpororation, v. being one. (Look a
the state statute)

DERIVATIVE SUIT: is a suit brought by a shareholder on behalf of the

corporation, and since they aren’t pursuing it the shareholder is.

Abreu v. Unica Indus. Sales, Inc. (1991)(p. 499)

Facts: Abreu’s (P’s) husband, Manny, c o-founded Ebro Foods, Inc. and owned
50%; the other 50% was owned by LaPreferida, Inc. (co-owned by Ralph and
William Steinbarth (Ds); LaPreferida was the distributor of Ebro’s products).
Manny died, P inherited his interest in Ebro and became its president and a
director. Ralph Steinbarth formed Unica (D) to compete with Ebro; it took away
Ebro’s business with Kraft Foods; Ds also tried to obtain Ebro’ formulas so they
could manufacture Ebro’s products themselves. P sued Ralph, William, and
Unica in a derivative suit under Illinois Business Corporate Act §12.55(b) which
provides for alternative remedies to dissolution in cases where there is a close
corporation and hostile factions exist and create oppression of one of the
ownership interests. This section provides for a court appointed provisional
director. The trial court found there was fraudulent self-dealing by Ds, removed
Ralph as an Ebro director (leaving P and one of Ds’ nominees in a deadlock),
and, to resolve the deadlock, appointed the general manager of Ebro, Silvo
Vega, P’s son-in-law, as the 3rd director, indicating he could vote only if there was
a deadlock between the other directors. Ds appeal on the basis that Vega is not
impartial, this, his appointment is a violation of the court’s discretion in
appointment of a provisional director, and that Vega has improperly exercised the
duties of such a director.
a) Must a provisional director be strictly impartial under the state statute?
b) Did the provisional director improperly exercise his authority?
Rules: a) No. b) Yes.
a) The state statute does not require strict impartiality in appointment of a
provisional director. The trial court must consider the best interest of the
corporation; if based on the particular situation, there is no strictly impartial 3rd
party to appoint who has the skills necessary in the urgent time frame to meet
the crisis involved, the court may use its discretion to appoint in the best
interests of the corporation, although he was not strictly impartial. He knew
the business, was a CPA, and was the best person for the job under the time
constraints involved.
b) Vega acts under the supervision of the court; he is to vote only if there is a
deadlock. There are 2 instances where he has acted beyond his authority –
appointment of a new auditor without a vote of the board (a board function),
and to reimburse P for expenses of this appeal. This was taken to the board,
Ds’ board member asked for time to study the proposal, and Vega voted with
P to pay P’s expenses. This action is reversed; it was a reasonable request
for time to study the matter, so there is not yet a deadlock here.
Comments: (Some states require a disinterested 3rd party). The court said that
the duty of directors makes them independent (this is a fiction – they are
probably influenced by the person who appointed them)
Keys: Understanding the remedies: ability to appoint directors, and when these
remedies can be invoked. Note on page 504 reviews what the statutes of
Georgia allows. Look at the continuing expansion of types of corporate
misconduct and the remedies for this.

E) Action by Directors (p. 504) The general rule is that the board must act as
a board, by resolution or vote at properly called meetings, at which
there is a quorum, or in some way approved by state law as an
alternative (i.e. by unanimous written consent), in order for an action by
the board to be valid.
Baldwin v. Canfield (1879)(p. 504)
Facts: King owned all the stock in a corporation. He pledged the stock for a
loan, partly to a bank and partly to Baldwin (P). The corporation’s only asset was
a piece of real property. King then agreed to sell Canfield (D) the property for
some bonds and a note. D knew about the corporation, but he did not know
about he pledge of its stock to P. King agreed with P to liquidate the loans with
the consideration received from the sale of the corporate property to D, but he
never did. King gave D a deed from the corporation (signed by some of the
directors). No directors’ meeting was ever held to authorize the sale of the
property. The pledgees (Baldwin) of the stock sued King and D to cancel the
Issues: When a board of directors acts separately and without a meeting in
passing a resolution, will the board’s actions be upheld?
Rules: No Judgement for P.
1) Title to property was in the corporation. The deed given by King was a valid
conveyance to D. Directors must act as a board; the separate action
individually of members of the board does not constitute official board
action. Hence, the directors never took action with reference to the sale
of the property, and the deed is ineffective since board action is
required in this transaction.
2) D has an equitable interest in the land, subject to the interest of the pledgees.
Comment:: Most states allow corporate action where all directors consent
in writing to the action, even if a meeting is not held. (some states don’t
require unanimous consent)

Mickshaw v. Coca Cola Bottling Co. (1950) (p. 506)

Facts: Coca Cola Bottling Co. (D) published a public announcement in a local
newspaper in 1940 stating that it would pay any of its workers who were drafted
the difference between their army wage and their former wage for the entire
length of their military service. The advertisement was authorized by Feinberg,
one of the 3 directors of the corporation, who showed it to Mickshaw (P), a
former employee who, under threat of conscription, joined the military and served
for 37 months. Mick Ackerman, one of the 2 other directors, knew of the
advertisement and acquiesced in its publication. Sam Ackerman, the 3rd director,
never disavowed the advertisement. P returned from the war and worked for D
for over a year. After leaving, P sued to recover the difference between his
military wage and former wage with D (he had not made a claim during his
employment for fear of losing his job). Lower court held for P. D appealed.
Issues: May a single director bind the corporation to a contract?
Rules: Yes. Affirmed.
1) Feinberg’s actions, coupled with the knowledge and acquiescence of all of
the other board members, is sufficient to bind D even though there was
no explicit authorization by the directors of D.
2) Even if the 3rd director did not authorize the ad, and never knew about it,
the promise is still valid since 2 of the 3 directors (a majority) did.
Comment: In Hurley v. Ornsteen it was found that a majority of the directors of a
corporation cannot bind the corporation by entering into a transaction without the
knowledge of the other directors where no formal directors meeting was held.
1) Other opinions are contra to Hurley and hold that where a majority of the
directors knew of the transaction at the time it occurred, or knew about it
afterward and took no action to disaffirm the unauthorized action by the
corporate officers, the action will be held to be ratified since it has been
acquiesced in by the corporation.
2) Some opinions hold that even where the directors did not know of the
transaction, such knowledge is chargeable to the corporation if the
corporation accepted the benefits thereof and if the directors
reasonably should have known of the transaction.

WHEN CAN A BOARD BE BOUND?: The simple concept is that the board can
be bound by 1) formal adoption of a resolution (before the action); 2) ratification
of the resolution (after the fact) or 2) resolution by acquiescence

Cooke v. Lynn Sand & Stone Company (1994)(p. 508)

Facts: Cooke (P) is a director officer and shareholder of D. He is suing to enforce
his employment contract. P served as an at will employee without a contract, he
is not head of the family who owns the business. In 1979 they hire a VP from
outside, and he gets an employment contract. Corporation wrote a 5 year
agreement, but did not bind the itself from the directors. The board set up a
resolution saying the Pres. and VP have the power to set up contracts when in
the best interest of the Corporation. The resolution is renewed every year and the
VP gets a new 5 year contract each year. (This done to protect his job against
buy outs) Cooke has the same contract drawn up to him. He shows a draft to the
board and said this is something for you to consider. No one responded, and a
year later the VP prepares a contract for Pres, as Pres. Prepares an employment
contract for the VP. They both sign each contract. Neither contract is given to
the board, and no notice is given to them. The company is in the process of the
buyout. During the purchase, the contract is disclosed and nothing was said.
The company is bought out and the purchaser wants to pay less than what the
contract reads. P does not getting less pay and is fired.
1) The contract was executed in violatoin of the fiduciary duties of the directors,
and duty of candor (duty to disclose things when they first happen). The
resolution was boiler plate and meant to deal with 3rd parties and not insider
deals. There was an acknowledgement that the board needed to look at the
2) Ratification: Cooke claimed that he listed it as a liabiity and this was a
ratification (or at least an adoption of the contract) This was only a listiing of
what the corporation may be liable for (i.e. if the corp. was being sued this
would be listed, but is not an admission of the corps guilt in a suit.
Key: more casual approach to holding the board more liable, There is a limit to
this. You can’t use a boiler plate for the insiders to bind the company.

F) Authority of Officers (p. 513)

Shareholders (appoint the board- act for themselves) No personal liability

Board (No day to day decisions – appoint officers, have duty to the corporation
and the shareholders)

Officers (make the ongoing decisions – sign the paper work. Make day to day
contracts) Have duties to shareholders and corporation.

