Klein, Ramseyer, Bainbridge 5th Ed Outline

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BUSINESS ASSOCIATIONS OUTLINE
Business Associations
Southwestern University School of Law – SCALE I and II
Ted Finamore
Text: Business Associations 5th Edition by Klein, Ramseyer & Bainbridge
Table of Contents
I. Overview of Business Associations.........................................................................................5
A. Are Corporate Lawyers Necessary?.......................................................................................5
B. The Transaction Cost Trade-Off.............................................................................................6
C. Structuring a Business Association........................................................................................6
D. Summary: Introduction to Business Associations..................................................................7
II. AGENCY – THE BUILDING BLOCK OF FIRMS.......................................................................8
I. Who is an Agent?.......................................................................................................................8
II. Liability of Principal to Third Parties in Contract...................................................................9
B. AUTHORITY..........................................................................................................................9
C. Apparent Authority.................................................................................................................9
D. Inherent Authority.................................................................................................................10
E. Authority Summary...............................................................................................................13
F. Ratification............................................................................................................................14
G. Estoppel...............................................................................................................................15
H. Agent’s Liability on Contract.................................................................................................16
I. Summary – Agency Relationship/Liability of Principal in Contracts.......................................16
III. Liability of Principal to Third Parties in Tort........................................................................17
J. What is the Justification for Imposing Liability?.....................................................................17
K. Servant Versus Independent Contractor..............................................................................18
L. Tort Liability and Apparent Agency.......................................................................................19
M. Scope of Employment..........................................................................................................20
N. Statutory Claims...................................................................................................................22
O. Liability for Torts of Independent Contractors......................................................................22
IV. FIDUCIARY OBLIGATIONS OF AGENTS.............................................................................23
P. Duties During Agency...........................................................................................................23
Q. Duties During and After Termination of Agency: Herein of “Grabbing and Leaving”Agency
.....................................................................................................................................24
R. Recap of Agents’ Fiduciary Duties: Miracle on 34th Street.................................................24
S. Summary - Liability of Principal in Torts/Fiduciary Duties of Agents.....................................25
III. PARTNERSHIPS.....................................................................................................................26
A. What is a Partnership? And Who Are the Partners?...........................................................26
B. Partners Compared With Employees...................................................................................30
C. Partners Compared With Lenders........................................................................................32
D. PARTNERSHIP BY ESTOPPEL..........................................................................................34
IV. II. The Fiduciary Obligations of Partners............................................................................34
A. Introduction..........................................................................................................................34
B. After Dissolution...................................................................................................................36
C. Grabbing and Leaving..........................................................................................................36
D. Expulsion.............................................................................................................................37
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E. Summary - Introduction to Partnerships/ Partners’ Fiduciary Duties....................................38

V. III. Partnership Property........................................................................................................38
A. Introduction..........................................................................................................................38
B. Liability in a Partnership.......................................................................................................39
VI. IV. Partnership Capital.........................................................................................................40
A. Overview..............................................................................................................................40
B. Raising Additional Capital....................................................................................................41
VII. V. The Rights of Partners in Management.........................................................................43
VIII. V. Partnership Dissolution.................................................................................................46
A. The Right to Dissolve...........................................................................................................46
B. The Consequences of Dissolution........................................................................................49
C. The Sharing of Losses.........................................................................................................53
D. Buy-out agreements.............................................................................................................53
E. Law Partnership Dissolutions...............................................................................................55
IX. VII. Limited Partnerships......................................................................................................56
X. THE CORPORATION...............................................................................................................58
A. Main Attributes.....................................................................................................................58
B. Comparing Partnerships and Corporations..........................................................................58
C. Public v. Close Corporations................................................................................................58
D. Introduction to the Corporation: ...........................................................................................59
E. Applicable Law.....................................................................................................................60
F. Mechanics of Forming a Corporation....................................................................................60
G. Liability for Pre-Incorporation Activity...................................................................................60
H. “Defective Corporations”......................................................................................................62
I. Enterprise Liability.................................................................................................................64
J. Agency..................................................................................................................................65
K. Piercing the Corporate Veil (PCV)........................................................................................65
L. Justifications for PCV: Contract Creditors............................................................................65
M. Comparing Our Suggested Rationale with the Case Law....................................................66
XI. Introduction to the Corporation: Summary Overview of Issues.......................................69
B. Derivative Actions.................................................................................................................71
C. Introduction – Fiduciary Duty to Corporations......................................................................71
D. Three Hurdles For Derivative Actions:.................................................................................72
E. First Hurdle: Security Req’t..................................................................................................72
F. Second Hurdle: Demand Requirement.................................................................................73
G. The Business Judgment Rule (BJR)....................................................................................75
H. The Demand Requirement in Derivative Actions (Accountability vs Strike Suits)................76
I. The Demand Requirement under MBCA...............................................................................76
J. The Demand Requirement under Delaware Law..................................................................76
K. Excusing the Demand Requirement under Delaware Law ..................................................77
L. Excusing the Demand Requirement under NY Law (Marx v. Akers)....................................77
M. Special Litigation Committees (SLCs).................................................................................78
N. Dismissing Derivative Actions Delaware vs. NY vs. MBCA..................................................78
O. Derivative Action Flowchart.................................................................................................78
P. Derivatives Recap ...............................................................................................................81
XII. The Role and Purposes of Corporations............................................................................84
A. Capital Structure 1/12/2005..................................................................................................84
B. Rights of a Shareholder 1/14/2005.......................................................................................85
C. Shareholder Rights (Knipprath) 1/21/2005 1/24/2005........................................................85

56932621.doc The Last FUCKING CORPORATIONS CLASS I’LL EVER TAKE! Page 2 of 255
D. Change in Control................................................................................................................87
E. Capital Structure Terminology..............................................................................................89
F. Special Types of Securities: Preferred Shares.....................................................................89
G. Special Types of Securities: Convertible Bonds..................................................................90
H. Special Types of Securities: Warrants.................................................................................91
XIII. Introduction to the Corporation: Overview of Issues.......................................................92
A. Forming the Corporation......................................................................................................92
B. Independent Legal Personality.............................................................................................92
C. Separation of Ownership and Control..................................................................................92
D. One last BA type: The Limited Liability Company 1/12/2005...............................................92
E. Hierarchy of Legal Sources .................................................................................................92
F. Governance of the Corporation: Separation of Ownership & Control..................................93
G. Corporate Powers ...............................................................................................................93
H. Corporate Purpose ..............................................................................................................93
I. Stakeholders in the Corporation ...........................................................................................94
J. Centralized Management and the Business Judgment Rule................................................94
XIV. Comparing Partnerships and Corporations: Development of the LLC.........................97
B. Piercing the LLC Veil ...........................................................................................................99
C. LLC Dissolution..................................................................................................................100
D. Duty of Care.......................................................................................................................101
E. Knipprath Fiduciary Duty Summary Review ......................................................................112
F. Duty of Loyalty....................................................................................................................112
G. Corporate Opportunity.......................................................................................................114
H. Ratification.........................................................................................................................116
I. Rule 10b-5 of Exchange Act 1934.....................................................................................117
J. Duty of Care........................................................................................................................119
K. Duty of Loyalty...................................................................................................................122
L. Dominant Shareholders and Parent-Subsidiary Dealings...................................................124
M. Intermediate Standard in Takeover context.......................................................................127
N. Prüfungsaufbau..................................................................................................................128
XV. DISCLOSURE AND FAIRNESS: FEDERAL SECURITIES REGULATION........................128
A. Definition of a Security.......................................................................................................128
B. Registration process...........................................................................................................130
C. Liability under 1933 Act......................................................................................................132
D. Rule 10b-5 of Exchange Act 1934......................................................................................134
E. Insider Trading...................................................................................................................141
F. Short-Swing Profits.............................................................................................................146
XVI. INDEMNIFICATION AND INSURANCE ............................................................................148
XVII. §7. The Question of Corporate Control.........................................................................153
A. PROXY FIGHTS.................................................................................................................153
B. Strategic Use of Proxies.....................................................................................................154
C. Private Actions for Proxy-Rule Violations...........................................................................155
D. Shareholder Proposals.......................................................................................................155
E. Shareholder Inspection Rights Cases................................................................................157
XVIII. PROBLEMS OF CONTROL.............................................................................................158
A. Shareholders Voting Control..............................................................................................158
B. Controlling Shareholders/Transfer of Control.....................................................................158
C. General authorization of transfer of control, except fraud, bad faith or looting:..................159
D. Limitation on transfers of control involving sacrifice of some of the corporation’s assets...160

E. Limitation On Transfers Of Control Made Without Any Compelling Business Purpose At The
Expense Of The Minority...........................................................................................161
F. Illegal Sale of Office without Sale of Control.......................................................................161
G. Control Problems in Close Corporations...........................................................................162
H. Ex Ante Solutions: Contractual Provisions/Agreements....................................................163
I. Long-Term Shareholder Tenure and Salary Agreements....................................................164
J. Comprehensive Shareholder Agreements..........................................................................165
K. Ex Post Solutions: Heightened Fiduciary Duties among Shareholders..............................167
L. Wilkes Doctrine...................................................................................................................168
M. ABUSE OF CONTROL IN CLOSELY HELD CORPORATIONS.......................................170
N. Squeeze-out Merger..........................................................................................................170
O. Control of the corporation..................................................................................................170
XIX. COUNTERMEASURES – CONTROL, DURATION & STATUTORY DISSOLUTION........172
A. Constructive Dividends as an Equitable Remedy...............................................................172
B. Statutory Dissolution..........................................................................................................172
XX. MERGERS AND ACQUISITIONS........................................................................................174
A. Mergers 1/26/2005............................................................................................................174
B. Sale of Assets....................................................................................................................175
C. Tender Offer/Takeover.......................................................................................................177
D. Appraisal Remedy..............................................................................................................177
E. Defacto Merger..................................................................................................................177
F. Defacto Non-Merger?.........................................................................................................178
G. Freezouts...........................................................................................................................178
H. Weinberger Analysis Method For Freeze Out Mergers......................................................181
XXI. Organic Changes in Corporations...................................................................................182
A. Mergers..............................................................................................................................182
B. Asset Sales & Liquidations.................................................................................................183
B. Freeze Out Mergers: Bus. Justification Coggins v. New England Patriots.........................189
C. Law in Delaware................................................................................................................189
D. Parent-Subsidiary Merger (Short Form).............................................................................192
C. Recapitalizations................................................................................................................193
XXII. Policy Issues....................................................................................................................194
A. Liability Issues/Remedies...................................................................................................195
XXIII. Takeovers/Tender Offers 1/24/2005..............................................................................195
A. Policy Issues......................................................................................................................195
B. Bidder Tactics....................................................................................................................196
C. Target Tactics....................................................................................................................198
D. Liability Issues....................................................................................................................199
E. Federal and State Regulation of Takeovers.......................................................................213
F. Preemption Review............................................................................................................214
G. Dormant Commerce Clause Review..................................................................................215
XXIV. CORPORATE DEBT........................................................................................................219
XXV. New Class: Business Transactions...............................................................................221
A. Forms of Business Entities:................................................................................................221
B. Comparing Partnerships and Corporations (Knipprath Analysis).......................................224
XXVI. Federal Securities Law...................................................................................................225
A. Financial Markets Do 3 Things...........................................................................................225
B. Different Markets................................................................................................................225

C. Equity Markets...................................................................................................................227
D. Regulatory Framework.......................................................................................................229
E. Distribution of Securities.....................................................................................................230
F. Public Offerings vs. Private Offerings.................................................................................232
XXVII. DISCLOSURE AND FAIRNESS: FEDERAL SECURITIES REGULATION...................234
A. Definition of a Security.......................................................................................................234
B. § 17 Anti Fraud Provision...................................................................................................244
XXVIII. III. Liability under 1933 Act...........................................................................................245
A. 1. Section 11......................................................................................................................245
B. 2. Section 12(a)(1) .............................................................................................................246
C. 3. Section 12(a)(2).............................................................................................................246
I. Overview of Business Associations

A. Are Corporate Lawyers Necessary?
1. Divide the Pie – The Bigger Slice Theory
Lawyers help business owners gain a larger share of the venture. This only works if your lawyer
is better than the other party’s lawyer. Eventually everyone gets an equally competent lawyer;
and then all the lawyers do is take a piece of the deal away from the parties.
2. Expand the Pie – Reduce Transaction Costs Theory

Typical Transactions Costs:
(a) Search costs (cost to find a business partner;
(b) Bargaining costs: defining and agreeing on terms acceptable to all parties;
(c) Enforcement costs: measuring what has been exchanged and ensuring the parties honor the
agreements.
(d) Opportunism costs: (Alaska Packers’ Assn. v. Domenico) when the other party tries to
hold you up for more money knowing that you have no real alternative.
Theoretically, a lawyer can help reduce the first three types of transaction costs by narrowing the
search for partners, understanding the essence of the transaction and thereby shortening the
bargaining period, and by understanding the law and ensuring that any agreement is enforceable
under the law.
3. Addressing Opportunism Costs Through Structure of Business Association

One way to avoid opportunism costs is to bring functions in-house. However, an employee on a
fixed salary doesn’t always see the need to work hard when the extra effort does not result in
additional income – often an employee will simply shirk their responsibilities. The simple fact is
that whenever ownership and control are separated, there is a loss of incentive to be
productive. One response is to try to bond the employee to the company by creating incentives
for the employee to work hard.
In short, in avoiding opportunism costs by bringing functions in-house, the party creates a form of
agency relationship and incurs related costs:
(a) Monitoring Costs: cost to monitor the input and output of the employee; is she being
productive?
(b) Bonding Costs: costs associated with creating the employee incentives;
(c) Residual Loss: the cost of lost productivity caused by shirking.

B. The Transaction Cost Trade-Off

1. Summary: The Choice between Market & Firm (Contracts v. Agency)
(a) Economic activity can be conducted across markets, or within a firm. The choice between
market and firm depends on which transaction costs are lower:
(b) Markets (contracts) are attractive when the costs of opportunism are lower than agency
costs
(1) Intense competition in the market (e.g., many competitors; no transaction-specific costs).
(2) High monitoring and bonding expenditures
(c) Firms (agency) are attractive when agency costs are lower than those of opportunism.
This insight was expressed by Ronald Coase, and is one of the chief contributions for which he
received the Nobel Prize.
C. Structuring a Business Association

Market vs. Firm = Contract vs. Agency = Debt vs. Equity
Market Firm
Economic Activity Contracts Agency Relationships
Capital Structure Debt Equity
Tax Deductibility of Interest
Advantages Access to Capital Markets
Payments
Disadvantages Cost of Debt Service Equity Dilution

1. Table: Rates of Return for Debt vs. Equity Investments

Debt vs. Equity Comparison of Rates of Return
Capital Bank
Contribution Loan
(Equity) (Debt) Total
Initial Investment for Startup 100 900 1,000
Bus iness Im proves 50% & is Sold

Principal to Bank 900
Interest to Bank @ 10% 90
Capital Return 510
Total Payout 510 990 1,500
Less Original Investment 100 900 1,000
Prof it on Transaction 410 90 500
Rate of Return 410% 10% 50%
Bus iness Breaks Even & is Sold

Capital Return 10
Total Payout 10 990 1,000
Prof it on Transaction -90 90 0
Rate of Return -90% 10% 0%
Bus iness Fails: Drops 50% & is Sold

Capital Return 0
Total Payout 0 500 500
Prof it on Transaction -100 -400 -500
Rate of Return -100% -44% -50%
D. Summary: Introduction to Business Associations

1. The role of corporate lawyers (and corporate law)
• Reducing transaction costs involved in doing business through a firm.
2. Transaction Costs and Business Organization

• Doing business incurs transaction costs whether done via the market (using prices as the
coordinating mechanism) or within a firm (using control as the coordinating mechanism).
• Agency Costs: result of a separation of ownership and control.
• Markets incur costs from opportunism (e.g., hold-ups), while firms incur agency costs.
The choice between doing business in markets or firms depends on which transaction
costs are lower for a given type of business.
3. Capital
• Comparing investments – Rate of Return calculations
• Comparing Debt and Equity Capital
• Divergence of interests among capital contributors: Creditors want conservative
management of the firm; equity owners prefer to take more risks.

II. AGENCY – THE BUILDING BLOCK OF FIRMS

I. Who is an Agent?
1. § 1. Agency; Principal; Agent
(1) Agency is the fiduciary relation which results from the manifestation of consent by one
person to another that the other shall act on his behalf and subject to his control, and
consent by the other so to act.
(2) The one for whom action is to be taken is the principal.
(3) The one who is to act is the agent.
2. § 3(1) General Agent

Every now and then, the Restatement of Agency (2nd) makes a distinction between acts done by
a "general" agent and acts done by a "special" agent. The Restatement defines a general agent
as "an agent authorized to conduct a series of transactions involving a continuity of
service."
3. Agent Test
1) Manifestation by the principal that the agent will act for him;
2) Acceptance by the agent of the undertaking
3) Understanding between the parties that the principal will be in control of the undertaking
Gorton v. Doty (p.1) – Mom, a teacher, lends car to High School football coach. Coach is
driving to game w/ student, has accident, is killed. Student in car sues Mom, claiming coach was
agent of Mom. Analyze this agency case.
Parties
Agent Coach
Principal Mom / Teacher /Car Owner
Third Party (3P) Injured Party / Π
Insurance only defends you up to the limits of your policy. And you are not covered for crimes
and torts.
Consent – she consented to use of the car.
Control – she conditioned use of her car on the coach driving.
The Court makes a point of her failure to tell the coach that she was “loaning” the car. Perhaps if
there had been a formalization of a borrowing, then perhaps she would have been excused.
Form vs. Substance – is this a form or a substance case? I think it’s a form case because
substantively I don’t think the mom and coach had a principal / agent relationship.
Case law in Idaho presumes that a driver is agent of the owner unless rebutted.
Mrs. Doty should have had a rental agreement w/ the coach which placed no conditions upon his
use of the car and control is his and disclaiming liability and requiring him to represent that he had
his own insurance and that he will indemnify her if there is an accident.
4. How Cases With Similar Fact Patterns are Determined Differently

Form v Substance
Risk v Control
Interpreting the Facts Differently
5. A. Gay Jenson Farms Co. v. Cargill, Inc. (p. 7)

Agency Relationship – when creditor became active participant in business, an agency
relationship was formed
Warren Grain officers raided the till and Cargill was left holding the bag. Farmers want their
money back. Since Warren was bankrupt they went after Cargill.
Court noted 9 factors of Cargill behavior that led Court to find an agency relationship.
1) Cargill’s constant recommendations to Warren by telephone;

2) Cargill’s right of first refusal on grain;

3) Warrant’s inability to enter into mortgages, to purchase stock or to pay dividends without
Cargill’s approval;
4) Cargill’s right of entry onto Warren’s premises to carry on periodic checks and audits;
5) Cargill’s correspondence and criticism regarding Warren’s finances, officers’ salary and
inventory;
6) Cargill’s determination that Warren needed “strong paternal guidance”;
7) Provision of drafts and forms to Warren upon which Cargill’s name was imprinted;
8) Financing all of Warren’s purchases of grain and operating expenses;
9) Cargill’s Power to discontinue the financing of Warren’s operations.
The Court cites R.2d (Agency) on p. 11 and says that suppliers must show an independent
business before it can be shown he is not an agent. Cargill had an agency relationship at the
point that they exercised defacto control over Warren. Warren was acting as an extension of
Cargill. Form vs. Substance: Cargill had great form but substantively they were in control.
II. Liability of Principal to Third Parties in Contract

B. AUTHORITY
1. § 7. Actual Authority (Principal  Agent)

Authority is the power of the agent to affect the legal relations of the principal by acts
done in accordance with the principal's manifestations of consent to him.
2. § 26. Creation Of Authority; General Rule

...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 principal's account.
in order to create actual authority a Principal must write, say, or do something that the Agent
could reasonably interpret as giving the Agent authority to act on the Principal's behalf.
3. Mill Street Church of Christ v. Hogan,

(The “I’ll paint the church, you paint the steeple” case.) P. 14
Authority that had been granted in the past was assumed reasonably granted under subsequent
similar circumstances absent notice to the contrary. Guy had hired his brother in the past,
assumed it was OK to do so now; church needed painting, it was his job to paint it, and he
couldn’t do it alone. Court ruled actual implied authority. Also, the brother hired by the church
(Bill) had apparent authority in the eyes of his brother, b/c he had been so authorized in the
past.
KEY QUESTION:
Is the third parties belief that the communication gave the agent the authority to enter into the
contract reasonable?
C. Apparent Authority
1. § 8. Apparent Authority (Principal  3rd Party)
Apparent authority is the power to affect the legal relations of another person by
transactions with third persons, professedly as agent for the other, arising from and in
accordance with the other's manifestations to such third persons.
To determine whether apparent authority exists we look at the principal's manifestation of consent
from the point of view of the third party, as made clear in § 27 of the Restatement:

2. § 27. Creation Of Apparent Authority: General Rule
...apparent authority to do an act is created as to a third person by written or spoken

words or any other conduct of the principal which, reasonably interpreted, causes the
third person to believe that the principal consents to have the act done on his behalf by
the person purporting to act for him.
Read sections 8 and 27 together: To create apparent authority a principal must write, say, or do
something that the third person could reasonably interpret as giving the (apparent) agent
authority to act on the principal's behalf. Apparent authority might exist even when there is no
agency relationship between the principal and the person who appears to be an agent of the
principal.
3. Lind v. Schenley Industries, Inc.

(The “Let’s screw the DM” case.) P. 16
Lind accepted a job as DM w/ 1% of gross commissions. Pretty good for the 1950’s. Of course,
the company tried to screw him out of his commission and he sued. The District Court, obviously
never having worked in retail, kept obsessing about the change in his base pay. The legal issue
was whether his boss had authority to make the offer and whether a reasonable person would
believe the offer. Answer: yes and yes b/c it was his direct boss and when you figure in total
earnings per annum the jump was commensurate w/ his increased responsibilities.
Lind talked to the big cheese of sales – Herrfeldt, who welcomed him and sent him to Kaufman
for the details. Did Herrfeldt do something to make Lind believe that Kaufmann was
authorized to do the deal? Yes, he said, “Go see Kaufmann and he’ll explain your salary to
you.” And then Lind went to Kaufmann and Kaufmann indeed did tell him his salary. Apparent
authority existed to bind the company. Also, the discussion between Lind and the president of
the company wherein the two discussed applying the commission toward the purchase price of a
plant that Lind wanted to buy from the company. So, that could be indicative of ratification by
the company.
4. Three-Seventy Leasing v. Ampex

(The “Hard time about the hard drives” case.) P.22
apparent authority – it is reasonable for parties to believe a salesman has authority to bind
employer to sell. Buyer was never informed that salesman did not have authority to make
sale, therefore letter confirming delivery date was construed to mean sale occurred
binding defendant
Π made deal to buy and simultaneously lease out some computer drives; they were basically
middleman on an equipment leasing deal. Correspondence was received from Ampex confirming
the order, so even though they never signed a contract, π reasonably relied on their
representation. It was reasonable to believe that the sales guy from Ampex had authority to sell
drives. Credit check bs later on was not π’s issue, Ampex should have gotten their approval
process straight b/c they represented to π that he had a deal. Ampex credit department was
worried about lending such a large sum to a one-man company with 5 year terms. Ampex could
have put on the form “not valid without proper signature of officer” to let all parties know that the
agent did not have authority to sign for the company
D. Inherent Authority
1. Inherent Authority (Agent  3rd Party Foreseeable Act By Agent)

Inherent authority is authority to take an action that a reasonable person in the principal's position
should have foreseen the agent would be likely to take, even though the action would be in
violation of the agent's instructions.
Inherent authority involves situations where an agent creates liability for the principal simply
because of an act done or a transaction entered into by an agent -- even though the act or

transaction was not actually or apparently authorized and there is no tort, contract, or restitutional
theory upon which the liability can be grounded.
2. Watteau v. Fenwick (The I Feel Your Pain Case) P. 25

apparent authority – while Humble did not have actual authority to purchase cigars, the
plaintiff had no reason to believe that he did not. The establishment appeared to be the
Humble’s establishment and the cigars would have been bought in the normal course of
business. The revelation that Humble was actually an agent for the defendant owner and
did not have authority to buy cigars does not relieve the actual owners of the obligation to
pay for the cigars.
Because of undisclosed principal, there could be no case for apparent authority. So, the
Court invented inherent authority.
FACTS: mgr beerhouse, name over the door, owned by the D’s. He had no authority to buy any
goods for the business except bottled ales and mineral waters, however he bought, on credit from
the Plaintiff other stuff
HELD: The principal is liable for all the acts of the agent which are within the authority
usually confided to an agent of that character, notwithstanding limitations, as between the
principal and the agent put upon that authority. If you give a manager/ agent a “secret limit”
which he knows but the outside world does not the principal will still be bound.
Issue 1: Was Humble an agent of Watteau’s?
Three part test (acting on behalf of principle, subject to control by principle, agent consents to
arrangement).
Defining an agent
Agency is the fiduciary relationship which results from the manifestation of consent by one
person to another that the other shall act on his behalf and subject to his control, and consent by
the other so to act. Restatement of Agency 2nd, § 1.
In other words:
1. Consent- can be either express or implied (but needs to be mutual consent in order
to have an agency relationship, can’t force someone to be an agent)
2. Benefit- the principal must benefit in some way from what the agent is doing for them
(the agent does not need any benefit but usually does like pay)
3. Control- how much control by the principal will determine the type of agent (i.e.
master and servant for tort liability).
Note: An agency relationship can be entirely voluntary and does not require
compensation from the principal to the agent.
Conclusion: Yes.
Issue 2: Did Humble have authority to purchase cigars and Bovril from Fenwick?
Actual Express Authority? No.
Actual Implied Authority? No. It was specifically prohibited.
Apparent Authority? No. Fenwick did not even know of Watteau’s connection to Humble at the
time of the transaction.
Inherent Authority? Apparently, yes.
Fenwick thought he was dealing with Humble, and gave him credit without checking his financial
situation and asking for guarantees of payment. Now, seemingly in a windfall, he gets Watteau
as a ‘guarantor’. Justifications for this rule?
Justifications for this rule?

Cheaper cost avoider (preventing principal from hiding behind agent to shirk from policing the
agent).
Principal can sue agent (if he can find him).
Restatement §194: “A general agent for an undisclosed principal authorized to conduct
transactions subjects his principal to liability for acts done on his account, if usual or necessary in
such transactions, although forbidden by the principal to do them.”
Restatement §195: “An undisclosed principal who entrusts an agent with the management of his
business is subject to liability to third persons with whom the agent enters into transactions usual

in such businesses and on the principal’s account, although contrary to the directions of the
principal.”
3. Kidd v. Thomas A. Edison, Inc. (The Is It Live Or Is It Memorex? Case) P. 28

INHERENT AUTHORITY is authority to take an action that a reasonable person in the
principal's position should have foreseen the agent would be likely to take, even though
the action would be in violation of the agent's instructions.
APPARENT AUTHORITY – must measure scope of agent’s authority not merely by words
used but the setting in which they were used, including customary powers of that type of
agent. Singer misunderstood terms and relied upon misunderstanding, agent’s manner of
work was misunderstood but binding to principal.
FACTS: Kidd signed recital tour. Edison’s agent not authorized to contractually bind Kidd for
regular non-Tone-test recitals. Kidd assumed that he was so authorized and detrimentally relied
on that assumption.
Hand’s characterization liability for acts of agents arises from status and not authority.
HELD: This is not an apparent authority argument. There has been no communication between
the principal and the 3rd party. No statement of “Fuller’s our man; deal with him.”
Instead this case deals with inherent authority. If the corporation puts someone out there as
its agent, the corporation bears a risk as principal that It has clothed its representatives
with a certain status so that it becomes liable for the actions its representatives takes that
would seem to be within that authority. This is how it was always done in that business. So,
Edison had to compensate Kidd for failing to give her the tour she expected. Merely putting an
agent out in the field is indirect communication to a 3rd party, thereby distinguishing it from
apparent authority’s direct communication between principal and the third party. If P has
reasonable grounds that is sufficient for agent to bind principal (customary in business, incidental
to transaction)
Kidd could have called the company and checked out Fuller’s status. Find out who had
authorization from the Board of Directors. Edison could have printed form agreements in
advance stating the limitations of the agreement.
What if PR knows agent is flaky & may bind co in undesirable way? Form K & tie bonus to use of
K or consider if risk of hiring ee is worth it thereby recognizing that PR responsible for agents
actions
Edison hired Fuller to engage singers for promotions of its phonograph records. Maxwell, an
Edison’s employee, told Fuller that Edison would act as a booking agent and guarantee payment
of the dealers who will agree to hire the singers for recitals, as well as cover the singers’ travel
expenses. Maxwell was also told to contract with the singers himself, and not bring them to
Maxwell. Fuller engaged Kidd, but Kidd proved that Fuller offered her a singing tour.
The usual custom in the industry was to promise a full singing tour (as Kidd claimed Fuller
promised her).
4. Nogales Service Center v. ARCO (The Pumped for Success Case) P. 31

Inherent authority is authority to take an action that a reasonable person in the principal's
position should have foreseen the agent would be likely to take, even though the action
would be in violation of the agent's instructions.
NSC wanted to build a truck stop. ARCO lent them money and signed an agreement to supply
their fuel. After facing financial difficulties, Terpenning, one of the owners of NSC, agreed orally
with Tucker, ARCO’s manager of truck stop marketing, that ARCO will lend NSC additional
money, receive a 1¢/gal discount on diesel fuels, and that ARCO will keep NSC “competitive”.
ARCO approved the loan application but not the diesel discount. ARCO sued after NSC
defaulted on the loan, and NSC counter-claimed compensation for not providing the discount
Tucker agreed to.

NSC loses for procedural reasons. But this case is useful to understand subtleties between
apparent and inherent authority. What sort of evidence would support apparent authority?
Inherent Authority? Terpenning could have asked for a signature from a higher-up at ARCO.
What Sort Of Evidence Would Support Apparent Authority? Inherent Authority?
Apparent Authority
Statements from Tucker’s superiors stating that Tucker is the person with whom to make the
deal; Evidence of other people who dealt with Tucker in similar deals and knew or believed he
had authority.
Inherent Authority
Prove it is an industry custom that agents such as Tucker have the authority to grant modest
price discounts (such as the one NSC got).
Why did NSC appeal the case just to contend the failure to instruct the jury on inherent authority?
To keep their options open.
What do you need to show with inherent agency? Because inherent agency allows you to cast a
broader net and look at industry standard. You are no longer limited to what the principal did or
represented in that same deal. You can now look at other service stations in the same area and
see what kind of discount that they got. Π wants to show that persons in Tucker’s position
normally have authority to give such discounts. You want to look for statements by ARCO that
Tucker was their “go to” guy for these affairs.
E. Authority Summary
Actual authority -- the agent reasonably interpreted manifestations of consent form the principal
that the act was authorized;
1. Apparent Authority – Elements:

1) Manifestations by the principal to a third party
2) That are the source of:
3) The third party’s actual belief that the agent has authority to act; and
4) The third party’s reasonable belief that the agent has authority to act.
2. Mitigating Risks of Apparent Authority

1) Attack elements 1 & 2:
a. Train employees (Herrfeldt/Kaufmann/Mueller/Kays) not to make representations of
authority;
b. Insist that employees only offer written contracts requiring signature of an authorized
person, or making explicit scope of authority.
2) Attack elements 3 & 4:
a. Make third parties belief of authority unreasonable by giving notice (actual or
constructive);
b. E.g., develop a publicly-available employee manual with clear rules as to who has
authority to what.
Inherent authority -- an agency relationship existed, although it may have been limited, but the
principal should be liable for the acts of the agent that are reasonably foreseeable.
3. Inherent Authority
1) Restatement, §8A: “Inherent agency power is a term used… 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.
2) Inherent authority requires an agency relationship, but doesn’t look to the principal at all as a
source for authority.

3) Why do we have inherent authority?

a. A cynical view: The people writing the restatement faced case law that did not fit into
existing categories (actual authority, apparent authority, estoppel or ratification).
They created a new category (inherent authority) to explain these cases.
4) How to analyzel with inherent authority:
a. Identify the situations in which case law tends to find inherent authority. If you face
such a situation, suggest application of inherent authority and analogize to the case
law.
5) Situations likely to invoke inherent authority:
a. Undisclosed principal [Restatement §§194, 195];
b. Disclosed general agent asserting authority that is in line with industry norms
[Restatement §161].
c. Restatement §161: “A general agent for a disclosed or partially disclosed principal
subjects his principal to liability for acts done on his account which usually
accompany or are incidental to transactions which the agent is authorized to conduct
if, although they are forbidden by the principal, the other party reasonably believes
that the agent is authorized to do them and has no notice that he is not so
authorized.”
d. General Agent – an agent authorized to conduct a series of transactions involving a
continuity of service [Restatement §3(1)]. Otherwise, agent is a ‘special agent’.
F. Ratification
1. § 82Ratification Defined
Restatement §82: The affirmance by a person of a prior act which did not bind him but which
was done or proffessedly done on his account. Ratification requires acceptance of the results of
the act with an intent to ratify, and with full knowledge of all the material circumstances.
2. Ratification Test
1) Was the act done on the party’s behalf?
2) Did the party accept the act or the benefits of the act?
3) Did the party have full knowledge of all the material circumstances?
3. Ratification Questions
What types of acts constitute an affirmation by the principal?;
What affect should we give to that affirmation?
1. Ratification requires acceptance of the results of the act with an intent to ratify, and with full
knowledge of the material circumstances.
2. Examples Of Affirmance:
a. Express Affirmance;
b. Implied Affirmance By:
i. acceptance of benefits of the transaction at a time in which it is possible to
decline the benefits; also,
ii. no implied affirmance if principal has reasonable claim to the benefits other
than due to the transaction;
iii. Implied affirmance through silence or inaction;
iv. Implied affirmance through bringing a lawsuit to enforce the contract.
4. Botticello v. Stefanovicz (What Do You Mean I Bought Half A Farm?) P. 36

Ratification requires the agent to have acted on behalf of the party, the party must either
expressly ratify, or accept the benefits of the act with full knowledge of the consequences.
Husband and wife are half owners of farm. Π discussed purchase of farm with husband and wife,
haggled over price, and eventually executed a lease to own transaction with the husband. Π, an
experienced real estate businessman, did not do a title search and was unaware of wife’s part

ownership. After lease, ∆ refused to transfer title due to wife’s refusal. Trial court ruled that
husband was agent of wife and that wife ratified. Appellate court reversed because the wife
manifested no intent to have the husband act on her behalf nor did she manifest any intent to
ratify.
5. Ratification: Limits on Valid Affirmance

1) Ratification is an all-or-nothing process. A principal must affirm the entire transaction or
repudiate it entirely.
a. Creative bypass: Breaking up the transaction into a series of severable
transactions (each of which can be affirmed or repudiated), or combining several
transactions into one (to force the other side into all-or-nothing).
2) Affirmance is valid only if at the time of the alleged affirmance the principal knew all material
facts (facts which substantially affect the existence or extent of the obligations involved in the
transaction).
3) A transaction can only be ratified if the principal could have entered it both at the time the
agent acted and the time the principal affirmed.
4) If ratification results in harm to innocent third parties, they may receive an option to deny the
ratification. Typically, this occurs when there has been a material change between the time
of the transaction and the time of the affirmance.
a. Example: A sells P’s house without authority. P’s house then burns down. P
cannot ratify the sale.
6. Ratification’s Effect on Authority

1) Ratification without notice to T that A was unauthorized may result in A
having apparent authority in future similar transactions.
2) Similarly, no notice to A that the act was unauthorized may result in
actual implied authority.
3) Restatement §43:
a. Acquiescence by the principal in conduct of an agent whose previously conferred
authorization reasonably might include it, indicates that the conduct was
authorized; if clearly not included in the authorization, acquiescence in it
indicates affirmance.
b. Acquiescence by the principal in a series of acts by the agent indicates
authorization to perform similar acts in the future.”
G. Estoppel
1. §8B Estoppel Defined:
1) A person who is not otherwise liable as a party to a transaction purported to be done on his
account is nevertheless subject to liability to persons who have changed their positions
because of their belief that the transaction was entered into by or for him, if:
a. he intentionally or carelessly caused such belief, or
b. knowing of such belief and that others might change their positions because of it, he
did not take reasonable steps to notify them of the facts.
2) An owner of property who represents to third persons that another is the owner of the
property or who permits the other so to represent, or who realizes that third persons believe
that another is the owner of the property, and that he could easily inform the third persons of
the facts, is subject to the loss of the property if the other disposes of it to third persons who,
in ignorance of the facts, purchase the property or otherwise change their position with
reference to it.
3) Change of position… indicates payment of money, expenditure of labor, suffering a loss or
subjection to legal liability.”

2. Estoppel Defined in Plain English:

1. Act or omission of principal leads public to believe 3rd party isacting as agent of principal;
2. 3rd Party relies in good faith;
3. 3rd Party changes postion.
3. Hoddeson v. Koos Bros. (The Phantom Furniture Salesman) P. 40

A merchant must take reasonable care to protect its customers from the harmful acts of 3rd
parties acting on the merchant’s premises.
Woman pays clerk in furniture store cash and he tells her the furniture must be ordered. Months
later store denies any record of the order. No one can find the phantom salesman. Trial court
rules that the phantom was an agent of the store. Appellate court reverses because no indicatin
that the store wanted him to act on their behalf. Failed agent test. But, they remanded with order
for a new trial recommending π pursue an estoppel argument because a furniture store has a
duty to protect their customers by doing “more than the dilligent observance and removal of
banana peels from the aisles.” How could they have an imposter operating in their store
swindling reasonable customers? Fallback position: if you’re Hoddeson’s lawyer, be sure to
make an argument for apparent authority.
H. Agent’s Liability on Contract

1) Disclosed Principal - No liability unless:
a. Clear intent of parties that agent will be bound (Rest. §323); or
b. Agent made contract without authority – the legal basis:
i. Party to the contract? In few states. Rest. rejects this basis (Rest. §328)
ii. Fraud/deceit? In some states. Rest. §330 allows this basis.
iii. Implied warranty of authority? In most states. Rest. §329 adopts this – third
party entitled to “amount by which he would have benefited had the authority existed.”
2) Undisclosed of Partially Disclosed (Unidentified) Principal
a. Agent treated as a party to the contract.
b. Third party must elect who to sue – agent or principal.
1. Atlantic Salmon A/S v. Curran (The Fishy Fish Dealer) P. 43

When an agent acts on behalf of an undisclosed or partially disclosed principal, he is a
party to the K unless he specifically discloses his role as an agent and structures all K’s
as between 3rd parties and the principal
Fish dealer never incorporated. Held himself out as a corporation, ran up bills, then tried to claim
he was an agent for a defunct holding company with no assets. When an agent acts on behalf of
an undisclosed or partially disclosed principal, he is a party to the K unless he specifically
discloses his role as an agent and structures all K’s as between 3rd parties and the principal.
1) What could Curran do to protect himself from liability?
a. Revive his corporation sooner and change its name. Easy to do, though it would
have done little good for Atlantic Salmon.
2) What could Atlantic Salmon do to prevent the need to litigate to enforce their claims?
a. Do a credit check of the corporations;
b. Demand a personal guarantee by Curran.
I. Summary – Agency Relationship/Liability of Principal in Contracts

1. The Principal-Agent Relationship
a. Three-part test;
b. Creditors dilemma regarding control.
2. Liability of P in Contracts – Depends on existence of authority:
a. Actual Authority (express or implied): P’s behavior causes A to reasonably
believe she has authority.

b. Apparent Authority: P’s behavior causes T to reasonably believe he has

authority.
c. Inherent Authority
i. Undisclosed Principal
ii. Disclosed general agent asserting authority that is in line with industry
norms
d. Ratification
e. Estoppel
3. Liability of Agent in Contracts
III. Liability of Principal to Third Parties in Tort

J. What is the Justification for Imposing Liability?
1. Justifications
1) Make injured party whole
2) Deep Pockets – Principal may be more solvent than agent
3) Risk Spreading – Even if the principal is not more solvent than the agent, two pockets are
bigger than one.
4) Mitigate likelihood of future injuries by creating incentives for an efficient level of care
5) Control – Insolvent agents are out of tort law’s reach and are thus undeterred; but if P is
able to control A, he could force A to be careful (affects A’s level of care);
6) Interest in or familiarity with A – P is likely better able to prevent A’s torts, or recoup for
A’s negligence, than the injured party (affects P’s level of care);
7) Appearances – Liability if principal creates appearance of responsibility (affects injured
party’s level of care).
2. Flaws in the justifications: Counter-Arguments to Tort Liability of Principal to 3rd

Parties
a. Deep Pockets/Risk Spreading – No guidance as to which deep pocket should
cover the loss. Why shouldn’t government pick the tab?
a. Liability forces P to control A more than he would otherwise want; result – less
hybrid business structures.
b. Control/Interest – Insolvency problem can be solved by forcing A to insure
liability. Insurer will then have incentive to control A;
c. Appearances – Same result could be achieved without liability (P’s that want T’s
to rely on their reputation would provide express guarantee).
3) One can make counter-counter arguments…
3. Counter-Counter-Arguments to Tort Liability of a Principal to 3rd Parties

a. Deep Pockets/Risk Spreading – This interest can be coupled with the control or
appearances arguments, which indicate what deep pocket should bear the
burden.
a. Less hybrid business structures – P doesn’t consider T’s interests in choosing
the business structure (externality).
b. Insurance – Who will monitor A’s to ensure that they have insurance?
c. Appearances – Often an express guarantee is awkward to provide (how do you
know that A has authority to provide P’s guarantee?)
The bottom line: Law regards control as a decisive factor.

4. Format for Analysis – Focus on Control Elements

1) Is A an agent of P?
a. Yes – Is A as servant of P, or an independent contractor? [General Rule: §220(1);
specific tests: §220(2)]
i. Servant – Was the tort committed within the scope of A’s employment?
[General Rule: §228; specific tests: §229(2)]
1. Yes – P is liable for A’s tort [Rest. §219(1)].
2. No – Does situation fall into an exception [Rest. §219(2)]?
a. Yes - P is liable for A’s tort.
b. No - P is not liable in agency law for A’s tort.
ii. Independent Contractor – Does situation fall into an exception?
1. Yes - P is liable for A’s tort.
2. No - P is not liable in agency law for A’s tort.
2) No Not an Agent of P = P is not liable in agency law for A’s tort.
K. Servant Versus Independent Contractor

1. Humble Oil & Refining Co. v. Martin
Master-Servant Relationship - …strict system of financial control with little or no business
discretion.
FACTS: M hit by an unoccupied car left at the station. The court held Humble responsible,
because it owned the station, and the principal products sold there. Despite fact that the station
employees did not consider Humble master, employees were paid and directed by Schneider as
their “boss”, and part of the agreement repudiates any authority of Humble over the employees.
The deal was terminable by Humble at will.
HELD: Schneider is a commission salesman and not the sole proprietor. Litttle control for
Schneider (who hired, fired, & supervised). There was a provisions for Schneider to make
reports and perform other duties required of him by the company. Humble is required to pay 75%
of the public utility bills. The title of the products remained with Humble until delivery to the
consumer. Humble furnished the location, equipment, and advertising. The hours of operation
were determined by Humble as well.
Low cost avoider of accidents (“Leonard” Hand theory)
-argument can be made that Schneider or Humble had the lowest cost. Schneider is on site and
deals with the actual employees on a daily basis.
-Humble could enact stricter regulations (rules), and also could purchase insurance. However
checking up on these rules would be a difficult task for Humble because spot checks are
inefficient.
-An alternative is to have Humble buy insurance and Schneider contribute or have Schneider
indernify Humble.
2. Hoover v. Sun Oil Company

Independent Contractor – lease agreement and dealer’s agreement fail to establish any
relationship other than landlord-tenant
FACTS: P’s car caught fire and suit was brought against Sunoco. Sunoco owned the station and
almost all the equipment. Sunoco and Barone entered an agreement where petroleum products
were to be purchased from Sunoco, and Sunoco was to lend equipment and advertising
materials. Barone could have sold competitive products. Barone could have sold competitive
products. Barone could only sell Sunoco products under their label, and could not blend them
with other products.
The station had large Sunoco signs and advertised under a Sunoco heading in the telephone
book, employees wore uniforms with Sunoco’s emblem. Barone attended a service school for
Sunoco service operators. Sunoco sent a representative to inspect weekly, and allowed Barone
to meet local competition by offering rebates on gas. Either party can terminate lease on 30 days
notice.

Barone made no written reports to Sunoco, and assumed overall risk of loss. He determined
the hours of operation (and was held o be liable, where in Humble Schneider did not control
hours of operation and Humble was responsible), pay scale and working conditions, and it was
his name listed as the proprietor.
HELD: Barone is an independent contractor, because Sunoco had no control over the details
of the day to day operation.
CARNEY: A strong point can be made for Sunoco’s control. Sunoco does not explicitly reserve
the right to tell Barone what to do, but they can still “strongly” suggest things, and Barone will
jump.
The contract (independent contractor) is intentionally written so that language is at odds with the
relationship (master-servant) which the company wants.
3. Murphy v. Holiday Inns, Inc.

