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Business Associations Spring 2003 Grimes AGENCY I. Purpose of Agency Law 1.

Agency law defines the rights and liabilities that occur when one party acts on another partys behalf. Because of the number of business transactions that occur based on the use of representation, agency law figures prominently in the commercial context. a. An agency is basically a type of a contractual relationship that arises through mutual consent between the partieshowever, there is no consideration needed to support an agency relationship. II. Contract Liability 1. The laws of agency determine in what instances it is best to bind the employer for valid contracts made by an employee even if the employer had no knowledge that such a contract was being made. a. Without such laws, it would be arguably more difficult and costly to transact business quickly and efficiently. 2. Questions a. Why type of relationship exists? Is it a principle-agent relationship b. What authority does the agent possess to engage in contracts? Authority c. Was there reliance on a reasonable belief based on the demonstrated principalagent relationship in order to support a cause of action? Reliance III. Creation of an Agency Relationship for Contract Liability 1. Elements for an agency relationship a. Legal Relationship i. There must be a legal relationship between the parties. The expressions or actions of each party ultimately determines whether or not an agency relationship exists, no matter what the parties might call the relationship. b. Mutual Consent i. Parties must somehow demonstrate that they intend to be in an agency relationship. c. Authority i. Authority in agency law is distinct from the everyday concept of authority. 1. Authority may be found even if no outright permission was granted or even if an employee was explicitly instructed to not undertake the action in dispute. IV. Types of Authority 1. Actual AuthorityPower expressly granted, by either oral or written statements, to an agent to act on behalf of the principle in order to effectuate the principals objective a. Occurs when the principle manifests consent to the agent that the agent should enter into a contract. i. This doctrine looks at the situation from the point of view of the Agent. 1. The principles consent can be manifest to the agent by express methods of the principle or by implied methods of the principle. a. The conduct of the principle must be reasonably interpreted by the agent as to have given him the authority in question, and the agent must have relied upon this reasonable belief in engaging in the disputed contract. b. 7Restatement 2d of AgencyActual Authority Outline, Business Associations, GrimesSpring 04 E. D. Baker 1of70

i. Actual authority is the power of the agent to affect the legal relations of the principal by acts done in accordance with the principals manifestations of consent to him. c. 26Rest. 2d of AgencyCreation of Authority i. Actual authority to do an act can be created by written or spoken words or other conduct of the principal which, reasonably interpreted, causes the agent to believe that the principal desires him so to act on the principals account. d. Nature of the Agents Relationship i. The agent has actual authority with respect to acts or types of acts designated in the principals manifestations to the agent, as well as acts necessary or incidental to achieving the principals objectives ii. The agent should interpret the principals manifestations in light of any meaning known by the agent to be ascribed by the principal and, in the absence of any meaning known to the agent, reasonably in light of the context, including facts known to the agent and the agents fiduciary duty to the principal. iii. The agents understanding of the principals objectives should reflect the principals manifestations to the agent and the inferences reasonably to be drawn from the circumstances creating the agency. e. Implied-Apparent Agency i. Argue that there was implied actual authoritybecause of prior similar practices, or there are similar market practicesor reasonable expectations. f. Mill Street Church of Christ v. Hogan i. Church hires brother A to work on church, brother A hires brother B to help him paint the church ceiling. Brother B breaks his leg, and filed for workers compensation To qualify for workers comp. he needed to be an employee of the church. Did brother A have the authority to hire brother B on behalf of the church? Yes, because of the history of this kind of practice. 1. A person possesses implied authority as an agent to hire another worker where such implied authority is necessary to implement the agents express authority. 2. Apparent Authority a. Apparent Authority occurs when the principal manifests consent through her actions to third parties. i. This doctrine looks at the situation from the point of view of the third party 1. Creationapparent authority can be created by written or spoken words or by any other conduct of the principal which is reasonably interpreted by a 3d person to mean that the agent has the consent of the principle. b. 8Rest. 2d of AgencyApparent Authority i. apparent authority is the power to affect the legal relations of another person by transactions with 3d persons, professedly as agent for the other, arising from an in accordance with the others manifestations to such 3d persons. ii. For apparent authority to exist the Principal must have held out the agent, as such. c. Creation i. Apparent authority can be created by written or spoken words or by any other conduct of the principal which is reasonably interpreted by a 3d person to mean that the agent has the consent of the principle. 1. There is some sort of interaction between the principle and the 3d party, because it is needed to establish apparent authority. a. This NEVER applies in a case of an undisclosed principle. ii. 27Rest 2dCreation of Apparent Authority Outline, Business Associations, GrimesSpring 04 2of70 E. D. Baker

1. Apparent authority to do an act is created as to a third person by written or spoken words or any other conduct of the principle which, reasonably interpreted, causes the 3d person to believe that the principle consents to have the act don on his behalf by the person purporting to act for him. iii. Lind v. Schenley Industries, Inc. 1. Lind accepted a position as a regional sales manager and argues that he was promised a 1% commission by , a sales manager. a. Was in a position to grant the commission, would a reasonable person believe that he had such authority? i. An agent can bind a principal despite a lack of authority to do so if it would seem to a reasonable person that the agent possessed such authority. b. Apparent Agency Factors i. Conduct of the Principle The principal had given instructions to to negotiate the terms of the new contract with his direct boss. ii. Reasonable Belief The terms conveyed to were reasonably believed even though the new salary would supercede that of the s direct boss iii. Reliance relied upon this reasonable belief to his detriment. 2. Three-Seven Leasing Corp. v. Ampex Corp. a. Salesperson at Ampex agreed to sell to 3-7 despite not having been given the authority to make such a sale by Ampex corp. Can Ampex be bound to the sale? Yes, if the transaction was conducted in such a way that would lead a buyer to believe that he had the authority to make such a sale. i. A salesperson binds his employer to a sale if he agrees to that sale in a manner that would lead the buyer to believe that a sale had been consummated. 3. Inherent Agency Power a. Agents Acting Similarly i. Inherent authority occurs when an agent acts in a typical manner as similar agents. 1. Therefore, inherent agency can be created simply by the act or contract entered into by the agenteven if expressly forbidden by the principal. a. This doctrine looks at the situation from the point of view of the principal in that this authority covers the types of acts which are reasonably foreseeable by the very existence of an agency relationship. ii. This is the authority that an agent in a similar position would have, an agent who acts with inherent authority binds his principal in actions done on the principals behalf so long as such actions are usual or necessary b. Undisclosed Principle i. Inherent authority is the only way an undisclosed principal can be bound c. 8A Restatement 2d of AgencyInherent Agency Power i. is a term used in the restatement of this subject to indicate the power of an agent which is derived not from authority, apparent authority, or estoppel, but solely from the agency relation and exists for the protection of persons harmed by or dealing with a servant or other agent. Outline, Business Associations, GrimesSpring 04 E. D. Baker 3of70

195 Rest. 2d of AgencyActs of Manager Appearing to be owner i. An undisclosed principal who entrusts an agent with the management of his business is subject to liability to 3d persons with whom the agent enters into transactions usual in such businesses and on the principals account, although contrary to the directions of the principal. e. Examples i. Watteau v. Fenwick 1. had only authorized the pub manager to purchase specific items, and forbid him from purchasing cigars. Manager purchased cigars on credit from who sued to recover the cost. Is responsible even though manager acted outside his expressed scope of authority? Yes. a. When one holds out another as an agent, that agent can bind the principal on matters normally incident to such agency, even if he was not authorized for a particular type of transaction. ii. Nogales Service center v. Atlantic Richfield Co. 1. An Agent acting within the usual boundaries of his role binds his principal even if the details of the transaction to which he agrees were not authorized iii. Kidd v. Thomas A. Edison, Inc. 1. A principal can be bound by a general agent based on his position as such, even if he lacks express or apparent authority for the commitment at issue. a. Although the court used the term apparent there was no manifestation of authority made, therefore the only authority possible is Inherent. f. Situations where Inherent Authority occurs i. An agent does something similar to what hes authorized to do, but in violation of express orders by principal. ii. Agent enters into a transaction purely for his own purposes by the transaction would be authorized if he acted with the proper motive of benefiting the principal iii. Agent is authorized to dispose of goods and uses an unauthorized method of disposal. 4. Ratification and Affirmance a. Even if no type of authority is found at the time of the agents actions, if the principal acts in a manner which expresses or implies that they authorize the contract after the fact, the principal will then be bound by ratification b. Conduct i. the principals conduct which signals an after-the-fact authorization is called affirmance; affirmance results in ratification of the previously unauthorized action or conduct. c. 82 Rest. 2dRatification i. is the affirmance by a person of a prior act which did not bind him but which was done or professedly done on his account, whereby the act, as to some of all persons, is given effect as if originally authorized to him. 1. 83Rest. 2dAffirmance is either; a. A manifestation of an election by one on whose account an unauthorized act has been done to treat the act as authorized, or b. Conduct by him justifiable only if there was such an election d. Marital status in and of itself cannot prove an agency relationship i. Hence, mere marital status can not ratify a person as an agent, or create an agency relationship in and of itself. 5. Estoppel Outline, Business Associations, GrimesSpring 04 4of70 E. D. Baker

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a. To establish agency by estoppel, the appearance of authority must be shown to have been created by the manifestations of the alleged principal and not solely by the supposed agent. V. Agents Personal Liability on the Contract 1. The Liability of the agent depends on the type of principal involved in the transaction. a. Disclosed Principal i. The agent is not a party to the contract and, therefore, cannot be held liable for the contract terms. b. Partially disclosed principal i. The agent is a party to the contract unless otherwise agreed c. Undisclosed principal i. The agent is party to the contract 2. It is the duty of an agent, in order to avoid personal liability on a K entered into on behalf of the principal, to disclose not only that he or she is acting in a representative capacity, but also the identity of the principal. VI. Statutory Claims 1. Statutory Claims a. To impose liability under civil rights legislation for the discriminatory actions of a 3d party, the must demonstrate an agency relationship between the and the 3d party. VII.Tort Liability 1. When a duty from one party to another is breached the victim in tort will seek to recover damages for the injuries from the actor and generally from the party in charge of the actor. 2. Elements a. Two Elements i. A master-servant relationship; and ii. The act occurs during the course or scope of employment 3. Is there a Master-Servant Relationship? a. Employer/Employee i. Whether an employer will have to pay for the torts of her employee primarily turns on what type of relationship has been legally established between the employer and her employee. ii. Master/Servant Relationship 1. If the employer and employee have a master servant relationship, then the master will be liable for the torts of her servant as long as the servant was acting within the scope of his employment. 2. Scope of Employment a. Conduct of an employee may be within the scope of employment even if the specific act does not serve the employers interests b. To recover damages from an employer for injuries from an employees assault, the must establish that the assault was in response to the s conduct which was presently interfering with the employees ability to perform his duties successfully. b. Respondeat Superior i. This is doctrine that places the burden of liability on the master for the torts of his servant. 1. this is a doctrine of strict liability because the guilt or innocence of the employer does not matter 2. This is a doctrine of vicarious liability because the employer is taking on the liabilities of someone else. Outline, Business Associations, GrimesSpring 04 E. D. Baker 5of70

ii. If a court finds that a Master-Servant relationship exists, then a tort victim will be allowed to sue the employer as well as the employee under the doctrine of Respondeat Superior. c. Master Servant Relationship Defined i. Rest. 2d 2 Master; Servant; Independent Contractor 1. A master is a principle who employs an agent to perform services in his affairs and who controls or has the right to control the physical conduct of the other in the performance of the service 2. A servant is an agent employed by a master to perform service in his affairs whose physical conduct in the performance of the services is controlled or is subject to the right to control by the master ii. Is there an Employment Relationship? 1. Control over physical conduct does not mean that the master has to physically direct her servant. It means that the master controls or has the right to control how the work is to be done, often through detailed instructions or authority over day-to-day actions. a. Factors Considered [Rest. 2d 220(s)] i. The agreed upon extent of control which the employer has over the work; the greater amount of control an employer has over her employee, the more likely the relationship is master-servant ii. Whether the employs is engaged in a distinct occupation or business from that of the employer; If the employees work is very different from the business of the employer, then the relationship is more likely an employerindependent contractor iii. Whether the work is normally supervised or not If the type of work that the employee does is usually done without supervision, then it is more likely that the relationship is employerindependent contractor iv. Skill required to do the work A higher level of skill usually implies more independence from the employer. v. Length of time the person is employed Independent Contractors are usually employed for short, defined amounts of time, agents or servants are usually employed for indefinite amounts of time vi. Method of Payment Most I.C.s are paid according to each project completed whereas agents or servant employees are usually paid by salaries. vii. Whether the work is part of the regular business of the employer; Employees who perform work that is part of the everyday business of the employer are more likely to be agents or servants, whereas independent contractors are more likely to be employed for nonfrequent purposes. viii. Whether the parties believe they have a master-servant relationship ix. Whether the principle is or is not in business iii. Is It an Independent Contractor Relationship? 1. No Liability a. If the actor truly is an independent contractor then the principle cannot be liable for tort. b. Exception i. Although a person who engages a contractor, who conducts an independent business using its own employees, is not ordinarily liable Outline, Business Associations, GrimesSpring 04 E. D. Baker 6of70

for negligence of the contractor in the performance of the K, such person is liable when the contractor performs inherently dangerous work. 2. Factors Considered a. Whether the employee of the employer supplies the tools or instrumentalities of the job, and the place where the work is to be completed; i. Employees that supply their own tools or work apart from the employers place of business are usually independentcontractors b. A party may be liable for a contractors torts if he exercises substantial control over the contractors operations c. A franchisee is considered an independent contractor of the franchisor If the franchisee retains control of inventory and operations iv. Is there day-to-day control? 1. Humble Oil & Refining Co. v. Martin a. Humble owned a gas station which it leased to Schneider. Humble and Schneider were found to have a master-servant relationship because of the following factors; i. Humble controlled the details of the station work, such as hours of operation ii. Humble paid 3/4ths of the important operating expenses iii. There was a strict system of financial control and supervision iv. Schneider had little or no business discretion v. Schneider had to report to Humble on a regular basis vi. Humble furnished all the stations equipment, advertising, and products; vii. Humble was able to terminate the leasing K w/Schneider at any time b. A party may be liable for a contractors torts if he exercises substantial control over the contractors operations. 2. Hoover v. Sun Oil Company a. A franchisee is considered an independent contractor of the franchisor if the franchise retains control of inventory and operations. i. i.e. Sun provided advice and the station was not required to follow the advice, station alone assumed the risk of profit or loss for the operation of the business. 3. Franchises a. If a franchisor controls or regulates the operations of the franchisees business that the franchisor possesses control within the rules of agency, liability may apply. i. If the franchise agreement allocates to the franchisor the right to exercise control over the daily operations of the franchise, an agency relationship exists. b. Courts have looked to who bears the greater risk of profit or loss rather than day-to-day control in the franchise context. c. Murphy v. Holiday Inns, Inc. i. IF a franchise contract so regulates the activities of a franchisee as to vest the franchisor with control within the definition of agency, a principle-agent relationship arises even if the parties expressly deny it. 4. Was the employee acting during the course of the employment? a. Even if a master servant relationship exists, a master will only be held liable for the acts committed by her servant if the act occurs during the course or scope of the servants employment. i. Rest 2d 219 When a Master is Liable for Torts of His Servants Outline, Business Associations, GrimesSpring 04 E. D. Baker 7of70

1. A master is liable for the torts of his servants committed while acting in the scope of their employment ii. Rest 2d 229 Kind of Conduct within Scope of Employment 1. To be within the scope of the employment conduct must be of the same general nature as that authorized, or incidental to the conduct authorized. b. Not explicitly within the scope of employment i. If an act was not explicitly authorized, then the following factors are considered in determining whether a particular act will nonetheless be considered as occurring within the scope of employment 1. Whether or not the conduct was foreseeable in the course of employment a. Whether the act is one commonly done by such employees b. the time, place and purpose of the act c. whether the act ever occurred in previous situations d. the extent to which the employers interests were advanced by the act e. whether the act was authorized to any other servants f. whether the employer had reason to know that the servant would be acting in the manner in question g. the similarity between the unauthorized act and authorized acts h. whether the employer furnished the means or tools by which the injury was inflicted i. the extent that the act departs from the normal methods of business j. whether the act involved the commission of a serious crime i. minor crimes are foreseeable . 2. Intentional Torts within the scope of employment a. An employer may be found liable under Respondeat superior for intentional torts of their servant if the tort occurred within the scope of employment. i. To prove that the action was taken in the scope of employment the must establish that the assault was in response to the s conduct which was presently interfering with the employees ability to perform his duties successfully. 5. Direct Liability of Servants to 3d Parties; Agent 3d party a. An actual tortfeasor is always liable for the tort committed whether in the scope of employment or not. A tort victim typically sues the employee as well as the employer. VIII. Fiduciary Obligation of Agents 1. Duties During Agency a. An agent who draws business away from his principal for his own enrichment is liable to the principal for the profits lost there from. b. An Agent who takes advantage of the agency to make a profit dishonestly is accountable to the principal for the wrongfully obtained proceeds. 2. Duties During and After termination of AgencyGrabbing and Leaving a. Former employees may not use confidential customer lists belonging to their former employer to solicit new customers.
Agency Analysis Identify the act at Issue o Is it a contract or a tort Identify the Legal Relationship among all parties o Is there a principal-agent relationship? o Is there a master-servant relationship? Identify the issues based on the act and legal relationship o If there is a principal-agent relationship at issue, what type of authority is present? o If there is a master-servant relationship at issue, was the servant acting within the scope of employment?

