CORPORATIONS & THE LAW OF BUSINESS ORGANIZATIONS

Virginia Kain | Fall 2019 | Shnitser

INTRODUCTION & OVERVIEW

- AGENCY & PARTNERSHIP (Ch. 1 – 2):

o Basic forms of business organization
- THE CORPORATE FORM (Ch. 3 – 5):
o Understanding the process and implications of corporation formation and capitalization
- “NORMAL” GOVERNANCE (Ch. 6 – 10):
o Study shareholder voting, directors’ duty of care and loyalty, conflicted transactions, and
shareholder suits
- EXTRAORDINARY GOVERNANCE (Ch. 11 – 13):
o Focus on mergers and acquisitions and contests for control.

THEMES & POLICY ISSUES

- THEMES
o Corporate law as an innovative, evolving product.
 We don’t have to take the existing tools and strategies available to us as a given;
legal innovations happen all the time.
 Ex: Benefit corporations and the changing role of shareholders –
advocating for social responsibility and alternative business forms.
o Tension between state versus federal regulation of corporate law.
o Judicial deference to business judgment
 Exceptions, heightened standards
o Shareholder Primacy vs. Roles of Other Stakeholders
o Shareholder vs. Management Primacy in Corporate Governance
 This is the central challenge in corporate governance. How do we structure the
set of rules to make sure that the shareholders are sufficiently protected?
 Why is the separation and ownership and control challenge in corporate law?
 Referring to the fact that shareholders own a portion of the company but
that they are not controlling it day to day. This can be challenging for
shareholders because of the misalignment of interests – trusting that the
company isn’t going to waste their money.
- POLICY ISSUES
o Corporate law governs relationships among people; it is part of the art and science of
organizational design.
 Orderly and efficient relationships among the parties to corporations are critical
to the success of business enterprise, and ultimately to economic growth.
o Governments are just corporations of a sort, and private corporations are also like
governments in an important sense.
o The interaction between public policy and corporate law is prevalent in our everyday
lives:
 We interact with corporations as consumers, employees, directors, service
providers, involuntary tort creditors of a corporation, shareholders, owners, and
through retirement assets of individuals which are invested primarily in public
corporations through 401k plans.

WHAT IS A CORPORATION & WHY FORM ONE?

- CORPORATION: A business that is a legal entity and shares in the profits of the business but
whose owners are not personally liable for any debts or losses of the business. A corporation has
indefinite life and limits the liability of the corporation’s owners (shareholders) and facilitates the
pooling of capital and labor.
o The corporation can continue its business regardless of what happens to any particular
individual.
o The corporate structure also allows an unlimited number of individuals to buy shares of
the corporation, which in turn entitles them to an ownership stake in the corporation.
 Shareholders are not generally entitled to get their investments back with interest
– they’re residual owners, which means that they are only entitled to what is left
over after the corporation settles its liabilities.
 The most that a shareholder can lose is their entire investment, but
not more.
o Creates a legal separation between the individual and the business.
 The corporate form shields the shareholder from the debts of the corporation.

- WHY DOES IT MATTER THAT A CORPORATION IS A LEGAL “PERSON?”

o Because of their status as legal entities, corporations can:
 Own property
 Pay taxes
 Sue and be sued
 Issue stock (units of ownership)
 Elect board of directors

- ADVANTAGES OVER SOLE PROPRIETORSHIP:

o In a sole proprietorship, there is no legal barrier between the proprietor and the business –
if anything happens to the proprietor, then that means the business probably will not
continue.
o The sole proprietor is personally liable for any legal consequences against the business.
o Likely fairly difficult financially to expand the business, because hardly any outside
investor is going to want to expose herself to the liability of the business.

WHAT DOES IT TAKE TO FORM A CORPORATION?

1. Decide in which state to incorporate. This is an important consideration because the state laws
govern the internal rules of the corporation. Delaware is the dominant state of incorporation; the
majority of US corporations are incorporated in Delaware.
a. Every state has enacted its own corporation statute that provides for the (1) creation of
corporations and (2) the legal attributes of corporations created in that state.
2. File articles of incorporation – the “charter” and pay a fee. The articles of incorporation
provide basic information about the corporation –
a. DGCL § 102(a) requires only six items:
1) name of the corporation;
2) name and address of registered agent and address of the registered office;
3) nature of the corporation’s business which can be “to engage in any lawful act
or activity”;
4) information about the corporation stock, including information about “classes
of stock”;
5) name and address of the incorporator;
6) names and addresses of initial directors.
b. DGCL § 102(b) provides information that can, but does not have to be, included in the
articles of incorporation.

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3. Prepare bylaws. Bylaws are the governance rules of the corporation, and establish the operating
rules for the governance of the corporation – e.g. size of the board, when meetings are, etc. These
are easier to amend than the charter.
4. Issue equity. Typically, contribute cash to purchase a share.

THE KEY PLAYERS

- SHAREHOLDERS: The owners of the corporation.

o As the residual claimants, shareholders bear the risk of failure.
o Shareholder primacy is the norm in corporate law – thus, shareholder interests should be
at the forefront of corporate decision making.
o Shareholders have voting rights, and elect board directors, and vote on certain
‘fundamental’ transactions.
o Shareholders do not control the day-to-day management of the company.
o Dual-class structure – some shareholders have more votes per share than others.

- BOARD OF DIRECTORS: Oversee the high-level corporate decisions, and select officers
(CEO etc.) to handle day-to-day operations.
o Elected by shareholders
o Subject to fiduciary duties of care and loyalty

- OFFICERS OF THE CORPORATION (SENIOR MANAGEMENT): Controls day-to-day

operation of the corporation.
o Senior managers are selected by the board of directors.
o Because they are regarded as agents of the corporation, they are subject to the fiduciary
duties of care and loyalty.
o In most cases, CEO has a seat on the board of directors.

- CREDITORS: Issue loans to the corporations.

- OTHER PLAYERS:
o Employees
o Customers
o Community

CORPORATE MILESTONES

- INITIAL PUBLIC OFFERING

o The IPO is a way in which a corporation raises capital, by offering shares of the
corporation to the general public. The corporation typically goes from being closely held,
(only a few members) to the general public (diverse group).
 What are the consequences of going public?
 Become subject to federal securities law and oversight by the Securities
and Exchange Commission (SEC) – SEC is there to protect the public
from scams
 Incur reporting and disclosure obligations for (1) the ordinary course of
business, and (2) in the case of a fundamental transaction (M&A)

- FUNDAMENTAL TRANSACTIONS
o Mergers and acquisitions
 Mergers, stock acquisitions, asset acquisitions
o Regulation by State/Federal Authorities
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  For all corporations: state law protections for shareholders
 For public companies: federal disclosure requirements

- DISPUTES AND LITIGATION

o Directors/Officers vs. Shareholders (directors didn’t meet certain obligations)
o Shareholders vs. shareholders
o Corporation vs. creditors

CHAPTER ONE – ACTING THROUGH OTHERS: THE LAW OF AGENCY

INTRODUCTION TO AGENCY

- AGENCY LAW: Governs the legal relationships among principals, their agents, and the third
parties with whom the agents interact. The source of agency law is the Restatement of Agency
Law, which is not binding, but is an attempt at summarizing the state of the law.

- REQUIREMENT OF AGENCY RELATIONSHIPS:

o (i) one person acting on behalf of another;
o (ii) the agent (A) is acting subject to the principal’s (P) control
o (iii) and that both A and P have consented to (i) and (ii).

- KEY QUESTIONS:
(1) When is the agency relationship formed?
(2) When is the principal bound by the agent’s actions (including unauthorized
contracts and torts)?
(3) What duties does the agent owe to the principal?

AGENCY FORMATION, TERMINATION AND PRINCIPAL’S LIABILITY

FORMATION

- DEFINITION: (Restatement 3d. § 101): Agency is the consensual fiduciary relationship that
arises when one person (principal) manifests assent to another person (agent) that the agent shall
act on the principal’s behalf and subject to the principal’s control, and the agent manifests
assent or otherwise consents so to act.
o Key concept: Agency is a voluntary relationship; while explicit consent is not required to
make the agency relationship valid, there must be a manifestation of consent in some
form.
o The agency relationship enables an agent to create rights and obligations between a
principal and third party - has to be established legally, as opposed to by contract.
 A can act on behalf of P, and A can actually bind P to the act.
 The core of the agency relationship is that A can bind P to third party T.
 The agent must have the proper authority to bind P to the transaction.
 The agent holds the power to affect the principal's legal relations within
the scope of the agent’s agreed-on appointment (employment) (authority)
and beyond this scope in some circumstances.

- PARTIES TO AN AGENCY RELATIONSHIP

o AGENTS
 Scope of Authority:
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 Special Agents: Agency is limited to a single act or transaction
General Agents: Agreed upon agency contemplates a series of acts or
transactions
 Types of Agents:
 Employee (servant): When the principal secures from her agent the
right to control in detail how the agent performs his task (time devoted to
task, etc)
 Independent Contractor: When the principal’s control rights are
limited, and the agent exercises considerable discretion
o PRINCIPAL
 Disclosed: third parties understand that an agent acts on behalf of a particular
principal.
 Partially Disclosed: third parties knowingly deal with an agent without knowing
the identity of the principal.
 Undisclosed: third parties believe that the agent is the principal.

o THIRD PARTIES

TERMINATION

- Either the principal or the agent may terminate an agency relationship at any time – once one
person decides to terminate it, it’s terminated, because agency relationships are built on consent
of both parties.
o If there is a contract setting the fixed term of agency: the principal’s decision to
revoke it or the agent’s decision to renounce it gives rise to a claim for damages for
breach of contract.
 If there is no set term: then “reasonable time” is contemplated in damages
action.
- In no event will the agency continue over the objection of one of the parties.
o What effect does this have? The rule that either party may freely terminate is equivalent
to limiting the remedy for breach of an agency contract to monetary damages rather than
specific performance.

PARTIES’ CONCEPTION DOES NOT CONTROL

- Agency relationships may be implied even where there is no explicit agreement.

- Jensen Farms Co. v. Cargill, Inc. (1981) – Implied Agency Relations

o R: A principal-agent relationship exists between a creditor and debtor when the creditor
intervenes in the business affairs of the debtor.
o F: Farmers brought an action against Cargill and Warren Grain & Seed Co. to recover
losses incurred when Warren defaulted on contracts made with the plaintiffs for the sale
of grain. Farmers went after Cargill to get the lost money after warrant defaulted on their
grain sales (they had given grain to Warren on credit).
 First contract (1964): security agreement, C loans money to W, on ‘open
account’ financing with a limit of $175k; W receives funds and pay expenses
through drafts drawn on C through Minneapolis banks. In exchange for the
financing, Cargill became Warren’s grain agent and C was given first right of
refusal to buy grain sold by W.
 Second Contract (1967): ): increased W’s credit line and gave C authority over
some of W’s internal operations, including requiring W to give C annual
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 financial statements, granting C access to W’s books, and requiring permission
for transactions over $5000. W also not allowed to become liable as a guarantor
on another party’s debt, or to encumber its assets except with Cargill’s
permission. C also needed to approve any selling/purchasing of stock and not
allowed to declare a dividend without C’s permission.
 Third Contract (1970): C contracts with W and other grain elevators to act as its
agent to seek growers for a new type of wheat. W entered into several contracts,
all with C named as the contracting party; farmers were paid directly by C for the
seed and all contracts performed in full.
 Fourth Contract (mid 1970s): Warren was shipping 90% of its grain to Cargill.
Cargill later discovered that Warren was engaging in some questionable uses of
funds, but instead of calling the loan, Cargill executed new security agreements
with Warren, increasing its limit to $1,250,000.
 C became increasingly involved in W’s finances, W goes bankrupt.
 What kind of relationship does Cargill claim it has with Warren?
 Cargill claims they’re only in a lender/borrower relationship.
 How do the plaintiffs characterize the relationship?
 Much more involved, because Cargill is managing the finances of
Warren and involved in daily operations. Plaintiffs say there is an agency
relationship and therefore Cargill is liable to pay for Warren’s
shortcomings.
o PH: Farmers sued C for $2 million, saying that C had acted as the principal for the grain
elevator and was therefore liable for W’s contractual obligations.
o Q: Was Cargill, by its course of dealing with Warren, liable as a principal on the
contracts made between Warren and the plaintiffs?
o H: Yes, Cargill is liable.
o A: When a creditor exerts control over the operations of a debtor, a principal-agent
relationship is created between the parties, and the creditor is liable for the contractual
obligations of the debtor.
 Parties’ conception of the relationship does not necessarily control. Consent to
agency relationship can be inferred from the actions of the parties.
 Evaluate the relationship in context:
o Cargill’s constant recommendations to Warren via phone
o Cargill’s right of first refusal
o Warren’s inability to enter into mortgages/purchase stock/pay
dividends without Cargill’s approval
o Cargill’s right of entry on to Warren’s premises to carry out
periodic checks and audits
o Cargill’s correspondence and criticism regarding Warren’s
finances, salaries of officers, inventory
o Cargill’s determination that Warren needed “strong paternal
guidance”
o Provision of drafts and forms to Warren upon which Cargill’s
name was printed
o Financing of all Warren’s purchases and operating expenses
o Cargill’s power to discontinue financing of Warren’s operations
 Policy: This holding upset banks and other lenders because banks want to be
able to control what the people that they are lending money to are doing, but the
critical question then becomes how much involvement is too much such that a
relationship crosses over the agency threshold? Since the decision, courts have
been reluctant to find an agency relationship unless the lender goes far beyond
what is typical – critical factor is the degree of control.
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 LIABILITY IN CONTRACT

- OVERVIEW
o Principal-Agent relationship gives rise to mutual duties: agent must reasonably
understand from the action by or communication of the principal that she has been
authorized to act on the principal’s behalf.
 Agency relationships confer legal power on the agent and gives rise to duties by
both the principal and the agent. Both parties must manifest their intention to
enter into an agency relationship. While this doesn’t have to be in writing, the
agent must reasonably understand from the action or speech of the principal that
she has been authorized to act on the principal’s behalf.
o Why hold principals liable for contracts entered into by agents? Want the agent to be
independent, and do not want the third party to have to question or not be able to rely
upon the contract. The limiting principle is how much authority the agent has. At
common law, a principal is liable for contracts when an agent has one of 3+ types of
authority.
o Scope of the actual authority conferred on the agent is that which a REASONABLE
PERSON in A’s position would infer from the conduct of P.

- (1) ACTUAL, EXPRESS AUTHORITY (P  A)

o P authorizes A to do X.
 Ex: P owns a movie production company, and tells A to go out and hire a
makeup artist for the production company.
o Includes incidental authority - the authority to do the steps that are ordinarily done in
connection with facilitating the authorized act.
- (2) APPARENT AUTHORITY (P  T)
o There is no actual authority for A to do X, but there is a manifestation by P to T that A
has the authority to do X. (See White v. Thomas).
o Authority that a reasonable third party would infer from the actions or statements of P.
 Sort of an equitable remedy, designed to prevent fraud or unfairness to third
parties who reasonably rely on P’s actions or statements in dealing with A.
 This is true even if the third party didn’t know that P had limited the
authority of A in a way that precluded A from engaging in that action.
o The key piece to examine is the manifestation to the third party – we care about the
communication between the third party and the principal – how did the principal
characterize the relationship between agent and principal?
 Ex: P tells T that A does all the hiring. T wants a job at P’s company. After they
hang up the phone, P tells A that she hates T and doesn’t want to hire him. A
hires T. P refuses to honor the agreement and fires A. T will win because A had
the apparent authority to hire him.
o White v. Thomas (1991) – Apparent Authority
 R: A purported agent’s claims regarding the existence or scope of his or her
authority, without more, are insufficient to create apparent authority.
 F: White had employed Betty Simpson part time to answer his phone, house sit,
and do typing for him.
 She once had signed on his behalf and under a POA, the closing papers on a
piece of property appellant was purchasing. Simpson had never negotiated
on his behalf or gone to an auction to buy property.
 In 1988, White instructed Simpson to attend an auction and bid on his behalf
up to $250k on a 220 acre farm except for the 3 acres where the house sat.
The property was sold to her for $327.5k, so Simpson approached appellants

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 about purchasing from her some of the lands surrounding their house. A/g to
sell ~45 acres of land to them; signed the deal “Betty Simpson, POA, Power
of Attorney for White”.
o White does not want to sell the land to the appellants and
repudiated Simpson’s O&A and informed appellees.
 Appellees seek specific performance of the contract as
well as release of the land in the contract from the
mortage.
o White and Simpson both denied that Simpson was expressly
authorized to enter into a contract of sale on White’s behalf.
o No power of attorney existed.
 Q: Will a principal be bound by a purported agent’s assertions regarding the
scope of his or her authority?
 H: No. Not reasonable for them to rely solely upon an admitted agent’s own
declarations as to her authority.
 Express authority refers to that which an agent is explicitly given the power
to do. Implied authority includes the right to do anything necessary to
complete the agent’s assigned task. Apparent authority refers to authority that
an agent does not actually possess, but appears to have. A purported agent’s
claims about his or her authority may be evidence of the existence and scope
of apparent authority, but this must be corroborated by outside evidence.
 Here, in order for appellant White to be liable for Simpson’s actions in
entering into the O&A with appellees, her actions must have fallen within the
scope of her apparent authority.
o BUT: there is no evidence that White knowingly permitted
Simpson to enter into a contract to sell, and the court cannot
conclude that the two types of transactions (purchasing vs
selling) are so closely related that a third person could
reasonably believe the authority to do one was the authority to
do the other).
o Selling off the land is way different than attending the auction to
buy land. The Thomas’ also didn’t fact check, or check with
White – there was nothing that White did that represented her to
have that authority.
 Policy: Why not hold White liable on all Ks made by A? We don’t want to make
principals liable for rogue agents. The Thomas’ should have monitored the
authority. Third party should have checked whether Simpson actually had the
authority to do what she did.
 Look towards the lowest cost monitor – which party is better able to check
the authority?

- (3) RATIFICATION (P  T)
o A does not have authority to do X, but does it anyways, and P ratifies.
o Affirming a prior act done by another that gives the act effect as if done by an agent
acting with actual authority.
 If the agent does something that the principal didn’t authorize, then P can ratify
by allowing it to happen/doing nothing/later affirming decision.
o Can be manifested through assent or conduct that justifies reasonable assumption of
consent.
o LIMITS TO RATIFICATION:
 P must know material facts; cannot be bound to ratification without the material
facts.

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  Ratification must encompass the entire act, not just the good parts – no partial
ratification allowed.
 Temporal limits – must precede circumstances that have adverse or inequitable
effects.
 Ratification must happen within sufficient time
 Cannot ratify where third party is harmed
 If Co-P, both must ratify.
o When P ratifies actions by A, P must bear the cost.

- (4) ESTOPPEL
o Estoppel elements: Failure to act when knowledge and an opportunity to act arise, plus a
reasonable change in the position of the third person. Alternatively, accepting benefits
under an unauthorized contract will constitute acceptance of its obligations as well as its
benefits.
o Note that Estoppel is not technically a form of authority; rather, it is a doctrine that (as
applied in this context) prevents a Principal from arguing that no authority existed.
However, even in circumstances in which the Principal might be bound to an agreement
by the doctrine of Estoppel, the doctrine may not be used independently by that Principal
to enforce the agreement against a third party.

- (5) INHERENT AUTHORITY (A  T)

o There is no actual or apparent authority present, but if A is doing something that is usual
for the business, P can be bound. (See Gallant Ins. v. Isaac)
o Authority to do steps of implementation that are normally done in connection with
facilitating the authorized act.
o Some courts have identified circumstances where agents have inherent authority to
bind principals to contracts. It is not conferred on agents by principals, but represents
consequences imposed on principals by the law.
o Inherent authority arises when there is no actual authority, and no apparent authority, but
if A is doing something that is usual for the business, P can be bound (Gallant).
 Under the traditional approach, the doctrine of inherent power gives a general
agent the power to bind a principal (disclosed or undisclosed) to an unauthorized
contract as long as a general agent would ordinarily have the power to enter such
a contract and the third party does not know that matters stand differently in this
case.
o Gallant Ins. Co. v. Isaac (2000) – Inherent Authority
 R: Some courts have held that a principal may be bound by the conduct of an
agent done under his or her inherent authority, which derives from the agency
relationship itself.
 If third party had no contact with P and reasonably relied on A 
inherent authority.
 F: Isaac (T) bought car insurance from Gallant (P) through an insurance agent
(A) (Thompson). Gallant sells car insurance to Isaac through its agent. Policy
states that any changes would have to be authorized by P. Isaac’s coverage was
set to expire on December 2, 1994.
 On that date, Isaac traded for a new car and contacted Thompson-Harris
about purchasing the full-coverage insurance required by her loan
provider.
 Thompson-Harris indicated that the new coverage would immediately
“bind” and that Isaac could come in on Monday, December 5 to make
payment.

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  Generally, Gallant’s coverage became binding on a new policy when
Thompson-Harris faxed or called in the necessary documents.
 Thompson-Harris had a “common practice” of orally telling clients that
they had coverage before payment was made, though this technically
violated Gallant’s policy.
 The original policy provided that the agent was not authorized to “waive
or change any part of the policy” without approval from Gallant.
 Thompson-Harris faxed in the policy change form on December 3,
adding Isaac’s new car and increasing the coverage. The form also
included a notation that Isaac would make payment on Monday. On
December 4, Isaac was in a car accident. The next day, Isaac paid the
new insurance premiums and reported the accident.
 T-H filled out the official form notifying police that Isaac had coverage
when the accident occurred. Gallant issued the new policy, which stated
that the coverage took effect on December 6.
 Q: May a principal be bound by the conduct of an agent done without actual or
apparent authority?
 H: Yes. In this case, Thompson-Harris was Gallant’s agent, with full authority to
bind it on new policies and policy changes. Renewing or updating policies is
typical of or incidental to the authority of an insurance agent. Further, insurance
coverage became binding on Gallant when Thomson-Harris sent in the
application, without the need for any further action by Gallant. Gallant was aware
of Thompson-Harris’s practice of orally informing clients that policies had taken
effect before payment was made and endorsed those policies afterward. Thus,
Thompson-Harris had actual authority to bind coverage orally.
o Isaac was on notice that T-H couldn’t bind Gallant without
explicit authorization but that duty was superseded by the oral
representation that T-H made to Isaac.
 Note: key is determining whether Gallant made the ‘necessary
manifestation’ to instill a reasonable belief in the mind of Isaac that T-H
had the authority to transfer the coverage between cars and renew the
policy.

PRINCIPAL’S LIABILITY IN TORT COMMITTED BY AGENT

- ONLY an employee-employer agency relationship triggers vicarious liability for all torts
committed within the agent’s scope of employment. Restatement of Agency imposes vicarious
liability of principal for agent’s torts when the agent is an employee - an agent whose principal
controls or has the right to control the manner and means of the agent’s performance of work –
when the tort falls within the employee’s scope of employment, but not in the case of independent
contractors.
- The distinction between employee and independent contractor is the degree of control that
the principal retains.
o CONSIDER: (Restatement of Agency 3d. § 7.07)
 Control over details of work
 Includes actual control, and what the parties have agreed to
 Whether employed in a distinct occupation or business
 Type of occupation - whether work in this field is usually under the direction of
the employer, or a specialist who acts without supervision.
 Skills required
 Who supplies the instruments/tools/workplace

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  Length of time employed
 Method of payment (job vs. time)
 Whether work is part of the regular business of the employer
 Whether the parties believe it’s a master-servant relationship
 Whether P is in business or not

- Humble Oil & Refining Co. v. Martin (1949) – Employee – Vicarious Liability
o R: A master-servant relationship exists when two parties agree that one party will work
on behalf of another party, and be subject to that party’s control of how the job will be
performed.
o F: An unoccupied car parked at a gas station owned by Humble rolled down a hill and
struck Martin and his 2 kids. The customer had left the car unattended at the gas station.
Humble owned the gas station but Schneider operated the station (and repaired cars there
as well). Customer parked in the station but didn’t set the parking brake; attendant on
duty fails to check whether the brake has been set, car rolls down a hill.
 Humble-Schneider:
 Humble owned, Schneider operated.The Agreement, which was
intended to enable Schneider to sell Humble products, contained a
number of provisions that gave Humble control over the gas station’s
operations.
o Q: Is an oil company liable for the negligence of an employee of a gas station manager
with whom the oil company contracts to sell their products, when the oil company has
power over the gas station’s daily business?
 When does a company like Humble become liable for the conduct of its agents?
o A: Yes. The master is responsible for the torts of the servant. A master-servant
relationship arises from a contract, such as the subject Agreement, provided that one
party has authority over the day-to-day operations of another party’s business. Although
the main purpose of the Agreement was to enable Schneider to market Humble’s retail
products at the gas station, it strongly indicates that a master-servant relationship existed
between Humble and Schneider.
 Schneider is considered an employee because Humble exerted considerable
control over the station  therefore Humble liable for tort.
 Court looks at the different factors of control.

- Hoover v. Sun Oil Co. (1965) – Independent Contractor – No Vicarious Liability

o R: An independent contractor relationship exists when no one party works on behalf of
another independently, with no control exerted by the other party over the contractor’s
day-to-day operations.
o F: The Hoovers were injured in a fire caused by the negligence of an employee of a
service station while their car was being filed at the gas station owned by Sun Oil, and
operated by Barone.
 Barone – Sun Oil:
 Barone’s business relationship with Sun was based on a lease/dealer’s
agreement that the parties executed when B started operating the station -
provided for rental fees based upon the amount of gasoline sold.
 B would purchase gas products from Sun and that Sun would loan
equipment and advertisements to Barone.
 B had weekly sales calls with a Sun representative, but was not required
to follow his advice; B set his own hours of operation, assumed the risk
of loss in his business, and had sole authority over his employees.

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  The Hoovers allege that Barone was acting as Sun’s agent at the time of the fire
and consequently Sun is liable for their injuries.
o Q: Is an oil company liable for the negligence of an employee of a service station
manager with whom the oil company contracted, when the oil company does not have
authority over the gas station’s daily business?
 Is Sun Oil vicariously liable for the torts of Barone’s employee?  Is Barone an
employee or independent contractor?
o A: No. A company is not responsible for the negligence of an independent contractor or
its employees. A company is an independent contractor if its contract with another entity
does not enable that entity to control the company’s day-to-day operations and that entity
does not exert any such control.
 Barone’s lease with Sun was that of a landlord-tenant agreement only. The lease
enables Barone to do business in Sun’s facilities and pay rent based on the
amount of gasoline sold. It also gives Barone termination rights.
 Barone is an independent contractor, so Sunoco not liable for tort.
 The dealer’s agreement provides for Barone’s purchase of Sun’s products, and
imposes some restrictions as to how those products will be sold.
 Neither of these agreements gives Sun the authority to influence Barone’s day-to-
day operation of the service station.
 There is also no evidence that Sun’s actions displayed control over Barone’s
business.
o Policy: Why not hold Sunoco liable? It doesn’t make sense for people to be able to go
after a company that basically puts their name on something without having direct day-
to-day control over the operations.

Virginia Kain  12
 HUMBLE/SCHNEIDER SUNOCO/BARONE
HOURS Humble set hours of operation Barone set hours of operation
PRODUCTS Schneider only sold Humble products Barone could sell non-Sunoco products
TITLE TO Humble held title to goods that Schneider Barone takes title to the goods – so if he
GOODS sold on consignment doesn’t sell them, then he has to deal with
the loss – carries more risk and has more
discretion.
DURATION Lease terminable at will Lease terminable annually
COSTS & Rent was at least in part based on the Barone had overall risk of profit and loss,
PROFITS amount of Humble’s products sold – though subsidies from Sunoco to ensure
Humble paid a big % of Schneider’s competitiveness
operating costs
OVERSIGHT Humble could require periodic reports No written reports required, but a
AND representative visited weekly in an advisory
REPORTING capacity.
OUTCOME EMPLOYEE INDEPENDENT CONTRACTOR

LIABILITY IN TORT UNDER THE APPARENT AUTHORITY DOCTRINE

- Apparent authority is also a basis for imposing vicarious liability in tory without regard to
the temporal, spatial, or incentive constraints that arise under the definition of “the scope of
employment.”
o A principal is liable for a class of intentional “communicative” torts when her agent
speaks on her behalf with the apparent authority to do so. See pg. 27 book for example.

