FORMATION OF CORPORATIONS A corporation is an artificial person. For most purposes it has legal personality.

It has an existence separate and distinct from the people who own or control it. A corporation has limited liability; the corporation is liable for its debts. Except in certain special circumstances no one else can be held liable for the corporate debts. Incorporation: A corporation can only be created by the action of a government. In the United States, corporations are almost always created by a state government. Originally a state created a corporation when the legislature passed a special statute creating the corporation. The statute enacted by the legislature became the charter (or basic set of rules) which governed the corporation. During the 19th Century, all states passed general incorporation statutes. These laws set forth the procedures, which must be followed to create a new corporation. Whenever the provisions of the law are complied with, the state will create a new corporation. The process of forming a new corporation is called incorporation. Under California law the process of incorporation consists of: 1 Preparation of the Articles of Incorporation. The articles are the basic law of the corporation; they may contain any provisions which are relevant to the operation of the corporation. The following things must be included in the articles: A) Name of the corporation. This name must be unique. Even if the name chosen is sufficiently different from names already in use to be accepted by the Secretary of States Office, if the name is similar enough to the name of a corporation created earlier to cause a likelihood of customer confusion the older corporation may successfully sue the new corporation for trademark
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infringement. If such a suit is successful, the corporation may be ordered to select a new name. B) Name and address of a registered agent for service of process. Each corporation must designate an agent to receive the necessary papers if the corporation is sued. The agents address must be within the state of California. C) Statement of Business Purpose. If the corporation is intended to be a bank, trust company or to carry on a professional practice, the statement in the Articles must say so. All other corporations must include a statement saying This corporation may engage in any lawful business purpose. Such a corporation may engage in any legal business other than being a bank or trust company or engaging in the practice of a profession (such as law, medicine or accounting). D) Capitalization Provisions. The articles of incorporation must contain a provision stating the maximum number of shares that the corporation is allowed to issue. If the corporation intends to issue more than one type or class of shares, each class or type must be specified in the Articles. (There are two types of shares: common and preferred. The corporation may decide to issue more than one class within each type of share.) The articles must contain provisions explaining the rights and privileges of each type and class of shares. A separate maximum number of shares must be stated for each class and type of shares 2 Execution of the Articles of Incorporation. The Articles must be signed by the incorporator. (One incorporator is required; more than one may be used.) The only function of the incorporator is the purely formal one of signing the Articles.
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Incorporators have no power over the corporation or liability for its debts unless the Articles of Incorporation do not include the names of the initial members of the Board of Directors. In such a case the incorporators will have the power to select the initial directors after the corporation is formed. 3 Submission of the Articles to the Secretary of State. The Articles must be submitted to the office of the Secretary of State together with the required filing fee. When the staff of the Secretary of State accepts the Articles the document will be stamped, indicating the date and time of acceptance. At the moment of acceptance the corporation comes into existence. Piercing the Corporate Veil: Usually only the corporation is liable for its debts. Under special circumstances the corporate veil can be pierced and the controlling person(s) may be held personally liable for the corporations debts. These are the requirements to pierce the veil: 1 The corporation must owe a debt or obligation to the person seeking to pierce the veil. 2 The corporation must be unable to pay this debt. 3 The corporation must be an alter ego of the controlling person. (Alter ego is a Latin term meaning other self) Several types of evidence can establish that the corporation is the alter ego of the controlling person: a) Commingling of Assets. This takes place when the assets of the corporation are not kept separate from those of controlling person. It also occurs when the controlling person uses assets of the corporation for personal purposes. b) Failure to observe Corporate Formalities. The law imposes certain rules which must be followed in the operation of corporations. For example, shareholders meetings and
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directors meetings must be held after proper notice has been given to the shareholders or directors. Minutes must be taken at the meetings. Failure to follow these legal requirements is a ground for piercing the corporate veil. (Under California law a corporation which has no more than 10 shareholders may include in its Articles a provision stating that the corporation will be a close corporation. Such a corporation is not required to observe these formalities its shareholders may decide to operate the corporation like a partnership with each of the shareholders having an equal role in management. The fact that a close corporation does not observe these corporate formalities is not by itself grounds for piercing the corporate veil. However the veil may be pierced on other grounds. For example, if such a corporation has commingled its funds with those of its shareholders, the corporate veil could be pierced for that reason.) c) Fraud. If the corporation is used to perpetrate a scheme of fraud, this will be a basis for piercing the corporate veil. EXAMPLE: Martin was the President of Vita Corporation. He used the corporation to solicit people to buy parcels of land in Baja California which were in fact located under water. Since the corporation was being used to carry out a fraudulent scheme, the corporate veil can be pierced and the controlling person Martin held personally liable for the corporations debts. d) Undercapitalization. If a corporation was initially set up without sufficient capital to meet the obligations, which might reasonably be expected to arise in the normal course of business, the corporation is undercapitalized. A corporation will not be considered undercapitalized simply because it cannot pay its debts. Undercapitalization exists only when the corporation began its business without sufficient capital to meet reasonable expectations, or when at some subsequent time capital is improperly removed from the corporation leaving it unable to meet the obligations which might reasonably be foreseen.
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EXAMPLE #1: Dyno Corporation was established to carry out demolitions of buildings with the use of explosives. It was set up with $5000 of paid-in capital; it did not carry any liability insurance. Dyno Corp. is undercapitalized. The use of explosives in demolition is very dangerous; significant damage claims against the corporation are easily foreseeable. Dyno was initially established without sufficient assets to meet these potential obligations. EXAMPLE #2: Vista Mar, Inc. operated a seaside hotel on Maui. It had been in business for 40 years. It had adequate insurance coverage. In the fall of 2001, tourists especially those from Japan became afraid to travel by air because of terrorist attacks using hijacked airliners. The hotel soon had an occupancy rate of less than 10%. Vista Mar thereby became insolvent and was unable to pay its bills. Vista Mar is NOT undercapitalized. It was originally established with sufficient capital. Subsequent economic conditions have rendered it unable to pay its debts, but these subsequent conditions do not cause a corporation to be considered undercapitalized. If the corporate veil is pierced, only the controlling person(s) can be held personally liable liability does not extend to all of the shareholders. Controlling persons are those persons who in the course of business operations have the power to determine corporate policy. Sometimes a group of people collectively have the power to determine corporate policy; in such a case all of the persons in the group can be held personally liable for the debts of the corporation when the veil is pierced and the separate existence of the corporation is disregarded. Promoters Liability Promoters are persons who bring a corporation into existence they have the idea to start it. They pay the attorney to draft the articles, pay the filing fee and take other steps to bring the corporation into existence.

