CORPORATIONS

TEACHING HYPOTHETICALS
By Richard D. Freer
Emory University School of Law
Six fact patterns:

1.
2.
3.
4.
5.
6.

Organization of corporation
Issuance of stock
Directors and officers
Shareholders
Fundamental corporate changes
Federal securities

FACT PATTERN 1: ORGANIZATION OF CORPORATIONS

I.

FORMATION REQUIREMENTS (People, Paper, Act)

(1) People: Incorporators. Must have one or more.
you sign and file the articles
What does an incorporator do? ____________________________________________

______________________________________________________________________
-- Can BAR/BRI, Inc. serve as an incorporator for Curl Up and Dye Beauty Supply
Yes, it can be a person or an entity - that is the majority view. in new york
Corp.? Can Joan Rivers? ________________________________________________
______________________________________________________________________
it has to be a human
(2) Paper: Articles of Incorporation.
A.

(1) The articles are a contract between corporation and shareholders.

(2) And also a contract between corporation and state.

B.

Information in articles.
(1) Names and addresses.
a.

Corporate name.
Can I form a corporation with the name Bubba=s Bountiful Biscuits?
No. It must include one of these Amagic words@ (or an abbreviation
thereof): __________________________________________________
corporation, company, incorporated, or limited
__________________________________________________________
_________________________________________________________

b.

Names and addresses of incorporators and initial directors.

CORPORATIONS

c.

Name of registered agent and address of registered office (registered

agent is the corporation=s official legal representativeCe.g., can receive
service of process).

(2) Statement of duration (can be perpetual).

(3) Statement of purpose.
a.

General statement of purpose.

-- Can the articles of Bubba=s Bountiful Biscuits, Inc. indicate that the
corporation=s purpose is to Aengage in all lawful activity, after first
yes, in a lot of modern states
obtaining necessary state agency approval@? _____________________
this is presumed. you can make

__________________________________________________________
this general statement in states which require.
b.

Specific statement of purpose and ultra vires rules.

-- What if the articles of Bubba=s Bountiful Biscuits, Inc. indicate that
the corporation=s purpose is to Asell Southern-style sausage biscuits@ and
the corporation later sells T-shirts as well as the biscuits? Selling Tshirts is an ultra vires act (beyond the scope of the articles). At common
law, the contract could be voided as beyond the corporation=s capacity.
How do we handle ultra vires today? ___________________________
t-shirt is an ultra vire act. at common law
__________________________________________________________
the contract could be voided. today, ultra vires contracts are valid. shareholders can seek
an
injunction. responsible O and D are liable to the corporation for ultra vires losses. if
__________________________________________________________

__________________________________________________________
this corporation goes into an ultra vire act then O and D are liable.
__________________________________________________________
__________________________________________________________
__________________________________________________________
(4) Capital structure (stock).
a.

Definitions of background terms (to impress friends at parties):

-- Authorized stock: maximum number of shares the corporation can sell.

-- Issued stock: number of shares the corporation actually sells.
-- Outstanding stock: shares that have been issued and not reacquired by the
corporation.
b.

Articles must include: (1) Authorized stock, (2) number of shares per
class and (3) information on par value, (4) voting rights and (5)
preferences of each class.
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CORPORATIONS

(3) Act.
File articles with Secretary of State and pay required fee. Acceptance by Secretary of
State is conclusive proof of valid formation. At that point, it is a de jure corporation.
-- Then, Board holds organizational meeting, where selects officers and adopts any
bylaws and conducts other appropriate business.
II. LEGAL SIGNIFICANCE OF FORMATION OF CORPORATION
(1) Internal affairs of corporation (e.g., roles and duties of directors, officers, and
shareholders) are governed by the law of the state of incorporation.
(2) A corporation is a separate legal person. It can sue and be sued, hold property, be a
partner in a partnership, make charitable contributions, must pay income taxes as an
entity, etc.
(3) Generally, officers and directors are not personally liable for what the entity does.
Generally, shareholders (owners) are not personally liable for debts of corporation.
This is the principle of Alimited liability,@ which means that shareholders generally are
liable only for the price of their stock.
the corporation is liable.
(4) So who is liable for what the corporation does? _______________________________

______________________________________________________________________
-- That means that if the proprietors fail to form a de jure corporation, they will be nervous
because they will be liable for what the business does. Then, think about:
III. DE FACTO CORPORATION DOCTRINE/CORPORATION BY ESTOPPEL
Doctrines by which a business failing to achieve de jure corporate status nonetheless is treated as
a corporation (so shareholders will not be personally liable for business debts). Generally, person
asserting either must be unaware of failure to form de jure corporation.
(1) De Facto Corporation: (a) there is a relevant incorporation statute; (b) the parties made
a good faith, colorable attempt to comply with it; and (c) some exercise of corporate
privileges. If applicable, treated as corporation for all purposes except in an action by
the state.
-- Example: incorporators draft articles and mail them to the Secretary of State.
Unbeknownst to them, the papers are lost in the mail. They are acting as a corporation
in the interim, not knowing of the failure to form a de jure corporation. They have the
business enter a contract. Are they liable on the contract (since there is no de jure
we have a strong argument that we may not be liable on the contract.
corporation)? __________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
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CORPORATIONS

(2) Corporation by estoppel: one dealing with a business as a corporation, treating it as a

corporation may be estopped from denying the business=s corporate status. May be
invoked against those who dealt directly with the business as a corporation. May also
be used to prevent company from avoiding an obligation by asserting its own lack of
valid formation. Usually available in contract, not tort, cases.
abolished in many states and alive in others
(3) Status of these two doctrines: _____________________________________________

IV. BYLAWS
(1) In most states, adoption of bylaws is not a condition precedent to formation of a
corporation. But virtually every corporation has them. They are for internal
governanceCe.g., lay out responsibilities, set regular meeting times and places,
prescribe methods of giving notice.
the board (the organizational meeting)
(2) Who adopts the initial bylaws? ____________________________________________
shareholders. in some states
(3) Who can repeal or amend the bylaws of a corporation? _________________________
the board can also do so.
______________________________________________________________________

_____________________________________________________________________
(4) If bylaws conflict with the articles, the articles control. Bylaws are an internal
document, not filed with a state agency.
V.

PRE-INCORPORATION CONTRACTS
(1) A promoter is a person acting on behalf of a corporation not yet formed. For example,
a promoter might enter a contract on behalf of a corporation-not-yet-formed.
(2) Liability on pre-incorporation contracts.
A.

Liability of the corporation: The corporation is not liable on pre-incorporation

contracts until it adopts the contract.
On January 10, P, acting as a promoter for a corporation not yet formed, leases a
building from Donald Trump and signs the lease AOscar de la Rental Cars, Inc.@
On February 20, Oscar de la Rental Cars, Inc. is formed.
-- Is the corporation liable on the contract? Yes, if it adopted the contract. How
can that happen?
-- (1) Express - board of directors action adopting the contract.
if the corporation accepts a benefit of the contract
-- (2) Implied - ____________________________________________________

__________________________________________________________________
__________________________________________________________________
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CORPORATIONS

B.

