BA Outline

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I. PARTNERSHIPS
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A. FORMATION OF PARTNERSHIPS
UPA § 6 (1914), § 101(6) (1997) Partnership Defined: Partnership is an association of two or more persons to
carry on as co-owners of a business for profit, with or without the intent to do so. No money is required, must
be willing to share risk and control. No documents need be written or filed. This lack of formality is the
fundamental characteristic that distinguishes the partnership from all other co-owner business
organizations, which are statutory in origin and require that a document be filed before an organization
can come into existence. Partnerships are seen as a default form of doing business. It is a widely and
deliberately chosen form of doing business for many kinds of enterprise including lawyers, doctors, and
accountants.
General Partnership
Partnerships can be governed by statutes, but mostly they are creatures of common law. A GP is an
association of two or more persons to carry on as co-owners of a business for profit. Note, the owners of a
business may create a general partnership without intending to do so or knowing they have done so. The
GP is the only type of business that can be formed without any sort of filing with a governmental
authority. It is the default form of business, so if two or more persons own a business association, they
may become partners in a general partnership.
Inadvertent Formation: Because the GP is the default form of business and no filing of any kind with the
state is required to form a GP, co-owners may create a partnership without knowing that they are doing
so. And certain consequences may result including joint and several personal liabilities for the debts and
obligations of the partnership. See Martin v. Peyton.
Written Partnership Agreements are highly desirable, especially if it lasts longer than a year and thus
involves real estate as such to be afforded protection under the Statute of Frauds. The UPA, RUPA, and
modern partnership statutes mainly provide default rules – rules that govern only if the partners have
not agreed to do so. (ex. Preclusion of salary payment to partners, equal division of profits and losses
among the partners, even though the partners contributed different amounts of capital). Partnerships
are enforceable as contracts.
Partnerships are seen as fragile. It is dissolved automatically when a partner dies or leaves the
partnership; it may also be dissolved by any partner by his express will at anytime. Upon dissolution, the
withdrawing partners are entitled to receive the value of their partnership interest from the partnership,
which may either be wound up and terminated, or continued by the remaining partners and possibly new
partners as well. However, the major drawbacks of the partnership are the unlimited sharing of losses
and the personal liability of partners for partnership obligations as such they are jointly and severally
liable, considering the modern litigious society in which we live. Partnership lacks formalities,
management is not centralized but divided amongst the partners, and GP’s do not typically continue
beyond the life of the partners.
ELEMENTS OF A PARTNERSHIP
• Association – organized body of persons who have some purpose in common. UPA § 18(g) asserts that
“no person can become a member of a partnership without the consent of all the partners.”
Business Associations/Garten/Fall 2008 1
• Persons – this word also includes corporations and other partnerships, not just individuals. Capacity to
contract is required because the partnership agreement is a contract.
• To carry on as co-owners of a business – ownership is defined in the UPA as the power of ultimate
control.
• For profit
UPA § 7 (1914) – Rules for Determining a Partnership;

(a) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property, or part
ownership does not of itself establish a partnership whether such co-owners do or do not share any
profits made by the use of the property.
(b) The sharing of gross returns does not in itself establish a partnership, whether or not the persons
sharing them have a joint or common right or interest in any property from which the returns are
derived.
(c) The receipt by a person of a share of the profits of a business is prima facie evidence that he is a
partner in the business, but no such inference shall be drawn if such profits were received in payment:
1) as a debt by installments or otherwise; 2) as wages of an employee or rent to a landlord; 3) as an
annuity to a widow or representative of a deceased partner; 4) as interest on a loan though the
amount of payment vary with the profits of the business; and 5) as the consideration for the sale of
a good-will of a business or other property by installments or otherwise.
UPA § 202(a) (1997) Partnership Formation:

(a) The association of two or more persons to carry on as co-owners a business for profit forms a
partnership, whether or not the persons intend to form a partnership.
(b) The foregoing rules above are applicable under this Act in determining whether a partnership exists.
For the section (c), there is a slight moderation in language but same meaning. “A person who
receives a share of the profits of a business is presumed to be a partner in the business, unless the
profits were received in payment: 1) of a debt by installments or otherwise; 2) for services as an
independent contractor or of wages or other compensation to an employee; 3) of rent; 4) of an
annuity or other retirement or health benefit to a beneficiary, representative, or designee of a
deceased or retired partner; 5) of interest or other charge on a loan, even if the amount of payment
varies with the profits of the business, including a direct or indirect present or future ownership of
the collateral, or rights to income, proceeds, or increase in value derived from the collateral; or 6)
for the sale of the good-will of a business or other property by installments or otherwise.
(c) [generally, sharing of gross returns or part ownership do not in themselves establish a
partnership]
Key Elements in determining a partnership - Sharing of risk/loss, profits, and

control/management. UPA § 202
NOTE that the sharing of losses also follows from the sharing of profits.
Uniform Partnership Agreement (UPA) - Partnership law is mostly a matter of state law, and most states
have adopted the UPA.
Three types of Partnerships:
1. Partnership by Agreement (contract – written or oral/ express or implied)
2. Partnership by Conduct (no mens rea required)
3. Partnership by Estoppel

Management of Partnership:
· Unless otherwise agreed, all partners have equal power
· Unless otherwise agreed, all partners are jointly & severally liable
· Unless otherwise agreed, all partners have equal rights in the management
· Unless otherwise agreed, or if partner received benefit, all partners are bound by a single partner’s
actions if those actions are within the scope of the business. (This provision was meant to protect the third
parties who complete their respective tasks in accordance to one partner despite the other partners’
contentions. The law looks at the perspective of the third parties > apparent authority: the court determines
whether a reasonable person under the circumstances would have foreseen the order as being part of the
business as such to complete the task. Ex. Chairs in a restaurant).
· § 403 (f) & (j): Ordinary matters must be decided by the majority, while extraordinary matters must be
decided by unanimous vote.
Partnership agreements are enforceable in the same way as contracts generally. Thus much of the law of
partnerships is contract law. When legal issues arise concerning internal relationships within a partnership the
two most basic questions likely to be asked are (1) was there a partnership; and (2) if so, what does the
agreement say about the issue in question? Only in the absence of a partnership agreement do we look to the
default rules contained in the partnership statutes. In short, as to question involving the internal rights and
obligations of the partnership and its partners, the primary source of partnership law is not the statutes or case
law, but the partnership agreement itself.
While a partnership agreement can govern almost every aspect of the partnership, there are a few mandatory
rules in the state partnership statutes that can not be trumped by a partnership agreement. These include: (1)
varying the partners’ rights to information regarding partnership affairs, (2) eliminating the duty of
good faith and fair dealing, (3) eliminating the partners’ fiduciary duties to another, (4) varying the
principle of joint and several personal liability of the partners, and (5) varying a partner’s power to
dissociate from the partnership.
I. Partnership Created by Conduct

• NO CAPITAL CONTRIBUTION REQUIRED TO BE A PARTNER
• No need for capital or work contribution
• A Partnership can be created through conduct, regardless of whether there is a Partnership
Agreement or not.
• Partnership comes into existence by operation of law without filing any formal papers
• calling yourself a partnership does not create a partnership
• burden of proof for a partnership is on the person claiming the existence of one
•  Sharing of profits does not in and of itself indicate or demonstrate the existence of a
Partnership
• § 202(c)(3) & no obligation to share in losses suggests no Partnership
Fenwick v. Unemployment Compensation Board (1945)

RULE: “A partnership is an association of two or more persons to carry on as co-owners of a
business for profit.”
Statement of the Case

Fenwick operated a beauty shop and hired Cheshire to be a cashier and a receptionist. They then entire
into a contract stating that they agree to associate themselves as partners for the operation of the beauty

shop. However, Cheshire could not make capital contributions nor did she receive any right to control
or manage the business. She bore no risk of the shop’s losses. She was paid a weekly salary with some
benefits. Cheshire terminates the contract 3 years later and sought unemployment compensation. The
Compensation Board ruled that she was merely an employee. This was an agreement that fixed the
compensation of this employee. The New Jersey Supreme Court disagreed and called them partners.
ISSUE: Does an agreement providing a person a potential share in the profits of a business, without
conferring a right to control the business or bear a share of the losses, establishes a partnership?
HOLDING: NO. The court analyzed a number of factors to determine a partnership here. The parties’
intent: here, the agreement came to be because Cheshire wanted more money so Fenwick made her
salary conditional to the financial success of the business. Second, a partnership involves the
partner’s rights to share in the profits. That is established here but as the UPA denotes, that alone
will not suffice to form a partnership. Third, a partnership involves an obligation to share losses.
This is not the case here. Fourth, partners share ownership and control over the partnership
property and business. Here, Cheshire had no rights. Fifth, partners maintain the power to
administer business affairs. Cheshire cannot tend any business matters without control. Sixth, the
court must consider the language of the agreement. The express terms withholds many of the rights
a partner has though they use the term partnership. However, that would not be conclusive. Seventh,
the parties’ conduct toward third parties may indicate a partnership. The parties represented to no
one that they were partners. Finally, the parties’ rights upon dissolution are instructive. Here,
Cheshire gains no interest in the partnership income or assets upon dissolution, but rather the partnership
continues as if it has merely lost an employee. After analyzing all the factors, the evidence is
undoubtedly clear that Fenwick never intended for Cheshire to be a partner. She was simply an
employee with benefits.
Elements and Indicators of Partnership

• Right to share in profits (not dispositive ie. bank loan). Not every agreement that
gives the right to share in profits is a partnership agreement.
• Obligation to SHARE IN LOSSES (RISK) (***). Absent here
• Sharing of ownership and CONTROL of the partnership property and business (***)
• § 18(e) “All partners have equal rights in the management and conduct of the P’ship
business.”
• Intention of parties
• Community of power in administration (control over management)
• Language in the agreement (how rights are allocated)
• Conduct of the parties toward third parties
• Rights of the parties upon dissolution
• “if you act like a partner, you may be treated as one”
• if no express agreement, default rule is to look at profits. If no profit agreement,
then we assume equal allocation.
*** = key factors
II. Partnership Created by Agreement

A. Partners Compared With Lenders
• Generally, we don’t consider lenders as partners

• § 202(c)(3)(i): A person who receives a share of the profits of a business is presumed to be a
partner in the business, unless the profits were received in payment of:
(i) of a debt by installment or otherwise
Public Policy Banks won’t lend if they face Partnership liability for simply trying to protect their
investment
• if banks are held out as partners, their liability increases and there is less
incentive to lend
Martin v. Peyton (1927)

RULE: “A partnership is created by an express or implied contract between two persons with the
intention to form a partnership.”

A banking firm was in financial trouble so it turned to Peyton for a loan. That loan was not sufficient to
cover the firm’s liabilities so the banking firm sought loans from Perkins and Freeman. While
discussing this second loan, it was proposed that Peyton, Freeman, and Perkins be partners to the firm.
The banking firm rejected this but offered them a collateral speculative securities owned by the firm and
40% of the firm’s profits until the loan was repaid. The agreement also contained an option for the three
to join the firm if they choose to do so. Martin, a creditor sough payment form the three of the debt
owned him by the banking firm arguing that these three became partners to the firm. Trial court ruled no
partnership existed and ruled against Martin.
ISSUE: Does the loan of money in exchange for securities owned by the debtor and a percentage of the
debtor’s income create a partnership?
HOLDING: NO, it does not. By receiving the firm’s speculative securities as collateral for the loans,
the defendants became mere trustees. As trustees, they have the right to be informed of all transactions
affecting the securities and the power to veto and decisions that are detrimental to their value. They have
no power to initiate any transaction or bind the firm. Their power is limited to only those transactions
that affect their collateral’s value. Also, the provision providing the defendants to a percentage of the
firm’s profits does not demonstrate an intent to become partners. All it does is protect the defendants’
loan. Finally, the option to join the firm presents itself as potentially a future partnership, not a
partnership to date. Judgment affirmed. The court here focuses on the intentions surrounding the
parties’ agreement.
• § 9(1) & § 301(1) Partner Agent of Partnership provides partners the power
to bind the Partnership
  in this case, the Court found these provisions to be proper lender safeguards and precautions for
their loan, not the level of control required for finding of a partnership
NOTE: The risk of liability for Peyton and co. would have been avoided if the law firm had
been organized as a corporation. Under that form of organization, the equity investors (the
counterparts of partners) enjoy “limited liability” – that is, they are not personally liable for the
debts of the firm and therefore stand to lose only the amount they have invested in it. Thus,
even if the purported lenders had been treated as shareholders, they would have been shielded
from the personal liability that the creditors sought to enforce. The same would be true if they
had formed a limited liability company or limited liability partnership.

B. Determining Partners
Southex Exhibitions v. Rhode Island Builders Association (2002)

RULE: “Sharing profits is prima facie evidence of a partnership, which can be rebutted by
evidence sufficiently demonstrating that the parties did not intend to create a partnership.” >>
The totality of the circumstances test

RIBA entered into a 5 year agreement with SEM to act as sponsors and partners in the production of
their home shows. They agreed that RIBA would produce only shows sponsored by SEM to persuade
RIBA members to exhibit SEM shows and to allow SEM to use RIBA’s name for promotional uses.
SEM agreed to secure all leases, licenses, and permits necessary for the shows’ profits, and to provide
capital needed to finance the shows. The profits were divided 55% to SEM and 45% to RIBA. SEM’s
president clearly did not want any ownership of the home shows because of the uncertainty of the
shows’ financial prospects. SEM referred to themselves as producers. 20 years later, Southex acquired
SEM and determined that the agreement between SEM and RIBA needed modifications. RIBA was
unhappy with the modifications and entered into contract with someone else. Southex brought suit
claiming they were partners. The district court found no [partnership.
ISSUE: Did RIBA and SEM enter into a partnership by agreeing to share profits earned from sponsored
home shows and mutually contributing time, skill, and intellectual property to the shows?
HOLDING: NO, there is no partnership. Southex asserts there was a partnership since both SEM and
RIBA shared profits, maintained control over the business operations, and contributed valuable property
to the business. The agreement was not titled a partnership and it did not last for an indefinite time.
There is no evidence that the IP contributed by RIBA and SEM was intended to convey a property
interest upon the other (Southex, who chose to enter into this contract upon its own name rather than the
name of the agreement), especially since the agreement covered only an annual event of a fixed
duration. Finally, SEM considered itself to be the producer of the home shows and subsequently denied
ownership to their works. Although the parties here referred themselves as partners in the agreement,
the evidence in this case suggests otherwise.
NOTE: although the agreement referred to each other as partners, this would not
conclusively establish a partnership between them. But such reference could establish a
partnership by estoppel. Under the estoppel theory, a partnership is established even if
the intended relationship does not amount to a partnership - if the parties manifest to
others that a partnership exists and third persons rely upon those manifestations, then a
partnership shall be formed.
III. Partnership Created by Estoppel

§ 16 Partner by Estoppel: As a general rule, persons who are not partners as to each other are not partners
as to third persons. However, a person who represents himself, or permits another to represent him, to
anyone as a partner in an existing partnership or with others not actual partners, is liable to any such
person to whom such a representation is made who has, on the faith of the representation, given credit to
the actual or apparent partnership.
• If a person holds themselves out as a partner in receiving credit, they are treated as a partner.
Young v. Jones (1992)

RULE: “A person who represents himself, or permits another to represent him, as a partner in an
existing partnership or with others not actual partners, is liable to any person to whom such a
representation is made who has, in reliance on the representation, given credit to the actual or
apparent partnership.”

Young representing SAFIG relied on an unqualified audit statement prepared by Price Waterhouse-
Bahamas and deposited a lot of money into a South Carolina Bank. The audit was prepared with the
Price Waterhouse letterhead and signed by them as well. SAFIG later learns that this was fraudulent and
thus they all lost their money. Young and SAFIG sued Jones and Price Waterhouse-US and Bahamas
who they presume are partners and thus are jointly liable. Price-US presented documents showing they
are distinct from Price-Bahamas. The district court ruled in favor of Jones.
ISSUE: Are Price-US and Price-Bahamas partners by estoppel?
HOLDING: NO, there are not partners in fact. Young provided no evidence that Price-US
represented itself as a partner to Price-Bahamas. There is no indication the Price-US is liable for the
debts of Price-Bahamas or any other affiliates. Furthermore, there is no licensing agreement between
the two to provide the nexus between the trademarks or names used. A partnership by estoppel arises
only when a third party has given credit in reliance upon a partnership representation. There is no
evidence that the plaintiffs have extended any credit to Price-Bahamas or Price-US. Finally no evidence
demonstrates that Price-US had anything to do with the preparation or dissemination of the fraudulent
audit statement. Absent some involvement or representation from Price-US, it cannot be held liable for
the actions of Price-Bahamas.
NOTE: A third party who deals with a business in reasonable reliance upon representations that a
partnership exists may hold each individual partner liable for any debts incurred, even if a partnership
does not exist.
• The key to partnership by estoppel is CREDIT
• Only protects third-persons who, in reliance upon the representations as to the existence of the
Partnership, gave credit to that Partnership
 like Promissory Estoppel – look for detrimental reliance
• Public Policy to protect 3rd parties (creditors) who do not have actual knowledge that the
Partner is acting outside of the scope of his authority in binding the Partnership and relies to his
detriment on the representation of such a Partnership.
 Do not want to impose a duty of inquiry on the creditor
 HOWEVER, 1996 Revised UPA shifted the law in favor of Partnerships by allowing
them to file Statements of Partnership Authority § 303 – thereby allegedly placing
creditors on constructive notice of individual partners’ ability to bind other partners
 Not adopted by many states
PARTNERSHIP LIABILITY
• All partners are individually liable for the obligations of the Partnership
• The UPA fills in the blanks if P/A is vague or non-existent.
§ 13 Partnership Bound by Partner’s Wrongful Act

• Partnership is equally liable for any wrongful act or omission of any partner acting in the ordinary
course of business (within the scope) of the Partnership that causes injury to a non-partner
§ 14 Partnership Bound by Partner’s Breach of Trust

• Partnership is liable for individual acts of partners that breach the trust of third parties as such that
the partner must make good of the loss – (a) where one partner acting within the scope of his
apparent authority receives money or property of a third person and misapplies it;
(misappropriation of funds by individual partner) and (b) where the partnership in the course of
its business receives money or property of a third person and the money or property so
received is misapplied by any partner while it is in the custody of the partnership;
(misappropriation of funds by Partnership).
§ 15 Nature of Partner’s Liability

(a) All partners are liable jointly and severally for acts chargeable to the partnership under §§ 13 & 14
§ 301: Each partner’s actions within the scope of their business bind the entire partnership unless the
partner had no authority to act for the partnership and a third party knew this or had received a
notification that the partner lacked authority.
• Exception; UPA § 301(2) states that a partnership is only bound by acts within the scope of
ordinary business. In this case, one partner can not bind the actions of other partners if the act
falls out of the scope of its partnership business. Thus, all the partners would be required to act
on such issue.
§ 305 Partnership Liable for Partner’s Actionable Conduct

• Combines §§ 13-15
§ 306 Partner’s Liability

(a) all partners are liable jointly and severally for all obligations of the Partnership
(b) persons admitted as a partner into an existing partnership are not personally liable for
Partnership conduct that occurred prior to their admission into the Partnership
THE RIGHTS OF PARTNERS IN MANAGEMENT

• § 18(e) & § 401(f) “absent agreement to the contrary, all partners have equal rights in the
management and conduct of the partnership business”
• § 18(h) & 401(j) “any difference arising as to ordinary matters relating to the partnership may be
decided by a majority of the partners” (does not work if only 2 partners; if there are only two
partners or an even number of partners, there could be no majority vote that will be effective to
deprive either partner of authority to act for the partnership). The majority can deprive the minority
partner of something. So, if the supplier is aware of the limitation, an order for break from the
minority partner would not bind the partnership or the other partners.
• Despite the agreements of partners on who has decision making authority, these decisions are
non-binding on the outside world if a partner fucks up and exceeds his decision making limit.
National Biscuit Company v. Stroud (1959)

RULE: “Every partner is an agent of the partnership for the purpose of its business, and every
partner’s acts for apparently carrying on in the usual way the partnership’s business binds the
partnership, unless the acting partners has in fact no authority to act for the partnership and the
person with whom he is dealing knows that he has no such authority.”
Stroud and Freeman enter into a partnership to operate a store. Nothing in the agreement indicates that
Freeman has less authority than Stroud. Stroud told Freeman he would not be liable for any bread
purchased from NBC. Though NBC was aware of Stroud’s remarks, it delivered the bread at Freeman’s
requests. NBC sued Stroud for payment after Stroud and Freeman dissolved the partnership and all
partnership assets and debts were assigned to Stroud for liquidation. The court found Stroud liable.
ISSUE: Is a partner bound to a 3rd party if the partner disagrees with the other partner’s business
decision and expresses to the 3rd party his or her intention not to be bound by the other partner’s
decision?
HOLDING: YES, the partner is liable. Generally all partners have equal power to bind the
partnership and any difference of business opinion must be resolved by a majority vote. Here, Freeman
was a general partner with equal powers as Stroud and Stroud could not restrict Freeman’s power to act
on behalf of the partnership because the bread purchase was an ordinary business transaction and Stroud
did not constitute a majority of the partners. When a disagreement arises between an even division of
partners, actions related to the partnership’s ordinary business are not restricted. Because Freeman had
the authority to make such purchase, the partnership is liable.
NOTE: As long as both parties act in good faith without violating any fiduciary duties, a disagreeing
partner is powerless to veto his or her partner’s ordinary business decisions.
RULE The acts of a partner, if performed on behalf of the partnership and within the scope of its ordinary
and legitimate business of the partnership, are binding upon all partners.
Exception: (1) when the partner had no authority to bind the Partnership, and (2) the 3rd party had ACTUAL
knowledge of the Partner’s inability to bind
Additional Notes:
1. Even if notice is given by a partner to a 3rd party, that partner is still liable for contract’s entered into by
other partners because no agreement or resolution of the majority under §401(h)
2. Partnership can file a Statement of Partnership Authority - § 303 which may place creditor’s on
notice of Partner’s ability to bind the corporation in certain transactions (property)
3. Partnership can control partner’s ability to bind through contract
4. BUT contract will not limit liability to unaware 3rd party creditors (will only allow Partnership to be
indemnified)
5. When no contract, the court looks to the Fiduciary relationship and the duties that it carries
6. Public Policy is to protect 3rd parties (creditors) who have no reason to know that the Partner is
acting outside of the scope of his authority. Burden is on partners. Revised UPA 303(a)(2) give a way
out to partners: limit the authority of partners. Partnership Authority
B. FIDUCIARY DUTIES OF PARTNERS

§ 404 General Standards of Partner’s Conduct
a) only fiduciary duties a partner owes another are loyalty and care
b) a partner’s duty of loyalty to the partnership and other partners is limited to the following:
1) to account and hold as trustee for it any property, profit, or benefit derived by the partner in
the conduct of partnership business or by use of partnership property; to share profits, or
advantages of a partnership opportunity;
2) to refrain from dealing w/ partnership on behalf of a party having an adverse interest to the
partnership
3) to refrain from competing w/ the partnership before dissolution
c) A partner’s duty of care in conduct of business is limited to refraining from engaging in

grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law in
conducting partnership business.
d) A partner shall discharge duties with the obligation of good faith and fair dealing. (Here when
you want out you have to do it in an upstanding not sneaky way… don’t try to hurt the partnership…
do it Fare. Again Meehan (the lawyers did things secretly, lied about starting their own partnership,
secretly took employees and clients in ways not proscribed by the partnership agreement. Court
found that they didn’t purposefully hurt the partnership by killing the cases, but were underhanded in
the way they obtained the clients)
e) Partner does not violate a duty or obligation merely because the partner’s conduct furthers the
partner’s own interest.
f) A partner may lend money to and transact other business with the partnership, and as to each
loan or transaction, the rights and obligations of the partners are the same as those of a person who is
not a partner.
Partners owe each other a fiduciary duty of “utmost good faith, loyalty, and fair dealings”
DUTY OF DISCLOSURE: LOYALTY

A PARTNER HAS A DUTY TO DISCLOSE, ON DEMAND, A TRUE AND FULL DISCLOSURE OF
INFORMATION ON ALL THINGS AFFECTING THE PARTNERSHIP TO ANY OTHER PARTNER.
• IF YOU HAVE SPECIAL INFO, YOU GOTTA GIVE IT UP
• this idea is similar to the Corporate Opportunity Doctrine
• a partner’s exclusive control and power of direction charges him w/ a greater duty of disclosure
to his fiduciaries, b/c only through disclosure could opportunity be equalized
• Joint adventurer (partner) only needs to act reasonably in the course of disclosure advise co-
adventurer of new opportunity.
Meinhard v. Salmon (1928)

RULE: “Like partners, joint adventurers owe one another the duty of loyalty.”

Salmon and Meinhard entered into a joint venture upon the lease he entered to with Gerry to convert a
hotel into a shopping mall. Each party bore equally any or the business’ losses but Salmon possessed all
management rights. When the lease ended, Salmon entered a new lease with Elbrige, who had acquired
the rights to the territory from Gerry in developing a new building. Salmon never informed Meinhard of
this. When Meinhard heard this, he demanded the lease to be for the joint venture. Salmon refused and
thus Meinhard sues.
ISSUE: Does a joint adventurer breach his or her duty of loyalty by seizing an opportunity for the joint
venture for his or her own personal gain?

HOLDING: YES; here Salmon held the lease as a fiduciary to Meinhard, his joint adventurer. Not
only did Salmon not disclose his plans to Meinhard, he also approached Elbrige as if he was acting
alone. If Salmon informed Elbrige of the venture, he would have presented this to Meinhard as well. By
failing to disclose this to Meinhard, he deprived him from the chance to compete for the new lease.
Salmon’s duty of loyalty to Meinhard requires a good faith disclosure of the joint venture to preserve his
opportunity. Salmon has breached his duty.
NOTE: courts often apply partnership law to joint ventures, although the two business relationships are
distinct. A partnership is generally a longstanding relationship with general undertakings designed to
generate profit. A joint venture is more limited in duration and generally for a specific undertaking. (Ex.
Two lawyers join together to form partnership to share profits; two lawyers join together as co-counsels to
defend a client in a specific case as joint adventurers with each contributing time, money, and labor.)
WHAT IS A JOINT VENTURE?

A joint venture is a business undertaking by two or more persons engaged in a single defined project.
The necessary elements are (1) an express or implied agreement; (2) a common purpose that the group
intends to carry out; (3) shared profits and losses; and (4) each member’s equal voice in controlling the
project.
NO FIDUCIARY DUTY TO FORMER PARTNERS

• liability and fiduciary duty is limited to other partners, not former partners
DISSOLUTION
Under the UPA, a partner always has the power to withdraw and thus dissolve the
partnership, regardless of what the partnership agreement might otherwise provide.
Dissolution does not mean that the business ends or is liquidated. The remaining partners
can, and often do, decide to continue the business after dissolution, but the business is
continued by a new legal partnership agreement. Under the UPA, the circumstances for
continuing the business of a partnership after dissolution depend on (1) the partnership
agreement’s provisions on continuing the business after dissolution and (2) if there are no
such provisions, the default rules of the UPA apply. Under the default rules, if there is no
term specified in the agreement or if the term specified has expired, then the partnership
business can be continued by other partners only if all of the partners, including the
partner who dissolved the partnership, agree that the business can be continued. If they
agree to continue, the withdrawing partner is paid the value of its interest in the business §
42. If the partner leaves before the end of the term specified in the agreement, then the
partnership can be continued if they agree to do so. The withdrawing partner must be
paid the value of its business. If the partners do not decide to continue the business, the
business is liquidated under UPA § 37 and § 40. The partnership winds up and assets are sold and
distributed to creditors.
Under RUPA (Revised UPA), the term dissociation is used rather than dissolution.
However, § 103 in RUPA asserts that dissociation does NOT trigger dissolution. Next,
RUPA § 801 provides that a partner’s dissociation during a term partnership triggers
dissolution only if at least half of the remaining partners so agree. Partners can waive
dissolution § 802. RUPA distinguishes between rightful and wrongful acts of dissociation.
The wrongful ones are (1) breaches of express provisions, (2) early withdrawal, (3)
wrongful conduct that adversely affects the partnership business, and (4) willful breach of
a duty of care, loyalty, good faith, or fair dealing owed to the partnership under § 404.
The partnership’s business does not end with dissolution under either statute. UPA and
RUPA provide that dissolution does not terminate the partnership; instead, the
partnership continues until the winding up process is complete. Winding up involves
selling the partnership’s assets and using the proceeds of the sale to pay the partnership’s
debts and settle the partner’s accounts. In winding up, outside debts as to creditors are
paid first prior to inside debts as to the partners acting as creditors then to capital
contributions. If the proceeds from liquidation are not enough to pay creditors, the
partners must contribute toward payment of the debt in the same proportion in which
they share losses. Dissolution occurs first – it is the point in time when partners cease to
carry on business together. Then there is winding up – this is the period between
dissolution and termination where all partnership affairs are being settled. Termination is
the point in time when all the partnership’s affairs have been wound up.
PLANS OF SEVERING THE PARTNERSHIP . . . UPON DEMAND, YOU MUST DISCLOSE
§ 20 UPA (1914). Duty of Partners to Render Information

ON DEMAND, partners shall render TRUE & FULL INFORMATION of all things affecting the
partnership to any partner or the legal representative of any deceased partner or partner under legal
disability.
§ 403(c)(1) & (2) UPA (1997). Partner's Rights and Duties with Respect to Information
(c) Each partner and the partnership shall furnish to a partner, and to the legal representative of a
deceased partner or partner under legal disability:
(1) MANDATORY VOLUNTARILY DISCLOSURE: without demand, any information concerning the
partnership's business and affairs reasonably required for the proper exercise of the partner's rights and
duties under the partnership agreement or this [Act]; and
(2) REQUIRED ON DEMAND - on demand, any other information concerning the partnership's
business and affairs, except to the extent the demand or the information demanded is unreasonable or
otherwise improper under the circumstances.
§ 306 Partner’s Liability  Partners are jointly and severally liable for all obligations of the partnership
unless otherwise provided
How are losses allocated?

1. partnership agreement
2. in absence of agreement, losses are allocated according to the allocation of profits § 401(b)
 partners who put in no capital but still carry’s on co-owner is still liable
 if share losses, then liable
 UPA is the default mechanism to be reasonably interpreted in absence of partnership agreement
Liquidating Partnerships § 807 (1996) or § 18 (1914 clearer)

1. All assets are sold and what is raised goes to outside creditors – sale of assets
2. repay partners capital contribution  capital contributors are subordinate creditors
3. Partnership losses are shared among partners

Bane v. Ferguson (1989)
RULE: “The fiduciary duties owed by one partner to another terminate when the partnership is
dissolved.”
Bane was part of a firm that offered retired partners a pension plan. The plan was to terminate in the
event the firm was dissolved. Four months later, Bane retired and got his pension. However, several
months later, the firm merged with another firm and dissolved without forming a new entity. The
pension plan ceased. Bane sues that the firm was negligent in merging and it was mismanagement.
ISSUE: Does a retired partner have either a common law or statutory claim against the firm’s managing
council for acts of negligence that, by causing the firm to dissolve, terminates his retirement benefits?
HOLDING: NO; first off, the UPA protects partners from liability from their partners’ negligence.
Secondly, Bane retired and was no longer a partner. His former partners owed him no fiduciary duty
upon retirement. The termination of partnership relationships terminates any duty owed. Furthermore,
even if a duty existed, the managing council’s decision would have been protected by the “Business
Judgment Rule.”
NOTE: Retired Partners lose all rights and privileges as a partner. Their former partners owe them no
fiduciary duty. However, if there was a contract that outlined their legal rights, then the retired partners
can be compensated only through a breach of contract.
GRABBING AND LEAVING
General Rule: “A partner has a duty to disclose, on demand, a true and full disclosure of information on
all things affecting the partnership to any other partner.”
A partner has the duty to:

§ 20 “render on demand true and full information of all things affecting the partnership to any
partner or legal representative of any deceased partner or any partner under legal disability”
§ 403(c) “Each partner and the Partnership shall furnish to a partner and to the legal representative of
a deceased partner
(1) Without demand, any information concerning the Partnership’s business and affairs
reasonably required for the proper exercise of the partner’s rights and duties under the
partnership agreement; and
(2) On demand, any other information concerning the Partnership’s business and affairs to
the extent that it is reasonable and proper.
Meehan v. Shaughnessy (1989)

RULE: “A partner must render on demand true and full information of all things affecting the
partnership to any partner.”

Meehan and Boyle were partners to the firm PC. Meehan and Boyle were dissatisfied with PC and left
along with Cohen. They did this all confidentially. Within a period of a month, they offered associates
position within their firm and told them to keep quiet about it. Prior to leaving and getting a good

number of associates to defect from PC, Meehan and Boyle wrote to their clients notifying of them of
the changes and thus requested authorization to remove them. Before leaving, other partners of PC
confronted the defects and asked them whether they were leaving, and they said no. Then Meehan,
Boyle, and several others gave in their notice of separation. The defects removed about 2/3s of the cases
from PC. The defects now sue PC for the amount of profits owed them for the cases they removed.
ISSUE: Does a partner breach his fiduciary duty of good faith and loyalty to his partners by inducing the
partnership’s clients to withdraw their business from the partnership without ample time for the
partnership to compete to retain the business?
HOLDING: YES; as a partner, each person owes his partners the duty of good faith and loyalty and must
refrain from self-dealing or participation in a transaction that benefits oneself instead of another who is
owed a fiduciary duty. Here, Meehan and Boyle breached their duty by secretly selecting those clients
they sought to remove to their new firm and failing to disclose their method of obtaining the clients’
consent to PC. On several occasions, the defects failed to render or disclose their plans to their former
partners. Meanwhile, they were communicating with clients and referring attorneys to obtain consent to
remove their cases. After giving their notice of separation, they continued to use their position of trust to
place the partnership at a competitive disadvantage. They delayed the PC’s request for a list of cases to be
removed until they obtained consents from all clients on the list. The letters they sent to the clients did not
give them a choice as to whether to stay with PC or go with the new firm. Plus, by sending those letters
too soon after separation, the defects deprived PC from effectively presenting the quality of its services to
those clients. The defects here have breached their fiduciary duty to PC.
NOTE: Courts typically prohibit partners from grabbing the partnership’s customers and taking them to
a new business venture. However, when there is a partnership agreement that allows such, which is here,
the court will enforce the agreement provided that the departing partner does not breach a fiduciary
duty to the partnership.
• “Fiduciaries may plan to compete with the entity to which they owe allegiance, ‘provided that in
the course of such arrangements they do not otherwise act in violation of their fiduciary duties.’”
• Partners owe each other a fiduciary duty of the utmost good faith and loyalty.
• As a fiduciary, a partner must consider his or her partners’ welfare, and refrain from acting
for purely private gain.
PARTNERS HAVE A RIGHT TO EXPEL OTHER PARTNERS: EXPULSION

§ 31(d) dissolution may be caused by the expulsion of any partner from the business bona fide in
accordance with such a power conferred by the agreement between the partners.
§ 601. Events Causing Partner's Dissociation. UPA (1997)

A partner is dissociated from a partnership upon the occurrence of any of the following events:
(2) an event agreed to in the partnership agreement as causing the partner's dissociation;
(3) the partner's expulsion pursuant to the partnership agreement;
(5) on application by the partnership or another partner, the partner's expulsion by judicial determination
because:
(i) the partner engaged in wrongful conduct that adversely and materially affected the partnership
business
Policy: If a partner engages in conduct that makes it impossible to carry on the partnership business, or if the
other partners feel he is a threat, they can vote to expel him.
NO DUTY TO REMAIN PARTNERS- If I Don't Trust You, We're Not Partner

A partnership can expel partners to protect relationship between the firm and clients
Concurrence: When a situation arises when a partner acts on what he believes was his ethical duty to
disclose unethical conduct, it may not necessarily result in liability. However, here the charges were
unfounded; therefore the expulsion was grounded because it was based on a serious error in
judgment.
Lawlis v. Kightlinger & Gray (1990)
RULE: “When a partner is involuntarily expelled from a business, his expulsion must be in good
faith for a dissolution to occur without violating the partnership agreement.”

Lawlis was part of the partnership of K&G. Twelve years later, Lawlis underwent treatment for alcohol
abuse but did not disclose this to the partnership. When he did tell the other partners, the partners
amended the agreement to accommodate his condition so that he would receive continued treatment and
therapy. Lawlis complied with the conditions but his annual units were reduced following the
amendments. Lawlis asserted he met all the conditions and wanted his units to increase. However, the
partners less than a month later expelled him from the partnership. The agreement allowed Lawlis to
stay on as partner for six more months where would obtain salary and benefits to make the smooth
transition. Lawlis refused and sued for breach of contract.
ISSUE: When a partnership agreement provides for involuntary expulsion of a partner without cause,
may the expelled partner recover damages for wrongful expulsion absent a showing of bad faith?
HOLDING: NO; first off, Lawlis cannot claim breach of contract when he remained on as partner for
every vote and thus was still compensated. Secondly, he cannot claim for a breach of fiduciary duty.
The partnership expressed concern for Lawlis though his work had become unproductive. The partners
attempted to work with Lawlis to solve his personal problems so he could return as a senior partner.
Though it did not work out, they expelled him but also allowed him to stay on for six more months for a
transitory period. The expulsion here was in the best interests of the partnership. There was no bad faith
here upon these facts.
NOTE: Courts look to the partnership agreement to determining the means of expulsion. In the absence
of an agreement, the law generally requires only that the partnership act in good faith. No notice or
cause is generally required, although proof of bad faith by the partnership can create a cause of action
for damages.
No cause expulsion: Where the remaining partners in a form deem it necessary to expel a partner under a no
cause expulsion clause in a partnership agreement freely negotiated and entered into, the expelling partners act
in “good faith” regardless of motivation if that act does not cause a wrongful withholding of money or property
legally due the expelled partner at the time expelled.
C. SHARING OF PROFITS AND LOSSES

THE SHARING OF LOSSES (partnership contributions go into the losses – compare
what the partners put in to what they owe)
§ 401(b) “Each partner is entitled to an equal share of the Partnership profits and is chargeable with a
share of the Partnership losses in proportion to the partner’s share of the profits”
• In the absence of a partnership agreement, profits and losses are administered based on a
proportional share of each partner’s interest. If there is no disparity in interest, or no arrangement
has been made, profits and losses are divided equally.
NOTE: this section also overrules Kovacik since it stipulates that proportionality is
maintained even if one partner only invests services and not capital.
§ 18(a) “Each partner shall be repaid his contributions, whether by way of capital or advances to the
Partnership property and share equally in the profits; and must contribute towards the losses
sustained by the Partnership according to his share in the profits.”
• NO capital contribution is required as long as (1) risk, and (2) control is shared
BUT [MINORITY VIEW] “where one partner contributes the money capital as against the other’s skill and
labor, neither party is liable to the other for contribution for any loss sustained”
• Each party valued his contributions to be equal, and thus have sustained equivalent
losses (one financial, one labor)
When a partner contributes services (no money), he is not liable to the other partners for partnership
losses.
HOWEVER, that partner is still liable to the CREDITOR for his portion of the losses.
POLICY: The courts will not undervalue expertise. All contributions (whether monetary or expertise)
have value
Kovacik v. Reed (1957)

RULE: “If one partner or joint adventurer contributes the money capital and the other
contributes the skill and labor necessary for the venture, neither party is entitled to contribution
from the other.”

Kovacik engaged into a joint venture with Reed where he acted as the superintendant and estimator on
kitchen remodeling jobs. Kovacik informed Reed he would invest the money for the jobs and split the
profits equally. There was no discussion as to who would bear the losses. After the year, both
completed remodeling jobs but at a loss. Kovacik demanded Reed to compensate for the loss in which
he refuses. Kovacik sues Reed for an accounting and Reed’s proportionate share of the losses.
ISSUE: Is a capital contributor to a joint adventure entitled to recover one-half of the business losses
from a joint adventurer who contributed his labor?
HOLDING: NO; generally in the absence of an agreement, each partner or joint adventurer shares
equally in the profits and losses of the business venture. However, if one partner or joint adventurer
contributes the money and the other contributes the skill and labor, neither party is entitled to
contribution from the other. In the event of a loss, each party loses the value of his contribution. The
party contributing money loses his monetary investment and the party contributing services loses his
time and labor. Here Kovacik is not entitled to contribution for his lost capital.
NOTE: The UPA issues a default rule that differs from Kovacik. Under the UPA, each partner shares
losses in proportion to their share of the profits. § 401 of the UPA does not base the burden of losses on
the type of contribution made by each partner, but rather on the share of profits each partner is entitled.
However, elsewhere in the UPA, losses realized upon dissolution are treated differently. § 807 provides
the comment that the parties may agree to share operating losses differently than capital losses in the
event of dissolution. Here, a court could determine an implied agreement that a partner contributing
only his services would not bear liability for capital losses.
THE SHARING OF PROFITS (all these people have to be paid first before you can
realize your profits)
§ 401(b) Rules for Distribution
The liabilities of the Partnership shall rank in order of payment as follows:
I. creditors other than partners,
II. partners other than for capital and profits, (a partner can also be a creditor and thus would
have to be the first paid partners after creditors)
III. partners in respect of capital contribution,
IV. partners in respect of profits
BUYOUT AGREEMENTS
G&S Investments v. Belman (1957)

RULE: “Under the UPA, a court may dissolve a partnership when a partner becomes incapable of
performing under the partnership agreement, when a partner’s conduct tends to affect the
business prejudicially, or when a partner willfully breaches the partnership agreement’s terms.”

G&S entered a partnership to operate an apartment with Nordale and others. After being subjected to
drugs, Nordale became suspicious of others and began threatening his partners for things they did not
do. He disrupted the tenants and refused to pay rent. He insisted on unreasonable business decisions
amongst the partnership. As a result, G&S filed suit for dissolution against Nordale to buyout his
interest. Then Nordale died and Belman, a representative to Nordale assumed his estate.
ISSUE: May a surviving partner continue the partnership business upon the death of a partner with
payment of the deceased partner’s interest to his estate as determined by the partnership agreement?
HOLDING: YES; dissolution occurs only when decreed by the court. The agreement asserts for the
partnership to continue upon any partner’s death. Here, the parties intended to measure a capital account
using the value of the assets on the partnership’s books.
A partnership buy-out agreement is valid and binding even it the purchase price is less than the value
of the partner interest, since partners may agree among themselves by contract as to their rights and
liabilities.
NOTE: A buyout agreement allows a partner to end his or her relationship with the other partners and receives
a cash payment or series of payments or some assets of the firm, in return for her or his interest in the firm.
General Partnership- a general partnership is created when two or more people associate to carry on a
business as co-owners to share profits and control. It requires no legal documentation. UPA § 6. A profit-
sharing arrangement creates a presumption of a partnership even if the parties do not intend to be partners. UPA
§ 7. A general partnership dissolves upon the death, bankruptcy, or withdrawal of any partner. UPA § 31.
Absent an agreement, any partner may withdraw and demand that the business be liquidated. UPA § 38(1).
GARTEN: UPA 306. All partners are liable jointly and severally for all liability; a creditor can go after any or
all of them
Losses are shared in the same was as profits. If the parties agree to share the profits equally, the law presumes
the losses will be shared in the same manner.
LAW PARTNERSHIP DISSOLUTIONS

• Two Fiduciary Duties:
• Each former partner has a duty to wind up and complete the unfinished business of the
dissolved partnership. §807(a)
• No former partner may take any action with respect to unfinished business which leads to
ensure personal gain
§807 Settlement of Accounts and Contributions Among Partners (asserts a responsibility to wind up/
governs conduct)
 (b) In settling accounts among the partners, profits and losses that result from the liquidation
of the partnership assets must be credited and charged to the partner’s accounts (therefore after
paying all debts, the profits get credited equally amongst the partners)
 The partnership shall make a distribution to a partner in an amount equal to any excess of the
credits over the charges in the partner’s account.
Dissolution of the Partnership (§ 807) - Liability is first paid off through the sale of partnership assets. The
income from the sale of the assets is distributed to:
1. outside Creditors
2. inside Creditors (ex. Partner)
3. Repayment of Partners’ Capital Contributions
4. Debts to 3rd Parties
Steps in partnership dissolution: (1) assets are sold to repay creditors; (2) any money left goes to repay
the partners capital contributions (last to get paid back). If there isn’t enough to go around, losses are
shared among partners according to their contributions.
Example: Chair dealer needs 100,000, A needs 250,000 (capital contribution), B needs 100,000 (capital
contribution), C contributed nothing.
Total = 450,000 loss that must be shared equally among partners. Each partners loss is 150,000 (450,000
divided by 3). So A is owed 100,000, B must pay 50,000, C must pay 150,000.
Jewel v. Boxer (1984)

RULE: “In the absence of a partnership agreement, the UPA requires that attorneys’ fees
received on cases in progress upon dissolution of a law partnership are to be shared by the former
partners according to their right to fees in the former partnership, regardless of which former
partner provides legal services in the case after the dissolution.”