AGENCY PROBLEMS INVOLVING TORTS

- When a tort occurs in an agency context, the question is frequently whether the principal is
responsible for the agent’s tort. Remember, the issue is not whether the principal was
negligent. If the principal was negligent, then he or she is liable under tort law. The question
in agency law is whether the principal may be found liable for the torts of an agent, even
though the principal was not negligent.
o In evaluating a tort question involving agency, whether a principal is responsible for the
wrongdoing of an agent depends upon the nature of the principal-agent relationship.
o ANALYSIS
 It is critical to determine if the agent was an employee of the principal because
the principal is liable for the torts committed by its employee within the scope of
that employee’s employment.
 When evaluating whether an agent is an “employee” for the purposes of
respondeat superior, one must assess whether the principal had the right
to exert control over the manner and the means by which the agent
performed his duty.
o Note that it is not just the actual exercise of control that is
critical; it is also the right to exercise control that is evaluated.
 Various factors are involved in assessing whether a principal has the
right to exert enough control over the agent for the agent to be
considered an “employee.”
 The distinction between employee and independent contractor (also known as a
“non-employee agent”) is important because employees and independent
contractors create different potential liabilities for their principals.

Virginia Kain  13
  Under the doctrine of Respondeat Superior, employers are vicariously
liable (i.e. responsible) for the torts of their employees that arise within
the scope of the employee’s employment.
o However, principals are not responsible for the torts of their
independent contractors unless the tort (1) arises out of an
area over which the principal exercised control, or (2) falls
into one of the exceptions such as an inherently dangerous
activity or a non-delegable duty.

THE GOVERNANCE OF AGENCY (THE AGENT’S DUTIES)

THE NATURE OF THE AGENT’S FIDUCIARY RELATIONSHIP

- At common law, an agent is a fiduciary of their principal → generally means legal power over
property (including info) held by the fiduciary is held for the sole purpose of advancing the aim
of a relationship pursuant to which she came to control that property; in the agency context it
means that the agent is to advance the purposes of the principal. In the corporate context, it is for
the directors to advance the aims of the corporation. Status as a fiduciary has certain obligations.
o (1) DUTY OF OBEDIENCE: Duty to obey the principal’s commands while the agency
relationship continues. Following the instructions that the principal provides – documents
or otherwise.
 Closed duty – confined by contract
 If optimal use of assets requires flexibility that can’t be defined in the document,
then duty of obedience might not fully encompass the relationship
 Obey principal’s demands
o (2) DUTY OF CARE: Act as a reasonable person would in similar circumstances - i.e.
becoming informed and exercising the power conferred by the principal. Care,
competence and diligence normally taken by agents in these circumstances.
 Open-ended duty (guiding principles)
o (3) DUTY OF LOYALTY: pervasive obligation to exercise legal power over the subject
of the relationship in a manner that the holder of the power believes, in good faith, is best
to advance the interest or purposes of the principal as communicated to the agent and not
to exercise such power for personal benefit.
 An agent must be loyal to the principal in all situations. Agent can’t act on behalf
on behalf of an adverse party or compete with the principal.
 The principal may consent to certain conduct that may technically violate
the loyalty agreement so long as the agent acted in good faith 
principal must consent.
o Policy: if the agent has to be loyal to the principal all the time,
then the relationship would be very inflexible – there are
situations where having the agent act on behalf of the principal
even though maybe competitive or something else would still be
beneficial.
 A must act in a way that she reasonably believes, in good faith, will best advance
to purposes of the P.
 A cannot exercise power for personal benefit – can’t obtain secret profits.
 More open ended – happens when it’s not feasible for P to write out every
contingency.

Virginia Kain  14
 THE AGENT’S DUTY OF LOYALTY TO THE PRINCIPAL

- Tarnowski v. Resop (1952)

o R: Under Minnesota law, a principal may recover any profits an agent derived from the
agency relationship or a breach of duty and any damages incurred as a result of the
agent’s breach.
o F: Plaintiff hired defendant to negotiate the purchase of a route of coin-operated music
machines. Resop (agent) agreed to act as an agent for Tarnowski (Principal) in a deal to
purchase a coin-operated music machine business. A was responsible for scoping out the
business and giving a recommendation to P. Resop recommended that Tarnowski
purchase Philllip Loechler and Lyle Mayer’s business. At Resop’s suggestion, Tarnowski
purchased such a business from sellers for $30,620, with $11,000 down. Defendant
claimed that he made a thorough investigation of the route, that it had 75 locations in
operation, that every machine was less than six months old, and that the gross income
amounted to over $3,000 per month. However, defendant had actually only looked at five
locations and then repeated the rest from what the sellers told him, but claiming it was his
own discovery. Sellers had also paid defendant $2,000 for suggesting them.
 However, sellers lied to defendant, who then repeated these lies to plaintiff.
There were only 47 locations, some had no machines, some machines were up to
seven years old, and the gross income was far less than $3,000 per month.
 When Tarnowski (P) discovered the fraud, he rescinded the contract and sued
the sellers in the District Court of Olmstead County.
 The sellers paid $9,500 (out of $11,500 down payment) to settle the
claim. Tarnowski then sued Resop to recover profits Resop made in
brokering the deal and expenses and attorney’s fees Tarnowski incurred
as a result of the sale. The jury awarded Tarnowski $5,200.
 In an earlier suit, P recovered his down payment from T after rescinding
the deal.
o Q: Under Minnesota law, may a principal recover against an agent for breach of fiduciary
duty?
o A: Yes. Plaintiff had an absolute right to defendant's $2,000 commission from sellers, as
well as his other damages. Affirmed. A principal may recover profits his agent derived
from the agency relationship, regardless of whether the profits are the result of a breach
of duty. The principal is entitled to recover even if no harm resulted or the
transaction was beneficial.
 Lum makes clear that the purpose of the law of fiduciary duty is not simply
to remedy actual harm. Rather, the law demands honesty and fidelity to the
principal and forbids the agent from accepting bribes or acting to the
detriment of the principal.
o If the agent has improperly disposed of property belonging to the
principal, however, the principal may not recover both the
property’s value and the agent’s benefit.
 Regardless of which the principal seeks to recover, the
principal may recover damages for any expenses
incurred as a result of the breach.
 In this suit, P recovers A’s secret commission as well as his own business
costs (lost time, etc) and the attorney’s fees paid for his suit against T.
o P recovered the commission he had paid to A as well.
o P ends up being OVER compensated.
 Policy: Why is it so important that P can recover the
secret commission? We want to discourage people from
taking bribes; want to encourage duty of loyalty to the P.
Virginia Kain  15
 This kind of conduct is REALLY hard to detect, so the
court wants to create a bunch of deterrents from acting
this way should you get caught doing it.
 Restatement of Agency § 407(1): "If an agent has received a benefit as
a result of violating his duty of loyalty, the principal is entitled to recover
from him what he has so received, its value, or its proceeds, and also the
amount of damage thereby caused, except that if the violation consists of
the wrongful disposal of the principal's property, the principal cannot
recover its value and also what the agent received in exchange therefor."
o “[W]hether or not the principal elects to get back the thing
improperly dealt with or to recover from the agent its value or
the amount of benefit which the agent has improperly received,
he is, in addition, entitled to be indemnified by the agent for any
loss which has been caused to his interests by the improper
transaction.”

CHAPTER TWO – JOINT OWNERSHIP OF A BUSINESS:

THE LAW OF PARTNERSHIP AND LIMITED LIABILITY COMPANIES

INTRODUCTION TO PARTNERSHIP

- A partnership is the simplest form of entity, and may be formed by two or more people. A
partnership is an association of two or more persons, to carry on as co-owners of a business, for
profit. Partnership is “where you bring together capital and ideas.”
o Partners are general agents of the partnership; each partner binds the partnership by
contracting in the usual course of business.
- HISTORY:
o Partnership was first codified in 1914 in the Uniform Partnership Act (minority of states).
o Most important contribution to the historical evolution of business parties is the
treatment of partnership property:
 Property held by the UPA partnership is titled in a special form (tenancy in
partnership), which provides that the partnership as a whole, not its individual
partners, exercise ownership rights over the partnership property, and that
creditors of the partnership have claims to partnership assets that have priority
over creditors of individual partners should the firm be liquidated.
 In treating creditors of the firm as more important than individual
creditors of the partners, partnership law removes a block between
contracting with third parties and partnerships.
o Policy: treating assets in this way was a big step towards
creating a freestanding legal entity. Because the firm owns its
own assets, a partnership (acting through a partner) can be a
trustworthy counterparty for its third-party
suppliers/customers/employees.
o Today most states have adopted variations of the Revised Uniform Partnership Act
(1997).
 Under the RUPA:
 General partnerships do not have to be registered with the state
 Partners are agents of the partnership

Virginia Kain  16
  Creditors of the partnership have first claims on property of the
partnership (before creditors of the individual partners)
 Partners are personally liable for the debts of the business – unlimited
liability (only in general partnership)
- BENEFITS OF JOINT OWNERSHIP
o The purpose of the partnership is that after a certain point, selling an ownership stake
may be cheaper than borrowing – the costs of co-ownership may be lower than the
agency costs of debt. Even in other cases, where there is no senior debt, a partnership
entices additional capital sources to get involved with the business.
 Hypo: Pam wants to buy a cat café for $200k.
 $20,000 of her own funds
 $150,000 senior debt (loan) from Walter at 10% interest
 Where can she get the remaining $30k?
o $30k potential jr. debt from A and B at 20% interest, but the debt
load might be too high, W might object, or both.
 Alternatives?
o Give A&B a residual claim (i.e. some share of the profits or
losses)
- DEFAULT RULES OF PARTNERSHIPS (RUPA § 103)
o Partners may not:
 Unreasonably restrict a partner’s access to books and records of the partnership;
 Eliminate the general duty of loyalty (although specific exceptions may be
approved) (Note that Delaware permits the elimination of liability for breach of
fiduciary duties, including the duty of loyalty, if specified in the partnership
agreement. However the actions of the partners are still subject to the obligation
of good faith and fair dealing, and few other states allow such complete
limitation of the duty of loyalty.)
 Unreasonably reduce the duty of care;
 Eliminate the obligation of good faith and fair dealing (although certain
reasonable standards by which the performance of this duty is measured may be
established);
 Vary the power of a partner to dissociate;
 Vary the right of a court to expel a partner under specific circumstances;
 Vary the requirement to wind up the partnership business in certain
circumstances; or
 Restrict the rights of third parties under RUPA.

AGENCY CONFLICTS AMONG CO-OWNERS: FIDUCIARY DUTIES

- Meinhard v. Salmon (1928)

o R: Co-adventurers, like partners, have a fiduciary duty to each other, including sharing in
any benefits that result from the parties’ joint venture.
o F: Meinhard and Salmon are in a joint venture.
 How is nature of the partnership described in the case?
 “The two were in it jointly – for better or for worse” – very close
relationship between partners. A JV is a partnership for a limited
purpose.
 Salmon takes a 20-year lease from Gerry to operate a hotel. Salmon holds the
lease in his name and runs the hotel; Meinhard supplies half the capital and is a
passive investor (doesn’t actively contribute to the business’s operations).

Virginia Kain  17
 Salmon gets 60% of the profits for the first five years, and for the next 15 years,
profits are split 50/50; losses split equally.
 Salmon leased a building for 20 years; he was in a contract with Meinhard.
Meinhard was going to pay Salmon half the money to make repairs on the
building, and Salmon was going to play Meinhard 40% of the net profits for the
first 5 years, and 50% for the remaining years. If there were losses, they had to
bear them equally. Salmon was the manager and operator of the building, so
while they were co-adventurers, Salmon had more power.
 When the first lease is about to run out, Gerry presents Salmon with a
new opportunity – lease the whole block for 80 years.
 Salmon accepts for his corporation (Midpoint), without consulting
Meinhard. Salmon did not inform Meinhard about the transaction.
 Meinhard is upset because he’s missing out on the deal – he wants a
piece of the action – lots of money in Manhattan real estate.
Approximately one month after the Midpoint Lease was executed,
Meinhard found out about Salmon’s Midpoint Lease, and demanded that
it be held in trust as an asset of the joint venture.
 Salmon refused, and Meinhard filed suit.
o Q: Is a co-adventurer required to inform another co-adventurer of a business opportunity
that occurs as a result of participation in a joint venture?
o A: Yes. As sharers in a joint venture, co-adventurers owe each other a high level of
fiduciary duty. A co-adventure who manages a joint venture’s enterprise has the
strongest fiduciary duty to other members of the joint venture.
 The Midpoint Lease was an extension of the subject matter of the Bristol Lease,
in which Meinhard had a substantial investment.
 Salmon was given the opportunity to enter into the Midpoint Lease because he
managed the Bristol Hotel property.
 Because Salmon’s opportunity arose as a result of his status as the managing co-
adventurer, he had a duty to tell Meinhard about it.
 Salmon breached his fiduciary duty by keeping his transaction from Meinhard,
which prevented Meinhard from enjoying an opportunity that arose out of their
joint venture.
 Court awarded Meinhard 50% minus one share of the corporation (to keep the
roles the same)
 How does Cardozo conceptualize the obligations that Salmon has?
(“Punctilio Paragraph”, p. 60)
 What is the extent of Salmon’s duty towards Meinhard? Salmon is
essentially a trustee for the business, so he owes a duty of loyalty and
honesty to Meinhard – “a trustee is held to something stricter than the
morals of the marketplace”; “a duty of the finest loyalty”. Joint
venturers, while the enterprise continues, owe each other loyalty.
o RUPA § 404:
 Duty of Loyalty:
 Account to the partnership for profits, property,
or benefits from the conduct (or winding up) of
partnership business or the use of partnership
property.
 Refrain from competing with the partnership in
the subject matter of the partnership business

Virginia Kain  18
  To perform all duties to the partnership and the
other parties consistent with the obligation of
good faith and fair dealing.
 Don’t take opportunities that belong to the
partnership for your own benefit.
o When faced with an opportunity that
arises out of/relates to the partnership
business, the managing partner must: (1)
disclose the business opportunity to the
other partners and (2) decide whether or
not to act on behalf of the partnership
and take the opportunity.

PARTNERSHIPS: PROS & CONS

 General Partnership: an association of two or more persons to carry on as co-owners a business

for profit. Each partner contributes money, property, labor or special skills, and each partner
shares in the profits and losses from the business.
o What is a major disadvantage of the GP form? Owners/partners are personally liable
for the liability of the business. Partnership doesn’t shield the partners from the liability.
o What is a major advantage of the GP form? Pass-through taxation (refers to an idea
that a partnership is one level of tax).
 Pass through taxation refers to whether the business entity is taxed separately or
if all the profits and losses “pass through” to the individual owners.
 Are there 1 or 2 levels of taxation on the net income of the business?
 Major shortcoming: owners/partners are personally liable  corporate form can
solve this, BUT requires (generally) the owners to give up the benefit of pass
through taxation.
 Question then becomes – how can we get the benefit of limited liability
and pass through taxation?
 TAX INCENTIVES
o PARTNERSHIP: business income is “passed through” to the partners  partners pay
individual income tax on the business income.
 So, because there is only one level of tax, the partnership relationship is more
desirable – pass through taxation results in less total tax on the business income.
o CORPORATION: 1st level: Corporate income is subject to corporate income tax 
distributions to shareholders (dividends) 2nd Level: Shareholders pay individual
income tax on dividends.
 EX: 2 spouses running a business with a net income of $80k. Two levels of
taxation is generally less preferable than the pass through taxation, so they should
stay as a partnership instead of incorporating.

Virginia Kain  19
 PARTNERSHIP CORPORATION
BUSINESS
Business Income $80k $80k
Business Tax $0 $16.8k
Distribution to Owners $80k $62.2k
PERSONAL
Salaries $70k $70k
Distributions from business $80k $62.2k
Taxable income $150k $132.2k
Personal Tax $11.4k $9.2k
TOTAL TAX $11.4k $26k (personal plus
business tax)

LIMITED LIABILITY SUCCESSORS OF THE GENERAL PARTNERSHIP

- Post RUPA reforms and changing nature of business today, limited liability should now be
regarded as the default term of business organizations, and personal liability has become a
contractual option available to organizers of a business.
o CREDITORS of these businesses must contract for personal liability in the form of
guarantees.

Virginia Kain  20
COMPARISON OF LIMITED STRUCTURES
DESCRIPTION
LIMITED A limited partnership allows
PARTNER limited liability and profit
SHIPS (LPs) sharing for passive investors.
Ex: Venture The general partner runs the
capital, private business and has unlimited
equity, hedge liability. Liability of Limited
funds Partners is limited to their
investment as long as they don’t
exercise control over the
business.
RULPA § 303, 2001: LP cannot
be personally liable for
partnership liabilities even if
the LP participates in the
management and control of the
enterprise. Full, status-based
shield for the LP.
LIMITED A general partnership in which
LIABILITY the partners retain limited
PARTNER liability, at least for certain
SHIPS liabilities and limited periods.
(LLPs)
Limit liability only with respect
Ex: Law firms, to partnership liabilities arising
accountants from the negligence,
malpractice, wrongful act, or
misconduct of another partner
or an agent of the partnership
not under the partners’ direct
control.
LIMITED Combines the best of both
LIABILITY worlds – takes a corporation
COMPANIES and makes it look like a
(LLCs) partnership for tax purposes.
Combines the best features of
the partnership with the best
parts of a limited liability form.
ADVANTAGES DISADVANTAGES
Combined pass through
tax advantages of
partnership (partnership
income and losses are
deemed to be those of
individual partners) with
limited liability.
Limited partnership assets
can be distributed and
traded on exchange
(though LP loses pass-
through tax status if it
does)
Unqualified, limited
liability for some partners.
Pass through taxation. No full, unqualified limited
liability.
Qualified limited liability
for all partners. Responsible for own
misconduct or negligence.
Not responsible for
negligence or misconduct
of others.
Members can assume Contractual flexibility can
management power lead to some conflicts though
without losing limited – can members contract out
liability. all fiduciary obligations with
the exception of the implied
LLC combines covenant of good faith and
participation in control fair dealing?
with limited liability, pass
through taxation, and
greater contracting
flexibility (i.e. fiduciary
duties).
Virginia Kain  21
 LIMITED PARTNERSHIP

- GENERALLY
o A limited partnership must have at least one general partner who, unlike the limited
partners, is liable for the debts of the partnership, and the name and address of the
general partner must be set out in the Certificate of Limited Partnership, which is
filed in public records.
 Note: the general partner can be – and often is – a corporation.
o A limited partnership is similar to a regular partnership in that it does not have to pay
income tax on its earnings, and that it has partners.
o Unlike a partnership, a limited partnership has two kinds of partners – a regular general
partner, and a limited partner.
 General partners (usually/at least one) have management rights and liability
exposure for the partnership’s debts that are similar to the management rights and
liability exposure of regular partnerships.
 Limited partners do not have personal liability for the limited partnership’s
debts. The most a limited partner can lose from their investment in an LP is their
investment.

- LIMITED PARTNERSHIP LAW

o Every state has a limited partnership statute, most are based on a uniform act. Most states,
including Delaware, follow the 1985 RULPA.
 Universal standard that LP is an entity.
 Also universal that an LP is subject to federal securities laws (Rule 10b-5) and
state securities laws.
o Unlike general partnerships, limited partnerships have to be filed publicly, usually with
the secretary of state. Must include the name of the business and the name and address of
general partners.

- WHO IS LIABLE FOR DEBTS OF LP?

o (1) The limited partnership is an entity and so it is liable for its own debts.
o (2) The general partners are jointly and severally liable for the debts of the limited
partnership.
 (Remember, limited partnership statutes treat the general partners of a limited
partnership the same way that partnership statutes treat partners.)
o (3) The limited partners of a limited partnership are generally not liable for the debts of a
limited partnership.
 (Remember, limited partners, like shareholders, are generally passive investors,
and so, like shareholders, are not personally liable for the business’s debts.)
o (4) What you are most likely to see on your exam are facts that suggest that a limited
partner is something more than a passive investor—facts that suggest that perhaps that
limited partner should be personally liable for the debts of the limited partnership.
 Historically, there has been a correlation between whether a limited partner is
active in making decisions for the limited partnership and whether the limited
partner is personally liable to the creditors of the limited partnership.
 Increasingly, limited partnership statutes have decreased the possible liability of
limited partners for debts of the limited partnership.
 Under RULPA, for example, a limited partner is personally liable for the
debts of the limited partnership only if she “participate[s] in the control
of the business but also her conduct causes the creditor to believe she
was a general partner.”

Virginia Kain  22
 o Moreover, the statute sets out “safe harbors,” i.e., things that a
limited partner can do without participating “in the control of the
business,” such as: (1) voting on the admission or removal of a
general partner; (2) voting on the limited partnership’s selling
assets or incurring debt; and (3) serving as a director or officer
of the corporate general partner.
- EVOLUTION OF THE “CONTROL TEST”
o Traditionally: registered partnership modified to allow limited liability and profit sharing
for passive investors deemed limited partners.
 Evolution of control test – if you had an LP that in effect acted as a GP,
then they’d lose the benefit of limited liability.
 Because these passive partners were barred from exercising any type of control,
all limited partnerships have at least one general partner who incurs
unlimited personal liability.
 The general partner runs the business, and has unlimited liability.
 The LP is usually the one that is contributing the capital – liability of LP
limited to their investment.
 But, in most cases, this general partner is actually a corporation – so
nobody is really bearing the entire cost.
 Limited partners (traditionally) enjoy limited liability and risked no more wealth
than they contributed to the partnership, while general partners are treated like
ordinary partners of a regular partnership.
o Governed by: Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited
Partnership Act (RULPA).
o Personal liability for limited partners that act like general partners: RULPA has
given a control test, where a limited partner who participates in the control of the
business is liable only to persons who transact business with the limited partnership
reasonably believing that the limited partner is a general partner based on the conduct of
that limited partner. (RULPA § 303, 1976)
 RULPA § 303, 2001: LP cannot be personally liable for partnership liabilities
even if the LP participates in the management and control of the enterprise. Full,
status-based shield for the LP.
- EXAMPLES
o In essence: large pools of money that is being invested by investment professionals with
the goal of making money. Buying and selling other corporations. Investors like
universities, public pension funds, etc. – looking for ways to generate returns on their
investment.
o Private equity – makes investment in private companies
o Venture capital – particularly focused on early stage companies
o Hedge funds – investment vehicle, but its focus is less on investment in private
companies, but instead on liquid, public assets – include financial engineering, buying
and selling of debt and equity
o General partner (GP – group of investment professionals)  VENTURE
CAPITAL/PRIVATE EQUITY/HEDGE FUND  LPs (pension fund, university
endowment, high net-worth individuals)
 How to make sure the interests of the GP are aligned with your interests? Profits,
typical compensation structure is that the GP gets a fixed number for running the
fund, and then they get a % of the profits.
- FIDUCIARY DUTIES
o The limited partnership statutes of some states allow considerable freedom to
contractually vary or even eliminate the general partner’s fiduciary obligations by
provisions in the limited partnership agreement. (This is also true of some limited liability
Virginia Kain  23
 company statutes as well.) For example, the Delaware Revised Uniform Limited
Partnership Act provides that the general partner’s duties and liabilities may be
“expanded or restricted” by provisions in the partnership agreement. When the limited
partnership agreement provides for fiduciary duties, the agreement sets the standard for
determining whether the general partner has breached its fiduciary duty to the
partnership. However, the Delaware Supreme Court has stated that this language does not
allow a limited partnership agreement to eliminate the duty of good faith.

LIMITED LIABILITY PARTNERSHIP

- GENERALLY
o In a limited liability partnership, all partners are general partners, and all the general
partners are protected from liability to creditors of the limited liability partnerships.
General partners have no liability for the LLP’s debts.
 LLPs provide a “liability shield” for ALL partners for certain kinds of liabilities.
In particular, partners in an LLP are not personally liable for negligence,
malpractice, wrongful act or misconduct by other partners.
 Only responsible for your own actions! Makes sense why attorneys
use this form – little oversight by others.
 Compare to LP form: LPs provide unqualified limited liability to some
partners; LLP form provides qualified limited liability to all partners.
o While state LLP statutes vary widely, in all states, LLPs must file a certificate with the
designated state official that includes the firm’s name, which must contain the words
“limited liability partnership” or the “LLP” abbreviation, and state that the business is
being operated as a limited liability partnership. In addition, some states require an LLP
to maintain a specified amount of liability insurance or provide a pool of funds for the
satisfaction of judgments against the LLP.
o A general partnership in which the partners retain limited liability, at least for
certain liabilities and limited periods.
 Most state statutes clearly were created to protect attorneys and accountants –
limit liability only with respect to partnership liabilities arising from the
negligence, malpractice, wrongful act, or misconduct of another partner or an
agent of the partnership not under the partners’ direct control.
 Some state statutes establish minimum capitalization/insurance requirements.
o See this often in the case of law firms  makes sense because you have very little
capacity to see/control what the other partners are doing
-

LIMITED LIABILITY COMPANY

- GENERALLY
o A Limited Liability Company combines (1) participation in control; (2) limited
liability; (3) pass-through taxation; and (4) greater contracting flexibility (e.g. fiduciary
duties).
 Most answers to LLC questions turn on the interpretation of the operating
agreement, not LLC statutes or case law; LLC statutes vary widely from state to
state.
o What is the innovation in this legal form?
 Combines the best of both worlds – takes a corporation and makes it look like a
partnership for tax purposes. Combines the best features of the partnership with
the best parts of a limited liability form.
 Owners of LLCs are called members – members can assume management power
without losing limited liability.

Virginia Kain  24
  LLC combines participation in control with limited liability, pass through
taxation, and greater contracting flexibility (i.e. fiduciary duties).
 Members of the LLC can structure these inter-relationships essentially
any way they want in their operating agreement.
o LLC is the choice for most modern smaller businesses, or large businesses with few
owners (corporate joint ventures).

- FEATURES
o Almost entirely contractual in nature, affords investors limited liability, and is taxed as a
partnership (i.e. pass through taxation).
o Management is by a board of managers who are designated as the constitution document
of the firm (LLC agreement/operating agreement) or by members themselves.
o Must file a copy of these AOC with the Secretary of State.

- WHO IS LIABLE FOR AN LLC’s DEBTS?

o An LLC is an entity, and can incur debts from the actions/inactions of its managers or
members.
o Generally, the members of an LLC are not liable to the company’s creditors.
 LLC statutes protect the owners from personal liability for claims against the
company. These statutes do not distinguish the personal liability of members in
member-managed LLCs from the personal liability of members in manager-
managed LLCs. The members are simply not liable for the company’s debts.
- TAXATION OF LLCs
o IRS in 1997 adopted new rules – ‘check the box’ regulations – that abandoned the game
of attempting to define a corporation and the four factor test (p. 67).
 The new rules allow for all unincorporated business entities (GP, LP, LLC,
LLP) to CHOOSE whether to be taxed as partnerships or corporations.
 LLCs can now combine pass through treatment for federal income tax
purposes with limited liability, participation in control by members
(without loss of limited liability), free transfer of interests, and continuity
of life.
 LLC statutes generally offer more flexibility than corporate statutes – can
opt out of default rules.
 LLCs and other unincorporated entities enjoy federal tax advantages beyond
those available to corporations.