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Partnerships I. Defining A Partnership 1. General Definition a. a partnership is a particular kind of business formed when two or more persons act as co-owners of a business for profit, whether or not they intend to form a partnership. i. 1997 UPA 101 (6) Definitions 1. Partnership means an association of two or more persons to carry on as coowners of a business for profit formed under [this act or comparable law] b. Characteristics of a Partnership i. The hallmark characteristics of a partnership are; 1. Shared ownership a. creates a partnership 2. Shared control, and a. Maintains the partnership 3. Shared liability a. results from a partnership 2. Is there a Partnership? a. Profit Sharing i. The right to share profits in the business is the key prerequisite for defining a partnership. 1. Profits are generally defined as the amount of revenue generated by a business minus the costs of operating that business. ii. The sharing of profits is viewed as the prime motivation for partners to act in the best interests of a partnership. iii. Profit sharing alone is a necessary factor to prove that a partnership existed. 1. NOTEeven though it is required, on its own it is usually insufficient b. Loss Sharing i. The sharing of business losses is strong evidence that a partnership exists c. Co-Ownership i. Partners usually co-own the assets of the partnership business in that all partners have the right to control the use of such property and also share in the gains and losses of such property d. Co-Management i. Though not necessary, many partners do share in managing the partnership business day-to-day 3. Partnership Distinguished from other Business Relationships a. Partnership v. Agency i. The primary distinction is that a partnership is comprised of co-owners of the businesswhile an agency relationship is comprised of employers and employees. ii. Fenwick v. Unemployment Compensation Commission 1. A partnership is an association of two or more persons to carry on as coowners of a business for profit. In this case the question was whether or not the receptionist and owner of a beauty shop were partners simply because they entered into a partnership agreement? a. There was no partnership formed even though the relationship was named a partnership. The court looked at the following FACTORS; i. 100% of the assets remained with the owner ii. 100% of the control remained with the owner iii. 1005 of the loses were borne by the owner iv. there was an 80/20 profit split Outline, Business Associations, GrimesSpring 04 9of70 E. D. Baker

b. 1997 UPA 202formation of a Partnership i. A person who receives a portion of the profits in a business is presumed to be a partner unless; ii. The payments are in return for services as an independent contractor or regular wages as an employee. b. Partners v. Lenders/Joint Ventures i. A joint venture or a lender of funds to a business usually agree to share in the profits and losses but, unlike a partnership the relationship is formed for the purpose of a single business transaction. II. Forming a Partnership 1. By Contract a. An express or implied contract is needed to form a partnership as a partnership is always voluntary, consensual association of interests. Without consent from all parties, a partnership cannot be formed i. A written contract [in the form of a partnership agreement], while not necessary to form a partnership, is usually undeniable evidence of consent. b. Martinthe absence of an explicit partnership agreement does not preclude the creation of a partnership. c. Southex Exhibitions, Inc.the existence of a partnership normally must be determined under a totality-of-the circumstances test. d. Provisions not modifiable by Contract if the UPA states that it controls over the partnership then that provision of the UPA controls. 2. Absence of a contract a. If parties cannot agree that a partnership was formed or the terms of the partnership agreement are in dispute, the law looks at certain factors to determine whether a partnership exists or not i. 1997 UPA 202Formation of Partnership 1. the association of two or more persons to act as co-owners of a business for profit are considered partners, whether or not they intended to form a partnership a. PROFIT SHARING IS KEY b. Other Factors to Consider i. Contribution of Capital 1. though not essential, contributing capital to an enterprise is indicative or a partnership agreement ii. Parties Own Designation 1. the mere fact that parties call one another a partner can be meaningful but is not conclusive proof of a partnership existing. 3. Partnership by Estoppel a. Estoppel in general is an idea born from equity. A partnership by estoppel may be created in regard to dealings with a 3d party in certain situations. i. The partnership by estoppel doctrine dictates that when someone pretends to be a partner (or goes along with representation that he or she is a partner) she will be liable to any 3d party who extends credit on reliance of that representation. 1. YongA 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 persons to whom such a representation is made who has given credit to the actual or apparent partnership. III. The Fiduciary Obligations of Partnership 1. Duty of Loyalty a. A partner is bound to be loyal to her partnership. i. Meinhard v. Salomon 1. Joint adventurers own one another the highest fiduciary duty of loyalty while the enterprise is ongoing. (duty to disclose) Outline, Business Associations, GrimesSpring 04 10of70 E. D. Baker

a. Two partners leased some property togetherright before the lease was to expire S made a deal with a 3d party regarding the property without including M. i. The court held that S had violated the duty of loyalty owed to M because the new deal was an extension of the old lease, and that S had a duty to disclose the opportunity to his partner. b. Even when a partner makes a decision, that partner has a fiduciary duty to make a full and fair disclosure to other partners of all information that may be of value to the partnershipDay v. Sidley & Austin c. Not applicable to X-Partners i. The fiduciary obligations owed by members in a partnership to one another do not flow to former partners, whose withdrawal terminates the partnership in relation to that partnerBane ii. A partners fiduciary duties extend beyond the partnership to persons who have dissolved the partnership and have not completely wound up and settled the partnership affairsMonin 2. Duty Not To Compete a. A partner cannot engage in conduct that directly competes with the partnership without the consent of all the other partners. i. If a partner does compete with consent, they must account for all profits derived from the competitive conduct to the partnership b. Meehan v. Shaughnessy i. Partners in a law firm decided to leave and they solicited other employees to follow them. 1. It was the solicitation to clients for the new firm that was a breach of the partners fiduciary duty because the letter gave the new firm an unfair advantage ii. A partner has an obligation to provide true and full information of all things affecting the partnership to any partner. 3. Duty of Care a. Each partner has a duty to refrain from gross negligence, recklessness, intentional misconduct and knowingly unlawful conduct while working on behalf of the partnership. IV. The Rights of Partners in Managements 1. Shared Management a. In most small partnerships each partner expects and is expected to play a role in conducting the business of the partnership. The right of each partner to participate in the business operations is implicit to the partnership agreement i. 1997 UPA 401Partners Rights and Duties 1. Each Partner has equal rights in the management and conduct of the partnership business b. Disagreements arise about business decisionsin the absence of an agreement to the contrary the default rule is that all partners have equal rights in the management of the business. i. Decisions about ordinary matters are to be decided by a majority of the partners 1. Large matters which involve the heart of the business must be agreed to unanimously by all the partners Summers c. National Biscuit Co. v. Stroud i. Both partners in a 2 person partnership disagreed about the purchase of bread, so one bought it without the consent of the other. 1. the court found that each partner has the power to enter into binding contracts as long as the conduct is part of a. the normal course of business and b. does not harm the other partner Outline, Business Associations, GrimesSpring 04 11of70 E. D. Baker

2. Binding the partnership in Tort a. Partners are jointly and severally liable for torts that injure 3d parties. Because of the joint and several liability, and action may be brought against any single partner without naming all the other partners i. 1997 UPA 305Partnership liable for Partners Actionable Conduct ii. 1997 UPA 306Partners Liability 3. Binding the partnership in Contract a. Every partner is an agent of the partnership for purposes of the partnership business. Therefore, any contract that a partner enters into for the purposes of carrying on the normal business of the partnership binds the entire partnership i. UNLESS, the partner really had no such authority and the 3d party knew that the partner lacked such authority. b. 1997 UPA 301Partner Agent of Partnership 4. Right to dissolve? a. A partner who has not fully performed the obligations required by the partnership agreement may not obtain an order dissolving the partnershipCollins b. A partnership may be dissolved by the express will of any partners when no definite term or particular undertaking is specified.Page V. Partnership Dissolution 1. Ways of ending a partnership relationship a. Dissociationwhere a partner no longer wishes to be a part of a partnership b. DissolutionIs the beginning to ending the partnershiponce a partnership is in dissolution, it is recognized that it is no longer in business except to finish up projects already started and to settle accounts among all the partners. 2. Dissociation a. Every partner has the power to dissociate at any time but, unless specifically provided, dissociation is considered wrongful. And could have financial consequences. b. Events Causing Dissociation i. Dissociation means that the individual will no longer be considered a partner but that the partnership itself will continue to exist. ii. Express Will 1. if a partner wishes to withdraw and does so, the effect of a partner expressly dissociating from the partnership is for the partnership to enter into dissolution iii. Partnership agreement 1. some agreements contain a condition of length of a partners involvement and that partner dissociates once the stated event or time occurs iv. Expulsion 1. expulsion procedures are generally outlined in the partnership agreement v. Unanimous Vote 1. if all partners agree to dissociate one partner may be dissociated vi. Judicial dissociation 1. a court can dissociate a partner for a. wrongful conduct that harms the partnership b. willful or persistent breach of the partnership agreement c. behavior which makes it not reasonably practicable to carry on business with that partner. 3. Dissolution a. The beginning of the ending up of a partnership. Once a partnership is in dissolution it is recognized that it is no longer in business except to finish up projects and settle accounts among the partners. 4. Events Causing Dissolution Outline, Business Associations, GrimesSpring 04 12of70 E. D. Baker

a. A partnership can only be dissolved upon the occurrence of i. A partners express will to dissociate from the partnership ii. Term partnership conditioned to end upon the occurrence of a specific event iii. A particular event agreed upon in the partnership agreement iv. Judicial dissolution can be determined when 1. the economic purpose of the partnership is unreasonably frustrated 2. another partner has engaged in conduct related to the partnership which makes it unreasonable to continue a partnership with that person 3. no longer practicable to carry on the partnership business in accordance with the partnership agreement. b. Owen v. Cohen bowling ally partnership sought a judicial dissolution of the partnership because the parties disagreed on practically all matters essential to operation of the partnership business i. The court found for dissolution using the following standard 1. Partner is guilty of conduct that hurts the business 2. Partner willfully or persistently breaches the partnership agreement or otherwise conducts himself in a way so that it is not reasonably practicable to carry on a partnership 3. Other equitable circumstances 5. Winding Upis the actual finishing of the partnership business and the settlement of accounts among the partners. a. Absent a contrary agreement, any income generated through the winding up of unfinished business should be allocated to former partners according to their respective interests in the partnershipJewel i. NOTE rights provided by a partnership agreement, even though different from those provided in the UPA control the method of dividing up assets upon dissolution, provided the dissolution is not prematureMeehan II b. Once a partnership goes into dissolution and finishes winding up it is no longer in existence c. Events of Winding Up i. Fulfillment of Obligations ii. Division/ liquidation of Partnership Property iii. Payment of Debts 1. Payment of creditors 2. Partner Creditors 3. Payback partnership capital contributions i. UPA 18 & Kovacik d. The Sharing of Losses i. In a joint venture where one party contributed funds and the other labor, neither party is liable to the other for contribution for any loss sustained.Kovacik ii. When a wrongful dissolution occurs [when one partner asks to dissociate] partners who have not wrongfully caused the dissolution shall have the right to continue the business in the same name and to receive damages for breach of the agreement.pav-saver e. Buyout agreements i. A partnership buy-out agreement is valid and binding even if the purchase price is less than the value of the partners interest, since partners may agree among themselves by contract as to their rights and liabilities ii. Buy-sell agreements allow a partner to end their relationship with the other partners and receive a cash payment, or series of payments, or some assets of the firm, in return for their interests in the firm, in return for their interest in the firm. iii. Buyout Agreements Outline, Business Associations, GrimesSpring 04 E. D. Baker 13of70

1. Buy-sell agreements allow a partner to end their relationship with the other partners and receive a cash payment, or series of payments, or some assets of the firm, in return for their interests in the firm, in return for their interest in the firm. iv. There are several issues and alternatives. 1. Trigger Events a. Death b. Disability c. Will of any Partner 2. Obligation to buy v. option to buy a. firm b. Other investors c. Consequences of refusal to buy i. If there is an obligation ii. If there is no obligation 3. Price a. Book Value b. Appraisal c. Formula (e.g. 5Xs the earnings) d. Set price each year e. Relation to duration (i.e. lower price in the first five years) 4. Method of Payment a. Cash b. Installments (with interest?) 5. Protection against debts of partnership 6. Procedure for offering either to buy or sell a. first mover sets price to buy or sell i. You Split, I Pick The theory is that the party setting the price doesnt know which way it is going to go so that they will try to set it pretty close to the center. b. First mover forces others to set price v. G & S v. Belmana partnership buy-out agreement is valid and binding even if the purchase price is less than the value of the partner interest, since the partners may agree among themselves by K as to their rights and liabilities. 1. Modern business practices allow parties to be bound by a K they enter into willingly, absent fraud or duress. f. Partnership Property i. Rights provided by a partnership agreement, even though different from those found in the UPA, control the method of dividing assets upon dissolution, provided the dissolution is not prematureMeehan ii. A co-partner owns no personal specific interest in any specific property or asset of the partnership, and may only convey an undivided interest in the value or deficit of the partnership.Putnam iii. Majority partners in a partnership-at-will may purchase the partnership assets at a judicially supervised sale.Prentiss iv. You can transfer your partnership interest, but not your interest in specific assets of the partnership VI. Limited Partnerships 1. Generally a. Limited partnerships, unlike general partnerships and more like LLPs can only be formed by observing certain formalities i. Filing with the appropriate office b. A limited partnership is comprised of two types of partners Outline, Business Associations, GrimesSpring 04 14of70 E. D. Baker

General Partners 1. are the typical, capital contributing, fully liable partners. ii. Limited Partners 1. are passive investors who only share in the profits and losses in some proportion to their investment, and are not personally liable for the debts of the partnership a. they have no rights to manage or direct the partnership 2. If a limited partners exercises control over the partnership business he becomes a general partner and is thus fully personally liable for the partnership. Limited Liability Companies I. Formation 1. The Members or managers of a LLC are not excused from personal liability on a contract where the other party to the contract did not have notice that the members or managers were negotiating on behalf for an LLC at the time the K was made. Water, Waste & Land, Inc. 2. Filing a. An LLC must be formed by filing its articles of organization with the secretary of state; the articles must contain i. A statement that the entity is an LLC ii. The name of the LLC which must include an indication that it is an LLC iii. The street address of the LLCs registered office and name of its registered agent; and iv. The names of all of the members. 3. Purpose a. An LLC is an entity eligible to be taxed like a partnership (pass through) while offering its owners the limited liability enjoyed by shareholders in a corporation. Notean LLC can request to be taxed as a corporation Operating Agreement 1. Because the policy of the ULLCA is to give maximum effect to the principal of freedom of contract and to the enforceability of LLC agreements the parties may contract to avoid the applicability of certain provisions of the act. Piercing the LLC Veil 1. In the absence of fraud, a claim to pierce the veil of a LLC is treated in the same manner as a court would pierce a corporate veil. Fiduciary Obligations 1. A member of an LLC does not breach a fiduciary duty to the company by directly competing against it where the operating agreement expressly permits competition. Dissolution 1. A member or manager of a LLC is not personally liable for any debt. obligation, or liability of the company only if the member or manager follows statutorily prescribed formalities of LLC incorporation, dissolution, and creditor notice. A Hybrid Business Formation 1. Treat like a partnership a. Unincorporated, pass through taxation b. No double taxation- kind of like an s chapter corp. c. Members all manage as per se book value (% of interest in the partnership)-default (the more % the more power in making decisions. 2. Like a corporation a. Limited liability even for active members b. Created by filing Articles of organization with state limited liability statutes. 3. Why people like it! a. Easy to alter by a contract- can plan central management. 15of70

i.

II.

III. IV. V.

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b. Operating agreement can have any agreement you want in it. c. Law firms like it because they can control and protect themselves; it is more difficult to get ruined in. VII. LLC Mergers 1. Generallythe managers of an LLC owe to one another a duty of loyalty to act in good faith a. VGS, inc. v. Castiel i. Although the LLC statute did not require notice to before could act by written consent, but s knew if they had notified he would have attempted to block the merge. 1. s owed a duty to to give him prior notice of the meeting even if he would have interfered with a plan that they believed to be in the best interest of the LLChence, they failed to discharge their duty of loyalty to him in good faith. Closely Held Corporations I. Generally 1. What is a closely held corporation? a. Generally a corporation with a small number of stockholders; and there is a lack of any ready market for the corporations stock; and there is substantial participation by the majority stockholder in the management, director, and operations of the corporation. 2. Characteristics of a Closely Held Corporation a. A small number of shareholders (1 or 2 up to 20) b. The lack of any resale market for the corporations stock c. A controlling shareholder who actively participates in the day-to-day management of the business 3. Planning a. The shareholder in a close corp., especially a minority shareholderwill probably not fare as well economically without a negotiated arrangement regarding matters such as who will be on the board of directors, who will be the managers, what salaries and dividends will be paid, how shares will be transferred ext. II. Allocation of Control 1. Shareholder Voting Agreements, Voting Trusts and Classified Stock a. Shareholder Voting Agreementssome or all shareholders agree to vote together as a unit on specified matters i. Content of the Agreementssome voting agreements attempt to resolve in the agreement itself exactly how the votes will be castother agreements merely commit the parties to vote together without specifying which way the vote it so go; it is then up to the parties to reach an agreement in the future. ii. Generally validboth the more specific and the more general agreement are generally valid. 1. Ringling Bros. Barnum & Bailey Combined Shows v. Ringling a. A group of shareholders may lawfully contract to vote in any manner they determine. i. In this case there was a general agreement binding two parties to vote together, and if they couldnt determine which way to vote the issue would be submitted to arbitration. 2. Ramos v. Estrada a. Voting agreements binding individual shareholders to vote in concurrence with the majority constitute valid contracts i. Therefore, a party who doesnt vote with the majority can be sued for breach of contract iii. No Restriction on directors authority Outline, Business Associations, GrimesSpring 04 E. D. Baker 16of70

1. The shareholders can be confident that the court will uphold their voting agreement only if the agreement does not try to deal with matters that are appropriately left to the discretion of the board of directors. a. A shareholder agreement that does restrict the authority of the board of directors may be found invalid as an illegal modification of the principle that a corporations business shall be managed by or under the direction of the board of directors. See Below iv. EnforcementVoting agreements are not self enforcing so if A and B agree to vote to elect each other as directors, and B then votes for C, what can A do? 1. Without judicial relief A would simply not be elected, and left with a claim for breach of K 2. Specific Performance as a solutionthe court can order the breaching shareholder to cast his vote as prescribed in the shareholders agreement however courts are reluctant to order a stockholder to vote a certain way a. Ringling Bros (under Del. Law) i. Facts Mrs. R, H and N are the 3 shareholders of corporation that runs the circus. R and H sign a voting agreement in which each agrees to consult and confer with the other and to vote their shares together on any issue put to a stockholder vote. They also agree that if they can't agree on how the shares should be voted, their lawyer. Mr. L, shall act as arbitrator. At subsequent shareholders meeting to elect directors. Hand R disagree and the arbitrator is called in. R agrees to vote her shares in accordance with the arbitrator's decision, but H refuses to do so. The chairman rules that the arbitrator may cast H's vote. For unclear reasons, R sues to overturn the election. The court holds that the agreement is valid, and orders a new election at which the agreement is to be followed. ii. Held: The agreement is VALID. However, the lower court was wrong in holding that the agreement created an implied irrevocable proxy. Instead. R's remedy for H's failure to follow the agreement should be that H's votes would not be counted. The court denied specific performance of the agreement. NOTE TODAY, MOST COURTS WOULD GRANT R THE SPECIFIC PERFORMANCE THAT SHE DESIRED. ALSO, MOST COURTS WOULD HAVE RECOGNIZED THE PROXY TRANSFER WHICH WOULD MAKE IT IRREVOCABLE. b. Voting Trustsshareholders relinquish their voting power to a voting trustee, often one who agrees to cast the votes in a prescribed way [i.e. to elect certain stockholders to the board] the shareholders retain their economic interest in the business i. Creationthe shareholders who are part of the voting trust must convey legal title to their shares to one or more voting trustees, under the terms of a voting trust agreement 1. The shareholders become beneficial owners, or equitable owners of the sharesthe shareholder is still entitled to dividends ext. but no longer has voting power. ii. Power of Trusteesthe voting trustees are subject to the fiduciary obligations of trusteesgenerally they may exercise only those powers that are specifically spelled out in the trust, and unless the trust expressly permits they may not vote in a way that damages the beneficial owners. c. Classified Stocka corporation can set up multiple classes of stock, each which gets different voting rights or financial rights. A common pattern is for a particular group Outline, Business Associations, GrimesSpring 04 E. D. Baker 17of70

of minority holders to get its own class of stock, which is guaranteed the right to elect one or more directors. i. Generallyusing different classes and weighting of votes is generally valid. The use of different classes of stock is an easy way to insure that the minority gets a disproportionate number of directors d. Super-majority voting and quorum requirementsthese devices provide that certain types of corporate action can only occur if an especially high percentage of shares or board votes are case in favor of the measure, and or an especially high percentage of shares or board members make up the quorum for the measure. The purpose is to give minority shareholders blocking power 2. Agreements Restricting the Boards Discretion a. How the problem Arisesif shareholders enter into voting agreements agreeing to restrict their discretion as directorsthe agreement may then be found to violate the principle that the business shall be managed by the board of directorssome cases have found that agreements that substantially fetter the discretion of the board of directors are unenforceable. i. Board has a fiduciary obligation to the corporation, all its shareholders and creditors. Therefore, an agreement that does not let the board use its own best judgment might result in unnecessary injury to a minority shareholder who did not agree to the restrictions, or to a creditor. b. New York Case Lawthis is the leading line of cases limiting the enforceability of agreements that restrict the boards discretion. i. Generally In New York the agreement must; 1. not harm creditors, the public, or non-consenting shareholders; 2. must involve only an innocuous variance [from the rule that a corporations business should be managed by the board] and; 3. may require all shareholders to consent. ii. *McQuade v. Stonham a shareholder agreement prohibiting the board of directors from changing officers, salaries, or policies, or retaining individuals in office, is illegal and void absent express contractual consent. 1. FactsThe majority shareholder (S) and two minority shareholders (M and M) agreed that all would use their best efforts to keep one another in office as directors and officers at certain salaries. S and M later refused to try and keep M in office. He was later dropped from the positions he had held and sued for breach. a. Holding agreement is invalid, and thus held for the 4's. Shareholders may NOT, by agreeing among themselves, place limitations on the power of directors to manage the business by the selection of agents at defined salaries. i. The board must be left free to exercise its own business judgment. The agreement here prevented the board from doing that by restricting the board from firing M from his treasurer's post iii. Clark v. DodgeWhere the directors are also the sole stockholders of a corporation, a K between them to vote for specified persons to serve as directors is legal and not in contravention of public policy 1. Facts P owned 25% and D owned 75% of two corporations. They signed an agreement whereby D was to vote for P as director and general manager, and to pay him one-forth of the business' income, so long as he remained faithful, efficient and competent. D argued that this agreement violated the McQuade rule since it purported to restrict the discretion of the board of directors. a. Holding The court upheld this agreement. This agreement was different from McQuade in two respects. Outline, Business Associations, GrimesSpring 04 E. D. Baker 18of70

i.