Sometimes promoters enter into contracts on behalf of the corporation before the corporation comes into existence. In such a situation, since the principal does not exist at the time the contract was made, the principal is not liable on the contract even after the corporation has come into existence. The corporation can become liable on such a pre-incorporation contract only if the contract is adopted by the corporation after it is legally formed. Adoption is similar to ratification; it can take place only if the corporation has knowledge of all of the material facts concerning the contract. Example #1: John, a promoter entered into a contract with Landlord to rent office space for the Bozo Corporation before Bozo was formed. After the corporation came into existence, its Board of Directors passed a resolution to accept the rental contract with Landlord entered into by John. This is express adoption; the contract is now binding on Bozo. Example #2: John, a promoter entered into a contract with Landlord to rent office space for the Bozo Corporation before Bozo was formed. The Board took no formal action concerning the contract, but employees of Bozo moved into the office space covered by the contract. Bozo moved furniture into the office and arranged to have phone and internet service connections made to the office. This is an example of implied adoption. This takes place when the corporation receives a benefit from the contract. All of the promoters are liable on a pre-incorporation contract if the contract is in writing even if the names of the promoters do not appear in the contract. The promoters remain liable on the contract even if the corporation adopts the contract unless the other party to the contract agrees to release the promoters from further personal liability. Promoters owe fiduciary duties to the corporation and to persons who are considering making investments in that corporation. Promoters may not take advantage of the corporation or of the other promoters.

If any promoter commits a tort in connection with setting up the corporation, all of the promoters are liable for that tort.

The power to manage the corporation is held by the Board of Directors. The Board may delegate powers of management to officers of the corporation that have been selected by the Board. There are certain management decisions that can be made only by the shareholders the directors do not have the power to take such decisions. The actions which can be taken only by a vote of the shareholders are: 1 AMENDEMENT OF THE ARTICLES OF INCORPORATION The articles of incorporation can only be changed by a vote of the shareholders; the amendment must then be filed at the office of the Secretary of State. 2 ELECTION OF DIRECTORS The shareholders have the power to elect members of the Board of Directors. 3 MERGER OR CONSOLIDATION If the corporation is to be combined with another corporation (and the corporation will in that way cease to exist it will not be the surviving corporation that merger or consolidation can only be carried out following a vote of the corporations shareholders. 4 SALE OF ALL (OR SUBSTANTIALLY ALL) OF THE CORPORATIONS ASSETS Any sale of all (or very nearly all) of the assets must be approved by a vote of the corporations shareholders.

FORMS OF BUSINESS ORGANIZATION

The most basic and simple form of business organization is the sole proprietorship. This form of business is simply an individual in his or her capacity as a business owner. The business has no existence separate or distinct from that of the owner or proprietor. All property of the business belongs to the proprietor. The proprietor is personally liable for all debts of the business. The proprietor makes all management decisions. If additional labor is needed beyond what the proprietor can supply, it can be obtained by hiring employees or independent contractors. If the business requires more capital than the proprietor can provide, it may be obtained by borrowing. The amount of capital which a single individual can borrow on his or her own credit is limited. For this reason other forms of legal organization of business developed. The first of these was the partnership; the form most important in todays economy is the corporation. The final part of this class will be devoted to the law of corporations. There will not be time for a detailed discussion of partnership law. However this handout will provide a basic introduction to the subject in the form of a comparison between the partnership and the corporation. (There are several other forms of business organization which are widely used in todays economy.) A partnership is defined as an association of two or more persons to carry on a business for profit as co-owners. Usually a partnership is formed by express agreement. Linda says to Mary: Lets form a partnership to sell magazine subscriptions over the Internet. Mary agreed to Lindas proposal. They are now partners. It would be a good idea for them to prepare a formal written contract including all of the provisions of their agreement, but even without one they are partners.

Partnerships can also be created by implied agreement. This happens whenever people act like partners. Even if they do not expressly agree to be partners the law will consider them to be partners. To determine if persons who have not specifically agreed to become partners are nevertheless partners, the courts will look at all relevant evidence to determine the intent of the parties. If a person is entitled to a share of the profits of a business, there is a presumption that such a person is a partner in that business. For example, if Bill is entitled to 5% of the profits of Valley Productions, a new motion picture business owned by John and George, then Bill will be presumed to be a partner with John and George in that business even if there was no express agreement that Bill would be a partner. However this presumption is rebuttable. This means that if the person who is entitled to a share of the profits can produce evidence showing that he received his share of the profits for reasons other than being a co-owner of that business, the presumption of partnership is overcome. The following types of evidence are among those which will rebut the presumption of partnership: 1. The profit share represents wages or salary. (In the above example, if Bill can show that he was promised 5% as his salary for directing some TV commercials because the company was unable to pay him in cash, the court would conclude that he was not a partner.) 2. The profit share represents rent for the use of property. (In the above example, assume that Mark agreed to lend camera equipment for use in the business. Since the business was financially unable to pay him rent in cash, he agreed to accept instead 5% of anticipated profits of the business for the next two years. The court would conclude that he was not a partner.) 3. The profit share represents interest on a loan or repayment of principal on a loan. (Suppose that Maria agreed to lend $50,000 to the business. Since the business was low on cash, Maria agreed to accept 5% of the profits of the business until such time as she had been repaid the value of the loan plus 10% interest. The court would conclude that she was not a partner.) The following chart compares partnerships with corporations. We will learn more about corporations during the rest of the semester. By providing a
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contrast with the law of corporations, the following table will provide you with the basics of partnership law.