Agency Relationship – franchise agreement did not give defendant sufficient control to
form an agency relationship
FACTS: P sued Holiday Inn for injuries suffered when she slipped on an area of a walk
Betsy-Len used name Holiday Inn, trade marks, architectural designs, color designs,
equipment, advertisements, & method of operation. For this Betsy-Len had to pay sum of $5,000
and construct inn in accordance to plans of a contractor . The business is conducted under a
system, in which a manual or handbook provides a tremendous level of detail and specificity.
Holiday Inn is not the owner, but Betsy-Len is. Betsy-Len had control “where it counted” over
profits, business expenditures, rates, hiring and firing, and actual ownership of building
and lot. Therefore the end of the franchise relationship would not be disaster for Betsy-Len.
A franchisee relationshop (the franchise enjoys the right to profit and runs the risk of loss). But
Holiday Inn does get a cut of the per-day charge for rooms and this money is used for
advertisements, etc….
HELD: Holiday Inn had no control or right to control the method or detail of doing the
work, therefore no principal-agent or master-servant relationship. No control of day-to-day
operation of hotel. No power to fix expenditures, fix rates, or demand part of profits. Maintaining
and regulating the architectual style is not enough.
If franchisor desires to have full control, but also to limit its liablity, it can force franchisee to “save
and hold harmless” franchisor (which is not an attempt to limit franchisor’s liability but is merely a
means by which franchisee will reimburse franchisor in the event of a judgment against the
franchisor). Blen extensive freedom to run its business as long as it abides by quality
control issues.
*Risk: hi Risk ; Return:Blen; Control: Blen ultimate control; Duration:
* even if disclaimer master/servant relationship can arise as matter of law if franchisor reg/control
active of f’ee w/in def of agency-agency rel arises
*diff w/Humble is that Schneider only rt to occupy; Blen owns own motel &has ultimate control
Murphy v. Holiday Inn (19; Va. 1975): slip-and-fall case, hotel guest sues HI chain, which
disclaims liability b/c of franchise K b/w HI and franchisor (Betsey-Len Corp.)
held: even though a franchise K, and parties expressly deny existence of agency relationship,
agency relationship may be created if the franchisor has control with respect to regulation of the
franchise
application: here, insufficient indicia of HI’s control of the operation of the hotel
no agency relationship b/w HI and Betsey-Len, ∴ HI not liable to guest in tort
liability in contract revolves around whether there is authority
L. Tort Liability and Apparent Agency
1. Billops v. Magness Construction Co. p. 58 (Ballroom Banquet Bust)

Apparent Authority – franchisor found to exercise day-to-day control via detailed
operating manual, enforceable by unilateral termination of the operating agreement for
violations. Manifestations by the alleged principal which create a reasonable belief in a

third party that the alleged agent is authorized to bind the principal create an apparent
agency…franchisee is the agent of the franchisor.
FACTS: The banquet direct of Brandywine Hilton Inn wrongfully attempted to extort funds in
addition to those previously paid by Plaintiffs for the use of one of the Inn’s ballrooms (by
inadequately heating the ballroom…).
ISSUE: Did a principal/ agency relationship existed between The Brandywine Hilton Inn and the
Hilton Corporation?
HELD: Because of ample evidence of authority, franchisee was the agent of the franchisor.
This evidence for actual authority is: a corporate manual, regulating advertisement, office and
cleaning staff procedures, financial records, inspection of hotel by franchisor. More substantial
evidence for apparent authority includes, the Hilton logo and sign displayed exclusively, and more
importantly, the reliance of the plaintiffs for the quality of the Hilton name. There can not be
apparent authority to commit a tort. This is not, in the realm of tort, a principal-agent relationship,
but a master-servant relationship. Therefore it is important to determine how much physical
control Hilton Inc. had over Brandywine Hilton.
If Hilton wanted to disassociate themselved from the Brandywine they could have taken steps to
vertify a certain level of quality, but retain indivudally owned franchises through such steps as not
requiring uniform appearance (like Great Western).
*Similar to oil corp case which depends on control of day to day operations
Class Notes 1/16/04
Issue is control. Control was used in Holiday Inn case to discuss the nature of the relationship.
Similar to Cargill. So, nothwithstanding the way you’ve structured your documents, you are
liable. That was in Holiday Inn and Cargill. But, in this case, the form of the relationship seems
more important to the court. The Court is worried about how customers viewed the agent
relationship and concludes that most customers thought they were at a Hilton hotel and that
Hilton was in charge. So, the question was, what did Hilton do to manifest its relationship as
master over Magness.. These are different questions from the past two cases which focused on
whether there was enough day-to-day control. Here, it’s all about what the public perceives and
whether Hilton actively fostered the public perception. Apparent authority is the key issue.
M. Scope of Employment
1. General Rule
1) Restatement §228(1): A’s conduct is within the scope of employment if:
a. It is of the kind A is employed to perform;
b. It occurs substantially within the authorized time and space limits (if not - it is a
“frolic and detour”);
c. It is actuated, at least in part, by a purpose to serve P;
d. If force is intentionally used by A against another, the use of force is not
unexpectable by P.
2) Restatement §229(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.”
3) An act may be within the scope of employment even if it is:
a. Forbidden or done in a forbidden manner (Restatement §230);
b. Consciously criminal or tortious (Restatement §231).
2.
3. Ira S. Bushey & Sons, Inc. v. United States p. 61 (Whoops, I Sank The Tamaroa)
PURPOSE OF SERVING THE PRINCIPAL TEST for agency (p. 63): An employer may be
held liable for an employee’s actions if the actions were taken in a motivated by serving
the company interests.
FORSEEABILITY TEST for agency (p. 64): A subset of respondeat superior. If an
employee acts in a foreseeable manner for which the employer could have taken

reasonable preventive measures but failed to do so, the employer is liable for the
employee’s actions.
p. 61. Drunken sailor returning from leave turns valves, floods drydock, sinks ship in drydock,
causing major damage. Π sues, alleging sailor was agent of United States Coast Guard and
therefore principal is liable for his actions. Court says no, because it was not conceivably in the
scope of the sailor’s duties. They also said “no” to the motivation test. But, the court said that the
Coast Guard was still liable because it is reasonably foreseeable that a drunken sailor would
come back and mess with the valves.
Class update 1/16/04
The forseability is not tortious, like as in negligence. More like in workers’ compensation. Not like
burning a bar in town which is not something in the scope of a sailor’s employment that the Navy
could protect against. But, the sailor had to walk past the valves to get back to the ship. So
he was in the scope of his employmen to walk past the valves and therefore it’s pretty easy
to forsee that some drunk sailors would walk by those valves.
4. Frolic and Detour

Clover v. Snowbird Ski Resort
Chef in ski resort leaves restaurant, takes four runs, then starts to head down the mountain to
another restaurant. He launches himself into an unsafe jump, landing on and injuring plaintiff.
Apply §228(1)’s test.
Q: Why isn’t this a ‘frolic and detour’?
A: Not a “total abandonment of his employment”.
5. Clover v. Snowbird Ski Resort p. 65 (Ski Chef Souffles Tourist)

Utah Court Rejects The Bushey Forseeability Test And Maintains Purpose Of Serving
Principal Test.
p. 65 Chef at ski resort skis recklessly and causes serious injury to π. Trial court granted
summary judgment in favor of ∆ on the theory that the chef was not within the scope of his
employment. The Utah Supreme Court reasoned that the only way the chef was outside the
scope of employment was if the brief detour to ski dangerously was so short that he had
abandoned his job; so they reversed and remanded for trial. The Court rejected the motivation
test and also the forseeablilty test from Bushey as not good law in Utah.
6. Manning v. Grimsley P. 66 (Bonehead Ballplayer Beans Boorish Spectator)

Employee Acts Taken In Response To Customer Conduct Interfering With The Employee’s
Performance Of His Work Are Acts For Which The Employer Is Liable.
p. 66 Grimsley, a pitcher for the Baltimore Orioles, hurled an 80 mph ball at the backstop right in
front of some fans who had been heckling him and at whom he had been glaring. Ball went
through the backstop and injured a fan. Because Grimsley was reacting to a customer
interfereing with his job activities, the Baltimore Orioles were held liable for his actions.
7. §219(2): Liability of Principal for Servant’s Actions When Not Within Scope of
Employment
A master is not subject to liability for the torts of his servants acting outside the scope of their
employment, unless:
1) The master intended the conduct or the consequences; or
2) The master was negligent or reckless; or
3) The conduct violated a non-delegable duty of the master; or
4) The servant purported to act or to speak on behalf of the principal and there was reliance
upon apparent authority, or he was aided in accomplishing the tort by the existence of the
agency relation.

N. Statutory Claims
1. Arguello v. Conoco p. 69 (Racist Comments by Store Clerks)
Employee acts taken in response to customer conduct interfereing with the employee’s
performance of his work are acts for which the employer is liable.
Two types of allegations of racial discrimination against Conoco:
1) Smith, a cashier at a Conoco-owned store, refused to recognize customers’ ID, and
in argument uttered racial slurs and obscenities at one group of the plaintiffs.
a. Conoco’s defense: employee animated by personal prejudices and therefore
acting outside scope of employment.
b. Court rejects non-delegable duty argument [see Rest. §219(2)(c)], but finds
summary judgment dismissal inappropriate. Duty not to discriminate is non-
delegable so that Conoco cannot be liable for franchisee’s failing to control
discrimination.
c. Π also argued that by not firing the employees who made the racist comments,
that Conoco had ratified the conduct. But, the employees were counseled so the
ratification argument did not work; the court said no on that theory.
d. Compare to the intentional torts line of cases (Manning/Lyon/Haddon).
2) Employees at Conoco-branded (but not owned) stores refused to serve minority
customers and insulted them.
a. Conoco’s defense: No agency relationship with Conoco-branded stores.
b. Court agrees. Affirms grant of summary judgment.
c. Compare analysis to Humble Oil/Sun Oil.
2. Scope Of Employment Factors:

1. The time, place and purpose of the act;
2. Its similarity to acts which the servant is authorized to perform;
3. Whether the act is commonly performed by servants
4. The extent of departure from normal methods; and
5. Whether the master would reasonably expect such act would be performed
O. Liability for Torts of Independent Contractors
1. General Rule: Principal Not Liable For Torts Of Independent Contractor.

Exceptions:
1) Principal retains control over the aspect of the activity in which the tort occurs (in that case –
P is a master);
2) Principal employs incompetent independent contractor [Rest. §213, §219(2)(b)];
3) Is a financially irresponsible contractor an incompetent one?
4) Performance of contractor’s task is inherently dangerous;
5) Duty is non-delegable [Same rationale as Rest. §219(2)(c)]. A duty so important to the
community that the principal may not delegate (usually applies to certain statutory duties).
2. Majestic Realty v. Toti Contracting p. 78 (Wrecking Ball Wrecked Target + Bldg

Next Door)
I. Principal can be held liable for actions of independent contractor if:
1. P retains control of the manner and means of the doing of the work
2. P engages an incompetent contractor
a. Dicta: Is hiring a financially incompetent contractory incompetent?
b. Capacity to respond in damages does not determine liability; contractors can easily
retain liability insurance.
c. Financial responsibility may become an issue; court couldn’t address b /c not in
brief.

3. The activity constitutes a nuisance per se (i.e. inherently dangerous activity)

II. Some duties may not be delegated.
p. 78 Plaintiff’s property was destroyed as a result of the demolition work of a city contractor.
The court discusses several theories of vicarious liability, especially the city’s potential duty to
hire a competent independent contractor. This competency might include financial solvency as
well. In this case there were two innocent parties: the city and the plaintiff. Although neither had
any control of the work, the city at least had the ability to choose the independent contractor.
Although principals are not normally liable for their independent contractors, there are three
exceptions:
 where the landowner retains control of the manner and means of the doing of the work
 where he engages an incompetent contractor
 where the activity constitutes a nuisance per se (i.e. superhazardous activity)
Here, the case was remanded to determine whether the contractor was competent.
Note that employers, even if liable, can still seek indemnification from the tortfeasor
contractor/agent.
IV. FIDUCIARY OBLIGATIONS OF AGENTS

P. Duties During Agency
(a) §13 Fiduciary: “An agent is a fiduciary with respect to matters within the scope of his
agency.”
(b) Fiduciary duties include:
(1) Duty of Care [Rest. §379];
i) Rest. §379(1): “Unless otherwise agreed, a paid agent is subject to a duty to the
principal to act with standard care and with the skill which is standard in the locality
for the kind of work which he is employed to perform and, in addition, to exercise any
special skills that he has.”
ii) Rest. §379(2): “Unless otherwise agreed, a gratuitous agent is under a duty to the
principal to act with the care and skill which is required of persons not agents
performing similar gratuitous undertakings for others.”
(c) Other related duties:
(1) Duty of good conduct [Rest. §380]
(2) Duty to give information [Rest. §381]
(3) Duty to keep and render accounts [Rest. §382]
(4) Duty to act only as authorized [Rest. §383]
(5) Duty not to attempt the impossible or impracticable [Rest. §384]
(6) Duty to obey [Rest. §385]
(7) Duty not to act as agent after termination of agency relationship [Rest. §386]
(d) Duty of Loyalty
(1) Rest. §387: “Unless otherwise agreed, an agent is subject to a duty to his principal to act
solely for the benefit of the principal in all matters connected with his agency.”
(2) Payment from T (kickbacks, bribes, tips) [Rest. §388];
(3) Secret Profits
i) From transacting with principal [Rest. §389];
ii) From use of position (Reading).
(4) Usurping business opportunities from principal (Singer);
(5) “Grabbing & Leaving” (Town & Country).
1. Reading v. Regem p. 81 (Sgt. Bilko in Cairo)

Servant may not enrich himself while acting as agent without consent of principle.
p. 81 British Army Sgt. accepts bribes to escort black-market trucks through streets of Cairo.
Only reason he got bribes was b/c his uniform allowed trucks to pass Egyptian police checkpoints

unmolested. Court made a big point of the difference between agency service which merely
provides an opportunity for money which is OK. Example: being stationed in Cairo might give
the Sgt. a chance to trade in Egyptian art and make money doing so. That would be OK. But
service as shown by the uniform was the only reason that the Sgt. got the deal.
2. General Automotive Manufacturing v. Singer p. 84 (Machine Shop Side Deals)

Fiduciary Duty – agent violated fiduciary duty to act solely on behalf of the principal by
failing to disclose all facts relating to orders received by him. Had a good faith duty to
disclose orders which, in his opinion, could not be filled by the principal.
p. 84 fiduciary duty – agent violated fiduciary duty to act solely on behalf of the principal by failing
to disclose all facts relating to orders received by him. Had a good faith duty to disclose orders
which, in his opinion, could not be filled by the principal.
3. Fiduciary Duty vs. Contract

Why did the court rely on fiduciary duty rather than on the contract’s language (and implied
terms)?
1) In “bad person” cases, breach of fiduciary duty is clear, while interpreting the contract’s
language may be ambiguous. Result: Less rigorous analysis when conduct seems “bad”.
2) Difference in remedies: Breach of fiduciary duty often results in disgorgement of profits (in
order to ensure that ‘crime never pays’). Damages for breach of contract cover reliance or
expectation, but not profits that are outside the scope of the contract.
a. Example: A works for P. He breaches his employment contract by working for B
portions of the time that he should spend working for P, and receives an additional
salary from B. P can sue A for breach of contract, but cannot recover in damages the
salary B paid A.
3) Fiduciary duty as a majoritarian default rule (rule most people would pick if they could
bargain about it costlessly).
a. But Singer (being the manager) seems like a case for specific tailoring.
Q. Duties During and After Termination of Agency: Herein of “Grabbing

and Leaving”Agency
1. Town & Country v. Newbery p. 88 (Cleaning Staff Cleans out Employer)
Cannot grab and leave while still under fiduciary duty to principle.
P. 88. fiduciary duty – agent violated fiduciary duty by taking confidential proprietary client
information to unfairly solicit plaintiff’s customers. Client list was proprietary because the
customers were screened at great effort and expense.
Class
As defense lawyer, recommend that your client target entire neighborhood. Do a neighborhood
canvassing; ad campaign. Say “formerly of Town & Country”. But can’t steal specific clients.
Grabbing and leaving is not legal.
R. Recap of Agents’ Fiduciary Duties: Miracle on 34th Street

Doris Walker, an executive of Macy’s (responsible for organizing the Thanksgiving Day Parade)
hires Kris Kringle to act as Santa Claus.
Mr. Shellhammer, Macy’s toy department manager, instructs Kris to persuade kids who haven't
made up their minds to ask for toys that Macy’s has overstocked.
Kringle is appalled by the idea, and sends parents to other stores – sometimes even Macy's big
rival Gimbels – when Macy's doesn't carry whatever a kid asked for.
[Here we depart from the movie] Macy’s sues Kringle for breach of fiduciary duties.
Argue the case as Macy’s attorneys and as Fred Gailey (Kringle’s attorney).

S. Summary - Liability of Principal in Torts/Fiduciary Duties of Agents

1) Justifications for P’s tort liability for A’s actions.
2) Liability of P for A’s torts
a. Is there an agency relationship?
b. The servant/independent contractor distinction
c. Servants – Was liability within scope of duty?
d. Special cases in which P is always liable.
3) Fiduciary duty of agents
a. Duty of care
b. Duty of loyalty
i. Payments from T
ii. Secret profits (dealing with P and using agency position)
iii. Usurping opportunities
iv. Post-termination duties (“grabbing & leaving”)

III. PARTNERSHIPS
A. What is a Partnership? And Who Are the Partners?
1. Partnership Defined
RUPA § 101(6): “Partnership” means an association of two or more persons to carry on as co-
owners a business for profit formed under § 202, predecessor law, or comparable law of another
jurisdiction.
UPA § 6: A partnership is an association of two or more persons to carry on as co-owners a

business for profit.
2. Formation of Partnership
RUPA § 202:
(a) Except as otherwise provided in subsection (b), the association of two or more persons to
carry on as co-owners a business for profit forms a partnership, whether or not the persons intend
to form a partnership.
(b) An association formed under a statute other than this [Act], a predecessor statute, or a
comparable statute of another jurisdiction is not a partnership under this [Act].
(c) In determining whether a partnership is formed, the following rules apply:
(1) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common
property, or part ownership does not by itself establish a partnership, even if the co-owners share
profits made by the use of the property.
(2) The sharing of gross returns does not by itself establish a partnership, even if the
persons sharing them have a joint or common right or interest in property from which the returns
are derived.
(3) A person who receives a share of the profits of a business is presumed to be a

partner in the business, unless the profits were received in payment:
(i) of a debt by installments or otherwise;
(ii) for services as an independent contractor or of wages or other compensation

to an employee;
(iii) of rent;
(iv) of an annuity or other retirement or health benefit to a beneficiary,

representative, or designee of a deceased or retired partner;
(v) of interest or other charge on a loan, even if the amount of payment varies
with the profits of the business, including a direct or indirect present or future ownership of the
collateral, or rights to income, proceeds, or increase in value derived from the collateral; or
(vi) for the sale of the goodwill of a business or other property by installments or
otherwise.

3. UPA § 7. Rules for Determining the Existence of a Partnership.
In determining whether a partnership exists, these rules shall apply:

(1) Except as provided by section 16 persons who are not partners as to each other are not
partners as to third persons.
(2) Joint tenancy, tenancy in common, tenancy by the entireties, joint property, common property,
or part ownership does not of itself establish a partnership, whether such co-owners do or do not
share any profits made by the use of the property.
(3) The sharing of gross returns does not of itself establish a partnership, whether or not the
persons sharing them have a joint or common right or interest in any property from which the
returns are derived.
(4) The receipt by a person of a share of the profits of a business is prima facie evidence that he
is a partner in the business, but no such inference shall be drawn if such profits were received in
payment:
(a) As a debt by installments or otherwise,
(b) As wages of an employee or rent to a landlord,
(c) As an annuity to a widow or representative of a deceased partner,
(d) As interest on a loan, though the amount of payment vary with the profits of the business,
(e) As the consideration for the sale of a good-will of a business or other property by installments
or otherwise.
4. Person Defined
RUPA § 101: "Person" means an individual, corporation, business trust, estate, trust, partnership,
association, joint venture, government, governmental subdivision, agency, or instrumentality, or
any other legal or commercial entity.
UPA § 2: "Person" includes individuals, partnerships, corporations, and other associations.
5. Nature of Partner's Liability
UPA § 15: All partners are liable
(a) Jointly and severally for everything chargeable to the partnership under sections 13 and 14.
(b) Jointly for all other debts and obligations of the partnership; but any partner may enter into a
separate obligation to perform a partnership contract.

6. UPA § 18. Rules Determining Rights and Duties of Partners.
The rights and duties of the partners in relation to the partnership shall be determined, subject to
any agreement between them, by the following rules:
1) Each partner shall be repaid his contributions, whether by way of capital or advances to the
partnership property and share equally in the profits and surplus remaining after all liabilities,
including those to partners, are satisfied; and must contribute towards the losses, whether of
capital or otherwise, sustained by the partnership according to his share in the profits.
2) The partnership must indemnify every partner in respect of payments made and personal
liabilities reasonably incurred by him in the ordinary and proper conduct of its business, or for
the preservation of its business or property.
3) A partner, who in aid of the partnership makes any payment or advance beyond the amount
of capital which he agreed to contribute, shall be paid interest from the date of the payment or
advance.
4) A partner shall receive interest on the capital contributed by him only from the date when
repayment should be made.
5) All partners have equal rights in the management and conduct of the partnership business.
6) No partner is entitled to remuneration for acting in the partnership business, except that a
surviving partner is entitled to reasonable compensation for his services in winding up the
partnership affairs.
7) No person can become a member of a partnership without the consent of all the partners.
8) Any difference arising as to ordinary matters connected with the partnership business may be
decided by a majority of the partners; but no act in contravention of any agreement between
the partners may be done rightfully without the consent of all the partners.
7. UPA § 19. Partnership Books.

The partnership books shall be kept, subject to any agreement between the partners, at the
principal place of business of the partnership, and every partner shall at all times have access to
and may inspect and copy any of them.

To Summarize: A PARTNERSHIP is an association of two (2) or more persons who want to

carry on as co-owners as business for profit.
• There is no definitive test which courts apply to determine whether a PARTNERSHIP exists.
Courts look to all the attendant facts and circumstances.
• See Wood v. Phillips, 2001 WL 1637293 (Ala. 2001) (no settled test for determining the
existence of a partnership; determination is made by reviewing all the attendant
circumstances, including the right to manage and control the business).
• When examining the facts and circumstances, courts look at the following elements:
 Sharing of Profits (Reward)
 Sharing of Losses (Risk)
 Right to Manage (Control) the business
 Intent of the Parties (express and implied)
 Contribution of Capital (cash or other property) to the business

• If all the factors indicate PARTNERSHIP, it is easy (and probably not challenged).
However, what happens when some of the factors indicate PARTNERSHIP but other
factors indicate other types of relationships?
• Overall, it comes down to a case-by-case determination. While courts will often assert
that no one element is controlling, the statute makes clear that profit sharing is prima
facie evidence of partnership. See UPA § 7(4), RUPA § 202(c)(3).
• In other words, if the parties do not share profits there can be no PARTNERSHIP.
Example 1
X, a third party, entered into a contract with a business (run by ANT). X would like to collect the
money owing under the contract, unfortunately, the business is not paying, and ANT has no
money. X knows that BUG (who has money) has a business relationship with ANT. Can X
recover the money from BUG?
X will allege that the business relationship between ANT and BUG is a PARTNERSHIP If ANT
and BUG are PARTNERS, BUG is personally liable for the debts of the PARTNERSHIP .
BUG may claim that the business relationship she has with ANT is not a PARTNERSHIP, rather
that ANT runs a SOLE PROPRIETORSHIP, and the relationship with BUG is that of:
EMPLOYER (Principal) --- EMPLOYEE (Agent)
DEBTOR --- CREDITOR
LESSEE --- LESSOR
If the Court finds that:
There is a PARTNERSHIP, BUG is liable for the debt even though it was an
INADVERTENT PARTNERSHIP.
ANT employed BUG, there is an AGENCY relationship. BUG (agent/employee) is NOT

liable for ANT's debt (her principal/employer).

ANT and BUG had a DEBTOR - CREDITOR relationship, BUG (creditor) is not liable for
ANT's debt (debtor).
ANT and BUG had a FRANCHISEE - FRANCHISOR relationship. BUG (franchisor) is not
generally liable for the debts of ANT (the independent franchisee).
ANT and BUG and a LESSEE - LESSOR relationship, BUG (lessor) is not liable for ANT's
debt (lessee).
Example 2
1. CAT and DOG have a profitable business relationship.
2. CAT, wanting a bigger share of the profits, may claim she is a PARTNER and is therefore
entitled to share profits with DOG.
3. DOG, on the other hand, may claim
a. he is a SOLE PROPRIETOR employing CAT, or
b. he is a SOLE PROPRIETORSHIP that borrowed money from CAT with a fixed rate of
return establishing a DEBTOR - CREDITOR relationship.
4. If the Court finds that there is:
a. a PARTNERSHIP, absent an express agreement otherwise, CAT and DOG share profits
equally.
5. On the other hand, if the Court find there is
a. an AGENCY relationship, CAT is an AGENT and not entitled to share profits.
b. a DEBTOR - CREDITOR relationship, CAT is not entitled to more than the fixed rate of
return agreed upon in the debt contract.
c. a FRANCHISEE - FRANCHISOR relationship, CAT is not entitled to more than the fixed
license fee agreed upon in the franchise contract.
B. Partners Compared With Employees
1. Fenwick v. Unemployment Compensation Commission (Receptionist Not a Partner)

Partnership Agreement – burden of proof is upon the person claiming a partnership exists.
Merely claiming a partnership exists is not sufficient, must look at activities. i.e. right to
share in profits, obligation to share losses, ownership and control of the business,
community of power in administration of the business, language of the agreement, rights
of parties in dissolution. Effectively, partnership did not exist no matter what document
said.
P. 92. FACTS: Hair Salon Case. HELD: A partnership did not exist:
1) Only one “partner” was liable for the debts of the partnership.
2) Did not hold themselves out as partners to suppliers or customers, but only to the
unemployment commission.
3) While under UPA §7(4) sharing of profits is prima facia evidence for a partnership, but
here under UPA §7(4)(b) determined that her share was merely a bonus to her salary.
4) She did not share in the losses. (Risk)

5) He put up all the capital, she did not own any assets.
6) When it dissolved it was the same as if she just quit, b/c the business continued to
function.
7) Risk -Fenwick ; Return - F 80%/20%; control- Fen; Duration - @ will
Class
Fenwick did the deal this was b/c Cheshire would have been his 8th employee and therefore he
would have been required to pay unemployment tax. The UCC did not care what Fenwick’s
intentions were. They just wanted a ruling on the employment status of Cheshire.
The best solution for Fenwick is to set up a partnership agreement and tie management voting to
the amount of capital contributed. Her salary would be her contribution. So now it’s an 80-20
partnership. Voting share percentage can be changed by vote under the rules back then.
Who disputed the existence of a partnership? Why?
• Unemployment Compensation Commission claimed Chesire was an employee, not a
partner, bringing the number of employees in the beauty shop past the threshold above
which the business must pay the unemployment comp fund.
What does Fenwick claim? What’s his best argument?
• Fenwick claims Chesire is a partner, based on UPA §7(4)
• UPA §7(4): The receipt by a person of a share of the profits of a business is prima facie
evidence that he is a partner in the business…”
• “…but no such inference shall be drawn if such profits were received in payment: …(b)
As wages of an employee…”
What’s the Commission’s argument? Why?
Commission argues that Chesire is an employee, not a partner. She is not a partner because,
despite shared profits, there is no shared control. Court agrees, based on the following criteria:
(a) Intention of parties: No change in business’ operation;
(b) Right to share in profits: Chesire gets 20% ;
(c) Obligation to share in losses: Chesire not obligated;
(d) Ownership and control of property and business: Fenwick retains;
(e) Community of power in administration: Chesire not involved;
(f) Language in agreement: Language excluded Chesire from control rights;
(g) Conduct of the parties toward third parties: Didn’t hold themselves out as partners;
(h) Rights of parties on dissolution: Chesire’s dissolving the agreement similar to quitting a
job.
An Exercise in Constructing Transactions [1]
A key reason for the court’s ruling was that ‘partnership agreement’ gave Chesire no
management rights. How would you structure an agreement that would give her formal
management rights but still allow Fenwick to ‘run the show’?
(a) “The partners shall confer on all business decisions and, in the event of disagreement, shall
vote.”
(b) Elsewhere in the agreement, state that “the number of votes each partner shall have will
equal the percentage of the partner’s share of the profits.”
(c) Another option: Make Fenwick the managing partner or general manager, while Chesire
manages receptionist activities.
The court considered the fact that Chesire did not share in the losses. How could you mitigate
this factor without increasing Chesire’s risk?
(a) Losses will be shared in proportion to each partner’s share of the profits.
(b) Losses will be charges against the partners’ capital accounts.
(c) In the event of dissolution of the partnership, all liabilities beyond the assets of the
partnership will be borne by Fenwick alone, and he will not have a right to recover any sum
from Chesire by virtue of her membership in the partnership or by virtue of any negative
amount in her capital account.
Suppose Fenwick decides to hire Chesire as an independent contractor instead of making her
partner or employee. What’s the key issue you need to address? How would you draft an
agreement to reach this result without changing the substance of the relationship)?

(a) The key issue is that F will have no control over the physical conduct of C’s job; otherwise
she will be a servant.
(b) C is hired to provide receptionist services. She will have the right to supply a person other
than herself, and the contract would describe generally her tasks, but would state that the
manner in which the tasks are performed will be determined by her, not by F. However, the
contract could be terminated within a short notice. This will likely allow F significant influence.
C. Partners Compared With Lenders

1. Martin v. Peyton p. 97 (Kuhn Loan, Guy Runs Bus. Into Ground)
Partnership Contract – may be express or implied, but if evidence of neither exists, a
partnership may be proved by production of some written instrument, testimony of some
conversation or by circumstantial evidence. Defendants were careful to avoid the creation
of a partnership and evidence provided did not rise to the level of proof needed to prove a
partnership existed.
Rule: Because D were not able to initiate any transaction like a partner, had no control of day to
day business, and could not bind the firm by any action of their own, they were held to be merely
creditors and not partners
1) Ct held not partners, even though
a. they could fire partners
b. they had opportunity to join firm as partners
c. they could veto any business and inspect the partnership books
2) -Ct held these to be merely measures of protection for their investments, and not
evidence of partnership
3) -how protect the investment?
a. -more frequent reports
b. -require that all money flow through lender
c. -watch things on daily basis - if risky transactions are taken, then loan becomes
due and payable immediately
4) -UPA §7(4) (p. 39) Rules For Determining the Existence of a Partnership
5) -How diff from Cargill : M/P all control by lender were negative controls - attempts to
control speculative acts, not for gen benefit of business but for benefit of
creditor: to ensure repayment. In Cargill, affirmative controls
The Fall of KNK: Martin v. Peyton

The year is 1921…
…Knauth, Nachod & Kuhne (KNK), a banking and brokerage partnership, is in financial
difficulties.
A well-connected KNK partner, John R. Hall, calls some friends…
Payton, Perkins and Freeman (PPF).
The Fall of KNK: Martin v. Peyton
• Hall’s goal
o Money, and quickly…
• PPF’s goals
o Help Hall
o Make a profitable investment
• The deal’s terms:
o Hall gets $2.5 million in marketable securities;
o PPF get:
 Collateral: KNK’s speculative stock of securities
 Dividends on the securities PPF lends;
 40% of KNK’s profits, with min. & max. caps;
 Option to join the firm;

 Inspection and veto rights; duty on KNK to consult with them;

 Hall is to manage KNK. All other partners must agree to be bought out.
• Do KNK and PPF have the same incentives re managing KNK?
o No. KNK is playing with other people’s money. If they make a fortune, they get
most of the profits. If they lose the money… well, PPF should have known they
were taking a risk…
• Does PPF realize this is a high-risk deal? What do they do?
o Hefty compensation (if things go well) – The high return on the deal is aimed to
compensate for the risk;
 Dividends
 40% of profits
 Option to buy into firm
• Mechanisms to minimize risk:
o Collateral (Why don’t they get better collateral?)
o Control: Inspection and veto rights, consultation rights (How can they enforce
these rights?)
o Placing their pal Hall in charge of KNK.
• Hall let his friends at PPF down. Despite the terms of the agreement, he speculated in
foreign currency, lost large amounts of money, and KNK became insolvent.
• KNK’s creditors claim that PPF are partners in KNK (they share profits and the terms of
the agreement may amount to shared control).
• How does this case compare with Cargill?
• The court decides they were not partners, but it’s a close call. How much did PPF think
they were risking in this venture?
• $2.5 million.
• How much were they actually risking?
2. Southex Exhibitions v. Rhode Island Builders Assn. p. 102 (Trade Show Promoter
Case)
Partnership Existence: Totality of Circumstances Test.
Π asserts partnership based on 1974 Agreement
Factors FOR Partnership
1) 55% - 45% profit sharing
2) mutual control over operations such as:
a. show dates
b. admission proces
c. choice of exhibitors
d. partnershp bank accounts
3) Respective contributions of valuable property to the partnership by the partners
4) Partners are designates as such in the agreement
5) Sharing profits (prima facie evidence)
Factors AGAINST Partnership
1) No partnership tax returns
2) Sherman (manager of SEM) referred to himself as producer – not partner
3) Title is just “agreement”
4) No partnership name
5) No jointly owned property
6) Only made reference to “partner” once in contract
7) Agreement for term
8) Management control to SEM mostly
9) No losses for RIBA

D. PARTNERSHIP BY ESTOPPEL
1. Young v. Jones p. 107 (PWC Audit Letter)
Partnership by Estoppel: Detrimental Reliance Test.
Π lost $550k when bank failed; sued PWC claiming that he only put money in bank b/c of PWC –
Bahamas clean audit opinion. PWC is an organization of shareholder corporations with a parent
company in Bermuda. Π alleged PWC-USA and PWC-Bahamas were partners in fact and
therefore responsbile for debts of the partnership. No paper trail to prove actual partnership; so Π
also alleged Partnership by estoppel by virtue of :
1. PWC promotes its image as a worldwide organization;
2. Common knowledge that PWC operates as a partnership;
3. Firm brochure asserts PWC is a “worldwide” organization;
4. Cross v. PWC – 1980 case found PWC-US liable for Bahamas
But the argument didn’t work because:
1. Cross decision was later vacated;
2. Π admitted that PWC brochures and assertions were not relied upon in making the
investment.
Rationale: There was no evidence that Plaintiff’s relied on any act or statement by any PW-US
partner which indicated the existence of a partnership with the Bahamian partnership. There was
no evidence, nor was there a single allegation that any member of the U.S. partnership had
anything to do with the audit letter complained of by Plaintiffs, or any other act related to
investment transaction.
Class:
Did PWC do anything that would lead someone to reasonably believe that PWC-US authorized
PWC-Bahamas? If so, then a good argument for apparent authority. Could have argued this
theory as well as the partnership theory. Would have been much easier to prove; web site,
brochures, etc.
IV. II. The Fiduciary Obligations of Partners

A. Introduction
1. Meinhard v. Salmon p. 111 (Hotel Leasing Case)

Fiduciary Duty – while the enterprise continues, a duty of the finest loyalty is owed to each
partner or co-adventurer. The duty holds until the very end of the enterprise even if the
enterprise is winding up regardless of innocent mistake or intentional breach.
Class
This is area right around Grand Central Station at the time the area was first being built up. Kind
of like have land around the Staples Center before it opened.
Meinhard v. Salmon
Salmon breached his fiduciary duty to the partnership by not disclosing the new lease opportunity
with Gerry to Meinhard. Joint adventurers, like co-partners, owe to one another, while the
enterprise continues, the duty of the finest loyalty. Many forms of conduct permissible in a
workaday world for those acting at arm’s length, are forbidden to those bound by fiduciary ties.
1) Meinhard v. Solomon (p.111)
2) Facts: Managing Partner (MP) of a real estate venture was approached by the owner of
the property with a proposal to expand the area and duration of the lease. MP took the
deal, set up a separate corp. to manage and did not tell his partner. The partner sued to
recover the business opportunity of the partnership that was appropriated.
3) Analysis: The opportunity to expand the lease was presented to MP as representative of
the partnership, and the opportunity was property that properly belonged to the
partnership.
a. MP had to share the property by telling the partner about it

b. Had he have done so, he may or may not been able to pursue it on your own.
4) Dissent: Distinguished the relationship as being within a single deal and thus a joint
venture. Therefore the business transaction in this case was not properly in the scope of
that relationship and the fiduciary obligations did not accrue.
5) Causation Issue
a. Reliance: How can Partner show he was injured by MP’s failure to disclose when
he looked into extending the business
i. Partner did not act on his own because he was properly relying on MP to
take care of such matters.
b. Loss Causation
i. MP argument that partner should have to demonstrate that he could do
the deal if it was presented to him is rejected.
ii. After the fact arguments in regard to lack of opportunity to do a deal it
was presented are not accepted to exculpate initial denial of an
opportunity.
iii. “If you knew nothing could be done, why did you keep silent?” On this
basis we do not believe you and we think you felt you had an advantage
and that advantage is what we penalize you for.
c. Remedy – The partner who is wronged is entitled to the same interest he had in
the new business as he had initial business.
i. MP is given an extra share in the new corp. so he can maintain
managerial control over the company.
1) Cardozo (p. 114): “Salmon has put himself in a position in which thought of self was to be
renounced, however hard the abnegation.”
a. If each partner abandons ‘thought of self’, who is going to benefit from the
business opportunities?
b. “You first.” “No, no. After you...”
c. Judge Andrews’ dissent focuses on the parties’ intent to limit the partnership to
20 years.
2) Fiduciary duty is a majoritarian default rule. What rule would most partners want? In
other words, if Meinhard & Salmon would have addressed this issue before the beginning
of their partnership, what would they put in the partnership agreement?
a. Probably not duty to have to stay together forever.
b. But probably not forcing Salmon to forfeit the opportunities to Meinhard.
c. Also, probably not allowing Salmon to keep Meinhard in the dark (S would
expend resources hiding things from M, and M – discovering what S is hiding).
d. Finally, probably not having the two compete against each other.
3) What does that leave us with?
a. Possibly, Salmon would have to tell Meinhard of the opportunity, and since they
don’t want to compete, one would buy off the other with a side payment.
4) Would we have the same rule if Salmon was hired solely as a manager, not also as a
partner?
a. Hence the difference in fiduciary duties between shareholders and directors
5) Compare with RUPA §404(b) and §103(b).
2. Usurping Business Opportunities: The Concept of ‘Third Party Check’

1) A key issue in Meinhard v. Salmon (and in General Automotive v. Singer) is whether the
opportunity seized by the agent (Salmon/Singer) was an opportunity for the principal as
well (i.e., could the principal exploit it).
2) If not, why force the agent to disclose it? Won’t the principal insist of his ability just to
extort a side payment from the agent?
3) But how can we trust the agent to make the right decision regarding the principal’s
ability? Won’t she always have the incentive to think the principal is unable to exploit it?

4) In some cases we have a ‘third party check’ – the third party offering the opportunity to
the agent knows about the principal. If the principal can do it, the third party would like
the competition, and inform the principal of the opportunity.
5) So, we may want to know whether the third party (in Meinhard v. Salmon, this is Gerry)
knew about Meinhard and yet made the offer only to Salmon.
MUST KNOW § 404 OF RUPA. (p. 44 in supplement; p. 117 in case book)
B. After Dissolution
1. Bane v. Ferguson p. 117 (Retired Law Partner Loses Pension When Firm Goes
Bust)
Fiduciary duties to partners ends when partnership relationship ends.
Bane was a corporate law partner at an old Chicago law firm. He retired to Florida to draw his
pension. Shortly thereafter, the firm entered into an ill-conceived merger with another large and
successful Chicago law firm. As a result of the merger, the combined firm failed and was
dissolved without successor less than three years later.
Bane sued the firm’s management council for negligent mismanagement. Judge Posner denied
the claim, noting that the defendants owed no fiduciary duty to former partners. Notwithstanding
his retirement draw against firm earnings, π is still not a partner. The partners who ruined the
firm are subject to the business judgment rule. Cardozo would be concerned about selfishness
causing a breach of trust and a breach of fiduciary duty. But here, Judge Posner is not willing to
go that far.
Compare to Town & Country: In T&C, fiduciary duty was breached while defendants were still
employees of the firm.
C. Grabbing and Leaving

1. Meehan v. Shaughnessy p. 119 (Unfair Separation Letter = Breach of Fiduciary
Duty)
Fiduciary duties to partners is breached when separation letters are one-sided and
designed to favor departing partners over the firm. OK to make plans to compete as long
as such planning does not violate other fiduciary duties.
Meehan and Boyle were senior partners with Parker Coulter. They planned to leave and start
their own firm but denied such plans to their partners on at least three occasions. Parker Coulter
sued on three causes of action:
1) Improper handling of cases for their own benefit and not the partnership;
a. Court said no. They worked just as hard after deciding to leave as they did before.
2) Secretly competing with the partnership;
a. Court said no. Fiduciaries may plan to compete against the entity to which they owe
allegiance provided that in doing so they do not violate their fiduciary duties. In this
case, the ∆ were just making logistical arrangments for new office space, etc.
3) Unfairly acquiring clients and referring attorneys consent to withdraw cases to the new firm.
a. Court said yes. Letters were sent to clients while they were denying plans to leave.
Timing and substance of the letters made it difficult for Parker Coulter to reasonably
attempt to retain clients. Letters did not have to follow the ethics guidelines which are
designed to protect clients. However, ethics rules can provide guidance as to what
partners may expect from each other as to their joint clients on the dividisoin of their
practice. Still, the court seemed relatively relaxed at the prospect of partners leaving
and taking clients with them because the partnership agreement included
accomodations for such eventualities.
1) Meehan and Boyle were partners at the law firm Parker, Coulter, Daley & White (PCDW), and
active in the firm’s management. They decided to leave and form their own firm, and began
recruiting lawyers and clients of PCDW.

2) Why did Meehan & Boyle want to leave?

a) Probably felt that they do not receive enough compensation.
b) Together, they had a 10.8% interest in the partnership.
c) Meehan, Boyle and Schaefer are responsible for at least 103 of roughly 350
contingent fee cases (~30%).
d) Meehan also attracted 4,000 asbestos cases (which he didn’t remove). Why didn’t
he take them? Probably cost of litigating those cases.
3) Compensation methods vary to reduce stresses between partners. Which compensation
method is more stable?
4) The remedy for MBC’s breach of fiduciary duty was to place the unfairly removed cases in a
constructive trust – Profits and fair charges from these cases will be placed in the trust, and
divided between PCDW and MBC according to the proportions prior to the time MBC left.
a) Is there a problem with this remedy? Who does all the work? Who gets the pay?
What’s the likely result?
1) The firm could be eligible for liquidated damages if it is proven that the departing
partners breached a K.
b) Meinhard set a “selfless” standard. Meehan seems to point to a standard of a “fair
fight”. It’s possible that such differences result from differences in partnership
agreements and cultures. PCDW allowed partners to remove their cases under
some conditions; this may be an indication that the business interests require some
“eat what you kill”. Forcing a selfless standard will make the partnership useless
for these businesses.
c) Modern law draws a distinction between disputes among partners and between
partner(s) and the firm. The interests of the firm come first and the standard is
higher than in disputes relating to differences of interests between or among
partners.
Compare to Town & Country: In T&C there was no written agreement dealing with departing
employees and how to divide the proceedes of client billings.
D. Expulsion
1. Lawlis v. Kightlinger & Gray p. 127 (Drunken Law Partner Gets Voted Off the
Island)
Absent a showing of bad faith, partners may expel members under the terms of a
partnership agreement mutually agreed upon and executed by the partners, even when
such agreement provides for the “guillotine method” of immediate separation.
Alcoholic partner hid condition for several months. Sought treatment, violated treatment
guidelines, eventually recovered after several unproductive years. As a condition of remaining
duing treatment, his partnership share was reduced. Upon recovery, he asked for re-instatement
of full shares. Partners voted him off the island. He sued and said the dismissal was predatory –
designed to improve profits of other partners. Court said no, all partners agreed to the method of
involuntarily dismissing partners. Good reasons for guillitone method, including expediency.
Partnership carried him in the lean years and bent over backwards to ensure that he’d have some
level of transitional salary instead of the mandated “guillitone” separation pay were all signs that
they were not being predatory.
1) Lawlis makes two arguments against his dismissal:
a. Expulsion requires 2/3 vote, but his expulsion was effected by one partner’s notice.
b. Court: No, this was just a notice of intent; expulsion effected appropriately in partners’
vote. Lawlis was present at and voted in his expulsion vote.
2) Expulsion was intended to increase other partners’ draw. This breaches their fiduciary duty
to him.
a. Court: Lawlis presented no evidence to support this. But whatever the intent, the
partnership agreement let them dissolve the partnership for any reason by a 2/3 vote.

Partners would have only violated fiduciary duty if they withheld money due to the
expelled partner.
3) This seems to indicate a qualification to the fiduciary duty: the partnership agreement can
empty the fiduciary duty of much of its content. How does this fit with RUPA §103(b)?
E. Summary - Introduction to Partnerships/ Partners’ Fiduciary Duties

1) Introduction to Partnership
a. Partnership and other business associations
b. Law governing partnerships
c. Definition of partnership (“an association… to carry on as co-owners a business
for profit”)
i. Sharing Profits
ii. Sharing Control
2) Liability in a partnership/Partners vs. Lenders
3) Fiduciary Duties of Partners
a. Meinhard v. Salmon – The ‘selfless’ standard
b. Bane, Meehan, Lawlis – More refined standards
c. Third Party Checks
V. III. Partnership Property

A. Introduction
1. Putnam v. Shoaf p. 134 (“Of All The Gin Joints, In All the World …)
Fiduciary Duty – former partners have no rights in assets (or liabilities) recovered or
discovered after their separation from the partnership.
Frog Jump Gin Company – two married couples were partners in money losing Tennessee gin
mill. Death of spouse led widow to sell partnership share in order to avoid partnership liability on
bank note. Subsequent to sale of her interest, it was discovered that the bookkeeper of many
years had been embezzling for many years. Recover from bank was effected (failure to stop
payment on fraudulently endorsed checks); widow sues partnership to recover her share of the
recovery. No dice says the court – you wouldn’t be so quick to jump in if there was a big liability
attached. You wanted out, and out you got.
2. UPA §24: The property rights of a partner are:
(1) his rights in specific partnership property,

(2) his interest in the partnership, and
(3) his right to participate in the management.
UPA §26: A partner’s interest in the partnership is his share of the profits and surplus…
Defining characteristics of a partnership are:
Shared profits [“interest in the partnership”];
Shared control [“right to participate in the managements”]
What is the third right [“rights in specific partnership property”]?
3. UPA §25: Partnership Property

UPA §25(1): “A partner is a co-owner with his partners of specific partnership property holding as
a tenant in partnership.”
UPA §25(2) describes the characteristics of tenancy in partnership, including:
1) Equal right as other partners to possess partnership property for partnership purposes; but,
no right to possess partnership property for any other purpose (unless the other partners
consent);

2) Rights in specific partnership property are not assignable except in connection with the
assignment of rights of all the partners in the same property.
B. Liability in a Partnership
1. Law Firm Hypo

April, Beverly and Charlie are partners in the ABC law firm.
1. Can a creditor of Beverly’s attach assets belonging to ABC in order to collect the debt?
RUPA §501: “A partner is not a co-owner of partnership property and has no interest in
partnership property which can be transferred, either voluntarily or involuntarily.” See also RUPA
§504(e).
Creditor can attach Beverly’s transferable interest in ABC. See RUPA §502, 504(a)-(b).
2. Can a creditor of ABC attach assets belonging to Charlie?
RUPA §306: All partners are liable jointly and severally for all obligations of the partnership
unless:
1) Otherwise agreed by the claimant;
2) Otherwise provided by law;
3) Partner admitted after obligation was incurred;
4) Obligation incurred while the partnership is a limited liability partnership.
2.
3. Partnership Property: An Alternative Putnam v. Shoaf (Hypo)

Toti Contracting Company, renown from the case of Majestic Realty v. Toti Contracting, is hired
again by the City of Paterson, NJ to demolish a house.
Toti once again ‘goofed’, and brought down a chunk of the building on top a duplex owned by
Mrs. Putnam and Mr. & Mrs. Charlton. Fortunately there were no casualties, but the $1 million
duplex was reduced to rubble. Putnam and the Charltons sell their property for $200,000 (the
value of the land on which the duplex stood) to Mr. & Mrs. Shoaf.
Toti Contracting, acknowledging responsibility for this incident, gives the Shoafs (being the
possessors of the duplex that they damaged) a check for $800,000 (equal to the damage they did
to the house).
Putnam claims that the money does not belong to the Shoafs, but to her and the Charltons. Is
she right? If the house was sold as an asset sale from the partnership, then the proceeds of the
suit against Toti would go to the π’s in that suit. But, if the Shoaf’s bought the actual partnership
interests of Putnam & the Charltons, then Shoaf gets the money (assuming that the partnership is
the π.)
Partnership Property: Almost Like Putnam v. Shoaf (Hypo 2)

A slight modification to the hypo from the previous slide. The duplex was not owned by Putnam
and the Charltons. Rather, it was owned by a partnership, in which Putnam and the Charltons
were the only partners. The partnership had no other assets or activities besides owning the
duplex.
After the destruction of the duplex by Toti, Putnam and the Charltons sold all their interests in the
partnership to the Shoafs.
Toti gives the Shoafs a check for $800,000. Putnam claims the money should be hers and the
Charltons’. Is she right?
Partnership: Separate Entity or Aggregate of Property?
If a partnership is a separate entity, then partnership property is its property, not the partners.
Therefore, a claim arising from the property will belong to the partnership, not to the partners.

On the other hand, if a partnership is not a separate entity, but a relationship between partners,
then partnership property is an aggregate of assets belonging to the partners. Therefore, a claim
arising from the property will become a separate personal property belonging to the partners.
Which approach does the court in Putnam v. Shoaf endorse?
RUPA §201(a): “A partnership is an entity distinct from its partners.”
RUPA §203: “Property acquired by the partnership is property of the partnership and not of the
partners individually.”
4. Non-living Legal Entities and the Concept of ‘Nexus of Contracts’

A car hits a pedestrian and kills him. The investigation reveals that the driver took proper care in
her driving, but the car brakes malfunctioned. So, it’s the car’s fault. The car is impounded (the
equivalent of imprisonment) for three years for negligent homicide. The car got lucky; if the brake
malfunction had been deemed intentional (rather than negligent), the car might have faced
dismantlement (equivalent to capital punishment).
Why does it seem ridiculous to make a physical but non-living object a legal entity (capable of
being punished), when it is plausible to give legal entity status to something that is not only non-
living, but lacks any physical manifestation (e.g., partnership, corporation)?
A business associations as a ‘nexus of contracts’.
If a partnership is a separate legal entity, why are partners liable for partnership debts? [UPA §15]
5. Transferring Partnership Rights

Hypo: April is a partner in a three-partner law firm. She wants to cash out.
Can she sell her membership in the partnership to Brian?
UPA §18(g): “No person can become a member of a partnership without the consent of all the
partners.”
Can she sell a 1/3 share of the partnership assets to Brian?
UPA§25(2)(b): “A partner’s right in specific partnership property is not assignable except in
connection with the assignment of rights of all the partners in the same property.”
Does she have any transferable rights in the partnership?
April’s interest in the partnership (the right to a share of the profits and surplus) is personal
property [UPA §26] that can be transferred, but this only transfers a right to share profits, not to
share control [UPA §27(1)]. Also see RUPA §502.
VI. IV. Partnership Capital

A. Overview
Capital Account: A running balance reflecting each partner’s ownership equity. See RUPA
§401(a).
The capital account begins with the initial contribution of each partner, to which the partner’s
share of the profits is added, and the partner’s share of losses and “draws” (distributions) is
reduced.
“Service Partner” – a partner that contributes labor, but not capital, to the partnership.
Example: April contributed $5,000 to ABC law firm. The firm ended the first year in a loss, and
April’s share of the loss was $1,000. The second year the firm made a profit, and April’s share of
that was $3,000. At the end of the second year, the partners made a draw, and April received
$1,500. April’s capital account at the end of the second year is:
5,000 - 1,000 + 3,000 – 1,500 = $5,500
Division of Profits and Losses
UPA and RUPA provide default rules on division of profits/loss.
Division of Profits
Default rule: Profits divided equally between partners [UPA §18(a), RUPA §401(b)]
What if one partner contributed 90% of capital? Equal distribution.
What if one partner contributed 90% of work? Equal distribution.