All shareholders had signed the agreement. and there was no sign that

anyone would be injured by the contract AND ii. The impairment of the board's powers was negligible because P could always be discharged for cause. NOTEthis case illustrates that the NY courts are willing to uphold a director-fettering agreement, if it is approved by all share holders. c. Other Jurisdictions i. other jurisdictions are becoming more willing to approve arrangements that interfere to some extent with the discretion of the board of directors 1. Galler v. Gallershareholders in a closely held corporation are free to contract regarding the management of the corporation absent the presence of an objecting minority, and threat of public injury a. Facts The two principal owners of the corporation, B and I. each owned 47.5% of the stock. They signed a shareholders' agreement in which they agreed to pay certain dividends each year and to pay, in the event either one died, a specified pension to his widow. B died and I refused to carry out the agreement. i. Holding The IL court upheld the agreement even though it limited the discretion of the board. The agreement will be upheld if it Does not injure any minority shareholder; Does not injure creditors of the public; and Does not violate any express statutory provision This is the MODERN VIEW III. Freeze Outs 1. Freezeouts and squeezeouts often take place in close corporationsthe majority shareholder or a group of shareholders forces out the minority holders either a. Through legal compulsion; or b. By making the minoritys stock ownership so unrewarding as a practical matter that the minority feels it has no choice but to sell to the controlling holders (squeezeout) IV. Resolution of Disputes 1. Statutory Dissolution a. In many close corporations no advanced planning is ever done, and the parties find themselves at odds with nothing but the general corporation statute of the jurisdiction to guide them as to their rights. i. Dissensionrefers to disagreements among the shareholders ii. Deadlockthe situation where the corporation becomes paralyzed and prevented from acting, this usually arises from some aspect of the control structure that the shareholders have adopted 1. this can be avoided by such advanced planning as shareholders voting agreements, super-majority requirements ext. b. Dissolutionis the most important judicial remedy for dissension or deadlock, the court can order the corporation to involuntarily dissolve.upon dissolution the corporation ceases to exist as a legal entity, the assets are sold off, its debts are paid, and any surplus is distributed to the shareholders. c. No General Right to dissolution i. No state gives a shareholder an automatic right to a judicially-ordered dissolution. Instead, each states statute sets forth the specific grounds for which dissolution may be granted. The statutes are strictly construed , and only if the shareholder shows that one of the statutory grounds applies will the court order involuntary dissolution. d. Stuparich v. Harbor furniture Mfg., Inc. Outline, Business Associations, GrimesSpring 04 E. D. Baker 19of70

Statutory dissolution of a close corporation is not reasonably necessary for shareholder protection on the grounds of animosity among the corporate directors. 1. Factsthere were significant disputes and severe animosity an dill will among the board members who were family members of s. Therefore s sued seeking involuntary statutory dissolution a. Holdingthe Ca. statute allows any shareholder of a close corporation to initiate involuntary dissolutionbut because the remedy is so drastic it should be limited, hard feelings and ill will, where there is no mismanagement or unfairness or evidence of corporate deadlock does not authorize dissolution. e. Alaska Plastics, Inc v. Coppock i. Even though the Alaska statute allows the court to liquidate a corporation when the acts of those in control are oppressive or fraudulent the courts retain equitable authority to fashion a less drastic remedy to fit the partys situation. 1. the court in this case found that there was a breach of the fiduciary duty owed to minority shareholders, and therefore forced the corporation to repurchase the stock as opposed to a dissolution. 2. Alternatives to Dissolution a. Fiduciary Obligation of Majority to Minority i. Some states have formulated a theory of fiduciary obligation to resolve close corporation disputes. The courts, especially Massachusetts, have held that a majority stockholder in a close corporation has a fiduciary obligation to a minority shareholder and must behave towards him in good faith. 1. Violation of this obligation can be compensated by an award of damages a. The fiduciary obligation is an important method of resolving disputes, because it gives the courts that apply it a method of rectifying the minority shareholders grievances without the strong medicine of dissolution. b. Squeeze-outs i. If the majority attempts a classic squeezeout of a minority holder, the majority holder may be found to have violated this fiduciary obligationif 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 may be a violation of the majoritys fiduciary obligation. 1. *Wilkes v. Springside Nursing Home, Inc (Mass.) a. Facts P and 3 other shareholders each owned 25% of the corporation. Each one participated in management and received an equal salary. Relations between P and one of the other shareholders deteriorated, and the other holders caused the corporation to terminate P's salary and to drop him from the board. b. HoldingThe court found that the other holders had violated their fiduciary obligation to P by this squeeze-out, since it stripped P of his ability to obtain his expected return on his investment. c. Legitimate Business Purpose Testthe court was careful to make it clear that not every act by the majority that is disadvantageous to a minoritys conduct will be upheld if i. there was a legitimate business purpose for it, and ii. that purpose could not have been achieved by a different course of action less harmful to the minority holder. Because in Wilkes the stockholders had not shown a legitimate business purpose from dropping P from the payroll and the board Outline, Business Associations, GrimesSpring 04 E. D. Baker 20of70

i.

they had violated their fiduciary duty to himstrictest duty of good faith 2. Sugarman v. Sugarman (Mass)shareholders in a close corporation owe one another a fiduciary duty of utmost good faith and loyalty. a. The overcompensation of one shareholder was designed to freeze out the other 3 from the companys benefits i. The offer to buy the stock at an inadequate price was the capstone of a plan to freeze them out 3. Exception a. *Ingle v. Glamore Moter Sales (NY law)a minority shareholder in a closely held corporation, who is also employed by the corporation is not afforded a fiduciary duty on the part of the majority against the termination of his employment. i. s shareholder agreement which retained a right of repurchase should s employment with Galmore Motor sales be terminated for any cause. Because NY is a jurisdiction which does not recognize a breach of fiduciary duty in the absence of statutory violations of a breach or express contractual provisions. Neither were present here. c. Obligation of a Minority shareholder i. In Mass one lower court has found that a minority shareholder has a fiduciary obligation to his co-stockholders, if the minority holder has been given a veto power over corporate actions. ii. Smith v. Atlantic Properties, Inc.Stockholders in a close corporation owe one another the same fiduciary duty in the operation of the enterprise that partners owe one another 1. Facts Dr. W is one of four equal shareholders in a corporation that owns real estate. The corporation's charter gives each shareholder an effective veto power over any corporate decision. Over the objections of the other 3 shareholders, W refuses to allow the corporation to pay a dividend out of its surplus. Consequently the corporation is assessed substantial penalties by the IRS for excess accumulations of earnings. a. Held W's refusal to allow a dividend was motivated more by his personal tax considerations and dislike for his fellow shareholders than for the corporation's benefit. Therefore, W must reimburse the corporation for the loss it suffered from his unreasonableness. d. Obligation with regard to stock sale i. Jordan v. Duff and PhelpsClose corporations buying their own stock have a fiduciary duty to disclose material facts. V. Transfer/Sale of Control 1. Nature of the problemA `controlling block' of shares in a corporation will often be worth more, per share, than a non-controlling block. May the controlling shareholder sell his block for a significantly higher price than that available to non-controlling shareholders who also want to sell? The general answer is yes. a. Controlling Blocka person has effective control [and his block of stock is a controlling block] if he has the power to use the assets of a corporation as he chooses. i. Not necessarily a majoritya minority interest may be controllingthe existence of a controlling interest is a factual question. 2. Why control might be worth a premium a. the person with control has the keys to the corporate treasury, and may attach economic value to those keys. This makes sense. An acquirer would rationally pay more per share of control than for a non-controlling interest. Often, the existing Outline, Business Associations, GrimesSpring 04 E. D. Baker 21of70

holder of control will often be unwilling to sell his stock without getting a control premium. 3. General Rule a. The general rule is that the controlling shareholder may sell his control block for a premium, and may keep the premium himself. i. Zetlin v. Hanson Holdings Inc 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 the purchaser is free to buy, that controlling interest at a premium price. 1. Facts The Defendant's and their families collectively own 44% of the stock of Gable Industries. The 4's sell their interests for $15 per share at a time when Gable stock is selling on the market for $7 per share. Plaintiff , small shareholder, contends that the minority shareholders should be entitled to share in his control premium. a. HeldThe court held for the Defendant's Absent looting of corporate assets, conversion of a corporate opportunity, fraud or other acts of bad faith, a controlling shareholder is free to sell that controlling interest at a premium price i. This sets up the exceptions to the general rule that there is a right to sell. 4. Exceptions a. Looting Exception i. An exception to the general rule that a controlling shareholder may sell for a premium his controlling shares 1. a holder of controlling shares may not knowingly, recklessly, or negligently sell his shares to one who intends to loot the corporation by unlawful activity b. Sale of Vote Exception i. As a matter of public policy, courts prohibit the bald sale of a corporate office. 1. An illegal sale of office is most likely to be found in 2 situations: a. Where the control block is much less than a majority of the shares, but the seller happens to have unusual influence over the composition of the board. b. Where the sales contract expressly provides for a separate, additional, payment if the seller delivers prompt control of the board 2. Working Control Blockthe sale of vote issue is hardest to resolve when what is being sold is something that is working controlthe problem is that there is no way to know in advance whether a substantial minority block will indeed turn out to be controlling in the buyers hands. a. Essex Universal Corp. v. Yatesa sale of a controlling interest in a corporation may include immediate transfer of control i. The block sold was 28.3% of the stock, the seller contracted to deliver to the buyer resignations of a majority of the directors and to cause the buyers nominees to replace them. It is the law in NY that the control of a corporation may not be sold absent the sale of sufficient shares to transfer such control this is based on the notion that control of a corporation derives from corporate voting not a personal right c. Diversion of collective opportunitythis exception refers to situations in which for one reason or another the control premium should really be found to belong either to the corporation or to all shareholders pro rata. Two Situations; i. Where the court decides that the control premium really represents a business opportunity that the corporation could and should have pursued as a corporation Outline, Business Associations, GrimesSpring 04 E. D. Baker 22of70

ii. Where a buyer initially tries to buy most or all of the corporations assets and the controlling shareholder instead talks him into buying the controlling shareholders block at a premium instead. 1. Displaced Corporate business opportunity a. Perlman v. Feldman i. Facts was the president and dominant shareholder of a steel corp. during the Korean was the steel industry refrained from increasing its prices. W bought s controlling interest at $20/share when the publicly traded price was $12/share, and book value was $17/share ii. Holdingthe court agreed with s that by selling his control block for a premium had violated his fiduciary duty to the other shareholders. The court made it clear that it was not imposing a general rule. But when there was an opportunity for corporate level gains, and instead the controlling shareholder appropriated that gain for himself, there is a breach of the fiduciary duty. 5. Right of First refusal a. Generallythe right of first refusal allows one to meet the terms of a proposed contract before it is executed b. Frandsen v. Jensen-Sundquist Agency, IncIn a transfer of control of a company, the rights of first refusal to buy shares at the offer price are to be interpreted narrowly i. Facts was a minority shareholder of company . had the right to buy shares at the offer price if ever offered to sell its shares. Bank negotiated to acquire , and countered stating that he was exercising his right of first refusal to buy the majority shares 1. Held In this case never made an offer within the scope of the stockholder agreement. Thus s right of first refusal was never triggered. Corporations v. Other Business Entities I. Corp. v. Sole Proprietorship 1. Sole Proprietorship a. One persons owns all of the assets of the business and the proprietorship does not exist apart from its owner. The owner of the sole proprietorship carries own business as an individual. This form of business entity is for all purposes a one person partnership. 2. Benefits and Burdens a. With a sole proprietorship you have centralized management, pass through taxation, and no limited liability. II. Corp. v. Partnership 1. A partnership can be created by the will of two or more people to enter a partnership so there are none of the formal costs that are associated with the creation of a corporation. 2. Even though partnership can be sued under the partnership name they are not separate legal entities, partners are personally liable for the obligations of the partnership. 3. Management is spread across the partners not centralized in a board (which can lead to conflict over the operations of the partnership) 4. Ownership interests in a partnership cannot be freely transferred but can only be transferred by the consent of all partners. 5. Pass through taxationall gains and losses are passed through to the individual partners in proportion to their share of ownership interest. III. Corp. v. Limited Partnership Outline, Business Associations, GrimesSpring 04 E. D. Baker 23of70

1. Limited Partnership in general a. A limited partnership provides for limited liability of some of the investors, there must be at least one general partner who is liable, but the other limited partners generally enjoy limited liability. 2. Benefits and burdens a. A limited partnership enjoys pass through taxation, and offers the limited partners limited liability (and limited managerial control) however, if a limited partner behaves like a general partner he may become fully liable for the obligations of the partnership. b. A limited partnership offers many of the benefits of an S Corporation without the shareholder limit. IV. Corp. v. Limited Liability Partnership 1. LLP Generally a. An LLP doesnt have the general partner requirement that you have with an LP, therefore, all partners are only liable for their portion of the partnership. b. There is a step of formal formation that must be filed with the secretary of state, but other than that these entities run like partnerships. Unlike an LP the LLP partners all have the managerial benefits of a partnership V. Corp. v. Limited Liability Company 1. Offers the limited liability of a corporation and the choice of pass through taxation of a partnership. 2. there are formal formation requirements and the appropriate documents must be filed with the secretary of state 3. Management and Business formthe LLC offers flexibility in the business form, and the owners may choose either centralized management or owner management, there is also free transferability of ownership or restricted depending on the agreement of the owners. 4. this choice offers a lot of flexibility for the owners of an LLC.

The Nature of the Corporation I. Formation of a Corporation 1. Where to incorporate? a. Because corporations are governed entirely by state law, the state you choose to incorporate will most likely govern all affairs and potential problems. This choice normally comes down to the state where the corporation will be headquartered or Delaware. 2. Mechanics of Incorporating a. Articles of Incorporation i. To form a corporation you must file with the Secretary of state your articles of incorporation, and pay the filing fee associated with this document. 1. The articles are reviewed by the designated state official to ensure they are completed and the corporation is formedthe date of incorporation is usually retroactive and is the date of filing. ii. Contents of the Articles of Incorporation 1. Namethe corporation name is checked by the Secertary of State to ensure that this name is not already being used by another business entity. 2. Purposethis clause sets forth the general purposes for which the corporation is being formed, this can be as broad as to engage in any lawful business. 3. Capitalization the number of shares the corporation is authorized to issue. If at any time in the future the corporation whishes to issue more shares than 24of70

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listed in this section the articles of incorporation must be altered by a shareholder vote. b. Board of Directors i. generally the Board of Directors is elected by the shareholders, but before the corporation is formed there are no shareholders to elect a board, and without a board no shares of stock can be issued. Therefore, states generally allow for the initial directors to be listed as the board. c. Bylaws once the corporation has been formed by the filing of the articles of incorporation it must adopt bylaws, which govern the corporations internal affairs i. Contents Date time and place of the annual meeting, number of directors of the corporation, whether or not cumulative voting for directors will be allowed, a listing of the officers of the corporation together with a description of the duties of each, what shall constitute a quorum for the meeting of directors 1. Conflictif there is any conflict between the articles of incorporation and the bylaws, the articles control. II. Characteristics of a Corporation 1. Distinct Legal Entitya corporation is a legal entity distinct from its owners, creation of such an entity requires the formal filings discussed above, and the structure of running a corporation requires more formalities than other business entities. 2. Limited Liability for Owners, Directors, and Officers a. The owners [shareholders] of a corporation are generally not personally liable for the obligations of the corporation; neither are the corp.s directors or officers. i. Normally only the corp. itself can be held liable for corporate obligations, the owners risk only the investment that they make in the business to purchase their ownership interests [shares]. 1. Thus, if a person wants to set up a business entity that protects his personal assets from the possibility of being seized to satisfy obligations of the business, a corporation would be a good business form to choose. 3. Centralized Management a. The right to manage a corporation is not spread among the shareholders [like it is in a partnership] but it centralized in a board of directors who then delegate the dayto-day management duties to officers. i. This makes a corporation a good choice to avoid conflicts with co-owners of a business regarding the management of that business. 4. Free Transferability of Ownership a. Ownership in a corporation is freely transferable; a shareholder can sell his shares to whomever he wants, whenever he wants, at whatever price he wants. i. Notetransferability of shares can be restricted by agreementsuch as with closely held corporations, and with S corporations. 5. Taxation a. Corporation i. A corporation is taxed as a separate legal entity distinct from its shareholders, it must pay income taxes on any profits that it makes, and generally shareholders dont have to pay income tax on the corp.s profits until the profits are distributed to them [dividend taxes] 1. Generally the corporate tax rate is lower than a personal tax rate, however, whenever a corporation distributes its profits in the form of dividend payments the shareholders are then taxed on that gain. b. S Corporation i. Corporations meeting the qualifications specified in subchapter S of the tax code may elect to be taxed like partnerships and retain the other advantages of a corporation [i.e. limited liability] there for there is the option for a corporate form with pass through taxation, while retaining the centralized management. Outline, Business Associations, GrimesSpring 04 E. D. Baker 25of70

1. however, S corps are more restrained in their formation and generally are better suited for smaller business entities [because there can be no more than 75 shareholders, and they can only issue one class of stock, ext.] III. Promoters and the Corporate Entity 1. Who is a Promoter? a. A promoter is a person who takes initiative in founding and organizing a business or enterprise. A promoter may act alone or with co-promoters. 2. Promoters Activities a. Arranging for the necessary capital b. Acquiring any needed assets or personnel and c. Arranging for the actual incorporation of the business 3. Transactions by promoters Pre-Incorporation a. The concerns are i. Under what circumstances does the promoter become personally liable for transactions he undertakes on behalf of the corporation? ii. Under what circumstances does the corporation, once formed, become liable based on the promoters pre-incorporation transactions iii. What, if any, are the promoters fiduciary obligations to the not-yet-formed corporation? 4. Liability of a Promoter a. If the corporation has already been formedand the promoter makes the contract in the corporations name there is generally no issue as to the promoters liability because the corporation is fully liable, and the promoter is not. b. IF the corporation has not yet been formedand the promoter purports to make a contract on the behalf of that to be formed corporation the promoter may or may not be personally liable if the corporation is never formed, or is formed but does not perform the contract. i. MBCA 2.04 All persons acting on behalf of a corporation that is not yet formed are jointly and severally liable for all liabilities created while so acting 1. But if the promoter tells the other parties that the corporation is not yet formed, or that she is only intending for the corporation to be bound. No liability. ii. Whether a promoter is bound depends on the INTENT of the contracting parties. If you dont want to be bound as a promoter, you have to make your intent COMPLETELY clear that you are not acting on behalf of the corporation. a. However, a promoter may be liable if he makes a contract on behalf of a not yet formed corporation. The Corporation is not automatically liable on promoters contract made for its benefits. Rather, an newly formed corporation may accept or reject pre-incorporation contracts iii. The several circumstances of promoters are: 1. Corporation not named: If the promoter makes the contract in his own name, the promoter is personally liable even if he has the intent to assign the contract to the corporation. 2. Contract in Corporations Name: If the promoter knows that the corporation has not yet been formed, he will almost certainly be held personally liable if the corporation is never formed, or it is formed but does not take over and fulfill the contract. This is because of an agency principle. a. A person who purports to act as agent for non-existent principal thereby automatically becomes a principle. 3. Contract States that Corporation is to be formed: The contract will say John Does, on behalf of ABC Corp. to be formed. When this situation occurs, you must always look at the parties intent. This is explained in the following situations Outline, Business Associations, GrimesSpring 04 E. D. Baker 26of70

a. Corporation never formed: if this occurs, the promoter is quite likely to be held personally liable b. Corporation formed, but no adoption: Again, the promoter will probably be held personally liable. c. Adoption by the Corporation: If the corporation is eventually formed, and it adopts the contract, the promoter has a much better chance of escaping liability. iv. IF YOU DONT WANT TO BE BOUND AS A PROMOTER, MAKE SURE YOUR INTENT IS COMPLETELY CLEAR. c. BUTWhen the promoter deals with a party who acknowledges that they are contracting with a to be formed corporation, that party cannot deny the existence or legal validity of such a corporation in order to escape the contract. Suthern-Gulf Marine Co. No. 9, Inc. v. Camcraft, Inc. IV. Piercing the Corporate Veil (3d party action through the corpshareholders) 1. The Problem a. Because a corporation has limited liability generally a harmed party can not reach through the corporation and extract liability from the shareholders. Generally a properly formed corporation will shield the stockholders from being personally liable for the corporations debts, so their losses will be limited to their investment. i. However the corporate shield is not complete, in a few cases courts will pierce the corporate veil and hold some or all of the shareholders personally liable for the corp.s debts. b. FACTORS CONSIDEREDCourts may allow corporate creditors to pierce the veil if they find; i. Unity of Interest & ii. Adherence to the fiction of a separate corporate existence would sanction a fraud or promote injustice. 2. Liability of a PRIVATE SHAREHOLDER a. FRAUD OR WRONGDOING i. Generally this involves a situation where those who control the corporation have siphoned out funds, and assets leaving too little in the corporation to satisfy the creditors. Normally fraud or wrongdoing amounts to leaving the corporation with inadequate capital. b. UNITY OF INTEREST i. Kinney Shoe Corp. v. Polan 1. leased a building to s corporation. s corporation had no assets and no income, and no bank account, nor did it follow any of the corporate formalities. corp. made no lease payments to and sued for back payments on the lease a. The court held that this corporation was nothing more than a shell and offered no protection to its owner. b. The corporate veil will be pierced where there is; i. a unity of interest and ownership between the corporation and the individual shareholder; and [Unity of InterestWhere there is no reasonable distinction between the sole shareholder and the corporation there is generally a unity of interest.] ii. an inequitable result would occur if the acts were treated as those of the corporation alone. ii. Sea-land Services, Inc. v. Pepper Source Outline, Business Associations, GrimesSpring 04 E. D. Baker 27of70