- CONTRACTUAL FLEXIBILITY
o LLCs are characterized by extensive contractual flexibility – LLCs are governed by state,
not federal law – see e.g. Delaware Limited Liability Company Act § 18-1101 – “it is the
policy of this chapter to give the maximum effect to the principle of freedom of contract
and to the enforceability of limited liability company agreements”.
 This can lead to some conflicts though – can members contract out all fiduciary
obligations with the exception of the implied covenant of good faith and fair
dealing?
 How would this type of contracting out affect business dealings?
o Can be relieved of fiduciary duty by explicit release – i.e. working for a competitor, but
you usually cannot waive the duties of care, competence and diligence exercised by an
agent in a similar system.
o Pappas et al. v. Tzolis (2012) – Emphasizing Contractual Flexibility of LLC
 R: The members of an LLC may explicitly restrict or eliminate the fiduciary
duties owed by the terms of the operating agreement.
 F:
Virginia Kain  25
  Defendant Tzolis and the plaintiffs (P&I) formed an LLC that leases one
NYC property.
o P&T contributed $50k each, I contributed $25k.
o Per LLC operating agreement, T agreed to post $1.9 million
security deposit in return for being allowed to sublet the
property.
o LLC agreement allowed for competing ventures of any sort.
 T subleases property to himself, with P&I’s consent (but they were
irritated about it and a series of disputes ensue)
 T purchases P&I’s membership interests for $1.5 million, and they
certify that they did not rely on T, and that they did their own due
diligence, etc.
o T then assigns the lease to a third party for $17.5 million.
 Tzolis, one of 3 managing partners of an LLC incorporated in Delaware
whose sole asset was a long-term lease on a commercial building in
Soho, negotiated an assignment of the interests of the other two members
without disclosing to them that he was at that time in negotiations with a
large real estate firm to assign the lease at a much higher price. Vrahos’s
operating agreement, which was governed by New York law, provided
that the members were free to engage in any outside business, even
competing business, and owed no obligation to the company or other
members.
o The plaintiffs sued for breach of fiduciary duty and
misappropriation of a business opportunity when they learned
that Tzolis began negotiating the deal with Charlton before
buying them out.
 Q: May the members of an LLC restrict or eliminate the fiduciary duties owed to
the company and the other members?
 What was the nature of the obligation that these members had to one
another? Did T have to disclose what he knew about the worth of this
property?
 A: Yes. All members of the LLC will owe traditional fiduciary duties to one
another unless the operating agreement explicitly restricts or eliminates those
duties. Under Delaware law, the LLC members can eliminate those duties.
Burden is on the breaching party to show that the duty was eliminated. Since the
parties were all knowledgeable businessmen that were represented by
counsel, basically too bad for the guys that got bought out - they should have
done their due diligence.
 Standard is whether the principal knows that he is willingly releasing the
fiduciary from his obligations and that that release is voluntary – when
this is the case, the principal cannot blindly trust the fiduciary’s
assertions.
o Defendant was released from his fiduciary duties to P&I.
Parties also represented that they did their own due diligence and
didn’t rely on the defendant.
 TEST: Whether, given the nature of the parties’ relationship at the time
of the release, the principal is aware of information about the fiduciary
that would make reliance on the fiduciary unreasonable.
 Takeaway: LLC is very flexible – allows for a lot of different contractual
flexibility, which can be a good thing, but also carries some costs.

Virginia Kain  26
COMPARISON OF KEY BUSINESS ENTITY ATTRIBUTES

CORPORATION GENERAL LIMITED LLP LLC

PARTNERSHIP PARTNERSHIP
Partners generally
General partners
Partners personally liable for their own
are personally Members not
liable for obligations of acts, but not acts of
Shareholders generally liable for all personally
LIABILITY OF the partnerships; RUPA others; under some
not personally liable for partnership liable for
OWNERS requires exhaustion of statutes may be
corporate obligations obligations; limited LLC’s
all partnership assets liable for
partners generally obligations.
first partnership
are not
contracts too

Generally managed by Generally managed

officers who are by the general Members may
controlled by directors; partner(s); limited manage, or
MANAGEMENT Partners manage Partners manage
shareholders usually partners may have appoint
have no management certain voting managers
rights rights

Firm taxation – firm is

taxable on its income
(dual taxation structure)
UNLESS for S May choose firm-
corporations, but taxation or pass
subchapter S of the IRC through taxation May choose
May choose firm- May choose firm-
imposes a number of (firm’s income or firm-taxation
TAXATION taxation or pass taxation or pass
restrictions on the nature losses are not attributed or pass through
through taxation through taxation
and number of to the firm but instead taxation.
shareholders/capital flow through to firm
structure/type of owners
business/type of income
that qualifies for pass
through taxation.

Can be formed by Must file certificate Must file articles of Must file
Must file articles of written or oral of limited limited liability articles of
FORMATION REQS
incorporation with state agreement or through partnership with partnership with the organization
contract the state state with state

Members
generally can
freely transfer
Partners (general or
Partners generally their financial
Shareholders generally Partners cannot transfer limited) cannot
cannot transfer their rights, but
TRANSFERABILITY free to transfer their their full ownership transfer their full
full ownership cannot transfer
OF OWNERSHIP personal ownership interests without ownership interests
interest without their
interest at will unanimous consent without unanimous
unanimous consent management
consent (usually)
rights without
unanimous
consent.

Virginia Kain  27
 CHAPTER THREE – THE CORPORATE FORM

INTRODUCTION TO THE CORPORATE FORM

- CORPORATION: A separate legal entity with indefinite life that limits the liability of the
corporation’s owners (shareholders) and facilitates the pooling of capital and labor.
o The corporation is the standard legal form adopted by large-scale private enterprises.
While the LP and LLC get rid of the limitations of the general partnership, the
corporation remains a superior structure for capitalizing large firms that require capital
contribution from many individuals.
 Why incorporate? Contracting problems with UPA-type general partnerships:
personal liability of those who contribute capital, instability of the firm,
illiquidity of an individual’s investment, and cumbersome joint management.
 Why do we need the corporate form?
 To govern relationships among people – need an orderly and efficient
structure
 To encourage people to start businesses
 Encourage risk taking in the market
- CHARACTERISTICS OF THE CORPORATE FORM
o (1) Legal “person” with indefinite life. A corporation is a legal entity created under the
authority of the legislature.
 Business can carry on even after someone dies
 Policy issue: To what extent is a corporate entity separate from its owners,
particularly in view of the newly available First Amendment corporate
personhood?
 Hobby Lobby v. Burwell: Religious Freedom Act allows a for-profit
company to deny employees birth control based on religious objections
of the owners? Majority said yes, viewing it through the corporate form –
extending RFRA to corporation is the same as extending it to the people
who own the corporation.
 Citizens United v. FEC: Holds that a corporation is nothing more than
association of many individuals and therefore the protections of political
speech apply to the corporate entity.
o (2) Limited liability for investors. Because a corporation is a legal entity, it’s
responsible for its own debts. A corporation’s shareholders are generally not liable for
corporate debts – their liability/risk is limited to their investment.
 Makes free transferability more valuable by reducing the costs associated with
transfers of interest, because the value of shares is independent from the assets of
the shareholder.
o (3) Free transferability of share interests. Ownership interests in a corporation are
represented by shares, which are freely transferable.
 Permits the development of large capital (equity/stock) markets, which is also
enhanced by centralized management.
o (4) Centralized management. The management and control of a corporation’s affairs are
centralized in a board of directors and in offers acting under the board’s authority.
Although shareholders elect the board, they cannot directly control its activities.
Shareholders generally have no power to either participate in management or to

Virginia Kain  28
 determine questions within the scope of the corporation’s business. As such, shareholders
have no authority to act on the corporation’s behalf.
 Management of business being handled by experts – there’s a division between
the investor/shareholders and the management, who generally have business
expertise and skills to run the business.
o (5) Appointed by Equity Investors

- TYPES OF CORPORATIONS
o NUMBER OF SHAREHOLDERS:
 Close Corporations
 Closely held corporation (only have a few shareholders) are often
businesses that incorporate for tax/liability purposes rather than for
capital purposes. Shareholders are often officers/directors of the
corporation.
o Shareholders are often a family – ex: Hobby Lobby
o These firms often drop the features of the corporate form that
conflict with their status as incorporated partnerships  usually
depends on tax objectives/transaction costs
 Public Corporations
 Any member of the public can purchase a share of the company – e.g.
Microsoft, Uber, Google.

o OWNERSHIP STRUCTURE
 Controlled Corporations
 Relates to the corporation’s ownership structure – who holds the
company’s stock and controls its voting rights.
 Controlled: In some corps, a single shareholder/group of shareholders
exercises control through its power to appoint the board. (controlled
corporation)
o Ex: Facebook – Mark Zuckerberg controls 57% of the voting
rights of his company via his ownership of a different class of
shares than everyone else.
 Dispersed Control: When there is no such person/group, the control is
said to be “in the market” – anyone can purchase control of these
corporations, but nobody controls until someone buys a majority.
o Ex: Apple: there isn’t a single shareholder with control; the
biggest shareholder in Apple has ~5%

CREATION OF A FICTIONAL LEGAL ENTITY

- Corporation = separate person in the eyes of the law  ability to own its own assets or make
deals in its own name allows it to enter into contracts such as bank loans.
o Enabling corporations to own assets delimits the pool of assets upon which corporate
creditors can rely on for repayment  artificial entity vastly reduces the costs of
contracting for credit.
o Allows for indefinite life – so business can carry on post death of founders/principals –
leads to stability of corporation
o Entity status is vital to business continuity, and allows for other parts of business
characteristics like tradable shares, centralized management, and limited liability.
- What are the limits of corporate personhood?

Virginia Kain  29
 o How do the rights of owners correlate with the rights of the corporation? Should they?
Do they? (religious preferences of owners, etc.)

HISTORY OF CORPORATE FORMATION

- Prior to the 19th century, creating a corporation was seen as a significant public act to be
undertaken only to achieve a special public advantage – in the 17th/18th centuries corporations
were usually formed for charitable purposes.
o Incorporation has always been a matter of state law
 Internal affairs doctrine: Law of the state where you are incorporated will govern
the internal affairs of the corporation.
 US firms can incorporate where they want to, not constrained by HQ or
principal place of business location.
o Decide what kind of corporation/partnership structure you want
to have
o Decide what state you want to incorporate in
 State competition for corporate charters: corporations are
paying taxes/fees to the state. Liberalization of
incorporation statutes and a “race to deregulate”. As a
result, state corporate law has few mandatory
requirements.
 Greater judicial weight given to the ‘fiduciary
obligations’ of corporate directors and officers.
 More weight given to standards, not rules. States
now have fewer rules in favor of states and state
courts not wanting to tell directors etc. about
what to do, but rather that they need to follow
fiduciary duty standards.
o Delaware wants to remain the primary
destination for incorporation, so its
legislature is very responsive and
updates regulations often.
o State competition for corporate charters
 Liberalization of incorporation statutes and a “race to deregulate”
 Today: state corporate law has few mandatory requirements
 Greater judicial weight given to the fiduciary obligations of corporate
directors and officers
 Mandatory rules for public companies under the federal securities law
o Dominance of Delaware
 Most headquarters = California; most incorporations = Delaware
 Delaware provides a lot of certainty to companies because there has been a lot of
litigation  creates perpetual cycle
 Delaware also known for being legislatively responsive

PROCESS OF INCORPORATING TODAY

- FORMATION PROBLEM CHECKLIST:

o (1) Was there substantial compliance with the statutory requirements?
 If yes, the would-be corporation may be a de jure corporation, which cannot be
attacked by anyone.

Virginia Kain  30
  De jure corporation: a business that has complied with all of the
requirements of its state incorporation statute and is legally allowed to do
business as a corporation.
o (2) Was there a good faith and colorable attempt to incorporate, and good faith actual use
of the corporate existence?
 If so, then even if the statutory compliance was insufficient to constitute a de jure
corporation, it may be enough to create a de facto corporation.
 De facto corporation: Legal recognition of a corporation, even if the
articles of incorporation for the corporation are not properly filed. In
order to be granted de facto status, there must be: (1) a relevant
incorporation statute; (2) a good faith attempt to comply with it, and (3)
evidence that the business is being run as a corporation.
 A de facto corporation has corporate status with regards to third parties,
but not with respect to the states. Note that statutes in many jurisdictions
have abrogated or modified the de facto doctrine.
o (3) Even if there is no de jure or de facto corporation, do the circumstances suggest a
corporation by estoppel?
 Persons who have claimed corporate status will generally be estopped to deny
that status if suit is brought against the corporation.
 Likewise, a party who has dealt with a business as a corporation may be estopped
from claiming that the business lacks corporate status.
o (4) If there is neither a de jure nor de facto corporation, nor a corporation by estoppel,
who may be held liable?
 Under the traditional view, all the would-be shareholders are subject to liability
for the would-be corporation’s debts and other obligations.
 However, the modern trend is to impose liability only on those owners who
participated in management or were otherwise active in the business.

- REVISED MODEL BUSINESS CORPORATION ACT (See also DGCL § 101)

o Look to the DGCL provisions to get started making your corporation.
o 1) Person or entity signs the documents and pays the fee
o 2) Incorporator drafts and signs a document (articles of incorporation/certificate of
incorporation)  this is the corporation’s charter, which states the purpose and powers of
the corporation, and defines all of its special features. (Lots of flexibility in designing this
part)
o 3) Charter is filed with a designated public official (secretary of state), which identifies
the principal place of office within the state or if there is none, the address of an agent to
serve process on
o 4) Another fee is paid – sometimes calculated in part as a function of how many shares
the new corporation is authorized to issue
o 5) New corporation then elects directors, adopts bylaws, and appoints officers.

THE ARTICLES OF INCORPORATION OR CHARTER

- May include any provision that is not contrary to law.

o Modern American charters usually don’t have that many provisions – contractual
freedom is the overriding concept.
- REQUIREMENTS: DGCL § 102(a) requires the following items to be included in the Articles
of Incorporation:
o (1) Name of the corporation
o (2) Name and address of registered agent and address of the registered office
o (3) Nature of the corporation’s business (can be as broad as “any lawful activity”)

Virginia Kain  31
 o (4) Information about the corporation stock, including information about “classes of
stock” (capital structure)
 i.e. how many shares and classes of shares the corporation is allowed to issue and
what the characteristics of those shares are (voting etc.).
 When you issue shares of stock, list total # of shares that you have
authority to issue. Set forth statement of designations: special rights (votes,
receive dividends). Equity (authorized; issued and outstanding); stock
(common or preferred).
o Debt vs. Equity: Capital is combination of debt and equity. Once
have revenue, have to pay debt month-to-month; cannot issue
dividends unless pay off debt! With equity, right to income is
residual (mom and dad paying loans have residual right)- not a
right to tell you what to do, rather right to get what given. When
money left over, doesn’t have to go to stockholders. Equity
holders will get dividends every once in a while.
 Separateness to avoid creditor intrusion!
o Rule: You cannot issue more shares than you have the authority
to issue.
o Outstanding shares: subset of authorized shares that have been
sold to SHs
o (5) Name and address of the incorporator
o (6) Names and addresses of the initial directors.

- OPTIONAL PROVISIONS (DGCL § 102(b)):

o “Any provision for the management of the business and for the conduct of the affairs of
the corporation, and any provision creating, defining, limiting and regulating the powers
of the corporation, the directors, and the stockholders, or any class of the stockholders, or
the governing body, members, or any class or group of members of a nonstock
corporation; if such provisions are not contrary to the laws of this State. Any provision
which is required or permitted by any section of this chapter to be stated in the bylaws
may instead be stated in the certificate of incorporation.”

THE CORPORATE BYLAWS

- Must conform to both the corporation statute and the corporation’s charter, but generally fix the
operating rules for the governance of the corporation – annual meeting date etc.
o Under some statutes, shareholders have an inalienable right to amend the bylaws; others
limit this power to the board of directors.

- TYPICAL STRUCTURE:
o Article I. Stockholders
o Article II. Board of Directors
o Article III. Committees
o Article IV. Officers
o Article V. Stock (voting rights, procedures)
o Article VI. Indemnification (of directors and officers)
o Article VII. Misc.

- ARTICLES OF INCORPORATION vs. BYLAWS: WHERE TO PUT RULES?

o Key deciding factor for non-mandatory items:
 Whether items will be part of the public record (if in the charter)

Virginia Kain  32
  Ease of changing the rules (i.e. amending the document – easier to change
bylaws than a charter)
 Amending the corporate charter:
o Requires approval of the BOARD and the MAJORITY OF THE
SHAREHOLDERS (DGCL § 242)
 Amending the bylaws:
o Only shareholders have the power to amend the bylaws, unless
the charter confers that power on board of directors (DGCL §
109(a) – Amazon does this)
 If shareholders aren’t happy with a provision in the
bylaws, they can change it, regardless of how managers
feel
 Different from charter, where the board has to approve
any changes
 Most of the governance rules go into the bylaws; usually just the
mandatory provisions are in the charter.

SHAREHOLDERS’ AGREEMENTS
- Typically address such questions as restriction on the disposition of shares, buy/sell agreements,
voting agreements, and agreements with respect to the employment of officers or the payment of
dividends.
o Generally, the corporation is a party to these contracts, so courts will enforce them
against the shareholders as well.
o Voting trust: an arrangement in which shareholders publicly agree to place their shares
with a trustee who then legally owns them and is to exercise voting power according to
the terms of the agreement  this agreement is subject to special statutory restrictions

DGCL § 101, 102, 106, 107, 108, 109

§ 101 Incorporators; How Corporation Formed; Purposes (any lawful purpose)

§ 102 (a) Contents of Certificate of Incorporation (rare mandatory language here)
- Name of the company, address of corporation’s registered office, set forth the
purpose (any lawful act), capital structure (classes/number of common
shares/rights of preferred shareholders if any), name/address of incorporators,
and temporary directors, if power of incorporators terminates upon
incorporation.
- 102 (b) has non-mandatory provisions.
§ 106 Commencement of Corporate Existence
§ 107 Powers of Incorporators
§ 108 Organization Meeting of Incorporators or Directors Named in Certificate of
Incorporation
- Next steps after incorporation – have to give notice that there will be a
meeting, bylaws will have to be approved, director(s) have to be selected.
§ 109 Bylaws
- What goes into the corporate findings?
- Fix the operating rules for the governance of the corporation.
- What can go in the bylaws?
o 109(b): Delaware law very permissive in what is allowed in the
bylaws
- Sets out how officers/directors/employees interact.

Virginia Kain  33
 LIMITED LIABILITY

- Technically, neither corporations nor shareholders have limited liability. Corporations have
unlimited liability, and shareholders, by reason of their shareholder status alone, have no liability
for the debts or obligations of the corporations – shareholders cannot lose more than they invest
(absent some special circumstances).
o The chief purpose of limited liability is to encourage investment in equity securities,
which makes capital more available for risky ventures.
o Limited liability is just the default term. Shareholders can undertake by contract to be
a corporate guarantor.
o Why is limited liability the default?
 Limited liability vastly simplifies the job of evaluating an equity investment – a
corporate investor who would naturally be concerned about his own liability can
ignore low probability events that may bankrupt the firm, and without limited
liability, would create a large liability on him. Also, don’t need to be concerned
about the financial status of co-investors since in no event will she be
jointly/severally liable with her co-investors. This encourages capital investment
in equity securities.
 Ability to segregate assets may encourage risk-adverse shareholders to invest in
risky ventures.
 May increase incentives for banks and other expert creditors to monitor corporate
debtors more closely.
 Reduces need to monitor agents (managers)  if you know you’re not personally
liable then you don’t need to evaluate them all the time
 Reduces need to monitor other shareholders.
 Makes shares fungible (which facilitates takeovers)
 Facilitates diversification (without LL, minimize exposure by holding only one
company).
 Enlists creditors in monitoring managers (because creditors bear some downside
risk)  can loan money to a corporation, and have incentive to monitor
management to make sure they won’t default on their investment.

TRANSFERABLE SHARES

- Corporate law provides that equity investors in the corporate entity legally own something
distinct from any part of the corporation’s property: they own a share interest.
- Shares can be relatively easily transferred between shareholders.
o The share is their personal legal property, and therefore they can transfer it with all the
rights that it confers.
 Transferability permits the firm to conduct business uninterruptedly as the
identities of its owners change, which avoids the complications of dissolution and
reformation, which can affect partnerships.
 Additionally, the ability of investors to freely trade stock encourages the
development of an active stock market, which facilitates investment by
facilitating liquidity and by facilitating the inexpensive diversification of
the risk of any equity investment.
 Permits takeovers  disciplines management
o Transferability is closely linked to limited liability. Without limited liability, the
creditworthiness of the firm as a whole could change as the identities of the shareholders
changed, so the value of shares would be difficult for potential purchasers to judge, and a
seller of shares could impose a cost on her fellow shareholders by selling to someone
with less assets.
Virginia Kain  34
  This is in contrast to the partnership form, which lacks both qualities.
o Free transferability also complements centralized management structures, by serving as a
potential constraint on the self-serving behavior of the managers of widely held
companies.
o Allows shareholders to exit without disrupting business
o Facilitates active stock markets, increasing liquidity

CENTRALIZED MANAGEMENT

BOARD OF DIRECTORS OFFICERS SHAREHOLDERS

HOW IN Elected by shareholders
POWER? (typically for one-year term;
DE allows up to three). Act
by majority vote.
DUTIES? Appoint officers, can
approve extraordinary
actions like amendments to
charters, mergers,
dissolutions and certain
major business decisions,
selling of assets
LIABILITIES? Carries some liabilities but
they try to limit them
Appointed by BOD. Some
officers can sit on the BOD
– e.g. CEO.
Day-to-day management,
hiring decisions.
Agents of corporation, so
subject to agent fiduciary
obligations, and liable for
their own behavior
Residual owners.
Elect BOD.
Limited liability, only
liable for investment.
BUT if there is only
one shareholder, then
not respecting
corporate form.

- The management of firms able to compete in the modern marketplace requires specialized
knowledge and skills. Powerful innovation, but gives rise to the principal problem of modern
corporate governance for publicly financed firms: determination of the set of legal rules and
remedies most likely to ensure that managers will strive to advance the financial interest of
investor without unduly impinging on management’s ability to manage the firm productively.
o What can the law do to encourage managers to be diligent?
o How can the law assist shareholders in acting collectively?

- CORPORATE LAW SOLUTION: CENTRALIZED MANAGEMENT

o 1) Shareholder elected board of directors oversee the management of the corporation
o 2) Shareholders become rationally apathetic  you can diversify your portfolio – doesn’t
really make sense for you to develop time and expertise for each company – waste of
time.
o 3) Corporate law seeks to mitigate agency problems or costs that arise in this arrangement
by putting power in BOD.
 Want to limit requirements but impose fiduciary obligations on officers/directors
etc  meant to protect shareholders so they can continue to be rationally
apathetic
- Under modern corporate law shareholder designed boards of directors, not investors, are
accorded the power to initiate corporate transactions and manage the day to day affairs of
the corporation.
o Publicly financed firms with centralized management breed apathetic investors – they
don’t need to get personally invested in finding out information about the firm because of
the diversification of risk  so a big problem for modern corporate law has been
Virginia Kain  35
 determining the set of legal rules and remedies most likely to ensure that these managers
will strive to advance the financial interests of investors, without unduly impinging on the
management’s ability to manage the firm properly.
 Three aspects to this problem:
 1) What can the law do to encourage management to be diligent given
that shareholders choose the directors that designate managers?
 2) How can the law assist shareholders in acting collectively via
managers, especially in the case of widely held companies with many
small shareholders?
o Corporate law cannot eliminate this collective action problem,
but the law can mitigate it by specifying when shareholder votes
are required, what information shareholders must be given, and
that shareholders must be able to vote in convenient ways (i.e.
not physical attendance).
 3) How can the law encourage companies to make investment decisions
that are best for shareholders/society at large?
o Mitigating the Agency Problem:
 Main technique is to require that management be
appointed by a board of directors that is elected by the
stockholders.
 Corporate form is unique because it makes
centralizing management power a default for
firms organized as corporations, and vests more
power in the board than even large partnerships
do.

BOARD OF DIRECTORS
- GENERALLY
o Elected by shareholders, subject to terms set forth in a charter; directors are typically
elected for one-year terms. Board acts by majority vote, through formally adopted and
recorded resolutions. Once elected, board members are not required to follow the wishes
of a majority shareholder (see Self Cleansing Filter).
 Board appoints officers of the corporation, and delegates day to day
management to them, while retaining oversight and exclusive power to
initiate and approve certain extraordinary actions (mergers, dissolutions).
 Non-management director – “the last great amateur roles in American
life”  historically, the idea was that the board of directors get
paid/corporate stock/they meet 4 times a year in a nice location etc – in
general not a full time job – usually former senior management. These
days, it’s a more involved role.
 The board “acts” by adopting resolutions at meetings that are recorded in the
board’s minutes, appoints officers and therefore are fundamentally separate from
the daily managers of the company; additionally, corporate law treats the board
as if it was a quasi-principal of the company.
 Separation: initiation and execution are usually management tasks, where
the board conducts monitoring and approval  serves as a check on
delegated decision making.
 Board also doesn’t have to respond directly to shareholder concerns more than at
annual meetings; empowering boards to act contrary to the will of shareholders
can provide a check on opportunistic behavior by controlling shareholders via
minority shareholders/employees/creditors.

Virginia Kain  36
  The board is also elected by the shareholders, which means they are more likely
to act in the shareholders’ interests.

- LEGAL CONSTRUCTION OF THE BOARD

o Board members are not required by duty to follow the wishes of a majority shareholder.
o Although the board of directors has the primary power to direct and manage the business
and affairs of the corporation, it rarely steps in and exercises management power –
usually designates a CEO
o THE HOLDER OF PRIMARY MANAGEMENT POWER
 Automatic Self-Cleansing Filter Syndicate Co., Ltd. v. Cunninghame (1906)
– Board not entirely beholden to shareholders; board has independent authority.
 R: A corporation’s board of directors is not bound to carry out the
resolution of a simple majority of the shareholders in violation of the
articles of association.
 F: Plaintiff, with friends, held 55% of the shares at Automatic Self-
Cleansing Filter, and wished to sell the company’s assets. The articles of
the company provided that the management of the business and control
of the company are vested in the directors, subject to regulations that
pass by 3/4ths of the shareholders. At a special shareholder’s meeting,
the vote to sell the company’s assets failed by a vote of 55%/45%.
Plaintiff then asked the court to order the board to proceed with a sale of
the assets on specific terms; the court denied the request.
 Q: Is a corporation's board of directors bound to carry out the resolution
of a simple majority of the shareholders in violation of the articles of
association?
o Whether, under the memo/articles of association the directors are
bound to accept, in substitution of their own view, the views
contained in the resolution of the company.
 A: No. A board of directors need not carry out a resolution passed by a
simple majority of the shareholders in violation of the articles of
association. Under Automatic’s articles of association, the board of
directors was endowed with the full powers of the company, excluding of
course those things that either statute or the articles require the company
itself to do. Further, the articles permit the shareholders to limit or
regulate the directors’ authority by passing an extraordinary resolution
(3/4ths). Although the directors might loosely be categorized as the
company’s agent, a majority of shareholders for a particular vote is not
the principal. The company and all its shareholders is the principal in this
analogy.

- STRUCTURE AND FUNCTION OF THE BOARD

o The board has inherent power to establish standing committees for the effective
organization of its own work, and it may delegate certain aspects of its task to these or
other committees.
 If a committee is advisory, it can include non-directors, but if they exercise any
part of the board’s operational power, they must be composed of only directors.
o Usually a one-year statutory term for directors; some boards have staggered terms.
o There is no specific statute as to what exactly a board is supposed to do, but generally:
 Selection, monitoring and compensating the firm’s CEO
 Assure that an appropriate managerial risk and legal compliance program is in
place
 Engage in CEO succession planning
Virginia Kain  37
  Review and approve strategic planning
 Be prepared to act in a crisis
 Assure that the firm acts in a socially responsible way
 Assure an appropriate and ethical tone at the top of the firm.

