Legit Cane Outline

CORPORATIONS OUTLINE ~ Cane I.
INTRODUCTION TO BUSINESS FORMS CLASSIFICATION OF BUSINESS TWO CATEGORIES: 1) Corporations 2) Unincorporated associations CLASSIFICATION OF CORPORATIONS BY OWNERSHIP INTERESTS 1. Closely held: one or a few owners Unincorporated are usually here. Closely held elect to be corporations. There is no liquidity b/c there is no obvious place to sell, thus no market. 2. Publicly held/traded: hundreds or thousands of owners; open to public to purchase shares and sell shares either in the exchange or over-the-counter market like NASDAQ. LIQUIDITY: selling the shares you bought for a publicly held business in exchange for SOURCE OF LAW: STATUTES 1. Uniform Partnership Act (UPA 1914): National conference of commissioners on Uniform state law. There are still states that follow this. 2. Uniform Partnership Acts (RUPA 1997): There are some states that use this act. And FL uses this act. The revised. 3. Uniform Limited Liability Company Act of 1996 (ULLCA) 4. Model Business Corporation Act (MBCA): the book has the 1969 legal capitol and par value. Traditional jurisdictions look to this. 5. Financial provisions of the Model Business Corporation Act of 1969 (MBCA 1969) The beginning of the uniform laws series there is a list of which states have the laws and which ones have put a variation on them. Annotations should tells how it differs. If dealing with the uniform laws if you do not have any case law on point then you can look to other states or the federal interpretation of that part of the act. The model act is the model for the rest, but not intended to be uniform. AGENCY LAW 1.01 Agency defined: Fiduciary duty that arises when one person (the principal) manifests consent to another person (the agent,) that the agent shall act on the principals behalf, and subject to the principals control and the agent consents so to act. Fiduciary: o A relationship of trust and confidence. o Manifests consent through written or spoken words so person has notice. o Agent must act in the best interest of the principle. Never for the interest of the agent. - Contrast fiduciary with contractual relationships, where you only have the obligations of good faith and fair dealing (dont be a bad guy) Good faith and fair dealing: is not the same as a fiduciary relationship, it only means that what I have agreed to do I have or will do. What is in the contract is what I have to do. No duty beyond that.
Arms length: (commercial relationships) Neighbors black acre and white acre selling cows to each other. Only limit is not affirmative misrepresentations. Caveat Emptor Principal person to whom a fiduciary duty is owed to. o Disclosed principle: 3rd party HAS notice that agent is acting for a principle and HAS notice of principles identity. o Undisclosed principle: the 3rd party NO notice that the agent is acting for principle. o Unidentified principle: the 3rd party HAS notice that agent is acting for principle but has NO notice of principles identity o Dual Agent: acts on behalf of more than one principle on the same transaction. (Matts realtor example). o Co-Agent: two agents for same principle.
Notice: person has thru following 1. Knows it 2. Reason to know it 3. Should know it Agency is consensual, not contractual (no consideration). 1.03 Consent can be manifested through written words, spoken words or other conduct (i.e., acquiescence is sufficient in some cases) ACTUAL AUTHORITY AND APPARENT AUTHORITY Actual authority: B/w the agent & principal Authority concept that defines scope of the agency relationship Power to bind principal is broader than agents authority to bind principal. How can you have power without authority? (a) Estoppel (b) Inherent agency power Actual authority issue is whether agent reasonably believed he had authority to act on behalf of principle. Manifestation of consent from principal to agent whereby the agent reasonably believed that the principle wishes the agent to act (reasonable person standard). May be express or implied Implied authority relies on industry custom One form of implied authority is incidental authority (which includes things needed to effectuate actual authority) Apparent authority issue is whether 3rd party reasonably believed agent had authority to act on behalf of principle (b/w 3rd party and principle) Power to affect a principals legal relations with third parties held by an agent or other actor when a third party reasonably believes actor has authority to act on behalf of principal and Third partys belief MUST be reasonable Belief must also be traceable to principals manifestations Example: Sole proprietor for a pet store. Alex is sent to the pet store and he wears a shirt with the name on it to get supplies for the pet store. Apparent authority by way of the Tshirt. 2
Example: Alex now goes to the radio store and now you would need actual authority because apparent is not sufficient. Cane goes out any gets note cards with agent for Trump but there are no words or manifestations as to the principle. The principle never authorized the alleged agent to do anything. However if there is a continuous notice to the principle.
Respondeat Superior Employer is subject to liability for torts committed by employees while acting in the scope of their employment. Independent Kors: not acting under employer and thus employers are not liable for the acts. Estoppel Very similar to apparent authority Compensates for loss caused by reliance While apparent authority requires affirmative manifestation, estoppel may follow mere inaction. Actual and apparent authority may co-exist, but are terminated differently. Apparent authority terminates when it is not reasonable for the 3rd party with whom the agent deals to believe that the agent acts with actual authority. Actual authority terminates when the either party has notice of such termination. CHOICE OF BUSINESS ENTITY What are the seven basic choices? Sole proprietorship one owner that is personally liable b/c there is no legal separation b/w owner and business. Corporations C type (designation for tax purposes); default. the filing of articles of incorporation. Corporate existence begins upon
Corporations S type small business (federal tax election, special elections creates tax benefits) Partnership General: two or more people who are co-owners of a business for profit; this is fragile b/c one person can leave anytime. Anytime there is a change in relation b/w or among the partners the partnership has been dissolved. Personal liability involved. Partnership Limited: same as general, but with this you have limited liability for obligations that exceed the assets of the general partnership. There is a general partner and a limited partner. The general partner usually is active where limited partner is silent (like giving $$). If silent partner becomes active then partner becomes liable. While the limited partnership is a traditional business form, it has evolved to involve the use of a corporation as the sole general partner of a limited partnership. Limited Liability Companies (LLCS) (hybrid between corporations and partnership; all owners have limited liability; liability is limited to amount you invest). No double taxation. Under Delaware, this is a distinct entity and requires an attorney b/c it is analogous to a corporation. One or more persons at beginning, now there may be a sole member LLC. Can either be member managed or manager managed. 3
Limited Liability Partnership: same taxation and looks as a general partnership. But with the advantage of limited liability. Here the partners are only liable for what they are doing and not for the malpractice of the others within the partnership. Limited liability limited partnership (LLLP): not in every state. LLP merges w/ an LP (has both limited and general partners but all general partners have protection of LLP). Publicly held means that the public may buy the stock. o You know what it is worth by looking in the paper. Closely held: not held out to the public, and not able to find out the worth LLP=UPA section 306 [pg 42]. . THEORIES OF CORPORATION Incorporation results in the creation of a new legal entity, a fictitious person with its own obligations. A corporation is an entity independent of its shareholders. Though corporation is recognized as a separate entity, it is not shielded with certain privileges extended to individuals. For example, a corporation has: no right to privacy no 5th Amendment privilege against self-incrimination But a Corporation has: First Amendment protection Cannot have property taken without just compensation Is protected from unreasonable search and seizures Can plead double jeopardy Is entitled to due process Entitled to equal protection. Theoretically, a corporation consists of three layers/tiers: 1. Shareholders, who are traditionally viewed as the ultimate owners of the enterprise 2. Board of Directors composed of managers of the corporations affairs 3. Officers act for the corporation to implement the decisions of the directors. A single individual can simultaneously be an officer, director, and a shareholder. Liability and Piercing the Veil: Only the corporation is liable for corporate obligations. i. However, if a director, officer, shareholder acts fraudulently or negligently, he can become personally liable to 3rd persons injured by that conduct. ii. If one is simply inefficient, neither A nor B will be personally liable for creditors losses. 4
a. In comes piercing the corporate veil! A court may pierce the corporate veil and permit creditors of closely held corporations to recover directly from directors, officers, or shareholders. b. Piercing the Corporate Veil refers to extreme situations where some or all shareholders will be personally liable for corporations obligations.
Models of Business Organizations 1. Nexus of contracts model argue the firm is not a single entity, but an aggregate of various inputs acting together with the common goal of producing goods or services. 2. Contractual theory of corporation is in stark contrast to the legal concept of the corporation as an entity created by the state. The entity theory of the corp supports state intervention (thru direct regulation or facilitation of shareholder litigation) in the corporation on the ground that the state created the corporation by granting it a charter. i. Contractual theory says that the corporation is founded in private contract, where the role of the state is limited to enforcing contracts. A state charter therefore merely recognizes the existence of a nexus of contracts. Called a corporation. Each contract warrants the same legal and constitutional protections as other legally enforceable contracts.
SARBANES OXLEY ACT Created stricter guidelines to protect investors as a result of Arthur Anderson.
CHAPTER 2 THE PARTNERSHIP A. THE NEED FOR A WRITTEN AGREEMENT A written agreement is not necessary to form a partnership but should have one. ADVANTAGES TO A WRITTEN AGREEMENT 1) Avoids future disagreements about the arrangement. a. (i.e. conflict of interest) always inform them of the potential conflict of interest IN WRITING disclosed advised and chosen not to. Clear about any previous contact with other clients, must clarify who they represent. b. If the corp is represented then the same attorney may not also represent any of the shareholders or the directors or the officers in their individual capacity. 2) Provable in court. a. No he said she said. Put an INTEGRATION clause. This represents the entire agreement between these parties as to this transaction. Otherwise you open the door to parol evidence. 3) May focus on potential trouble spots in the relationship that may go unnoticed in an oral agreement. a. Taxes 5
b. Meetings voting 4) Provides proof to the IRS that a partnership exists, ensuring that the partners to allocate the tax burdens among themselves. 5) Upon death or retirement of a partner, UPA provides that the business is either disposed of or the interest of the deceased partner is to be purchased by the other parties. a. Having such provisions in writing should protect spouses and others that may be affected by the agreement. b. The amount of the business at the time of the death. No written agreement as to her interests of the decedent. c. Purchase life insurance for the persons then that will pay them and their estates when the die and the corporation would not have to pay by agreement. d. In the case of retirement: pay in installments. Monthly annually, interest, and what will secure the interest, assets of the partnership. e. Use the form Exhibit A. and make it easily ascertainable so as to be able to actually comply with the terms of the note. 6) Where a partner lends property to the partnership, a. Personal property of one of the shareholders or is it obtained as partnership property. b. Black white & gray acres but only gray is owned as and by the corporation, so only gray can be touched by the corporation. 7) Where real estate is to be contributed as partnership property or the agreement includes a term of more than one year, a written agreement may be necessary to comply with the statute of frauds. 8) Helpful to the attorney setting up the partnership, providing fewer reasons for a misunderstanding. LIMITED LIABILITY PARTNERSHIP (LLP) UPA 306 (c): An obligation of a partnership incurred while the partnership is a LLP is solely the obligation of the partnership. A partners is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or so acting as a partner.
MANAGEMENT NATIONAL BISCUIT CO. V. STROUD 1959 All partners are jointly and severally liable for the acts and obligations of the partnership. All partners have equal rights in management even if sharing profits are unequal. UPA 18 P: Natl Biscuit sold bread to the grocery store even after one of the partners told them they were not going to be personally responsible for the purchase of the bread anymore. To the damage of $171. 04. Court says that indeed Stroud is liable for the partnership. He was acting in the scope of his business to order the bread. The partnership is the principle and the principle is the one who creates the authority. Stroud has not created his own authority, since Stroud only owned of the partnership and without any majority of the general partnership. There was no agreement. Thus the authority was not destroyed by the act of the one partner without a majority vote. 6
9 unless no partner has no authority. SMITH V. DIXON 1965 - -In this case, the managing/general partner contracted to sell land to Defendant for $200,000. - The partnership refused to close the sale because these other partners said they only gave the general partner the authority to sell the land at $225,000. - The court held that one partner has the authority to sign for the partnership in transferring land as long as that partner is operating with apparent authority. Here the court determined that the D was acting with apparent authority, which he did. R: A partnership is bound by the acts of a partner when he acts within the scope or apparent scope of his authority. UPA 11 (reasonable expectation standard). R: Partnership agreement governs the relations b/w the partners. RUPA 103. ROUSE V. POLLARD 1941 Law firm which was a partnership where one of the partners took it upon himself to invest for one of his clients and then embezzle most of the money while representing to her. Little old lady in tennis shoes. He is not acting within his authority. Issue: what is the scope of the law firm. - All partners are jointly and severally liable 15 of the old Act. - Here the court said that receiving money and buying mortgages is not part of the business (to do it at their discretion.) - They took judicial notice of how the practice of law is decided. In this case the partner (an attorney) did not act within the scope of (law) partnership when he embezzled money from a client and invested it, as the partnership was a law firm, not an investment firm Each partner is authorized to act as the general agent for his co-partners in all matters coming within the scope of the business of the firm, All partners are responsible for the acts of each of their agents If the transaction is outside the partnership business, the other partners are not liable and they are not bound by a statement of the partner who conducts such transaction that he is acting on behalf of the firm. To hold partners for the fraudulent acts of a co-partner, the acts with which the fraud is committed must have been within the general scope of the partnership business. R: UPA 11 partners liable for anything done w/I scope of business. ROACH V. MEAD 1986 Is the general partner in practice? Is he responsible for the acts of the other partner? In this case, the partner (an attorney) failed to advise client on the legal consequences of a loan. The court held this was in the ordinary course of the business of the partnership and his law partner was vicariously liable for these negligent acts. Partners are jointly and severally liable for the acts of copartners based on the principalagent relationship between the partners and the partnership. 7
This case is also concerned with Ethics and this practice of loaning: A lawyer shall not do this in accordance with Model Rules of Professional conduct. i. This doesnt mean that you can never do business with the client, but only with certain safe guards. And make sure that your legal advice is not tainted and must be fair. ii. None of this was done at the case at bar. Partners are jointly and severally liable for the tortious acts of other partners if they have authorized those acts or if the wrongful acts are committed in the ordinary course of the business of the partnership. Notes (read in class) Model Rules of Professional Conduct, Rule 1.8 A lawyer shall not enter into a business transaction with a client or knowingly acquire an ownership, possessory, security or other pecuniary interest adverse to a client unless: (1) The transaction and terms on which the lawyer acquires the interest are fair and reasonable to the client and are fully disclosed and transmitted in writing to the client in a manner that can be reasonably understood by the client. (2) The client is given a reasonable opportunity to seek the advice of independent counsel in the transaction; and (3) The client consents in writing thereto. UPA 17, 306 (b) Note 5: the argument was that this was outside the scope of the legal realm, because this legal mal practice insurance. - They will attempt not to cover - Ct up held the summary judgment b/c there was no attorney client relationship as to the personal loan. Note 6: In coming partners: UPA 17 IS liable for all obligations but the liability is only to be satisfied out of partnership property. (the money you put forward to become a partner.) 306 (b). person admitted to a partnership is not personally liable for any partnership. DUTIES OF PARTNERS TO EACH OTHER Partners and co-adventures have a fiduciary relationship. Joint Venture: partnership of limited term or scope.
MEINHARD V. SALMON When a partnership is offered a profitable lease, one partner accepts it for himself, prompting the other to demand participation. R: IF NEGOTIATIONS BEGIN BEFORE AGENCY R/S IS TERMINATED, EACH PARTY IS ENTITLED THE OPPORTUNITY TO PARTICIPATE. PARTNERSHIP PROPERTY Official Comment to Subdivisions (1) and (2-B) of Section 25 of the Uniform Partnership Act Partners for partnership purposes can only use the physical property of a partnership. Interest in the partnership is personalty. The transfer of interest of one partner is only the right to income. 8
UPA 24 & 25 (1) Partners are co-owners of partnership property. UPA 25 (2-b) The right of a partner as co-owner in specific partnership property is not separately assignable. Example: A and B are partners. A wants to assign all his rights in partnership property to C. He cannot do so without the consent of B because the rights of A in the property is to possess the property for a partnership purpose; and because a partnership is voluntary and A cannot force a partner on B without Bs consent.
PARTNERSHIP ACCOUNTING - The interests of partners are reflected in capital accounts. - Capital account: sets forth the partners ownership interest in the partnership. - RUPA 401: describes how each partners capital account is maintained. - Equation: that account equals: the (capital contributed by the partner) less (the amount of any distributions to the partner) plus (the partners share of the profits) less (the partners share of the losses). - When a partnership is terminated, a partner with a negative capital account must pay the partnership that amount. UPA (1997) 807b. - Most partnerships also have a second set of books to record transactions for tax purposes. - Equity = Assets Liabilities (net worth of a business = assets liabilities) - Equity: ownership or net worth. - Balance sheet: most fundamental financial statement. Equity = Assets liabilities. - Asset side is the left-hand side. - Liability/equity side is the right hand side. - Records a situation at one instant at a time, therefore every transaction potentially creates a new balance sheet when the transaction is recorded. - The bottom line of a balance sheet is not itself a meaningful figure, because transactions such as a bank loan that do not affect the real worth of the business to the owners may increase or decrease it. - Profit and loss statement/income statement can be created for a business for one day of operation. - It is a right-hand entry on the balance sheet. - Income = Revenues Expenses - Gross profit: total sales - Net profit: sales expenses Balance sheet v. Income statement: -- Balance sheet: shows the status of a business at a particular instant in time. -- The basic document which all financial statements are constructed -- Income statement: describes the results of operations over some period of time-daily, monthly, quarterly, or annually. -- It provides the bridge between the balance sheet at the beginning of the period and the balance sheet at the end of the period. Four concepts of financial accounting: 1. Assumes the business is an entity. 2. All entries are in terms of dollars. - Both tangible and intangible property are shown on the balance sheet either at historical cost or fair market value. (Ex. Land and rights to a patent) -- Some assets such as a salesperson good with clients is not reflected on the balance sheet. -- A liability in the balance sheet sense is a recognized debt or obligation to someone else. 9