1. could not collect a shipping bill from because had been dissolved, sought to pierce the corporate veil and hold corp.s sole shareholder personally liable. a. The court held that the veil will be pierced where; i. There is a unity of interest and ownership between the corporation and an individual; and ii. Where adherence to the fiction of a separate corporate existence would sanction a fraud or promote injustice. b. Factors determining unity of interest i. Corporate formalities were not followed ii. Funds and assets were commingled iii. corp. was undercapitalized iv. corporate assets were moved, tapped and borrowed without regard to their source iii. Inadequate Capital 1. Walkovsky v. Carlton a. although Grossly inadequate capitalization is a factor in determining whether to pierce the veil is it not dispositive, the court required that there be i. some affirmative fraud or wrongdoing by the shareholder, or ii. a gross failure to follow the corporate formalities b. In this casethe owned 10 corp.s each owning two taxis. when was injured the corp. holding the cab he was injured in had insufficient assets to assure the recovery sought. i. The court held that where a corporation is a fragment of a larger corporate combine which actually conducts the business, a court will not pierce the corporate veil to hold individual shareholders liable. iv. Tort v. Contract 1. For public policy reasons courts are often more likely to pierce the veil for tort cases. v. Corporate Formalities 1. As illustrated by the above cases the courts will look at whether corporate formalities were followed when determining whether or not it is appropriate to pierce the corporate veil. a. Formalities not followed i. Shares are never formally issued, or consideration for them is never received by the corporation ii. Shareholders meetings and directors meetings are not held iii. Shareholders do not sharply distinguish between corporate property and personal property; and iv. Proper corporate financial records are not maintained. 3. Parent/Subsidiary a. Courts are more likely to pierce the corporate veil when the situation involves a parent/subsidiary relationship rather than seeking liability for individual shareholders. b. General Rule of Non-Liabilitythe parent company will not be liable for the debts of the subsidiary so long as; i. Proper corporate formalities are observed ii. The public is not confused about whether it is dealing with the parent or the subsidiary iii. The subsidiary is operated in a fair manner with some hope of profit making, and iv. There is no other manifest unfairness c. Direct liability by patent for exercising control of subsidiary Outline, Business Associations, GrimesSpring 04 E. D. Baker 28of70

i.

If the parent is found to have been so deeply involved in conducting the particular activity that has given rise to the claim that the court finds that the parent is responsible. This is generally based on tort principles and not the veil piercing doctrine. 1. In the case that an officer of the parent has specifically directed that the subsidiary take a particular action that turns out to be tortuousthe parent can be found liable on a direct liability theory with no need to evaluate the veil-piercing doctrine.

V. Shareholder Derivative Actions (shareholders corp., on behalf of corp.) 1. In General a. Shareholders enjoy a dual personalitythere are entitled to enforce their own claims against the corporation, officers, directors, or majority shareholders by direct action. Shareholders are also the guardians of the corporations causes of action, and may sue derivatively to enforce the corporate cause of action, as long as they meet the requirements specified by lat and the y have made necessary demands on the corporation or the directors to enforce the cause of action 2. Why are Derivative suits brought? a. If the injury is an injury to the corporation and not to an individual shareholder the derivative action is brought to rectify the harm done to the corporation. b. When does this occur? i. Most cases brought against insiders for breach of the fiduciary duty of care or loyalty are derivative; Examples; 1. Due Carea suit against the board members for failing to use due care in overseeing the companys operations (e.g. by grossly negligently approving a disastrous acquisition) 2. Duty of Loyalty a. Self-Dealingan officer has engaged in self-dealing when they influence the corporation to take action that benefits them directly (e.g. when an officer induced the corporation to purchase property from him at an above-market price) b. Excessive Compensationany suit to recover the excessive compensation paid by the corporation to its officers c. Corporate opportunitya suit against an officer alleging that he has usurped a corporate opportunity for himself (e.g. by acquiring a piece of property that the corporation would have been interested in) 3. Requirements for asserting a Derivative Suit a. There are three main procedural requirements that, in most states, a must meet in order to maintain a derivative suit; i. Contemporaneous ownership must have been a shareholder at the time of the acts complained of; ii. Continued ownership must still be a shareholder at the time of the suit; and iii. Demand must made a demand (unless excused) upon the board of the corporation, requesting that the board attempt to obtain redress for the injury the corporation has suffered. b. Contemporaneous Ownership i. All states require that the be a stock holders in the corp. on whose behalf the suit is broughtthis person must be a stockholder (a holder of an equity security)Bond holders are not covered. c. Continued Ownership

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The must continue to own shares in the corporation up until the moment of judgment. must continue to have an economic stake in the outcome of the suit until its conclusion. d. Demand (need to know NY and Del. Law) i. The shareholder must make a written demand on the corporation to take suitable action. A derivative proceeding may not be commenced until 90 days after the date of the demand, UNLESS; 1. The shareholder has earlier been notified that the corporation has rejected the demand 2. Irreparable injury to the corporation would result by waiting for the 90 days to pass ii. When Demand is Not Required 1. If the Demand is Futile a. Many jurisdictions excuse the demand requirement where such a demand would clearly be futile. 2. Generally Demand is Futile when; (duty of loyalty breach) a. A majority of the board has a material financial of familial interest b. A majority of the board is incapable of acting independently for some other reason such as domination of control, or c. The underlying transaction is not the product of a valid exercise of business judgment 4. The Demand Requirement a. Problem i. A derivative action is brought on behalf of the corporationand the decisions about how the corp.s affairs should be run are ordinarily reserved to the board of directors. 1. If may litigate a derivative suit on the corp.s behalf even though the board opposes the action, the boards customary power to make major business decisions concerning the corp.s operations is effectively curtailed. 2. therefore, there may be incentive for the and the s lawyer to bring frivolous claims for their nuisance/settlement value, and the corp. may suffer if the time of the board and executives is used up in dealing with these types of suits 3. These problems create a need to give the board, or a special committee of the board some power to review the action, and determine whether it is in the corporations best interest, and if not to dismiss the suit. ii. Insiders as Defendants 1. Many serious derivative suits allege wrongdoing by corporate insiders, including (1) board members and/or (2) the senior executives [who are responsible for the board members getting their positions on the board] a. If left solely to the boards discretion, the board will rarely institute action against a corporate insiderthis is precisely the situation where derivative actions serve their intended purpose, and giving the board a substantial say in whether the action should proceed will undermine the purpose of allowing derivative suits in the first place. b. Dilemma i. Courts have struggled to find rules that will, on the one hand, maintain the boards ability to control the corporations affairs and to terminate frivolous actions at an early stage, yet, on the other hand prevent the board from covering up for wrongdoing by its own members or other insiders. ii. Three Topics Early termination based on board of committee action can be broken down into three situations 1. When is demand on the board excused, and what are the consequences of
such an excuse?>

i.

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2. If demand is not excused, and the board rejects the demand, when should the
court nonetheless allow the action to go forward?

3. If the demand is made, and the board appoints a special independent committee to review the merits of the action, and the committee recommends dismissal, how much weight should the court give to that
recommendation?

c. Demand Excusedwhen a demand made on the board is excused what are the consequences of that excuse? i. When is Demand Excused? 1. where demand on the board is futile the demand requirement will be excused. Typically, demand will be deemed excused if the board is accused of having participated in the wrongdoing, because in this situation it is unlikely that the board will recommend suit against itself. a. NOTECourts differ on what kind of board conduct the must allege in order to avoid the demand requirement, the two main views are the Delaware (where it is quite tough to get the demand requirement excused) and New York (where it is much easier to get the demand requirement excused) 2. MBCA 7.42 a. Demand is required in all cases, and therefore is not excused, evaluate if the demand has been refused, because it is never excused. 3. Delaware View [tougher] a. The who attacks a board decision as wrongful must nonetheless make a demand on the board, unless he carries the burden of showing reasonable doubt about whether the board either i. Was disinterested and independent; or Examplethe board was not disinterested or independent, the can show that each member of the board was hand-picked by (either the president or controlling shareholder) and that when the board members approved (something like a salary) for the they were motivated principally by a desire to ensure their continued reelection to the board. ii. Was entitled to the protections of the business judgment rule This might involve a case where the decision was not entitled to protection of the business judgment rule by showing either; That the board members did not follow adequate procedures in reaching their decision; or That the boards decision was, substantively, so irrational as to be outside the bounds of the reasonable business judgment. b. Difficulties i. Specificitythe plead the facts to get the case within one of the categories with great specificity. The has to come up with a particularized showing of what is alleged. ii. Liability of the board the fact that the board itself is being charged with a violation of the duty of due chare for having approved the transaction is not enough to render the demand futile and thus excused. iii. Discoverythe will normally not be able to obtain discovery in order to make the particularized allegations required. iv. Self-Dealing transactioneven though the suit alleges gross self-dealing, usurpation of corporate opportunity or other breach of loyalty by an insider, and even though this self-dealing was approved in advance or after-the-fact by the board, the demand will not be excused unless Outline, Business Associations, GrimesSpring 04 E. D. Baker 31of70

there is a particularized showing that the board was not independent or acted irrationally. 4. New York View [easier] a. Although, it follows the same lines as the Del. View, the NY Court gave a more succinct summary of when demand will be excused in Marx v. Akers. b. Demand will be excused if (and only if) the alleges with particularity any of the following; i. That the majority of the board is interested in the challenged transaction A director can be interested either because of direct self-interest in the transaction, or because they have lost their independence by being controlled by a self-interested director. ii. That the board did not fully inform themselves about the challenged transaction to the extend reasonably appropriate under the circumstances A director who passively rubber-stamps the decisions of active manages. iii. That the challenged transaction was so egregious on its face that it could not have been the product of sound business judgment. d. Demand Refused If the makes his demand on the board, and the board rejects the demand and refuses to sue, may the continue with the suit? i. Suit against an unaffiliated 3d party 1. the will almost never be allowed to continue his suit, because in this situation the boards rejection of demand constitutes a decision about how the corp. Should conduct its ordinary business affairs. a. The court will almost always give the directors decision the protection of the business judgment rule. ii. Suit against an Insider 1. the court will give the boards decision not to sue the protection of the business judgment rule unless alleges that; a. the board somehow participated in the alleged wrong (or got some personal benefit from it); or b. the directors who voted to reject the suit were dominated or controlled by the primary wrongdoer. i. IF the can show either of these two situations the court will generally remove the protection of the business judgment rule and allow s suit to go forward. 5. The Role of Special Committees a. Corporations have begun appointing independent/special committees to evaluate the merits of a demand, and have that committee advise the board as to whether to dismiss or pursue the suit. b. How the committee worksas soon as files the derivative suit or makes a demand on the board, the board appoints an independent committee of directors to investigate s allegations i. No financial Staketo ensure that the committee is independent only those directors who have no financial stake in the transaction that is complaining about are put on the committee. 1. if all directors are being sued, the board may vote to enlarge itself by the appointment of one or more additional new directors, who are immediately appointed as the committee. ii. Investigation and report the committee typically procures independent counsel, and then goes on to make an extensive investigation, usually including extensive interviewing of witnesses and culminating in an extensive written report. Outline, Business Associations, GrimesSpring 04 E. D. Baker 32of70

iii. Dismissal Recommended in most instances the committee recommends that the suit be dismissed. Sometimes, this recommendation is based on a finding that s allegations have no substantive merit. Other times, however the committee reasons that although the allegations have merit, the burden on the corp. of pursuing the suit would outweigh any possible recovery. c. Judicial Review of the special committees decision i. If can show that the committee was not truly independent, or did not conduct even a reasonably careful investigation, the court is unlikely to dismiss s suit based on the committee recommendation. 1. NOTEif the court is convinced that the committee was independent and used appropriate procedures the court may nonetheless use its independent judgment about whether s suit has merit. a. Delaware Position on judicial independent judgment i. Delaware will in some situations let its courts review the substantive merits of the committees recommendation that the suit be dismissed. ii. In Zapata Corp. the court established a two-step test to determine whether the committees recommendation of dismissal should be followed; The court must determine whether the committee acted independently, in good faith, and made a reasonable investigation; and Apply the courts own independent business judgment iii. Test only applies in demand excused cases this test only applies to cases falling into the demand excused, rather than the demand required cases. If demand is required and the corporation responds by appointing an independent committee that then recommends not continuing the suit, the court will apparently treat the case just as it would treat a case in which the main board rejects the s demand. Therefore, only independence, procedural correctness, and good faith of the committee, and not the substantive merit of its decision will be reviewed by the court. b. New York position on judicial independent judgment i. NY makes it difficult for to over come the independent committees recommendation that the suit be terminated. The is entitled to show that the members of the committee were not in fact independent, or that the committee did not use reasonable procedures in reaching its conclusion. NOTE Once the court is satisfied with the committees independence and procedures the NY courts will not review the merits of the substantive recommendation that the suit be dismissed. Business Judgment Rule The court will not attempt to make an independent determination of whether the committee was correct in its conclusion that the probability of recovery was low, the costs of proceeding with the suit would be high, ext. Instead, the committees substantive recommendation that the suit be dismissed, and the boards approval of that recommendation receive the protection of the business judgment rule. Auerbach v. Bennett VI. The Role and Purpose of Corporations Outline, Business Associations, GrimesSpring 04 E. D. Baker 33of70

1. State Legislation adopted in the public interest can be constitutionally applied to preexisting corporations under the reserved power 2. A Corporations primary purpose is to provide profits for its stockholders 3. A shareholders derivative suit can only be based on conduct by the directors which borders on fraud, illegality, or conflict of interest. The Duties of Officers, Directors and Other Insiders I. Duty of Care 1. Generallya director or officer must behave with the level of care that a reasonable person in similar circumstances would use. 2. Standardthe officers and directors of a corporation owe a duty of care, and must exercise that degree of skill, diligence, and care that a reasonably prudent person would exercise in similar circumstances. a. MBCA 8.30(a) i. Each member of the board or directors, when discharging the duties of a director, shall act: (1) in good faith, and (2) in a manner the director reasonably believes to be in the best interest of the corporation. b. Subjective v. Objective Standard the standard of care is basically an objective onethe director will be held to the standard of char that would be exercised by a reasonable person in the directors position. i. Special Skills of Directorif a director has special skills that go beyond what an ordinary director would have, he must use those skills in his actions. i.e. if the information would cause an ordinary director with those skills/training, to act, and this director fails to do that, then there can be liability. 3. Personal Liabilityif a director or officer is found to have breached this duty of care in a way that causes loss to the corporation, he may be liable for money damages, which are to be paid to the corporation. a. Note on Business Judgment Rule the actual business decisions made by a director or officer will not be second-guessed by the court as long as they are rational, made in good faith, and based on reasonable information (no rubber stamping) See Below for further discussion. 4. When Will a Director be Held Liable for Breach? a. When a director totally fails to act as a director. i. A director might be found grossly negligent if he does some or all of the following: 1. Fails to attend meetings. 2. Fails to learn anything of substance about the business. 3. Fails to read reports or financial statements given to him by the corporation. 4. Fails to obtain help when he sees or ought to see signals that things are going seriously wrong with the business. 5. Otherwise neglects to go through the standard motions of diligent behavior. b. When A director is not acting in good faith i. NOTE for there to be liability for a breach of duty of care the must demonstrated that; (1) a duty existed, (2) the directors breached that duty; and (3) the breach was the proximate cause of the clients losses. 1. Francis v. United Jersey Bank a. Mrs. P is a director of a reinsurance broker. Her 2 sons are the two officers and have misappropriated $12 million from trust accounts held on the company's behalf. When the misappropriation took place, Mrs. P was elderly, alcoholic and depressed over the death of her husband. She hardly ever attended board meetings, knew nothing of the corporation's 34of70

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affairs, never read or obtained financial statements, and in general did not pay attention to her duties as a director or the affairs of the corporation. i. Held: Mrs. P breached her duty of due care to the corporation, and therefore is liable for the losses caused by the misappropriations. Directors are not required to conduct a detailed inspection of day to day activities, but they must at least become familiar with the fundamentals of the business and keep informed in a general way about the corporation activities. ii. No Win Transactions 1. Courts have found gross negligence on facts that establish that the directors approved what was basically a no win transactionif the transaction could at best benefit the corp. only slightly if at all, and the worst could damage it greatly, the court may find that the decision was so irrational as to amount to gross negligence. iii. Self-Dealing 1. If the court believes that the directors acted in pursuit of their own ends rather than for the good of the corporation, yet there is not enough evidence of this to make it the basis for finding liability the court can find a breach of the duty of care. 5. Circumstances where Breach may/may not ariseThe level of care required is that which is reasonable in the circumstances in which the director finds himself. a. Reliance on Experts or Committeesa director is entitled to rely on experts, unless such reliance is unreasonable. i. Reliance is unreasonable when the director knows facts which indicate that the expert is lying, or otherwise mistaken. The director cannot bury his head in the sand and continue to rely on the 3d partys statements. ii. MBCA 8.30(d) 1. In discharging board or committee duties a director, who does not have knowledge that makes reliance unwarranted, is entitled to rely on information, opinion, reports or statements, including financial statements and other financial data, prepared or presented by any of the persons specified in sub e[officers or employees, legal counsel, public accountants, or other persons retained by the corp.] b. Passive Negligencewhen there is a situation which the board ought to notice and do something about, but instead the board members do notingthey can be liable, typically this situation arises when the board fails to detect wrongdoing by officers or employees. if not detected breach of duty of care. i. Reasonable Controls 1. The duty of care does require that reasonable control systems be put in place to detect wrong doing, even where the board has no prior reason to suspect that wrongdoing is occurring. 2. A board of directors has an affirmative duty to attempt in good faith to assure that a corporate information and reporting system exist and are adequateIn re Caremark International Inc. Derivative Litigation i. Note the court stated that the burden on a seeking to prove that there was a breach of care based on similar facts is a high one, only a sustained or systematic failure of the board to exercise oversight such as an utter failure to attempt to assure a reasonable information and reporting systems exists will establish the lack of good faith that is a necessary condition to liability. 6. Business Judgment Rule (only for breach of duty of due care) a. Generallythe BJR is a judicial gloss on what it means for a director to exercise due care. Even if the directors conduct might seem to lack due care when viewed from Outline, Business Associations, GrimesSpring 04 E. D. Baker 35of70