PARTNERSHIPS Partnerships are legally formed by the agreement of the parties. As explained above, this agreement may be either express or implied. Each partner has an equal right to participate in management of the business unless the partners have agreed otherwise. In day to day affairs decisions are made by a majority vote (unless otherwise agreed.) When making very important decisions--those which could change the very nature of the business---a unanimous vote of the partners is required. The partnership is a separate entity for some purposes and an aggregate of individuals for other purposes. The partnership as an entity is liable for all of the business debts. Each partner is also personally liable for all of the partnership debts. The partnership as an entity owns all of the partnership property; the partners each have an ownership interest in the partnership. Partners do not directly have any ownership interest in the partnership property

CORPORATIONS Corporations are legally formed by actions of the government, though in practice the government will form a corporation when people have properly requested such action. Management power is vested in a board of directors elected by the shareholders. In this election each shareholder is entitled to one vote for each share which he or she owns. The shareholders have no individual right to participate in management.

A corporation is an entity separate and distinct from the persons who own or are otherwise involved with it. The corporation is liable for the business debts. Except in a few special situations, shareholders have no personal liability for the corporations debts. The corporation owns all of the business property. The shareholders own shares in the corporation. They do not have any direct ownership interest in the corporations property.

The partnership is an association of persons bound together by ties of agency. Each partner is an agent of the partnership and of all of the other partners; each partner is therefore also a principal to each of the other partners. Partners may have express, implied or apparent authority to bind the partnership. The scope of this authority is determined by the ordinary rules of agency law. The partnership may also ratify unauthorized acts of partners Partnerships are not liable for income tax. They are required to file tax returns with the IRS to provide the government with information, but they are not themselves required to pay tax. The income of the partnership is allocated among the partners for tax purposes; each partner must pay income taxes on his or her share of the partnership income even if that income is retained by the partnership instead of being distributed to the partners. Partners share equally in the partnership income unless otherwise agreed by the partners.

Corporations are represented by agents who have been given authority--express, implied or apparent--- by the Board of Directors. This scope of this authority is determined by the ordinary rules of agency law. Shareholders have no authority to represent the corporation unless they have received such authority from the Board.

The corporation must pay income taxes at the corporate rate on its income. Corporate income which is passed on to shareholders in the form of dividends is taxable income to the shareholder. (Under a special section of the Internal Revenue Code some small corporations are taxed like partnerships.)

Shareholders have no right to the corporations income unless the Board of Directors has declared a dividend. In that case each shareholder is entitled to the same amount for each share which that person owns.

LIMITED LIABILITY COMPANIES Limited liability companies -- LLCs -- began in Wyoming in 1977. Now they can be established in all states. In California they are governed by Corporations Code 17000 et seq.) LLCs have members; these members own and control the business. Natural persons, partnerships, corporations and other LLCs may be members of an LLC. LLCs are taxed like partnerships all income is passed on to the members of the LLC. Each member must report his or her share of the income as personal income of that member. LLCs do not pay income tax. FORMATION LLCs are formed by executing Articles of Organization. At least one person must sign the articles. (This person is not required to be a member of the LLC.) The Articles must then be filed with the Secretary of State. Four things must be included in all Articles of Organization. The NAME of the LLC (all names must include either the words limited liability company or the abbreviation LLC) A statement of business purpose (this must state that the LLC may either engage in the practice of a profession or engage in any lawful business purpose) The name and address of a registered agent for service of process If the business is not to be managed by its members, the alternative structure of its management must be indicated The members of an LLC may enter into an Operating Agreement. Such an agreement may be made either orally or in writing; it is a legally binding contract. Such a contract functions like the by-laws of a corporation and governs the operation of the LLC.

LIABILITY FOR DEBTS An LLC is a separate legal entity. Only the LLC is liable for its debts. The members of the LLC are not personally liable for the debts of the business. In some special circumstances the persons who control the LLC may be held personally liable for its debts. The veil of immunity may be pierced and the controlling persons held liable under in situations comparable to those in which the controlling persons of a corporation could be held liable for the corporations debts. However the failure to hold meetings or observe formalities in connection with the operation of the LLC will be grounds for holding the controlling persons liable for the LLCs debts only if the holding of such meetings is specifically required in the Articles of Organization or the Operating Agreement. PROFITS AND LOSSES Unless otherwise provided in the Articles of Organization or the Operating Agreement, profits are shared among the members in the ratio of the amount of capital they have contributed to the LLC. Losses are also shared in the proportion of capital contributions unless the Articles or Operating Agreement provide for a different method of division. EXAMPLE #1: Alpha, Baker and Charlie were the members of ABC LLC. Alpha contributed $500,000 to the capital of the LLC. Baker contributed $300,000 and Charlie contributed $200,000. The business made a profit of $1 million. Since Alpha contributed 50% of the LLCs capital -- $500,000 of a total of $1 million in capital contributions -- he will receive 50% of the profits (in this case $500,000). Baker contributed 30% of the capital and will receive 30% of the profits. Charlie contributed 20% of the capital and will receive 20% of the profits of the LLC.