In many companies the same person wears all three hats.

Black v. Harrison Home Co. (1909)(p. 513)

Facts: C.G. Harrison, his wife Sarah, daughter Olive, son Lewis, and a brother-
in-law incorporated Harrison Home Co. (D) and elected C.G. Harrison president,
Sarah vice-president, and Olive secretary. Sarah and Olive owned most of the
stock, and the officers plus 2 other family members were the directors. The
bylaws authorized the president and secretary, acting jointly, to sell land owned
by the corporation. After C.G. died, Sarah became president, and after Olive
died, Sarah authorized an agent to sell certain property owned by the
corporation. Black (P) purchased the property through the agent, but D refused to
convey, arguing that Sarah could not bind the corporation acting alone. P sued D
for specific performance, and the lower court held for D. P appeals.
Issues: May the president, contrary to the bylaws of the corporation, bind it in a
contractual relationship?
Rules: No. reversed.
1) Absent a bylaw or resolution of the board, a president may not bind a
corporation to a contract. Since D has always required both the president
and secretary to act jointly to bind the corporation to a contract, Sarah, acting
alone, could not bind it.
2) The argument that Sarah should be estopped from denying authority to make
the sale since she owns all of the stock of the corporation is not persuasive,
since the estate of Olive also owns stock in the corporation.
Comment:: This case represents the old, common law notion that management
rests with the directors and that the officers must have express authority (or
authority implied from express authority) in order to act for the corporation. The
modern view accords much more scope to the officers – either from inherent
authority arising from their positions, or from apparent authority – to perform
actions that are acquiesced in by the board of directors.

Implied and Inherent authority of the officers.
MBCA 8.01
KEY: Check the scope of the authority of the person you are contracting with
(what does the statute say, and what do the (up to date) by-laws say. The
secretary can certify the accuracy of the by laws)
Authority has been broadened, because the layman has a reasonable
expectation that the president has more power.
Officers of a company:
President: has the authority to sign things in the “usual and ordinary course of
business” and presides over meetings
VP: delegated authority of the president
Treasurer: Keeps the funds
Secretary: Keeps minutes, stock transfer book, sends out notices, and co-signs
with the president when needed.
A corporation must have 2 different people as officers.

Lee v. Jenkins Bros. (1959)(p. 517)

Facts: Lee sued Jenkins Bros. to recover pension payments allegedly due under
an oral contract made on behalf of the corporation by the president. The lower
court dismissed on the grounds that there was insufficient evidence of the oral
contract to enforce it. The court of appeals affirmed, and went on to discuss the
following issue:
Issue: Whether, as a matter of law, a president of a corporation does not have
the authority to secure employment of badly needed personnel by granting a “life
Rule: No.
The actual authority (granted either implicitly or explicitly by a corporation) of a
corporate officer is augmented by his apparent authority to third persons. As a
general rule, the president only has the authority to bind the corporation by acts
arising from the usual and regular course of business, but not for contracts
of “extraordinary” nature. It is generally settled that a president may hire and fire
employees, but it is a question of fact as to whether the granting of a life pension
is so “extraordinary” as to defeat the apparent authority of the president.
Apparent Authority: What has been done in the past.

In the Matter of Drive-In Dev. Corp. (1966)(p. 522)

Facts: The parent company of Drive-In (Tastee Freez) wanted to borrow money
from the National Boulevard Bank (P). P required that Drive-In (D) guarantee the
loan, which guarantee was signed by Maranz as “Chairman” and attested to by
Dick as “Secretary.” P asked for a resolution of D’s board showing the authority
of Maranz to sign the guarantee. P received a certified copy (by Dick as
secretary) of D’s board minutes, showing the authority of Maranz to sign the
guarantee. Later D went into Chapter XI proceedings under the Bankruptcy Act,
and P filed its claim for the amount of the unpaid loan. The referee disallowed
P’s claim on the basis that D’s corporate minutes did not show the authorization
to make the loan guarantee. Testimony of D’s directors was unclear as to
whether Maranz had ever been authorized to enter the guarantee on behalf of D.
From a judgement affirming the referee’s decision, P appealed.
Issues: May a plaintiff who enters into a guarantee transaction with a corporation
on the representation of its officers that they had authority to enter the
transaction rely upon these representations?
Rules: Yes. Lower court judgement reversed.
1) Here, the officers of D appeared to be acting within the scope of their
apparent authority.
2) D’s officers had no actual, express authority. But it is the secretary’s duty in
the corporation to keep the corporate records, and once P received a copy of
the certification of board resolutions, it was reasonable for P to assume that
D’s officers had the authority to enter into the guarantee agreement. P had no
duty to investigate further.
Key: Get a secretary’s certificate and this binds the corporation.

Duty of Care and the Business Judgement Rule (pp 663-752) By law,
directors have the duty of management of the corporation. This duty is normally
delegated to the officers, thus, the directors must supervise the officers. The
legal duties of the directors and officers are owed to the corporation;
performance of these duties is enforceable by an action on behalf of the
corporation brought by an individual shareholder (called a “derivative suit”).
1) Fiduciary relationship of directors to the corporation
a) Duty of loyalty or good faith
b) Duty of reasonable care
c) Business judgement
(1) A different standard of care would apply to directors and to
officers (i..e. if there is a more limited role for directors then
negligence is failure to perform with care expected of a
director, but not necessarily failure to perform with the
prudence that a director would give his own personal
business dealings).
(2) Business Judgement Rule: where a matter of business
judgement is involved the directors meet their responsibility
of reasonable care and diligence if they exercise an honest,
good-faith, unbiased judgement. Where this standard is
applied, a director would only be liable (if his actions were in
good faith) if he were guilty of gross negligence or worse.
2) Damages: To form a cause of action, it must be shown that the director or
officer failed to exercise reasonable care and that as a direct and proximate
res ult the corporation has suffered damages.
a) Joint and several liability: Either one director may be held liable for his
own acts, or all directors may be held liable (all those participating in the
negligent act.) Where more than one director is held responsible liability is
joint and several.
Litwin v. Allen (1940)(p. 663)
Facts: A shareholder (P) brought a derivative action against the directors of
Guaranty Trust and it’s wholly owned subsidiary (the Guaranty Company). The
Trust Company purchased some bonds from Alleghany Corporation (J.P. Morgan
is the broker) and gave an option to Alleghany to repurchase them in 6 months
for the same price. If Alleghany did not repurchase, the subsidiary (Guaranty
Company) was obligated to purchase the bonds at the same price from the Trust
Company. Alleghany could not get a loan, and so the subsidiary bought the
bonds at $105 (market value was then in the $80’s). The bonds subsequently
dropped drastically in price, and the Guaranty Company lost substantial amounts
of money.
Issue: Has there been a violation of the director’s duty of due care in entering the
transaction with Allegheny Corporation?
Rule: Yes. Judgement for P.
1) The duty of due care is higher for bank directors than for other companies
since banks are affected with the public interest. Thus, bank directors must
exercise the care of “reasonably prudent bankers.”
2) The purchase by Guaranty subject to the option to buy in Alleghany at the
same price is an ultra vires act (“beyond the powers” When a corporation
does an act or enters into a contract beyond the scope of its charter) of the
corporation (i.e. against public policy for the bank to give such an option).
3) Furthermore, all of the directors of both companies that voted for or ratified
the purchase have violated their duty of due care. They have not shown
sufficient diligence in allowing the bank to purchase bonds with an option to
sell at the same price (all of the risk is on the bank for a drop in price; if the
price rises, they get no gain.)
4) The directors are responsible for the losses from holding the bonds up to the
expiration date of the option.
Conclusion: This case indicates that the standard of care may vary according
to the kind of business involved and the precise circumstance in which the
directors acted. Good faith makes the difference..
BUSINESS JUDGMENT RULE: (This protects directors from negligence). As
long as a director acts with reasonable skill and prudence the courts will not hold
them liable. The directors are required to act as an ordinary man would at the
time of the act
Business Judgement Rule:
Protects: Directors (and to a lesser degree officers) from decision that don’t
Not liable when they act with reasonable skill and prudence.
Court presumes good faith on the part of the director (including that they are
disinterested and they are not beholding to a majority stock holder. They act with
due care: exercise informed, independent juudgement) They are liable if they
don’t exercise due care and make grossly unsound decisions.
Lttlum/VanGorkhom: Grossly unsound makes you unsound (not heavily accepted
and clauses in the articles limit this via clauses in the Ariticles or insurance)
July 8, 1998 Class Starts Here
Shlensky v. Wrigley (1968)(p. 671)
Facts: Shlensky (P), a minority shareholder in the corporation (D) that owns
Wrigley Field and the Chicago Cubs, brought a shareholder’s derivative suit
against the directors of the corporation for their refusal to install lights at Wrigley
Field and schedule night games for the Cubs as other teams in the league had
done (to increase revenues). The directors’ motivation was allegedly the result of
the views of Mr. Wrigley (also a defendant), the majority shareholder, president,
and a director of the corporation, who wanted to preserve the neighborhood
surrounding Wrigley Field and who believed that baseball was a daytime sport.
The lower court dismissed P’s action.
Issue: May a shareholder bring a derivative action where there are no allegations
of fraud, illegality, or conflict of interest?
Rule: No. Affirmed.
1) The court will not disturb the “business judgement” of a majority of the
directors – absent fraud, illegality, or a conflict of interest. There is no
conclusive evidence that the installation of lights and the scheduling of night
games will accrue a net benefit in revenues to D, and there appear to be
other valid reasons for refusing to install lights, e.g. the detrimental effect on
the surrounding neighborhood.
2) Corporations are not obliged to follow the direction taken by other similar
corporations. Directors are elected for their own business capabilities and not
for their ability to follow others.
Key: Note 8 (p. 675) review. Also (p. 683) Notes 9 & 10
Good faith and process is about the directors take care in the process of
making the decision. Not that the decision was bad.