J, B, and L were partners in a law firm without an agreement. Upon mutual agreement, the partnership
dissolved and J and L formed two new firms. The agreement failed to allocate legal fees earned after
dissolution on cases in progress while the old partnership existed. Thus B sent a letter to his active
clients announcing dissolution and asking them to sign a substitution for counsel. J and L did the same
for their clients. J and L then filed suit for an accounting claiming their interests in fees as members of
the former partnership. The court issued a quantum meruit which considered the time spent on each
case, the source of each case, and the result received.

ISSUE: Should post-dissolution legal fees generated from cases originating with a former partnership be
allocated to all former partners based on their respective interests in the former partnership?
HOLDING: YES; The UPA provides that the partnership continues until the winding up of all
unfinished business, and any income generated from unfinished business is shared among the former
partners. Courts in other states have held that legal fees generated on cases originating in the old
partnership should be distributed according to the former partners’ interests in the partnership and not as
quantum meruit. This is the rule that will govern here.
NOTE: An accounting is a legal action to compel the defendant to account for and pay over money owed to the
plaintiff but held by the defendant. Quantum Meruit is the reasonable value of services; damages awarded in an
amount considered reasonable to compensate a person who has rendered services in a quasi-contractual
relationship.
Law firm is dissolved and disagreement erupts over distribution of profits resulting from cases finished after the
insolvency of the firm.
Rule: If not stipulated in the P/A, the share of profits from attorney’s fees from cases in progress at time
of dissolution is split in the same proportion as fees were split before the dissolution of the firm.
Rule: Absent a contrary agreement, any income generated through the winding up of unfinished
business is allocated to former partners according to their respective interests, regardless of which
former partners actually provides legal services after the dissolution.
Note: Partners are free to contract around this holding in the P/A.
Public Policy- The rule in Jewel prevents partners from competing for the most lucrative cases during
the life of the partnership, and discourages partners from seeking physical possession of the most
lucrative files upon dissolution of the firm.
• Avoids mad scramble to pick lucrative projects during the winding up period [§ 807 Settlement of
Accounts and Contributions Among Partners]
D. OTHER TYPES OF PARTNERSHIPS (LP, LLP, & LLC)

Limited Partnerships (LP) (there must be a partnership agreement)/ (not allowed for law
firms – this form is limited in use)
Definition of Limited Partnership- Must have at least one General Partner that retains unlimited liability for
all of the debts of the partnership and one or more limited partners who are only liable for their capital
contributions (no personal liability for partnership debts). However, if a negligence claim prevails against a
Limited Partner, that partner alone is responsible for the damages in excess of his capital contribution. Makes
sense for passive money investors. As a trade off, LPs cannot take control of the business management
(exertion of control may make them a de factor general partner – Holzman v. De Escamilla)
LPs are creatures of statutes. In order to form this, a General Partner must execute a Certificate of
Limited Partnership and file it with the appropriate state official, usually the Secretary of State.
RULPA §201: there must also be a written agreement among all the partners
The certificate must set out the name of the LP, the address of the registered office and registered agent
for service of process, the name and address of each general partner, etc. Once the certificate has been
filed and fees paid, The LP is thus formed. The partners typically enter into a LP agreement which is
executed by all general and limited partners. LPs are governed by contract law. The LP agreement may
contain provisions governing matters such as the admission of new general and limited partners,
remedies for breach of the partnership agreement and the manner and process for dissolution and wind
up of the LP. It will also likely to contain provisions pertaining to contributions and distributions. It will
also set out the manner in which the profits and losses will be allocated amongst the members. If the
agreement is silent, under the statute, the profits and losses will be allocated on the basis of the value of
the partners’ contributions to the LP.
Limited Partner: is a partner who received profits from the business but does not take part in managing the
business and is not liable for any amount greater than his or her original investment.
Limited Partnership: a partnership composed of one or more persons who control the business and are
personally liable for the partnership’s debts (called general partners), and one or more persons who contribute
capital and share profits but who cannot manage the business and are liable only for the amount of their
contribution (called limited partners). However, modern limited partnership statutes permit limited partners to
participate in management in limited circumstances without becoming personally responsible for its debts. Note
that management is centralized in the general partner.
Note: A Limited Partner (have a voice in the matter of huge things that may
affect the nature of their partnership) gets no control and he will lose his status
if he actively takes part in the control of the business (management). The exact
definition of control use to be vague, but now we know that Limited Partners may: choose other partners and
vote out General Partners; and vote on the nature of the business. § 303(b): Advising & counseling do not
constitute control.
Limited Partners can perform the following actions WITHOUT being deemed to be
participating in the management or control:
(1) Being a contractor for or agent or employee of the limited partnership or a general partner;
(2) Being an officer, director, or shareholder of a corporation that is a general partner;
(3) Acting as a surety, guarantor or endorser for the limited partnership;
(4) Serving on a committee of the limited partnership or the general partner; and
(5) Participating (usually by voting) in a variety of decisions relating to the limited partnership, including
the removing of a general partner, changing the nature of the business, dissolution, etc.
ALSO, ESTOPPEL CAN APPLY TO LIMITED PARTNERS as such that if an LP does business as an
GP in the eyes of a third party, nothing shall prevent the LP in being liable as a GP to the Limited
Partnership.
Types of Partners:
1. General Partners - where each partner has a right to exercise control, but is also liable for losses -
shared liability
2. Limited Partners - where each partner has a right to profits, but liability is limited to the amount
contributed to the partnership.
IF A LIMITED PARTNER EXERCISES CONTROL AND THUS VIOLATES THE NO

PARTICPATION RULE, HE BECOMES A GENERAL PARTNER - SUBJECT TO SHARED
LIABILITY FOR LOSSES- Holzman v.DeEscamilla
Benefits: Limited partners are only liable for their capital contributions
"LIMITED PARTNERSHIPS" - There is NO PERSONAL LIABILITY FOR PARTNERSHIP DEBTS
Limited partnerships are required to have at least one general partner, who is subject to unlimited debt
for partnership debts.
Holzman v. De Escamilla (1948)
RULE: “A limited partner is not liable as a general partner unless, in addition to exercising his
rights and powers as a limited partner, he takes part in the control of the business.”

Russell and Andrews enter into a LP with De Escamilla. Pursuant to the agreement, De Escamilla was a
GP and the other two were LPs. They often had discussions as to what crops to plant. Sometime later,
Russell and Andrews called for the resignation of De Escamilla who was replaced by another person.
Bank transactions for the business required signatures of two of the three partners; however, De
Escamilla was no longer a GP. Thus the bank, Holzman, sued the two remaining partners as general
partners.
ISSUE: Do limited partners who give business advice and dictate business transactions have sufficient
control of the limited partnership’s business to convert them into general partners?
HOLDING: YES; Here, Russell and Andrews clearly took control of the control of the business. They
were free to dictate business transactions through their own initiative and could veto any business
transaction by refusing to sign checks. They actively chose the crops to be planted and replaced De
Escamilla with a suitable successor. Because they took control of the business, they are liable as general
partners for the partnership’s debts.
NOTE: A limited partner is liable as general partner only if, in addition to exercising his rights and powers as a
limited partner, he participates in the control of the business. Therefore, to hold a limited partner liable for the
partnership’s debts, a court must draw a line between activities in control of the business and those in control of
the limited partner’s investment. Actions such as consulting with general partners, acting as a general partner’s
agent, voting or conferring on business decisions that relate to financing or dissolution, or deciding on a charge
in the business do not establish control over the business sufficient to hold the limited partner liable as a general
partner.
F: Limited Partnership provided that the General Partner could not withdraw money from the accounts
without the signature of one of the Limited Partners.
RULE “a limited partner shall not become liable as a general partner, unless, in addition to the
exercise of his rights and powers as a limited partner, he takes part in the control of the
business.”
R: A limited partner who participates in control is liable “only to persons who transact business with the
limited Partnership reasonably believing, based upon the limited partner’s conduct, that the limited
partner is a general partner.” [Revised Uniform Limited Partnership Act - § 303(a)] – similar to an
estoppel theory – there must be reliance
R: A limited partner does not exert control by simply advising the general partner [Revised Uniform
Limited Partnership Act - § 303(b)]
Limited Partnerships today are extensively used in three areas: (1) tax sheltered
investments (i.e. oil and gas drilling deals and real estate ventures, (2) deals put together
by leveraged buy-out firms and venture capital firms, and (3) as an estate planning tool
(I.e. family limited partnerships).
Limited Liability Partnerships (LLP) – people do this because nobody wants to carry
the full negligence
Definition of Limited Liability Partnership - Organization where partners have limited liability with respect
to negligence and similar misconduct (excluding contract obligations). A partner’s direct misconduct may lead
to his own liability and subject to unlimited liability, not uninvolved partners. This organization requires filing
the Partnership Agreement with a state official and including the “LLP” on all letterhead so that creditors know
of the limitation. There are also fees that must be paid and are thus valid for one year in most states and would
have to be renewed annually.
LLPs are authorized in about 20 states. This partnership provides innocent partners protection against
malpractice or similar tort claims arising from actions of other partners. In some states, an LLP election
also protects innocent partners from contract claims as well as torts.
This organization is generally a subset to general partnerships. They have limited in common to LPs.
Limited Liability Partnership (LLP) [Partners are limited to their liability and that of the firm]
Creation: § 1001. UPA (1997) Statement of Qualification
(b) must be approved by vote necessary to amend a general partnership
(c) must file a statement of qualification, to the effect that the partnership elects to be a limited
liability partnership
(stationary must identify partnership as a limited liability partnership with the words, "Registered
Limited Liability
Partnership," "Limited Liability Partnership" or LLP
Benefits: Liability of Limited Liability Partners is limited to 3d parties for negligence attributable to the
conduct of other parties
1) Eliminates partnership liability for the negligent acts (malpractice/tort) of the partners
2) LLP partners may actively participate in management
Detriments/negatives: May act as a negative indication of firm culture - eliminates the "we are all in it
together' mentality
Typical use: LLP's are typically used by law firms, accounting firms, etc.
Law firms:
• this type is big for firms
• LLP develops exclusively for law firms where the concern was malpractice
• Must tell clients, creditors, 3d parties so it counts as notice to 3d party creditors
• Even though reasons not to become LLP, many going in this direction b/c of reality of crushing
burdens of malpractice
Why would a law firm choose to remain a general partnership?
 change to LLP might reflect a different culture of firm
 unlimited liability [general partnership] fosters trust & relationship when they are share losses
 all are taxed as equals
How to choose the type of partnership?
• If you need $, limited partnership makes the most sense because then you can raise a lot of
money without sacrificing control  Real estate, venture capital markets
• For a small business, general partnership makes more sense
 Sharing liability is bonding experience and causes partners to act in best interest of
partnership
 LLP doesn’t offer much protection because still wholly liable for K breaches
UPA §1001
• Eliminates Partnership liability for the negligent acts (malpractice, tort claims) of partners. Only
protects against tort liability, not criminal.
• Used mostly by legal and accounting firms
• Can allocate profits anyway you want. Allows limited liability
• May act as a negative indication of firm culture – eliminates the “we are all in it together mentality” –
no partner is not responsible for what the other partners do)
• LLP partners may actively participate in management
• Required to have insurance and set aside funds for malpractice
NOTE: Limited Liability Partnerships are hybrids between a general partnership and a
limited partnership. It allows individual partners to limit their own liabilities to third
parties for negligence or misconduct of other partners. In contractual claims, the partners
are jointly and severally liable, but for tortous claims, the actual tort-feasor is fully liable
and the others, though not involved, would be liable for their amount capital contributions
to the partnership. However, nothing would be coming out their pockets since their
insurance policy would cover this. All partners get control with limited liability.
Limited Liability Company (LLC)

Definition of Limited Liability Corporation- Organization where members have greater control than in
regular corporations but are protected from liability and obtain tax advantage. The investors are called
members
LLC is analogous to a limited partnership but composed only of limited partners. However its internal
structure may closely resemble that of a corporation. It is created by filing a document with a state
officer called “articles of organization that is patterned after corporate articles of incorporation. An
LLC may also adopt regulations or an operating agreement that is patterned after corporate bylaws.
LLCs provide limited liability for all its members. Unlike a LP, members of an LLC can freely
participate in the management of the business without incurring personal liability for the obligations of
the business. LLC statutes permit the internal management to be structured after a corporation or a
general partnership. LLC statutes permit each LLC to decide whether to be member-managed or
manager-managed. A member-managed LLC is governed in a manner similar to a partnership where
the members manage the business. A manager-managed LLC is governed in a manner more analogous to
a corporation where the members elect one or more managers to manage the business. The
attractiveness of the LLC combines (1) limited liability for all members, (2) flexibility of management
structure (in contrast to a partnership or a corporation), and (3) most importantly, a desirable income

tax treatment, similar to a partnership. Almost all LLCs are closely held businesses because if they were
publicly held, their tax rules would change as such to be taxed as a corporation.
LLCs differ from corporations in that they do not obtain a charter or franchise from the state, for the
purposes for income tax classification. Limited Liability is provided to members of an LLC simply by a
statutory provision that states that limited partners are not personally liable for the organization’s debts
in most circumstances. LLC’s are governed by contract law through its operating agreement.
Limited Liability Company (LLC)
* This is not a corporation; it is a business entity where by the owners/members can
a) Participate in managing the entity's affairs, but
b) Has the limited liability of a corporation
Duration: May exist indefinitely or for a fixed duration. Ownership interests may generally be structured as
members desired, and there is no limit on the number or type of owners. Managers and owners own limited
liability
Water, Waste & Land, Inc. v. Lanham (1998)

RULE: “If a limited liability company’s agent fails to inform a third party that he is acting as the
company’s agent, the LLC Act’s notice provision does not relieve the agent of liability to the third
party.”

WWL does business as a land developer and engineer. Lanham and Clark were members and managers
of a LLC. Clark contacted WWL to do work for them. Clark gave WWL a business card that showed
Lanham’s address as Clark’s place of business. The LLC’s name was not on the card, nor was LLC.
Clark and WWL reached an agreement for services and thus told WWL to send the proposal to Lanham.
Lanham and Clark did not return the contract to WWL and thus told WWL to start the work. When
finished, WWL billed Lanham but Lanham did not pay them. WWL filed suit against Clark, Lanham,
and the LLC. The trial court ruled that Clark was an agent of both Lanham and the LLC, that WWL
dealt with Lanham and Clark as individuals, and because WWL believed Clark was Lanham’s agent,
Clark was not personable liable.
ISSUE: Is a member of an LLC personally liable under a contract if the other party to the contract was
not aware that the member was negotiating on behalf of an LLC?
HOLDING: YES; the statutory notice provision applies only to parties looking to impose personal
liability on the members or managers of an LLC when they know the individuals have formed an
LLC. Here the court found that WWL had no knowledge that Clark was an agent to the LLC. WWL
believed that Clark was Lanham’s agent. Because Clark and Lanham failed to disclose the LLC, they
remain liable as individuals. The fact that the LLC filed papers with the secretary of state does not put
WWL on notice that it was dealing with a LLC. The act’s presumption prevents a third party from
pleading ignorance only once it knows the entity’s name.
NOTE: Unless the third party and the agent agree otherwise, an agent who makes a contract on behalf of a
disclosed principal is not a party to the contract. In contrast, an agent who makes a contract for an unidentified
principal becomes a party to the contract unless the third party and the agent agree otherwise. These rules
recognize that a contracting party often needs to evaluate the other party’s creditworthiness.
OPERATING AGREEMENT

Elf Atochem N. America, Inc. v. Jaffari (1999)
RULE: “A LLC is bound by the terms of an operating agreement that is signed by some of its
members and that defines the LLC’s governance and operation, even if the LLC did not execute
the agreement.”

Elf makes manufactured chemicals that mask odors. Because these chemicals are hazardous, Elf entered
into a joint venture with Jaffari using the LLC to operate the enterprise. Elf had 30% ownership in the
LLC and Jaffari had 70%. After filing the operating agreement, the two entered into another agreement
as such for Elf to be the exclusive distributor for Jaffari. Jaffari was manager of the LLC. The members
also signed an extensive operating agreement, not the LLC. The agreement asserted for arbitration to be
the means for settling any action individually or derivatively. Elf sues Jaffari and the LLC for
mismanagement and fraud.
ISSUE: If an LLC fails to execute its operating agreement, are the provisions nevertheless binding on
the LLC?
HOLDING: YES; the agreement requires all LLC members to consent exclusively to the
jurisdiction of California state and federal courts for any action arising out of the rights and
privileges contained in the agreement provided the claim is not required to be arbitrated. Here the
LLC members signed the agreement and the LLC Act provides that an operating agreement is an
agreement by LLC members regarding the company’s business operations. Thus, the members are the
real parties in interest. Elf agreed to settle his issues through arbitration under the exclusive jurisdiction
of the California courts. He has no derivative action in Delaware, neither does the agreement make a
distinction between what’d direct and what’s derivative. This court will not allow a party to avoid
arbitration by characterizing its claims as derivative.
NOTE: An operating agreement is drafted for the member’s benefit. The agreement is binding.
PIERCING THE “LLC” VEIL
Kaycee Land and Livestock v. Flahive (2002)

RULE: “The common law doctrine of piercing the corporate veil is not abrogated by the LLC Act
and may be used against LLC members in appropriate cases.”

Flahive was a managing member of an LLC which negotiated a lease with Kaycee for real estate.
Kaycee contended that the LLC member Flahive contaminated the property. Kaycee attempted to pierce
the corporate veil by reaching Flahive’s personal assets.
ISSUE: May a court pierce the corporate veil of a LLC to reach its members’ assets?
HOLDING: YES; courts have long recognized the common law doctrine of piercing the corporate
veil as an equitable remedy. Here although the LLC act generally prevents personal liability, nothing
restricts a court from piercing the veil if the LLC is used improperly. The facts here are somewhat
limited in ascertaining whether fraudulent activity exists. Judgment remanded.

NOTE: Some states like Minnesota and Colorado allow courts to pierce the corporate veil to an LLC. Because
tax or other financial considerations drive most choice-of-entity decisions, it makes sense to treat all entities
alike, and if misused, to allow creditors to make claims directly against the LLC membership for moneys owed.
FIDUCIARY OBLIGATIONS
McConnell v. Hunt Sports Enter. (1999)

RULE: “LLC members are bound by the terms of their operating agreement, and if the
agreement expressly allows them to engage in any other business venture of any nature, they are
not prohibited from participating in a competing venture.”
Wealthy individuals, such as McConnell and Hunt, and their LLC invested in a new hockey team for the
NHL in Columbus. The investors needed an arena for the team in which the voters rejected. Nationwide
expressed an interest in building an arena and leasing it. Hunt, acting for the LLC met with Nationwide to
discuss a lease proposal. Hunt rejected the proposal. As the NHL deadline approached, McConnell contact
Nationwide and agreed to their proposal. The LLC and Hunt disagreed with the terms. Thus McConnell
favored it and signed the agreement. Afterwards, he filed suit seeking to exclude Hunt and the LLC from
the franchise under the terms of the operating agreement.
ISSUE: Should a court allow extrinsic evidence of the meaning of an operating agreement’s terms that
purports to do away with the fiduciary protections ordinarily afford the members of a business
organization such as a LLC?
HOLDING: NO; courts permit extrinsic language only if the language is not clear or if the
agreement’s circumstances suggest the contract language has special meaning. Here the agreement
asserts that the parties agree that its members will not be restricted from engaging in any business of any
nature, even a business that may compete with the company’s business. Generally fiduciary obligations
prohibit members from competing with one another in the same business. However here, the agreement
eliminates this protection. Furthermore, the agreement does not designate Hunt as the operating member
and because Hunt lacked authority to act, his conduct does not deserve protection as an official duty. In
light of Hunt’s knowledge that the agreement required a majority vote before he acted on behalf of the
company, he acted willfully when he filed his answer and counterclaim without a vote.
NOTE: The primary concern when an officer, director or other fiduciary competes with its company is the
existence of good faith. Courts have frequently not found bad faith when a fiduciary later secured a missed
corporate opportunity. If a fiduciary misappropriated a business opportunity, the corporation may ask the court
to impose a constructive trust within which it may accumulate the fiduciary’s profits to be distributed to the
corporation.
DISSOLUTION
New Horizons Supply Co-op v. Haack (1999)

RULE: “A LLC member may be responsible for the company’s debts if the member fails to take
the appropriate steps to dissolve the company when it winds up its operations.”

Haack signed an agreement to New Horizons where she would be responsible for all fuel purchased on
the credit card. An LLC that Haack is associated with was named on the agreement. Thus when the
account became delinquent, New Horizons contacted the LLC. New Horizons was told that the LLC has
dissolved and that Haack as partner would take responsibility for the company and start making
payments the next month using the business assets. Haack never made the payments so New Horizons
sued the LLC.
ISSUE: Should a LLC member who fails to take the appropriate steps to dissolve the company be
permitted to defend against an action to recover against her personally by establishing that the debts in
question were the LLC’s obligation?
HOLDING: NO; the doctrine of piercing the corporate veil has been adopted in the state’s LLC
law. Here, Haack did not keep her obligations separate from the LLC’s obligations and thus took no
steps to insulate herself from liability for the company’s debts. Hack offered no evidence that the
articles were filed. On dissolution, there were no formal steps taken to wind up the LLC. In winding up,
all creditors must be paid. With no evidence that the company was properly wound up, Haack remains
liable for the obligation to New Horizons.
Assume we are looking to expand the business. If people want to invest in this partnership, does it make sense
to bring them in as general partners at the same status as A, B, and C from the previous example?
• Probably not b/c A, B, & C don’t want to give up any control.
• There are three choices: General Partnership, Limited Partnership, and Limited Liability Partnership.
What about a LIMITED PARTNERSHIP?

• A limited partnership would give a share of the profits to the partner, but the losses are limited to the
partner’s contribution. So, if D contributes 100k, then this will be the extent of the possible losses.
Predictable loss and D doesn’t have to exercise any control; in fact, he is not allowed to exercise any
control.
• Limited partners are now given some control over the business without becoming general partners.
However, day to day operations are usually still left to the general partners in a business.
• Members are liable for only their investment

• All members are able to take part in control
• Complex to form – requires filing an “operating agreement form”
• Entity may choose to be taxed as a corp. or a Partnership (to avoid double taxation, most choose
Partnership)
• What happens to fiduciary duty concept with LLCs? Courts don’t seem to apply fiduciary
duty as strongly in LLCs b/c LLCs structure through contracts, so Courts do not want to intervene
and add additional duties
• There are no separate directors, books, officers, etc. because you aren’t trying to maintain business
entity
GP small businesses where everyone is expected to participate

LP’s venture capitalists – seek investment w/o control
LLP’s limits Tort liability from the whole partnership but not to the individuals (malpractice) ideal for law &
accounting firms (must register w/ state)
LLC’s hybrid that permits (1) members to limit liability to amount invested, and (2) entity can choose to be
taxed as a corp. or a Partnership. Complex to form – requires filing an “operating agreement.” LLC’s
must have insurance

PARTNERSHIP V. CORPORATION
Type CREATION LIABILITY TAX

PARTNERSHIP * Conduct Each partner is Each person/partner pays tax on
individually liable their individual income
for the debts of the *However, the partner may off set
partnership his pro rata share of firm losses
*Tax return filed by the partnership
is informational only
CORPORATION * Must Limited Liability Corporation is a separate tax entity.

incorporate in Shareholders are
state limited to the Double Taxation
File Charter/ extent of their a) The corporation pays income tax,
Certificate of contribution and
Incorporation (limited to shares) b) the shareholders' dividends are
with the Sec. of also taxed individually.
State
To get tax break, use LLC-
Shareholders get limited liability,
while having the tax status of the
general partnership
NOTES
The selection of business forms today largely revolves around two core issues: limitation of personal
liability of owners for debts of the business and the proper classification of the business for purposes of
the federal income tax law. Of these two, tax treatment is the most important simply because this is
something that every business has to face almost constantly. It involves real dollars that must be paid
each year whereas limited liability is only a possibility or a risk that may never mature.
Today, many of the unincorporated businesses provide limited liability for some or all owners and yet
remain eligible for partnership type taxation under the Kintner regulations. The determination of
whether an unincorporated business entity is eligible for partnership type taxation under these
regulations rests on the question whether the entity has a predominance of non-corporate characteristics.
There are four characteristics that determine whether an entity should be classified as a corporation –
continuity of life, centralization of management, limited liability, and free transferability of interests. An
unincorporated business that has three of the four characteristics will be taxed as a corporation.

*********************************************************************
II. CORPORATIONS
*********************************************************************
A. FORMATION OF THE CORPORATE ENTITY
In a corporation, the fundamental idea is that ownership of business is separated from control. The
fundamental attributes of a corporation are (1) separate legal entity status – separate person in the eyes
of the law from its shareholders and board of directors as such that it can sue in its own name, be sued,
and convey property from its own name; (2) Limited liability to the owners of the corporation or
shareholders flows from the concept of separate entity status of the corporation. The directors and
officers also are not personally liable for the obligations of the corporation; this flows from the business
judgment rule. Generally the corporation itself can be held liable for corporate obligations. A
corporation would be a good business to start if you are protecting your personal assets; the shareholders
will not be held liable for the unsatisfied debts of the corporation; (3) double taxation – means that the
corporation itself pays taxes on the income it earns and the owners pay taxes on the income they receive
as dividends; and (4) centralized management - the owners of the corporation, shareholders, annually
elect a board of directors to set policy for the corporation. The board would then appoint officers to
carry out the day to day functions of the corporation. Other than electing the board, shareholders have
no authority to manage. They do have veto power in situations where the corporation maybe dissolved,
the capital structure changes, or making an acquisition. (5) Free Transferability of ownership – a
shareholder can transfer his share to whomever they want at whatever price whenever they want.
However, transferability can be restricted by agreement which is typically popular in closely held
corporations where management decides who can join their business or not.
GENERAL
• The Corporation is treated as an independent entity.
• Every Shareholder has Limited Liability because corporation is treated as a separate person, and thus
only entity is responsible for debts.
• Two Basic Rights of Common Stock Shareholders
1. Right to vote (Board, changes to Articles of Incorporation & Bylaws, fundamental changes
not in the ordinary course of business-merger); Shareholders have to consent /vote for
amendments to the charter.
2. Right to dividends (issuance is subject to BJR however)
INCORPORATION
DGCL § 101 – Incorporators; how corporation formed; purposes

(a) any person or entity w/o regard to state of residence, domicile or state of incorporation, may
incorporate by filing w/ the Division of Corporations in the Dept. of State
DGCL § 102 – Contents of certificate or articles of incorporation

(a) The certificate of incorporation shall set forth:
(1) Name (including identifier of incorporation) – evidence of incorporation (I.e. Corp. or
Inc.)
(2) address of registered office in this State (were service of process may be made –
lawyers office)
(3) nature of business or purposes to be conducted or promoted (can be as broad as “to
make money”)
(4) if one class of stock: total # of shares corp. can issue and par value for each; if more than
one class: total # of shares of each class, and par value (identify the type of stock the
company is authorized to issue as such to be enjoyed by the shareholders)
(5) name and mailing address of incorporator(s)
(6) name and mailing address of persons to serve as directors until first annual meeting of
stockholders or their successors are elected
(7) Some states requires that the size of the corporation must be included here, others say the
bylaws would be sufficient.
(b) may also contain:
(1) Any provision limiting or defining the rights and obligations of the corp. actors.
• Good place to exert control prior to requiring shareholder approval
• Pre-emptive rights
• “more than 50% voting requirements
• Limitations on corporate existence
• Limitations on liability for breach of FD
• By-law provisions
DGCL § 106 – Commencement of corporate existence

Upon filing and proper execution with the Secretary of State, incorporator(s) shall be and constitute
a corporate body, by the name set forth in the certificate
Selection of State of Incorporation

Most corporations choose Delaware because of its corporate friendly laws; however, a large publicly held
corporation can choose any of the 50 states to be incorporated. See Del Gen Corp Law § 101-02 for rules
of incorporation. Why Delaware? (1) It has a broadly permissive statute – empowers
managers with great discretion to carry out the affairs of the corporation; (2) its law is
very stable – Delaware Constitution provides that general corporate law cannot be
amended without 2/3s vote of all the sitting legislators of the state.; (3) large body of case-
law interpreting statutory provisions – attorneys have a more certain law in advising their
clients as to what actions they can engage in; and (4) it has a special court of chancery –
lawyers of corporate practice migrate here then eventually to the Supreme Court of
Delaware.
Mechanics of Incorporation
1. File Articles of Incorporation or Certificate of Incorporation or charter w/ Secretary of State
2. Articles are reviewed by State officials
3. If approved, the secretary issues the certificate and a corporation is formed
4. Should have Bylaws to govern internal affairs – not filed or made part of the public record
• If the Articles conflict w/ the Bylaws, the Articles control
Incorporators
The person or persons who execute the articles of incorporation are called incorporators. The incorporators can
either (1) execute and deliver the articles to the secretary of state; (2) they can receive the charter or certificate
of incorporation back from the secretary of state; (3) they can either meet to complete the organization of the
corporation or can call the first meeting of the initial board of directors named in the articles as which the
organization of the corporation is completed; (4) they can voluntarily dissolve the corporation if the corporation
has not commenced business and has not issued any shares; and (5) they can amend the articles by unanimous
consent if the corporation has not commenced business and has not issued any shares.
Articles of Incorporation (once a corp. is legally in existence, it is called a De

Jure Corporation)
This document filed with the Secretary of State must have the following: (a) the name of the corporation; (b)
the period of duration which may be perpetual; (c) the purpose or purposes of the corporation, which may be
generally described as for any lawful business purpose; (d) the number of shares authorized to be issued,
including information about the rights and preferences of such shares; (e) the address of its registered office
and the name of its registered agent at that office; (f) the number of directors and the names and addresses
of the members of the initial board of directors; and (g) the names and addresses of each incorporator.
As a result of concern about the liability imposed on directors in the case Smith v. Van Gorkom, the
corporation statutes of many states have been amended to permit the shareholders to limit the personal
liability of directors for monetary damages for violation of the duty of due care.
Bylaws are generally not filed with the secretary of state and are not a matter of public record. The
corporate seal is not required either.
Ultra Vires
The term means “beyond the power.” They refer to illegal acts performed by the corporation such as
bribes, political contributions, charitable donations, etc. The corporation has exceeded its authority and
its corporate purpose. The main use of this doctrine was to disaffirm contracts. Today, this doctrine is
no longer relevant since corporations now have (1) broad purpose clauses as such to engage in any lawful
activity, and (2) modern corporate statutes have provisions that state no contract or conveyance shall be
invalid because it was beyond the scope of the corporation’s power. The policy implication for rejecting
this doctrine is that corporations might get too big and powerful, but that is why antitrust laws are still in
existence today.
NOTE: THE CHOICE OF LAW RULE IS THE INTERNAL AFFAIRS DOCTRINE – THE LAW OF THE
STATE THE CORPORATION DOMICILES…THIS MUST ALSO BE FILED WITH THE SECRETARY OF
STATE
DIFFICULTIES WITH INCORPORATION PROCESS/ DE FACTO INCORPORATION DOCTRINE

SITUATIONS WHERE THERE IS A MISTAKE IN INCORPORATION
Southern-Gulf Marine Company v. Camcraft, Inc. (1982)

RULE: “A defendant may not interpose as a defense to a breach of contract that a plaintiff
corporation lacked the capacity to contract because it was not incorporated at the time it executed
the contract, unless the failure to incorporate actually harmed the defendant.”

Southern was designated as a company to be formed and thus executed a letter of agreement to purchase
a vessel from Camcraft. The presidents of both companies signed the agreement in which Camcraft had
to purchase the parts for the vessel and deliver it to Southern who in turn would give them the money.
Due to financial concerns, Southern decided to incorporate in Cayman, the British West Indies and thus
assured Camcraft that this would not affect their negotiations in which Camcraft consented to. Camcraft
however did not deliver the vessel in time. Southern sues for breach of contract. Camcraft contends that
the contract was unenforceable since the plaintiff was not incorporated at the time.
ISSUE: Does a party’s failure to have incorporated before signing a contract with the defendant render
the contract unenforceable?
HOLDING: NO; since the defendant agreed to build the ship, it should not be permitted for them to
escape their obligations under such theory of un-incorporation unless the un-incorporation affects the
defendant’s rights. Nothing showed that the lack of the plaintiff’s corporate status affected the defendant
adversely. The reason Camcraft rejected to build the vessel was because it could have sold it to another
person for a higher price. The plaintiff’s status is not relevant here and thus cannot be used to avoid the
contractual obligations.
• RULE “where a party has contracted with what he considers to be a corporation, and is
sued upon the contract, neither is permitted to deny the existence or legal validity of such
corporation” and is estopped from denying its corporate existence, particularly when the
obligations are sought to be enforced.
NOTE: Most states have abolished this doctrine.
• What to do when a Client wants to proceed with a deal with a not yet incorporated entity?
• Require that all parties sign the letter in a personal capacity and create provision to
transfer liability when incorporation is achieved
• Include a provision to void contract if Incorporation is not achieved by a specific
date – may require you to eat losses up to that point
De facto Corporation vs. Corporation by Estoppel

These two terms are noted to be defenses to personal liability for the debts of a business that was
defectively incorporated.
De facto corporation provides that persons who purport to act as or on the behalf of a corporation
knowing that there was no incorporation are liable for all liabilities created in so acting. It follows that
persons who do not know that there was no incorporation will not be liable. It is a partially formed
corporation that provides a shield against personal liability of shareholders for corporate obligations.
When this doctrine is invoked, the court is saying that it will treat the business as if it was a corporation
for purposes of adjudicating the rights and duties of private parties, even though all of the statutory
formalities were not met. To invoke this doctrine, these three elements must be established: (1) colorable
compliance: the organizers of the corporation attempted to comply with the applicable statutes, but failed
to do so; technical defect or single defect; (2) good faith: (pure heart, empty head standard) the
organizers were unaware of the defect that kept the corporation from being formed; and (3) use of
corporate power: the company carried on as though they believed the corporation existed, by issuing
stock, holding meetings, entering contracts, etc. If these three elements are met, shareholders will be
shielded from personal liability. (applied in contracts and tort cases) NO one will be liable for a defect
unless they have knowledge of the defect.
Corporation by Estoppel provides that persons who treat an entity as a corporation will be estopped
from later claiming that the entity was not a corporation. The doctrine can be applied either to an
outsider seeking to avoid liability on a contract with the purported corporation or to a purported
corporation seeking to avoid liability on a contract with an outsider. It is an equitable defense from that
of de facto corporation. Here, a third party who has dealt with an entity as though it were a corporation
and without any expectation that the shareholders will be personal liable for the corporation’s debt will
be estopped from holding the shareholders liable when it is subsequently discovered that the corporation
was not properly formed. Therefore, the party asserting the defense must have acted in good faith and
not affirmatively misled the other party. The requirements for equitable estoppel are (1) there must be a
false representation or concealment of a fact from a person ignorant of the truth (2) with the intention by
the person making the representation of causing reliance, and (3) actual reliance by the innocent party on
the basis of the false representation. (applied in contract cases) . . . even though the corporation acted as
if it was a corporation and thus acted in good faith to do so, the third party honestly contracted with the
corp. as if it was a corporation and now wants to break the contract, this third party will be estopped
from asserting that the corp. was not duly formed
Assuring and Determining the Validity of Incorporation

• When contracting with a Corporation, the party should check that the Corporation has been duly
incorporated and remains in good standing and to make sure there is no dissolution statement.
• Obtain a copy of the Corporation’s certificate of incorporation and/or contact state tax department to
assure that taxes have been paid
• The lawyers job to give an opinion as to whether the Corporation is in good standing
B. PIERCING THE CORPORATE VEIL – REACHING THE SHAREHOLDERS
The law permits the incorporation of a business for the very purpose of enabling its
proprietors to escape personal liability, but the privilege is not without its limits. The courts
will disregard the corporate form and pierce the corporate veil whenever necessary to prevent
fraud or to achieve equity. The court will not allow a corporation to evade liability if it has
been used as an alter ego or instrumentality. In other words, the courts will hold the
shareholders, officers, or directors personally liable for corporate obligations because the
corporation is abusing the legislative privilege of conducting business in the corporate form.
This doctrine counterbalances the de facto and estoppel doctrines since the validity of
corporate existence is ignored as a means of equity to serve the ends of justice.
2 theories of liability:
 Piercing the corporate veil makes the owner liable. (look to see if the party has intermingled funds
between personal and company accounts)
 Enterprise Liability - Make the owner of the tanker liable, since they are essentially one company.
(Look to see if funds are intermingled between companies). Sort of like reverse piercing. The parent and
subsidiary fails to follow corporate formalities
o Clincher – no interest loan from 1 company to another.
Normally: Courtswill refer to the legal fiction that a properly formed

corporation is an entity, separate and distinct from its officers and
stockholders and the individual stockholders are not personally responsible for
the debts of the corporation.
Creation of the corporation will normally shield the shareholders from
personal liability for the corporation's debt. Thus, shareholder's liability is
limited to their investment.
Piercing the Corporate Veil: However, the fiction should be disregarded when it is urged with an intent not
within its reason and purpose, and in such a way that its retention would produce injustices or inequitable
consequences.
 Despite adequate formation of a corporation, individual shareholders may be personally liable for the
corporation’s obligations / the corporate veil may be pierced, when it is necessary to "prevent fraud or
injustice” Also note that creditors are more likely to pierce the veil than are shareholders.
 When the veil of limited liability is pierced as such the corporate entity is ignored, active persons
meaning persons who were active in management or operation of the business will be held liable.
However, passive investors who acted in good faith will not be liable.
Exception- Courts are reluctant to pierce the corporate veil in contract cases because the contracting
party had an opportunity to investigate and bargain. Contractual parties assume the risk and thus
had an opportunity to investigate the capitalization.
Shareholders are liable for corporate obligations under either contract or tort law. Under
contracts, shareholders often assume personal liability for corporate obligations. A lender
may refuse to extend credit to a corporation with limited assets unless one or more of that
corporation’s shareholders agree to personally pay the debt if the corporation does not do
so. Under tort law, a shareholder will be liable under general principles of tort and
agency law if the shareholder commits a tort in the course of the corporation’s business.
The courts are more willing to pierce the veil in tort cases rather than in contract cases.
People who are injured in a tort claim don’t have the opportunity to investigate the shady
corporation before dealing with them while people in a contract claim have the
opportunity to investigate and bargain for and employ protective measures before signing
the contract
• Though not dispositive, the court will be more likely to pierce for the
benefit of an involuntary creditor that did not have the opportunity to
investigate
3 APPROACHES COURTS USE IN DECIDING WHETHER TO PIERCE

THE CORPORATE VEIL
(Piercing the Corporate Veil will require more than just ONE of these factors, with
exception to only Fraud)
1. LACK OF A SEPARATE CORPORATE EXISTENCE ALSO COMMINGLING OF BUSINESS

FISCAL ASSETS – ALTER EGO APPROACH (NEW YORK Approach)

Commingling of Assets: shareholders co-mingle personal and company funds. This includes a failure
to keep separate bank accounts for the corporation and the controlling shareholder and writing checks to cover
personal expenses out of the corporate account. It also includes situations in which the dominant shareholder
treats the corporation’s bank account as his private piggy back. The personal assets may be so commingled that
a third party may think he is dealing with the shareholder rather than a corporation.
Self-Dealing: similar to commingling of assets.
Failure of formalities: shareholders have failed to follow corporate formalities in running the business.
Shares are never formally issued, directors’ meetings are not held, no minutes of meetings kept, etc.)
Shareholder does not distinguish between corporate property and personal property, and proper corporate
financial records are not maintained, etc.
Control or domination: this alone is NEVER sufficient to pierce the corporate veil. There must be
fraud, self-dealing, commingling of assets, etc. Control is relevant in telling the court “WHO” has potential
piercing liability.
a) Individual shareholders – if the shareholders treat the assets of the corporation as their own, use
corporate funds to pay their private debts, fail to keep separate corporate books, and fail to observe
corporate formalities (such as holding meetings, issuing stock, and conducting business by resolution),
courts often find that the corporate entity is a mere “alter ego” of the shareholders. The operation of
the corporation must result in some basic injustice so that equity would require that the individual
shareholders respond to the damage they have caused.
b) Parent-Subsidiary Corporations (Enterprise Liability) – a subsidiary or affiliated corporation will

not be deemed to be a separate corporate entity if the formalities of separate corporate procedures for
each corporation are not observed, as such there is an overlapping of identical directors and officers,
same meetings of the directors and officers, corporate policies are similar, etc. The plaintiff here is
seeking to hold the parent corporation liable for the subsidiary corporation’s debts. Factors considered in
piercing the veil here are: (1) the relationship is so structured that all profits of the
subsidiary inure to the benefit of the parent, (2) there is no clear delineation as to
which transactions are the parent’s and which are the subsidiary’s, (3) the parent does
not allow the subsidiary to have adequate capital, or (4) the board of directors of the
parent makes decisions for the subsidiary.
c) Affiliated Corporations – if one person owns most or all of the stock in several corporations, a question
arises as to whether one of the corporations, although not formally related to the other, should be held
liable for the other’s liabilities. Dominating stock ownership alone is not enough in such a case, unless
the majority shareholder dominates finances, policies, and practices of both corporations so that both are
a business conduit for the principal shareholder.
POLICY: It gives some certainty to shareholders, especially to dispersed or passive shareholders. They know
what to do to avoid liability. They are the beneficiaries of this rule. This formalized test has nothing to do with
3rd parties. This alter-ego approach is a pro-certainty approach, which is a pro-shareholder approach. It is also a
small price to pay to get this limited liability benefit.
2. INSUFFICIENT CAPITALIZATION – (CALIFORNIA Approach) –NOT ENOUGH TO

PIERCE THE CORPORATE VEIL…THIS PLAYS A SUPPORTING ROLE (usually fraud
and/or lack of corporate formalities is necessary here)

The corporation veil should be pierced when there’s capital insufficient to meet liabilities which are certain to
arise in the ordinary course of the corporation’s business. It is generally accepted that shareholders will be
personally liable for their corporation’s obligations if at incorporation they fail to provide adequate
capitalization. The shareholders must “put at the risk of the business unencumbered capital reasonable
adequate for its prospective liabilities.” Undercapitalization cannot be proved merely by showing that the
corporation is now insolvent. However, if insolvency occurs soon after incorporation, it may be a primary
indicator of undercapitalization.
• When there is undercapitalization of the corporation, the corporate veil should be pierced.
(CALIFORNIA RULE)
• Undercapitalization is used to protect the assets of the corporation. By not having sufficient funds the
financial liability of a corporation is limited.
• What is adequate capitalization?—enough to cover any liabilities. The only corporations that would be
hurt by such a rule would be those that should be held liable for under capitalization.
• However, if adequate capitalization is whatever you can be sued for, then this is not a workable standard.
When you charter a company there is no general minimum capitalization requirement. As a practical
matter, courts tend to stay away from insufficient capitalization in determining whether to piece the
corporate veil.
• Ultimately, there needs to be a balance between protection of consumers & encouraging investment in
business.
• Inadequate capitalization may occur when the corporation is set up with adequate initial capital, but the
Defendant Shareholder DRAINS OUT or SIPHONS all of the profits/capital through salaries, loans,
etc.
• when the share holder invests no money whatsoever in the corporation (ZERO CAPITAL or
CORPORATE SEHLLS), courts are likely to pierce the veil
• Uncertainty is the real reason that this is not the majority’s approach. Courts
avoid making under capitalization a measure for piercing the corporate veil because they are unprepared
to set an ultimate standard of what level of capital is adequate. It is theoretically appealing, but largely
impractical.
o Parent-Subsidiary Corporations – a parent corporation’s inadequate
capitalization of a subsidiary corporation may constitute constructive fraud on all
persons who deal with that subsidiary. One additional test should be applied here:
whether the subsidiary may reasonably expect to achieve independent financial
stability from its operation.
3. FRAUD or DECEPTION – (ILLINOIS Approach) – THIS IS ENOUGH ON ITS OWN

TO PIERCE THE VEIL
The corporate entity will be disregarded any time it is necessary to prevent fraud or to prevent an individual
shareholder from using the corporate entity to avoid his existing personal obligations. Note that the mere fact
that an individual chooses to adopt the corporate form of business to avoid personal liability is not, of itself, a
reason to pierce the corporate veil. The corporate veil will be pierced whenever the avoidance of personal
liability through the information of a corporation operates as fraud on creditors or other outsiders. Fraud also
occurs where there is a siphoning of corporate assets which leaves little in the company to pay the creditors
Totality of the Circumstances Test:

This incorporates the two-part Van Dorn Test: Was the corporate form the vehicle
for 1) Alter Ego - Where the shareholders fail to deal with the corporation as a

separate, distinct entity, the corporate shield will be disregarded (incorporates the
New York and California Approach), 2) Fraud (Illinois Approach)
Sea-Land Services, Inc. v. Pepper Source (1991) – Alter Ego Plus (Illinois)
Theory
RULE: “In order to pierce the corporation veil and impose individual liability, a creditor must
show (1) there was such a unity of interest between the individual and the corporate entity that
separate identities no longer existed, and (2) that a failure to do so would promote injustice in
some way beyond simply leaving a creditor unable to satisfy its judgment.”