a general reasonable person benefit v. burden tort perspective, the more precise BJR may save a director from liability. b. The Rule i. General Basis for the rulebusiness decisions made upon reasonable information and with some rationality do not give rise to directorial liability even if they turn out badly from the perspective of the corporationthe court will not use hindsight to judge the judgment of the directors. c. Requirements for Application of the Rule i. Generally courts impose three requirements before the director or officer will gain the protection of the BJR. 1. No Self DealingDirector must not have any private interest in the outcome different from the corporations interests (no breach of the duty of loyalty) 2. Informationthe director must have made the judgment only after gathering the reasonably needed information 3. Rationalthe director must have rationally believed that his judgment was in the corps best interest. d. No Self Dealingthe director or officer will lose the protection of the BJR if he has an interest in the transaction. Any taint of self-dealing by the director will be enough to deprive them of BJR protection. e. Informed Decisionthe director/officer must have gathered at least a reasonable amount of information about the decision before they made it. i. All Circumstances Consideredin determining whether the decisions was an informed one the court will consider all of ht surrounding circumstances. ii. Smith v. Van Gorkom 1. so long as there is no taint of self-dealing and at least some attention was paid to directorial responsibilities the BJR will shield the directors from liability for their decisions. a. Van Gorkom was the CEO/Chairman of Trans Union Corp. Trans Union offered to sell the company for $55/share at the time the shares of stock were fluxing between $29 and $38. i. The largest issue is that Van Gorkom told the board that this is the price and the board failed to look into whether or not this was a fair price any further. The court held that the board had been grossly negligent, the key factors were; ii. That Van Gorkom had promoted the deal and named the sale price but the board was never told that iii. That the board made no real attempt to learn the intrinsic value of the company iv. The board had no written documentation before it and relied completely on oral statements made at the board meeting, mostly by Van Gorkom v. That the board made its entire decision in that two hour board meeting and the surrounding circumstances did not call for such immediacy. vi. It is the process the board takes to make a decision that is important to the court when deciding whether or not to extend the protection of the business judgment rule. f. Rational Beliefthe director must rationally believe that their business judgment is in the best interest of the corporation. For a belief to be rational it must not be totally beyond the bounds of reason. i. Notethe court will not evaluate the rationality of the decision, only the belief that the decision was in the best interest of the corporation. 7. Relation Between general duty of care and BJR Outline, Business Associations, GrimesSpring 04 E. D. Baker 36of70

a. The duty of care imposes a harsh set of procedural requirements for directors actions, a director must act in good faith, must get all reasonably needed information before making a decisiononce these requirements are satisfied, the BJR sets out a far more easily satisfied standard with respect to the substance of the business decision, and so long as the decision was rational, then the action will be upheld by the court. II. Duty of Loyalty 1. Self-Dealing Transactions/Conflict of Interest a. How this arises? i. When a officer/director/controlling shareholder, and the corporation are on opposite sides of the transaction; when that party has helped to influence the corporations decision to enter the transaction; and when the parties personal financial interests are at least potentially in conflict with the financial interests of the corporation, to such a degree that there is reason to doubt whether the interested party is motivated to act in the corporations best interest. b. Rule i. Most courts, acting in a combination of statutory interpretation and common-law divide self dealing transactions into three categories. 1. Fair Transactions a. If the transaction is found to the fair to the corporation, considering all the circumstances, nearly all courts will uphold the transaction. i. This is true whether or not the transaction was ever approved by disinterested directors or ratified by the shareholders. ii. NOTEwhere the directors of a corporation are engaged in a transaction with an entity in which the directors have an interest, the burden of proof rests on the interested directors to show that the transaction was fair and reasonable to the corporationLewis v. S.L. & E, Inc. iii. NOTEthe court will not question [absent a showing of fraud, improper motive or self interest] the policies of business management because that is left solely to the discretion of the board of directorshowever, the business judgment rule only protects directors from personal liability if they have not violated their duty of loyalty. In cases where directors enter into personal transactions with their companies, such transactions are rigorously scrutinized and upon the showing of any unfair advantage, voidedBayer v. Beran b. Fairness as the Key Criterion: i. The final method of defending a self-dealing transaction against attack is by showing that it is. under all circumstances, fair to the corporation. ii. Fairness Alone Sufficient: In most states, fairness alone will cause the transaction to be upheld, even if there has been NO APPROVAL by disinterested directors or ratification by disinterested shareholders. Fairness is measured by the facts as they were known at the time of the transaction. iii. No Requirement of Prior Disclosure: Usually, the transaction will withstand attack if it is proven fair, even though no disclosure whatsoever is made by the officer to his fellow executives, directors or shareholders. iv. Authorization/Ratification Does Not Immunize From Unfairness: If the transaction is found by the court to be grossly unfair, under most statutes the fact that there was approval by disinterested Outline, Business Associations, GrimesSpring 04 E. D. Baker 37of70

directors or ratification by shareholders will NOT immunize the directors. c. Fairness Test Should not Apply i. The intrinsic fairness test should not be applied to business transactions where a fiduciary duty exists but is unaccompanied by self-dealingSinclair Oil Corp. v. Levien 2. Waste/Fraud a. If the transaction is so one-sided that it amounts to waste or fraud against the corporation, the court will usually void the transaction if a stockholder complains. i. This is true even though the transaction has been approved by a majority of disinterested directors or ratified by the stockholders. 3. Middle Ground a. If the transaction does not fall into either category above, the court is not convinced it is fairhowever, the unfairness may not amount to waste or fraud, the courts response will then most likely depend on whether there has been director approval and/or shareholder ratification. i. If a majority of disinterested and knowledgeable directors have approved the transaction, the court will probably up hold it; the court will similarly uphold the transaction if it has been ratified. Notethe burden of proof is on the director/officer to prove that the transaction was approved by either; A disinterested and knowledgeable majority of the board without their participation; or A majority of shareholders after full disclosure of the relevant facts, approved the transaction. c. Approval By disinterested holders or directors (a good defense to a questionable transaction) i. NOTE Grimes thinks it is best to get approval, much better than ratification.A corporation cannot go after a director for self-dealing if the transaction was authorized by a majority of the disinterested directors, after a full disclosure of the nature of the conflict and the transaction. ii. What Must be Disclosed? Most courts require disclosure of the material facts about the conflict and the material facts about the transaction. 1. Conflict: This is often obvious, but if it is not the conflict must be disclosed to the disinterested officers 2. Transaction: The officer must disclose all facts about the underlying transaction that a reasonable observer would consider material' For example, if the officer knows of facts that are likely to make the proposed contract turn out badly for the corporation, he must disclose those facts. iii. When Must Disclosure be made? Courts are in disagreement about when information must be disclosed, Grimes thinks that before the transaction is best, but some courts do accept ratification (disclosure to come after the transaction) iv. Who are Disinterested Directors? 1. Any director that does not have either; (1) a conflicting interest respecting the transaction, or (2) a familial, financial, professional, or employment relationship with a second director who does have a conflicting interest respecting the transaction. d. Shareholder Ratification i. Ratification by shareholders must follow a disclosure to shareholders, similar to the disclosure that must be made to a disinterested board of directors. 1. there must be a full disclosure to the shareholders of both the conflict and the material facts of the transaction itself. Outline, Business Associations, GrimesSpring 04 E. D. Baker 38of70

ii. Ratification of an [self dealing] transaction by a majority of independent, fully informed shareholders shifts the burden of proof to the objecting shareholder to demonstrate that the terms of the transaction are so unequal as to amount to a gift or a waste of corporate assetsFliegler v. Lawrence iii. A fully informed shareholder ratification does not extinguish a duty of loyalty claim, but it serves to make the business judgment rule the applicable review standard with the burden of proof resting on the shareholder. 2. Corporate Opportunity a. The Problem: i. These situations involve when a director appropriates himself to some business opportunity or property that is found to belong to the corporation. If the officer has taken something that belongs or ought to belong to the corporation, this is per se wrongful and the corporation may recover. 1. This can happen where the director/officer is either; a. in the same line of business, or b. found out about the opportunity as a result of their fiduciary obligation to the corporation. ii. The 3 main issues are, the corporate opportunity doctrine, competition with the corporation, and use of corporate assets. b. Corporate Opportunity Doctrine i. If a manger is found to have taken for himself an opportunity that belongs to the corporation (i.e. has usurped the corporate opportunity) the rules are very strict because this is per se wrongful to the corporation and the corporation may recover damages equal to the loss suffered, of the profits it would have made had it been given the chance to pursue the opportunity. 1. No Issue of Fairness once the court decides that a manager has taken a corporate opportunity, most courts do not recognize any separate issue of fairness. ii. Is there a corporate opportunity? 1. The corporate opportunity doctrine is implicated only in cases where the fiduciarys seizure of an opportunity results in a conflict between the fiduciarys duties to the corporation and the self-interest of the director as actualized by the exploitation of the opportunityBroz v. Cellular Information Systems, Inc. 2. How was the opportunity learned of? a. Whether or not the officer or director learned of the opportunity while acting in his role as the corporations agent is a relevant factor, and is considered by the courts. However, the corporate opportunity will not apply unless it was learned of either; i. Because the opportunity is in the same line of business; or ii. Because the opportunity came to the fiduciary as a result of their fiduciary obligation to the corporation. 3. Rejection by the corporation a. Even if an opportunity is a corporate opportunity, the fiduciary is not necessarily barred from pursuing the opportunity himself, if he offers the corporation the chance to pursue the opportunity and the corporation rejects the opportunity by a majority vote of disinterested directors or disinterested shareholders. c. Competition with the corporation i. A director or senior executive may not compete with the corporation, where this is likely to harm the corporation. ii. Seek Approval or Ratification: 1. This type of conduct may be validated by being approved by disinterested directors or being ratified by the shareholders. However, the director must Outline, Business Associations, GrimesSpring 04 39of70 E. D. Baker

first make full disclosure about the conflict of interest and the competition that he proposes to engage in. iii. Competition After End of Employment: 1. Generally, the executive is not barred from basic competition with his former employer. 2. Trade SecretsThe executive may NOT compete by the taking of the former employer's trade secrets. 3. Non-competeThe executive may be barred from competing if he has signed a valid non competition agreement. However, courts have become increasingly reluctant to enforce broad non-competition agreements. To be enforced, the clause must be reasonable as to time, area and scope. 3. Executive Compensation a. Self-Dealing? i. Grimes raised this frequently because when an executive is sufficiently senior he can influence the corporations decision on his compensation, or approve his own compensation. This situation presents all the traditional dangers of selfdealing. 1. the executive is on both sides of the transaction because they are representing themselves and their interest in the highest compensation reasonable, and they are on the side of the corporation who is interest in the lowest compensation reasonable. b. Forms of Compensation i. There are generally three executive compensation arrangements; current payments (salary plus annual bonus); stock-based incentive arrangements; and pensions and other deferred cash compensation. c. The Self-Dealing Problem i. There is a self-dealing problem whenever the compensation is fixed for either; (1) a director; or (2) an executive who is sufficiently senior that they can influence the corporations decision about how much they should be paid. ii. Generally 1. courts deal with self dealing in this context in much of the same way they deal with self dealing in other contexts. They look for fairness, and then look to see if either a majority of disinterested directors have approved the compensation following a disclosure of all material facts, or whether the shareholders have approved it, after a full disclosure. iii. Business Judgment Rule 1. In many courts the disinterested directors decision to approve a scheme will be awarded the protection of the BJR d. Problem of excessive/unreasonable compensation i. Even if compensation has been approved by the shareholders or disinterested directors, the court may overturn it if the level of compensation does not bear a reasonable relationship to the value of the services performed to the corporation. 4. Duty of Dominant Shareholders a. Duty of Loyalty owedin a publicly held corporation [closely held corps are discussed later] under Zahn controlling shareholders owe some form of fiduciary obligation to avoid injuring the interests of the non-controlling shareholders. i. Zahn v. Transamerica Corp. 1. 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 that duty if he votes for his own personal benefit at the expense of the stockholders. 2. Therefore, the controlling shareholder owes a duty of complete disclosure. a. Nature of Stock Interests: Outline, Business Associations, GrimesSpring 04 40of70 E. D. Baker

AFT Co. had 2 types of `common' stock, class A and B. Transamerica owned all of class B stock and the public owned most of class A stock. The classes differed in the following ways. ii. Voting: B was the voting stock. A had no voting rights, but gained equal rights if there were four successive defaults on the payment of quarterly dividends on the stock. This occurred, so A had equal voting rights here. iii. Liquidation Preference: If liquidated, A would get twice as much of the company's assets as would B. iv. Conversion Rights: A stock was convertible into B stock at any time. B stock was NOT convertible. v. Call by Company: A stock was also callable at any time by the corporation for $60. b. Possible Transactions: i. Class B became aware that the company's tobacco inventory was much more valuable than shown on the company's books. It therefore decided to have the company sell its assets to a third party and liquidate. It had 3 main choices about how to deal with A shareholders. ii. Full Notice: It could explain the situation and give notice of call, in which case all A shareholders would convert into B because it got more $ upon liquidation than A stock did at $60. iii. Simple Liquidation: The company could have just liquidated without calling. A shares would get twice what B shares got in the liquidation. iv. No Disclosure: The board could call or redeem the A shares without making any disclosure about the expected liquidation and the valuable inventory. This would be great for the B holders and terrible for the A holders. c. No Disclosure Chosen: i. The board, which was dominated by the B holders, chose to call without any disclosure. The A shareholders received S60 per share and were never given the valuation information that would have motivated them to exercise their conversion rights. ii. The call took place. A holders received $60 per share and B holders liquidated and received the entire fruits of the valuable inventory sale. Class A then sued the Class B shareholders. d. Significance: i. Controlling shareholders must MAKE FULL DISCLOSURE to their fellow shareholders when they propose a transaction with those fellow holders. ii. The board's PRIMARY RESPONSIBILITY is to the common shareholders. Stock Issues I. Public Offerings 1. General regulations of Public Offerings a. The Securities Act of 1933 governs the first time sale of securities, i.e. new market, stock is being sold to the public for the first time. b. The Securities Act of 1934 governs sales between investors or any other sale of the stock other than the sale directly from the corporation in the 1st sale. 2. Definition of a Security a. The 1933 act and its requirements (discussed below) applies only to the sale of securities, so we must determine what a security isthe term security includes any note, stock, bond, evidence of indebtedness, certificate of interest or participation in 41of70

i.

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any profit-sharing agreement, investment contract, certificate of deposit or any put, call or other option on the above. b. The Key for our purposes is that profits to come solely from the efforts of others. This is why a partnership interest is not a security, because if you are an interested partner you are also active in generating profits. i. Great Lakes Chemical Corp. v. Monsanto Co. 1. The interests of a LLC do not constitute a security for purposes of the SEC Act. a. The basic test for distinguishing the transaction from other commercial dealings is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. It would be improper to extend the definition of security by reinterpreting this term [to include the transaction at hand] 3. The Registration Process a. Under 5 of the 1933 act it is unlawful to sell any security by use of the mails or other facilities of interstate commerce, unless a registration statement is in effect for that security. i. The registration statement must contain a large amount of information about the security being offered and the company offering it [the issuer]. Additionally 5 prohibits the sale of any security unless there is delivered to the buyer before or at the same time as the security a prospectus, which contains the most important parts of the registration statement. ii. Elements of 5 1. A security may not be offered for sale through the mails or by use of other means of interstate commerce unless a registration statement has been filed with the SEC 2. Securities may not be sold until the registration statement has become effective; and 3. The prospectus must be delivered to the purchaser before the sale. iii. Regulation D 1. Tells you if certain criteria are meet you dont have to file with the SEC. 2. Establishes the category of safe-harbors that allow issuers to come within the private-placement exemption. 3. This regulation only applies to the initial offering. 4. There are three categories a. Less than $1mil. i. You may sell them to an unlimited number of buyers without registering the securities b. If it raises no more than $5mil. i. You can sell to no more than 35 shareholders c. If you raise more than $5mil. i. Sell to mo more than 35 shareholders, and each buyer must pass various tests of financial sophistication. 5. In these cases the security can not be advertised widely. And the stock must be purchased to be held for some period of time, which is why under Reg. D investment firms may not qualify. a. Most buyers can resell their securities only if they find another exemption if the buyer is not an issuer, underwriter, or dealer they will be able to rely on 4(1) 4. Mechanics of Public Offerings a. Filing Required under 5 of the 1933 act i. Registration Statementis filed with the SEC, it must disclose a considerable amount about the issuer. Outline, Business Associations, GrimesSpring 04 E. D. Baker 42of70

ii. 20 day waiting periodthe issuer must wait until the registration statement becomes effective. The statement automatically becomes effective 20 days after filing. NOTEthe public can access these filings on EDGAR shortly after they are filed. 1. Stop Ordersif the SEC finds that the filing is unsatisfactory they can delay or suspend the effectiveness of a registration statement 5. Exemptions a. Balance the broad sweep of 5 i. Which appears to cover virtually any sale of a security, however there are several exemptions which allows exempted transactions to escape the often costly registration requirement. b. Key ExemptionNon-public Offerings/Private Offerings i. Transactions by an issuer not involving any public offering need not comply with the registration requirements. 1. How does the court determine if this is a public or private offer; 4 factors a. Number of offerees and their relationship to each other and the issuer i. The larger the amount the less likely it is a private offer. b. The number of units offered i. How many shares are being sold, if it is a large number is less likely to be a private placement c. The size of the offering i. How much money is being raised. d. The manner of the offering i. One on one solicitation for investment e. An Advertisement [looses the person to person contact] i. Conveyance of information is a requirement no matter how it is offered, there still must be full disclosure that is relevant to the investors decision. Even if you dont tell them all the information have they been made aware of where they can find the information. 2. Even where an offering of securities is relatively small and is made informally to just a few investors, it will not be deemed a private offering exempt from the registration requirements of the 1933 act absent proof that each offeree had been furnished, or had access to, such information about the issuer that a registration statement would have disclosed. a. NOTEEven where an offering of securities is relatively small and made informally to just a few sophisticated investors, it will not be deemed a private offering exempt from the registration requirements of the 33 act absent proof that each offeree had been furnished, or had access to, such information about the issuer that a registration statement would have disclosedDoran v. Petroleum Management Corp. ii. Rule 506 (part of Regulation D which governs private and small offerings) 1. if a transaction satisfies the requirements of Rule 506 it will be deemed a private offering. 2. Requirements a. An issuer may sell an unlimited amount of securities to any number of accredited investors; and up to 35 non-accredited purchasers. i. Accredited Investorsomeone whose net worth is more than 1mil. And who has an income of more than $200,000 in each of the two past years, and has a reasonable expectation of reaching the same income level in the current year. This factor rests solely on income Outline, Business Associations, GrimesSpring 04 E. D. Baker 43of70

ii. Non-Accredited investors must be sophisticated, meaning they must have such knowledge and expertise in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment. c. ExemptionSmall Offerings i. An issuer may sell up to 1 mil. Of securities and be considered a small offering. 1. unlimited number of investors, no specific disclosure required ii. Of you can sell up to $5 Million of securities to 35 investors 6. Liabilities for untrue/misleading offerings a. The 33 act contains 4 liability provisions, (3 discussed) i. 11 imposes liability for false statements in a registration statement ii. 12(1) imposes liability on anyone who offers or sells a security in violation of 5 of the 33 act [this generally arises when registration is required and a party fails to do so] iii. 12(2) is a general anti fraud provision. b. 11 is the only section we discussed in class. i. Under 11 if a registration statement tat the time it became effective, contained an untrue statement of a material fact, or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading, anyone who buys the stock may sue the issuer, this provision applies to both the actual registration statement, and the prospectus. ii. Measure of Damages 1. the measure of damages in 11 cases is the difference between; the price the paid for the stock, the value of the stock at the time of the suit. iii. Affirmative Defenses 1. Due Diligencea may raise a Due Diligence defense to a 11 claim [note a corporate may not]if the believes after a reasonable investigation, and there are reasonable grounds to believe, that the alleged misstatements are correct and that there are no material omissions, then the defense may be successfulEscott v. Barchris Construction Corp. Note on Integrated Disclosure and Exchange Act Disclosures o The problem goes back to there being two different disclosure systems The 33 initial disclosure The 34 all other disclosures Reports of disclosure required to be filed with the SEC o 10K report Annual report filed with the SEC, and contains a audited financial statement and the managements report of the previous years activity. The public can access these on EDGER on the SEC web site. o 10Q Report the quarterly report filed for the 1st 3 quarters of the year. o 8K Report Special Events filed within 15 days after a triggering event, which would affect the companys operations or financial condition. Integrated disclosure o Before there was an integrated disclosure system a reporting company that whished to sell securities in a registered public offering was obliged to prepare a registration statement containing most of the information already disclosed in the periodic disclosures. The integrated Disclosure System, an issuer planning a registered offering 1st looks to the various registration statement forms that direct the drafter to Regulation S-K for the substantive periodic disclosure statements. 44of70