Smith v. Van Gorkhom (1985)(p. 684)

(Thought to be a bad decision in corporate law)
Facts: Shareholders (Ps) of Trans Union sued Trans Union seeking rescission of
a merger into New T Company (a wholly owned subsidiary of defendant Marmon
Group, controlled by Prizker), or alternatively, damages against members of
Trans Union’s board (Ds).
1) Trans Union was a profitable, multi-million dollar leasing corporation that was
not able to use all of the tax credits it was generating. Several solutions were
explored. Van Gorkom (chairman) asked for a study by Romans (financial
officer) regarding a leveraged buy-out by management. Romans reported
that the company would generate enough cash to pay $50 per share for the
company’s stock, but not $60 per share. Van Gorkom rejected the idea of
this type of buy-out (conflict of interest) but indicated he would take $55 per
share for his own stock (he was 65 and about to retire). On his own, Van
Gorkom approached Pritzker, a takeover specialist, and began negotiating a
sale of Trans Union. He suggested $55 per share and 5 year payout method
without consulting the board or management. The price was above the $39
per share market value, but no study was done by anyone to determine the
intrinsic value of Trans Union’s shares. In the final deal, Trans Union got 3
days to consider the offer, which included selling a million shares to Pritzker
at market, so that even if Trans Union found someone else who would pay a
better price Pritzker would profit; For 90 days Trans Union could receive but
not solicit competing offers.
2) Van Gorkom hired outside legal counsel to review the deal, ignoring his
company lawyer and a lawyer on the board. He called a board meeting for 2
days later. At the meeting, Trans Union’s investment banker was not invited,
no copies of the proposed merger were given, senior management was
against it, and Romans said the price was to low. Van Gorkom presented the
deal in 20 minutes, saying that the price might not be the highest that could
be received, but it was fair. The outside lawyer told the board that they might
be sued if they did not accept the offer and that they did not need to get an
outside “fairness” opinion as a matter of law. Romans said he had not done a
fairness study but that he thought $55 per share was on the low end.
Discussions lasted 2 hours, and the merger offer was accepted.
3) Within 10 days, management of Trans Union was in an uproar. Pritzker and
Van Gorkom agreed to some amendments, which the board approved. Trans
Union retained Salomon Bros. To solicit other offers. Kohlberg, Kravis,
Roberts & Co. made an offer at $60 per share. Van Gorkom discouraged the
offer and spoke with management people who were participating in it. Hours
before a board meeting to consider it, it was canceled, and was never
presented to the board. General Electric Credit Corp. made a proposal at $60
per share, but wanted more time, which Pritzker refused to give, so it too was
4) On December 19, some shareholders began this suit. On February 10, 70%
of the shareholders approved the deal. The trial court held that the board’s
actions from its first meeting on September 20 until January 26 were
informed. Ps appealed.
Issue: Did the directors act in accordance with the requirements of the business
judgement rule?
Rule: No. Reversed.
1) The business judgement rule presumes that directors act on an informed
basis, in good faith, and in an honest belief that their actions are for the good
of the company. Plaintiffs must rebut this presumption. There is no fraud here,
or bad faith. The issue is whether the directors informed themselves properly.
All reasonably material information available must be looked at prior to a
decision. This is a duty of care. And the directors are liable if they were
grossly negligent in failing to inform themselves.
2) The directors were grossly negligent in the way they acted in the first board
meeting that approved the merger. They did not know about Van Gorkom’s
role, and they did not gather information on the intrinsic value of the company.
Receiving a premium price over market is not enough evidence of intrinsic
3) An outside opinion is not always necessary, but here there was not even an
opinion given by inside management. The Van Gorkom opinion of value
could be relied on had it been based on sound factors; it was not and the
board members did not check it. The post September market test of value
was insufficient to confirm the reasonableness of the board’s decision.
4) Although the 10 board members knew that company well and had
outstanding business experience, this was not enough to base a finding that
they reached an informed decision.
5) There is no real evidence of what the outside lawyer said, and as he refused
to testify, Ds cannot rely on the fact that they based their acts on his opinions.
6) The actions taken by the board to review the proposal on October 9, 1980,
and January 26, 1981, did not cure the defects in the September 20 meeting.
7) All directors take a unified position, so all are being treated the same way.
8) The shareholder vote accepting the offer does not clear Ds because it
was not based on full information.
Dissent:: There were 10 directors; the 5 outside ones were chief executives of
successful companies. The 5 inside directors had years of experience with
Trans Union. All knew about the company in detail. No “fast shuffle” took place
over these men. Based on this experience, the directors made an informed


The approaches in these shareholders derivative suits are:
1) Misconduct/ Breach
2) COA
Del. Gen. Corp. Law (p. 703)
Gall v. Exxon Corp. (1976)(p. 706)
Facts: Gall (P) brought a shareholder’s derivative action alleging that directors of
Exxon (D) had given $38MM improperly as campaign contributions to secure
political favors in Italy. P claimed violations of the 1934 Act for filing false reports
with the S.E.C. and soliciting proxies from shareholders without revealing the
illegal contributions, and for a breach of fiduciary duties, and waste and
spoliation. D formed a special committee of the board of directors to investigate
the charges, and the committee determined that the corporation would not be
aided by bringing suit against any of the directors since most of the directors
involved had little actual knowledge of the nature or legality of the payments and
since all such payments had ceased in 1972. D moved for summary judgement
arguing that the decision of the committee was within the sound business
judgement rule and should not be disturbed by the court.
Issue: Is this decision (made by a special committee of the board of directors)
not to bring a cause of action held by the corporation within the sound business
judgement of the corporate management?
Rule: Yes.
1) The directors are empowered to determine by the exercise of their business
judgement whether bringing the cause of action would benefit the corporation,
and absent prejudice in the decision, the court should allow the decision to
2) P will be given time for discovery to determine whether there was prejudice in
the decision before summary judgement will be granted.
Conclusion: The special committee consisted of directors who had had no
knowledge of the illegal contribution at the time they were made.