3. A balance sheet must balance. (The sum of the left must be the same as the sum of the right.) 4. Double entry bookkeeping: Every transaction entered into by a business must be recorded in at least two ways if the balance sheet is to continue to balance. (It is the cornerstone of modern accounting) Cash flow accounting: -- considers only transactions that involve dollars in and dollars out, whereas traditional accounting includes some expenses that do not reduce the amount of available cash of the business. -- Most businesses prepare cash flow financial statements for internal purposes and to make sure that there will be cash available when foreseeable payments come due. PARTNERSHIP DISSOLUTION Steps to ending a partnership: 1 Dissolution 2 Winding up 3 Termination of partnership Dissolution: DOES NOT IMMEDIATELY TERMINATE THE PARTNERSHIP. A change in the legal relationship caused by any partner ceasing to be associated in the carrying on of the business. UPA (1914) 29 Refers to a change in personal relationships among partners within the partnership and has nothing to do with the disposition of assets or closing down or selling the business. CHAPTER THREE The Limited Partnership and Federal Income Taxation The Internal Revenue Code recognizes two distinct methods of taxing business income: (a) Corporate Income taxation described in Subchapters C and S of the Internal Revenue Code (b) Partnership Income taxation described in Subchapter K of the Internal Revenue Code CORPORATE TAX RATES: Marginal tax rate is applicable to a corporation with exactly $75,000 of income is 34% because that is the rate applicable to each additional dollar of taxable income the corporation earns over $75,000 and up to $100,000. Effective tax rate is 18% since a corporations tax bill on exactly $75,000 of taxable income is $13,750 (15% of $50,000 plus 25% of $25,000). FEDERAL TAXATION The fundamental difference in the tax treatment of partnerships and corporations is that a corporation is taxed as a separate entity with its own tax rate, whereas the partnership is taxed as an extension of the individual. There is an element of double taxation in the corporate form if the corporation pays dividends. The corporate earnings are taxed to the corporation, and when the diminished earnings are distributed in dividends, they are treated as income in the hands of the shareholders, and taxed again. Pass through (applies to S and Partnerships): pass through corporate level and goes straight to shareholders/partners. 10
E.g. Draws are not included in the amount allocated for income calculations. If A, B, C own a business that made $300k and each got $100k and each drew $10k. The amount taxed is the $100k. S CORPORATION: o A.k.a. taxed as a partnership or electing partnership taxation o Only a single tax on corporate income is imposed on individual income tax rates at the shareholder level. o The income is taxable to the shareholder whether or not the income is actually distributed. o To be eligible, a corporation must meet the following conditions on the date of election, in order to be for a S corporation: o Has corporate characteristics of limited liability and centralization of management. It must be a domestic corporation It must NOT be part of an affiliated group of corporations It must have no more than 75 shareholders Each shareholder must be an individual citizen not a non-resident alien It may have only one class of stock outstanding (preferred not allowed), except that classes of common stock differing only in voting rights is OK
C CORPORATION A C corporation can minimize the disadvantages by reducing the substantial tax at the corporate level through the payment of salaries, rent, or interest to the shareholders. If reasonable, such payments are deductible as ordinary and necessary business expenses. A factor favoring corporate tax treatment is the availability of tax-free employee fringe benefits for shareholders that are employees of the corporations. Such benefits include medical insurance, life insurance and so forth. Capital Gain is taxed at a lower rate (20%) if held for more than one year like stock. K CORPORATION Pass through applies Its income or loss is reported on proprietors income tax return. Not a separate taxable entity Partnership must file an information return showing income & expenses Partners are taxed on each individuals share.
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PROPRIETORSHIPS Proprietorships, businesses wholly owned by a single individual, are not a separate taxable entity. Its income is reported on the proprietors personal income tax return. The taxation of unincorporated business forms, such as general and limited partnerships and limited liability companies, is set forth in Chapter K of the Internal Revenue Code. The partnership itself does not pay tax; rather it allocates the income or loss of the partnership among the individual partners in accordance with the partnership agreement. Each partner then includes in his or her personal income tax return, the amount allocated.
LIMITED PARTNERSHIPS WITH CORPORATE GENERAL PARTNERS: A limited partnership with a corporation as the sole general partner creates a totally different kind of entity than the traditional limited partnership. No individual is personally liable for the firms debt. Most of the capital is provided by passive investors who have no right to participate in management. Control of the limited partnership is vested solely in the hands of the corporate general partner.
IN RE USACAFES LP LITIGATION Court of Chancery of Delaware (1991) Metsa bought almost all of the assets of USACafes LP. The unit holders of USA cafes wants a constructive trust declared on certain funds and damages to the class of unit holders resulting from the sale. USA CAFES is the general partner: and few acting as the officers and directors The Ps claim that the Ds sold the company for too little because they got incentives on the side and thus breached their fiduciary duty to the unit holders. P is suing D on the theory of breach of fiduciary duty. The Ds claim they owe no such fiduciary duty to the Unit holders as directors only the General Partner would owe such a duty and they were acting as directors at the time of the sale. UP UNTIl now there was no case law as to the LPs and the duty owed. This court then looks to the law of trusts. And finds. However the court holds that they were acting personally as the Gen Partner and thus did owe a duty to the limited partners or unit holders. Thos in control of the corporate general partner they owe some duty to the limited partners. Cause the loss bear the burden if the Wiles caused the loss they breached their fiduciary duty and thus should be personally responsible for the damages. P wins the motion and the Ds motion to dismiss is denied. o WHEN retained to represent someone in this situation you make sure that it is clear who you are representing, A as a general partner of B corp or LP. o Limited partnerships would originally have a human but now it is most likely a fictitious person a.k.a the corporate 12
R: Directors of a CGP stand in fiduciary r/s w/ limited partners. SIX CHARACTERISTICS IN A PURE CORPORATION: 1. Associates 2. An objective to carry on a business and divide the gains there from 3. Continuity of life 4. Centralization of management 5. Liability for corporate debts limited to corporate property 6. Free transferability of interest * A Partnership will be treated as an association taxable as a corporation if it more merely resembles a corporation than a partnership CHAPTER FOUR LIMITED LIABILITY COMPANIES An LLC is an entity designed to be taxed as a partnership while offering the owners the limited liability that shareholders of a corporation enjoy. Compared with a S corporation, an LLC may be better because it is not subject to the limitations of Subchapter S (75 or fewer shareholders, one class of stock, etc.) Compared with a limited partnerships, an LLC may be better because it does not require that there be at least one general partner that is personally liable for the partnerships obligation; no member need be personally liable for the obligations under an LLC, Although LLCs are governed by statute, the statute provides that members can adopt operating agreements that will control. Best understood in terms of four general characteristics: (a) Limited liability (b) Partnership tax features (c) Ability to choose between centralized and direct member management chameleon management. (d) Creditor protection provisions Management of an LLC is presumed to be by all members (unless specified in the articles) Management by members must follow these rules: (a) Majority vote is required to approve most decisions and (b) Each member is an agent of the LLC (meaning: LLC may be bound by the acts of any member) (c) Management rights are transferred ONLY with the consent of ALL members (d) Disassociation of an LLC member by resignation, death, retirement, generally causes the dissolution of the LLC. ELF ATOCHEM NORTH AMERICA, INC. V. JAFFARI AND MALEK LLC Malek LLC was formed as a LLC in Delaware by filing a certificate of formation but with limited articles of governance. Then Elf Malek INC. and Jafarri entered into the agreement setting forth detailed provisions for the governance of Malek LLC which is not a signatory to the agreement. Arbitration clause and a forum selection clause. Elf alleged that Jafarri breached his fiduciary duty to the LLC by making it insolvent and filed suit in Deleware. 13
Elf put a million bucks in and Jafarri. INTERNAL affairs rule states that Elf wants to be in Delaware b/c they are concerned that the court imposes a fiduciary duty. o ISSUES: are they bound by the agreement o Is the arbitration clause valid. Court looked to contract principles and found that two entities should be able to contract and the arbitration clause should thus be valid. Like partnership law. Which means that they have a broad authority to contract. ELF wants to be able to not contract away the jurisdiction. You should stick to Delaware because of the Internal affairs rule: Legislature says this should be interpreted as broad like partnership law. o UPA RUPA: there are limits to what you can contract away. IE you may not completely contract away the duty of loyalty you may limit the duty of loyalty to a reasonable limit. o R: Court will give deference to a member agreement that falls outside provisions of statute, so long as it is reasonable.
POORE V. FOX HOLLOW ENTERPRISES R: An LLC requires representation by legal counsel in court proceedings. Mr. Cambell wrote a brief for Fox Hollow. This is more like corporation b/c members represent shareholders (artificial entity) than like a partnership when partners are not distinct. Check the BOX: May elect the S corporation treatment under the check the box in order to have pass through treatment while avoiding the complexities of subchapter K Asset protection: you dont have to organize the LLC to be for profit: You dont have to be a profit making enterprise You have protection from creditors. To the extent of a charging order. Ie the owing of the vacation house. Create a Single Member LLC SMLLC: then you cant touch the vacation home. When does a Limited Liability get pierced and when doesnt it? No case law on point as of now. CHAPTER 6 THE FORMATION OF A CLOSELY HELD CORPORATION A. Where To Incorporate Selection of a state to incorporate in involves two factors: 1) Cost of incorporation 2) Advantages and disadvantages available under the state's laws of incorporation Most practical is to incorporate in the jurisdiction where most business activities will take place - DE is the most popular outside jurisdiction - If the corp. is incorporated in Delaware but wants to do business in FL then the corporations have to get qualification and must put filings with the sec of state in Fl thus providing a way to sue in FL. IF you are not qualified to do business may mean that you cannot maintain a lawsuit in the state.
if the corp is closely held and its business is to be conducted largely or entirely within a single state, local incorporation is preferred Delaware is a closely-knit legal community. Normally unless you are going public then there is no specific reason to go to DE to incorporate. Makes sense to incorporate in the state that you plan on doing business. BUT Delaware has a sophisticated chancery business court!.
B. How To Incorporate: file art of incorp with the secretary of state and pay filing fee = corporation begins to exist. In Florida: SunBIZ.org Forms that you can use to modify the corporation. Look up corporations Forms to amend the articles of incorporation Find articles of merge Issues to be addressed: Whether substantive provisions should be placed in the articles of incorporation, the bylaws, or a shareholders agreement Modern trend is to limit the articles of incorporation to provisions that are required by law to appear in that public document while all other substantive provisions are placed in documents that are not filed of public record but placing things in the public records gives legal notice to the world formal requirements for filing documents found in MBCA Section 1.20-1.26 Page 95 of the supplement tells you how Chapter 1 forms the backbone of the Floridas laws. o Fees, filing requirements Dates and times and effectiveness. o 1.29 o Look to 1.4 for definitions.
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Corp Names a. 4.01 Names: i. Corp. name must be distinguishable upon the records of the Sec. of State from other corp names 1. If your client comes in wanting to use the work gator in the name. Not available: Palm probably not. 2. Just because the sec of state allows the name does not protect against a lawsuit by someone of a similar name under the intellectual property laws. ii. Purpose of corp name regulation is to prevent unfair competition iii. A corp may conduct business under an assumed or fictitious name to the same extent that an individual may...test for the lawfulness of doing business under an assumed or fictitious name is that it is proper to do if the purpose is not to defraud. The fictitious names are governed in another statute. iv. 3.02 automatically grant every corp perpetual duration and succession in its corp name, unless the Articles of Incorp provide otherwise.
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III.
Exam Q: May a corp serves as an incorporator: YES! According to MBCA 2.01 states that one or more personsand person is defined as an individual or entity and 1.40 subsection defines that to be a corporation. Preemptive rights and cumulative voting: statue says that you must put that right in the articles. When the statute says where to put it whether it be the articles or the bylawsthen you must do so! That which you put in the articles is a matter of public record. That which you put in the bylaws is not public record. 2.02 Articles of Incorporation: Must versus May a. The name for the corporation b. 6.01: The number of shares and type of shares (common/preferred) that it is authorized to issue: this total number of shares may not exceed this number except by amendment to the articles. I.e. going public. i. IE authorized to issue 200 shares of common stock par value of $1.00 per share. You have A B C D as owners who have a prescription of shares per owner (here they have equal shares). 10 shares each. And are authorized to ABCD and are outstanding 1. What is the number of shared authorized? 100 what is the number issues and outstanding? 40 and are so because they are voting shares. 2. Each of ABCD has a of the shares. This board of directors can only issue up to 100. What if they want to authorize 40 to E. Then there are 80 shared outstanding and issued THUS diluting the ownership percentage. Now the ABCD only own 1/8 of the interest ii. They authorize 1,000 shares and ABCD all have 10 shares. And E has 400 shares. SO the percentage interest ABCD is 10/440. thus DILUTED! The number of shares authorized also sets the limit which is the ultimate limit of the dilution of the ownership interest. iii. You cant issue more shares unless you authorize more shares through amendment to the articles of incorporation. 1. If you want to create different classes of sharesi.e. voting and non voting or preferred stock, or preference on liquidation or non preference. You must describe them in the articles. 2. i.e. stating series A preferred, par value, has liquidation preference of $100 per share, and has a preference on dividends of $10 per share cumulatively. You must describe them and not just state that there are 1000 shares of preferred. Must be in the articles. 3. BLANK check provision: BOD can write into art of incorp amount of stock they are willing to sell to investor for an incentive. They are flexible to come up with what that venture capitalist wants if they are going to invest in the company. 4. 6.03 issued c. Street address of corps registered office & name of its initial registered agent at that office d. Name and address of each incorporator. Purposes: a. 3.01: not required to include purpose class unless limited.
b. Corp. may list multiple purposes without any limitation on the number of purposes specified and without any obligation that the corp actually pursue all the purposes contained in the articles c. Several reasons why want a narrow purpose: i. Some types of corp may be engaged in businesses subject to state regulation that permits incorp under general business statutes but requires limitations on corp activities ii. Founders may be uncomfortable with the complete lack of useful info about the purpose of the corp permitted by the MBCA, preferring that some description of the principal business of the corp appear in the articles of incorp iii. In closely held corp, a limited purposes clause may be used where one or more persons interested in the corp wish to restrict the lines of business the corp may enter III. Powers 3.02 Must distinguish between powers and purposes within the articles of incorporation Easiest way to do this is to precede each statement with the phrase to engage in the business of when stating purposes. It is not necessary to make any reference to corporate powers in the Art. Of Incorp. CHAPTER 5 Registered office and registered agent 1. All about service of process. 2. Having both a registered office and agent ensures that every corp has publicly stated a current place where it may be found for purposes of service of process, tax notices, etc. 3. Agent must give written consent for a change. 4. Solve the problem by making an attorney the registered agent so that he can receive all important documents and deal with them accordingly 5. Bylaws of a corporation constitute the internal set of operating rules for the corporation 1. Prepared by an attorney overseeing the formation of the corp 2. Can someone resign? Yes but must also file it with the sec of state and replace someone new Prepare the bylaws i. WHERE AND WHEN the annual meeting ii. What are the office positions going to be iii. BY-laws are able to be amended by the board DECLINE OF THE DOCTRINE OF ULTRA VIRES: ONLY IMPORTANT ON THE BAR EXAM a. Beyond the powers: An act performed w/o the powers or purposes of the corporationit lacked power to do the act or enter into a K. b. Traditional CL: was a defense.
c. Modern: no defense: art of incorp usu., authorize corp to undertake any legal action, the ultra vires doctrine has limited significance & is in decline. d. Pursuant to law or its articles of incorporation e. When a corporation does act or enters into a contract beyond the scope of its charter, it is not necessarily illegal and it is not necessarily void INSTEAD its voidable. f. The legislature would then have to enact a statute to over come this problem. 711 KINGS HIGHWAY CORP V. FIM'S MARINE REPAIR SERV., INC 1966 The art of incorp that D was in business of marine life. D entered into a 15-year lease to build movie theater. Defaulted on payment. P sued. D raised ultra vires defense alleging it was outside the scope of its charter. Where as the common law stated that unless it was within the purview of the articles, the Statue says that the doctrine of ultra vires is limited in its use. Finally the second point made is that the defense may not be invoked as a sword in support of a cause fo action. Modern trend: ultra vires is NOT a defense. The decline of the Ultra vires: look to 3.01 purposes: which states that no matter what.
Theodora Holding Corp. v. Henderson -- Charitable Contributions Rule of law: a majority stockholder may cause a charitable contribution to be made out of corporate funds if such charitable gift is within reasonable limits as to amount and purpose The test applied in passing on the validity of any corp gift is that of reasonableness from IRS. When a corp makes a gift of corporate property or funds, such transactions can raise an ultra vires issue. Question is whether the gift is reasonably necessary to furthering a valid corp objective
PREMATURE COMMENCEMENT OF BUSINESS 1. Promoters 2.04 a. Promoter: a person who, acting alone or in conjunction with 1 or more persons, directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer. Often referred to as the founder or organizer or an enterprise. b. Owe significant fiduciary duties to other participants in the venture c. Boss Rule: A promoter though he may have assumed to act on behalf of projected corp and not for himself, will be personally liable for the K unless other party agreed to look to some other person or fund for payment. d. Adoption and ratification will not let the promoters initial obligation go away. e. Only time promoter is off the hook is when there is a novation in which there is a new K with a new party.
f. Corp is not liable for promoters K unless it expressly ratifies or adopts it. g. Newly formed corp can disaffirm Ks entered into by promoters based on theory that BOD has not voted on it. 2. Co-promoters Fiduciary relationship exists between co-promoters. 3. Corporation itself Must be done after corp has come under the control of subsequent investors or other persons FOUR THEORIES: ABOUT AGREEMENTS PRE INCORPORATION