Liability of the promoter.

Unless the contract clearly provides otherwise, the promoter remains liable on
pre-incorporation contracts until there is a novation. That means until there is an
agreement of the promoter, the corporation, and the other contracting party that
the corporation will replace the promoter under the contract.
(Assume here the contract says nothing about promoter liability.)
-- Will P be liable on the lease if Oscar de la Rental Cars, Inc. is never formed?
yes. you signed it, you are liabl.e.

__________________________________________________________________
-- Will P be liable on the lease if Oscar de la Rental Cars, Inc. is formed and
yes. p is liable until novation. here, there is no novation so he is liable.
adopts the lease? ___________________________________________________
we had the adoption here, this means that the corporation and the promoter are liable.
__________________________________________________________________

__________________________________________________________________
-- Remember: Adoption makes the corporation liable too, but does not relieve P.
So on this fact pattern, both the corporation and P are liable.
VI. FOREIGN CORPORATIONS
Foreign corporations transacting business in this state must qualify.
(1) A foreign corporation is one incorporated outside this state. So is a corporation formed
yes
in Florida foreign? ____________________________________________________
_____________________________________________________________________
(2) Transacting business means the regular course of intrastate (not interstate) business
activity. Not occasional or sporadic activity.
(3) Qualify by getting a certificate of authority from Secretary of State. Apply by giving
information from articles and a certificate of good standing from home state. Must pay
fees to state.
-- Generally, must appoint registered agent here too.
(4) Consequences of foreign corporation transacting business without qualifying: civil fine
and the corporation cannot sue in state (but it can be sued). There are no other
consequences for the foreign corporation.
-- Can the foreign corporation sue once it qualifies and pays fees and fines? ________
yes, once you qualify.
_____________________________________________________________________

CORPORATIONS

FACT PATTERN 2: ISSUANCE OF STOCK

I.

WHAT IS ISSUANCE?

Issuance of stock occurs when a corporation sells or trades its own stock. It is a way to raise
capital for the corporation.
-- Mayberry Realty Corp. sells 10,000 shares of Mayberry stock. That is an issuance, because the
corporation is selling its own stock.
no. only an issuance if the corporation
-- Family Guy sells 3,000 shares of Mayberry stock. Issuance? __________________________

is selling the stock themselves.

______________________________________________________________________________

-- So that means that all these rules in this fact pattern apply only when the corporation is selling
its own stock. NOT when you or I sell stock.
II. SUBSCRIPTIONS [written offers to buy stock from corporation]
(1) Revocation of pre-incorporation subscriptions.
On January 10, S signs a subscription, offering to buy 100 shares of C Corp., a
corporation not yet formed. A week later, S changes his mind. Can S revoke? No. A
pre-incorporation subscription is irrevocable for six months unless it provides
otherwise or all subscribers agree.
yes, until acceptance.
(2) Are post-incorporation subscriptions revocable? ______________________________

_____________________________________________________________________
(3) When do the corporation and the subscriber become obligated under a subscription
when the board accepts the offer. once the board of directors accepts the offer, then
agreement? ___________________________________________________________
the offer is irrevocable.
_____________________________________________________________________

III. CONSIDERATIONCwhat must the corporation receive when it issues stock?

(1) Form of Consideration: split of authority on this.
A.

Every state agrees that these are permitted: (1) money (cash or check), (2)
tangible or intangible property, or (3) services already performed for the
corporation. _______________________________________________________
__________________________________________________________________

B.

The split of authority is about two other forms. In some states these are OK but
in some states they are prohibited (so using them results in Aunpaid stock,@
1) promissory notes 2) future services. if on your exam,
meaning its all treated as water): ______________________________________
you see either of these, you must flag them. they are ok under the model act, but many states dont follow
__________________________________________________________________

CORPORATIONS

(2) Amount of Consideration.

A.

Par means Aminimum issuance price.@

$30,000
C Corp. is selling 10,000 shares of $3 par stock. It must receive at least ________

__________________________________________________________________
B.

No par means Ano minimum issuance price.@ Board of directors sets any price.

C.

Treasury stock.
This is stock that was previously issued and has been reacquired by the
corporation. The corporation can then resell it. Treat the sale as no par.

D.

Who determines the value of consideration received for an issuance? The board
of directors. And its valuation is conclusive if it was made in good faith. (In
some states, its conclusive if the board acted without fraud.)

E.

Consequences of issuing par stock for less than par value; i.e., Awatered stock.@
C Corp. issues 10,000 shares of $3 par to X for $22,000. The corporation (or its
creditors if it is insolvent) wants to recover the $8,000 of Awater.@ Who is liable?
(1) Directors? Yes, if they knowingly authorized the issuance.
he is liable also. no defense
(2) X (the person who bought it)? _____________________________________

(3) What if X transfers the stock to A? A is not liable if she acts in good faith
(did not know about the water).
-- But A=s status (good faith or not) has no effect on the liability of X or the
directors.
IV. PREEMPTIVE RIGHTS
(1) Preemptive right is the right of an existing shareholder to maintain her percentage of
ownership by buying stock whenever there is a new issuance of stock for money (cash
or equivalent). Some states do not include sale of treasury stock as Anew issuance.@
-- S owns 1,000 shares of C Corp. There are 5,000 shares outstanding. C Corp. is
planning to issue an additional 3,000 shares. If S has preemptive rights, then S has the
right to _______________________________________________________________
he has the right to buy 600, it is a percentage deal. 1k of 5k is 20% and then she is entitled to
20% of 3,000, which is 600.
______________________________________________________________________

(2) What if the bar exam question does not indicate whether the articles of C Corp. provide
for preemptive rights? Split of authority. Traditionally, preemptive rights exist unless
the articles provide otherwise. Strong trend says preemptive rights do not exist unless
the articles provide for them. figure out what we covered in class
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CORPORATIONS

-- The articles of C Corp. provide for preemptive rights. C Corp. is issuing stock
to G to acquire Green Acres from G. Are there preemptive rights? NO. Why?
this is not an issuance for money. here, it is for property.
_________________________________________________________________

_________________________________________________________________
FACT PATTERN 3: DIRECTORS AND OFFICERS
I.

STATUTORY REQUIREMENTSCDIRECTORS
(1) Number: one or more adult natural persons.
(2) Election: Shareholders elect directors (at the annual meeting).
(3) Shareholders can remove directors before their terms expire. Generally, majority of
with or without cause.
shares entitled to vote must vote for removal. On what bases? ___________________
_____________________________________________________________________
-- But shareholders cannot remove a director if cumulative voting is in effect and the
number of votes against removal would be enough to elect the director. We will see
21
cumulative voting on page ________.
board or shareholders, generally
(4) Who selects the person who fills a vacancy on the Board? ______________________

_____________________________________________________________________
_____________________________________________________________________
--But if the shareholders created the vacancy by removing a director, the shareholders
generally must select the replacement.
(5) Board action.
A.