Division of Losses
Default rule: Losses divided the same way as profits. [UPA §18(a), RUPA §401(b)]
Partnership agreement can change this default. There need not be symmetry between division of
profits and losses.
B. Raising Additional Capital

In designing a partnership agreement, the lawyer needs to anticipate the future business needs of
the partnership. One of the more obvious needs is raising more resources (to seize a business
opportunity, expand business, etc.). Most resources (e.g., labor, raw materials) can be
purchased by the partnership with money. But what should be done when the partnership needs
more money (i.e., when the needed resource is capital)?
• Can the partnership count on its ability to borrow the needed money? [Imagine Martin v.
Payton if Hall didn’t have friends]
• Can the partnership count on adding new partners to raise the needed money?
o Partnership may not find sufficient interested people;
o More partners dilute each existing partner’s share of profits
o Some partners may not like the new partners.
o This is why a partnership agreement needs to anticipate raising more capital
from the existing partners.
1. Raising Additional Capital - The Hypo

A real estate developer plans to construct an apartment building at a cost of $10 million. He
forms a partnership and gets 40 people to invest $25,000 each (for a total of $1 million), and
borrows an additional $9 million. A partner receives on “point” (a unit measuring interest in the
partnership) for each $1,000 he invests (so, each partner gets 25 “points”).
Unfortunately, after the $10 million are spent, the building is not yet complete. The incomplete
building can’t generate rents, but can be sold for (after deducting sale expenses) $9 million.
If the unfinished building is sold, the partnership will have $9 million in cash. After paying out the
$9 million debt, the partnership will have no surplus, so the partners lost all of their investment.
However, if another $500,000 are invested, the building can be completed and will be usable.
Such a building will be worth $10 million.
If the building is completed and sold, and the debt is repaid, the partners will have a $1 million
surplus. In other words, if the partners can raise another $500,000, they will increase their
surplus by $1 million – a good deal.
Raising Additional Capital 1. Partners’ Voluntary Loan
But how to get the $500,000? One way is for each of the 40 partners to lend $12,500. Suppose
this loan bears no interest.
If a partner lends the money, the partnership will have a $10 million building, and $9.5 million in
debt. This leaves a surplus of $500,000, or $12,500 per partner.
If a partner doesn’t lend the money, but all other partners do, the partnership may find someone
else to lend the little additional money that is needed. Then, the shirking partner’s share of the
surplus would still be $12,500, but he would not have additional money tied up in a no-interest
loan to the partnership.
Thus, many partners may shirk.
Raising Additional Capital 2. Issuing “Points” at Original Price
Instead of raising debt capital from the partners, the partnership offers each partner to buy 12.5
additional points, at the same price as the original points cost ($1,000/point). This will raise: 40
(partners) x 12.5 (points) x $1,000 (price) = $500,000.
The problem is that the value of the partnership dropped (even if it gets the additional capital, it
will cost $10.5 million to build a $10 million building). Therefore, the value of a point in the
partnership has dropped below the original value of $1,000.
The value of a point right now is $500 (I won’t bother you with the math of calculating this). No
rational partner would pay $1,000 to buy a point worth $500, so this attempt to raise capital will
fail.
Raising Additional Capital 3. Issuing “Points” at Reduced Price

If the partnership offered points at their actual value ($500), it would need to issue 1,000 points to
raise $500,000. With this money it will complete the building, sell it for $10 million, pay off the $9
million debt, and divide the surplus between the 2,000 points (1,000 original points and 1,000 new
points), distributing $500 ($1,000,000/2,000) per point.
This may be too close a margin for some partners – if there are any additional costs, the value of
a point will drop below $500, so why buy additional points? To attract the partners to do so, a
partnership may offer the new points at a discount from their expected value. For example, offer
2,000 new points for $250 each. Since the expected value of the points is $500, this is a good
deal for each partner.
This is sometimes called a “penalty dilution”, because a partner that does not buy the reduced
price points may lose some of the value of her investment. The intuition is this: A partnership
interest is like a slice of the “partnership pie” (the pie is the total assets of the partnership).
Issuing a new point reduces the size of each slice in the partnership, because the pie is divided
into one more part. But the money for which the point was purchased increases the partnership
assets, so it makes the pie larger.
Raising Additional Capital “Penalty Dillution” – Intuitive Explanation
Suppose a partnership issued 4 points when it was formed. Each point represents a slice of the
partnership assets.
Size of each slice (i.e., value of point) = size of pie/number of slices (i.e., total partnership
assets/number of points)
Now the partnership has issued another point. Another slice was added to the partnership pie,
making the relative size of each slice smaller. But the price of the point was added to the
partnership assets, making the pie larger.
Is each slice in the lower pie larger or smaller than a slice in the higher pie?
When a point is bought for exactly its value, the size of each slice doesn’t change – the increase
to the size of the pie (money paid for the point) is equal to the size of the new “slice”.
If a point is sold below its value, this means that the increase to the size of the pie was less than
the size of the new slice. Therefore, the other slices become smaller.
Purchasing a point below its value results in a transfer of wealth from the owners of the existing
points to the owner of the new point. This is called “dilution” of the existing partners.
If the owners of the existing points buy the all of the newly issued points pro rata (i.e., at the same
proportions as their current ownership), then the wealth will be transferred from them (as the
owners of the existing points) to… them (as the owners of the newly issued points). In other
words, they will not be diluted – they will neither gain nor lose from buying the new points.
Meanwhile, the partnership will raise more capital.
There are two problems with this method of raising capital:
1. A partner that doesn’t have available money to invest will lose value (“be diluted”)
Example: Alice owns two of the four points (50%) in ABC law firm (which is a partnership). ABC
offers its partners 6 new points, pro rata (i.e., Alice has the right to purchase 50% of the new
points, that is 3 points) for a price of $10,000 a point. Alice does not have $40,000 in cash. She
has to decline the offer. Brian purchases the 3 points offered to him, plus the 3 points that Alice
declined.
He now has 8 of the 10 points, which gives him both a larger stake in the profits and possibly
control of the partnership.
Suppose Brian wanted to take over the partnership. He could wait until Alice has no money and
then have the partnership issue new points.
2. A partner who does not want to invest more in the partnership, either because he is
dissatisfied with the partnership or because he wants to diversify his investments, will lose some
of the value of his investment.
Example: Alice owns two of the four points (50%) in ABC law firm (which is a partnership). ABC
offers its partners 6 new points, pro rata (i.e., Alice has the right to purchase 50% of the new
points, that is 3 points) for a price of $10,000 a point. Alice has the cash, but she fears that
investing all of it in the firm would be irresponsible. She prefers to invest the $40,000 in
government bonds, in case the firm does poorly. If she declines the offer, Brian will purchase the
3 points offered to him, plus the 3 points that Alice declined, and will dilute Alice (who will now
have two of ten points, or 20%).

Raising Additional Capital “Penalty Dillution” – Numerical Example

Suppose that Ted is a partner (he bought 25 points when the partnership formed). He’s upset at
the failure to complete the building with the original capital, and doesn’t want to invest more. The
partnership offers 2,000 points (50/partner) @ $250/point.
If Ted buys the 50 additional points he is offered, he pays an additional $12,500 (50 x $250). The
partnership completes the building, sells it, repays debt, and distributes the $1 million surplus
among the 3,000 points (1,000 original + 2,000 new), for $333 a point. Ted receives $24,975 (75
x $333). After deducting the cost of the reduced price points, Ted’s profit is $12,475.
If Ted refuses to buy, and the other partners buy all the points (including Ted’s), each point will
still be worth $333. Ted will not pay more money, but will have only 25 points. When the
partnership is dissolved, Ted will receive $8,325 (25 x $333).
Thus, Ted is financially pressured to buy the points or lose some of the value of his stake in the
partnership.
Raising Additional Capital 4. Partner Loans at High Interest Rate
Another option is to raise the money as a loan (as in Option 1), but pay a very high interest on the
loan. If all partners provide the loan, the interest rate does not matter – the interest comes out of
one pocket (partners owners of partnership assets) into their other pocket (partners as creditors
of the firm).
But if some partners refuse to provide the loan, they pay high interest payments (i.e., the value of
their points shrinks), but do not receive the interest payments (since they did not lend).
The result is similar to a penalty dilution, and has the same flaws.
Raising Additional Capital 5. Mandatory Capital Contributions
Options 1 and 2 for raising capital from the partners were completely voluntary. Options 3 and 4
were voluntary, but refusal resulted in a loss to the refusing party.
Another option is to determine that the managing partner has the right to require each partner to
contribute more capital to the firm, pro rata.
This creates a tremendous risk to the partners – what if they don’t have the money, or don’t want
to invest more money in the partnership, or don’t trust the managing partner’s judgment.
If this approach is taken, the mandatory contribution is usually capped. For example, each
partner is told that the original investment in the partnership is $40,000, but only $25,000 need be
paid up front. The other $15,000 may or may not be demanded later by the managing partner.
Raising Additional Capital 6. Issuing Points to Outsiders
Options 1-5 raised the additional capital from the existing partners. Another approach could be to
authorize (in the partnership agreement) the managing partner to sell points to non-partners.
Advantage: Can raise capital even when partners don’t want or can’t invest more.
Disadvantages:
Often it is hard to get outsiders interested.
If points issued below value, existing partners will be diluted.
Existing partners may not like the new partners.
VII. V. The Rights of Partners in Management

UPA §18(e): “All partners have equal rights in the management and conduct of the partnership
business.”
UPA §18(f): “No partner is entitled to re numeration for acting in the partnership business…”
UPA §18(h): “Any difference arising as to ordinary matters connected with the partnership
business may be decided by a majority of the partners; but no act in contravention of any
agreement between the partners may be done rightfully without the consent of all the partners.”
1. Hypo
Andy and Barbara form a partnership, and state in the partnership agreement that Andy and
Barbara will each receive a specified monthly compensation for managing the partnership (Andy’s
salary is three times that of Barbara). The agreement also states that Andy will have the right to
decide every aspect of the partnership management except for adding additional partners,
dismissing existing partners, and changing the partners’ compensation. On these three issues,
unanimous consent is needed.

Are these provisions valid? Is this a partnership?
2. Partnership and Agency

UPA §9(1): “Every partner is an agent of the partnership for the purpose of its business, and the
act of every partner… for apparently carrying on in the usual way the business of the
partnership… binds the partnership, unless the partner so acting has in fact no authority to act for
the partnership in the particular matter, and the person with whom he is dealing has knowledge of
the fact that he has no such authority.”
UPA §9(2): “An act of the partner which is not apparently for the carrying of the business of the
partnership in the usual way does not bind the partnership unless authorized by the other
partners.” See also RUPA §301.
To avoid liability for actions that may be seen as carrying on the business in the usual way,
there must be neither actual nor apparent authority. RUPA §303 suggests a method of doing so,
by filing a Statement of Partnership Authority.
Is purchasing a lot of bread considered “carrying on in the usual way the business” of a grocery
store?
Is hiring an employee considered “carrying on in the usual way the business” of trash-collecting?
Why the difference between Nabisco and Summers?
3. Partnership Liability to Partner’s Acts
4. NABISCO v. Stroud p. 142 (Half a Loaf)

Management Duty – partners are jointly liable for debts of the partnership incurred in the
ordinary course of business, regardless of their desires to the contrary.
Stroud and Freeman formed a partnership to sell groceries. Stroud told Freeman and NABISCO
that he did not want to buy bread from NABISCO. Freeman continued to buy bread from
NABISCO. Upon dissolution of the partnership, the invoice to NABISCO was ruled a valid debt of
the partnership because only a majority vote of partners can enforce a management decision
contrary to that of another partner. NABISCO could have asked to see the partnership statement
of authority and also could have asked to have the contract signed by more than one partner.
Just like asking for board minutes in support of a corporate decision.
5. Summers v. Dooley p. 144 (Another Garbageman)

Management Duty – partners have no right to hire personnel against the wishes of other
partners.
Partners in a garbage business; one wanted to hire a helper. He did so and continued to retain
the helper despite the continuous objections of his partner. Court ruled this was for the benefit of
only one partner and not in the normal course of business.
Why the difference between Nabisco and Summers ?
“Carrying on in the usual way the business” – For a small business, purchasing bread may be
more mundane than hiring a worker.
Nabisco deals with a third party; Summers deals with relationship between the partners. Thus,
§18(b) applies, rather than §9(1). §18(h) limits §18(b) by requiring a majority vote in case of
disagreement.
UPA §18(b): “The partnership must indemnify every partner in respect of payments made and
personal liabilities reasonably incurred by him in the ordinary and proper conduct of its business,
or for the preservation of its business or property.”
In other words, there is a conflict between two principles: (1)that all partners are agents of the
partnership and able to bind the partnership, and (2) that partners have equal rights in
management. In conflicts with third parties, the first principle controls; in conflicts between
partners, the latter principle controls.
Centralized Management of a Partnership
Nabisco and Summers both regard small partnerships. A common problem in those
partnerships is deadlock – each member can prevent the other from acquiring a majority, and as
a result, the partnership can’t take any actions.

What can be done to prevent deadlocks?

1) Voting rights can be allotted so that there is not a 50/50 split. But the partner(s) in the
minority would be vulnerable.
2) Appointing a third party as a tie-breaker in case of deadlock.
3) Appoint a third party as manager, with partners voting only on issues outside of day to day
management (this doesn’t prevent deadlock, but reduces points of contention and enables
partnership to operate during deadlock.
4) The latter technique is a form of centralized management.
5) If unresolvable deadlock, partnership dissolution may be only solution.
6. Hypo – What is a “Normal” Business Decision? p. 146

Look at UPA § 18(h). If firing Don is in the normal course of business, then majority vote of
partners wins out. But, if the partnership agreement says that Charles is in charge of the meat
department and makes all decisions relevant to that department, then you could argue that the
firing of Don would be in contravention of the partnership agreement and would require a
unanimous vote.
7. Centralized Management of a Partnership

Large partnerships tend to suffer from high costs of communication and negotiation between all
the partners, and from a problem of “hold out” (a partner blocking decisions requiring unanimity in
order to extort benefits for himself).
Example: Suppose that ABC law firm (which has 200 partners) is about to merge with DEF law
firm, and that this merger requires unanimous consent of all of ABC’s partners. One junior
partner, who has a 0.25% interest, rejects the merger, though he hints that he would be willing to
go along if his share of the partnership was boosted to 1%. The merger will add all other partners
more value than they would lose by the concession to the hold-out partner. But what will happen
if they concede?
Centralized management helps reduce the risk of hold-outs as well as transaction costs in a
partnership with many members. There is less need for negotiations between partners, and less
opportunities to threaten a hold-out. What is the disadvantage of this mechanism? [Recall Bane]
8. Day v. Sidley & Austin p. 146 (Ouster of Partner Upon Merger)

Sidley & Austin have a form of centralized management. According to footnote 8 of the decision,
the Executive Committee decides on all matters, except for determination of participation,
admission and severance of partners, which require the approval of partners holding a majority of
partnership interests (not majority of partners). This majority vote is considered unanimous
approval by all partners.
How does this fit with UPA/RUPA’s rules on partner’s rights of management? How does this fit
with Meinhard’s standard of fiduciary duties? Does a junior partner have shared control in S&A?
The court seems to endorse the narrow holding of Meinhard (partner can’t advantage self at the
expense of the firm), but not the “selfless” standard. Why?
Day was postmaster general and invented zip codes. If the management committee becomes
weak and the powerful partners are not on the committee, then you wind up with Meehan v.
Shaughnessy.
Centralized Management: Consensus v. Authority
Consensus:
 Collective decision-making
 Requires constituents with:
 Similar business interests
 Comparable access to information
 Minimal costs of acting collectively
 Partnership optimized for these characteristics.
Authority:
 Central decision-making body

 Needed when constituents have:

 Differing business interests
 Unequal access to information
 High costs of acting collectively
 Corporation optimized for these characteristics.
VIII. V. Partnership Dissolution

A. The Right to Dissolve
Disagreements between business partners are inevitable. Law can take two approaches to
enable operating the business association despite the disagreements:
1) It can prohibit forced dissolution of the entity, but allow any partner to exit (sell his
interest in the entity) or sue the other business partners (while still a member of the entity)
i. This allows for the entity’s longevity, but requires transferability of the
interest in the entity. Otherwise, a lot of litigation will ensue.
ii. This is, generally, the governing principle in corporations.
2) It can allow forced dissolution of the entity, and limit suits between business
partners while they are still partners.
i. This is, generally, the governing principle in partnerships.
ii. This sacrifices longevity but allows greater restrictions on transferability.
3) In past, partners couldn’t sue each other regarding partnership while still partners
(except suit for dissolution and accounting). Many states have changed that.
4) Which approach is more similar to law’s treatment of marriage?
1. The right to dissolve

• Consequences of dissolution
• Division of remaining profits/losses
• Exit Mechanism: Buy-out agreements
“[T]here always exists the power, as opposed to the right, of dissolution” [Collins v. Lewis] What
does this mean?
Three types of dissolution:
1) by act of one or more partners [UPA §31(1)-(2)]; e.g.:
a. At the termination of the partnership’s term or particular undertaking, or, if it has
none, at the will of any partner;
b. Wrongful dissolution: In contravention of the agreement between the partners, by the
express will of any partner at any time.
2) by operation of law [UPA §31(3)-(5)]
a. Due to death or bankruptcy of a partner, or due to bankruptcy or unlawfulness of the
partnership.
3) by court order [UPA §31(6); §32]

2. Owen v. Cohen p. 154 (Pickwick Bowl)

Partnership Dissolution: Constant harrassment by a partner is grounds for dissolution.
“I had not worked yet in 47 years and do not intend to start now!” (Cohen)
Owen and Cohen become partners in a bowling alley. Owen provides money, that is to be repaid
out of the profits of the business. Cohen is a service partner, but turns out to be a disservice
partner – he’s abusive to Owen, and does not do any work. Partners in a bowling alley business
in Burbank (Pickwick?); one was a huge jerk and kept demeaning the other and fought over every
decision. Trial court ruled him a jerk and appellate court upheld being a huge jerk as reasonable
basis for partnership dissolution. The whole thing was a scam from the beginning. It’s like Owen
got into bed with a mobster. Scam is partnership borrows money from Owen, repayable from
partnership profits. But Owen wants out. But if he dissolves the partnership, he is in breach of
the agreement and therefore, as the breaching party, he is not entitled to recover the money. So,
Cohen did everything he could to get Owen to sue him for dissolution so that he (Cohen) would
not have to repay the money and he could continue to bilk the firm.
Owen sues for dissolution. Why go to court?
• Cohen disputes that Owen’s loan to the partnership is to be repaid before dividing the
proceeds. Owen seeks judicial determination of the loan’s priority.
• Cohen is unlikely to cooperate in winding up the partnership, so an appointment of a
receiver (by the court) is needed.
o Cohen might claim that Owen undertook a wrongful dissolution
o Owen claims his dissolution is according to UPA §31(1)(b) [i.e., the partnership
agreement had no defined term or particular undertaking]
What can Cohen argue to characterize Owen’s dissolution as wrongful?
• Cohen claims the partnership is “for a term”; an implied term in the agreement is that the
partnership will last until Owen is repaid his loan from the profits. Thus, by ending the
partnership prematurely Owen causes wrongful dissolution of the partnership.
Does this annul the dissolution?
o A dissolution is valid even if it is wrongful [UPA §31(2)], but wrongful dissolution
will result in adverse consequences to Owen [UPA §38(c)].
If court finds this is a term partnership, is Owen’s dissolution necessarily wrongful?
• No. A dissolution is wrongful under UPA §31(2) only “where the circumstances do not
permit a dissolution under any other provision of this section.” Since other sections did
apply (UPA §32(c), (d) and (f)), dissolution was not wrongful.
3. Collins v. Lewis p. 157 (Unprofitable Cafeteria)

Partnership Dissolution: If loans defined in partnership agreement are paid on time, other
loans cannot be used as basis for involuntary judicial dissolution of partnership.
Collins and Lewis were partners for building an operating a cafeteria. Lewis was to supervise
construction and operate the cafeteria (“service partner”), while Collins was to put up the money.
They originally estimated building costs at $300,000. Collins was to be repaid $30,000 in the first
year of operation and $60,000/yr. thereafter, secured by Lewis’ interest in the partnership.
Building costs run up. When they reach $600,000, Collins refuses to put up more money, and
sues for dissolution.
Court finds that this is a term partnership, and Collins must continue financing it or suffer
consequences of wrongful dissolution. Unlike in Owen, bad blood between partners was
seen as insufficient to require dissolution.
Collins has to continue to finance partnership; Lewis doesn’t provide any money at all. Is
this fair?
• Lewis contributes his labor. Does he get a salary reflecting this value?
• Capital may have priority over labor in distribution priority [cf. §40(b) w/ Kovacik]
• Collins could have protected interests in agreement. “You made your bed, now lie in it”
[similar to Lawlis, Day, Prentiss] Collins signed an agreement that was way too broad.
He should have capped his commitment (no more than $x; anything in excess will come
from you or you will put in 80%, …)

4. Page v. Page p. 162 (Brothers in Linen Supply)

Partnership At Will vs Term: Absent any indication of plan to limit partnership to term, it is
at-will.
“We never figured on losing, I guess” (George Page)
Linen firm finally starts to make money b/c of Vandenburg AF Base; then brother decides to
dissolve partnership. Other brother objects, claiming that his brother only wants to steal all the
future profits. Court says facts don’t support a claim of partnership for term, so it must be at will.
Also, dissolution as all other partnership issues, must be handled in good faith. The Page
brothers, H.B. (Plaintiff) and George (Defendant) were partners in a linen supply business. For 8
years it had suffered losses, but now it was beginning to show a profit. H.B., who is in better
financial condition than George, wants dissolution and sues for a declaratory judgment that
partnership is terminable at will. Why not just sue for dissolution?
Court imposes (in dicta) fiduciary duty in suing for dissolution.
• To dissolve rightfully, need to show cause for dissolution (e.g., partnership terminable at
will) and
• Can’t breach fiduciary duty (e.g., partner can’t dissolve a partnership in order to capture
the partnership business individually).
George claims that H.B. was content to share losses, but now that an Air Force base opened
near the business and prospects are up, he is not content to share profits. Court finds no
evidence of this (this isn’t a suit for dissolution anyway).
5. Terminating the Partnership - The right to dissolve

1) Consequences of dissolution
2) Overview of the process [Differences between UPA & RUPA]
3) Disposing the partnership’s assets/business
4) Continuation per agreement
5) Continuation following wrongful dissolution
6) Division of remaining profits/losses
7) Exit Mechanism: Buy-out agreements

6. The Process of Terminating the Partnership (1/10/2005)
Under UPA:
1) Dissolution does not terminate the partnership [UPA §30]. Rather, it limits all partners’
authority to act for the partnership [UPA §33-35], and prompts the “winding up” of the
partnership.
2) “Winding up” consists of disposing of the partnership’s assets/business, then dividing
between the partners the remaining assets or the liability for remaining losses.
3) Subject to certain limitations, some partners may pay off other partner and continue the
partnership after dissolution [UPA §38(2)(b)].
Under RUPA:
1) Triggering event is “disassociation” [RUPA §601]. After that:
2) Business may be continued under Article 7
3) Purchase of disassociated partner’s interest [RUPA §701]
4) Disassociated partner not automatically released from liability [RUPA §703]
5) Business may be dissolved (and “wound up”) under Article 8
6) Not every event allowing disassociation also allows dissolution [cf. §801 w/§601]
7) Limitation on partner’s authority to act for the partnership [RUPA §804]
B. The Consequences of Dissolution
1. RUPA § 603
(a) If a partner's dissociation results in a dissolution and winding up of the partnership business,
Article 8 applies; otherwise, Article 7 applies.
Section 603(a) indicates that one of two things can happen when a partner dissociates.
(1) It can result in a dissolution and winding up of the partnership business, in which case Article
8 applies.
(2) If it does not result in a dissolution of the partnership, Article 7 applies. Article 7, as we will
see, provides for a buyout of the dissociated partner.
But how do you know which one of those two happens? The answer lies in Section 801,
which indicates that "A partnership is dissolved, and its business must be wound up, only upon
the occurrence of any of the following events: . . ." Section 801, in other words, tells us when
dissolution occurs. If the partner's dissociation is an event listed in section 801, there's a
dissolution and Article 8 applies. If the partner's dissociation is not an event listed in section 801,
there's no dissolution, and Article 7 applies.

RUPA § 801. Events Causing Dissolution and Winding Up of Partnership Business.
A partnership is dissolved, and its business must be wound up, only upon the occurrence of any
of the following events:
(1) in a partnership at will, the partnership's having notice from a partner, other than a partner
who is dissociated under Section 601(2) through (10), of that partner's express will to withdraw
as a partner [as of the time of the notice], or on a later date specified by the partner;
(2) in a partnership for a definite term or particular undertaking:
(i) within 90 days after a partner's dissociation by death or otherwise under Section
601(6) through (10) or wrongful dissociation under Section 602(b), the express will of at least
half of the remaining partners to wind up the partnership business, for which purpose a
partner's rightful dissociation pursuant to Section 602(b)(2)(i) constitutes the expression of that
partner's will to wind up the partnership business;
(ii) the express will of all of the partners to wind up the partnership business; or
(iii) the expiration of the term or the completion of the undertaking;
(3) an event agreed to in the partnership agreement resulting in the winding up of the
partnership business;
(4) an event that makes it unlawful for all or substantially all of the business of the
partnership to be continued, but a cure of illegality within 90 days after notice to the partnership
of the event is effective retroactively to the date of the event for purposes of this section;
(5) on application by a partner, a judicial determination that:
(i) the economic purpose of the partnership is likely to be unreasonably frustrated;
(ii) another partner has engaged in conduct relating to the partnership business which
makes it not reasonably practicable to carry on the business in partnership with that partner; or
(iii) it is not otherwise reasonably practicable to carry on the partnership business in

conformity with the partnership agreement;
or
(6) on application by a transferee of a partner's transferable interest, a judicial determination

that it is equitable to wind up the partnership business:
(i) after the expiration of the term or completion of the undertaking, if the partnership was
for a definite term or particular undertaking at the time of the transfer or entry of the charging
order that gave rise to the transfer; or
(ii) at any time, if the partnership was a partnership at will at the time of the transfer or
entry of the charging order that gave rise to the transfer.
2. Prentiss v. Sheffel, p. 165 (Arizona Shopping Mall Partnership)

A partner of a dissolved partnership may not prevent other partners from submitting bids
at a sale of the partnership’s assets on the grounds that he was wrongfully excluded from
managing the partnership unless it can be shown that the other partners excluded him for
the wrongful purpose of obtaining the assets of the partnership in bad faith.

In a shopping center partnership, Sheffel and Iger each own 42.5% of the interests; Prentiss
owns the remaining 15%. Prentiss claims he was “frozen out” (kept out of the decision making
process to force him to sell his interest below its value), and refuses to contribute his share of the
operating deficit. S and I sue for dissolution. Court orders an auction of the property. S & I make
highest bid. P appeals, claiming S & I can’t bid since they have an unfair advantage of using
“paper dollars” (their interest in the partnership equity).
“Paper Dollars”
Let’s assume the partnership has assets (and goodwill) worth $1,000,000, and has no debt. S & I,
jointly, have an 85% interest; P has 15%.
If S & I value the partnership at $1,000,000, their out of pocket expenses are $150,000 (15% of
$1,000,000), paid to P.
If P values the partnership at the same value, his out of pocket expenses (paid to S&I) are
$850,000 (85% of $1,000,000).
If a third party values the partnership at the same value, her out of pocket expenses (paid to S, I
& P) are $1,000,000.
Therefore, P claims S & I have an unfair advantage – they incur much lower out of pocket
expenses to buy the partnership. Why does that happen?
Third parties are also likely to be concerned about hidden problems with the partnership, and
lower their bids to account for this risk. That’s gives S&I an advantage over third parties. Would
prohibiting S&I from bidding result in a higher winning bid? Why does P want to prohibit their
participation?
Freeze-outs and “Coat-tailing”
Why does P want to prohibit their participation?
• Animosity
• A low third party bid hurts S&I more than it hurts P (since they get 85% of the bid). To
prevent that from happening, they’ll offer P a sweeter buy-out deal.
• If S&I know they can’t bid (and thus lose the partnership when they oust P), they might be
deterred from freezing-out P.
• Court rules that S&I are allowed to bid. If P wanted protection from being bought out, he
should have addressed that in the partnership agreement.
• Prentiss is unhappy that he can be forced to take cash for his interest in the partnership.
S&I’s fiduciary duty probably requires them to pay P for the value of any new
opportunities/fortunes they are aware of. So why does P prefer to tag along on their
coat-tails?
• If S&I did know of a new opportunity, why would they tell? S&I: “Do as we say, not as we
do.” Later, it will be hard for P to prove the opportunity existed when he cashed out. He
is in an informational disadvantage, so he prefers to imitate those who know more.
Similar to the Carney laundry case where the laundry started making money so then the
one partner tried to dissolve and take over.
Continuation Per Agreement (After Dissolution)
Effect on the partnership
• Technically, this creates a new partnership (confusing treatment in Putnam v. Shoaf)
• Creditors of former partnership automatically become creditors of the new partnership
[UPA §41]
Effect on the departing partner(s)
• Departing partner entitled to an accounting
• Fair value of the partnership, plus interest from the date of dissolution in the event of an
unreasonable delay in payment.
• Departing partner remains liable on all firm obligations unless released by creditors [UPA
§36, RUPA §703]
Effect on a new partner
A new partner that joins the partnership when it continues after dissolution is liable to old debts,
but his liability can only be satisfied out of the partnership assets (i.e., he has no personal liability)
[UPA §41(1), RUPA §306(B)].
Continuation Following Wrongful Dissolution

Effects of wrongful dissolution (e.g., early termination of a term partnership):

• Wrongful dissolver subject to damages for breach of the partnership agreement [UPA
§38(2)(a)(II)];
• Wrongful dissolver limited in participation in winding-up [UPA §37];
• Remaining partners have the right to continue the business even absent an agreement to
do so, subject to payment to the wrongful dissolver [UPA §38(2)(b)-(c)]
• Wrongful dissolver entitled to the fair value of his interest in the partnership (not including
the value of the partnership’s goodwill), minus any damages caused by the breach of the
partnership agreement.
• RUPA has very similar rules, except that the fair value of the interest, to which the
wrongful dissolver is entitled, includes the value of the partnership’s goodwill.
3. Monin v. Monin, p. 168 (Milk Partnership)

A partner’s fiduciary duty to the partnership extends beyond the dissolution of the
partnership until the partnership terminates. UPA § 30
Failure to withdraw from competing bid at time of dissolution unfairly disadvantaged
partnership.
Brothers in milk hauling partnership decide to dissolve the partnership. One brother sends a
letter to their most important client shortly before contract comes up for renewal, announcing
dissolution and offering personal bid on the contract. Other brother buys out partnership,
including the major client. Then the major client refuses his services and goes with other brother.
Trial court ruled no problem b/c major client could hire whomever they wished and partnership
was already dissolved. Appellate court reversed reasoning that the brother should have
withdrawn his bid.
4. Pav-Saver Corp. v. Vasso Corp., p. 171 (Paving Machine Manufacturer Break-up)

Wrongful Dissolution – Partnership agreement specified that dissolution could only occur
upon mutual approval of both parties. PSC unilaterally terminated the partnership
agreement, trial court determined that the remainder of the agreement allowed Vasso to
continue the partnership and possess the assets while paying the value agreed upon in
the partnership agreement to PSC and to be paid the damages as agreed upon in the
partnership agreement. Rights controlled by UPA § 38(2)(a)(b)(c).
Yet another example of how important it is to anticipate disagreement and draft appropriate, clear
language into the partnership agreement to address such contingencies.
Key issue is: Can Meersman (Vasso) elect to continue the partnership after Dale (PSC)
terminates their ‘permanent partnership’?
Section 3.B(2) addresses returning patents to Dale upon “expiration” of the partnership. Does
this mean dissolution or termination? I.e., if Dale breaches and Meersman elects to continue the
business, has the partnership ‘expired’?
Section 11 of the Pav-Saver Mfg. Co. partnership agreement:
“It is contemplated that this joint venture partnership shall be permanent, and shall not be
terminated or dissolved by either party except upon mutual approval of both parties. If, however,
either party shall terminate or dissolve said relationship, the terminating party shall pay to the
other party [liquidated damages].”
Does this mean that the partnership can be terminated (overriding §38), subject to paying
liquidated damages, or (as court rules) that partnership is permanent, dissolution is wrongful, and
the latter part of section 11 of the agreement specifies the damages to be awarded under §38.
Terminating the Partnership
The right to dissolve
Consequences of dissolution
Division of remaining profits/losses
Exit Mechanism: Buy-out agreements

C. The Sharing of Losses

1. Kovacik v. Reed, p. 177 (Contractor Partnership to Build Kitchens) EXCEPTION TO
UPA
When a partner contributes only equity (labor), there is no obligation to pay in cash to
cover losses upon dissolution. Rationale is that where one party conributes money and
the other contributes services, then in the event of a loss each would lose his own capital
– the one his money and the other his labor.
UPA §18(a): Each partner… must contribute towards the losses, whether capital or otherwise
sustained by the partnership accounting to his share in the profits.”
UPA §40(b): gives priority to rights a partnership owes a partner “in respect of capital”, over rights
it owes a partner “in respect of profits”. UPA §40(d) requires that “partners shall contribute, as
provided by [§18(a)], the amount necessary to satisfy the liabilities [set forth in §40(b)]...”
The rule seems clear: Absent an agreement to the contrary, all partners must satisfy (from
personal assets) the partnership’s liabilities, and these liabilities are divided among partners
based on their agreed division of profits.
Kovacik v. Reed: Reed is a service partner; Kovacik contributes $10,000. Profits divided equally.
No salaries paid. After 10 months of losses, the partnership has only $1,320 (i.e., it lost $8,680 ).
Kovacik sues to dissolve and demands that Reed share half the loss ($4,340).
Kovacik’s capital account: $10,000 – 4,340 = $5,660
Reed’s capital account: $ 0 – 4,340 = ($4,340)
Held: Reed is not liable. A partner who contributed capital is not entitled to recover losses of
capital from a service partner.
Rationale: When partnership fails, partner contributing capital loses his capital, and service
partner losses the value of his labor.
Personal liability to partnership debts means that service partner bears a potentially infinite
liability if partnership fails. This is a problem if we thing that the service partner is poorer than the
partner providing capital.
But if that is the case, why not use a Limited Partnership (or a corporation)?
• Courts have not followed Kovacik in the following circumstances:
• When service worker was compensated for work.
• When service partner made a nominal capital contribution.
Suppose Reed knew in advance of the court’s decision in Kovacik. As the service partner, he
may be the one in charge of managing the partnership. The partnership is about to go bankrupt.
What would Reed likely do?
The Kovacik ruling may create a discrepancy between ownership (Kovacik is the residual
claimant – the person affected by the partnership’s gains and losses) and control (assuming that
Reed is the one who manages the business day-to-day). This results in a problem not unlike that
between creditors and shareholders.
RUPA repeats UPA’s rule. Comments to RUPA specifically reject Kovacik.
Loophole: Comments to RUPA also state that partners may agree to share ‘operating’ losses
differently from ‘capital’ losses. This allows a court that wants to implement Kovacik, to find an
implied term in the partnership agreement, to treat ‘capital’ losses differently. 34 Calrptr 491 Witt
V Calhoun – subsequent case – hinges on one party contributing only services.. If one party
only put labor at risk, he probably was not willing to put cash at risk.
D. Buy-out agreements
Exit Mechanisms
Buyout agreements replace (or fill with detailed content) the default rules of UPA/RUPA and the
court’s discretion. Effective buy-out clauses allow disagreements to be solved by the exiting of
one of the partners.
Selling partnership interest to third parties
May have limited value if market is very thin;
Raises issues regarding undesirable partners.

Selling partnership interest to partnership (or to the other partner)

Raises problems with liquidity of partners (recall our discussion on raising additional capital from
the partners), or with liquidity of the partnership.
Can be used opportunistically to extract benefits (or else the partner will cash out, forcing the
other partners or the partnership into insolvency).
Estate planning problem: In the case of death, partner may want his interest liquidated
immediately to pay estate taxes; other partners may want more control over who buys the interest
(or may not have enough money available immediately to buy it themselves), which slows down
liquidation of the interest.
Exit Mechanism Price
Price is a crucial aspect of the exit mechanism.
Parties may determine the value annually by agreement
Parties often neglect to do so.
As interests diverge, parties may disagree.
Parties may hire an appraiser
It may be difficult to agree ex post on the identity of the appraiser.
Parties may set a formula
E.g., based on annual cash flow or earnings, multiplied by a certain factor.
Parties may use book value
Book value is the price of the assets when purchased, reduced over the years for wear and tear.
This may not reflect their real value (e.g., stock that has appreciated in value; a car that lost much
of its value in the first year, etc.).
“You Pick, I choose”: One party names a price, and the other decides whether it will buy from the
other, or sell to the other, at that price.
Works well if both parties have sufficient cash.
Exit Mechanism “You Cut, I Choose”
Hypo: Bank A and Bank B have a partnership that provides home financing. Bank A (which was
much larger than Bank B) owns 75 “points”, and bank B owns 25 points.
As a result of antitrust enforcement, the Banks are required to break up the partnership. The
agreement has a buyout clause that incorporates the “you cut, I choose” concept: Bank A is to
decide on a price per “point” (any price it wants). Bank B then gets the option of either selling its
interest to Bank A at that price per point, or buying from Bank A its points for that price.
Assume that both banks have no financial constraints. Would Bank A decide on a price that is
higher or lower than the perceived value of the partnership?
Now assume that Bank A expects Bank B to have liquidity problems – it is smaller so it has less
money, and it has to pay for three times the number of points. Would Bank A decide on a price
that is higher or lower than the perceived value of the partnership?
Do we have a preference as to which side determines the price?
1. G&S Investments v. Belman, p. 181 (Death of a Partner)

A partnership buy-out agreement valid and binding even if the purchase price is less than
the value of the partner interest, since partners may agree among themselves by contract
as to their rights and liabilities?
This case is straightforward. It raises, however, a question as to the applicable law: Century park
(the partnership at stake in this case) is a limited partnership. Why are we applying the general
partnership statute (the UPA)? Nordale (the partner whose interest required valuation) was a
general partner; The ULPA did not address the specific issue presented; UPA §6 states that it
applies to limited partnerships. The issue is whether Nordale’s estate gets his partnership
account which is his historical basis in the partnershp; or whether they get the liquidated market
value of the property. The difference could be huge, especially where the basis is flat but the
value increases each year. It would be like getting the $15k your parents paid for their house in
1958 or getting the $4 million it’s worth today.
Limited Partnerships
Sole Proprietorship
Partnership
General Partnership

Limited Partnership (LP)

Limited Liability Partnership (LLP)
Limited Liability Company (LLC)
Corporation
Closely-Held (Private) Corporation
Public Corporation
Why the need for Limited Liability in Partnerships?
Trends in 1980s:
Growth of very large partnerships (esp. in professional services sector);
Rise of mass financial torts (esp. for lawyers and accountants);
Rapid rise in liability insurance premium;
Increased willingness of IRS to grant pass-through tax treatment to unincorporated business
associations possessing limited liability.
History of the Uniform Limited Partnership Act
ULPA (1916);
ULPA (1976);
RULPA – 1985 amendments to ULPA (1976);
ULPA (2001).
E. Law Partnership Dissolutions

1. Jewel v. Boxer (p.185)(1984)
firm of 4 partners splits into 2 firms w/ 2 partners each--there was no partnership agreement, so
issue of how to divide profits of old cases which are transferred to the new firms?
- b/c no partnership agreement, the UPA rules this case (default rules)
- trial ct ruled for ∆ allocating post-dissolution fees on a quantum meruit basis according
to 3 factors re: post-dissolution work
- app ct liked the trial ct’s approach, but since it wasn’t what UPA called for, reversed for
Π saying fees should be allocated according to their shares under the old partnership
- the partners could’ve (& probably should’ve) agreed amongst themselves to a
different partitioning in a partnership agreement or even at dissolution
- [got a little lost here...see slide handouts re: incentives & effects of “sharing
contracts”]
further notes...
- Champion v. Superior Ct. (CA, 1988) chose not to follow Jewel in case of w/drawl of
partner (but partnership agreement provided for survival of partnership)
- if partner w/draws but her share is not a large portion of firm’s work then there is
no pro-rata sharing imposed during winding up phase
- RUPA §401(h) allows for reasonable compensation for services rendered during
winding up...similar to trial courts reasoning
2. Meehan v. Shaughnessy...revisited from 2/1 (p.191)(1989)

issue: how to split up fees of clients that were taken to ∆ ’s new firm from Π firm (notwithstanding
fiduciary duty claim)--here there is enforceable partnership agreement
- ct distinguishes b/w cases ∆ s fairly v. unfairly took...
- w/ cases took fairly, resolved according to partnership agreement
- w/ cases took unfairly,
For Fiduciary Duty Claim:

- factors determining causation (burden on removing partner)
(i) who originally drew client to old firm
(ii) who managed case at old firm
(iii) sophistication & informed-ness of client
(iv) reputation & skill of removing attorneys

- remedy (if breach found):

- imposition of constructive trust (disgorgement)
- to be split by partners on pro rata basis
3.
4. Characteristics of Limited Partnerships 1/12/2005

A limited partnership is composed of at least one general partner, and of at least one limited
partners. The formation of the partnership requires filing certain documents (typically with the
state’s Secretary of State).
The death of a limited partner does not cause the dissolution of the partnership, and limited
partnership shares are often transferable. Limited partners may have restricted voting rights.
The general partner is personally liable to creditors. However, some states allow the general
partner to be a corporation. This allows both unlimited life to the partnership, and limited liability
to all the people involved.
According to RULPA (Uniform Limited Partnership Act (1976), which replaced ULPA (1916))
§303(a), limited partners are liable only to the extent of their contributions, unless:
They are also general partners
They exercised control or had a right to exercise control – in such case, they are liable only to
persons who reasonably believed, based on the limited partner’s conduct, that the limited partner
is a general partner).
IX. VII. Limited Partnerships

Holzman v. de Escamilla, p. 196 (Farming Partnership)
p. 198 Control v. Risk – A limited partner may become a general partner as a result of how
he is perceived by 3rd parties.
How could Russel and Andrews have the control they crave w/o the risk?
Russell and Andrews form a limited partnership, in which de Escamilla is the general partner. R
& A participated in deciding what crops to plant, they had check writing power, and they asked de
Escamilla to resign as manager (which he did).
The partnership became insolvent, and creditors claimed R & A were personally liable because
they exercised control.
Court finds that they did exercise sufficient control to be found liable.
RULPA §303(b) create “safe harbors” of activity that is not deemed as participation in control.
1. Revised Uniform Limited Partnership Act (RULPA) §303

(a) A limited partner is not liable for the obligations of a limited partnership unless the limited
partner is also general partner or, in addition to the exercise of his rights and powers as a limited
partner, he takes part in the control of the business. However, if the limited partner takes part in
the control of the business and is not also a general partner, the limited partner is liable only to
person who transact business with the limited partnership and who reasonably believe, based
upon the limited partner’s conduct, that the limited partner is a general partner.
(b) A limited partner does not participate in control solely by…(2) consulting with and advising a
general partner with respect to the business of the limited partnership
2. Limited Liability Partnership [Article 10 of RUPA] 1/12/2005

Similar to a limited partnership, but grants general partner limited liability as well (somewhat
similar to making a corporation the general partner).
Acts like a general partnership, but with limited liability.
Formed by filing a ‘statement of qualification’ (usually, with the state’s Secretary of State).

General partnership may convert to LLP. Conversion does not cause a dissolution [RUPA
§201(b)]
Liability – RUPA §306(c): “An obligation of [a limited liability partnership]… is solely an obligation
of the partnership… A partner is not personally liable… solely by reason of being… a partner.”
Some states restrict the liability limitation to tort actions, and leave contract liability unlimited.
The ruling seems to say that you should act in one manner behind the scenes and in another to
the public. As de Escamilla’s attorney, you should recommend that he resign.
Knipprath: Partners have limited liability for the negligent act of their co-partners. It gives more
protection to the partners than the GP, but less than the LP. Usually used by professionals.
Lawyers don’t want to be liable for the mistakes of their partners. The liability limitation applies to
the acts of your co-partners and employees.

BUSINESS ASSOCIATIONS OUTLINE CORPORATIONS
X. THE CORPORATION
Corporations are generally optimized for a larger number of participants, greater discrepancy in
business interests, and larger volume of business.
The corporation has two main characteristics:
Independent legal personality
Separation of ownership and control
Units of equity in a corporation are called shares (similar to “points” in a partnership). Owners of
equity in the corporation are called shareholders (“SH”).
“Republican” form of control (i.e., control by delegates of the SH, not by direct vote of the SH):
Shareholders - nominal owners, but usually no direct control
Board of Directors – elected by shareholders; oversight of corporation
Officers – appointed by Board of Directors; day-to-day management
A. Main Attributes
1. Independent Legal Personality

Limited Liability
MBCA §6.22(b): “Unless otherwise provided in the articles of incorporation, a shareholder of a
corporation is not personally liable for the acts or debts of the corporation except that he may
become personally liable by reason of his own acts or conduct.”
Longevity
Tax treatment (taxed as a separate entity)
2. Separation of Ownership and Control

Centralized Management
MBCA §8.01(b): “All corporate powers shall be exercised by or under the authority of, and the
business and affairs of the corporation managed by or under the direction of, its board of
directors.” [See also DGCL §141]
Transferability of interest (liquidity)
Flexible Capital Structure
B. Comparing Partnerships and Corporations
1. Tax Considerations In Choice Among BA’s 1/10/2005

A partnership is not taxed individually; it reports its profits or losses to the partners, who
report these (and other personal income and losses) on their tax returns.
In comparison, a corporation is taxed on its profits. Then, if it distributes dividends to the
SH, the distribution is not deductible by the corporation, but it is taxable to the SH.
Why is this two-tier taxation bad for a SH?
1) If business profits – double taxation is worse than being taxed once (duh!)
2) If business loses – you can’t offset losses with other personal profits
Are corporations always worse from a tax perspective? No.
1) Different tax rates for individual income and corporate tax.
2) Corp. income could be distributed through deductible expenses (rent, interest,
wages, etc.).
3) Corporations can elect to be taxed as S Corporations.
C. Public v. Close Corporations
1. Publicly-held (“Public”)
A public secondary market in which the corporation’s shares are listed and traded.