When a promoter makes an agreement with another on behalf of a corporation to be formed, the following alternatives may represent the intent of the parties: **A corporation not yet formed means promoter liability 1) Understanding that the other party made a revocable offer to the non-existent corp which will result in a K if the corp is formed and accepts the offer prior to withdrawal. - Revocable offer: does not mean a K not enforceable (no one bound) 2) Understanding that the 3d party is making an irrevocable offer for a limited time. Consideration to support the promise to keep the offer open can be found in an express or limited promise by the promoter to organize the corporation and use his best efforts to cause it to accept the offer. - There was a 3rd party, corp to be formed, and promoter - Revocable offer bw 3rd party and promoter (not enforceable) - Could also say there was a K to form the corp (irrevocable for a limited time) 3) May agree to a present K by which the promoter is bound, but with an agreement that his liability terminates if the corporation is formed and manifests its willingness to become a party. There can be no ratification by the newly formed corp, since it was not in existence when the agreement was made. - Between 3rd party and corp to be formed Novation: when you substitute a party in a K. In order to have a novation, the other party must agree. - If it was a novation, liability to the promoter ends, when new party becomes part of the K 4) May agree to a present K on which, even though the corp becomes a party, the promoter remains liable either primarily or as surety for the performance of the corps obligation. - Adoption Ratification - Promoter makes a K with the 3rd party, and the formed corporation adopts the K. irrevocable. - Corp adopts the K of promoter and 3rd party, but the promoter remains liable. (secondary, like a subtenant).
Revocable offer: parties understand that promoter will not be liable and the corp will only be liable when its formed. Condition precedent. May be quantum meriut. Irrevocable offer: parties understand that the promoter is binding himself until the corporation is formed.
Present contract by which the promoter is bound: NOVATION: substitution of a party entirely because it is a new contract. the third party has to agree to the substitution of liability. There can be no ratification b/c the corp was not in existence at the time the agreement was made. Present contract: both corp and promoter are liable. PROPER EXECUTION: The name of the corporation BY ____ the name of the promoter
McArthur v. Times Printing Co R: formal adoption or acceptance of a contract by a corporation Is not a requirement, but acceptance may be inferred from acts or acquiescence on the part of the corporation or its authorized agents DEFECTIVE INCORPORATION Corporation de Jure (at law): Corporation formed under law. Corporation de facto (by fact): an appearance that corporation is formed. 1. Requisites established by the Supreme Court to establish a de facto corporation. 1) Valid law under which such a corporation can be lawfully organized 2) An attempt to organize under that law. i. What is an attempt? You must try to file with the secretary of state. It is more than just writing the art of incorp. You must put them in the mail or send by courier. 3) Actual doing business as a corporation. 4) Good faith in claiming to be in, and, doing business. Note: You can assert that you are a de facto corporation against anyone but the state. Corporation by Estoppel: if a 3rd party deals with what it believes is a corporation, then the 3rd party will be estopped from denying there is not a corporation. Usu., the person estopped is the person acting. ROBERTSON V. LEVY R: officers and directors who attempt to act for a defectively formed corporation or prior to its formation are jointly and severally liable for those acts CANTOR V. SUNSHINE GREENERY, INC. R: one who deals with a de facto corporation as a corporation is estopped to deny its existence in an attempt to hold those with whom he dealt personally liable on its contracts CRANSON V. INTERNATIONAL BUSINESS MACHINES CORP. Doctrine of estoppel: where the person seeking to hold the officer personally liable has contracted or otherwise dealt with the association as a corporation.
ISSUE SPOTTER: If the person believes there is a corporation: De facto and estoppel: If the person is acting before then look to promoter liability.
CHAPTER 7 DISREGARDING THE CORPORATE ENTITY
BOD = board of directors, S/h = shareholders, BJR = bus judgment rule
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COMMON LAW DOCTRINE OF PIERCING THE CORPORATE VEIL A court may pierce the corporate veil and hold owners liable for corps debts. Piercing the Corporate Veil refers to extreme situations where some or all shareholders will be personally liable for corporations obligations. TESTS TO PIERCE Alter ego Mere instrumentality Fraud illegality Reasons to pierce corporate veil: 1. Prevent fraud, illegality, misrepresentation, or 2. Achieve equity
Factors to consider for piercing corp veil: 1. Undercapitalization (depends on nature of specific business) 2. Failure to observe corp formalities (ex: if not holding meetings then one person is really running corp and not really a corp) 3. Non-payment dividends. 4. Insolvency of a corporation. 5. Siphoning of corporate funds by a dominant shareholder. 6. Corporation is a faade of the dominant shareholder. One of the key attributes of the corporate form is limited liability Cane - Piercing is the exception, not the rule. The rule is that corporations limit liability and the burden of proof is on the party trying to pierce. DEWITT TRUCK BROKERS V. W. RAY FLEMMING FRUIT CO. (4TH CIR. 1976) In this case, the Dewitt is the shipping co., who is suing Flemming in their capacity as a creditor of the corporation. The Corporation was withholding the transportation costs and running it out of his back pocket. Thus he was not treating the corporation as a separate entity. There was no meeting there was no observation of corporate formalities. Court looks at equity and fairness to see if subsidiary is mere instrumentality or alter ego - theres no real separation between the person and the corporation. No fraud required. The corporation is not really there, because it is just himself or his evil twin Skippy, there was no distinction between the two. Factors of which courts may consider any number: a. Undercapitalization for purposes of corporate undertaking. i. If you are running a business with less then what it takes to run the business. Doesnt mean sufficient assets to satisfy every claim, but enough to run the business with expectation of some liability. b. Failure to observe corporate formalities. Evidence of treating it as a separate entity c. Non-payment of dividends. d. Insolvency of debtor corporation at the time. e. Siphoning of funds of corporation by dominant stockholder. Merged funds. Interchangeable between the individual and the corporation. f. Non-functioning of other officers and directors. g. Absence of corporate records. h. Element of injustice or fundamental unfairness required.
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The court will look to the circumstances, and not just to one single element to achieve their decision. Note: Piercing is entirely a phenomenon of closely held corporations, and predominantly one-person corporations. Here the Court found that this was just an alter ego and mere instrumentality. BAATZ V. ARROW BAR (SD, 1990) TORT CASE Piercing is allowed to avoid injustices and inequitable consequences. This is the tort case. Concerning a car accident. The individuals are not held liable in the majority because it would produce injustices and inequitable consequences of piercing the veil. Note: Courts are more likely to pierce in tort cases than in contract cases. Voluntary Creditor Doctrine - in a contract case, there is the opportunity to look into the credit of a corporation or bargain for personal guarantee. In tort, such opportunity for the plaintiff/creditor/victim to protect themselves. RADASZEWSKI V. TELECOM CORP. (8TH CIR. 1992)= A tort victim may not pierce the veil of a sub to reach the parents assets when the sub has liability insurance adequate enough to cover victims injury, when sub is otherwise insolvent, regardless of whether victim can recover under insurance. Choice of Law is determinative because different states have different tests for piercing. Federal courts, through Erie, will apply state law. FLETCHER V. ATEX, INC. (2ND CIR. 1995) In order to hold a parent corp liable for its subsidiarys conduct under the alter ego theory, the P has the burden to prove that: 1. The parent and subsidiary operated as a single economic entity and 2. That an overall element of injustice or unfairness is present. Note that fraud is not a required element!
i.
THE PIERCING DOCTRINE IN FEDERAL/STATE RELATIONS UNITED STATES V. BESTFOODS (S.CT. 1998) DIRECT LIABILITY The fact that a parent corporation affects the operation of the business of the subsidiary is not enough. There must be a domination and control of the subsidiary. Here, you need specific control of the subsidiary and not just general control for normal piercing Control Test: 2. Active involvement 3. Actually exercised control over the subsidiary immediately responsible of the acti STARK V. FLEMMING (9TH CIR. 1960) social security benefits -- nothing useful. ROCCOGRANDI V. UNEMPLOYMENT COMP. BD. OF REVIEW (1962) If youre self-employed, you cant lay yourself off. Court will ignore the existence of your corporation. The Superior court corporate entity may be ignored when determining that as a matter of public policy they had the control to lay themselves off and they had the power to not lay themselves off. REVERSE PIERCING The owners of the incorporation desire the veil to be pierced and want to be individuals.
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CARGILL, INC. V. HEDGE (MN, 1985) BANKRUPTCY HOMESTEAD EXEMPTION. Factors the court considered: A. Degree of identity between individual and his/her corporation. B. Extent to which corporation is an alter ego. C. Whether others, such as creditor or other shareholders, would be harmed by the pierce. D. Policy reasons. Ex: furtherance of homestead exemption. HYPO: A, B, C, D Corps are in the business of construction. Fred is an employee of D corporation and was injured by the crane that was not owned by D corporation. Workers compensation means that I cannot sue my employer for tort, I must work within the workers compensation statutes. If Fred was injured by the crane owed by D corp and was an employee of D corp she would be limited. But if A corporation (which is all related to B C D) Is the one that owned the crane, then she should be able to sue A in tort, and not in workers compensation. Reverse veil piecing fits into this because we represent A corporation and its affiliates. We want to say that ABCD are all one big happy family and thus make all the corporations the same thus workers comp applies. PEPPER V. LITTON (S.CT. 1939) Pepper is a 3rd party. Litton is the sole shareholder of Dixie. Litton paid himself for back pay, he did that b/c he knew that creditors were coming after that debt. As a result, the back pay made the corp insolvent. A. Deep Rock Doctrine - a dominant-controlling shareholder will have his claim against the corporation subordinated if he abused his position to make his claim come ahead of other creditors. Its a matter of equity. Equitable subordination of controlling s/hs claim. B. The test is a violation of fair play and good conscience; a breach of fiduciary standards of conduct owed to your corporation, its stockholders, and creditors. Florida Veil Piercing DANIA JAI-ALAI PALACE, INC. V. SYKES (FL, 1984) Alter ego & mere instrumentality adopted. Supreme ct said that it is not alter ego. Fraud -----improper conduct ------alter ego. For purposes of pleading in complaint, in Florida to pierce the corp veil you must allege improper conduct. Problem: No set definition for improper conduct. If you dont plead it, then it is dismissed. Piercing may be granted if you prove Improper Conduct, on part of parent. Its conduct worse than in the alter ego test, but better than fraud.
CHAPTER 8 FINANCIAL MATTERS AND THE CLOSELY HELD CORPORATION
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DEBT AND EQUITY CAPITAL Debt Financing Contractual r/s involving promissory notes or bonds that involve a promise to repay the investors loan at a certain rate of interest. Exception: bankruptcy but you can get a charging order and Risk is low b/c its a contractual r/s and guaranteed your $$ back. Reward is lower for bonds b/c its a fixed amount & interest rate. Law and contracts protect bondholders. Equity Financing Buying stock.
Risk is high.
Reward is higher b/c value of interest goes up. Stockholders are protected by fiduciary r/s.
BONDS VERSUS PROMISSORY NOTES. What makes bonds more & less valuable? Pricing of bonds depends on risk involved. Bond rates on based on how solvent and steady the company is. Risk is built into price of bond in form of interest. JUNK BONDS (HIGH RISK, HIGH YIELD, HIGH INTEREST) CAPITAL MAY BE OBTAINED BY: 1. Borrowing funds (from friends or banks) 2. Capital contributions (from owners or persons who wish to remain inactive outside investors) 3. Retaining earnings of the business (rather than distributing them to owners) Debt: must at some point be paid back; interest is paid periodically, and its repayment is not dependent on the earnings of the business. Equity Capital is composed of contributions by: 1. The original entrepreneur(s) 2. Other investors in exchange for ownership interests 3. Retained interests Blue Sky Laws: State statutes that regulate the sales of securities within the specific state. Applicable whenever a business seeks funds a.k.a. capital from 3rd partiesno limit as to amount. TYPES OF EQUITY SECURITIES Common shares: represent residual ownership interest; they get whatever is left over after creditors, bondholders, and preferred s/hs are paid. They generally have voting rights but not dividends. Preferred shares: hybrid b/w debt and common stock. It has a preference on dividend versus liquidation. Traditionally not sold publicly, thus preferred stockholders would want conversion rights in articles of a closely held in order to convert their preferred to common if corp goes public. Three types of preferred dividends/shares: 1. Cumulative preferred: if dividends not paid in year 1 they rollover into year 2. 2. Non-cumulative preferred: if no dividends paid in year 1, too bad. 3. Partially cumulative: depends on financial status of corp.
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Ex: if dividends not paid in year 1 and corp had adequate earnings to pay in year 1, then it rolls over into year 2. NOTE: if you have preferred stock, corp CANNOT elect to be an S corp. Participation Rights: if corp pays out dividends to preferred and common and there is surplus in dividends, then preferred and common share. Non-participating: entitled to specified amount for dividend and liquidation and nothing else. Shares: (defined in MBCA 1.40(21) as the units into which the ownership interests in a business are divided) There may be different classes of shares They may have different preferences, They may have different limitations and relative rights. There may only be one class issued and they may be called: 1) Common shares, 2) Capital shares, 3) Shares, or 4) Stock. All shares w/in a single class must have identical rights. Various designations and rights of shares must be set forth in the art of incorp (MBCA 6.01).
US HOUSING FOUNDATION, INC. V. FORMAN, 421 US 837: enumerates the rights of Common Shareholders: 1. Right to receive dividends 2. Negotiability 3. Ability to be pledged or hypothecated 4. Capacity to increase in value and 5. Voting rights in proportion to the number of shares owned. Redemption rights: corporation has the power to redeem or call back the preferred shares at any time at a fixed price when corporation anticipates that dividends on preferred may become more expensive than other forms of financing. The fixed price is usually set by the art. of incorp., or typically more than the liquidation preference. Redemption can usually only be exercised after a specific amount of time. Ex: If the corporation calls back the stock and the stockholder has a $100 liquidation preference, the fixed price of the redemption would probably be $105 + any unpaid cumulative dividends. If the stockholder refuses, the corp will simply put the $105 in a bank and refuse to recognize the stock certificate. Classes of common shares (MBCA 6.01) Classes of common shares are usually referenced alphabetically, i.e., Class A common shares, or by description, i.e., nonvoting common shares. ISSUANCE OF SHARES: HEREIN OF SUBSCRIPTIONS, PAR VALUE AND WATERED STOCK Shared subscriptions and agreements to purchase securities (MBCA 6.20) Historically, subscription agreements were utilized to raise capital for a new corporation. Subscription agreements: occurs when persons agree to purchase a specified number of shares contingent upon a specified number of capital being raised. Now, we use (mostly) Contractual Agreements to purchase securities.
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AUTHORIZATION AND ISSUANCE OF COMMON SHARES UNDER THE MBCA Prices for shares must be the same for, say A and B shares if they are to be treated equally, but the # of shares and corresponding price may be set at any level. PAR VALUE AND STATED CAPITAL Par value: represents amount that must be paid for shares so that they are issued as fully paid. Par value is a may in RMBCA 2.02(b)(2)(iv). Par value does not apply to re-sale only applies to issuance. MBCA (1969) 54(d), 15 (second sentence), 18, 21. Par value is whatever amount is designated by the drafter could be one mill, one cent, etc. If you issue stock for less than par value then you are liable for difference for what he paid for it and what the par value actually is. Watered Stock: stock issued for less than par value. o Two issues: 1. Non-cash consideration given for stock i. BOD gets deference, absent fraud, to accept but has fiduciary duty to assure that property is equivalent to shares issued. 2. Stock issued for less than par value for cash instant liability. Reasons in Florida to have the par value nominal, or low is because of the MBCA state in addition to the documentary stamps that must be put on all documents. The Doc stamp tax is based on the par value. If you dont put a par value on the corp, then it is the documents transactional value. Thou shall not issue less then their par value. Thou shall not issue for illegal consideration. Thou shall not hurt creditors to advance interest of s/hs and s/hs economically. 45(MBCA) talks about dividends. You cant pay dividends to s/hs if creditors would be negatively affected by it. HANEWALD v. BRYANS INC R: A shareholder may be held personally liable to his corporate creditors to the extent that his stock has not been paid for. MBCA 25. Purpose is to protect the public and those dealing with the corporation. The shareholder is liable to the extent of the difference between the par value and the amount actually paid and to such an extent only as may be necessary for the satisfaction of the creditors claim. Shareholders loan is a debt and not an asset of the corporation. Here the corporation repaid a loan to the shareholders before its operations were abandoned, the loan cannot be considered a capital contribution. Traditional Rules 1. Insolvency: look at what money you have, types of assets, what money you owe, and when the debts are due. When you are looking at balance sheet for purposes of declaring and paying a dividend & when corp is repurchasing shares from its own s/hs (s. 6). You cannot pay out a dividend to s/h in detriment of creditors. A, B, C & D are s/hs. You may not pay or declare dividends if it makes corp insolvent. 2. Surplus Lesser: you can only re-purchase and/or you can only pay dividend out of the restricted/unrestricted surplus. 2 Definitions Stated capital: # of shares x par value Capital surplus: difference in amount paid per share minus par value (x) # of shares. Earned Surplus: the aggregation of income from all profit and loss s/ts going back to the time the corp was organized (i.e. amount of $$ corp has made since its inception).
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New rule Ex: Insolvency by looking at Balance Sheet Assets Liabilities Cash ($500) Account payable (A/P) - $100 Building ($500) Note due in 2050 -- $400 Equity Stated Capital 10 shares @ $1 per share Surplus -- $490 ______________________________ $1000 $1000 500 cash 100 A/P = 400. Surplus is 490 Surplus is total assets total liabilities stated capital. Take lesser of two, which is the 400. So corp can only spend up to 400. 1st part of test to make determination if corp will go insolvent: What are the liquid assets and what are current liabilities? Modern Rule Distributions 6.40 P.123, 106 s. 1.40(6) defn of distribution 1) Insolvency Test liquid assets (-) accounts payable = gives you surplus. And 2) Modified balance sheet Test: total assets (total liabilities + preference) = equity. FN in balance sheet will tell you if there is a preferred class and what the preference per share is. Always take the lesser of the two no matter what test you apply: traditional & new. TORRES v. SPEISER There was a resale of stock in exchange for future services as consideration. R: Watered stock only arises in connection w/ original issuance & any subsequent re-sale is NOT governed by the par value. R: Liability for watered stock arises from initial issuance of stock in a NEW corp for less than par value. 45: The BOD may declare and pay dividends, EXCEPT if that payment would create insolvency, as stated in 2(n). Assets: General R: for the purpose of insolvency: Is there a sufficient amount of cash such that if I pay the dividend may I still be able to pay my creditors, so that I am not favoring shareholders over creditors. Treasury shares: MBCA 2(h) If you double the amount of shares then you should half the par value: Stock split means that the # of shares issued and out increases but the proportional amount of shared has remained the same. It just changes the number of slices in the pie. The real reason as opposed to the legal capitol.. IT happened in the public market place, for psychological reasons. 2 for one split where if your shares were worth 100 you would reduce the cost per share to 50 and