There are two ways the board can take a valid act: (1) unanimous written consent
to act without a meeting, or (2) a meeting (can be held anywhere) that satisfies
quorum and voting requirements. What if neither of these is met? ____________
any act is void, unless it is ratified by a valid act which has to be met by the 2 things listed above
__________________________________________________________________

__________________________________________________________________
__________________________________________________________________
-- Does a conference call qualify as a meeting (assuming all participants can hear
yes
each other simultaneously)? __________________________________________
B.

Notice is required for special meetings but not regular meetings. (The time and
place of regular meetings is set in bylaws.) The method for giving notice is
usually in the bylaws. If the corporation fails to give notice of a special meeting
to all directors, the meeting is void unless those not given notice waive the defect.
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CORPORATIONS

C.

no, they are void and

Are proxies or voting agreements OK for director voting? __________________
against public policy. here, it is important to remember that one person can play diff roles (shareholder & director)
_________________________________________________________________
if she is a shareholder then proxy voting and voting agreements are fine.

D.

Quorum for meetings. We need a majority of all directors to do business (unless

bylaws require otherwise). If a quorum is present at a meeting, to pass a resolution
(how the Board takes an act at a meeting) we need only a majority vote of those
present.
-- So, if there are 9 directors, at least ________
directors must attend the meeting
5
3
to constitute a quorum. If 5 directors attend, at least ________
must vote yes to
pass a resolution.

II. ROLE OF DIRECTORS

(1) The board manages the business of corporation., e.g., it sets policy, selects and
supervises officers, declares distributions, decides when to issue stock, recommends
fundamental changes to the shareholders. So note that the shareholders do not run the
corporation. They elect the directors, who run the corporation.
(2) The board can delegate substantial management functions to a committee, but a
committee cannot: (1) amend bylaws, (2) declare dividends or (3) recommend a
a committee is usually one or more directors
fundamental corporate change to shareholders. _______________________________
_____________________________________________________________________
III. DUTY OF CARE (Burden on Plaintiff)
Duty of care standard: A director owes the corporation a duty of care. She must do what a
prudent person would do with regard to her own business.
(1) Nonfeasance (the director does nothing).

lazy director

Justin Timberlake, a director of C Corp., fails to attend any of the board of directors=
meetings or to keep abreast of the company business in any way. The corporation
loses money on several deals. Will Justin be held liable for these losses for breaching
the duty of care?
--State the duty of care standard. A prudent person would attend some meetings and do
some work. Justin never did anything, so he has breached the duty of care. BUT HE IS
his breach caused a loss to the corporation. it is not enough for the P to show
LIABLE ONLY IF: _____________________________________________________
that there has been a breach of duty of care. you must show CAUSATION. it is very tough to do that because
______________________________________________________________________
the corporation would have lost money anyways.
______________________________________________________________________

______________________________________________________________________
______________________________________________________________________
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CORPORATIONS

(2) Misfeasance (the board does something that hurts the corporation).
The directors of Hedonists= Hot Tubs, Inc., vote to start a new line of hot tubs with
built-in wine coolers and video cameras. The idea is a disaster and the corporation
loses money. Are the directors liable for breach of the duty of care?
-- State the duty of care standard. Here, the directors= action caused a loss to the
corporation. BUT, a director is not liable if she meets the business judgment rule
the standard is what a prudent person would do. prudent people do appropriate homework.
(ABJR@). ______________________________________________________________
did they deliberate, analyze, etc.... prudent people do these things. if they do these things then they are not
______________________________________________________________________
liable.
______________________________________________________________________

______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
BJR: So a court will not second-guess a business decision if it was made in good faith,
as a director you don't have to be right 100%. you just
was informed, and had a rational basis. _____________________________________
have to do the homework that a prudent person would do. grossly negligent or irrational is usually when you are
_____________________________________________________________________

going to be liable

IV. DUTY OF LOYALTY (Burden on Defendant because BJR does not apply in cases
involving conflict of interest.)
Duty of loyalty standard: A director owes the corporation a duty of loyalty. She must act in
good faith and with a reasonable belief that what she does is in the corporation=s best interest.
(1) Interested Director TransactionCany deal between the corporation and one of its
directors or another business of the director=s.
Martha is a director of XYZ, Inc. She sells wreaths to the corporation. That is an
interested director transaction. Is Martha in trouble?
-- State the duty of loyalty standard. Interested director transaction will be set aside
UNLESS the director shows: (1) the deal was fair to the corporation when entered, OR
(2) her interest and the relevant facts were disclosed or known and the deal was
the burden on the D. she must show that the deal was fair when entered.
approved by either of these: ______________________________________________
second, her interest and relevant facts were disclosed or know and then deal
_____________________________________________________________________
then
it gets the green light by either majority of disinterested directors or majority of disinterested shares.
_____________________________________________________________________

_____________________________________________________________________
-- Special quorum rules: interested directors count toward quorum.
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CORPORATIONS

-- Directors can set their own compensation, but it must be reasonable. If excessive, it=s
waste of corporate assets, and a breach of the duty of loyalty.
(2) Competing Ventures.
Sharon is a director of Ozzie's Music Co. She can also serve on the board of directors
of Home Depot because it does not compete with Ozzie's. But can Sharon start her
own music company?
-- State the duty of loyalty standard. Director cannot compete directly with her
corporation.
constructive trust on sharon's profit. if sharon goes into business then she has to cough up the
-- Remedy: ___________________________________________________________

_____________________________________________________________________
profits to Ozzie
(3) Corporate Opportunity (Expectancy).
Cheatem is a director of C Realty Corp., which develops condo projects. Cheatem
learns of some land that has been zoned for condos and buys it for himself as an
investment. What are C=s rights, if any, against Cheatem?
-- State the duty of loyalty standard. Director cannot USURP a corporate opportunity.
That means the director cannot take it until he (1) tells the board and (2) waits for the
board to reject the opportunity.
--

What is a corporate opportunity? Some say it=s anything in the corporation=s

business line is the delaware test. something the corporation has an interest or an
business line. ______________________________________________________
an expectancy in. did the director find this on her time or company time? if it is on her own time then
__________________________________________________________________
it may not be a corporate opportunity. the answer to the example above is that it looks like a corporate
__________________________________________________________________

opportunity.
__________________________________________________________________

__________________________________________________________________
-- Is the company=s financial inability to pay for the opportunity a defense? _____
generally
not.
__________________________________________________________________

__________________________________________________________________
-- Remedy: If Cheatem still has it, he must sell it to the corporation at his cost. If
Cheatem has sold it at a profit, the corporation gets the profit. (Constructive trust.)
V.

OTHER BASES OF DIRECTOR LIABILITY

(1) Ultra vires acts. Responsible officers and directors are liable for ultra vires losses.
Remember we did this back on page ________.
2
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CORPORATIONS

(2) Improper loans.