- FORMALITY IN BOARD OPERATION

o Corporate directors are not legal agents of the corporation (but could enter into an agency
relationship if they wanted to – but the contract would have to be fair to the corporation.
o Governance power resides in the board of directors, not the individual directors
themselves.
o Directors act as a board only at a duly constituted board meeting and by majority vote
(unless requiring a supermajority vote) that is formally recorded in the meeting minutes
 also requiring proper notice, quorums (usually requirements set by statute).
o Fogel v US Energy Systems (2007)
 F: 4-member board of directors – CEO and three outside directors. Just before a
scheduled board meeting, the 3 outside directors convened and decided to fire the
CEO, then went to the board meeting and announced their decision. The CEO
called a special meeting of shareholders two days later with the purpose of
removing the other directors from office.
 Q: Whether the outside directors had a valid board meeting when they decided
to fire the CEO; if not, then the CEO was improperly fired and retained the right
to call a special meeting of shareholders.
 A: Meeting of the 3 directors did not constitute a valid board meeting.

- A CRITIQUE OF BOARDS – p. 98
o American law locates the center of energy and power of the corporation with the board of
directors and most statutes do not even mention the CEO position.
o Yet, directors are part-timers and have other full-time responsibilities.
o Carter and Losch: significant gap between what boards are expected to do and the time
and knowledge available to directors to do their work.
o Proposal: outside directors.

- RELEVANT DGCL PROVISIONS

o DGCL § 141(a): Powers
 Every corporation must have a board of directors. Power to manage and direct
business and affairs of the corporation.
 Complete discretion besides any restrictions in the Articles of Incorporation
o DGCL § 141(b): Resignation
 Directors may resign at any time, board must have 1+ members (number fixed by
certificate of incorporation); directors don’t need to be shareholders; directors
hold office until successor elected or removal; director resignation can be
conditioned upon failure of director to receive specified vote.
 Plurality voting – first past the post (not majority)
 Quorum - [default is 50%] A majority of the total number of directors
shall constitute a quorum for the transaction of business unless the
certificate of incorporation or the bylaws require a greater number.
Unless the certificate of incorporation provides otherwise, the bylaws
may provide that a number less than a majority shall constitute a quorum
which in no case shall be less than ⅓ of the total number of directors.
The vote of the majority of the directors present at a meeting at which a
quorum is present shall be the act of the board of directors unless the

Virginia Kain  38
 certificate of incorporation or the bylaws shall require a vote of a greater
number.
o DGCL § 141(c): Committees & Subcommittees
 Directors are permitted to establish committees and subcommittees and delegate
power to them.
 Cannot issue stock/shares.
o DGCL § 141(d): Staggered/Class Board
 Allowed to have a staggered or class structure board – divided so that a particular
ratio (usually 1/3) is up for election every year
o DGCL § 141(e): Advisor Reliance
 Board members allowed to rely on advisors in good faith as well as on records of
the corporation – don’t have to know everything. (Accountants, bankers,
lawyers)
o DGCL § 141(f): Action without Meeting
 Board can act without a meeting if they have the unanimous written consent of
the board (either written or electronic) – good if directors are spread out
o DGCL § 141(h): Compensation
 Board has ability to set compensation for directors
o DGCL § 141(k): Removal
 Majority of shareholders can remove director or board with or without cause
EXCEPT:
 (1) Class/Staggered Boards: need cause
o Harder to remove than unitary board
 (2) If cumulative voting:
o If less than the entire board is to be removed, no director may be
removed without cause if the votes cast against such director’s
removal would be sufficient to elect such director if then
cumulatively voted at an election of the entire board of directors,
or, if there be classes of directors, at an election of the class of
directors of which such director is a part. Whenever the holders
of any class or series are entitled to elect 1 or more directors by
the charter, this subsection shall apply, in respect to the
removal without cause of director(s) so elected, to the vote of
that class or series and not to the vote of the outstanding shares
as a whole.

CORPORATE OFFICERS: AGENTS OF THE CORPORATION

- GENERALLY: Corporate officers, unlike directors, are unquestionable agents of the corporation
and therefore are subject to the fiduciary duty of agents.
o Appointed and removed by the board of directors.
o Agents of the corporation  subject to the fiduciary obligations of agents
o Typically include CEO, VP, Treasurer, Secretary
 CEO typically has a seat on the board, other officers may as well
- Jennings v. Pittsburgh Mercantile Co. (1964) – Rejects the idea that a single officer can bind
corporation; sale of assets requires BOD approval.
o R: Apparent authority cannot be established through the actions of the agent suggesting
apparent authority, but may be established through prior actions that are sufficiently
similar and repetitive.
o F: Jennings and Cantor (broker and real estate investment counselor/attorney) entered
into an agreement with Pittsburgh Merc. Co., to solicit bids for real estate purchases.
Jennings met with VP/treasurer of Mercantile Egmore and his financial consultant Stern

Virginia Kain  39
 to discuss Merc.’s finances and plans. Egmore said he was a member of Merc.’s
executive committee, which controlled Merc., and that the executive committee would
determine whether the company would accept any offers solicited by Jennings – and that
the approval of the board of directors would be automatic.
 Jennings brought in an offer close to the acceptable terms and Stern informed
Jennings the executive committee had agreed to the deal. However, within a
week, Egmore informed Jennings the offer had been rejected and refused to pay
Jennings his commission. Jennings and Cantor filed suit in assumpsit to recover
the commission.
 Mercantile is a publicly held corporation with 9 directors and a three-member
executive committee of directors
 Egmore (Merc’s VP and Treasurer-Controller, corporate officer and director,
along with Stern (financial consultant), instructs Jennings to solicit offers for a
sale and leaseback of its real property.
 Selling $1.5 million in property and leasing it back to pursue a store
modernization scheme
 Egmore tells Jennings that the executive committee has the power to accept an
offer, and it eventually does.
 Board rejects the deal that Egmore brought, and Jennings sues for his
commission.
 Mercantile’s Argument: Company is arguing that Egmore didn’t have
the authority to do the deal, and because he didn’t have the authority, the
company isn’t bound.
 Jennings’ Argument: Yes, there was authority, and the company should
be bound. Egmore has apparent authority.
o Q: Can apparent authority to act be established when the agent’s own actions suggest
apparent authority or when prior actions are insufficiently similar and repetitive?
o A: No. Apparent authority is that which, though not explicitly granted, the principal
knowingly allows an agent to exercise or holds the agent out as possessing. The agent
does not gain apparent authority based solely upon his own actions or words. Prior
dealings may establish apparent authority, but only if two conditions are met: (1) the
prior acts are sufficiently similar to the act at issue and (2) they were sufficiently
repetitive. In the current matter, Jennings cannot establish apparent authority simply
because Egmore maintained that Mercantile had given him authority. Additionally, while
there were substantial prior actions by Egmore to which the act at issue could be
compared, those prior acts were not sufficiently similar.
 Egmore’s titles alone were not enough to establish apparent authority –
Jennings and his partner should have inquired about his actual authority.
 NOT apparent authority. Apparent authority would require representation by
the principal to the third party, and the corporate office itself isn’t dispositive of
his authority, and neither would prior conduct. Also need the entire board! Board
acts as a body; has to have the appropriate formalities.

CHAPTER FOUR – THE PROTECTION OF CREDITORS

- Limited liability widely praised as genius invention, but limited liability exacerbates the
traditional problems of debtor-creditor relationships. GREAT for shareholders, but presents
challenges for creditors. Most corporations have a mix of debt and equity.
o Limited liability (1) opens opportunities for both express and tacit misrepresentation in
transactions with voluntary creditors; and (2) limited liability makes it easy to shift assets
Virginia Kain  40
 out of the contracting corporation after a creditor has extended credit – shareholders can
undertake risky investments or increase leverage in order to shift uncompensated risk
onto the shoulders of voluntary/involuntary creditors.
o Generally, corporate creditors protect themselves through contractual agreements.
 Covenants, oversight rights, security interests
- Corporate law seeks to protect corporate creditors – pursue three basic strategies in limited efforts
to protect creditors.
o Mandatory disclosure (minimal for private companies, extensive for public companies).
o Capital Regulation (minimal in the US)
o “Revoking” Limited liability – piercing the corporate veil

MANDATORY DISCLOSURE

- Federal securities law imposes extensive mandatory disclosure requirements on public

corporations; state corporation law generally makes limited use of mandatory disclosure to
protect creditors of closely held corporations which are not subject to federal securities law
regulation.
o BUT, can negotiate for further disclosures
o No state requires closely held corporations to prepared audited financial statements or to
file financial statement with a commercial register or AG’s office
o U.S. law in this area contrasts with EU jurisdictions where at least large closely held
corporations are required to prepare audited financial statements annually and even the
smallest corps are frequently required to file financial statements with public authorities.
o Corporate disclosure: telling a story through accounting
- ACCOUNTING
 Introduction:
 Case for accounting: firms expect/want the skillset
 Corporate disclosure: telling the story through accounting
 Part art, part science
 Every year, public companies file Form 10-K report
 Focusing on two types of financial statements: [public corporations must make these
public under SEC regulations]
 Balance sheets
 Income statements
 BALANCE SHEETS: fundamental accounting equation.
 The balance sheet is a snapshot of the business at a particular moment (i.e. a
corporate selfie)
 Balance sheet shows the assets, liabilities, and the value of the owners’
equity in the company.
 ASSETS
o Property owned by firm
o Liabilities + Equity
o Listed in order of liquidity (cash is first)
o TYPES:
 Accounts receivable (amounts not yet collected from
customers of goods already shipped)
 Inventories (goods already produced ready for
customers)
 Prepaid expenses (payments company has made
in advance for services it’ll receive in the future)
o Property (plant equipment, building, etc. – could depreciate)

Virginia Kain  41
  LIABILITIES
o Amount firm owes to others
o Short term obligations to suppliers
o Notes payable – short term debt, companies borrow money and
have to disclose how much they owe to creditors
o Long term notes payable
 EQUITY
o Assets = Liabilities + equity (Or: equity = assets – liabilities)
o Represents owners’ interest in firm, or firm’s net worth
 How much owners’ stake is worth
o This is the value of what shareholders have in the company
o Initial equity = paid in capital, total amount company has
received for those who purchased its stock
o Purpose of selling stock is to raise capital and w/ equity its
retained capital were looking at
 Assets on the left; equity and liabilities on the right
 Balance sheet: a snapshot in time [See Class 8 Handout]
o Assets: current assets; fixed assets and depreciation; intangible assets
 Most liquid to least liquid
 Current: actual cash in hand, inventories, prepaid expenses,
accounts receivable
 Fixed: Property, plant, and equipment; depreciation
o Liabilities: current liabilities (due the soonest; within the year); long-
term liability (1+ year)
o Equity
 Represents the owners’ interests in the firm; net worth
 Paid-in capital: total amount corps have received from those
who have purchased stock
 Retained earnings: cumulative result of corporation’s
operations
o In example, assets (5.26) = liabilities (3.75) + equity
 INCOME STATEMENTS
 Income statement shows how a firm has performed during a particular period
of time and how much is left over as profit. Earned money and spent money.
 Key income statement items:
o Net sales
 Total value of company’s revenue during relevant year;
money that the company brings in
o Operating Expenses
 Cost to produce product, cost of goods (cost of goods
sold – depreciation), selling and administrative costs,
research and expenses
o Interest Expense
 Subtract how much interest accruing on loans
o Tax Expense
 Subtract how much paying into tax
o Net Income
 Net Sales - Operating expense; whatever is net income
can be reinvested or given to SHs as dividends

Virginia Kain  42
 PIERCING THE CORPORATE VEIL – SHAREHOLDER LIABILITY

- GENERALLY: Piercing the corporate veil is an exception to the general rule that a member
has no personal liability for debts or obligations of the corporation. A court may pierce the
corporate veil by setting aside the principle of limited liability and disregarding the corporate
entity, if the corporate form has been abused in such a way that recognizing limited liability
would work unfair harm or injustice.
o This is an equitable power of the court to set aside the entity status of the corporation to
hold its shareholders liable directly on contract or tort obligations. Veil piercing is an
equitable mechanism through which courts declare that they will not permit the
attributes of the corporate form to be used to perpetuate a fraud.

- THINGS TO REMEMBER:
(1) Piercing the corporate veil imposes liability on one or more shareholders. A court can pierce
the veil as to all, or only some shareholders.
(2) How to avoid veil piercing? Just follow those minimum formalities that are required; in most
cases that will foreclose veil piercing.
(3) Piercing the corporate veil is a court-created concept.
(4) While courts can pierce the corporate veil, they rarely do.
- All courts applying veil piercing standards agree that some abuse of the corporate
form must be found in order to ignore the separate legal identity of the corporation,
and should be done sparingly.
(5) There is no general rule with respect to corporate veil piercing – very fact specific inquiry.
(6) There can be corporations with only one shareholder, and that shareholder itself can be a
corporation. The fact that a corporation only has one shareholder is not itself basis for veil
piercing.
(7) The number of shareholders is relevant, but not generally mentioned in casebooks. Veil
piercing doesn’t generally happen in big, public companies – it normally happens in 10 or
less shareholder situations.
(8) Facts commonly mentioned by cases in discussing veil piercing:
- Failure to observe corporate formalities
- Ex: Failure to hold directors’ meetings, failure to hold shareholders’
meetings, and failure to prepare and preserve minutes of such meetings,
shifting money a lot between businesses.
- Shareholders’ treatment of the funds and other assets of the corporation as her
own
- Policy: If a shareholder does not treat the funds and other assets of the
corporation as a separate entity, why should she be able to escape liability
by asserting that the corporation’s creditors, unlike her, must treat the
corporation as a separate entity?
- Undercapitalization
- Court compares the resources of the corporation, including liability
insurance, and its possible liability risk.
- TESTS
o VAN DORN TEST (Sea-Land) (default)
 The veil of limited corporate liability will be pierced when the plaintiff proves
that (1) there is a unity of interest between the individual and the corporation
such that the individual/separate personalities of the corporation and individual
[or other corporation] no longer exist, and (2) to allow the limited liability would
promote an injustice or sanction a fraud.
 Must be “some wrong beyond a creditor’s inability to collect.”

Virginia Kain  43
 o Pederson v. Paragon Enterprises: “some element of unfairness,
something akin to fraud or deception or the existence of a
compelling public interest must be present in order to disregard
the corporate fiction”.
 FACTORS:
o Failure to maintain adequate corporate records
o Comingling of funds
o Undercapitalization
o One corporation/individual treating assets
o LOWENDAHL TEST
 Veil piercing requires that plaintiff shows the existence of the shareholder who
completely dominates corporate policy and uses their control to commit a fraud
or wrong that proximately caused plaintiff’s injury.
 Domination required – often includes a failure to treat the corporation
formality seriously.
o LAYA/KINNEY TEST (Kinney Shoe)
 (1) Shareholder must have failed to maintain the separate character of the
corporation, and; (2) refusing to impose liability on the shareholder would cause
an ‘inequitable result’.
 OPTIONAL (3): Was it reasonable for the creditor to assume the risk of
default?
o ADDITIONAL TEST: Another formulation of the test calls on the courts to disregard
the corporate form whenever recognition of it would extend the principle of incorporation
beyond the legitimate purposes and would produce injustices or inequitable
consequences.

- Sea-Land Services, Inc. v. The Pepper Source (1991) – Van Dorn Test
o R: When a company’s owner does not take care to observe the formal separation between
himself and his business, the business’s creditors can collect their debts directly from
him.
o F: Defendant Marchese owned 6 separate corporations, and ran them all out of a single
office. The companies shared bank accounts and lent funds to each other, and Marchese
used the business accounts as his personal account. One of those businesses (Pepper
Source) contracted with Sea-Land Services for the delivery of some peppers; Pepper
Source failed to pay SLS. SLS initiated a collection suit; PS never appeared and had been
dissolved to pay business taxes. SLS then brought suit against Marchese and all his
companies, seeking to pierce PS’s veil and collect from defendant, and to ‘reverse pierce’
all the other companies to collect from them.
 P. 124: Court discusses how Marchese is using these corporations as his
‘playthings’ and that he isn’t respecting the corporate form.
o PH: Lower court held SLS could collect PS’s debt from Marchese and the companies he
owned.
o Q: When multiple companies share all the funds and staff with each other and with their
owner, can a creditor to one of those businesses collect its debt from the other
companies?
o A: Yes.
 A corporate entity will be disregarded and the veil of limited liability pierced
when two requirements are met: (Van Dorn Test)
 (1) When there is such unity of interest and ownership that the
separate personalities of the corporation and the individual (or other
corporation) no longer exist; and

Virginia Kain  44
 o In order to determine whether a corporation is so controlled by
another to justify disregarding separate entities, IL cases focus
on four factors:
 (1) failure to maintain adequate corporate records or to
comply with corporate formalities
 (2) Commingling of funds or assets
 (3) Under-capitalization
 (4) One corporation treating the assets of another
corporation as its own.
 (2): Circumstances must be such that adherence to the fiction of
separate corporate existence would sanction a fraud or promote
injustice.
o Strategic use of the corporate form to avoid liability – whether or
not the corporation is being used to play a ‘shell’ game, or to
avoid creditors.
o Pederson v. Paragon Enterprises: “some element of unfairness,
something akin to fraud or deception or the existence of a
compelling public interest must be present in order to disregard
the corporate fiction”.
o Must be a wrong beyond failing to honor a contract or not paying
a debt.
o Why do we need the second prong?
 Because if it was just the first half, any corporation that
has control over/between multiple corporations would be
veil pierced – would make VP very common even in run
of the mill contract actions.
 Court is looking for something more,
recognizing that veil piercing is a pretty extreme
remedy and wanting to maintain limited liability
structure.
- Kinney Shoe Corp. v. Polan (1991)
o R: A shareholder in a corporation may be held personally liable for corporate obligations
once the corporate veil is pierced to prevent injustice.
o F: Polan incorporated Industrial Realty Corp (IRC) and Polan Industries (PI); made no
capital investment in either company, held no initial meetings, didn’t elect directors, and
no stock was ever issued. Kinney had a long-term lease on a building; subleased to IRC.
IRC then subleased a portion of the building to PI; Polan signed both documents. Polan
made a single rental payment from his personal account and then defaulted on the lease.
Kinney sued and obtained a judgment of $166k against IRC; Kinney then sued Polan
personally.
o PH: District court concluded that Kinney had assumed the risk of IRC’s
undercapitalization and refused to pierce the corporate veil.
o Q: May a shareholder in a corporation ever be held personally liable for corporate
obligations?
o A: Yes. Under WV laws, the corporate veil may be pierced and personal liability
imposed on shareholders if equity so requires; burden falls on plaintiff.
 Laya Test:
 (1) Shareholder must have failed to maintain the separate character of the
corporation, and;
o Polan made no capital contributions to the corporation/didn’t
follow any formalities

Virginia Kain  45
  (2) refusing to impose liability on the shareholder would cause an
‘inequitable result’.
o Polan obviously created Industrial as a shell corporation to
provide another layer of insulation from personal liability –
“paper curtain constructed of nothing more than Industrial’s
certificate of incorporation”.
 (3) OPTIONAL: Was it reasonable for the creditor to assume the risk of
default?
o In cases involving sophisticated parties (financial
institutions/banks) who assume the risk of default  these
parties are thought capable for ‘reasonable credit investigation’
and will be imputed with the knowledge that such an
investigation would turn up.
o This prong of the test is NOT mandatory; the two first parts are
satisfied, so the lower court is reversed and Polan is personally
liable.
 Appeals court thinks that it was not reasonable for
Kinney to assume the risk.
 Counterpoint: Kinney was a very sophisticated
actor; why would they not investigate before
entering into a contract with some random
company? Why didn’t they conduct basic due
diligence? Why didn’t they include a fallback
provision/contractual provision?

DISTRICT COURT CIRCUIT COURT

Sea-Land Pierce: Van Dorn test satisfied. Don’t pierce:
Services (1) Does corporation have separate existence or is it a remanded for factual
mere instrumentality? inquiry on second
(2) If not separate, would failure to pierce sanction fraud prong
or promote injustice?
Kinney Shoe Don’t Pierce: Kinney assumed risk under 3rd prong of Laya Pierce: 3rd prong not
test. applicable here
(1) Is the unity of interest and ownership such that the
separate personalities of the corporate and the
individual shareholder no longer exist?
(2) Would it be an inequitable result if the acts were
treated as those of the corporation alone?
(3) Was it reasonable for the creditor to assume the risk
of default?

VEIL-PIERCING ON BEHALF OF INVOLUNTARY CREDITORS

- Involuntary creditors: have suffered some harm and are trying to recover after involuntarily
extending themselves. Contrast with contract creditor (past 2 cases)
o Tort creditors generally (1) don’t rely on the creditworthiness of the corporation and (2)
cannot typically negotiate for contractual protections from risk.
o BUT: General rule remains – thin capitalization alone is insufficient grounds for
piercing the corporate veil.

Virginia Kain  46
- Walkovszky v. Carlton (1966)
o R: In order to maintain a cause of action for piercing the corporate veil, the plaintiff must
allege that a shareholder used the corporate form to conduct business in his individual
capacity.
o F: Plaintiff was severely injured in NYC when he was run down by a cab owned by Seon
Cab Corporation, and negligently operated by defendant Marchese. Carlton is claimed to
be a stockholder of 10 corporations, including Seon, each that has 2 cabs each, insured
with the minimum policy of $10k. Although seemingly independent, the corporations
were operated as a fleet in regard to financing/supplies/repairs/employees.
o Q: May a party maintain a cause of action to pierce the corporate veil without alleging
that a shareholder used the corporate form to conduct business in an individual capacity?
o A: No. Under NY law, courts will pierce the corporate veil when necessary to prevent
fraud or achieve equity. Agency-law principles guide the inquiry into possible abuse of
the corporate form. If a corporation functions merely as an agent of its shareholder, courts
will hold the principal vicariously liable for the corporation’s conduct on the theory of
respondeat superior. Plaintiff must show that a shareholder used the corporation as his
agent to conduct business in an individual capacity.
 Even though Seon was undercapitalized and carried only the bare minimum of
insurance, it is not enough for the plaintiff to pierce the corporate veil.
 If that was enough, then limited liability would be meaningless and
owners would be on the hook every time their corporation accrued
liabilities higher than its assets.
 Must be some evidence that the owners themselves were merely using
the company as a shell.
o Here, the mere fact that Walkovszky might not have been able to
fully recover his damages is not enough to justify letting him
pierce Seon’s veil.
 Decision of appellate court is therefore reversed.
o D (Keating): When the legislature passed these insurance minimums, it was clearly so
that corporations would purchase more than the minimum insurance. The cab companies
had enough money to buy more insurance, but deliberately kept them undercapitalized.
 A participating shareholder of a corporation vested with a public interest,
organized with capital insufficient to meet liabilities which are certain to
arise in the ordinary course of the corporation’s business, may be held
personally responsible for such liabilities. Where corporate income is not
sufficient to cover the cost of insurance premiums above the statutory minimum
or where initially adequate finances dwindle under the pressure of competition,
bad times or extraordinary/unexpected liability, obviously the shareholder will
not be held liable.
 Seon is designed solely to abuse the corporate privilege at the expense of
the public interest.
- THEORIES OF VEIL PIERCING – p. 137
o SINGLE BUSINESS ENTERPRISE THEORY:
 Modern business has grown into large networks of corporations under the
common control of a central holding company and argued that the holding/parent
company ultimately controls and directs the entire network for the benefit of the
its shareholders, it should be liable for the legal obligations of all entities in the
network
 US v. Best Foods (1998)
o General principle of corporate law that a parent corporation is
not liable for the acts of its subsidiaries

Virginia Kain  47
 o However, particular facts of a situation may demonstrate that the
parent corporations is in fact controlling the subsidiary and then
can be liable.
o SUBSTANTIVE CONSOLIDATION:
 Equitable remedy in bankruptcy that consolidates assets among corporate
subsidiaries for the benefit of creditors of the various corporate subsidiaries. Can
be thought of as horizontal veil piercing  some problems with this because if
horizontal piercing is allowed or becomes prevalent the protections of the
corporate form will be missing.
o DISSOLUTION AND SUCCESSOR LIABILITY:
 Doctrine of successor corporation liability: buyer of the liquidating firm’s
product line picks up the tort liability of the seller, at least as that liability relates
to the purchased product line
 Anticipating the liability, the purchasing firm will lower their asking price and
the liquidator cannot escape liability through sale of the damage-causing product
line.
 Most states have a restrictive approach.
o STRATEGIES TO MANAGE LIMITED LIABILITY EXTERNALITIES
 (1) Direct regulation
 (2) Mandatory insurance requirements
 (3) First priority in bankruptcy to tort creditors – therefore more precautions will
be taken.

CHAPTER FIVE – DEBT, EQUITY AND ECONOMIC VALUE

CAPITAL STRUCTURE

- WHAT IS CAPITAL STRUCTURE?

o The composition of a corporation or company’s capital that consists of both the equity
and debt claims against the company.
- WHAT ARE THE SOURCES OF CAPITAL FOR A CORPORATION?
o Debt Securities: those who buy corporate debt have a contractual right to receive a
periodic payment of interest, and to be repaid their principal at a stated maturity date.
o Equity Securities: Charter specifies the classes/types of equity securities and the rights of
each class.
 Common stock: No right to payments, but typically certain rights to control. By
default, owners of common stock have voting rights, typically on a one-
share/one-vote basis.
 Main distinction between classes is the number of votes per share.
 Shares of ownership in a corporation that convey voting rights upon the
shareholder; common stockholders have the lowest priority in the event
of a liquidation or bankruptcy.
 Preferred stock: Hybrid between debt and common shares. A preferred share is
any share on which the charter confers a special right, privilege, or limitation.
Generally carry a stated dividend (pro-rata payment to shareholders based on
earnings). Have preference over common stock in liquidation. Typically does not
vote so long as its dividend is “current”.
 Shares of ownership in a corporation that convey a priority in the
corporation’s earnings and assets in the shareholder; preferred

Virginia Kain  48
 stockholders generally have no voting rights but may be entitled to
dividend preferences.

LEGAL CHARACTER OF DEBT

- Debt Securities are Contracts (loan agreements)

- Indenture: publicly sold bonds, contract between issuer and trustee (represents the interests of the
bond buyer).
- Very Flexible: Loan agreements are contractual in nature and flexible in design
o Can construct whatever terms the parties want (within the realm of legality)
 Characteristics  contractual terms
o Allocates risk and responsibilities between the debtor and creditor.
o Terms can range from low risk to high risk.
- Maturity Date:
o Single most common characteristic of debt
o A critical advantage of bonds is that the investor faces less risk as a creditor than as an
equity holder because creditors have a legal right to periodic payment of a return
(interest) and a priority claim over a company’s shareholder on corporate assets in the
event of default.
o Issuer of debt will almost always have a legal obligation to pay at a stated date in the
future.
o Principal + Interest: Interest typically accrues at a stated rate which debtor must pay
periodically.
o If any part hasn’t been paid, bonds are said to be in default, debtor has defaulted.
- Advantage of bonds: Remedies
o Investor generally faces less risk as creditor than equity holder because creditors have a
legal right to periodic payment of return and a priority claim over the company’s
shareholders on corporate assets in bankruptcy. Suable!
o Sue on contract, protective covenants
o Compare with equity holders who can’t do anything with periodic dividends
- Tax Treatment:
o Interest paid by borrower is a deductible cost of business when firm calculates taxable
income.
o No deduction available for dividends paid to stockholders.
o SO, cost to corporation of debt is less than equity.
 Reduces taxable income by interest, lowering the corporation’s tax burden
overall.