Sea-Land engaged in business with Pepper Source. Pepper refused to pay Sea-Land for shipping so the
trial court ruled that Pepper had to pay damages. Sea-Land tried to collect these damages but Pepper
had dissolved for failure to pay its franchise taxes. Thus in order to claim his damages, Sea-Land
brought suit against Marchese, the shareholder of Pepper and 5 of his businesses. Sea-Land attempted to
pierce the corporate veil by arguing that all these businesses were Marchese’s alter egos.
ISSUE: Should the corporate veil be pierced simply to prevent the injustice that would result from a
substantial debt going unpaid?
HOLDING: NO; based on the record, these companies are Marchese’s playthings. Only one of the
companies has ever adhered to corporate formalities. All the companies share same legal expenses,
accounts, and were used to provide loans to Marchese. Here, the first element of the Van Dorn case
is satisfied – unity of interest. However, in order to pierce the veil, the plaintiff had to show that
honoring separate existences would promote a fraud or injustice. Sea-Land expounded on the notion
of injustice by asserting it would be unjust to allow Pepper to avoid his debt. The level of proof for
injustice is less than fraud. However, injustice cannot be shown through an unsatisfied debt. There
must be something more like unjust enrichment or intentional scheme to defraud creditors.
• Alter Ego Plus Theory: that the corporation was not kept as a separate entity and
there was fraud or unfairness.
o Basically: all of these corporations “are alter egos of each other, and hide
behind the veils of alleged separate corporate existence for the sole
purpose of defrauding P and other creditors.”
 REVERSE PIERCE
o attempt to not only hold the shareholder who is employing the corporation
as an alter ego personally liable, but also to reach the other corporation
entities that he maintains as further alter egos
 Court found that this piercing was NOT appropriate because Van Dorn’s second prong
had not been satisfied; the case was remanded for the second prong: In order to pierce
the corporate veil, the Plaintiff must show that: Van Dorn Test:
1. there is a unity of interest and ownership that the separate personalities of the
corporation and the individual [or other corporation] no longer exist
a) failure to comply with corporate formalities
i. shares not issued
ii. shareholder’s and director’s meetings not held
iii. financial records not maintained

b) commingling of funds or assets
c) undercapitalization
d) one corporation treating the assets of another corporation as its own; and
2. That adherence to the fiction of separate corporate existence would sanction a
fraud (intentional wrongdoing) or promote injustice.
 An unsatisfied judgment is NOT enough to show that injustice would be
promoted
  Need to show on remand that Marchese used these corporate
facades to avoid responsibility to creditors and unjustly benefited.
How do you satisfy these prongs?

(1) Check corporate records for: formalities (corporation run with undue dominion or control);
commingling of assets (moved in and out of corporation with reckless abandon, under-capitalization
(insufficient funds in corporate account to satisfy any judgments).
(2) Check to see if judgment in Defendant’s favor would result in some wrong beyond a creditor’s ability
to collect. Check to see if common rules of adverse possession would be undermined or if there would be
unjust enrichment. You can also check to see if assets have been intentionally placed beyond a reach of
judgment.
Walkovsky v. Carlton (1966) – New York Rule: Alter Ego Theory

RULE: “Absent an allegation that the defendant was conducting business in his individual
capacity, a complaint charging that an individual defendant organized a fleet of taxicabs in a
fragmented manner solely to limit his liability for personal injury claims is insufficient to hold the
individual liable for the claim.”

Walkovsky was injured when he was struck by a taxicab owned by Seon Cab Corporation and driven by
Marchese. Carlton is a stockholder in 10 taxicab corporations including the one at fault. Walkovsky
sued each of the 10 companies because each company shared the same financing, supplies, repairs,
employees, and garages all with minimum insurance. Walkovsky’s injury resulted in more damages then
the insurance policy allocated by the taxi company.
ISSUE: May a plaintiff recover against individual stockholders if a corporate structure limits the
corporations’ liability for personal injuries, even if there is no showing that the stockholders used the
companies for personal, rather than corporate gain?
HOLDING: NO; although the law permits individuals to incorporate solely to avoid personal liability,
courts disregard the corporate form as needed to prevent fraud and ensure equity. In deciding whether to
pierce the corporate veil, the courts are guided by general agency rules. If an individual controls a
corporation for personal gain rather than the corporation’s gain, the individual is responsible under
respondent superior for the corporation’s acts in commercial dealings and in tort claims. The plaintiff
fails to establish whether the defendants were acting in their individual capacities. There are no
allegations that the stockholder here commingled funds, that the companies were undercapitalized, or
that the stockholder is operating the business without regard to corporate formalities. The plaintiff
alleges fraud when no evidence exists of that.
NOTE: Alter Ego is a corporation used by an individual in conducting personal business, the result being
that a court may impose liability on the individual by piercing the corporate veil when fraud has been
perpetrated on someone dealing with the corporation. Alter Ego Rule is a doctrine asserting
shareholders to be treated as the owners of a corporation’s property, or as the real parties in interest,
whenever it is necessary to do so to prevent fraud or to do justice. The corporate veil is the legal
assumption that the acts of a corporation are not the actions of its stockholders, so that the stockholders
are exempt from liability for the corporation’s actions. Piercing the Corporate Veil is a judicial act of
imposing personal liability on otherwise immune corporate officers, directors, and stockholders for the
corporation’s wrongful acts.
o MINORITY RULE(California approach):

o inadequate capitalization IS enough for an involuntary creditor to pierce the corporate
veil ; no fraud or failure to follow corporate formalities is required
o  Hard to determine what adequate capitalization is and may discourage the corporate
form because the chance that the court may deem the corporation undercapitalized and
pierce it, thereby rendering Shareholders personally liable.
PIERCING THE CORPORATE VEIL IN A PARENT-SUBSIDIARY CONTEXT
• Parents are generally not liable for the debts of subsidiary if:
(1) proper formalities are observed,
(2) the public is not confused about dealing w/ sub or parent,
(3) the subsidiary is operated in a fair manner for profit, and
(4) there exist no manifest unfairness
• DELWARE COURTS DO NOT require a finding of fraud or like misconduct if

o a subsidiary is found to be the mere instrumentality OR
o alter ego of its sole stockholder (especially in a Tort action w/ an unaware
creditor)
• MAJORITY RULE: Van-Dorn Test
o (1) ALTER EGO (New York Rule)
o (2) FRAUD (Illinois Rule)
• If a corporation is so controlled as to be the alter ego or mere instrumentality of its shareholder, the
corporate form may be disregarded for the sake of justice.
Roman Catholic of San Francisco v. Sheffield (1971) – Van Dorn Test to

Enterprise Liability
RULE: “To impose personal liability under the alter ego theory, a corporation must not only be
influenced and governed by the individual, but there must be such a unity of interest and
ownership that the separateness of the person and the corporation has ceased, and the facts must
be such that adherence to corporate protections would sanction a fraud or promote injustice.”

In Switzerland, Sheffield visited a monastery operated by the Roman Catholic Church where he agreed
to purchase a dog. According to the agreement, he would pay $125 up front for the dog including
shipping and the remaining payments by installment till $175. After paying, the dog had not arrived to
his home in Los Angeles. He brings a breach of contract claim against the Catholic Church in San
Francisco, the Pope, the Vatican, etc. claiming they were all alter egos and thus shared a unity in
interest.
ISSUE: Is the Roman Catholic of SF the alter ego of the Pope, the Vatican, and the Roman Catholic
Church?
HOLDING: NO; Alter ego theory is imposed in situations involving an abuse of corporate privilege,
holding the equitable owner of a corporation to be liable for the corporation’s actions. The facts must
show a commingling of assets, one company holding itself as liable for the other’s debts, identical
equitable ownership of the two entities, use of the same offices and employees, and the use of one
entity as a conduit for the affairs of the other. The issue here is whether the Archbishop controls the
Canons Regular, not the Pope. The ego theory imposes liability upon the parent for the liability of its
subsidiaries. One subsidiary cannot be liable for another subsidiary’s actions merely because the parent
controls both. Injustice cannot be shown here by suing the church here than from abroad.
NOTE: Parent corporations utilize subsidiary corporations for a variety of legitimate business objectives.
As long as both parent and subsidiary observe proper corporate formalities and act as distinct, though
related, entities, the alter ego theory will not apply. If however, the parent uses the subsidiary
corporation to conduct business transactions or otherwise act on the parent’s behalf, the parent risks
liability for the subsidiary’s misconduct. (Parent Corporations have a controlling interest in the subsidiary
corporation and usually owns a majority of the voting stock).
ENTERPRISE LIABILITY (Brother-Sister Corps) if the various pieces are, for all economic
Purposes, a single business, the court may treat all the pieces as coming from one pot, from which all
creditors may be satisfied. Spin off of respondent superior.
o Viewed as a single enterprise despite the existence of corporate formalities.
o mixing pot of all subsidiaries idea
In re Silicone Gel Breast Implants (1995)

RULE: “If a parent corporation uses a subsidiary as its alter ego, as demonstrated by shared
common directors or business departments, consolidated financial statements and tax returns, and
an inadequately capitalized subsidiary, a plaintiff may assert its claims against the parent.”

Bristol Myers Co. bought MEC and it is its sole shareholder. Bristol Myers sits on the board of directors
of MEC. Bristol acts as MEC’s banker, sets its employment policies and wages, approves upper
management hires, permits MEC employees to participate in Bristol Myers’ pension plans, funded tests
on implant safety, monitored FDA regulations, audited MEC, tested MEC’s manufacturing process, and
included MEC’s income on its federal tax returns. Plaintiffs brings products liability suit against Bristol
Myers.
ISSUE: If a parent corporation exercised almost total control over the activities of its subsidiary, should
the court allow the plaintiffs to pierce the corporate veil between the parent and its subsidiary?
HOLDING: YES; the court notes that when a corporation has a single shareholder, the potential for
abuse is great. In determining the existence of an alter ego, a court should consider whether the
entities had common directors or officers, common business departments, or consolidated
financial statements and tax returns. The court may also consider whether the subsidiary is
adequately capitalized or relies on the parent for its business, whether the parent pays the
subsidiary’s expenses or uses the subsidiary’s property as its own, whether the subsidiary has
separate daily operations, and whether the subsidiary observes basic corporate formalities.
Evidence here concludes that these factors existed here to show that MEC was Bristol Myers’ alter ego.
Here, the defendant is also liable for negligent undertaking which includes rendering services to another
that are used to protect a third party. Under this theory, if a third party sustains an injury, the party
indirectly involved may be liable for the harm that results from an absence of due care if the actor
increases another’s risk of harm, performs a duty owed to another, and cause harm to a third party who
relied on the actor to perform his actions properly. Bristol Myers allowed its name to be placed on the
packages to boost customer confidence. It cannot complain now when it assumed the risk of purchasing
MEC and thus putting its name on their products.
NOTE: Usually, the parent-subsidiary relation alone is never sufficient to hold a parent responsible for
its subsidiaries’ torts. However, this case brought an exception since their activities were too inter-
related.
Rule: When a corporation is so controlled as to be the alter ego or mere

instrumentality of its stockholder, the corporate form may be disregarded in the
interests of justice. (There is NO NEED to show fraud or misconduct in alter ego
subsidiary cases.)
1. Totality of Circumstances: The totality of circumstances must be evaluated in determining
whether a subsidiary may be found to be the alter ego or mere instrumentality of the parent
corporation. Although the standards are not identical in each state, all jurisdictions require a
showing of substantial domination. Among the factors to be considered are whether:
1. The parent and the subsidiary have common directors or officers
2. The parent and the subsidiary have common business departments
3. The parent and the subsidiary file consolidated financial statement and tax
returns
4. The parent finances the subsidiary
5. The parent caused the incorporation of the subsidiary
6. The subsidiary operates with grossly inadequate capital
7. The parent pays the salaries and other expenses of the subsidiary
8. The subsidiary receives no business except that given to it by the parent
9. The parent uses the subsidiary’s property as its own
10. The daily operations of the two corporations are not kept separate
11. The subsidiary does not observe the basic corporate formalities, such as
keeping separate book and records and holding shareholder and board
meetings.
2. Negligent undertaking: (Tort) One who undertakes, gratuitously or for consideration, to
render services to another which he should recognize as necessary for the protection of a
third person or his things, is subject to liability to the third person for physical harm
resulting from his failure to exercise reasonable care to perform his undertakings, if
i. His failure to exercise reasonable care increases the risk or harm, or
ii. He has undertaken to perform a duty owed by the other to the third person, or
iii. The harm is suffered because of a reliance of the other or the third person
upon the undertaking
How can parent avoid the result in In re Silicon? The result could be avoided by maintaining separate entity
identity before the public, keeping separate boards, meetings and policies. Parents should probably also make
sure subsidiaries are adequately capitalized.
Parents have subsidiaries because:

1. People like to invest in companies they understand
2. Tax Reasons
3. Regulatory Reasons
4. Public Appearance Reasons
5. Other reasons (mergers, etc…)
 LLCs are pierce-able where there is an issue of fraud. This may occur when there is no separate
bank account.
Frigidaire Sales Corporation v. Union Property, Inc. (1977)

RULE: “Limited partners are not liable for the debts of a LP simply by their statues as officers,
directors, or stockholders of the corporate general partner as long as they conscientiously keep the
corporate matters separate from their personal business and no fraud or manifest injustice
results.”

Frigidaire contracted with Commercial Investors, a LP. Mannon and Baxter were limited partners who
served as officers and directors on Union Prop. These two ran the day-to-day affairs of Commercial.
When Commercial breached its contract with Frigidaire, Frigidaire sued Union Prop., Mannon, and
Baxter. Frigidaire asserts that Union Properties is the alter ego to Commercial and that Mannon and
Baxter are to be treated as general partners.
ISSUE: If a limited partnership’s general partner is a corporation, whose controlling members are also
the limited partners in the partnership, may a creditor treat the limited partners as additional general
partners?
HOLDING: NO; Limited partnership statutes allow a corporation to be an LP’s general partner.
Minimal capitalization of the general partner does not necessarily mean that the limited partners must
incur general liability because they control the general partner. If the general partner has been
inadequately capitalized, a creditor may without remedy pierce the corporate veil to recover its loss.
Frigidaire must look to Commercial and Union Properties to recover. Frigidaire knew UP was the
general partner of Commercial and did not ask for the personal guarantees of the individual defendants.
Commercial signed the contract and the plaintiff was not misled into believing the defendants were
acting as anything other than corporate officers.
C. THE CAPITAL STRUCTURE OF CORPORATIONS

Corporate capital comes from the issuance of many types of securities. Securities describe many
obligations including equity (shares of stock) and debt obligations (bonds). A debt security represents a
creditor-debtor relationship with the corporation, whereby the corporation has borrowed funds from an
outside creditor and promises to repay the creditor. A debt security holder has no ownership interest in
the corporation. These obligations usually have a stated maturity date and a provision for interest. Debt
obligations may be secured (a mortgage bond) or unsecured (a debenture) and may be payable either to
the holder of the bond or to the owner registered in the corporation’s records. These bonds may convert
into equity or may be redeemed at a specified price before maturity of the obligation.
An equity security is an instrument representing an investment in the corporation whereby its holder
becomes a part owner of the business. Equity securities are shares of the corporation, and the investor is
called a shareholder.
D. THE ROLE AND PURPOSE OF CORPORATIONS
All statutes provide that a corporation may be formed for any lawful purpose. Many state statutes still
require that the articles specify what the corporation’s purpose or purposes are, but permit a general
statement such as the corporation is formed for general business purposes or to engage in any lawful
business. At one time charitable donations were thought to be outside the scope of any business purpose,
but most states now allow corporations to make these donations. Also, some courts formerly held that
corporations did not have the power to make loans to employees, officers, or directors. Today, most
states allow such loans.
General Rule- Corporations exist for the benefit of the shareholders
CHARITABLE DONATIONS
• Charitable donations are NOT ULTRA VIRES
o Ultra Vires is anything not within statute or articles of incorporation
• CL RULE: donations are a reasonable way to promote corporate objectives unless manifestly
unreasonable
A.P. Smith MFG v. Barlow (1953)

RULE: “A corporation may make charitable contributions, even in the absence of express
statutory provisions.”

A.P. is a company that contributes regularly to colleges and the local community. The board donated
$1500 to Princeton University and the shareholders rejected. The president thought this was sound
business practice in promoting good will in the community. The donation also ensured interest by some
of its top graduates. The shareholders argue that this act goes against the business purpose in the
certificate of incorporation and that the statute the board relies on should not be applied retroactively.
ISSUE: May a corporation make charitable contributions in the absence of any specific authorization in
the company’s charter or the state’s statutes?
HOLDING: YES; early in history it was believed that the corporation must derive a benefit from its
contributions. However, since corporate economic wealth increased, many seek for these contributions.
In times of crisis, corporations have provided donations to maintain societal survival. The law does not
demand contributions, it encourages them and public policy supports these laws. The contribution was a
lawful exercise of power.
 DGCL § 122 “every corporation created under this chapter shall have the power
to . . . (9) make donation for public welfare or for charitable, scientific or
educational purposes, and in time of war or other national emergency in the aid
thereof”
Public Policy Wealth has shifted to Corp. and we therefore need to encourage contributions for the
arts and the benefit of society.
• There is no such thing as a Right to Dividends, they are discretionary
Dodge v. Ford Motor (1919)

RULE: “Although a corporation’s directors have discretion in the means they choose to make
products and earn a profit, the directors may not reduce profits or withhold dividends from the
corporation’s shareholders in order to benefit the public.”

Ford was incorporated with sizeable money. Its majority shareholder was Henry Ford and its minorities
were the Dodge brothers who received extraordinary dividends as the rest of the minority holders. The
dodge brothers received 1 million in dividends. Hennery however wanted to use the profits to purchase
an iron ore plant to make its own metal parts and he wanted to lower the price of his cars for the public
good. Because of this, he lowered the shareholder dividends down to 120,000 dollars per year. The
dodge brothers sued.
ISSUE: May courts interfere with a corporation’s internal operations by reviewing a board’s decision
and ordering the payment of dividends to its shareholders?
HOLDING: YES; the court found that because Ford was receiving astronomical profits year to year
and it furthermore practices the declaration of large dividends, the reduction of such dividends here is
arbitrary. The court here did not find Ford to be making charitable contributions. A corporation is
organized for the benefit of its shareholders. While a corporation’s directors may exercise discretion in
deciding how to reach that goal, it cannot divert profits from its shareholders and devote them to other
purposes. It is not lawful for a company to direct profits from the shareholders to others. As for its
future goals, the court cannot interfere in such judgment.
RULE it is up to the BD’s to declare dividends. “Courts of equity will not interfere in the
management of the directors unless it appears that they are guilty of fraud or
misappropriation of corp. funds, or refuse to declare a dividend when the corp. has a surplus
of net profits which it can, with out detriment to its business, divide among its stockholders,
and when refusal to do so would amount to a abuse of discretion as would constitute a fraud,
or breach of the good faith which they owe shareholders.” Decision to pay dividends must be
based on the interest of the entire C, not individual SH.
A business corporation is organized and carried on primarily for the profit of the
stockholders. The powers of the directors are to be employed for that end. The discretion of
directors is to be exercised in the choice of means to attain that end, and does not extend to a
change in the end itself, to the reduction of profits, or to the non-distribution of profits
among stockholders in order devote them to other purposes.
Additionally, management may consider the long term interests of the corp. over the short
tern interests of SH. C is not engaged in doing humanitarian work.
Shlensky v. Wrigley (1968) – Business Judgment Rule

RULE: “A shareholder fails to state a cause of action unless it alleges that a corporation’s
directors’ conduct was causing financial loss to the shareholder and was based upon fraud,
illegality, or conflict of interest.”

Shlensky is a minority shareholder of the Chicago NL Ball Club which manages the Chicago Cubs. The
club also manages Wrigley Field and is responsible for television and radio broadcasts, concession sales,
etc. Shlensky claims that the cubs are the only team that plays in the daytime and that because we play
in the day, we lose revenue. The last four years, the cubs have sustained financial loss which can be
attributed to poor attendance. Shlensky believes management should install lights and thus upgrade the
facility. Wrigley however refused this advice due to his concern about the quality of the neighborhood
surrounding the park. Wrigley said if they relocated, the cubs would be able to play at night.
ISSUE: Does a shareholder’s action that seeks to overturn a board’s decision and does not make
allegations of fraud, illegality, or conflict of interest state a cause of action?
HOLDING: NO; courts have historically given broad discretion to corporate managers for making
policy decision and typically give due regard for the board’s decisions unless the decisions are tainted.
Here, Wrigley chose not to install lighting due to the neighborhood that surrounds the park. Without
some showing that the defendant’s actions are based on fraud, illegality, or a conflict of interest, a court
should not interfere, especially because the plaintiff did not prove that the Cubs’ revenues would
increase with night games. With no correlation between installing lights and an increase in the
company’s revenues, the plaintiff has failed to establish serious and irreparable harm to the shareholders.
Directors are elected for their business judgment and courts cannot order their decisions to be
disregarded simply because others may disagree.
o Rule: The case stands for the proposition that courts are not going to interfere in companies’
short term decisions involving questions of policy and business management. The directors are
chosen to pass upon such questions and their judgment unless shown to be tainted with fraud,
illegality or conflict of interest. You can find a reasonable short or long term profit motive, court
will leave you alone.
NOTE: conflict of interest is a real or seeming incompatibility between one’s private interests and one’s
public or fiduciary duties.
Public Policy: Justifications for the Business Judgment Rule include:

1) Slippery slope if the court entered the board room
2) Courts are in the business of law, not business; courts are poor judges of business reality.
3) The market is the best judge of business decisions
4) Courts do not want directors to fear liability when making business decisions-would deter risk taking,
which would affect the overall economic performance of corps. A certain amount of risk taking and
innovation is essential for businesses to grow and proper.
5) Shareholders assume the risk voluntarily (Shareholder sovereignty)
If it’s really bad for the Company, shareholder can:
• vote the directors out of office
• sell their shares
• They should be the one to do something when they do not like their behavior (but
shareholders have many procedural handicaps.)
6) After the fact litigation is not a good way to evaluate business decisions gone bad. A reasoned
decision may seem a wild hung viewed years later against a backdrop of perfect knowledge.
7) Judicial Economy: fewer lawsuits
*********************************************************************

III. THE DUTIES OF OFFICERS, DIRECTORS,
and SHAREHOLDERS
*********************************************************************
A. THE OBLIGATIONS OF CONTROL: THE DUTY OF CARE
BUSINESS JUDGMENT RULE
THE EXAMINATION OF THE FIDUCIARY DUTY OF CARE AND DUTY OF LOYALTY
Under Delaware law, the Business Judgment Rule is the offspring of the fundamental principle,
codified in § 141(a), that the business and affairs of a Delaware corporation are managed by or
under its board of directors…. The rule itself is a “presumption that in making a business
decision, the directors of a corporation acted on an informed basis, in good faith and in
the honest belief that the action taken was in the best interest of the company and
therefore even though they make decisions that give rise to financial losses to the
corporation, they are not personally responsible for that loss. This encourages risk-taking. If
liability would incur, there would be no directors due to fear of lawsuit. The genius of corporate law
allows the board of directors to do what they do best, which is manage the business > Passive
investors committing their funds to an enterprise which then will be run under the direction of the
board of directors who then appoint officers who take care of the day-to-day tasks of the corporation.
NOTE: The Duty of care is the objective standard as such that it is

measured as to what a reasonable director or officer would have done in
that predicament. The breach of such care is triggered by some wrong
action by management or by no action or omission resulting form
inattention. Exception: Special skills heighten the standard. Examples include
CPA, lawyer, banker, etc… If one of these professionals learns of facts that would
make someone in his position suspicious, he must investigate those facts. Defendants
will not be responsible if they relied on the report or opinion of an expert. BUT-
reliance must be reasonable
Who makes the decisions? If there is a fundamental decision as to dissolution, sale of all
assets, amending the articles of incorporation, mergers and acquisitions, etc., the board of directors cannot
make this decision on its own. Shareholders have the ability to act when their interests are being
substantially affected which is provided in the statute.
The dichotomy of powers between the board of directors and shareholders – shareholders
elect board of directors…this is a proper subject for shareholder action, not officer issues as to the day-to-
day affairs of the corporation. Shareholders may propose amendments to the bylaws; some have the power
to amend the bylaws in certain states.
Board of directors is required to provide shareholders with notice for meetings, quorum, and voting
requirements.

RULE it is not the function of courts to resolve for corporations questions of policy and business
management. The judgment of the Board of Director’s enjoys the benefit of the presumption that it was
formed in good faith and was in the best interests of the corporation.
“In actions by stockholders, which assail the acts of their directors or trustees, courts will
not interfere unless the powers have been illegally or unconscientiously executed; or
unless it be made to appear that the acts were fraudulent or collusive, and destructive of
the rights of the stockholders. Mere errors of judgment are not sufficient as grounds for
equity interference, for the powers of those entrusted with corporate management are
largely discretionary.” Leslie v. Lorillard.
“Courts will not interfere with such discretion unless it be first made to appear that the
directors have acted or are about to act in bad faith and for a dishonest purpose. It is for
the directors to say, acting in good faith of course, when and to what extent dividends
shall be declared… The statute confers upon the directors this power, and the minority
shareholders are not in a position to question this right so long as the directors are acting
in good faith.” Liebman v. Auto Strop Company.
ALI § 4.01(c) A director or officer who makes a business judgment in good

faith fulfills the duty of care of the director
1. is not interested in the subject of the business judgment (no
conflicting self interest)
2. is informed w/ respect to the subject of the business judgment to
the extent the director or officer reasonably believes that it is
appropriate under the circumstances (adequately informed)
3. Rationally believes that the business judgment is in the best
interests of the corporation (not a wholly irrational response).
There must be no fraud, illegality, or conflict of interest.
• Though high deference is granted to the directors of a corporation, the Business Judgment Rule is
NOT absolute.
• Burden on the plaintiff. If the plaintiff rebuts the presumption, then you force the directors to
justify their conduct and the case would go to trial.
• Scrutinizes the process by which the director makes his decision while giving very little
examination to the decision itself
 “Business decisions made upon reasonable information and with some rationality
do not give rise to discretional liability even if they turn out badly or disastrously
from the standpoint of the corporation.” Other than in special situations
like MERGERS and PUBLIC OFFERINGS where DUE
DILIGENCE of investigation is required, the directors can rely on
the information provided them by officers and other employees, as
long as the reliance is REASONABLE and in HOOD FAITH.
•
It is a process orientated analysis, does not address the wisdom of the decision itself –
even when procedures are not followed, most courts impose liability only in cases of
gross negligence or recklessness. And conflict of interest.
• MORE THAN IMPRUDENCE OR MISTAKEN JUDGEMENT MUST BE SHOWN TO FALL
OUTSIDE BUSINESS JUDGMENT RULE
• courts will only interfere with a board’s decision to issue dividends when
FRAUD, OPPRESSION, ARBITRARY ACTION OR BREACH OF TRUST is
established
Kamin v. American Express Company (1976) – Duty of having a rational

basis (Duty of Care)
RULE: “A complaint alleging that some course of action other than that taken by the board would
have been more advantageous does not give rise to a cause of action for damages.”

Shareholders brought a derivative action, asking for a declaration that a certain dividend in kind was a
waste of corporate assets.
ISSUE: Are directors liable to stockholders for losses if a different action than that taken would have
been more advantageous?
HOLDING: NO; directors are liable only if their actions were illegal or unconscionable. Errors in
judgment do not warrant suits in equity. In order for a director to be negligent for his decision-making
process, the plaintiff must show that fraud, dishonesty, or malfeasance was present. The board had a
rational basis for its decision as such that it said if we sold the shares, and recognized the loss, it would
have a depressing effect on our stock price. The plaintiffs allege that it was not compelling. However, it
needs not be compelling; it needs to be supported by one school of thought.
NOTE: Public Policy concerns – if potential for liability were expanded to include situations in which other
avenues turned out to be more advantageous, the liability could encompass virtually every decision made in a
corporate setting. If a director is to be open to liability for his or her uncompromised decisions, few people will
seek out or accept a position on a board.
REQUIREMENTS IN APPLYING BUSINESS JUDGMENT RULE: If there is within the business

judgment of the directors, there is a presumption that the decision is correct and the court will not interfere.
Court will first look to see if proper procedures have been followed:
(1) THERE MUST BE NO SELF DEALING

o If a director is a party to a transaction or otherwise has some financial stake in the outcome that
is adverse to the corp’s stake, BJR does not apply.
(2) THE DECISION MUST BE INFORMED

o the director or officer must have gathered at least a REASONABLE AMOUNT OF
INFORMATION about the decision before me made it
o a totality of the circumstances will be examined in deciding whether or not a decision was
informed
o the standard is grossly negligent

Smith v. Van Gorkom (1985) – Duty to make a reasonable investigation
(Duty of Care)
RULE: “The Business Judgment Rule presumes that when making business decisions, directors
act on an informed basis in good faith and in the company’s best interests.”

 The process of becoming informed is extremely important to invoke BJR.
Director Defendant was approached with an offer to sell the corporation for $55 a share while shares
were selling for $39 on the open market
When Director Defendant presented this opportunity to sell to the Board of Directors, they hastily
made the decision to sell without being well-informed on the topic. Initially, they dissented but
eventually agreed due to the persuasion by Van Gorkem when he made several amendments. Prior to
finalizing the deal, Van Gorkem did not consult with the board about the financing of their shares, nor
did he want the comptroller to do the same. Van Gorkem thought it was good to sell the company to
Pitzer.
There were no investment bankers present. Here the Investment bankers hired too late and for the
wrong purpose (to solicit competing bids instead of appraise the one already offered).
the board was not shown a proposed merger agreement
Board of Directors passively relied on Director defendant’s oral statements in making their decision
Board of Directors didn’t even know the actual value of their own company which can be obtained
through a FAIRNESS OPINION (in this opinion, a reliable third party renders the value of the
company)
Director defendant made the offer, not the acquirer
Board of Directors made no real attempt to learn the intrinsic value of the corp. by conducting due
diligence (availing themselves of all relevant information
Board of Directors made the decision to sell in a 2 hour meeting with no advance notice
ISSUE: Is a board negligent in approving a proposed cash-out merger, if the merger was not the
product of informed business judgment, the board acted in a grossly negligent manner in approving
amendments to the proposal, and the board failed to disclose all material facts that they knew or
should have known before obtaining the stockholders’ approval?
HOLDING: YES; a party alleging that the board’s decision was not informed must rebut the
presumption that it is well-informed. To do so, the directors must have considered all information
reasonably available to them before making the decision. If they do not make an informed decision,
they must cure any defects in their decision as soon as they learn the problem. Here, the directors
approved the merger without determining Van Gorkem’s role in the process. The board did not know
of the corporation’s intrinsic value, nor did it have prior notice. The board here was not properly
informed nor did they cure the defects in its decision. They approved amendments without waiting for
them to be drafted for review.
• Court found GROSS NEGLIGENCE despite the fact that the selling price was much higher
than the market price for shares ever was. No informed decision. The meeting lasted only 2
hours as such the board could never propose any analytical questions as to the sale of their
company; there was no materials circulated in the meeting in regards to the sale; the board
never received inside or outside reports as to their actual stock value
• Consequences of Smith v. Van Gorkem- Boards immediately hire investment
bankers today before making any deals (FAIRNESS OPINIONS). Also, states have
changed their laws to limit liability or shield ONLY directors,
NOT OFFICERS from personal liability for breach of their duty
of care (NOT LOYLATY). Del. Corp. Law § 102(b)(7)- allows
corporations to limit liability for breach of Duty of Care in charter except in cases of self-
dealing or intentional misconduct. However, liability limited only to shareholders, not to 3rd
parties. Statutory change in response to exorbitant increase in insurance costs.
• PUBLIC POLICY: Directors must often make quick decisions with huge impacts.
Directors must trust that if their decision looks poor in hindsight, they cannot be sued if
they made their best efforts to understand the factors relating to the issue. If they are
not shielded from liability in those situations, business decision making processes will be
hindered by directors worrying whether they have adequately covered their steps.
(3) THE REQUIREMENT OF A RATIONAL BELIEF

o the director must have RATIONALLY BELIEVED that his business judgment was in the
corp.’s best interest
• BJR only protects directors from personal liability for negligence if they have not violated their duty of
loyalty to the corp.
• P must show fraud, illegality or conflict of interest
• Exceptions To Business Judgment Rule:

1. when the corp. decision lacks a business purpose
2. when the corp. decision is tainted by a conflict of interest
3. when the corp. decision is so egregious to amount to a no-win
situation
4. when the corp. decision results from an obvious and prolonged
failure to exercise oversight or supervision
 JUST BECAUSE A CORP MADE A BAD DECISION MEANS DOES NOT MEAN IT’S GUILTY.
BJR PROTECTS AGAINST THIS
DUTY OF CARE
“A director’s duty of care does not exist in the abstract, but must be considered in relation to
specific obliges. In general, the relationship of a corporate director to the corporation and its
stockholders is that of a fiduciary. Shareholders have a right to expect that directors will
exercise reasonable supervision and control over the policies and practices of a corporation.
The institutional integrity of a corporation depends upon the proper discharge by the
directors of those duties.”
The duty of care has three distinct elements: the

obligation to be attentive, the obligation
to carry out a reasonable investigation (must be informed under a reasonable
basis), and the obligation of having a rational basis for your decision. The burden
is on the plaintiff in proving that this presumption is inapplicable because there is a prima facie case for a

breach of fiduciary duty of care. The plaintiff also has to prove that the losses were the proximate cause
of the breach of duty.
Definition- The law imposes on a director or officer a duty of care with respect to the corporation’s business.
Procedure – Director
is given the presumption of good faith and Plaintiff has the
burden of presenting a prima facie case of breach of duty. If that is shown,
then the burden shifts to the Director to show that they just made the right
business decision.
Success – Breach of duty of care cases are generally successful ONLY when there is
reckless, or grossly negligent behavior.
NOTE: a knowing violation of a criminal statute automatically removes the protection of the business
judgment rule from the directors and officers. That does not mean they are automatically liable unless
the plaintiff can prove that there was a net loss – if the company has benefitted from the criminal
violation as such to exceed its losses, no harm, no foul, thus no recovery. The plaintiff has to prove that
crime did not pay.
States Attempts to Limit the Duty of Care:

· Some states allow articles of incorporation to include limitations on liability
· Some states require outrageous conduct for a breach
· Some states limit the amount of money damages that can be awarded
· Most states allow the corporation to indemnify for liability
• Officers & Directors are required to behave with the level of care that a reasonable prudent
person in a similar situation would use
• Shareholders often assume the risk of bad business judgment, after the fact judgment is
an imperfect device to evaluate business decisions, and if liability were imposed too
readily it might deter many persons from serving as directors.
• Officers & Directors may be held personally liable for money damages to the corporation
(through a derivative suit), if their breach of the duty of care causes loss to the corporation
• Corporations however protect their Officers & Directors by purchasing insurance
• Rare that courts find a violation of the duty of care, most successful actions
against Officers & Directors are based on breach of duty of loyalty
• Courts should not look into the content of Director’s decision, only the process (BJR)
• To bring an actionable claim, P must show when fraud, oppression, arbitrary action, or
breach of trust is established
• Director’s duty to monitor – a lack of monitoring requires sustained and systematic overlook
of the board.
DUTY TO MAKE INFORMED DECISIONS REGARDING THE CORPORATION

• Officers & Directors must act in an informed basis, availing themselves to all
material info reasonably available
• Officers & Directors may not passively rely on info provided by other Officers &
Directors
•  duty to make further investigations on credible info provided by competent
individuals
• Smith v. Van Gorkom
DUTY TO DISCLOSE: A combination of the fiduciary duties of care and loyalty

gives rise to the requirement that a director disclose to shareholders all
material facts bearing upon a merger vote.
DUTY RE: COMPENSATION OF OFFICERS & DIRECTORS:
Brehm v. Eisner (2000) – Can be applied to Duty of Loyalty

RULE: “In order to constitute waste, an exchange must be so one-sided that no person of a
reasonable mind would have entered into it.” – THE WASTE TEST IS VERY STRINGENT

Eisner, CEO for Walt Disney hired Ovitz to be President. Ovitz has no managing experience. However,
he was rewarded a very lucrative contract with favorable provisions. Upon resigning, he received over
15 million dollars under the provisions of his contract and the vesting of 3 million A-stock shares. A
derivative suit was brought by Brehm and other shareholders due to the extravagant and wasteful
employment package Ovitz received. Plaintiff alleged that the Board failed properly to inform itself
about the total costs and incentives of the Ovitz employment agreement, especially the severance
package.
ISSUE: Are corporate directors personally liable for lack of adequate care in the decision-making
process that results in a waste of corporate assets?
HOLDING: YES; if the directors fail to use adequate care in decision making process and waste
corporate assets, they are personally liable to the corporation for their breach of fiduciary duty. The
waste test is stringent so the courts grant enormous deference to the officers and directors. The size and
structure of executive compensation are matters of judgment, so waste regarding executive
compensation generally involves squandering money irrationally or giving away corporate assets. Each
director has a duty to be informed of all information material to his or her decisions. Here, the board
relied on expert testimony in determining financial pitfalls. The board’s decision here does not
constitute waste.
NOTE: Courts will not use the doctrine of waste to punish directors simply because a decision results in
economic hardship to the corporation or its stockholders.
Rule: Legal presumption that the board’s conduct was a proper exercise of business judgment.
That presumption includes the statutory protection for a board that relies in good faith on an
expert advising the board.
Rule: In making business decisions, directors must consider all material information reasonably
available, and that the directors’ process is actionable only if grossly negligent. This does not
mean that the board must be informed of every fact. The board is responsible for considering

only material facts that are reasonably available, not those that are immaterial or out of the
board’s reasonable reach.
In order to pass the Waste Test, Plaintiff must allege particularized
facts and show that:
• the directors did not in fact rely on the expert;
• their reliance was not in good faith;
• they did not reasonably believe that the expert’s advise was
within the expert’s professional competence;
• the expert was not selected with reasonable care by or on
behalf of the corporation, and the faulty selection process was
attributable to the directors;
• the subject matter that was material and reasonably available
was so obvious that the board’s failure to consider it was
grossly negligent regardless of the expert’s advice or lack of
advice;
• That the decision of the board was so unconscionable as such
to constitute waste or fraud.
Waste Test: an exchange that is so one sided that no business person of
ordinary, sound judgment could conclude that the corporation has received
adequate consideration.
DUTY TO KEEP INFORMED AND TO OBJECT
• at a minimum, Officers & Directors should acquire a rudimentary understanding of the
business
• a lack of understanding cannot be a defense
• Basic Obligations of Officers & Directors

(1) Continued obligation to keep informed (attend meetings)
(2) General monitoring of corporate affairs and policies
• even where the Board has no prior reason to detect wrong doing, they are required
to have in place reasonable control systems to detect wrongdoing
(3) Familiarity of financial status (or be informed about the performance of the company)
(4) Be vigilant and make the appropriate degree of inquiry
(5) Duty to object
• correct conduct/ resign when illegal conduct is discovered
• failure to do so amounts to “passive negligence” or nonfeasance
(6) Act for the general welfare of the corporation
Francis v. United Jersey Bank (1981) –Duty to be attentive

RULE: “Directors have the duty to act honestly and in good faith and with same degree of
diligence, care, and skills that a reasonable prudent person would use in similar circumstances.”

Lillian Pritchard inherited 48% interest in P&B Company from her husband. She was the largest
shareholder and director but was not active in the business and knew nothing of its dealings. She also
paid no attention to her duties as director and she also had alcohol problems. Her sons Charles and
William were also directors and owned the remaining shares. Charles was the manager. The sons
withdrew a large sum of money in the form of loans in which they should have been held in trust for its
clients. (Embezzlement) The company went bankrupt after the misappropriation of the funds. Lillian
died thereafter and made no effort to ensure that the company’s policies and practices complied with
industry custom or laws. The corporation’s bankruptcy trustee sued to recover the funds for the benefit
of the bankrupt estate.
ISSUE: Can an inattentive and uninterested director be held liable for a corporation’s actions?
HOLDING: YES; corporate directors are usually afforded broad immunity for their decisions and
actions related to corporate matters. However, the director of a corporation stands in a fiduciary
relationship to both the corporation and its stockholders. Inherent in this role is a duty to acquire a basic
understanding of the corporation’s business, and a continuing duty to keep informed of its activities.
This entails an overall monitoring of the corporation’s affairs, and a regular review of its financial
statements. Such a review may present a duty of further inquiry. Pritchard had a duty to protect the
clients of company against policies and practices that would result in the misappropriation of money
they had entrusted to the corporation. She breached and blatantly ignored that duty to the shareholders,
which included basic knowledge and supervision of business.
NOTE: When a director has no working knowledge of a business, a director may either make an inquiry to
gain the necessary knowledge or the director may refuse to act and step down. It is obvious that if the
director refuses to act, someone needs to act in his or her place. However, the director must make a wise
choice if delegating duties and must closely monitor persons making decisions on the corporation’s behalf.
Informed decision: The business judgment rule shields directors or officers of a corporation from liability only
if, in reaching a business decision, the directors or officers acted on an informed basis, availing themselves of
all material information reasonably available. Therefore, under the business judgment rule there is no
protection for directors who have made “an unintelligent or unadvised judgment.” DL § 141(e)
DUTY TO SUPERVISE/MONITOR
• A director’s obligation includes a duty to attempt in good faith to assure that a corporation’s
information and reporting system (in which the Board concludes as adequate) exists; and the
directors have an affirmative duty to set up monitoring systems to prevent illegal acts by
employees, even before they suspect illegal activity.
o failure to do so under any circumstances may render a director liable for losses caused
by non-compliance with applicable legal standards
• Absent grounds to suspect deception, neither corporate boards/officers can be charged with
wrongdoing simply for assuming the integrity of employees and the honesty of their dealings on the
company’s behalf.
BUT
• Even where the Board has no prior reason to detect wrongdoing, they are required to have in place
reasonable control systems to detect wrongdoing
• If an officer or director are put on notice of facts that would make a reasonable
person suspicious that wrongdoing is taking place, they must act.
In re Caremark International Inc. (1996)

RULE: “Although directors have a duty to monitor a corporation’s ongoing operation, they are
not liable for wrongdoings of which they had no real or constructive knowledge.”