Zapata Corp. v. Maldonado (1981)(p. 713)

Court looks at what the committee did
1) Did it exercise due care on an informed judgement (If yes) (if no go to step 3)
2) Court makes an independent decision to whether killing the suit is in the
company’s best interest.
3) Only the shareholder can kill the suit.
Facts: Maldonado (P), a shareholder in Zapata Corp. (D), instituted a derivative
action on D’s behalf. The suit alleged breaches of fiduciary duty by 10 of D’s
officers and directors. P brought this suit without first demanding that the board
bring it, on the ground that the demand would be futile since all directors were
named as defendants. Several years later, the board appointed an independent
investigating committee. By this time, four of the defendants were off the board,
and the remaining directors appointed 2 new outside directors. These new
directors comprised the investigating committee. After its investigation, it
recommended that the action be dismissed. Its determination was binding on D,
which moved for dismissal or summary judgement. The trial court denied the
motions, holding that the business judgement rule is not a grant of authority to
dismiss derivative suits, and that a shareholder sometimes has an individual right
to maintain such actions. D filed an interlocutory appeal.
Issue: Did the committee have the power to cause this action to be dismissed?
Rule: Yes. Trial court interlocutory order reversed; case remanded for
proceedings consistent with this opinion.
1) A shareholder does not have an individual right, once demand is made and
refused, to continue a derivative suit. Unless it was wrongful, the board’s
decision that the suit would harm the company will be respected as a matter
of business judgment. A shareholder has the right to initiate the action
himself when demand may be properly excused as futile. However, excusing
demand does not strip the board of its corporate power. There may be
circumstances where the suit, although properly initiated, would not be in the
corporation’s best interests. This is the context here.
2) The court must find a balancing point where bona fide shareholder power to
bring corporation causes of action cannot be unfairly trampled on by the
board, but where the corporation can rid itself of detrimental litigation. A 2
step process is involved:
a) The court must recognize that the board, even if tainted by self-interest,
can legally delegate its authority to a committee of disinterested directors.
The court, also may inquire on its own into the independence and good
faith of the committee and the bases supporting its conclusions.
b) If the court is satisfied on both counts, the second step is to apply its own
business judgement as to whether the motion to dismiss should be
Thus the suit will be heard when corporate actions meet the criteria of the 1st
step, but where the result would terminate a grievance worthy of

Cuker v. Mikalauskas (1997)(p. 74)

Facts: A minority shareholder in an energy company brings a derivative action
for not poor collections. The members of the board not named plus 3 outside
directors and had never been employed by the company found no bad faith, and
had made decisions in the best interest of the company. The 12 non-defendant
board members decide to kill the suit. The lower court says that it is not up to the
board to kill the suit. The higher court overturns this.
Issue: Can the board decide to kill the suit.
Rule: The court says that the board of directors decision to kill the suit, they will
not look to the merits of the claim, as long as the process of making that
decision are done by following the Business Judgement Rule (i.e. see if the 1st
step of the Delaware test (step one of Zapata)) then their judgement is OK. The
court will not substitute. If the Board did not follow the Business Judgment Rule,
then the case goes to court.
Conclusion: There are many variations on this.

Aronson v. Lewis (1984)(p. 721)

Facts: Lewis (P) was a shareholder of Meyers Parking Systems; he brought a
shareholders derivative suit challenging transactions between Meyers and one of
its directors, Fink, who owns 47% of its stock. Meyers’ board approved an
employment contract for Fink, 75 years old, for $150,000 a year plus an override
on profits; on termination Fink was to receive at least $100,000 a year for life;
Fink was to devote substantially all of his time to the business. Also, Meyers
made $225,000 in interest free loans to Fink. P alleged there was no business
purpose and a waste of corporate assets in these transactions. P did not make a
demand on the board before bringing the derivative suit because:
1) all directors were named as defendants and they participated in the wrongs;
2) Fink picked and controlled all directors; and
3) To bring this action, the defendant directors would have to have the
corporation sue themselves.
P sought cancellation of the employment contract. The defendant directors bring
an interlocutory appeal of a trial court finding for P that no request for actions
need be made on the board of directors.
Issue: Where state law requires that demand on the directors be made prior to
bringing a shareholder’s derivative suit, will such a demand be excused?
Rule: Yes. While the trial court finding for P is reversed, P is given leave to
amend his complaint.
1) The demand requirement is to ensure that shareholders first pursue intra-
corporate remedies and to avoid strike suits.
2) The issue of the futility of a demand is bound up with the business judgement
rule; directors apply it in addressing a demand notice. The business
judgement rule can only be claimed by disinterested directors whose conduct
meets the rule’s standards. The business judgement rule applies in a board’s
determination of whether to pursue a derivative suit and whether to terminate
one already brought by a shareholder (where demand on the board was
3) This case involves the question of when demand is futile and thus excused.
The trial court test was whether the allegations in the complaint, when taken
to be true, show that there is a reasonable inference that the business
judgement rule is not applicable for purposes of a pre-suit demand. This test
means that where director action itself is challenged, demand futility is almost
automatic. There must be a better test.
4) The test is: Based on the particularized facts alleged, is there a reasonable
doubt that:
a) the directors were disinterested and independent; and
b) the challenged transaction was the product of a valid exercise of
business judgement
5) A general claim that Fink controls the board and owns 47% of the stock does
not support a claim that the directors lack independence. P must allege
particularized facts showing that control and showing that entering the
contract was a breach of good faith or shows control.
6) A bare claim that defendants would have to sue themselves s also not
enough. Particular facts again must be alleged showing lack of director
independence or failure to adhere to standards of the business judgement
1) Injury must be to corporation and not to the shareholder, the corporation can
only recover
2) Shareholder’s ownership is contemporaneous. The shareholder must own the
shares at the time of alleged misconduct.
a) Exception: If you obtain the shares by devolution of law (not by choice –
i.e. court forces ownership, example inherit in a will)

3) Shareholder must continue to hold shares until the suit is settled.(unless by

4) Shareholder must make demand unless it would be futile. (Some states say
even if it is futile, you still have to make demand if irreparable damage can’t
be avoided)
5) Corporation has the right to take over the suit.
6) Corporation can kill the suit (This can be done by a disinterested board, or an
investigative committee who decide it is not in the best interest of the
corporation to pursue the suit – Business Judgment Rule applies) Exceptions:
a) When self interest is potential some states will follow Zapata
b) Some states say it is still at the court’s discretion.
7) Futility requires reasonable doubt that the directors are liable


JULY 13, 1998 Class Starts Here

Duty of Loyalty and Conflict of Interest (pp. 753-809) The officers and
directors owe a duty of loyalty to the corporation. This means that the directors
must place the interests of the corporation above their own personal gain.
Problems arise because directors have other business involvements, and it is
often for this reason that they are placed on the board. Therefore, no rule of law
that prevents a corporation from dealing with its own directors is feasible, but it is
difficult to develop rules that properly circumscribe these dealings.
there has been an evolution in the rules applied by the courts.
Early rule: Common law was that any contract between a director and his
corporation, whether fair or not, was voidable. This rule not only applied to
individual contracts with directors, but also to the situation of interlocking
directorates (2 or more corporations having common directors). It was even
applied to the situation where one corporation owned the majority of the stock of
another and appointed its directors (parent – subsidiary relationship).
Disinterested Majority Rule: Earlier many courts held (and some still do) that
conflict of interest dealings were voidable only where the directors had not made
a full and complete disclosure of the transaction (its value, his interest, profit,
etc.) to an “independent board” (quorum of non-interested directors), or the
transaction was shown to be unfair and unreasonable to the corporation. The
burden of proof as to the fairness of the transaction was on the director.
Liberal Rule: Many courts now hold that it makes no difference whether the
board is disinterested or not. The issue is whether the transaction is fair to the
corporation. Part of the “fairness” is that the director’s interest be fully disclosed,
however. Where the board is not disinterested, the contract will be given very
close scrutiny.
State Statutes: Many states have adopted statutes that combine elements from
all of the previous judicial positions.

Marciano v. Nakash (1987)(p. 753)

Facts: A jeans-manufacturing corporation had two principle shareholder families.
When the corporation fell into financial problems, the shareholders deadlocked
on the issue of how to proceed. One of the families, without consulting the other,
loaned the corporation $2.3 million of their personal funds at an interest rate of
1% over prime. The loan was an interested transaction, and was not approved by
a disinterested majority of the directors or shareholders. The other family brought
an action to have the debt declared void.
Issue: Whether the loan, although an interested transaction not approved by a
disinterested majority of the directors or shareholders, was nonetheless fair and
therefore valid.
Rule: Yes.
Del. Section 144(a) provides a basis for immunizing self-interested transactions.
Its tests were not satisfied. However, section 144(a) merely removes an
"interested director" cloud, preventing invalidation "solely" because an interested
director was involved. Thus, the proper analysis is a two-tiered analysis: first
apply 144(a), then apply a fairness test. Here, the loans compared favorably with
what was available from market lenders. Thus, they were objectively fair.
Furthermore, the loans were made in the good faith effort to keep the corporation
alive. On the other hand, approval by fully informed disinterested directors under
section 144(a)(1) or disinterested stockholders under section 144(a)(2) permits
invocation of the business judgment rule and limits judicial review to issues of
waste with the burden of proof upon the party attacking the transaction.