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Therefore, when a co. who has been filing periodic statements and has done so for some years wants to issue stock they only have to refer investors to the previous statements they dont have to create a new statement. II. Insider Trading Rule 10b-5 1. What is insider Trading? a. A person engages in insider trading when they buy or sell stock in a publicly-traded company based on material non-public information about that company. 2. Common Law Disclose or Abstain a. The insider has a choice in trading, they must either disclose the inside information or abstain from tradingthis is illustrated in Goodwin v. Agassiz where the court held that a director of a corporation may not personally seek out a stockholder for the purpose of buying his shares without disclosing material facts within his peculiar knowledge as a director and not within reach of the stockholder (material non public information) i. this was built on and adopted as the disclose or abstain rule in SEC v. Texas Gulf Sulfur Co. 3. Rule 10b-5SEC promulgated Rule regulating the use of manipulative and deceptive devices. a. Makes it unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange to i. Employ any device, scheme or artifice to defraud ii. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or iii. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person ** In connection with the purchase or sale of any security 4. Inside Information a. Rule 10b-5 does not expressly state that an insider who buys or sells based on material non-public information, without making any affirmative misstatements, has engaged in fraud or deceit, however in Cady Roberts the SEC concluded that this behavior dos qualify as insider trading. i. This makes clear the holding in Santa Fe Insustries, Inc. v. Green in which the court held that the must show manipulation or deception. This can be shown by the act of trading material non-public information, no showing of affirmative misrepresentation is necessary. ii. SEC v. Texas Gulf Sulfur Co. 1. Generally It is unlawful to trade on material inside information until such information has been disclosed to the public and has had time to become equally available to all investors, A company press release is considered to have been issued in connection with the purchase or sale of a security for purposes of imposing liability under the federal securities laws, and liability will flow if a reasonable investor in the exercise of due care would have been mislead by it. 2. Facts: a. TGS had been looking for minerals in Canada for years. In 11-63 it drilled a test hole at K-55-1 near Ontario. This test showed a higher % of minerals that TGS's geologists had ever seen before. From November until February. 1964, TGS stopped drilling to keep its find confidential (and to obtain leases on nearby acreage) b. Shares Bought: Outline, Business Associations, GrimesSpring 04 E. D. Baker 45of70

During the non-drilling period, various employees of TGS, including 4 members of the geological team and executives of TGS bought stock and call options. c. Release: i. Drilling resumed in 3-64 and immediately produced very favorable results. Rumors of a major ore strike began to circulate. To diffuse speculation the company released a press release in April 12th that said the rumors `exaggerate the scale of operations', and that the work done to date `has not been sufficient to reach definite conclusions and any statement as to size and grade of ore would be premature and possibly misleading'. At the moment of the release, TGS had already discovered at least S 150 million in minerals. d. Final Announcement: i. TGS finally released the size of the strike on 4-16. Some employees who knew of the strike kept buying stock between the 4-12 press release and the 4-16 announcement. e. Stock Price: i. When drilling began, the stock traded at 517. On 4-16 the stock closed at $36. 3. Sec's Suit: a. The SEC sued the employees who had traded with knowledge of the probable strike between 11-8 and 4-16. It sought to make them disgorge their trading profits. b. It also sued TGS itself on the theory that although TGS did not buy or sell, that by issuing the misleading 4-12 press release it induced outsiders to sell at prices lower than they would have gotten had the misleading release not been issued. c. The court found in favor of the SEC on virtually all points. The aspects worthy of special notice are as follows: 4. Disclose or Abstain Rule: The court adopts this rule. An insider with material nonpublic information must choose between disclosing it to the public OR abstaining from trading the stock. 5. `Material' Inside Information: The court defined material inside information. It is information which a reasonable man would attach importance in determining his choice of action in the transaction in question. 6. Time to Disseminate Information: It is not enough that the insiders have waited until the company has made a public announcement of the inside information. Rather, they must wait until this information has been widely disseminated to the marketplace. 7. Press Release: The court held that TGS itself, even though it did not buy or sell its own securities, could be found to have violated 10b-5 if it failed to use due diligence in preparing its news release. The release's great generality was itself enough to make the report misleading. a. Today, it remains the case that a corporation can have 10b-5 liability for misleading statements even where it does not buy or sell its own stock. However, the corporation must be shown to have known of the falsity or recklessly disregarded the danger of the falsity. 5. Materiality of a misstatement or omission a. Affirmative Misrepresentation i. If the s claim is that the has made an affirmative misrepresentation or told a half-truth the main impact of this requirement is that the must show that the misstatement was material. ii. No Fiduciary Duty Necessary A purchaser of options to buy stock in a corporation may state a 10(b) claim against that corporation and its officers for affirmative Outline, Business Associations, GrimesSpring 04 46of70 E. D. Baker

i.

misrepresentations affecting the market price of the options whether or not there is any fiduciary relationship between the purchaser and the corporation or officersDeutschman v. Bedneficial Corp. b. Silent Insider Trading i. The most common form of violation. Absent an affirmative misrepresentation, the must show that there was a duty to disclose, the easiest way to do this is to show that someone traded on material non-public information. Because under the abstain or disclose rule, you cannot trade unless you disclose. c. Materiality i. Under 10b-5 a fact is material if there is a substantial likelihood that a reasonable shareholder would consider this fact important when deciding whether to buy, or sell the security. Basic Inc. v. Levinson ii. Put otherwise, a statement is material when there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made availablePommer v. Medtest Corp. 1. Application to Mergers If the company and its suitor have not yet agreed on price or other important terms the mere fact that a suitor is attempting to buy the company is not necessarily material. a. When the event may occur materiality will depend on the balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity. 6. Theories of Insider liability; Insider, Quasi-Insider, Tippee or Misappropriator a. Violation of a dutya person who owes no fiduciary duty to the company, is not compelled to disclose or abstain. Therefore, if a person who has no fiduciary duty trades on material non-public information they can not be civilly liable. i. Chiarella illustrated this, before the court was willing to accept a misappropriator theory, they found that Chiarella had traded on material non-public information but that he had not breached a fiduciary duty because there was not relationship of trust and confidence between the parties to the transaction. ii. Insidera person who obtains information by virtue of his employment with the company whose stock they are trading in. 1. This includes both high level employees and low level employees, so long as the information is obtained by virtue of employment 2. Quasi-Insiders/Constructive Insiders a. People who do not work for the company but who have nonetheless been entrusted by it with confidential information; these persons become insiders because they do owe a fiduciary duty to the corporation and its shareholders by nature of their involvement. These persons are generally outside professionals, lawyers, accountants and the like. iii. Tippeea person who is not an insider but who has received information from an insider. 1. Requirementsa tippee is liable under 10b-5 if the tipper has violated some fiduciary duty to the company or its shareholders; and the tipper has acted for personal benefit. (when the tipper acts for reasons other than personal gain, the tippee may not be found liable of a 10b-5 violation) a. Dirks v. SEC a tippee will be held liable for openly disclosing nonpublic information received from an insider, if the tippee knows or should have known that the insider will benefit in some fashion from disclosing the information to the tippee in breach of their fiduciary duty to the corporation. iv. Misappropriatora person who improperly uses confidential information from one other than the issuer. A person who has breached a duty to someone other than the shareholders. Outline, Business Associations, GrimesSpring 04 47of70 E. D. Baker

1. US v. OHagan a. when a person misappropriates confidential information in violation of a fiduciary duty, and trades on that information for his own personal benefit he is in violation of 10b-5. 7. Causation a. Reliance i. A in a 10b-5 action must show that his harm was caused in fact by s wrongdoing. Some courts require that reliance be shown, but in other cases you can prove reliance through fraud on the market theory. ii. 10b-5 Reliance 1. in 10b-5 cases can be hurt by s misrepresentations or insider trading without having directly relied on s conduct. Therefore, in 10b-5 cases must show that his losses were caused in fact by s misconduct iii. Fraud on the Market a. Generally, the argument is that someone was unfairly manipulating the market, when I purchased stock I relied on the fact that the market would bear out a fair price, however, because of your actions the market didnt reflect the accurate price. i. NoteA class action may not be brought on behalf of everyone who purchased stock during a period when a broker was violating securities laws by providing material non-public informationWest v. Prudential Securities, Inc. b. Basic Inc. v. Levinson i. In Basic the court accepted the fraud on the market theory essentially giving the a presumption of reliance on the s misleading statements/actions. Instead of requiring to prove that he personally knew of s misstatements and relied on them in making his decision to sell the stock, the court will presume that The price of stock at any time reflected everything that was publicly known about s prospects; and Therefore, the price each received was affected by any material misrepresentations made to the public by . ii. An investors reliance on material, public misrepresentations may be presumed under a fraud on the market theory for purposes of a rule 10b-5 action. III. Short-Swing Profits Rule 16(b) 1. Purposea bright line rule that would effectively stamp out some more specific forms of insider trading, essentially if one of the statutorily-defined insiders buys stock in his company and then sells it within 6 months, they are automatically required to return the profits to the corporationregardless of any insider knowledge, or lack of such knowledge. 2. Who is a 16(b) Insider? a. Either someone who is an officer or someone who is a beneficial owner (10%) b. OfficerGenerally anyone who is an officer/director of a company is an officer. c. Beneficial Owner someone who owns more than 10% of one class of the companies stock. i. Notewhile you cant string together smaller percentages of various classes of stock, if the person is a 10% owner of any class of the companies stock they count. 3. Timing a. Qualifying under 16(b) i. Directors/ OfficersONE SIDE ONLY Outline, Business Associations, GrimesSpring 04 E. D. Baker 48of70

1. if is a director/officer at either the time they purchase or sell their stock 16(b) applies to them. ii. 10% OwnersBOTH SIDES 1. 16(b) does not apply to a transaction where such beneficial owner was not such both at the time of the purchase and sale, or the time of the sale and purchase, of the security involved. a. Clearly if you are a 10% owner you must be such at both ends of the swing. 2. What about the purchase that puts you over 10%? a. The purchase that puts a person over 10% does not count for 16(b) purposesa particular purchase will not be the 1st part of a buy-sell short swing unless the buyer already owned more than 10% at the time of the purchase. 3. In a purchase-sale sequence, a beneficial owner must account for profits only if he was a beneficial owner before the purchaseForemost-McKesson, Inc. v. Provident Securities Co. 4. 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 within 6 months of its original purchase, they are not liable for the profit made on the second saleReliance Electric Co. v. Emerson Electric Co. 4. SaleWhat is a sale? a. Generallyit is not difficult to determine whether or not a sale of stock has occurred. However, in the case of mergers there is some difficulty. b. Kern County Land Co. v. Occidental Petroleum Corp. i. Neither accrual of the right to exchange recently acquired shares for shares in the survivor of a merger, not the granting of an option to buy the shares received in such exchange, constitute a sale within the meaning of 16(b), absent any abuse, or potential for abuse of any inside information. ii. Facts Occidental Petroleum bought shares in Kern County Land Co. pursuant to a tender offer. By the time the tender offer expired, Occidental owned more than 10% of Old Kern. The management of Old Kern then arranged a defensive merger with a white knight, Tenneco. All of the shareholders of Old Kern (including Occidental) would receive Tenneco stock in exchange for their Old Kern stock. Occidental did NOT want to be locked into a minority position in Tenneco, so just before the expiration of its own tender offer it sold an option to Tenneco to purchase all of the shares that Occidental might receive as a result of the merger. 1. The option was not exercisable by Tenneco until more than 6 months after the expiration of Occidental's tender offer. On 8-30, Occidental became entitled to receive Tenneco stock for its Old Kern shares. After the 6 month waiting period. Tenneco exercised its option, paying Occidental cash for Occidental's Tenneco shares. iii. Nature of Suit: 1. The company formed by Tenneco to cam, on Old Kern's business brought suit against Occidental, claiming that either or both of the following were 'sales' within the meaning of 16(b): Occidental's grant of an option to Tenneco on 6-2 for Occidental's shares in Old Kern AND The closing of the merger of Old Kern into Occidental, whereby Occidental became entitled to the preference shares. Plaintiff claimed that Occidental had sold its entire Old Kern holdings within 6 months following its 6-8 acquisition. iv. Holding: 1. Occidental won. Neither of the transactions was considered a sale for 16(b) purposes. The court gave 2 reasons for its decision. Outline, Business Associations, GrimesSpring 04 E. D. Baker 49of70

a. Given the adversarial nature of the relations, at no time did Occidental have any inside access to Old Kern's affairs? AND b. The exchange was essentially involuntary. Occidental did not want the Tenneco preference shares, and it was compelled to do so. c. Two-Part Test: i. Per Kern there is a two-part test to determine whether an unorthodox transaction will be deemed a 16(b) sale 1. That the transaction was essentially involuntary. AND 2. The transaction was of a type in which the defendant almost certainly did not have access to inside information. 5. Computation of Profits a. If 16(b) applies the insider must forfeit to the corporation any profit realized by the purchase-sale, or sale-purchase transactions, in the case of multiple purchases or sales within a 6 month period, the court will perform the calculation so as to produce the maximum possible profits. b. Lowest purchase price matched against highest Saleit doesnt matter what order something occurred in the court will mach the shares having the lowest purchase price to the shares sold at the highest sale price, regardless of any losses created by this method. c. Profit i. This method might create profits even though had an overall loss in the 6 month period. IV. Indemnification and Insurance 1. Generally a. A director or officer who is charged with breach of the duty of due care, the duty of loyalty or other wrongdoing, can face substantial damages. Therefore, two methods have been created for reducing the burden on the individuals acting as directors; (1) indemnification, in which the corporation reimburses the director/officer for expenses and/or judgments they incur relating to their actions on behalf of the corporation, and (2) D&O Insurance [directors and officers] which can be paid either to the corporation or directly to the director/officer. b. Considerations i. Third-Party v. Derivative Actions 1. We need to distinguish between third party actions brought directly against the individual and derivative actions brought in the name of the corporation. Courts are less likely to permit indemnification in derivative actions because it would lead to circular recovery. ii. Self-Dealing 1. courts are much more likely to permit indemnification and insurance where the is guilty of a breach of the duty of due care, than where his wrong consists of improperly receiving a financial benefit at the corporations expense. iii. Mandatory v. Permissive 1. in most states there are few situations in which a corporation must indemnify a director/officer, but a large range of circumstances in which the corporation may chose to indemnify them. 2. Mandatory a. For our exam we are only dealing with Del. Law. And the corporation may be required to indemnify the officer/director when, the director/officer is completely successful in defending himself against the charges, or where the corporation has previously bound itself by charter, by law or contract to indemnify. i. Success145 of the Del. Code provide mandatory indemnification so long as the is successful on the merits or otherwise. [this includes settlements] Outline, Business Associations, GrimesSpring 04 E. D. Baker 50of70

1. A corporate director/officer who has been successful on the merits or otherwise vindicated from the claims asserted against him is entitled to indemnification from the corporation against reasonably incurred legal expensesWaltuch v. Conticommodity Services, Inc. ii. By charter, law or contractif a corporation obligates itself, the court will enforce such a provision, so long as it does not conflict with some explicit statutory prohibition. 3. Permissive a. There is generally a large zone of circumstances in which a corporation may choose to indemnify the director or officer, but is not required to do so. b. Delaware 145 allows for indemnification generally in most situations where the director was acting in good faith and is a party to the litigation because he is a director. i. LIMITATIONSthe Del. Codes forbids indemnification in suits by or on behalf of the corporation [including derivative suits] in which the is found liable to the corporation, unless the court orders indemnification. c. Third Party Action i. Breach of duty of due careif a director/officer, while acting on behalf of the corporation, acts negligently the corporation will be able to indemnify them for their expenses in defending a 3d party suit, and for any judgment or settlement they might be required to pay 1. Bad Faithif a director/officer acted in bad faith they may not be indemnified furthermore the indemnities must have no reasonable cause to believe that his conduct was unlawful. a. Provision cannot be overridden i. The bad faith rule can not be overridden by contract or otherwise. If an agreement is inconsistent with this provision 145 will rule, and no indemnification will be allowed. d. Derivative Litigation i. Settlements or Judgmentsa corporation is not permitted to indemnify a director or officer for a judgment on behalf of the corporation or for a settlement payment made by to the corp. ii. Expensesa may be indemnified for litigation expenses if has settled the case with the corporation, however, if is found liable no payment of expenses is permitted. 4. Advancing of Expenses a. A corporation may advance reasonable costs in defending a suit to a director even when the suit is brought by the corporationCitadel Holding Corp. v Rovan i. Generally statutes require the director/officer to promise to repay these advances if they are found not entitled to indemnification. 5. InsuranceNearly all companies carry liability insurance for their directors and officers. Typical Policy: The typical policy has two parts: a. Corporate Reimbursement: This reimburses the corporation for indemnification payments it makes to an officer. The corporation is made whole when it indemnifies an officer. b. Personal Coverage: This reimburses the officer directly for his losses to the extent that the corporation does not indemnify him. This comes into play if the corporation is unable to indemnify the individual.

Control
I. Proxy Fights 1. What is a Proxy? 51of70

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a. A document in which the shareholder appoints someone to cast his vote for one or more specified actionsthe solicitation of proxies is subject to SEC regulation, and the rules include requirements about what information must be disclosed by the party whos soliciting the proxy (this information is contained in the proxy statement) 2. Proxy Contest a. Generallya proxy contest is any competition between two competing factions (generally management and outside insurgents) to obtain shareholder votes on a proposal.generally proxy fights involve either the election of directors, or proposals. 3. Regulation of Proxy Contests a. Advantages for management i. Stockholders usually tend to vote for management ii. Management can use corporate funds to pay for its side of the contest iii. Management knows who the shareholders are, whereas the insurgents will usually have to litigate to get access to the list, if they are able to get it at all. b. Insurgents right to get information i. The SEC proxy rules very slightly redress the imbalance by requiring management to give the insurgents limited assistance in communicating with shareholders 1. Rule 14a-7 requires management to tell the insurgents how many stockholders of record there are, how many beneficial owners there are and how much it will cost to mail the insurgents proxy materials to all the holders. c. Access to the List/inspection rights it is vital for the insurgents to obtain access to the list of shareholders, however, the SEC rules do not grant the insurgents the right to the list, some state laws doinspection rights i. Proxy Rules14a-7 if the insurgents want to communicate with the shareholders they bear the expense of doing so. Management is required to either hand over the list, or mail the proxy materials, however, in a fight for control management can charge the insurgents for the cost of the mailing. e d. Disclosure Required i. Both sides of a proxy contest must comply with the usual disclosure and antifraud rules of the 1934 act. The insurgents, like management must make sure that any solicitation is preceded by a written proxy statement.and both must respect rule 14a-9s prohibition on any false or misleading statement in the proxy statement or in any other communication. 4. Costs a. The ability to have the corporation reimburse proxy contest expenses is governed by state law, and most states seem to apply the same general rules. b. Management Expenses i. Generallythe corporation may pay for management expenses. 1. incumbent directors may use corporate funds and resources in a proxy solicitation contest if the sums are not excessive and the shareholders are fully informed. Levin v. MGM ii. Policy Contest 1. Most courts have held that so long as the contest is a conflict over policy and not personality then the corporation may pay for managements reasonable expenses a. In a contest over policy corporate directors have the right to make reasonable and proper expenditures from the corporate treasury for the purpose of persuading the stockholders of the correctness of their position and collecting their support for the policies that the directors believe, in Outline, Business Associations, GrimesSpring 04 E. D. Baker 52of70