MANAGEMENT Unless stated otherwise in the Articles of Organization, all members have an equal right to participate in management. They make decisions by majority vote. However unless the Articles of Organization or the Operating Agreement provide otherwise the members vote in accordance with their right to receive profits. EXAMPLE #2: XYZ LLC had three members: Xilo, Yolo and Zeno. Xilo contributed $600,000 in capital to XYZ; Yolo contributed $300,000 and Zeno contributed $100,000. Since there was no provision in the Articles of Organization or the Operating Agreement on how the profits would be distributed, Xilo would receive 60% of the profits; Yolo would receive 30% and Zeno would receive 10%. If a vote were held concerning a management decision, Xilo would cast 7 votes; Yolo would cast 3 and Zeno 1. (The position that received Yolos voting support would therefore prevail no matter how the other members voted.) However amendment of the Articles of Organization requires a unanimous vote of the members. The Articles may provide for the use of other forms of management including management by persons who are not members of the LLC. TRANSFER OF OWNERSHIP INTERESTS Members may transfer or assign their ownership interest in the LLC to another party. The assignee the new owner of the interest has the right to receive the share of the income of the LLC that the member would have received had he or she not assigned the interest. However the assignee is NOT a member and will not be allowed to participate in the management of the LLC. The assignee can become a member of the LLC only if the existing members of the LLC vote to admit the assignee as a member. Any such vote will be made in accordance with the members voting power. EXAMPLE #3:

WXYZ LLC had 4 members: Wizardo, Xilo, Yolo and Zeno. Wizardo contributed $400,000 in capital to WXYZ; Xilo contributed $300,000; Yolo contributed$200,000 and Zeno contributed $100,000. Zeno assigned his interest in WXYZ to Milo. Milo desired to become a member of WXYZ. Milo could become a member only if the existing members approved his becoming a member. If such a vote were held Wizardo would have 4 votes; Xilo would have 3; Yolo would have 2 votes and Zeno would have 1. If a majority of the votes were cast to approve Milo becoming a member of WXYZ, then Milo would become a member of the limited liability company in place of Zeno.

LIMITED PARTNERSHIPS Limited partnerships are a form of business organization. A limited partnership is created by filing a document Articles of Limited Partnership -- containing certain information about the limited partnership with the office of the Secretary of State of the state in which the limited partnership is formed. A limited partnership must have at least one general partner. The general partners manage the partnership; they have unlimited personal liability for all debts of the partnership. A limited partnership may also have limited partners who invest money in the limited partnership. These limited partners are entitled to a share of the profits the amount of the profits that a limited partner is entitled to receive is determined by the provisions in the Articles of Limited Partnership. Limited partners generally do not have the right to participate in management. Limited partners have no personal liability for the debts of the limited partnership. (It is possible that a limited partner may ultimately lose the amount that he invested in the partnership. That is the only loss that a limited partner may suffer from the operations of a limited partnership.)

EXAMPLE: On 10 December 2000 Loren filed Articles of Limited Partnership with the office of the California Secretary of State. These articles provided that the general partner would be entitled to 20% of the limited partnerships profits; the limited partners would share equally in the other 80% of the partnership profits. XYZ Inc. became the general partner. A, B, C and D each became limited partners. The limited partnership owed $10 million to Bozo Bank. Is XYZ Inc. liable for this debt to Bozo Bank? YES the general partner has unlimited liability for the debts and obligations of the limited partnership. Is A liable for this debt to Bozo Bank? NO limited partners have no liability for the debts of the limited partnership.

For income tax purposes limited partnerships are not taxable entities. All partnership income is allocated to the general and limited partners and is taxable income to them.

SECURITIES REGULATION INTRODUCTION Before 1933 there was little legal regulation of the securities markets. Many people thought that uncontrolled speculation in securities had brought about the Great Depression which began in 1929. Congress decided to establish legal regulation of the securities markets. THE 1933 ACT The first securities regulation statute passed by Congress was the SECURITIES ACT OF 1933. This act was designed to regulate the primary securities market. This market consists of the issuance of new securities by corporations. For example, suppose that XYZ Corporation decided to issue 5 million new shares and sell them to investors. This would be part of the primary securities market. The 1933 Act requires most new issues of securities to be registered with an agency of the federal government, the Securities and Exchange Commission (SEC). The registration must contain certain information concerning the securities that are to be issued. Along with the registration statement, the corporation issuing the securities must prepare a document called a prospectus. The prospectus also must disclose certain information concerning the securities which are to be issued. A copy of this prospectus must be provided to each prospective purchaser of the securities before that person can buy the securities. It is a violation of the 1933 Act to make any false or misleading statement in the registration statement or the prospectus. It is also a violation of this law for the registration statement or the prospectus to fail to disclose certain types of information which the law requires to be included in the statements. In other words, it is sometimes illegal to remain silent about certain matters. It is illegal under the 1933 Act to sell any securities that have not been registered. Violations of these rules are civil violations of the law; under certain circumstances they may also be criminal violations of the law.

DEFINITION OF A SECURITY The federal securities laws apply to all securities. What is a security? Obviously stock (or shares) in a corporation are securities. Also included within the definition are corporate bonds certificates which represent loans which have been made to the corporation. (Since the holders of corporate bonds are creditors of the corporation, bonds are referred to as debt securities.) Some investment vehicles other than stocks and bonds are also considered to be securities. Decisions of the Supreme Court have established that any investment scheme as part of which money is invested in any sort of common situation in which the profitability of the investment depends in part on the activities of the managers of the investment scheme is a security. EXAMPLE A: A developer owned a large orange grove. He sold narrow strips of land containing orange trees to investors; the investors were also required to enter into a contract under which the developer would manage and maintain all of the strips of land which had been sold to the investors. The developer would cultivate the land, harvest and market the crops and then share the profits with the owners of the strips of land. The Supreme Court held that even though this scheme in theory involved the sale of land which is not a security these investments should be legally considered to be securities. The purchasers invested their money in a common situation in which the potential profitability of the investment depended in part on the managers of the investment scheme. The 1934 ACT THE SECURITIES EXCHANGE ACT OF 1934 was designed to regulate the secondary market in securities. This is the market where already issued securities are bought and sold. EXAMPLE B: John directed his broker to buy for him 1000 shares of Microsoft. These shares would be purchased from another owner. This is a transaction in the secondary securities market.