Curly, Moe and Larry are directors of C Corp. The board of directors votes to lend
Curly $100,000 of corporate funds. Generally, such a loan is OK only if the board
finds that it is reasonably expected to benefit the corporation. ____________________
this is the general standard.
______________________________________________________________________

-- Sarbanes-Oxley Act (federal law) prohibits most loans to executives in registered

(publicly traded) corporations.
24
(3) Improper distributions. See page ________.

(4) Which directors are liable for all the things directors be liable for?
A.

General rule.
A director is presumed to have concurred with Board action unless her dissent or
abstention is noted in writing in corporate records. That means (1) in the minutes
or (2) in writing to the corporate secretary at the meeting or (3) registered letter to
the corporate secretary immediately after the meeting.
not by itself, it must get into writing by the ways listed above.
-- So is an oral dissent effective? ______________________________________

__________________________________________________________________
-- You cannot dissent if you voted for the resolution at the meeting.
B.

Exceptions.
(1) Absent directors are not liable.
(2) Good faith reliance on (a) book value of assets or (b) opinion of a competent
employee, officer, professional, or committee of which the director relying
was not a member, or (c) financial statements by auditors. Must have a
reasonable belief in the competence of the persons providing such
information.

VI.

OFFICERS (owe the same duties of care and loyalty as directors).

(1) Status: Officers are agents of the corporation. So they can bind the
corporation by acts for which they have authority to bind it.
-- President generally has inherent authority to bind the corporation to contracts in
the ordinary course of business.
Traditionally, must have a president, a secretary and a treasurer. Can also have
generally yes.
others. Today, can one person hold multiple offices simultaneously? __________
__________________________________________________________________
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CORPORATIONS

(2) Selection and removal of officers.

Officers are selected by and removed by the directors. Directors also set officer
compensation.
The directors of Pharmacy Inc. appoint Tom Cruise as president. What happens if
they fire him from the presidency?
-- Toms gone, although the corporation may be liable for breach of contract
if we breached the contract, he will get damages....he wont get the job back.
damages. _________________________________________________________
__________________________________________________________________
-- So shareholders hire and fire directors, but directors hire and fire officers. Generally,
then, shareholders do NOT hire and fire officers.
VII.

INDEMNIFICATION OF DIRECTORS AND OFFICERS

(1)

An officer or director gets sued by or on behalf of the corporation. She has incurred
costs, attorneys= fees, maybe even fines, a judgment or settlement. She seeks
reimbursement from the corporation.
A.

No indemnification; i.e., when is corporation barred from indemnifying?

If held liable to the corporation or held to have received an improper personal
benefit.

B.

Mandatory indemnification; i.e., when is a corporation required to indemnify?

In some states, if she was Awholly successful@ (on the merits or otherwise) in
for an example,
defending the action. In others, Ato the extent@ she was successful. ____________
if she wins on 1 cause of action out of 4 causes of actions then it will be valid under "to the extent"
__________________________________________________________________

but not under "wholly successful."

__________________________________________________________________

C.

Permissive indemnification; i.e., when is a corporation permitted to indemnify?

1.

Situations: anything not satisfying A. and B. above. Watch for settlement.

2.

Eligibility standards: she must show that she acted in good faith and with the
reasonable belief that her actions were in the company=s best interests. duty of loyalty

3.

Who determines eligibility? Disinterested directors or disinterested shares or

independent legal counsel.

(2) Notwithstanding these rules, the court where director or officer was sued can order
indemnification if it is justified in view of all circumstances. Usually limited to costs
and attorneys= fees (not any judgment against the director or officer).

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CORPORATIONS

(3) Articles can provide for limitation or elimination of liability for damages, but not for
breach of the duty of loyalty, intentional misconduct or wrongful personal benefit. In
some states, such provisions are available for directors only, not officers.
FACT PATTERN 4: SHAREHOLDERS
I.

HOLDING SHAREHOLDERS LIABLE FOR THE ACTS OR DEBTS OF THE

CORPORATION (SHAREHOLDER AS DEFENDANT)
Generally, a shareholder is not liable for the acts or debts of a corporation. But a court
might Apierce the corporate veil@ (PCV), which means the court will hold shareholders
personally liable for what the corporation did. To do this, two things must be true: (1) the
shareholders have abused the privilege of incorporating and (2) fairness requires it. PCV
has only been used in close corporations.
-- PCV standard (when fairness requires piercing): most courts will PCV to avoid fraud
you can make the argument based on the abuse of the corporation
or unfairness. (PCV is never automatic.) ______________________________________
__________________________________________________________________________
(1) Alter ego (identity of interests).
X and Y are the shareholders of C Corp. X is also the chief executive officer. X
commingles personal and corporate funds, uses the corporate car as his own, and uses
the corporate credit card to pay for personal purchases. Can a creditor of the
corporation who has been unable to collect its claim from the corporation collect from
either X or Y?
-- Start with general rule (shareholders not liable for acts or debts of corporation). Then
PCV standard. Here a court MIGHT PCV if X=s failure to respect the separate
corporate entity harmed creditors. Sloppy administration generally is not enough for
PCV, but here X treated the corporation as his alter ego by treating the corporation and
if the abuse harmed the creditors then both elements are met
personal assets as interchangeable. _________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
-- If PCV on these facts, only X would be liable. Y has done nothing wrong.

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CORPORATIONS

(2) Undercapitalization.
S is a shareholder of Glowco, Inc., G, a corporation that hauls and disposes of nuclear
waste. G does not carry insurance. G has an initial capitalization of $1,000. V is
injured when one of G=s trucks melts down. Can V sue S?
general rule => shareholders are generally not liable personally

-- General rule; PCV standard. Here a court MIGHT PCV because the corporation was
undercapitalized when formed. Why? Because shareholders failed to invest enough to
that is true here.
cover prospective liabilities. ______________________________________________
_____________________________________________________________________
_____________________________________________________________________
_____________________________________________________________________
-- Instead of PCV here, a court might subordinate debt owed to the responsible
shareholders (if any) to that of other creditors.
Remember (always say this in a PCV hypo): courts are generally more willing to PCV for
a tort victim than for a contract claimant.
II. SHAREHOLDER MANAGEMENT OF CORPORATION
(1) Remember that generally the board of directors manages a corporation.
(2) Shareholders can manage corporation directly in a close corporation. What are the
1) few shareholders (no magic number) 2) the stock
characteristics of a close corporation? ______________________________________
is
not publicly traded.
_____________________________________________________________________

_____________________________________________________________________
_____________________________________________________________________
-- The shareholders in a close corporation can elect a board of directors, and the board
will manage the corporation. Or they can eliminate the board of directors and run the
corporation themselves. Usually, this is done by unanimous shareholder agreement. If
the shareholders eliminate the board and take over management, who owes the duties
the managing shareholders, they are fiduciaries
of care and loyalty to the corporation? ______________________________________
_____________________________________________________________________
_____________________________________________________________________
(3)