Primary market – transactions to which the corporation is a party

 e.g., issuing or repurchasing shares
Secondary market – transactions in which corp. is not a party
 e.g., A sells to B shares in X Corp.
Public Secondary Market – e.g., stock exchange
 e.g., NYSE; NASDAQ
2. Closely-held (“Close”) 1/12/2005

Formation: 2 Methods
 Statutory (Just comply with the statute in your state)
 Judicially imposed
Absence of a secondary market for its shares.
 Often (but not always) a small number of shareholders, who actively participate
in the firm’s management.
Firm exhibits characteristics somewhat similar to those of a partnership.
 Why is a difference in the liquidity (i.e., the degree of transferability of interests in
the corporation) so important as to create these classifications?
 Limited number of shareholders; statutorily regulated by state.
Liability
 Shield
Management
Existence
 Technically, indefinite
Transferability
 Few shareholders
 Not as freely alieanable shares as a public corp
 Per share value typically very high due to fewer shares o/s
 Usually closely held by people who know each other (unlike big NYSE
companies)
 This is more similar to a partnership
 SH typically do not want the shares to be freely alienable
D. Introduction to the Corporation:

1. Overview of Issues
Forming the Corporation
 Mechanics of Forming the Corporation
 Liability for Pre-Incorporation Activity (Promoters)
Independent Legal Personality
 Limited Liability
 Derivative Actions
Separation of Ownership and Control
 Capital Structure
 Centralized Management

2. One last BA type: The Limited Liability Company
E. Applicable Law
Corporations are incorporated according to state law. Therefore, the first issue is choosing the
state of incorporation.
Over 300,000 companies are incorporated in Delaware including 58% of Fortune 500 firms, and
over 50% of publicly-traded companies. Therefore, familiarity with the Delaware General
Corporation Law (DGCL) is important.
Refer to the ABA’s Model Business Corporation Act (1984) (MBCA).
F. Mechanics of Forming a Corporation

In practice, many lawyers use an incorporation service to handle the paperwork. But it’s useful to
understand the process: 2/12/04
1) Draft The Articles Of Incorporation
2) Decide What State To Incorporate In
3) Pick A Name
4) Mandatory Terms – MBCA §2.02(A); Optional Terms – MBCA §2.02(B)
5) File Articles With The Relevant State’s Secretary Of State
a. The person filing articles is the incorporator (MBCA §2.01).
b. State will process and send a certificate of incorporation – Corporation has been
formed! (MBCA §2.03)
6) Draft Bylaws (MBCA §2.06)
7) Organizational Meeting (MBCA §2.05)
a. Name Directors
b. Adopt Bylaws
8) Directors Convene And Appoint Officers
9) Issue Stock
G. Liability for Pre-Incorporation Activity

1. Fiduciary Obligation Hypos (pp.199-201)
Case 1:
Third Party Sales: Ann buys land for $125,000, and sells it to total stranger Sean for
$200,000, without disclosing her purchase price. Sean sues to recover $75,000.
Sean can’t recover unless he can prove fraud – this requires proof of
misrepresentation and damage.
Cases 2-3:
Principal-Agent Sales: Art buys land for $125K. Paula hires him as an agent to buy
that land, and he sells to Paula for $200,000. Paula sues to recover $75,000.
Paula can disgorge Art’s profit (even if land is actually worth $200K), because agent
breaches fiduciary duty by secret dealing with principal. Art should have disclosed
relevant information to avoid liability.
Same rule applies whether principal is an individual or a corporation.

Case 4:
Promoter Sales: A promoter is an agent of the corporation he forms, and owes it a
fiduciary duty.
Approach (a): Art forms corporation C, sells C’s stock to Paula, and then (as part of
an integrated transaction) sells land he owns to C, without disclosing his interest in it.
If the sale was part of the same transaction as forming C, Art is C’s agent and has
made a secret profit, which he must disgorge to C.
Approach (b): Art sells land he owns to Paula. Paula then forms C, and gives the
land to C (which she owns 100%).
Art is not a promoter of C. No fiduciary duty to C.
Alternative Approach (b): Art forms C, sells C’s stock to Paula, and then sells land he
owns to Paula. She gives the land to C.
Art did not transact with C (which is his principal), so he breached no duties to C.
Is there a substantive difference between approaches (a) and (b)? Probably not, but
formalities matter, especially in corporations.
Approach (c): Art forms C, buys its stock for 200K, then has C pay the $200K to buy
the land he owns (which he bought for $125). Finally, he sells C’s stock to Paula,
without disclosing the price for which he initially purchased the land.
Courts are split regarding A’s liability in this case (Old Dominion).
If A breached a duty to C in selling the land for $200K, then Paula could have C sue
A for the breach of duty (déjà vu from Putnam v. Shoaf?)
But A owned C and (as a director) approved the purchase. A knew what he paid, so
there was full disclosure to C. Thus, A breached no duty to C
The only difference between approach (a) and (c) is that in the former, A didn’t
control C when he sold the land. He was promoter but not owner, so he owed
fiduciary duties yet couldn’t act for C and approve the sale.
Again, a slight difference in form results in a big difference in liability.
2. Case 4:
Promoter Pam contracts with third party Tom, on behalf of C Corp., a corporation not
yet formed.
If Pam later forms C, can C become party to the contract? Yes. C can unilaterally
adopt the contract. If the contract was worded properly, C may even automatically be
a third-party beneficiary.
If Pam later forms C, can Pam avoid liability? Pam must receive Tom’s consent
(either in the original contract or later). Absent an agreement, a promoter, as agent
of a yet to be formed corporation, is liable on the contract.
Who is liable if C is never formed? What happens if Pam forms a different
corporation than the one contemplated in the contract? Pam is liable (see above).
Are the investors who were to form C liable? If they share profits and control, they
may be partners and liable as such to the actions of any of the partners. Also, courts
formed doctrines to recognize a “defective corporation” (one that has not
incorporated as planned).

H. “Defective Corporations”
1. De facto Corporation:
2/12/04A court may treat an improperly incorporated firm as a corporation IF organizers:
1) Acted in good faith to incorporate;
2) Had the legal right to incorporate; and
3) Acted as if they were incorporated.
2. Corporation by Estoppel:
A court will also treat a firm improperly incorporated as a corporation IF third parties:
1) Thought business was a corporation; and
2) Would earn a windfall if it were now allowed to deny that the business was a
corporation.
3. Significant overlap between doctrines, but not always. E.g.:

1) If firm did not act to incorporate, can’t be De facto corporation.
2) If firm incurred liability by doing a tort, the injured party likely did not choose to deal
with the firm as a corporation. Still may be De facto corporation.
4. Southern-Gulf Marine Co. No. 9 v. Camcraft, Inc., p. 201 (The Ship Price)
If a third party treats an entity as if it is a corporation, the party is estopped from
denying its corporate existence at a later time.
Contract to sell a vessel signed by Camcraft (represented by Bowman) and Barrett,
who signs individually and on behalf of Southern-Gulf Marine, a Texas corporation. At
the time, SGM was not formed.
SGM then incorporated in the Cayman Islands (rather than Texas). Barrett informs
Bowman of the decision to incorporate elsewhere and of SGM’s decision to ratify and
adopt the agreement signed by Barrett. Bowman signs the letter.
Price of the vessel rises, and Camcraft reneges on the contract.
Appellate Court enters judgment for SGM. SGM’s status as a non-Texan corporation did
not cause Camcraft any substantive problems, and Bowman was informed of the
Cayman incorporation and accepted it. Camcraft is estopped from raising issue of
SGM’s incorporations.
Suppose you are Bowman’s lawyer and are now drafting the agreement with Barrett.
1) How would you mitigate the risk of SGM not being formed as contemplated?
2) How would you mitigate the risk of SGM not being formed as contemplated?
 State that Barrett is personally liable, at least until SGM is formed;
 Have Barrett commit to form SGM in compliance with certain key requirements (e.g.,
specified capitalization, state of incorporation). State that failure to do so is a
material breach of the contract;
 Have Barrett or SGM’s investors post a bond;
 Demand progress payments from SGM (and state that failure to pay any installment
is a material breach);
 Require that SGM be formed by a certain date (and state that failure to do so is a
material breach);
 Specify whether there is to be a new agreement between the two corporations when
SGM is formed;

 Specify what happens if SGM is not formed or, if formed, does not adopt the
agreement.
 Why does the plaintiff have this weird name? Why “…No. 9”?
5. Hypo: Limiting Liability

Abe is a very planned person. He keeps portions of his savings in separate accounts to
fund unexpected financial liabilities. For example, he keeps $20,000 in an account, to
cover damages he might cause to his neighbor Beth’s apartment if his convector leaks.
Unfortunately, Abe’s convector does leak. Even more unfortunately, the leak completely
destroys Beth’s antique furniture, causing $100,000 in damages. Beth sues Abe for
$100,000 and wins.
Abe says he is really sorry for the damage he caused, but asks that he pay no more than
$20,000, because this is the amount he allotted (in good faith) for such contingencies.
Does Abe need to pay $100,000, or $20,000? He pays for all of it.
Suppose that an expert civil engineer testified that $20,000 are usually more than enough
to cover damage caused by a leaking convector and that only 2% of leaks cause damage
higher than $20,000. Would Abe still need to pay Beth $100,000? No, he still owes the
whole thing.
Would the result be different if the apartment belonged not to Abe, but to his wholly
owned corporation, AbeCo., and AbeCo’s net worth was $20,000? PCV
What justifications are there for limited liability in a corporation?
6. Justifications for Limiting Liability

(1) Facilitate small and more risk-averse equity investments (diversification)
Iris has $1,000 available for investment. Barbara offers that Iris will invest this money
in return for a 1% interest in Barbara’s restaurant business (which is a general
partnership). Iris expresses concern about the risk of losing more than her
investment if the business fails. Barbara agrees to add a clause in the partnership
agreement stating that Iris’ share of the losses is zero. What is the largest loss Iris is
exposed to?
UPA §15, 40(d). This problem of ‘small investment, unlimited exposure’ was exactly
what bothered the court in Kovacik (but that case covered service partners, not
partners with small capital contributions).
(2) Facilitating transferability of equity interests (liquidity)
Igor saved $10,000, with which he plans to pay for law school, where he will enroll
next year. Meanwhile, he wants to invest the money and reap some returns. Bob
offers Igor to invest in his produce supply business (a general partnership). Igor likes
the idea, but wants to make sure he can cash out easily next year. Can he do so?
7. Who is Harmed by Limited Liability?

Are Lenders Harmed from limited liability?
Laura has $1,000 available for investment. She wants to lend the money rather than
make an equity investment. Ben offers her to lend to his general partnership, while Betty
offers her to lend to her corporation. Assuming both firms are in the same business and
expect similar profits, which investment is better?
In which firm is it easier to ascertain the assets available to satisfy the debt?
Now assume that Laura is indifferent to the risk of her investment, provided the return is
right. Assume Ben is very wealthy, and both the corporation and the partnership have
the same amount of capital. Which is the better investment?
Are involuntary creditors harmed from limited liability?
Could limited liability cause corps. To take excessive risks?

8. Limited Liability MBCA §6.22(b)

MBCA §6.22(b): “Unless otherwise provided in the articles of incorporation, a shareholder
of a corporation is not personally liable for the acts or debts of the corporation except that
he may become personally liable by reason of his own acts or conduct.”
“…not personally liable…”: Liability extends to what shareholder invested in the
corporation (i.e., the shareholder’s portion of the corporation’s assets).
“…except that he may become personally liable by reason of his own acts or conduct…”:
This exception is known as “piercing the [corporate] veil” (as if a veil separates between
the corporation and its shareholders).
9. Walkovszky v. Carlton p. 207 (Respecting the Formalities of the Corp. Structure)

Carlton and others had a taxicab business. They owned 10 corporations, each of which
owned two taxi cabs. Each cab was heavily mortgaged, and each corporation carried
only the legally mandated minimum liability insurance. The shareholders regularly
drained the corporations of assets. All cabs operated out of a single garage (held by yet
another corporation).
One of the cabs, owned by Seon Cab Corp., injured Walkovszky, who sued all 10
corporations and Carlton. Carlton moves to dismiss.
W offers two theories of liability:
1) All ten corporations were part of a single enterprise
2) Multiple corporate structure was a fraud on the public
a. What is the court’s analysis?
i. The court makes a distinction between liability based on fraud
and liability based on agency. This is somewhat muddled. In
fact there are three kinds of liability W might argue for:
1. Enterprise liability
a. All 10 corporations are de facto a single firm
b. Thus, each should be liable for acts or omissions of the other
2. Agency (respondeat superior)
a. Seon corp. acted on behalf of Carlton and subject to his control.
b. Seon was Carlton’s agent, and Carlton (principal), is liable for
Seon’s tort.
3. Piercing the Corporate Veil
a. Carlton disregarded the separate existence of Seon, and it would
promote injustice to require W to respect that separation.
I. Enterprise Liability
Enterprise liability occurs when: (1) there is such a high degree of unity of interest between
two (or more) entities, that their separate existence had de facto ceased; and (2) treating the
entities as separate would sanction fraud or promote injustice.
In Olympic Financial Ltd. V. Consumer Credit Corp. (S.D. Tex.), the court examined
whether the corporations had:
1. Common employees;
2. Common record keeping;
3. Centralized accounting;
4. Payment of wages by one corp. to another corp.’s employees;
5. A common business name;
6. Services rendered by the employees of one corporation on behalf of another;
7. Undocumented transfers between corporations;
8. Unclear allocation of profits and losses between the corporations;
9. The same officers;
10. The same shareholders;
11. The same telephone number.

J. Agency
1. SH Would Be Liable As A Principal To The Corporation’s Torts If:
1) The corporation was under SH’s control;
2) The corporation acted on SH’s behalf;
3) And the corporation consented to do so.
2. Corporation under SH’s control

1) Suppose Seon’s CEO was Adam, and 100% of Seon shares were owned by Carlton. Adam
runs Seon in a way that maximizes the SH wealth (i.e., in a way that benefits Carlton). Is Seon
Carlton’s agent? If so, could there ever be a situation in which a SH is NOT liable as principal
to the corporation’s actions? What’s left of limited liability then?
2) In our case, there is no Adam; Carlton is both SH and CEO. Does Seon do Carlton’s bidding,
or does Carlton, as an officer/director of Seon, do Seon’s bidding, which happens to be in
Carlton’s interest because Carlton is the main SH? In other words, which of them is principal
and which is agent?
3) As the paradox demonstrates, this theory does not work well when SH is also a director/officer
of the corporation (which will often happen in close corporations).
3. Corporation acted on SH behalf

1) Principle of SH wealth maximization states that directors should act to maximize SH
wealth. If corporation has just one SH, who’s interests must it pursue?
2) The agency theory of SH liability works poorly, therefore, when corp. has just one
SH.
K. Piercing the Corporate Veil (PCV)

Sea-Land Services, Inc. v. Pepper Source
1. Presents the black-letter law for PCV in Illinois [quoting Van Dorn]:
“Such unity of interest and ownership that the separate personalities of the corporation
and the individual [or other corporation] no longer exist”
1. Failure to maintain adequate corp. records or to comply w/corp. formalities
2. Commingling of funds and assets
3. Undercapitalization
4. One corporation treating the assets of another corporation as its own
5. “[C]ircumstances must be such that adherence to the fiction of separate
corporate existence would sanction a fraud or promote injustice.”
6. Prospect of unsatisfied judgment does not satisfy this prong of the test
7. But Sea-Land court endorses Kreisman (SH defaulted on debt for purchasing equipment,
and used this equipment for several years), in which “unjust enrichment” satisfied the 2nd
prong requirement.
8. Sea-Land court suggests that 2nd prong will be satisfied if SH used corp. to avoid
responsibilities to creditors, or if one of the corporations will be “unjustly enriched”
unless liability is shared by all corporations.
L. Justifications for PCV: Contract Creditors

What can a contract creditor do to mitigate risk of corporation defaulting?
1) Investigate corporation’s credit-worthiness; require personal guarantees.
2) Require higher interest to compensate for higher risk.
3) Is contract creditor harmed by undercapitalization?
4) Is contract creditor harmed by failure to abide by formalities, or by moving assets
between firm and other firms/SH? Fraud?
5) Why can’t contract creditor protect her interests through contractual terms?

Tort Creditors
1) Does a tort creditor care about SH’s respect for corp. formalities?
2) Does a tort creditor care about corporation’s undercapitalization?
If SH doesn’t respect corporation’s independent entity, why should a creditor?
1) Other than issues discussed above, does the SH respect or lack of respect to the
corporation’s independent entity matter to a creditor?
M. Comparing Our Suggested Rationale with the Case Law

The rationale we suggest is:
1) PCV for a contract creditor – if SH fraudulently failed to observe formalities and
siphoned money between corporation and other corporations or SH, but only if
creditor can’t acquire contractual protection.
2) PCV for a tort creditor – if corporation was undercapitalized.
Walkovszky?
1) Creditor: Tort
2) Lack of formalities: Fraud not proven
3) Undercapitalization: Yes (but satisfied insurance minimum requirement)
4) Suggested result according to our rationale: PCV
5) Court: No PCV (Keating’s dissent stresses undercapitalization)
Sea-Land Services?
1) Creditor: Contract
2) Lack of formalities: Yes. Seems fraudulent.
3) Contractual protection possible: Seems possible.
4) Undercapitalization: Yes
5) Suggested result according to our rationale: Depends on contractual protection
6) Court: No PCV, unless injustice proven on remand (PCV on remand).
Kinney:
1) Creditor: Contract
2) Lack of formalities: Yes. But is it fraudulent?
3) Contractual protection possible: Yes.
4) Undercapitalization: Yes
5) Suggested result according to our rationale: No PCV
6) Court: PCV
1. Kinny Shoe Corp. v. Polan, (1991) page 217 (PCV)

Two prong test for PCV: Unity of purpose + equity. Third prong (due diligence by π)
only applies to financial institution π’s.
Appellant corporation (Kinny) sued 66avourab (Polan) seeking to recover money owed
on sublease with appellee’s realty company. Appellee was realty company’s sole
shareholder. Finding two prong test in Laya satisfied, the district court concluded
appellant was damaged by appellee’s failure to carry out corporate formalities and realty
company’s gross undercapitalization. However, district court then applied Laya’s third
prong and concluded “piercing the corporate veil” doctrine did not apply because
appellant assumed risk of appellee’s company defaulting.
Although agreeing that two-part Laya test was met, court reversed and remanded
because, under totality of the circumstances, district court clearly erred applying Laya’s
permissive third prong since even if it applied to creditors like appellant, it did not prevent
appellant from piercing the corporate veil in this case. Because 66avourab failed to follow
corporate formalities and invested nothing in his company, appellant could pierce the
corporate veil.
Two prong test:

1. Is the unity of interst and ownership such that the separate personalities of the
corporation and the individual shareholder no longer exist? AND
2. Would an equitable result occur if the acts are treated as those of the corporation alone?
3. Third prong not applicable.
Why a different test for PCV in contract cases versus tort cases? In contract cases the
parties have plenty of opportunities to check on the parties they were doing business
with. But, in tort cases you don’t necessarily have those opportunities. You run the risk
of the other side 67avourab when you do business. You need the element of fraud. In
tort cases you don’t have as much opportunity to check out the other side. Example:
Walkovszky. There was nothing that Walkovsky could have done to impact the liability
of Seon Corp.

In re Silicone Gel Breast Implants Products Liability Litigation, (1995) page 221
Summary
1. Creditor: Tort (But is it really a contract case? Did consumers have a choice?)
2. Lack of formalities: Yes. But not fraudulent.
3. Undercapitalization: No; in fact, parent company saved subsidiary money (forgone
dividends and provided subsidiary with free services)
4. Suggested result according to our rationale: No PCV (but is there apparent agency
from Bristol Myers’ name and logo in MEC’s promotions?)
5. Court: PCV
Defendant parent corporation filed a motion for summary judgment in plaintiff victims’
multidistrict silicone gel breast implant products liability litigation. It asserted that the
evidence was inadequate for plaintiffs to support any of their claims against it, whether
based on piercing the corporate veil or on a theory of direct liability. The district court,
considering the law of the transferor states, denied the motion. It held that under the
corporate control theory, there was ample evidence from which a jury could find
that defendant’s subsidiary, the manufacturer of the breast implants was
defendant’s alter ego.
This included evidence that they
1. shared directors;
2. that the manufacturer was part of defendant’s health care group and used its legal,
auditing, and communications departments;
3. that they filed consolidated federal tax returns; and
4. that defendant prepared consolidated financial reports.
As for the direct liability claims, by allowing its name to be placed on breast implant
packages and product inserts, defendant held itself out as supporting the product, and
thus could not deny its potential liability on a theory of negligent undertaking.
2. PCV Recap
1. 1½ out of 5. Our rationale is not a very good predictor…
2. No bright-line rule in PCV. Policy arguments may help, but it is important to argue
based on two-prong test (or equivalent in the relevant state), study similar case law
and analogize/make distinctions.
3. Alternatives to PCV: Direct liability (re Silicone Gel), commercial misrepresentation,
fraudulent transfer, targeted legislation (e.g., toxic waste, taxis)

3. THE PERFECT STORM
Frigidaire Sales Corporation v. Union Properties, Inc., (1977) page 229

Limited partners may have a corporation as their general partner; and the limited
partners may act as officers of that corporation without incurring personal liability as
long as all corporate formalities are recognized.
The contractor sued when the limited partnership breached its contract. Noting that the
limited partners were also the officers, directors, and shareholders of the corporate
general partner, the contractor sought to impose general liability upon the limited
partners, claiming that they exercised the day-to-day control of the partnership through
the general partner and were therefore liable under Wash. Rev. Code § 25.08.070. The
trial court denied their claim that the limited partners incurred general liability and the
appellate court affirmed.
The supreme court agreed, ruling that the limited partners did not incur general liability for
the partnership’s liabilities under § 25.08.070 simply because they controlled the
corporate general partner. The record showed that the limited partners did not form the
general partner for the sole purpose of operating the partnership, but to create
several business opportunities. Thus, their control of the general partner was not
merely for the benefit of the partnership. Also, although the limited partners signed the
contract, the contractor knew they were agents and it was dealing with a limited
partnership with a corporate general partner.
CONTROL AND RISK – THE TWO KEY ELEMENTS TO BUSINESS ASSOCIATIONS.
THIS IS A KEY CASE ACCORDING TO EPSTEIN.
Frigidaire Summary
1. Creditor: Contract
2. Lack of formalities: No. The court respects Mannon & Baxter acting in different roles
3. Contractual protection possible: Yes. But protection from what? M&B seemed to act
OK.
4. Undercapitalization: Maybe.
5. Suggested result according to our rationale: No PCV
6. Court: No PCV. But this isn’t really a PCV case, but a Limited Partnership case.
XI. Introduction to the Corporation: Summary Overview of Issues

Forming the Corporation
1. Mechanics of Forming the Corporation
2. Liability for Pre-Incorporation Activity (Promoters)
Independent Legal Personality
1. Limited Liability
2. Derivative Actions
Separation of Ownership and Control
1. Capital Structure
2. Centralized Management
One last BA type: The Limited Liability Company
(1) Independent Legal Personality and Litigation
Charlie, a widower, gets run over by Tanya. He refuses to sue Tanya because of his
infatuation with her, but his injuries cause him financial hardship. He tells his
daughter, Sarah, that he will not be able to pay her college tuition. Can Sarah sue
Tanya for the loss of her father’s financial support?
Since a corporation is an independent legal person, it can sue or be sued.

When a corporation suffers harm, SH are indirectly harmed by the decrease in their
shares’ value. But this is indirect harm, similar to Sarah’s harm in the above hypo.
To repair the harm, the corporation must sue. Is there any reason for us to think the
corporation wouldn’t sue when it has a strong claim?

B. Derivative Actions
C. Introduction – Fiduciary Duty to Corporations

Tuesday, March 16, 2004, Fiduciary Duty. Remember Mannon & Baxter from Frigidaire? They
got away with not liability. But, if they had breached their fiduciary duty to their own corporation,
then they could be punished.
Derivative actions are suits in equity to force a corporation to take action against a wrong-doing
third party. This is necessary because shareholders don’t have standing to sue the third party.
The third party made no promises to the shareholder; only to the corporation. You sue for the
derivative harm to the corporation. The shareholders sue to make the corporation whole; to bring
the money back into the corporation. The money goes back to the corporation except for the
carve-out for legal fees. This is a very lucrative area of practice. Procedural hurdles are
sometimes very complicated for derivative actions.
Equity Courts are concerned with fairness. You can actually still have separate equity Courts.
Delaware has a separate equity Court to deal with corporate fiduciary cases.
1. Hypo
Danny, David and Dana, C Corp.’s three directors, embezzle $1 million from C Corp.’s
treasury. Steve, a shareholder in C, wants to sue the three, but is told by his lawyer that the
cause of action is the corporations’, not his. He therefore writes an angry letter to the
corporation, demanding that it sue the directors. The board convenes to decide on Steve’s
request, and after very short deliberation votes 3-0 not to sue.
 Can’t the shareholders just vote the directors out?
 Danny, David and Dana together may own 51% of C’s stock.
 Or, most shareholders might have too small a stake to bother.
 What can Steve do?
 Steve can sue C Corp., requesting the court to order C to sue the three directors.
Such a suit is called a derivative action.
 Derivative suits are dismissed if they do not comply with certain requirements,
including:
 SH needs to post bond to cover corp’s legal costs in case of frivolous suit;
 In many cases, SH needs to ask the corporation to sue before he can sue
derivatively.
 Therefore, we need a rule to determine which suits may be filed directly, and
which have to be derivative. In other words: whether a given cause of action is the
shareholder’s (direct suit), or the corporation’s (derivative suit).
 Suppose the three directors did not embezzle money from the corporation.
Instead, they reconfigured the rights of preferred stock to the advantage of the common
stock owners. Steve owns preferred stock.
 Did the reconfiguration harm the corporation?
 Preferred stock holders are harmed, but the corporation is not. The cause of
action is Steve’s, not the corporation’s, and Steve may commence a direct suit.
2. Derivative Actions –
1. In a Derivative Action (a suit in equity or law depending on remedy) by a SH or group of
that has self-appointed himself to try to get the court to force the corporation to file
another suit against the officer or directorsimultaneous suits in equity by a SH against
corp. to compel it to sue another (usually officer or director and rarely a trade person), the
actual suit by corp. against that other party
2. Most time, named as one SH against the corp (or officers too if that SH is arguing both
the individual and derivative)

3. B/c the SH is suing “in right” of corporation, any remedy from principal suit goes to
corporation; the corporation is required to pay for SH’s attorneys’ fees if suit is successful
(or often if it settles
4. Derivative versus Direct Actions – lots of borderline cases, so may be able to take your
choice how you want to take, but must plead your case why bringing it as one and not the
other
Direct – Wrong complained of constitutes injury to SH directly
(1) Force payment of declared dividend (if paid, goes directly to SH);
(2) Enjoin activities that are ultra vires;
(3) Claims of securities fraud/blue sky laws (b/c individual claims to damages);
(4) Protecting participatory rights for SHs
Derivative – The wrong is where the wrong complained of primarily involves an injury to
corp. and indirectly to the SH
(1) Breach of DoC
(2) Breach of DoL
(3) Enjoin Management Retrenching Practices (activities where managers try to
avoid takeover b/c they don’t want to be fired by takeover firm)
5. Why does the distinction matter?
Advantages of Derivative Suits – more attractive fee allocation (One way fee shifting if SH
wins)
Disadvantages of Derivative suits – procedural hurdles. Damages on other remedies
usually go to corp. and not SH.
D. Three Hurdles For Derivative Actions:

1. Bonding/Security
for expenses statutes: some states require. Requires you to have a large stake
2. Demand Req’ts:
At times must first demand to BoD that corp. pursue litigation. There are times
when demand is futile (excused form formally demanding BoD sue itself)
3. Special Litigation Committees

(even in cases where demand is excused, there are req’ts that such
committees review and recommend litigation to courts
E. First Hurdle: Security Req’t

In some states (but not Del), a derivative req’t w/”low stakes” must post security for corp’s
legal expenses
This req’t exists to effect strategy of lawyers?
1. Cohen v. Beneficial, (Bond OK to Ensure Reasonable Expenses)
(Cohen owned 150 shares of Beneficial against corp. that had million shares issued; he
filed in federal court claiming waste; beneficial moved to require posting of bond)
(1) Relevant Stat: Required that to avoid bond, must own 5% of voting shares w/in
collective voting trust (small stake SHs team up to vote together)
(2) Erie says that applicable state law used in matters of substantive law
(3) Is the security for expenses statute a procedural rule or substantive rule?

(4) Court finds it is a substantive rule of law, and even though no federal req’t to post
security, the court applies state law. It does not violate due process concerns
(5) What’s peculiar about the holding? Under Internal Affairs Doctrine you should
apply state of incorporation’s substantive law and in this case, it should be Delaware
law. But this is an exception to the internal affairs doctrine. Inspection rights of SHs
also fall outside doctrine and follow state where corp. resides instead of where
incorporated.
(6) What is it about SH derivative actions that make “strike suits” a potential
problem? It lets lawyer and BoD agree to settlement. Does NY’s remedy this
problem?
(7) Suppose Cohen posted the requisite security, the claims will be analyzed under
Delaware law.
(8) What alternatives are there for SH that doesn’t have the money to post security?
1. Make his lawyer front it. 2. Get some other SHs in that state and form a voting
trust. 3. Sue in state of incorporation. 4. Sue as a Direct Action (likely not here b/c
this is mismanagement claim)
(9) Because the statute only 73avourab payment of reasonable expenses, the Court
deemed that it was NOT a due process violation.
(10)Application of statute to shareholders with <$50k invested was NOT an equal
protection violation because it applied to everyone in that class and it was a
reasonable measure to further the state’s legitimate goal in limiting strike suits.
2. Eisenberg v. FTL (No Need to Post Security for Direct Action Suit)
(Flying Tiger created Flying Tiger Corp. that then created FTL; then Flying Tiger merged
w/FTL; Flying Tiger SHs shares would be exchanged for FTL shares. Thus, the subsidiary
would end up owning and controlling the corp. b/c of the merger; Eisenberg brought a
direct action suit claiming he lost his voting rights for Flying Tiger in the transaction. This
was a direct right he had individually. But he can still vote in the Flying Tiger Corp. stuff.
The arg is that they are ruining his investments.
(1) FTL’s counterarg: His claim is derivative, he must post security under NY Law
(2) Trial court: He was req’d to post as per the NY Law, he refused to pay and the
complaint was dismisses
3. In Some States, There Is Another Avenue To Escape Security-Posting Statutes:
Cohen teaches that such statutes are presumptively substantive parts of state law, and thus
apply to diversity SH litigation
But if state law itself says that its own bonding statute is procedural, then the question of posting
security is once again a federal one …and under federal law. No security-for-expenses statutes
exist.
F. Second Hurdle: Demand Requirement

Constitutionally Permissible (i.e., does not violate DP or EP) if reasonable (i.e., instituting
bond requirement unless s/h owns > 5% aggregate par value or stock worth > $50K, set as
indicia of P’s interest in the corp and thus good faith interest in the litigation)
Most States Require Shs In Derivative Suits First To Approach Bod And Demand That
They Pursue Legal Action
Demand Usually Takes The Form Of A Letter
Can Get Out Of It If You Can Establish That Demand Would Be Futile (Two Part Aronson
Test From Brehm)

(1) Board can not just dismiss now

(2) But it can try to dismiss as part of Special Litigation Committee
(3) If demand excused but still made, SH waives any possible excuse claim
If Demand Required, Board Has The Discretion To Dismiss Action (This Falls Under BJR =
Presumption Of Due Care
Rationale Of Demand Requirement– Trying To Get You To Use All Intra Firm Options First
Some States Have Implemented A Universal Demand Requirement: But Then Courts Apply
A More Liberal Test For Wrongful Refusal To Prosecute The Claim By Corporation.
1. Cohen v. Beneficial, (1949) – Bonding Requirement for DA

Bonding requirement is not a due process violation—only requires payment of
reasonable expenses and a state is entitled to set the terms on which it will permit access
to its courts. No equal protection violation—differentiation between small and large
shareholders is consistent with the state’s interest in deterring nuisance claims.
2. Eisenberg v. Flying Tiger (2nd Cir. 1971) (No Need to Post Security for Direct Action
Suit)
What is Eisenberg asking of the court?
To determine that his suit is direct, so as to avoid NY law’s requirement that a plaintiff in a
derivative suit post security for the corporation’s costs.
Eisenberg’s claim: Reorganization deprived him and other FT shareholders from voting
on the operating company’s affairs. Since it only affected Eisenberg and/or a very small
number of shareholders, it was not a derivative action. In-other-words, since the
corporation was not harmed, it is a derivative action. Maybe it has 74avourabl to do with
the small number of shareholders affected, but Epstein is not clear on this point.
Possible rules for determining type of suit:
Is the injury one to the plaintiff (as a SH) individually, and not to the corp?
 Court: This rule isn’t useful to decide borderline cases.
 Who does the defendant owe a duty? [Gordon v. Elliman]
 If directors have a duty not to merge, they owe that duty to the corporation
 Court: this sweeps away the distinction between representative & derivative
actions.
 Is suit aimed to force corporation to procure a judgment “in its favor”?
3. The Dark Side of Derivative Actions (Hypo)

Facts: Acme Corp., a large steel company, has 1 billion shares outstanding. The current
price of an Acme share is $20. Acme’s directors embezzle $10 million from Acme’s
treasury.
Issue: How much will the value of an Acme share drop as a result of the $10 million
embezzlement?
Rule: Each share will lose 1 cent ($10,000,000/1,000,000,000 shares).
Analysis: Suppose that there are 20 million Acme shareholders, and each owns 50
shares (a $1,000 investment).
 What is the loss to each SH from the embezzlement?
 Is this loss sufficiently large to make a SH expend the energy to initiate a
derivative action?
 So, who has the incentive to initiate a derivative action?
 What can the directors do to settle the suit without losing the loot?
4. Another Dark Side of Derivative Actions

We have just seen how meritorious suits can be settled without compensating the SH, by
“bribing” the lawyers.

5. There’s Another Risk In Derivative Actions (Hypo):

Acme Corp. is sued derivatively by John Doe, a SH. The suit is frivolous, and Acme’s
counsel expects that there is a 90% chance of winning it (there’s never absolute certainty
of winning). A loss will cost Acme $10 million in actual costs and in harm to PR.
Litigating the case would cost $100,000. The media attention will also cause a $200,000
harm to Acme’s PR (even if it ultimately wins).
So, the cost to Acme from litigating is $1.3 million (10% x $10 million + $100,000 +
$200,000). If Acme could settle the case for under $1.3 million, it is better off than
litigating.
Settling the frivolous suit (which is called a “strike suit”) would invite more such suits, but
if the suit results from a one-time event (e.g., financial scandal), there are not likely to be
many similarly situated plaintiffs.
 Would this concern be eliminated by making the plaintiff bear Acme’s litigation costs if the
defendant prevails?
Kahn v. Sullivan (Armand Hammer Museum Case –(DA Can Be Settled )
Armand Hammer was the CEO of Occidental Petroleum Company. Over the years he
acquired an extensive art collection. He induced Occidental to expend $89 million to
build and operate the “Hammer Museum”, which will contain his art, next to its office
building (Occidental’s net profit that year was $256 million).
Two derivative suits were filed, one led by Khan, another led by Sullivan. Occidental
settled with Sullivan (in a way that had the effect of settling Khan’s action as well).
The court approved a settlement: that allowed the museum to be created:
Its name is to be changed to the “Occidental Petroleum Center Building”;
Occidental would have representation on the museum board;
A limit was placed on future support of the museum;
Hammer agreed to donate the art collection to the museum upon his death.
Occidental will pay Sullivan’s lawyers $800,000 (occidental offered to pay $1.4 million,
but the court reduced this sum). Khan’s lawyers get zero.
Why did the court approve the settlement? Courts don’t like making decisions contrary to
the parties where the parties have already agreed to settle. BJR sets default to faith in
management.
G. The Business Judgment Rule (BJR)
1. Why Did The Court Approve Occidental Petroleum’s Settlement?
 Busy judges prefer not to dwell on suits when both parties agree to settle.
 The prospect for Khan’s suit to succeed on the merits was poor, due to the Business Judgment Rule.
 A presumption that the board of directors is acting in the best

interests of the shareholders, unless it can be clearly established that it is not.
 If the board was found to violate the business judgment rule,
it would be in violation of its fiduciary duties to the shareholders.
 Underlying rationale: Courts are not well-equipped to make
business decisions.
2. This Is A Tough Presumption To Rebut; Tougher Still If The Plaintiff Is Not Entitled
To Discovery
 Plaintiff can use “tools at hand”, such as information from the media or the government (e.g.,
SEC), or a shareholder’s right to inspect books and records (8 Del C. §220).
 But how likely is it that evidence on self-interest would be found there?

H. The Demand Requirement in Derivative Actions (Accountability vs

Strike Suits)
Balancing Requirement & Rationale
(1) Rules regulating derivative actions must balance between holding directors
accountable and deterring strike suits, with minimal encroachment on the board’s
decision-making authority.
(2) Since the corporation incurs significant costs (legal and PR) once a trial on the
merits begins and discovery takes place, the strike suits need to be deterred at
the threshold of litigation.
Rules Creating This Balance Include:
(1) Fee shifting if defendant prevails, and
(2) requirement that plaintiff post a bond to cover the corporation’s legal expenses in
such cases.
(a) On an exam, argue that this is insufficient, since corporation can still be
harmed from litigation.
Demand Requirement & Rationale
(1) Requirement that SH make a demand on the board to assert the claim.
(2) The rationale: The claim is the company’s, not the plaintiff shareholder’s, so the
other shareholders should have a say on whether to pursue it, through their
representatives, the directors.
(3) When demand is excused, ability of corporation to form Special Litigation
Committees (SLCs) to investigate and recommend dismissal of suit.
I. The Demand Requirement under MBCA

MBCA §7.42
(1) Universal requirement to make a demand in all cases.
(2) SH must refrain from brining suit for 90 days after the demand is made, unless:
(a) Irreparable injury would result; or
(b) Board rejected demand.
MBCA §7.44 - Three Alternatives For The Review Of The Demand:
(1) If independent directors constitute a quorum, the demand may be reviewed by
the board.
(2) In all cases, the independent directors may appoint by majority vote a committee
of two or more independent directors to review the demand;
(3) Upon motion by corporation, court may appoint independent panel.
Effect of Investigation
(1) If the reviewing institution determines in good faith, after conducting a reasonable
investigation, that the maintenance of the derivative action is not in the best
interest of the corporation, the court will dismiss the complaint (without examining
the reasonableness of the determination).
(2) Burden Of Proof As To Good Faith And Reasonable Investigation Lies On:
(a) SH – if majority of the board are independent, or if review was by court
appointed panel;
(b) Corporation – if majority of the board are not independent.
(c) Why would the corporation opt for a court appointed panel?
J. The Demand Requirement under Delaware Law

Board Has Two Choices When Faced With A Derivative Action:
The demand requirement allows the company to either

(1) take over the cause of action (and sue directly); or

(2) resist the suit.
The Business Judgment Rule & Futility of Demand
(1) decision is up to the business judgment of the directors.
(2) But where the directors cannot be expected to make a fair decision, demand
would be futile and is excused.
Demand Rules in Delaware
(1) Plaintiff is not entitled to discovery;
(2) The decision of the directors as to whether to assert the claim is considered a
matter of business judgment, so the BJR applies.
(a) Result: Plaintiff will usually lose if demand was made and directors refused to
assert the claim.
(3) Making a demand is deemed as conceding that a demand was required.
Therefore, in most cases, a plaintiff will not make a demand, and instead argue
that demand was excused.
(a) Furthermore, if demand is required but plaintiff does not make the demand, it
is not fatal to plaintiff’s case; litigation will be stayed briefly while plaintiff
makes the demand.
K. Excusing the Demand Requirement under Delaware Law

1. Aronson rule (followed in Grimes v. Donald):
The demand requirement is excused if π shows REASONABLE DOUBT that either:
A Majority Of The Board Is Independent For The Purpose Of Responding To The Demand;
(1) A director is not independent if she has a material interest in the challenged
transaction or is dominated/controlled by the alleged wrongdoer or an interested
party.
(a) A director may be independent even if:
(i) She was nominated by the alleged wrongdoer;
(ii) She was named as a defendant; or
(iii) She approved the challenged transaction.
Or - The Challenged Transaction Is Protected By The BJR
(1) Plaintiff needs to show that the challenged transaction was not the product of a
valid business judgment.
Making a demand does not prevent SH from subsequently arguing that demand had been
wrongfully refused (then, the court examines the decision to refuse demand, not the underlying
transaction).
L. Excusing the Demand Requirement under NY Law (Marx v. Akers)

1. Demand Futility Test New York (Marx)
Demand is futile (and therefore excused) if plaintiff shows with particularity that:
(1) Majority of directors interested in challenged transaction or controlled by an
interested party.
(2) Directors failed to inform themselves to a degree reasonably appropriate.
(3) Challenged transaction so egregious that it could not have been the product of
sound business judgment of the directors.
2. Demand Futility Test Delaware (Aronson)

The demand requirement is excused if plaintiff shows reasonable doubt that:

(1) A majority of the board is independent for the purpose of responding to the
demand; or
(2) The challenged transaction is protected by the BJR; or
(3) Carelessness and waste
M. Special Litigation Committees (SLCs)

1. A Problem When A Majority Of The Board Is Not Independent:
(1) Can’t trust board’s decision that derivative claim lacks merit;
(2) But for that reason, corporation is a more attractive target for strike suits.
(3) Solution: Corporation asks court to apply BJR (i.e., defer) to a decision of an SLC
(composed of disinterested persons) that the derivative action lacks merit.
2. SLCs under NY law (Auerbach):

(1) Court applies BJR to SLC’s decision, but judicial inquiry permitted regarding SLC
members’ independence, and the adequacy of the SLC’s investigation (burden of
proof on plaintiff).
3. SLCs under Delaware law (Zapata): Two steps.

(1) Inquiry into the independence and good faith of the SLC, and into the bases
supporting the SLC’s recommendations;
(2) Court may apply own business judgment as to whether to dismiss suit.
Exam Prep: Build a Chart to show how I would justify each state’s approach?
N. Dismissing Derivative Actions Delaware vs. NY vs. MBCA

1. Demand Requirement
(1) MBCA: Universal Demand Rule.
(2) Delaware/ New York: Demand may be excused in certain circumstances.
BOTTOM LINE: Is Demand Excused?  Was Board’s Decision To Terminate Justified?
Universal demand rule shifts the focus of threshold litigation from whether demand is excused, to
whether directors’ decision to terminate the suit is entitled to deference (both issues ultimately
depend on the board’s objectivity and good judgment).
2. SLCs
(1) MBCA: Not relevant (because demand requirement is universal).
(2) New York: Court defers to SLC’s decision unless P proves SLC was not
independent or did not conduct an adequate investigation.
(3) Delaware: Court examines independence & good faith of SLC and bases
supporting SLC’s recommendations, but may also apply own bus. Judgment.
BOTTOM LINE: Easier for Π to get past SLC in Delaware than NY.
O. Derivative Action Flowchart

nts
Is Suit Direct or Derivative?
Derivative? me
re
Direct Derivative qui
S/H Suit Allowed
Re
nd
Universal Demand Non-Universal Demand
ma
(MCBA §7.42) (Delaware/NY) De
#2:
e
Did Board Find Suit Is Demand Futile?
NOT in Corp’s Best DelawareTest
rdl
Interest? (Aronson)NY Test Hu
(Marx)Reasonable Doubt That:Π Shows That:Maj. Of Board is ion
Independent; or
Yes No
BJR applies; or Act
Carelessness & WasteMaj. Of Board has a direct interest in the ve
challenged trans; or is controlled by an interested party; or
S/H Suit Directors failed to reasonably inform themselves; or
ati
Allowed Challenged transaction so egregious that it could not have been of riv
sound business judgment. De
Was Decision Based on
Good Faith or Reasonable Yes No
Investigation?
Burden on S/H Only if

Majority of Board is Demand Excused; Demand NOT
Independent or Court S/H Suit Allowed; Excused
Appointed. Corp. May Use SLC’s to Get
Court To Dismiss Demand Made?
Yes No
Yes No
S/H Suit S/H Suit

Dismissed Allowed Demand S/H Suit
Refused? Dismissed
or Stayed
Until
Demand
Wrongful Refusal? Yes
Made
(Apply BJR To Decision)
No
Yes No
Board Takes
Control of S/H
S/H Suit S/H Suit Suit.
Allowed Dismissed

NY law: Auerbach v. Bennett (265; N.Y. 1979):

based on internal audit revealing evidence of illegal bribery and kickbacks to
gov’t agencies and foreign entities, s/h initiated derivative action; corp’s
SLC recommended not to pursue; court used 2-part test:
is the SLC independent? (here, SLC comprised new Directors; court
not too concerned about structural bias b/c concedes that some
bias is inevitable and court will not deal with it as long as SLC s
members appear facially independent)
if SLC is independent, court analyzes two components of SLC’s
tee
decision: mit
• substantive decision of SLC m
(protected under BJR—i.e., no review)
• procedures used to arrive at
Co
the decision (court examines “adequacy and n
appropriateness of SLC’s investigative procedures and tio
methodologies” to determine whether inquiry was made
“in good faith”) iga
Lit
DL law: Zapata v. Maldonado (Del. Sup. Ct. 1981):
al
in demand-excused cases in which SLC has recommended dismissal, 2-part eci
test: Sp
(procedural aspect) did SLC act independently, in good faith, and with a
reasonable investigation (i.e., with the BoP on defendants)?
(substantive aspect; higher scrutiny) does dismissal pass independent #3:
judicial inquiry into business judgment? e
rdl
1. SLCs Hu
(1) MBCA: Not relevant (because demand requirement is universal). ion
(2) New York: Court defers to SLC’s decision unless P proves SLC was not
independent or did not conduct an adequate investigation.
Act
(3) Delaware: Court examines independence & good faith of SLC and bases ve
supporting SLC’s recommendations, but may also apply own bus. Judgment. ati
BOTTOM LINE: Easier for Π to get past SLC in Delaware than NY. riv
De
2. SLCs under NY law (Auerbach):
(1) Court applies BJR to SLC’s decision, but judicial inquiry permitted regarding SLC
members’ independence, and the adequacy of the SLC’s investigation (burden of
proof on plaintiff).
3. SLCs under Delaware law (Zapata): Two steps.

(1) Inquiry into the independence and good faith of the SLC, and into the bases
supporting the SLC’s recommendations;
(2) Court may apply own business judgment as to whether to dismiss suit.