LEGAL CHARACTER OF EQUITY

- Usually in the form of common stock, contractual in nature, but unlike debt, there are fixed terms.
o No right to periodic payment nor can they demand the return of investment
o Right to vote: most important characteristic
o A corporate charter can create classes of stock (Class A, Class B).
- Common Stock
o Vote to elect directors  default one share = one vote (deviation must be in charter); no
right to payment; charter must state the different classes of common stock and what each
class’ rights are; if company wants to issue additional shares, must amend charter which
must be voted on
o Residual Claims & Residual Control

Virginia Kain  49
  Common stock has control rights via power to appoint board and residual claim
on corp’s assets & income (after expenses, eg payroll, and interest to creditors
are paid) that they get in the form of dividends
- Preferred Stock
o Holder has “special” right/privilege that must be set out in charter; special right is usually
a stated dividend based on earnings; receive dividends before common stock holders; if
dividends aren’t paid regularly may get a special voting right or seat on BOD
o Usually less risky than common stock b/c it has preference in liquidation as well as
dividends
o Under some statutes, they will be accorded a class vote in certain fundamental
transactions (M&A)
o Considered a hybrid between debt & common shares

CHAPTER SIX – NORMAL GOVERNANCE: THE VOTING SYSTEM

INTRODUCTION: SHAREHOLDER VOTING IN THE NEW CORPORATE GOVERNANCE

- DEFAULT POWERS OF SHAREHOLDERS:

o (1) THE RIGHT TO VOTE
 Power to elect the board of directors, and to vote upon the most fundamental
corporate transactions (mergers, sales of all assets, corporate dissolutions, charter
amendments – anything that fundamentally changes the nature of the business;
also shareholder resolutions).
 Biggest problem with shareholder voting is the collective action problem faced
by shareholders in large public companies – any one shareholder’s vote is
unlikely to affect the outcome of the vote. Thus, since becoming informed takes
effort and time, the shareholder will get the same proportionate share of any
benefit the vote may produce, whether she votes intelligently or not. The larger
shareholder’s proportionate stake, the greater the probability that her vote affects
the outcome, so the less she suffers from rational apathy.
 Passive shareholders are the model of the large American public corporation.
 Several rules have been passed encouraging informed shareholder
voting, but mandated disclosures don’t necessarily make shareholders
effective monitors.
o Collective action problem is sometimes fatal no matter how
much information there is – managers arguably are constrained
by the pressures of different markets (product market, market for
managerial services (compensation incentives), capital market
(which must be accessed for funds), and the market for corporate
control).
 Shareholders have increasingly exercised their rights post-1992 when an
amendment to the SEC rule allowed for communication between large
investors relating to forthcoming votes without filing proxy solicitation
materials.
 Changes between 2004-2014  pressure from shareholder interests has
effectively:
o Required a change to majority of independent directors on the
boards of public companies

Virginia Kain  50
 o Successfully promoted the widespread change of the standard for
electing directors from plurality to majority of shares voting in
uncontested elections
o Successfully promoted the widespread abandonment of
staggered board structures
o Advocated for the frequent splitting of the board chair position
from that of the CEO
o Successfully begun the process of gaining access by shareholders
to the company’s own proxy statement on a company-by-
company basis
o Facilitated greater openness on the part of outside directors to
communicate with institutional shareholders.
 Modern structure: Collective action costs continue to be significant but not large
enough to preclude shareholders from monitoring and even redirecting
managerial performance.

CORPORATE ACTION VOTE REQUIRED

§ 216(1) – All Majority of shares present with a quorum
matters/generally
A quorum refers to the minimum acceptable level of individuals with
a vested interest in a company needed to make the proceedings of a
meeting valid under the corporate charter.

§ 216(3) – Director Election Plurality, with quorum

§ 228 – Actions by Written
Consent
§ 242 – Amending Corporate
Charter
§ 109(a) – Amending bylaws
§ 251 – Statutory Merger
§ 271 – Sale of Substantially
All Assets
§ 275 – Dissolution
Majority of shares outstanding (not shareholders – actual shares)
Requires approval of the board and the majority of the shareholders
Only shareholders have the power to amend the bylaws, unless the
charter confers that power on board of directors – majority
Majority of shares outstanding
Majority of shares outstanding
Majority of shares outstanding

- Note: difference between cumulative and straight-line voting – usually straight-line voting but
there is a passage about cumulative voting pg. 168/on double page outline p. 28 if you need it

o (2) THE RIGHT TO SELL

 Shareholders can sell their stock if they are disappointed with the company’s
performance
 “Voting with your feet”
o (3) THE RIGHT TO SUE
 Shareholders have the right to sue their directors for breach of fiduciary duty in
certain circumstances.
o Note that these shareholder practices for disciplining management interact with others –
the investor selling her stock may facilitate a hostile takeover, but the effectiveness of the
takeover attempt may, in turn, depend on the ability to conduct a proxy fight for
shareholder votes. Similarly, the effectiveness of a proxy fight may be impaired by
management actions that shareholders can attack in court as a breach of fiduciary duty.

Virginia Kain  51
 ELECTING AND REMOVING DIRECTORS

ELECTING DIRECTORS

- BOARD OF DIRECTORS:
o DGCL § 141(a): Electing directors is the foundational (mandatory) voting right, as every
corporation must have a board of directors, even if it’s just one person.

- ONE SHARE/ONE VOTE:

o In the absence of any customization in the charter, each share of stock has exactly one
vote. (DGCL § 212(a)).
 Why does almost all common stock carry voting rights?
 Common Stock carries voting rights because the right to appoint the
board of directors is more valuable to common stock investors than to
any other class of investors because their security has no maturity date
and they have no legal right to periodic payments, so they need the
default protection of voting rights
o By contrast, bond holders are protected by a contractual right to
interest payments and the return of their principal, usually on a
stated maturity date/sometimes secured with the property of the
debtor.

- ANNUAL ELECTION OF DIRECTORS:

o DGCL § 211: Another mandatory feature of the voting system is the annual election of
directors. Each year, holders of voting stock elect either the whole board (single class) or
some fraction of the board (staggered class).
 When do shareholders get to vote?
 Annually, other than special meetings or written consent solicitations
(DGCL § 211(b)).
 How many directors are elected at once?
 Depends on whether there is a single class of directors or a staggered
board (DGCL §141(d))  purpose of staggered board is to make it
harder for shareholders to vote an entire board out
 How many votes are needed to elect a director?
 Default rules in DGCL § 216 (quorum and election requirements):
Director elections  Under the DGCL, the vote required to elect a
director can bet set in the charter or in the bylaws, but as a default,
candidates are elected if they win a plurality of the votes of the shares
present in person or represented by a proxy at the meeting and entitled to
vote on the election of directors (called a quorum).
o DGCL § 216: specifically provides that the board may not
amend or repeal a stockholder adopted by law setting the vote
requirement.
o Corporate law facilitates the election of directors by creating a flexible framework for
holding the annual meetings of shareholders. Generally, the state statutes set:
 DGCL § 222(b): Notice of Annual Meeting (e.g. 10-60 days)
 DGCL § 216: Quorum
 DGCL §211(c): Minimum/maximum period for the board to fix a so-called
record date  shareholders who are registered as shareholders as of the record
date are legal shareholders who are entitled to vote at the meeting.

REMOVING DIRECTORS
Virginia Kain  52
- DGCL 141(k): Shareholders may remove directors from office at any time and for any reason,
except in the case of ‘staggered boards’, in which case they may only do so for cause, unless the
charter provides otherwise. Removal may be accomplished at a shareholder’s meeting or by
action of written consent.
o See Campbell v. Loew’s, Inc., which established that a director is entitled to certain due
process rights when he or she is removed for cause.
- State law usually forbids directors from removing fellow directors (with or without cause) in the
absence of express shareholder authorization  which means that a board typically cannot adopt
a bylaw that would authorize it to exercise a removal power.
o But: if a board uncovers cause for removal of a director, it can petition a court to remove
the director from office.

SHAREHOLDER MEETINGS AND ALTERNATIVES

- In addition to electing the board at the annual meeting, shareholders may also be able to vote to
adopt, repeal, and amend bylaws, to remove directors, and to adopt shareholder resolutions that
may ratify board actions or request the board to take certain actions.
o If the board fails to convene an annual meeting within 13 months of the last annual
meeting, shareholders can petition the court, which can require the meeting to be held.
DGCL § 211.
o SPECIAL MEETINGS: Meetings other than the annual meeting – usually called for
fundamental transactions; also, in most jurisdictions, a special meeting is the only way
that shareholders can initiate action (such as the amendment of bylaws/removing
directors) between annual meetings.
 RMBCA § 7.02: A corporation must hold a special meeting of stockholders if (i)
such a meeting is called by the board of directors or a person authorized in the
charter/bylaws to do so, or (ii) the holders of at least 10% of all votes entitled to
be cast demand such a meeting in writing.
 Note that Delaware doesn’t have these kinds of minimums; it just says
that special meetings may be called by the board/persons who are
designated in the charter or bylaws.
 DGCL §211(d) provides that special meetings may be called by the board or by
persons designated in charter and bylaws.
o SHAREHOLDER CONSENT SOLICITATIONS: Shareholders may have alternatives
to special meetings in the form of a statutory provision permitting them to act in lieu of a
meeting by filing written consents.
 DGCL § 228: The stockholder consent statute in Delaware provides that any
action that may be taken at a meeting of shareholders may also be taken by
written concurrence of the holders of the number of voting shares required to
approve that action at a meeting attended by all shareholders.
 Can shareholders act without a meeting?
 DGCL § 228 provides that any action that may be taken at a meeting of
shareholders may also be taken through written consent

PROXY VOTING AND ITS COSTS

- Shareholder meetings require a quorum to act; because shareholders are so widespread and
unlikely to attend a meeting in person, meetings and voting are usually held by proxy.

- PROXY VOTING is a form of voting whereby a member of a decision-making body may

delegate his or her voting power to a representative, to enable a vote in absence. The
representative may be another member of the same body, or external.
Virginia Kain  53
 o Shareholders not generally showing up to the annual meeting, so they vote through a
proxy – fill out a proxy card, which designates an agent to cast that shareholder’s vote
in the manner that the shareholder has specified. Shareholder doesn’t have to go to
the meeting but does so through an agent.
 State corporation law establishes its validity as well as the legal structure in
which proxies are given, exercised, and revoked. (DGCL § 212(b)). BUT federal
law (SEC) regulates a great deal about the solicitation and use of proxies in firms
with publicly traded shares.
- PROXY CARD: No single form that is mandated for a valid proxy, but generally, proxies must
record the designation of the proxy holder by the shareholder and authenticate the grant of the
proxy (usually a “proxy card” – essentially a ballot).
o Under SEC regulations, management supplies a proxy card to shareholders for them to
sign and return; lists management’s nominees. If there is a contest, the challengers will
provide their own card (at their own cost) listing their nominees. Currently not an option
to mix and match nominees. The shareholder picks the card that they want and then signs
one – the last one that they sign revokes the other ones.
- PROXY STATEMENT: disclosure material that the company prepares ahead of any
shareholder vote. Tells shareholders what they are voting on, who is up for election, proposals,
board of directors etc.
o Federal securities law and the SEC rules mandate extensive disclosure for publicly
traded securities; state law mandates neither an annual report nor any other financial
statements. DGCL § 220(b) codifies the common law right to inspect a company’s
books/records for a proper purpose.
 Two different requests: stock list (discloses the identity, ownership interest and
address of each registered owner of company stock – easily accessible, proper
purpose is widely construed) and inspection of books & records (because these
jeopardize proprietary information, under Delaware law, plaintiffs are required to
carry the burden of showing a proper purpose; the plaintiffs’ motives are
carefully inspected. NY law accords shareholders a statutory right to inspect key
financial statements/balance sheet/income statement. Stock lists and meeting
minutes are also available for inspection unless the company can show that the
shareholder lacks a proper purpose).

- PROXY ACCESS: refers to the debate in corporate law about who has control about what is put
on the ballot/corporate proxy. Debate about whether the shareholders should have the right to
nominate directly. How much control should the shareholders have over the nominees?
Incumbent board currently has a great amount of control over it.

- POINTS TO REMEMBER:
o First, a proxy is effective for eleven months unless the proxy states otherwise.
o Second, a proxy is revocable by the record shareholder even if the proxy states otherwise.
Third, a proxy is irrevocable only if it both states that it is irrevocable and is also
“coupled with an interest.”
o Fourth, “coupled with an interest” means that the proxy holder has some interest in the
stock other than just voting the shares

- WHO PAYS FOR ELECTION COSTS?

o Cost of proxy solicitations: who pays for the expense of soliciting proxies?  Incumbent
board  can use the corporate treasury.
 Challengers  not reimbursed unless victorious, and then only with shareholder
approval.

Virginia Kain  54
  Rosenfeld v. Fairchild Engine & Airplane Corp. (1955): if you challenge
the board and are successful, you can go to the shareholders and get
permission to be reimbursed for the expenses of the election.

o OFFSETTING COST: E-Proxy Rules (2007)

 DGCL § 212(c)(2): Electronic communications may also be used to designate a
proxy, so long as sufficient evidence of authenticity is supplied.
 Proxy-Access Debate (who gets to decide what is on the ballot)
 Universal Proxy
 Microsoft is moving to a virtual-only shareholder meeting to increase
shareholder participation.

- AGENCY RELATIONSHIP: Proxy holders may (generally) exercise independent judgment on

issues arising at the shareholder meeting for which they have not received specific instructions.
Proxies, like all agency relationships, are revocable unless the holder has contracted for the proxy
as a means to protect a legal interest or property, such as an interest in the shares themselves. (see
DGCL § 212(e) and Haft v. Haft, holding that proxy held by CEO was irrevocable because of
proxy holder’s interest as officer of the corporation).

- Rosenfeld v. Fairchild Engine & Airplane Corp. (1955)

o R: In a proxy contest over policy, corporate directors have the right to make reasonable
and proper expenditures from the corporate treasury for the purpose of persuading the
stockholders of the correctness of their position and soliciting their support for policies
which the directors believe are in the best interests of the corporation.
o F: In a policy related proxy contest for a board of directors’ election at Fairchild,
Fairchild’s treasury paid $106k in defense of the old board of director’s position; $28k to
the old board by the new board after the change to compensate the old board for its failed
campaign, and $127k reimbursing the new board members for the expenses incurred in
their campaign. The reimbursement was ratified by a majority of the stockholders; the
policy decision was regarding an expensive pension contract of a former director.
o PH: Rosenfeld brought suit to compel the return of the payments to the treasury; the
lower court dismissed the complaint and he appealed.
o Q: In a proxy contest over policy, may directors make expenditures from the corporate
treasury in order to solicit stockholders’ support?
o A: Yes. Because corporations have so many stockholders, if directors weren’t allowed to
use corporate funds for solicitation of proxies, it is very possible that corporate business
would be seriously interfered with. There are so many stockholders that each individual
stockholder doesn’t make much difference in a vote, but the use of proxies is a way to
pool stockholders’ votes. Proxies also wouldn’t be used as much if the directors had to
pay for the solicitation out of their own pockets. Therefore, if acting in good faith,
directors may incur reasonable expenses in the solicitation of proxies in a policy related
proxy contest.
 Win or lose, incumbent managers are reimbursed for expenses that are
reasonable in amount and can be attributed to deciding issues of policy or
principle.
 Challengers usually only get reimbursed if they win; the rationale is that
the shareholders have decided that the expenses were made in a good
faith effort to advance a corporate interest; without ratification by
shareholders, reimbursement to successful dissidents can be seen as self-
dealing. Heineman v. Datapoint Corp (1992).

Virginia Kain  55
 CLASS VOTING
- A corporate charter can create classes of stock (Class A, B). A transaction that is subject to
class voting means that a majority (or higher as specified) of the votes in every class that is
entitled to a separate class vote must approve the transaction for its authorization.
o Conferring class votes also gives each class a veto right.
o DGCL § 241(b)(2) provides that the charter may define such rights, but provides very
limited class voting rights in default of contracting for them in the charter.
 Many state statutes
- The charter can further specify that if certain transactions are subject to class voting
o A majority (or higher, if specified), of the votes in every class must approve the
transaction.
- DGCL § 242(b)(2) requires class votes for certain types of charter amendments.

SHAREHOLDER INFORMATION RIGHTS

- FEDERAL: Securities law mandates extensive disclosure for publicly traded securities.
- STATE: Shareholders don’t have much of a right to information under state corporate law. State
corporate law imposes no financial disclosure obligations, but does provide for:
o (1) THE RIGHT TO THE SHAREHOLDER LIST FOR A PROPER PURPOSE,
AND
 Stock list (discloses the identity, ownership interest and address of each
registered owner of company stock – easily accessible, proper purpose is widely
construed)
o (2) THE RIGHT TO INSPECT THE FIRM’S BOOKS AND RECORDS.
 Inspection of books & records (because these jeopardize proprietary
information, under Delaware law, plaintiffs are required to carry the burden of
showing a proper purpose; the plaintiffs’ motives are carefully inspected. NY law
accords shareholders a statutory right to inspect key financial statements/balance
sheet/income statement. Stock lists and meeting minutes are also available for
inspection unless the company can show that the shareholder lacks a proper
purpose).
- DELAWARE APPROACH:
o DGCL § 220: DGCL § 220(c) – for shareholder list, burden is on corporation to show
improper purpose.
 220 gives access to shareholder list as well as books and records
 A section 220 plaintiff with a proper purpose must further prove that it has
some credible evidence of wrongdoing sufficient to warrant continued
investigation.
 Main issue is what the scope of the access is going to be and what the good faith
purpose is; the court polices the purpose
 Over the last 15 years there has been a broadening of the
communications that can be considered for a 220 request
 For books and records, burden is on shareholder to show proper purpose.
o When will DE allow shareholder/books/records requests?
 In Highland Select Equity Fund v Motient, a 220 demand was rejected because
its purported purpose verged on being ‘a ruse’.
 The shareholder activist had intended to file a proxy contest and had
sufficient information for the contest before issuing its demand.
o Highland appeared to have maintained its books/records demand
in large part because it derived utility from the demand itself as a
rhetorical platform.

Virginia Kain  56
MITIGATING A COLLECTIVE ACTION PROBLEM TODAY: ACTIVIST INVESTORS

THE COLLECTIVE ACTION PROBLEM

- When there is a highly splintered ownership structure, shareholders are rationally apathetic 
“why would I invest the time to research this company, there’s no way my vote will make a
difference”.
- Powerful free rider problem
o What has changed over the last 30 years or so?
 The role of institutional investors (relevant expertise) (hedge funds, large public
pension funds, university endowments, private equity funds)
 New era of corporate governance
- Since 2000, pressure from shareholder interests has resulted in significant changes in US
corporate governance norms:
o Director independence  more directors who are non-management; objective point of
view/unbiased opinion
o Higher voting standards for electing directors (default is plurality; most companies have a
majority)
o Abandoning staggered boards
o Splitting CEO and chairman roles
o PROXY ACCESS – ability to nominate directors using the company’s proxy
o Advisory shareholder votes on executive compensation
o Board of directors increased engagement with shareholders

INFLUX OF INSTITUTIONAL INVESTORS

PROS CONS
- Addresses free-rider problem – have some - Are the interests of institutional investors
shareholders that are paying attention aligned with other shareholders?
because not all shareholders have the - When you have hedge funds trying to
incentive to monitor closely restructure a company or sell off a piece
- Can help turn a failing company around – of it, it may generate short term profits at
lots of capital the expense of long-term goals
- Increased activism creates more corporate - Short term interests emphasized
accountability - Want companies to act immediately –
problem for company

ACTIVIST INVESTORS

- Even with many changes in corporate governance, change still requires a shareholder to initiate
board interaction.
o In instances where business policy/practices are sought to be changed, this role is usually
filled by a hedge fund (investment fund that is lightly regulated and not required to
diversify its investment portfolio).
o Over the last 10 years, activist hedge funds have become increasingly significant.
- Hedge fund investment strategies in general: investigate opportunity, do sophisticated analysis,
and acquire a substantial position in only a handful of target companies; rarely ever want to take
over management and control of the business. (Policy pg. 202; more on 207)
o Once they have their investment positions, the activist will approach the CEO or the
board to begin to lobby or even agitate for the desired changes.
o In the event that management does not approve their changes, the major tool is to threaten
a short slate proxy contest.

Virginia Kain  57
  Short slate proxy contest: a contest in which the insurgent offers nominees for
only a minority of board positions; the other positions on the insurgents’ proxy
card are filled in with some of the company’s nominees.
 1992 SEC Amendment made this possible by allowing the short slate
proponent to round out its proxy card with nominees from the
management slate.
 The short slate proxy contest is advantageous because it gives
dissatisfied shareholders the opportunity to shake up existing
management without turning control over to the activists completely.

THE FEDERAL PROXY RULES

GENERALLY

- Securities Act of 1933 (‘33 Act)

o Deals with disclosure procedures that companies must follow when selling securities on
the public markets
- Securities Exchange Act of 1934 (’34 Act)
o Establishes disclosure requirements for corporations after they have gone public
o All public companies are subject to proxy regulation under § 14(a) of the Act
 Regulation 14A (14a-112): SEC rules governing communication among
shareholders and the process of soliciting proxies

o SEA RULE ELEMENTS:

 (1) Disclosure requirements and a mandatory vetting regime that permit the
SEC to assure the disclosure of relevant information and to protect shareholders
from misleading communications
 Rules 14a-1 through 14a-7
 (2) Substantive regulation of the process of soliciting proxies from shareholders
 Rule 14a-3 through 14a-7
 (3) Specialized “town meeting” Provision
 Rule 14a-8
 (4) A general anti-fraud provision that allows courts to imply a private
shareholder remedy for false or misleading proxy materials.
 Rule 14a-9

RULES 14A THROUGH 14A-7: DISCLOSURE AND SHAREHOLDER COMMUNICATION

- Disclosure requirements and a mandatory vetting regime that permit the SEC to assure the
disclosure of relevant information and to protect shareholders from misleading
communications.
o Rule 14a made it unlawful for any person, in contravention of any rule that the
commission may adopt, to solicit any proxy to vote any security registered under §12 of
the act. These rules were drafted to force disclosure by corporations to the shareholders
from whom they sought proxies. Had the unintended consequence of discouraging proxy
fights.
 1992 Amendments – limited term of ‘solicitation’ and created new exemptions
that released institutional shareholders (in limited circumstances) from the

Virginia Kain  58
 requirement to file a disclosure form before they could communicate with other
investors about a corporation.
o SEA Rule 14a-1(1): The definitions of “proxy” and “solicitation” are extremely broad.
“Proxy” means “every proxy, consent, or authorization within the meaning of section
14(a) of the Act. The consent or authorization may take the form of failure to object or to
dissent.” [Exchange Act Rule 14a-1(f)] “Solicitation” includes: (i) a request for a proxy;
(ii) a request to execute, not to execute, or to revoke a proxy; or (iii) furnishing a form of
proxy or other communication to shareholders under circumstances reasonably calculated
to result in procuring, withholding, or revoking a proxy.
 SAFE HARBORS:
 14a-2(b)(2): The proxy rules do not apply to a solicitation of 10 or fewer
shareholders made on behalf of persons other than management
 14a-2(b)(1): A safe harbor provision under the proxy rules excludes
communications between shareholders from the definition of
“solicitation” if the communications (i) do not solicit proxy voting
authority and (ii) are sent by persons who have no material interest in the
solicitation other than their interest as shareholders.
 Rule 14a-(2)(iv) provides that the following communication by a
security holder that states how the security holder intends to vote and the
reasons for how the security will so vote is exempt provided the security
holder does not otherwise solicit a proxy, and (1) The statement is made
in a public manner such as a press release, public forum, advertisement,
etc.; (2) The statement is directed to persons to whom the shareholder
owes a fiduciary duty in connection with voting the shares; or (3) The
statement is made in response to an unsolicited request for information
with respect to a prior communication by the shareholder.

REGULATORY REQUIREMENTS

- Rule 14a-3 contains the central regulatory requirement of the proxy rules. No one may be
solicited for a proxy unless they are, or have been, furnished with a proxy statement “containing
the information specified in Schedule 14A”.
o When the solicitation is made on behalf of the company itself and relates to an annual
meeting for the election of the directors, it must include  considerable information
about the company, including related party transactions and detailed information about
the compensation of top managers.
o When the proxy statement is filed by anyone else, it requires detailed disclosure of the
identity of the soliciting parties, their holdings and the financing of the campaign.
- Rules 14a-4 and 14a-5 regulate the form of the proxy and the proxy statement.
- Rule 14a-6 lists formal filing requirements for preliminary and definitive proxy materials, as well
as for solicitation materials and Notices of Exempt Solicitations.
- Rule 14a-7 sets forth the list or mail rule, under which the company must either provide a
shareholder’s list or undertake to mail the dissident’s proxy statement/solicitation materials to
record holders (aka the intermediaries) in quantities sufficient to make sure that all beneficial
holders get copies.

ACTIVIST INVESTORS AND THE SHORT SLATE PROXY CONTEST

- A short slate proxy contest is one in which the insurgent offers nominees for only a minority of
the board positions; the other positions on the insurgents’ proxy card are filled in with some of
the company’s nominees. This technique is allowed per SEA Rule 14a-4(d)(4), which permits
the short slate proponent to round out its proxy card with nominees from the management slate.

Virginia Kain  59
 o Advantages: gives dissatisfied shareholders an opportunity to shake up the existing
management without turning control over entirely to the activists.
o This has gotten really popular – 29 in 2000 to over 250 in 2014. In approximately 50%
of their efforts, activists win board representation, either through vote or settlement.
o Ultimate question is whether they help to create long term value for shareholders
generally or whether the threat of them and their actions divert productive management.

ACCESS TO THE COMPANY’S PROXY STATEMENT:

RULE 14A-8: SHAREHOLDER PROPOSALS

- Rule 14a-8 is a specialized “town meeting” provision that permits shareholders to gain access
to the corporation’s proxy materials and thus gain a low-cost way to promote certain kinds of
shareholder resolutions.
- Rule 14a-8 entitles shareholders to include certain proposals in the company’s proxy
materials  kind of a democratic notion where shareholders have a right to make suggestions
o TO SUBMIT A 14a-8 PROPOSAL:
 (b)(1): Must hold @ least $2000 or 1% of corporation’s stock for a year
 (e)(2): Must file with management at least 120 days before management plans to
release its proxy statement
 (d): proposal must not exceed 500 words
 Must not run afoul of subject matter restrictions
o MUST INCLUDE FORMAL PROTOCOL:
 14a-8(b)(1): identity of shareholder
 14a-8(c): number of proposals
 14a-8(d): length of supporting statement
 14a-8(i): subject matter of proposal
 SUBJECT MATTER SPECIFICS:
o Must be proper subject for shareholder vote under state and
federal law (1, 2)
o Must relate to more than 5% of the business (5)
o Cannot relate to the ordinary conduct of business (7)
o Can’t seek to remove directors/include specific individuals on
corporate proxy for election to BOD
o Can’t counter a management proposal (9)
o Can’t be a proposal that is already ‘substantially implemented”
by the company (10)
o A proposal must focus on significant social policy issues and
must not seek to micromanage the business in order to avoid
violating the ordinary course of business exception.
 14a-8(j): Excluding Proposals
 This section also lists 13 grounds for excluding proposals from
company’s solicitation materials  companies that wish to exclude a
shareholder proposal generally seek SEC approval to do so  “no action
letter”
o Burden is on the company to demonstrate grounds for exclusion
in the form of a no action letter, which is an opinion letter
written by an attorney at the Securities and Exchange
Commission recommending a course of action be taken by the
commission.
o  Allows management to exclude matters that fall within the
ordinary business of the corporation  purpose being to relieve
management of the necessity of including in its proxy material

Virginia Kain  60
 security holder proposals which relate to matters falling within
the province of management. Certain tasks are so fundamental to
management’s ability to run a company on a daily basis that they
couldn’t be subject to direct shareholder oversight.
 April 2012: SEC announced that shareholders could have access to their
company’s proxy statements on a company by company basis.
 Companies make it pretty hard to get proxy access – requirements that
shareholders own at least 3% of the company’s shares for at least 3 years
(which is a lot)
o But some companies allow for groupings of shareholders
o SUBSTANTIVE PROXY ACCESS ISSUES:
 Proxy Access Bylaws Proposed by Shareholders  Substantive Issues
 (1) size of shareholding qualifying for access
 (2) length of continuous township required to qualify
 (3) number of shareholders that may join together to satisfy the share
ownership requirement
 (4) Maximum number of directors that may be nominated
o TYPES OF SHAREHOLDER PROPOSALS
 Corporate (Social) Responsibility – Asking company to change sourcing/not
test on animals/etc.
 Corporate Governance: De-staggering board, separation of CEO/chairman
roles.
 Institutional investors have used this mechanism to advocate and push
for change.
- HYPOS:
o (1) Ex: Shareholders of the Company ask the board of directors to take the steps
necessary to adopt a "proxy access" bylaw. Such a bylaw shall require the Company to
include in proxy materials prepared for a shareholder meeting at which directors are to be
elected the name, Disclosure and Statement of any person nominated for election to the
board by a shareholder or group that meets the criteria established below. The Company
shall allow shareholders to vote on such nominee on the Company's proxy card. Can the
company exclude this proposal?
 Change the election process  a proxy access shareholder
proposal; give shareholders access to the corporate proxy.
 14a-8(i)(8)  since 2014, shareholders have submitted proxy
access proposals; a growing number of companies have voluntarily
adopted proxy access (over 71% of S&P 500 firms now allow
shareholders proxy access.
o (2) Resolved: Shareholders request that the Company issue an annual sustainability
report describing the company's short- and long-term responses to environmental, social
and governance related issues. The report should be prepared at a reasonable cost, omit
proprietary information, and be made available to shareholders.
 Cannot properly be excluded
 Trinity Church v. Walmart:
o Trinity had a proposal regarding the formulation and
implementation of a policies and standards that determine
whether or not Walmart should sell a product (guns) that
endangers public safety/wellbeing, and has the substantial
potential to impair the reputation of Walmart and would be
reasonably be considered by many to be offensive to the
family/community values that it promotes.