Shareholders in a close corporation owe each other fiduciary duties. Watch especially
a controlling shareholder who oppresses minority shareholders, e.g., selling control
(without reasonable investigation of the buyer) to someone who loots the corporation
or other oppression of minority shareholders. Courts may be willing to help the
minority shareholder here. WHY? Because there is no public market for the shares
(so the minority shareholder cannot just get out by selling shares).
15

CORPORATIONS

(4) Licensed professionals, including lawyers, medical professionals, and CPAs, may
incorporate as a Aprofessional corporation.@ The name must include the designation
Aprofessional corporation@ or Aprofessional association@ or an abbreviation of one of
those. The shareholders must be licensed professionals and generally the P.C. may
practice only one profession. The P.C. may employ non-professionals (not to render
professional services). The professionals and the P.C. remain personally liable for their
own malpractice or misconduct in rendering professional services. Shareholders are
generally not liable for each other=s malpractice or for corporate obligations. Generally,
the rules governing regular corporations apply to the P.C.
III. SHAREHOLDER DERIVATIVE SUITS (SHAREHOLDER AS PLAINTIFF)
(1) In a derivative suit, a shareholder is suing to enforce the corporation=s claim, not her
own personal claim.
To determine if its a derivative suit, ask: could the corporation have brought this suit?
If so, it is probably a derivative suit.
-- S sues the board of directors of C Corp. for usurping corporate opportunities.
Derivative suit? YESC duty of loyalty (and care) are owed to corporation. _________
a breach hurts the corporation
_____________________________________________________________________

_____________________________________________________________________
-- S sues board of directors of C Corp. for issuing new stock without honoring her
preemptive rights. Derivative suit? NoCthis is a direct suit, to vindicate S=s personal
claim.
(2) What are the consequences of a successful derivative suit?
Generally, the recovery in any successful derivative suit goes to the corporation (not to
the shareholder (S)) who brought the suit on behalf of the corporation. ____________
it is the corporation's claim so they should get the benefits.
_____________________________________________________________________

-- What does S receive? Costs and attorneys= fees, usually from the corporation. After
all, the shareholder conferred a benefit on the corporation by suing and winning.
(3) What are the consequences of an unsuccessful shareholders= derivative suit?
no

-- Can S still recover costs and attorneys= fees? _______________________________

-- Is S liable to the people he sued for their costs and attorneys= fees? Yes, if he sued
without reasonable cause.
no, res judicata
-- Can other shareholders later sue X on the same transaction? ___________________

_____________________________________________________________________
16

CORPORATIONS

(4) What are the requirements for bringing a shareholder derivative suit?
A.

Stock ownership.
The person bringing suit must have owned stock at the time the claim arose or
have gotten it by operation of law from someone who did own stock when the
claim arose. What are examples of operation of law? ______________________
inheritance, divorce decree
__________________________________________________________________
__________________________________________________________________

B.

Must also show that S will adequately represent the interest of the corporation.
__________________________________________________________________

C.

Must also make a written demand on directors that the corporation bring suit
UNLESS demand would be futile. Why would demand be futile? ____________
if the defendants in the suits are the directors who are reviewing the demand
__________________________________________________________________

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
D.

Usually must plead with particularity the efforts to get the corporation to sue or
why demand was excused.

E.

Corporation can move to dismiss the derivative suit based on findings by

disinterested directors (or a committee of disinterested directors) that suit is not in
the corporation=s best interest (e.g., low chance of success or cost of litigation
would exceed recovery).
-- The court will scrutinize whether the directors making the recommendation are
truly disinterested and, if so, dismiss. In some states, the court will also make an
independent determination of whether dismissal is in the corporation=s best
interest.

(5) Litigation.
A.

The corporation must be joined as a defendant. Even though the suit asserts the
corporation's claim, the corporation did not do so, so it is joined initially as a
defendant.

B.

No dismissal or settlement without court approval. Court can give notice to those
who would be affected, and get their input on whether dismissal or settlement
should be approved.
17

CORPORATIONS

IV. SHAREHOLDER VOTING

(1) Who votes?
General rule is that record shareholder as of record date has the right to vote.
A.

The record shareholder is the person shown as the owner in the corporate records.
The record date is a voter eligibility cut-off.
C Corp. sets its annual meeting for July 7 and record date for June 6. S sells B her
C Corp. stock on June 25. Who is entitled to vote the shares at the meeting, S or
S
B? ______________________________________________________________
__________________________________________________________________

B.

Exceptions to the general rule that record owner on record date votes.
1.

Treasury stock. Suppose the corporation reacquires stock before record date.
So the corporation is the record owner on the record date of this treasury
no
stock. Does the corporation vote the treasury stock? __________________.

2.

Death of shareholder.
-- S owns stock in C Corp.; S is the record shareholder. After the record date,
yes
S dies. Can S=s executor vote the shares? ____________________________

3.

Proxies.
A proxy is a (i) writing (fax increasingly OK; e-mail OK in some states), (ii)
signed by record shareholder, (iii) directed to secretary of corporation, (iv)
authorizing another to vote the shares.
-- On February 2, 2007, S sends a letter to secretary of C Corp. authorizing
Charlie Whitebread to vote her shares. Can Charlie vote S=s shares at the
2007 annual meeting in July? Yes. This is a proxy.
-- This is OK in shareholder voting. Remember, proxies are not permitted
for voting by directors. Page ________.
-- Can Charlie vote S=s shares at the 2008 annual meeting in July 2008? ___
no, 11 months
______________________________________________________________
______________________________________________________________
-- What if, prior to the 2007 meeting, S writes to the secretary of C Corp. that
she now wants Jim Cramer to vote her shares at the 2007 meeting? _______
that is okay, she has revoked charlie's proxy
______________________________________________________________

18

CORPORATIONS

-- Can S revoke her proxy even though it states that it is irrevocable? _____
yes.
______________________________________________________________

-- S sells B her shares after the record date but before the annual meeting. S
gives B an Airrevocable proxy@ to vote the shares at the annual meeting. Can
S revoke this proxy? No, because (1) it says irrevocable and (2) the
proxyholder has some interest in the shares other than voting. This is a
Aproxy coupled with an interest.@ ___________________________________
it is met here
______________________________________________________________
______________________________________________________________
-- Here, the interest is ownership. But it could be an option, pledge, etc.
C.

Voting trusts and voting agreements.

X, Y, and Z own relatively few shares of C Corp. They decide that they can
increase their influence on corporate policy by Ablock voting,@ i.e., voting alike.
1.

Requirements for voting trust.

a.
b.
c.
d.

Written trust agreement controlling how the shares will be voted;

Copy to corporation;
Transfer legal title of shares to voting trustee;
Original shareholders receive trust certificates and retain all shareholder
10 year max in most states.
rights except for voting. _____________________________________
__________________________________________________________

2.