Heller v. Boylan (1941)(p. 761)

Facts: In 1912 the shareholders adopted a bylaw providing for an incentive
compensation system whereby the president and the vice presidents of American
Tobacco Company divided 10% of the company’s annual profits over the
earnings from comparable company properties held in 1910. This system
occasioned salaries and bonuses totaling $15,457,919 for 1929 through 1939 for
the 6 officers. This is a shareholder’s derivative suit brought by 7 out of the
company’s 62,000 shareholders (the 7 owning 1,000 out of a total of over 5
million shares), protesting these payments as waste and spoliation of corporate
property (in that they bore no reasonable relationship to the value of the services
for which they were given) by the majority shareholders. The bylaws had been
ratified twice, in 1933 and 140, and had been held valid by the court on a prior
Issue: Did the huge bonus payments to the president and vice presidents
mandated by the shareholder-adopted bylaw amount to waste or spoliation of
corporate assets to the detriment of minority shareholders?
Rule: No.
1) Although the sums are large, the shareholders adopted the bylaw and have
ratified it, so the court will not replace the shareholder’s judgement with its
2) If a bonus payment bears no reasonable relationship to the value of services
for which it is given, then the majority shareholders cannot give it, since to do
so is waste and adversely affects minority shareholders. But there must be
proof of waste (beyond the mere amount of the payments, as here). Since
the plaintiff has entered no such proof, the court will not substitute its
judgement for that of the shareholders.

Obligation of Majority Shareholders to Minority

a) Duty of loyalty and good faith: The majority shareholder(s) have a fiduciary
relationship to the corporation (such as in a contractual relationship), the
transaction will be closely scrutinized to see that minority shareholders are
treated fairly. An example would be the situation where a corporation loans a
majority shareholder money.

Sinclair Oil Corp. v. Levien (1971)(p. 773)

Facts: Sinclair Oil Co. (D) owned 97% of stock of a subsidiary involved in the
crude oil business in South America; D appointed all of the subsidiary’s board
members and officers. Then over 6 years D drained off dividends from the
subsidiary to meet its own needs for cash. The dividends paid met the limitations
of state law, but exceeded the current earnings of the same period. Levien (P), a
shareholder of the subsidiary, filed a derivative suit, charging that the dividend
payments limited the subsidiary’s ability to grow; also, that in a contract between
D and the subsidiary for the purchase of crude oil, D had failed to pay on time
and had not purchased the minimum amounts as required by the contract.
Rule: Yes. Judgement for D on the dividend

Weinberger v. UOP, Inc. (1983)(p. 778)

Facts: Signal Co. owned a majority of UOP stock, and wished to acquire the rest
of the stock by a tender offer, and then merge with UOP. Using UOP resources,
two of the UOP directors, who were also Signal directors, completed a valuation
study that indicated that a fair price for the tender offer would be up to $24 per
share. Signal then made a $21 per share offer, and obtained a fairness opinion
from their banker, Lehman Brothers. However, the $24 per share study was
never disclosed to UOP’s shareholders when they voted to approve the merger
at $21 per share. A class action by the minority shareholders challenging the
fairness of the merger. The lower court found for the defendants.
Issue: Whether the burden of proof shifts to the plaintiff to prove the unfairness
of an action when it has been approved by a majority of disinterested but not
adequately informed shareholders.
Rule: No.
The burden always remains on the interested shareholders to show that they
made a full disclosure to the disinterested shareholders. The proxy statement to
the disinterested shareholders did not reveal the study assessing a fair price at
$24 per share. This was a matter of material significance, and the interested
shareholder’s (Signal’s) failure to disclose it prevented the minority shareholders’
vote from being a valid ratification of the transaction, thus requiring that it be
subject to the intrinsic fairness standard. Fairness has two aspects: 1) fair
dealing, and 2) fair price. Here it was not fair dealing to use UOP’s resources to
generate a report, and then fail to disclose that favorable report. It was a breach
of fiduciary duty for the dual directors to withhold this information from the
minority shareholders. Also, the price was not fair because it was less than the
amount indicated by the report, and the fairness opinion was too hastily prepared
to be relied on.

Corporate Opportunity (p. 794) The duty of loyalty of directors and officers to
the corporation prevents them from taking opportunities for themselves that
should belong to the corporation.
1) Use of corporate property: Clearly a director may not use corporate
property or assets to develop his own business or for other personal use.

2) Corporate expectancies: A director or officer may not assume for himself

properties or interests in which the corporation is “interested,” or in which the
corporation can be said to have a tangible “expectancy,” or which are
important to the corporation’s business or purposes.
a) i.e. If a corporation has leased a piece of property, a director cannot buy
the property for himself. And if it is “reasonably foreseeable” that the
corporation would be interested in the property, then there is the
necessary expectancy. Where opportunities relate very closely to the
business of the corporation, there is also the necessary expectancy.

Northeast Harbor Golf Club, Inc. v. Harris (1995)(p. 794)

Facts: Harris was the president of the Golf Club corporation. Harris, in her
capacity as president, was approached by a real estate agent with an opportunity
to purchase surrounding land. Without disclosing the offer to the corporation,
Harris purchased the land with her own funds. Later, Harris informed the board,
but they took no action, apparently in reliance on her statement that she would
not develop the land. Later, Harris began to develop the land. The corporation
brought an action to enjoin the development, and to put a constructive trust on
the property in favor of the corporation. The trial court found that Harris had not
taken a corporate opportunity because the real estate investment was not in the
line of business of the corporation, and also that it did not have the financial
ability to purchase the land.
Issue: What is the proper test for determining whether a corporate opportunity
Rule: According to the ALI Principle of Corporate Governance Section 5.05, a
corporate opportunity is one which a director
1) becomes aware of in his corporate capacity, or
2) uses corporate information or property to acquire, or
3) is closely related to a business in which the corporation is engaged or
expects to engage.
The ALI defines corporate opportunity broadly. There is evidence that the
property was offered to her in her capacity as president - making it a corporate
opportunity. If it is a corporate opportunity, then Harris must offer it to the
corporation first and have the board reject it after full disclosure, AND either
1) have the rejection ratified by a disinterested majority of the directors, or
2) a disinterested majority of the shareholders. If these tests are met,
then the burden of proof is on the challenger to show that the
transaction was unfair to the corporation.
However, if Harris failed to offer the opportunity, then she loses outright. Also, if
Harris offered the opportunity, but it was not ratified by a majority of disinterested
directors or shareholders, then the burden of proof is on her to prove that it was
fair to the corporation. The case must be remanded for application of these
standards of law.

Duties to other Constituencies (p. 805)


A) The Development of the Federal Remedy: Rule 10B-5 (p. 810)
1) Securities Exchange Act of 1934 (p. 810)
2) RULE 10B-5: Employment of Manipulative & Deceptive Devices (p. 810)
B) Insider Trading (p. 833)
The Regulation of Insider Trading (p. 834) Rule 10b-5 has very broad
application to securities transactions. Even though it does not mention
“insiders” specifically, not specifically require that one person having
information not had by another disclose this in a securities transaction,
nevertheless the S.E.C. and the court have used Rule 10b-5 to cover such
1) Fiduciary relationship: The origin of the concept of an “insider” is the idea
that where one person occupies a “fiduciary relationship” with another, this
fiduciary must disclose relevant, material information to the person for
whom she has the responsibility.
2) Insider Defined: There are 2 elements that must be shown in order to
designate someone an “insider”:
a) The person must have a relationship giving access, directly or
indirectly, to information intended to be available only for a business
purpose and not for the personal benefit of anyone; and
b) An inherent unfairness must be present where a party takes advantage
of such information, knowing it is unavailable to those with whom she
is dealing.