Caremark’s shareholders have brought an action claiming that Caremark’s Board of Director’s breached
their fiduciary duty of care by failing to adequately supervise the conduct of the Caremark employees
whose violations initiated the suit.
ISSUE: Are directors always liable for breach of duty for their failure to monitor the corporation’s
ongoing business operations?
HOLDING: NO; directors are not liable for activities they know nothing about or have reason to know
about. If directors have no grounds to suspect deception by their employees, they cannot be liable for
assuming their employees are acting honestly and diligently on their behalf. The degree to which
directors monitor employees at each level is a question of business judgment, best left up to the
corporation. No evidence here shows that Caremark’s directors knew of any wrongdoings or that they
should have known of such wrongdoings. Caremark’s managers believed the employees were not doing
anything illegal.
NOTE: Requiring directors to manage the day-to-day activities of each employee would waste resources and
is not feasible in large corporations. Also constant monitoring would hinder workplace progress.
 Directors are protected from liability if their decision was the product of a process that
was either deliberately considered in good faith or was otherwise rational.
 Absent cause for suspicion there is no duty upon the directors to install and operate
corporate system of espionage to ferret out wrongdoing which they have no reason to suspect
exists.
 Breach of duty of care for lack of monitoring requires a sustained or systematic failure of
the board to exercise oversight.
 The level of detail that is appropriate for the requisite information system is a question of
business judgment.
• ESTABLISHING A CAUSE OF ACTION FOR A BREACH OF DUTY TO
SUPERVISE/CONTROL
• the directors knew or should have known
• that violations of the law were occurring, and in either event
• that the directors took no steps in a good faith effort to prevent or remedy
the situation and
• that such failure was the proximate cause of the alleged loss
DGCL §102(b)(7): Provision eliminating/limiting the personal liability of a corp. director or its
Shareholders for monetary damages for breach of fiduciary duty as a director, provided that such
provision not eliminate or limit the liability for (i) breach of duty of loyalty to the corp.; (ii) for acts of
omissions not in good faith or which involve intentional misconduct or a knowing violation of the law
(iii) relating to the payment of dividends or (v) for any transaction from which the director derived an
improper personal benefit
 allows corps to limit the liability of their Officers &Directors for breach of duty, BUT NOT
BREACH OF LOYALTY

Passive negligence: A director will not be liable merely for failing to detect wrongdoing by officers or
employees. However, if the director is on notice of facts suggesting wrongdoing, he cannot close his eyes to
these facts. Also, in large corporations, it may constitute a violation of due care for the directors not to put into
place monitoring mechanisms (e.g., stringent internal accounting controls, and/or an audit committee) to detect
wrongdoing. Joy v. North
• Absent directors are held to the same standard as directors who attended the meeting during which the board
approved a particular action.
B. THE DUTY OF LOYALTY

A director owes a duty of loyalty to her corporation and will not be permitted to profit at the
expense of the corporation. The problems in this area involve the (1) director’s dealings with
corporation and their potential conflict of interest; (2) their dealings with third parties and
their usurpation of a corporate opportunity; and (3) their dealings with shareholders, which
may raise insider trading issues. Directors are obligated to act in a manner to advance the
interests of the corporation. Thus they must act in good faith. In sum, the officers and
directors breach their duty of loyalty by acting greedy – they put their own financial interests
ahead of the interests of the corporation or its shareholders.
NOTE: The Duty of Loyalty looks at a director’s intent, motives, and purposes,
and if they are in conflict with the corporation, then a director will be seen to
have violated his duty of loyalty. This is a subjective standard. Immunity
shields in state statutes protect directors from breaches in a duty of care, not
loyalty.
When is the Duty of Loyalty invoked?
1) Interested Contracts
2) Corporate Opportunity
3) Defection to a Competing Business
4) Insider Trading
INTERESTED CONTRACTS (Conflicts of Interest)
NOTE: this precludes the application of the Business Judgment Rule.
§ 144(a) No contract or transaction between a corporation & 1 or more of its directors

or officers or between a corporation and any other corporation …shall be void or voidable
solely because the director has a financial interest or participates in the meeting of the
board that authorizes the transaction, or because his votes are counted, if:
(1) the material facts are known to the board or fully
disclosed to the board and the board authorizes the transaction in good faith by
affirmative vote of disinterested directors and the interested director abstains
from voting; or
(2) same language… disclosed or known to the
shareholders entitled to vote and approved in good faith by vote of the
shareholders; or
(3) the contract or transaction is fair to the corporation as
of the time it is authorized, approved, or ratified by Board, committee, or
Shareholders
• Interested Director must disclose and abstain under § 144(A)(1) &
(2)
• If requirements of § 144(A)(1) or (2) are followed, P has the burden
of defeating the BJR
• much more common than breach of duty
 BE AWARE OF THE STRUCTURAL BIAS AND HOW IT MAY COME INTO PLAY
• there may be an element of “you scratch my back and I’ll scratch yours” within the BOD
§ 144(a) Arises and is invoked in 3 instances

(1) Key player and corporation are on opposite sides
(2) Key player has helped influence the corporation’s decision to enter the
transaction
(3) Key player’s personal financial interests are at least potentially in conflict with
the financial interests of the corporation
WORKING FOR A COMPETITOR

• Director may not compete with a corporation where his competing is likely to harm the corporation
• director violated duty simply by preparing to compete
• director may have his competing actions approved by disinterested directors, ratified by shareholders
after a full disclosure
• where a director has a personal interest in a transaction which his

corporation is considering, he is ordinarily obliged to a) disclose that
interest to the entire board of directors; b) refrain from voting upon it; and
c) disclose any information indicating that the transaction may not be in the
corporations’ best interests (thus the contract must be fair to the
corporation).
Old Rule- Plaintiff must prove that the director has an interested stake in the outcome of the transaction so
that her advocacy on behalf of the corporation is biased, and that this director had the ability to influence the
other directors. Thus a mere showing that a director or officer had a financial stake on both sides of a
transaction was enough to void the transaction. It would not have matter whether the corporation benefitted
from the transaction. This rule was eventually changed because it is sometimes favorable to have interested
parties on the Board.

New Rule- Codified in Del. § 144(a)(1-3): The general approach of these statutes is that even if there
is a conflict of interest, the transaction is not voidable if certain statutory tests are met. In Delaware, its statute
incorporates a three step process of analysis:
(1) Is the transaction within the statute? [A transaction falls within the statute if the
transaction is between the corporation and an officer or director of the corporation who
has a direct or indirect interest in the transaction]
(2) What is required by the statute to avoid voidability? [First, full disclosure of all
material facts concerning the conflict of interest and the transaction; second, ratification
of the transaction by a majority of the disinterested directors; third, if cannot get director
or shareholder ratification, the interested party can still defeat voidability if one can meet
the burden of proving that the transaction was fair.
(3) What is the effect of satisfying the statute? [If the requirements of the statute are
satisfied, the transaction is not voidable, even though there was a conflict of interest].
PLAINTIFF’S BURDEN Procedure
Plaintiff must show that the Board knew of the officer/member’s personal
interest (must be financial) and that the decision was approved through a
formal meeting and vote amongst only interested parties.
If he satisfies that burden, then it shifts to the Defendant to show that their actions
complied with § 144(a)(1) or that the decision was fair to the company. If established,
BJR attaches and no liability found.
• RULE a proponent of the contract must affirmatively establish that the contract was fair
and reasonable as to the corporation at the time it was approved by the board § 144(A)(3)
There are three ways of overcoming direct and indirect conflicts of interest: (1) full
approval by the board of directors (disclosure) and by a majority approval of the
disinterested board members, (2) full approval to the shareholders (disclosure) and
approval by a majority of the disinterred shareholders, (3) if neither of these occur, the
burden of proof is on the interested party to uphold the transaction as such to show that
there was full disclosure of all material facts, it has a benefit to the corporation, and there
were disinterested approval. If no disinterested director or shareholder can be obtained,
then the transaction can be upheld by showing that it is fair.
· Interested contract is ok so long as the Board is aware of the conflict and the vote is conducted
only amongst disinterested parties (disclose & abstain rule)
· Interested contract is ok in a closely held corporation so long as the director tells the
shareholders and abstains from the vote.
· Interested contract is ok if it is fair to the corporation at the time it is authorized, approved or
ratified by the Board, committee, or shareholders.
• Standard  Does director have personal stake? Did this stake lead him to make bad decisions? Did it
sway his judgment? Did director have enough clout to sway the whole Board (Structural Bias)? Is
there an “appearance of impropriety?”
• a director’s dealings with the corporation are subjected to rigorous scrutiny
• burden is on the director to (1) prove the good faith of the transaction, and
(2) show the inherent fairness from the point of view of the corporation

Bayer v. Beran (1944)
RULE: “A director does not breach his or her fiduciary duty by approving a radio advertising
program in which the wife of the corporate president, who was also member of board of directors,
was one of the featured performers.”

CCA has been advertising its products at a high rate, but also got one of their directors to campaign by
singing. This director is the wife of CCA’s president. When the FTC announced that all of their
products had to be labeled rayon, they believed it would hurt their sales so they had to advertise to the
public to gets their message across. They spent 1 million per year. Bayer and other shareholders
brought a derivative action for breach of fiduciary duty in approving this radio advertising program.
ISSUE: Does a director breach his fiduciary duty by approving a radio program in which the wife of the
corporate president, who is a member of the board, was one of the featured performers?
HOLDING: NO; directors have no duty to act out of self-interest, which is known as the rule of
undivided loyalty. The rule’s purpose is to prevent fraud. The court may apply the rule in situations
where the director stands to benefit personally from the transaction or works so closely with the third
person that he may take advantage of that person for his own benefit. The directors here did not breach
that duty. The evidence does not show that program was to enhance the wife’s career or give her
financial benefit. She is only one of several performers on the program and is well-known before the
program campaign. Her wages were comparable to other performers. Furthermore, the show was
successful and produced revenue for the corporation. Though there was no disclosure of the program
campaign, it was nonetheless inherently fair.
o Court found under the modern day §144(a)(3) standard that although he didn’t disclose and
abstain to the board his conflict, the contract was still fair for the corp.
o The general rule is that Board members acting separately cannot bind the company. Here,
subsequent actions of the full Board indicated that the decision was approved. However, the
Board was required to observe the formalities in the future.
• BUT than what is the point of having a formal board and strict rules of corporate formality?
• * CONFLICTS of INTEREST * hurt the Shareholders of a corporation. To find a
conflict, you ask: 1. does the director have a personal stake (substantial
interest) that will bias a business decision and 2. Does the interested
director have the clout to sway other independent directors to share the
same bias?
• If a plaintiff can show the director has a bias and the directors went a long with that
bias, a court may still allow the interested contract to stand.
Lewis v. S.L. & E. Inc. (1980)

RULE: “A transaction in which a director has an interest, other than as the corporation’s
director, is automatically suspect and subject to further review.” – DIRCTORS MAY NOT
ENGAGE IN SELF-DEALING

LGT occupied SLE premises through a lease. Managers of LGT were also shareholders of SLE and SLE
shareholders have not met in quite sometime. LGT ignored the corporate existence to SLE, not taking

into account its other shareholders and their needs though most decisions made by SLE largely benefited
LGT.
ISSUE: Do directors commit waste by failing to charge adequate rent for property out of self-interest?
HOLDING: YES; a director’s interest in a transaction other than the corp.’s interest is subject to review
unless the director can prove it is fair and reasonable to the corporation. Here Ds’ failed to prove that the
rental paid by LGT to SLE was fair and reasonable. There was no evidence that the parties tried to
uncover the fair rental value. SLE had a strong interest in the amount of money LGT paid them since
they were not on the corporate board for LGT and LGT sat on their board.
o Rule: BJR presupposes that there isn’t a conflict of interest. Directors may not immunize
their actions under the BJR where a shareholder demonstrates a conflict of interest.
o Rule: a contract between a corporation and an entity in which its directors are interested may
be set aside unless the proponent of the contract shall establish affirmatively that the contract
or transaction was fair and reasonable as to the corporation at the time it was approved by the
board.
CORPORATE OPPORTUNITIES (DISCUSS BOTH AMERICAN LAW INSTITUTE AND

GENERAL TEST)
This doctrine only applies in cases where the fiduciary’s seizure of an opportunity results in
a conflict between the fiduciary’s duty to the corporation and the self-interest of the director.
PUBLIC POLICY: You don’t want directors to exploit the board for personal
reasons/interests
Seizing a corporate opportunity violates the basic rule that directors and officers cannot
utilized their positions with a corporation to whom they owe fiduciary duties to profit
personally at the expense of the corporation. However, this may be difficult to apply since
courts try to strike a balance between 2 conflicting policies (1) discouraging disloyal behavior
by directors and officers toward the corporations they serve; and (2) permitting directors and
officers of corporations to engage in entrepreneurial activities in their individual capacity.
Over the years, courts have not developed a clear test to determine which opportunities
belong to the corporation and which opportunities the directors and officers may take for
themselves.
FIVE major approaches of determining whether an opportunity is a corporate

opportunity:
(1) Interest or expectancy – imposes the least demands on the directors or officers in terms of seizing the
opportunity; thus, this restricts a director or officer from taking property or a business opportunity for
himself where the corporation has an existing interest in the property or opportunity or has an
expectancy growing out of an existing interest, i.e. leasing space in a building,
(2) Line of business test (General Test) – wide/liberal test – an officer or director must turn over to the
corporation any opportunity which is in, or relates to, the corporation’s business (what are the activities
the company is currently engaged in or likely to engage in).

If a corporate officer or director is presented with a business opportunity which the corporation is
financially able to undertake, is in line with the corporation’s business, is of practical advantage to it
and is one in which the corporation has an interest, the self-interest of the officer or director will be
brought into conflict with that of the corporation, the law will not allow him to seize the opportunity
for himself.
“If there is presented to a corporate officer or director a business opportunity which

the corporation is financially able to undertake, is from its nature, in line of the
corporation’s business and is of practical advantage to it, is one which the corporation
has an interest or a reasonable expectancy, and, by embracing the opportunity, the
self-interest of the officer or director will be brought into conflict with that of the
corporation, the law will not permit him to seize the opportunity for himself.” Guth v.
Loft.
 GARTEN DOESN’T LIKE THE GENERAL TEST because how can you
determine if a corporation is financially able to undertake the venture?
 its not fair that decisions can be made by a single individual with everything to
gain without going to board first
 that’s why the ALI approach is preferable in this analysis
• they can always raise funds or take on a debt to seize the corporate
opportunity
• DAMAGEScourt may impose (1) a constructive trust – transferring the property attached to the
opportunity to the corp., and (2) an accounting for profits
(3) Fairness test – seizing a corporate opportunity is a matter of fairness. Courts apply several factors
such as (1) did the information come to the defendant by reason of his position with the corporation, (2) how
important the opportunity was to the corporation, (3) was the corporation seeking the opportunity, (4)
whether the defendant used corporate funds or facilities in acquiring or developing the opportunity, and (5)
whether the corporation had the resources to develop the opportunity.
(4) Multi-factor test (2 step test) – this test combines the line of business test with the fairness test. The
court first determines whether the opportunity is within the corporation’s line of business, if it is within
the line of business, then the court considers whether it was nevertheless fair for the defendant to pursue
the opportunity. The burden of proof is on the plaintiff as to whether the opportunity falls in line with the
business. If the plaintiff meets this burden, then the burden shifts to the defendant to show that despite
being in the same line of business, defendant’s taking of the opportunity was fair based on equitable
considerations.
(5) ALI Test – defines a corporate opportunity as a business opportunity that (1) the director of officer
becomes aware of in his corporate capacity or through the use of corporate information or property,
which the director or officer should reasonably know is being offered to the corporation or reasonably
believes would be of interest to the corporation; or (2) the director or officer knows is closely related to a
business in which the corporation is engaged or expects to engage. If there is a corporate opportunity,
then question becomes whether the taking of the opportunity was approved in a manner which generally
requires the officer or director to make full disclosure and give the corporation the chance to take or
reject the opportunity. (DISCLOSE & WAIT RULE). Director to whom the corporate opportunity has
come may only act after full disclosure to the corporation and their (a majority of disinterested directors
or shareholders) decision not to take action in exploiting it

• “A corporation’s directors, officers, and employees are precluded from using
information gained in corporate capacity to take personal advantage of any
business opportunity that the corporation has an expectancy right or property
interest in, or that in fairness should otherwise belong to the corporation.”
• When a director or senior executive seizes for himself a business opportunity that is found to belong
to the corporation, the doctrine will preclude such action since it breaches his fiduciary duty to the
shareholders and the corporation. The fiduciary duty of loyalty requires Officers, Directors, full-time
directors and controlling shareholders NOT TO DIVERT a corporate opportunity that properly
belongs to the corporation for their own benefit. A key player must first offer the opportunity to
the corporation.
• Under this theory, a director is obligated to refrain from gaining any personal
advantage to the detriment of his company as a consequence of information derived
through his corporate position.
• DEFENSES: If the corporate opportunity is offered to the corporation with full disclosure and an
impartial board declines to take the opportunity, thus this alone will be a complete defense from suit.
Thus the inquiry comes into play as to whether the board was in fact IMPARTIAL and whether
there was FULL DISCLOSURE.
• REMEDY: The remedy to a corporate opportunity seized is to place the property or opportunity
wrongfully acquired and any profits derived there from in a constructive trust for the benefit of the
corporation.
Courts will consider:

1. Whom and when did the opportunity present itself to and in what capacity
(individual or corporate manager; outside director or full time employee).
2. Whether the company was financially capable to exploit the opportunity
(controversial b/c corps can always raise funds OR creates an incentive for
executives to prevent raising of cash and may encourage them to divert funds)
3. Did the corp. have an interest or expectancy of the opportunity (corp. may
have an expectancy to renew corp. lease)
4. Is the opportunity closely related to the corps existing or prospective line of
business (is there a functional relationship between the corps current line of
business and the opportunity)
5. Is the corp. unable to exploit the opportunity – legal (antitrust) or refusal (of
offeree)
6. Was the opportunity fully disclosed and rejected by a majority of the
disinterested Directors or shareholders (formal presentation creates a “safe
harbor”
Broz v. Cellular Info. Systems, Inc. (1996)

RULE: “Under the doctrine of corporate opportunity, a corporate fiduciary must place the
corporation’s interests before his or her own interests in appropriate circumstances, but a
corporate fiduciary does not breach his or her fiduciary duty by not considering the interests of
another corporation proposing to acquire the corporation in deciding to make a corporate
purchase.” – DIRCTORS MUST PUT A CORPORATION’S INTERESTS BEFORE THEIR
OWN INTERESTS

Broz is the President and sole stockholder of RFB Cellular, Inc (RBC). At the time of the conduct at
issue, Broz was also a member of the board of directors of CIS. The conduct before the Court involves
the purchase by Broz of a cellular telephone services license for the benefit of RBC. CIS brings suit for
breach of fiduciary duty alleging Broz to put his interests before that of CIS.
ISSUE: Does a corporate fiduciary breach his or her duty by not considering the interests of a
corporation proposing to acquire the corporation in reaching a decision to make a corporate purchase?
HOLDING: NO; Broz as a fiduciary to CIS must put the corporation’s interests first, not his. However,
CIS did not have a valid expectancy interest in the license. CIS was not offered an opportunity to
purchase Michigan-2, RBC was. Michigan-2 did not have an equity interest in CIS. Furthermore,
acquiring Michigan-2 did not create any duties that conflicted with his obligations to CIS nor did it seize
any opportunity that CIS was willing and able to pursue.
 There are two exceptions to the Business Opportunity Rule

Refusal to Deal as a Defense: Refusal to deal has not been favored as a defense, for diverting a corporate
opportunity, unless the refusal has first been disclosed to the corporation. Without full disclosure it is too to
verify the unwillingness to deal and too easy for the executive to induce unwillingness. Two
requirements: (1) unambiguously disclose refusal to corporation and (2) fair statement
of reasons for that refusal.
In re eBay, Inc. Shareholders Litigation (2004)

RULE: “The fiduciary duty of loyalty requires directors and officers to offer investment
opportunities derived from corporate business to the corporation before acting on them
individually.” – OFFICERS AND DIRCTORS MAY NOT SEIZE A CORPORATE
INVESTMENT OPPORTUNITY

Individual eBay directors and officers accepted high-profit IPO investments from Goldman Sachs as an
incentive for maintaining a future business relationship. The shareholders alleged that this profit
rightfully belongs to eBay and that the directors and officers seized a corporate opportunity. The
shareholders filed for a derivative suit against the directors and officers.
ISSUE: Did the eBay shareholders state a claim for breach of duty of loyalty and for aiding and abetting
the breach?
HOLDING: YES; shareholders alleged that the directors and officers took a corporate opportunity that
was not in line with eBay’s business, but rather presented them with individual wealth. Here, the
defendants were extended an offer as inducement to continue doing business with them. Acceptance
clearly creates a conflict of interest between them and the corporation. Even if it was not an
opportunity, the defendants nonetheless breached their duty of loyalty to the shareholders by accepting
individual offers. Furthermore, Goldman Sachs aided and abetted the situation when they knew first
hand what type of business eBay deals with and that they were a corporation that owed certain duties to
their shareholders.
CONTROLLING or DOMINANT SHAREHOLDERS

The obligations of a controlling shareholder in which they exercise influence over the corporation arise in
two contexts: (1) dealings between a parent and a majority-owned subsidiary, (2) freeze-out merger
transactions (DISCUSSED LATER), and (3) selling control or sale of control (DISCUSSED LATER).
Control may be identified as the majority stockholder in a corporation, usually 51% or more. In close
corporations, it is likely that such majority is required whereas in a publicly held corporation, a plurality
may be necessary for control. A control person may be a parent corporation, an individual or a so called
control group, etc. DE FACTO CONTROL TEST – if a person can walk into a room and say they want
certain things done and what he wants gets done without argument, that person is a control person.
Rule- Normally, a shareholder owes no duty to the Board of Directors or other shareholders. However,
a controlling shareholder serving as a member of the Board owes fiduciary obligations to the
corporation. Even when the controlling shareholder does not serve as a Board member, he
may owe a fiduciary duty to the minority shareholders and the corporation in general. A
controlling shareholder may not use his control to obtain special advantages, or to cause the
corporation to take an action that unfairly prejudices the minority. A control shareholder’s
fiduciary duties do not parallel those of officers and directors but rather depends on the
nature and scope of a transaction and whether the corporation is publicly held or closed.
Parent vs. Subsidiary: A parent corporation dictates how the subsidiary will operate and usually
executives of the parent control the board of the subsidiary. This creates multiple conflicts of
interest and often raises this question: Should the questioned transaction be given a presumption of
propriety under the business judgment rule or should the transaction be subject to fairness review as a
conflict of interest situation? Usually, the latter issue will take course.
When the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing the
terms, the test of intrinsic fairness, with the resulting shifting burden of proof, is applied (e.g., the basic
situation for application of the rule is the one in which the parent has received a benefit to the exclusion and at
the expense of the subsidiary).
THE PARENT SUBSIDIARY CONTEXT
• The Paying of Dividends (BJR Analysis)
• the parent, by virtue of control will control the subsidiary’s dividend policy
• as long as the dividends are paid pro-rata to the subsidiary’s minority shareholders, its OK
• the payment of dividends to the parent and minority shareholders of the subsidiary will be
viewed under the BJR
• BJR applies to dividends because dominant shareholders receives nothing from the
corporation to the exclusion of the minority shareholders – everyone regardless of % of
ownership is receiving the same dividend
• Self Dealing Between Parent and Subsidiary (Intrinsic Fairness Analysis)
• the minority shareholders of subsidiary can get a self-dealing transaction struck down if they
can demonstrate that it was not fair to the sub and not approved by the disinterested dir

• Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the
subsidiary to act in such a way that the parent receives something from the subsidiary to the
exclusion of, and detriment of, the minority shareholders of the subsidiary.
• when the parent is benefiting to the detriment of the sub, the parent must prove
intrinsic fairness to exonerate themselves
• The interested party (dominant shareholder) has the burden to prove fairness.
Intrinsic Fairness Test (OPPOSITE ANALYSIS OF THE BJR) – When the parent has
received a benefit to the exclusion and at the expense of the subsidiary, the parent has burden of showing the
intrinsic fairness of its decision.
• Applies only when there is a true disparate impact
o Will not apply when parent gains and the subsidiary does not lose
“Transactions between parent and subsidiary companies are subject to
FAIRNESS REVIW only if the minority shareholders show SELF
DEALING in which the controlling parent prefers itself at the expense of
the minority shareholders.” In other words, this standard is applied where
the parent has received a clear benefit and the subsidiary’s minority
shareholders suffered a detriment. (BENEFIT-DETRIMENT ANALYSIS)
Sinclair Oil Corp. V. Levien (1971) – Intrinsic Fairness Test: (exercising

influence over the corp.)
RULE: “If, in a transaction involving a parent company and its subsidiary, the parent company
controls the transaction fixes the terms, the transaction must meet the intrinsic fairness test.” – A
TRANSACTION BETWEEN A PARENT AND ITS SUBSIDIARY MUST BE INTRINSICALLY
FAIR

Sinclair owned 97% of the shares to Sinclair Venezuela. The subsidiary had to pay a huge amount of
dividends at one point to its parent. Sinclair then created International for the purposes of coordinating
all of Sinclair’s foreign affairs. Sinclair then made Sinclair Venezuela enter into contract with
International to sell all of its crude oil and refined products to International which in turn International
would have to purchase a minimum. International was late with payments and did not purchase the
fixed minimum of goods in the contract. Pursuant to the contract, Sinclair received Sinclair Venezuelan
products but the Levien and the minority shareholders did not share in the profits and thus brought suit
for breach of contract and for damages since Sinclair denied Sinclair Venezuela industrial development.
ISSUE: If in a transaction where the parent company controls the subsidiary, must the transaction be
intrinsically fair?
HOLDING: YES; under the intrinsic test, the dominant company must prove
that its transaction with the subsidiary was objectively fair. The test is
invoked only if the parent company is on both sides of the transaction with
its subsidiary and self-dealing is suspect. Self-dealing will be deemed to be
present if the parent company uses its power to enter into a transaction with
the subsidiary and the parent received a benefit from the subsidiary to the
subsidiary’s detriment. Minority shareholders here were paid the same dividend percentages per
share that Sinclair received. The dividend payments were not self-dealing. However, Sinclair forcing
both the subsidiaries to engage in contract was self-dealing. Sinclair caused the sale to happen and
Sinclair received the products form the sale. The shareholders received little from this transaction.
Sinclair failed to prove that the transaction was intrinsically fair.
• Rule- A parent does owe a fiduciary duty to its subsidiary when there are parent-subsidiary
dealings. However, to invoke the intrinsic fairness standard – similar to the conflict of
interest test under 144 (higher burden of fairness) in lieu of the BJR, it must be shown that
the parent is dealing on both sides of the transaction to the detriment of the subsidiary.
 Disparate impact here where the wholly owned subsidiary benefited at the expense of
the partly owned subsidiary. Looking at impact. The inquiry is basically a showing
that money is being taken out of the subsidiary to the benefit of the parent. However,
this is difficult to prove because the parent company has control over the subsidiary
and you can argue BJR.
Majority vs. Minority Shareholder: Majority shareholders owe a duty to minority shareholders that is similar
to the duty owed by a director, and when a controlling stockholder is voting, he violates his duty if he votes for
his own personal benefit at the expense of the stockholders. Examples are Dodge v. Ford and U.S. Steel
When is the Intrinsic Fairness Test Used? - Notion of creating FD of controlling

SH to minority shareholders.
1. In situations involving a parent and subsidiary, with the parent controlling the
transaction and fixing its terms.
2. Parent must receive a benefit to the exclusion and expense of the subsidiary. One
party must be benefiting at the expense of the other.
3. There must be a fiduciary duty coupled with self-dealing.
CONTROLLING SHAREHOLDER RELATIONSHIP WITH MINORITY
• A controlling shareholder or a controlling block of stock. = A person has effective “control” if he has the
power to use the assets of a corporation as he chooses.
• When a controlling shareholder deals with a group of non controlling shareholders,
he owes the latter the duty of complete disclosure with respect to the transaction
• When a director (controlling shareholder) votes for the benefit of an outside
interest, rather than for the benefit of the shareholders as a whole, there has been a
breach of duty.
• When voting as a stockholder, a controlling stockholder may have the legal right to
vote for personal benefit; but when he votes as a director he represents all the
stockholders in the capacity of a trustee for them and cannot use his office as a
director for his personal benefit at the detriment of the minority stockholders.
Zahn v. Transamerica Corp. (1947) – Hostile Takeover

RULE: “If a stockholder who is also a director is voting as a director, he or she represents all
stockholders in the capacity of a trustee and cannot use the director’s position for his or her
personal benefit to the stockholder’s detriment.” – A STOCKHOLDER VOTING AS A
DIRECTOR MUST VOTE IN ALL SHAREHOLDER’S BEST INTERESTS

Stockholders of the Axton-Fisher Tobacco Company sued Transamerica (who claimed 72% of class B
stock and 66% of class A stock in Axton-Fisher) claiming that they cause Axton-Fisher to redeem or
cash in their class A stock at a well low price instead of allowing them to participate in the liquidation of
company assets, in which case they would have received 240 dollars per share.
ISSUE: May a stockholder use the director’s position for his personal benefit to the stockholder’s
detriment?
HOLDING: NO; the directors knew of Axton’s right to call shares of Class A stock for redemption
because it was in the charter, but the right was not expressly disclosed to the stockholders. Axton was
an instrument to Transamerica and thus were voting in their interests. There was no reason for Axton to
liquidate after the redemption of class A stock, other than to ensure that class B holders would benefit
from the liquidation. The redemption of the class A stock was not necessary for the financial welfare of
the company. The decision to call class A stock was made by Class B shareholders, right before
liquidation sale, so that as a result, on class B holders profited.
To whom did the directors owe a duty? To common shareholders because they take more risk. They are
in the back of the line. No rights except rights under common law. So, arguable, when directors face a
choice between creditors and shareholder, choose shareholders. Between groups of shareholders,
directors should prefer a group with least amount of power and rights. As such, B is junior class who
assuming greater risk. Thus directors owe them a duty.
• Third circuit dismisses this. Key to this is director’s motive. They had to choose an option
that wasn’t going to benefit them. As such, the duty runs to group to whom they are not
beholden.
• Neither approach is satisfactory because someone is getting hurt.
• Transamerica should have told them about the intent to liquidate. That may have been the
key piece of information. What’s unfair was that Transamerica didn’t reveal its future plans, in
which case a shareholder would have made an informed decision.
• Court treats the case as a failure to disclose case because Transamerica failed to reveal the true
valuation of the company assets. Thus, a controlling shareholder owes a duty to minority
shareholders that are similar to the duty owed by a director. He has the burden of proving
(1) good faith of the transaction and also (2) fairness to minority interests.
• When a director votes for the benefit of an outside interest, rather than for the benefit of the SH
as a whole, there has been a breach of duty.
• The Court said even though Class B has the reduced rights, we look at this situation as a
majority/minority distinction, and the duty of the directors is not to disadvantage the
minority in favor of the majority and to maximize the profits of A, not to enrich itself in
favor of the minority. The 3rd Cir. says they aren’t going to get into who the duty is owed to but
will rather look at the motive and in this case, Transamerica acted in its own self-interest and not
for the shareholders.
SHORT-SWING PROFITS
The Securities Exchange Act contains a prophylactic rule banning insider trading in § 16(b) where
“officers, directors, and 10% shareholders must pay to the corporation any profits they make, within a

six-month period, from buying and selling the firm’s stock.” This section penalizes insiders for trades
unrelated to non-public information and misses many trades based squarely on such information.
There are two requirements under Section 16, (1) statutory insiders must file information regarding their
trades in their company’s stock with the SEC, (2) if you make profits on those shares by a purchase and
sale or sale and purchase within 6 months of each other, then you must give up those profits to the
corporation > Short-Swing Profit Provision.
Two types of Markets:

1. Primary Market securities sold directly through the company that created the shares
• Controlled by the Securities Act of 1933 – with two goals (1) mandating the
disclosure of material information to investors, and (2) the prevention of
fraud
• initial public offerings take place in the primary market
• regulation began - “Blue Sky Law” in Kansas (1911)
2. Secondary Market investors trade securities w/o any significant participation of the
original issuer
• Controlled by the Securities Exchange Act of 1934
• Insider trading, securities fraud, short-swing profits, regulation of shareholder
voting via proxy solicitations, and regulation of tender offers
SHORT-SWING PROFITS – ENFORCED BY THE CORPORATION
IN ANALYZING SECTION 16(B), THREE ELEMENTS MUST BE PROVEN: (1) DOES THE FEDERAL GOVERNMENT HAVE
JURISDICTION (IS THE COMPANY LISTED ON A NATIONAL STOCK EXCHANGE; DOES THE SHARES OF THE COMPANY HAVE 10
MILLION DOLLARS OR MORE OF THOSE ASSETS (2) IS THERE A STATUTORY INSIDER (OFFICER, DIRECTOR, OR BENEFICIAL
OWNER), AND (3) ARE THERE SHORT-SWING PORFITS (SALE FOLLOWED BY A PURCHASE WITHIN SIX MONTHS). NOTE OFFICERS
AND DIRECTORS MUST BE SUCH FROM THE BEGINNING TO END OF PURCHASES AND SALES.
§ 16(b) 1934 Securities Exchange Act

§ 16(b) – provides that for the purpose of preventing the unfair use of information, a
corporation may recover for itself any profits realized by a director, officer, or 10%
shareholder (beneficial owner), from a purchase and sale (or sale and purchase) of
its stock within any six-month period, irrespective of intention, provided that the
owner held more than 10% (of any class) “both at the time of the purchase and sale.
• Officers, Directors and 10% shareholders (at both ends) must pay to the corp. any profits
they make, within a 6 month period, from buying and selling the shares
• Rationale: we want directors to own stock so that their interests are aligned with
shareholders, but we don’t want them to speculate.
• Debentures are treated as shares under § 16(b)
• Officers and Directors need only hold that position at either side of the sale or purchase for
§ 16(b) to apply
• Beneficial owners must hold 10% on both ends of the transaction
• Applies only to companies that register their stock under § 12 of the 1934 Act – typically publicly held
corporations
• Companies that (1) w/ stock traded on a national exchange, (2) w/ assets of $5 million
and 500 or more shareholders – (thus likely does NOT apply to close corps)

Generally: Section 16(b) of the Securities Exchange Act of 1934 contains a "bright line" rule by which all
"short-swing" trading profits received by insiders must be returned to the company. The gist of § 16(b) is
that if a statutorily-defined insider buys stock in his company and then resells within six months, or sells
and then re-purchases within six months, any profits he makes must be returned to the corporate treasury.
This rule applies even if the person in fact had no material non-public information.
Section 16(b) applies to any "officer," "director," or beneficial owner of more than 10% of any class of the
company’s stock.
Public companies: Section 16(b) applies only to the insiders of companies which have a class of stock
registered with the SEC under § 12 of the ’34 Act. Thus a company’s insiders are covered only if the
company either: (1) is listed on a national securities exchange; or (2) has assets greater than $5 million
and a class of stock held of record by 500 or more people.
Who may sue: Suit may be brought by the corporation or by any shareholder. But any recovery goes into
the corporate treasury. (The incentive is to the plaintiff’s lawyer, who gets attorney’s fees out of the
recovery.)
Plaintiff must continue to be stockholder: P must not only be a stockholder in the corporation at the time
she files suit under 16(b), but she must also continue to be a stockholder as the suit progresses. However,
if P is forced to exchange her shares for shares in a different corporation as the result of the target
corporation’s merger, P may continue her suit as long as she keeps the shares in the surviving
corporation. Gollust v. Mendell.
Public filings: To aid enforcement, any officer, director, or 10%-owner must file with the SEC (under
16(a)) a statement showing any change in his ownership of the company’s stock. This must be filed within
10 days after any calendar month in which the level of ownership changes.
Who is an insider?
"Officer": Two groups of people may be "officers" for § 16(b) purposes: (1) anyone who holds the title of
"President," "Vice President," "Secretary," "Treasurer" (or "Principal Financial Officer"), or
"Comptroller" (or "Principal Accounting Officer"); anyone (regardless of title) who performs functions
that correspond to the functions typically performed by these named persons in other corporations.
"Beneficial owner": A person is a beneficial owner covered by § 16(b) if he is "directly or indirectly" the
beneficial owner of more than 10% of any class of the company’s stock (he need not own 10% of the
overall equity).
Attribution: Stock listed in A’s name may be attributed to B. A person will generally be regarded as the
beneficial owner of securities held in the name of his or her spouse and their minor children (but usually
not grown children). Thus a sale by Husband might be matched against a purchase by Wife; similarly, a
sale and purchase by Wife might be attributed to Husband if Husband is a director or officer.
Deputization as director: A corporation may be treated as a "director" of another corporation if the

former appoints one of its employees to serve on the latter’s board. (Example: ABC Corp owns a
significant minority interest in XYZ Corp. ABC appoints E, its employee, to serve on the board of XYZ.
ABC will be deemed to have "deputized" E to serve as director, so ABC will be treated as a constructive
director of XYZ, and any short-swing trading profits reaped by ABC in XYZ stock will have to be
returned to XYZ.)
When insider status required?

Director or officer at only one end of the swing: If D is a director or officer at the time of either his sale or
his purchase of stock, § 16(b) applies to him even though he does not have the status at the other end of
the trade.
10% owner: But the same rule does not apply to a 10% owner. A person is caught by the "10% owner"
prong only if he has the more-than-10% status at both ends of the swing.
Purchase that puts one over: The purchase that puts a person over 10% does not count for § 16(b)
purposes. (Example: D has owned 5% of XYZ for a long time. On January 1, he buys another 10%. On
February 1, he sells 4%. There are no short-swing profits that must be returned to the company.)
Sale that puts one below 10%: In the case of a sale that puts a person below 10% ownership,
probably we measure the insider status before the sale. (Example: D already owns 15% of XYZ. He then
buys another 10% on January 1. On February 1, he sells 16%. On March 1, he sells the remaining 9%.
Probably D has short-swing liability for 16% sale, but not for the second 9%, since we probably measure
his insider status as of the moment just before the sale.)
What is a "sale," in the case of a merger: If the corporation merges into another company (and thus
disappears), the insiders will not necessarily be deemed to have made a "sale." D will escape short-swing
liability for a merger or other unorthodox transaction if he shows that: (1) the transaction was essentially
involuntary; and (2) the transaction was of a type such that D almost certainly did not have access to
inside information.
Example: Raider launches a hostile tender offer for Target. On Feb. 1, Raider buys 15% of Target
pursuant to the tender offer. Target then arranges a defensive merger into White Knight, whereby each
share of Target will be exchanged for one share of White Knight. The merger closes on May 1, at which
time Raider (like all other Target shareholder) receives White Knight shares in exchange for his Target
stock. On June 1, Raider sells his White Knight stock on the open market for a total greater than he
originally paid for the Target stock. Raider does not have any § 16(b) problem, because the overall
transaction was essentially involuntary, and was of a type in which Raider almost certainly did not have
access to inside information about White Knight’s affairs.
10% SHAREHOLDERS
• The purchase that places a person over 10% does not count in the § 16(b) analysis – to
applicable, the buyer must have already owned 10% at the time of the purchase
• In a purchase-sale sequence, a beneficial owner must account for profits only if he was a
beneficial owner before the purchase.
Reliance Electric Company v. Emerson Electric Company (1972)

RULE: “A corporation may recover the profits realized by an owner of more than 10% of its
outstanding shares from a purchase and sale of its stock within any six month period, provided the
owner held more than 10% at the time of both the purchase and the sale.”

Emerson tried to takeover Dodge but only acquired 13.2% of its stock in June at $63 per share. Dodge
then merged with Reliance. In attempt to protect its shares from liability under the act, Emerson
reduced its holdings to less than 10% of Dodge’s shares in August. Then Emerson sold the rest of its

shares on September. Reliance demanded the profits on both sides but Emerson sought a declaratory
judgment as to its liability under 16(b).
ISSUE: Are the profits from two sales, each of which constitutes less than 10% of a corporation’s
outstanding shares, recoverable by the corporation under 16(b)?
HOLDING: NO; the rule imposes strict liability on any transactions occurring in six month by
preventing insiders from purchasing large quantities of stock in their company based on private
information and then quickly dumping the stock when the information goes public and the stock
increases. Emerson’s intent is irrelevant here. Once the shareholder owns less than 10%, any additional
sales are not governed under 16(b). Emerson is not liable from profits arising under the second sale.
• a particular purchase will not be the first of a buy-sell short swing unless the buyer already
owned more than 10% before the purchase
o the purchase that lifts the buyer over 10% cannot be matched against a subsequent
sale w/in 6 months
Foremost-McKesson, Inc. v. Provident Sec. Company (1976)

RULE: “A corporation may capture for itself the profits realized on a purchase and sale of its
securities within six months by a director, officer, or beneficial owner, but a beneficial owner is
accountable to the issuer only if it was a beneficial owner before the purchase and before the sale.”
A Beneficial Owner is a corporate shareholder who has the power to buy or sell the shares, but
who is not registered on the corporation’s books as the owner.