Requirements for voting (Apooling@) agreement.

a.

yes
Can shareholders enter into voting agreements? ___________________

b.

in writing and signed

What is required? __________________________________________

__________________________________________________________
_________________________________________________________
c.

split of authority
Are voting agreements specifically enforceable? __________________

(2) Where do shareholders vote?

A.

There are two ways shareholders can take a valid corporate act: (1) unanimous
written consent of the holders of all voting shares, or (2) a meeting (held
anywhere) that satisfies quorum and voting rules.

19

B.

Annual meeting: to elect directors. If not held, a shareholder can petition the court
to order one.

C.

Special meeting can be called by (a) the Board, (b) the president, (c) the holders
of at least 10 percent of the voting shares or (d) someone else as provided in the
articles.
-- Suppose a proper person calls a shareholder meeting for the purpose of
removing an officer. There is a problem with this. Why? __________________
shareholders cannot remove officers (tricky question)
________________________________________________________________

________________________________________________________________
________________________________________________________________
D.

Notice requirementCmust give written notice to every shareholder entitled to

vote, for every meeting (annual or special).
1.

Contents of the notice: always must tell them when and where and must state
purpose. Why is statement of purpose important? Because that is the only
business that can be transacted at that meeting. _______________________
______________________________________________________________

2.

Consequence of failure to give proper notice to all shareholdersCaction

taken at the meeting is void unless those not sent notice waive the notice
defect.
How does waiver occur?
-- (1) ExpressCin writing and signed any time; or
-- (2) ImpliedCattend the meeting without objection.

(3) How do shareholders vote?

There must be a quorum represented at the meeting. Determination of a quorum
focuses on the number of shares represented, not the number of shareholders.
Generally, a quorum requires a majority of outstanding shares.
-- X Corp. has 120,000 shares outstanding. X Corp. has 700 shareholders. What or who
constitutes a quorum? ___________________________________________________
we need at least 60,001 shares
______________________________________________________________________
______________________________________________________________________
-- If quorum requirement is met, a majority may act to bind the corporation unless the
articles or the bylaws require higher vote. But Amajority@ of whatCshares present or
shares actually voting?
20

CORPORATIONS

-- X Corp. has 120,000 shares outstanding. 62,000 shares are represented at the
meeting, but only 50,000 shares vote on a particular proposal. How many shares must
vote for the proposal for it to be accepted by the shareholders? ___________________
we need at least 25,001 (only those who have voted)
______________________________________________________________________

______________________________________________________________________
(4)

How and when do shareholders use cumulative voting?

A.

Cumulative voting is only available in voting for directors. It is a device to give

small shareholders a better chance of electing someone to the Board.

B.

Multiply number of shares times number of directors to be elected.

You own 1,000 shares of stock in C Corp. C Corp. has nine directorships open for
election. You believe that Napleon Dynamite should be director of C Corp. Under
cumulative voting, how many votes can you cast for Napoleon? ______________
9,000 votes
__________________________________________________________________
__________________________________________________________________

C.

V.

The articles of C Corp. are silent as to whether shareholders can vote

cumulatively. Can C=s shareholders still vote cumulatively? Generally noCthis
exists in most states only if the articles provide.

STOCK TRANSFER RESTRICTIONS

One nice thing about stock is that it is freely transferable you can sell it, will it, give it
away. Sometimes people want to impose restrictions on the transferability of stock. Often,
this is in a close corporation, to keep outsiders out. Example:
Federline is a shareholder of Famous For No Reason, Inc. His stock is subject to a stock
transfer restriction that requires him to offer it first to the corporation (this is a Aright of first
refusal@). Federline sells the stock to Paris Hilton in violation of the agreement.
A.

Stock transfer restrictions will be upheld provided they are reasonable under the
circumstances, which means not an undue restraint on alienation. The right of first
refusal is OK, assuming the corporation offers a reasonable price. ____________
you have to offer it to the corporation first
__________________________________________________________________

__________________________________________________________________
B.

Action against the transferee of the stock.

Even if the restriction is reasonable and thus valid, it cannot be invoked against
the transferee unless either (a) it is conspicuously noted on the stock certificate or
(b) the transferee had actual knowledge of the restriction.
21

CORPORATIONS

VI. RIGHT OF SHAREHOLDER (PERSONALLY OR BY AGENT) TO INSPECT (AND

COPY) THE BOOKS AND RECORDS OF THE CORPORATION
(1) Standing: who can demand access? Generally, any shareholder.
(2) Procedure: written demand stating a proper purpose, which means: _______________
related to her role as a shareholder. for example that could be hostile to management, so you can get
_____________________________________________________________________
a list of members for proxy voting, etc....
_____________________________________________________________________

_____________________________________________________________________
(3) What are the consequences if the corporation does not allow inspection after proper
demand? Shareholder moves for court order. If successful, also generally recovers
costs and attorneys= fees incurred in making the motion.
(4) Directors dont have to make any showing to get access to the books and records.
Because of their management responsibilities, they have unfettered access. ________
this is for shareholders
_____________________________________________________________________

VII. DISTRIBUTIONS (Payments to shareholdersCcan be (1) a dividend or (2) to repurchase

a shareholder=s stock or (3) to redeem stock (redemption is a forced sale to corporation at
a price set in the articles).)
(1) Distributions are to be declared in the Board=s discretion. An action to compel
declaration of a distribution is tough to win. Can win only on a very strong showing of
abuse of discretion. For example, if the corporation consistently makes profits and the
board refuses to declare a dividend while paying themselves a bonus.
(2) Which shareholders get dividends? (Preferred, Participating, Cumulative, Common)
-- The board of directors of C Corp. decides to declare dividends totalling $400,000.
Who receives dividends if the outstanding stock is:
1.

$4 per share
100,000 shares of common stock. ______________________________________

__________________________________________________________________
2.

100,000 shares of common and 20,000 shares of preferred with $2 dividend

preference. Preferred means pay first. 20,000 preferred shares multiplied by $2
preference equals a total preference of $40,000. That is paid first. That leaves
$360,000, which goes to the common shares. Because there are 100,000 of those,
each common share gets $3.60. _______________________________________
__________________________________________________________________
__________________________________________________________________
22

CORPORATIONS

3.

100,000 shares of common and 20,000 shares of $2 preferred that is participating.

Participating means pay again. So these 20,000 shares get paid first (because they
are preferred) and also get paid again (because they are participating). Work the
preferred aspect same as in hypo #2: 20,000 shares multiplied by $2 equals
$40,000 total preference. Pay that first. That leaves $360,000, as in hypo #2.
here that 360,000 gets divided 120,000 shares. so the participating gets paid the original $2. also, he gets paid $3
__________________________________________________________________
from the 360,000 / 120,000

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
4.

100,000 shares of common and 20,000 shares of $2 preferred that is cumulative

(and no dividends have been paid in the three prior years).Cumulative means add
them up. A cumulative dividend accrues year-to-year. So the corporation owes the
cumulative holders for the three prior years, plus this year (when the dividend was
declared). That means the corporation owes them four years= worth of a $2
preference. Four years multiplied by $2 equals $8 per share. So the corporation
owes $8 to each cumulative preferred share. There are 20,000 such shares.
you pay $60,000 first.
__________________________________________________________________

__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
__________________________________________________________________
(3) For any distribution (dividend, repurchase, redemption), which funds can be used?
1.