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you now own 2 thus you havent changed what you own. Thus psychologically it is a good thing for your shareholders. But what happens is that it might increase about a buck. Reverse Stock Split: you now have half as many shares. The assets and liabilities have not changed. The pie is just split into smaller pieces. On the equity side you either create surplus when you dont change the par value. By monkeying around with the number of shares you increase the surplus. THE importance is the dividend or the repurchase, and the surplus would be more! The most common reason is that the stock is trading too low! So psychologically the reverse split so that for every two shares you now have 1 share and it trades at 20 bucks a share. DEBT FINANCING Debenture is an unsecured corporate obligation. Bond is secured by a lien or mortgage on corporate property. Traditionally, debentures and bonds were payable to bearer and the interest was kept track of by way of interest coupons, which were attached to the debt security. The owner would clip, or cut off the coupon and submit it to the corporation for payment. A registered bond is one that has been registered in the name of a specific individual. Why a corporation does debt as a manner of financing. THE CONCEPT OF LEVERAGE Leverage: Debt owed to third persons is leverage when you earn more than the cost of borrowing. Leverage = other peoples money; earn more than cost of borrowing. So if its costing 8 percent to borrow and you can take that money and earn 15 percent, that is where you get leverage from. Past a break even point. Leverage is favorable to the borrower when the borrower is able to earn more on the borrowed capital than the cost of the borrowing. TAX TREATMENT OF DEBT A loan by a shareholder to his corp. reduces the double tax problem of a C corp. Interest on debt is tax deductible. Risk of business formulation = contributors of capital undertake the risk because of the potential return in the form of profits and enhanced value on their underlying investment. If the IRS reclassifies the debt as equity then it is no longer deductible because it is now seen as a dividend. If you are a creditor and you use your position as a director (like in pepper) you would have an insubordination, which is not good! DEBT AS A PLANNING DEVICE Subordinating equity concept is the same as the deep rock doctrine at a state level. Debt/Equity Ratio: Problems: (1) If you have a lot of debt over equity, IRS may reallocate back to equity side. This means interest you thought was being paid will become dividends subject to tax and it is not deductible. Varies depending on type of business you have. (2) Amount of insider debt to insider equity how much do s/hs of corporation own as creditors. If high ratio then there is a problem under deep rock doctrine.
PLANNING THE CAPITAL STRUCTURE FOR THE CLOSELY HELD CORPORATION Questions to ask when approached by a client for purposes of the capital structure: 1. Will the structure stand up when later faced with disagreements? I.e., a legal attack? 2. Will the structure provide the desired result, i.e., the client should be aware that the directors may choose to forego dividends on the preferred stock if they so choose? 3. Is the desired tax treatment available; C or S corp.?
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4. Unexpected liabilities? 5. Clients financial contributions reasonably protected? NOTE: watered stock issuing for less than par or improper or illegal consideration. 1. The stock is issued for future consideration thus it is watered stock Problems on page 387 Watered stock: Issued at less than par value & no future consideration allowed. Securities Act regulation: Prior to 1933 no securities laws. The regulation was governed by the state regulation of the sale of stock called the BLUE SKY LAWS (securities law in every state). Both systems still exist. Must deal with these problems on both levels. 1933 Act: how you may lawfully sell securities. Key to Act is s. 5 that says: thou shall register. Registration is required unless there is an exemption. Underwriters: investment bankers; they buy the stock from corporation and sell it to public. Public Offerings Securities involve state and fed laws
Going Public Negatives of going public: 1. Cost is high 2. Regulation 3. What was private is now public 4. Quarterly financial statements are required so the world could see how its doing. You have a company, and the company wants to get money (could get from bank, but wants a certain amount of capital) and wants to build another factory (company 2) Comp 1 goes to the underwriter (investment banker) Figured out it needs 75 million for IPO. Underwriter forms a syndicate to say that there are enough people who would want to buy stock. Public distribution: process of getting stock from issuer to public. Underwriter prices the stock! The co and counsel with underwriter registration statement (will be filed with SEC) Piggy-backing registration: when closely held corp is thinking of going public instead of selling entire stock to underwriter, s/hs will keep some for themselves and just give underwriter share of profit.
1) Pre-file Quiet period pre-filing b/c you do not want to predispose people to buy 2) File (waiting period) You file then you are in the waiting period, b/c you are waiting for the SEC to give you comments 3) Effective SEC will declare your registration effective - can do this by prospectus
Underwriters The person/organization that acquires shares for resale or who arranges the direct sale of shares by the issuer. 1. Usually a firm commitment
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Means that on the day you go effective that the underwriter will be you the co real money then up to them to sell the stock thru the distribution channel the syndicate. They usually take a mark up of 15%. the co gets what the co Ked for and the underwriter is on the hook. The pricing of the security determined the day it offered.
2. Best Effort Underwriting What we cant sell, you get back
If the IPO price is $25 dollar per share it means the co is being compensated on this price. If after effective price goes up to $75 per share. This does not go to the co, b/c it is in the market. The co is locked in at the IPO price for that stock. The amount it goes up or down has nothing to do with the co they dont care The magic of going public is that you have created a new form of currency Once you (the corp) have gone public, you can use shares of stock that the company owns to buy things instead of cash.
Blue Sky Laws State securities law. Focus disclosure and regulation of securities. Needed because people were selling anything up to the Blue Sky. Securities Act of 1933: First fed regulation dealing with securities laws. Deals w/ the sale and distribution of securities. Securities Exchange Act: of 1934: Deals with how securities are traded after sale and distribution TWO VIEWS: 1. Full and Fair disclosure: Congress opted for disclosure because investors are adequately protected if all of aspects of the securities being marketed are fully and fairly disclosed. All material facts w/o material omissions permit you to sell shares. 2. Merit regulation (paternalistic view): state looks at offering and decides whether its worth of investment. Fed acts do not necessarily preempt state securities laws. Securities Act of 1933: - When you are going to disseminate securities publicly you have a document that must be filed with the SEC (independent regulatory agency of the fed gov). Other part of this act is about fraud. Actionable in addition to failure to register. e.g. material omissions General Rule: Federal Registration 5: Thou shall register (give SEC prospectus and other info) - Requires registration of a public issue that is offered or sold through the use of any means or instrument of transportation or communication in interstate commerce of the mails 0 includes phone, e-mail, fax. - Prospectus: a document that contains the info essential to make an informed investment decision. Ex: financial information, senior mgmt, etc. - You have to register unless an exemption applies.
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Exemptions 4(2):
Failure to register unintentionally (mala prohibitum): purchaser gets stock back plus interest and subject to civil liability.
Private Placement: corp selling stock to make capital before it goes public. You dont have to register. You do not have to register transactions not involving public offerings (Ralston Purina) - In a private placement, the info never gets to professionals, because the potential investors are educated enough to understand. - Guideline for the cts is whether or not the people in the private placement would have the necessary expertise to make an informed decision. (e.g. top level management would, but not production line workers). - Look at (1) who the offeree and (2) what info is available to offerees to make an informed decision. Intrastate Offering: Exempts any security which is a part of an issue offered and sold only to persons resident within a single state, where the issuer of the security is a person resident and doing business in, or if a corp, incorporated by and doing business within the state, - Basically, a one state offering. An offer to a single non-resident destroys the exemption. - Purchaser cannot act as a conduit to out of state investors in order to get exemption and issuer has a duty to inquire where purchaser resides. Even if there is a purely intrastate offering, this does not mean you are exempt under state Blue Sky Laws. (So, you would also have to look at the state statutes to see if you are exempt from registering within the state. - If a corporation seeking to take advantage of the non-public offering exemption inadvertently makes one offer to a person who needs the protection of the Securities Act loses the exemption and full-scale registration is required. - Intrastate exemption is limited in FL, because everyone is from different places Rule 147 provides objective standards for determining when a person is considered a resident within a state, and the doing business within requirement that the business should be located within the state (and the principal business must be carried on there) and substantially all the proceeds of the offering must be put to use within the local area.
3(a)(11):
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Failure to register gives purchaser right to tender back plus interest SEC v Ralston Purina Co - Tried to encourage stock ownership among employees. They did not register bc they said they were not offering to the public as a whole. They said key employees. (Would have been ok for managers who had access to info and knowledgeable) - Exemption to though shall not register is if not public - Financial analysts also gets prospectus. In a private placement, the info never gets to professional - Ct said this was not an exemption under non-public offering, so had to register. - If not register get to sell back to co with interest.
An exemption from registration NEVER frees you from anti-fraud concerns under securities laws.
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The burden to prove all elements of the exemption is on the issuer If no exemption, everyone who purchased can give back securities and get money with interest.
How the 33 act works: Sec 11 provisions creates liability Says that if the underwriter did not act with due diligence to determine that there has been no misstatement in the registration statement, they have liability. - Can find filings under EDGAR (sec.com): best way to get original info on stock Administration Rules Promulgated by the SEC Regulation D - Rules Governing the Limited Offer and Sale of Securities Without Registration Under the SEC of 1933 - These are exemptions from 5 - thou shall register. - (More popular exemption - a series of safe harbor exemptions) - 3(b) of SEC act of 1933- SEC may promulgate rules as long as they are in the interest of the investment protection. - 3(b) gives no exemptions, SEC does in the rules (b/c congress let them decide what to exempt). - Was to facilitate capital formation consistent with the protection of investors. 230.504-506 are the operative provisions (the actual exemptions) 1. There is NEVER exemption from anti-fraud requirement (information is missing essential material). 2. Still have to worry about state Blue Sky laws 230.504 Exemption for Limited Offerings and Sales of Securities Not Exceeding $1,00,000 - Aggregate offering price shall not exceed 1 million dollars sold within 12 months before start of and during the offering of securities. - Must wait 6 months to avoid integration problem. - Governed by state rules. - What this rule is about is that the SEC says that these deals are too little for them to worry about, even if interstate (can raise a million dollars without registering). - Still must comply with the state Blue Sky laws you are offering in. No investor CAP but could be if doing a deal w/ another state. If you were doing a 504 deal in OH and ILL, would have to look at their Blue Sky Laws 9 mths 504 504 500,000 500,000 230.505 Exemption for Limited Offerings and Sales of Securities Not Exceeding $5,00,000 - This is another 3(b) exemption - Aggregate offering price cannot exceed $5,000,000 within 12 months before start of and during the offering of securities. - No more than 35 non-accredited investors (regular people & family members). - No cap on accredited investor (ex: institutional investors to millionaires). - Issuance of stock is Restricted securities: sold outside the registration process and must be held for ONE year otherwise purchaser is considered an underwriter. - Quid pro quo: quid = dont have to register; quo = you are restricted. - Paragraph (c) also states that there are limitations on the manner of offering in that the issuer may not offer or sell the securities by any form of general solicitation e.g. TV, magazine, newspaper, seminar 230.506 Exemption for Limited Offers and Sales Without regard to Dollar Amount of Offering
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PRIVATE OFFERINGS SUBJECT TO SEC SAFE HARBOR CONDITIONS. (This is the SEC Safe Harbor Rule for private placements under section 4 (2) of the act, and is the most important part of Regulation D). You can buy and sell as much as you want!! a) Must meet 501: Accredited investor e.g. bank, natural person whose individual net worth with spouse exceeds $1,000,000, individual income in excess of $200,000 or joint income in excess of $300,000 in 2 most recent years, director, general partner, executive officer of the issuer, and 502 (a): Integration: Offers made 6 months before or after Regulation D will not be considered part of the Reg D offering so long as there are no other offers or sales of securities in the same or similar class. b) No more than 35 purchasers. c) Each purchaser who is not an accredited investor must have knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment. Factors that should be considered in determining whether offers and sales should be integrated for purposes of exemption under Regulation D: Whether the sales are part of a single plan of financing, whether sales involve issuance of the same class of securities, whether the sales have been made at or about the same time, whether same type of consideration is received, whether the sales are made for the same general purpose.
Private Placement memorandum (Preparation of this is essential for anti fraud purposes under 504, 5, 6 - Warn person of the risks. And for anti fraud requirements - Contains all the info required in Reg D and states you are offering a contains risk factors up front. - State in the memo that this is the only thing the purchaser should rely on. If you sell a security under 505 or 506 of Regulation D (issued in connection with the rules or the act), it is deemed a restrictive security. This involves a holding period: You have to hold (not sell) for a minimum of 1 yr. If you want freely traded security, you have to register If getting restricted stock, you cannot sell for a yr. Might want to ask for more stock e.g. from Ford. (or get them to register (which is unlikely)
Calculation on Number of Purchasers for 505 and 506 The following purchasers are excluded: - relative, spouse or relative of the spouse of a purchaser who has the same principal residence - Any trust, estate, or corporation in which a person or those related to him have more than 50% interest - Any accredited investor (so can have more than 35 unaccredited investors) What a Security is: Any note, bond, treasury stock, stock, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement, collateral-trust certificate, ... investment contract, voting trust, ... INVESTMENT CONTRACT HOWEY TEST Elements (most commonly used) to determine whether there is an Investment Contract (Howey) 1. Whether a scheme involves an investment of money 2. Whether the scheme is a common enterprise (comes in 2 forms - horizontal and vertical) Horizontal Commonality: Fortunes of investors are intertwined e.g. ltd partners in a ltd partnership (risks intertwined in a common way success of the venture). This is enough to meet the 2d prong of the Howey test. (only one investor)
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Vertical Commonality (recognized by some state cts): Vertical between broker and client. Is recognized mush less frequently as satisfying the 2d prong. 3. Expectation of profits solely from efforts of others. Question to ask for solely: Whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts that affect failure or success of the enterprise. Effect: If meet the 3 prongs: an investment K and a security so must register, unless an exemption applies. Ponzi Sceme: Not really selling a product: essentially the same as a pyramid and found to be a security. Borrowing from Pete to Paul. Money from suckers. Your ability to make money is based on getting it from people lower down the chain. Selling the opportunity to sell a product, not really a product. Smith v Gross - Gross solicited via investors to raise the earthworm, and would buy back alleging it was greater than the purchase price - 3rd party was not really buying earthworms - it was a scheme to get $$$, b/c investor would sell at inflated price. - Essentially the guy was really selling the chance to make money and not earthworms - Question: Was the thing sold a security or not - Important bc if deemed a sec then the fed and state securities law applies - Earthworms could be a security under something called an investment K. - Howey test applied: Investment K when 1) the Ds persuaded the Ps to invest by representing that the efforts would be minimal and 2) even with effort, the Ps would still not gain the promised profits b/c those profits could be achieved only if the D secured additional investors at the inflated prices. When Analyzing Securities: 1. Is there a security (earthworm case)? If so then proceed on. 2. Did the corp register? 3. Is there an exemption? i. A statutory exemption? ii. A regulatory safe harbor? - Reg. D Must register securities unless you have an exemption Anti fraud rule: However, allows actionable omissions and actionable misstatements So, the S corp in securities fraud is bigger If not a security, may have an action under c/l fraud, but this is a high standard If not registered and you prove what was offered and sold was a security you get your money back with exemptions.
Issuance of Shares: Preemptive Rights and Dilution At common law, there is a preemptive right to purchase shares to maintain a stockholders proportionate interest. (Stokes). 1000 authorized ABCD 25 each E 100 Right of shareholder to purchase stock so they could maintain their proportionate share and right to vote.
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Under the MBCA 6.30, shareholders of a corp do not have a preemptive right to acquire the corps unissued shares unless the preemptive right is granted in the articles of incorporation. - Not every state is uniform on this. If this is stated in the articles of incorporation, shareholders have a fair and reasonable opportunity to acquire proportional amounts of the corps unissued shares upon the decision of the board of directors to issue them. A shareholder may waive his preemptive right There is no preemptive right for: i. Shares issued as compensation to directors, officers, agents, or employees of the corp ii. Shares issued to satisfy conversion or option rights for those groups iii. Shares authorized in the articles of incorporation that are issued within 6 months from the effective date of incorporation (e.g. 100%) iv. Shares sold for anything other than for money - If corp wants to acquire property, cant do preemptive rights Shareholders cannot abuse preemptive rights by offering stock at a price below par value. (Katzowitz). What is Fair Market Value? - Book value: taken from financial statements. - Assets booked in at historic cost (this is not market value) - Fair value depends on who you ask E.g. in liquidation, as a going concern What a fair value is in closely held corporation stock or any non-public entity (e.g. LLP) is a matter of debate. E.g. measure by going concern value. But how determine it? Apple Tree example: Liquidation value - cut down the tree. Value of crop right there - Book value. If tree over many years - Based on capitalization of the earnings.