P. Derivatives Recap
Cohen v. Beneficial (241, Sup. Ct. 1949),
upholding constitutionality of NJ bonding statute because it called for payment of
reasonable fees; and it was substantive Delaware law and under Erie, the
Court imposed Delaware law.
Applicability in federal courts: such statutes are both procedural and substantive
substance provided by creation of liability—in that it requires s/h to post
bond and potentially incur liability for corp’s costs should he lose
procedure provided by requirement that s/h post the bond
applicability in other s/h actions: bonding requirements are not applicable to

s/h direct actions
Eisenberg v. Flying Tiger (245, 2nd Cir. 1971):

court rejects Gordon test of recovery to determine the distinction b/c s/h direct
and s/h derivative actions
distinction is:
s/h derivative action = s/h is contesting management’s actions as
harming the corp;
s/h direct action = s/h is contesting management’s actions as
depriving s/h of rights
practical application: only 8 states have bonding requirements … but among

them are the important ones (CA, NY, etc.)
DL law: Grimes v. Donald (250; Del. Sup. Ct. 1996):

underlying controversy was a highly favorable exec employment agreement; s/h
makes demand and it is refused, then s/h contests that demand was futile
held: if s/h makes demand on the board, he waives the right to assert
that demand is excused—however, he may contend that
demand was wrongfully refused
This is a catch 22 because you can only seek excusal when it would be futile
but in order to show futility, if you make demand, then you cannot argue that
it is futile or you would not have made the demand. So, Grimes never gets
past the procedural hurdle and cannot be heard on the merits of the case.
So, in Delaware, you would only make demand if you have evidence of
wrongdoing that does not involve current management.
1. Table Of DL Law:
Demand Made Demand Not Made
s/h waives futility claim;

Demand court will grant corp’s
refusal of demand
Req’d motion to dismiss
subject to BJR
in theory, s/h can
Demand s/h waives futility claim, proceed—but subject to
Not but may still claim special litigation
Req’d “wrongful refusal” committee (II.C.3.b.iii,
infra)

Test for Demand Excusal

 A majority of the board is independent for the purpose of responding to the demand; or
 The challenged transaction is protected by the BJR; or
 Carelessness and waste
compare NY law: Marx v. Akers (259; N.Y. 1996):

rule: demand is futile if complaint alleges with particularity that
(1) a majority of Directors are interested in the transaction (gloss: Ds
either directly self-interested, or controlled) OR
(2) the Directors fail to inform themselves to a degree reasonably
necessary about the transaction, OR
(3) the Directors failed to exercise their business judgment (gloss: the
transaction is “egregious on its face”)
diff b/w DL and NY law: DL has “reasonable doubt” clause; NY does not 
harder in NY to show demand futility as a matter of law
DL criticized as subjectivized and confusing
this is pre-disclovery stage, so might not amount to that much of
a difference
2. compare MBCA § 7.42 (the universal demand requirement):

rule: no s/h may commence a derivative proceeding until
(1) a written demand is made AND
(2) 90 days have passed from date of demand UNLESS
• corp reject demand earlier OR
• there would be irreparable
injury to corp
diff b/w NY/DL and MBCA: under demand futility, court looks at underlying
transaction; under universal demand, tx is not considered and decision is
scrutinized
3. Hurdle 3: Special Litigation Committees (SLCs)
definition: Directors appoint SLC, delegate decisionmaking authority concerning litigation

to the SLC, and make decisions based on SLC’s assessment of the merits of
proceeding on a s/h derivative action
creation and delegation of power to SLCs valid under most state statutes
but out of fairness, SLCs usually comprise disinterested Directors not involved in
the offending tx (or new Directors who weren’t around when the offending tx
occurred)
concern with SLCs is problem of structural bias: SLCs’ reluctance to effectively pass
judgment on other Directors with whom they closely work
validity of SLC determinations:
courts recognize the decisions of SLCs (Auerbach, infra: business judgment doctrine—
essentially, using the BJR as a sword rather than a shield—justified corp’s allocation
of power to, and deference to decisions of, SLCs)

4. scope of judicial review of SLC decisions:
NY law: Auerbach v. Bennett (265; N.Y. 1979):

based on internal audit revealing evidence of illegal bribery and kickbacks to
gov’t agencies and foreign entities, s/h initiated derivative action; corp’s
SLC recommended not to pursue; court used 2-part test:
is the SLC independent? (here, SLC comprised new Directors; court
not too concerned about structural bias b/c concedes that some
bias is inevitable and court will not deal with it as long as SLC
members appear facially independent)
if SLC is independent, court analyzes two components of SLC’s
decision:
• substantive decision of SLC
(protected under BJR—i.e., no review)
• procedures used to arrive at
the decision (court examines “adequacy and
appropriateness of SLC’s investigative procedures and
methodologies” to determine whether inquiry was made
“in good faith”)
Auerbach v. Bennett
Facts: Corporation had engaged in paying bribes to foreign officials and companies and
board members had participated in such payments. Based on an internal investigation
Shareholder sued derivatively. Because demand was probably excused, Board appointed
a Special Litigation Committee, made up of impartial members to determine whether to
continue the suit. Committee decided not to and Shareholder appealed the decision and
lost.
Analysis: Business Judgement Rule shields the decisions of a Special Litigation Committee if
they use proper procedures to insure that the deliberations were complete and done in
good faith.
- If the Special Litigation Committee is independent then there are two types of
scrutiny:
o Procedures used by the board to become informed ➜ Courts are well
positioned to scrutinize procedures.
o Substantive decision of the Special Litigation Committee given the info
acquired is subject to the Business Judgement Rule and extreme court
deference.
- If members of the Special Litigation Committee were interested themselves,
then demand is still excused
o This is not the case here because all the members of the Special
Litigation Committee joined the board after the alleged wrongs.
DL law: Zapata v. Maldonado (Del. Sup. Ct. 1981):

in demand-excused cases in which SLC has recommended dismissal, 2-part
test:
(procedural aspect) did SLC act independently, in good faith, and with a
reasonable investigation (i.e., with the BoP on defendants)?
(substantive aspect; higher scrutiny) does dismissal pass independent
judicial inquiry into business judgment?
Zapata v. Maldonado
Facts: Shareholder brought a Derivative Suit alleging breach of fiduciary duty by the
board, and stated demand futility (no demand was made). The board set up a
Special Litigation Committee to review the case and determine whether such a suit

should be pursued. The Special Litigation Committee concluded the suit was not in
the Corporate interest, and the Corporation moved to dismiss. The court held that the
Special Litigation Committee appointed by a tainted board has the power to press
dismissal.
Analysis: In cases where demand is excused, Corporate power to control the suit
continues and will be respected if delegated to a disinterested committee.
However the decision of the Special Litigation Committee will be somewhat scrutinized
because:
Special Litigation Committee is more suspect because if demand is excused
either a majority of the board is interested or no Business Judgement Rule
Β legitimately invested in the suit.
Β is allowed limited discovery to look into the independence and good faith of the
Special Litigation Committee and the basis supporting its conclusions.
Zapata vs. Auerbach rationale:

in demand-required case, majority of board is independent as a matter of
doctrine (otherwise demand is futile) so board gets benefit of BJR
in demand-excused case (futile), sense of bias affecting SLC’s decision, meriting
higher degree of judicial review
MBCA § 7.44 follows Auerbach; rejects Zapata’s higher scrutiny:
so long as SLC is independent, court shall adhere to its recommendation
to dismiss as long as it was made in “good faith” and after
“reasonable inquiry”
court therefore scrutinizes procedure but not substance
5. The Bottom Line
s/h derivative actions are effective means of exercising s/h control, but procedurally they
can be nearly impossible to get going!
Epstein 3/25/2004 – What is the purpose of the corporation? Why do we have corporations?
Profit is one possibility.
XII. The Role and Purposes of Corporations

1. A.P. Smith v. Barlow, (NJ 1953) (Corporate Donation to Princeton)
Facts: Corporation that made and sold valves made a contribution to a University. Shareholders
challenged the action as Ultra Vires or Outside of the power of the Corporation.
Analysis: Charitable contributions are allowable so long as:
a. The contribution is in the best interest of the firm
i. Can it pass the straight face text.
b. The Directors were disinterested
Charity is good business, but there are limits. Look for indiscriminate giving or pet charities.
Armand Hammer
A. Capital Structure 1/12/2005

1. Debt
Bank Line of Credit or Bank Loan
European Business use bank loans more; are more closely associated with their banks
U.S. favors bonds, investment bankers, higher risk

Bonds
2. Equity (Issue Shares)
A firm’s capital structure is the set of claims to its assets and future earnings. In corporations,
most of these claims are attached to ownership of securities:
Shares – These are securities attached to equity capital (equivalent to “points” in a partnership).
Shares entail certain voting rights in the firm, rights to dividends (distribution of profits to
shareholders), and rights to the residual assets of the firm after all debts have been paid.
Bonds – These are securities attached to debt capital. Bonds entail rights to payment of interest
and principal, often specify collateral, and in some cases gives some rights to control (e.g.,
Cargill).
A corporation may have several different classes of shares/bonds, with each class conveying
different rights.
Very few individual investors in this market
Investment Grade or Junk Bonds
Knipprath: he couldn’t sell a bond because no one would want it; even a junk bond.
A trustee of a trust could probably invest in first trust deeds; not too much risk. But, 2nd or 3rd trust
deeds are riskier. Used to be not allowed; now it’s just not recommended. But the trustee can
make a decision.
Stock may be certificated or not; but it must be authorized and issued. Can come in different
classes (preferred or common).
Preferred is any stock with a preference over common. Can have more than one class of
common.
Common shares vote. Can have another class of common that does not vote; but at least one
class must vote. Classifications of voting stock can complement an estate planning device.
If you want to transfer stock to your children, you might create a non-voting class of stock to give
them. Can be a way to transfer wealth and avoid certain estate taxes. No death tax but a
recapture credit. Other states might have a death tax. So different classes of stock could can
aid in estate planning.
B. Rights of a Shareholder 1/14/2005

Right to share in dividends, if dividends are declared by the company;
Right to the residual assets of the firm after all debts have been paid.
Right to vote on certain issues (ensure accountability of board):
o Election of directors (MBCA §§8.03-8.04);
o Amendments to articles of incorporation and bylaws (MBCA §§10.03, 10.20);
o Fundamental transactions (e.g., mergers, MBCA §11.04);
o Miscellaneous, such as approval of independent auditors.
o CSH elect BoD’s if no preferreds
o If no dividends issues, CSH enjoy accretion of value
o Can have split BoD’s where each class has a right to elect some directors.
C. Shareholder Rights (Knipprath) 1/21/2005 1/24/2005

1. Right To Vote
Right to 100 shares and you’re voting for 9 directors. You can cast up to 900 votes but it must be
straight 9 times, divided equally.
Cumulative (need at least 3 directors; votes multiplied by the number of directors that you are
voting for.) No maximum number of directors. Allows you to take your 100 shares and if there
are 9 directors, you still cast 900 votes, but you can place all 900 votes with one director. So, the
difference is NOT the number of shares you vote; you get 900 votes each way. But with

cumulative, you can pile all your votes onto one candidate if you so choose. Only applies to
director voting. Not proposal voting which is just “yes” or “no.”
Up to state law; some states require cumulative voting.
Only available in voting for directors to help minority SHs get representation on the board
Must have an annual election of directors.
This won’t help a coalesced minority defeat the majority
But, it is useful to help a minority SH get on the board. These are typically looking out for their
own self interests. Greenmail. Knipprath says this is why cumulative voting is no longer very
popular.
2. Appraisal Right
You have the value of your shares appraised, the company pays you that amount. It’s the right to
be bought out in a merger.
Knipprath says you might not need it with publicly traded shares where there is a ready market
for the shares.
It can also be used as an equitable remedy.
It’s up to state law.
The parallel right is the preemptive right.
Usually depends on the form of the merger, whether your shares are in the surviving or target
company.
3. Right to Sell Shares

Important for free transferability. Also, how can you affect corporate actions by voting with your
feet? Is there an economic sacrifice you’d have to make in order to sell?
4. Right to or Opportunity to Share in Profits of the Company
5. Right to Solicit Proxies

Subject to certain limitations; board controls the meeting agenda. Can’t put normal business
management matters up for proxy vote.
Ordinary proxy: it is revocable up until the time of the vote. So you can give someone the right
to vote your shares but then revoke it. You can revoke by:
(1) Direct notice
(2) By giving some else the right to vote your shares, superseding the previous
proxy
(3) By showing up at the annual meeting to vote.
(4) By operation of law (normally 11 months)
Proxy Coupled With an Interest
(1) Someone lends you money to invest in a company, but makes you vote your
shares in accordance with his interests.
(2) Must be in writing
(3) Irrevocable Under the Terms of the Proxy Agreement
Shareholder Voting Agreements
(1) Nothing in public policy or statute say that this is bad
(2) Commonly seen in close corporations.
(3) It’s a contract subject to contract remedies

Voting Trusts
(1) SH might appoint a trustee to vote the shares according to their direction.
(2) Big difference: Voting Trust is more likely the most honest
(3) Must be in writing
(4) Usually subject to a 10 year limit.
6. Shareholder Lists
Subject to management limitation by mailing the proxy for you
7. Right to Inspect the Books

There are limitations.
(1) Reasonable Circumstances: location, hours, etc
(2) Can be limited based on duration of share ownership
8. Right to Sue To Protect Your Position

Direct Suits
(1) You can sue in contract
(2) You can convert to a class action
Derivative Suits
(1) You allege a breach of fiduciary duty of the board to the corp. The harm was to
the corporation and my injury is an indirect result of my position as shareholder;
maybe my harm is loss in stock value.
(2) Procedural Prerequisites
(a) Stock Ownership (can’t buy into a lawsuit)
(b) Must be able to adequately represent the interests of the corporation and SH
9. Right to Dissolve The Corporation
10. Preemptive Rights

Issuance of Shares That Could Result In Dilution of Shares: This gives rise to the right of
preemptive action.
If you are a shareholder in a corporation, before any shares can be offered for sale, the existing
SH have a right to buy at the same proportion; so their voting position isn’t diluted.
Sometimes we are willing to pay appraisal rights in order to drive out SH or to dilute their shares
and then force them out via a short form merger.
Effectively it’s a freeze out.
D. Change in Control
1. Proxy Solicitation
a. Go to SH’s
b. Get proxy (right) to vote shares
c. No consideration being exchanged No $$; it is not a proxy coupled with an
interest
d. If successful, get control of board of directors
e. The person soliciting the proxy has NO fiduciary duty unless they ultimately wind
up on the board of directors.
f. SH can vote out the Board on the next vote if they are unhappy
g. SH can sell shares if they are unhappy
h. SH position remains same as before the proxy solicitation

Federal Laws To Consider

i. Securities Law
i. § 14A(9) - Proxy Solicitation Anti Omissions Anti Fraud provision
ii. Anti Trust Law,
1. probably not a problem if no change in economic position of SH.
iii. Tax Law
1. Probably not an issue because you’re just getting the right to
vote shares
iv. Other Regulatory Laws
1. Look for restrictions on who may own the company
State Laws To Consider
j. Corporate law for any state in which the company is chartered
k. Fraud and Tort law
l. State anti trust laws
m. State tax laws
n. State securities (Blue Sky) laws
o. State corporation law
i. Short form merger requires 90%
ii. Appraisal Rights
1. No appraisal rights because the SH position in the company has
not changed; no need to protect the SH position
iii. Disclosure
iv. Who has to vote on the transaction; the board and SH of which
corporations need to vote
v. Corporations are principally governed by state laws
vi. Debtor creditor law if assuming debt of target company
1. Not at issue in a simple proxy solicitation
vii. PreemptionNo preemptive rights issue
1. Is SH position diluted after the transadtion? No, it’s the same
company, just a new board.
p. Who Votes?
i. Board and / or SH
ii. Board NOT required to vote on the solicitation
iii. Raider does NOT need Board approval to solicit proxies
Tender Offer
(1) May have a fiduciary duty if there are ? rights or control premium
(2) Can come at any time
(3) Proxy solicitation can only come at annual meeting
(4) Give $ or shares or any property that SH will take in consideration of their shares;
can issue bonds (junk bonds)
(5) You get control of the company
(6) SH position is different after the transaction
(7) Remember that raider need not tender for all the shares; can tender for only 51%
(8)
Rule 14a-9. False or Misleading Statements

(a) No solicitation subject to [these rules] shall be made by means of any proxy
statement, form of proxy, notice of meeting or other communication, written or
oral, containing any statement which, at the time and in light of the circumstances
under which it is made, is false or misleading with respect to any material fact, or
which omits to state any material fact necessary in order to make the statements

therein not false or misleading or necessary to correct any statement in any

earlier communication with respect to the solicitation of a proxy for the same
meeting or subject matter which has become false or misleading. . . .
E. Capital Structure Terminology

 Authorized shares: The articles of incorporation
must specify the number of shares the corporation is authorized to issue.
 Outstanding shares: The number of shares the
corporation has sold and not repurchased.
 Authorized but unissued shares: Shares that are
authorized but have not been sold by the firm.
 Example: Acme Corp.’s articles of incorporation authorize it to issue up
to 1,000 shares. The firm sells 200 shares to investors. It now has 1,000
authorized shares, 200 outstanding shares and 800 authorized but unissued
shares.
 Shares that were issued and then repurchased by the firm were once
called “treasury shares”. The MBCA eliminated this concept, and classifies
treasury shares as authorized but unissued shares.
• Example: Acme Corp. now buys 50 of its 200 outstanding
shares. After the purchase, it has 1,000 authorized shares, 150 outstanding
shares, and 850 authorized but unissued shares.
F. Special Types of Securities: Preferred Shares

If dividends are distributed, owners of preferred shares receive a certain amount of dividends
before any dividends are distributed to the holders of the other shares. Preference rights are
established under the shareholder agreement. Can be estate planning or financing devices. They
come in varied forms. Voting, nonvoting, cumulative, non-cumulative, etc. One reason to issue
PS is to protect debt/equity ratio. Can have conversion rights as well.
1. Dividend preferences.
Example: A company issues 100 regular shares and 100 preferred shares, which receive
a $3/share dividend preference. The company decides to distribute $500 in dividends.
 The preferred shareholders first receive $3 a share.
 This leaves $200 to be distributed among all 200 shares (preferred and
regular). Each share receives $1, so the holder of each preferred share receives
a total of $4, while a holder of a regular share receives $1.
 Decision to issue dividends is up to the Board and is protected by the
BJR.
 The preference protects the preferred SH against the Board giving
dividends to CSH before them. Usually the dividend preference is fixed.
Example: 5% of par.
2. Distribution (Dissolution) Preference

Protects the PSH in case of dissolution of business. Puts PSH ahead of CSH. Depends
on SH agreement. Example: Preferred SH are due the face value of the stock plus any
declared and unpaid dividends.
3. Disadvantages of PS
 Not Preferred Over Secure Creditors,
 No Guarantee Of Dividends,
 No Participation In Appreciation Of Corporation

 Same old relationship of risk and reward
4. Cumulative and Non-Cumulative Dividend Preferences

Cumulative vs Non Cumulative: Non Cumulative PS at the end of the calendar year if
that dividend has not been paid it expires.
Disadvantages of Cumulative Dividend Preferences
 Shows a sign of financial desperation (Knipprath); and
 it puts a great burden on the value of the CS.
Ways to Offset Disadvantages
 Limit # of Years of Cumulation
 Limit On Earnings (No Liquidating Dividends)
 Can limit cumulation to current earnings.
Rationale of Paying or Not Paying Dividends
 Can pay dividends: it gives image of profitability
 Can pay even if not profitable (but leads to liquidation at some point)
 Market may respond if no dividend paid
Limitations Based on Insolvency
 Limits on dividends which may lead to insolvency; various tests. Traditional
balance sheet test; ability to pay debts test
 Directors might be personally liable for liquidating dividends leading to insolvency
Nimble Dividend Rule
 Delaware and other states have the nimble dividend rule. Dividend may be
declared based on current or prior year earnings, despite insolvency of
corporation.
5. Participating Preferred Shares - Estate Planning Technique

Can share in remaining earned surplus after payment of preferred and common
dividends. Can also be limited to net after dividend preference. Of course, this
depresses the value of the CS. Usually participation is limited. Fully participating is
pretty rare. In this way, they can be very useful estate planning devices. Have a voting
preferred class. Put a ridiculous preference on it. That’s what the parents get. Then the
kids get a non-voting common. (Only required to have one class of voting stock; can be
common or preferred; usually common votes but not required). This has the effect of
limiting the gift tax effect.
6. Restricted Shares
Will cover in securities law portion of the course.
7. Par Value
• Can have no par
• Accounting Device
• No relationship to market price
G. Special Types of Securities: Convertible Bonds

A convertible bond is a bond that may be converted into (common) stock
Example: Acme Corp.’s shares are currently selling for $5/share. It issues a $100 bond, that is
convertible to 10 regular shares.
 Would it make sense for a bondholder to convert it immediately?

 Would it make sense for a bondholder to convert it if the price of a share went up to
$12/share?
 Benefits for the bondholder: Convertible bonds give the creditor the security of a bond
(guaranteed interest and priority over shareholders in claim from the corp. assets), while
they also have some of the upside of rising stock prices.
 Benefits for the corporation: The company needs to pay a lower interest rate on the bond.
 Reducing transaction costs (benefit to both parties): Remember the conflict of interests
between bondholders and shareholders? What effect do convertible bonds have on that?
H. Special Types of Securities: Warrants

A warrant is a security issued by the corporation, giving the holder the right to purchase, by a
certain date, a share for a certain price.
Example: Acme Corp. sells 100 warrants, for $2/warrant. Each warrant allows the holder to
purchase a share for $6. The warrant expires a year after issue.
 Assume the current market price for a share is $10. Would it make sense to buy a
warrant? Would it make sense for the corporation to issue one?
 Assume the current market price for a share is $4. Would it make sense to buy a
warrant?
 Warrants are like selling a share in two installment payments, with the share delivered
only if both payments are made, and with the buyer allowed to cancel the agreement
within a certain time, subject to losing the first payment.
 Benefits for the corporation: If share price went down – keeps the “first installment
payment” (price of the warrant); if share price went up – total of both installment
payments is greater than market price when shares were issued.
 Benefits for buyers: Like any installment purchase – lets you buy more shares than you
currently have money for; also – higher rate of return on the money if stock goes up, but
full loss of investment if stock goes down.
Don’t confuse a warrant with an option: options are issued by third parties (not the corporation),
and the money paid for purchasing or exercising them does not go to the company).

XIII. Introduction to the Corporation: Overview of Issues

A. Forming the Corporation
1. Mechanics of Forming the Corporation
2. Liability for Pre-Incorporation Activity (Promoters)
B. Independent Legal Personality
2. Derivative Actions
C. Separation of Ownership and Control
1. Capital Structure
2. Centralized Management
D. One last BA type: The Limited Liability Company 1/12/2005
1. GmBH in Germany
2. Designed to provide liability protection to all members but still allow partnership
taxation
3. Corporate liability protection and partnership tax treatment
4. Problem: is it a management LLC or a member controlled LLC? What’s the

difference?
5. Some centralized structure will be found.
E. Hierarchy of Legal Sources
1. Corporation
Applicable Federal/State Laws
Articles of Incorporation
Bylaws [MBCA §2.06]
Board of Directors’ Decisions
Decisions of Officers
2. Country
Laws of Physics
Constitution
Laws/Regulations
Presidential Directive

Decisions of Gov’t employees
F. Governance of the Corporation: Separation of Ownership & Control

1. Shareholders
SH own the corporation and have powers to keep the directors accountable.
Shareholders are entitled to vote on:
(1) Electing directors [MBCA §8.04-8.04];
(2) Amendments to the Articles of Incorporation (and possibly Bylaws);
(3) Fundamental transactions (e.g., mergers [MBCA § 11.04]);
(4) Some miscellaneous issues (e.g., approval of independent auditors).
2. Board of Directors
Directors control the corporation
MBCA §8.01(b):
(1) “All corporate powers shall be exercised by or under the authority of, and the
business and affairs of the corporation managed by or under the direction of, its
board of directors.” [See also DGCL §141]
3. Hierarchy of Employees
G. Corporate Powers
MBCA § 3.02:
(1) “Unless its articles provide otherwise, every corporation has perpetual duration…
and has the same powers as an individual to do all things necessary or
convenient to carry out its business and affairs…” [Also see Del. GCL §121-2]
(2) “… including without limitation power: … (13) to make donations for the public
welfare or for charitable, scientific, or educational purposes.” [Also see Del. GCL
§122(9)]
2. U of C Hypo
All three directors of Acme are alumni of the University of California. They make the corporation
donate $100,000 to the U of C. Alice, a shareholder of Acme and a Yale alum, sues Acme in
order to have half the donation go to Yale. Bob, another shareholder, sues Acme in order to
enjoin the donation and make Acme distribute the $100,000 as dividends.
Acme’s directors respond by pointing to MBCA §3.02(13), in combination with MBCA §8.01(b).
Do these sections authorize the directors’ actions?
H. Corporate Purpose
MBCA §3.02 states the corporation’s powers, not the corporation’s purpose.
(1) MBCA §3.02(1) adds the power “to sue and be sued”; MBCA §3.02(7) adds the
power “to make contracts”. But obviously not every suit and every contract the
directors decide on is automatically immune of judicial scrutiny. If it were so,
what would keep the directors accountable?
(2) A corporation’s powers determine what the corporation can do. But directors are
to use those powers to advance the corporation’s purpose. MBCA 3.01 states
that a corporation “has the purpose of engaging in any lawful business unless a
more limited purpose is set forth in the articles of incorporation.”
(3) This doesn’t provide a lot of guidance. For whose benefit should the corporation
operate (SH, creditors, employees, the community)? Which groups can protect

their interests contractually (or otherwise)?
I. Stakeholders in the Corporation

1. Creditors Have A Defined Entitlement (Principal + Interest):
Creditors have little interest in the corp’s prosperity above what is needed to pay interest.
Creditors can more easily protect their interests by contract.
2. Employees Can Protect Themselves By Contract, But:

Their entitlements are less easily defined (e.g., job security, working conditions), so harder to
protect contractually.
Information asymmetries and discrepancy in bargaining power between corporation and many of
its employees.
Limited interest in corp’s prosperity.
Some foreign countries (notably, Germany) require a portion of the board to be appointed by
employees.
3. The Community (E.G., The Environment) – Can Protect Itself By Legislation.

Example: History of Wrigley Field after Shlensky v. Wrigley (under new ownership of Chicago
Tribune, lights were installed, but # of night games was limited).
4. Shareholders
Own a residual claim on the corp’s assets – hard to define entitlement.
Have most interest in corp’s prosperity (own both “upside” and “downside”), except when corp is
insolvent (because then they only own the “upside”).
Therefore, it makes most sense that corp would operate for benefit of SH, subject to contractual
and legislative protection of the interests of the other stakeholders.
J. Centralized Management and the Business Judgment Rule

1. Shareholder Wealth Maximization Norm:
 The corporation should be operated in a manner that maximizes shareholder
wealth (i.e., the value of the residual claim) [But cf. 15 Penn. Consol. Stat. §102(d)
(CB p. 275); ALI’s Principles of Corporate Governance §2.01(b) (CB p. 285)].
 Having the corporation operate for the benefit of SH doesn’t mean that it would
be operated by the SH. We discussed earlier the benefits of centralized
management (management by authority rather than by consensus). To reap those
benefits, managerial discretion must be protected (if SH or judges second-guess
directors often, the directors will have no authority with which to manage).
 On the other hand, having the board run the SH’s company results in a
separation of ownership and control (recall the hypo on Jane and the Newspaper,
and discussion of conflicts between creditors and SH). The separation creates a risk
of managerial shirking.
 Law needs to balance between preserving managerial discretion and preventing
managerial shirking. The corporate balance is struck by the Business Judgment
Rule.

2. Business Judgment Rule (BJR) –

 Absent fraud, illegality or conflict of interest, the board’s business judgment is not
second guessed by the court.
 BJR applies only when the board made a business judgment, which requires
some investigation and deliberation by the board. More on this when we discuss the
Duty of Care.
Dodge v. Ford Motor Company

 FMC is highly successful. Henry Ford owns 58% of stock. He makes FMC cut
its dividend. Soon, FMC has large retained earnings. Ford plans to use those to cut
prices on cars, double salaries, and build a plant in River Rouge.
 Dodge brothers, owning 10% of FMC, sue to enjoin construction of the plant, and
to require FMC to issue special dividends.
Holding: FMC Must Issue The Special Dividends, But Can Continue With Its Construction Plans.
(1) Why does the court allow building the plant but forces dividends?
(2) How is FMC harmed by being forced to issue dividends? Can it raise the money
it is forced to distribute?
Possible Interpretation Of Holding: Directors have discretion over the means to the end of
serving SH, but cannot change the end to include actions contrary to SH interests.
But we are being too charitable with the court’s analysis. FMC was no charity. How
can the following decisions benefit SH: Reducing the price of cars? Doubling
salaries? Building the River Rouge plant?
Justifications For Ford’s Plans:
(1) Reducing car prices – more sales, and thus greater revenues. Also, competition
was driving car prices down. If FMC didn’t reduce prices, cheaper competitors
would capture its market share.
(2) Doubling wages – FMC paid the going rate to employees. There were many
other jobs at that salary range, and FMC had an annual employee turnover rate
of 370%. Doubling salaries resulted in loyal employees and reduced training
costs.
(3) River Run Plant – large plant that possibly would have exploited mass production
and reduced manufacturing costs. Also, builds more cars in anticipation of a
growing market.
Why Doesn’t Ford Tell The Court These Justifications?
(1) Ford doesn’t want to be perceived as a robber baron.
(2) Excerpt from Ford’s cross-examination:
Counsel for Dodge: [D]o you still think that those profits were awful
profits?
Ford: Well, I guess I do, yes.
C: And for that reason you were not satisfied to continue to make such
awful profits?
F: We don’t seem to be able to keep the profits down.
C: Are you trying to keep them down? What is the Ford Motor
Company organized for except profits, will you tell me, Mr. Ford?
F: Organized to do as much good as we can, everywhere, for
everybody concerned… And incidentally to make money.
C: Incidentally make money?
F: Yes, sir.
But If Ford’s Policies Create Value For SH, Why Are The Dodge Brothers Unhappy About Them?
(1) The Dodge brothers own the Dodge company, which competes with Ford.
(a) If Ford’s cars are cheaper, Dodge loses sales and profits.

(b) If Ford raises salaries, Dodge has to follow suit or get less reliable
employees.
(c) Dodge is strapped for cash to invest in new plants, and they want to invest
the dividends from FMC into Dodge.
(2) Ford is not a saint, either. Knowing that his competitors need cash to compete
with FMC, he denies them dividends. But this isn’t a conflict of interests (for BJR
purposes) since Ford’s interests are identical to FMC’s.
(3) Another possible reason for cutting dividends: Top bracket of federal income tax
rates rose from 7% in 1913 to 73% in 1920. Ford is likely in top bracket. Maybe
Dodge bros. are not.
(a) Problem of differing SH interests due to taxation does not exist in
partnerships.
(4) Note on dividends: often the problem is the reverse; SH distribute too many
dividends, risking insolvency (which harms creditors). Some states have
statutory limits on the maximum dividend a firm can issue.
Preferred stock has some of the indicia of K; it is preferred in bankruptcy proceedings.
Shlensky v. Wrigley
(5) Shlensky is a minority SH in corporation that owns the Chicago Cubs and
operates Wrigley Field. Wrigley, who owns 80%, refuses to install lights (that
would enable Cubs to play night games).
(6) Shlensky alleges that Cubs are losing money because of poor home attendance,
which was possibly due to lack of night games (for people who work during the
day).
(7) Wrigley rejects night games because he believes baseball is a day-time sport,
and night baseball might negatively impact the neighborhood surrounding
Wrigley Field.
(8) Court goes out of its way to find SH benefit – night games may increase crime in
area, and deter attendance, thus harming SH.
(9) BJR – No evidence of fraud, illegality or conflict of interest, so court does not
second guess Wrigley’s judgment, despite evidence Shlensky wants to present
showing that night games will increase profits.
(10)Instead of arguing for a lack of business justification (in the face of the BJR),
Shlensky might have been better off trying to argue that Wrigley refused to
investigate option of night games, and thus did not make an informed business
decision to which the BJR can apply.
(11)Epilogue: Ownership of the Cubs and Wrigley Field eventually passed to the
Chicago Tribune, which tried to install lights. Local residents complained, and
the Cubs ultimately got lights, but were limited in the number of night games they
could play.
3. Back to the U of C Hypo

All three directors of Acme are alumni of the University of California. They make the corporation
donate $100,000 to the U of C. Alice, a shareholder of Acme and a Yale alum, sues Acme in
order to have half the donation go to Yale. Bob, another shareholder, sues Acme in order to
enjoin the donation and make Acme distribute the $100,000 as dividends.
(1) Acme has power to give to charity [MBCA §3.02(13)], and directors wield that
power [MBCA §8.01(b)].
(2) Does BJR apply to directors’ decision?
(a) Fraud/Illegality? No
(b) Conflict of interest? “Pet charity” exception in Barlow. Being a U of C alum
probably does not create in itself conflict. But if one of the directors was on U
of C’s board of visitors – possibly yes.
(c) Absent fraud, illegality or conflict of interest, the directors’ decision stands.

Application of Dodge v. Ford suggests BJR may not apply in Bob’s suit, if $100K is a large
portion of Acme’s assets, since this suggests directors are determining the ends for which the
corporation is run, not just the means to reach those ends. Courts tend to be receptive to
business justifications for charity donations (e.g., long-term benefits to SH from PR). If gift were
anonymous, though, Bob may have a stronger case.
XIV. Comparing Partnerships and Corporations: Development of the LLC

 LLC introduced in Wyoming in 1977. Created as a vehicle for ownership of real estate
and development of oil, gas and other mineral rights.
 Few states adopted this form until 1988, when the IRS ruled that LLCs could qualify for
partnership-like tax treatment. IRS further liberalized tax treatment in 1997. Result:
explosive growth in use of this form of business association. Avoid the double taxation
trap of the corporate model.
 Model Code: Uniform Limited Liability Company Act (1996) [ULLCA].
 LLC’s allow you to enjoy the shield from liability and the control not normally found in
corporations.
 Participants in an LLC are members.
 S Corps; can elect individual or corporate tax treatment; only certain businesses; 30
shareholders max.
1. LLC Terms and Corporation Equivalents

Corporation and Partnership LLC
Shareholders/Partners Members
Directors & Officers/ - Managers
Articles of Incorporation/ - Articles of Organization
Bylaws/Partnership Agreement Operating Agreement
2. Formation
File Articles of Organization In The Designated State Office [ULLCA §202(a)]
(1) Required terms: §203(a); Optional terms: §203(b). Mandatory terms: §103(b).
(2) Pay filing fees and franchise tax.
(3) Choose and register name [ULLCA §105(a)].
(4) Designate office and agent for service of process.
Draft Operating Agreement
(1) Relationship between AoO & OA [ULLCA §203(c)]: When they conflict -
(a) OA controls as to managers, members & members’ transferees.
(b) AoO control as to any other person, who reasonably relied on the articles to
their detriment.
Conversion of Existing Entities
(1) Partnerships - ULLCA §902 authorizes conversion of GP/LP to LLC.
(a) ULLCA §903(b)(2) converts GP/LP debts to LLC debts. To protect creditors
from limited liability, should make conversion an event of default.
(2) Corporations – No provision for conversion [Can convert by merging the
Corporation into a newly-formed LLC; §904 would then govern procedure].
3. Member’s Interest in LLC

A member’s rights include:
(1) Management Rights
(2) Financial interest (right to distributions and participation in liquidation)

(a) No direct rights in the LLC property [ULLCA §501(a)]

Profit and loss sharing
(1) ULLCA §405(a) – Equal shares (like a partnership).
(2) Most states allocate profits and losses on the basis of the value of members’
contributions (unless agreed otherwise).
(3) Member may withdraw and demand payment of his interest upon giving notice as
specified in statute or in LLC’s operating agreement.
Assignment of LLC interest – similar to partnership
(1) Default: Member may assign financial interest; transferee becomes a member
only if OA allows this or if all members consent.
4. Management Rights 1/12/2005

Two options for LLC management
(1) Member management
(2) Manager management
Member-Managed Company - Each Member Has An Equal Right In The Management Of The
LLC [ULLCA §404(a)(1)]
(1) Issues decided by majority vote, except for matters specified in ULLCA §404(c),
which require unanimous consent.
Manager-Managed Company [ULLCA §404(b)]
(1) Managers elected/removed by majority vote of members.
(2) Managers decide all matters except those specified in ULLCA §404(c), which
require unanimous consent of the LLC members.
(3) Members have no management rights except for those retained in AoO/OA, and
those specified in ULLCA §404(c).
The cost of flexibility is lack of specificity. AoO/OA need to create detailed arrangements.
5. Fiduciary Duties in the LLC

In a manager-managed LLC:
(1) Managers owe fiduciary duties.
(2) Usually, members do not owe fiduciary duties to the LLC or its members by
reason of being members.
In a member-managed LLC:
(1) All members owe fiduciary duties.
Standard for fiduciary duties set in ULLCA §409.
(1) ULLCA §103(b)(2): OA may not eliminate the duty of loyalty, but may “identify
specific types or categories of activities that do not violate the duty of loyalty, if
not manifestly unreasonable.”
Derivative Actions
(1) Members may bring an action on behalf of the LLC to recover a judgment in its
favor if the members with authority to bring the action refuse to do so.
LLC is liable for member’s or manager’s conduct if it is in the ordinary course of business of the
LLC or with authority of the LLC [ULLCA §302].
ULLCA §303(a): Members’/managers’ liability limited to their contribution to the LLC (i.e., no
personal liability).
(1) Exception [ULLCA §303(c)]: If AoO allows personal liability and member

consented in writing.
B. Piercing the LLC Veil

1. MBCA §6.22(b):
“Unless otherwise provided in the articles of incorporation, a shareholder of a corporation is not
personally liable for the acts or debts of the corporation except that he may become personally
liable by reason of his own acts or conduct.”
2. ULLCA §303(a):
“... A member or manager is not personally liable for a debt, obligation, or liability of the company
solely by reason of being or acting as a member or manager.”
(1) No explicit exception that opens the door to piercing the veil.
(2) Cf. Minn. Stat. §322B.302(2): “Case law that states the conditions and
circumstances under which the corporate veil of a corporation may be pierced
under Minnesota law also applies to limited liability companies.”
Kaycee Land & Livestock v. Flahive:

LLC Veil may be pierced if equity demands and statute doesn’t explicitly prohibit.
(3) If the members and officers of an LLC fail to treat it as a separate entity as
contemplated by statute, they should not enjoy immunity from individual liability
for the LLC’s acts that cause damage to third parties.
(4) The Rules of Common Law are not to be changed by doubtful implication, nor
overturned except by clear and 99avourable99 language.
(5) Unlike Minnesota, Wyoming law is silent regarding piercing the veil. Court allows
it. Is this justified? Court uses common law equity as its justification. Appellant
wanted a blanket prohibition on such piercing; Courts never grant blanket
prohibitions unless it is to protect the rights of criminals.
(6) But cf. ULLCA §303(b): “The failure of a [LLC] to observe the usual company
formalities… is not a ground for imposing personal liability on the members or
managers for liabilities of the company.”
(7) Can you pierce the corporate veil when there is no corporation? This is a
certified question of law; the facts don’t matter.
Tom Thumb Food Markets, Inc. v. TLH Properties, LLC (Minn App. 1999) (Another Grocery
Store Case)
The practice of piercing the corporate veil is generally a creditor’s remedy used to
reach an individual who has used a corporation as an instrument to defraud
creditors. Absent injustice or fundamental unfairness, Courts will refuse to pierce
the corporate veil.
Developer signs lease agreement with Tom Thumb, appellant. Lease agreement
contains integration clause stating that there are no other contingencies to the lease.
Later, Bank checks credit of lessee (Thumb) and finds he has a negative net worth.
Because the proposed tenant doesn’t qualify, bank refuses to finance the developer and
the true land owner takes a walk; the deal collapses.
Thumb sues the developer for breach of contract (not leasing him the land). Then Thumb
discovers that the developer did not really own the land, so he moves to amend his
complaint to add a claim that Hartmann (the developer) should be held personally liable
under the theory of piercing the corporate veil. The district court allowed the amendment
and concluded after trial that Hartmann was personally liable. The district court found that
Hartmann breached the lease and Tom Thumb was entitled to 12 years of lost profits at a
present value of $492,000.
Appellate Court rejected Hartman’s theory that the lease deal was contingent upon
financing; the integration clause proved otherwise. However, Hartman was not trying to

defraud Thumb, he was trying to do business with him. It was Thumb’s insolvency and
stalling that caused the bank to withdraw financing. Far from creating the company to
perpetrate a fraud, the undisputed testimony was that the company was formed to
achieve development of a Tom Thumb store. Furthermore, a party seeking equity “must
come with clean hands.” As such, the Court would be sanctioning an “inequitable result”
if benefit to party whose conduct forced other party to breach contract); piercing denied.
McConnell v. Hunt Sports (Ohio App. 1999)

An LLC OA (operating agreement) may limit the scope of fiduciary duties imposed
upon its members.
McConnell and Hunt form an LLC to bring and NHL Hockey franchise to Columbus, Ohio.
Hunt repeatedly and unilaterally rejected a development agreement with Nationwide
Insurance, whereby Nationwide would develop the needed sports arena. McConnell
learns of Hunt’s unilateral and undisclosed actions from Nationwide. Because Hunt
purported to act on behalf of the LLC but did not disclose his actions to the LLC; and
because the OA permitted members to “engage or own an interest in any other business
venture of any nature, including any venture which might be competitive with the
business of the Company,” McConnell made the deal with Nationwide himself.
Hunt sued in NY Court; lawsuits everywhere. Appellate Court held that McConnell acted
within the bounds of the OA. This case distinguishes from Meinhard v. Salmon because
in that case the partner cut the lease deal without letting the other partner know. Here,
Nationwide treated both parties as viable contenders until the deal was done (smart
business); and the OA permitted self-dealing. Court found that Hunt’s unilateral act of
filing suit in NY was a violation of the OA and fined him $1.00.
C. LLC Dissolution
1. Dissociation v. Dissolution
Similar to RUPA – Dissociation events [§601] result in withdrawal or expulsion of members, but
not necessarily to winding up of LLC. Dissolution events [§801] result in winding up of LLC.
Dissociated member’s interest must be purchased by LLC [§701]
(1) Judicial appraisal proceeding available [§702]
Member’s right to participate in LLC management terminates upon dissociation [§603(b)(1)].
(1) Exception: participation in a post-dissolution winding up process [§603(b)(2)]
New Horizons Supply Cooperative v. Haack, (WI 1999) (Failure to Follow Dissolution
Rules)
Liquidation distributions are subject to reclamation by creditors if LLC not
properly dissolved.
Facts
(1) Brother and sister form LLC freight company.
(2) LLC collapses in debt; brother disappears.
(3) Brother & Sister did not observe formalities of LLC and few records were
available and admitted into evidence.
(4) LLC was treated as a partnership for tax return purposes
(5) TC used this fact as basis for piercing LLC veil
Key Points
(1) Tax treatment not proper basis for piercing LLC veil
(2) Failure to observe LLC dissolution rules subjects members to liability for LLC
debts
Conclusion

(1) TC judgment affirmed

Much more like partnership for compliance purposes.
D. Duty of Care
1. BJR and Fiduciary Duties
Business Judgment Rule (BJR) – Absent fraud, illegality or conflict of interest, the board’s
business judgment is not second guessed by the court.
So, the court defers to the BoD’s decisions, unless:
Directors breach their Duty of Loyalty, because their decision is tainted by fraud, illegality, or
conflict of interest.
(1) We have seen this in Agency & Partnership
(2) We are looking for conflicts of interest.
Directors breach their Duty of Care, because they do not conduct sufficient investigation or
deliberation to make a business judgment.
(1) Applies to directors, officers, and – in certain cases -- dominant shareholders
(2) Similar to a negligence action; it is an allegation of shirking by those with the duty
of care
Directors are liable for Waste of Assets, the flip side of which is the Business Judgment Rule;if
they do something egregious enough that a Court would believe faild the BJR.
2. Understanding Kamin v. AmEx Co. When Do Losses Affect Share Value?

Acme Corp. owns a parcel of land that it bought for $30 M. After a real-estate bubble bursts, the
land is only worth $4 M. A newspaper article in the Wall Street Journal mentions the fact that
Acme lost $26 M on its investment.
Acme’s CEO consults with his accountants, who advise him that he does not need to report the
loss in the mid-year financial statements (which he is about to issue that day), but he will need to
report the loss in the annual report, which will be issued about half a year later [This might not be
the correct accounting standard in the real world; but for the purposes of this hypo, let’s treat is
as honest, correct advice].
The same day the WSJ article appears, Acme issues financial statements showing no loss
(according to these statements, the land is still worth $30 M). Acme’s CEO tells reporters that
Acme indeed lost $26 M on the investment, but followed proper accounting standards in not
reporting it in the statements at this point.
(1) What is likely to happen to Acme’s share value in the following days?
(2) Half a year later, when Acme’s annual report is issued, it reports the $26 M loss.
(3) What is likely to happen to Acme’s share value now?
Kamin v. AmEx Co.

Facts:
(1) AmEx held DLJ stock that it had bought for $30 M, but declined in value to $4 M.
AmEx decided to distribute the DLJ stock to SH as a dividend in kind.
(2) Result: Amex disposes of the investment without having to report the
investment’s loss in AmEx’s profit & loss statements (reporting is required only
when AmEx sells the investment, and AmEx never sells it; just gives it to SH).
(3) Since the loss was well-known, not reporting the loss doesn’t hide any
information from the market, though it affects the accounting figures.
Could AmEx prevent its shares from declining in value by (legally) not reporting the $26 M loss in
their profit & loss statements?

What other reason could the directors have?

(1) If AmEx sold the DLJ stock instead of distributing it as a dividend, it would have
had to report the loss, but this loss could offset profits, and reduce its tax liability
by $8 M. SH file a derivative suit, challenging AmEx’s decision.
The court rules for the AmEx board. Why?
(1) Business Judgment Rule: Court defers to BoD’s decision unless:
Directors breach their Duty of Loyalty, because their decision is tainted by fraud, illegality, or
(1) Four of the 20 directors receive compensation that is affected by AmEx’s profits
(as reported in its statements). A reported $26 M loss would reduce those profits
and thus their compensation. Is this fraud? Illegality? Conflict of Interest?
(2) But all other 16 directors are not affected. So, no breach of DoL.
(1) BoD acted only after due deliberation, and on the basis of expert advice. So, no
breach of DoC.
Non-Feasance is ignoring facts called to your attention.
(1) P. 318 the Board acted on the information so the rule is “do something, even if
it’s wrong.” And you’re covered by the BJR.
Joy v. North, 2nd Cir.1981

The business judgment rule does not apply in cases in which
(i) The corporate decision lacks a business purpose;
(ii) Is tainted with a conflict of interest, fraud, bad faith or illegality
(iii) Is so egregious (unerhört) as to amount to a no-win decision or
(iv) Constitutes waste (i. e. what the corporation received in a transaction was so
inadequate in value that no person of ordinary sound business judgment would
deem it worth what the corporation paid; high standard, very difficult to prove!)
(this is not Joy!)
(v) Nonfeasance; or an obvious and prolonged failure to exercise oversight or
supervision
Smith v. Van Gorkom

Timeline 1980
(1) August-September: Internal Management Discussions
(2) TU Stock priced around $38.
(3) CFO (Romans) suggests a Management Buyout (MBO), in which the
management borrows money and uses it to buy the shares from SH.
(4) Romans runs a feasibility study (i.e., what’s the highest price that can be offered
for TU’s shares and still allow management to finance the deal)?
(5) Van Gorkom rejects MBO to avoid conflict of interest.
Knipprath says that legislators and other Courts thought this case was an aberration in that it did
not apply a gross negligence standard. But the 3-2 decision imposed liability and scholars think it
was improperly applying a ordinary negligence standard. So, the legislature passed a statute
defining gross negligence.
Sept. 13-19: Van Gorkom negotiates with Pritzker an agreement under which Pritzker woud buy
TU in a Leveraged Buyout (LBO).
(1) What’s an LBO?
3. Leveraged Buyout (LBO)

The Mortgage Analogy

(1) Jay spots an apartment building that he expects will rise significantly in value. At
current rent levels, renting the apartments will yield $90,000/year. Jay plans to
get a mortgage, buy the building and rent the rooms, then pay the interest on the
mortgage from the rent income.
(2) Suppose that Jay can get a mortgage at 10% interest. How much money can he
borrow, if he uses the rent income (and only it) to pay the interest on the
mortgage?
(3) Jay adds $100K of his own money, and buys the building for $1M.
Risk & Reward in an LBO
(1) Suppose the value of the building goes up 10%:
(a) Jay sells house for $1.1 M
(b) Jay pays $900K debt
(c) Jay keeps $200K.
(d) His investment (the amount of his own money he risked) was $100K.
(e) His RoR: +100%
(f) Investment up 10%; Jay’s profits up 100%.
(2) Suppose the value of the building goes down 10%:
(a) Jay sells house for $900K
(b) Jay pays $900K debt
(c) Jay is left with nothing.
(d) His investment (the amount of his own money he risked) was $100K.
(e) His RoR: -100%
(f) Investment down 10%; Jay’s profits down 100%.
Leveraged Buyout (LBO) The Business Structure of the Deal
(1) Hypo: Jay (Pritzker) spots Trans Union, a company he expects will rise
significantly in value. TU’s annual profits are $90,000. TU has 20,000 shares
outstanding. Jay plans to get a loan, buy all of TU’s shares and pay the interest
on the loan from TU’s profits.
(2) Suppose that Jay can get a loan at 10% interest. How much money can he
borrow, if he uses TU’s income (and only it) to pay the interest on the loan?
(3) To make his offer more attractive, Jay adds $200K of his own money, for a total
purchase price of $1.1M. He offers to purchase TU shares at $55
($1.1M/20,000).
(4) Hypo is similar to calculations Romans made in Van Gorkom
(a) At $50/share – easy to finance LBO
(b) At $60/share – hard to finance LBO
(c) Van Gorkom splits the difference: “I’d take $55”. Does this reflect TU’s
value?
Value of the Firm
(1) TU’s shares were selling at the time for $38/share. Pritzker agreed to buy the
shares for $55 (~45% premium).
(2) Why isn’t the market price accepted as an indicator of the firm’s true value? Is
there something Pritzker would get in a buyout that he won’t get by buying
shares on the market?
(3) Market price of shares assumes buyer purchases one share. If buyer purchases
a large number of shares, price will move upwards.
(4) The value of a share is composes of two parts: Economic rights (rights to
dividends and Corp’s assets in dissolution), and Voting rights (rights to control
the company). A single share’s voting rights are usually worth close to zero.
(5) Acme has 100 shares outstanding. Alice holds 51, and Becky holds 49. What’s
the value of Becky’s voting rights? Is this unfair to Becky?
(6) Market price usually reflects only economic rights, since you can’t get control by
buying a single share. Exception: Control fights – when a large number of
shares are acquired in the market, price rises to reflect control premium.