Provident dissolved and liquated its assets. Foremost was interested in its purchase. The parties entered
into agreement where Foremost would buy 2/3’s of Provident assets in exchange for 4.24 million in cash
and 49.75 million in debentures. Foremost then delivered 2.5 million debentures to an agent and 7.5
million to Provident, representing the balance of the purchase price. The debentures were converted into
over 10% of Foremost’s common stock. A couple days later, Provident, Foremost, and a group of
underwriters sold 25 million debentures. Provident distributed the profits to its stockholders and then
dissolved. Foremost brought suit to recover profits realized on the sale of debentures to the
underwriters.
ISSUE: Is a beneficial owner accountable to the issuer for profits if it was not a beneficial owner before
the purchase?
HOLDING: NO; in a purchase sale sequence, a beneficial owner must account for profits only if it was a
beneficial owner before the purchase. Historically, 16(b) applied to shot term purchase and sale
sequences by a beneficial owner if it had that status before the purchase. This should not change.
Congress had a reason to impose a 10% threshold ownership for insider abuse. The court may not
impose liability on the basis of a purchase made when the percentage of ownership required for
beneficial ownership had not been reached before the sale. Short-swing transactions by a director or
officer are always suspect whereas a shareholder only becomes suspicious if he owns large quantities of
stock.
• Examples (p 519)
o (1) X is an investor w/ 200,000 shares of SCLI that she has held for several years

 she sells all her shares on 1/1 for $50 p/share
 she buys 50,000 shares on 5/1 at $10 and 110,000 shares on 5/2
  16(b) not in effect because she is not a 10% holder
• her next transaction would fall under 16(b)
 (2) X owns 200,000 shares for several years
• sell all shares on 1/1 at $50
• buys 110,000 shares on 5/1 for $10
• buys 50,000 shares on 5/2 for $10
• 16(b) in effect for 50,000 shares because she obtains 10% status after
purchasing 110,000 shares
 the 50,000 shares are taxed
 (3) X has owned 200,000 shares for several years
• she sells 110,000 shares on 1/1 at $50
• sells remaining 90,000 shares in 1/2 at $50
• buys 300,000 shares on 5/1 for $10 p/share
•  16(b) not in effect because she just obtained 10% status again
• When a holder of more than 10% of the stock in a corporation sells enough shares to reduce its
holdings to less than 10%, and then sells the balance of its shares to another buyer within six
months of its original purchase, it is NOT LIABLE to the corporation for the profit it made on
the second sale.
• Most insider trading cases are brought under the SEA §10(b) because there isn’t a 6-month
limitation.
Class Notes: (p. 503)
Problem 1. Why relevant stock registered under 1934 Act because only applies to public company whose
shares are exchanged in the stock exchange/NASDAC*. When it comes to 16b taking large co not family
owned companies; types who shares can go out and buy in the market.
(a) Does 16b cover this situation? Yes, chief CEO thus officer and therefore law applies and he
is a 16b defendant. Moreover, bought/sold shares in 6 months. What are his damages? $40
x 200,000 shares - ? = profit $ 8million so how much must return to shareholders.
(b) Same result – no matter split sale since still looking is there director buying and selling
within the six month period thus exactly the same result – does not matter sells all at one or
split it up
a. What till June 2 to sell remaining shares – would this effect result? Yes, past 6 month
window – only within 6 month period. Still on the book for share sold on May 1.
100,000 x 50 = 5.5 million; 1.1 million= profit 4.4 milliom. Must match actual
shares. Tell him as advisor to hold on to share until June 2 so can hold on to profits.
(c) Does resignation get him off the hook? Director when purchased but his argument is not a
director when sold other 90,000 shares – so is he off the hook for the second share of sales.
Only need to be officer or director on one side of train; regardless still director when does
sell so long within sex months liable for all profits and *it works the other way around as
well – if buys and then becomes director still liable for both sales since sufficient if director
on sales side, intent not to director when sold stock irrelevant. So if d/o on either of the
trades liable. Rules straight forward when d/o – must be cognizant of 6 month window.
**16(b) Issue- who is an officer: 16b says any officer – so the question becomes who is
an officer. Depends on where you are and the court (Most require senior responsibility
with access to information; Scalia type judge says if officer in title then officer; problem
comes in when lawyer of corporation – should they be treated as officer; one way to
avoid liability is not to take officer title).
Problem 2.
(a) Renee is not o/d so is she subject to 16(b). Yes, if 10% +1 shareholder of company stock.
At first transaction she was a 10% shareholder – moment before transaction she was at least a
10% holder (20% exactly). Second transaction, she did not holder any shares moment
before. Third transaction, moment of transaction only owned 5% shares. Not as 10%
shareholder when made purchases. *Have to have owned 10% at the time of both
transactions – buying. (See reliance + forense case). She is off the hook because she was not
10% shareholder at the time of the other two transactions.
(b) 10% holder when sold; not 10% holder when bought on May 1st; but 10% holder when
bought stock on May 2nd because moment before transaction had 12% share. Two
transactions covered under 16(b) and both took place within six month period.
a. If match two transactions (# of shares) – lang of 16b penalizes any purchases and
sales or sale and purchase – chron irrelevant. # of share involved in transaction is
what we consider. Profit of 2million that she will have to give up – 200,000 x $50
bought - $ 10 x 50,000 sale. Will not get her for purchase. Must limit to 50,000
shares.
Problem 3. Director and has everything within six month so liable under 16b. But did he make a profit in his
transaction? 16b would say he made a profit. Under law can match any sale with any purchase but also can in
… ignore – match lowest purchase with highest sale and ignore the rest. 16b profit of 2 million – 100,000
purchase w/ 100,000 sale at higher price. Do not take losses into account just find a profit and ignore every
other transaction.
Why do we do this? Maximize penalty in order to discourage trading – they should not be doing
this is the bottom line. This is why corporate executives hate 16b so much.
Problem 4. 16b covers stock – trading profit and stock and debentures are a form of debt – but these are
convertible – exchangeable in to stack – treat them as if all ready own there shares. Thus she is treated as
owner of 500,000 shares.
**16b always interpreted in way benefits company the most; to detriment of d/o.
How would a corporation ever find out of such transactions? 16(a) must report to sec about all
transactions in their company stock. In the new lately – use to have lag time; now since
amendments last year must report electronically virtually simultaneously. Reason is market
finds it interesting when o/d trading their own stock. Otherwise took time to get this
information. Hope with sim reporting people who follow can get early notice. *Recent reform.
Damages Example:
A, the CEO buys 1,000 shares at $10 on May 1.
On Aug 1, A sold 1,000 shares at $20.
Profits = 20,000 – 10,000 = 10,000
• The court will use any purchase and sale within a six month period to create a profit – “maximum
possible profits”
o In instances of multiple purchases and sales w/in a 6 month period, the court will match
the lowest purchase price w/ the highest sale price to create a profit to determine
damages.
Creating Profits (assume that X is a O&D:

Transaction Date Price Date
Buy 200 $10 Feb.1
Sell 200 $5 March 1
Buy 100 $20 Apr. 1
Sell 100 $15 May 1
Though X experienced an overall loss of $1,500 the court will find a profit
of $500 (bought 100 for $10 [$1,000] and sold 100 for $15 [$1,500] =
$500)
UNORTHODOX TRANSACTIONS IN 16(B)

General Rules of § 16(b)-
· The rule only applies to corporations that register their stock under the SEA, including companies with
stock traded on a national exchange, and companies with assets of at least $5 million.
· Officers and directors are subject so long as they occupied their position either at the time of the
purchase or sale.
· You may be liable if you deputize an officer to sit on the board of another corporation and you profit
from stock trades of that corporation within a 6 month period.
· The rule aggregates all classes of stock so that you cannot immunize yourself if you own 9% of one
and 1% of another.
· Applies to equity securities and convertible bonds
· Can be enforced derivatively
· Can possibly apply to mergers, acquisitions, and liquidations, but won’t apply if the party could not
have had inside information and therefore is not a speculator (See Kern County).
Two Part Test to Determine if Unorthodox Transactions (merger) Qualify as Sales Under §16(b):
1. was the transaction involuntary; and
2. did the key player have access to insider information
• thus if a takeover target arranges a defensive merger to avoid takeover after a hostile
bidder has compiled shares, the unsuccessful bidder may surrender his shares within 6
months of acquiring them w/o facing § 16(b) liability (even if the raider owned 10%
prior to acquiring additional shares in its tender). Unsuccessful raider may not
however sell his shares on the open market and remain protected b/c that would make
the sale voluntary, instead he should want and redeem
C. DERIVATIVE SUITS
DIRECT v. DERIVATIVE ACTIONS (they are brought on behalf of the Corp. or a
shareholder for the benefit of the Corp. or the shareholder for breach of Fiduciary Duty)
The Basic Tests: (1) who suffers the most immediate and direct damage? (2) To whom did
the defendant’s duty run?
• Shareholders enjoy dual personalities in that they can sue directly or derivatively. A shareholder’s derivative
suit is a suit in which the shareholder sues on behalf of the corporation, on the theory that the corporation
has been injured by the wrongdoing of a third person, typically an insider.
The derivative action is often described as a representative action, since the shareholders are enforcing
the rights of another, the corporation. Recovery in derivative actions goes to the corporation rather than
to the shareholder bringing the suit. To commence or maintain such action, a shareholder must have
(STANDING) been a shareholder of the corp. at the time of the act or omission complained of or has
become a shareholder through a transfer. The corporation is named as a defendant though it also is the
party of interest. Furthermore, if the corp. finds in good faith through reasonable inquiry that partaking
in such litigation is not in the best interests of the corp., they can motion to dismiss the suit. Reasons for
dismissal might be the fact that there is no likelihood of prevailing or that the damage to the corporation
from litigating would outweigh any possible recovery. To prevent dismissal, the plaintiff shareholder has
the burden of proof in asserting that the decision was not made in good faith after reasonable inquiry.
In derivative suits, the shareholder sues the corporation in equity, seeking to force the corporation to
bring suit against the directors and officers for violating their fiduciary duties.
Direct Action shareholder Plaintiff must allege more than an injury resulting from a wrong to the
corporation; plaintiff sues the corporation to enforce her rights as a shareholder.
• Plaintiff must state a claim that is separate and distinct from a claim that may be suffered by other
shareholders or a wrong involving a contractual right of a shareholder which exists independently of any
right of the corp.
• Direct claims include:
o action to enforce voting rights
A breach of fiduciary duties owed to the shareholder by an officer or director of a corp. is a
proper subject for a shareholder’s direct action against that officer or director. However, it is
important to note the distinctions between breaches of duty owed to a shareholder versus the
duties owed to the corporation. If the duty is to the corp., the action is derivative, not direct.
Illustration of derivative suits (equitable and procedural suits): Most cases brought against
insiders for breach of the fiduciary duties of care or loyalty are derivative. All monetary recovery goes to the
corporation. The corporation is a necessary party defendant.
Examples include:
(1) Suits against board members for failing to use due care;
(2) Suits against an officer for self-dealing;
(3) Suits to recover excessive compensation paid to an officer; and
(4) Suits to reacquire a corporate opportunity usurped by an officer
(5) Suits to recover against conflicts of interest
Illustration of direct actions: Here are some of the types of suits generally held to be direct:
(1) An action to enforce the holder’s voting rights;
(2) An action to compel the payment of dividends;
(3) An action to prevent management from improperly entrenching itself (e.g., to enjoin the
enactment of a "poison pill" as an anti-takeover device);
(4) A suit to prevent oppression of minority shareholders; and
(5) A suit to compel inspection of the company’s books and records.
(6) Suits for misrepresentations instead of perpetrating directly upon investors
(7) Suits to enforce your preemptive rights
(8) Suits to compel the corporation to declare a dividend
(9) Suits of the appraisal remedies
(10) Suit to compel the corporation to dissolve
Eisenberg v. Flying Tiger Line, Inc. (1971)

RULE: “An action seeking to overturn a reorganization and merger that deprived an acquired
corporation’s shareholders from having a voice in the surviving corporation’s business
operations is a personal action rather than a derivative action under the New York statute
requiring the posting of security for the corporation’s costs.”

Flying Tiger formed FTC as its subsidiary. A month later, FTC organized its own subsidiary FTL. In a
reorganizing plan issued by management in Flying Tiger, Flying Tiger was merged into FTL and Flying
Tiger ceased to exist. After a while, FTL renamed itself as the former Flying Tiger and thus continued
their operations. The shares traded in this new organization were also shares in FTC, the holding
company for FTL. The holding company’s stockholders were the owners of the former Flying Tiger.
Eisenberg brought a derivative suit to enjoin the plan of reorganization and merger since their corp.
ceased to exist due to the merger. Under NY Law, Flying Tiger Line requested the plaintiff to post a
bond.
ISSUE: Is an action seeking to enjoin a reorganization and merger brought by the former stockholders
of the corporation to be acquired, a derivative action subject to the rules requiring the plaintiff in a
derivative action to post security?
HOLDING: NO; Eisenberg asserts that the reorganization deprives P and other minority SHs of any
voice in the affairs of their previously existing operating company. The essence of Eisenberg’s claim is
that the reorganization, a transfer of shares to a holding company whose only asset was Flying Tiger,
deprived him and fellow shareholders of their right to vote on Flying Tiger’s affairs. Since this right
never belonged to Flying Tiger, and belonged to stockholders, it is not derivative. It’s also not
derivative because the company itself is not being hurt. P’s loss of voting rights is the injury so it is a
direct suit. The court here found the suit to be not derivative but a direct suit.
Derivative vs. Non-derivative Actions: The test formulated to distinguish between

derivative and non-derivative suits is “whether the object of the lawsuit is to recover
upon a chose in action belonging directly to stockholders, or whether it is to compel
the performance of corporate acts which good faith requires the directors to take in
order to perform a duty which they owe to the corporation, and through it, to the
shareholders.” Eisenberg v. Flying Tiger Line, Inc.
Critiques of Derivative Suits

• Plainitff’s lawyer’s economic interest drives this suit.
• Most states have c/l to say that you have to be shareholder at the time of the harm, and through the
duration of the suit. This prevents lawyers from buying 3 shares and initiating their own derivative
suits.
• Shareholders can just sell their stocks.
Three General Requirements to Maintain a Derivative Action:

1. contemporaneous ownership at time of breach
2. ownership at time of adjudication

3. demand or excusal
SECURITY FOR EXPENSE STATUTES

• certain states require plaintiffs to post a bond to guarantee that if the corp. incurs expenses in connection
with the derivative suit
• this is intended to dissuade “strike suits”
• DE DOES NOT REQUIRE THE POSTING OF A BOND OR DEPOSIT FOR COSTS - MORE
PLAINTIFF FRIENDLY.
Cohen v. Beneficial Industry Loan Corp. (1949)

RULE: “A New Jersey statute that requires a holder of less than 5% of a corp.’s outstanding
shares who brings a derivative suit to pay all expenses of defending the suit and that requires
security for the payment of these expenses should be enforced in cases prosecuted under federal
diversity jurisdiction.”

Cohen brought a derivative suit against the managers in his respective corp. because they were engaged
in a plot to get rich at the corp.’s expense. This mismanagement has led to fiscal waste and diversions.
Cohen owed about 100 shares which equated to .0125% ownership of the company. New Jersey passed
a law asserting that a minimal shareholder who brings a derivative suit must be responsible for their
defense if unsuccessful and must indemnify the corp. against those costs before proceeding. Beneficial
required Cohen to post a bond.
ISSUE: Must a federal court hearing a stockholder’s derivative suit based only on diversity apply the
law of the forum state and require the plaintiff to provide security for the payment of costs if he or she is
ultimately unsuccessful?
HOLDING: YES; New Jersey passed this law to prevent nuisance claims of small owners abusing their
rights to a derivative suit. Derivative actions are intended to help stockholders in large corporations in
making their managers stop wrongful conduct. Small stockholders must provide security in the event
they are unsuccessful.
• H: Use of the NJ statute ok. You look to state of incorporation for substantive law and forum
state for procedural law.
• state is not forbidden to use the amount of one’s financial interest, as some measure of the
good faith and responsibility of one who seeks at his own election to act as custodian of the
interests of all stockholders
• Found to be constitutional as a measure of good faith given the nuisance value courts want to
protect corporations from harassment suits. While the derivative action concept serves a
valid purpose, the process can be long, drawn out and expensive.
• Even at this early state, business judgment rule protects directors against lawsuits. So,
plaintiff has to allege that directors were acting in self-interest; self-dealing; breach of
loyalty. You would frame the suit as breach of duty of care.
• Mismanagement and other misfeasance that gives rise to breach of duty generally harms
corporations directly and shareholders indirectly. The harm also affects other constituents in
the corporation.
• Corporation is an independent entity for the purpose of law and legal obligations; thus, it’s
the primary victim. Thus, if harmed, the right to sue belongs to the corporation; it’s up to

beneficial to sue. As a matter of corporate company bring lawsuit? Board of directors would
have to authorize an officer to sign the complaint. Problem: directors would be asked to sue
themselves. This led to the authorization of derivative claim: breach of duty by own
directors or by third party. Derivate standing in the shoes of company allows shareholders to
sue the company, in the name of the company.
DGCL § 145(b) – The corporation may indemnify a defendants’ expenses only if the court determines
that “despite the adjudication of liability but in view of all the circumstances of the case, [the defendant]
is fairly entitled to indemnity.”
THE DEMAND REQUIREMENT
The demand requirement rests on the notion that it gives the board of directors, which is
charged with managing the corporation, an opportunity to decide whether or not a suit is
in the corporation’s best interest.
Demand on board: Plaintiff must make a written demand on the board of directors before
commencing the derivative suit. The demand asks the board to bring a suit or take other
corrective action. Only if the board refuses to act may Plaintiff then commence suit. (But
often the demand is "excused," as is discussed below.)
Demand excused: Demand on the board is excused where it would be "futile." In general,
demand will be deemed to be futile (and thus excused) if the board is accused of having
participated in the wrongdoing.
1. Delaware view: In Delaware, demand will not be excused unless Plaintiff
carries the burden of showing a reasonable doubt about whether the board either:
(1) was disinterested and independent; or (2) was entitled to the protections of the
business judgment rule (i.e., acted rationally after reasonable investigation and
without self-dealing).
A. Difficult to get: But Delaware makes it very difficult for P to make either of
these showings. For instance, he must plead facts showing either (1) or (2)
with great specificity. Also, it is usually not sufficient that P is charging the
board with a violation of the duty of due care for approving the transaction;
usually, a breach of the duty of loyalty by the board must be alleged with
specificity.
2. New York: New York makes it much easier than Delaware to get demand
excused. For instance, demand will be excused if the board is charged with
breaching the duty of due care, not just the duty of loyalty. Also, New York
requires less specificity in the pleading.

• The Demand Requirement is an Intra-corporate remedy: Corporate affairs are done under the
control of the board. One of the affairs of the board of directors is simply to prosecute its own
causes of actions, so there is a procedure in corporate law which allocates a voice to the board
of directors in determining whether the suit should be brought or maintained. As a
predicate to a stockholder bringing a derivative suit, a demand must
either be made on the board of directors or the demand on the board
must be excused. If the demand is made on the board, the board’s
response is typically protected by the Business Judgment Rule unless it is
not a decision that is reasonable or in good faith. It is very unlikely for the
board to approve this suit. Absent that proof that the board acted without reason or in good
faith, the decision of the board stands. A demand on the board is excused when a court is
persuaded by the pleadings that the demand on the board would be futile. What evidence does
a plaintiff have to bring in to establish futility? A lot of states hold that the plaintiff must show
very strong facts of other bias or self interest by a majority of the directors to be able to excuse
the demand.
The Demand Requirement in Perspective

The demand requires the plaintiff to write a letter to the board of
directors demanding that they bring suit. The letter must allege the
wrong and the relevant facts supporting the allegation in much the same
way as is done in a complaint.
When the board receives the demand letter, they have 2 obvious choices:
(1) accept the demand and bring suit (RARE), or (2) reject the
demand/not sue. If the board accepts the demand and decides to sue,
there is no need for the derivative suit. The board will hire its own lawyer
and take over the suit. If the board rejects the demand and can show that
the rejection was made IN GOOD FAITH and BY AN INDEPENDENT
BOARD, then the derivative suit cannot go forward. The decision to
reject the demand is given the presumption of propriety under the
BUSINESS JUDGMENT RULE.
If the board rejects the demand, the plaintiff’s attorney is faced with the tough burden of
overcoming the business judgment rule. He must show that the board was NOT INDEPENDENT
(EX. A majority of the board was involved in the wrongdoing) or that THERE WAS NO
RATIONAL BASIS FOR THE DECISION NOT TO SUE. This burden is insurmountable. Thus
the plaintiff can try to get around this burden by showing excuse.
The Excuse Requirement in Perspective – The Demand Excused

The main ground for excusing demand is futility. There are three
approaches followed:

(1) The Delaware Approach - Aronson v. Lewis asserts that Demand is
excused if the plaintiff can state with PARTICULARITY, facts that
create a reasonable doubt (1) that a majority of the directors on whom
demand would have been made are disinterested, or (2) that the
challenged transaction which constituted waste on its face and was self-
dealing was not protected by the Business Judgment Rule. Thus in other
words, the plaintiff under this TWO-PART TEST must show (1) the
board is not disinterested or independent, or (2) the underlying
transaction was improper as tested under the Business Judgment Rule.
(2) The Model Act Approach - …. NOT APPLICABLE
(3) The New York Approach – Marx v. Akers asserts that Demand is
excused if any of the following is alleged with PARTICULARITY in the
complaint: (1) a majority of the board is interested in the challenged deal;
(2) the board did not fully inform itself about the challenged deal; or (3)
the challenged deal was so unfair on its face that it could not have been
the product of sound business judgment.
In sum, to file a derivative suit, a shareholder must either:

1. make a demand upon the BOD, that the Board assert the corporations claim, or
2. Claim excusal –SH can show that such a demand would be futile because the board has
participated in the breaching conduct and there exists a reasonable doubt as to whether: basis
of excusal.
a. A majority of the board has a material financial or familial interest
b. A majority of the board is incapable of acting independently for some other reason
such as domination or control – accused board member holds undue control over the
other shareholders (Pres hand picked the BOD). Structural bias isn’t enough; you
need to show undue influence.
c. The underlying transaction is not the product of a valid exercise of BJR. This is
basically saying that the Plaintiff has to demonstrate that he has a case on the merits
even though the discovery phase has not yet begun.
d. Show with particularity that Board’s decision to reject claim was rendered in bad
faith.
• If a demand is made and rejected, the Board is entitled to protection under BJR.
• following the rejected demand, the shareholder is precluded from continuing w/
the derivative action
Valid Possible Reasons Why the Board Would Reject A Demand

• fear of bad publicity – may lead to drop in stock price
• court and litigation costs
• may be frivolous
• litigation may paralyze the Board and operations of the company

Justifications for the Demand Rule- The demand is useful because it affects a cost-benefit analysis of
bringing the suit. These suits almost always affect the company’s stock market value. Also, derivative suits
present an internal conflict because the Board is running the company while being sued by it.
NOTE: If you bring suit in the name of the corporation, for some act that gave rise to a derivative suit,
you should go to the BOD first and determine if they want to bring the suit.
WRONGFUL REFUSAL
• When a BOD rejects a shareholder’s demand to bring suit, the shareholder’s only form of redress is a
wrongful refusal claim
• The court will then only scrutinize the process through which the demand was refused.
Demand required and refused: If demand is made and rejected, the board rejecting to the demand is
entitled to the presumption of the business judgment rule unless the stockholder can allege facts with
particularly creating a reasonable doubt that the board is entitled to benefit of the presumption. Further,
Plaintiff, by making a demand, waives his right to contest the independence of the board; a shareholder
who makes a demand can no longer argue that demand is excused.
Grimes v. Donald (1996)

RULE: “A shareholder need not make a demand that a company’s board institute a lawsuit
before bringing a derivative suit on behalf of the corporation on a showing the demand would be
futile, and if a demand is made and rejected, a shareholder may still proceed by establishing that
the board’s refusal was wrongful.”

Donald entered into agreement to manage DSC. The agreement gave him employment till the age of 75
allowing him to quit without cause if either the board or management interfered with his management.
Upon termination, Donald would receive a generous severance package. Grimes, a shareholder asked
DSC to annul this agreement. The board refused his demand claiming that Donald’s compensation is fair
and his duties do not an impermissible delegation of the board’s duties.
ISSUE: Must a shareholder make a demand of the company’s board before pursuing a derivative claim
if he or she has no reason to believe the demand would be futile, and may the shareholder pursue his or
her claim if the board’s decision is not the result of considered business judgment?
HOLDING: YES; the delegation here is protected by the judgment rule. Grimes must make a demand of
the corporation before instituting his own action, and his complaint must either allege that the board
denied his request or offer a reason why the demand would be futile. The demand is excused only if the
shareholder has reasonable doubt that the board could exercise appropriate judgment. If the
shareholder’s demand is rejected, the presumption is that the board acted properly unless the shareholder
can allege a basis from which reasonable doubt would be raised. If evidence suggests that the board did
not act properly, the shareholder can bring his claim based on wrongful refusal. The plaintiff here made
a pre-suit demand and cannot later contend that the demand was excused. Because DSC made an effort
to review Grimes’ claims, its decision is protected under the BJR.
• Golden Parachute (granting upper management lucrative severance benefits): often
challenged; legal basis of suit – breach of duty of loyalty if you find conflict of interest. In the
absence of conflict, you can allege corporate waste, breach of duty of care.
• If there is reason to doubt that the board acted independently or with due care in responding
to the demand, the stockholder may claim wrongful refusal in a direct action.
• Rule- The Board may refuse suit and be protected under the BJR unless the shareholder can
allege with particularity and create a reasonable doubt that the Board is not entitled to the
benefit of the presumption. How? By showing that a majority of the Board had a personal
interest, stake or benefit in the underlying transaction.
• Rule: Directors may not delegate duties which lie at the heart of the management of the
corporation.
• Rule: An informed decision to delegate a task is as much an exercise of business judgment as
any other. Thus, business decisions are not an abdication of directorial authority merely
because they limit a board’s freedom of future action.
• THREE (3) INSTANCES WHERE DEMAND IS EXCUSED
o The majority of the board has a financial interest; the Court examines the directors’
stake in the underlying transaction that is the subject of the litigation (Ex: the
directors have no financial interest in a Golden Parachute suit). Garten says this is a
high threshold to meet
o When there is doubt the board will make a reasoned decision (BJR) because of the
domination or control of other board members or someone they
o If there is any reasonable doubt that the underlying transaction is a product of the
valid exercise of reasonable business judgment. Garten says this seems like making
the plaintiff prove a likelihood to prevail on the merits.
SPECIAL LITIGATION COMMITTEES

If the demand on the board has been excused because it was futile, courts will still allow
demand to come in indirectly through Special Litigation Committees. It arises in demand-
excuse cases. In the 1970s, corporate defense attorneys came up with a way for the “innocent
minority” of directors to make the decision whether the corporation should sue the other
board members. The board creates a committee consisting of some or all of the directors not
implicated in the alleged wrongdoing and delegates to that committee the power to decide if
the corporation should pursue a lawsuit against the majority. Thus, this committee speaks
for the board of directors.
The composition is critical. Often, the committee is composed of people who are NOT
directors at the time of the alleged wrongdoing. This committee typically hires counsel to
investigate the facts that lead to the derivative suit. The committee, with the aide of the
attorney and other experts, than investigates the facts and evaluates the merits of the case –
projected costs, potential benefits to the corporation, etc. the committee then incorporates its
findings into a report which it submits to the court with the committee’s recommendation as
to whether the suit should be continued or terminated – couched in terms of the best interests
of the corporation. Usually, it is to dismiss the suit. Because of this, skepticism often
develops as to whether the committee was unbiased and whether its recommendation is based
solely on the best interests of the corporation. Directors are judging their own. This
skepticism has led to three main approaches:
(1) The (Majority Rule) Delaware Approach – Zapata Corp. v. Maldonado
asserts that (1) the defendants have the burden of proving the committee
members’ independence and the procedural completeness of their
investigation; basically, committee must establish its independence
(individuals who are on the committee are not involve in the wrongdoing
that is alleged in the suit complaint and that they are not subject to the
control, either financial or to family ties, to the defendants in the suit), its
good faith (thoroughness of its investigation of the facts and law), and
that its recommendations are supported by reasonable basis (suit lacks
merit, the cost of proceeding with the suit outweighs the benefits, the
continuance of the suit has a negative morale on the corporation, it’s a
huge deflection of employee time, etc.) and (2) if the special litigation
committee’s recommendation passes the first part of the test, the court
exercises its own independent judicial discretion or business judgment in
determining whether or not it is the corporation’s best interest to dismiss
the suit; thus, the court is asked to stand back and make an evaluation as
to whether under the totality of the circumstances, would it appear that
the dismissal is in the best interest of the company. The court will not
dismiss the suit on the second level if the first level is established.
(2) The New York Approach – Auerback v. Bennett asserts that unless the
plaintiff can prove that the Special Litigation Committee LACKED
INDEPENDENCE or FAILED TO OPERATE ON AN INFORMED
BASIS, the committee’s recommendation is entitled to the presumption of
propriety afforded by the business judgment rule. Thus if the committee
meets regularly, systematically reviews the facts, relies on opinions of
independent counsel, makes a detailed record, has a rational basis for
their decision, shows the potential claim lacks merit, litigations expenses
might exceed potential gains to the corporation, the suit would create bad
publicity for the corporation or damage the corporate image, the court
will follow the recommendations and dismiss suit.
(3) The Minority (Iowa) Approach – Miller v. Register and Tribune

Syndicate asserts that if the board is disqualified from recommending
dismissal, than any committee appointed by that board would be likewise
disqualified.
The law of the state where the corporation is formed determines whether they adhere to the
Auerbach approach or Zapata approach or something else in addressing a special litigation
question.

• §141(c): allows a board to delegate its authority. Committees set up to evaluate suit and make
suggestion for Board’s decision after being presented with demand. Must be comprised of insider
directors who have FD to shareholders.
• created to test validity of a SHs request for derivative action while preserving the appearance of
disinterested independence of the Board Members
• disinterested independence exists when the Special Committee Members have no direct
financial stake in the litigation
• made up of non-implicated or new “independent” directors (who happen to be chosen by the
defendant directors, thereby creating an obvious conflict of interest)
• The decisions of independent Special Litigation Committees are protected by BJR
• shareholder will claim wrongful refusal when committee chooses not to proceed
Business Judgment Doctrine: The action of the special litigation committee is comprised of two
components: (1) the selection of procedures appropriate to the pursuit of its charge and (2) ultimate
substantive decision. The latter, substantive decision falls squarely within the embrace of the business
judgment doctrine and to this extent the conclusion reached is outside the scope of the court review. As to
the methodologies and procedures best suited to the conduct of an investigation of facts and the
determination of legal liability, the courts are well equipped by long and continuing experience and practice
to maker determination. Auerbach v. Bennett
Auerbach v. Bennett (1979) – New York View (plaintiff assumes the burden
of proof)
RULE: “A special litigation committee’s determination forecloses further inquiry into a matter,
provided the committee’s investigation is bona fide.”

GTE conducted an investigation to determine whether bribes had been paid to public officials or
political parties. Based on the report, matters were brought before the GTE board and they referred the
matter to an audit committee. Several months later, the group asserted and filed with SEC that GTE and
its subsidiaries had made foreign payments of more than 11 million and that some of the transactions
were handles by GTE directors. After those reports, Auerbach filed a derivative suit seeking to have
those officials reimburse GTE for the bribes. Afterwards, GTE created a special litigation committee
after the scandal to represent them. The committee found that GTE performed its audit in good faith, it
found no self-dealing, and that absent valid claims against the defendants, this suit would pose a drain
on management’s time and resources. GTE won below.
ISSUE: May a board appoint a special committee to investigate the allegations contained in a derivative
suit and to determine whether the lawsuit should be dismissed?
HOLDING: YES; the judgment rule holds that business is in better position than the courts to determine
their best course. The rule will shield the committee’s decisions only if the members are found to have a
disinterested independence. Based on the facts here, it is clear the committee members were
independent of the transactions. The board chose a committee that was excluded from personal
prejudice. This was prudent business practice. To have the board have no members of its board on the
committee would make the board powerless it their decision to forego a derivative suit. Again, such
judgments made by this committee are shielded under the rule. However, the court may review the
process and methods the committee used to reach its decision to ensure the committee exercised good
faith in its investigation. Proof that the investigation was a sham would raise questions of good faith that
would not shield the committee under the rule. The plaintiff here offered no evidence in establishing a
lack of good faith.
Reasoning: That committee promptly engaged eminent special counsel to guide its deliberations and to
advise it. The committee reviewed the prior work of the audit committee, testing its completeness,
accuracy and thoroughness by interviewing representatives of Wilmer, Cutler & Pickering, reviewing
transcripts of the testimony of 10 corporate officers and employees before the Securities and Exchange
Commission, and studying documents collected by and work papers of the Washington law firm.
Individual interviews were conducted with the directors found to have participated in any way in the
questioned payments, and with representatives of Arthur Andersen & Co. Questionnaires were sent to
and answered by each of the corporation’s management directors. At the conclusion of its investigation
the special litigation committee sought and obtained pertinent legal advice from its special counsel.
Rule: The BJR does not foreclose inquiry by the courts into the disinterested independence
(people nominated by board to act on behalf of the corporation MUST be independent of
the board’s control and not tied to the matter at issue) of those members of the board chosen
by it to make the corporate decision on its behalf. Indeed the rule shields the deliberations and
conclusions of the chosen representatives of the board only if they possess a disinterested
independence and do not stand in a dual relation which prevents an un-prejudicial exercise of
judgment.
Zapata v. Maldonado (1981) – Delaware View (defendant assumes the

burden of proof)
RULE: “While a majority of a board may lack the independence to evaluate a derivative claim,
the taint of self-interest is not necessarily sufficient to prevent the board from delegating the
evaluation to an independent committee comprised of disinterested board members who may
recommend dismissal of a shareholder’s action.”

Maldonado sued Zapata officers and directors charging them for a breach of fiduciary duty to the
company. The plaintiff did not demand Zapata to bring forth the action for it may be futile since all the
directors were named as defendants and all had participated. Four years later, four of the directors were
no longer on the board and thus they replaced them with 2 outside directors. The board then created a
committee to investigate the plaintiff’s case. The committee decided not to go ahead with the litigation.
ISSUE: Must a trial court, when facing a motion brought by a committee appointed by a corporation’s
board of directors, demanding the dismissal of a shareholder suit, grant that motion notwithstanding the
fact that members of the board may have had an interest in the committee’s result?
HOLDING: YES; the trial correctly ruled that when a shareholder’s demand is refused, he or she obtains
an independent right to pursue a derivative action. The plaintiff failed to make demand. However, a
board’s decision can be overturned upon showing that the decision was wrongful. Note that deference is
granted to the board under the judgment rule. Unless the board was wrongfully refused or the plaintiff
brought the action without consent because of futility, a shareholder cannot override the company’s
decision. However, this rule is irrelevant here. Statutes permit the board to delegate a committee in
deciding whether to litigate. Allowing a corporation to use committees to stop plaintiffs takes the power
away from a derivative suit but at the same time it is undesirable dealing with frivolous suits. The court
must find a balance between the two. Thus, if the committee determines in good faith that the action
must be dismissed, then the court is to oblige, absent bad faith, a lack of independence, and an

inadequate investigation. More than a business judgment must be shown to excuse the suit. The
committee must present to trial court its recommendations including its investigations, findings, proof of
independence and good faith. The trial will determine under its discretion whether to dismiss the claim
or not.
• A demand, when required and refused (if not wrongful), terminates a stockholder’s
legal ability to initiate a derivative action. But where demand is properly excused,
the stock holder does possess the ability to initiate the action on his corporation’s
behalf.
• The procedures that a SLC uses to come to its decision are not protected by the BJR, but
their substantive decision is.
• §141(c) allows a board to delegate all of its authority to a committee. Accordingly, a
committee with properly delegated authority would have the power to move for
dismissal or summary judgment if the entire board did.
• As a matter of policy, courts want directors to make decisions wherever possible.
Courts do not want to impose their own judgments.
DELAWARE VIEW IN DEMAND-EXCUSED CASES ONLY Zapata Corp. v. Maldonado
• If Plaintiff is arguing that demand is excused, and the committee petitions the court
to dismiss the case, the following analysis will occur. Here, the court went further
than Grimes and Auerbach and examined the substance of the SLC decision:
o The Court looked at whether the board members in the SLC
are independent and the Court required the board members to
show that they are INDEPENDENT and the plaintiff
shareholder does not have to make this showing anymore
o The plaintiff must plead with particularity, facts that raise a
reasonable doubt that either the directors are disinterested or
independent or plead with particularity that the challenged
transaction based on the facts is beyond the business judgment
rule; on its face it constituted a non-rational basis or waste
action since it was too extreme.
o Must show a self-dealing transaction
Why the shift in Zapata? The new rule lets corporations know that they cannot get away with bad
behavior. It may also be useful by letting more suits get into the courtroom so that the law can be clarified
in unsettled areas. The obvious problem is that most suits settle so this really isn’t a great justification!
Pros and Cons of SLC

• allows “strike suits” to be terminated at an early stage
• a SH can always argue that a “structural bias” is unavoidable when Committee Members are
appointed by the Board that has been implicated
In re Oracle Corp. Derivative Litigation (2003) – Delaware Case (Zapata

applies)

RULE: “A director’s lack of independence turns on whether the director is, for any substantial
reason, incapable of making a decision with only the best interest of the corporation in mind.”

Oracle shareholders filed a derivative suit against Oracle directors, which an Oracle special litigation
committee sought to dismiss.
ISSUE: Has the SLC established its independence from the Oracle board of its directors?
HOLDING: NO; here the ties between the SLC, the trading defendants, and Stanford University are so
strong that independence cannot be proven. The defendants here have an extensive history together and
it is without doubt that bad faith was involved in dismissing the suit.
INDEMNIFICATION AND INSURANCE
Indemnification Rights of officers of directors – if they are successful, they would be

indemnified from the expenses incurred (attorney fees, court fees). If they are unsuccessful,
the court will analyze whether or not to grant the officers indemnification nonetheless.
Waltuch v. Conticommodity Services, Inc. – the party seeking indemnification must act in
good faith as such that the officer did not knowingly violated the law or regulatory provision.
Indemnification: All states have statutes dealing with when the corporation may (and/or must) indemnify
a director or officer against losses he incurs by virtue of his corporate duties.
1. Mandatory: Under most statutes, in two situations the corporation is required to indemnify
an officer or director: (1) when the director/officer is completely successful in defending himself
against the charges; and (2) when the corporation has previously bound itself by charter, law or
contract to indemnify.
2. Permissive: Nearly all states, in addition to this mandatory indemnification, allow for
"permissive" indemnification. In other words, in a large range of circumstances the corporation
may, but need not, indemnify the director or officer.
a. Third party suits: In suits brought by a third party (in other words, suits not brought
by the corporation or by a shareholder suing derivatively), the corporation is permitted to
indemnify the director or officer if the latter: (1) acted in good faith; (2) was pursuing
what he reasonably believed to be the best interests of the corporation; and (3) had no
reason to believe that his conduct was unlawful. (Example: D, a director of XYZ, acts
grossly negligently, but not dishonestly, when he approves a particular corporate
transaction. XYZ may, but need not, indemnify D for his expenses in defending a suit
brought by an unaffiliated third person against D, and for any judgment or settlement D
may pay.)
b. Derivative suit: If the suit is brought by or on behalf of the corporation (e.g., a
derivative suit), the indemnification rules are stricter. The corporation may not indemnify
the director or officer for a judgment on behalf of the corporation, or for a settlement
payment. But indemnification for litigation expenses (including attorney’s fees) is
allowed, if D is not found liable on the underlying claim by a court.

c. Fines and penalties: D may be indemnified for a fine or penalty he has to pay, unless:
(1) he knew or had reason to believe that his conduct was unlawful; or (2) the deterrent
function of the statute would be frustrated by indemnification.
3. Who decides: Typically, the decision on whether D should be indemnified is made by
independent members of the board of directors. Also, this decision is sometimes made by
independent legal counsel.
4. Advancing of expenses: Most states allow the corporation to advance to the director or
officer money for counsel fees and other expenses as the action proceeds. The director or officer
must generally promise to repay the advances if he is ultimately found not entitled to
indemnification (but usually need not make a showing of financial ability to make the
repayment).
5. Court-ordered: Most states allow D to petition the court for indemnification, even under
circumstances where the corporation is not permitted or not willing, to make the payment
voluntarily.
INDEMNIFICATION
• The corporation reimburses the officer and director for expenses and/or judgments he incurs relating to
his actions on behalf of the corporation.
Pros promotes employee moral; employers will not be able to retain w/o protection
Cons if an employee may escape liability, he may be prone to be more negligent
• a corps indemnification provisions are most likely found in the corps bylaws
• In DELAWARE, indemnification is provided “on the merits or OTHERWISE
o DGCL §145(c) affirmatively requires corporations to indemnify its
officers and directors for the “success on the merits or otherwise.”
Success means escape from an adverse judgment or other detriment –
like settlement w/o direct payment by the shareholder.
o § 145(a) fixes the outer boundaries (good faith) of a corp.’s ability to
indemnify further under §145(f)
§ 102(b)(7) DELAWARE protective provision that applies only to the liability of a director to the
corporation or its shareholders for monetary damages for breach of fiduciary duty as a director
§ 145(a) allows indemnification (in direct suits) in certain circumstances for expenses, judgments, fines
and amounts paid in settlement when the Officer, Director, or employee has acted in “good
faith” and in the interest of the corporation – the Board will conduct a case-by-case analysis
• If acting in good faith and in the Company’s best interest, may get indemnified for
everything. But if you engage in criminal conduct, Company can’t indemnify.
§ 145(b) allows indemnification for expenses in derivative suits (judicial approval of indemnification is
required if the employee is found liable – NOT often granted often because would lead to
circular recovery)
§ 145(c) expenses must be reimbursed if you are successful on the merits OR otherwise (has escaped
adverse judgment)
• if corp. pays settlement on behalf of defendant employee, he is deemed otherwise successful
and qualifies for indemnification
• some courts allow pro rata indemnification when multiple charges are being brought
§ 145(d) Board has the right to determine if an employee should be indemnified – protected by the BJR
• If the Board denies indemnification, the employee will likely bring a breach of fiduciary duty
claim.
• If indemnification is granted the Board will usually be sued by the shareholders for breach of
fiduciary duty
§ 145(e) allows for advancement in expenses
• DGCL § 145(e) expressly permits a corporation to advance the costs of defending a suit to a
director. Therefore, a corporation may advance reasonable costs in defending a suit
to a director even when the suit will does not satisfy indemnification requirements
• 145(b): can be indemnified under derivative suit. Different standard than 145(a); directors sued under
derivative suit are not indemnification if found liable; no indemnification; 145(a) is for direct suits. In a
derivative action, you can get indemnified if you win under 145(c) but if you lose you get nothing under 145(b);
if you settle, you may get indemnified; Incentive to settle and for plaintiff to bring suit.
• In general, section 145 isn’t mandatory but….

Indemnification is mandatory when:
1. Director/officer is completely successful in his defense against charges
2. Corporation has specified particular circumstances when it will indemnify in its charter, K, or law so long as
good faith is shown.
Indemnification is permissive when:

1. A 3rd party suit is brought and the directors and officers acted in good faith, pursued what he believed to be
the best interest of the corporation, and had no reason to believe that his conduct was unlawful.
2. A derivative suit is brought and directors and officers are not found liable on the underlying claim, the
corporation may indemnify for litigation expenses.
3. A fine or penalty is imposed unless the directors and officers knew or had reason to believe that his conduct
was unlawful, or the deterrent of the statute would be frustrated by indemnification.
Advancement of Expenses- Defendant may request advancement of litigation expenses in most states with a
promise to repay if ultimately not found entitled to indemnification.
Court Ordered Indemnification- Most states allow the D to petition the court for indemnification, even if
corporation is unable or unwilling.
How does company decide to indemnify? The Board meets (members must be independent, otherwise
delegate to subcommittee) and considers whether it can legally indemnify. Must make sure that D/O acted
in good faith otherwise they may be subject to a duty of care case.
Waltuch v. Conticommodity Services, Inc. (1996)

RULE: “A corporation must indemnify its officers, directors, and employees against legal
expenses related to the defense of any legal action brought against them by reason of their position
or capacity, provided the individual acted in good faith.”

Waltuch, VP of CS traded silver for the firm’s clients and himself. Silver prices rose sharply in late 1979
then dropped rapidly causing the silver market to crash. Numerous lawsuits were filed against Waltuch
alleging fraud, market manipulation, and antitrust violations since the consumers engaged into silver
futures contract with CS prior to the crash. Waltuch agreed to pay numerous fees that resulted from his

litigations. He paid more than 35 million to plaintiffs, incurred 1.2 million in defending himself, was
fined 100,000 dollars and now incurs a current legal fee of 1 million in which he is seeking to the corp.
to indemnify.
ISSUE: Must a corporation indemnify its employees against legal expenses related to the defense of any
action brought against them by reason of their position or capacity, even if they did not act completely in
good faith?
HOLDING: NO; a corporation may choose to provide its employees with additional indemnification
rights and other forms of indemnification, but it is not required to do so.
o It is not the court’s business to ask why a result was reached
Citadel Holding Corp. v. Roven (1992)

RULE: “A corporation may advance a director the costs of defending a lawsuit.”

Citadel was a savings and loan company. Roven was a director. He entered into an indemnity agreement
with Citadel where it would indemnify Roven in a threatened or actual suit, civil or criminal, etc.
However, actions brought under section 16(b) would be a bar to indemnification. The agreement allows
Roven to advance costs of defending certain lawsuits as long as Roven pays the advances back. Citadel
sued Roven since he violated section 16(b) by purchasing options to buy Citadel stock while as director.
Roven contests he did violate the section but is entitled to make advances.
ISSUE: Is an employee party to an indemnity agreement with his or her employer entitled to an advance
for costs related to a federal action the employer brought against him?
HOLDING: YES; a corporation may advance to a director the costs of defending a lawsuit. Although the
law § 145(e) makes this authority permissive, the parties’ agreement makes it mandatory.
o Under both the statute and the Agreement, the corporation’s obligation to pay expenses is
subject to a reasonableness requirement.
o Delaware law applies unless the charter has established greater protection for its employees
that are not violative of other states’ statute.
§ 145(f) contemplates agreements that provide greater protections than the statute provides – CAN not
circumvent the “good faith rule” of § 145(a)
INSURANCE
• Nearly all large companies today carry directors’ and officers’ (D&O) liability insurance. Most states
explicitly allow the corporation to purchase such insurance. Furthermore, D&O insurance may cover certain
director’s or officer’s expenses even where those expenses could not be indemnified.
1. Typical policy: The typical policy excludes many types of claims (e.g., a claim that the
director or officer acted dishonestly, received illegal compensation, engaged in self-dealing,
etc.).
2. Practical effect: Insurance will often cover an expense that could not be indemnified by the
corporation. For instance, money paid to the corporation as a judgment or settlement in a
derivative action can usually be reimbursed to the director or officer under the director and
officer policy.