Distributions by a Closely Held Corp General Rule: Cts do not decide whether dividends should be granted. (Gottfried). Even if there is surplus, s/hs are not automatically entitled to dividends unless there is a showing of bad faith or unreasonableness. - The court in Gottfried used a BAD FAITH standard (this is harder!). - The court in Ford used a REASONABLENESS standard. In the Ford case, the judge said that not giving dividends could not be justified because so much money was involved, and it was corporation money, not Henry Fords, so his personal charitable intent was of no consequence. Only duty is to shareholders, not members of the public. If courts force dividends, it essentially means the judge is making a business decision Presumption of regularity to the board of directors. Given the protection of the business judgment rule that what they did is lawful. Difference in a corporation compared to a partnership: When board of directors (majority shareholders) refuse to declare dividends, courts will generally not compel. Under the UPA, partner could dissolve. Under RUPA, he could get the value of his interest.
IRS Characterization of Payments is Important
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If you have a corporation and pay yourself an excessive salary, the IRS determines whether a salary is reasonable based on an industry wide standard in the field. (Wilderman). - When the IRS determines that there is an excessive salary that is not reasonable, they will tax the reasonable salary to the shareholder (deductible to the corp), and tax the excess as a dividend. Example: $145,000 payment by Mr X $100,000 determined reasonable by IRS = salary = deductible $45,000 is tax liked a dividend, and not deductible
When a corporation buys back its own stock, it receives nothing of value in the hands of the corp. - The remaining shareholders remain to own 100% of the corp assets (reduced by the amount used to reacquire the shares) - A corp cannot treat stock that it has purchased from itself as an asset any more than it can treat its authorized but unissued stock as an asset. However, stock issued by another corp is different. Shares purchased from another corp are an asset of the corp. Generally, stockholders do not owe a fiduciary duty to each other. BUT, In a closely held corp, stockholders owe a fiduciary duty to each other (a minority shareholder), like a partnership, because there is no market for the shares.. - So if a corp offers shares at a certain price to a majority stockholder who wants to retire, it must also offer to buy the minority shareholders shares at the same price. (Donahue). - Rationale for this in a partnership is the complete lack of liquidity. - In a partnership, the default rule is that a partner has a right to leave. May be a breach of k, but partnership has to buy interest back. - This is different with the corp, b/c in theory you have liquidity (illusory in a closely held corp b/c no one will buy the stock) - Traditional legal response would be too bad for the minority shareholder:- as long as corp not acting in bad faith, corp can sell or offer shares at different prices - Contractarian argument: could have had an agreement that other shareholders have to redeem. However, they did not here.
Stokes v Continental Trust Co - Action brought by a stockholder to compel his corp to issue to him at par a proportion of the increase made in its capital stock as the number of shares held by him b4 such increase bore to the number of all shares originally issued - He was concerned with dilution and his interest in company being diluted - Ct said that he had inherent right to buy stock to maintain his proportionate interest means preemptive R: Stockholders have a Common Law preemptive right to buy or turn down an offer to buy more stock and have their stock diluted, as a matter of property law (the ownership of the stock, you have the right to vote). R: Existing shareholders have rights to acquire newly issued stock. Katzowitz v Sidler 2 guys in a corp, the 2d one (Katzowitz) didnt want to buy shares. They offered him a preemptive right and a price below market value. He wanted dividends and did not want to reinvest in the corp. Ratio bw value of the shares and the price was significantly less than the book value
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- Only reason for them to issue stock was to get rid of him or make him such a minor player So, they abused preemptive right to ct said cannot do that On dissolution, they received $18,885.52 and Katzowitz only received $3,147.59 R: Closely held corporations may not issue new stocks for the sole purposes of squeezing out or diluting the shares of the partners who do not wish to purchase more shares and have no reason to purchase more shares. The price of the shares must also be offered to the remaining shareholders at a set, fair and legally adequate price. Gottfried v Gottfried Action brought by minority stockholders of Gottfried Baking Corp to compel the board of dirs to declare dividends on its common stock. Dividends regularly not paid on common stock. Although were at the time of action. Purpose of action was to get board to declare dividends that were fair and adequate for the corp/stockholders. Ps claimed the majority stockholder dirs wanted the minority to sell their stock, and to avoid personal income taxes on dividends, and they gave themselves excessive salaries. R: If an adequate corporate surplus is available for the purpose of distribution, directors may not withhold the declaration of dividends in bad faith. But the mere existence of an adequate corporate surplus is not sufficient to invoke court action to compel such a dividend UNLESS there is bad faith by the directors. Admissible evidence of bad faith (Note: they must be motivating factors). i. Intense hostility of the controlling faction against the minority; ii. Exclusion of the minority from employment by the corporation; iii. High salaries, or bonuses or corporate loans made to the officers in control; iv. The fact that the majority group may be subject to high personal income taxes if substantial dividends are paid; v. The existence of a desire by the controlling directors to acquire the minority stock interest as cheaply as possible.
Dodge v Ford - Minority shareholders wanted special dividend - Ford wanted to use the money so more people could own cars - Dodge wanted to start a competing car co so they wanted dividends - Usual rule: cts do not get involved in making dividend decisions. - Only duty to shareholders, not others - What was special about the dividend so much money (48 million), so judge got involved - Judge said you couldnt justify not distributing some of the money Ct looks to justification for refusal to pay a dividend and here the directors had a duty to distribute the money to its s/hs b/c the expenditures were not immediate and were to be made over time. R: A corps BOD has discretion to decide whether to pay dividends, but that discretion to decide is abused when there is a large accumulation of surplus cash that is not needed for corporate business. R: BOD has discretion to pay dividends.
Wilderman v Wilderman - Husband and wife formed the corp and were now divotced. Each owned 50% of the stock. - Wife (P) sought a ruling that the D former husband (pres of the corp) caused excessive and unauthorized payments (unearned and unauthorized salary and bonuses) that must be
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returned to Marble Craft Corp. and they they be treated as dividends so P could share net profits. - Ct said amount drawn was not reasonable R: Directors have a fiduciary duty to the stockholders and may not deduct a salary that is unreasonable as according to the Internal Revenue Service. R: A closely held corp may avoid double taxation by paying out all profits in the form of compensation, rather than dividends. R: If IRS finds that salary is unreasonable it may be transferred to equity side and taxed as a dividend. Donahue v Rodd Electrotype Co Harry Dodd started corp and his sons took over Harry wanted to retire. Problem with closely held corps is that no one wants to buy the stock He wanted a way to get some money e.g. sell stock Minority shareholder Donahue sued corp What she wanted: If you offered Harry $800 a share you should do same for my dead husbands shares Fiduciary relationship owed to minority shareholder in a closely held corp corp had to offer same opportunity to minority shareholder. R: Because this is a closely held corp, that is like a partnership, if the stockholder whose shares were purchased was a member of the controlling group, the controlling stockholders must cause the corporation to offer each stockholder as equal opportunity to sell his shares at an identical price. Green Mail: Where a corporate raider will buy stock in a co. To prevent takeover, board will buy back at a premium. Greenmailer gets more price for the stock than we would. Donahue would say Freeze out is not allowed Usual remedy would be in a form of action to dissolve the corp (see later cases)
Legal Restrictions on Dividends MBCA (1969): Equitable Insolvency and Surplus Test Modern Act: Equitable Insolvency and Modified Balance Sheet test
MANAGEMENT AND CONTROL OF THE CLOSELY HELD CORPORATION TRADITIONAL ROLES OF SHAREHOLDERS AND DIRECTORS Directors: - Owe a fiduciary duty to the corporation and the shareholders. - They are the policy makers. - Officers and directors set salaries, not the shareholders - Elect officers (who implement the decisions of the board). Generally, elected annually. Found in bylaws. - Only board may decide to issue dividends. - Some states say that a director may be removed w/o cause - You can delegate managerial authority to a committee that consists of members of the board Shareholders: - Do not owe a fiduciary duty to the corporation.
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Their only duty is to vote for the board of directors & amend the bylaws Their real goals are their personal interests and to make money.
Importance is to understand that the traditional ways cts approach governance of corps depends on the what you are wearing to determine to whom you owe a fiduciary relationship.
SHAREHOLDER VOTING AND SHAREHOLDER AGREEMENTS - The scope of shareholders vote is narrow: 99% of the time it is to: 1. Elect directors 2. Vote when there is a fundamental change in the corp (amend articles, merge corp into another, consolidation, sale of substantially all the assets) Right of appraisal in the statute means you have the right to dissent and get the value of your shares back (this only happens in a tiny percent of cases) Shareholders CAN agree about who they want to elect, but NOT make a K that limit the powers placed on the directors to manage the business of the corp. A shareholder agreement that interferes with the traditional roles in a corporation will not be enforced. Shareholders CANNOT make agreements that decide who the officers will be, who the directors will be, how much their salaries would be, and for how long. (McQuade). Sterilization: s/h agreement that interferes w/ traditional roles of directors in a corp (i.e. limits them). Where complete sterilization occurs, it is invalid even if unanimous by all shareholders and no public harm. Galler 3-part test to determine if s/h agreement is invalid where BODs discretion is limited (i.e. Sterilization) R: A s/h agreement limiting the discretion of BOD in a closely held corp will be upheld where no minority s/h is prejudiced, neither the corp creditors nor public is injured, and no clearly prohibitory statutory language is violated by its enforcement. Voting Agreements (MBCA 7.31): Two or more shareholders may provide for the manner in which they will vote their shares by signing an agreement for that purpose. Shareholder Agreements (MBCA 7.32): An agreement among the shareholders of a corp is valid, even if it does the things that McQuade said you cannot do, if:1. The agreement is approved by ALL shareholders in a written agreement 2. The existence of the agreement is noted on the front and back of the certificate of each outstanding shares.
If another corp wants to go after the assets and control of a corp - Shark around target - Target owned by bunch of shareholders - If the shark cannot induce management, it will make a tender offer to the shareholders directly to sell their shares, to get a controlling interest. Usually tender offers are cash directly to shareholders. - Share will say if I get 51% outstanding you will get $60 a share (and stock value is $55 per share) - Once the tender offer is announced (Williams Act), the price of the stock will start to rise (they sell to others, not the shark)
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Importance: Tender offeror not dealing with management wants 51% of outstanding stock. Once got, will call a special meeting to replace the board to put who they want there. Once shark takes control, it creates another corp (Shark New Co), that he owes a 100% of a causes a merger b/w target and shark. 49% of old shareholders who do not want the merger can dissent, but they will not get premium the others got. Shark Co got the $ to make tender offer get money from Shark Co in exchange from Junk Bonds (a high paying bond) secured by nothing, so pays a lot of money. (may pay 12% and you are taking the risk that there may be a default) Target Co merged out of existence. New Co has the assets of Target Co and Shark The assets flow into the newly merged entity and become available to pay off the junk bonds. People who get screwed are those who bought AAA rated Target bonds. She now has a bond issued at 6% whereas others have bond issued by Shark New co at 12%. Tender Offer A public announcement by a company or individual indicating that it will pay a price above the current market price for the shares tendered of a company it wishes to acquire or take control of. - a corporate takeover technique i.e. if person wants to takeover company X, he must get approval of board of directors - they will say no b/c they will lose their jobs. So, go to shareholders, who want to make more $$$, and arent happy. If stocks value is $50/share, person publicly advertises in newspaper (subject to SEC act of 1934) and makes an over greater say $65/share and announces his intent to buy 51% of the company. Interested shareholder will sell.
Record Owner: (Registered/Record/Legal) MBCA 7.07 Record Date - In most closely held corps, the record owner is also the beneficial owner. - Record owner: a person who is listed in the corps books as the owner of shares but is not necessarily the person who actually owns the shares. - The s/hs of record as of the record date are the ones who get to vote and get dividends. - Does not mean the benefits of the shares goes to these people. - Where the record holder and beneficial owner are different, the beneficial owner can compel the record owner to execute a proxy appointment in the name of the beneficial owner, so he can vote Beneficial Owner: (equitable) -- Actual owner of the shares who retains the right to dividends. - Beneficial owner: a person who owns shares BUT those shares are listed in the corps records under someone elses name. - When you have a split between the record and beneficial owner, the corp must determine who has been authorized to vote the shares by the beneficial owner (Salgo) - In Salgo, the ct waited until after the shareholder meeting re disputed proxies and decision of election inspector to see whether his wrong decision would matter. Said must exhaust inner corporate remedies first. Proxy: Form that gives someone the right to vote for a shareholder in a corp. MBCA 7.22 General Rule: they are revocable and good up to 11 months. Exception: the appointment form must conspicuously state it is irrevocable and and coupled w/ an interest Proxies are coupled w/ an interest: MBCA 7.22 1. Appointment of a pledgee (bank). 2. Economic interest in corporation (person who has purchased or agrees to purchase the shares).
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3. Appointment of a creditor of corp who extended it credit under terms requiring the appointment. 4. Appointment of employee whose employment K requires the employment 5. Ringling Solution under the MBCA 7.31 (voting agreement) What does it mean to pledge stock?: you are giving your shares as collateral. Once the debt is paid off, the proxy becomes revocable. How can a shareholder issue a proxy? (1) Execute a writing (2) By transmitting or authorizing the transmission of a telegram, cablegram or any other electronic transmission provided that the info in it can be reasonably determined to be an authorization (3) Any copy, fax, or other reliable reproduction can be used in lieu of an original writing provided that the copy id a complete reproduction of original Note: Later in time proxy appointment gets to vote X appoints A as proxy today, B day after, C day after that All go to the meeting X votes If X does not show up, C gets to vote Corporations Acceptance of Votes 7.24 (a) If the name signed on a vote, consent, or proxy appointment corresponds to the name of a shareholder, the corp if acting in good faith is entitled to accept it and give it the same effect as the act of the shareholder (b) If the name signed on a vote, consent, or proxy appointment does not correspond to the name of a shareholder, the corp if acting in good faith is entitled to accept it and give it the same effect as the act of the shareholder if: 1) Shareholder is an entity and the name signed is an officer or agent of the entity 2) The name signed is an administrator, guardian 3) The name signed is a receiver, trustee in bankruptcy (can get evidence from bankruptcy ct) 4) The name signed is a pledgee, beneficial owner, attorney-in-fact Record Date: The date on which a person must be registered as a shareholder on the books of a company in order to receive dividends or other benefits, such as the right to vote on company affairs. If there is a stock certificate for 100 shares in ABC Corp:Record Date is 6/20/00 Shareholders Meeting is 7/14 If between 06/20/00 and day of meeting, A sold shares to B, B would be on record even though A had stock certificate. B should request a proxy. Dividends are different. CT would not necessarily give the benefit, b/c they could be negotiated. The Mechanics of Meetings Bylaws state the dates of annual meeting (Usu., in spring thus done with financial reports) Must send timely notice of meeting: Look in bylaws for notice requirement, then statute - You can waive notice in a close corp if a quorum shows up. Quorum: MBCA 7.25 Minimum number of shareholders needed to conduct business in a shareholder meeting
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If it is a board meeting, it is the minimum number of directors needed Only a quorum is needed b/c if everyone was needed, the meeting might never happen Cant reduce them usually to less than 1/3rd The usual requirement is that a majority of the quorum is required for business Once a quorum is established to elect directors, plurality is what matters.
Shareholder Meetings - The smaller the quorum, the smaller no of shareholder votes required for action 400 issued an outstanding: 201 is a majority Majority of quorum (201) = 101 If reduce quorum to 120 shares (30% of 400) Majority shares is 61 If you could go down to 10% 40, could have 21 Once a quorum has been established in a shareholder meeting it cannot be broken b/c the shareholder has the option to give someone else his proxy and could leave.
Directors Meetings If you have a directorate of 5 3 is the majority, so 2 must vote in favor Directors can NEVER give a proxy b/c they were elected If there is a quorum and a director leaves, the meeting cannot take place.
Super majority: benefit for minority s/hs enables the articles to dictates a requirement of higher percentage in order to have a quorum (i.e. 80% instead of 51%).
Annual Meeting 7.01 (a) A corp shall hold annually at a time stated or fixed in accordance with the bylaws a meeting of shareholders (b) The failure to hold an annual meeting at the time stated in the bylaws does not affect the validity of any corporate action. Special Meeting 7.02 A corp shall hold special meetings of shareholders: 1. On call of its board of directors or person authorized in articles or bylaws 2. If holders of 10% of the votes in writing Notice of Meeting 7.05 S/hs must be given notice at least 10 days before meeting date. Action Without Meeting 7.04 Action required or permitted at a shareholders meeting may be taken without a meeting if the action is taken by ALL the shareholders entitled to vote, evidenced by written consent. Quorum and voting requirements for Voting Groups 7.25 Voting Group: Class A common, B Common A preferred can vote in groups a) Need a quorum for each voting group
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b) Once a share is represented for any purpose at a meeting, it is deemed present for quorum purposes for the remainder of the meeting and for any adjournment of that meeting unless a new record date is/must be set. c) If a quorum exists, action on a matter (other than election of directors) by a voting group is approved if the votes cast within the voting group favoring action exceed the votes cast opposing the action, unless articles require a greater number of votes. Voting for Directors; Cumulative Voting 7.28 Unless otherwise provided in the articles, directors are elected by a plurality of the votes cast by the shares entitled to vote in the election at a meeting at which a quorum is present. Difference between a majority and plurality Majority: Person who receives the most amount of votes and wins Plurality: Highest number of votes even if it is not a pure majority (at least 51% of votes its higher than plurality).