(7) August-September: Internal Management Discussions

(a) Sept. 13-19: Van Gorkom negotiates with Pritzker an agreement under which
Pritzker would buy TU in a Leveraged Buyout (LBO).
(b) What was the deal they agreed on?

4. Smith v. Van Gorkom Legal Structure of the Deal
Smith v. Van Gorkom Legal

Structure of the Deal
Before After
SH Pritzker SH Pritzker
Trans Marmon Marmon

Union Group, Inc. Group, Inc.
$55/share
Legal effect of merger: see DGCL

§259(a): Ends the separate NewCo., Inc.
Trans Union Merger (Surviving Entity)
existence of all entities except one
surviving entity. All property and
liabilities of merging parties vest
in/attach to surviving entity.
Smith v. Van Gorkom Legal Structure – “Lockups”

(1) Hypo: Acme currently has a market value of $100K. If Kelly spends $10K worth
of time and money, she could find hidden value in Acme corp., that would make
Acme worth $150K. Would it make sense for Kelly to spend the $10K in
research, then buy Acme’s shares and implement the idea? What’s the highest
Kelly should consider offering for Acme’s shares?
(a) Kelly spends the $10K, and asks Acme’s board to endorse her buyout offer
of Acme’s shares for $135K. Craig, Acme’s CEO, then tells Larry of Kelly’s
offer. Larry trusts Kelly’s business acumen, and knows she spent some
effort (perhaps at a cost of about $10K) to discover Acme’s value. He
doesn’t know what exactly she found, but if she spent $10K and then offered
$135K for the company, then she must have found Acme is worth at least
$145K.
(b) Therefore, Larry offers to buy Acme for $145K (that’s what Craig was hoping
for when he told Larry of Kelly’s offer). Should Kelly match that offer?
(c) Would the problem be solved if Kelly made an ‘exploding offer’ (offer
withdrawn if not accepted immediately)?
(d) If Larry knew Kelly’s offer was withdrawn, he wouldn’t need to compete with
her offer, so he’d offer less. Knowing that, Craig won’t have an incentive to
shop around.
(e) But this solution is not feasible. A merger or takeover requires BoD and SH
votes, due diligence, etc. An exploding offer isn’t feasible.
(f) The next best alternative is contractual terms either “locking-up” the
negotiating parties (i.e., ensuring they do not shop around), or compensating
the bidder.
(2) Pritzker demands that TU not solicit other bids, and not furnish inside information

to other bidders (the board claimed it rejected the latter demand). What effect do
these demands have?
(a) Pritzker also tells Van Gorkom he “would serve as a ‘stalking horse’ for an
‘auction contest’” only if TU agrees to sell to Pritzker 1.75M shares [later
negotiated down to 1M shares] at current market price [$38], which he may
sell to third parties.
(b) Does P profit from this if someone else makes a higher bid? Does P profit
from the reduced price shares if his bid wins?
(c) Why did Romans say this “would inhibit other offers”?
(d) If another bidder wins, P receives a value of $17M [$55-38 x 1M shares] from
TU, reducing TU’s value by $17M. For P the reduced price shares don’t
change the valuation – he buys his own reduced price shares. P could
therefore offer up to $17M more than a rival that values TU the same.
Knowing P’s advantage, others may be reluctant to bid.
August-September: Internal Management Discussions
(1) Sept. 13-19: Van Gorkom negotiates with Pritzker an agreement under which
(2) Sept. 20: Senior management meeting.
(3) Senior management’s reaction: Very hostile. Why?
(4) Sept. 20: TU BoD approves merger after a two-hour meeting.
Smith v. Van Gorkom What Should the Board Have Done?
(1) Attempt to investigate what TU is worth specifically to P
(a) Board expected to get best possible price, not just ‘fair price’.
(2) More supervision and control of the CEO
(a) Examine: valuation, course of negotiations, review actual contract.
(b) Both the Sept. 20 and Oct. 8 approvals were done based on representations
of VG and other senior management. Very little documentation or outside
support.
(c) DGCL §141(e) provides a defense for directors who rely on reports from
officers. Why didn’t this section apply here?
(i) Board has duty to inquire – can’t rely solely on CEO’s representations.
(d) Problem is particularly severe since VG is about to retire (endgame problem).
(3) Consult with experts
(a) Romans, who prepared the feasibility study, didn’t regularly do such studies.
But how independent are the ‘experts’?
(b) TU hired Salomon Brothers (an investment banker) to find better offers, and
Solomon Bros. found only one possible buyer (GE Credit), who conditioned
its bid on rescinding TU’s agreement with P (P refused this).
(4) Judge McNeilly did not find these shortcomings convincing, and dissented. What
were his reasons?
August-September: Internal Management Discussions
(1) Sept. 13-19: Van Gorkom negotiates with Pritzker an agreement under which
(2) Sept. 20: Senior management meeting.
(3) Sept. 20: TU BoD approves merger after a two-hour meeting.
(4) Van Gorkom signs agreement w/ Pritzker during a party at the Opera House.
(5) Oct. 8: TU BoD approves revised deal (conceding to senior management)
(6) Oct. 10: P adds in revised deal limitations on TU’s ability to shop. VG signs.
(7) Oct. 21-Jan. 21: Salomon Bros. try to find alternative suitor; find one candidate
(GE Credit), who later withdraws.
(8) Early December: KKR, the only other concern to make a firm offer for TU,
withdraws its offer.
(9) Feb. 10: TU’s SH approve merger by 69.9% to 7.25% (22.85% abstain).
(10)Why didn’t court see this as ratifying the directors’ decision (and as an indicator

that SH saw price as fair)?

(a) SH were not fully informed, so the vote could not be seen as ratification.
BJR: Court defers to BoD’s decision unless:
(1) Directors breach their Duty of Loyalty, because their decision is tainted by
fraud, illegality, or conflict of interest.
(2) No fraud or illegality.
(3) Conflict of interest?
(4) Van Gorkom specifically rejected management buyout idea to avoid conflict of
interest.
(5) Van Gorkom is near retirement. Why does the court think it noteworthy?
(1) BoD decided after a two-hour deliberation, and informed itself with only a 20
minute oral presentation, with no written studies, no written summary of the
proposed agreement/letter of intent. Expert advice was not sought.
(2) Court: This breaches the DoC – board failed to investigate the offer adequately
and consider options. Board had only sketchy information on the company’s
value.
(3) Information is costly to acquire. Isn’t the decision how much information to
acquire a business decision itself?
A Note on Smith v. Van Gorkom Keeping Excess Cash in the Corporation
(1) Trans Union had:
(2) More tax credits than it can use (i.e., not enough taxable income to use them);
(3) Lots of spare cash.
(4) TU’s management seems to have cash that they can invest, but cannot find an
investment that is good enough. Is keeping the cash good for SH?
Hypo: Ann thinks of a business opportunity that would require $10,000 and that has an expected
annual RoR of 50%. She forms Acme and sells 100 shares for $100 a share.
(1) Acme invests the $10,000, and makes the predicted 50% profit, so by year’s end
it has $5,000 in cash (in addition to $10,000 in assets used for the business).
Ann can’t find another profitable business opportunity, however. So, she has
Acme deposit the $5,000 in a savings account.
(2) Is the interest rate on the deposit likely to be higher or lower than the expected
return on an equity investment in a business? (Remember the relationship
between risk & return. Which investment is riskier?)
(3) If SH & Corp. get the same interest rate for deposit, are SH better off having the
money stay in the corporation, or paid to them as dividends?
(4) If SH & Corp. get the same interest rate for deposit, are SH better off having the
money stay in the corporation, or paid to them as dividends?
(5) SH likely to prefer dividends than keep cash in the corporation:
(6) SH may want riskier investment (Acme is the risky portion of diversified portfolio).
(7) SH can make risk-free investments on his own, and save management costs.
(8) What is SH’s right to a deposit of the corporation’s? Is it the same as his right to
a deposit of his own money?
(9) So why allow Corp. to keep any profits at all?
(10)If the management expects to find a profitable business opportunity, it may need
money to be able to seize it when it appears.
(11)Back to Trans Union. TU can’t find a business opportunity. What can TU do with
the spare cash?
(12)Buy other businesses (or enter new line of business) – but BoD can’t find a good
investment.
(13)Any other options?
A Note on Smith v. Van Gorkom Uses for Spare Cash

(1) Trans Union’s management seems to have cash that they can invest, but cannot
find an investment that is good enough. What can they do with the spare cash?
(a) Buy other businesses (or enter new line of business)
(i) But TU’s BoD could not find good investments.
(b) Sell the firm to someone who can better use the cash (and tax credits).
(i) This is what Van Gorkom and TU’s board opted for.
(c) Pay spare money to SH as dividends.
(i) Repurchase stock with the spare cash.
A Note on Smith v. Van Gorkom Dividends and Repurchases
(1) Acme has assets and goodwill worth $100, and $100 in cash (so its total value is
$200). It has 100 shares outstanding. Jim owns 5 shares. How much is each
share worth? How much is Jim’s interest in Acme worth?
(2) Alternative (a): Acme pays $100 in dividends.
(a) After dividend payment, Acme is worth $100. There are still 100 shares
outstanding. How much is each share worth now?
(b) How much are Jim’s shares worth? How much did he receive in dividends?
What’s the total of the two?
(3) Alternative (b): Acme uses the $100 to repurchase its shares.
(4) What’s the share price? How many shares can it purchase? How many shares
left?
(5) After repurchasing shares, Acme is worth $100 (repurchased shares have zero
value to Acme). How much is each share worth now? If Jim still has 5 shares,
how much is their total worth?
(6) Conclusion – Repurchases and dividends do not change SH wealth (this point
was made by Modigliani & Miller). Exceptions include:
(7) Tax considerations
(8) SH and Corp. have different RoR on investments.
Legislative Response to Smith and Van Gorkum 1/21/2005
(1) P. 338 Delaware Legislature enacts Del.Gen.Corp.Law § 102(b)(7) which allows
any Delaware corp. to limit its director liability by adding such limits to its
certificate of incorporation except in instances of:
(a) Breach of Loyalty
(b) Bad faith or illegal acts
(c) § 174 violations of dividend policy
(d) Self-dealing
(2) So, after § 102(b)(7) can there still be a duty of care in Delaware? Yes, because
even if the company does impose this limitiations, you can still be on the hook if
your duty of care breach involves a breach of the duty of loyalty.
Defenses to Breach of Duty of Loyalty (Knipprath)
Disclosure and approval of Board
Brehm v. Eisner
Facts:
(1) Disney BoD hires Ovitz as President
(2) Salary of $1M + bonus + stock options on 5M shares.
(3) In the event of non-fault termination:
(4) Discounted present value of 5 years’ salary
(5) $10 million severance payment
(6) Immediate vesting of options on 3M shares.
(7) Total value: $140M
(8) Ovitz was non-fault terminated after 14 months
(9) Actions by Ovitz could have been construed as de facto resignation or
termination for fault, but Disney did not try to argue this.

Brehm alleges:
(1) Old BoD violated duty of care & committed corporate waste when it approved the
compensation package.
(2) New BoD violated duty of care & committed corporate waste when it approved
non-fault termination.
(3) Court affirms dismissal of allegations.
Brehm v. Eisner Can Courts Consider BoD’s Decision Substantively?
(1) Corporate Waste: A transaction “that is so one-sided that no business person of
ordinary, sound judgment could conclude that the corporation has received
adequate consideration.” Does the court consider the substance of the BoD’s
decision to determine whether it indicates ordinary, sound judgment?
(2) Brehm court answers “no”. It considers “process due care” only. This is similar
to Shlensky v. Wrigley, where Shlensky was not permitted to present evidence of
Wrigley’s lack of concern to SH interests.
(3) In another Delaware decision, Technicolor, the court states that directors who
violate their duty of care do not get the protections of the BJR, and that the BJR
is rebutted by a showing that directors violated their fiduciary duty of “due care”.
This may indicate authority of the court to assess substantive due care.
What’s the big deal in limiting substantive review?
(1) If the court gets to second guess the substance of BoD’s decision, BoD loses its
authority to the court, resulting either in decentralized management, or in
management of the corporation by the court.
(2) Harder for SH to predict quality of random judge’s business judgment than that of
the directors they elected (compare to limited scope of suit in Page v. Page).
(3) Directors can plan their actions to comply with procedural standards, but can’t
predict (and accommodate) a random judge’s substantive business judgment.
Brehm sets ‘irrationality’ as the ‘outer limit’ of the BJR.
(1) “Irrationality” may be an exception allowing substantive review; or
(2) “Irrationality” may be a proxy for conflict of interests.
5. Brehm v. Eisner Comparing Brehm & Van Gorkom

Van Gorkom involved an endgame problem (VG retires). This may require BoD to exercise more
oversight over CEO.
Van Gorkom involved a critical decision (selling the company). Brehm involved a more mundane
decision (hiring an employee; though a senior employee). BoD may need to devote more
attention the more central the decision is.
(1) In Van Gorkum, record did not show any significant deliberative process in the
BoD. In Brehm, BoD hired a compensation expert. This provided them with a
DGCL §141(e) defense.
(2) Court suggests exceptions to DGCL §141(e) defense:
(3) BoD did not in fact rely on the expert
(4) BoD’ reliance was not in good faith
(5) BoD didn’t reasonably believe advice was within expert’s competence
(6) The expert was not selected with reasonable care & fault attributable to BoD
(7) The subject matter was so obvious that BoD’s failure to consider it is grossly
negl.
(8) BoD decision so unconscionable as to constitute waste or fraud.
(9) Look at Grimes v Donald & compare; these guys didn’t even run the numbers on
the comp package.
(10)Why doesn’t the duty of care apply? Because they went through the process and
hired the outside consultant.

Francis v. United Jersey Bank

Facts:
(1) Lillian Pritchard is a director of Pritchard & Baird’s, a reinsurance company, and
owned a 48% interest in it (largest SH). She is the widow of the company’s
founder. She:
(a) “[B]riefly visited the corporate offices… on only one occasion”;
(b) “[N]ever read or obtained the annual financial statements”;
(c) “[W]as unfamiliar with the rudiments of reinsurance”;
(2) After her husband’s death, became incapacitated; started to drink heavily;
(3) “[M]ade no effort to assure that the policies and practices of the corporation,
particularly pertaining to the withdrawal of funds, complied with industry custom
or relevant law”.
(4) Charles Jr. & William Pritchard (Romulus & Remus) own the rest of the shares,
were also directors and managed the company. They withdrew $12M of clients’
funds as “loans” that they never returned.
(5) P&B is bankrupt. UJB, as trustee of P&B (i.e., on behalf of P&B’s creditors) sues
Mrs. Pritchard’s estate to recover “loans”.
(6) What’s UJB’s theory for Mrs. Pritchard’s liability?
Apply the Business Judgment Rule. What business decision of Mrs. Pritchard is challenged?
(1) P&B is bankrupt. UJB, as trustee of P&B (i.e., on behalf of P&B’s creditors) sues
Mrs. Pritchard’s estate to recover “loans”.
(2) What’s UJB’s theory for Mrs. Pritchard’s liability?
(3) Mrs. P breached Duty of Care by failing to police the other directors (her sons).
Apply the Business Judgment Rule. What business decision of Mrs. Pritchard is challenged?
(1) No decision. Mrs. P failed to exercise business judgment, so BJR doesn’t apply.
(2) Is Mrs. P automatically liable because BJR doesn’t apply?
(a) No. Need to prove breach of her Duty of Care. Did she breach?
(3) Is Mrs. P automatically liable because BJR doesn’t apply?
(a) No.
(4) Need to prove breach of her Duty of Care. Did she breach?
(a) Yes. She was inattentive. It is no defense that she was ignorant of
business, old, drunk, or depressed.
(b) Director may usually rely on officers, but not when director has notice that
officer is acting inappropriately (Charles Sr. said that Charles Jr. would “take
the shirt off my back”), or have potential conflict of interest (Van Gorkom).
Also, proactive measures needed when risk to corp. from negative behavior
is high (Caremark).
Causation: Could Mrs. P’s protests have made a difference? If protests would not stop her sons,
she had a duty to make the company sue them.
(1) Why does DoC apply to creditors? Don’t directors owe it to SH?
(a) Special obligations of financial institutions (quasi-trust relationship)
(b) When corp. is insolvent, creditors have residual interest (replace SH)
(c) Fiduciary duties owed to corp., and cause of action is asset of corp.,
available to the trustee in bankruptcy.
In re Caremark Int’l Inc. Derivative Action on DoC

Facts:
(1) Caremark is a managed health care company, subject to the Anti-Referral
Payments Law (ARPL). ARPL prohibits managed care organizations that receive
Medicare/Medicaid funds from paying doctors to refer patients to the company.
(2) Caremark is sued by government. Pleads/settles suits, pays $250M. SH sues
Caremark’s directors derivatively for breaching DoC by failing to supervise

employees and institute corrective measures to prevent ARPL violations.

(3) Derivative suit settled: Directors pay nothing; Caremark promises to be good;
attorneys receive $1M legal fees. Settlement subject to court’s approval.
(4) Court approves settlement, but reduces legal fees to $870K. Court discusses in
depth Delaware law on DoC when no business judgment made.
Allegation: Caremark employees violated ARPL.
(1) Did Caremark BoD make decision to allow or require ARPL violations?
(2) If it did, would this decision be protected by BJR?
(3) If it didn’t, does BJR apply?
Graham v. Allis-Chalmers – BoD only has a duty if they are on notice of wrongdoing.
Did BoD violate its duty of care?
(1) Inapplicability of BJR does not automatically result in breach of DoC.
(2) Need to show one of following:
(a) Director had notice that officer is acting inappropriately (Francis);
(b) Director had notice that officer has a conflict of interest (Van Gorkom);
(c) Director failed to monitor/institute compliance program regarding important
aspects of the firm’s activity (e.g., compliance with laws that the company is
at high risk of violating). Caremark rejects an interpretation of Allis-Chalmers
that suggests director liability only if director had notice of misconduct.
Good Faith & Proper procedures will shield the BoD w/ the BJR.
(1) Some level of oversight must be in place; need some system.
If BoD actively decides not to adopt a compliance program (arguing, e.g., that program’s costs
outweigh harm to corp. from lack of compliance). Corp. then implicated in violations of law, and
corp. pays heavy fine. Are directors liable?
(1) Probably not. BJR applies as long as directors acted in good faith and followed
rational process. But BoD can’t decide not to monitor important aspects in the
firm’s operation, it can only decide the way in which it will monitor them (analogy
to Dodge v. Ford). So, if directors decide not to have a compliance program,
they need to decide on an alternative way to monitor the important aspect.
(2) Besides, directors are unlikely to make such a decision. It invites bad PR and
increased scrutiny by regulators.
(3) Caremark notes increased penalties and enforcement of laws on corporations.
How does this affect directors’ liability for failure to monitor?
(4) Increased penalties and enforcement indicate greater social importance – public
policy considerations may require directors to proactively monitor.
(5) Increased penalties/enforcement tilt the cost/benefit analysis towards instituting
compliance programs.
6. Directors’ Duty to Monitor Compliance with Law & The Sarbanes-Oxley Act
Following Enron and other recent financial scandals, Congress passed the Sarbanes-Oxley Act,
which:
(1) Makes it easier to prosecute securities fraud;
(2) Imposes greater responsibility on senior management and directors (mainly
independent directors and audit committee members), by requiring them to take
a substantially more proactive role in overseeing and monitoring the financial
reporting process.
(3) No change to common law duty of care, but increased civil and criminal
enforcement authority over conduct of corporate officers/directors will very likely
increase potential liability.
We can expect increased litigation (and possibly expansion of director duties) regarding
compliance with S-Ox Act and similar laws.

Fiduciary Duty 1/14/2005

Duty of Care
Duty of Loyalty
BJR
E. Knipprath Fiduciary Duty Summary Review

No SH duty to corp. BoD duty is to Corp, not SH. Sometimes a controlling SH may owe a
duty to other SH or the corp; example: controlling SH cannot sell to looter who will ruin
company and kill investment value of all other SH.
F. Duty of Loyalty
1. Directors and Managers
The duty of loyalty requires a fiduciary to act in the best interest of the corporation and in
good faith. Knipprath emphasizes that the BoD’s owes its duty to the corporation, not to the
individual SH. It usually focuses on situations in which the fiduciary has a conflict of
interest with the corporation, suggesting that personal interests may be advanced over
corporate interests. While the duty of care involves poor decision-making or lack of attention,
but no personal benefit, the duty of loyalty seeks to prevent directors from acting in such a
way as to reap a personal benefit unavailable to other shareholders. Such self-dealing raises
the specter of corruption and personal profit at the expense of shareholders.
In order to prove a breach, must show a prima facie conflict of interest. When the duty of
loyalty applies, there is a duty of complete candor. There is also greater judicial scrutiny
of both the fairness of the process and the substance of the decision. The business judgment
rule and its presumption that the directors acted in the best interests of the corporation does
not apply. The burden of proof shifts to the directors to demonstrate the transaction’s
good faith and inherent fairness to the corporation (Bayer v. Beran).
N.B.: A more modern version of the test of intrinsic fairness is the entire fairness standard
(1994, Kahn v. Lynch Communications). The entire fairness standard requires
(1) fair dealing (manner in which the transaction is negotiated),
(2) fair price and
(3) shift of the burden of proof.
The classic duty of loyalty defendant is a fiduciary who contracts or transacts with her
own corporation, receiving a benefit that is not equally shared with the other shareholders.
Examples:
• An officer or director sells personal property to the corporation
• a fiduciary’s corporation contracts with another corporation or business entity in which the
fiduciary has a significant financial interest (e.g.: corp. A sells property to corp. B and a
director of A is the controlling shareholder of B)
• two corporations have common directors (interlocking directors), even if there is no
significant financial interest in either
• a parent corporations contracts with its subsidiaries, that it controls, and there are other
shareholders in the subsidiaries
Following the duty of loyalty standard, courts in these cases generally focus on the fairness of
the process and substance of the transaction. Generally, the process requires full disclosure
and approval by either disinterested directors or shareholders. The contract itself needs to
be fair, and the burden of proof will be placed on the fiduciary. Therefore, the fiduciary
must prove that he bargained with the corporation at arm’s length. Some cases suggest that
lack of disclosure alone is a grounds for voiding a contract without regard to its fairness.

Employees owe a duty of loyalty to their employers; can’t steal office supplies. Knipprath
says that full disclosure and Board approval are the ways to defend against breach of duty of
loyalty. If you don’t fully disclose, then you have to show that the company could not have
availed itself of the opportunity. That is a tough case to argue.
Courts sometimes look at the fairness of the transaction. Procedural fairness, substantive
fairness, combined fairness. It varies by jurisdiction. Procedural fairness looks to full and fair
disclosure. The substantive fairness looks to fairness to the corporation. Could the
corporation have taken advantage of the opportunity? Conflict of interest between an officer’s
position in companies (making a deal that’s good for one and not the other and he is an
officer of both); or where the directors are setting their own compensation. Did they act fairly
compared to the market, other similar companies, etc.?
Fairness test is sometimes used to see if the duty of loyalty has been breached through
either conflict of interest, or self-dealing. Same crap in agency and partnership.
Bayer v. Beran (NY SC, 1944)

Must prove prima facie conflict of interest in order to shift the burden of proof to
the ∆ to show that the transaction in question was fair to the Company.
Test of Entire Fairness: Must look at all circumstances and determine whether or
not it was a fair deal.
Directors of Celanese Corporation of America were charged with negligence and self-
interest in commencing a radio-advertising program. The performer/singer was the
CEO’s/director’s wife.
Where a close relative of the CEO, and one of its dominant directors, takes a position
closely associated with a new and expensive field of activity, the motives of the directors
are likely to be questioned. The board would be placed in a position where selfish,
personal interests might be in conflict with the duty it owed to the corporation. Therefore,
the entire transaction must be subjected to the most rigorous scrutiny to determine
whether the action of the directors was inconsistent with the interests of the corporation.
Here, there is no evidence that the advertising program was inefficient, disproportionate
in price or conducted for the personal gain of Mrs. Dreyfus. There is no ground for
subjecting the directors to liability as long as the advertising served a legitimate and
useful corporate purpose and the company received the full benefit thereof. The fact that
Mrs. Dreyfus also profited personally is no ground for subjecting the directors to liability
(win-win situation). She was paid, but in return for rendering services at fair value. There
was no evidence of an improper personal benefit.
Compare this to Brehem v Eisner; that was a DoC case. No real problem in hiring
relatives as long as it is an arm’s length transaction.
Lewis v. S.L. & E.Inc. (2nd Cir. 1980)

A corporate officer acting in his own self-interest may be held liable for breach of
DoL.
Donald Lewis, a s/h of SLE claimed that its directors had committed waste by
undercharging a tenant, which was another corporation owned by the directors.
Where 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 corporation. Defendants failed to
carry their burden.
Notice that you have family members on both sides of the transaction. In some Delaware
cases, the Court will kick it if the parties are on both sides of the same case.
The could have shown:
(1) stable tenant
(2) long term tenant
(3) land not fit for any other use
(4) maybe the rent actually was fair.

Common to have family members fighting with each other.This case came up after many
years because the π didn’t realize his losses until he tried to cash out his shares.
Duty of Loyalty Test of Entire Fairness

Prima Facie Conflict of Interest
Must show that this is somehow unfair to the Company
= No BJR and The Court Must Review The Fairness to the Deal
4/15/04
Classic case is where there is no decision; see Joy v. Noth;
G. Corporate Opportunity
4/16/2004 1/14/2005 If an investment opportunity is viewed as belonging to the corporation (i.
e. a corporate opportunity), the corporation should be given the opportunity to invest in it. A
director may not take advantage of a corporate opportunity. Similar to the loyalty concept in
Meinhard v. Salmon and GM v. Singer. Although, Cardozo would not have viewed simply
informing the others as sufficient expression of loyalty. Usurping a corporate opportunity.
Usually this applies to officers & directors.
1. Definition of Corporate Opportunity

As a general rule, a corporate opportunity is defined as any opportunity to engage in a
business activity that has come to the attention of a director either through the
performance of his functions as a director or under circumstances that would lead him to
believe that the opportunity would be offered to the corporation.
Broz v. Cellular Information Systems (Del. 1996)

Corporate opportunity is a business opportunity presented to an officer or director, which
the corporation
(1) Is financially able to undertake (courts usually rejects the lack of
financial capacity defense unless the defendant has explicitly disclosed the
corporate opportunity and the corporation rejects it)
(2) Is, from its nature, in the line of the corporation’s business and is
of practical advantage to it (how closely related to existing business)
(3) Is one in which the corporation has a reasonable interest or
expectancy (got to be a special or unique interest, e. g. if already negotiated
about opportunity); and
(4) By taking the opportunity, the self-interested director will be brought
into conflict with the interest of the corporation.
Thus, the fiduciary can take the opportunity if
(1) Opportunity became known to him in his individual capacity: lessens
the duty to some extent
(2) The opportunity is not essential to the corporation
(3) There is no corporate interest or expectancy in the opportunity
(4) There is no wrongful use of corporate resources
Epstein: don’t be a director of a competitor company. The only reason Broz got
away with this is because there were no shareholders at the table complaining about
being harmed by the deal.
See Energy Resources Airco
2. Hornbook test modern view:

A business opportunity is likely to be considered a corporate opportunity if it becomes
available to the director or officer (1) as a result of his work for the corporation; (2)
through the use of corporate information or property; or (3) with the knowledge that

the opportunity is closely related to a business in which the corporation is engaged or

can reasonably be excepted to be engaged.
3. American Law Institute Principles § 5.05:

(a) General Rule: A director or senior executive may not take advantage of a corporate
opportunity, unless:
(1) The director or senior executive first offers it to the corporation and discloses its
(2) The corporation rejects the corporate opportunity.
(3) Either:
(A) The rejection is fair to the corporation / or /
(B) The opportunity is rejected in advance voted by a majority of the
disinterested directors or by a disinterested superior if the 115avour
executive is not on the board in a manner compliant with the BJR / or /
(C) The rejection is authorized in advance or ratified following such
disclosure, by disinterested shareholders, and the rejection is not
equivalent to a waste of corporate assets.
(b) Definition of a Corporate Opportunity:
(1) Any opportunity to engage in a business activity of which a director or senior
executive becomes aware, either:
(A) In connection with the performance of functions as a director or senior
executive, or under circumstances that should reasonably lead the
director or senior executive to believe that the person offering the
opportunity expects it to be offered to the corporation; or
(B) Through the use of corporation information or property, if the resulting
opportunity is one that the director or senior executive should reasonably
be expected to believe would be of interest to the corporation
(2) Any opportunity to engage in a business activity of which a senior executive
becomes aware and knows is closely related to a business in which the
corporation is engaged or expects to engage.
(c) The burden of proof will lie with the defendant unless the corporate opportunity
was disclosed to the disinterested directors or shareholders.
Dominant Shareholders and Parent-Subsidiary Dealings
Generally, shareholders are expected and allowed to act according to their self-interest.
However, a shareholder who controls the corporations, because of the potential abuse of
the corporation, owes a fiduciary duty to the minority shareholders. A controlling
shareholder is expected to act fairly in a manner that will not exploit or oppress the
minority. (see more below: “Problems of Control”)
Sinclair Oil Corp v. Levien (Del. App. Ct. 1971) p. 372

Sinclair, an oil company, owned 97% of the shares of Sinven, which operated as an oil
company in Venezuela. The directors of Sinven were not independent from Sinclair. A
derivative action was brought by minority shareholders of Sinven claiming, among others,
that dividend policy was established to favor Sinclair, and that a contract between
Sinclair and Sinven was unfairly administered.
The court held that, as a controlling shareholder, Sinclair was required to meet an
intrinsic fairness test whenever a conflict of interest existed. The judicial inquiry
involved a shift of burden of proof and inquiry into whether the transaction was fair. It
held Sinclair liable as to the dividends. However, contrary to the conclusions of the court,
the large dividend payments did not constitute a breach of the duty of loyalty since all
shareholders received them, i. e. the minority was not excluded. That there were large
dividends paid out to Sinclair was not significant, because it did not receive a
proportionally larger amount than the minority shareholders.
The court did also find liability for Sinclair as a result of a contract between Sinven and
another Sinclair subsidiary. The contract was breached by failure to make payments to,

and purchases from Sinven. The court held that self-dealing in the parent-subsidiary
setting required, like in all other cases of interested transactions, exclusion (i. e. the
parent receives a benefit not received by the minority through the contract) and an
additional showing of detriment (which was here the breach of contract). Therefore, in
the parent-subsidiary context, plaintiff must show both exclusion and detriment before the
intrinsic fairness standard applies.
Zahn v. Transamerica Corp. (3rd Cir. 1947)

Axton-Fisher Tobacco Co. had two classes of shares, Class A and Class B. Class A were
similar to preferred shares. They were entitled to higher dividends and, in liquidation, to
receive twice as much as the Class B shares. Class A shares could be converted into
Class B shares on a one for one basis. Class A shares could also be redeemed by the
corporation at any time for $ 60 plus outstanding dividends and upon 60 days’ notice.
Both classes of shares carried voting rights. AF owned leaf tobacco that was listed in its
books with a value of $ 6 million, but in fact was worth about $ 20 million. Transamerica
had acquired a majority of stock in AF and controlled its board of directors. Transamerica
then decided that it would acquire the tobacco by having the board eliminate the Class A
shares by having them redeemed. It would then liquidate AF and appropriate the
tobacco. There was no disclosure of this plan to the Class A shareholders.
The court held that there was a breach of the duty of loyalty by Transamerica, because it
was not only acting as shareholder, but through its control of AF’s directors. Directors
must act for the benefit of all, not just some shareholders. Controlling shareholders
may not use their control to self-deal with assets of the corporation.
The directors were under a duty to disclose their plans to the Class A shareholders and
let them decide if they wanted to accept the redeem-offer or convert their shares into
Class B, and participate in the liquidation of the corporation. The appropriate remedy
was, therefore, to have them shared in the liquidation value 1/1 (i. e. treat them as if they
had converted into Class B). This is an example of the right of appraisal. The equitable
solution was available because the Court was addressing a breach of fiduciary duty.
H. Ratification
Fliegler v. Lawrence (Del. SC 1976) p. 396
Ratification of an interested transaction by a majority of independent, fully
informed s/h 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 assets, i.e. that the transaction was
intrinsically unfair.
Del. C. § 144:
(a) No contract or transaction between a corporation and 1 or more of its directors or
officers, or (…), shall be void or voidable solely for this reason, or solely because the
director or officer is present at or participates in the meeting of the board or
committee which authorizes the contract or transaction, or solely because his or their
votes are counted for such purpose, if:
(1) The material facts as to his relationship or interest and as to the contract
or transaction are disclosed or are known to the board of directors or the
committee, and the board of directors or committee in good faith authorizes the
contract or transaction by the affirmative votes of the disinterested directors,
even though the disinterested directors be less than a quorum; or
(2) The material facts as to his relationship or interest and as to the contract
or transaction are disclosed or are known to the shareholders entitled to vote
thereon, and the contract or transaction is specifically approved in good faith by
vote of the shareholders; or

(3) The contract or transaction is fair as to the corporation as of the time it is

authorized, approved or ratified, by the board of directors, a committee, or the
shareholders.
Issues:
• The transaction can be void or voidable because of reasons, other than the
breach of the duty or loyalty.
Courts have interpreted § 144(a)2 in the sense that the approving shareholders have
to the disinterested (Flieger v. Lawrence (Del. SC 1976) p. 77
• The disclosure to disinterested directors [§ 144(a)1] or disinterested shareholders
[§ 144(a)2] will shift the burden of proof to the plaintiff and sets the standard on BJR,
limiting judicial review to issues of gift or waste (In re Wheelabrator Technologies,
Del. Ch. 1995, p. 385).
• If there is no disclosure of the material facts of the conflict of interest the burden
of proof will be on the defendant and the standard will be entire fairness.
Absent COI, Π HAS bop and will lose due to bjr

∆ directors have bop to prove test of entire fairness
given a 117avourable117 txn w/ coi, but disinterested s/h ratification, π again has bop; but
standard is bifurcated:
If directory, π must show waste, does not meet bjr; tough standard
If Controlling s/h, test of entire fairness;
But if disclosure is inadequate, then ratification is inadequate and bop goes back to ∆ .
I. Rule 10b-5 of Exchange Act 1934
“It shall be 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,
1) To employ any device, scheme, or artifice to defraud,
2) 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
3) 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”.
General comments:
Courts have recognized a private right of action under § 10(b) of the Exchange Act and Rule
10b-5.
§ 10(b) applies to any security, including securities of closely held corporations not subject to the
Exchange Act.
The Supreme Court has held in Central Bank of Denver v. First Interstate Bank (1994) that there
was no implied right of action against those who aid and abet violations of Rule 10b-5.
1. Standing
Blue Chip Stamps v. Manor Drug Stores (1975),

The Supreme Court put some bite in the rule that the protections of Rule 10b-5
extend only to purchasers and sellers of a corporation’s securities. Thus, the
plaintiff must either have bought or sold securities.
(Deutschman v. Beneficial Corp (3rd Cir. 1988)

However, the plaintiff need not be in any relationship of privity with the defendant
charged with misrepresentation. There is no obligation to disclose under § 10(b)
so long as insiders stay out of the market, but if they choose to speak, they are
not free to lie. There is no need under § 10(b) to show some special relationship
of trust and confidence to establish standing
2. Materiality
There can be liability under 10b-5 only if there is non-disclosure or misrepresentation of material
facts.
(i) Standard of materiality:

The Supreme Court in TSC Industries v. Northway (1976) defined the standard of materiality (in
the context of proxy solicitation):
“an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote”, “there must be 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 available.
Thus, materiality depends on the significance the reasonable investor would place on the
withheld or misrepresented information.
(ii) Application of this standard to contingent or speculative information or events:
Basic v. Levinson (US 1988) p. 444

To determine the materiality of contingent or speculative information or events, the
following test must be applied: The Probability/Magnitude Test
“Materiality will depend at any given time upon a 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”.
SEC v. Texas Gulf Sulphur (2nd cir. 1968) p. 86
In order to assess the probability that the event will occur, a factfinder will
need to look at indicia of interest in the transaction at the highest
corporate levels.
To assess the magnitude of the transaction, a factfinder will need to
consider such facts as the size of the 2 corporate entities and of the
potential premiums over market value. No particular event or factor short
of closing the transaction need be either necessary or sufficient by itself
to render merger discussions material.
Pommer v. Medtest Corporation (7th Cir. 1992) p. 82

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 a significantly altered the “total mix of information”
made available
3. Disclosure and Fairness

J. Duty of Care
1. Standard of Care
The courts, in determining liability, will distinguish between inside and outside
directors. Inside directors are held to a higher standard of care, because they are more
involved and aware of the business. Moreover, the distinction is often justified by the
need to attract outside directors who would be unwilling to serve if their liability were the
same as that of inside directors.
Generally, breach of duty of care can occur in two different situations: when the directors
have acted in a negligent manner (i. e. malfeasance) and where is a failure to act when a
loss could have been prevented (i. e. nonfeasance)
Knipprath says that the standard may vary based on responsibilities. Which is pretty
much what I already said. Trustee distinguished from a director; different fiduciary duties.
Francis v. United Jersey Bank, N.J. 1981

Francis was a case of nonfeasance involving a family-owned closely held
corporation which operated as a reinsurance broker. These brokers hold funds
for other insurance companies that need to be segregated. The Pritchard sons,
who ran the business, commingled the various funds in a single account and then
personally “borrowed” from the account without subsequent repayment. Mrs.
Pritchard, their mother, who was a grieving widow and was drinking heavily, had
become a director of the corporation after her husband had passed away.
However, she never became involved with the business and didn’t have the
slightest idea what was going on. She was sued by the trustee in bankruptcy for
breach of her duty of care.
In Francis, the court spelled out what is expected of directors: The duty of care
requires directors to perform their duties with the diligence of a reasonably
prudent person in similar circumstances which vary depending on the context.
Generally they should have some understanding of the business, keep
informed on activities, perform general monitoring including attendance at
meetings, and have some familiarity with the financial status of the business
as reflected on the financial statements. The court rejected the idea that a
director could serve as a “dummy director” being a mere ornament. The court
acknowledged that generally, the duties of directors of publicly traded
corporations are greater than that of family-owned closely-held corporations. But
here, on the other hand, the reinsurance business with the holding of other
people’s money in a trust like situation required greater care of the directors.
In Re Caremark International Inc. Del. Ch. 1996 (Duty of Care in Delaware)

The issue of liability for failure to monitor or act raised by Francis takes on
significance in large enterprises in which boards should make overall policy and
implementation is by officers and employees.
In Caremark, the corporation had paid $ 250 million in fines and damages
because employees had violated the law applicable to health care providers. A
derivative suit was brought against the directors for breach of their duty of care
by a failure to monitor the employees.
In Caremark, the court found that directors have a responsibility to assure that an
adequate system exists for receiving corporate information and reporting,
including compliance with relevant statutes and regulations. Even if there is no

reason to suspect a lack of compliance, some monitoring system must be in

place. Directors will be liable if there is a sustained or systematic failure to
exercise oversight. However, the court indicated that this test of liability is high.
Further, the level of detail appropriate for the system is itself a question of
business judgment.
Even though huge fines were imposed, in this case the court found no breach of
the duty of care. There was no evidence of lack of good faith in monitoring or a
knowing violation of law.
2. . The Business Judgment Rule
Shareholders want directors to make decisions and take risks to produce gain even
though mistakes may lose money. If the directors would be liable for every imprudent or
mistaken decision, they would become overly cautious, resulting in reduced shareholder
value. Shareholder undertake the risks of bad business judgments by buying shares as
opposed to other less risky investments. In addition, after the fact litigation cannot replace
the situation that took place when the decision was made. Therefore, liability is rarely
imposed upon corporate directors or officers simply for bad judgment and this reluctance
to impose liability for unsuccessful business decisions has been doctrinally labeled as the
Business Judgment Rule (Joy v. North, 2nd Cir.1981). In a purely business corporation
the authority of the directors in the conduct of the business of the corporation must be
regarded as absolute when they act within the law, and the court is without authority to
substitute its judgment for that of the directors (Shlensky v. Wrigley, Ill App. 1968).
Knipprath says director will argue: (a) good faith; (b) reasonable investigation.
The business judgment rule only applies to malfeasance (i. e. when directors are
accused of violating their duty of care by making a negligent or ill advised decision), not
to nonfeasance cases (i. e. when there is a failure to act when a loss could have been
prevented).
In malfeasance cases, the duty of care sets the standard of conduct while the
business judgment rule limits judicial inquiry into business decisions and protects
directors who are not negligent in the decision making process. Under the rule
the courts will only examine whether the director acted negligently in the decision
making process, i. e. whether they acted on an informed basis. Delaware courts
have suggested that gross negligence is the appropriate standard in
determining whether a business judgment was an informed one. Under the rule,
courts will not review the outcome of the decision, even if it is a wrong or poor
decision. In Delaware, the business judgment rule provides a presumption that in
making a decision directors were informed, acted in good faith and honestly
believed that the decision was in the best interests of the corporation. The party
attacking a directorial decision as uninformed must rebut the presumption that its
business judgment was an informed one (Smith v. Van Gorkom), or that the
business judgment rule does not apply. However, once the presumption is
rebutted, the burden shifts to the defendant to prove entire fairness, and a duty of
loyalty standard is applied (Cinerama v. Technicolor)
Kamin v. American Express

In Kamin, the directors decided to distribute to its shareholders shares the
corporation owned in another corporation. By distributing them among the
shareholders as a dividend it avoided selling them on the market which would
have been at a loss. However, selling the shares would have produced a

significant tax benefit (8 mill USD) to the corporation because the loss could have
been used to offset other taxable gains.
In Kamin, the court found no self dealing and it held that dividend decisions are
normally business decisions left to the board. The board was not negligent in
making its decision because it had acted in an informed manner after due
consideration of the alternatives. Even if the decision was imprudent or mistaken
that is not what is important since a breach of duty of care focuses on neglect of
duty, not on the decision itself.
Joy v. North, 2nd Cir.1981

The business judgment rule does not apply in cases in which
(vi) The corporate decision lacks a business purpose;
(vii) Is tainted with a conflict of interest, fraud, bad faith or illegality
(viii) Is so egregious (unerhört) as to amount to a no-win decision or
(ix) Constitutes waste (i. e. what the corporation received in a
transaction was so inadequate in value that no person of ordinary sound
business judgment would deem it worth what the corporation paid; high
standard, very difficult to prove!) (this is not Joy!)
(x) Nonfeasance; or an obvious and prolonged failure to exercise
oversight or supervision
3. . Causation
If a director has acted negligently, this does not end the inquiry, because for
there to be liability, the negligence must be the proximate cause of the loss. The
plaintiff usually has the burden of proof and must show the amount of loss or
damages caused by the negligence.
Finding such a link between damages and loss is particularly difficult in
nonfeasance cases, because there are no actual actions to relate to the losses.
Therefore, the plaintiff must prove that if the director had done her duty there
would not be damage. Since there cannot be certainty about what would have
occurred if the director had acted diligently, the standard is whether it is
reasonable to conclude that the failure to act would have produced a particular
result. Thus, in nonfeasance cases, courts first have to determine the reasonable
steps a diligent director would have taken, and thereafter, whether theses steps,
as a matter of common sense, would have prevented the damage caused to the
defendant. In Francis, the court found that directors can have a duty to stop the
wrongdoing of other management members, including the duty to hire an
attorney and sue them (note: Francis was a case involving a trust-like business
with heightened fiduciary duties).
However, also in malfeasance cases loss causation is difficult to prove.
Generally, the plaintiff carries the burden of proof. In Cinerama however, the
Delaware Supreme Court held that proof of injury by the plaintiff is unnecessary
once the business judgment rule is rebutted, because then the burden of proving
entire fairness would shift to the defendant. Therefore, he would also have to
prove that there was no loss caused to the plaintiff by his negligent behavior.
4. Shareholder ratification of business decisions

Smith v. Van Gorkom, Del. SC 1985

Van Gorkom, chairman of the board and CEO sold company for good price very
quickly to Pritzker; other board members had no prior knowledge of offer and
approved the sale after two hour meeting without any further info
(held liable b/c no informed decision; business community was upset b/c s/h received big
premium from sale; reaction: Del. And most other states enacted a new provision that
allows corp. to amend their articles of incorporation to eliminate monetary damages for
duty of care cases; most large corp. have placed such a provision in their articles; this
effectively eliminated most duty of care cases between directors and s/h; good example of
law & economics contract view!)
The shareholders can ratify a business decision, as long as they are provided
with all the material information.
Failure of the Board of Directors in reaching an informed business judgment
constitutes a voidable —rather that void— act.
Hence, the decision can be sustained notwithstanding its infirmity if it is approved
by a majority vote of the shareholders. However, to ratify director action the
shareholder vote must be fully informed. That question rests upon the
fairness and completeness of the proxy materials submitted to the stockholders.
5. To whom may directors be liable?
Directors can be liable to:

• The corporation;
• The shareholders;
• Creditors (only in case of insolvency, unless a fiduciary relationship
exists between the director and the creditor).
N.B. While directors may owe a fiduciary duty to creditors also, that
obligation generally has not been recognized in the absence of
insolvency. With certain corporations, however, directors are deemed
to owe a duty to creditors and other third parties even when the
corporation is solvent (trust-like situations). Although depositors of a
bank are considered in some respects to be creditors, directors may
owe them a fiduciary duty. Directors of non-banking corporations may
owe a similar duty when the corporation holds funds of others in trust
(Francis v. United Jersey Bank, N.J. 1981).
K. Duty of Loyalty
The duty of loyalty requires a fiduciary to act in the best interest of the corporation and in
good faith. It usually focuses on situations in which the fiduciary has a conflict of
interest with the corporation, suggesting that personal interests may be advanced over
corporate interests. While the duty of care involves poor decision-making or lack of
attention, but no personal benefit, the duty of loyalty seeks to prevent directors from
acting in such a way as to reap a personal benefit unavailable to other shareholders.
Such self-dealing raises the specter of corruption and personal profit at the expense of
shareholders.
When the duty of loyalty applies, there is a duty of complete candor. There is also
greater judicial scrutiny of both the fairness of the process and the substance of the
decision. The business judgment rule and its presumption that the directors acted in the
best interests of the corporation does not apply. The burden of proof shifts to the

directors to demonstrate the transaction’s good faith and inherent fairness to the
corporation (Bayer v. Beran).
N.B.: A more modern version of the test of intrinsic fairness is the entire fairness
standard (1994, Kahn v. Lynch Communications). The entire fairness standard
requires (1) fair dealing (manner in which the transaction is negotiated), (2) fair
price and (3) shift of the burden of proof.
1. Interested Director Transactions
The classic duty of loyalty defendant is a fiduciary who contracts or transacts with her
own corporation, receiving a benefit that is not equally shared with the other
shareholders.
Examples:
o An officer or director sells personal property to the corporation
o a fiduciary’s corporation contracts with another corporation or business entity in
which the fiduciary has a significant financial interest (e.g.: corp. A sells property
to corp. B and a director of A is the controlling shareholder of B)
o two corporations have common directors (interlocking directors), even if there is
no significant financial interest in either
o a parent corporations contracts with its subsidiaries, that it controls, and there are
other shareholders in the subsidiaries
Following the duty of loyalty standard, courts in these cases generally focus on the
fairness of the process and substance of the transaction. Generally, the process requires
full disclosure and approval by either disinterested directors or shareholders. The
contract itself needs to be fair, and the burden of proof will be placed on the
fiduciary. Therefore, the fiduciary must prove that he bargained with the corporation at
arm’s length. Some cases suggest that lack of disclosure alone is a grounds for voiding
a contract without regard to its fairness.
Bayer v. Beran (NY SC, 1944)

Directors of Celanese Corporation of America were charged with negligence and
self-interest in commencing a radio-advertising program. The performer/singer
was the CEO’s/director’s wife.
Where a close relative of the CEO, and one of its dominant directors, takes a
position closely associated with a new and expensive field of activity, the motives
of the directors are likely to be questioned. The board would be placed in a
position where selfish, personal interests might be in conflict with the duty it owed
to the corporation. Therefore, the entire transaction must be subjected to the
most rigorous scrutiny to determine whether the action of the directors was
inconsistent with the interests of the corporation.
Here, there is no evidence that the advertising program was inefficient,
disproportionate in price or conducted for the personal gain of Mrs. Dreyfus.
There is no ground for subjecting the directors to liability as long as the
advertising served a legitimate and useful corporate purpose and the company
received the full benefit thereof. The fact that Mrs. Dreyfus also profited
personally is no ground for subjecting the directors to liability (win-win situation).