SEC v. Texas Gulf Sulphur Co. (1968)(p. 837)

Facts: Texas Gulf Sulphur (TGS)(D) was engaged in exploration mining of
minerals. In November 1963, it drilled a test hole on property near Timmins,
Ontario, Canada, and the sample revealed significant deposits of copper, zinc,
and silver. Present at the site, were employees Clayton (D) and Holyk (D). TGS
then began to acquire rights to the surrounding property (which was completed
by March 27, 1964). The assay report of the drilling indicated that the oee
discovery could be very significant, and the president (Stephens, also a
defendant)instructed those employees who knew of the discovery to keep it
quiet. Additional holes were drilled to track the extent of the ore deposit, and all
indicated that the discovery was significant. By April 10, 1964, rumors of the find
had reached the New York newspapers. Stephens therefore had 2 TGS
executives (Ds) prepare a news release that was issued on April 12. The release
discounted the rumors, indicated that insufficient information was available upon
which to evaluate a possible ore discovery, and stated that additional drilling
would be required before definite conclusions could be arrived at. In the
meantime, more holes were drilled, and the company’s analysis of the results
was completed by April 16. Between April 12 and April 16 TGS (through
company employees, including 2 additional defendants, Mollison and Darke)
gave out 2 reports that indicated that a discovery had been made, and on April
16 a disclosure was made to representatives of the press that a discovery had
been made. A written release concerning the discovery went over a brokerage
firm wire service that morning. TGS stock on the New York Stock Exchange went
from $17.50 per share on the date of the first test hole, to $32 on April 12 to $37
on April 16, and finally to $58 per share in the middle of May 1964. The S.E.C.
(P) brought an action under Rule 10b-5 against employees of TGS that bought
stock or calls to buy TGS stock prior to the full disclosure to the public concerning
the ore discovery. , P also sued TGS for the misleading press release of April 12
and the employees who received options to purchase TGS stock prior to public
disclosure (or disclosure to the TGS directors granting the options for that
matter). And finally, tippees (of the insiders) who bought TGS stock were also
joined as defendants.
1) Is it a violation of Rule 10b-5 for officers, directors, and employees of a
corporation, having inside information concerning the probability of a major
ore discovery by the corporation, which information has not been disclosed to
the public and which if it were disclosed would affect the price of the
corporation’s securities, to purchase the corporation’s securities or to receive
options to purchase such securities without public disclosure of the material
2) May those communicating the inside information to others (who purhcase
securities based on this information) also be held liable under Fule 10b-5?
3) Is it a violation of Rule 10b-5 for TGS to have issued a misleading press
release concerning information that could have a material effect on the price
of its securities?
Rule: Yes to all three issues.
1) Inside Information: Rule 10b-5 says that anyone trading for his own account
in securities of the corporation who has access, directly or indirectly, to
information intended only for corporate purposes and not or personal benefit,
may not take advantage of such information knowing that it is unavailable to
those with whom he is dealing. Either the information must be disclosed to the
investing public or trading in or recommending the securities must be
discontinued until after such disclosure. This includes “tippees” (those who
are told of the material information by corporate insiders).
2) Materiality: Only information that is essentially extraordinary in nature and
which is reasonably certain to have a substantial effect on the market price of
the security if disclosed need be disclosed. The test is whether a reasonable
investor would attach importance to the information in determining his course
of action. To make the determination, the probability that the event will occur
and the magnitude of the event if it does occur must be balanced. Here, the
first public disclosure may have been misleading – the case is remanded to
determine if it was such that a “reasonable investor” would have relied on it.
3) Press release: If corporate management can show that it was diligent in
ascertaining that the information that it published in the press release was the
whole truth, and that such information was disseminated in good faith, Rule
10b-5 is not violated. The court remands to the trial court for a determination
of whether the press release was misleading and, if it was, whether the
corporation violated the required standard of care in issuing it so that an
S.E.C. injunction will issue against further violations.
4) When may insiders act?: Before insiders may act, the information must
have been effectively disclosed in a manner sufficient to ensure its availability
to the investing public. So the director who left the news conference on April
16 to call his broker to purchase securities is liable.
5) Good faith as defense: Specific intent to defraud need not be shown.
Negligent insider conduct is sufficient for liability. Hence, the claim that the
news was pubic when the officer [honed his order the night before the
company news conference is not a reasonable belief, and the officer is liable
for negligent violation of the Act.
6) Stock options: Accepting stock options in February 1964 from a company
committee and the board, neither of which knew of the information, is a
violation by officers who did know.
7) The “in connection with” requirement: The 1934 Act was meant to
promote a free market and protect the investing pubic. Section 10(b) protects
against fraudulent or misleading statements or acts “in connection with” the
purchase or sale of securities. This means that any device is proscribed,
whatever it might be, that would cause reasonable investors to rely thereon in
connection with buying or selling corporate securities. It need not be shown
that the party using the device was involved in the purchase or sale

Charella v. United States (1980)(p. 850)

Facts: A printer, in the course of his job, prints press releases from different
corporations. Several press releases from acquiring companies which
announced mergers passed through his hands, and from their information, he
was able to deduce the parties, and purchased the stock of the target company
before the information became public. The printer was convicted of insider
trading under SEC Rule 10(b) for failing to disclose this non-public information,
and trading on it. The court of appeals affirmed stating that no person, whether
or not a corporate insider may trade on any illegally obtained non-public
Issue: Whether a person who learns from the confidential documents of one
corporation that it is planning to attempt to secure control of a second corporation
violates SEC rule 10(b) if he fails to disclose the impending takeover before
trading the in the target company stock.
Holding: No.
A corporate insider must refrain from insider trading without disclosure because
the insider owes a duty to the corporation based on his position. Specifically, the
insider should not be allowed to profit personally from his access to confidential
information by virtue of his position. However, a purchaser of stock who is
neither an insider or a fiduciary has no duty to the prospective seller to disclose
non-public information because he does not stand in a position of trust and
confidence to the seller which would make the transaction unfair. The jury
instructions here were too broad, and thus the conviction must be reversed. The
court makes no opinion as to whether the printer breached a duty to the acquiring
corporation who hired him.

Synopsis of Rule (p. 860)

United States v. O’Hagan (1997)(p. 861)

Dirk v. SEC (1983)(p. 873)

Facts: Dirks (D) was an employee of a broker-dealer firm that specialized in
providing investment analysis of insurance companies for institutional investors.
He received information from Ronald Secrist, a former officer of Equity Funding
(a New York Stock Exchange Company), that its assets were vastly overstated
since the company was creating false insurance policies. D investigated by
interviewing company officers and employees. Some of the employees verified
the charge. D discussed this information with some of his clients, who sold the
stock, driving the market price down. Finally, the S.E.C. halted trading in the
stock. Then the California insurance commissioner investigated and discovered
the fraud. Equity Funding entered receivership. The S.E.C. sued D under section
17(a) of the 1933 Act for aiding and abetting his clients that sold their stock
based on the inside information. The circuit court affirmed the S.E.C.’s decision
against D. The Supreme Court granted certiorari.
Issue: Where the insider is not motivated by personal gain, is a person who got
the inside information from an insider and who gave it to tippees that traded on
the information in violation of Rule 10b-5?
Rule: No. Judgement of the circuit court was reversed.
1) To be an insider, a person must have a fiduciary relationship with the
shareholders of the company whose stock is traded.
2) The S.E.C.’s position is that a tippee from such an insider inherits the
fiduciary duty of the insider if he knows the information is material and non-
public and if he knows that the insider has a fiduciary duty not to disclose it.
3) But a rule such as that suggested by the S.E.C. might inhibit market analysis
form doing their work, which is to question corporate insiders and discuss this
information with their clients.
4) The motivation of the insider is critical. The test is whether the insider will
personally benefit, directly or indirectly, from his disclosure. Absent some
such personal gain, there is no breach, and the tippee who takes such
information and gives it to those who might trade on it has not breached any
duty, since his duty is derivative from the insider’s duty. Gain might be
monetary, reputational , etc.
Dissent:: Secrist could not trade on his information. He could not get someone
to do the trading for him. But he used D to disseminate information to D’s clients,
who traded with unknowing purchasers. It makes no difference to these
unknowing shareholders whether Secrist had a good or bad purpose in
disclosing the inside information. The breach is to take action disadvantageous to
one to whom a duty is owed.
Comment:: The Court noted that in certain circumstances, such as where
corporate information is revealed legitimately to an underwriter, accountant,
lawyer, or consultant working for the corporation, these outsiders may become
fiduciaries of the shareholders because they have entered into a confidential
relationship in the conduct of the business of the corporation and are given
access to information solely for corporate purposes.