all good faith, are in the best interests of the corporation. Rosenfeld v. Fairchild Engine & Airplance Corp. c. Expenses of Successful Insurgents i. If the insurgents succeed and end up with control of the board of directors, the newly-appointed board will often approve the corporations reimbursement of the insurgents proxy-contest expenses 1. the court have generally allowed such reimbursement if three requirements are satisfied a. the contest involved policy rather than being a pure power struggle b. the stockholders approve the reimbursement c. Intrinsically fair ii. Result 1. if the insurgents win, and reimburse their expenses, the corporation generally ends up paying for both sides of the contest.[ because the corporation already paid for the directors expenses before they were booted out] 5. Private Actions for Proxy Rule Violations a. Implied Right of Action i. There is nothing in the 34 act of the SEC rules that expressly gives a private investor the right to sue if the proxy rules are violated. But the Supremes have recognized an implied right of action on behalf of individuals who have been injured by a violation of proxy rules. ii. J.I. Case Co. v. Borakestablished the implied private right of action on behalf of shareholders for proxy violations Where a federal securities act has been violated, but no private right of action is specifically authorized or prohibited, a private civil action will lie and the court is free to fashion an appropriate remedy 1. Facts a minority shareholder in C sued to enjoin a proposed merger between C and ATC. claimed that Cs managers had engaged in illegal self dealing, that the merger was unfair to shareholders, and that the proxy materials were false and misleading in that they did not disclose the true facts about the merger and its value to the shareholders. 2. Supreme Courtprivate stockholders do have an implied right to bring a federal court action for violation of the proxy solicitation rules a. Remedies the court stated that if proved a violation of the proxy rules, the federal district court had the power to grant all necessary remedial relief i. This relief was not limited to injunction, the court hinted that damages, or the undoing or an already completed merger might be appropriate. b. Elements i. Materiality 1. Importantthe shareholder/ must show that there was a material misstatement or omission in the proxy materials, but it is not necessary that the misstated or omitted fact would probably have caused a reasonable shareholder to change his vote; all that is required is that the fact would have been regarded as important, or would have assumed actual significance in the decision-making of a reasonable shareholder. 2. Valuations of option grants to outside directors are not material information which must be included in a corporations shareholder statement to solicit proxy votes. Seinfeld v. Bartz ii. Causation 1. the /Shareholder does not have to show that they relied on the falsehoods or omissions in the proxy statement. Instead the court will presume that injury was caused, so long as the falsehood or omission was material and the Outline, Business Associations, GrimesSpring 04 E. D. Baker 53of70

proxy materials were an essential link in the accomplishment of the transaction. a. Where the trial court makes a finding that a proxy solicitation contains a materially false or misleading statement under SEC 14(a), a stockholder seeking to establish a cause of action under such finding dies not have to further prove that his reliance on the contents of the defects in the proxy solicitation caused him to vote for proposed transactions that later proved unfair to his interests in the corp. Mills v. Electric Auto-Lite Co. iii. Standard of Fault 1. the Supreme Court has never ruled on whether scienter [intent to deceive] must be shown on the party of the s, notesome lower courts have held that mere negligence is sufficient. II. Shareholder Rights & Control 1. Shareholder ProposalsCommunications between Shareholders a. Two Methods by which a shareholder may communicate with fellow shareholders to solicit their proxies in favor of their own proposal or against a proposal of management. i. Shareholder Bears Cost 1. if the shareholder is willing to bear the cost [which sometimes can be prohibitive] of printing and postage, SEC rule 14a-7 requires the company to either mail the shareholders solicitation or give the shareholder a stockholder list so that the shareholder can do the mailing. (most corporations chose the former over the later) ii. Company Bears the Cost 1. Rule 14a-8 requires management to include a shareholders proposal in managements own proxy materials, at the corporations expense. [this occurs in a narrow set of circumstances] b. Shareholder Bears the ExpenseRule 14a-7 i. Requirements 1. To gain the assistance of rule 14a-7 the soliciting shareholder must meet a few requirements; a. The proxy materials must related to a meeting in which the company will be making its own solicitation b. The stockholder must be entitled to vote on the matter; and c. The shareholder must defray the expenses that the corporation will incur in mailing the materials ii. No Length Limits or Censorship 1. If the shareholder meets the requirements his materials are not subject to any length limits and under rule 14a-7 management has basically no grounds for censorship or objection. iii. Timing 1. To prevent management from delaying the mailing, the rule requires that materials be mailed with reasonable promptnesshowever, in the usual case the mailing relates to an annual meeting, and management may put itself on an equal footing with the soliciting shareholder by delaying the mailing until the earlier or (1) the day corresponding to the first date on which managements proxy materials were mailed in connection with the last annual meeting; or (2) the first day on which management makes its solicitation this year. c. Corporation Bears the ExpenseRule 14a-8 i. Rule 14a-8 v. Rule 14a-7 1. A shareholder who prepares his own proxy materials and uses Rule 14a-7 will bear substantial expense. Therefore, that section tends to be used only Outline, Business Associations, GrimesSpring 04 E. D. Baker 54of70

ii.

iii.

iv.

v.

where the soliciting shareholder has a very large financial stake in the corporation and the matter is of direct and large economic importance 2. By contrast 14a-8 shareholder proposal rule costs the proposing shareholder almost nothing, and is mainly used by persons with small stock holdings who seek to influence the corporations policies concerning matters of social or political interest. Eligibility 1. for a shareholder proposal to be covered by rule 14a-8 the shareholder must a. Own either at least 1% of the total shares or $2,000 in market value of securities in the company [and must hold this amount of stock through the meeting] ; and b. Have held shares for at least one year prior to the submission [therefore, it is not possible for an activist group to buy shares just before submitting the proposal] Included in Managements Proxy Materials 1. When rule 14a-8 applies the shareholders proposal must be included in the managements own proxy materials. The submitting shareholder bears essentially no expensehe does not have to pay to print up the materials, or the postage. Length of Proposal 1. A shareholder [meeting the above requirements] may submit only one proposal for inclusion in managements proxy materials. The proposal and its supporting statement may not together exceed five hundred words. [note, in rule 14a-7 there is no length limit] Exclusions 1. Corporations may omit shareholder proposals from proxy materials only if the proposal falls within the exception listed in rule 14a-8 NYC Employees Retirement System v. Dole Food Co., Inc. a. under question 9 there is a list of 13 exclusions, below are the ones we discussed i. the proposal is improper under state law ii. is a violation of law iii. violation of the proxy rules iv. Relevance if the proposal relates to operations which account for less than 5% of the companys total assets at the end of its most recent fiscal year, and for less than 5% of its net earnings and gross sales for its most recent fiscal year, and is not otherwise significantly related to the companys business Major Social/Political and Ethical Questions * A shareholder proposal can be significantly related to the business of a securities issuer for non-economic reasons, including social and ethical issues, and therefore may not be omitted from the issuers proxy statement even if it relates to operations which account for less than 5% of the issuers total assets Lovenheim v. Iroquois Brands, Ltd. v. Relates to a Routine Business Matter If the proposal relates to the ordinary business operations of the company, the question may be properly excluded because the matter is too routine. Burden of Proof * In attempting to exclude a shareholder proposal from its proxy materials the burden of proof is on the corp. to 55of70

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demonstrate whether the proposal relates to the ordinary business operations of the company 2. Shareholder Inspection Rights a. Derivation of the right i. Common Law v. Statutory Right 1. the right of inspection can be based on either, or on both 2. Common LawIn most states, shareholders have a common-law right to inspect the corporations books and records, if they show a proper purpose for doing so. a. If the corporation does not make the books and records available voluntarily, a shareholder may obtain a court order compelling the corporation to grant the right of inspection. 3. Statutory Right most states have codified statutes to allow a right of inspection requiring a proper purpose and establishing penalties for corporations failing to comply. b. Who May Inspect i. At common law both the shareholders of record and the beneficial owners of shares had the right to inspectionstate laws vary on whether or not beneficial owners are able to inspect. ii. Holding Requirements 1. some statutes restrict the right of inspection to shareholders who have either held their shares for a certain amount of time, or hold more than a certain percentage of the total shares a. New York law i. Generally anyone who has held their shares at least 6 months, or who holds at least 5% of any class of stock has the right to examine certain documents, without showing need or proper purpose. c. What records may be examined i. Generallythe shareholder has the right to inspect the corp.s records in general. This can be reasonably interpreted to mean that a shareholder has the right to inspect any document that may has a reasonable bearing upon his investment ii. Shareholder Lists 1. under the Model Business Code the shareholder list can only be accessed when the shareholder makes a showing of good faith, proper purpose, reasonable particularity and direct connection. 2. NOTEA shareholder wishing to inform others regarding a pending tender offer should be permitted access to the companys shareholder list unless it is sought for an objective adverse to the company or its stockholdersAustin v. Consolidated Edison Co. of New York, inc. a. Types of Lists i. Seed List The list of who owns the stocks, this doesnt break down who owns under which clearing house. ii. Nobo list Non Objecting Beneficial OwnersList of who owns shares under the holding company (i.e. you own Microsoft through Merrill lynch, and Merrill lynch has a list of who owns that stock) b. Solicitation of Proxies i. This is the most common reason a shareholder would want the list of shareholders. If the corporation is publicly held, the federal law gives the corp. a choice. They can either mail out the shit, or turn over the list. Therefore, a list doesnt have to be produced. Outline, Business Associations, GrimesSpring 04 E. D. Baker 56of70

c. No Obligation to Create a List i. If a corporation does not itself possess a list of shareholders it does not have an obligation to create such a list. d. Proper Purpose i. In almost all states and exam-land the shareholder will be allowed to inspect corporate records only if he does so for a proper purpose ii. Definition 1. Delaware has defined the term as a purpose reasonably related to such persons interests as a stockholder iii. Dealing with Shareholders as investors 1. If the shareholder wishes to contact fellow shareholders to persuade them to take some sort of action regarding the corporationsuch as soliciting proxies or to initiate a tender offer, the courts generally conclude that the shareholders desire to have a shareholder list constitutes a proper purpose since the purpose is closely related to the business and financial affairs of the corporation. 2. NOBO lists a. Some states shareholder-list statutes have been interpreted to allow access to lists of people who are beneficial owners rather than shareholders of record. i. Sadler v. NCR Corp. held that NY law allows a party to a proxy fight to require a corporation to furnish a NOBO list even where the corporation is not domiciled in NY but does business there. A state may require a foreign corporation with substantial ties to its forum to provide resident shareholders access to its shareholder list and to compile a NOBO list, in a situation where the shareholder could not obtain such documents in the companys state of incorporation. iv. Pursuit of social and/or political goals 1. When it is clear that the shareholder is pursuing only social or political goals that are relatively unrelated to the corporations business, most courts will find that the shareholders purpose is improper and will therefore deny inspection rights. 2. State ex rel. Pillsbury v. Honeywell, Inc. a. In order for a stockholder to inspect shareholder lists and corporate records the stockholder must demonstrate a proper purpose relating to an economic interest. i. A stockholder has the right to inspect only if he has a proper purpose germane to his economic interest as a shareholder To be a proper purpose it must generally concern investment return In this case the shareholder was merely interest in persuading the company to adopt his social and political concerns. 3. Shareholder Voting Control a. Stroh i. A corporation may prescribe whatever restrictions or limitations it deems necessary in regards to the issuance of stock, provided that it not limit or negate the voting power of any share b. State of Wisconsin i. Shareholder need not attend a shareholders meeting and record an objection in order to challenge the propriety of the vote

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1. Where the primary purpose of an adjournment of a shareholders meeting is to ensure passage of a proposal by interfering with the shareholder vote, corporate directors breach their fiduciary duty of loyalty Mergers & Acquisitions I. Different forms of Acquisition 1. Merger v. Sale a. A merger type deal is one in which the shareholders of A will end up mainly with stock in B as their payment for surrendering control of A and its assets. A sale type transaction is one in which shareholders in A end up with cash as payment for their interest A. 2. Merger-Type Acquisitions a. Statutory Merger i. By following the procedures set out in the state corporation statute, one corporation can merge into another, the 1st corporation ceases to have any legal identity and the 2nd(surviving) corporation continues in existence 1. Keythe key of statutory merger is that the shareholders of the acquired company are not cashed out instead, they continue to have equity participation. b. Stock-for-stock exchange i. the result is essentially the same as a statutory merger, the acquiring corporation makes a separate deal with each target shareholder, giving that holder shares in the acquirer in exchange for shares in the target. 3. Sale-Type Acquisitions a. Distinguishedthe stockholder in the acquired company is cashed out. Stockholder gives up his equity interest in the target company for cashbasically the target company shareholder no longer has a common stock interest in the assets of either the target or the acquiring corp. b. Asset Acquisition (asset-sale-and-liquidation) i. this transaction is carried out by corporate action on the targets part. The targets board of directors approve the sale or all or substantially all of the targets assets to the acquirer, and this proposed sale is approved by a majority of the target shareholders. 1. Typically the target dissolves, and pays the cash or debt to the shareholder in proportion to their holdings, this is called a liquidating distribution a. This form of transaction allows acquiring corp. to acquire target without diluting its shareholders, or the value of their stock. c. Stock Acquisition i. No corporate level transaction takes place on the target side, the acquirer buys stock from each target company shareholder. After the acquirer controls all or a majority of the target company stock, it may then dissolve the target and distribute the assets to itself. 1. Tender Offer takes place generally a. In this situation the acquirer may either make a classic tender offer [by publicly announcing that it will buy shares offered to it by target corps share holders] or by privately negotiated purchases d. Detail of Sale Type Transactions i. A sale type transaction is one where 1. There is a sale of the targets assets, followed by a liquidation of the target and the payment of the sale proceeds to the shareholders pro rata; and 2. A sale of stock by some or all target shareholders, possibly followed by a back end merger of the target corporation into the acquiring corporation ii. Substantially All 58of70

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1. If a corporation sells a small percentage of its assets in one transaction, that transaction requires neither board nor shareholder approval. a. State corporation statutes almost always have a provision covering the sale of all or substantially all of the corporations assetsthis type of a large scale sale requires both board approval and shareholder approval. II. Protecting Shareholders Interests 1. Generallywhen a corporate combination takes place, there is a substantial risk that stockholders in target company may be treated unfairly or at least differently from how they expect to be treated. There are three main ways that legislatures try to protect shareholders in a merger/acquisition situation a. Appraisal rights, by which a shareholder may demand payment of the value of his shares in cash, rather than being forced to accept other securities b. Judicial scrutiny of the substantive fairness of the transaction and c. The De Facto merger doctrine, by which the court will treat what is not formally a merger as a merger, usually for the purpose of conferring appraisal rights that would not otherwise exist. 2. Appraisal Rights a. A merger must be approved by majority vote of the shareholders of each corporation (and must always be approved by the shareholders of target corp.) similarly the shareholders must approve a sale of corporate assets, but as long as the approval of the targets shareholders is not unanimous there are unhappy shareholders i. Solutionthe appraisal is a remedy that permits a shareholder to disinvest at a fair price, instead of being forced to trade his shares for shares in a different corporation. 1. Appraisal rights give the dissatisfied shareholder a way to be cashed out of his investment at a price determined by the court to be fair ii. Sales of Substantially all assets 1. Appraisal rights apply in most states when the corporation sells substantially all of its assets a. Not DEL Del. Does not give appraisal rights to the stockholders of a corporation that sells its assets. This is true even though a corporation sells its assets in return for stock, the selling corp. then liquidates, and the acquirers stock is distributed to the sellers stockholders.thus producing the same result as a merge without any appraisal rights 3. The De Facto Merger Doctrine a. Essence of the de facto merger theorya transaction which is not literally a merger, but which is the functional equivalent of a merger, should be treated as it were [a merger] for purposes of appraisal rights and shareholder vote. i. Only Occasionally acceptedonly a few courts have ever accepted the de facto merger theory, and have done so only in specialized circumstances.since there is no bright line rule, it is generally the more like a merger something is the more likely the court will determine that de facto merger applies. 1. Farris v. Glen Alden Corp. a transaction which is in the form of a sale of corporate assets but which is in effect a de facto merger of two corporations must meet the statutory merger requirements in order to protect the rights of minority shareholders. a. Facts L was a large Delaware conglomerate. GA was a somewhat smaller Pennsylvania corporation. In economic terms. L agreed to acquire GA. However. the transaction had a very unusual form. GA was to acquire L instead of the other -way around. The parties agreed to take the following steps. (1)GA would acquire all the assets of L. (2) GA would pay for these assets by issuing a large amount of its own stock. (3) GA would assume all of L's liabilities. (4) GA would change its name from GA to LA. (5) All Outline, Business Associations, GrimesSpring 04 59of70 E. D. Baker

directors of both companies would become directors of LA. (6) L would be dissolved, and its assets would be distributed to L shareholders. i. Rationale Why Statutory Merger Not Used: Under DE law, L's shareholders would not get appraisal rights by the agreement because the company merely sold all of its assets. However, L's shareholders would have had appraisal rights had L simply merged with GA. Why Use the reverse method? because GA was a Pa. corp. under Pa. law the stockholders of both corporations get appraisal rights in a merger. But Pa. law does not give appraisal rights to the shareholders of a company that is buying another companys assets. b. Holding The PA Supreme Court held that this transaction was a de facto merger. Therefore, GA shareholders had appraisal rights. The court said to look at the realities of the transaction' rather than its form. Herethe reality was that L acquired GA and NOT the other way around. Therefore, the GA shareholders had appraisal rights just as they would if GA had been selling al of its assets in return for stock. ii. Doctrine RejectedPa. is one of the few courts to ever accept the De Facto Merger doctrine, but DELEWARE has never accepted the doctrine. 1. Hariton v. Arco Electrics, Inca sale of assets involving dissolution of the selling corporation and distribution of the shares to its shareholders is legal. a. This is a DELEWARE casethe result of the sale was essentially the same as a merge, the shareholders of target ended up with shares of acquiring corp. stock. i. De Facto Doctrine Rejectedthe court decisively rejected the de facto merger doctrine. The Del. Legislature has created two statutory procedures, one for mergers and one for sale-of-assets 2. Rauch v. RCA Corp. a. Facts Shareholders of acquired corporation contend that a merger that involved a forced sale of their shares triggered redemption rights which were contained in corps articles of incorporation. b. Holdinga cash-out merger that is otherwise legal does not trigger any right the shareholders may have with respect to share redemption, because it is a corporate reorganizationin Del. Mergers and redemptions rights are treated separately and this action did not trigger the redemption rights. i. Basically-DEL. Will not recognize the De Facto Merger doctrine, and make a merger to enforce shareholder rights. 4. Judicial Review of Substantial Fairness of the Transaction a. If a shareholder thinks a proposed merger is unfair to the corporations shareholders, can shareholder get a court to review the substantive fairness of the arrangement, and to enjoin the transaction? i. Most courts believe that they do indeed have the power to review the substantial fairness of the proposed acquisition or merger; ii. In an arms-length arrangement, the court will set aside the deal only if the unfairness is extreme; and iii. where there is a strong self-dealing aspect to the transaction the court will scrutinize it more closely. III. Freeze-out Mergers 1. Meaning of Freezeoutit is a transaction in which those in control of a corporation eliminate the equity ownership of the non-controlling stockholders a. The insiders somehow force the outsiders to sell their shares, or the insiders find some other way of eliminating the outsiders as common shareholders. Outline, Business Associations, GrimesSpring 04 E. D. Baker 60of70

b. Resultthe controlling shareholders go from mere control to exclusive ownership of the corporation 2. Laws Governing Freezeoutsmost courts scrutinize freezeout transactions closely on the assumption that minority outsider shareholders need to be protected against possible self-dealing by the insiders. The state law in this area is more powerful than federal law. a. Federal Law i. A person can use rule 10b-5s requirement of full disclosure. If there has not been full disclosure it can be argued that they concealed or misrepresented material facts about the transaction. b. State Law i. Nearly any freezeout transaction requires the insiders to be on both sides of the transaction; therefore, the courts will give close scrutiny to the fairness of the transaction. ii. General Approach 1. The transaction must be basically fair, taken in its entirety, the minority shareholder/ outsider 2. The transaction must be undertaken for some valid business purpose iii. Intrinsic Fairness Testvirtually all courts will carefully scrutinize the transaction to make sure that it is basically or intrinsically fair to the outsider/minority shareholder. 1. Three aspects of fairness a. A fair price b. Fair procedures under which the corporations board decided to approve the transaction c. Adequate disclosure to the outsider shareholders concerning the transaction 2. * Winberger v. UOP, Inc. a freezeout merger approved without full disclosure of share value to minority shareholders is invalid a. Facts S Corp. owned 50.5% of UOP Corp., with the balance owned by public shareholders. Four key directors of UOP Corp. were also directors of S Corp. Two of these directors prepared a feasibility study that concluded that anything up to $24 per share would be a fair price for S Corp. to acquire the balance of the UOP Corp. shares. But S eventually offered to buy out the UOP minority stockholders for just $21 per share. [This price was based upon a hurriedly prepared fairness opinion by U's investment bankers.] U's board approved the $21 / share price. NOTE there was never any real negotiation between S and U on this price, and the non-S affiliated UOP director were never shown or told about the feasibility study indicating $24 as a fair price. after the deal went through the minority shareholders who opposed the price per share brought a class action for damages. b. Holding Not A fair Transaction i. Not procedurally fair, because there was never any real negotiation about the price. Not fair with regard to the price because the feasibility study demonstrated a fair price would be closer to $24. Disclosurethe companies did not make a fair disclosure to UOPs minority public shareholders. The documents describing the merger, mentioned the investment bankers fairness opinion but did not disclose the hurried manner in which it was preparednor did they disclose that S Corp.s valuation came up with $24/share as a fair price. Outline, Business Associations, GrimesSpring 04 E. D. Baker 61of70