Typically 2 types of insurance to protect directors and officers:
1. Directors and officers have their own liability policies paid by company.
2. Company has insurance to cover expenses for reasons of indemnification.
• Does it matter what indemnification is? Why not rely on insurance? Cost is an enormous factor. There are
certain industries (drug/pharmaceutical) that have no insurance, thus resort to self-insurance (indemnification).
• Policymaker: what should they do? Corporate law stands in the middle. Procedural hurdles but you can stay
bring it. Safety valve: Zapata case.
Some corporations have combined to form their own captive insurance companies or have established trust
funds to pay for damages and expenses.
§ 145(g) authorizes the use of insurance to limit further liability of officers and directors
o allows a corporation to circumvent the “good faith” clause of § 145(a) by purchasing O&D’s
liability insurance
D. THE SHAREHOLDERS
THE SHAREHOLDERS ARE THE CORPORATE OWNERS BUT THEY DO NOT PARTICIPATE IN MANAGEMENT NOR DO THEY HAVE ANY
AUTHORITY TO ACT FOR OR BIND THE CORPORATION. THEIR VOTE IS REQUIRED TO APPROVE FUNDAMENTAL TRANSACTIONS
THAT AFFECT THEIR INTEREST. THROUGH THIS, THEY INDIRECTLY EXERCISE A GREAT DEAL OF INFLUENCE OVER THE BOARD.
THE LAW PROTECTS SHAREHOLDERS BY PROVIDING THEM WIITH (1) THE RIGHT TO VOTE [WHICH IN MOST CORPORATE
STATUTES ALLOWS SHAREHOLDERS TO REMOVE DIRECTORS], (2) THE RIGHT TO INFORMATION, AND (3) THE RIGHT TO SUE
BOTH DIRECTORS AND OFFICERS FOR BREACH OF THEIR FIDUCIARY DUTIES.
PROXY SOLICITATION – FEDERAL LAW GOVERNS, NOT STATE
PROXY VOTE IS CONFERRING AUTHORITY ON AN INDIVIDUAL TO VOTE SHARES FOR THE PERSON WHO CONFERRED SUCH
AUTHORITY, OR SIMPLY A SHAREHOLDER GRANTS THE POWER TO VOTER HER SHARES TO SOMEONE ELSE. THE PARTIES
NECESSARY ARE THE PROXY-GIVER, WHICH OWNS THE SHARES AND THEN TRANSFERS THE POWER AND AUTHORITY TO THE
PROXY-HOLDER. THE PROXY IS NOTHING MORE THAN AN AGENCY ARRANGEMENT. THE PROXY-GIVER AUTHORIZES THE
PROXY-HOLDER TO ACT CONSISTENTLY WITH THE AGENCY, AS SUCH TO VOTE ON BEHALF OF HIM. PROXIES ARE
REVOCABLE BY WORD, ACTION, OR DEED UNLESS COUPLED WITH AN INTEREST.
• REASONING: Shareholders appoint agents to attend shareholder meetings and vote on their behalf
because voting for directors at the company’s annual meeting in a publicly held corporation is typically
not a matter of high priority for the overwhelming majority of shareholders. (ex. A company’s annual
meeting is held in NYC. It is unlikely that a shareholder that lives in Arizona would make the flight to
NY for such meeting). Thus if shareholders vote at all, it is usually be proxy. Management must
solicit or request for proxies to obtain a quorum so that business can be transacted at
the meeting. The quorum is typically a majority of the shares entitled to vote.
• shareholders seldom find it cost-effective to become well informed in corporate disputes, much
less to attend any meeting in person
• the document by which shareholder appoints an agent is also called a proxy card
• “Proxy fights”  occur in contested elections (which are rare) where an insurgent group tries to
oust incumbent Officers and Directors by soliciting proxy cards and electing its own
representatives to the Board of Directors. Non-contested elections involve the usual annual
meeting of shareholders where the holders are required by state corporate law to meet and elect

directors. The only party soliciting proxies in this situation is management. (THIS IS THE
USUAL COURSE OF BUSINESS)
• Proxy fights are regulated by § 14(a) of 1934 Securities and Exchange Act which lists what
type of information needs to be disclosed in a proxy. These fights are operated much like a political
campaign in order to gain operating control.
• Section 14(a) does not expressly authorize private actions. However, the U.S. Supreme Court has
interpreted implied rights of actions under the proxy rules.
• To come within proxy regulation under the federal act, the securities of the
corporation must be listed on a national exchange (typically any national market with
the name exchange in it), or if they are not listed on the national exchange, the
company must have assets of about 10 million dollars or more, 500 or more
shareholders of that class of stock at the end of the fiscal year, and either its securities
or businesses engage in interstate commerce. – ONLY Publicly Held Corporations fall
into these categories.
• The proxy rules have three different orientations (1) protocols – these are procedures that the SEC has
adopted as rules that make sure that the proxy solicitation is fairly understood to be a proxy solicitation
and that investors have the right kind of information before them to be able to decide how they are going
to vote their shares in response to proxy solicitation; (2) basic information package – this package
changes with the type of proxies; it mandates certain sets of information that must accompany or
precede a proxy solicitation that is regulated by section 15(a); (3) pre-filing requirement - proxy
materials must be filed with the SEC in advance before mailing them out to investors. So there is a pre-
filing requirement which is found in 14(a)-6
• Three major exceptions to what is not a proxy solicitations – (1) Section 14(a)-2(b)-2
provides that a communication that is sent to no more than 10 individuals is not a proxy
solicitation; (2) Section 14(a)-2(b)-1 provides that public communication through press release or
a letter towards someone who one have a fiduciary relation to announcing how one intends to vote
their shares at an upcoming meeting is not a proxy solicitation; (3) there is an exemption of a
communication that urges a shareholder to vote in a particular matter providing the person
writing the letter does not solicit a proxy
• Communications through proxy solicitations must be free from any material omissions and
misstatements – section 14(a)-9 > this provision broadly prohibits any false or misleading statements
with respect to any material fact in regards to the solicitation of proxies.
• If a party is attempting to recover damages or seeking to rescind a transaction that was taken on the basis
of a misleading proxy solicitation, most circuits require proof of a negligent commission of the omission
or misstatement of material fact.
• A proxy solicitation that is misleading must have a causal connection of the material omission and
misstatement to the transaction in order to bring suit.
• The remedies available for violation of the proxy rules include injunctions, rescission and damages, or a
combination of these remedies.
Why are Proxies regulated by the Federal Government?

The proxy rules are not about raising money or buying and selling stock. They are about corporate governance,
an area traditionally regulated by the several states. However, since a lot of corporate activity crosses over
several states, it makes obvious sense, especially for large corporations, for the federal government to regulate
activity > efficiency.
§ 14(a) of 1934 Act – Proxies

• Courts construe the concept of “solicitation”
Rules 14a-3, 14a-4, (format) 14a-5, and 14a-11 require people who solicit proxies to furnish each
shareholder with a proxy statement containing (1) an annual report, (2) disclosure of any conflict of
interests and (3) disclosure of any major issues expected to be raised at the shareholders meeting
Rule 14a-6 requires that parties soliciting proxies file their proxy statements with the SEC
Rule 14a-7 Insurgent’s rights to obtain info from management (distance access rule): grants
incumbent management the choice of (a) mailing the insurgent groups proxy materials out and then
charging for cost, or (b) providing insurgent group with shareholder list so they may conduct their
own distribution. (Tactical Importance) Those who want to solicit proxy in opposition to
management; the dissident prepares its own materials and gives those to management so they can
mail it out to the shareholders. Management can choose not to mail this out, but if it does so, it must
available to you the list of shareholders in a publicly held corporation. The dissident has to pay the
printing costs and postage which is a lot of money in a publicly held corp.
• Most corps will choose to mail and charge so as to avoid giving up shareholder list and allowing insurgent to
learn identities of major players. However, identities of +10% shareholders may be discovered through SEC
filings under 16(a)
When do corporations typically need proxies?

1. To select the Board (done annually). Usually there is only one slate nominated for the
Board. However, occasionally there is a proxy contest where a competing slate seeks
nomination. If the contest is successful the new Board may be reimbursed by the
corporation for its proxy costs.
2. To select outside auditors
3. To vote on shareholder proposals (§ 14(a) (A) discusses when this must be included in
the proxy materials)
4. To vote on mergers or other changes in corporate structure
ADVANTAGES FOR MANAGEMENT

1) incumbent management also has the ability to use corporate funds to pay for its defense, and have the
advantage of knowing who the shareholders are – thus allowing them to wine & dine the big shots
2) Shareholders usually vote for the management
3) management usually knows who the shareholders are whereas the insurgents will usually have to litigate
to obtain the shareholder list
SHAREHOLDER PROPOSALS - § 14a-8

Surgical Staple Co. Hypo- This hypo discussed in class involves a company that tests their staples on live dogs.
A group of shareholders wants to contest this practice and seeks to do so in a proxy statement. However, the
Board wants to exclude the proxy proposal. The issue is under what circumstances a Board can exclude a
proposal? § 14(a)(8) deals with shareholder proposals and lists 13 reasons why a company may exclude one.
They include:
· Improper shareholder action under state law (where corporation is located)
· Proposed action is illegal under state, federal or foreign law
· Personal grievance against the corporation or D/O, or if action pertains to a special interest that is not
shared by shareholders at large.
· Insignificant relationship- the proposal accounts for less than 5% of the issuer’s total assets and for less
than 5% of its net earnings and gross sales in the last fiscal year, and is not otherwise significantly
related to the issuer’s business. A significant relationship can be financial, social or ethical.

· If the proposal deals with ordinary business of the company. Why? Because day to day operations
would be inefficient if subject to constant shareholder approval and seeks to micromanage a company
which is a task shareholders are not informed enough to do.
· Specific amounts of dividends
• For a shareholder proposal under § 14a-8(b)(1) the shareholder must have owned at least 1% or $2,000 in
market value of securities for at least a year
• Proposal must be no longer than 500 words
• SEC favors the inclusion of social policy proposals
• Proposals are considered non-binding recommendations made to the BOD (SH can not demand that the board
follow their determination)
• DGCL § 109 – shareholders may unilaterally vote in changes to the corporations by-laws, but at the same
time the Board retains the right to unilaterally rescind
•  BURDEN OF PROOF TO SHOW THAT A PROPOSAL SHOULD BE EXCLUDED IS
ON THE CORPORATION
• Very few ever succeed, 3% is considered a victory b/c it allows the proposal to be resubmitted
• May expose issues to the public at large and initiate policy changes
PROPOSAL PROCESS – REQUIRES THE FILING OF A PROXY STATEMENT
Rule 14a-8: this is a method of allowing shareholders to introduce their proposals to stockholders
through management proxy statements. A proxy statement is a comprehensive disclosure
document which must accurately and truthfully provide all of the information relevant to the matters
to be voted on at the meeting. Rule 14a-3 provides that no one may solicit a proxy unless the
solicitation is accompanied or preceded by a proxy statement. The rule also requires the proxy
statements to be accompanied or preceded by an annual report to shareholders, containing specified
financial data. Rule 14a-4 regulates the form of the proxy card on which shareholders indicate their
approval or disapproval of each matter voted on at the meeting. Rule 14a-6 requires copies of the
proxy statements and form of proxy be filed with the SEC at or before the time they are first mailed
to the shareholders. If the proxy statements however relate to other matters rather than election of
directors, shareholder proposals, etc., the statement and proxy must be filed at least 10 days with the
SEC prior to mailing.
The proposal, which is also regaled by the proxy rules, cannot be in opposition to management, the
stockholder must own at least 1% of company stock or must be owner of $2000 market value for a
year, then take proposal, which must be a proper subject for shareholder action, and give it to
management. If they agree with the proposal, then it rides with their materials, if not, then a
proponent is allowed to write a rebuttal letter. This provision can allow shareholders to have his or
her materials “piggy back” management materials. The proposals usually address management
compensation, environmental matters, discrimination, health issues, etc.
• If corporate management believes that a proposal may be excluded from its
proxy, it will send a notice setting forth its reasons of its intent to exclude to the
SEC and the shareholder. If the company decides to exclude the proposal, the
shareholder may appeal to the courts.
• If the SEC agrees with the issuer decision to exclude, it will issue a NO ACTION
NOTICE
o if SEC determines that the proposal should be included, it will inform the issuer that the SEC
may bring an enforcement action

Exclusions Rule 14a-8: Many kinds of proposals are excluded from Rule 14a-8, so management can
refuse to include them. Some of the important exclusions generally are:
(1) Proposals that are contrary to state law;
(2) Proposals that violate the law or rules of the SEC,
(3) Proposals that relate to personal claims or grievances,
(4) Proposals that relate to operations that account for less than 5% of the companies business or
that have been rendered moot,
(5) Proposals similar to proposals previously submitted during the past five years, which
received less than a specified percentage of votes.
Exclusions - BREAKDOWN:
a. Beyond Power to Effectuate: A proposal may be excluded if the proposal deals with a matter
beyond the registrant’s power to effectuate. (Example: national solution to the problems of growing
health insurance costs.) Rule 14a-(8)(i)(6)
b. Not significantly related to corporation’s business: A proposal may be excluded or disallowed if it
is not significantly related to the company’s business (i.e., if it counts for less than 5% of the
corporation’s total assets and less than 5% of its earnings and gross sales, and is "not otherwise
significantly related to the [corporation’s] business"). (Example: A proposal calls for Corp’s widget
division to be divested because it has a poor return on equity; if the widget division accounts for less
than 5% of Corp’s assets, earnings and sales, the proposal may be excluded.) Rule 14a-(8)(i)(5)
I. EXCEPTION – Ethical/social issues: But ethical or social issues may usually not
be excluded for failure to meet these 5% tests, if the issues are otherwise related
to the corporation’s business.
Lovenheim v. Iroquois Brands, Ltd. (1985)

RULE: “Under section 14(a) of the SEC, shareholders may include in the company’s proxy
statements certain materials that have limited, if any, economic impact on the company as long as
they are otherwise significantly related to the issuer’s business.”

Lovenhein owned 200 shares of common stock in Iroquois and thus wanted a proxy statement included
in the materials as to the treatment of geese in their production. He wanted to use the annual shareholder
meeting as a forum for his belief that the company is fostering animal cruelty by its sales. He claims to
have this right under the act especially in presenting a rebuttal letter. Iroquois refused under the
exception above Rule 14a-(8)(i)(5), asserting that its revenue from these sales comes under the 5%
threshold.
ISSUE: May an issuer refuse in its proxy materials a shareholder’s information on a proposed resolution
if the issuer decides the materials relate to a subject that is not economically significant to the company?
HOLDING: NO; while plaintiff is aware that his resolution may not pass, the loss of an arena to voice
his concerns is real and the harm may be irreparable. Iroquois is not likely to be injured by the message.
Furthermore, the drafters of the act used the clause “otherwise significantly related to the issuer’s
business” which would indicate a distribution of information of a non-economic nature. The court found
that the issue here was sufficiently related to the business.

Rule: significance of the shareholder proposal rule is aimed at guaranteeing that SH have access
to proxy statements whether or not their proposals are likely to pass and regardless of the
immediate force of the resolution if enacted. Absent a preliminary injunction, plaintiff will
suffer irreparable harm by losing the opportunity to communicate his concern with those SH not
attending the upcoming SH meeting.
c. Ordinary Business Operations: A proposal may be excluded if it relates to the "conduct of the
ordinary business operations" of the company. (Example: A proposal that the company charge 10%
less for one of its many products would relate to ordinary business operations, and thus be
excludible.) Rule 14a(8)(i)(7)
i. Compensation issues: Proposals concerning senior executive compensation are not
matters relating to the "ordinary business operations" of the company, and may therefore
not be excluded. (Example: A proposal suggesting that the board cancel any "golden
parachute" contracts it has given to senior executives — i.e., contracts that give the
executive a large payment if the company is taken over — must be included in the proxy
materials.)
d. Personal claim or grievance: A proposal may be excluded if the proposal relates “to the redress
of a personal claim or grievance against the registrant or any other person, or if it designed to result
in a benefit to the proponent, or the further a personal interest, which benefit or interest is not shared
with the other security holders at large. (Example: Company who makes surgical staples invites sales
people to come to facility to experiment by surgery on dogs. Group of shareholders did not like such
sale tactics. Company refused to include it arguing personal interest and grievance). Rule 14a(8)(i)
(4)
NYC Employees’ Retirement Sys. v. Dole Food Company, Inc. (1992)

RULE: “A shareholder’s proposal to form a committee to evaluate health insurance proposals
before Congress does not relate to the company’s ordinary business operations, but the
corporation must include the proposal’s information in its proxy statements.”

NYCERS holds 164,841 common shares in Dole Food. The NYC Comptroller required Dole to include
a statement concerning the impact of health care costs on employees’ ability to retire. NYCERS
proposed a shareholder resolution on the matter to be included within Dole’s proxy statements. Dole
sought input by the SEC which agreed with Dole’s right to exclude the proposal based on ordinary
operations.
ISSUE: Must a company include a shareholder proposal seeking to have the issuer create a committee to
investigate federal proposals affecting employee health care and insurance with its proxy materials?
HOLDING: NO; under the rule in 14(a)-8, the company must include the shareholder’s proposal unless
company can show that an exception applies. SEC asserts that if proposals affect a business’s mundane
operations, the company may reject the materials, provided they do not touch on a significant strategic
decision or significantly affect the manner in which the company does business. The proposal here does
not specifically relate to the health care of the company, thus the exception is inapplicable.
• Corporation has the burden of showing that the proposal falls under the exceptions enumerated under
14a-8[i] – “ordinary business operation,” “insignificant relation,” and “beyond the power to effectuate”
1. 14a-8[i](7) – “Ordinary Business Operations” – court finds that the proposal
does not concern ordinary business operations
2. 14a-8[i](5) – “Insignificant Relationship” (5% Rule) – court determines that
the activity addressed by the proposal, insurance, occupies more than 5% of Dole’s income
3. 14a-8[i](6) – “Beyond Power to Effectuate” – court rules that the proposal does
not require that Dole seek to lobby for insurance reform, but only that it study the impact of
insurance on Dole – a task that is within there capabilities
Austin v. Consolidated Edison Company of NY, Inc. (1992)

RULE: “Shareholders may not require a corporation to include materials concerning a
stockholder proposal supporting an employee’s right to retire with full pension benefits with 30
years of service regardless of their age, because the proposal concerns ‘ordinary business
operations.’”
Austin was employed by Con-Ed. Austin wanted Con-Ed to include in its proxy materials support of a
resolution allowing an employee to retire after 30 years of service. This was to be part of the upcoming
labor negotiations event with their employees. However, this proposal conflicts with the company’s
policy of retirement at age 60. Con-Ed obtained a no-action letter from the SEC.
ISSUE: May an issuer exclude from its annual proxy statement information on a proposal by the issuer’s
employees concerning retirement qualifications and benefits?
HOLDING: YES; the SEC has a long record of allowing companies to exclude pension proposal
information from the proxy statements. The plaintiff may use collective bargaining to press their issue.
While the availability of collective bargaining to address an issue is not determinative, it is a more
effective forum to resolve issues such as this.
• Con Ed prevailed on exclusions under:
Rule 14a-8([i])(7) – relates to ordinary business functions; and
• Rule 14a-8([i])(4) – may exclude if the proposal relates to the redress of a personal claim or
grievance, or if it is designed to result in a benefit to the proponent, or to
further a personal interest, which benefit or interest is not shared with the
other security holders at large.
• Burden: In attempting to exclude a shareholder proposal from its proxy materials, the burden of
proof is on the corporation to demonstrate whether the proposal relates to the ordinary business
operations of the company. (Held, Edison has shown that the proffered resolution comes within
the exception for ordinary business operations, there is no need to deal also with whether it is
designed simply to confer a benefit on and further personal interest of its proponents)
CLOSELY HELD CORPORATIONS

This is a corporation with relatively few shareholders and no regular markets for its shares.
Close corporations usually have never made a public offering of shares and the shares
themselves may be subject to restrictions on transfer.
The controlling shareholders, who are the seat of power in this corporation, typically elect
themselves as directors and officers of the corporation. Thus they run all three tiers of
corporate governance. A close corporation can be related to a general partnership since they
run the business they own, thus they ignore the corporate formalities imposed by the statute.
Nonetheless, if a controlling shareholder is not on the board of directors, that shareholder
cannot mange the corporation (as authorized by statute). However, in so small a
corporation, the controlling shareholder will usually be on the board. There are four
governance problems in close corporations: (1) controlling board decisions, (2) controlling
voting by other shareholders, (3) controlling the transfer of shares (LATER DESCRIBED
BELOW), and (4) abuse of minority shareholders by majority shareholders.
Characteristics
• a small company with a small number of shareholders that were deeply involved in the operations of the
business (owner & control unified); participants often want an incorporated partnership of shared
governance and limited liability
• Directors and managers have a larger stake
• a lack of marketability of the corporate shares (harder to exit because there is no market for
shares), and
• Extensive and substantial shareholder participation in management, board of directors, etc.
• There are super-votes and super-quorums in closely held corporations before action
can take place before shareholder and director/management meetings. The bad
thing about this is the ability to move forward because you are at a dead-lock
situation (filibuster). This gives shareholders equal political power within the
company so they won’t get frozen out. Thus they almost retain a veto power. (IT IS
TYPICAL FOR A MINORITY HOLDER TO HAVE POWER HERE AS SUCH
THE HOLDER BECOMES THE CONTROLLING SHAREHOLDER)
• There is a very high chance for deadlock and oppression in which can be remedied by involuntary
dissolution
• Close corporation form is often used to take advantage of limited liability that
would not be granted under a partnership
• Usually in the best interest of the Close corp. shareholders to enter into contractual arrangements to
preserve their benefits as shareholders – must counter the absence of a market out – most actions
surrounding Close Corporation disputes result from bad lawyering
(a) Ensure employment with the corp. (shareholders profits are achieved through a weekly draw, not
dividends [shareholding officer and directors would be taxing themselves twice], so want to
contractually ensure employments as a pro rata apportionment)
(b) Severance provisions – corp. or remaining shareholders will buy back by the shares at a fair price
(c) Provision that prevents other shareholders from transferring their shares to an outsider who may
fuck with the business
(d) Assure participation in important business decisions
• In a closely held corporation, the majority stockholders have a duty to deal with the minority in
accordance with utmost good faith and loyalty, as in partnerships (case-by-case basis). The
majority view is that closely held corporations are likened to partnerships, and the duty of loyalty
attaches. The minority’s (Delaware) philosophy is that they made their bed and now they must lie
in it.
• In Delaware, the articles must state that the company is a close corporation, which is subject to a transfer
restriction, and has 30 or less shareholders. The shareholders can make decisions that affect the business
of the corporation, unlike publicly held ones.
• Courts traditionally decline to intercede in the business affairs of a corporation. However, such
noninterference has led to the abuse of minority shareholders under the close corporations.
o This relationship is very similar to a partnership, these people can’t get out unless at an extreme
cost as opposed to a shareholder who can just sell.

CLOSELY HELD CORPORATION PUBLICLY HELD CORPORATION
Small, tightly knit group of Large number of investors (more than
participants (no more than 30 to 50) – 500) – no relationship with each other
often family members of former besides their share ownership that has
partners that has not issued their issued their shares publicly
shares publicly
Active, often informal participation by Limited participation by shareholders
non-specialized investor/owners in in business through proxy voting at
managing the business formal meetings; active, specialized
management by business executives
Undiversified participants who often Diversified investors who look for an
look to the corporation for livelihood investment return from appreciation
through payment of salaries or in market price and dividend income
dividends
No ready market for shareholders to Public trading markets (such as stock
dispose of their shares – sometimes exchanges) for shareholders to easily
contractual limits on transferability dispose of freely transferable shares
Significance of close corporation status: Close corporations present special problems relating to
control. The various devices examined here are mainly ways of insuring that a minority stockholder will not be
taken advantage of by the majority holder(s). The primary dangers faced by minority shareholders in these
corporations are (1) the liquidity problem, and (2) the threat of oppression and freeze-out.
There are transfer restrictions in closely held corporations: (1) membership (who is going to be a
shareholder; this position is consequential in this corporation because they exude a lot of power), (2) liquidity
(gives the corporation the opportunity to buy the shares from a shareholder who passes away or leaves), (3)
right of first refusal, (4) mandatory sell or buy provision back to the corporation, and (5)
consent restriction – a transfer cannot occur without the approval of the board of directors or without the
approval of the majority of the remaining shareholders. This is authorized by many statutes now. If a statute
does not authorize a restriction, then it is not reasonable and thus does not uphold to the standard of
reasonableness.
DUTY OF CARE IN CLOSELY HELD CORPORATIONS

 Shareholders in a closed corporation owe each other a fiduciary obligation of utmost good
faith. The duty imposed on its shareholders is a lot more stringent than that of publicly held
corporations. Courts tend to fuse the duty imposed on corporations with the duty imposed on
partnerships in closely held corporations.
 Donahue v. Rodd Electrotype Company is the ruling case in establishing fiduciary
obligations in a closely held corporation. This rule is denoted to be the “Equal Opportunity
Doctrine.” This case held that “stockholders in a close corporation owe one another
substantially the same fiduciary duty in the operation of the enterprise that partners owe to
one another. The standard of duty owed by partners to one another is one of ‘utmost good
faith and loyalty.’”
DUTY FROM THE MAJORITY TO THE MINORITY (SQUEEZE-OUTS) – ABUSE OF POWER
• Occurs when the majority refuses to pay dividends and refuses to employ the minority holder so
that the minority has no way to participate in the economic fruits of ownership
• This is due to the ability of a majority of shareholders in a close corporation to “freeze out” – “squeeze
out” minority holders b/c of the absence of a ready market for close corporation stock
• By eliminating employment, he is unable to reap the benefit of his investment
• to satisfy their duty to the minority, the majority or controlling group must demonstrate a
legitimate business purpose for their actions related to the operation of the business
• Could the same purpose be achieved by a different course of action less harmful to the
minority holder?
• even if majority’s action satisfies a legitimate business purpose, the minority shareholder
may than show that the same legitimate objective could have been accomplished through
a less harmful alternative course of action
• a court will balance the purposes of legitimate business purpose and a less harmful
course of action
Wilkes v. Springside Nursing Home, Inc. (1976) – FREEZE-OUTS

RULE: “Majority shareholders acting to freeze out a minority shareholder by terminating his
employment without a valid business purpose have breached their duty to act as fiduciaries.’”

A company was operated to form a nursing home. There were four owners, Wilkes, Riche, Quinn, and
Pipkin. Each was equal owners. As a result of their success, they started to pay themselves an increase
of $100 in salary. Thereafter, bad will develops between Wilkes and Quinn because Wilkes forced
Quinn to pay a higher price for the Springside real estate that was sold to him. This affected the
operations at Springside. As a result, Wilkes continued to fulfill his duties and responsibilities but also
gave notice that he wanted an appraisal on his shares so he could sell them. The month later, the board
met to set salaries for its officers and employees. Quinn received nothing and they did not reelect Wilkes
as an officer or director and told him his services were no longer needed. Wilkes claimed his fiduciary
duty was breached. They took action that was inconsistent with his reasonable expectations. The
dominant group froze him out.
ISSUE: In a close corporation, in which each shareholder was employed and paid a salary by the
company and served as a director, does the board breach its duty if it terminates a shareholder’s
employment without a legitimate business purpose?
HOLDING: YES; in discharging the duty in Donahue, shareholders may not act out of
avarice, expediency, or self-interest. The dominant shareholders are frequently in a
position to freeze out minority shareholders. Secure employment is a motivating factor for
many shareholders to make a serious investment in a close corporation, and a salary may be the
shareholder’s only return on the investment, so termination effectively frustrates the incentive for the
investment. His expectation must be protected. In bringing forth such claim, the court places the burden
on the defendants in assessing why they froze out the minority; was their a legitimate business purpose
and could they accomplish such feat in a less harmful fashion without injuring the minority shareholder.
The minority shareholder is to present evidence of a less harmful disposition as well. Here, the court
determines that there was no business purpose for the termination and that Wilkes was not guilty of
misconduct. They have breached their duty to Wilkes and his is entitled to compensatory damages.

o The minority stockholder typically depends on his salary as the principal return on his
investment, since the earnings of a close corporation are distributed in major part in salaries,
bonuses and retirement benefits.
o HOW COULD THIS SITUATION BE RESOLVED WITH LESS HARM TO
PLAINTIFF?
(1) Plaintiff could have sold to a total outsider and have him join the closed corp.
• he could do this to spite the other 3
(2) Other 3 Shareholders could have attempted to buy him out
• the price offered by other 3 could have been under-valued
• maybe 3 others didn’t have enough cash
• or maybe P just flat out refused to spite them
(3)  Garten suggests that 3 others should have attempted to negotiate with Plaintiff
in good faith to buy him out
•  EITHER WAY, THERE IS NO MARKET SOLUTION TO THE PROBLEM
RULE Although Majority Stockholders in a closely held corporation does have a right to assert its
own business interest, they nevertheless owe minority holders substantially the same fiduciary duty
in the operation of the enterprise that partners owe one another and the burden is on the minority
to show that the same legitimate interest could have been conducted in a less harmful
manner to the minority.
• Here, the majority cut his salary and took the real value he was getting out of his shares.
Consequently, the other members of the corporation are now receiving that benefit. This now
looks like a case of self-dealing which is enough to get past the business judgment rule. So,
the court basically treats this as a partnership case, not a corporate case, because they impose a
duty of utmost care and good faith to fellow shareholders, which they would never impose on a
large corporation.
DUTIES OF MINORITY SHAREHOLDERS TO MAJORITY– ABUSE OF POWER

• Shareholders in a closed corp. owe one another the same fiduciary duty in the operation of the
enterprise that partners own to one another
• In average traded corp. – Shareholders don’t owe a duty unless they own a majority and they
take to enrich themselves
• minority SH has a fiduciary obligation to his co-Shareholders, if the minority has been given veto
power over corp. actions
• a SH in a closely held corp. may not recklessly expose the corp. to serious and unjustified risks (like
a tax penalty)
•  by exposing a corp. to risk, the SH is not exercising utmost good faith and loyalty
Smith v. Atlantic Props., Inc. (1981) – “anything the majority does the
minority can do better”
RULE: “A minority shareholder may abuse his position by using measures designed to safeguard
his position in a manner that fails to take into consideration his duty to act in the ‘utmost good
faith and loyalty’ toward the company and his fellow shareholders.’”

Wolfson agreed to buy Norwood and thus told 3 other men about it who too bought one-fourth of the
deal. One of the 3 men, Smith, an attorney, formed the articles for the company Atlantic Props. There
was a veto provision asserted that Wolfson wanted that can only bind the corporation upon an
affirmative vote from 80% of the capital stock. Thus any shareholder can stand in the way of any
proposal by others. Disagreements arose between Dr. Wolfson and the other stockholders. Wolfson
wanted the profits realized by Atlantic Props. to go to repairs and some existing buildings. The other
stockholders desired the dividends. Wolfson stubbornly refused to declare dividends although it was
told to him and he knew that the IRS would impose penalties for refusal to declare dividends. Some of
the shareholders agreed to some improvements but nonetheless required the dividends. Wolfson
disagreed again. The other shareholders brought a derivative suit against Atlantic seeking dividends,
Wolfson’s removal as director, and Wolfson’s reimbursement of the IRS penalties.
ISSUE: Does a minority shareholder breach his fiduciary duty to fellow shareholders by relying on a
provision in the corporate charter and bylaws that allows him to thwart any action desired by the
majority shareholders?
HOLDING: YES; in discharging the duty in Donahue, shareholders may not act out of avarice,
expediency, or self-interest. Under such case, the court also recognized that the majority shareholders
may need protection from the minority. Here, there were only 4 equal holding shareholders, so under the
provision, any one can halt the progression of any measure. Though Wolfson did not want the others to
gang up on him and thus he had the right to protect himself, his actions here are nonetheless irrational
and without reason. The company was exposed to excess charges and penalties by the IRS. Wolfson also
did not take steps to minimize the recurrence of these charges. His actions were far from good faith and
loyalty.
• General principle of not deadlocking a corp. may have been in play
• Court treated Wolfson as a controlling shareholder by virtue of power to prevent decision
making.
•  HOWEVER, NOTE THAT THIS CASE WAS A MASS CASE AND DELAWARE
TAKES A DIFFERENT APPROACH
• DELAWARE APPROACH NIXON V. BLACKWELL

o Rule: “a stockholder who bargains for stock in a closely held corporation can make a business
judgment whether to buy into such a minority position and if so on what terms.”
o YOU MADE YOUR BED AND YOU MUST LIE IN IT.
o Shareholders need not always be treated equally for all purposes
o Examine whether or not the decision met the standard of ENTIRE FAIRNESS
DUTY TO DISCLOSE MATERIAL FACTS

• Close corporations buying their own stock have a fiduciary duty to disclose facts that meets the
standard of materiality.
• The duty to disclose occurs when SH offers resignation
• The corp. does not have to disclose generally to shareholders.
Jordan v. Duff & Phelps, Inc. (1981)
RULE: “If a closely held company withholds from an employee-stockholder material information
about possible increases in stock value in breach of its fiduciary duty, the employee-stockholder
may be entitled to damages if he or she can show that the nondisclosure cause the employee-
stockholder to act to his or her financial detriment.’”

Jordan got a new job and went to the president to resign. He was not informed of the potential merger
that would have increased the value of his stock, that he was forced to sell back upon his severance from
the corporation. Jordan later learned of the merger which would have made his stock far more valuable
and he filed suit, asking for damages measured by the value his stock would have had under the terms of
the acquisition. After the merger fell through he amended his complaint and demanded rescission
(wanted stock back).
ISSUE: Does a corporation owe a duty to notify an employee-stockholder leaving the corporation of
potential actions that may substantially increase the value of that stockholder’s shares in the
corporation?
HOLDING: YES; close corporations buying back their own stock must disclose all information that is
material. Rule 10(b) of the SEC and rule 10b-5 require a party to a securities transaction to provide all
necessary material disclosures to avoid fraud (prevents deceptive conduct through omissions and
misstatements of material facts). The provisions cannot be changed by contract. Furthermore, Jordan
being an at-will employee is not conclusive as to whether a company can or cannot disclose certain
materials. At-will employees have contractual rights as well. The company cannot fire the employee to
undertake in an opportunistic advantage. The court finds that such non-disclosure raises the possibility
of damages.
• Rule: The relevance of the fact does not depend on how things turn out. Failure to disclose an
important beneficial event is a violation even if things later go sour (didn’t matter that the deal
fell through b/c it may have placed J on notice of the true market value of the corp.)
• The fact that a buyer thought that the corp. was worth $50 million is a material fact
• When should a company disclose re: merger negotiations? Should be disclosed early:
Easterbrook. People in the market can decide.
Dissent- Posner argues that the company could have fired him at any point because he was an at-will
employee. Easterbrook responds with argument found in Wilkes, that the company has an obligation not to
take opportunistic advantage of its employees based on the duty of utmost good faith (conduct a balancing
test b/w the uncertainty of the merger occurring and the need for the investor to know). Furthermore, he
believes that firing an employee would ultimately lead to the resolution that he may keep his stock.
Materiality is all information which is substantially likely, given all of the circumstances, that the omitted
fact would have assumed actual significance in the deliberations of the reasonable shareholder and would
have been viewed by the reasonable investor as having significantly altered the total mix of information
available. Jordan should have been informed because the average investor would have wanted to know and
the information would have affected the average investor’s decision.
Book Value = (Net assets listed on bal. sheet) /(# of shares)

o Book value may be undervalued b/c value of assets are determined by purchase price of those assets
o Utilized when no market value is ascertainable
Two Contrasting Views of Fiduciary Law:

1. To guarantee some objective standard or fairness in corporate dealings
2. To supply missing contract terms
Garten’s View- She feels that Smith and Wilkes meet both views of fiduciary law, but Jordan only meets
the first because the contract looked complete, but the court ignored it. Case law reveals that the court will
usually bend over backwards to ensure that the first view is satisfied.
SALE OF CONTROL

Obligations of a controlling shareholder arise in two contexts: (1) exercising influence over the
corporation, and (2) selling control. In exercising control or influence over a corporation is guided by
Sinclair. The controlling stockholder breaches his fiduciary duty if it exercises
influence for the purposes of producing an exclusive benefit to itself and a
corresponding detriment to the corporation. This is the benefit-detriment test and it is
breached by proving an exclusive benefit reaped by the controlling stockholder but that benefit was a
detriment to the minority shareholders.
Sale of Control is exhibited under the case Perlman v. Feldman.
General Rule: A controlling shareholder is free to sell, and a purchaser is free to buy, that
controlling interest as a premium price, which is the added amount an investor is willing to
pay for the privilege of directly influencing the corporation’s affairs. Zetlin v. Hanson
Holding, Inc.
A control premium is the excess over and above the market value of a block of stock that comes with
controlling the corporation’s business. Control is a valuable commodity; it is the key to the corporation’s assets
and earning power.
EXCEPTIONS TO GENERAL RULE: the sale of control here violates fiduciary duties owed by the
controlling shareholder to the corporation or the minority shareholders. The two exceptions are (1) a control
person cannot sell to a person he has reason to believe will loot the corporation (this boils
down to the duty of inquiry regarding the buyer); and (2) a control person cannot divert a
corporate opportunity to himself.
Controlling Block number of shares that grant control of the corp. and the power to use the assets of a corp.
as he chooses
• Does not have to be a majority – even a minority interest may have effective control if it holds the
largest single interest (plurality) and the shareholders are fragmented and dispersed and no other SH is
as large.
• Shareholders may enter into agreements that restrict each others ability to dispose of their close corp.
shares
“First Option”  agreement that no holder may sell shares to an outside party until the corp. has first been
given the right to buy them at a predetermined price
“Right of First Refusal” the right to buy the shares of a selling shareholder, by matching the price the
outside party is willing to purchase them at
Why would An Outsider Pay A Control Premium To Gain the Controlling Block of a Closed Corp?
• Though he is paying a higher price than market value, the economic assumption is that it would be
more costly and time consuming to negotiate the purchase of a controlling bloc from minority
holders
• May have to issue a formal tender offer to acquire a majority bloc, which may be very costly
• A Purchaser of a Controlling Block Is Entitled to an Immediate Control of Management

• A contract for immediate transfer of management control must be accompanied by a sale of
sufficient stock to carry voting control

• the courts allow an immediate control of management if the purchased control block allows for it to
promote corporate efficiency and marketability
DGCL § 141(k) – “any director or the entire board of directors may be removed, with or
w/o cause, by the holders of a majority of the shares then entitled vote at an election of
directors,” with exceptions protecting cumulative voting or unless the certificate of
incorporation otherwise provides (for corps who have classes of board), shareholders may
remove only for cause.
MERGERS ARE NOT SALES

• if a corp. merges with another, the stocks are effectively exchanged and distinguished, NOT SOLD
Frandsen v. Jensen-Sundquist Agency, Inc. (1986)

RULE: “A minority shareholder’s right of first refusal that is triggered by the majority
stockholders’ sale of their stock does not apply to a transaction in which an acquiring entity
purchases the corporation’s principal asset, after which the corporation is liquidated.”

Jensen owned all of the stock in his agency. His principal asset was the bank but he also owned a small
insurance company. Then Jensen sold 52% of his shares to family relatives called the majority bloc.
Jensen, a lawyer for the bloc, and the Bank signed an agreement which gave the minority shareholders
the right to first refusal in case the bloc decided to sell their shares. Later on, the agency’s president
negotiated with First Wisconsin Corporation to acquire the bank for $88 per share. Each agency
stockholder was to receive $62 per share. The agency told the minority shareholders to sign a waiver.
All did except Frandsen. He chose to invoke the provision in the agreement to buy the shares from the
other shareholders for $62 per share. This in effect restructured the agreement so the company would
dissolve after the transfer.
ISSUE: Does a corporation owe a duty to notify an employee-stockholder leaving the corporation of
potential actions that may substantially increase the value of that stockholder’s shares in the
corporation?
HOLDING: YES; close corporations buying back their own stock must disclose all information that is
material. Rule 10(b) of the SEC and rule 10b-5 require a party to a securities transaction to provide all
necessary material disclosures to avoid fraud (prevents deceptive conduct through omissions and
misstatements of material facts). The provisions cannot be changed by contract. Furthermore, Jordan
being an at-will employee is not conclusive as to whether a company can or cannot disclose certain
materials. At-will employees have contractual rights as well. The company cannot fire the employee to
undertake in an opportunistic advantage. The court finds that such non-disclosure raises the possibility
of damages.
• Mergers are not considered sales – b/c shares have been exchanged and extinguished not sold.
In a merger, the acquired firm disappears as a distinct legal entity. In effect, the SH of the
merged firm yield up all of the assets of the firm, receiving either cash or securities in
exchange, and the firm dissolves. In this case the SH would have received cash. Their shares
would have disappeared but not by sale, for in a merger the shares of the acquired firms are
not bought, they are distinguished. There would have been no Jensen-Sundquist after the
merger and no SH in Jensen-Sundquist.

• A sale of the majority bloc’s shares is not the same thing as a sale of either all or some of the holding
company’s assets. The sale of assets does not result in substituting a new majority bloc, and that is
the possibility at which the protective provisions are aimed.
• The transfer of a company’s assets is a merger and not a sale of shares, thus
Frandsen does not have a right of 1st refusal b/c the shares in a merger are not bought but rather
they are extinguished.
• The sale of a holding company’s largest asset does not trigger the Right of First Refusal
because they are not selling shares.
• P is unable to buy because he still retained something that he bargained for – the “take
me along” provision.
Zetlin v. Hanson Holdings, Inc. (1979)

RULE: “In the absence of an allegation that a shareholder is looting corporate assets, conversion
of a corporate opportunity, fraud or other acts of bad faith, a shareholder may obtain a premium
price for the sale of the controlling block of shares.”

Zetlin owed 2% of Gable while Hanson and Sylvestri owed 44.4% in conjunction which is the
controlling stock of Gable. The controlling stock sold their shares to Flintkote for $15 per share, which
was a lot higher than the market value of $7.38 per share. Zetlin, a minority shareholder sought to
obtain the additional profits attained by the controlling stock.
ISSUE: If the controlling shareholders transfer their entire interest in a corporation to a new buyer and
receive a price in excess of the market price for their shares, are the selling shareholders obligated to
share their premium with the minority shareholders?
HOLDING: NO; minority holders may be protected from abuse and unfair advantage from the majority
holders, but they may not inhibit the majority holders’ financial interests. The majority invested a lot
more money in the business as such to attain the majority block. Thus a premium on a sale of their
control represents a return on their greater investment. Furthermore, a sale of control allows the new
owner to implement their decisions and policy. HOWEVER, Courts have held a controlling
shareholder who is offered a higher price for his or her shares, must inquire of the
buyer’s motives if the premium is excessive, if the corporation’s assets are financing
the payment, if the buyers are in a hurry, or if the corporate assets are extremely
liquid.
Rule: those who invest the capital necessary to acquire a dominant position in the ownership of a
corporation have the right of controlling that corporation, and absent looting of corporate assets,
conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling stockholder is
free to sell, and a purchaser is free to buy, that controlling interest at a premium price.
Rule: Although minority shareholders are entitled to protection against abuse by the majority SH, they
are not entitled to inhibit the legitimate interests of the other stockholders. Thus, control shares usually
command a premium price. The premium is the added amount an investor is willing to pay for the
privilege of directly influencing the corporations’ affairs.
DUTY OF CONTROLLING BLOCK TO NOT DIVERT A COLLECTIVE OPPORTUNITY

Pearlman v. Feldman (1955)
RULE: “A shareholder with a controlling interest who transfers his or her shares is accountable
to the minority shareholders for the amount in excess of the market price if the premium is
attributable to the sale of a corporate asset.”