United States v. Chestman (1991)(p. 881)

Facts: Ira Waldbaum was the controlling shareholder of Waldbaum, Inc. In 1986,
Waldbaum agreed to sell the corporation. He told his sister and his children
about the pending sale, and admonished them to keep the news confidential until
after the public announcement of the sale. However, Waldbaum’s sister told her
daughter, Susan, who then told her husband, Keith, about the pending tender
offer. Keith told Chestman (D), a stockbroker, that Waldbaum, Inc. was going to
be sold for a substantially higher price than market price. D then traded on
behalf of himself, several clients, and Keith based on this information. Keith
agreed to cooperate with the S.E.C. in their investigation. D was convicted under
Rule 10b-5 as an aider and abettor of the misappropriation and as a tippee of the
misappropriated information and for mail fraud. D appeals.
Issue: If a wife tells her husband about a pending tender offer for stock in her
family’s business, and the husband tells his stockbroker who then trades based
on the information, has the husband breached a fiduciary or “similar relationship
of trust and confidence” sufficient to impose liability for violation of 10b-5 and mail
Rule: No. Conviction reversed.
1) The relationship between Keith and Susan Loeb does not fall within any of
the traditional fiduciary relationships, this, we must determine whether their
relationship constitutes a “similar relationship of trust and confidence”
sufficient to impose Rule 10b-5 liability.
2) A “similar relationship of trust and confidence” must share the same qualities
as a fiduciary relationship. A fiduciary relationship depends on reliance,
control, and dominance and exists when confidence is reposed on one side
and there is a resulting superiority and influence on the other. A fiduciary
relationship involves discretionary authority and dependency: one person
depends on the other to serve his interests. Because the fiduciary obtains
access to the other person’s property to serve the ends of the fiduciary
relationship, he becomes duty bound not to appropriate the property for his
own use.
3) The court found that the government presented insufficient evidence to
establish a fiduciary relationship or its functional equivalent between Keith
Loeb and the Waldbaum company. Keith had not been brought into the
family’s inner circle whose members discussed confidential business
information. Keith was not an employee of Waldbaum and he did not
participate in confidential communications regarding the business. The
confidential information was gratuitously communicated to him and did not
serve the interests of the Waldbaum company. Nor was the relationship
characterized by influence and reliance of any sort. A fiduciary duty cannot
be imposed unilaterally by entrusting a person with confidential information.
4) Nor was there sufficient evidence to establish a fiduciary relationship or its
functional equivalent between Keith Loeb and his wife. Kinship alone does
not create a fiduciary relationship. Susan admonished Keith not to disclose
that Waldbaum was the target of a tender offer. Although they had
maintained confidences in the past, there was no evidence of the nature of
the confidences, therefore, the jury could not reasonably find that there
existed a fiduciary relationship. In the absence of explicit acceptance by
Keith of the duty of confidentiality, there is no fiduciary relationship. While
acceptance can be implied, it must be implied from a preexisting fiduciary-like
relationship between the parties, Susan’s disclosure of the information served
no business purpose and was unprompted; Keith did not induce her to convey
the information. The government did not prove a pattern of sharing business
confidences between Keith and Susan.
5) Keith did not owe a fiduciary duty to either Susan or the Waldbaum company,
and he did not defraud them by disclosing the news of the tender offer to D.
Since Keith is not guilty of fraud, D cannot be held derivatively liable as
Keith’s tippee or as an aider and abettor. A mail fraud conviction requires a
breach of the same fiduciary like duty, which we have found does not exist
here. D’s convictions must be reversed.
Concurrence: A family member who has received or expects benefits from
family control of a corporation, who is no a position to learn confidential corporate
information through ordinary family interactions, and who knows that under the
circumstances both the corporation and the family desire confidentiality, has a
duty not to use such information for personal profit where the use risks
disclosure. To hold otherwise would discourage open family communication and
would mean that a family-controlled corporation is subject to greater risk of
disclosure of confidential information than a publicly-owned corporation. Thus, I
would affirm D’s conviction.
Concurrence: Judge Winder’s proposed familial rule adds an element of
uncertainty to this area of the law; it is unclear who would be subject to the duty
of confidentiality.

Securities Exchange Act of 1934 15 USCA §78u-1 (1997)(p. 893)

Securities Exchange Act of 1934 15 USCA §78t-1 (1997)(p. 897)
Securities Exchange Act of 1934 15 USCA §78p-1 (1997)(p. 899)


Materiality: The misrepresented or undisclosed fact must be a “material” one. A
number of tests of “materiality” have been suggested by the courts.
1) Reasonable person standard: In List (1965) the court stated that the “basic
test of materiality…is whether a reasonable man would attach importance to
the misrepresented fact) in determining his choice of action in the (securities)
transaction in question.”
a) in a situation where the impact of a fact is uncertain, it has also been
suggested that in applying this materiality test, the probability that the
event will occur must be balanced against the magnitude of the event if it
occurs. (i.e. a high probability, high magnitude event is clearly material.)
b) IN SEC v. Texas Gulf Sulphur Co, the issue was whether the corporation
had met its disclosure responsibility concerning a huge potential ore
discovery. It had issued a press release that acknowledged drilling
operations but hedged as to the possible results (even though the know
information was favorable and the magnitude of the potential effect on the
company was huge).
2) Value of Corporation’s Securities: Another test used to determine the
materiality is whether the fact in “reasonable contemplation” would affect the
value of the corporation’s securities Kohler v. Kohler (1963)
3) Consider all of the Facts: Under whatever test is used, it is clear that the
courts consider all of the facts to determine whether the undisclosed
information might reasonably have influenced the plaintiff’s conduct.
4) Examples of material Facts: include the intention of company management
to pay a dividend, or a significant drop in the profit level of the company.

Basic Inc. v. Levinson (1988)(p. 906)

Facts: Officers and directors of Basic, Inc., including Ds, opened merger
discussions with Combustion Engineering in September 1976. During 1977 and
1978, Basic denied 3 times that it was conducting merger negotiations. On
December 18, 1978, it halted trading on the NYSE, saying it had been
approached. On December 19, 1978, it announced that the board had approved
Combustion’s $46 per share tender offer. Levinson and others (Ps) are a class
of shareholders who sold their stock after Basic’s 1977 statement and before the
trading halt on December 18, 1978. They sued under Rule 10b-5. The district
court, on the basis of a “fraud-on-the-market theory,” adopted a rebuttable
presumption of reliance by members of the class. On a motion for summary
judgement, the district court ruled for Ds, holding that at the time of the 1st
announcement in 1977, no negotiations were actually going on, and that the
negotiations conducted at the time of the 2nd and 3rd announcements were not
destined with reasonable certainty to become a merger agreement. The court of
appeals affirmed the holding about reliance, but reversed the summary
judgement. It held that preliminary merger discussions could be material.
Further, it held that once a statement is made denying the existence of
discussions, then even discussions that might otherwise have been immaterial
can be material. The Supreme Court granted certiorari.
1) Is the standard used to determine whether preliminary merger negotiations
must be disclosed a materiality standard under Rule 10b-5?
2) Is it appropriate to use rebuttable presumption of reliance for all members of a
class on the basis that there has been a fraud on the market?
Rule: 1) Yes. 2) Yes.
1) The TSC Industries test is the test of materiality for Rule 10b-5 cases; that is,
a fact is material if there is a substantial likelihood that a reasonable
shareholder would consider it important.
2) With contingent events like mergers (that may or may not happen), the
probability that the merger will occur and the magnitude of the possible event
are looked at. All relevant facts bearing on these 2 issues should be
3) An absolute rule (such as the one requiring that a preliminary agreement be
arrived at before negotiations are material), while convenient, is not in accord
with the TSC Industries test. The circuit court was wrong. If a fact is
immaterial, it makes no difference that Ds made misrepresentations about it.
4) The case must be remanded to consider whether the lower court’s grant of
summary judgement for Ds was appropriate.
5) Reliance, is an element of a Rule 10b-5 cause of action. It provides a causal
connection between a defendant’s misrepresentation and a plaintiff’s injury.
But this causal connection can be proved in a number of ways. In the case of
face to face negotiations, the issue is whether the buyer subjectively
considered the seller’s representations. In the case of a securities market,
the dissemination or withholding of information by the issuer affects the price
of the stock in the market, and investors rely on the market price as a
reflection of the stock’s value.
6) The presumption of reliance in this situation assists courts to manage a
situation where direct proof of reliance would be unwieldy. The presumption
serves to allocate the burden of proof to defendants in situations where the
plaintiffs have relied on the integrity of the markets, which Rule 10b-5 was
enacted to protect. The presumption is supported by common sense. Most
investors rely on market integrity in buying and selling securities.
7) Ds can rebut the presumption.
a) Ds could show that misrepresentation or omission did not distort the
market price (i.e., Ds could show that market makers knew the real facts
and set prices based on these facts despite any misrepresentation that
might have been made.)
b) Or Ds could show that an individual plaintiff sold his shares for reasons
other than the market price, knowing that Ds had probably misrepresented
the status of merger negotiations.
Dissent (as to the fraud on the market theory::
1) The fraud-on-the-market theory should not be applied in this case.
2) The fraud-on –the-market theory is an economic doctrine, not a doctrine
based on traditional legal fraud principles. If Rule 10b-5 is to be changed,
Congress should do it.
3) It is not clear that investors rely on the “integrity” of the markets (i.e. on the
price of a stock reflecting its value).
4) In rejecting the original version of section 18 of the Securities Exchange Act,
Congress rejected a liability provision that allowed an investor recovery based
solely on the fact that the price of the security bought or sold was affected by
a misrepresentation. Congress altered section 18 to include a specific
reliance requirement.
5) The fraud-on-the-market theory is in opposition to the fundamental policy of
disclosure, which is based on the idea of investors looking out for themselves
by reading and relying on publicly disclosed information.
6) This is a bad case in which to apply the fraud-on-the-market theory. Ps’ sales
occurred over a 14 month period. At the time the period began, Basic’s tock
sold for $20 per share; when it ended, the stock sold for $30 per share, so all
Ps made money. Also, Basic did not withhold information to defraud anyone.
And no one connected with Basic was trading in its securities. Finally, some
Ps bought stock after Ds’ first false statement in 1977, disbelieving the
statement. They then made a profit, and can still recover under the fraud-on-
market theory. These Ps are speculators. Their judgement comes from
other, innocent shareholders who held the stock.