RULE 10(b)5. Section 10(b)5 of the Securities Exchange Act of 1934 is one of the most important provisions of the securities laws. It was intended to restrict fraudulent manipulation of the securities markets. It provides that it is unlawful to "use or employ...any manipulative or deceptive device" in connection with the purchase or sale of any security. In 1941, the SEC issued Rule 10(b)5. This was an attempt to interpret and explain the statute. The provisions of this rule are printed on p. 903 (footnote 6) of the textbook. The language of this rule is also quite general. The contours of the modern law of 10(b)5 have been developed on a case by case basis in the courts. The original intention was that enforcement of Rule 10(b)5 would be limited to the SEC and other government agencies. However the courts have held that in addition to the government's power to enforce this law there is also an implied private right of action. This means that any private party who believes that he has been injured by another party's actions in violation of 10(b)5 may bring a private lawsuit for damages against the allegedly offending party. In effect 10(b)5 has become a new tort. This outline will set forth the prima facie case for a private lawsuit under Rule 10(b)5. I. MISREPRESENTATION OR FAILURE TO DISCLOSE

A 10(b)5 action can be based on misrepresentation (a false or misleading statement) or upon failure to disclose (remaining silent about a fact). Some cases are of course based in part upon both of these theories. In cases involving failure to disclose, it must be decided to whom disclosure must be made. In face to face transactions, disclosure must be made to the other party. For example, Bill is a geologist for Ewing Oil. He knows that the company has just made a major oil discovery. He offers to buy Tom's shares of Ewing stock. He must make full disclosure to Tom before buying the securities. When a transaction is made indirectly (for example through a broker or on a stock exchange) disclosure must be made to the entire investing public. In practice this means that disclosure must be made through the business media. The person making disclosure must not buy or

sell the securities until the financial markets have had time to absorb the information. II. (DUTY TO DISCLOSE)

There is no need to show that a duty existed if the case is based upon a misrepresentation theory since all persons have a duty not to make false and misleading statements concerning securities. However if the case is based on a claim that the defendant failed to disclose some fact, it is necessary first to establish that the defendant had a duty to disclose. Only persons in certain categories are under such a duty to make full disclosure. A. INSIDERS

These are people who because of their relationship with the corporation have access to inside information concerning the corporation. Possession of this non-public information would give them an unfair advantage in the securities markets. Eliminating this advantage is one of the chief purposes of the rule. Insiders include directors, officers, and controlling shareholders. Lower level employees are also included if their connection with the corporation brings them into contact with inside information. For example, a secretary who types a document containing reference to a new oil discovery made by the corporation which has not yet become public knowledge is an insider. The insider category also includes independent contractors who while working for the corporation gain access to non-public information. This would include outside legal counsel, accountants and auditors, investment bankers and many others. Insiders violate Rule 10(b)5 if they buy or sell securities issued by their corporation without first making full disclosure of the inside information. B. TIPPERS

Tippers are persons who give tips. They possess inside information and pass that information on to other persons without disclosing it to everybody. Tippers are in violation even if they do not trade (i.e. buy or sell securities of the corporation in question). For example, the chairman of the board of Weaponsco, Inc. calls his girlfriend and says
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"we just got a huge new government contract, but it won't be publicly announced until next Monday. Buy shares before Wall Street finds out!". The chairman is liable for violating Rule 10(b)5 even if he does not buy any shares himself. C. TIPPEES

Tippees are persons who receive tips from tippers. Tippees are treated like insiders; that is they violate 10(b)5 only if they trade in the corporation's securities. They can also incur liability by passing their information to other people without disclosing to everyone, in which case they become tippers. Tips must be distinguished from mere rumors. A tip is information which the recipient knows to come from an informed source and which the recipient knows to be non-public. For example, if a director of RCA calls a friend and says "GE has told us they want to take us over" the friend is a tippee. He got his information from an informed source (a director) and he knows that the public has not yet learned of the news. D. MISAPPROPRIATORS

The categories listed above all involve people who have inside information from the corporation whose securities are being traded. In recent years some courts have extended the duty to disclose to persons who possess non-public information (even though it did not come from within the corporation whose shares are being traded) if the defendant had a fiduciary duty to keep the information secret and breached that duty. For example, in one case a printer was employed by a financial printing house. In this job he obtained nonpublic information about corporations that were the targets of upcoming takeover bids. His employer obtained this information from law firms representing the companies which were planning to make the takeover bids. It did not come from the target companies whose shares would be involved in any market speculation based on this information. The defendant had a duty of secrecy to his employer to keep this information confidential. He breached this duty by trading in the shares. The court held that anyone in such a position has a duty under Rule 10(b)5 to make full disclosure before trading in the shares of the takeover-target corporations. (Obviously if he complies with this duty and discloses the information he will have breached his
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fiduciary duty to his employer. The only legal course of conduct for a person in this position is to refrain from trading the shares of corporations concerning which he possesses non-public information.) Another example involved a reporter who wrote the "Heard on the Street" column for the Wall Street Journal. This was a sort of gossip column for the financial world. The reporter knew that the publication of items in this column often caused short-term fluctuations in the price of the shares. He gave advance word of the contents of each column to a friend who was a broker. The broker then traded in the shares. The court held that the reporter had a duty to the Wall Street Journal not to disclose its' publication schedule to outsiders. When he breached this duty the court held that he had the same duty as a tipper, even though his tip was not true inside information from the corporation whose shares were traded. All he disclosed was information concerning the Journals publication schedule. Misappropriators are treated like true insiders. They are liable only if they trade shares or if they pass the information to others, thereby becoming tippers. III. MATERIALITY