Earned surplus: this is generated by business activity.

a.

How is earned surplus computed? All earnings minus all losses minus
distributions previously paid.

b.

it is a proper fund for distribution. it is up to the board

How can earned surplus be used? __________________________________

__________________________________________________________________
__________________________________________________________________

23

2.

Stated capital: this is generated by issuing stock. (So is capital surplus, below.)
--So when we have an issuance, the consideration will be allocated between stated
capital and capital surplus.
a.

no
Can stated capital be used for distributions? __________________________

b.

How is stated capital computed?

-- C Corp. has issued 10,000 shares of $2 par stock for $50,000. Of that,
$20,000 goes to stated capital and $30,000 goes to capital surplus. Why?
On a par issuance, the par value goes to stated capital. Here thats $20,000.
______________________________________________________________
because we sold 10,000 shares at $2 par
______________________________________________________________
-- And the excess over par goes to capital surplus. Here, thats $30,000.
______________________________________________________________
______________________________________________________________
If we had a no-par issuance, the board allocates the consideration between
stated capital and capital surplus. __________________________________

3.

Capital surplus: this is also generated by issuing stock.

a.

How is capital surplus computed? Payments in excess of par plus amounts

allocated on a no-par issuance.

b.

yes, if you inform the shareholders

Can capital surplus be used for distributions? _________________________

_____________________________________________________________
(4) Instead of the foregoing fund requirements, many states now simply say the
corporation can declare a distribution as long as the corporation is not insolvent or if
the distribution would render it insolvent. Insolvent means either:
a. the corporation is unable to pay debts as they come due OR
b. its assets are less than its liabilities (and liabilities include liquidation (or
dissolution) preferences); we will see liquidation preferences on page 29.
(5) Directors are personally liable for unlawful distributions, as are shareholders who
knew the distribution was unlawful when they received it. In some states, director
liability here is strict; in some, directors are only liable if the distribution is made in
breach of a duty. Remember, however, directors= possible defense of good faith
12
reliance. Cross-reference page _________
.
24

FACT PATTERN 5: FUNDAMENTAL CORPORATE CHANGES

I.

CHARACTERISTICS OF FUNDAMENTAL CORPORATE CHANGE

(1) Unusual occurrences, so they require board of director action and
a majority
(2) Approval by __________________________
of the shares entitled to vote. So this is
different from shareholder voting before. Here its not enough to get a majority of the
shares present or that actually vote we need a majority of those entitled to vote.

(3) Possibility of dissenting shareholder right of appraisal.

A.

The right of appraisal is the right of a shareholder to force the corporation to buy
her shares at fair value. This is the shareholders sole remedy for these
fundamental changes unless there is fraud.

B.

When will a shareholder have a dissenting shareholder right of appraisal?

1.

Actions by corporation to trigger right -- any of these:

a.
b.
c.

2.

Actions by shareholder to perfect right:

a.
b.
c.

C.

merger or consolidation;
transfer of substantially all assets not in the ordinary course of business;
transfer of shares in a share exchange.

Before shareholder vote, file with the corporation written notice of

objection and intent to demand payment;
Abstain or vote against the proposed change; and
After the vote, make written demand to be bought out.

If the shareholder and the corporation cannot agree on fair value of the shares,
we litigate
what happens? _____________________________________________________
__________________________________________________________________

D.

Some states do not grant the right of appraisal if the company=s stock is listed on a
national exchange or has a large number of shareholders (e.g., 2,000 or more).
This makes sense, because in such a large corporation, there is a public market for
the shares, so the disgruntled shareholder can just sell on the market. She doesnt
need to force the corporation to buy her out.

II. AMENDMENT OF THE ARTICLES

(1) Board of director action and notice to shareholders.
(2) Shareholder approval.
If there are 4,000 outstanding shares entitled to vote, how many must vote for the
at least 2,001
amendment? __________________________________________________________
25

CORPORATIONS
you still need at least
-- What if only 2,400 shares showed up to vote on the amendment? _______________
2,001 votes
_____________________________________________________________________

_____________________________________________________________________
(3) If approved, file amended articles with Secretary of State.
(4) Are there dissenting shareholder rights of appraisal? No. But if the amendment harms a
class of stock, the amendment must be approved by the shares of that class itself as
well as by the overall majority of all shares entitled to vote. This is Aclass voting.@
III. MERGERS [B, Inc. merges into A Corp.] OR CONSOLIDATIONS [A Corp. and B,
Inc. form C Corp.]
(1) Board of director action (both corporations), and notice to shareholders.
(2) Shareholder approval (generally both corporations). ___________________________
majority of the shares entitled to vote
______________________________________________________________________
(3) If approved, file articles of merger (or consolidation) with Secretary of State.
(4) REMEMBER DISSENTING SHAREHOLDER RIGHT OF APPRAISAL.
(5) Effect of merger or consolidation: the
_________________________________________
surviving company succeeds to all rights and liability of the constituent
______________________________________________________________________
______________________________________________________________________
-- This rule makes sense because the constituent corporation disappeared. So a creditor
of that corporation can sue the survivor.
IV. TRANSFER OF ALL OR SUBSTANTIALLY ALL OF THE ASSETS NOT IN THE
ORDINARY COURSE OF BUSINESS OR SHARE EXCHANGE (one company
acquires all the stock of another)
yes

(1) Are these fundamental changes for the transferring corporation? _________________
no
(2) Are these fundamental changes for the buying corporation? _____________________

So the shareholders of the buying corporation DO NOT VOTE ON THESE.

-- S Corp. wants to sell all of its assets to B, Inc. or B, Inc. wants to buy all the shares of S
Corp. We need:
(1) Board of director action (both corporations), and notice to selling corporation=s
shareholders.
26

CORPORATIONS

(2) Approval by transferring corporation=s shareholders.

A.

majority of the shares entitled to vote

Number of shares of S Corp. that must approve the sale? _______________

_________________________________________________________________
_________________________________________________________________
B.

Number of shares of B, Inc. that must approve the sale? NONE. THEY
DON'T VOTE, BECAUSE IT'S NOT A FUNDAMENTAL CHANGE FOR
THE BUYING CORPORATION.

(3) Are there dissenting shareholders= rights of appraisal? Yes, for shareholders of the
transferring corporation only.
(4) File articles of exchange with the Secretary of State in share exchange. Usually,
no filing in transfer of assets.
(5) Generally, acquiring company is not liable for debts of the acquired company
unless the deal says otherwise or unless the company purchasing assets is merely
a continuation of the selling corporation. This makes sense, because the
corporation that sold its assets still exists, so a creditor can still sue it.
V.

DISSOLUTION
(1) Voluntary.
A.