McQuade v Stoneham (1934) R: An s/h agreement may NOT restrict their discretion as directors of the corp and is invalild and unenforceable. Questions 1. If a majority shareholder demands that the board enter into a specific transaction on behalf of the corp, must the directors comply? No 2. Should a majority shareholder be permitted to remove directors simply b/c they refuse to do as they agreed to do or as the shareholder wishes? It depends on the state. Some states say a director may be removed w/o cause. 3. Are long-term management Ks entered into by the corp with a person who is not the director enforceable? The board can hire a chief accountant for 5 years, even though the board could potentially change every year. 4. What about the delegation of managerial authority to a committee of the board? You can delegate to a committee that consists of the board 5. What about one board binding a later board in a 99 yr lease? Yes 2 yr employment K with the pres of the corp? Depends. Officers are generally elected annually. Found in bylaws. Can be amended by the board. Argument that it is not binding: Board did not have the power to elect X as pres for 2 yrs b/c the bylaws say a yearly basis . Counter-Argument: Board could amend bylaws Response: They did not. Response: They implicitly changed the bylaws b/c they formed the K Response: Implicit amendments of bylaws not allowed This is different to hiring accountants b/c officers have a special role What if board amends for officer 5 yrs, then amendment by the next board? This would probably be grandfathered. Galler v Galler - P Emma Galler sued in equity for spec perf of an agreement made bw her and her husband and the Ds Isadore Galler and his wife Rose - Benjamin and Isadore were equal partners in Galler Drug Co, and Ked to sell 12 shares to Rosenberg.
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- Ds Isadore and Rose Galler purchased the shares after he died. - Benjamin and Isadore entered into a shareholder agreement. Power of attorney authorized Emma to vote Benjamins 104 shares. Benjamin then died. - Agreement that the bylaws amended to 4 board of dirs, shareholders would cast votes as stated, dir could be nominated in event of death of either brother, annual dividends found to be valid. R: An agreement that limits the BODs power will not be invalidated in a closely held corp if: - There was no minority interest who is injured by it; - There was no injury to the public or creditors; - The agreement must not violate a clear statutory prohibition; Zion v Kurtz - NY Supreme Court hearing a Corp. case but applying Delaware law - Internal Affairs Rule. Governed by law of incorporation - Problem: Minority shareholder who could veto anything and shareholders contended agreement was unenforceable - Delaware has 2 laws - one for closely held corps and one for non-closely held. Under general corp. statute an agreement of this nature is not valid. Under closely held corp. statute - it would be valid. - Required to register as a close corp to put people on notice that you were going under a different set of rules and to avoid this problem. - Argument: this corp could have been a close corp if registered under the Del statute (could have varied the obligation of board and shareholders under this) argument that they did nothing wrong. Majority agreed - Dissent: Is legal under the close corp statute, but they did not incorporate under it, so illegal. Choice of Law: aka internal affairs doctrine: permits parties through incorporation process to fix the law that applies to their corp r/s wherever litigation is brought. Salgo v Matthews - Equitable proceeding involved a proxy contest for control of General Electrodynamics Corp (Texas Corp) - Stockholders Matthews and Thorp represented the faction opposed to the current management. - Ps wanted the dist ct to require the pres (chairman of stockholders meeting) and the election inspector (Meer) appointed by him to accept disputed proxies executed in Ps favor on behalf of Pioneer Casualty Co- in receivership) that were transferred to Shepherd and the lower ct gave a proxy to the Ps to vote these shares and a proxy by the receiver of Pioneer which were was ignored by D, count the votes on these and declare that the candidates supported by the Ps to be elected dirs. - Problem: Matthews entered a proxy, but at the time beneficial owner was Shepard who was in bankruptcy - Dist Ct order was presented to the inspector of election to say that the person had the right to vote - Ct waited til after the election even though inspector was wrong. Ct did this to see if it mattered in the end result. Ct said exhaust the inner corporate remedies first. Cumulative and Straight Voting Straight Voting: - Defn: each s/h votes his entire number of shares for each director.
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Whoever has the majority of votes (the majority shareholder) wins every time for a voting for each director Shareholder may place the number of shares he owns for each position (can elect the entire board) Example: If A has 18 shares and B has 82 shares, A may cast 18 votes for each candidate and be may cast 82 votes for each candidate. Therefore, all Bs candidates are elected.
Cumulative Voting: 7.28 - R: S/hs have a right to cumulate their votes unless otherwise stated in the articles. - What happens if art of incorp are silent on cum voting? You must look to state law and state constitution. - This is the number of shares you have multiplied by the number of directors to be elected (No of Shares x No of Dirs to be Elected) = # of votes - Allows the minority shareholders to have a chance to elect some of the members of the board - Increases minority participation on the board of directors. A relatively small faction may obtain representation on the board. Example 5 director positions available; A = 60 shares; B = 40 shares A: 60 shares x 5 = 300 votes and B has 40 x 5 = 200 votes A1 60 A2 60 A3 60 A4 60 A5 60 = 300 votes B is smarter and says B1 67 B2 66 B3 65 B4 1 B5 1 = 200 votes Election is by plurality vote So, B1 B2 B3 A A on board This shouldnt happen majority shareholder voted in a way where he only elected a minority of the directors!! A voted straight, while B accumulated. To determine the number of shares needed to elect one director: S ______ D+1 S = D = Total Number of Shares Voting / outstanding No of directors to be elected
+1
A = 60 shares; B = 40 shares So, there are 100 votes 100 divided by 6 (5+1) = 16.6 16.6+ 1 = 17.6 shares So, 17.6 votes needed to elect one director To get a guarantee director, take the number of shares required (17.6) and multiply it by the number of vacancies (5) and that will give you the number of shares you must give to guarantee you one spot. A has 60, and 17.6 goes into 60 = 3.4
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17.6 into 40 = 2.2 The formula tells us what will happen if if everyone does what they are supposed to. A gets 3 directors, B gets 2. The formula to elect n directors (To determine whether your shares can elect a majority) is: NS ________ D+1 N = Number of directors you want to elect (e.g. to get a majority and see if you have enough votes) So, if 5 vacancies 3 is the majority multiplied by 100 shares outstanding (300) Divided by 6, plus 1 = 51 So, 51 shares needed to elect 3 directors, and A has enough If you wanted to elect 4 directors 4 multiplied by 100 = 400 Divided by 6, plus 1 = 67.6 So, 67 votes needed, and A only has 60, so does not have enough to elect 4 directors Who fills the vacancy on he board of directors? 8.10 (a) Unless the articles of incorporation provide otherwise, if a vacancy occurs on the board of dirs, including a vacancy resulting from an increase in the number of directors, it may be filled by: 1. The shareholders 2. The board of dirs 3. If the dirs remaining in office constitute fewer than a quorum, they may fill the vacancy by the affirmative vote of a majority of all the dirs remaining in office. - Special Meeting of shareholders an be held 1. On call of directors or persons authorized to do so in the articles or bylaws or 2. If holders of at least 10% of all votes entitled to be cast on any issue proposed to be considered at the meeting make a signed, written demand.
+1
Removal of Directors By Shareholders 8.08 (a) The shareholders may remove one or more directors with or without cause unless the articles of incorporation provide that the directors may only be removed for cause. (c) If cumulative voting is authorized, a director may not be removed if the number of votes sufficient to elect him under cumulative voting is voted against his removal. If cumulative voting is not authorized, a director may be removed only if the number of votes cast to remove him exceeds the number of votes cast not to remove him (d) A director may be removed by the shareholders only at a meeting called for the purpose of removing him and the meeting notice must state that the purpose, or one of the purposes, of the meeting is the removal of the director. Staggered (classified) Board: - Terms of corporate board of directors are staggered, thus making a takeover attempt difficult; protects minority.
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Non-Staggered (non-classified) Board: - Terms of all the board members are the same - i.e. each term all new directors are elected. If a takeover occurs, a hostile majority shareholder can elect an entire new board and have total control State C re cumulative voting v. state statutes that allow cumulative voting and staggered boards Where some states have a constitutional right to cumulative voting, that provision may prevail over staggering the board to dilute the effect. Where there are 2 statutes (1 permitting cumulative voting, and one permitting staggered boards) they are of equal authority. - have a right to cumulative voting, but no right to it being effective. Cumulative Voting: If you change in the denominator, the number to 1, you reduce cumulative voting to straight voting. The lower the no, the closer you get to straight voting
Humphry v Winous - Case dealing with a situation where cumulative voting and ability to have a staggered board. Complaint that by reducing the number to 1, was reducing ability of minority shareholders to have an impact on the election. - Here there was cumulative voting permitted, but the board consisting of 5 directors was classified to vote for 1 director per year over 5 years. B/c only 1 director was voted on each election the S / D + 1 formula = ## of votes / 2 + 1 = A majority. - The classified board defeated cumulative voting. b/c in statute and not constitution - too bad- go to legislature and have them fix this problem. - Wolfson was different b/c cumulative voting was in the state C in ILL - Different to the case at bar b/c state constitution trumps statute - In Humphreys in OH, the difference was that ct was saying we had statutes that said statues and one stagerred and they are on the same level, and ct ends up saying that there is a right to cumulative voting, but does not guarantee the effectiveness - R: The statutory right to cumulative voting only guarantees the right to cumulative votes, not the right to representation on the BOD
CONTROL DEVICES I. POOLING (Combining Cumulative Votes With Another Shareholder) VOTING AGREEMENT WITH IRREVOCABLE PROXY When you combine votes in cumulative voting, with another shareholder, you can get a solid majority and control of he board It is always better to have more than a simple majority i.e. in Ringling case, the 2 women each had 315 shares equal to 2205 votes. Alone, each could be sure to elect 2 directors (of the board of 7). But, if they pooled their votes together, they could elect 5 board members. The Ringling case demonstrates the importance of cumulative voting There is nothing wrong with agreements to vote Problem arises when shareholders dont vote the way they agree to vote cannot agree who to vote for. If a proxy was given to an arbitrator, that would not have been useful, b/c revocable usually. 7.22: To fix the problem, issue a irrevocable proxy to the tiebreaker (atty) and have him vote the shares under the shareholders agreement.
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7.32 Shareholder Agreements states that they can establish who will be directors and officer if unanimous and written on front and back of each certificate even if it restricts the discretion/power of the board. A s/h who buys in after the agreement is signed is NOT bound but is put on notice. 7.31 Voting Agreements: Do not need unanimity. 2 or more shareholders A shareholder agreement is simply to vote the shares To make enforceable and effective, should include the creation of an irrevocable proxy to the arbitrator, otherwise election inspector looking at the corporate records will say who are you, you have no shares.
Ringling Bros - Part of case is about cumulative voting - Ringling brothers stock was owned by three people. 2 of them got toghether and pooled their votes to elect 5 of the 7 directors. Problem - they each chose 2 (themselves and their husband), but they could not agree on a 5th. They had an atty who was the arbitrator, and he decided for them, but one of the women ignored him and voted her way anyway. - This suit arose out of that. Problem - atty had no power other than arbitration. He could not vote for the women who ignored him - he needed a proxy. Shareholders were: Edith Ringling 315 x 7 = 2205 votes; Aubrey Ringling 315 x 7 = 2205; John Ringling North 370 x7 = 2590 = 7000 votes - Board consisted of 7. In terms of shares, in order to elect one director would need 126 shares to elect one S divided by D + 1 + 1 (1000 divided by 7 +1 + 1 ) To translate into votes 126 x 7 = 882 votes If you divide 126 into 315, you get 2.5 - Individually, each can elect 2, because you cannot elect .5 of a director - If you had an agreement that they vote together 315 x 2 630 divided by 126 = 5 - So, by combining their voting power under cumulative voting, they end up with 5 of 7. rity, but better to have more II. VOTING TRUSTS 7.30 Voting Trusts Defn: s/hs transfer legal title of their shares to a voting trustee and during that period, the trustee has both legal title and voting rights. - Beneficiary of trust takes a voting trust certificate that gives them all the rights except to vote they can get dividends and can sell shares w/o voting rights. Creating a voting trust is different to a shareholder agreement. - It is valid for no more than 10 years, unless stated otherwise. - Purpose of voting trust: takes any uncertainties out of pooling agreements. Abercrombie Test for finding a De facto Corp: 1. Voting rights separated from other ownership rights. 2. Grant of voting rights intended to be irrevocable for a definite period of time. 3. Principle purpose of granting voting rights is to acquire voting control of corporation. Three places that a voting trust is high beneficial: 1. Regulatory Agency (i.e. banking) 2. Multi-generational family business
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3. Creditors they may condition the extension of credit In the voting trust, title to the stock is transferred In a shareholder voting agreement, shares remain in their name - Voting trust certificates can be sold Trustee has legal title of shares in the trust & right to vote the shares is in trustee Beneficiary receives a voting trust certificate that gives the right to everything (such as dividends, and a right to even sell the shares) but not the right to vote - Remember that in a shareholders agreement, shareholder still retains legal title and right to vote. Trustees owe a fiduciary duty to the beneficiaries (voting trust certificate holders) of the voting trust and the transferees.
Uses for Voting Trusts 1. Centralizes voting power for a period of time (e.g in corporate reorganizations) 2. In family businesses as a control device i.e. if several heirs to majority shareholder and he does not want them fighting over the power of corp, he may use voting trust and have trustee the one heir he trusts the most to run the business for 10 years or so. Therefore avoiding a family feud. 3. Creditors may insist that controlling shares be placed in a voting trust as a condition to the extension of credit. i.e. creditors give a big loan and want to protect it w/o buy shares so they will have the majority shareholder create a voting trust and the creditors friends will be the trustees.
III. TIEBREAKER STOCK - Lerhman closely held corp and there were 2 factions, L & C; each owned 50% stock. In order to prevent deadlock, they created Danzansky stock. - A tiebreaker is unlimited in duration and can only be used in scenarios of deadlocks. - This is where you have a class of stock that carries no right to dividends, no economic interests, and is just used as a voting tiebreaker to prevent stalemate in corps. - A court will uphold the structure of this stock as long as it is not secret, even if it is for an unlimited time because it is not a voting trust, therefore not subject to the 10 yr requirement. (Lehrman) - It is in the articles, and the public can see this. - Drawbacks under tax law: no s corp b/c it did not participate economically Restriction on Transfer of Shares and Other Securities 6.27 -- Reasonable & Conspicuous (a) The articles, bylaws, an agreement among shareholders or an agreement among shareholders and a corp may impose restrictions on the transfer of registration of transfer of shares. (b) Restriction is valid and enforceable if noted conspicuously on front and back of certificate (c) Authorized to maintain corp status, to preserve fed or state securities exemptions, or for any other reasonable purpose (d) Restriction on transfer/registration may offer first refusal to corp/person, obligate corp/person to buy, require corp/person to approve transfer if this is not unreasonable, prohibit the transfer if not unreasonable. The restriction must be reasonable and conspicuous Conspicuous: one that is written so that it would attract the attention of a reasonable person when looks at the certificate. Knowledge of the restrictions albeit inconspicuous still binds the s/h. Rationale - it is a restraint on alienation and can choke of economic usefulness of the stock.
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e.g. Right of first refusal to corp is reasonable: b/c you can sell to whoever you want and your position is not alienable or to maintain S corp status Unreasonable restraint would be that you may not transfer w/o consent of corp and shareholders or shares of stock can only be sold to red heads:- unreasonable (see Ling) must not be an unreasonable restraint or prohibit transferability Brown v McLanahan - A co went bankrupt and in bankruptcy, was allowed to continue existing, but had to issue debentures, preferred stock to bondholders, and common stock. - Voting rights were places in a voting trust for 10 years. Credit companies sold their voting trust certificates - (Brown bought one). - Here trustees tried to shaft voting trust certificate holders - i.e. extend 10 year voting trust period, create more stock and dilute their shares, gave the creditors shares and rights as debenture holders.. - Court said the trustees breached their fiduciary duty to the beneficiaries of the voting trust. - Dorothy Brown was the holder of a voting trust certificate. - Sam was a face, voting trust certificate you can sell - He sold to Dorothy who paid money. - She was mad b/c original voting trust was going to be 10 yrs, and get expectation it would end in 2 yrs and she would get the transfer of shares and the right to vote - They were deleted and debenture holders would get right to vote under the amendment and her rights were diluted - Had 500 shares of stock. Brought action against voting trustee - Co filed for bankruptcy and reorganization. Holders of debentures creditors (unsecured debt) Reorganization of capital structure - Provided for issuance of 3 securities - Old creditors got for their bonds a combination of debentures and preferred stock - Power to elect 1 director left to common - Old creditors of RR were now in control. Trust good for 10 yrs, b4 it was going to end Summary: Preferred and common shares transferred into a trust Transferee being deprived her expected return end of voting trust and right not significantly diluted R: if you are in a position that you owe a duty to voting trust certificate holders, fiduciary duty to transferees
Ling and Co v Trinity NYSE involved bc Ling was a public corp - Policy: you want to know whose controlling the banks Objection to the foreclose and public sale of the stock based on restrictions imposed on the transfer of stock by the articles of Ling. Question: whether the restrictions on the transferability of the shares could be upheld - restrictions required approval of NYSE prior to sale, and corp can first have opportunity to buy. - 1st requirement- Any restriction on transfer of stock in a corp must be conspicuously noted If not, outcome will be restriction is not valid - Whether restrictions where reasonable Right of first refusal is reasonable: this reasonable b/c you can sell to whoever you want your position is not alienable
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BUY SELL AGREEMENTS - Defn: Upon the triggering of some specified event, the corp or other s/hs must buy back the shares AND the price must be pre-determined. The price will represent the fair value of the stock. - In a closely held corp, no market for shares and on death, shares dissolve upon estate (only good for feds) Dont need a buy sell agreement in a public co, b/c there is liquidity
1. Cross--purchase: Agreement between shareholders whereby the s/hs agree to buy the proportionate interest in the stock upon a triggering event (e.g. death, disability, retirement). E.g. A, B, C and triggering event is death of A, it could obligate B and C to purchase As shares 4 ways to determine value of stock 1. Book value (this is unreflective of true value of corp b/c sometimes it is there name) 2. Fixed price on the certificate which include a provision to make it modifiable 3. Price fixed after death by appraisal: each party has one come in and then a 3rd comes in to break the tie. 4. Some self-adjusting formula Problem - Purchases by shareholders are after tax dollars - (either dividends - taxed to corp & shareholder, or from salary - which is taxed to shareholder). Corp. redemption is untaxed dollars. Life Insurance for death is a useful means for these types of agreements. Shareholders or Corp enter into agreement and have life insurance on each shareholder. Typically upon the death of a shareholder, the life insurance amount is the cost of the shares and is paid to the deceased shareholder for his shares. Problem arises when triggering event is not the death of a shareholder - no insurance & there are 2 problems: 1. How do we value the shares? (Life insurance would have set the price) 2. Who will have to pay and over what time period? 2. Redemption: Instead of the other shareholders being obligated to repurchase it is the corp. These are the most usual. Advantage: Corp is using pre-tax dollars. From a tax perspective it is generally better to make corp obligated to buy shares e.g. from widower Legal capital concern- no redemption and repurchase can be done when insolvency created or unable to pay debts. Must meet equitable solvency and modified balance sheet tests. Would be illegal to do redemption if it would create insolvency