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c. PLANINGIndependent Committee to negotiatethe court clearly points out that one of the best steps insiders can take to insulate the transaction from subsequent attack it by making sure that a special committee of independent directors is appointed to negotiate the transaction 3. Summary of Delaware law on Freezeouts a. Entire Fairness a freezeout transaction as well as any other transaction, in which insiders are on both sides of the transaction, will be sustained only if it is entirely fair as measured by fair procedures, fair price and adequate disclosure. b. Damagesthe /shareholder attacking the fairness of a freezeout or other merger transaction will normally have to be content with a monetary recovery equal to what they would have gotten under appraisal. Weinberger iv. The Business Purpose Test [ Del. But Y in Mass and NY] 1. A number of courts (not DEL.) impose an additional requirement following entirely fair, when evaluating a freezeout; this requirement is that the transaction serve a valid business purpose. a. Even if insiders pay a fair price, they cannot put through a transaction whose sole purpose is to eliminate the minority stock holders. The transaction must serve some other valid corporate purpose 2. Although DEL had decided that the business purpose requirement should be dropped, but other courts, such as MASS and NY have applied the Business Purpose Test a. Coggins v. New England Patriots Football club, inc Controlling stockholders violate their fiduciary duties when they cause a merger to be made for the sole purpose of eliminating a minority on a cash-out basis. i. To be valid a freezeout merger must be fair, to be fair there must be fair dealing and fair price. Fair Dealingthe majority shareholder must act not only for his own benefit, but for the benefit of the corporation as a wholethe action must serve a business purpose. Takeovers Takeover Terms 1. Crown Jewelthe targets crown jewels are its most valuable businesses or properties if the target is desperate to prevent the original bidder from acquiring the company the targets management may grant a 3d party an option to acquire those jewels at an attractive price, in order to induce the 3d party to enter the bidding. 2. Golden Parachutea k between a company and its senior executives, providing for very generous payments to be made to the executives in the event the company is taken over and the executives are forced to leave the company 3. Greenmailthe payment by a target to a bidder or an above-market price for repurchase of shares in the target owned by bidder. In return for a chance to sell his shares back to the target at a high price the bidder usually agrees not o try to take over the target again for a specified period of time. 4. Junk Bonda high-interest bearing bond, usually of relatively low investment quality. In the take over context junk bonds are issued by the bidder to help pay for the take over 5. No-Shop Clausea provision in a merger agreement between target and bidder in which the target agrees that the board will recommend the merger to shareholders, and will not shop around for a more attractive offerthe courts are split as to the legality of a no-shop clause. 6. Poison Pillthe variety of provisions that will discourage a hostile takeover by making the target more expensive or less desirable to the bidder 62of70

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7. White Knighta suitor who is friendly to the targets management, and who at the managements request acquires the target so it wont be acquired by the original unwelcome bidder. II. Tender Offersbefore you can have a takeover, hostile or otherwise, there has to be a tender offerwhere the stockholders of a publicly owned corporation are extended an offer to exchange their shares for cash or securities at a price above the quoted market price. 1. Hostile Takeoversthe principle reason that a cash tender offer is so popular is that it is the best way to successfully engineer a hostile takeoverthe acquisition of a publicly held company over the opposition of the targets management 2. The Williams Actthe federal Williams act was enacted in 1968 as an amendment to the SEA of 1934the act attempts to make takeovers fairer to the targets shareholders, by reducing the pressure on them to make a quick decision to tender or not. a. Provisions of the act i. Disclosure for 5% shareholders 1. Anyone who purchases more than 5% of the stock of a publicly held company must disclose that fact along with a statement of intention. Specifically they must disclose the a. Exact number of shares purchased by the person or group doing the filing b. The source and amount of the funds used to make the purchase c. The purchasers purpose in buying the shares, including any plans he may have to seek control, to cause a merger to take place, to sell a large part of the companys assets ext. d. Any plans to take the company private ii. Tender Offers 1. Disclosure Rulesthere must be comprehensive disclosure by any bidder of the bidders identity, financing, plans for the company if the bid is successful, and other information. 2. Traffic Rulestight limitations on the form of the tender offer. a. Stockholders are given extensive rights to withdraw their shares even after they tender them. b. Bidders are required to buy up stock from all shareholders equallyon a pro rata basis, rather than on a first come first serve basis. c. All stock holders must be offered the same price at the same time d. The offer must be left open for at least 20 days. III. State Anti-Takeover Statutes 1. State Regulation of Hostile Takeovers a. Federal regulation of take over attempts is basically even-handedthis is not the case with the state laws. States have a natural and strong incentive to protect incumbent management against hostile takeover attempts, especially attempts by out-of-state bidders. 2. State Statutes a. Most operate not by preventing the bidder from buying shares form targets shareholders, but rather, depriving the bidder of the benefit of his share acquisition. There are three main ways to legislate this i. By preventing the bidder from voting the shares he has bought unless certain conditions are satisfied ii. By preventing the bidder from conducting a back-end merger of the target corporation into the bidders shell iii. By requiring the bidder to pay a specified fair price in any back ended merger. 1. The Supreme Court upheld such a statute in Indiana in the following case.

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b. CTS Corp. v. Dynamics Corporation of Americaa law permitting in-state corporations to require shareholder approval prior to significant shifts in corporate control is constitutional. i. Factsthe statute restricts hostile takeovers by preventing the bidder from voting the shares he has acquiredwhenever a person passes one of the thresholds of ownership they are not allowed to vote the controlling block unless they obtain approval by a majority of the pre-existing disinterested shareholders. ii. Holdingthe Supreme Court upheld the statute, rejecting the arguments of the bidder that the statute was in conflict with the Williams Act and that the statute violated the commerce clause. c. Delaware State Anti-Takeover Statute 203 i. General Ban 1. the law kicks in when a bidder acquires at least 15% of a targets stock thereafter the bidder may not engage in a business combination with the target for at least 3 years. ii. Exceptions 1. if the bidder acquires more than 85% of the stock the ban will not apply 2. if the targets board approves a tender offer or business combination before the 15% is reached then the ban will not apply. 3. if the targets board approves a merger after the bidder acquires 15% then 2/3 of the other (not bidder) shareholders must also approve the merger IV. Defensive Maneuvers to Hostile Takeover attempts 1. Defensive Maneuversa targets management may employ any of the following in an attempt to defeat a hostile bidder. a. Pre-Offer Techniquesbefore an offer is ever made, a targets management can make sure that an attack is less likely to occurshark repellants i. Super-majority provisionsthe target can amend its articles of incorporation to requires that more than a simple majority of the stockholders approve any merger or major sale of assets ii. Staggered boardthe target may put in place a staggered board of directors, so that only a minority of the board will stand for election in any given year. Therefore, even if a bidder acquires a majority of the targets shares hi will not be able to gain control immediately and will have to wait to elect his own board. iii. Anti-greenmail provisionsmaking an attempt to takeover less likely because there is no chance that the stock will be repurchased. iv. Poison Pill Plansany of the below can make a corporation less attractive to a bidder 1. Flip Overgive stockholders the right to buy cheap stock in certain circumstances, these provisions are targeted when an outsider buys a designated % of the stock. The provision then flips over and the right entitles its holder to acquire shares of the bidder at price. 2. Flip In provisionsa flip in provision allows the right-holder to buy cheap stock when ever there is a merger or other self-dealing transaction. This allows the right holder to buy cheap shares in the bidder and the target 3. Dead Hand & No Hand provisionsmost pills allow the targets board to redeem the rights, giving the board leverage in negotiating with the acquirer however, this ability to redeem the rights has a major downside, the acquirer may persuade a majority of targets shareholders to elect new directors who are friendly to the acquirer. a. Dead Hand provisionwhich restricts the ability of the boardincluding any successors to redeem the rights. Outline, Business Associations, GrimesSpring 04 E. D. Baker 64of70

b. No Hand Provisionsset a minimum period of time that the board must wait before redeeming the rights b. Post-offer techniques i. Defensive Lawsuitsthe targets management can sue the bidder directly ii. White knightthe targets board may find a white knight to bid on the stock 1. Lock Ups is an advantage given by the target to one bidder over other present or potential bidders, in order to make it more likely that the favored bidder will win in the auction and discourage other biddersgenerally to induce a 3d person to become a white knightthe target may give the would-be white knight a crown jewels optionthe grant of this option does not require shareholder approval because it is not a sale of substantially all of the targets assets a. Lockups are especially vulnerable to attack in state courti.e. Revlon v. MacAndrews iii. Greenmailthe target may decide to pay greenmail to the acquirer to prevent them from completely taking over the corporation. 1. How courts treat Greenmail a. Courts have given a targets directors and management considerable leeway to pay greenmailDEL. Applies its general analysis to greenmail payments [reasonable grounds for belief in corporate objective, reasonable response, good faith and reasonable investigation, independent directors, then BJR] b. Justifiable Fearsif the board shows that it is worried that a particular hostile takeover will damage the corporations existence or business policies, and buying back the raiders shares at a premium in return for a standstill agreement will prevent the hostile takeover, the DEL courts generally approve the transaction. i. Cheff v. Mathes Activities that are undertaken for the good of the corporation that have the incidental effect of maintaining the directors control are permissible, but acts effected for no other reason than to maintain control over the corporation are invalid. Burden of proofis initially presumed that the boards action is in good faith, and this presumption can be overcome only on an affirmative showing of bad faith or self dealing. In this case the fear that the acquiring corp. would loot the corporation, justified the action taken. c. Entrenchmentif the decision to pay greenmail is shown to have been motivated mostly by the boards desire to retain their positions the greenmail payment will be struck down d. Size of Premiumthe size of the premium paid above market value is not a key aspect in the DEL decisions iv. Exclusionary repurchasesthe target may try to repulse a hostile bidder by embarking on its own aggressive program of share repurchasesif the target offers a higher price for its own shares than the bidder is offering, the targets holders will be less likely to tender to bidder.but may the target exclude the bidder form participating in the share repurchase program? In DELYES. 1. Unocal Corp. v. Mesa Petroleum Co a selective tender offer effected to thwart a takeover is not in itself invalid a. Facts M owned 13% of U and instituted a two-tier- front -loaded tender offer for another 37% of U . M would then bring about back end cash out merger in which the remaining half of U stock would be bought out for junk bonds .U's board then offered to have U repurchase up to 49% o of Outline, Business Associations, GrimesSpring 04 E. D. Baker 65of70

its shares in exchange for debt that U claimed to be worth $72 per share. U's offer to repurchase its shares specifically excluded M. b. Holdingthe DEL Supremes upheld the share repurchase program, including its exclusion of Mesa. The U directors had the burden of showing reasonable grounds to believe i. That Ms takeover threat posed a danger to the corporations welfare (not just the directors and managers) ii. That the repurchase program undertaken as a defensive measure was proportional to the threat posed. 2. Delaware Law Generallywhen will the court overturn managements anti-takeover tactics? a. Modified Business Judgment rule/ Enhanced Scrutinythe Delaware courts dont apply the business judgment rule automatically, the court requires a higher-thanusual probability that the targets management and board will be acting for self interest rather than for stockholder benefit. i. Showing Required In Delaware there are 4 rules for governing when the targets management and board will obtain the protection of the BJR for the antitakeover measures. 1. Reasonable Grounds for Belief in Corporate Objective (basis for fear) a. The board must show that they had reasonable grounds for believing that there was a danger to the corporations welfare from the takeover attempt. i. The insiders must show that they have acted in a good-faith desire to protect the corporation, not their own jobs. Dangers the court will consider Change of business practiceif the board believes that the bidder will change the business practices of the corporation in a way that will be harmful to the corporations ongoing business Coercive Tacticsif the board believes that the takeover attempt is unfair or coercive to the targets shareholders this will meet the reasonable fear test Excessive Debtif the tender offer will leave the target with unreasonably high levels of debt the court will likely find that the defensive measures are justified. 2. Reasonable Response a. The measures actually used were reasonable in relation to the threat posed i. Proportionality required Cant be preclusive or coerciveto meet the proportionality requirement a defensive measure must not be either preclusive or
coercive

Preclusivemeaning any action which would prevent the hostile bidder from succeeding in its tender offer no matter what it did.

3. Good faith and reasonable investigation a. The board must demonstrate that it acted in good faith upon reasonable investigationthus if measures were hurriedly passed, without extensive discussion or analysis, the measures are less likely to be sustained i. E.g. If the directors approve a proposed defensive measure with very little discussion 4. Independent Directors a. The court is more likely to find the above requirements are satisfied if the takeover measures were approved by a board with a majority of members who are disinterested directors. Outline, Business Associations, GrimesSpring 04 E. D. Baker 66of70

This requirement is not absolutethe court will be more likely to find that the board has meet its duty. 5. Business Judgment Ruleonce the insiders have showing that they had reasonable grounds to perceive a threat to the corporate welfare, and the defensive measures taken were in reasonable proportion to the threat, and they are acting after reasonable investigationthen the defensive measures taken will be subject to the business judgment rule ii. Consequences if Requirements Not Meet 1. the DEL court will not automatically strike down the defensive measure however the court will be more likely to threat the directors decision as it would treat any other act of self dealing a. then the board would have the burden of showing that the transaction is entirely fair to their shareholders. 3. When Enhanced Scrutiny Applies to defensive measures a. Enhanced Scrutiny isreasonable basis for fear, reasonable response, good faith and reasonable investigation, independent directors. b. Abandonment of Long-term strategyonce the targets management has announced that they are will consider selling the company the rules governing their actions shiftthe courts from this point on give enhanced scrutiny to the steps that the targets board takes. i. Level Playing Fieldthe board has a duty to obtain the highest price for the shareholders. 1. Revlon, Inc. v. MacAndrews & Forbs Holdings, Inc. a. This case illustrates how defensive measures that might be valid if employed while the target is struggling to preserve its independence are likely to be invalid if used to favor one bidder over another once a decision to sell the company has been made. b. Facts PP sought to buy R. R's board rejected PP's initial hostile offer of $45 per share as grossly inadequate. R then adopted a poison pill and announced a share repurchase plan. R also began looking for a white knight and found F. F and PP began topping each other's bids. The R board finally approved F's bid of $57.25 a share, versus PP highest bid of $56.25. i. Lock Ups R gave F several key concessions that effectively ended the auction. (1) It gave F a crown jewels option to buy two key R subsidiaries for a much cheaper price than the market was demanding (2) It agreed to a no-shop provision that it would not deal with any other would-be acquirer. (3) It agreed to a $25 million cancellation fee. The R board also gave F private financial information about R that it did not make available to PP. R tried to justify its choice because F would protect certain note holders more than the PP offer. c. Holding the DEL Supremes enjoined Revlon from going forward with F i. Duty ViolatedRevlon violated its duty to get the highest price for its shareholders. When the deal with F was accepted PP had not entered a final bid, the auction was ended by Revlons own actions. ii. Lock UpsWhile lockups are not per se illegal, they must be used to expand the competition not destroy it. iii. Consequence Once management decides to offer the company for sale, or decides that a sale is inevitable, it may no longer use defensive measures, and must instead make every effort to achieve the best price for the stockholders Getting the best price means treating all bidders equally and not preferring one bidder over another Outline, Business Associations, GrimesSpring 04 E. D. Baker 67of70

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The use of lock-ups to one bidder rather than another are the kinds of actions that constitute inappropriate favoritism In choosing among offers the boards sole duty is to the common stockholders c. Active Bidding Processif the boards action might have the effect of putting the corporation in play, this action does not by itself trigger the Revlon Rule i. Paramount Communications, Inc. v Time IncDirectors of a corporation involved in an ongoing business enterprise may take into account all long-term corporate objectives in responding to an offer to take over toe corporation 1. FactsTimes board decided to merge with another company, the DEL Supremes concluded that the fact that Times directors knew that the merger might put time in play, was not itself enough to trigger the Revlon rule. 2. Holdingonly when a corporation initiates an active bidding process for itself, or otherwise seeks some transaction involving a breakup of the company the Revlon rule will apply. a. However, Revlon is not triggered when there is a decision to acquire for cash. Revlon duties arise when : i. A corporation initiates an active bidding process seeking to sell itself, or ii. In response to a bidders offer, the corporation abandons its long-term strategy and seeks an alternative transaction also involving the breakup of the company iii. When there is a sale of control. d. Sale of Control i. Revlon establishes that where the board decides to sell the company the court will give enhanced scrutiny both the process that the directors followed and to the substantive fairness of the result. 1. However a board might trigger similar scrutiny when the board sells control of the company to a single individual or group. a. Paramount Communications, Inc. v. QVC Network Inc i. FactsAfter P unsuccessfully tried to merger with Time Ps directors decided that if they didnt arrange a defensive merger, they might be the subject of a hostile takeover bid. The directors agreed to have Paramount merge into Viacom. Viacom was under the control of R who wanted to make sure that P was never put in play. Protective MeasuresViacom insisted that the merger agreement contain a number of features that would make it hard to sell P to someone else No-Shoplimited Ps directors rights to offer to sell or merge with anyone else. P couldnt initiate such a transaction, nor could they respond to unsolicited offers from 3d parties. Termination feethere was a $100 million termination fee to be paid to Viacom if the deal didnt go through. Lock-up stock optiongave Viacom the right to purchase 19.9% of Paramount outstanding stock and $69.14/share. ii. Holdingthe DEL Supremes held that the Viacom-Paramount deal was unreasonable, and enjoined the parties from going through with it. the sale of control triggered the Revlon scrutiny, and in this case the deal failed because the board paid insufficient attention to the ways in which the various features of the Viacom deal impeded the boards ability to get the best deal far shareholders.

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iii. Importancethe point is that the Revlon enhanced scrutiny will apply whenever the board enters into a transaction that would result in a shift of control from the public to a particular individual or small entity. e. Other Contexts i. Negotiated Acquisitionsa bidder cannot prevent the target board of directors from entering into a deal that effectively prevents emergence of a more valuable transaction or that disables the target board from exercising its fiduciary responsibilities. 1. ACE Ltd. v. Capital Re Corp. a. Facts (capital) failed to comply with a no talk provision of the merger agreement with (ace), then sued to enforce the no talk provision b. Holdingthe law of mergers and acquisitions gives primacy to the interests of stockholders in being free to maximize value from their ownership. ACE should have known that its contract was so restrictive that could not properly agree to it. s board was at all times required to exercise its duties of care and loyalty when it entered into the merger agreement, and could not simply contract those rights away. ii. Shareholder Disenfranchisementa board has power over the management and assets of a corporation, but that power is limited by the right of shareholders to vote for the members of the board. 1. Hilton Hotels Corp. v. ITT Corp. a. FactsH attempted a hostile takeover bid for ITT, ITT then proposed a comprehensive plan as a defensive measure. Through this plan ITT would break into three new entities. The court looked to DEL law on defensive measures. b. Holdingis the primary purpose of ITTs action to disenfranchise its shareholders? In this case the comprehensive plan would violate the duty the board owes to the shareholders by impermissibly infringing on the shareholders right to vote on members of the board. Corporate Debt I. Terms of Corporate Debt 1. Debenturesforms of unsecured debt. a. Indentures i. The binding agreement (K) enforced on behalf of the debt holders by the trustee ii. Covenants 1. Provisions in the indenture agreements which are supposed to protect the owners of the debt 2. Bondssecured debt instrument a. Zero coupon Bonds i. No dividends are paid and the value is all paid out at the end 3. Callable Bond a. It can be paid off at any time II. Debtors Sale of Substantially All its Assets 1. Sharon Steel Corp. v. Chase Manhattan Bank a. A clause in a debt instrument preventing accelerated maturity in the event of a sale of all or substantially all or the debtors assets is inapplicable if the assets are sold piecemeal III. Incurrence of Additional Debt 1. Metropolitan life Ins. Co. v. RJR Nabisco, Inc. Outline, Business Associations, GrimesSpring 04 E. D. Baker 69of70

a. The assumption of additional debt by a bond issuer in an leveraged buy out which results in a downgrading of the bonds does not constitutes a breach of covenant of good faith and fair dealing.

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