Feldman was the chairman and majority shareholder of Newport. Wilport sought to buy the controlling
interest of Newport and offered Feldman $20 per share which was higher than the market price of $17
per share. Feldman agreed to the purchase. The minority holders argued that Feldman received payment
for a corporate asset with the sale of his shares because Wilport obtained the ability to direct the
corporation’s end product to itself.
ISSUE: If a majority shareholder receives a premium for the sale of shares that is attributable to a
corporate asset, must the majority holder account for that premium to the other shareholders?
HOLDING: YES; Feldman has a fiduciary duty to the minority holders. By siphoning corporate
advantages for personal gain in the form of market advantages, a shareholder acts for personal gain and
against the company and its shareholders. When Feldman sold his interests, he received funds that could
have been used to make the company more productive, sacrificing the company’s good will. However,
the plaintiffs here must bring a direct suit because a derivative one will allow Wilport to benefit too.
NOTE that this case seems to be at odds with Zetlin; however the distinction between this
case and that rests in the propriety of the acquiring company’s motive. The Wilport
management did not want simply the ability to run the company and make a profit; they
wanted to use the company to further their original business, not Newport.
• Controlling shareholder breached his fiduciary duty of loyalty to minority shareholders when
siphoning off for personal gain corporate advantages derived from favorable market conditions
• the control premium D received for his shares was directly due to the premium buyers were
willing to pay for steel in a time of shortage and that this premium was therefore essentially a
corporate asset that should have belonged to the shareholders’ pro-rata
o  with the Feldman plan, the corp. was experiencing profits and when D sold the corp.,
the plan was dismantled, thereby DIVERTING A COLLECTIVE OPPORTUNITY
FROM THE CORPORATION AND SHAREHOLDERS
• Rule- A majority many not sell to a group that they know or suspect will loot the corporation.
Furthermore, even when the shareholder does not have any reason to know that the group will
loot the company, the seller is accountable when he knows or has reason to know that the person
intends to use their newly purchased control to prevent the company from realizing profits that it
would have otherwise obtained.
• How do you determine whether the majority has reason to know that potential buyer will loot?
Court will examine the facts- was the sale reasonable? Second, based on all of the facts, would a
reasonable, prudent businessperson suspect looting? Third, was it negligent for the majority to
fail to recognize the potential for looting?
General RuleA majority stockholder can sell his controlling block to outsiders at a Premium w/o having to
account to his for profits.
Exceptions:
1. “Looting” controlling shareholder may not knowingly, recklessly, or perhaps
negligently, sell his shares at a premium to one who intends to loot the corp.
by unlawful activity. Look for
• willingness to pay excess price
• excessive interest in liquid and readily salable assets
• insistence on immediate possession of liquid assets
But
•Is it reasonable to require that the majority block owner
investigate the buying parties’ intention?
2. “Sale of Vote” Essex v. Yates – looks to situations where the buyer purchases
directorship positions by having the seller have people resign so the buyer
does not have to wait till the next shareholder meaning to exert control –
ONLY bad when the new shareholder would not have been able to get the
position through vote at subsequent meetings anyway
3. “Diversion of Collective Opportunity” Situations where the control premium is
found to belong to the corp. as a whole not the controlling shareholder:
i. when the control premium really represents a business opportunity that
the corp. could and should have pursued as a corp. (Perlman v.
Feldmann)
ii. when buyer initially tries to gain control through open market purchase
of minority shares and the controlling shareholder convinces the buyer
to buy his controlling block a premium
• In a time of market shortage, where a call on a corp.’s product

commands an unusually large premium, a fiduciary may not appropriate to himself the value of this
premium. There were various outside circumstances such as the Korean War in need of steel. [Garten
say it is not clear what this means]
Essex Universal Corp. v. Yates (1962)

RULE: “If the transfer of shares is sufficient to constitute the transfer of a controlling interest, a
seller may lawfully agree to assist the buyer in installing a favorable board of directors.”

Yates was the president and chairman of Republic Pictures. Essex wanted to purchase somewhere
between 500,000 to 600,000 shares. Upon closing, Yates was to deliver the resignation of the majority
of his board so that Essex can put their replacements in. Yates told Essex that he could give him 567,000
which is good for 28.3% of the stock (controlling interest). Essex brought bank drafts totaling 1 million
for the closing. Essex’s banker endorsed the drafts to Yates, but Yates refused to deal because he
believed the change in directors would be held improper. Essex sued Yates demanding a transfer of
shares and a loss of 2.7 million in stock appreciation.
ISSUE: Is a contract that provides for the transfer and control of the board of directors illegal per se
under NY Law?
HOLDING: NO; NY Law prohibits the sale of corporate office. Here there was a purchase of the
controlling stock of the Republic. Essex could have easily elected a majority of the board or installed its
own set of directors without Yates’ assistance. But because the directors’ terms are staggered, it had to
wait 18 months in order to get official control. The transfer here is immediate. A court usually does not
question a shareholder’s ability to completer a transaction. The court here permitted the parties to

contract to change the board more rapidly than the new owner could have because there was no air of
wrong-doing.
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IV. MERGERS, ACQUISITIONS, AND
TAKEOVERS
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A. MERGERS AND ACQUISITIONS
• In a merger, the boards of directors of the respective corporations formulate a plan of combination
under statutory provisions. If the statutory merger procedure had been used, approval by votes of the
board of directors and shareholders of each of the two corporations are required. The “plan of merger”
or “agreement of merger” or merger agreement will specify which is to be the surviving entity, who is to
receive what (in terms of shares of stock of the surviving corporation, or cash), what warranties and
representations the parties make to one another, and a myriad of details.
• When the articles of merger are filed, the acquired corporation ceases to exist, by operation of law. All
the acquired shareholders become acquirer’s shareholders. Note that the shareholders who voted against
the merger are entitled to demand to be paid in cash the fair value of their shares. This is called
appraisal rights. Sharedolders in a merger situation can also request for their “preemptive rights” since
the incoming shares of the target corporation and their shareholders will dilute their stock in their
corporation. They must be givcen the right to purchase enough stock for them to maintain their
percentage in the company prior to the merger. (Amendments to the articles may be key here, issuance
of stock)
• If the surviving corporation is to be an entirely new entity, into which both of the constituent
corporations are to be merged, the transaction is often called a “consolidation.”
Merger-type v. Sale-type:
• In a merger-type transaction, shareholders in the “target” corporation end up with stock in

the acquiring corporation. The acquiring corporation now owns the acquired business as
well as the acquirer’s original business. So in a merger, the target shareholders have a
continuing stake in the newly-combined enterprise. From the acquirer’s view, their share
ownership of business is shared with new people and its shares are diluted. In a merger, the
acquirer can issue stock to the target company or they can be paid cash in a cash-out merger,
or can be paid a combination of stock and cash. Creditors of the target corporation become
creditors of the acquiring corporation.
• In a sale-type deal, the target’s shareholders end up with cash (or, perhaps, some type of
debt instrument issued by the acquirer, like notes). Those holders thus no longer have any
ongoing stake or equity interest, in either the target or the acquirer. From the acquirer’s
view, they don’t have to give up any claims to its own assets, it may have more debt or less
cash but they still own the entire business and now the target’s business.
Four main techniques that fall into the merger-style category:

1. Traditional statutory merger: by following procedures set out in the state corporation statute, one
corporation can merge into another, with the former ceasing to have any legal identity and the latter
(surviving corporation) continuing in existence. Shareholder approval needed and requires the consent
of board for both companies. By automatic operation of law, acquirer acquires all of target’s assets and
all of its liabilities.
2. Stock for Stock Exchange (stock swap): the essence of the stock swap is that the acquiring
corporation, instead of entering into a plan of merger with the target corporation, makes a separate deal
with each target shareholder, giving that holder shares in the acquiring corporation in exchange for the
shares in the target. The target keeps its separate corporate identity (though it is now a subsidiary of the
acquirer). Acquirer can liquidate the target and distribute its assets to itself. No consent needed and no
approval needed. Minority interest in the target can disrupt the share for share exchange by simply
refusing to tender their shares.
3. Stock for Assets Exchange: TWO STEPS: a) the acquiring company gives stock to the target
company, and the target company gives all or substantially all of its assets to the acquiring company in
exchange. B) The target dissolves and distributes the acquirer’s stock to its own shareholders. If both
steps are carried out, the net result is virtually identical to the result in the true merger scenario. Here,
there is no need for acquirer’s shareholder approval, assuming that there were enough authorized but
unissued shares to fund the transaction, and assuming that the increase in the number of issued shares
that would result from the transaction would be reasonably small. Also, chance to acquire assets without
its liabilities.
4. Triangular Mergers: they involve three parties: the acquirer, a subsidiary of the acquirer created
especially for the transaction, and the target. This type of merger deals with the new effects of having
new assets, new liabilities, and possibly new shareholders.
Sale-Type Transactions: The key distinction between sale and merger ones is that in the sale case the
stockholder in the acquired company is effectively cashed out. He gives up his equity interest in the target
company for cash, or perhaps a combination of cash and debt. The target company shareholder no longer has a
common stock interest in the assets of either the target or the acquiring company.
1. A sale of the target’s assets for cash, followed by a liquidation and distribution to shareholders
(asset-sale-and-liquidation): this is carried out by corporate action on the target’s part. The target
board approves a sale of all or substantially all of the target’s assets to the acquirer, and this sale is
approved by a majority of the target shareholders. The target conveys the assets to the acquirer, and the
target receives the cash, or debt, payment from the acquirer. Typically, the target then dissolves, and
pays the cash or debt to the shareholders in proportion to their shareholdings, in the form of a liquidating
distribution. Here, if the target board doesn’t approve, it can block a sale.
2. A sale by each shareholder of his target company stock in return for cash, perhaps followed by a
liquidation of the target (stock sale): Here, no corporate level transaction takes place on the target’s
side. Instead, the acquirer buys stock from each target company shareholder. After the acquirer controls
all or a majority of the target company stock, it may take the second step of dissolving the target and
distributing the assets to itself. If there remain minority holders in the target, the acquirer would
distribute assets both to itself and to those other minority holders, in proportion to their stockholdings.
To eliminate minority, acquiring company can a) liquidate the target, distribute proportional
percentage to minority holders and the balance to itself; b) it can merge the target
company in which the minority holders will receive either cash or acquirer’s shares.
“Back-end Merger”

a. Tender offer v. individually-negotiated purchases; there are two ways in which the
acquirer might carry out this stock purchase plan: a) by a classic tender offer, in which the
acquirer publicly announces that it will buy all of shares offered to it by the target company’s
SH; and b) by privately negotiated purchases from some of all of the shareholders.
Elimination of Minority Shareholder: This is a much cleaner way to eliminate any minority interest in the
acquired company than does the stock-sale approach because the acquirer pays the consideration directly to
the corporation, and receives the assets free and clear of any minority interest. If the acquire buys stock, by
contrast, the acquirer may not succeed in getting all of the shares; the acquirer will thus be left with minority
stockholders to whom it will owe a Fiduciary Duty. (These might be eliminated by a majority shareholder
approved plan of share exchange or by an eventual back end merger of the target into the acquirer. Thus, if
the transaction is a friendly one, an asset sale if clearly superior to a stock sale from the standpoint of giving
the acquirer complete control over the target’s business.
Short Form Mergers: In a case in which a parent corporation owns 90 or 95% of the shares of a subsidiary, the
parent may merge the subsidiary into another subsidiary and the 5 or 10% minority has no voting rights. They
are also called practical mergers.
Cash Tender Offer (takeover bids): A takeover bid, or tender offer, is an offer to purchase made directly to a
company’s shareholders, for cash or stock, without the intervention of any intermediary, such as a stock
exchange. The bid, or offer, has as its objective control, or a measure of control, in the target company. The
offer may be conditional on obtaining a certain percentage, only for a certain percent, or for any or all shares
tendered. If a tender offer is for less than the entire target company shares (e.g. 50%), and the offer is
oversubscribed, the bidder must take up pro rata shares (pro rata take-up rule) tendered in the first 21 days
(e.g. 70%). Thus, the bidder may not take up 100% of friends’ or cronies’ shares, ad less of strangers’ shares.
In the example, the bidder must take up 5/7ths of each tendering shareholder’s shares.
Cash Takeover: The cash takeover has as its advantages secrecy, speed, simply
Phase one: A bidder usually begins by purchasing target company shares in the
market. Purchase exceeding 5% must be disclosed.
Phase two: once the 5% threshold has been reached, bidders step up their market
purchasing in the ten-day window which follows. The average hostile takeover
bidder owns about 14% of the target company by the time it files with the SEC and
gives the target company notice.
Phase three: is the takeover bid itself. Bidders offer to pay a premium over market
price sufficient at least to obtain 51% control. (offer to whom????)
Phase four: involves use of the shares, and votes, obtained via the market
purchasing and the takeover bid to install the bidder’s own nominees as directors of
the target company.
Phase five: which doesn’t always necessarily follow, involves the recommendation
by the new target company board of a merger into the takeover bidder or a
subsidiary of the takeover bidder. This is often called the “back-end” or “second
stage” of a two stage takeover bid while the takeover bid is the “front end” of the
deal or “first stage.” The merger is a “cash merger” in which the minority shares
are offered cash. They are thus squeezed out of the company. No more public
shareholder will be left.

Proxy Contest or Proxy Fight: is the other principal means of taking over a company by hostile means. It
entails delays, for regulatory fillings with the SEC ad for the actual solicitation process, just like tender offers.
Reverse Transaction: the true target, or acquired corporation, is the surviving corporation for legal purposes
(that is, is specified in the articles of merger as the surviving corporation).
Sale of Assets: A principal difference from merger is that, in a sale of assets transaction, the
target corporation does not disappear by operation of law. After the smoke clears, the target,
or selling corporation will still exist, holding the cash or stock received for the assets. It
could reinvest those proceeds to go into an entirely new line of business. Or, as is usually the
case, it could distribute the shares or cash received to its shareholders. But, even after a
distribution to its shareholders, the selling corporation would still exist, if only as a corporate
shell. It takes a separate, voluntary act of dissolution for the target to disappear.
Shareholder Protection
Case law and statutes provide protection for shareholders from the effect of mergers and
acquisitions:
(1) Sue the directors who approved the merger alleging breach of the duty of care or
loyalty
[Shareholders who sometimes are dissatisfied with what they receive in a merger sometimes
sue the directors, who approved the merger, alleging they breached their duty of care in
approving the merger (Smith v. Van Gorkom). Shareholders may also sue for breach of
loyalty when a director engages in self-dealing or is on both sides of the deal (Weinberger v.
UOP)]; and
(2) Vote against the merger and assert dissenting shareholder’s right of appraisal.
Appraisal is granted for ONLY mergers and consolidations, NOT sale purchases.
[This is a cash-out remedy for those shareholders that who opposes the merger. A
shareholder who opposes with the merger and complies with the notice and procedural
requirements of Delaware § 262 has more than the right to have her shares appraised or valued.
Rather the shareholder can force the company to pay her in cash the fair value of her shares as
determined by the judicial appraisal process. NOTE in this process, the shareholders are typically
alleging that the corporation stole the shareholder liquidation value or they hindered the corporation’s
book value].
Appraisal rights protect shareholders against fundamental nature of ownership interest;
Delaware reserves appraisal for private and closed companies because Shareholders can
always sell their shares in the open market if in publicly traded company; appraisal
protects Shareholders against unfair price.
Del Corp Law § 262(b)(1)- Appraisal rights are barred if:
1. Stock is listed on a national security exchange or NASDAQ
2. Stock is held of record by 2000 or more people
NOTE HOWEVER - § 262(b)(2) restores appraisal rights for ALL types of corporations
if it is a cash merger
Public Policy- You don’t want to force people to own companies that are fundamentally
different than the one that they originally bought. Appraisal rights are restricted on
publicly traded stock because if a person does not like the new company all they have to
do is sell their shares. Second, appraisal rights protect shareholders from being raided
because companies won’t force shareholders to accept artificially low price for their stock
if they can just force the company to buy it back after the merger.
NOTE: Most mergers today are securities mergers so appraisal rights are rare.
DE FACTO MERGERS
This is a judge made doctrine that typically comes into play in a sale of assets transactions
and thus impacts the rights of both shareholders and creditors. The rationale behind this
doctrine is that since the end result of a sale of asset transaction is substantially the same as
a merger, the impact on shareholders and creditors should be equivalent. (The law should
treat the transaction like a statutory merger, with effect that the purchasing company should
automatically assume the debt of the acquired company and the shareholders should have
appraisal rights comparable to those in a statutory merger. Furthermore, the shareholders of
the selling company can now get the right to vote on such transaction.)
See Del. Corp. Law §§ 251, 262, 271
Only occasionally accepted - Only a few courts have accepted the de facto merger
theory, and they have done so only in specialized circumstances. They are most likely to
do so when the target has transferred all of its assets and then dissolves, and when the
target’s shareholders receive most of their consideration as shares in the acquirer
rather than cash and/or bonds.
Test: When a corporation combines with another so as to lose its essential nature and
alter the original fundamental relationships of the shareholders among themselves and
to the corporation, a shareholder who does not wish to continue his membership
therein may treat his membership in the original corporation as terminated and have
the value of his shares paid to him.
Farris v. Glen Alden Corp. (1958) – minority view/ Pennsylvania

RULE: “If a contemplated transaction’s result is the same as a merger, the transaction is a de
facto merger, and the target corporation’s shareholders have the right to dissent and receive fair
value for their shares.”

Glen Alden has been experiencing a decline in revenues. List Industries own a number of companies
and one of its subsidiaries purchased 38.5% of Glen shares which allowed List to put 3 of its directors
on Glen’s board. Both companies signed an agreement where Glen would acquire all of List assets and
distribute it to their shareholders; Glen would assume List liabilities; Glen must change its name to List
Alden; the board of both companies would combine; and List would be dissolved leaving List Alden to
operate both businesses. Glen mailed its shareholders a note and proxy statement describing the
reorganization and recommending its approval. Farris sought to enjoin Glen since the notice failed to
denote the company’s true purpose which was to approve a merger, which in turn did not inform the
shareholders of their right to appraisal, and that the company would suffer irreparable harm if such
merger occurred. The defendants denied it was a merger.
ISSUE: If the result of a transaction between 2 companies accomplishes the same result as a merger,
should the target company’s management be required to treat the reorganization as a de facto merger and
permit its shareholders the right to dissent and receive fair value for their shares?
HOLDING: YES; pursuant to section 908 of Penn. Corporate Law, a shareholder in a company
proposing a merger is entitled to appraisal. Certain transactions, even if not called mergers do result in
one. If the transaction changes the corporate nature significantly that a shareholder may not want to
remain, he should be able to leave without economic harm. Under the terms, List Alden is a diversified
company, no longer a coal mining business. It will have a lot more debt since it is diversified as such
that the minority holders may suffer net losses. The defendants argue that minority rights are eliminated
in reorganization transaction in dealing with asset purchases. The result of the transaction here is a
merger, not a sale.
AFTERMATH: The Pennsylvania Legislature modified the corporate law to defeat and eradicate de
facto mergers.
• Usually rejected: Most courts, including most notably Delaware, reject the de facto doctrine.
• Court held that in deciding whether a transaction is in fact a merger, a court must look not the
formalities of the agreement but to its practical effect. There is no fairness standard such as in
DELAWARE, which gives companies flexibility in structuring their merger.
• Rule: When as part of a transaction b/t two corporations, one corporation dissolves, its liabilities
are assumed by the survivor, its executives and directors take over the management and control of
the survivor, and, as consideration for the transfer, its stockholders are forced to acquire a
majority of the shares of stock of the survivor, then the transaction is no longer a sale of assets,
but a de facto merger.
Hariton v. Arco Electronics, Inc. (1963) – Majority Rule/ Delaware

RULE: “A reorganization plan that requires one corporation to sell its assets to a second
corporation in exchange for stock in the second corporation and that calls for the first corporation
to liquidate and distribute the second corporation’s shares to its stockholders constitutes a
permissible de facto merger.”

Arco and Loral engaged in a contract to combine the companies. Arco would sell their assets to Loral in
exchange for 283,000 shares of Loral stock and the Arco would hold a shareholders’ meeting to approve
the reorganization agreement and then dissolve. Upon dissolution, Arco would distribute the Loral
shares to its former shareholders. Hariton, an Arco shareholder, who did not vote at the meeting sued to
enjoin the reorganization arguing it was illegal.
ISSUE: May two companies agree to reorganize if the result is a de facto merger, using the statutory
provisions concerning the sale of assets rather than the provision governing mergers?
HOLDING: YES; in a statutory merger, the target company shareholders retain their rights, but in a
transaction, the former company shareholders are left owning only part of a holding company that is
removed from the business’ day to day operations. The plan that allows the companies to accomplish

indirectly what they preferred not to do directly, is protected under the statute, since the merger and sale
of asset statutes are independent provisions.
SALE OF ASSETS
With the sale of assets, one corporation can sell all of its assets to another corporation,
in consideration for cash, stock of the acquiring corporation or a combination of the
two. This actually has the same effect as a merger, though it is not written or seen as a
merger. Furthermore, while state corporation statutes require a corporation to obtain
the approval of its shareholders in order to sell all or substantially all of its assets,
Delaware and most other states do not provide appraisal rights for the shareholders of
the selling corporation. The acquiring company’s shareholders have neither appraisal
rights nor the right to vote on their corporation’s buying the assets. However, unlike
mergers where the acquiring company would be liable to the target’s creditors, here,
there are no comparable statutory provisions making a buyer of the assets of a
corporation liable to that corporation’s creditors. A general common law rule is that
the buyer of a corporation’s assets is not liable for the selling corporation’s debts. A
sale of assets, whether all or substantially all, does not destroy or terminate the target
corporation’s legal entity or legal existence as a corporate entity. Sale of all assets is
followed by dissolution, which does not refer to termination. The corporation here is in
the process of winding up.
• DELAWARE REJECTS DE FACTO MERGER DOCTRINE

Delaware Law-
1. Only the shareholders of the selling corporation get to vote
2. Shareholders get to vote on the creation of new shares because the charter needs
to be amended to do this
3. Appraisal rights are not conferred under a sale of assets type merger
• Sale of assets: A sale of assets involving dissolution of the selling corporation and
distribution of the shares to its shareholders is legal. Legislatures tend to place
greater scrutiny on mergers than on asset sales. The perception appears to be that
the chances of injuring minority shareholders are greater in a merger, especially
cash mergers (which can be very abusive). For that reason, restrictions may be
placed on mergers that are not place on asset sales.
• RULE: In a true sale of assets, the stockholder of the seller retains the right to
elect whether the selling company shall continue as a holding company.
Moreover, the stockholder of the selling company is forced to accept an
investment in a new enterprise without the right of appraisal granted under the
merger statute.
• If an asset sale meets the legal requirements of such a sale, the fact that it might be a de facto
merger should not invalidate.
•The sale of assets accomplished through § 271 and resulting corporate reorganization (as well as
mandatory plan of dissolution and distribution) is legal.
• court reasoned in Hariton that Plaintiff could have taken either an assets for sale liquidation or
statutory merger route (the court calls this equal dignity)
o under equal dignity, there were 2 avenues
 §271 (Sale of Assets)
 §251 (Statutory Merger)
Under DELAWARE law, you need shareholder approval for §271 and §251
Under DELAWARE law, de facto mergers where there is a sale of assets for stock under §271 DOES
NOT INVOKE APPRAISAL.
DGCL § 251 – Merger and consolidation of domestic corporations

• It does not amend the certificate of incorporation of such constituent corporation
• Each share is identical to share in surviving corporation after date of merger
• No shares of the surviving corp. are to be issued or delivered
• Shares to be issued or delivered do not exceed 20% of the common stock
DGCL § 271 – a corporation may sell or exchange all or substantially all of its property or
assets as its board of directors sees fit for best interests of the corporation if authorized by
resolution adopted by a majority of voting shareholders.
EFFECT OF MERGERS ON DEBENTURE HOLDERS
Sharon Steel Corporation v. Chase Manhattan Bank, N.A. (1983)

RULE: “Boilerplate successor obligor clauses that do not permit assignment of public debt to
another party in the course of a liquidation unless all or substantially all of the company’s assets
are transferred to a single purchaser prevent a purchasing company that acquires only 51% of the
liquidating debtor’s assets in the last of a series of sales from becoming the successor obligor.”

Sharon Steel pays over a million dollars to pay for the steel division of UV. A (debentures) debt
instrument of UV is purchased by Sharon Steel under the terms that UV will pay the debenture at a
specific rate over a period of time. The face value of the debenture purchased by Sharon Steel was
higher than that of the market value because the interest rate on the debenture was lower than other
equivalent debentures. When assessing the debt market value, you look at the failure risk associated with
the issuer of the debt (in other words you look at the credit risk of the issuing company-will they be able
to pay the debt back?), you look at whether you can find a debenture with an equal value, and a same
maturity date, that pays a higher interest rate. You value more a company that is a lower credit risk and
you value less a company that is a greater credit risk. You value more a company paying a higher
interest rate on the same face value.
Sharon Steel may have been willing to purchase the debenture from UV because the interest rate was
low and it amounted to a low interest loan. They assumed the debenture and would be able to subtract
the debenture from the purchase price of UV’s steel division. UV was a diversified conglomerate with
many different industries unified under a single name. UV begins selling industries because selling the
assets would allow them to make more money for shareholders (so UV could dissolve and give the cash
to shareholders to reinvest in another company). Debt holders of UV (such as Sharon Steel) would not
like the selling of assets because once UV dissolves, there is no money left to pay the debt holders
during and at the end of the term of the debenture. The selling of assets would leave the company with
no money for creditors to be paid on the debts of UV, which makes holding a debenture in UV risky.
UV and Sharon Steel had an agreement that said SS would assume all the debenture obligations of UV if
it began to sell its assets off. UV argues that this provision is boiler plate and is not really a term that
was negotiated. An Indenture is the contract that sets for the rights and obligations of the debenture
agreement and Chase was the Trustee of this Indenture contract. Chase’s role however was miniscule.
UV pays the interest payments to Chase and Chase maintains the books and ensures SS get its money.
Chase’s legal obligation to the debt holders and debt issuers is very little.
ISSUE: Is a purchasing company deemed to have purchased substantially all of an issuing company’s
assets if the purchasing company buys only half the issuing company’s assets as part of the last in a
series of sales disposing of portions of the company’s assets? ?
HOLDING: NO; boilerplate successor obligor clauses comes from basic contract law and presents
questions of law. A bondholder is generally not protected against the issuer’s actions unless he or she
brings an action based on the contract terms governing the indenture. Sharon Steel claims it owns UV
since it bought all it assets. However, the bank claimed that Sharon Steel only bought 1/3 of the
companies sold off by UV. If UV still owned what it sold to Sharon, this suit would be dismissed since
no event would have triggered these clauses. Sharon says the purpose of the clause is to allow the corp.
the freedom to merge or sell assets, not protect lenders whereas the bank argues just that, the purpose is
to protect lenders by assuring continuity of ownership. Under rules of construction, if there is
conflicting interpretations, the court must apply the one that does the least harm to both sides. The bank
is the most appropriate here.
Judge Winter says we want the debt to follow the assets and we don’t want debt holders to be left with a
shell of a company. If UV debenture holders stick with UV and UV sells all its assets, then the money
goes to the debenture holders. On the other hand, if SS holds all of UV’s debentures, then the
shareholders get all of the money that occurs when the sale of the corporation occurs. The latter is what
UV wanted to occur but SS did not. Judge Winter says management has to think about debt holders in
the same way you think about shareholders. Because if the value of debt can be diminished so quickly
by this type of transaction, debt holders would never supply debt and the debt market would crash so
this judgment is meant to protect the market by putting a duty on a corporation by telling management
they cannot overreach to harm debt holders.
A clause in a debt instrument preventing accelerated maturity in the event of a sale of all or substantially all the
debtor’s assets is inapplicable if the assets are sold piecemeal. Because such a clause is boilerplate, the term
“all or substantially all” means those assets existing before divestiture begins.
• Fiduciary duty is owed to shareholders, not debenture holders. Debenture has a contract.
Doesn’t deserve extra duties.
• Purpose of corporation is to make money for shareholders, not debt holders or employees: Dodge v.
Ford rule. Fiduciary Duty runs from Board of Directors to Shareholders. No corresponding duty that
runs from BOD to debt holders. Debenture holders are not owed a duty because of conflict of interest
in relation to Shareholders. Does this make sense as a business matter? How well did these debenture
holders protect themselves? In the event of a merger, consolidation or sale of UV assets, the buyer had
to assume debt obligations. This is exactly what Sharon Steel did. Debt holder argued that the clause
doesn’t apply to this transaction; no merger, no consolidation and not a sale of substantial assets
because Sharon Steel is only buying 1 of 3 assets.

• If the debenture holders don’t were not purchased by Sharon Steel, then they would be left with UV; so
how are they better off? Because UV would be liquidated and pays off the creditors (debenture
holders) then to the remaining shareholders.
• The judge bought the argument of the debt holders. SS only bought part of the assets. Is this right?
• Could UV enter into separate assignment whereby SS would assume the debenture? Look at the
contract: source of debenture holder’s rights and obligations. If nothing is said, then there is nothing to
prohibit it, except for one thing: is it fair?
• Trustee’s function (chase): they collect the money from UB and distributes to holders.
• Are people going to buy debt if they know that their value can diminish like it did here? The judge took
the boiler plate and construed it liberally as possible to benefit the holders. Money is coming at the
direct expense of shareholders. This case illustrates when debt holders rights are legitimately
jeopardized.
• RULE no assignment of debentures unless all or substantially all of a company’s assets at the
time the plan of liquidation is determined upon are transferred to a single purchaser
o all the assets that the debtor assumes are still available to back the debentures
o in this case, the corp. no longer exists after the merger, (as a result of the liquidation) so the
debt must go somewhere
PURCHASE OF STOCK
One corporation buys all or most of another corporation’s outstanding stock. There is a
difference between a purchase of stock versus mergers and sale of assets. Only ownership
changes. Equally obvious, the purchase of stock does not require any agreement between the
board of the purchasing company and the board of the target company. The deal is simply
between the acquiring corporation and the individual shareholders of the target corporation.
This means the acquisition can go forward even if the board of the target corporation
opposes the deal. This is typically a vehicle used in hostile takeovers of publicly held
corporations.
HOSTILE TAKEOVER
A hostile takeover is used to describe an attempt to gain control of a corporation over the
objection of that corporation’s management. The acquiring company is termed to be the
bidder, or better yet, the raider or shark. This shark is after the stock of the target company.
Sometimes control of a target can be acquired by buying a controlling block of outstanding
shares from a control person or members of a control group. Acquiring control by buying
the interest of a control shareholder is a type of friendly acquisition. Hostile takeovers
involve situations where the bidder is not able to acquire a sufficient number of shares of the
target company to gain control from a single shareholder or an allied group. In these
situations, the bidder does not want to pay for any shares of the target company unless it is
able to buy a sufficient number of shares to gain control of the target company. If the target
is a public company, which is usually the case, the usual process of hostile takeovers is by
tender offers, in which the existing shareholders are being asked to tender their shares for
sale. In these offers, the bidder offers cash or securities of the bidder (or a package

consisting of a combination of cash and securities) to the stockholders of the target company
who tender their stock. The tender offer will almost always be conditioned on a sufficient
number of the target’s shares being tendered to ensure that the bidder gains control of the
target company.
Marathon Oil Company v. U.S. Steel Corp. (1982) – FIRST CLASS CASE
Mobile Corporation initially instituted a hostile tender offer of Marathon Oil Company for $85 per
share. Marathon was vulnerable because its common stock price has been depressed and because the
ownership of its common stock was widely dispersed with no one person or institution owning a
controlling interest in the company. The board believed this offer to be grossly inadequate. However,
Marathon was driven to the wall because they had failed to previously take adequate precautions against
hostile takeovers, especially since their bargaining power is completely jeopardized here. Marathon
attempted to solicit “white knight” bids. US Steel came to the rescue and presented an offer to purchase
51% of the outstanding common stock of Marathon at $125 per share. The shares not owned by US
Steel would be subjected to a fee. US Steel’s plan causes these shares to be converted into notes which
in theory will cause Marathon to dissipate. Since this is a publicly held corporation, the minority
shareholders could have easily sold their shares based on any disapproval of merger. However, they
decided to stay. In addition, the directors and officers of the Marathon Company had obtained a
personal profit not shared by other shareholders. US Steel also had demanded from Marathon that it
consented to its “lock-up options” and “poison well” options in order to defeat any other competitive
offers. Thus, US Steel has acquired roughly 80% of the company and sought to squeeze out the minority
holders. The plaintiff shareholders claim the defendant officers and directors had breached their duty of
good faith, care, and loyalty to their company. The acts of the directors and officers were willful,
malicious, and oppressive. The shareholders all together brought both a derivative and direct suit.
Furthermore, the plaintiffs allege that the merger price did not adequately reflect the company’s market
and liquidation value. The directors and officers in here engaged into a quick deal without any
reasonable investigation of the matter. (Similar to Smith v. Van Gorkum)
FREEZE-OUT OR CASH-OUT MERGERS (DEALING WITH THE

MINORITY)
Freeze Out Mergers- When a controlling shareholder seeks to eliminate the minority
shareholder from any participation in the corporation; thus the minority holders will
typically receive cash while the majority takes the whole company. NOTE that the minority
holders are entitled to receive a fair price for their shares. “Freeze-out” refers to the
techniques with which controlling shareholders legally compel the non-controlling
shareholders to give up their common stock or ownership. Since a freeze-out transaction will
usually involve self-dealing by the insiders, conflicts of interest, and potential for abuse, state
courts will closely scrutinize the fairness of the transaction. The court scrutinizes severely
here because the majority holders want to pay the minority holders as little as possible for
their interests. Thus the common action or remedy is breach of fiduciary duty.
2 step cash out merger:

• tender offer
• Merger to get rid of minority shareholder
Weinberger v. UOP, Inc. (1983) – Entire Fairness Test: Fair Dealing & Fair
Price
RULE: “Minority shareholders in a cash-out merger are entitled to damages based on their
shares’ fair value, as determined by taking into account all relevant factors (including damages
based on rescission), if the merger’s approval was obtained on less than full disclosure and the
merger’s terms were unfair.”

Signal Corp. was looking for an investment and saw UOP as its target. The parties agreed that UOP
would acquire 1.5 million shares of unissued UOP stock at $21 per share and Signal would purchase 4.3
million shares of UOP stock at the same rate. Thus UOP would have 50.5% ownership of UOP. Signal
wanted to obtain more of UOP’s stock and thus had its directors on the UOP board to conduct the study.
Signal proposed a cash-out merger to remaining UOP shareholders for $21 per share. UOP president
supported the transaction but the UOP directors sought review by the Lehman Brothers to determine its
fairness. After due diligence, they found the deal to be fair as well. The companies’ boards and
shareholders approved the deal. The UOP minority shareholders had a slight majority of them who
agreed. Weinberger constituted the minority of the minority and thus challenges the merger’s fairness.
ISSUE: In a cash-out merger, must a majority shareholder prove that the minority shareholders received
all material facts necessary to evaluate a transaction before casting their vote?
HOLDING: YES; in a cash-out merger, if the plaintiff offers some basis to attack the
merger as unfair, the majority shareholders bear the burden of showing that the
transaction is fair. Also, if the majority of minority shareholders approve the
transaction, the plaintiff must prove the transaction is unfair to the minority. In either
case, the majority must show that the information it provided before the vote disclosed
all material facts. The record here does not support a finding that all material
information was provided, and withholding information is a breach of fiduciary duty.
The merger’s terms are not fair. The report Signal authorized asserts the market price
max to be at $24 per share, so to charge them $21 was unfair. The study is offensive
because Signal had its members on the UOP board preparing the report. If the same
directors are on both sides of the transaction, the parties must demonstrate good faith
and fairness. For fairness, the court looks to fair dealing and fair price. Fair dealing
involves evaluating how the transaction was initiated, structured, negotiated, and
disclosed to the directors, and how the directors’ and stockholders’ approvals were
obtained. As for price, the court must consider the corporation’s assets, market value,
earning and future business. Here, there is impropriety in both respects. Fair dealing encompasses
the duty of candor. The motivation of merger came from Signal and was done on their timetable.
Though the Lehman Brothers provided a study the directors did not tell that the study was rushed and
could be flawed.
NOTE: Signal first sale was legal because it was a purchase as an outsider. However, the second sale provided
problems since it now represented a significant amount of shares on the UOP board. Thus, Signal directors
became the fiduciaries to UOP and thus owed them a duty of care. Signal decided to save millions at the
expense of those whom it owed such duty to, the shareholders.
• DELAWARE DROPS THE LEGITIMATE BUSINESS PURPOSE PRONG OF FREEZE OUTS

AND JUST EXAMINES FAIRNESS: Intrinsic Fairness Test
o Fairness in a freeze out has three elements: Court’s analysis of Freeze Out Mergers:
Basic Fairness Test
(1) Fair dealing which includes the duty of candor to the minority SHs and the directors
must disclose all information in their possession germane to the transaction so that the
voting is informed. If the majority shareholder acts solely for his own benefit, then fair
dealing is not present.
(2) Fair price. Fair price is the fair value considering all relevant factors exclusive of the
element of value that may arise from the accomplishment or expectation of the merger.
This element is narrowly interpreted.
(3) Disclosure: must make full disclosure to minority SH.
• in Weinberger, the court found that there was no fair dealing bc some of the maj
BODs knew that the price could go as high as $24, but they accepted the $21.
• there was a breach of duty by the Ds by being on both sides of the
transaction and not disclosing the high price
How do you resolve a problem of dual loyalties? Signal could have done their own independent study, or
better yet, joint directors could have abstained from involving themselves in the transaction.
Lesson of UOP- It seems like it would have been easier to do this all in one step as a straight out merger.
However, UOP would have been able to vote and its Board may have held out and caused problems. If they
did this then Signal would have to resort to the two step (coercive tender followed by merger) approach
anyway.
• in Wilkes, the court will examine a legit business purpose and balance it against a less harmful course of
action
•  DELAWARE RULE
• GENERALLY the minority (P) challenging a cash-out merger must allege
specific acts of fraud, misrepresentation, or other items of misconduct to
demonstrate the unfairness of the merger terms to the minority.
o The burden is then shifted to the majority (D) shareholder to show by a
preponderance of the evidence that the transaction is fair.
• RULE However, where corporate action has been approved by an informed vote of a majority of
the minority shareholders, the burden entirely shifts to the plaintiff to show that the transaction
was unfair to the minority.
Freeze-out Techniques
1. Cash-out Merger: This most popular freeze-out technique occurs when the insider causes the
corporation to merge into a well funded shell, and the minority is paid cash in exchange for their shares
in an amount determined by the insiders.

2. Short Form Merger: Occurs when one corporation owns a large majority of another the former
can buy out the minority of the latter in cash instead of stock.
Reverse Stock Split: Company can issue a reverse stock split where nearly all outsiders get a
fraction of the ownership that they previously enjoyed. The corporation can then compel the
owners of fractional shares to exchange their shares for cash.
Burden: The burden to show fairness is on the majority shareholder. He bears the burden of proving first, that
the merger was a legitimate business purpose, and second, that considering the totality of the circumstances, it
was fair to the majority.
Business Purpose Test- Some courts will strike down a freeze-out even if basic fairness is found if it does not
involve a valid business purpose. Even if insiders pay a fair price, their sole purpose cannot be to eliminate the
minority. An acceptable concomitant motive is that the merger will increase corporate assets or income.
Companies that merge to go private usually do not pass the business purpose test. Note- Delaware does not
use the business purpose test!
Coggins v. New England Patriots Football Club, Inc. (1986)

RULE: “If a company cannot show that a freeze-out merger served a valid corporate objective
beyond advancing the majority shareholder’s personal interests, the minority shareholders who
were frozen-out by the merger are entitled to relief.”

Sullivan bought an AFL franchise for team of Boston and contributed the franchise to the corporation in
exchange for 10,000 shares of its common stock. Nine other investors bought this stock as well.
Although Sullivan held more than 20,000 shares, he was voted out as president. Eventually, Sullivan
regained control by buying all of the company’s voting shares and thus remained the team the Patriots.
There was board that he created, favorable to his interests that voted him as president. Sullivan now tried
to get rid of all of the non-voting shareholders and thus did this by setting up a new Patriots team that
would be merged into the old team. Upon merger, the non-voting stock would be extinguished and their
holders would be required to exchange their shares for cash. When Coggins heard of the plan, he voted
against it.
ISSUE: If a company cannot show that a freeze-out merger served a valid corporate objective beyond
advancing the majority shareholder’s personal interests, are the minority shareholders who were frozen-
out by the merger entitled to relief?
HOLDING: YES; if a merger is illegal, the correct remedy is its undoing. However, this merger was in
effect for ten years which would make rescission impossible. Sullivan’s freeze out merger was executed
in furtherance of his own benefit and to eliminate the interests of the shareholder minority. The merger
did not further the interests of the corporation, and Sullivan breached his fiduciary duty to the minority.
This case illustrates that the court will scrutinize a transaction more closely if it involves a closely held
corporation.
•  STRICTLY A MASSACHUSETTES AND NEW YORK RULE

• Defendants bear the burden of proving
(1) the merger was for a legit business purpose
 includes:
• potential cost of dealing with minority

• even if dividends are not paid out, the costs of conducting meetings,
proxies and SEC filings may be substantial to contribute to a legit
business purpose
(2) considering the totality of the circumstances, the merger was fair to the minority
 fairness must include an inquiry into:
(a) fair price
(b) fair dealing
o disclosure
o how the transaction was timed, structured, negotiated and
initiated
• A controlling shareholder who is also a director standing on both sides of the transaction bears the
burden of showing that the transaction
(1) does not violate fiduciary duties and
(2) Not a decision which was personally beneficial.
• controlling shareholders and corporate directors does not violate a fiduciary duty to the shareholders
o The transaction was entered to further the corp.’s interest (not for the personal interest of the
individual).
• Fair dealing means that the majority shareholder must act not only for his own benefit, but for the
benefit of the corporation as a whole. It must serve a business purpose.
• There has to be a business purpose to get rid of minority SH, but not in DE law, where you have to
treat SH fairly and shareholders have the right to challenge in squeezed out transaction.
Rabkin v. Philip A. Hunt Chemical Corp. (1985)

RULE: “Majority shareholders owe a fiduciary duty to minority shareholders and may not
unfairly manipulate the timing of a merger to avoid paying the minority shareholders the price
agreed upon as part of an earlier transaction.”

Hunt merged with Olin Corp. as recommended by Hunt’s board. Before merger, Olin purchased 63.4%
of Hunt’s stock in Turner and Newall. Olin agreed with Turner that if Olin bought the rest of Hunt’s
stock, then Olin would pay the same price per share as it did earlier ($25 per share). Olin then later
considered buying the rest of Hunt’s shares a week before the price commitment period expired. When it
did expired, Olin offered the remaining shareholders $20 per share, less than $25 as he offered before.
The fairness opinion supported the new price based on Hunt’s earning history and prospects for the next
year. Hunt appointed a committee to study the proposal, which asserted the price to be fair but not
generous. Hunt sought an increase and Olin refused. Hunt recommended the merger nonetheless to its
shareholders and thus made full disclose to them in the proxy statements. Remaining minority
shareholders were irrelevant since Hunt owed the majority as such he can pass the proposal on his own.
The shareholders sued claiming that the majority in the targeted company purposely timed the
transaction to avoid paying the minority shareholders a fair price.
ISSUE: Does an acquiring company’s offer to purchase the remaining minority shares of a target
corporation after the expiration of a one year price guarantee constitute a violation of the acquiring
corporation’s fiduciary duty to the minority shareholders?
HOLDING: YES; the low court found that Olin always wanted to acquire Hunt’s minority shares but at a
lower price. The Weinberger rule did not limit concepts of fair dealing solely to deceit issues. Here the
plaintiffs have a contractual right to $25 per share, a right Olin destroyed by delaying the purchase date.