It is important to have an agreement. Draft so rights and obligations are clear. Be specific. E.g. how many days notice, what if it is not given anticipate things that are likely to happen in a closely held corp.
DEADLOCKS Defn: Prevents the board or s/hs from taking action. Caused by a 50/50 split in votes regarding directors or shareholder votes Shareholder Deadlocks - They vote on fundamental changes in the corp: -- i. Amendments to the articles; ii. Sale of Substantially all the Assets; iii. Dissolution)
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May also be caused by high voting requirements (e.g. 2/3rds instead of majority) and/or high quorum Director Deadlocks Equal (even) numbers of dirs High voting requirements / high quorum
If the directors are deadlocked, corps cannot function well
What if 2 people came to you and said they want to set up a corp with 50/50 share split? - You cannot suggest one takes 50 and one takes 49. Problem is that 50% is not a majority - Can suggest a 3d party as a director (can be a problem if a friend), bad for attorney to be the tiebreaker this b/c potential conflict of interest. (be careful in multiple roles). Good idea if you can find one to break a dir deadlock. To avoid a deadlock, suggest either of: 1. Shareholder Voting Agreement: Where there is an arbitration clause and an irrevocable proxy 2. Voting Trust 3. Tiebreaker Stock: Problem with tiebreaker is that you vest a lot of power in tiebreaker Dazansky stock. 4. Buy-sell agreement. 5. The drastic remedy of dissolution. Problem with deadlock is that in a deadlock situation, the statute is going to permit eventually for a shareholder to apply for dissolution as a judicial remedy. However, courts are not obligated to give you this. See below. Take me along clause (SHAREHOLDER/3RD PARTY OFFEROR) All for one and one for all 3 musketeers S/hs have an obligation to tell offeror that he must buy all s/hs shares. The shareholders say if you get bought out we also get bought out. To the extent there is a bona fide offer for shares, that shareholder must communicate to the bona fide offeror that that is conveyed to the other shareholders. Only works if you have agreed to it previously and since it is a restriction, must be conspicuous & reasonable. Russian Roulette Clause (SHAREHOLDER/SHAREHOLDER) (prevention for deadlock) If you have this clause it means you have agreed at the outset that each shareholder can offer to purchase each others shares, any offer to buy shares will automatically be treated by offeree as an offer to purchase or offer to sell on the same terms and conditions Offeree has no choice he must buy OR sell b/c he is bound by K. 1. Offering Shareholder makes an offer to buy ALL of the offeree shareholders shares. 2. Offeree shareholder then has to elect to either i. Sell all his shares to Offeror at such price per share OR ii. Purchase all of the shares of the offeror at the price he offered. - If this is chosen - the offeror must sell out. - Dangers: - If offer too low - offeror will get bought out. - If offer to high - Offeror will buy corp but have to pay offeree a lot of $$$. Problem: Only works if both parties have roughly equal shares and equal bargaining power.
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I.e. if 1 shareholder is well off - he can buy out other b/c other wont be able to afford it. Offeror sets the terms - if he says In cash - Offeree may have no choice but to sell. 2 would end up in deadlock, and have to go to court W/o Russian Roulette - X offers Y $100 per shares. Y says No - then they go to court b/c of deadlock. With Russian Roulette - X offers Y $100 per shares. Either Y says OK and is bought out OR Y says No I will buy you out for $100K. - Depending on Ys decision X or Y will be the sole owner. Gearing There were 2 factions, and there were 2 vacancies and the remaining board had to fill the vacancies. One of the directors intentionally missed the meeting to avoid the quorum. MBCA 8.10 If there is a deadlock in election, those who are in office REMAIN in office indefinitely until something happens to break the deadlock. REMEDIES FOR DEADLOCK/OPPRESSION 1. Dissolution - Ct acts as a neutral arbiter. This is a remedy that is provided in nearly all state statutes. - A party asking for dissolution of a corp is not necessarily asking for a neutral remedy. E.g. one party may be able to buy the corporate assets cheap and use the value of the corps goodwill to set up a new business - Problem: Drastic for a corp & shareholders, employees, customers get disrupted. In Radom, A and B were brother and sister. A ran the company; B was a housewife as case was in early 50s. Bs husband died, leaving brother in charge of business. She wanted dividends but he said he would not give dividends. She wouldnt sign her brothers paychecks. Radom wanted to dissolve the business. It had assets and was making a lot of money per year. R: Dissolution will only be granted if the corporation is no longer able to economically function. 2. Forced Buy Out (more modern view) R: Oppressive conduct occurs when majoritys conduct substantially defeats the expectations that objectively viewed were both reasonable under the circumstances and were central to the minoritys decision to join the venture. - This is a common remedy for oppressive conduct. Oppressive conduct is an expansive term for inappropriate conduct/fair dealing (e.g. majority shareholder in a closely held corp refusing to let the other shareholder inspect the corporate books.) - The majority shareholder is required to buy out the minority shareholders at a fair price - Lesser remedy than dissolution. - Does not occur in pub traded corps, b/c you could just sell stock. - In a partnership, there is fiduciary duty, so oppressive conduct is wrong. Under UPA and RUPA, you have a right to go and partnership must pay you, minus any damages. This is diff in a corp. Davis v Sheerin Forced buy out was authorized b/c conduct was so oppressive b/c majority s/h was denying the minoritys ownership of the stock. 3. Provisional Director
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Defn: A person appointed by court to temporarily sit on the BOD and break deadlocks if the court finds that the board is so divided that it can no longer act in the best interest of the corp and anticipates that the board will soon be able to run w/o that provisional director. Provisional director serves for the court and not any one shareholder, and reports to the court. Ct will say even one that may have partiality is better than a deadlock, as there is no requirement of strict impartiality. (Abreu) This is a good idea as an alternative to dissolution.
Custodian: supersedes BOD, replaces it. Provisional director: acts on BOD Custodian and Receivership: MBCA 14.32 ACTION BY DIRECTORS AND OFFICERS R: S/ts made by corp officer in the course of a transaction in which the corp is engaged and that relate to a matter w/I the scope of the officers authority are binding upon the corp, absent knowledge by offeree. (In the Matter of Drive-In) TO PROTECT YOUR CLIENT ASK FOR A CERTIFIED COPY OF THE CORPORATE RESOLUTION Effect of corp resolution given to 3rd party: Binds the corporation -- obligates them to comply w/ the resolution. Exception: unless they had knowledge by looking at the minute book that there was no quorum. Elements of corp resolution: 1. Corporation needs to adopt the resolution 2. Set forth what the resolution is 3. It needs to be signed by the secretary 4. It needs to be certified Traditional rule is that officers of the corp have little inherent authority. It rests in the board of directors. When dealing with the corporations on a significant matter (e.g. loans, purchases of major assets) ask for a certified resolution of the board to see if the resolution is authorized. (But not worth your while for just supplying paper clips!) If you get a copy of the resolution authorizing the officer to act, this estopps the corp from claiming that the officer did not have the authority to act. You have a right to rely on the resolution. Black v Harrison Delegation of Power President of corp signed a K to sell some of the corps land but later tried to back out of the deal. R: A president may not K for the corp b/c president does not run the corp, the BOD does.
Lee v Jenkins Bros Employee induced to switch employers by corps president that promised a pension plan at retirement but then corp fired him prior to reaching retirement & did not pay. R: President has power to promise a pension plan if its in his ordinary and usual duty of hiring and firing employees and thus such a promise by the president is binding on the corp.
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What is extraordinary? Lifetime employment Ks. TRANSACTIONS IN CONTROLLING SHARES General Rule: Controlling s/h is free to sell his shares that represent control at a premium price and does not have to share that premium w/ the other shareholders. Exception: You cannot sell to someone who you have reason to believe will loot the corp, conversion of a corporate opportunity, fraud, bad faith, etc DUTY OF CARE AND THE BUSINESS JUDGMENT RULE Business Judgment Rule (court will look at the process NOT the outcome) A rebuttable presumption that directors in performing their functions are honest and well meaning and that their decisions are informed and rationally undertaken. Allows members of the board to act on a corporate decision and not be 2d guessed and will normally insulate them from liability for honest mistakes of judgment when there is due care and good faith. The board is held to some standards: The Duty of Care and the Business Judgment Rule. Absent bad faith and fraud, cts will defer to the business judgments of a board. Rationale: Shareholders elect BOD and judges are not business people. To assess the risk of a business decision should not be done by ct
R: In order to invoke the BJR and have the presumption of regularity, the board must be (Gorkom): 1. Informed (or try to inform themselves) 2. Not grossly negligent In order to overcome presumption, s/hs must prove: 1. Fraud, illegality, conflict of interest (self-serving) 2. Lack of rational business purpose 3. Gross negligence Duty of Care: BOD made bad decision (intertwined w/ BJR) Corp directors who exercise reasonable prudence in approving/ratifying/participating in corp transactions are not personally liable for any losses proximately caused by those transactions if they also made the decision in good faith and w/o self-dealing. Standard of Care: Directors, in making business decisions are held to a reasonable person or prudent man. Standard of Review: Whether a business decision was reasonable when made is almost always a factual question & involves considering what the directors knew or should have known at the time the decision was made. Duty to Inspect Failure to control BOD has an obligation to monitor financial status of corp. Failure to do so holds BOD personally liable for any losses to corp (ex: embezzlement).
Even though board may sell shares for a price above their market value, this is just the price in the market, and not the intrinsic value of the shares. It may represent a minority interest in selling, but there is an inherent value that can be figured out by investment bankers.
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- if a members of board was an attorney and he said they would have gotten sued if not accepted higher price, he could defend by saying that they did not have sufficient time to consider the offer. (Gorkom) Other points: - FL has a statute that in order to get money damages you must prove they did not use business judgment, but seeking money damages form dirs not an easy thing to do. - Breach of duty will generally not result in money damages. - Many states have incorporated form of BJR into statutes
Derivative Proceedings (7.40): A suit brought by the shareholders on the corps behalf. - Shareholders in derivative suit is saying corp, sue your own board. In duty of care bc in realm of board to determine whether to bring suit against other dirs Important to understand that if what being effected is the corp then the proper suit is the derivative suit. If suit is not derivative it will be dismissed Must know difference between derivative and direct. Derivative: When corp harmed and shareholders indirectly effected. Direct suit: Where shareholder effected directly as a shareholder, such as misappropriation or fraud or where corp declares dividends and does not pay them, employment K. There is a split re whether there should be a universal demand on the board or not. Most jurisdictions have requirement of a demand: exhaust internal corp remedies
Shareholder Standing ( 7.41) A shareholder may not commence or maintain a derivative proceeding unless the shareholder (1) Was a shareholder of the corp at the time of the act or omission complained of or transfers - Contemporaneous (2) Fairly and adequately represents the interests of the corp in enforcing the right of the corp You cannot buy a derivative suit. Need a continuity of interest and fairly and adequately represent the corp (like class action certification in civ pro)
Demand (7.42) No shareholder may commence a derivative proceeding until: (1) A written demand has been made upon the corp to take suitable action (b/c corp may take action and would not need derivative suit) (2) 90 days have expired from the date the demand was made unles the shareholder has earlier been notified that the demand has been rejected by the corp or unless irreparable injury to the corp would result by waiting for the expiration of the 90 day period.
Stay of Proceedings ( 7.43) If the corp commences an inquiry into the allegations made in the demand or complaint, the court may stay any derivative proceeding for such period as the court deems appropriate.
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Dismissal ( 7.44) (a) A derivative proceeding shall be dismissed by the court on motion by the corp if one of the groups specified in subsections (b) or (f) has determined in good faith after conducting a reasonable inquiry upon which its conclusions are based that the maintenance of the derivative proceeding is not in the best interests of the corp. (b) Unless a panel is appointed pursuant to subsection (f), the determination in subsection (a) shall be made by: (1) a majority vote of independent directors present at a meeting of the board of directors if the independent directors constitute a quorum; or - question as to what is independent (2) a majority vote of a committee consisting of 2 or more independent directors present at a meeting of the board of directors, whether or not such independent directors constituted a quorum. - usually a special committee Litigation Committee 7.44(f): A special committee, acting as the board and in their sound business judgment may determine that a suit against present/former dirs may be contrary to best interests of corp if they act in an independent manner. (Exxon). - When a corps board learns of a suit, it can creates a special committee if dirs A B C were being sued, so committee consist of D E and F to examine whether the corp should intervene in the derivative suit to have it dismissed. DELAWARE LAW DERIVATIVE SUITS Demand Futile: BOD is so biased & so dominated that if s/hs went the BOD it would be futile gesture b/c they are so infected w/ self-interest and cant be trusted. Note: This will last longer and will give more attorneys fees. Delaware law says if you dont file a demand b/c your claim is futile and BOD wont listen then 1. Special Litigation Committee will be formed and must be: a. Independent b. Acted in good faith, and c. Reasonable investigation of what the claim is in the derivative suit Note: If SLC misses one of these then the suit continues. If SLC complies and decides suit should be dismissed then go to #2. 2. Court can then apply their own business judgment to determine whether suit should be dismissed based on best interests of the corp. Demand Made: s/hs write a letter to BOD informing them and they want to correct it and take legal action. Generally, there is a universal demand requirement but NOT in Delaware. BODs decision will be upheld unless it was wrongful. Demand Excused if s/h can prove with particularized facts (complaint) that: 1. The majority of directors were not independent or disinterested OR 2. By showing conflict of interest OR 3. Grossly uninformed decision-making. R: State procedural requirements are substantive under Erie (i.e. federal derivative suit based on diversity will apply states procedural requirements under Erie)
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Payment of Expenses ( 7.46) Litwin v Allen General Rule: Corporate directors are not liable for bad business decisions if made w/ reasonable care. Look to directors knowledge at the time they made the decision w/o benefit of hindsight. Imprudent per se: a transaction that has no chance of benefiting the corp but carries a risk of loss.
Shlensky v Wrigley Baseball park owner refused to intall lights or play night games over concerns about deteriorating the neighborhood, a minority s/h sued to force changes. General Rule: Minority s/hs cannot challenge BODs business decisions absent fraud, illegality, self-dealing, or wrongdoing (look to charter for violations). Courts give directors honest business decisions/policies deference. Smith v Gorkom Leveraged buy-out (LBO): purchase of controlling interest in a corp using money borrowed (leverage) from investors/bankers & usu., secured by corp assets. General Rule: Directors who sell the corporation w/o determining its true value have breached their duty of care. Decision cant be grossly negligent or uninformed. In re Caremark Intern v Derivative Litigation General Rule: Directors must implement monitoring system to eliminate illegal acts of employees but not liable if a reasonable system fails to detect wrongdoing. Malone v Brincat Rule: Directors who knowingly disseminate false information that results in corp injury or damage to an individual s/h violates his fiduciary duty to the corp or s/h & may be held liable. Gall v Exxon- NOT a duty of loyalty case! Derivative suit: brought by s/h to enforce corps (not s/hs) rights usu., against someone who breach a fiduciary duty owed to the corp. Any recovery from wrongdoer goes to corp. General Rule: Directors who discover wrongdoing by officers have discretion to file derivative suit & s/h cannot compel them unless directors refusal is based on directors fraud, collusion, self-interest, dishonesty or other misconduct equaling a breach of trust and unless directors judgment was grossly unsound.
DUTY OF LOYALTY AND CONFLICT OF INTEREST Duty of loyalty can also be thought of as self dealing (party on both sides of transaction) This is separate and apart from the duty of care (as above)
SELF-DEALING TRANSACTIONS Corporation and the director are both parties OR the director has a financial and personal interest in that transaction.
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Intrinsic Fairness: A director who enters into a self-dealing transaction has the burden of proving that the transaction is intrinsically fair to the corp that the terms of the transaction are procedurally and substantively fair and reasonable and that the director has not used his or her position to take advantage of the corporation. Substantively fair: based on an objective standard: a reasonable person in the corporation shoes would have entered into the transaction. Procedurally fair: (1) material facts were disclosed to the BOD and (2) fair price. To determine if a self-dealing transaction is valid: 1. Material facts are disclosed to BOD or a committee & its authorized by BOD or committee 2. Material facts are disclosed to s/hs and they get to vote 3. K is fair to corporation Marciano A corp director loaned $$$ to corp when the corp liquidated it sought to disclaim liability for the loan claiming that a self-interested loan form a director is voidable as a matter of law. R: A self-interested transaction b/w a director and a corp will not be voided if it is intrinsically fair to the corp.
Are dirs in self-dealing transaction going to be liable? This diff question rules in 8.60, 61, 62 Standards of Conduct General Standards for Directors (8.30) This is a form that is codification of the BJR (When dirs may be liable) Conflict of Interest: when a director sits on 2 boards, he owes a duty to both (like Meinhard). The duty here is one of: 1. Fair dealing (act with honest and candor tell people where the money offer for shares came from) 2. Fair Price (can be based on testimony and not necessarily a math formula) Weinberger Signal had majority of UOPs shares and they wanted to buy out the minority s/hs in UOP. They wanted full control. Signal had to do a study. The study was brief and not thorough. S/h sued corp claiming that the directors who sat on both boards breached their duty of loyalty when they withheld info and agreed to sell the corp too cheaply. R: Corps director owes an equal duty of loyalty to each corp on whose board the director sits. Duty of loyalty requires the director to deal w/ the corp w/ complete candor, to refrain from doing anything that would harm the corp or would deprive the corp of an advantage or profit.
Sinclair Minority s/h in a wholly owned sub sued the parent corp for causing the sub to pay out excessive dividends and for breach of K. R: When transactions involves a parent and a sub, w/ parent controlling the transaction and fixing the terms, the test of intrinsic fairness with its resulting shift of the BOP is applied. CORPORATE OPPORTUNITY (part of duty of loyalty) Corp Opportunity 1. A director may not take advantage of a business opportunity in the corps line of business. a. Line of business: any business closely related to the business in which the copr is engaged