Board of directors action and approval by a majority of the shares entitled to vote.

B.

File articles of dissolution and give notice to creditors.

(2) Involuntary (by court order).

A.

Shareholder can petition because of: (1) director abuse, waste of assets,
misconduct; or (2) director deadlock that harms the company; or (3) shareholder
deadlock and failure for at least two annual meetings to fill a vacant board
position.
-- Alternative to dissolution: the court might order the corporation or majority
to buyout the petitioning shareholder
shareholders to: ____________________________________________________
__________________________________________________________________
-- This is especially likely in a close corporation.

B.

Creditor can petition because the corporation is insolvent and the creditor either
has an unsatisfied judgment against the corporation or the corporation admits the
debt in writing.

27

CORPORATIONS

(3) After filing articles of voluntary dissolution, or after court order of involuntary
dissolution, corporation stays in existence to wind up. Winding up: (a) gather all assets,
(b) convert to cash, (c) pay creditors, and (d) distribute remainder to shareholders prorata by share unless there is a dissolution (or liquidation) preference.
-- What's a liquidation preference? Works like a dividend preference; pay first.
this would be in the articles

______________________________________________________________________
FACT PATTERN 6: FEDERAL SECURITIES LAW
I.

SECURITIES ARE INVESTMENTS.

(1) Debt. Investor lends capital to the corporation, to be repaid (usually with interest) as
specified in the agreement. Shes a creditor, not an owner, of the corporation.
A.
B.

Secured by corporate assetsCAbond@

UnsecuredCAdebenture@

(2) Equity. Investor buys stock, and has an ownership interest in the corporation. This
status carries various rights, e.g., to inspect records, bring derivative suits. Shes an
owner, not a creditor, of the corporation.
II. RULE 10b-5CAIMED AT DECEITFUL BEHAVIOR.
This federal law prohibits fraud and misrepresentation (or nondisclosure) in connection with the
purchase or sale of any security (debt or equity).
(1) AInstrumentality of interstate commerce@ (telephone, mail or if deal goes through
national exchange)
(2) Type transactions
A.

Misrepresentation of material information.

B.

Trading on inside information when duty to disclose exists (relationship of trust

and confidence with shareholders of the corporation). This means insiders cannot
trade on secrets. They must abstain or disclose so everybodys on the same
footing.

C.

Tipping (passing along material inside information for a wrongful purpose).

(3) Materiality. The misrepresentation or omission must concern a Amaterial@ factCone

that a reasonable investor would consider important in making an investment decision.
(4) Possible plaintiffs:
A.

SEC

B.

Private action for damages by buyer or seller of securities

28

CORPORATIONS

Widget Corp. issues a press release that Buffett has expressed an interest in
acquiring a major block of its stock. The release fails to indicate that it is Jimmy
Buffett and not Warren Buffett who is interested. Because of this press release,
Duffy does not sell his Widget stock. Does Duffy have a 10b-5 cause of action?
no, because he did not buy or sold

__________________________________________________________________
__________________________________________________________________
(5) Possible defendantsCAany person@ (including entities).
A.
B.
C.

Company that issues a misleading press release.

Buyer or seller of securities who misrepresents material information.
Buyer or seller of securities who trades on material inside information (when
there is a duty to abstain or disclose, which comes from relationship of trust and
confidence with shareholders of the corporation).

D.

Tipper or tippee.
1.

L, a lawyer for X Co., learns that X Co. is planning to merge with Y Corp.
She telephones her son-in-law Joe about this, and urges him to buy X Co.
stock. Acting on the tip, Joe buys the stock. Any violations of Rule 10b-5?
L is a tipper because: (1) she passed inside information in breach of a duty to
X Co., and (2) she benefitted. How did she benefit? ___________________
making a gift or enhancing reputation is enough
_____________________________________________________________

-- Joe is a tippee because (1) he traded on the tip and (2) knew or should
have known that the information was improperly passed. _______________
______________________________________________________________
2.

D is a director of C Corp. While waiting for a concert to start, D tells her

husband about a new, secret processing method that C Corp. has just
developed. Bobbitt, who is sitting in the next row, overhears the conversation
and buys C Corp. stock on a national exchange. Any violations of 10b-5?
No. At worst, D was merely negligent, which is not enough for 10b-5
liability.
-- So D is not a tipper. UNDER 10B-5, IF THERE IS NO TIPPER, THERE
bobbitt is okay
CANNOT BE A TIPPEE. ________________________________________
______________________________________________________________

(6) Scienter. D must have an intent to deceive, manipulate or defraud. Recklessness may
suffice.
(7) Reliance. Said to be a separate element, as in fraud, but is presumed in public
misrepresentation and nondisclosure cases.
29

CORPORATIONS

III. SECTION 16BCAIMED AT SPECULATION BY DIRECTORS, OFFICERS, AND

TEN PERCENT SHAREHOLDERS. THIS IS STRICT LIABILITY! INTENT IS
IRRELEVANT.
This federal law provides for recovery by the corporation (so it could be a shareholder
derivative suit) of Aprofits@ gained by certain insiders from buying and selling the company=s
stock.
The theory is that it is bad for market confidence to have these insiders buying and selling
their own corporation=s stock.
(1) When does 16b apply?
A.

AReporting@ corporationC(i) listed on a national exchange or (ii) at least 500

shareholders and $10 million in assets.

B.

Type defendant.
-- Director (either when she bought or sold) or
-- Officer (either when she bought or sold) or
-- Shareholder who owns more than 10 percent of the corporations stock (to be
covered, she must own this much both when she bought and sold)

C.

Type transaction.
Buying and selling stock within a single six-month period (short-swing trading)

(2) What happens when 16b applies?

All Aprofits@ from such Ashort-swing trading@ are recoverable by the corporation. If,
within six months before or after any sale, there was a purchase at a lower price, there
is a profit.
-- D is a director of Acme, Inc., which is a reporting corporation. In 2005, D bought
700 shares of Acme stock for $10 a share. In January 2007, D sold 700 shares for $6.
In March 2007, D bought 200 Acme shares for $1 a share. What result? Doesnt seem
like theres a profit but there is a $1,000 profit under 16B. D owes the corporation
$1,000. KEY TO 16B -- FOCUS ON THE SALE. HERE THE SALE WAS
JANUARY 2007, D SOLD AT $6. ________________________________________
f
--Did she buy at less than $6 within 6 months before the sale in January 2007? ______
no
____________________________________________________________________

--Did she buy at less than $6 within 6 months after the sale in January 2007? _______
yes

____________________________________________________________________
____________________________________________________________________
30

CORPORATIONS

-- Multiply $5 profit times 200 shares. Why 200? Because that is the largest number
of shares she both bought and sold within the six months._______________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________
______________________________________________________________________

LAST POINT: If you have questions, call me. Please do not e-mail; e-mail is not a good
option for me. Call and if Im not there, leave your question and your phone number and I will
call you back. My phone number is: _______________________________________________

31