Sales Controls: The most complex problem involving the sale of corporate
stock is the situation where a shareholder owning a majority interest (or a
controlling minority interest) of the shares sells that control in a transaction from
which the other shareholders are excluded (the controlling shareholder receiving
a premium price per share on the stock over book or market value), or where all
sell, but the owner of the control shares receives more per share than the other
shareholders. Since a person purchasing “control” can dictate the affairs of the
corporation, “control” is something of value.
General Rule: Is that a shareholder may sell his stock to whomever he wants to
at the best price he can get.
1) Majority shareholder: Most courts would say that a majority shareholder
has the same right. Where the majority shareholder agrees to have a
majority of the board of directors resign and the purchaser’s appointees
elected (where this would naturally occur anyway), this is also not illegal per
Zetlin v. Hanson Holding Inc. (1979)(p. 937)
Facts: Zetlin (P) owned 2% o Gable Industries. A group of shareholders
including Hanson (Ds) sold their interest in Gable (44.6%), which was effective
control, to another party for $15 per share when the market price was $7.38 per
share. P wanted to be paid the same price as Ds and to share a proportionate
amount of his stock. The trial court found for Ds; P appeals.
Issue: Absent fraud, can a controlling shareholder sell control for a premium
Rule: Yes Affirmed.
1) A majority interest can control the affairs of the company. Absent looting,
conversion of a corporate opportunity, or other acts of bad faith, a controlling
shareholder can sell the right to control the affairs of the corporation for a
premium price.

Looting Theory: In a situation where the purchaser buys only the controlling
stock, the controlling shareholders may be liable to the minority when the
purchaser later “loots” the corporation (if the majority shareholders knew or had
reason to know that the purchaser intended to loot the corporation). Paying a
“premium” is one indication or notice of possibly intended “looting.”

Debaun v. First W. Bank and Trust Co. (1975)(p. 938)

Facts: DeBaun and Stephens (Ps) held 30 of the 100 shares of stock in a photo
finishing business where they worked. They were also directors. After the death
of the founder, who held the balance of the stock in 1964, the 70 shares passed
to a testamentary trust administered by First Western (D). Ps and another
managed the business very successfully until 1968. In 1966, D decided to sell
the 70 shares (on the basis that it was not an appropriate trust investment)
without informing Ps. After an appraisal and aid from a broker, D located a
tentative buyer, Mattison. About the same time, DeBaun learned of the proposed
sale and submitted an offer, which was refused. D, after receiving a sketchy
balance sheet of the trust through which Mattison was seeking to purchase the
shares, ordered a Dunn & Bradstreet report on Mattison (which report noted
pending litigation, past bankruptcies, and existing tax liens against corporate
entities in which Mattison had been a principal).
Also one of the officers of D had knowledge that there was an unsatisfied
judgement that had been rendered against Mattison in favor of D'’ predecessor.
Mattison explained these problems on the basis that he usually acquired failing
companies and tried to turn them around. The public records of Los Angeles
County, which were not checked by D, revealed $330,886 in unsatisfied
judgements against Mattison and his entities and 54 pending actions totaling
$373,588, as well as 22 recorded abstracts of judgements against him for
$385,700 and 18 tax liens aggregating $20,327. Notwithstanding the information
available to D, on the basis of the fact that one of D’s officers knew Mattison and
that Mattison was warmly received at an exclusive club, D accepted Mattison’s
offer of $50,000 in securities with the balance of the purchase price to be paid
out of the revenues of the corporation (even though D knew Mattison would be
forced to make some of these payments out of the capital assets of the
corporation). D sold Mattison the shares in July, and in less than one year the
corporation’s net worth of $220,000 was reduced to a net deficit of over $200,000
by Mattison’s diversion of corporate assets to himself through various schemes.
Ps sued D to recover for its breach of duty to minority shareholders in selling to
Mattison. The trial court found for Ps an awarded damages of $438,000
($220,000, or the net asset value at the time of sale by Mattison, plus $218,000
as the discounted value of the anticipated corporate profits for the next 10 years).
D appealed.
Issue: Does a controlling shareholder owe the other shareholders a duty not to
sell its controlling interest to an individual who was likely to loot the corporation?
Rule: Yes. D breached its duty to P by selling to Mattison.
1) D knew of Mattison’s numerous financial failures and that Mattison could not
meet his obligations to pay for the corporation without using its assets.
2) A majority shareholder owes a duty to the minority shareholders to investigate
an individual and not to sell to him if they reasonably should know he will loot
the corporation.

Sale of corporate assets: Where the purchaser buys only the majority stock, the
majority may be liable for any premium received if the corporation has some
particular “corporate asset” that creates this premium, since this asset belongs to
all shareholders equally. But what constitutes a “corporate asset”? Isn’t this
involved in every corporate sale, so that whenever a purchaser offers to buy
control he must give this same offer to minority shareholders?

Perlman v. Feldman (1955)(p. 947)

Facts: Newport Steel is a mid-sized steel company trying to expand its market
during the steel shortages of the Korean war. Feldmann is the chairman and
controlling stockholder of Newport. Feldman sold his controlling interest in
Newport for $20 per share to a customer company, Wilport, who needed to
secure a stable source of steel during the shortage. This enabled Wilport to
allocate more steel to itself by placing several people on Newport’s board. The
book value of the stock was $17 per share and the market value was $12 per
share. A derivative action brought by minority shareholders against Feldmann
for an accounting and restitution of the profits that Feldmann personally realized
from the sale of his controlling interest. The trial judge found that the $20 per
share price was fair and was not the sale of a corporate asset.
Issue: Whether the sale of control under these facts was the sale of a corporate
asset which would entitle the corporation to the profit realized by Feldmann.
Holding: Yes.
A fiduciary has the responsibility to dedicate his uncorrupted business judgment
for the sole benefit of the corporation in any dealings which may adversely affect
it. The possibility that the corporation would have benefited is all that is required,
not a showing of absolute certainty. Feldmann’s actions prevented the
corporation from obtaining interest-free advances from prospective purchasers to
expand production. It also prevented the corporation from building up its
customer base. The defendant must show that there was no possibility of any
gain by the corporation and he has not met that burden of proof. In a time of a
market shortage, where the power to allocate a corporation’s product commands
an unusually large premium, a fiduciary may not appropriate to himself the value
of that premium.

Sale of a corporate office: In a purchase transaction, the majority also agrees

to assist the purchaser in the accomplishment of some corporate action requiring
the exercise of their corporate office. Some courts have held that any premium
paid to majority shareholders must be distributed pro rata to all shareholders
where a premium price has been paid based on the majority’s exercise of its
“corporate office” (on the basis that this belongs to the corporation as a whole,
not to the majority shareholder exclusively).

Petition of Caplan (1964)(p. 956)

Facts: Cohn owned 3% of Lionel Corporation stock but controlled 7 of the 10
directors of the corporation. He agreed to sell his shares to Defiance Industries,
Inc. and the have the directors he had nominated resign to allow Defiance
nominee to take their positions. Defiance then sold its interest in the contract to
Sonnabend and agreed to have its nominees resign to be replaced by
Sonnabend nominees. A shareholder of Lionel challenged the elections of the 7
Sonnabend nominees.
Issue: May control of a corporation, apart from stock control, be traded?
Rule: No. Control may only be traded as part of the trade of actual stock control.

(The Following will not be covered)

PROXY REGULATION (pp. 593-606, 615-631, 647-662)