Virginia Kain  61
 o Can Walmart exclude this proposal?
 Relevant rule was 14a-8(i)(7): was this a matter related
to the company’s ordinary business operation 
 Arg for proper exclusion: micromanaging the
sale of products
 Arg for inclusion: social concern – corporate
social issue; transcends daily sales of a particular
product. There’s an overarching social concern!
o March 2014 – SEC grants Walmart’s no action letter, stating
that the staff would not object to Walmart excluding
Trinity’s proposal.
o November 2014  US District Ct for DE concludes Walmart is
not entitled to exclude the proposal
o April 2015  Third circuit permits Walmart to exclude
proposal.
o October 2015  SEC issues new guidance on the scope and
application of Rule 14a-8(i)(7)
 Proposals focusing on a significant policy issue are not
excludable under the ordinary business exception
because the proposals would transcend the day to tday
business matters and raise policy issues so significant
that it would be appropriate for a shareholder vote
 A proposal may transcend a company’s ordinary
business operations even if the significant policy issue
relates to the nitty gritty of its core business.
 Therefore, proposals that focus on a significant policy
issue transcends a company’s ordinary business
operations and are not excludable under 14a-8(i)(7).

RULE 14A-9: THE ANTI-FRAUD RULE

- Rule 14a-9 is general anti-fraud provision that allows courts to imply a private shareholder
remedy for false or misleading proxy materials.
o RULE 14a-9(a): No solicitation subject to this regulation shall be made by means of any
proxy statement, form of proxy, notice of meeting or other communication, written or
oral, containing any statement which, at the time and in the light of the circumstances
under which it is made, is false or misleading with respect to any material fact, or which
omits to state any material fact necessary in order to make the statements therein not
false or misleading or necessary to correct any statement in any earlier communication
with respect to the solicitation of a proxy for the same meeting or subject matter which
has become false or misleading.
 This is a private right to action, so shareholders can bring suits under this; usually
under the materiality standard.
- ELEMENTS
o (1) Materiality – a misrepresentation or omission in a proxy solicitation can trigger
liability if there is a substantial likelihood that a reasonable shareholder would consider it
important in deciding how to vote.
o (2) Culpability – SCOTUS has not yet determined a standard of culpability under 14a-9,
but 2nd and 3rd circuits = negligence; 6th circuit requires proof of intentionality or
extreme recklessness
o (3) Causation and Reliance – unlike a traditional case of fraud, Plaintiff need not prove
actual reliance on a misrepresentation to complete a Rule 14a-9. Causation is assumed if

Virginia Kain  62
 a misrepresentation is material and the proxy solicitation was an essential link in the
accomplishment of the transaction.
o (4) Remedies – Courts might award injunctive relief, rescission or monetary damages.

JUDICIAL OVERSIGHT OF SHAREHOLDER VOTING – PROTECTING THE FRANCHISE

FIDUCIARY SUPERINTENDENCE OF SHAREHOLDER VOTING

- Application of fiduciary duties to directors and officers  the duty not to unfairly manipulate the
voting process for their own advantage and the duty to make truthful statements when addressing
the shareholders (and maybe to make truthful statements when publicly speaking about the firm)
- The fundamental nature of shareholder voting in corporate governance, coupled with the wide
and flexible power of management in elections to possibly effect voting outcomes has led to the
recognition of broad, general powers of courts of equity to supervise the voting process under
fiduciary standards of good faith.

- Schnell v. Chris-Craft Industries, Inc. (1971)

o R: Corporate directors may not act with the sole purpose of obstructing shareholder
action, even if the methods are legally permissible.
o F: Dissident shareholders of Chris-Craft wanted to replace the directors at the next
annual meeting. The board of directors were concerned about appellant’s challenge to
management’s slate of directors at the next shareholder meeting. The directors moved the
annual meeting from Jan. to Dec. and selected a remote location for the meeting. The
directors made things really difficult for the shareholders – refused to turn over their list
of shareholders and hired proxy solicitors to work on their behalf. They also amended the
bylaws to move the annual meeting to a month earlier; the change made it basically
impossible for the dissidents to wage a successful proxy contest against the incumbent
directors. Dissidents brought suit, seeking an injunction to delay the meeting date.
o Q: May corporate directors act solely for the purpose of obstructing shareholder
objectives?
o A: No. Directors of a corporation are bound to act in the best interest of the shareholders.
They may not take steps designed to perpetuate their own power at shareholder expense,
even if the maneuvers are technically legal. The result of the date change of the meeting
was legal, but would have the result of totally obstructing the efforts to unseat existing
management and is therefore inequitable.
 FUNDAMENTAL RULE: Legal power held by a fiduciary may not be
deployed in a way that is intended to treat a beneficiary of the duty unfairly.

- Throughout the 20th century, two themes since the enactment of SEC 1934:
o (1) Gradual Disappearance of Substantive Regulation
 No more par value for stock, no more required shareholder preemption rights, no
more right to continue an equity interest in the corporation or its successor in a
merger.
 These developments have rendered the corporate form more flexible.
o (2) Growing Importance of Fiduciary Duties
 Courts have gradually become more willing to insert themselves ex post into
disputes between shareholders and corporate managers.
 Ex: Duty based law of corporate disclosure – a controlling shareholder
making a cash tender offer for stock held by the minority shareholders
had a fiduciary duty to make full disclosure of all germane facts.
o Court has also tried to minimize conflict between its holdings
and federal law.

Virginia Kain  63
 CHAPTER SEVEN – NORMAL GOVERNANCE: THE DUTY OF CARE
(SHAREHOLDER’S RIGHT TO SUE)

FIDUCIARY DUTIES

- Fiduciary standards play a role in normal governance procedures:

o (1) DUTY OF OBEDIENCE: Doesn’t play a huge role in corporate governance.
o (2) DUTY OF LOYALTY: that corporate fiduciaries exercise their authority in a good
faith effort to advance corporate purposes. Bars corporate officers and directors from
competing with the corporation (w/o informed consent), misappropriating
property/information/or business opportunities, and especially from conducting business
unfairly.
o (3) DUTY OF CARE: Reaches every aspect of an officer’s or directors conduct –
requires these parties to act with the care of a reasonably prudent person in the same or
similar circumstances.
 Litigated much less than duty of loyalty, primarily because the law insulates
officers and directors from liability based on negligence.
 EXAM FACT PATTERN: Look for the possibility that:
 (1) Board made a bad decision
 (2) Board decided without the appropriate level of study and preparation
 (3) Board did not spend enough time and effort in supervising others

INTRODUCTION TO THE DUTY OF CARE

- Partners are agents, officers of a corporation are agents of the corporation, but directors
are not agents of the corporation.
o While directors are not agents, directors are fiduciaries. A fiduciary is someone who is
acting in the interest of someone else. For example, a trustee acts on behalf of a
beneficiary of the trust and owes a legal duty, i.e., a fiduciary duty, to the beneficiaries.
Similarly, directors act on behalf of the corporation, and so directors are fiduciaries and
owe a fiduciary duty to the corporation.
- PRIMARY SOURCES AFFECTING DIRECTOR OBLIGATIONS:
o (1) RELEVANT STATE STATUTE [corporation statute in state of incorporation]
 DELAWARE: ***Note that DGCL never creates a DUTY OF CARE, so in
Delaware, a director’s duty of care is based on case law, not statutory law.
 BUT: the Delaware statute does provide for the possible elimination of a
director’s duty of care in the corporation’s certificate of incorporation.
Under section 102(b)(7), added in 1986, a corporation’s certificate of
incorporation can provide that directors have no personal liability for
breach of duty of care. Such a provision is almost certain to be included
in the certificate of incorporation of corporations in the real world.
 Delaware also protects directors from liability for breach of duty of
care in section 141(e). Under section 141(e) of the Delaware General
Corporation Law, directors can escape liability for breach of duty of care
if their actions or inactions were based on reasonable reliance on the
information and advice of officers, employees, or outside experts.
o In the event that you have a law school exam question involving
(1) a Delaware corporation, (2) without a section 102(b)(7)

Virginia Kain  64
 provision in its certificate of incorporation, and (3) with facts
that suggest the board or a director was dumb or lazy, then look
for facts about reliance on officers or outside experts.

o (2) CORPORATION’S ARTICLES OF INCORPORATION

o (3) CASE LAW

THE DUTY OF CARE AND THE NEED TO MITIGATE DIRECTOR RISK AVERSION

HISTORICAL ROOTS

- The concept of the duty of care comes from an English Court of Chancery case in 1742 –
concerning the liability of directors who had not participated in the fraud, but whose inattention
had allowed it to occur. Established that a director has a duty of reasonable diligence.

GENERALLY

- AMERICAN LAW INSTITUTE – PRINCIPLES OF CORPORATE GOVERNANCE

o DUTY OF CARE - § 4.01(a)
 Corporate director or officer is required to perform his or her functions
 (1) in good faith
 (2) in a manner that she reasonably believes to be in the best interests of
the corporation and
 (3) with the care that an ordinary prudent person would reasonably be
expected to exercise in a similar position under similar circumstances.
 The core of the standard is the level of care that would be exercised by an
ordinarily prudent person.

THE NEED TO MITIGATE

- Duty of care is different than ordinary negligence because (1) corporate directors and officers
invest other people’s money; (2) they bear the full costs of any personal liability but (3) receive
only a small fraction of a gain from a risky decision.
o POLICY: Liability under a negligence standard would discourage officers and directors
from undertaking risky but valuable projects.

- Gagliardi v. TriFoods International Inc. (1996)

o R: An independent and disinterested corporate director is not liable for a corporate loss if
the director acted in good faith.
o Q: What must a shareholder plead in order to state a derivative claim to recover corporate
losses allegedly sustained by reason of mismanagement unaffected by directly conflicting
financial interests?
 Is an independent and disinterested corporate director liable for a corporate loss if
they acted in good faith?
o A: No. In the absence of facts showing self-dealing or improper motive, a corporate
officer or director is not legally responsible to the corporation for losses that may be
suffered as a result of a decision that an officer made or that directors authorized in good
faith.

Virginia Kain  65
  Exception being that some decisions are so egregious that liability for losses they
cause may follow even in the absence of proof of conflict of interest/improper
motivation.
 Shareholders can diversify the risks of their corporate investments; it is in their
economic interest for the corporation to accept in rank order all positive net
present value investment projects available to the corporation, starting with the
highest risk adjusted rate of return first.
 Shareholders should not rationally want directors to be risk adverse
 it is in the shareholders’ economic interest to offer sufficient
protection to directors from liability for negligence, etc, so that they are
free to act in good faith.
 RULE: In other words, if there is an allegation that a corporation has suffered a
loss that was (1) the result of a lawful transaction, (2) within the corporation’s
powers, and (3) authorized by a corporate fiduciary acting in a good faith pursuit
of corporate purposes, then that allegation does not state a claim for relief against
the fiduciary, regardless of how foolish the decision may appear in hindsight.

TECHNIQUES FOR LIMITING DIRECTOR AND OFFICE RISK EXPOSURE

STATUTORY: INDEMNIFICATION

- Statutory law authorizes corporations to indemnify the expenses (including sometimes

judgment costs) incurred by officers or directors who are sued by reason of their corporate
activities (DGCL § 145).
- Indemnification: Payment to an individual who has been held liable for the act of another and as
a result, suffered a loss without fault.
o Most corporate statutes prescribe mandatory indemnification rights for directors/officers
and allow a broad range of elective indemnification rights.
o These statutes generally allow corporations to commit to reimburse any
agent/employee/officer/director for reasonable expenses for losses of any sort (attorney’s
fees, investigation fees, settlement amounts, and in some instances judgments) arising
from threatened or actual judicial proceedings/investigations.
 The limits are that the losses must result from actions undertaken on behalf of the
corporation in good faith and that they cannot arise from a criminal
conviction. (DGCL 145 (a-c))

STATUTORY: DIRECTOR/OFFICER INSURANCE

- Statutory law authorizes corporations to purchase liability insurance for their directors and
officers, which may even cover some risks that are not subject to indemnification.
o Designed to insulate officers/directors from liability – corporations can pay the premium
on director and officer liability insurance (DGCL 145) – these group policies, financed by
the corporation, place the finances of the company behind the promise to make directors
whole when they act in good faith.
 Policy: Why purchase insurance instead of raising salaries?  (1) D&O
insurance might be cheaper if corporation is central bargaining agent; (2)
uniformity has value in that it standardizes directors’ individual risk profiles; (3)
tax law may favor firm wide insurance coverage – D&O insurance is deductible
expense for corporations; (4) directors might get D&O on their own anyways
and under invest in it.

Virginia Kain  66
 JUDICIAL PROTECTION: THE BUSINESS JUDGMENT RULE

- Courts have evolved the protection of the business judgment rule; legislatures have followed
suit and specifically authorized companies to waive director/officer liability for acts of
negligence/gross negligence.
o BUSINESS JUDGMENT RULE (ALI § 4.01(C)):
 A presumption that the duty of care has been satisfied; burden shifts on to the
plaintiff to show why it shouldn’t apply. Courts are very reluctant to second
guess decisions by independent/disinterested officer.
 A director or officer who makes a business judgment in good faith
fulfills the duty under this section if the director or officer:
o (1) is not interested in the subject of the business judgment
o (2) is informed with respect to the subject of the business
judgment that the director or officer reasonably believe is
appropriate under the circumstances, and
o (3) rationally believes that the business judgment is in in the best
interests of the corporation
- The business judgment rule is a presumption that, in making a business decision, the directors of
a corporation acted on an informed basis, in good faith and honest belief that the action taken
was in the best interests of the company. (Aronson)
o CORE IDEA: Courts should not second guess good faith decisions made by independent
and disinterested directors – courts will not decide whether the decisions are either
substantially reasonable by the reasonably prudent person test, or sufficiently well
informed by the same test.

- Kamin v. American Express Co. (1976) – Codifies the BJR

o R: Courts will not interfere with a business decision made by directors/officers unless
there is bad faith, fraud, self-dealing etc.
o F: In 1972, Amex acquired 2 million shares of DLJ common stock for $29.9 million
dollars; by $1976 the stake was worth approximately $4 million.
 What to do with the bad investment?
 (1) Distribute the stock to the shareholders as a special dividend (taxable
event for shareholder) OR (2) liquidate the stock at the corporate level
and get a corporate tax deduction (advantage at corporate level).
 Amex decides to distribute to the shareholders as a special dividend 
some shareholders are unhappy; sue to enjoin the distribution, or for
monetary damages, claiming a waste of corporate assets. Claim that other
strategy would have produced tax savings of $8 million.
 Board did consider that possibility, but they rejected it due to negative impact on
accounting profits and move for summary judgment.
o Q: Can a stockholder maintain a claim against the directors of a corporation if the
stockholder alleges only that a particular course of action would have been more
advantageous than the course of action the directors took?
o A: No. Courts will not interfere with a business decision made by directors of a business
unless there is a claim of fraud, bad faith, or self-dealing  only a hint of self-dealing; 4
of the 20 directors were officers/employees of Amex and members of its Executive
Incentive Compensation Plan. Executive compensation is often tied to share prices 
could increase any stock-based compensation (but court doesn’t really care about this).
 An error of judgment by directors, as long as the business decision was made in
good faith, is not sufficient to maintain a claim against them. In the present case,
the plaintiffs do not allege any bad faith on the part of the directors. The only

Virginia Kain  67
 wrongdoing that the plaintiffs claim is that the directors should have done
something differently with the DLJ stock. This allegation without more is not
sufficient to maintain a claim. Consequently, the directors’ motion to dismiss is
granted.
 Afforded a lot of deference.
 A complaint must be dismissed if all that is presented is a decision to pay
dividends rather than pursuing some other course of conduct… Courts have more
than enough to do; this should have been dealt with in the BOARD ROOM, not
the COURT ROOM.

UNDERSTANDING THE BUSINESS JUDGMENT RULE

- A director or officer has a duty to the corporation to perform the director or officer’s function (1)
in good faith (2) in a manner that he reasonably believes to be in the best interests of the
corporation and (3) with the care that a reasonably prudent person would exercise in a like
position under similar circumstances.
o What options does a shareholder have when the director makes a bad business decision?
What barriers might you face?  Business judgment rule is the main hurdle; the business
judgment rule is that the courts won’t second guess business decisions that were made in
good faith by a director.
o Business judgment rule is a presumption that directors and officers acted on an informed
basis, in good faith, and in the honest belief that the action taken was in the best interest
of the company. The burden is on the plaintiff to rebut the presumption by showing
one or more of the following:
1. Conflict of interest
2. Lack of good faith (fraud/illegal/conscious disregard of duties)
3. Absence of rational business purpose for the action (waste)
4. Failure to become informed in decision making (gross negligence)
5. Failure to oversee the corporation’s activities (inattention)
a. BJR doesn’t protect directors who are asleep at the wheel.
ii. Practical implication of BJR is that clear mistakes of judgment RARELY result
in personal liability for corporate directors.
- Rule from Gagliardi  Where a director is independent and disinterested, there can be no
liability for corporate loss, unless the facts are such that no person could possibly authorize such a
transaction if he or she were attempting in good faith to meet their duty.
- The business judgment rule provides protection for directors from lawsuits that might seek to
challenge the business judgment of those directors. The idea underlying the BJR is to give
directors wide latitude in taking steps to benefit a corporation. In addition, because many strategic
business decisions are judgment calls, the BJR allows directors to use their best judgment,
without fear that a court will attempt to second guess their decision.
- The basic rule is that the protections afforded under the BJR apply unless a plaintiff can show:
o Fraud
o Illegality/wrongful conduct
o Bad faith (duty of loyalty analysis applies)
 “Subjective bad faith” – conduct motivated by an actual intent to do harm
 Intentional dereliction of duty, a conscious disregard for one’s responsibilities
(Disney)
 Acts with a purpose other than that of advancing the best interests of the
corporation.
 Egregious/Irrational decision (a decision with literally no business justification)

Virginia Kain  68
  Waste (a transaction that lacks any business rationale to support it or one that is
so one sided that no business person of ordinary, sound judgment could conclude
that the corporation has received adequate consideration – Zapata)
 Uninformed decision (incl. lack of investigation)
 No decision (no action taken by the board, but plaintiff alleges that some action
should have been taken).
o In instances where there is a conflict of interest, or bad faith, the BJR does not
apply.
 Note that the existence of a conflict of interest does not mean that the duty of
care has been violated. It just means that the decision involving the conflict is not
protected by the BJR unless the conflict was cleansed. In instances involving a
conflict of interest or bad faith, a plaintiff would need to show a breach of
fiduciary duty by showing that there was a violation of the duty of loyalty.

- PROCEDURAL REQUIREMENTS OF THE BJR

o BJR protects directors when they make an informed decision. There is no BJR protection
when a Board does not act to make a decision, or when it makes an uninformed decision.
 In order to prevail in such a challenge, a plaintiff must show that the Board was
grossly negligent in failing to inform itself of all material information reasonably
available to it, and that the decision itself was grossly negligent.
o Directors are allowed to be wrong or make mistakes and still have the protection of the
BJR!
o In order to avoid liability for violating the duty of care on procedural grounds,
directors should:
 Keep informed about and properly oversee the corporation’s activities and
policies
 Be adequately informed about the corporation, its business, its interests, and the
relevant issues before making decisions
 Possess a minimum level of skill and expertise with regard to the role of director
for the specific business; and
 Be aware of the financial status of the corporation (e.g. regularly review the
corporation’s financial statements).
- SUBSTANTIVE REQUIREMENTS OF THE BJR
o Where the board has complied with the procedural requirements, in order to avoid the
BJR, a plaintiff must show that there has been a substantive violation.
o If the BJR does NOT apply, whether because of a procedural defect or a substantive
violation, in order for a plaintiff to successfully argue that a fiduciary duty was violated,
that plaintiff often must still show a violation of the underlying duty of care.
o In instances where there is illegality, an egregious decision, an uninformed decision,
waste, or no decision, it is possible to lose the protection of the BJR but not have acted
negligently.
 Court must ask: “Even though this situation does not warrant the protections
provided by the BJR, did the defendant violate the applicable duty of care?”
 Ex: If the Board of Directors of an overnight delivery service instructs its
drivers to get parking tickets because it is more important to get packages
delivered on time, that is “illegality.” The Board is saying “Break the law
(park illegally) in order to help our business.” This decision is, therefore,
not protected by the BJR. The decision may also subject the company to
fines and perhaps other penalties under the vehicle code. However, it
might not necessarily be a violation of the duty of care. A court would
need to determine whether that decision was a negligent business

Virginia Kain  69
 decision. One could argue that it might be a good business decision,
albeit a violation of other rules.
- WHY IS BJR NECESSARY AT ALL?
o (1) Procedural: When courts invoke the BJR, they are essentially converting what would
otherwise be a question of fact (whether financially disinterested directors who
authorized the money-losing transaction exercised the same care as would a reasonable
person in similar circumstances) into a question of law for the court to decide – which
takes it out of the realm of the jury. The BJR insulates disinterested directors from jury
trials, which encourages the dismissal of some claims before trial and allows judicial
resolution of the remaining case-based claims that do go to trial.
o (2) Substantive: Converting the question “was the standard of care breached” into
related, but different questions of whether the directors were truly disinterested and
independent and whether their actions were not so extreme, unconsidered, or inexplicable
as not to be an exercise of good faith judgment.
o (3) Policy: Directors who risk liability for unreasonable decisions, or even for failing to
become adequately informed or engaging in appropriate deliberation before acting – are
likely to behave in a risk averse manner that harms shareholders.
o (4) BJR vs. Duty of Care: There is a social value to announcing a standard (“you must
act like a reasonable person would act”) that is not enforced with a liability rule. When
most corporate lawyers charge directors with their legal duty of care, most board
members will act in accordance because of their personal liability, nonlegal sanctions like
personal reputation, or just a simple motivation to do the right thing.

THE DUTY OF CARE IN TAKEOVER CASES

 Smith v. Van Gorkom (1985)

o R: There is a rebuttable presumption that a business determination made by a
corporation’s board of directors is fully informed and made in good faith and in the best
interests of the corporation.
o F:
 Trans Union Corp. is a publicly held company with unused net operating losses,
and a CEO looking to retire. Stock was selling at $35 per share.
 NOLs can be used to reduce taxes, but you have to have profits to be able to do
that. If it were to combine with another business, the NOLs would be a good
asset for that other business.
 Acting mainly on his own, Van Gorkom (CEO) arranges a sale to Jay Pritzker’s
company for $55/share. CEO calls a special meeting of the board but does not
give them an agenda beforehand; board approves the merger after a 2-hour
meeting. Approve sale; directors had no documents summarizing the merger or
any info as to why it was $55/share.
 Trans Union shareholder sues, claiming breach of the duty of care. No allegation
of conflict of interest, but claim that the board did not act in an informed matter
in agreeing to the deal.
o PH: Chancery court approves the transaction, finding that the board approval fell within
the BJR; Delaware SC reverses, finding that the directors had been grossly negligent.
o Notes: The holding in Van Gorkom precipitated a statutory response (enactment of
DGCL § 102(b)(7); insurance premiums raise)
 How would you compare the decision-making process in Amex vs in this case?
 This was an insanely fast decision; not enough diligence done.
 Van Gorkom also was clearly going to benefit from the transaction.
 First Delaware case to actually hold disinterested directors who made a business
decision personally liable for breach of the duty of care.

Virginia Kain  70
  This case ultimately settles, and the fair value for the share is actually a little
higher based on the liability that was imposed on the CEO.
 Context is that these are “cash-out mergers”  end of life transaction for the
company in the sense that the investment of the shareholders would shift from
holding stock to actual money.

ADDITIONAL STATUTORY PROTECTION: AUTHORIZATION FOR CHARACTER

PROVISIONS WAIVING LIABILITY FOR DUE CARE VIOLATIONS

- FRAMEWORK FOR LIMITING DIRECTOR/OFFICER LIABILITY (DGCL § 145)

(1) WAIVER OF LIABILITY (DGCL (102)(B)(7)): 90% of Delaware companies eliminate
director liability for duty of care violations.
o Cannot eliminate/limit director liability for any breach of the director’s duty of loyalty or
for acts or omissions not in good faith or which involve intentional misconduct or a
knowing violation of the law.
(2) BUSINESS JUDGMENT RULE: presumes the duty of care was met.
o Delaware’s default standard of review is the BJR, a principle of non-review that reflects
and promotes the role of the BOD as the proper body to manage the business and affairs
of the corporation.
o The rule presumes that in making a business decision the directors of a corporation acted
on an informed basis, in good faith, and in the honest belief that the action taken was in
the best interests of the company
o Unless one of its elements is rebutted, the court looks to see whether the decision was
rational in the sense of being one logical approach to advancing the corporation’s
objectives.
o Only when a decision lacks any rationally conceivable basis will a court infer bad faith
and a breach of duty.
o Plaintiffs can rebut the BJR presumption by showing a failure to oversee the
corporation’s activities, inattention, failure to exercise business judgment, lack of good
faith, conflict of interest, absence of rational business purpose for an action, failure to
become informed in decision making.
(3) INDEMNIFICATION: corporations may indemnify D&Os for D&O actions taken in good
faith (DGCL § 145(a)). If the director defends themselves successfully, on the merits or
otherwise, then indemnification of the expenses is mandatory. § 145(g).
(4) D & O INSURANCE: Corporations may buy director and officer insurance, whether or not
the corporation would have the power to indemnify such person against such liability. DGCL
§145(g).

- DGCL § 102(b)(7): Purpose: threat of personal liability doesn’t dissuade them from taking risky
business decisions.
o The certificate of incorporation may contain:
o (7) A provision eliminating or limiting the personal liability of a director to the
corporation or its stockholders for monetary damages for breach of fiduciary duty as a
director, provided that such provision shall not eliminate or limit the liability of a
director:
 (i) For any breach of the director’s duty of loyalty to the corporation or its
stockholders;
 (ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law;
 (iii) under § 174 of this title; or
 (iv) for any transaction from which the director derived an improper personal
benefit.

Virginia Kain  71
 o No such provision shall eliminate or limit the liability of a director for any act or
omission occurring prior to the date when such provision becomes effective.
o All references in this paragraph to a director shall also be deemed to refer to such other
person or persons, if any, who, pursuant to a provision of the certificate of incorporation
in accordance with § 141(a) of this title, exercise or perform any of the powers or duties
otherwise conferred or imposed upon the board of directors by this title.