Lewis v. S.L. & E.Inc. (2nd Cir. 1980)

Donald Lewis, a s/h of SLE claimed that its directors had committed waste by
undercharging a tenant, which was another corporation owned by the directors.
Where 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 corporation.
Defendants failed to carry their burden.
L. Dominant Shareholders and Parent-Subsidiary Dealings
Generally, shareholders are expected and allowed to act according to their self-interest.
However, a shareholder who controls the corporations, because of the potential abuse of
the corporation, owes a fiduciary duty to the minority shareholders. A controlling
shareholder is expected to act fairly in a manner that will not exploit or oppress the
minority. (see more below: “Problems of Control”)
Sinclair Oil Corp v. Levien (Del. App. Ct. 1971) p. 385

Sinclair, an oil company, owned 97% of the shares of Sinven, which operated as
an oil company in Venezuela. The directors of Sinven were not independent from
Sinclair. A derivative action was brought by minority shareholders of Sinven
claiming, among others, that dividend policy was established to favor Sinclair,
and that a contract between Sinclair and Sinven was unfairly administered.
The court held that, as a controlling shareholder, Sinclair was required to meet an
intrinsic fairness test whenever a conflict of interest existed. The judicial
inquiry involved a shift of burden of proof and inquiry into whether the
transaction was fair. It held Sinclair liable as to the dividends. However, contrary
to the conclusions of the court, the large dividend payments did not constitute a
breach of the duty of loyalty since all shareholders received them, i. e. the
minority was not excluded. That there were large dividends paid out to Sinclair
was not significant, because it did not receive a proportionally larger amount than
the minority shareholders.
The court did also find liability for Sinclair as a result of a contract between
Sinven and another Sinclair subsidiary. The contract was breached by failure to
make payments to, and purchases from Sinven. The court held that self-dealing
in the parent-subsidiary setting required, like in all other cases of interested
transactions, exclusion (i. e. the parent receives a benefit not received by the
minority through the contract) and an additional showing of detriment (which
was here the breach of contract). Therefore, in the parent-subsidiary context,
plaintiff must show both exclusion and detriment before the intrinsic fairness
standard applies.
Zahn v. Transamerica Corp. (3rd Cir. 1947) p. 389

Axton-Fisher Tobacco Co. had two classes of shares, Class A and Class B.
Class A were similar to preferred shares. They were entitled to higher dividends
and, in liquidation, to receive twice as much as the Class B shares. Class A
shares could be converted into Class B shares on a one for one basis. Class A
shares could also be redeemed by the corporation at any time for $ 60 plus
outstanding dividends and upon 60 days’ notice. Both classes of shares carried

voting rights. AF owned leaf tobacco that was listed in its books with a value of $
6 million, but in fact was worth about $ 20 million. Transamerica had acquired a
majority of stock in AF and controlled its board of directors. Transamerica then
decided that it would acquire the tobacco by having the board eliminate the Class
A shares by having them redeemed. It would then liquidate AF and appropriate
the tobacco. There was no disclosure of this plan to the Class A shareholders.
The court held that there was a breach of the duty of loyalty by
Transamerica, because it was not only acting as shareholder, but through its
control of AF’s directors. Directors must act for the benefit of all, not just
some shareholders. Controlling shareholders may not use their control to self-
deal with assets of the corporation.
The directors were under a duty to disclose their plans to the Class A
shareholders and let them decide if they wanted to accept the redeem-offer or
convert their shares into Class B, and participate in the liquidation of the
corporation. The appropriate remedy was, therefore, to have them shared in the
liquidation value 1/1 (i. e. treat them as if they had converted into Class B).
1. Executive Compensation
can raise self dealing issues; see Understanding, p. 211 ff.
2. Corporate Opportunity
4/16/2004 If an investment opportunity is viewed as belonging to the corporation (i. e. a

corporate opportunity), the corporation should be given the opportunity to invest in it. A
director may not take advantage of a corporate opportunity. Similar to the loyalty concept
in Meinhard v. Salmon and GM v. Singer. Although, Cardozo would not have viewed
simply informing the others as sufficient expression of loyalty. Usurping a corporate
opportunity. Usually this applies to officers & directors.
Definition of Corporate Opportunity
As a general rule, a corporate opportunity is defined as any opportunity to engage

in a business activity that has come to the attention of a director either through
the performance of his functions as a director or under circumstances that would
lead him to believe that the opportunity would be offered to the corporation.
Broz v. Cellular Information Systems (Del. 1996)

Test from Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939): Corporate opportunity is
a business opportunity presented to an officer or director, which the
corporation
(5) Is financially able to undertake (courts usually rejects the lack of
financial capacity defense unless the defendant has explicitly
disclosed the corporate opportunity and the corporation rejects it)
(6) Is, from its nature, in the line of the corporation’s business and is
of practical advantage to it (how closely related to existing business)

(7) Is one in which the corporation has a reasonable interest or

expectancy (got to be a special or unique interest, e. g. if already
negotiated about opportunity); and
(8) By taking the opportunity, the self-interested director will be brought
into conflict with the interest of the corporation.
Thus, the fiduciary can take the opportunity if
(5) Opportunity became known to him in his individual capacity: lessens
the duty to some extent
(6) The opportunity is not essential to the corporation
(7) There is no corporate interest or expectancy in the opportunity
(8) There is no wrongful use of corporate resources
Epstein: don’t be a director of a competitor company. The only reason Broz got
away with this is because there were no shareholders at the table complaining about
being harmed by the deal.
See Energy Resources Airco
3. Hornbook test modern view:

A business opportunity is likely to be considered a corporate opportunity if it becomes
available to the director or officer (1) as a result of his work for the corporation; (2)
through the use of corporate information or property; or (3) with the knowledge that
the opportunity is closely related to a business in which the corporation is engaged or
can reasonably be excepted to be engaged.
Corporate Opportunity:
4. American Law Institute Principles § 5.05:

(i)Any opportunity to engage in a business activity of which a director or
senior executive becomes aware, either:
(1) in connection with the performance of functions as a director or
senior executive, or under circumstances that should reasonably lead the
director or senior executive to believe that the person offering the
opportunity expects it to be offered to the corporation; or
(2) through the use of corporation information or property, if the
resulting opportunity is one that the director or senior executive should
reasonably be expected to believe would be of interest to the corporation
(ii) Any opportunity to engage in a business activity of which a
senior executive becomes aware and knows is closely related to a
business in which the corporation is engaged or expects to engage.
A director may not take advantage of a corporate opportunity, unless:

1)First offers it to the corporation and discloses its conflict of interest.
2)The corporation rejects the corporate opportunity.
3)The rejection is fair to the corporation / or / rejection voted by a majority
of the disinterested directors or disinterested shareholders.
The burden of proof will lie with the defendant unless the corporate opportunity
was disclosed to the disinterested directors or shareholders.
5. Ratification (not touched in course)

Fliegler v. Lawrence (Del. SC 1976) p. 396

Ratification of an interested transaction by a majority of
independent, fully informed s/h 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 assets, i.e. that the transaction was intrinsically unfair.
6. Del. C. § 144:
(b) No contract or transaction between a corporation and 1 or more of its
directors or officers, or (…), shall be void or voidable solely for this reason, or
solely because the director or officer is present at or participates in the
meeting of the board or committee which authorizes the contract or
transaction, or solely because his or their votes are counted for such
purpose, if:
(4) The material facts as to his relationship or interest and as to the
contract or transaction are disclosed or are known to the board of
directors or the committee, and the board of directors or committee in
good faith authorizes the contract or transaction by the affirmative votes
of the disinterested directors, even though the disinterested directors be
less than a quorum; or
(5) The material facts as to his relationship or interest and as to the
contract or transaction are disclosed or are known to the shareholders
entitled to vote thereon, and the contract or transaction is specifically
approved in good faith by vote of the shareholders; or
(6) The contract or transaction is fair as to the corporation as of the
time it is authorized, approved or ratified, by the board of directors, a
committee, or the shareholders.
Issues:
• The transaction can be void or voidable because of reasons, other than
the breach of the duty or loyalty.
Courts have interpreted § 144(a)2 in the sense that the approving
shareholders have to the disinterested (Flieger v. Lawrence (Del. SC 1976) p.
77
• The disclosure to disinterested directors [§ 144(a)1] or disinterested
shareholders [§ 144(a)2] will shift the burden of proof to the plaintiff and sets
the standard on BJR, limiting judicial review to issues of gift or waste (In re
Wheelabrator Technologies, Del. Ch. 1995, p. 385).
• If there is no disclosure of the material facts of the conflict of interest the
burden of proof will be on the defendant and the standard will be entire
fairness.
M. Intermediate Standard in Takeover context
There is a tension between the judicial hands off approach reflected by the business judgment
rule and the extensive judicial scrutiny of a fairness enquiry. Thus, Delaware courts have
developed an intermediate standard (proportionality test) in reviewing directors’ defensive tactics
against a hostile tender offer, recognizing that battles for control involve both important business
decisions as well as possible conflicts of interest by directors protecting their positions.

N. Prüfungsaufbau
1. Breach of fiduciary duty?
(1) duty of care or duty of loyalty?

Self interest/self dealing?
(2) if duty of care:
(1) have directors acted negligently?

Burden of proof: plaintiff
In malfeasance cases, director’s decisions protected by the BJR;
analysis focuses on decision making process, not on result;
presumption that directors acted in corporation’s best interests
Burden on plaintiff to rebut that presumption
If rebutted, BJR not applicable, b/c fraud or gross negligence in
decision making process:
(2) loss causation?

Particularly difficult in nonfeasance cases
Burden of proof: generally plaintiff (however: Cinerama: defendant)
(3) if duty of loyalty:
(3) was transaction fair to corporation?

Disclosure and intrinsic fairness test; burden of proof: defendant
Rigorous judicial scrutiny
XV. DISCLOSURE AND FAIRNESS: FEDERAL SECURITIES REGULATION
A. Definition of a Security
1. § 2 (1) of the ‘33 Act
“The term “security” means any note, stock, treasury stock, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-
trust certificate, preorganization certificate or subscription, transferable share, investment
contract, voting- trust certificate, certificate of deposit for a security, fractional undivided interest in
oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security,
certificate of deposit, or group or index of securities (including any interest therein or based on the
value thereof), or any put, call, straddle, option, or privilege entered into on a national securities
exchange relating to foreign currency, or, in general, any interest or instrument commonly known
as a “security”, or any certificate of interest or participation in, temporary or interim certificate for,
receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing”.

The statutory definition is divided into 2 broad categories:

A list of specific instruments such a stock, bonds, notes...
A list of general catch-all phrases such as evidence of indebtedness, investment contracts, any
instrument commonly known as a security... etc.
Requires with very few exceptions all publicly traded companies to register their securities with
the SEC. Part of that registration is a prospectus.
Many people don’t read them b/c they are long and boring and full of boilerplate language
disclosing risks.
The company is selling security which is a piece of paper representing an ownership interest in
the enterprise. It is different from a partnership agreement b/c shareholders or security holders
don’t have a management role in the company.
Howey Test – how much control do you have? This will tell us if it is a security.
Landreth – stock is automatically a security
It is tough to tell if it is a security if there is no writing.
Was it disclosed.
2. Investment Contract
An investment contract means a contract, transaction or scheme whereby a person

Invest his money, in
A common enterprise and is led to
Expect profits predominantly from the efforts of the promoter or a third party.
These 3 factors are not exclusive.
The Supreme Court has interpreted it broadly to reach “novel, uncommon or irregular devices,
whatever they appear to be”.
Koch v. Hankins (9th Circuit, 1991)

The fact that the investments are structured as general partnerships is not determinative
of their status as securities; rather we must examine the economic realities of the
transactions to determine whether they are in fact investment contracts.
Most issues are raised regarding the third element, “control”.
Test to determine where “control” exists: The critical determination is whether

(1) The investor retains substantial control over his investment and
(2) An ability to protect himself from the managing partner.
“A general partnership or joint venture interest can be designated a security if the investor
can establish, for example, that
(i) An agreement among the parties leaves so little power in the hands of partner or
venturer that the arrangement in fat distributes power as would a limited
partnership; or
(ii) The partner or venturer is so inexperienced and unknowledgeable in business
affairs that he is incapable of intelligently exercising his partnership or venture
powers; or
(iii) The partner or venturer is so dependent on some unique entrepreneurial or
managerial ability of the promoter or manager that he cannot replace the
manager of the enterprise or otherwise exercise meaningful partnership or
venture powers.”

In determining whether the investors relied on the efforts of others, we look not only to the
partnership agreement itself, but also to other documents structuring the investment, to
promotional materials, to oral representations made by the promoters at the time of the
investment and to the practical possibility of the investors exercising the powers they
possessed pursuant to the partnership agreement.
3. Options
Deutschman v. Beneficial Corp (3rd Cir. 1988) p. 472

An option is a security; a contract to sell (put) or buy (call) stock at a certain price.
B. Registration process
1. § 5 Securities Act of 1933
(a) Unless a registration statement is in effect as to a security, it shall be unlawful for any
person, directly or indirectly—
(1) to make use of any means or instruments of transportation or communication in
interstate commerce or of the mails to sell such security through the use or medium
of any prospectus or otherwise; or
(2) to carry or cause to be carried through the mails or in interstate commerce, by any
means or instruments of transportation, any such security for the purpose of sale or
for delivery after sale.
(b) It shall be unlawful for any person, directly or indirectly—
(1) to make use of any means or instruments of transportation or communication in
interstate commerce or of the mails to carry or transmit any prospectus relating to
any security with respect to which a registration statement has been filed under
this title, unless such prospectus meets the requirements of section 10; or
(2) to carry or cause to be carried through the mails or in interstate commerce any such
security for the purpose of sale or for delivery after sale, unless accompanied or
preceded by a prospectus that meets the requirements of subsection (a) of section
10.
I It shall be unlawful for any person, directly or indirectly, to make use of any means or
instruments of transportation or communication in interstate commerce or of the mails to offer to
sell or offer to buy through the use or medium of any prospectus or otherwise any security,
unless a registration statement has been filed as to such security, or while the registration
statement is the subject of a refusal order or stop order or (prior to the effective date of the
registration statement) any public proceeding or examination under section 8.
2. The Principle: Registration under § 5
The Securities Act prohibits under § 5, the sale of securities unless the company issuing the
securities has registered them with the SEC.
§ 5 imposes 3 basic rules:

- 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;
- securities may not be sold until the registration statement has become effective;
- a prospectus (disclosure document) must be delivered to the purchaser before a sale.
3. Exemptions from Registration: § 4 ’33 Act
2 types of exemptions to the registration requirement:

(4) Exempt Securities;
(5) Exempt transactions.
The most common exemption is the private offering under § 4(2), and belongs to the latter
category.
(1) Private offering exemption:
Doran v. Petroleum Management, (5th Circuit, 1977)

Even when an offering of securities is relatively small and is made informally to
just a few sophisticated investors, in order for § 4(2) to be available, the offerees,
(which should be a sophisticated investor if it wants to rely on the more objective
Safe Harbor provided by Rule 146), must have been furnished or have access to
such information about the issuer that a registration statement would have
disclosed.
Ralston Purina v. SEC (US 1953)

The applicability of § 4(2) should turn on whether the particular class of persons
affected need the protection of the Act. An offering to those who are shown to be
able to fend for themselves is a transaction not involving any public offering
N.B. 4 Factors are relevant to consider whether an offering qualifies for

exemption under § 4(2):
(i) Number of offerees and their relationship to each other and the issuer:
The number of offerees is relevant both to ascertain the magnitude of the offering and in order to
determine the characteristics and knowledge of the offerees. However it is not a decisive factor.
Sophistication is not a substitute for access to the information that registration would disclose, so
there must be sufficient basis of accurate information upon which the sophisticated investor may
exercise his skills.
(ii) The number of units offered:
(iii) The size of the offering; and
(iv) The manner of the offering
4. Regulation D Safe Harbors
The issuers can use these safe harbors to come within the private-placement exemption and
avoid or reduce their required disclosure.

♦ Rule 504: if an issuer raises no more than $1 million through the securities, it may sell them
to an unlimited number of buyers without registering them.
♦ Rule 505: if an issuer raises no more than $5 million through the securities, it may sell them
to 35 buyers without registering them.
♦ Rule 506: if an issuer raises more than $5 million through the securities, it may sell them to
no more than 35 buyers without registering them, and each buyer must pass
various tests of financial sophistication. The limits on the number of buyers do
not apply to accredited investors (banks, brokers, wealthy buyers).
♦ Rule 144: the buyer may resell stock he acquired in a Regulation D offering if he first holds
if for 2 years and then resell it in limited volumes.
COMMENT: Regulation D and §4(2) exempt only the initial sale. So most buyers can resell
the securities only if they find another exemption.
BUT 504 may allow a public distribution; public advertising, no restriction on resale. As long as
<$1mm.
C. Liability under 1933 Act
1. 1. Section 11
§ 11 is a cause of action directed at fraud committed in connection with the

sale of securities through the use of a registration statement. § 11 cannot be
used in connection with an exempt offering.
(i) Neither reliance nor causation is an element of the plaintiff’s prima
facie case. The defendant has the burden of proving that his misconduct
didn’t cause plaintiff’s damages.
(ii) No privity requirement, the list of defendants can be quite expansive.
It includes: everyone who signed the registration statement (the issuer, its
principal executive officers and a majority of the board of directors); every
director at the time the registration statement became effective, including
directors who didn’t sign the registration statement; every person named in
the registration statement as someone about to become a director; every
expert named as having prepared or certified any part of the statement;
every underwriter involved in the distribution.
(iii) The issuer has a strict liability.
As to defendant other than the issuer, the degree of fault required is essentially a negligence
standard.
(iv) No need to prove scienter, the defendant’s state of mind is irrelevant.
(v) Due diligence defenses: §11 (b) (3) have you left no stone
unturned?
Due diligence is not an affirmative obligation.
Escott v. BarChris Construction (SDNY 1968)
Distinctions expertised non-expertised information
Insider/outsiders

Amy Says:
Escott v. Barchris Construction Co. (pg457)—Bowling alley builder went bankrupt.
33 ACT §11--A false or misleading statement must be material under Section 11. “Matters which
the average prudent investor out to reasonably be informed” about.
The errors on the balance sheet are an example of material false statements.
ESCOTT v. BARCHRIS CONSTRUCTION CORP.

Debenture purchaser (P) v. Corporation (DJ
283 F. Supp. 643 (S.D.N.Y. 1968).
NATURE OF CASE: Motion to dismiss an action for damages for material false statement of facts
and material omissions to shareholders.
FACT SUMMARY: Escott (P) and other purchasers of debentures (P) sued BarChris (D) for
material false statements and material omissions on the registration statement of the debentures.
CONCISE RULE OF LAW: Due diligence is a defense under 5 11 of the Securities Act of 1933
when the defendant believes after a reasonable investigation, and there are reasonable grounds
to believe, that alleged misstatements are correct and that there are no material omissions.
FACTS: BarChris (D) was engaged in the construction of bowling alleys. As BarChris's (D)
business increased from 1956 to 1960. it was in constant need of capital. Debentures were sold
in early 1961 to fulfill this need. The registration statement for the debentures became effective
on May 16, 1961. The capital infusion, however, did not end BarChris's (D) problems, and
BarChris (D) filed for bankruptcy on October 29, 1962. Escott (P) claimed that the registration
statement of the debentures had material false statements and material omissions. Defendants
were BarChris (D), persons signing the registration statement (D), the underwriters (D), and
Barchris's auditors, Peat. Marwick. Mitchell, and Co. (D). All defendants argued that there were
no material false statements or material omissions. Due diligence was pled by Vitolo (D),
Pugliese (D), Kircher (D), Birnbaum. Auslander (D), and Grant (D), who all signed the registration
statement and by Peat, Marwick (D), who certified the 1960 figures. but not the 1961 figures.
ISSUE: Is due diligence a defense under $ 11 of the Securities Act of 1933 when the defendant
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.
HOLDING AND DECISION: [Judge not stated in casebook excerpt.] Yes. Due diligence is a
defense under § 11 of the Securities Act of 1933 when the defendant 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. Section 1 l(c) defines reasonable investigation
as that "required of a prudent man in the management of his business." In this case, the certified
section of the registration statement contained an abundance of material misstatements
pertaining to 1961 affairs. Vitolo (D) and Pugliese (D), who were officers of BarChris (D), did not
exert due diligence with regards to the registration statements, since .-: personally knew the
financial problems BarChris (D) was ha: - : and could not have believed the registration statement
to :c completely true or that there were no material omissions '-6 same holds true for K~rcher (D),
who was BarChris's (D) treas~r-.. and chief financial officer (D), and knew that the registrat1:-
statement contained incorrect figures. Birnbaum (D), asa dlrectc. for BarChris (D), had no
personal knowledge of the inaccuracies of the registration statement. but was under an
obligation t: Investigate uncertified portions of the registration statement :: see if there were
reasonable grounds to believe it was true Birnbaum (D) does not qualify for the due diligence
defense except for the certified 1960 figures. Auslander (D), as an outside director, has failed to
prove his due diligence defense for t h ~ certified sections of the registration statement, because
he reliec solely on others and on general information provided to hlrr Grant (D), who drafted the
registration statement, has proved hs due diligence defense for the certified figures but not for the
uncertified figures, because Grant (D) made no reasonable investigation into the certified
portions. Lastly, Peat. Marwick (D were BarChris's (D) auditors who were given answers by
BarChris (D) but did nothing to verify the answers. As such. Peat. Marwick (D) has not proven the
defense of due diligence as to the 1960 figures only, whlch they certified. Motion to dismiss
denied

EDITOR'S ANALYSIS: To successfully assert the due diligence defense under $ 11, newly
elected directors and outside counsel cannot rely on corporate officers and directors as to the
accuracy of statements. They must conduct a reasonable investigation of the accuracy of these
statements. These may include reviewing corporate documents and speaking with employees.
QUICKNOTES
DEBENTURES - Long-term unsecured debt securit~es ~ssued by a corporation
DUE DILIGENCE - The standard of care as would be laken by a reasonable person n accordance w~th the attendant
facts and crcumstances
MATERIALITY - Importance thedegreeof relevance or necess~ty tothe partcular matter
SECURITIES ACT tj 11 - Makes t mlawful to make untrue statements In reg~stration statements
2. Section 12(a)(1)
It imposes strict liability on sellers of securities for offers or sales made in violation of § 5,
i. e. when the sellers improperly fails to register the securities, to deliver a statutory prospectus,
violates the gun-jumping rule. The term seller also encompasses persons who successfully solicit
offers to purchase securities motivated at least in part by a desire to serve their own financial
interests or for those of the securities’ owner. Main remedy: rescission, unless the buyer is no
longer the owner of the securities then damages.
3. Section 12(a)(2)
It is a general civil liability provision for fraud and misrepresentation. Liability under this
section may be imposed where defendant made oral statements, used written selling materials
containing a material misrepresentation or omission. Liability may generally also be imposed in
exempt offerings, but after Gustafson only if the sale occurred in a public offering, i. e not in
secondary market nor privately negotiated transactions. Liability is limited to the seller of a
security (like § 12(a)(1)).
D. Rule 10b-5 of Exchange Act 1934
“It shall be 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,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact
necessary in order to make the statements made, in the light of the
circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would
operate as a fraud or deceit upon any person, in connection with the purchase or
sale of any security”.
General comments:
Courts have recognized a private right of action under § 10(b) of the Exchange Act and Rule
10b-5.
§ 10(b) applies to any security, including securities of closely held corporations not subject to the
Exchange Act.

The Supreme Court has held in Central Bank of Denver v. First Interstate Bank (1994) that there
was no implied right of action against those who aid and abet violations of Rule 10b-5.
Duty to disclose material information.
§10b of the 1934 Act authorizes SEC Rule 10(b)(5) Omnibus Fraud Provision.
§16b is another rule we will cover – short swing trades. (Insider trading).
Elements of 10(b)(5)
1. Need a Statement or Omission
2. In connection to purch or sale of a security
3. With 4 provisos:
a. Stmt is material
b. Scienter
c. Causation
d. Reliance
Remedies Under 10(b)(5)

1. Criminal; /or/
2. Civil; /or/
3. Private right of action
1. Standing
Blue Chip Stamps v. Manor Drug Stores (1975),

The Supreme Court put some bite in the rule that the protections of Rule 10b-5
extend only to purchasers and sellers of a corporation’s securities. Thus, the
plaintiff must either have bought or sold securities.
Deutschman v. Beneficial Corp (3rd Cir. 1988) p. 472

However, the plaintiff need not be in any relationship of privity with the defendant
charged with misrepresentation. There is no obligation to disclose under § 10(b)
so long as insiders stay out of the market, but if they choose to speak, they are
not free to lie. There is no need under § 10(b) to show some special relationship
of trust and confidence to establish standing. We know that 10(b)(5) is a federal
fiduciary duty to shareholders. But option holders don’t yet own shares. Trial
Court Dismissed but 3rd Circuit said there was a duty to disclose. Options are
now officially securities under the ’34 Act.
2. Materiality
There can be liability under 10b-5 only if there is non-disclosure or misrepresentation of material
facts.
(iii) Standard of materiality:

The Supreme Court in TSC Industries v. Northway (1976) defined the standard of materiality (in
the context of proxy solicitation):
“an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would
consider it important in deciding how to vote”, “there must be 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 available.

Thus, materiality depends on the significance the reasonable investor would place on the
withheld or misrepresented information.
What is material? Is a key person leaving? Is your key person 90 years old? Usually the
disclosures are very thorough; they try to include every possible risk.
Epstein example: disclosure for acquisition; he discovered underground storage tanks that had
not been disclosed. Too much liability; due diligence led him to kill the deal.
If they still wanted to do the deal, then he would have to disclose everything. Like “this deal could
put us out of business”
No one cares whether it’s a good deal; it’s all about the disclosure. CYA through disclosure.
Risk disclosure under the ’33 Act is a negligence standard; written in reaction to widespread
corporate malfeasance.
The government will regulate the disclosure, but not the risk. No matter how crappy your
business plan, if you disclose everything, you’re OK.
S1 Registration Statement is most common registration form under ’33 Act. If the company is
deemed to be selling securities, and they did not make these disclosures, then they are liable
under the Act.
Some private placement exemptions – Reg. D, etc.
(iv) Application of this standard to contingent or speculative information or events:
Basic v. Levinson (US 1988) p. 444

To determine the materiality of contingent or speculative information or
events, the following test must be applied: The Probability/Magnitude
Test
“Materiality will depend at any given time upon a 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”.
The SEC is concerned about the integrity of the markets. The
company’s denials led to a class action. These people want the
money they lost during the 15 months of negotiation that the
company denied there was a negotiation.
Reasonable investor – will he care?
Scienter – knowledge: π must show that ∆ acted with intent to
defraud; negligence will not suffice. Ernst & Ernst v. Hochfelder.
Although, some Courts say that intentional malice will suffice;
recklessness counts in some courts. But, the Supreme Court
says you need an intent to defraud or deceive.
Causation: see p. 452. Just need to show that the ∆ made
material misstatements and the π sold stock at that time. Fraud
on the market theory.
But, ∆ can rebut by showing that π was not affected.
But, how do you show reliance by each member of the class
action?

The Fraud on the Market Theory creates a rebuttable

presumption of reliance. It gets around this issue of trying to
prove causation. If the π can prove an affirmative false
disclosure, then the π has to prove reliance. But if ∆ failed to
disclose, then π gets rebuttable presumption.
Disclose Falsley – π must prove reliance
Failure to Disclose – rebuttable presumption.
Did the 137avourab cause the loss? Loss Causation
Did the omission cause you to buy or sell? Transaction Causation.
How do they come together under causation & reliance under 10b5?
SEC v. Texas Gulf Sulphur (2nd cir. 1968) p. 480

In order to assess the probability that the event will occur, a factfinder will
need to look at indicia of interest in the transaction at the highest
corporate levels.
To assess the magnitude of the transaction, a factfinder will need to
consider such facts as the size of the 2 corporate entities and of the
potential premiums over market value. No particular event or factor short
of closing the transaction need be either necessary or sufficient by itself
to render merger discussions material.
Pommer v. Medtest Corporation (7th Cir. 1992) p. 462

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 a significantly altered the “total mix of information”
made available Epstein: the wide range in the price anticipated from
Abbott - $50-$100 mil – means that they really weren’t close to a deal.
3. Manipulation or Deception
The claim of fraud and fiduciary breach states a cause of action under any part of rule 10b-5 only
if the conduct alleged can be fairly viewed as “manipulative or deceptive”.
Santa Fe Industries v. S. William Green (1977) p. 466

Before a claim of fraud or breach of fiduciary duty may be maintained under
10(b) or Rule 10b 5, there must be a showing of manipulation or deception.
The Supreme Court rejects the proposal that a breach of a fiduciary duty by
majority stockholders, without any deception, misrepresentation or non-
disclosure, violates § 10(b) and Rule 10b-5.
Breach of duty alone, without deception or manipulation, does not constitute
ground for a 10 b or Rule 10b 5 action.
Here, there was full disclosure. If the minority were dissatisfied they could seek
a court appraisal under the state statute. And ample state remedies exist for
breach of duty actions and for appraisals.
Santa Fe started with 60% of Kirby Lumber and eventually acquired 95%. Short
Form Merger allowed Santa Fe to push out the minority shareholders. According

to ∆ FMV was $125 per share but π ’s insist that it’s $775 per share. π ’s say
that there are all kinds of factors that could lead to a much higher analysis.
This is not fraud; there is a system here and the corporation followed it. If you
don’t like our valuation, go get your own appraisal. No manipulation or deception
involved.
Hypo #2 p 472: What if they used a short form merger but issued a misleading
statement to the minority shareholders? Epstein: What would it cause the
minority shareholders to do? They could not claim that it caused them to do the
transaction, but they might argue that the misleading statement caused them to
not get a separate appraisal as was their right under state law. Remember
Robert F. Broz: minority shareholders can be a real pain in the neck.
N.B.:
The philosophy of the Act is full disclosure, and the court is reluctant to recognize a cause of
action to serve at best a subsidiary purpose, i.e. fairness.
The Delaware Legislature has supplied minority shareholders with a cause of action in the
Delaware Court of Chancery to recover the fair value of the shares allegedly undervalued in a
short-form merger.
Corporations are creatures of state law, and investors commit their funds to corporate directors
on the understanding that, except where federal law expressly requires certain responsibilities of
directors with respect to stockholders, state law will govern the internal affairs of the corporation.
Congress by § 10(b) did not seek to regulate transactions, which constitute no more than internal
corporate mismanagement.
Non-disclosure is usually essential to the success of a manipulative scheme.
4. When is the truth or falsehood of the statement appreciated?
West v. Prudential Securities (7th Cir. 2002) p. 457

NATURE OF CASE: appeal from a class certification in a securities fraud suit.
FACT SUMMARY: James Hofman, a Prudential Securities’ (D) stockbroker, gave
material non-public information (apparently false) to his clients about a
forthcoming company merger. A class action was certified on behalf of everyone
who bought the touted stock during the period the misinformation was being
given.
CONCISE RULE OF LAW: a class action may not be brought on behalf of
everyone who purchased stock during a period with a broker was violating
securities laws by providing material non-public information.
FACTS: James Hofman, a stockbroker working for Prudential Securities (D), told
eleven of his customers that Jefferson Savings Bancorp was “certain” to be
acquired, at a big premium, in the near future. Hofman continued making this
statement for seven months. The statement was a lie since no acquisition was
pending. And, if the statement had been the truth, then Hofman was inviting
unlawful trading on the basis of material non-public information. A class action
was brought against Prudential (D) not on behalf of those who received Hofman’s
“news” in person, but on behalf of everyone who bought Jefferson stock during
the months when Hofman was misbehaving. The district judge certified such a
class, invoking the fraud-on-the-market doctrine. Prudential (D) appealed the
class certification.
ISSUE: May a class action be brought on behalf on everyone who purchased
stock during a period when a broker was violating securities laws by providing
material non-public information?
HOLDING AND DECISION: NO. The district court’s order, certifying everyone
who purchased stock during this period as a class, would mark substantial

extension of the fraud-on-the-market approach whose rationale is that public

information reaches profession investors whose evaluations of that information
and trades quickly influence securities prices. Here, however, Hofman did not
release information to the public, and his clients thought that they were receiving
and acting on non-public information; its value, if any, lay precisely in the fact that
other traders did not know the news. No news paper or other organ of general
circulation reported that Jefferson was soon to be acquired. Extending the fraud-
on-the-market doctrine in this way would require a departure not only from
existing law, but also a novelty in fraud cases as a class. Oral frauds have not
been allowed to proceed as class actions since the details of the deceit differ
from victim to victim, and the nature of the loss also may be statement specific.
Furthermore, very few securities class actions are litigated to conclusion, thus
review of this novel and important legal issue may be possible only through other
devices. Here, causation is the shortcoming in this class certification. With many
professional investors alert to news, markets are efficient in the sense that they
rapidly adjust to all public information. If some of this information is false, the
price will reach an incorrect level, staying there until the truth emerges. Few
propositions in economics are better established than the quick adjustment of
securities prices to public information. However, no similar mechanism explains
how prices would respond to non-public information such as the statements
made by Hofman to a handful of his clients. These do not come to the attention
of professional investors or money managers, so the price –adjustment
mechanism does not operate. This, it is hard to see how Hofman’s non-public
statements could have caused changes in the price of Jefferson’s Savings Stock.
The class action is reversed. The Appellate Court rejects the theory that private
information can effect public stock prices. Because even if the false information
was disclosed to everyone, the market would have discounted it. Increased
demand by a few investors is not enough to cause the price to rise.
EDITOR’S ANALYSIS: as noted in the West decision, sometimes full-market
watchers can infer important news from the identity of a trader (when the
corporation’s CEO goes on a buying spree, this implies good news) or from the
sheer volume of trades (an unprecedented buying volume may suggest that a
bidder is accumulating stock in anticipation of a tender offer), but here neither the
identity of Hofman’s customers not the volume of their trades would have
conveyed information to the market in this fashion.
Facts: Hofman, a broker for prudential securities, allegedly told eleven of his
customers that Jefferson Savings was about to be acquired at a premium. This
was a lie. Plaintiffs bought Jefferson stock during the time Hofman was
persuading clients to buy that stock.
(6) Plaintiffs claim that Hofman’s clients drove Jefferson’s price up, so that plaintiffs
bought the stock at artificially high prices.
(7) Court: Hofman’s “information” was private (not public) information. FotM theory
covers only fraud through publicly available information.
Elements of a Rule 10b-5 Violation

 Jurisdictional Nexus
 Transactional Nexus
 Materiality
 Reliance
 Causation
 Scienter
5. Causation
 Two types of causation:

 Transaction causation: But for the misrepresentation, plaintiff would not have
purchased (or sold) the securities.
 This is closely related to the reliance element. When reliance is presumed,
courts would also assume transaction causation. E.g.:
 Omissions [Litton v. Lehman Bros.];
 Fraud on the Market.
 Loss causation: The misrepresentation caused the loss.
 Courts do not presume loss causation.
 Examples of reasons for lack of loss causation:
 Market did not believe the misrepresentation;
 Market price changed due to general stock market trends [e.g., Fed raises or
decreases the interest rate].
Pommer v. Medtest Corporation (7th Cir. 1992) p. 462 patent/patentable?

4/29/2004 The securities laws approach matters from an ex-ante perspective:
just as statement true when made does not become fraudulent because things
unexpectedly go wrong, so as a statement materially false when made does not
become acceptable because it happens to come true.
Good fortune may affect damages but it does not make the falsehood any the
less material. What if the odds of getting the patent were 90% but if the patent
were not issued the company would have no value? If the Pommers were willing
to pay $200k for a company with a patent, then presumably they would have paid
$180k for a company with a 90% likelihood of success. Pommer’s damage in
that hypo would be $20k.
6. Scienter
Mere negligence is not enough. To establish a claim for damages under Rule 10b-5, it must be
proven that the defendant acted with scienter
“Scienter”: A mental state consisting in an intent to deceive, manipulate or defraud.
Recklessness is generally sufficient.
Deutschman v. Beneficial Co. (pg472)--

Π alleges losses when, upon disclosure of the facts, call options on Beneficial’s stock that he had
purchased in reliance on the market price created by ∆ s misstatements, became worthless.
Options are hurt by: 1) insider trading, and 2) affirmative misrepresentations. Π alleges #2. Ct.
says that option traders should not be treated any differently than stock traders, just because they
are “gambling”. Epstein: on remand, how will Deutschman prove that Beneficial intended to
manipulate; Scienter. Will recklessness be good enough? Ernst & Ernst case (Supreme Court)
could help. What if the Halvorsen and his sidekick issue a press release saying that they are not
in negotiations and then they get the shareholders to ratify their treatment? The shareholders
would probably ratify because the stock price went up and they made money? What about the
option holders who lost money? In-other-words, what happens when the interests of the
shareholders are at odds with those of the option holders.
7. Reliance and Fraud-on-the-Market Theory:

Reliance is an element of a rule 10b-5 cause of action, because it provides the requisite causal
connection between a defendant’s misrepresentation and a plaintiff’s injury.
An investor who buys or sells stock at the price set by the market does so in reliance on the
integrity of that market price. According to the Efficient Capital Market Hypothesis, most publicly
available information is reflected in market price. The market is performing a substantial part of
the valuation process performed by the investor in a face-to-face transaction. The market is
acting as the unpaid agent of the investor, informing him that given all the information available to
it, the value of the stock is worth the market price. An investor’s reliance on any public
material misrepresentations, therefore, may be presumed for purposes of a rule 10b-5
action.
The presumption may be rebutted, in fact any showing that severs the link between the alleged
misrepresentation and either the price received or paid by the plaintiff, or his decision to trade at a
fair market price, will be sufficient to rebut the presumption of reliance (Basic v. Levinson).
Fluctuation of the stock price at the time of the false disclosure tells you that people were relying
on the false disclosure.
To avoid the presumption of reliance, they must show that their misrepresentation did not affect
the stock price. So, if ppp accuses, then you have to show that the market makers did not rely on
the price, you might break the causal chain.
Some discrepancy between whether it’s the loss causation or the transaction causation. In other
words, did you lose $ or is your loss just the fact that you did the transaction?
Rebuttal example: you bought months in advance; or if you can prove in some way that the ∆
bought for a different reason. OR, the stock price changed for a different reason.
The best thing to do is say NO COMMENT.
E. Insider Trading
1. Definition of Insider Trading

General approach: A person violates Rule 10b-5 for insider trading, if he has
(1) A special relationship with the issuer,
(2) Trades with the stock of the issuer, while in possession of material and 141avourable
information.
2. Justification for Insider Trading Regulation

a) Harms from insider trading:
(a) Market Efficiency:
• Resources are not allocated as well, because the information available to the
market is out-of-date.
• With insider trading, market makers will sell only at higher prices and will buy at
lower, because he can infer that there is information not available to him that increases
his risk. Thus, the bid-ask spread will be wider and the liquidity of the market smaller.
• Every time an insider trades securities, the market will infer information about the
corporation that might not necessarily be true, cause greater volatility.
• The common law doctrine of caveat emptor is not applicable in an impersonal
market.

• The incentives of management will be to create volatility of the company’s stock,

from which they can profit trading, and not efficiently manage the company.
Moral:
• The market is to some extent based on the idea of a fair game in which all participant
should have equal access to information SEC v. Texas Gulf Sulphur (2nd cir. 1968) p.
480
• Inside information is a corporate asset that cannot be appropriated by the insider.
• The insiders owe a fiduciary duty to the shareholders, who they will profit from by
insider trading.
Arguments in support of insider trading: (Epstein’s view)
(1) Market efficiency:
• Argument: Insider trading will provide incentives to the insiders to bring
information to the market and reflect it in the price. Moreover, the prices of the stock
would move more smoothly and will be closer to the true value of the stock at most time.
Using the information to enter the market, the market begins to respond to this.
• Rebuttal: Full disclosure will adjust the prices to the available information faster
than insider trading;
(a) Compensation:
• Argument: Insider trading provides a reasonable compensation for managers and gives
incentives to take riskier decisions.
• Rebuttal: Management will not profit from its good efforts managing the company, but from
the variability in the price of the stock SEC v. Texas Gulf Sulphur (2nd cir. 1968) p. 480.
(b) High costs: It is very expensive to policy insider trading.
3. Liability under Rule 10b-5
The rule resulting from 10b-5 in relation to insider trading is DISCLOSE OR ABSTAIN FROM TRADING (In
re Cady, Roberts and SEC v. Texas Gulf Sulphur (2nd cir. 1968) p. 480). The rationale is that
Rule 10b-5 does not require any kind of disclosure and sometimes the latter might be premature
or against the corporation’s best interest. By this token, the insider must either disclose the
information or abstain from trading.
Standing
Standing is limited to purchasers or sellers of securities to which the insider trading relates at the
time of the insider trading: Blue Chip Stamps v. Manor Drug Stores. Potential purchasers and
non-seller stockholders do not have standing ⇒ Birnbaum doctrine. But buyers of options can:
Deutschmann v Beneficial Corp.!
Material Nonpublic Information
Materiality depends on the significance the reasonable investor would place on the withheld
or misrepresented information; probability/magnitude test (see above)
Epstein: Theory for insider trading: If you are an insider and you trade on the information,
you can never really deny the materiality of the information. To the extent there is a reaction
to this information, it also has to be material to the other person.
Deception: Fiduciary Duty

The Rule 10b-5 traditional theory holds an insider liable for trading securities of his corporation
based on relevant, non-public information. Such trading is viewed as a deception due to the
relationship of trust and confidence reposed in the insider by virtue of his position. The
duty applies to officers and directors, as well as anyone else who acts in a fiduciary capacity
towards the corporation, i.e. Attorneys, accountants and consultants.
The duty to “disclose or abstain” only applies to those who have some kind of fiduciary
relationship of trust and confidence with the company, by means of which they have had access
to the material non public information: insiders, constructive insiders, tippees or misappropriators.
Chiarella v. US
Trading with inside information will only violate Rule 10b-5 when the trader has violated,
or knowingly benefited from another’s violation of, a fiduciary duty. Epstein says 14(e)(3)
would catch Chiarella. It was written in response to this case.
Epstein: Whereas common law is not clear about the question whether directors owe fiduciary
duties to someone who is not yet a shareholder, but rather becomes one through the
questionable transaction, Rule 10b-5 is clear as to this point: if you finally bought the shares you
can sue! This constitutes a certain asymmetry.
• Insider: One who obtains inside information by virtue of his employment with the company
whose stock he trades in.
Goodwin v. Agassiz (Mass. SC 1933) p. 477

A director may not personally seek out a stockholder for the
purpose of buying his shares without disclosing material facts within
his peculiar knowledge as director and not within reach of the
stockholder. But the fiduciary obligations of directors are not so
onerous as to preclude all dealings in the corporation’s stock where
there is no evidence of fraud.
Here there is no evidence of fraud because
(1) There was no personal solicitation by the director
(2) The stockholder was an experienced stock dealer
(3) At the time of the sale, the undisclosed theory had not yet been proven, and
(4) Had the director disclosed it prematurely, he would have been exposed to
litigation if it proved to be false
4. Constructive Insider:
• One who is entrusted with inside information by virtue of professional relation with the
company whose stock he trades in (e.g. attorneys; outside counsel) See footnote 14 on p.
495.
5. Tippee:
• One who receives inside information from an insider/tipper. The tippee will only violate Rule
10b-5
(1) if the insider/tipper has consciously violated his fiduciary duties to the company
whose stock the tippee trades in

(2) For his (insider/tipper) own personal direct or indirect gain. The insider/tipper must
receive some benefit or at least, must have intended to make a pecuniary gift to the
tippee.
Dirks v. SEC (1983) p. 493

SEC charged Dirks with disclosure of material non-public information. The liability of
a tippee is derivative. A tippee assumes a fiduciary duty to the shareholders of a
corporation not to trade on material favourable information only :
(1) When the insider/tipper has breached his fiduciary duty to shareholders
RULE (earns a personal benefit from the tip) by disclosing the information to the
tippee, and
(2) the tippee knows or should know that there has been a breach
DIRKS v. SECURITIES AND EXCHANGE COMMISSION, 463 U.S. 646 1983)

NATURE OF CASE: SEC action for violation of 5 10(b). FACT SUMMARY: Dirks
(D), based on some 144avourable information he received and a subsequent
investigation, aided the SEC (P) in convicting EFA for corporate fraud and was
then sued by theSEC (P)for violating § 1O(b) because he openly disclosed the
144avourable information to investors.
CONCISE RULE OF LAW: A tippee will be held liable for openly disclosing
144avourable information received from an insider, if the tippee knows or should
know that the insider will benefit in some fashion from disclosing the information
to the tippee.
Epstein: This is the “fiduciary flow” case because it flows liability from insider to
outsider. Scienter is required under 10(b)(5) That is why Dirks got off.
Footnote 14: wouldn’t work w/ O’Hagan b /c he was not a constructive insider to
Pillsbury. That is why you need the misappropriation theory. Read note 14.
6. Misappropriator:
• One who misappropriates information by breaching a fiduciary relationship with the source of
the information.
US v. O’Hagan and Carpenter (US 1997) p. 501

This case affirmed the application of the misappropriation theory with respect to
the scope of Rule 10b-5. Rule 10b-5 is an anti-fraud statute requiring a high
degree of scienter. The Supreme Court did not formally hold that disclosure
would relieve a person of liability under 10b-5; but they imply that this would be
the case and aggrieved s/h would have to pursue action under State law.
Apart form the deceptive device traditional theory of Rule 10b-5, a person may
be liable for the misappropriation of
(1) Material non-public information for the purpose of trading thereon
(2) In breach of a fiduciary duty due to the provider of the information
Here, O’Hagan did not owe a duty to the shareholders of the corporation since he
was not an attorney involved in the case. But he owed a fiduciary duty to his law
firm to refrain from trading on the basis of material non-public information he may
have acquired by virtue of his position in the firm
Epstein: The Hagemeister owes no duty to Pillsbury and there is no evidence of

a Dirks type tipee situation.

UNITED STATES v. O’HAGAN, 521 U.S 642 (1997).