A misrepresentation or omission is material if a reasonable person would take the information into account in deciding whether to buy or sell the securities. There is no requirement that it be the only factor -or even the most important factor -- merely that it be important enough for the other party to take into account in deciding whether or not to buy or sell. IV. (RELIANCE)

In a suit based on a misrepresentation theory, the injured party must show that he bought or sold securities in reliance upon the defendant's false or misleading statement. Reliance is a subjective requirement: Did this particular plaintiff rely on this misrepresentation in deciding whether or not to buy or sell the shares? In contrast materiality is an objective test: would a reasonable person have relied on this information? When the plaintiff has bought or sold shares through a stock exchange or broker, the courts now assume
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that reliance existed; it is not required that the plaintiff be able to show specifically that she relied on the misrepresentation or even that she had heard the false or misleading information. The theory supporting this rule is that the plaintiff "relied on the fairness of the markets". When a 10(b)5 case is brought by the SEC or other government agency, the reliance requirement is not applicable. Obviously the reliance requirement is not applicable to failure to disclose cases, since there is no way to rely on something that has not been disclosed. V. PLAINTIFF WAS PURCHASER OR SELLER OF SECURITIES

In order to win a lawsuit, the plaintiff must show that he actually bought or sold some of the corporation's securities. If shares are exchanged as part of a merger this requirement is considered to have been met. This requirement does not apply to suits brought by the SEC or other government agencies. VI. INTERSTATE COMMERCE

Rule 10(b)5 was promulgated pursuant to an act of Congress. Under the U.S. system of government, Congress is allowed to exercise power only if it is authorized to do so by the U.S. Constitution. Since the Constitution is silent concerning power to regulate securities markets, it was necessary for Congress to enact this law under some section of the Constitution which could be interpreted to include power over the securities markets. The only plausible choice was the provision included in Article I Section 8 which gives Congress power "to regulate Commerce with foreign Nations, and among the several States". The federal courts have jurisdiction over a securities case only if interstate (or international) commerce is involved. This means either that there must have been some activity which crossed state lines or that some use must have been made of a facility of interstate commerce even if in fact it was not used to do business across state lines. Any use of the U.S. mail, or of the telephone system, or of a securities exchange satisfies this requirement even if no state lines were crossed. For example Broker has offices in Beverly Hills. He calls Customer at his home in San Francisco and makes false statements concerning a security. Interstate commerce is involved since the same telephone system could have been used to
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communicate across state lines, even though it was not in fact used in that manner. VII. SCIENTER

Scienter is a Latin word meaning knowledge. In a case based upon misrepresentation, the plaintiff must show that the defendant knew that his statement was false. In a case based upon a theory of failure to disclose, it must be shown that the defendant had actual knowledge of the fact which she did not disclose. It is not enough to show that the defendant was negligent and that if the defendant had acted reasonably she would have discovered the material fact which was not disclosed. REMEDIES If all of the elements of the prima facie case can be established, the plaintiff's lawsuit will be successful. What remedies will the court grant? The basic remedy is money damages. In cases involving face to face transactions, the amount of damages is the difference between the actual sales price of the shares and the price that the shares would have had if the whole truth had been known to both parties. For example, when Bill bought shares of Ewing Oil from Tom, he failed to disclose that Ewing had just made a large oil discovery. Bill paid $5 per share. The evidence indicated that if the truth had been known the true market value of the shares would have been $15 each. Tom is entitled to damages of $10 per share. This measure of damages also applies in cases where the plaintiff is a buyer rather than a seller. As an alternative, the plaintiff may ask for the remedies of rescission and restitution. This means that the buyer must return the securities and the seller must return the purchase price. In addition to private lawsuits, the SEC may bring enforcement actions under Rule 10(b)5. The SEC can ask for an injunction, which is a court order requiring the defendant to cease all further violations of 10(b)5. If the defendant subsequently violates such an injunction, the defendant may be fined or imprisoned for contempt of court. The SEC can bring disciplinary actions against any defendant who is a regulated broker, dealer, or underwriter. The SEC can also ask the
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court to require the defendants to disgorge their illicit profits and to impose a civil penalty of up to three times the profits gained or losses avoided. (Ivan Boesky agreed to disgorge profits of $50 million and to pay a fine of $100 million.) Finally the SEC may refer cases to the Department of Justice for criminal prosecution. Criminal violation of 10(b)5 is punishable by 10 years in prison and a fine of $1 million ($2.5 million for partnerships or corporations) for each count. SECTION 16: SHORT TERM INSIDER TRADING Section 16 of the Securities Exchange Act of 1934 governs trading of securities by certain persons designated as insiders of a corporation with securities registered pursuant to that law. There are two types of securities that must be registered under the 1934 Act. 1. Any class of securities of a corporation with assets that exceed $10 million held by at least 500 owners that are traded in interstate commerce. 2. Any securities that are traded on a national stock exchange.