THE BOARD’S DUTY TO MONITOR: LOSSES “CAUSED” BY BOARD PASSIVITY

- What is the scope of director liability for losses that arise not from business decisions but rather
from causes that the board might arguably have deflected but did not? The BJR protects
decisions, and most BJR cases arise out of situations in which directors just simply failed to do
anything.
o Plaintiffs can rebut the BJR presumption by showing a failure to oversee the
corporation’s activities (inattention, failure to exercise business judgment).
- All directors must satisfy the same legal standard of care, but the determination of liability is a
director-by-director analysis – i.e. a court might conclude that a reasonable engineer or
investment banker serving on a board should have acted in certain circumstances while a
reasonable person without that training and experience might not have known to do so.

- Francis v. United Jersey Bank (1981) – Duty to stay informed [general monitoring – note that
this is the majority view: there is a general continuing obligation of directors to stay informed
about the activities/policies of a corp.]
o R: A director has a duty to know generally the business affairs of the corporation.
o F: Pritchard & Baird is a closely held reinsurance firm with 4 directors (Charles Sr.,
founder; Mrs. Pritchard, and their two sons). Charles Sr. starts the practice of co-mingling
accounts and making “shareholder loans” which he pays back. After he dies, Charles Jr.
and William run the business, continue the practice of “shareholder loans”, but they don’t
pay the money back. Firm goes bankrupt; trustees in bankruptcy bring suit against Mrs.
Pritchard, and eventually her estate, for negligence in the conduct of her duties as a
director of the corporation. Mrs. Pritchard was warned by Charles Sr. that her kids were
trash humans and would steal from the company, but she had literally nothing to do with
the company.
 Primary insurer writes the policy to the insured, then gets reinsurer to take on
some portion of the risk, e.g. primary insurer takes the first $X in liability, then
the reinsurer takes the rest.
 Reinsurance brokers like P&B move premium payments and loss payments from
primary insurers to reinsurers and back.
o Q: Can a director be held liable for failure to monitor the business affairs of the
corporation?
o A: Yes. A director has a duty to know generally the business affairs of the corporation.
This duty includes a basic understanding of what the company does; being informed on
how the company is performing; monitoring corporate affairs and policies; attending
board meetings regularly; and making inquiries into questionable matters. In the case at
bar, Mrs. Pritchard did none of the above. She did not seem to know what a reinsurance
agency does; she never received or read financial statements; and she generally knew
nothing of the corporation’s business affairs. Her failure to keep herself informed
breached not only a duty of care to the corporation, but a fiduciary duty to Pritchard &
Baird’s clients. It would have only taken a brief, non-expert reading of the financial
statements to know that something was wrong and money was being misappropriated.
Her failure to do so was the proximate cause of the misappropriations of the clients’
money not being discovered. The fact that her husband had warned her about the sons,

Virginia Kain  72
 but she still made no effort to monitor them is even more evidence that she violated her
fiduciary duties. Consequently, the estate of Mrs. Pritchard is liable to the clients and the
judgment in favor of the trustee in bankruptcy is affirmed.
 How involved are directors supposed to be?  Directors are under a continuing
obligation to keep informed about the activities of the corporation…. Directorial
management does not require a detailed inspection of daily activities, but rather a
general monitoring of corporate affairs and policies. Accordingly, a director is
well advised to attend board meetings regularly; director just can’t tune out what
is happening in the corporation.
 She should have reviewed the financial statements or at least gotten
someone from an outside party to do so especially since she had been
warned by her husband.
 Analysis of negligent omissions calls for determination of the reasonable steps a
director should have taken and whether that course of action would have averted
that loss; also, sons knew she wasn’t paying attention.
 Expectation has been the subject of changing DE law.
 What is it that directors must generally do to prevent the “spawning of fraud in
the backwater of their neglect”?
 Court thought the director should attend meetings and have some
familiarity with the business; doesn’t need to be daily involvement, but a
general monitoring of corporate affairs.

- Graham v. Allis-Chambers Manufacturing Co. (1963) – Red Flag Doctrine

o R: Under DE law, corporate directors and officers will not be held liable for losses
resulting from their failure to supervise and manage the business so long as they
reasonably relied on subordinates.
o F: Allis Chalmers is a very large, decentralized public corporation that makes
electrical equipment. In 1937, entered into a consent decree with the federal trade
commission to stop fixing prices on condensers and turbine generators. Some employees
of the business back in 1930s were involved in price fixing. More than 10 years later (late
1950s) this company/4 mid-level managers get in trouble for price fixing – pleads guilty
to price fixing charges, pay big fines out of the owner’s equity. Since defendant directors
had no knowledge of anti-trust violations, the theory is that they breached their duty of
care.
o PH: Shareholders bring derivative suit against directors and top officers to recover on
behalf of the corporation. Argue that the directors were put on notice of the price fixing
by some decrees several years prior and that they failed to put a system in place to
monitor the situation.
o A: Directors are entitled to rely on the honesty and integrity of their subordinates until
something occurs to put them on suspicion that something is wrong (red flag doctrine).
If such an occasion happens, and goes unchecked, then the liability of the directors might
follow, but absent a cause for suspicion, there is no duty upon the directors to install and
operate a corporate system of espionage to find wrongdoing which they have no reason to
suspect exists.
 RED FLAG DOCTRINE/GRAHAM STANDARD: Imposes duty of inquiry
only when there are obvious signs of employee wrongdoing. A director is entitled
to trust subordinates, assume no law violations, until there is a clear cut, red flag
warning. Once there is a red flag, the director should no longer rely on
subordinates and there is a duty to actively monitor for misconduct.

- In re Caremark International Inc. Derivative Litigation (1996)

o A new articulation of what DE expects from directors.

Virginia Kain  73
o R: Corporate directors must implement monitoring system to eliminate illegal acts of
employees. Corporate directors have a duty to make good faith efforts to institute a
corporate monitoring system they believe will alert them of material events, but are not
liable if the system fails to detect wrongdoing.
o F: Caremark is a publicly traded healthcare provider. Subject to complex anti-referral
payments law. Caremark had always had an ethics guidebook, an internal audit plan, and
an ethics hotline. Auditor gave control system a clean bill of health. Despite the
safeguards, lower level officers engaged in enough misconduct to cost the company $250
million. When a corporation charged with health care bribery is forced to pay $250
million and promise better management in a settlement with government agencies, angry
shareholders request the court reject the settlement and permit them to sue the directors
for negligently permitting bribery.
o PH: Shareholders file derivative suit seeking recovery from the board of directors,
claiming breach of the duty of care.
o A: Red flags are not the only thing that can trigger liability; there should be a monitoring
system. The directors of a corporation have a duty to act in good faith and make sure that
an internal information and reporting system exist. However, there is a very low
probability that the BOD at Caremark breached any duty to appropriately monitor and
supervise the enterprise. Has to be a system to report up the chain, so that the directors
have a chance to monitor the health of the corporation. [Exact Caremark Standard pg.
271]
 This case sets a sort of “business judgement rule” for corporate monitoring:
directors are responsible for instituting a reasonable corporate monitoring system,
but are not held personally liable each time the reasonable system fails to detect
wrongdoing. Here, the decision to foreclose shareholder suits seems fair in light
of evidence the directors made honest and reasonable efforts to avoid liability.
Bear in mind many of the practices seem to have predated the directors’ (D)
appointment, so that even if they could have immediately stopped all of the
suspect payments, the company would still remain liable for past payments that
had already occurred before the directors’ (D) tenure. Here, it would have been
especially unfair to impose liability because there was apparently real legal
uncertainty—among Caremark directors (D), employees, and even their
lawyers—as to whether some types of payments, such as research grants, were
actually prohibited as “kickbacks” (though it is admitted that at least some of the
payments were intentional bribes)
o ELEMENTS OF CAREMARK:
 Under Caremark and its progeny, a director “must make a good faith effort to
oversee the company’s operations.” Failing to make that effort “breaches the duty
of loyalty and can expose a director to liability.” For a plaintiff to prevail on
a Caremark claim, the plaintiff must show that a fiduciary acted in bad faith. Bad
faith is established when “the directors completely fail to implement any
reporting information system or controls,” or having implemented such controls
failing to monitor or oversee.
 In short, to satisfy their duty of loyalty, “directors must make a good faith effort
to implement an oversight system and then monitor it.” Caremark’s “bottom-line
requirement is that the “board must make a good faith effort – i.e., try – to put in
place a reasonable board-level system of monitoring and reporting.” Under these
principles, a court’s inquiry in a Caremark liability case is not to examine the
effectiveness of a board-level monitoring system, but rather to determine with the
complaint “pleads facts supporting a reasonable inference that the board did not
undertake good faith efforts to put a board level system of monitoring and
reporting in place.”

Virginia Kain  74
  Note that Caremark is a really tough standard for plaintiffs to meet.
 But see: Blue Bell Ice Cream Case [listeria in ice cream – Del. SC
reversed the Chancery Ct.’s dismissal of a Caremark liability case and
allowed the case to proceed against the board.]
o “In short, to satisfy their duty of loyalty, “directors must make a
good faith effort to implement an oversight system and then
monitor it.” Caremark’s “bottom-line requirement is that the
“board must make a good faith effort – i.e., try – to put in place a
reasonable board-level system of monitoring and
reporting.” Under these principles, a court’s inquiry in
a Caremark liability case is not to examine the effectiveness of a
board-level monitoring system, but rather to determine with the
complaint “pleads facts supporting a reasonable inference that
the board did not undertake good faith efforts to put a board level
system of monitoring and reporting in place.”

- SARBANES-OXLEY ACT OF 2002: Mandatory disclosure of weaknesses/firm’s internal

control for financial reporting.

- Stone v. Ritter (2006) – Clarified Caremark

o F: AmSouth shareholders brought suit against directors for failing to detect a scheme
among certain employees which led to a $40 million fine against the company.
o H: Absent any red flags, in order for directors to be held liable for lack of oversight of
officers and employees, there must be a finding that directors either (1) utterly failed to
implement any reporting or information system or controls” or (2) having implemented
such system or controls, consciously failed to monitor or oversee its operations thus
disabling themselves from being informed of risks or problems requiring their attention.
Have to pay attention to what information the system is reporting.

- In re Citigroup Inc. Shareholder Derivative Litigation (2009) – Ds get BJR for risky business
decisions even if obligated to have monitoring systems. Caremark obligations not triggered.
o R: Under the business-judgment rule, corporate directors will not be held personally
liable for failure to manage the company's business risk unless their conduct rose to the
level of gross negligence.
o F: Citigroup is deep into so-called “toxic assets” which leads to massive losses by late
2007. Plaintiffs allege that the board should be liable under Caremark for failing to:
“make a good faith attempt to follow the procedures put in place for failing to assure that
adequate and proper corporate information and reporting systems existed that would
enable them to be fully informed regarding Citigroup’s risk to the subprime mortgage
market”. Plaintiffs argue that public reports on deterioration of subprime mortgage
market should have served as red flags. Citigroup has a 102(b)(7) waiver in its charter.
o Q: May corporate directors be held personally liable for failure to manage the company’s
business risk if their conduct does not rise to the level of gross negligence?
o A: No. The business-judgment rule prohibits judicial second-guessing of corporate
business decisions. This is not the kind of oversight issue that Caremark goes to.
 Makes a distinction on page 276  the Caremark system goes to employee
misconduct/illegal activity, not oversight of business decisions that didn’t
turn out well.
 While it may be tempting to say that directors have the same duties to
monitor and oversee business risk, imposing Caremark type duties on
directors to monitor business risk is fundamentally different. Citigroup
was in the business of taking on and managing investment/business risks.

Virginia Kain  75
 Oversight duties under DE law are not designed to subject directors to
personal liability for failure to predict the future and to properly evaluate
business risk.
 Policy: To impose oversight liability on directors for failing to monitor
“excessive” risk (when their business was literally to take on and manage risks
and investments) would involve courts in conducting hindsight evaluations of
decisions at the heart of the business judgment of directors.

- Marchand v. Barnhill, No. 533 (2019)

o F: In 2015, Bluebell Creameries, one of the country’s largest ice cream manufacturers,
distributed ice cream tainted with listeria. The contaminated food killed three people, and
the company had to recall its products, suspend its operations and lay off employees.
Stockholders also suffered losses because, after the shutdown, Blue Bell suffered a
liquidity crisis that forced it to accept a dilutive private equity investment. Plaintiffs then
sued to recoup investment losses.
o PH: Caremark claim, accusing directors of failing to exert appropriate oversight to
prevent the outbreak and the resulting issues. Court of Chancery dismissed the lawsuit,
ruling that BB’s existing compliance programs satisfied the Caremark standard. Plaintiffs
appealed.
o A: Supreme Court reverses. While BB had certain safety programs in place and
“nominally complied with FDA regulations”, it had no board committee overseeing food
safety, no full board level process to address food safety issues, and no protocol by which
the board was expected to be advised of food safety reports/developments.
 The lack of any board level effort of monitoring the company’s risk management
supported an inference that the directors had breached their oversight obligations.
 To satisfy their duty of loyalty, the court held that directors must make a good
faith effort to implement an oversight system and then monitor it themselves.
Without more, the existence of management-level compliance programs is not
enough for the directors to avoid Caremark exposure.
 If Caremark means anything, it is that a corporate board must make a good
faith effort to exercise its duty of care. A failure to make that effort
constitutes a breach of the duty of loyalty.
- The duty of loyalty requires a corporate director, officer, or controlling shareholder to exercise
her institutional power over corporate processes or property in a good faith effort to advance the
interests of the company. Corporate officers, directors and controlling shareholders may not deal
with the corporation in any way that benefits themselves at its expense.
o Must disclose all material facts regarding conflicts of interest.
o Must deal with the company on terms that are intrinsically fair in all respects.

Virginia Kain  76
 CHAPTER EIGHT – THE DUTY OF LOYALTY: CONFLICT TRANSACTIONS

- The duty of loyalty requires a corporate director, officer, or controlling shareholder to exercise
her institutional power over corporate processes or property in a good faith effort to advance the
interests of the company.
- Corporate officers, directors and controlling shareholders may not deal with the corporation in
any way that benefits themselves at its expense.
o Must disclose all material facts regarding conflicts of interest
o Must deal with the company on terms that are intrinsically fair in all respects
- No 102(b)(7) waiver is available for this duty.
- Ex. A director of a US corporation comes to you and asks you what it means to be loyal to the
corporation. How do you advise?
o Must act in a good faith effort to advance the interest of the company; cannot benefit at
the expense of the corporation, have to expose any conflicts of interest you might have,
have to deal with corporations on terms that are intrinsically fair in all respects. In sum:
(1) exercise good faith effort (2) to advance the interests of the company.

DUTY TO WHOM?

THE SHAREHOLDER PRIMACY NORM

- The corporation has numerous stakeholders: shareholders, creditors, employees, suppliers,

customers.
o Shareholder primacy norm in US corporate law  this generally refers to
monetary/pecuniary interests

- Dodge v. Ford Motor Co. (Mich. 1919) – origin of shareholder primacy norm; note that this
isn’t as big of a deal these days because of constituency statutes.
o F: The Dodge brothers (plaintiffs), who owned their own motor company, were minority
shareholders in Ford, and sued to reinstate the special dividends and stop the building of
Ford’s proposed smelting plant. The lower court ordered the payment of a special
dividend and enjoined Ford from building the smelting plant. Ford appealed.
o Q: Can a company choose to stop paying dividends and instead invest its profits in the
communities in which it is active?
o R: A company cannot take actions that harm its shareholders and are motivated solely by
humanitarian concerns, not by business concerns. It is not within the lawful powers of a
board of directors to shape and conduct the affairs of a corporation for the merely
incidental benefit of shareholders and for the primary purpose of benefiting others.
o A: No. A business exists to conduct business on behalf of its shareholders. It is not a
charity to be run for its employees, or neighbors.
 In this case, Ford was even more profitable in 1916 than it was in 1915, when it
paid over $10 million in dividends. However, in 1916, Ford paid only its
$120,000 dividend.
 While a corporation may choose to invest in future ventures, and may choose to
maintain cash on hand to plan for future shortfalls, Ford had done that in prior
years and still managed to pay special dividends.
 These actions, combined with Henry Ford’s statements about putting profits into
the business to provide for the workers, suggest that the decree against new
special dividends was not motivated by any business concern.

Virginia Kain  77
  By taking an action with no business concerns motivating it, Henry Ford and the
Ford directors who supported his decision were acting arbitrarily, to the direct
detriment of the shareholders in whose interest they were supposed to be acting.
o H: The portion of the lower court opinion enjoining Ford from investing in the smelting
plant is reversed, but the portion ordering Ford to pay out a multi-million-dollar special
dividend is sustained.
 It is not within the lawful powers of a board of directors to shape and conduct the
affairs of a corporation for the merely incidental benefit of shareholders and for
the primary purpose of benefitting others.
 We don’t see this type of business litigation today because no business
leader would make this argument today  so how might you frame your
actions or decisions today, in Delaware?  Shareholder primacy norm,
so any action, whether to benefit charity, community, etc., can be framed
in terms of shareholder value.

CONSTITUENCY STATUTES

- In response to 1980s transactions, managerial advocates turned to the rationale that directors owe
loyalty to something other than the shareholders alone: the corporation should be viewed as a
combination of all its stakeholders – creditors, managers, workers, suppliers, customers.
- State legislatures attempted to rescue directors – directors have the power but not the
obligation to balance the interests of shareholders in setting corporate policy.
o Delaware doesn’t have a statute like this.
o PENNSYLVANIA “OTHER CONSTITUENCY STATUTE”: PCBL § 1715(A):
 General rule: In discharging the duties of their respective positions, the board of
directors, committees of the board, and individual directors of a business corporation
may, in considering the best interests of the corporation, consider to the extent they deem
appropriate:
 (1) The effects of any action upon any and all groups affected by such action,
including shareholders, employees, suppliers, customers and creditors of the
corporation and upon communities in which offices or other establishments of
the corporation are located.
 (2) The short-term and long-term interests of the corporation, including benefits
that may accrue to the corporation from its long-term plans and the possibility
that these interests may be best served by the continued independence of the
corporation.
 (3) The resources, intent and conduct (past, stated and potential) of any person
seeking to acquire control of the corporation.
 (4) All other pertinent factors.

- Case study: Timberland (p. 287):

o CEO gave $3k to every employee that bought a hybrid; nobody said anything because the
company was doing well.
o How can corporate directors ever justify giving away the corporation’s profits to worthy
causes if their principal duty is owed to shareholders?
 When faced with defendant directors who, unlike Henry Ford, justified their
actions by reference to long-term corporate benefits, courts have deferred to
director action.

BENEFIT CORPORATIONS

- A traditional for-profit corporation's purpose is to make profits for shareholders. This means that
corporate managers are judged based on the company's financial performance. They may face

Virginia Kain  78
 shareholder action if they make decisions that sacrifice profits to achieve nonmonetary goals. A
benefit corporation still has a profit-making goal, but it also has a broader public benefit
purpose: to make a material positive impact on society and the environment. Managers must work
to achieve this purpose and therefore they have flexibility to make decisions that balance profits
with social causes and environmental responsibility.
o A benefit corporation is best suited to a company that has an important social or
environmental mission, but also wants to generate profits.

- RISE OF BENEFIT CORPORATIONS

o Since 2010, 32 states have passed legislation authorizing the formation of so-called
“benefit corporations”.
 These statutes contemplate the inclusion in the corporation’s charter of one or
more specific social purposes along with the profit-making purpose.
 A fiduciary obligation arises – from directors to the corporation and its
shareholders to pursue that purpose in addition to shareholder long term
gain. This gives directors and officers explicit legal protection to pursue
the stated social mission and to consider additional stakeholders as well
as equity investors.
o Reporting requirements: directors are generally required at
least every two years to report to shareholders on their non-
market-based actions.
o Directors of a B corp. do not need to worry about investors’
opposition to their social purpose, because that work is
defined in the charter.
 Benefits corporations are less vulnerable to hostile
takeovers since two thirds of all shares must accept the
hostile offer, not just the majority as under the general
provisions of the DGCL.
o In Feb 2017, Laureate Education became the first benefit corporation to go public.
o As of 2019, over 5000 companies have been formed as or converted to benefit
corporations, including Kickstarter, Patagonia, and Method.
- “B-CORP CERTIFICATION”
o The “B-Corp” Certification by B Lab Certification involves completing an assessment
that evaluates the company's overall impact on its stakeholders. The assessment is then
reviewed by B Lab staff members, who may require supporting documentation. Some
companies must amend corporate formation documents or bylaws to include a general
benefit purpose.
 B Corp is to business what Fair Trade Certification is to coffee or what USDA
Organic certification is to milk.

- POLICY: Pros and Cons of Benefit Corporations

o Pros:
 Way that companies can tell their constituents that they care about more than just
shareholders
 You might have an edge when it comes to hiring talent. The Harvard Business
Reviewfound that millennials, who make up a large part of the global workforce,
want to work for businesses that connect to a larger purpose. Often, talented
people who feel strongly about a cause will be attracted to job positions with
companies that have the same focus. Anybody can work for a paycheck, but if
your potential employees feel as if they’re working for a greater good, then you
could have an easier sell.

Virginia Kain  79
  Gives directors more protection to stick with the mission of furthering public
benefit
 More flexibility in the law – could give company precedential value, legal
entrepreneur
 Certification and reporting requirements help business managers assess progress
and set new goals.
 Being a benefit corporation helps a corporation stand out from the crowd by
demonstrating their commitment to employees/community/environment.
 Many investors are attracted to the social and environmental impacts of B Corps.
This type of business “speaks” to a very specific pool of investors who are eager
to put their money toward a business that not only makes a profit, but actually
has an impact on the world. That’s an incredibly attractive selling point when
discussing investment potential.
 You have to meet a standard to qualify as a B Corp. If your company possesses
the coveted B Corp certification, then that tells consumers that your company
meets exceptional standards when it comes to social and environmental
performance.
oCons:
 B Corps are new to the business world. There is a level of uncertainty that exists
that only time will tell of its challenges and how businesses owners will navigate
potential problems in the future.
 There aren’t any corporate tax breaks (unless you have tax-exempt status). This
could be considered a bad thing based on the goals you have for your business.
 Accountability that comes with a B Corp can be a double-edged sword. You have
to be sure that your business remains at the standards set forth in the certification
or else you’ll run the risk of losing it.
 Reporting requirements can be expensive
 Not a lot of precedent – regular corporations sit on decades of case law
- HYPOS
o A director of a US corporation comes to you and asks what it means for her
to be loyal to the corporation; how would you advise if the corporation at
issue is a benefit corporation under DE law?
 Statutorily required balancing of shareholder interests and the benefit that
they have delineated in their own charter.
o How would you advise a startup about the costs and benefits of doing
business as a benefit corporation?
 Social benefits in terms of marketing/reputation – a corporation that
actively works to advance social welfare of the community. Benefit
corporation is a new legal form, which investors may be nervous about.
Almost no caselaw involving benefit corporations; hard for them to know
what to expect. Cost associated with the report that they have to make.
 Also note that B Corp certification is different than being
incorporated as a B corporation.
o Example: Summer – wants to get rid of student loans, and
just raised $10M to do it; they have chosen to incorporate
as a B corp; want to be a trusted advisor to student loan
borrower.

Virginia Kain  80
DELAWARE BENEFIT CORPORATIONS
§ 361 Law applicable to public benefit corporations, how formed
§ 362 Public benefit corporation defined; contents of certificate of incorporation.
A “public benefit corporation” is a for-profit corporation organized under and subject to the
requirements of this chapter that is intended to produce a public benefit or public benefits and
to operate in a responsible and sustainable manner. To that end, a public benefit corporation
shall be managed in a manner that balances the stockholders’ pecuniary interests, the best
interests of those materially affected by the corporation’s conduct, and the public benefit or
public benefits identified in its certificate of incorporation.
- Has to identify itself as this type of corporation, and balance the interest of the
shareholders with the public benefit.
§ 363 Certain amendments and mergers, votes required, appraisal rights
(a) Notwithstanding any other provisions of this chapter, a corporation that is not a public
benefit corporation, may not, without the approval of 2/3 of the outstanding stock of
the corporation entitled to vote thereon:
(1) Amend its certificate of incorporation to include a provision authorized by §
362(a)(1) of this title; or
….

(c) Notwithstanding any other provisions of this chapter, a corporation that is a public benefit
corporation may not, without the approval of 2/3 of the outstanding stock of the corporation
entitled to vote thereon:
(1) Amend its certificate of incorporation to delete or amend a provision authorized by §
362(a)(1) or § 366(c) of this title; or
(2) Merge or consolidate with or into another entity if, as a result of such merger or
consolidation, the shares in such corporation would become, or be converted into or
exchanged for the right to receive, shares or other equity interests in a domestic or foreign
corporation that is not a public benefit corporation or similar entity and the certificate of
incorporation (or similar governing instrument) of which does not contain the identical
provisions identifying the public benefit or public benefits pursuant to § 362(a) of this title or
imposing requirements pursuant to § 366(c) of this title.
§ 364 Stock certificates, notices regarding uncertified stock
§ 365 Duties of Directors
(a) The board of directors shall manage or direct the business and affairs of the public benefit
corporation in a manner that balances the pecuniary interests of the stockholders, the best
interests of those materially affected by the corporation’s conduct, and the specific public
benefit or public benefits identified in its certificate of incorporation.

§ 366 Periodic Statements and Third-Party Certification

- Have to produce a report that shows stockholders what is happening
§ 367 Derivative Suits
§ 368 No effect on Other Corporations

Virginia Kain  81
 SELF-DEALING TRANSACTIONS

STANDARDS OF REVIEW - DELAWARE

Self-Dealing Transaction with Director Self-Dealing Transaction with
or Officer (not controlling shareholder) Controlling Shareholder

Fairness
(Burden on Defendant)
Disinterested Note that in M&A transactions, the proper
Business Judgment Rule
Directors use of an independent special committee can
(burden on plaintiff)
Approve shift the burden to P to show that the
transaction was unfair. In M&A transactions
with a controlling shareholder, the fairness
test requires a showing of (1) procedural and
(2) substantive fairness.
If interested shareholders participate in If interested shareholders participate in
the vote  Fairness the vote  Fairness
(Burden on Defendant) (Burden on Defendant)
Shareholders
Approve Approval by a majority of disinterested If majority of minority approves, burden
shareholders  BJR shifts to Plaintiff to show transaction was
(Burden on Plaintiff) unfair.

Neither approve
or approval is Fairness Fairness
meaningless (Burden on Defendant) (Burden on Defendant)
because of
inadequate
disclosure

BIG PICTURE

- What’s so bad about self-dealing? Why shouldn’t the BJR apply to such transactions?
o We want a system of incentives that is going to discourage this type of behavior,
otherwise it will be really hard to detect self-dealing problems.
- Why might we not want to ban ALL transactions in which fiduciaries have a conflict of interest?
o There are some transactions that may still be the best option for the corporation despite
being self-dealing.
- Focus on who is doing the self-dealing, and what are their fiduciary duties?
o Directors/officers vs. Controlling Shareholders
- Has the conflict of interest been disclosed to and has the transaction been ratified by:
o Independent directors?
o Shareholders?
- Conflicted interest transactions take two forms.
o In a direct transaction, the director is dealing directly with the firm, such as where a
director sells property to the firm.
o In an indirect transaction, a person or entity in which the director has an interest is
dealing with the firm.

Virginia Kain  82
 o Both types potentially create a conflict of interest. Indirect conflicted interest
transactions, however, present greater problems in several respects. On the one hand, they
are more likely to escape ex ante notice, whether because of deliberate concealment or
mere inadvertence. On the other hand, as the director’s interest becomes more attenuated,
an indirect transaction may not rise to the level of a legitimate conflict of interest.