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b. Corp bears BOP that opportunity was in corps line of business. 2. Director may take advantage when: a. Director first makes full disclosure of opportunity & allow corp the opportunity to act. b. Corp must reject it before the director can take advantage. 1st issue: whether it is a corp opportunity? 2nd issue: whether director usurped the corp opportunity? Effect of directors usurpation of corp opportunity: constructive trust things placed in trust for the benefit of a 3rd party. Line of business test: any business opportunity, which the corporation is financially able to undertake and is in the line of the corps business. Some courts view (majority): even if in the line of business, if corp is unable to financially exploit then it is not a corp opportunity and director is not obligated to disclose. Other courts view (minority): corp may not have present financially ability to take advantage at that time but if in the future the corp can find a method to finance it then it may be a corp opportunity (ex: refinancing corps debts). Fairness test: Two-step analysis 1. Determine whether a particular opportunity was w/I corps line of business. 2. Scrutinize equitable consideration existing prior to, at the time of, and following directors acquisition. Expectancy Test: Corp expects opportunity to come to them first. The best legal answer is that if you have a doubt regarding a corporate opportunity, fully disclose what you want to do to the corporation and wait until they tell you what you can do. ALI Approach re taking of corporate opportunities (a) A director or senior executive may not take advantage of a corporate opportunity unless: 1. He first offers the corporate opportunity to the corp and makes disclosure concerning the conflict of interest and the corp opportunity 2. The corporate opportunity is rejected by the corp and 3. Either a) The rejection of the opportunity is fair to the corp; b) The opportunity is rejected in advance, following such disclosure, by disinterested directors, or, in the case of a senior executive who is not a director, by a superior, in a manner that satisfies the standards of the BJR; c) The rejection is authorized in advance or ratified, following such disclosure, by disinterested shareholders, and the rejection is not equivalent to a waste of corporate assets.
TRANSACTIONS IN SHARES: RULE 10B-5, INSIDER TRADING AND SECURITIES FRAUD THE DEVELOPMENT OF A FEDERAL REMEDY: RULE 10B-5 - Now we are dealing with federal law SEC of 1934 states that a person cannot use any manipulative or deceptive devices in connection with the purchase or sale of any security that contravene the rules and regulations as the Commission may prescribe in the public interest for the protection of investors RULE 10b5 States, it shall be unlawful for any person by use of interstate commerce (a) To employ any device, scheme or artifice to defraud
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(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person in connection with the purchase or sale of any security - Essentially, 10b5 is rooted in fraud and deception. Commission promulgated these regs in the CFR If not connected with purchase or sale of securities, 10 b5 does not apply Extends to purchase of securities: If you know there is something that is material info that is not public and you buy, you may have defrauded in the purchase. To make an untrue statement of material fact is where a lot of the fights take place. Important to understand is that the rule makes material omissions actionable At common law there is no obligation to disclose things unless you were asked. Couldnt make material misrepresentations. It was acceptable to OMIT making a statement. Under current law, material omissions become actionable. It shall be unlawful: What does that mean? This gives the power to the GOVERNMENT. This is important because there are thousands of statutes of regulations that use this language and the vast majority does not support a private cause of action. One of the significant things about 10b5 is that the judiciary implied a private right of action. An express cause of action is where the statute specifically grants the right to sue. Courts specifically embrace the private cause of action. The case was a 1947 case that allowed for this private cause of action. The judiciary created this private cause of action and the parameters of that private cause of action has been set by the judiciary. If it is express, the rules will come right in the statute of the legislature. For any person: That brings in tippees, tippors, Martha Stewart, etc Directly or indirectrly, by the use of any means or instrumentality of interstate commerce: If I pick up the telephone in Lauderdale and use it to purchase a security in Miami, even though it is an intrastate call, I am using an instrumentality of interstate commerce and thus I fit under this portion of the rule. a. to employ any device, scheme, or artifice to defraud: The court looks to the common law deceit. b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading: what is materiality? Under the common law of deceit: General Rule: OMMISSIONS are NOT ACTIONABLE absent a special relation. EX: We have Farmer A and Farmer B and they live next door to each other. Farmer A shoots his gun on his property and hits oil. So he discovers oil on his land. Farmer A thinks, if there is oil under my land, there is oil under Farmer Bs land. At common law, Farmer A wants to buy Farmer Bs property because he found oil on his own land. Question 1: If farmer B asks why do you want my land, can farmer A say, I am not gonna tell you? Yes. Question 2: Can farmer A say to Farmer B, ummmmmm, I want this land to raise cattle? No. Question 3: If farmer B says, are you drilling for oil, can farmer A say no? You cant say no. Can farmer A do all of his oil exploration from midnight to 5 am? YES! Omissions are not actionable under the law of deceit or fraud ABSENT special circumstances. If farmer A is the parent and Farmer B is the child. Absent that, everything else is at arms length. It doesnt mean I have
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to tell you the truth unless you ask me a direct question, you can say, I am not going to tell you You just cant make a misstatement. What about half-truths? Half-truths: That may be actionable under common law IF it is material. OMISSIONS ARE NEVER ACTIONABLE UNDER COMMON LAW!!!!!! Under the SECURITIES law under 10b5: General Rule: Material OMMISSIONS ARE actionable!!! This is important because if I am buying a stock in a business and they do not disclose a contingent liability, that is a material omission and actionable under 10b5 IF it is IN CONNECTION WITH A PURCHASE AND SALE OF SECURITY. In connection with is important. To be actionable under 10b5, the fraud must be IN CONNECTION with the sale or purchse of security. Otherwise what happens if the fraud is not in connection with the sale or security? The claim can only be brought under state law. 10b5 is unique because it is under the purchase or sale of security. Many laws deal with people defrauding people in selling securities (I am telling you things that are not true or telling you things that adversely affect you). This also covers the purchasing the security. If I know stuff that is going on that you dont know, I can buy your stock and cheat. If you knew what I knew, you wouldnt sell it. SPECIAL FACTS DOCTRINE (COMMON LAW DOCTRINE) A doctrine whereby in face to face transactions where an insider (director or senior officer) is purchasing stock from a s/h and something else is going on (the something else is I am going to buy stock, being the CEO of the company, if I want to buy your stock in that company, what are you going to ask? You ask the CEO why!!!!!! In one of these cases, I got my friend to offer to buy the stock because she is not the CEO, the difference is that when an insider buys the stock, they presumably have knowledge. If I hide my identity as an insider, that invoked the SPECIAL FACTS DOCTRINE. The other Special fact cases are face to face transactions where the insider (CEO or DIRECTOR is buying from a shareholder and being extremely tight lipped. He knows that the next dividend is going to be a buck and a half and he buys for 4 bucks. The growth of 10b5: Why is Rule 10b5 favored? 5REASONS FIRST: You got to federal court and lots of Ps like to be in federal court. If you get there and you have a common law state law claim or blue sky law, you can try it with pendent jurisdiction. The reason you would be in federal court with 10b5 is because you would have a federal question. SECOND: Nationwide service of process, THIRD: Liberal venue FOURTH: Generous discovery rules and; FIFTH: The doctrine of pendent jurisdiction while the state court cant hear the 10b5 claim. Blue chip: Basic facts from the case: I would have purchased the security, but because of this disclosure, I didnt. The disclosure was misleading and pessimistic there fore I believe I have a cause of action. Birnbaum rule: This is a standing rule, which says that only actual purchasers and actual sellers have standing as Ps (NOT AS D) to bring a private 10b5 suit. 3 ways to use 10b5: 10b5 can be used as an adminitstrative proceeding for fees. 10b5 can be used by the department of criminal justice 10b5 can be used as private Ps in a private cause of action for damages.
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Earnst and Earnst v. Hockfelder: Basic facts from Earnst: This case involved a complaint against an accounting firm in failing to find a securities fraud. Nay basically controlled everything and converted these funds to his own use. The fraud came to light when he committed suicide. Obviously suing Mr. Nay would be fruitless because he is not there. The theory was that Earnst and Earnst was negligent because they should have discovered this rule that Nay implemented. Nay had all the mail coming to him first before it went anywhere else. First: Whether or not through appropriate accounting procedures Earnst and Earnst could be liable for negligence? The first and most important part of this case is that the SC said that negligence is not the proper standard here. General Rule: YOU must prove Scienter which is intent to deceive, manipulate or defraud OR acting recklessly. Why must you prove scienter? Because they talk in terms of manipulation and decption (the tort of deceit involves scienter). Scienter means intent to deceive, manipulate or defraud. The proper question was not whether Earnst and Earnst was negligent, but whether they acted in a way that was intentionally wrong or at a minimum reckless. All the lower courts embrace the words reckless. Pleadings and Scienter: General Rule: If you dont plead scienter, your complaint will be dismissed. This was great for lawyers, because scienter was a whole knew ball of wax. If you dont plead that the actions constituted scienter, they will be thrown out. What constitutes recklessness is higher than negligence and even gross negligence. For accountants and lawyers, the concern was that they could be sued (the corporations) for mere negligence, but not after this case. Santa Fe Indus v. Green: This case involved a question that would restrict 10b5. The SC is getting annoyed at Ps attorneys at private 10b5 actions. The issue was whether 10b5 could be applied to Delaware short form cash out merger? They key thing was for the SC was to give a message that 10b5 was not a cure all for everything and to keep a respectful boundry between federal law and state law. The SC said that it had to be fraud IN CONNECTION with the purchase and sale of securities. The minority shareholders thought they were being squeezed out and they said that there was manipulation here. The court says this really is not a matter for the federal securities laws, but is a matter traditionally relegated to state law and that is what the court did. The SC lays down the law and the Delaware courts picks it up later in weinberguer v. UOP. Delaware at that time had a Delaware formula so counsel for the Ps said we might to better in terms of the damages we can prove if we cast this as a 10b5 claim rather than going to state court. The Delaware response in Wienberger v. UOP was that we are no longer tied completely to this computation of damages. They said 10b5 is NOT A REMEDY FOR EVERYTHING THAT HAPPENS IN A CORPORATION. Statute of limitations: They imposed a 1 year of statute of limitations with a 3 years of statute of repose. When a statute of limitations is 1 year that means that you have 1 year within which to file the claim when you discover or should have discovered the facts. So if we are talking a period of time with an event in Jan of 2002. If it is a fraud, I have till December 31 2002. If I discovered it in june, I would have a year from that. Statute of repose:
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There might have been a tolling of the SOL, and thus, this will give some more time to you, however, this is an ultimate bar to suit. Aiding and abetting: Who can bring them? NOT private citizens, but the government can! The literal reading of 10b5 did not permit aiding and abetting crimes. The government can bring them, but not individuals in private lawsuits. Section 16b: Express cause of action. Congress in 16b said that suit to recover the profit may be brought by the issuer and here when you have to bring it, etc. Insider Trading: Look at the relationship to see if there is a position of trust (fiduciary duty) What is the problem? It all comes down to FAIRNESS. What is fair? SEC v. Texas Gulf Sulphur: What was the event that started this tremendous rise? There was a big ore strike and this is one of the ore strikes of all of North American history. What happened is that there was this ore strike and at that point and certain people (including the geologist) began telling his buddies and telling them to buy TGS stock and call options on TGS stock. First of all, the information about the ore strike is valuable to TGS. The idea is that you cant trade inside material or inside information. The thing is you can make it no longer inside by disclosing and disseminating it. The geologist could not have called the wall street journal. He could have called the SEC and tell them just letting you know that there has been a big ore striked That isnt public dissemination either though. Each of the Ds had knowledge and they could have told someone and whetherh they were officers, when they told an outsider about the ore, the breached their duty to texas gulf sulfur. The idea that you either DISCLOSE or ABSTAIN from trading is a very harsh rule. Why was it important for TGS not to have the info disseminated when the geologist was tipping his friends? Once these people began trading on this information is when thigns got strange. What is a stock call? When you buy a call option, that is an option to purchase the security at a certain price for a certain amount of time. Buying a foot, the person who bought it has a right to sell it at a certain price for a certain amount of time. When I purchase a call, my understanding is that the price of the stock is going to go up, and not only does it have to go up, it also has to happen within the time that the option is good. Once that option is expired, it is worthless. If you have inside information, what can you do? The calls here cost 1 buck a piece. Fox liquidated his position and makes a 60,000 profit on a 2000 dollar investment. If you buy stock, the stock goes up, the stock goes down. If you buy a call option, you can purchase it at a certain price and that price increase has to happen before that option extinguishes. You have the option to purchase at a certain price for a certain amount of time. What does that tell you about the nature of what these guys were tipping the other guys? When can insiders ever trade and buy and sell their own stock? You cannot do it if there is material inside information and you are trading on it. That is a violation fo 10b5. The NYSE set up a pattern of purchasing after the quarterly results are out and have been published. Materiality: There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having altered his investment decision-making. Tippor: A person who gives another person a tip Tippee: A person who gets the tip.
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Are tippees liable for using inside information? Yes. Remember you have to use it. You might use it to use a sub-tipee. Are tippors? Yes. Chiarella: This press company was hired by a law firm to do documents for a tender offer. Mr. Chiarella was a printer and worked for the press company and the company who hired him is the company that is going to be making the tender offer. He is doing this printing work and even though the actual name of the target was not there, he figured out the target is X company. You know and I know, if you have advance knowledge that there is going to be a tender offer then the value of that stock is going to go way up. Mr. Chiarella goes out and buys some stock to make some money of the targets and makes some money. The US attorney decided to make this a criminal case. The first criminal case is brought against Chiarella. The problem in this case is how the court is going to deal withthere is no doubt that Mr. Chiarella did something, there is no doubt that he had information, that he used it and that it wasnt public, but there is a roadblock to this case because in order to bring a 10b5 case, you have to show that there was a duty that was breached. The problem is, who did Mr. Chiarella owe a duty to? He doesnt owe a duty to the public at large. He bought stock in the target corporation. He had no relationship with those people who owned the stock. He had no duty to breach. He DID NOT HAVE A DUTY THAT WAS BREACHED. The dissent states that the problem here was that Chirallea misappropriated the information. He took that information and he wasnt supposed to. Misappropriation doctrine: Misappropriation of non-public information should have been sufficient to meet the requirement of duty and breach. THIS IS NOW THE LAW AND CAN BE SUCCESSFULLY EMPLOYED. There still must be a fiduciary relationship. Fraud in the Market Doctrine: DEF IS IN POWER POINT PRES. This occurs when the investor doesnt directly rely on the insider information, but it is clear that there was a tip. The theory is that the price of the stock represented untruths in the marketplace that were relied upon. Thus, the market sustained the injury under the theory. 10b5 is available where there is a material misstatement or omission It is a fed cause of action under 10b5 This means that if you are in a closely held corp and you are going to be selling stock and you do not provide financial statements, that private sale of stock could be the basis of a fed case under rule 10b5 So, 10b5 federalized a lot of bz transactions that involved the purchase or sales of securities. The modern history of 10b5 is the SCT carving back on the rule after 1975. Said acorn had grown out of bounds when they created private cause of action - The first trim was in Blue Chip One of the issues was who could bring a 10b5 case One group said I would have bought stock but it was not in the press release, and I missed out. Other group said it owned stock in the company and was going to sell it, but there was a false, misleading statement, so now my stock is worth less. (this group more limited) Notwithstanding the Blue Chip case, Rehnquist says in order to bring a 10b5 civil case (private litigant P) a person must be an actual purchaser or actual seller The 2d step was in Ernst There is no longer actionable as a private plaintiff for aiding and abetting in a 10b5 case Issue in 1976 was could you successfully get a 10b5 claim against a party that was negligent or grossly negligent
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SCT in Ernst, going back to c/l of deceit, said scienter is an important element that is now part of 10b5 that all claimants, P, and SEC (later than 76) must prove.
Scienter: Mental state embracing the intent to manipulate, defrauds, and in some lower cts, recklessness Where recklessness deemed to reflect mental state, lower cts deemed this to suffice. Means mere negligence or gross negligence are no longer actionable under 10b5. Needing to prove scienter, thus cut back on the cause of action significantly.
Temporary Insiders: Those such as underwriters and consultants are liable under 10B5 for violations. Note: To determine if the Tippee is liable, you must first determine if the tippor is liable, such as the underwriter, exec., or consultant. The tippee is not liable if the tippor had no fiduciary duty. RULE 16: Liability comes when the purchase and sale are within 6 months (A): Directors, Officers, and principal stockholders (those holding > 10%) These people must register with the SEC as the beneficial owner indicating ownership of the stock. This requires these owners to divulge profit for shares bough and sold in a six months period. The profit is returned to the issuer.
(B): Provides cause of action for these claims. If you buy < 10% in your first purchase and then purchase over, you dont fall under this section. If you are over, as in the above example, and sell under, you are fine. You can play this game all you want. Must return anything over $3800. Unlike, 10b5, the plaintiff doesnt need to be a owner at the time of the insider trading, but only at the time of the trial.
PUT 10B5 AND 16B SLIDE SHOWS IN BOOK

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CORPORATIONS OUTLINE ~ Cane I.

CHAPTER 7 DISREGARDING THE CORPORATE ENTITY

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

CHAPTER 8 FINANCIAL MATTERS AND THE CLOSELY HELD CORPORATION

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

2. Best Effort Underwriting What we cant sell, you get back

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

IRS Characterization of Payments is Important

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

If the directors are deadlocked, corps cannot function well

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

BOD = board of directors, S/h = shareholders, BJR = bus judgment rule

PUT 10B5 AND 16B SLIDE SHOWS IN BOOK

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