A court must examine a majority shareholder’s misconduct carefully. Weinberger holds that many
of a transaction’s characteristics, such as timing, structure, negotiation and disclosure,
impact fairness; as a result, conduct may be inequitable even though it is legal. Once
Olin obtained the majority interest in Hunt, it had a duty to refrain from unfairly manipulating its
bargain with the minority holders.
• Rule: Delaying a merger to avoid paying a contractual price may give rise to liability to the
minority shareholders.
DEFENSIVE TACTICS: SHARE REPURCHASES

While taking over control of a company by acquiring a majority of that target company’s
outstanding stock does not require any action by the management of the target company’s
board of directors, it usually triggers defensive action by management of the target company
to prevent the takeover. Lawyers for companies that have been or are likely to be targets of
hostile takeovers have been creative in developing (and naming) responses to takeover
threats: “poison pills,” “golden parachutes,” “white knights,” etc.
Defensive measures are maneuvers or transactions undertaken for the purpose of making it
more difficult for the bidder to acquire control of the target company. When management
uses defensive measures to repel a takeover, the action is often challenged on grounds that
the officers and directors of the target company breached their fiduciary duties by using
specific defensive measures to defend against the hostile takeover.
The courts, particularly Delaware, have developed a body of case law which deals with the
standard to apply in reviewing challenges to these defenses. These opinions are adjudicated
on the facts. These cases present conflict of interest problems. Officers and directors of a
target company who oppose a takeover to their company will have a conflict of interest.
There is a high likelihood they will lose their jobs in the event of a takeover. Management of
the target company are typically opposing the takeover for reasons they honestly and
reasonably believe are in the best interests of the target company. Or basically, they are
opposing the takeover to save their jobs.
1. Lock-up- Device designed to protect a bidder (usually friendly) against competition from other bidders.
Normally, the favored bidder is given an option to buy a valuable asset at a good price given a certain set of
circumstances.
2. Crown Jewels- Lock-up or sale of the most valued asset of a corporation to prevent or discourage a takeover.
The hostile bidder may obtain control, but of a company that has lost value because of the options exercise.
3. Poison Pill- Device adopted by potential takeover target to make stock less attractive. One way is to give
shareholders a right to redeem or cash in their stock at an inflated price in the event of a takeover. Another way
is to give the existing shareholders the ability to buy shares at a discount price. Both mechanisms deter
takeover by making it more costly. Thus shareholders here are granted the right to acquire equity or debt
securities at a favorable price to increase the bidder’s acquisition costs.
POISON PILLS

Widely used, highly complex plans designed to provide varying degrees of protection against takeovers. Most
are based on a form of security known as a “right.” When adopted, (usually by the board of directors) the
rights attach to the corporations outstanding common stock, cannot be traded separately from the common
stock, and are priced so that exercise of the option would be economically irrational.
• a corporation’s right to poison pills is included in their articles of incorporation
• Form of security known as a “right” or typically as a warrant, granting the holder the option to
purchase new shares of stock of the issuing corporation at a discount when exercised.
• Exercise is economically irrational until a distribution event, which is the acquisition of, or
announcement of an intent to acquire, some percentage of the issuer’s stock by a prospective
acquirer.
• Flip-in element is triggered by actual acquisition of a specified % of the issuer’s common stock.
o If triggered, the shareholder of each right except the acquirer and its associates gets to
buy two shares of the issuer’s common stock at half price.
o essentially diluting the shares by making more shares available
•Flip-over is triggered if, following the acquisition of a specified % of the target stock, the target is
subsequently merged into the acquirer.
•Then the holder of each right becomes entitled to purchase stock of the acquiring company at half-price.
4. Junk Bond- A bond with an unusually high risk of default, coupled with an unusually high rate of return.
This is issued by a company with a credit rating below investment grade. (Play Big, Win Big!).
5. No Shop Clause- When a corporation agrees not to pursue other merger opportunities; in other words, it is a
stipulation prohibiting one or more parties to a commercial contract from pursuing or entering into a more
favorable agreement with a third party.
6. Green Mailing- When a targeted company buys out the acquirer- meaning, it buys back its stock from the
acquirer at a premium. Basically, it is a way to buy off a potential buyer. It is the act or practice of buying
enough stock in a company to threaten a hostile takeover and then selling the stock back to the corporation at an
inflated price; the money paid for stock in the corporation’s buyback; a shareholder’s act of filing or threatening
to file a derivative action and then seeking a disproportionate settlement.
To be a good candidate for takeover and subsequent liquidation, the corporation must have a high
liquidation value and a low book/market value. Because a takeover bid is an episodic development in the life
of a company, and one in which directors share jurisdiction with shareholders, it is unlike a type of decision
where directors have a exclusive jurisdiction. Accordingly, the adoption of takeover defenses must be
governed by a modified and less deferential version of the business judgment rule.
How far can management go in their defensive measures without violating
their fiduciary duties?
This answer depends on the MOTIVES or SUBJECTIVE STATE OF MIND

of the officers and directors, which is later denoted in Unocal and Revlon.
However but in Cheff v. Mathes, courts readily accepted almost any business
justification for defensive tactics. The target board had only to identify a policy
dispute between the bidder and management.

Burden of Reasonable Grounds: Corporate fiduciaries cannot use corporate funds to
perpetuate their control of the corporation. Directors can satisfy their burden by showing
good faith and reasonable investigation; the directors will not be penalized for an honest
mistake of judgment, if the judgment appeared reasonable at the time the decision was
made.
Cheff v. Mathes (1964)

RULE: “If a company’s board sincerely believes that buying out a dissident stockholder is
necessary to maintain proper business practices, the board is not liable for the decision even if, in
hindsight, the decision may not have been the best course.”
Cheff (Holland) meets with Maremont to discuss a merger. Cheff later declined any further negotiations
with Maremont due to their sales practices. A month later, Maremont informs Cheff that it bought
55,000 of Holland’s shares. Holland checks Maremont’s background and found that it liquidated its
corporation a number of times and its corporate image was not highly regarded. Maremont bought more
shares and it grew to 100,000 and now demanded to be on Holland’s board. The target board denied.
This pressure led to several key Holland employees to leave. Holland now started to buy their own stock
causing the shares’ price to increase. Then Maremont offered to purchase Holland’s other company,
Hazelbank in which a number of the board of directors there agreed. Now Holland met with Maremont
to discuss the purchase of Holland stock. Holland’s board authorized the purchase at a high market
price. Cheff brought a derivative suit asserting that Holland’s dealing in its own stock was undertaken
solely to allow the directors to retain control of their company.
ISSUE: May a board of directors trade its own stock to frustrate an outside investor’s efforts to liquidate
the company or change its character to the detriment of the company and its shareholders, if the directors
acted on their belief that the outside investor had a reputation for ruining targeted companies?
HOLDING: YES; Delaware statutes give corporations the right to trade in their own stock. Courts do not
permit a board to use corporate funds merely to further the board’s desire to stay in power. However, if
the directors believe that buying out a dissident shareholder is necessary to maintain proper business
practices, a court will respect the board’s decision. The burden of proof lies with the plaintiff as
the board is presumed to have acted in good faith, but if the board members are also
shareholders, they have a conflict of interest that requires them to show that the stock
purchase was motivated by the corporation’s best interests. The conflict of interest was
present so the board must meet the test. The ultimate concern was whether the board had a
reasonable basis for believing that Maremont would pose a danger to Holland’s corporate policy. If the
board engaged in reasonable investigation, any honest mistaken judgment does not support a finding of
blame.
The court comes up with its own test- The Board must show that they have reason to
believe that the takeover poses a danger to corporate policy and effectiveness.
The court found that the Board met its burden because:
1. Potential buyer was looking to get rid of the retail sales force
2. Potential buyer had a history of takeover and liquidation (This actually may be a good
thing for the shareholders because they would share in profits from liquidation)

3. Company posed by potential buyer would cause employee unrest. (Again, this is
problematic because by accepting this argument the court is saying that the Board has an
additional duty to company employees aside from their duty to shareholders)
Rule- Corporation can buy its own stock at a higher price to fend off a potential takeover so long as the reason
is not for the Board to keep their positions.
Business judgment rule: In Delaware, the target and its management will get the
protection of the business judgment rule and thus their defensive measures will be upheld
(Cheff v. Mathes). The fact that the target management can bring forth any defensive
tactic led to a storm of judicial response. For one, several courts imposed
heightened standards of deliberative care in takeover fights. Thus this
requires directors to probe into the business and financial justifications for
takeover defenses which puts teeth in the reasonable investigation standard.
Thus the presumption of the business judgment rule was curtailed thereafter
as evidenced under the following circumstances summarized in Unocal Corp. v.
Mesa Petroleum Co.: which incorporated the procedural and substantive
heightened standards of intrinsic fairness and rational basis.
Unocal Corp. v. Mesa Petroleum Co. (1985) – what defensive measures are
proper?
RULE: “A board may use corporate funds to purchase its own shares to remove a threat to
corporate policy and may deny the dissident shareholder the right to participate in the self-tender
offer provided the actions are motivated by a genuine concern for the company and its
shareholders and provided that the proposed defensive measures are not out of balance with the
treat’s significance.”

Mesa owned 13% of Unocal. Mesa made a 2-tier offer to buy 54% of Unocal at $54 per share. The
remaining shares would be eliminated under an exchange for stock for junk bonds. Goldman Sachs
noted that the offer was inadequate and informed them of defensive strategies to thwart the takeover,
such as a self-tender to itself of 6 to 6.5 billion shares. Though it would create debt, it would be viable.
The board rejected Mesa’s proposal and then later reconvened and made an offer for $72 per share under
a purchase agreement that asserts if Mesa obtained 64 million shares, Unocal would buy 49% of the
remaining shares and exchange them for debt securities. The board prohibited Mesa from tendering any
of Unocal’s shares. Mesa brought suit challenging the agreement. Goldman Sachs told Unocal to waive
the restriction down to 50 million shares and suggested that the board should tender their own shares.
The board ruled that its exclusion of Mesa was justified in order to prevent their shareholders from
receiving junk bonds and ensured that their assets won’t be used to fund Mesa’s inadequate capital.
ISSUE: Is a company’s purchase of its own shares in an effort to remove a take-over threat protected by
the business judgment rule if the purchase is reasonable in relation to the threat posed and is supported
by a thorough evaluation of the takeover bid?
HOLDING: YES. Unocal’s board decided to exclude Mesa in good faith on an informed basis and in the
exercise of due care. Therefore, it is entitled to protection under the business judgment rule. The

board’s authority to act comes from three sources: (1) its inherent power to manage
the corporation’s business; (2) its statutory power to trade in its own stock; and (3) its
fundamental duty to protect the company and its stockholders. The BJR protects a
board’s decision to thwart a takeover if the decision has a rational business purpose.
The board must determine that the offer is in the best interests of the company and its
shareholders. The directors must show that they have a reasonable belief, based on
good faith and a reasonable investigation, that the takeover poses a danger to
corporate policy and that they are acting in the stockholders’ best interests, not solely
to keep their offices. The Unocal board concluded that Mesa’ offer was inadequate and unfair to
their shareholders. The board’s distrust of Mesa was reinforced by Mesa’s reputation as a corporate
raider.
NOTE: the case represented a TWO-TIER OFFER by Mesa. A Two-tier offer is a technique by which a
bidder tries to acquire a target corporation where the first step involves a cash tender offer and the second step
involves usually a merger in which the target company’s remaining shareholders receive securities from the
bidder.
TWO-PART (UNOCAL) TAKEOVER TEST IN ADOPTING A DEFENSIVE

TACTIC
(BURDEN OF PROOF ON DEFENDANTS) After a reasonable investigation, the…
1. BOARD OF DIRECTORS MUST DEMONSTRATE THAT THE

RAIDER POSES A THREAT TO THE CONTINUED
EXISTENCE/WELFARE OF THE CORPORATION. THIS MUST BE
SHOWN IN GOOD FAITH UPON A RATIONAL BASIS
First, the board and management must show that they had reasonable
grounds based on a reasonable investigation for believing that there was a
danger to the corporation’s welfare from the takeover attempt. In other
words, the insiders may not use anti-takeover measures merely to
entrench themselves in power — they must reasonably believe that they
are protecting the stockholders’ interests, not their own interests. (Some
dangers that will justify anti-takeover measures are: (1) a reasonable
belief that the bidder would change the business practices of the
corporation in a way that would be harmful to the company’s ongoing
business and existence; (2) a reasonable fear that the particular takeover
attempt is unfair and coercive, such as a two-tier front-loaded offer; and
(3) a reasonable fear that the offer will leave the target with unreasonably
high levels of debt.).
2. THE THREAT MUST BE PROPORTIONAL TO THE REACTION

The anti-takeover defenses must represent a response that is “reasonable
to the threat posed” (element of balance); Factors that may be examined
are: adequacy of the price, timing of the offer, nature of the bid/bidders,
impact on constituents aside from shareholders (creditors, employees,
customers), risk of deal falling apart, quality of securities or cash offered,
interests of short term speculators that may self-deal and push the deal to
the disadvantage of long term investors. (1) To meet the proportionality
requirement, a defensive measure must not be either "preclusive" or
"coercive." A "preclusive" action is one that has the effect of foreclosing
virtually all takeovers (e.g., a poison pill plan whose terms would
dissuade any bidder or the granting of a "crown jewels option" to a white
knight on way-below-market terms). A "coercive" measure is one which
"crams down" on the target’s shareholders a management-sponsored
alternative (e.g., a lower competing bid by management, if management
has enough votes to veto the hostile bid and makes it clear that it will use
this power to block the hostile bid).
Note: The court cuts back a little from the test implemented in Cheff because it imposes a reasonable and
proportionate requirement.
 after applying the 2 Part Unocal Test, everything else falls under Business Judgment Rule
EXCLUSIONARY REPURCHASES (buy back everyone’s shares except for the threat’s shares)
• target tries to repel a hostile two-tier front loaded tender offer by embarking on its own
aggressive program of share repurchases that excluded the repurchase of the hostile bidders
shares
o if the target offers a higher price for its shares than the bidder, target holders will less
likely tender to the bidder
 target has the right to exclude the bidder from participating in the share repurchase program
(Unocal v. Mesa)
GREENMAIL (buy back the threat’s shares)

The target may pay "greenmail" to the bidder (i.e., it buys the bidder’s stake back at an above-market
price, usually in return for a "standstill" agreement under which the bidder agrees not to attempt to re-
acquire the target for some specified number of years).
• The purchase by a corporation of a potential acquirer’s stock, at a premium over the market price.
o §160 grants a corporation power to purchase and sell shares of its own stock
• in demonstrating the threat a raider poses to the continued existence and welfare of the corp., BOD
may argue that the shareholders are better off in the long term over short term when fulfilling
fiduciary duty to act in the interests of the shareholders
o Use the Wrigley argument of long term being an acceptable reason
•  under a breach of loyalty, shareholders will argue that the board
prevented them from liquidation and further diluted the value of their
shares by repurchasing more shares with debt
o in terms of sheer economics, shareholders are probably better off with liquidation
o further, there is an inherent element of self interest for the board
 they could be providing greenmail to preserve their own jobs rather than pursuing the
corporation’s best interests
 if they greenmail to protect their own positions, they have breached their duty of
loyalty
• greenmail payment will be OK when the board can demonstrate that the hostile
takeover will damage the corporation’s existence or business policies, and buying
back the raider’s shares at a premium in return for a standstill agreement will
prevent the hostile takeover,
o NOTE HOWEVER, if there are no justifiable fears other than the desire of the board to
retain their position, greenmail will be struck down
• A repurchase is a form of self-dealing, and therefore the burden should
be on the directors to show that there was a legitimate business purpose
by showing good faith and reasonable investigation. Cheff v. Mathes
• Greenmail has been upheld in every court it has been challenged in
Two-Tier Front Loaded Tender Offer

• the bidder can offer to pay an attractive premium for a majority but not all of the target’s shares
• Bidder can further tell target’s shareholders that if successful in acquiring a majority at a premium
price, he will subsequently conduct a back-end merger of the balance at a less attractive price. The
merger is a “cash merger” in which the minority shares are offered cash. They are thus squeezed out
of the company. No more public shareholders will be left. The reason for the “squeeze out” merger
transaction is so that the bidder may fully get its hands on the assets and cash flow of the target
company.
•  such an offer has a coercive effect on shareholders (shareholders here have appraisal
rights)
• they are afraid of what will happen on the back end, not because they want to be bought out
• CONSEQUENCES OF NOT SELLING
 if successful, the bidder can implement a SHORT FORM MERGER
 ex: if ABC Corp owns 90% or more of XYZ Corp, then in most states at ABC’s
request, XYZ can be merged into ABC with all XYZ shareholders paid off in cash
Rule 133-4(f)(8) – after Unocal, the SEC amended the rules to prohibit issuer tender offers other than
those made to all shareholders, but not pills.
Decision to sell the company: Once the target’s management decides that it is willing to sell
the company, then the courts give "enhanced scrutiny" to the steps that the target’s board
and managers take. Most importantly, management and the board must make every effort
to obtain the highest price for the shareholders. Thus the target’s insiders must create a
level playing field: all would-be bidders must be treated equally.
DEFENSIVE TACTICS: AUCTIONS

Revlon v. MacAndrews & Forbes Holdings, Inc. (1985) – when must the
target give up the fight?
RULE: “Delaware law permits agreements to forestall or prohibit hostile forces from acquiring a
company, but the methods may not breach a director’s fiduciary duty, so that once the sale
appears inevitable, board must work to maximize the company’s value to ensure the highest
possible price.”

Pantry Pride wanted to acquire Revlon. Pantry and Revlon discussed plans for acquisition at $40 -50 per
share. Revlon said it was inadequate and asserted that Pantry would need Revlon’s consent to purchase
their stocks. Revlon’s investment banker warned them that Pantry would try to buy the company with
junk bonds and then break it up which would give Pantry a good profit. Revlon’s counsel recommended
two defensive tactics: a self-tender offer for up to 5 million shares and a Note Purchase Rights Plan
containing a POISON PILL which allowed each of Revlon’s shareholders to exchange a share of stock
for a $65 note bearing 12% interest. The pill would kick in whenever someone acquired 20% of
Revlon’s shares. A hostile buyer could not partake in the agreement. Pantry offered $47.50 per share and
the board rejected. Revlon started their self tender offer. Pantry made a revised offer up to $56.25 per
share. Then Revlon approved a leveraged buyout (the purchase of a publicly held corporation’s
outstanding stock by its management or outside investors, financed mainly with funds borrowed from
investment bankers or brokers and usually secured by the corporation’s assets) with Forstmann Little in
which shareholders receive $56 per share and the management would receive stock in their new
company under their golden parachutes. Revlon cashed in on their notes and waived the NPRP
conditions to Forstmann. Eventually, Revlon stock prices fell after the deal which made shareholders
upset. Pantry continued bidding. MacAndrews, on behalf of Pantry challenges the Forstmann deal.
ISSUE: In the face of active bidding for a company where the sale of the company appears unavoidable,
may the target company’s board continue to thwart take over attempts instead of ensuring a maximum
sales price for its stockholders’ shares?
HOLDING: NO; the BJR protects a company’s board’s defensive actions to a takeover
ONLY if the board observes principles of care, loyalty, and independence in reaching
its decisions. Actions taken by a board in defense of a takeover bid are presumed to be
motivated by self-interest. The board has the burden of proving it was motivated by a
belief that the takeover posed a threat to the company’s welfare and that its response
was proportional to the threat posed. Revlon had the power to enact the poison pill. The question
is whether the measure was reasonable. Revlon claim that the $45 offer was inadequate and so it
adopted the pill to protect themselves from hostile takeover while maintaining their ability to analyze
better offers. A board’s steps must be strictly scrutinized to ensure no fiduciary duty was breached.
When Pantry’s offer reached $53 per share then it was fair and Revlon’s breakup would be inevitable.
Thus, the board must make every effort to maximize the price per share. Instead, they provided
concessions to Forstmann at their shareholders’ expense.
Holding: This case involves an asset lockup option conceded by Revlon’s Board to white knight (a person
that rescues the target corporation from an unfriendly takeover by acquiring a controlling interest in the target
or by making a competing tender offer) bidder, Forstmann Little. A Board must assume the role of an
auctioneer once a sale or breakup becomes inevitable. (Revlon imposes the Duty to

Auction). As a result, the Board failed as an auctioneer with their lockup option because it
ended the auction with very little improvement in the final bid.
NOTE: this case represents that the court will investigate the board’s motives with strict scrutiny. There is a
difference in the court’s analysis between first and second stage defensive tactics. The first was found to be
reasonable since the offer was indeed inadequate. As to the second stage, once Revlon’s Board asked
management to find a white knight, the Board’s duty shifted because the sale of the company became
inevitable. Before the company is going to be sold the directors have a great amount of discretion to determine
what is best for the company. This is ironic because it is at this point that the Directors may take their own self-
interest in retaining their position over the interest of the shareholders whereas when the company is up for sale
this is less likely because they are going to lose their jobs either way. However, it is still possible because they
could still look for a management friendly buyer. Key to the decision here is that the Board favored Forstmann
because he would have taken care of the debt note holders. Once the Board decides to sell, it is up to the
shareholders to determine which offer to take.
Once a corporation is up for auction the Board’s sole duty is to maximize the profits that will be received
by shareholders in return for their shares.
Once the corporation is up for sale the Board cannot favor one bidder over another, nor can it take into
account non-shareholder constituencies.
• Defensive tactics against a takeover are acceptable, subject to Unocal, until a corporation seeks a
white knight, thereby inevitably putting the corporation up for sale
o Board of Directors’ duties changes from preservation of the
corporation bastion to the maximization of the company’s value
at a sale for the stockholders’ benefit
o  Board of Directors’ role changed from defenders to
auctioneers.
• Revlon represents a limit on director’s discretion and draws the line on where defensive tactics
must stop and maximizing shareholder profit must commence. Also, duty to find someone less
demanding on the conditions; affirmative duty for directors to obtaining the best price and least
restrictive conditions, etc.
• Once the Company is in play or sold, leave it to the shareholder to make the decision who is giving
the best offer because when a Company is for sale, the only decision is who is offering more money.
Revlon duties are triggered under two circumstances
(1) When a corporation initiates an active bidding process seeking to
sell itself or to effect a reorganization involving a clear break-up of the
company (Revlon)
(2) When, in response to a bidder’s offer, a target company abandons
its long-term strategy and seeks an alternative transaction involving
break-up of the company. (Time v. Paramount)
• In other words, Revlon duties attach when a sale or breakup of the target company
becomes inevitable.
• lock-ups will not be per se illegal under DELAWARE law BUT they must be used to expand the
competition, not destroy it

o for example, if a lock up were the only way to induce a second bidder to enter the
competition, it might well be legal since it would be shareholder-value-maximizing
• Although Unocal permits consideration of other corporate constituencies, provided there
are rationally related benefits accruing to the stockholders, such concern for non-
stockholders is inappropriate when an auction among active bidders is in progress, and
the object no longer is to protect or maintain the corporate enterprise but to sell it to
the highest bidder.
The duty of loyalty and care changes when a company is being sold because the action of
attaining the corporation may be a conflict of interest when it is inevitable that it will
be sold. The shareholders’ best interest would be to maximize their profits. The search
for the “white knight” in this circumstance breached a fiduciary duty to the
shareholders.
CLEARING UP UNOCAL AND REVLON
The main consequences of the Revlon case are (1) if the target company is in the Revlon
Mode (this occurs when it is CLEAR from the facts that the company will no longer remain
independent in its present form), management has to give up the fight but (2) the converse
is also true > which is until the company gets into the Revlon Mode it can use defensive
measures, thus management can fight to make it more difficult for the bidder to acquire
their company. The Unocal case sets the limits on the kind of defensive measures the
target company’s management can take prior to getting into the Revlon Mode. It is often
asserted, “Until you get into the Revlon Mode, a target company can invoke its Unocal
defenses – accordingly to the test laid in the case.
The Unocal test requires management to show that it took defensive measures for the
purpose of protecting the company’s interests, rather than for the purpose of protecting
managements’ jobs or negotiating a better severance package.
FIDUCIARY DUTIES OF MANAGEMENT

Court gave management leeway and that was the conventional wisdom in DELAWARE – very broad
discretion by management to prevent hostile bids. This was the general trend until REVLON!
In defining the duties owed by management, the court attempts to find a balance between giving
managers the flexibility to run the business and hold the managers accountable to the owners of the
business. The duties owed my officers and directors are the same. They owe to their corporations (1) the
duty of care and (2) the duty of loyalty. (BOTH ARE MENTIONED IN GREATER DETAIL
EARLIER)
Paramount Communications, Inc. v. Time Inc. (1989)

RULE: “If a board is pursuing a merger for strategic reasons beyond merely the sale or
acquisition of another company’s assets, it may decline to entertain a competing bid that may

yield a higher short-term gain for its shareholders in favor of merger that ensures greater long-
range goals.”

Time sought to expand into the entertainment industry. Time met with Warner to discuss a joint venture
that was strongly recommended by Time’s board. The board for Time approved a plan to expand with
Warner as long as Time retained control of the resulting entity so it could remain true to its journalistic
commitments. Time deemed Warner the prime candidate. Time wanted an all cash acquisition but
Warner wanted a stock for stock exchange in which Time agreed. Warner would own 62% of the new
company. Both boards approved the merger. Time received letters from lenders as such not to finance
any transactions that would interfere with the merger. Before the final vote, Paramount offered to
purchase Time for $175 per share provided they broke from Warner. Time’s board discussed the offer
and declined. Time then restructured their agreement with Warner providing for the purchase of 51% of
Warner’s stock at $70 per share with the remaining shares to be obtained later. Paramount increased
offer to $200 per share but Time rejected again believing that Paramount’s culture was not a good fit.
Paramount filed suit arguing that Time-Warner agreement was an effective sale of Time requiring its
board to maximize short term shareholder value. Paramount is arguing under the standard in Revlon.
ISSUE: If a second merger proposal presents a higher per-share price than the transaction being pursued
by the company’s board, is the board obligated by its fiduciary duty to pursue the second proposal to
maximize benefits to its shareholders?
HOLDING: NO; Time did not put itself up for sale by entering the agreement with
Warner. Time’s original shareholders are not in a minority position in the new venture to establish
existence of a sale. Paramount argues the directors here failed to maximize the shareholder profits as in
Revlon. The court ruled that Revlon considerations are relevant ONLY IF evidence
shows that the contemplated transactions will result in the company’s break-up. The
board anticipated Time’s continued existence, and Revlon does not apply if a transaction
simply has some characteristics in common with a sale. A court must determine
whether sufficient evidence exists to find that the Time-Warner agreement was made
in the proper exercise of business judgment. Time said Paramount did not present a strategic
business combination in the long run. Furthermore, this offer came right before decision as such to
capture and sway its shareholders away from their plans. The board here conducted a
reasonable investigation before it began conducting business with Warner. The
board’s decision to reject Paramount was made in good faith. Directors are not obliged
to take a better short term offer for their shareholders if to do so would harm long
range plans.
NOTE: This case also echoed Cheff v. Mathes in which the board in Time was concerned that if the
outsider was successful, the business as it was known in the market would cease to exist. Time wanted to
maintain its reputation and integrity of its journalistic publications. Thus it never intended to sell its
company.
The court specified that Revlon duties are only triggered when a target initiates an active
bidding process or seeks a breakup of a company. Because the deal would not result in a
breakup and ownership would remain public, the court did not find a change of control
necessary to induce the auctioneering duty. Furthermore, the court found that excluding the
shareholders’ voice in the deal did not violate the proportionality test in Unocal because the shareholders were
not as knowledgeable about the prospects of the Paramount deal as the Board and outside Directors.
• The decision by Time board of directors to merge with Warner is upheld under the BJR. The Unocal
standard was applicable here.
o If the directors arrived at the decision to reject an offer after appropriate analysis and
consideration of legitimate factors, a court will not substitute its judgment for that of the
directors. Long term growth is ok versus short-term profits because the corporation
was NOT for sale.
• REVLON MODE - Change in control: When a corporation undertakes a transaction

which will cause: (a) a change in corporate control; or (b) a break-up of the corporate, the
directors; obligation is to seek the best value reasonably available to stockholders. Therefore,
a break-up of the company is not essential to give rise to this obligation where there is a sale
of control.
Enhanced Scrutiny Test: The key features are: (1) a judicial determination regarding the adequacy of
the decision making process employed by the directors, including information on which the directors
based their decision; and (2) a judicial examination of the reasonableness of the directors’ action in light
of the circumstances then existing. The directors have a burden of proving that they are adequately
informed and acted reasonably.
Paramount Communications, Inc. v. OVC Network Inc. (1994) – STANDING

CURRENT LAW
RULE: “A board selling its corporation has a duty to obtain the best value for its shareholders
and cannot give preference to one of the competing bidders.”

Viacom and Paramount formed an alliance to thwart an unsolicited tender offer by OVC. This offer was
made to Paramount. Paramount renewed its efforts to negotiate with Viacom. QVC was interested in
Paramount and Paramount told QVC they are not for sale. Through due diligence, Paramount and
Viacom approved a merger that would convert Paramount stock into Viacom shares and Paramount
exempted the transaction from its POISON PILL provisions. This attempted to ward off other buyers by
imposing a NO-SHOP provision where Paramount would not negotiate with any other buyer and
Viacom would receive $100 million termination fee if the companies’ merger cancelled. It also granted
Viacom an agreement that allowed Viacom to purchase 24,000,000 shares of Paramount’s stock at $69
per share if the triggering event occurred. The merger was announced but QVC was persistent. QVC
presented a tender offer for 51% of Paramount shares at $80 per share, with remaining shares to be
purchased in a stock for stock exchange. Viacom realized that the QVC deal was better so it
renegotiated with Paramount. Thus they reached a new agreement, a little better, but not better than
QVC. QVC remained persistent but the Paramount board denied since the proposal had too many
stipulations and because the Viacom deal was better. QVC sought to have the court enjoin the merger.
The low court issued the injunction against the merger.
ISSUE: Is a board that agrees to the sale of a corporation or transfer of control obligated to obtain the
best price for the shares?
HOLDING: YES; the law recognizes that managing the company’s affairs is protected by the BJR.
However, a court must closely scrutinize the board’s conduct if the transaction being
considered results in a sale of the corporation or if the actions are designed to defend a
threat to corporate control. In this case, the transaction will create a new majority shareholder and
is effectively a grant of control to the purchaser. Therefore, the stockholders should be paid for the loss
of control. If a board decides to resist an acquisition, the decision must be well-
informed, but if control is for sale, the board must insist on obtaining the best value for
its stockholders. Deciding the best value may be more than simply the price, so the
transaction must be analyzed as a whole, with any non-cash component quantified. A
court must review a board’s action with enhanced scrutiny anytime there is a
diminution of voting power, the sale of a control premium, or an action to impede a
stockholder’s voting rights. Only after the decision passes the enhanced scrutiny will
the BJR protect the board’s decision. The court’s enhanced scrutiny must include a
review of both the directors’ decision-making process, including an examination of the
information used by the board, and the reasonableness of the directors’ action in light
of the circumstances. The directors have the burden of proving they were adequately
informed and acted reasonably. Paramount argues that such scrutiny is inapplicable in a merger
case that does not breakup the corporation. This court however disagrees. If a corporation leads to
a transaction that leads to a change in corporate control or a break-up of the corporate
entity, the directors’ obligation is to seek the best value for the stockholders. Here, the
agreement shifts control of Paramount to Viacom. Once Paramount directors decide to sell control of the
company, they must determine that all material aspects of the Paramount-Viacom transaction are in the
Paramount’s best interests. Though the contract precludes Paramount from outside offers, such
measures will nonetheless be invalidated if they conflict with fiduciary duties. Paramount had a duty to
decide the best offer for their shareholders. Here, it was plainly QVC but Paramount decided to remain
blind to the better offer.
The deal is not a merger of equals but a sale of control. Paramount would gain a new controlling
shareholder. Because the transaction involved a sale of control, Revlon duties to seek the best price
devolved upon the Paramount directors.
• The Board has a duty to evaluate alternatives and seek the best value reasonably available.
• Court says the use of Revlon is not for just the breakup of companies but for a change of control.
Expand Revlon Test from being invoked upon sale of corporation to WHENEVER A
CHANGE IN CONTROL OCCURS
• Why wasn’t Time-Warner a change in control?
o Because Viacom is controlled by a sole-shareholder and thus when the Viacom-Paramount
deal goes through, it will transform a publicly held company to a closely held corporation
o Court also changes the application of the Revlon Test by stating that the director’s fiduciary
duty during the auctioneer process does not require him to only consider the highest cash
value, but other factors as well
o directors may consider the value of a given strategic alliance and the synergies that come
along with it
o QVC is a middle ground between Time and Revlon
APPLY UNOCAL TEST UP UNTIL THE POINT OF INVOKING REVLON.

REVLON IS INVOKED WHEN:
(1) corporation initiates an active bidding process seeking to sell itself
(2) in response to a bidder’s offer, the corporation “abandons its long term strategy and seeks
an alternative transaction also involving the break up of the company”
(3) change in control (added by Paramount v. QVC)
Note: Paramount here refused to consider price and long term debt. Paramount could
not justify that the merger represented a chance for the company to improve its long
range market objectives.
The Unocal-Revlon-QVC Test:

When (1) change of control, (2) an active bidding process for corporate sell, or
(3) a corporate abandoning of a long term strategy which may lead to a break-
up is bound to occur, the directors of the target company have a fiduciary duty
to find the best value for their shareholders and at the same time consider
other factors as such to enhance the shareholders’ interests.
And if it is a change of control, the board must consider the long term goals of the
corporation.
“The court asserted the duty to seek the best value – the Revlon auction duty –
arises not only when the company initiates a bidding process or when its
breakup is inevitable, but also when there will be a change in control.”
KAPLAN AUDIO
Corporation – artificial business entities authorized the state statute. They draft their articles and
bylaws. It authority is derived by statute, articles, bylaws, and the board’s resolution. It can only
act out of one of these doctrines. If it does not, the ultra vires doctrine is triggered. Corporation is

separate and distinct from its owners/investors as such they are not responsible for their debts or
obligations. Organization of corporation: (1) how is limited liability attained to the shareholders,
and (2) once its there, how do the creditors pierce the veil.
Look for a situation where the shareholders are not seeking to be liable for their debts which
triggers either a De Jure Corporation, De Facto Corporation, or Corporation by Estoppel. The
articles must include the name, the business purpose which will authorize and limit what a
corporation can do, and capital stock issuance. Also, there must be a registered agent to get
service of process (notice). De Facto and Estoppel have the same elements however, estoppel has
one more, the 3rd party had reasonably relied that they are a corporation and thus later cannot
claim they are not a corporation. These doctrines no longer exist in a large number of states.
Piercing the Veil: the corporation will clearly be liable where there is a breach of contract or tort;
thus, are the shareholders are liable? (1) Fraud doctrine – if the corporate entity is used as a
vehicle to defraud someone or promotes injustice, the corporate veil will be disregarded; (2)
Under-capitalization doctrine – was this corporation given enough capital or money to conduct
their business at the offset? Shareholders are responsible for capitalizing the corporation. Loans
do not count also furthermore, the court is more likely to go after a tort victim than a contract
breach because contractual issues are more of an assumption of risk; and (3) alter-ego
doctrine/enterprise liability doctrine – 3rd party must know whether they are doing business with a
shareholder or its corporation. Corporate formalities must be maintained. The corporation
should use its own name, no commingling of assets, filing of reports and keep minutes of meetings,
etc. When formalities are not followed, the identities tend to merge. When this occurs in a
multiple corporate setting, enterprise liability is triggered – Brother-Sister corporations.
It is important to note who are they testing you on and in what capacity is he
in. In a closely held, it is typically the shareholder holds all positions.
Promoters – act on behalf of the corporation or solicit business that is not in existence yet.
Shareholders – (stockholders) – collect dividends only if the board of directors

declares them.
(1) Shareholder rights – voting and inspection
Shareholders vote at an annual meeting and a special meeting. The special meeting may be
called at anytime by a beneficial owner, directors, or officers. Notice requirement is
mandatory. The shareholders can attend in person or by sending someone else in their
place or proxy, which must be in writing, signed by the giver and it will expire in 11
months. They are easily revocable unless coupled with an interest. This irrevocable proxy
has been given with consideration; the interest was bought.
Voting Mechanism: shareholders vote straight (the number of votes casted must be
proportional to the shares allotted to that shareholder) or cumulatively (votes may be
casted all for one candidate). The bylaws decide whether to use what type of voting.
(2) Shareholder agreements – is the agreement is valid? If so, it is enforceable. Voting

shareholder pooling agreements (combine their interests to be a powerful political force in

“pooling” their interest to vote a certain way against directors); voting trusts (must be in
writing and are valid for 10 years) – to be valid, if the pooling agreement or voting trust is
acting within the shareholder’s sphere of authority, it is valid. (Board elects officers – not
in shareholder sphere; shareholders cannot declare dividends; etc.) Sphere of authority
does not matter in a closely held corporation.
Stock sale agreements (typically in close corporations) – restrict ability to sell stock in
order to keep stock in-house. Here, the test is whether or not the agreement is reasonable.
If it is not, it is not valid. (ex. Consent of all shareholders is impossible and unreasonable)
(3) Enforcement of shareholder rights (derivative suit) – look for a situation in

which the corporation has been harm by either a tort or contract etc. Shareholder has to
been a shareholder at the time the cause of action arouse and throughout the litigation
(contemporaneous ownership). Some states require a bond to put up to prevent frivolous
lawsuits. Shareholders must make a demand upon the directors that they cause the
corporation to bring the lawsuit or show that the demand would be futile. If the demand is
made in good faith and the corporation has decided not to take the suit, that decision will
be barred by the judgment rule unless the plaintiff can show wrongful refusal.
(4) Controlling shareholder – a person who owns enough stock to elect a majority of the
board. Typically there is a majority owner or a plurality of the stock. This triggers a
special responsibility on them. They are fiduciaries to the corporations and the other
shareholders. Thus they cannot take action to benefit of themselves and that is to the
detriment of the corporation. Simply having a benefit is enough to trigger a breach.
However, the equal opportunity doctrine says do not take anything that is only going to
benefit you without sharing it with the several shareholders of the corporation.
Board of Directors – they run the business organization

(1) Selection & retention – shareholders elect the board of directors. Removal of directors
requires a majority vote by the shareholders with or without cause. If you are seeking to
remove less than the entire board, then you need to ascertain the minimum percentage
necessary to elect one board member. Also if the number of votes cast against removal is
sufficient to keep the director on the board, then the director is not removed.
(2) Director authority and powers – when they act, they act as a board. A director can
never act on their own. They do not act as an agent or employee of the corporation. The
board acts upon the majority of the quorum or majority. (Ex. 9 directors, 5 directors show
up to meeting, quorum is met so 3 are necessary to pass a corporate resolution). They
bylaws can always change the voting requirements and restrictions.
(3) Director’s duties (care and loyalty) – the duty of care is a test on competence (the
board as a whole acts upon a situation) in office. The fiduciary duty of loyalty tests fairness
and loyalty (usually here one director is always acting). The duty of care requires the
“prudent person standard” under the business judgment rule. Directors are required to
act in good faith, non-negligently, and in the corporation’s best interests. The duty of care
and the business judgment rule are interchangeable. The directors have defenses as to if
they breached their care. These are their cures: (1) submission to the shareholders for
them to ratify a transaction; and (2) blame another person, typically an expert who they
brought in to analyze the situation – they must have relied on the expert in good faith.
The duty of loyalty occurs when a director takes a personal action or is solely profiting.
There are four ways it can be breached: (1) common law rules for stock transfer liability –
special facts doctrine; (2) interested contract – where a conflict of interest exists: the
director is buying something from or selling something to the corporation – director is
sitting on both sides of the transaction since he benefiting personally but also is at odds
with the board since he sits there as well. 3 saving mechanisms here: (1) interested director
discloses the information to the other directors and the disinterested ones must approve;
(2) disclosure to the shareholders and they approve the transaction; and (3) the transaction
is deemed to be fair – this is when the shareholders and disinterested directors disapprove.
(3) Seizing a corporate opportunity – there is a business opportunity for the corporation
but took it himself. The corporation can recover profits, damages, constructive trust, or
recover the opportunity at cost and repay the director for what he paid. To be a corporate
opportunity, it must be related to the line of business and the corporation must be able to
finance it. (4) Direct competition – the recovery is injunction, damages, etc.
(4) Corporate Officers – they are appointed by the directors as fiduciaries. An officer is
both an officer and an agent of the corporation. What capacity was the officer acting in?
Officers’ actions can bind the corporation.
Corporate Fundamental Changes – standard approval procedure: (1) the board must pass a
resolution, (2) the shareholders must approve the transaction (each class must approve by a 2/3s
majority), and (3) filing papers with payment of fees to the state.
In a merger, one corporation absorbs another – the acquiring corporation survives and the target
is dead. In a consolidation, both corporations come together while their existence extinguishes
and a new one emerges. Statutory Short form merger arise when there is a parent subsidiary
relationship. This merger occurs when the parent has 85% or above of the subsidiary’s stock
where the parent’s company must approve the merger.
Standard approval procedure is necessary to amend the articles of incorporation for any major
issues.
Liquidation is the gathering of corporate assets and distributed to the shareholders (the
governments get paid first, the creditors would be next (first secured then unsecured), and then
finally the shareholders (preferred stock – liquidation preference and then finally general
shareholders). Voluntary Dissolution requires the following of the standard approval procedure.
Involuntary Dissolution may be a remedy to fraud, deception, deadlock, or gross mismanagement.
This is done by the courts.

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UPA § 7 (1914) – Rules for Determining a Partnership;

UPA § 202(a) (1997) Partnership Formation:

Key Elements in determining a partnership - Sharing of risk/loss, profits, and

2. Partnership by Conduct (no mens rea required)

Business Associations/Garten/Fall 2008 2

I. Partnership Created by Conduct

Fenwick v. Unemployment Compensation Board (1945)

Statement of the Case

Business Associations/Garten/Fall 2008 3

Elements and Indicators of Partnership

II. Partnership Created by Agreement

Business Associations/Garten/Fall 2008 4

Martin v. Peyton (1927)

Statement of the Case

Business Associations/Garten/Fall 2008 5

Southex Exhibitions v. Rhode Island Builders Association (2002)

Statement of the Case

III. Partnership Created by Estoppel

Young v. Jones (1992)

Statement of the Case

ISSUE: Are Price-US and Price-Bahamas partners by estoppel?

§ 13 Partnership Bound by Partner’s Wrongful Act

§ 14 Partnership Bound by Partner’s Breach of Trust

§ 15 Nature of Partner’s Liability

§ 305 Partnership Liable for Partner’s Actionable Conduct

§ 306 Partner’s Liability

THE RIGHTS OF PARTNERS IN MANAGEMENT

National Biscuit Company v. Stroud (1959)

Business Associations/Garten/Fall 2008 8

B. FIDUCIARY DUTIES OF PARTNERS

c) A partner’s duty of care in conduct of business is limited to refraining from engaging in

DUTY OF DISCLOSURE: LOYALTY

Meinhard v. Salmon (1928)

Statement of the Case

Business Associations/Garten/Fall 2008 10

WHAT IS A JOINT VENTURE?

NO FIDUCIARY DUTY TO FORMER PARTNERS

PLANS OF SEVERING THE PARTNERSHIP . . . UPON DEMAND, YOU MUST DISCLOSE

§ 20 UPA (1914). Duty of Partners to Render Information

How are losses allocated?

Liquidating Partnerships § 807 (1996) or § 18 (1914 clearer)

Business Associations/Garten/Fall 2008 12

GRABBING AND LEAVING

A partner has the duty to:

Meehan v. Shaughnessy (1989)

Statement of the Case

Business Associations/Garten/Fall 2008 13

PARTNERS HAVE A RIGHT TO EXPEL OTHER PARTNERS: EXPULSION

§ 601. Events Causing Partner's Dissociation. UPA (1997)

NO DUTY TO REMAIN PARTNERS- If I Don't Trust You, We're Not Partner

Statement of the Case

C. SHARING OF PROFITS AND LOSSES

Kovacik v. Reed (1957)

Statement of the Case

G&S Investments v. Belman (1957)

Statement of the Case

LAW PARTNERSHIP DISSOLUTIONS

Jewel v. Boxer (1984)

Statement of the Case

Business Associations/Garten/Fall 2008 18

D. OTHER TYPES OF PARTNERSHIPS (LP, LLP, & LLC)

IF A LIMITED PARTNER EXERCISES CONTROL AND THUS VIOLATES THE NO