- DUTY OF LOYALTY ANALYSIS:

o Who is doing the alleged self-dealing and what are their fiduciary obligations?
 Director? Officer? Controlling shareholder?
o Is there a conflict of interest? (direct or indirect)
 Self-dealing? (fiduciary of the corporation enters into a transaction with himself
or with an entity in which he (or a family member) have a substantial financial
interest)
 Taking a corporate opportunity? (fiduciary of the corporation misappropriates
an opportunity that belongs to the corporation)
 Applies to a corporation’s officers and board members (but not its
shareholders who do not have another position with the firm); certain
other individuals who have a fiduciary or a fiduciary-like relationship
with the corporation (i.e. lawyer, consultant).
 Stealing? (fiduciary of the corporation takes something of value – money/assets
of the corporation for himself)
 Executive compensation? (executives whose compensation is at issue are also
on the BOD that votes to determine their compensation)
 Evaluation by BOD of whether, and how much information to disclose to
shareholders (particularly where the nature of disclosure might impact the
liability of all or some of the BOD)
 Entrenchment? (directors take steps to prevent others from removing them from
their positions with the company for any reason)
 Personal financial interests of a key player are (at least potentially) in
conflict with the financial interests of the corporation? (Board member of
corporation A also owned stock in a competing company B, and corporation A
was preparing to take action which might capture market share from company
B.)
 If no  no duty of loyalty issue
o If there is a conflict of interest, has it been cleansed?
 Has the transaction been approved by a vote of a majority of the fully informed,
disinterested directors? (not majority of every director, only disinterested ones)
 Note: if the transaction is cleansed by a vote of disinterested directors,
the decision that cleansed the transaction will itself be subject to scrutiny,
but usually covered by the BJR.
 Has the transaction been ratified by the informed shareholders?
 Has the transaction been shown to be intrinsically fair to the corporation?
 If yes  the transaction is protected and may proceed.
 If no  The transaction is voidable by the corporation; the director(s)
who violated their fiduciary duty of loyalty may be subject to damages.
o What standard of review applies?
 Why doesn’t BJR apply? Seen as worse than negligence or just making a bad
decision because they’re intentional – greater moral culpability, don’t want to
‘reward’ for bad behavior.
- HYPO:
o Ex. East Wing Baking Company is a widely held Delaware corporation and operates a
bakery chain that has traditionally offered a wide selection of whole wheat and low sugar
Virginia Kain  83
 breads and pastries. After hours of discussion at several board meetings, EW’s board of
directors vote to dramatically increase the use of sugar in the menu items, because the
board thinks that American preferences has moved away from the low sugar preferences
of the past and that it will provide more revenue for EW. Unfortunately, it turns out that
EW customers don’t like the change. S, an angry shareholder, believes the BOD violated
its duty of care, and is considering bringing a lawsuit.
 How would you assess S’s likelihood of success?
 Low. This goes to day-to-day management; court will be reviewing
under the BJR. 102(b)(7) provision in charter that waives director
liability for breaches of duty of care. Even if in hindsight the decision
was bad, low likelihood of success.
o Ex. EW looking for new bakery location in Boston. A, one of 7 directors, suggests that
they purchase a building that she owns downtown. The transaction is approved by
directors B, C, D, E, F. G votes against the deal, A abstains. EW purchases the space for
$3 million and A makes $300k , which she had disclose to the board in advance.
 If this transaction is challenge by a shareholder as self-dealing, how will the court
approach the review?
 DGCL 144 cleanses of conflict of interest – fine if the material facts and
the D/O interest is disclosed. Goes back to ordinary decision; BJR. Was
the transaction fair?

EVOLUTION OF SELF DEALING REGULATION

- EARLY APPROACH: ban self-dealing outright; borrowed from the law of trusts; but it doesn’t
always make sense to ban self-dealing; sometimes a corporation and the director/whatever would
both benefit from the transaction.

- CURRENT APPROACH: Fairness review and ‘safe harbor’ statutes like DGCL § 144 that
govern and cleanse self-dealing transactions. Some statutes set limits on voiding transactions
involving conflicts of interest. Can cleanse by requiring that boards or shareholders approve
transactions after providing them with adequate disclosure; the policy being that some
transactions that are beneficial to the company might also be self-dealing, so a one size fits all
approach isn’t the best way to go about it.
o TRANSACTION TYPES (STEPS OF ANALYSIS):
 Transaction between director/manager and corporation:
 Disclosure and properly informed shareholder approval invoke BJR and
shifts burden to defendant to prove waste
 Only rejected if complete waste (high standard)
o Shareholders cannot ratify waste unless it is unanimous
 Shareholder approval has a lot of weight in this type of transaction
because the shareholders are not
 Transaction between controlling shareholder and corporation:
 Approval by a majority of the minority shareholders; shifts the burden to
plaintiff to show unfairness
 Shareholder approval has less weight where there is a controlling
shareholder – courts are suspicious about transactions that might be
unfair to minority shareholders.
 Switches the burden of proof – generally if you are an agent with a
conflict of interest, you have the burden of showing the transaction is
fair; only if majority of minority shareholders approve does plaintiff have
to show unfairness.

Virginia Kain  84
 DISCLOSURE REQUIREMENT

- Boards of directors may approve transactions between the corporation and one or more of
directors or officers, but they may only approve transactions that are FAIR to the
corporation. The interested director must make FULL DISCLOSURE of ALL MATERIAL
FACTS of which she is aware at the time of authorization.
o DGCL § 144: Interested Directors
 (a) No contract or transaction between a corporation and 1 or more of its
directors or officers, or between a corporation and any other corporation,
partnership, association, or other organization in which 1 or more of its directors
or officers, are directors or officers, or have a financial interest, shall be void or
voidable solely for this reason, or solely because the director or officer is
present at or participates in the meeting of the board or committee which
authorizes the contract or transaction, or solely because any such director’s or
officer’s votes are counted for such purpose, if:
 (1) The material facts as to the director’s or officer’s relationship or
interest and as to the contract or transaction are disclosed or are known
to the board of directors or the committee, and the board or committee
in good faith authorizes the contract or transaction by the affirmative
votes of a majority of the disinterested directors, even though the
disinterested directors be less than a quorum; or
o Director must disclose the nature of the conflict to the rest of the
board, and a majority of the rest of the directors (disinterested
can vote to approve  makes transactions no longer void or
voidable.
 (2) The material facts as to the director’s or officer’s relationship or
interest and as to the contract or transaction are disclosed or are known
to the stockholders entitled to vote thereon, and the contract or
transaction is specifically approved in good faith by vote of the
stockholders; or
 (3) The contract or transaction is fair as to the corporation as of the time
it is authorized, approved or ratified, by the board of directors, a
committee or the stockholders.
 (b) Common or interested directors may be counted in determining the presence
of a quorum at a meeting of the board of directors or of a committee which
authorizes the contract or transaction.
 Conflicted directors can be counted, even though they can’t vote.

- Benihana of Tokyo v. Benihana, Inc. (2006)

o F: Rocky Aoki founded Benihana of Tokyo (BOT) and its subsidiary, Benihana Inc
(BHI), which operated restaurants worldwide. BHI needed to raise funds necessary to
renovate its restaurants. The BHI approved the issuance of $20M in convertible, preferred
stock, after considering other alternatives and obtaining a fairness opinion on the sale
(from the bank). The buyer of these securities was to be BFC Financial. John Abdo, a
director of BHI, owned 30% of BFC and served as a director and vice chairman of BFC.
Abdo negotiated on behalf of BFC with BHI. [Red flag]. The BHI knew about Abdo’s
stake in BFC, and approved the sale.
o Q: Issuance of the preferred stock diluted Aoki/BOT’s share of BHI. Aoki, through BOT,
filed suit against all of the BHI directors except himself for breach of fiduciary duty, and
against BFC for aiding/abetting the fiduciary obligations.
 (1) Was BFC authorized to issue the 20M in stock? Yes, authorized.
Virginia Kain  85
  (2) Did the BHI board act improperly in approving the transaction? Did the
directors engage in prohibited self-dealing?
 What standard of review? Despite the fact that there is a conflict of interest, so
long as the procedural points have been met, the court will apply the BJR.
o A: The stock issuance was lawful and the directors did not breach their fiduciary duties;
the disinterested directors possessed all of the material information on Abdo’s interest in
the transaction, and their approval at the board meeting satisfies DGCL § 144(A)(1).
Abdo did not set the terms of the deal, he did not deceive the board, and he did not
dominate or control the other directors’ approval of the Transaction, thus he didn’t breach
his duty of loyalty.
 Critical piece here is process – the ability of disinterested directors with full
information to approve the transaction.

- Lewis v. Vogelstein (1997)

o R: Disinterested corporate shareholders may ratify the act of the board in adopting a
director compensation plan granting outside directors stock options, subject to judicial
review for corporate waste.
o F: A shareholder’s suit challenged a stock option compensation plan for the directors of
Mattel Inc. The plan had been approved by the shareholders of the company at its annual
shareholders’ meeting. Direct reflection of what is required under the DGCL.
 There were two types of compensation arrangements under the plan.
 The first was a grant of 15,000 one time options with the exercisable
price equal to that of the market price on the date granted, exercisable for
up to 10 years.
 The second was a grant of 5,000 annual options that vest over a 4-year
period with an exercise price equal to the market price when granted,
exercisable for up to 10 years.
 The shareholders were given some information about the plan, but were
not given the estimated present value of the options.
o Q: May shareholders ratify the act of a board in adopting a director compensation plan
granting outside directors stock options? Was this a breach of duty of loyalty, or was the
self-dealing implicit in directors’ decision about their own pay packages effectively
‘cured’ by shareholder vote?
o A: The shareholder ratification was informed and therefore effective. When an agent acts
without authority, the agent’s principal may retroactively approve that act through a
process called ratification. Restatement (Second) of Agency § 82 (1958). The principal’s
ratification means nothing unless it is given after full disclosure of all significant facts. In
addition, the agent, as a fiduciary, still owes duties of candor and loyalty to the principal.
This means that the agent may not manipulate the principal in an effort to secure
ratification. Shareholders may ratify the acts of the corporation’s directors. Remand to
check transaction for waste.
 Focuses on process – shareholders with enough info about the contested
transaction ratified it, thus the transaction is okay.

- WHEN MAY SHAREHOLDER RATIFICATION BE CHALLENGED AS

INEFFECTIVE?
o (1) Absence of adequate information; vote can’t be valid because we didn’t have all the
material.
o (2) When shareholders themselves have a conflict of interest – for example, when a
director owns shares, and if their votes counted in the ratification, that could be
challenged.
 Process to cure:

Virginia Kain  86
  Shareholders have to have adequate information, AND the majority of
shareholders cannot be conflicted.
o Ex. Assume proper process. Can a plaintiff still challenge the transaction, and if so, what
grounds?
 The theory of waste; there is no conceivable, rational basis. Can only overcome
by unanimous vote.
o Ex. Consider a self-dealing transaction with director or officer who is not a controlling
shareholder.
 What effect should courts give to ratification by disinterested, informed
directors?
 Benihana: Transaction will be subject to BJR, burden on P
 What effect should courts give to ratification by informed shareholders?
 Lewis v Vogelstein: transaction approved by majority of disinterested
shareholders will be subject to BJR (Burden on P)
- Delaware cares a lot about fair process; have to meet 144(a)(1) or (2). Process has to be
managed carefully and fairly; otherwise the BJR won’t be available. The Court will review
a transaction for fairness, which is a much higher level of scrutiny.

CONTROLLING SHAREHOLDERS AND THE FAIRNESS STANDARD

- US corporate law has long recognized that controlling shareholders owe a fiduciary duty to the
minority shareholders because, practically speaking, they have more power over the corporation
in the long run than any one director.
o BUT: Controlling shareholders are also just regular shareholders, so is entitled to pursue
his or her investment interests. The dominant view is that once you become a controlling
shareholder, you have to take on some obligations to the minority shareholders.
o What is the scope of the fiduciary obligation on the part of controlling
shareholders?
 Not a hard and fast line – a shareholder with less than 50% of the outstanding
voting power may have a fiduciary obligation by the reason of corporate control.
A shareholder with more than 50% of the vote will be deemed to owe such a
duty.
- Tension between two concepts: Controlling shareholders owe a duty of fairness to minority
shareholders should they exercise or command the exercise of corporate powers, but at the same
time, they’re also just a shareholder and therefore entitled to pursue their own investment interest.
o Dominant value (at least in Delaware) is that a controlling shareholder’s power over
the corporation and the resulting power to affect other shareholders gives rise to a duty to
consider their interest fairly whenever the corporation enters into a contract with the
controller or its affiliate.
o Subsidiary value: the entitlement of all shareholders to sell or vote in their own interests.

DIFFERENT TREATMENT FOR CONTROLLING SHAREHOLDERS?

- Sinclair Oil Corp. v. Levien (1971) – Threshold test for applying the fairness norm to parent-
subsidiary corporations; now, majority view is to review all majority actions under the entire
fairness test.
o R: A parent corporation must pass the intrinsic fairness test only when its transactions
with its subsidiary constitute self-dealing.
o F: Sinclair Oil Company owns 97% of Sinven’s stock and dominates Sinven’s board.
Sinven is involved in oil exploration and production in Venezuela.

Virginia Kain  87
  Sinven minority shareholders bring suit against Sinclair for paying excessive
dividends ($108M when earnings for same period were only $70M), which
prevented Sinven’s industrial development.
 Shareholders are getting money in proportion to how much stock they have;
being distributed equally.
 Sinclair argues that dividends and other decisions should be judged under the
business judgment rule.
o PH: Chancellor finds that Sinclair owed Sinven a fiduciary duty and applies the intrinsic
fairness test. Finds that Sinclair did not sustain its burden of proving that the dividends
were intrinsically fair to the minority shareholders.
o Q: Must a parent corporation always pass the intrinsic fairness test when it transacts
business that affects its subsidiary?
o A: No, only when its transactions with its subsidiary constitute self-dealing. Self-dealing
occurs when the parent, by virtue of its domination of the subsidiary, cause the subsidiary
to act in such a way that the parent receives something from the subsidiary to the
exclusion of, and detriment to, the minority shareholders of the subsidiary.
o Sinclair didn’t get anything that the minority shareholders didn’t get – didn’t receive
anything to the exclusion of the minority, therefore no self dealing  apply the business
judgment rule.
 In the absence of a disproportionate benefit to controlling shareholders, there is
no self-dealing.
 Also, there were really no other opportunities that they could have been
pursuing.
o Does the controlling shareholder have an interest that does not align with the minority
shareholder’s interest?  usually aligned

- Weinberger v. UOP, Inc. (1983)

o R: Minority shareholders voting in favor of a proposed merger must be informed of
all material information regarding the merger for the merger to be considered fair.
o F: Signal owns 50.5% of UOP and 6 of 13 UOP board seats. Signal board decides to buy
the remainder of UOP. Arledge and Chitiea (UOP and Signal directors) write report that
any price up to $24 per share would be a “good investment” for Signal; study is shared
with Signal board, but not with UOP. Signal board offers $21 per share, a 55% premium
over pre-bid market price, conditioned on approval by majority of the minority UOP
shareholders. CEO of UOP, Crawford, makes no effort to negotiate with Signal, and UOP
board approves the offer with a hastily-drafted opinion from Lehman Bros. Signal
directors Walkup and Crawford withdraw from the UOP board meeting approving the
transaction, but were involve in the negotiations up to that point, and persuade Crawford
to seal the deal. 52% of the total outstanding minority shares approve the merger.
Plaintiff UOP shareholders bring a class action challenging the transaction as a breach of
UOP’s board’s fiduciary duty. Chancery Court rules for directors.
o Q: Will the other public shareholders get enough cash in exchange for giving up their
shares?
o A: Applying “entire fairness review” (standards that corporations do not like). Court
makes an assessment about whether the transaction is ‘entirely fair’. Defendants in this
case have the burden of convincing the court the transaction is entirely fair. Lack of
disclosure for both votes; remands case for damages.
 ENTIRE FAIRNESS: (1) fair dealing AND (2) fair price. Legal
standard used to evaluate “interested transactions,” or dealings between a
corporation and a controlling shareholder, under which a transaction is
scrutinized to ensure that the ultimate price was fair and that it was a
product of fair dealing.

Virginia Kain  88
  The “entire fairness” of a merger is comprised of fair dealing and fair price.
Minority shareholders voting in favor of a proposed merger must be informed of
all material information regarding the merger for the dealing to be fair. Failure to
provide the minority shareholders with all material information is a breach of
fiduciary duty. Here, although Arledge and Chitiea had prepared their study for
Signal and were actually Signal officers, they still owed a duty to UOP because
they were also UOP directors. The feasibility study and, more specifically, the
possible sale price of $24 per share and the resulting $17 million difference in
amount paid to the UOP minority shareholders clearly constitute material
information that the shareholders were entitled to know before voting. Arledge
and Chitiea’s failure to disclose that information was a breach of their fiduciary
duties and their actions thus cannot be considered fair dealing.
 Failure to disclose means that the shareholder votes were not validating. They
used insider information to prepare the report, so that wasn’t fair.
o UOP Footnote 7 (p. 323): Special Committee Roadmap: If UOP had appointed an
independent negotiating committee of its outside directors to deal with Signal at arm’s
length, then the entire fairness review could have been avoided. If the attempt to make
things arm length is robust enough, court will allow the company to avoid the fairness
review.

APPROVAL BY A BOARD MINORITY OF INDEPENDENT DIRECTORS:

SPECIAL COMMITTEES

- ENTIRE FAIRNESS REVIEW: When there is a controlling shareholder and self-dealing,

there is a high standard that requires good faith and inherent fairness of the bargain.
o Evaluates both the procedural fairness by which the judgment was made AND the
substantive result/outcome. (Was it a good deal?) – If both these are met, then the
decision is protected.
o (1) Fair Dealing: Look at timing of transaction, how it was initiated, structured,
negotiated, disclosed to directors, and how the approvals of the directors and shareholders
were obtained.
o (2) Fair Price: Refers to the price and terms of the deal. Look at economic and financial
considerations of merger, including assets, market value, earnings, future prospects,
elements that effect intrinsic or inherent value of the company or its stock.

- AVOIDING ENTIRE FAIRNESS REVIEW: SPECIAL COMMITTEES

o If there is a special committee of independent directors who negotiate against the
controlling stockholder, then the burden shifts back to the plaintiff.

- Following Weinburger, there has evolved a standard template for controlled transactions between
a subsidiary corporation and its parents of affiliates.
o Parent companies have a clear obligation to treat their subsidiaries fairly when the
subsidiaries have public shareholders and they can expect SH lawsuits to trigger judicial
scrutiny of large transactions with their subsidiaries.
- Techniques that assure the appearance as well as the reality of a fair deal are useful
- Formation of a special committee of disinterested independent directors to consider and
recommend the transaction is the most common such technique.
o To be given effect under DE law, a special committee must minimally:
 (1) be properly charged by the full board;
 (2) comprised of independent members, and
 (3) vested with the resources to accomplish its task.

Virginia Kain  89
- Committee members must understand that their mission is not only to negotiate a fair deal, but
also to obtain the best available deal.
o A conclusion that the deal is merely within a range of fairness will not serve to shift the
burden of proof if the deal is attacked
- Committee must say no when a controlling shareholder refuses to consider advantageous
alternatives unless the controller proposes terms that are their financial equivalent
- Committee has real bargaining power  Courts are likely to be skeptical of any deal forced on
the minority shareholders without committee approval.
- Committee likely to retain outside bankers and lawyers to advise it
- Choice of firms and method of compensation may be important  most importantly they are
INDEPENDENT!
CORPORATE OPPORTUNITY DOCTRINE

- IS THERE A CORPORATE OPPORTUNITY?

o Most states use some type of hybrid test that includes a blend of tests. Almost all tests
include some question of whether the opportunity is something that is consistent with the
corporation’s current, or anticipated future, business, and whether it is something that the
corporation has the financial resources to pursue.
 An early definition of a corporate opportunity was something in which the
corporation had an interest, an “expectancy” or a necessity.
 An “interest” is something in which the corporation has a preexisting
contractual right.
 An “expectancy” is something to which the corporation does not
necessarily have a legal right, but, given the other contractual dealings of
the corporation, there is a reasonable expectancy that the opportunity
would be offered to the corporation (e.g., a lease renewal).
 A “necessity” is something that the corporation needs in order to stay in
business (e.g., certain raw materials necessary to manufacture a product).
- IF NO: If a corporate opportunity is not present, the doctrine does not apply, and the opportunity
may be “taken” by the individual in question. No breach of fiduciary duty, even if the person
takes the opportunity.
- YES: If a corporate opportunity is present, must evaluate the fact pattern to determine whether
the opportunity was “misappropriated” and, if so, whether there are any defenses.
o Was the opportunity disclosed to the appropriate corporate authority?
 If no  breach of duty of loyalty
 If properly disclosed AND corporation properly rejects the opportunity 
there is no breach of fiduciary duty.
 Note that if full disclosure is made to the Board of Directors, and the
Board votes to permit the fiduciary to take the opportunity, this creates a
“safe harbor” for the individual (subject of course to the limits of the
BJR). (There are cases in which courts have found that more informal
disclosures to Board members or senior management have been
sufficient, but, since they do not create a “safe harbor,” those more
informal disclosures might still be subject to review by a court.)
 If properly disclosed BUT corporation does not properly reject the
opportunity AND the opportunity is taken by the individual  breach of
duty of loyalty (although this can be cleansed by shareholder vote or showing
fairness).

Virginia Kain  90
ANALYSIS OF DUTY OF LOYALTY (SELF-DEALING) CASES UNDER DELAWARE LAW

1) Is there a controlling shareholder?

a. If no  Move to (2).
b. If yes 
i. Is there self-dealing under the Sinclair Oil standard?
1. (Self-dealing occurs when the parent, by virtue of its domination of the
subsidiary, cause the subsidiary to act in such a way that the parent
receives something from the subsidiary to the exclusion of, and detriment
to, the minority shareholders of the subsidiary.)
ii. If yes, was there adequate disclosure?
1. If no: ENTIRE FAIRNESS REVIEW. Neither shareholder nor director
approval helps; high judicial scrutiny.
2. If yes, did the majority of the minority shareholders approve the
transaction?
a. If yes, burden shifts to plaintiff to show unfairness of
transaction.
b. If no, then approval by the controlling shareholders or the board
(because the controlling shareholders elect the board) doesn’t
help  ENTIRE FAIRNESS REVIEW.
c. If M&A  Was there a special committee of independent
and disinterested directors?
i. If yes, are they:
1. Properly charged by the full board?
2. Comprised of independent members?
3. Vested with the resources to accomplish its task?
2) Was all relevant information disclosed?
a. If no  FAIRNESS REVIEW
3) Was the transaction ratified by disinterested board members?
a. If yes  Court applies BJR
b. If no  Was the transaction ratified by a majority of disinterested shareholders?
i. If yes  Court applies BJR
ii. If no  Can the defendant show that the transaction was fair to the
company?
1. Procedural fairness?
2. Substantive fairness?

Virginia Kain  91
 CHAPTER NINE – EXECUTIVE COMPENSATION

INTRODUCTION

THE CHALLENGE OF EXECUTIVE PAY

CREATING INCENTIVES THAT ALIGN MANAGERS WITH INVESTORS
POLITICAL AND REGULATORY RESPONSES TO EXECUTIVE PAY

ARE U.S. CEOS PAID TOO MUCH?

JUDICIAL REVIEW OF COMPENSATION

THE LAW OF EXECUTIVE OFFICER COMPENSATION
In re The Goldman Sachs Group, Inc. Shareholder Litigation

JUDICIAL REVIEW OF DIRECTOR COMPENSATION

Calma v. Templeton

Virginia Kain  92
 CHAPTER TEN – SHAREHOLDER LAWSUITS

DISTINGUISHING BETWEEN DIRECT AND DERIVATIVE CLAIMS

SOLVING A COLLECTIVE ACTION PROBLEM:

ATTORNEY’S FEES & INCENTIVE TO SUE

STANDING REQUIREMENTS

BALANCING THE RIGHTS OF BOARD MEMBERS TO MANAGE THE CORPORATION

AND SHAREHOLDERS’ RIGHT TO OBTAIN JUDICIAL REVIEW
THE DEMAND REQUIREMENT OF RULE 23
Levine v. Smith

SPECIAL LITIGATION COMMITTEES

Zapata Corp. v. Maldonado
In re Oracle Corp. Derivative Litigation

SETTLEMENT AND INDEMNIFICATION

SETTLEMENT BY CLASS REPRESENTATIVES
SETTLEMENT BY SPECIAL COMMITTEE

Virginia Kain  93
 CHAPTER ELEVEN – TRANSACTIONS IN CONTROL

INTRODUCTION

SALES OF CONTROL BLOCKS: THE SELLER’S DUTIES

THE REGULATION OF CONTROL PREMIUMS
Zetlin v. Hanson Holdings Inc.
Perlman v. Feldmann

A DEFENSE OF THE MARKET RULE IN SALES OF CONTROL

TENDER OFFERS: THE BUYER’S DUTIES

Virginia Kain  94
 CHAPTER TWELVE – FUNDAMENTAL TRANSACTIONS: MERGERS & ACQUISITIONS

INTRODUCTION

ECONOMIC MOTIVES FOR MERGERS

INTEGRATION AS A SOURCE OF VALUE
OTHER SOURCES OF VALUE IN ACQUISITIONS: TAX, AGENCY COSTS, AND
DIVERSIFICATION
SUSPECT MOTIVES FOR MERGERS
DO MERGERS CREATE VALUE?
THE EVOLUTION OF U.S. CORPORATE LAW OF MERGERS
WHEN MERGERS WERE RARE
MODERN ERA MERGERS

THE ALLOCATION OF POWER IN FUNDAMENTAL TRANSACTIONS

OVERVIEW OF TRANSACTIONAL FORM

ASSET ACQUISITION
Katz v. Bregman

STOCK ACQUISITION
MERGERS
TRIANGULAR MERGERS

STRUCTURING THE M&A TRANSACTION

TIMING

REGULATORY APPROVALS, CONSENTS AND TITLE TRANSFERS

PLANNING AROUND VOTING AND APPRAISAL RIGHTS

DUE DILIGENCE, REPRESENTATIONS AND WARRANTIES, COVENANTS, AND

INDEMNIFICATION

DEAL PROTECTIONS AND TERMINATION FEES

ACCOUNTING TREATMENT

TIMBERJACK AGREEMENT

THE APPRAISAL REMEDY

HISTORY AND THEORY
THE APPRAISAL ALTERNATIVE IN INTERESTED MERGERS
THE MARKET OUT RULE
THE NATURE OF “FAIR VALUE”

THE DUTY OF LOYALTY IN CONTROLLED MERGERS

CASH MERGERS OR FREEZE-OUTS

Virginia Kain  95
Kahn v. Lynch Communications Systems Inc.
Kahn v. M&F Worldwide Corp et al.
DO CONTROLLING SHAREHOLDERS HAVE A DUTY TO OFFER ONLY A FAIR PRICE ON
THE FIRST, TENDER OFFER STEP OF A TWO-STEP FREEZE OUT?
In re CNX Gas Corporation Shareholders Litigation

Virginia Kain  96
 CHAPTER THIRTEEN – PUBLIC CONTESTS FOR CORPORATE CONTROL

INTRODUCTION

DEFENDING AGAINST HOSTILE TENDER OFFERS

Unocal Corp v. Mesa Petroleum Co.
PRIVATE LAW INNOVATION: THE POISON PILL

CHOOSING A MERGER OR BUYOUT PARTNER:

REVLON, ITS SEQUELS AND PREQUELS
Smith v. Van Gorkom
Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc.
PULLING TOGETHER UNOCAL AND REVLON
Paramount Communications, Inc. v. Time, Inc.
Paramount Communications, Inc. v. QVC
PROTECTING THE DEAL
NO SHOPS/NO TALKS AND FIDUCIARY OUTS
SHAREHOLDER LOCK-UPS

PROXY CONTESTS FOR CORPORATE CONTROL

Blasius Industries, Inc. v. Atlas Corp.

Virginia Kain  97