Registration consists of filing a document with the SEC containing certain required information about the corporation and the securities. The definition of insider under Section 16 is different from that under Rule 10(b)5. Under Section 16 any person in any of the following categories is an insider: 1. An officer of any corporation that has issued equity securities registered under the 1934 Act. An officer is the President of the corporation, the Treasurer (or other principal financial officer), the Secretary of the corporation and any other person performing comparable functions. Vice-presidents are also considered to be officers if they have actual executive functions within the corporation. Also considered to be officers are assistants to officers that
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carry out the functions of the officer, and any other employees who perform executive duties that are likely to provide the employee with access to inside information from within the corporation. The head of any division or unit of the corporation is also an officer. 2. A director of any corporation that has issued equity securities registered under the 1934 Act. 3. Any person that owns more than 10 percent of any class of equity securities of any corporation that has issued equity securities registered under the 1934 Act. A person is an owner under Rule 16 only if that person has actual control over the securities and the ability to use any profits made from their purchase and sale. It is presumed that the legal owner of the shares does indeed have such control, but that presumption may be rebutted by contrary evidence. Whenever any person in any of these categories engages in shortswing trading of securities issued by the corporation of which he or she is an insider, the corporation may recover from the insider any profit made. Short-swing trading means the purchase of securities followed by their sale (or the sale of securities followed by re-purchase of equivalent securities) within a period of 6 months or less. This liability exists without regard to the insiders intent to use inside information or actual use of that information. The corporation is entitled to acquire the profit made only if the purchaser-seller was an insider at the time of both transactions. EXAMPLE #1: The Dingbat Corporation had 100,000 shares of stock. John purchased 100 shares of the Dingbat Corporation on 10 January for $10 each at this time he had no other connection with the corporation. On 10 February John was elected to the Dingbat Board of Directors. On 10 May John sold 100 shares of Dingbat for

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$15 each. John will NOT be required to turn his profit over to Dingbat John was not an insider at the time he purchased the shares. At the time of the purchase of shares that brings a persons stock ownership over the 10% threshold that person is NOT an insider for Rule 16 purposes. EXAMPLE #2: There were 100,000 shares outstanding of common stock of the Nitwit Corp. Lou had owned 6000 shares since 2000. On 10 June 2005 Lou bought another 5000 shares of Nitwit stock at a price of $10 each. On 10 August 2005 Lou sold 500 shares at a price of $12 per share. The corporation is not entitled to the profit made by Lou. The transaction on 10 June 2005 pushed Lou over the 10% limit at the time of that transaction Lou was NOT considered to be an insider. EXAMPLE #3: After the events in Example #2, Lou bought 2000 shares on 12 September 2005 at a price of $10 each. On 18 October 2005 he sold 1000 shares at a price of $12 each. When the purchase of 2000 shares is matched up with the sale of 1000 shares, Lou has made a profit of $2000. The corporation is entitled to recover this profit of $2000 since Lou was the owner of 10% of the shares at both the time of the purchase and the time of the sale and the events happened within 6 months of each other. EXAMPLE #4: LMN Corporation had 9500 shares of stock outstanding. On 15 May 2006 Linda, who had owned 1000 shares of LMN Corp. stock since 2003, purchased 2000 shares at a price of $100 each. On 15 August 2006 Linda sold the 3000 shares of LMN that she owned at a price of $110 each. (After this transaction Linda owned no shares of LMN.) LMN is entitled to recover $20,000 from Linda this is the profit she made from the sale of those shares that she had purchased less than 6 months before the sale of the shares. At the time of a transaction that takes a shareholder below the 10% threshold (such as the sale by Linda on 15 August 2006) the shareholder IS considered to be an insider for purposes of Rule 16. EXAMPLE #5: In 2000 Holly was elected to the Board of Directors of Moneybags Industries; she has been a member of the Board continuously since that time. On 5 June 2005 (at which time she
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owned no shares of Moneybags stock) Holly purchased 10,000 shares at a price of $10 each. On 10 October 2010 Holly purchased 1000 shares at a price of $15 each. On 25 February 2011 she sold 1000 shares at a price of $17 per share. In deciding whether Rule 16 requires the profits made from a securities transaction to be paid to the corporation the last-in-first-out (LIFO) rule applies. The most recently purchased shares those purchased on 10 October 2011 are assumed to be the shares that were sold on 25 February 2012. The sale of shares on 25 February 2011 came less than six months after the purchase of shares on 10 October 2010. Therefore Moneybags Industries is entitled to recover $2000 from Holly. EXAMPLE 6: In 2000 Hortense was elected to the Board of Directors of Moneybags Industries; she has been a member of the Board continuously since that time. On 5 July 2005 (at which time she owned no shares of Moneybags stock) Hortense purchased 10,000 shares at a price of $10 each. On 10 November 2010 Hortense purchased 500 shares at a price of $15 each. On 25 March 2011 she sold 1000 shares at a price of $17 per share. In deciding whether Rule 16 requires the profits made from a securities transaction to be paid to the corporation the last-in-first-out (LIFO) rule applies. The most recently purchased shares those purchased on 10 November 2011 are assumed to be among the shares that were sold on 25 February 2012. The sale of shares on 25 February 2011 came less than six months after the purchase of shares on 10 November 2010. Therefore Moneybags Industries is entitled to recover $1000 from Hortense from the sale of the 500 shares that were assumed to have been purchased by her on 10 November 2011. Hortense may keep the profit made from the sale of the other 500 shares that she sold on 15 February 2012. These shares must have been purchased on 5 July 2005. Since this was more than 6 months before the date of the sale Hortense is NOT required to turn over the profit from their sale to Moneybags Industries. All insiders of corporations that have registered securities under the 1934 Act must report any purchases or sales of securities in the corporation of which they are insiders to the SEC no later than the second business day following the purchase or sale of the securities.

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FIDUCIARY DUTIES OF SHAREHOLDERS Under most circumstances shareholders are not fiduciaries they do not owe any fiduciary duties to the corporation. For example, no duties are violated if a shareholder of General Motors purchases shares in one of that corporations competitors such as Ford. However under some special circumstances shareholders do owe fiduciary duties. Several of these circumstances involve fiduciary duties that are imposed only on controlling shareholders. A controlling shareholder is a shareholder who has the power to determine the policies of the corporation in the ordinary course of the corporations business. Persons who own a majority of the shares are of course controlling shareholders. (A person who owns a majority of the shares can always determine the election of a majority of the directors and therefore such a shareholder can determine the policies of the corporation.) Under some circumstances a shareholder who owns less than a majority of the shares may still be a controlling shareholder. EXAMPLE: Martin owned 40% of the shares of Bozo Corporation. The remainder of the shares were held by 5000 other shareholders, none of whom owned more than of 1% of the shares. Unless the other shareholders have organized themselves as a bloc to outvote Martin, Martins 40% of the shares will allow him to elect a majority of the directors; therefore Martin would be a controlling shareholder. Listed below are the situations under which shareholders are subject to fiduciary duties to the corporation or to the other shareholders. 1. Duty of controlling shareholders not to sell control of the corporation to a looter. Controlling shareholders have a duty not to sell their controlling interest in the corporation to a looter. A looter is a person that the controlling person knows or has reason to know is likely to loot the

corporation. A corporation is looted if its assets are stolen by fraud, embezzlement or any other illegal method. EXAMPLE: Wilson founded Super Corporation; the business was very successful. Wilson owned 60% of the shares. The remaining 40% had been given by Wilson to Alpha, Beta, Gamma and Delta, who were valuable employees of Super Corp. Wilson decided to retire from business. For this reason Wilson sold his 60% of the shares to Harding. Harding had once been convicted of embezzlement; he had also been successfully sued in three civil suits for fraud. All of these cases involved corporations for which Harding had once worked. Information about these suits was publicly available; however Wilson made no effort to check on prior lawsuits. Harding was a very good friend of Wilsons and Wilson did not believe that he needed to check on Hardings background. Harding paid a fair price for the shares. During the next three years, Harding used his control of Super Corp. to divert its assets. Harding then disappeared and Super Corp declared bankruptcy. The minority shareholders sued Wilson for breach of fiduciary duty. If Wilson had done a background check on Harding, he would have learned from the court records that there was a good chance that Harding might loot the corporation. Therefore Wilson should have known that Harding might loot the corporation. Wilson has breached his fiduciary duty; the suit brought by the minority shareholders would be successful. 2. Duty of controlling shareholders to act fairly towards the corporation and towards the other shareholders in connection with any transaction to which control of the corporation is relevant. EXAMPLE: Santa Ana Savings and Loan Association had 1000 outstanding shares. Roto owned 520 of these shares; the remainder were held by other owners. Santa Ana was very profitable; but because of the small number of shares outstanding there was no regular market in Santa Ana shares. Roto then established a new corporation, Fullerton Holding Corporation. It was authorized by its articles to issue 1 million shares. Roto obtained all of the Fullerton shares; as consideration he transferred his 520 shares of Santa Ana to Fullerton Holding Corp. Roto, working through local brokerage

houses, then sold 499,000 of his Fullerton Holdings shares to other investors. A regular market in Fullerton Holdings shares then developed. Since there was no market for Santa Ana savings shares, the minority shareholders of that corporation could not easily sell their interest in that corporation. They were unable to participate in the share market created by the establishment of Fullerton Holdings. The minority Santa Ana shareholders sued Roto, seeking compensation for having been frozen out of the market for shares. Of course Roto had not sold control of the corporation; through his control of Fullerton Holdings, which owned a majority of the shares of Santa Ana Savings, Roto still had the power to control Santa Ana. But controlling shareholders have a fiduciary duty to act fairly towards both the corporation and the minority shareholders in connection with any transaction to which control of the corporation is relevant. Control of Santa Ana Savings was clearly relevant to Rotos transactions here. By failing to grant equal treatment to the minority shareholders of Santa Ana Roto breached this fiduciary duty. He could be ordered either to buy the shares of the minority shareholders in Santa Ana at a value determined by an independent appraiser or to permit those minority shareholders to exchange their Santa Ana shares for new Fullerton shares (at the same ratio for which Roto had exchanged his shares). 3. Fiduciary Duties of shareholders in closely held corporations. A closely held corporation is one for which there is no regular market for the shares the shares are not regularly traded. Shareholders in closely held corporations are subject to the same fiduciary duties as are partners. This means that they are subject to the full set of fiduciary duties: loyalty, care and skill, obedience and the duty to account. The duties are owed both to the corporation and to the other shareholders. (These duties are imposed because in closely held corporations the shareholders often participate directly in management in ways similar to partnership management.) EXAMPLE: Xitro Corp. had 2 shareholders: Loraine and Mike. Loraine owned 51% of the shares; Mike owned 49%. Mike was the

corporations secretary-treasurer; he received a salary of $100,000 per year, which was his only source of income. Loraine decided to force Mike out of the management of the corporation. She and the other directors whom she had elected voted to fire him from his position as secretary. Loraine, who was already Xitros president, was also appointed to be secretary-treasurer. By freezing out Mike from the corporation, Loraine has violated her fiduciary duties to other shareholders. Normally this duty protects minority shareholders from oppressive conduct by controlling shareholders. However minority shareholders in closely held corporations are also subject to these fiduciary duties. EXAMPLE: Selwyn owned 50% of the shares of Rexford Rand Corporation; his sons Gregory and Albert each owned 25% of the shares. The name Rexford Rand was used on the corporations products and in its advertising. Selwyn and Albert decided to remove Gregory from his position as Vice-President and Treasurer of the corporation. (Gregorys salary from this position was his only source of income.) One year later, Rexford Rand failed to file its annual report with the state of Illinois; as a result the corporation was dissolved by the state. Gregory learned about the dissolution. Since the name Rexford Rand was once again available in Illinois as a corporate name, Gregory set up a new corporation using the name Rexford Rand Corporation. (As a result, the original corporation could not re-incorporate under the Rexford Rand name.) Selwyn and Albert sued Gregory. The court held that Gregory, as a minority shareholder, owed fiduciary duties to the corporation and to the other shareholders. He breached those duties by appropriating an asset that belonged to the corporation the trade name Rexford Rand for his own use. (Note that in this case Gregory could have sued Selwyn and Albert for breach of fiduciary duty, since they had frozen him out of the corporation. Instead, Gregory breached his duty to the corporation by misappropriating the trade name.)