NATURE OF CASE: Writ of certiori reviewing reversal of convictions for mail and
securities fraud, fraudulent trading, and money laundering.
FACT SUMMARY: O’Hagan (D), an attorney, was indicted for trading securities
in Pillsbury based on confidential information he obtained by virtue of his
association with the corporation’s law firm.
CONCISE RULE OF LAW:
(1) 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 SEC §10(b) and Rule 10b-5.
(2) The SEC did not exceed its rulemaking authority by promulgating Rule 14e-3(a),
which prohibits trading on undisclosed information in a tender offer situation, even where the
person has no fiduciary duty to disclose the information.
US v. Chestman (2d Cir. 1991) p. 508

A mere familial relationship between the source of information and the tipper was
not enough to impose a fiduciary duty in the tipper (Second Circuit).
Rule 10b5-2 (Untested in the Supreme Court – SEC Response to Chestman)

In 2000, the SEC passed Rule 10b5-2 sets forth a non-exclusive list of 3
situations in which a person has a duty of trust or confidence for purposes of the
“misappropriation theory”:
1. Whenever someone agrees to keep information in confidence;
2. A duty exists between 2 people who have a pattern or practice of sharing
confidences such that you know confidence is expected;
3. Receipt of material non-public information from a spouse, parent, child,
or sibling;
NEED TO UNDERSTAND 14E-3 – LIABILITY IF YOU TRADE ON MATERIAL NON-PUBLIC

INSIDE INFORMATION IN CONNECTION WITH A TENDER OFFER
Scienter
The defendant must know that the information to which he had access while trading was both, (1)
material and (2) 145avourable. Recklessness will also satisfy the requirement, especially in
connection with the failure to control another person’s insider trading.
Causation/Reliance
Basic v. Levinson (US 1988) accepted the fraud on the market theory, whereby a plaintiff has
the benefit of the presumption that he relied on the market price being fair. (see above)
West v. Prudential Securities: No loss causation when the alleged misrepresentation was not
public. This is because an increase in the price of stock, with no publicly-known information to
justify it, would result in the stock seeming too expensive, and some SH selling it, bringing price
back
Jurisdiction
The defendant must have used the phone or mail, or some national security exchange in
connection with his trade.
1. Stock Parking
a. Stock parking occurs when the first party, who is the true owner of the stock,
arranges w/ a second party (the nominal owner) to hold the stock in the

nominal owner's name. Under such an arrangement, any profits and losses
that the nominal owner has are later transferred to the real owner.
b. Why would you park stock?
i. Margin rules limit the amount that can be borrowed to buy stock; if a
stock owner exceeded or is about to exceed that limit the owner can
temporarily sell (park) the stock so it won't apply to the margin limit
ii. Avoid taxes (sell some stock at a loss w/ the agreement to buy it back
later)
U.S. v. Bilzerian (2nd Cir.1991) p. 70

Stock parking scheme; he filed motion in limine to testify that he had good faith based on attorney
advise without subjecting himself to cross-examination which would pierce the attorney-client
privilege. 2nd Circuit told him to get fucked and try the damn case without whining. The attorney-
client privilege cannot be used at once as a sword and a shield.
F. Short-Swing Profits
1. § 16 (b) Securities Exchange Act
03/05/2004 Statute,not a rule.

Passed during New Deal in the 1930’s and was originally the only insider trading rule. It
wasn’t until the 1960’s that 10b-5 was judicially interpreted as an insider trading rule.
For the purposes of preventing the unfair use of information which may have been
obtained by such beneficial owner, director, or officer by reason of his relationship to
the issuer, any profit realized by him from any purchase and sale, or sale and
purchase of any equity security of such issuer (other than an exempted security) within a
period of less than six months ... shall inure to and be recoverable by the issuer,
irrespective of any intention on the part of such beneficial owner, director, or officer in
entering into such transaction of holding the security purchased or of not repurchasing
the security sold for a period exceeding six months. Do it and disgorge.
...
This subsection shall not be construed to cover any transaction where such beneficial
owner was not such both at the time of the purchase and sale, or the sale and the
purchase, of the security involved, or any transaction or transactions which the
Commission by rules and regulations may exempt as not comprehended within the
purpose of this subsection.
The term “such beneficial owner” refers to one who owns “more than 10 per centum of
any class of any equity security (other than exempted security) which is registered
pursuant to §12 of this title.
2. Elements of § 16(b):
Director, officer or such beneficial owner:
The rationale of this provision is that directors, officers and 10% beneficial owners are likely to
have material 146avourable information by virtue of their relation with the issuer. Any type of
director, it doesn’t matter if you have a special fiduciary duty. It’s based on your position in the
Company.

(1) Such beneficial owner refers to one who owns:

(1) directly or indirectly,
(2) more than 10% of any class,
(3) both, at the time of purchase and sale or sale and purchase
Foremost-McKesson v. Provident Securities (1976) p. 515

In a purchase-sale sequence, a beneficial owner must account for profits only if
he was a beneficial owner before the purchase
Reliance Electric v. Emerson Electric (1972), p. 512

When a holder of more than 10% of the stock in a corporation sells enough
shares to reduce its holdings to less than 10%, and then sells the balance of its
shares to another buyer within six months of its original purchase, it is not liable
to the corporation for the profit it made on the second sale (but he is liable for the
profits of the first!)
• Directors and officers are insiders at the time of the sale or purchase (not necessarily both).
• 10% Beneficial Owners must be insiders at both the time of sale and the time of purchase.
3. Exam Approach:
Set up a timeline
Mark activities and status of parties at time of each transaction
Must be above the threshold at the time of the transaction.
If the transaction puts you over the 10%, it doesn’t count.
|__________^_______________________^__________^___________|
Take highest price of selling and lowest price of buying to determine maximum possible profits.
Price per share

Purchase or sell
Months
Status
Sha
Any profit:
Any profit is ambiguous. Courts have interpreted the maximum possible profits within a six
months period.
Purchase and sell, or sale and purchase:
Unorthodox or borderline transactions courts will decide to include or exclude it as a sale on the
basis of whether the transaction is likely to serve as a vehicle for insider trading, which Congress
intended to prevent.
Kern County Land v. Occidental Petroleum (1973) p. 517

After an unsuccessful attempt to merge with Kern County Land Co., Occidental
purchased in May and June 1967 approximately 20% of the outstanding shares
of Old Kern which merged with Tenecco. The shares of Old Kern were to be
exchanged against Tenecco shares. Then Occidental granted to a subsidiary of
Tenecco an option to purchase all its Tenecco stock pursuant to the merger. The
option agreement was executed on June 1967 but it could not be exercised prior
to a date more than six months after Occidental’s original acquisition of Old Kern
shares.

It was held that neither accrual of the right to exchange recently acquired shares
for shares in the survivor of a merger, nor the granting of an option to buy the
shares received in exchange, constitute a sale within the meaning of s.16(b),
absent any abuse, or potential for abuse, of inside information.
Here, Occidental, as the former tender offeror, had no say in the Old Kern-
Tenecco merger negotiations. There is no indication that the option agreement
between Occidental and Tenecco created a potential for speculative abuse of
inside information.
Any equity security registered under the Exchange Act §12.
§16(b) is only applicable to equity securities (stock and convertible debt) of public traded
companies. In contrast with Rule 10b-5 that is applicable to any security (including pure debt)
registered or not registered.
Six months.
Recoverable by the issuer.
The plaintiff must be always the issuer, whether in a direct or a derivative action. The issuer will
collect the judgment.
4. Comparison of Rule 10b-5 and §16(b).
Clear Rule [§16(b)] Fuzzy Rule [Rule 10b-5]

benefits • Parties are on notice. • Covers all possible cases.
• Avoids litigation. • Judicial Activism.
• Easily enforced.
Costs • Underdeterrence • Unintended might be liable.
• Overdeterrance. • Risk exposure.
• Litigation.
• Difficult to plan conduct.
P. 523, problem 1.
XVI. INDEMNIFICATION AND INSURANCE
Corporations often enter into indemnification agreements in an effort to recruit key employees or
retain them. These agreements, however, are criticized by some as leading to irresponsible
actions by the employees. This is because the employee would not really be personally liable for
anything except intentional misconduct.
Waltuch v. Conticommodity Services (2nd cir. 1996) p. 526

A corporate director or 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 expenses.
A corporate director or 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 expenses
However, indemnifications rights provided by contract cannot exceed the scope
of a corporation’s indemnification powers as set out by statute

Citadel holding Corporation v. Roven (Del. SC 19992) p. 534

A corporation may advance reasonable costs in defending a suit to a director even
when the suit is brought by the corporation.
1. Proxy Contest
Entails gaining control of X corporation thru the SH voting mechanism (“proxy machine”)
The Proxy Machine: Mostly passive; SHs appoint someone as agent/proxy to vote for the
SH
Akin to absentee ballot; fully controlled by insiders
How: B acquires 1 or more shares, puts a proposition to vote by other SHs
Problem is that no single SH has access to the machinery so you have to go thru the
corporation itself; Ds will likely reject & refuse to put it on D’s slate on ballot
2. Wholly independent proxy campaign

a) In theory, B can use a proxy to implement better management in X instead of
takeover. B would buy shares of X, and then submit a shareholder resolution about
composition of corporation, etc, at next shareholder’s meeting, and try to take over
corporation by electing a new slate of directors who would then put into effect B’s
better mousetrap and increase value of corporation.
b) This is the way shifts in corporate control were supposed to occur.
c) Proxy machinery – Mechanism through which shareholders exercise their voting rights.
If B can make a case for better prospects under new management, then shareholders
should vote for that.
d) BUT this method is hopeless because:
e) Inherent advantage that incumbent managers have. They control the voting process –
laws require them to adhere to certain rules. BUT in practice because they hold the
shareholder lists, etc, they have a decisive upper hand in a broad range of situations.
f) Nothing in it for the outsider (owner of better mousetrap). A proponent of new
management or change in corporate policy might be able to prevail, but the benefits are
negligible because of small number of shares owned.
2) Payoff is further minimized by the fact that an unsuccessful proxy contests are not
subsidized by the corporation, whereas incumbent managers’ campaigns are.
3) Gives other shareholders a free ride.
4) In a publicly traded corporation, no one shareholder has a large stake in the
outcome in a proxy contest over a change in corporate policy, and will not likely
take time to inform themselves of the issues involved.
(2) Most common use of proxy contests = social activism platforms Underlying energy is
therefore ideological and not for profits.
(4) Shareholder Proposals: a shareholder proposal can be significantly related to the business
of a securities issuer for noneconomic 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 issuer’s total assets (Lovenheim v Iroquois Brands, Ltd
(D DC 1985)
(5) Corps may omit shareholder proposals from proxy materials only if the proposal falls within
an exception listed in Rule 14a-8. The NYC Employees’ Retirement Sys v Dole Food Co, Inc
(2d Cir 1992)
(6) One resurgent use of proxy contests in connection with takeover defenses. Not used as
instrument to gain control directly, but instead to defeat attempts at takeovers.
(c) Limitations of proxy contests – Almost entirely broken down as a major element in
takeover contests, and instead contests for control take the form of hostile takeovers
(tender offers). Easier for shareholders to assess which is the better alternative in the
context of a hostile takeover (compare amount being offered to current FMV of their
shares).

Levin v Metro-Goldwyn-Mayer, Inc (SD NY 1967) (pg485)

Π s want an injunction to keep the board from spending company money soliciting proxies in
a proxy fight.
Holding: Court denies the injunction. They say that it is essential that the SH be informed,
and there are definite differences between these 2 groups. If there was just a difference in
personalities, then using corp $ is not allowed. The court also said the expenses aren’t
outrageous, and they aren’t doing anything illegal. Also the proxy statement disclosed that
MGM would be paying for it.
Levin v Metro-Goldwyn-Mayer, Inc (SD NY 1967): Proxy contest between two factions, one
led by present management and one led by a present director. Director charges that
management is wrongfully committing corporation to pay for its proxy contest (using
attorneys, public relations firm, proxy soliciting organizations, etc). Held incumbent Ds may
use corporate funds and resources in a proxy solicitation contest if the sums are not
excessive and SHs are fully informed. Such a rule protects incumbents from insurgent
groups with enough money to take on a proxy fight. Court’s concern is that SHs are fully
and truthfully informed as to merits of contentions of contesting parties.
Rosenfeld v. Fairchild Engine & Airplane (pg543)

Derivative action to get the return of money paid out to both sides in a proxy fight. New
winners reimbursed themselves and the departing group. Since the differences in the 2
groups were about policies of the company, the money is fine.
Holding: case dismissed. Getting a quorum is fine. Also, the new board having its own
expenses reimbursed is fine, if approved by SH. So, if the contest is one about policy and
conducted in good faith, then reasonable expenses may be reimbursed.
Dissent: this was an expensive, persuasive campaign complete with parties and corporate
jets. Informing is one thing, but the rest is needless expenditure.
L: what if incumbents reimburse insurgent losers? Not a conflict, Rosenfeld might say it
is okay.
Regulation of proxy fights—pg492 SEE the rules §14, etc.

(4) SEC Rule 14a-9—Private cause of action for breach of §14(a), soliciting proxies by means of
materially false or misleading statements.
(5) Rosenfeld v Fairchild Engine & Airplane Corp (1955)
(6) Insurgent s/h win the proxy fight and try to not pay the old guys. Rejects challenge where π
seeks to compel return of funds paid out of corporate treasury to reimburse both sides in a
proxy contest for their expenses.
(7) Rule as stated in the case. How does in hurt incumbents?
1. No reimbursement unless involves
matters of policy.
2. Only if reasonable.
3. Incumbents can be reimbursed whether
they win or lose.
4. Firm may reimburse insurgents only if
they win and only if the shareholders ratify the payment.
(a) Rule ⇒ When the directors act in good faith in a contest over policy, they have the right
to incur reasonable and proper expenses for solicitation of proxies and in defense
of their corporate policies, which they believe, in good faith, to be correct. However, if
the proxy fight is merely a personal power fight, then the directors are not entitled to
charge the corporation. Moreover, shareholders have the right to reimburse successful
contestants for reasonable and bona fide expenses incurred by them in any such policy
contest, subject to court scrutiny.
(b) Dissent ⇒ Argues that the expenses in question in fact were personal rather than
business expenses associated with a proxy fight. Suggests putting burden of proof on
directors to show propriety and reasonableness of specific items. Moreover, if purpose

of expenses was ultra vires, then must be ratified by unanimous vote of shareholders.
Otherwise, simple majority is sufficient.
(8) Regulatory Scheme ⇒ Section 14(a) of 1934 Act (requires proxy statement be sent to every
shareholder containing relevant information and gives management a choice between mailing
insurgent group’s material or giving them a list of shareholders).
(9) Economics of Proxy Fights: Tender offers are a more efficient and cost-effective way to
gain control of corporation because of the enormous expense of putting up a proxy fight,
which will either be at the cost of the individual if the fight is unsuccessful, or from the
corporation if it is successful. With tender offers, all of the increased earnings can be
captured without a lot of overhead or transaction costs.
J.I. Case Co. v. Borak (1964) (p.550)

a. Facts: It was alleged that a merger was effected by the circulation of a false and
misleading proxy.
a. Issue: Whether §27 of the 1934 Act creates a federal cause of
action to a corporate stockholder with respect to a consummated merger authorized
pursuant to the use of a proxy statement alleged to contain false and misleading
statements violating §14(a) of the Act.
b. Holding: Private parties have a right under §27 to bring suit for
violation of §14(a) of the Act.
1. This right of action exists both directly and derivatively.
2. The possibility of civil damages serves as an effective weapon in
the enforcement of the proxy requirements of §14.
3. That state law questions must be decided doesn’t preclude a
federal question. Federal claims for a disclosure failing under §14 usually imply
violation of fiduciary duty, which is also a state claim.
4. In Touche Ross v. Redington, the Supreme Court changed
course to deny that §17(a) provides a private damages action on behalf of
broker’s customers. Plaintiff’s rights must be found in the substantive
provisions of the Act, not in §27.
Need to review the rule in the supplement on p. 271.
Mills v. Electric Auto-Lite Co., [p.553]

FACTS: Shareholders bring suit against Electric Auto-Lite Company under
Rule 14a-9 and § 14(a). The shareholders alleged that the proxy statements
used in a merger of Electric and American Manufacturing Corp. were
misleading in that it told Auto-lite shareholders that the board of Directors
approved the merger without informing them that all of the directors were
nominees of and under the control and domination of Merganthaler (Auto-lite
had merged into this corp).
HOLDING: There is an implied private right of action for violation of § 14(a) [Borak].
However, a shareholder must establish that the defect was of such a character that it would
have a significant propensity to affect the voting process. “Where there has been a finding
of Materiality, a shareholder has made a sufficient showing of casual relationship
between the violation and the injury for which he seeks relief if the shareholder can
establish that the proxy solicitation established an essential link in effectuating the
transaction.” The shareholders have showed enough to sustain their cause of action.
Note: “Where there has been a finding of materiality, a shareholder has made a
sufficient showing of causal relationship between the violation and the injury for which
he seeks redress, if, as here, he proves that the proxy solicitation itself, rather than the

particular defect in the solicitation materials, was an essential link in the

accomplishment of the transaction.”
 The concept of causation has been separated into two tests:
(1) Loss Causation = the transaction caused harm to the plaintiff (relatively easy to
demonstrate) e.g. in Borak, the shareholders got less for their shares than the shares were
worth.
(2) Transaction Causation = requires the plaintiff to show that the defendant’s violation
caused the company to engage in the transaction in question (harder to prove) e.g. in Mills
the loss was occasioned by the merger and the merger was caused by the solicitation of
proxies to secure sufficient votes for its approval.
Epstein: it’s all about materiality. As long as the proxy solicitation itself, rather than the defect
152avour was a essential link: Need 2 things:
Defective Proxy
Material impact of defect
Epstein says it was a hollow victory b/c on remand the 7 th Circuit something happened which I
have no idea. It was material and essential but they could have done it anyway. You had to have
needed to proxy solicitation to get what you needed. This tends to limit matters because the
company had a right to do some things without a proxy.
Matriality standard: Might have been considered significant by a shareholder.

Keep in mind that since this case, the TSC Industries decision set forth a single unified
152avourable152 for all securities law:
TSC INDUSTRIES MATERIALITY DEFINITION

SUBSTANTIAL LIKELIHOOD THAT A REASONABLE S/H WOULD CONSITDER IT
IMPORTANT IN DECIDING HOW TO VOTE.
Seinfeld v. Bartz, (N.D. Cal. 2002) p. 561

Valuations of option grants to outside directors are not material information which must
be included in a corporation’s shareholder statement to solicit proxy votes.
This case uses the TSC Industries, standard definition of materiality to say that option grants to
directors do not need to be disclosed. When Cisco Systems, Inc. (D) and its directors (D) mailed
shareholders a solicitation for proxy votes, they did not include the value of option grants based
on a commonly used theoretical so-called Black-Scholes pricing model, whereupon Seinfeld (P)
sued Cisco (D) and its directors (D) for the violation of SEC rules relating to proxy solicitations.
Lovenheim v. Iroquois Brands, Ltd., (D.D.C. 1985)[p. 565]

FACTS: This is an animal right case addressing the force feeding of geese to make pate. A
shareholder, Lovenheim, submits a proposal to Iroquois in the form of a resolution regarding the
force feeding of geese to make pate that Iroquois imports and distributes, the resolution
recommended the forming of a committee to look at the issue. Iroquois omits the proposal on the
grounds that it does not significantly relate to Iroquois’ business under Rule 14a-8I(5) [its annual
revenues are $141 million and pate sales were only $79,000 the last year, and only $34,000 in
assets are related to pate.

HOLDING: The meaning of significantly related to issuer’s business does not

solely hinge on
Economic significance. During the 1970’s proposals relating to only 1% of a
company’s were not allowed to be omitted because the proposals raised
important policy questions to be considered important enough to be considered
significantly related to the issuer’s business. The court granted Lovenheim’s
request for a preliminary injunction.
Rule 14(a)(8): it’s in question form.
NYCERS v. Dole Food Co. P. 570

B) Facts: Shareholder of Corporation wanted to propose that the Corporation analyze the
impact of various contemplated changes in National Health Care policy on Corporate
competitive standing. Shareholder sought to include the proposal in Corporate proxy
materials. Corporation wanted to exclude the proposal and received a no action letter
from the Securities Exchange Commission. Shareholder sued for inclusion and won.
C) Analysis: The Corporation did not meet its burden of demonstrating that a proposal fits
within the exceptions under rule. Courts do not look beyond the reasons facially given
by Shareholders for the proposals.
1) The outcome of the adoption of national health policy will have a large impact on the
firm, and therefore do not fall within ordinary business operations exclusion
2) There is a significant relationship between the policy and the business of the firm
(a) The Corporation tried to argue that operations that account for less than 5% of
annual earnings are not sufficiently relevant to require inclusion of a proposal.
(b) Loveheim: This exception only applies if the issue in the proposal is not significantly
related to the business of the Corporation. ➜ If there is a significant relationship
then the 5% exclusion does not apply.
3) The proposal does not call for the Corporation to attempt to affect the national health
care debate, only that the Corporation study the issue
(a) Shareholder is actually trying to get the Corporation to weigh in the debate politically
through its study of the matter.
XVII.§7. The Question of Corporate Control

A. PROXY FIGHTS
1. Federal Proxy Regulation – To avoid proxy abuse, the regulations require:

(1) SEC-mandated disclosure – SEC requires that anyone soliciting
proxies from public shareholders must file with the SEC and distribute to
shareholders specified info. In a stylized proxy statement.
(2) No open-ended proxies – SEC mandates form of proxy card and scope
of proxy holder’s power.
(3) Shareholder access – SEC requires management to include “proper”
proposals by shareholders with management’s proxy materials, though
this access is conditioned.
(4) Private remedies – Fed. Cts. Allow private causes of action for
shareholders to seek relief for violation of SEC proxy rules, particularly
the proxy anti-fraud rule.

2. Mandatory Disclosure when Proxies Not Solicited

(5) When a majority of a public corporation’s shares are held by a parent
corporation, it may be unnecessary to solicit proxies from minority
shareholders.
(6) Proxy rules require the company to file with the SEC and send
shareholders, at least 20 days before the meeting, information similar to
that required for proxy solicitation.
3. Antifraud Prohibitions – Rule 14a-9

(7) Rule 14a-9 – Any solicitation that is false or misleading with respect to
any material fact, or that omits a material fact necessary to make
statements in the solicitation not false or misleading is prohibited.
a. Full disclosure – Proxy stmt must fully disclose all material
information about the matters on which the shareholders are to
vote.
(8) Private suit – Although Rule 14a-9 does not specifically authorize suits,
federal courts have inferred a private cause of action.
B. Strategic Use of Proxies
Levin v. MGM, Inc. (KRB, 520–23) –

(9) In a proxy fight between two groups vying to elect their own slate of
directors, the incumbents hired specially retained attorneys, a public
relations firm with the proxy soliciting organization, and used the good-
will and business contacts of MGM to secure support. Held: These
actions did not constitute illegal or unfair means of communication since
the proxy statement filed by MGM stated that MGM would bear all the
costs in connection with the management solicitation of proxies.
1. Reimbursement of Costs
Rosenfeld v. Fairchild Engine & Airplane (p. 543) –

(10) In a contest over policy, as compared to a purely personal power
contest, corporate directors can be reimbursed for reasonable and
proper expenditures from the corporate treasury. This is subject to court
scrutiny.
a. Where it is established that money was spent for personal power
and not in the best interests of the stockholders/corporation,
such expenses can be disallowed. Epstein: this is the key,
personal expenses may not be reimbursed, even if incurred by
an incumbent. So, why is this important. This is a typical essay
type question. So, if you try to oust management over purely
personal issues, the company may not be liable for reimbursing
the directors for the amounts they spend on lawyers. Rationale:
why should s/h pay for fights that have nothing to do with policy?
b. Epstein: say that the policy is changing I the insurgent is not on-
board with our new policy; he’s still stuck on our old policy.

C. Private Actions for Proxy-Rule Violations

1. Nature of Action
c. Either direct or derivative – Shareholder can bring suit either in
her own name (class action) or in a derivative suit on behalf of
the corporation
(i) Federal suit advantages – Allows Shareholder-π s to recover
litigation expenses, including attorney fees, and to avoid
derivative suit procedures.
2. Elements of Action
d. Misrepresentation or omission
e. Statement of opinions, motives or reasons – Board’s
statement of its reasons for approving a merger can be
actionable.
(i) Virginia Bankshares, Inc. v. Sandberg (KRB, 530–37)
(S.Ct. ’91) – A statement of opinion, motives or reasons is
not actionable just because a shareholder did not believe
what the board said. Shareholder must prove:
 Speaker believes his opinion to be correct and
 Speaker has some basis for making it or Speaker
knows of nothing contradicting it.
(ii) An opinion by the Board must both misstate the board’s true
beliefs and mislead about the subject matter of the
statement, such as the value of the shares in a merger.
f. Materiality– The challenged misrepresentation must be “with
respect to a material fact.”
g. Culpability – Scienter is not required.
h. Reliance – Complaining shareholders do not need to show they
actually read and relied on the alleged misstatement.
i. Causation – Federal courts require that the challenged
transaction have caused harm to the shareholder. (Virginia
Bankshares)
(i) Loss causation: Easy to show if shareholders of the
acquired company claim the merger price was less than
what their shares were worth.
(ii) Transaction causation – No recovery if the transaction did
not depend on the shareholder vote.
j. Prospective or retrospective relief – Federal courts can enjoin
the voting of proxies obtained through proxy fraud, enjoin the
shareholders’ meeting, rescind the transaction or award
damages.
k. Attorney fees – Attorneys’ fees available under Mills (S.Ct.).
(11) Stahl v. Girbralter Financial Corporation (KRB, 537–40) –
Shareholders who do not vote their proxies in reliance on alleged
misstatements have standing to sue under SEC §14(a), both before and
after the vote is taken.
D. Shareholder Proposals
(12) Rule 14a-8 Procedures

a. Any shareholder who has owned 1% or $2,000 worth of a public

company’s shares for at least one year may submit a proposal.
b. The Proposal must be in the form of a resolution that the
shareholder intends to introduce at the shareholder’s meeting.
c. If management decides to exclude the submitted proposal, it
must give the submitting shareholder a chance to correct
deficiencies.
(i) Management must also file its reasons with the SEC for
review.
d. NY City Employees’ Retirement Sys. V. Dole Food Co. (KRB,
547–52) (2d Cir ’95) – The SEC can reinterpret the rule without
formal rulemaking proceeding, but corporations can only omit
shareholder proposals from proxy materials if the proposal falls
within an exception listed in Rule 14(a)–8(c).
(13) Proper Proposals
a. Proposals inconsistent with centralized management –
Interference with traditional structure of corporate governance.
(i) Not a proper subject – Where a proposal is not a proper
subject for shareholder action under state law, it can be
excluded. 14a-18(i)(1)
 Auer v. Dressel (Supp. 44) (NY 1954) – Shareholders
could properly make a nonbinding recommendation that
the corporation’s former president be reinstated, even
though the recommendation had no binding effect on the
board.
(ii) Not significantly related – Where proposal doesn’t relate to
the company’s business. 14a-8(i)(5)
 Lovenheim v. Iroquois Brands, Ltd. (KRB, 542–46)
(DDC) – Holding to be “significantly related” a resolution
calling for report to shareholders on forced geese
feeding even though the company lost money on goose
pate sales, which accounted for less than .05% of
revenues.
(iii) Not part of co’s ordinary business operations
 Austin v. Consolidated Edison Co. of NY (KRB, 552–
54) – (SDNY ’92) In attempting to exclude a shareholder
proposal from its proxy materials, the burden of proof is
on the corporation to demonstrate whether the proposal
relates to the ordinary business operations of the
company. Since here, there is an SEC stance of no
enforcement with respect to exclusion of pension
proposals from a company’s proxy materials, summary
judgment granted.
(iv) Proposals relating to the specific amt of dividends –
Recognizing the fundamental feature of U.S. corporate law
that the Board had discretion to declare dividends, without
shareholder initiative or approval.
b. Proposals that interfere with management’s proxy
solicitation
(i) Election – Proposals relating to the election of
directors/officers
(ii) Direct conflict – Proposals that “directly conflict” with
management proposals

(iii) Duplicative - Proposals that duplicate another shareholder

proposal that will be included
(iv) Recidivist – Proposals that are recidivist and failed in the
past.
c. Proposals that are illegal, deceptive, or confused
(i) Violation of law
(ii) Personal grievance
(iii) Out of power – Proposals dealing with matters beyond
corporation’s power to effectuate
(iv) Mootness – If co. is already doing what shareholders want.
E. Shareholder Inspection Rights Cases
Crane v. Anaconda
(a) Facts: Crane made a tender offer for Anaconda stock offering Corporate debt.
Upon acquiring 11% of the firm, Crane requested a copy of the
Shareholder list under state Corporate law. Corporation denied the list
alleging the requirements of the statute had not been met. Crane sued
and lost but was reversed on appeal and affirmed.
(b) Analysis: The court rejected the Corporation’s argument that the request was
not related to the business of the firm, because the transfer of effective
control will have a substantial effect on firm profitability and therefore
impacts all Shareholder’s welfare.
1. The statute was liberally construed based on an interest in Shareholder
welfare with respect to the value of the stock when a buy out is
attempted.
(c) Class: this is NY Law; it is all about what the s/h list will be used for. §1315
provides access to s/h list under NY law. NY law says you can refuse
the s/h list if you refuse to sign and 157avourabl saying you want the
list for purposes other than s/h interst.
1. Court sayst that trying to take control of a company is part of company
business.
Pillsbury v. Honeywell
(d) Facts: Shareholder was a member of an anti-war group that purchased stock
in the Corporation for the purpose to oppose the manufacturing by the
Corporation of fragmentation bombs. Shareholder requested access to
Shareholder lists and Corporate records. Corporation refused the
request, and the Shareholder sued. Trial court held for the Corporation
and was affirmed.
(e) Analysis: Shareholder purpose must be germane to their interest as
Shareholders, and these interest are not moral, they are based on
profit.
1. The court viewed the power of inspection as similar to a weapon of
Corporate warfare, and only Shareholders with a proper interest (i.e.
the benefit of the Corporation itself) should be able to exercise that
power.
(f) Alternatives for Shareholders:
1. Be more choosy in their investments, and only invest in Corporations that
adhere to certain moral values

XVIII. PROBLEMS OF CONTROL
A. Shareholders Voting Control
Stroh v. Blackhawk Holding Corp. (Ill. SC 1971) p.592 5/20/04

(2) All stock must have some voting rights
Corporation issues Class A and Class B shares. Both classes carry same voting
power. Class have claims on assets and dividends and have a real price, Class B
shares sell for a quarter and don’t have any rights to dividends or assets in
liquidation. In fact, they are used by the founders to maintain control over the
company.
Pursuant to the “freedom of contract” idea, the proprietary rights conferred by the
ownership of stock may consist of one or more of the rights to participate
(1) In the control of the corporation,
(2) In its profits, and
(3) In the distribution of its assets.
Under the Illinois Laws, the rights to earnings and the rights to assets – the
economic rights – may be removed and eliminated from the other attributes of a
share of stock.
A Corporation may prescribe whatever restrictions it deems necessary in regard to
the issuance of stock, provided that it does not limit or negate the voting power of
any share.
Minority decision: What remains then is a disembodied right to manage the
assets of a corporation, divorced from any financial interest in those assets
except such as may accrue from the power to manage them. What is left after the
economic rights are removed is not a share of corporate stock under the laws of
Illinois.
Epstein: It would be simpler to have non-voting shares: Freedom of Contract. You
could also set up some favorable treatment for non-voting shares like preference on
liquidation and dividends.
Providence & Worcestor Co v. Baker - Corporate Charter laissez faire.

The greater the number of shares you buy, the less each of those shares may vote.
If you acquire 28% of the shares you get 3% of the votes.
Company can structure itself to be practically takeover proof. So long as there is
disclosure everything is OK.
B. Controlling Shareholders/Transfer of Control
If a single shareholder or group of shareholders acting together controls the corporations, it

means that they have control over most shareholder decisions, including the selection of the
directors. Control is always established if a shareholder owns 51% or more of the voting shares.
However, owning less than a majority may also provide a shareholder with de facto or so-called
working control if there are no other shareholders with a significant ownership interest. This is
particularly true in large publicly traded corporations with a large number of shareholders and a
lack of concentrated ownership. The percentage needed to have this control will depend on a
number of factors including how widely dispersed are the other shareholders.

There are both advantages and risks for shareholders in a corporation with a control group. The
advantage is that the control group will closely monitor the managers to assure that they are
running the business effectively. Therefore, agency costs may be reduced. The risks are that
there might be conflicts of interest between the controlling and the minority shareholders. Many of
the controlling devices existing when there is a separation of ownership and control are not
available when there is a control bloc. The possibility of proxy fights or hostile takeovers is
diminished. Moreover, the directors may not be independent of the controlling group. Therefore,
the minority shareholders must rely more on disclosure and fiduciary duty rules.
Controlling shareholders owe a duty of loyalty to the minority shareholders. Therefore, they must
prove intrinsic fairness whenever a conflict of interest arises (Zahn and Sinclair; above under
“Duty of Loyalty).
1. Transfer of Control Context

Shares sufficient to grant someone control of the corporation are worth more per share than other
shares - control premium. Why is that so? The usual presumption is that someone wants to
acquire the majority because he thinks that he can run the business more efficiently and,
therefore, increase its value. However, generally, any benefit from the improvement of the value
of the company is shared between the majority and the minority shareholders. Thus, the majority
shareholders will often be inclined to take advantage of their control position and benefit
privately through self dealing (e.g. increase in the compensation paid for manager when the
manager is the majority shareholder himself), because by this way the majority takes advantage
of 100% of the benefit and not only a part of it. This leads us to the understanding that a main risk
associated with buying the control for a big premium is actually to take advantage of private
benefits to the detriment of the minority shareholders. (N.B.: Why did the purchaser not simply
buy all the shares of the company and take legally all the benefit this way? He may have
insufficient funds to buy the whole outstanding shares, or may want to divide it into two steps, and
only when it feels that it actually can increase the value, it buys the rest of the shares, taking
advantage of information asymmetry)
Sale of control raises the issue of whether a rule of equal treatment of the shareholders should
be a goal of corporate law. A response to the problem could be to require buyers to give the
minority an equal opportunity to either buy the shares pro rata or to buy 100% of the shares. But
a requirement of equal opportunity would make acquisitions more difficult and more
expensive.
C. General authorization of transfer of control, except fraud, bad faith or

looting:
Zetlin v. Hanson Holdings (NY Ct. App. 1979) p.700

Absent looting (=pillage) of corporate assets, conversion of a corporate
opportunity, fraud, or other acts of bad faith, a controlling shareholder is free to
sell, and a purchaser is free to buy, that controlling interest at a premium
price (Control Premium is OK).
The plaintiff’s contention would have required essentially that a controlling
interest be transferred only by means of an offer to all stockholders, i.e. a tender
offer. The NY Court of Appeals declared that this would be contrary to existing
law and that the legislature is best suited to make radical changes.
Example for looting: paying $ 2 for shares worth $ 0,06 in order to “steal” the
assets of the corporation

Frandsen v. Jensen-Sundquist Agency (7th Cir. 1986) p.695

Frandsen, a minority shareholder, had a right of first refusal to buy the shares of
the Jensen Family majority bloc if they were ever offered to sell its shares. When
first Wisconsin negotiated with a view to acquire one of the assets of the
corporation, Frandsen tried to exercise his right.
The court held that in a transfer of control of a company, the right of first refusal to
buy shares at the offer price is to be interpreted narrowly. A sale of assets is
different from the purchase of shares. It was a take me along agreement so that
he doesn’t lose the control premium. Posner took a contractrarian approach;
“you made your bed, now lie in it.” He could have put a merger clause into his
contract, enjoining any merger without first allowing him to execute the merger at
the offer price. Epstein says this is form over substance.
N.B.: Right of first refusal discourages other bidders because you can always
be outbid. The outsider can value the assets and the holder of the right can
simply freeride on that and make a slightly higher offer because he didn’t have to
spend money valuing the assets. (Exception: company-specific synergies can
make the value to an outside buyer higher than that for an inside buyer). Deal
was restructured to avoid Frandsen’s right of first refusal. Frandsen should have
tried to write as broad a right of first refusal as possible.
D. Limitation on transfers of control involving sacrifice of some of the

corporation’s assets
Perlman v. Feldman (2nd Cir. 1955) p.703

Perlman controls 37% of a Newport Steel Corporation, a steel business during
the steel shortages of the Korean War. Perlman sells his control block to Wilport,
a syndicate of steel customers at a large premium. The syndicate members had
previously issued interest free loans to Newport and other steel companies for
160avourable treatment. Now that Wilport owns a controlling interest, it needn’t
offer this perk to Newport anymore
Directors and dominant shareholders stand in a fiduciary relationship to the
corporation and to the minority shareholders as beneficiaries thereof.
Therefore, the fiduciary should account for his gains when the sale of a
controlling block of stocks to outsiders results:
(1) In a sacrifice of an element of corporate good will, and
(2) Consequent unusual profits to the fiduciary who has caused the sacrifice
Epstein: Two possible outcomes: Wilport decides to stop the interest free
loans in which case the shares of Newport won’t be worth as much, or
Wilport decides to continue the loans with Newport and everyone is
happy.
Remedy: Tragedy is that the remedy in a derivative suit pays damages
back into the corporate coffers, so that Wilport gets much of the damages
back. Here, Plaintiff recovered for his own right, not derivatively p. 686.
Best to wait and see if the loans continue. If yes, you are fine, if no, you
can still sue.
(even though these interest free loans are “unpatriotic” and “unethical”
they are still a corporate opportunity which cannot be squandered)

E. Limitation On Transfers Of Control Made Without Any Compelling

Business Purpose At The Expense Of The Minority
Jones v. H.F. Ahmanson & Company (1969) p.125

Majority shareholders tried to create a new corporation that would make it more
marketable to investors, but exclude the minority shareholders
The court indicated that there was a comprehensive rule of good faith and
inherent fairness to the minority in any transaction where control of the
corporation is material. Absent compelling business purpose, majority
shareholders cannot obtain an advantage unavailable to the minority
shareholders.
There were alternative methods for making more marketable corporation while
still being fair to everyone.
Note: very broad statement pro fiduciary duty in control transactions; could be
viewed in a more limited fashion because corporation could be seen as a close
corporation (see below). Epstein didn’t like the outcome.
F. Illegal Sale of Office without Sale of Control
When a sale of control takes place, the directors usually resign and select the designated
nominees of the purchaser to replace them as directors. While the purchaser could arrange for a
shareholder vote, they prefer to act quickly and without the expense.
Note: Someone purchasing a control premium should be able to put his ideas into place asap
rather than sitting around waiting for the next round of elections. It makes no sense to have
directors who no longer hold shares and have no interest in the company. Payment of a control
premium implies confidence that he can do better than a premium.
These resignations raise an issue of whether an illegal sale of office has occurred. Courts
recognize the reality that if the purchaser has actual or de facto control the replacements are
legitimate. The problem occurs when the purchaser buys less than 51%. At what point does the
ownership interest assure that if there is an election they will be able to replace the directors?
General rule: controlling s/h as holder of management control cannot benefit from selling
such control to the detriment of minority s/h
Essex v. Yates (Supp-17; 2nd Cir. 1962):

P K’ed to purchase D’s controlling interest in corp for premium price on condition that
corp’s Directors would immediately resign and P would choose new ones; D
refused to complete tx, claiming as a defense to P’s charge of breach that the tx
would be illegal
analysis: court initially observes it is illegal to sell corp office, but not illegal to sell
shares, and not illegal to sell controlling interest which would allow purchaser
to reappoint Directors … only question remaining is if it is injurious to minority
s/h or public policy to accelerate the process of reappointment: court says no
—an immediate change of control may in fact benefit the corp by avoiding the
possibility that holdover Directors, if not supportive of the change, engage in
conduct that might injure the corp before they’re ousted
tougher Q is if the legality of sale of office if transfer of ownership is < 50%
Lumbard: it’s legal unless person attacking tx can show that purchasing
s/h would not have been able to elect board majority

Friendly: not legal … in such a case, purchasing s/h should have to call
s/h meeting and elect board majority
Epstein: what if he’s only selling 3% of the corporate stock with the same idea of
control of the board. It’s not only about having 51% to have control. With
control you may be able to transfer control of the board.
Under Friendly, you’d need at least 50% of the shares so that the change
in board would be a „mere formality.“
Under Lumbard it would be ok unless the person protesting could prove
that the purchasing s/h would not be able to elect a board
majority.
Essex Universal Corp. V. Yates p. 707

In Essex, a 28% seller attempted to get out of the contract for sale (the price of
the shares had increased) claiming that a provision in the contract calling for
replacement of the directors was illegal.
The court rejected the argument that there was no sale of control. It held that in a
publicly traded corporation a 28% ownership was a practical certainty of control
which the seller could try to rebut. Control premium is not only about selling stock
at a higher price.
G. Control Problems in Close Corporations

1/12/2005
The main problem of the close corporation is illiquidity and exploitation. In the standard model,
a majority of shares elects the directors, may amend the articles of incorporation, sells the assets,
or merges the corporation with another entity. In a corporation with a market for its shares,
shareholders who are dissatisfied with the decisions made by the majority may vote with their feet
– by simply selling their shares. In the closely held corporation, however, they are not able to do
so. The second half of the problem is that the majority, knowing of the minority’s illiquidity, may
attempt to exploit the minority. They may do so by excessive salaries for themselves and family
members, generous perquisites, denial of dividends, or denial of minority voice in governance.
 Concerns about the ability of new sh to participate in growing the corp: do they
have enough $ to contribute?
 Liquidity is always an issue
 Balancing needs of different SH
 “Partnership Happens” but it is much better to have an express, written
agreement delineating the intent of the parties. So, you must decide to what
extent you will allow free transferability of shares.
 How would you balance the concerns of the SH?
 Right of first refusal to buy shares is one solution
 Could also just prohibit sale of shares to outsiders
• But that would be a severe restriction on transferability; not as
important for tax purposes any more now that IRS has the
“check the box” approach to choosing between partnership and
corporate tax treatment
 Could say “no sale without consent which will not be unreasonable
withheld.”
 Different classes of stock (voting vs. non-voting); could be useful for maintaining
control or for estate planning purposes.
Remember the Knipprath Analysis:
 Liability
 Management

 Existence
 Transferability
Solutions for the close corporation problems:
- ex ante by contractual provisions: voting and pooling agreements, irrevocable proxies,
voting
trusts, class voting, cumulative voting
- ex post by special legal remedies: heightened fiduciary duties among shareholders
similar
to those among partners
H. Ex Ante Solutions: Contractual Provisions/Agreements

Shareholder agreements regarding the transfer of shares, voting rights, and election of directors
are necessary for shareholders in close corporations to safeguard their investment.
1. Validity of Voting/Pooling Agreements
Ringling Bros.-Barnum & Bailey v. Ringling (Del. SC 1947) p. 606

In Ringling, two shareholders, each of them holding a minority position in a three
shareholder close corporation, entered into a pooling agreement whereby they would
vote their shares together in order to reach a majority position. If there were a dissent an
arbitrator would decide how to vote. One of the shareholders declined to follow the
arbitrator’s command. The other shareholder sued for specific performance.
The court upheld the agreement. It stated that in a close corporation a group of
shareholders may lawfully contract to vote in any manner they determine. It
refused, however, to grant specific performance, but rather, in a somewhat punitive
manner, threw out all of the votes voted against the arbitrator’s command. There was no
express provision in the agreement about the consequences if one or the other signatory
to the agreement refused to follow the arbitrator’s decision and the court refused to
supply the missing terms.
Party Shares Owned Cumulative 7 Member Board

Shares
Edit R. 315 2205
Aubrey 315 2205
J. North 370 2590
Total 1,000
Edith and Aubrey have a pooling agreement to vote for the same 5 directors of a 7
director board.
If North can come up with 882 shares or more he wins. But he can on I have NO
FUCKING IDEA.
Edith Robt Dunn Aubrey James John Woods Griffin

Edith 882 882 441

1103 1102
John 863 864 863
This was the easieset way to ensure that Robert could be president of Ringling Brothers.
He got it, put up a crappy tent in Connecticut, it burned down, killed a few hundred
people, North went to jail b/c Robert took a powder, but when he got out of the slammer,
John regained control and built the circus up to the current glory and eventually sold the
circus in the 1960’s.
I. Long-Term Shareholder Tenure and Salary Agreements

These agreements, which provide long term job security (tenure) and salary for close
corporations interfere with the standard model of corporate governance by taking control over
certain decisions away from the board of directors.
McQuade v. Stoneham (NY Ct. App. 1934)

Shareholders own everything and have a lot of power; but they cannot
hamstring the Board of Directors in their duty to manage the corporation in
the best interests of the shareholders.
McQuade purchased a 10% interest in a close corporation.
McGraw held also 10%, and Stoneham held 35%. The three
entered into an agreement in two parts: First there was an
agreement to use their best endeavors to elect each other as
directors. Second was an agreement to keep Stoneham in office as
president, Mc Graw as vice president, and McQuade as treasurer.
McQuade and Stoneham quarrelled, primarily over Stoneham’s
repeated invasion of the corporate treasury. Stoneham then caused
McQuade’s ouster as director and officer. McQuade on the
agreement seeking to recover his position.
The court held that the first part of the agreement was valid.
Shareholders may combine to elect directors. Therefore, McQuade
could possibly regain his position as a director. However, as to the
second agreement the court felt that it interfered with “public policy”
of corporate governance. It held that it interfered with the fiduciary
duties of directors to exercise their functions in the best interest of
the corporation. Shareholders may not enter agreements
interfering with the directors’ powers to exercise their
independent judgement in the management of the corporation’s
affairs. A shareholder agreement was held illegal and void so far as
it precludes the board of directors, at risk of incurring legal ability,
from changing officers, salaries or policies or retaining individuals
in office, except by consent of the contracting parties.
N.B.: Courts decline to validate agreements not approved by all the

shareholders in an effect to protect the interests of the minority.

Such a holding is fatal to many close corporation schemes in which

a shareholder invests his money and expects his primary return in a
capacity as officer or employee rather than as investor. The court
began to notice this two years later in
Clark v. Dodge (NY Ct. App. 1936)

If shareholder agreement binds directors judgment to the detriment of other
shareholders, the agreement is not enforceable. The Directors’
independent judgment cannot be limited
Dodge owned 75% of a pharmaceutical company but was inactive in
management. Clark owned the remaining 25%, acted as general manager, and
had sole possession of the formulae for the manufacture of the corporation’s
product. Dodge and Clark then entered into an agreement to keep Clark in office
as director and general manager so long as he should be “faithful, efficient and
competent.” In return, Clark agreed to disclose the formulae to Dodge’s son and
to instruct him in the methods of the manufacture. Then, a dispute arose
between Clark and Dodge and Dodge ousted Clark. Clark sued for reinstatement
both as a director and officer.
The court asked itself if it was bound by McQuade to the doctrine that there may
be no variation to the norm that the business shall be managed by its board of
directors. The court decided that it was not and upheld the agreement. Here
where all shareholders were signatory to the agreement there was no
damage suffered by or threatened to anybody. Moreover, with the
requirement that Clark remain in office only so long as he continued to be faithful,
efficient and competent, any impingement on the statutory norm was slight
and any harm to the creditors was remote.
NEW YORK LAW ON 620 AND DELAWARE GENERAL LAW ON 621 IS ON FINAL
S/H AGREEMENTS OK AS LONG AS DIRECTORS’ INDEPENDENCE NOT IMPAIRED
J. Comprehensive Shareholder Agreements

In Galler the court went even further and upheld a comprehensive contractual arrangement in a
close corporation that handcuffed present and future directors and infringed upon the traditional
prerogatives of directors in many ways.
Galler v. Galler (Ill. SC 1964) p.624

For the provisions of the agreement see: Understanding, p. 276
The court upheld the entire agreement and made a strong statement in favor of
differing judicial treatment of close corporations (Understanding, p. 276f.). It held
that shareholders in a closely held corporation are generally free to contract
regarding the management of the corporation absent the presence of an
objecting minority, and threat of injuring public policy or the creditors. In Galler,
two 47.5% shareholders were signatory to the agreement. Epstein: this
agreement sucks b/c it guarantees that the board will be gridlocked for the
remainder of Emma’s life. Also, Isadore and Aaron will try everything they can to
pull cash out of the company since they know that Emma will never vote to give
them another dime. Isadore fucked up by buying out Rosenberg; he should have
used Rosenberg to assert a minority s/h complaint which would have changed
the Court’s decision which was based on the fact that there was no minority s/h
complaint.
a. Galler v. Galler (1964), 624

i. Facts: 2 bros own drug company; they enter into a SH agreement, which says
each family gets 2 board seats, mandated dividends and mandated benefits; one
bro dies, and the other refuses to perform the agreement; wife sues to enforce
agreement
ii. Holding: agreement was valid, and unanimity not required if:
1. corp is closely held
2. minority SH doesn’t object
3. terms are reasonable
iii. Remedy: I and R must account, and presumably pay to Emma back dividends
1. they could’ve had a provision that would allow surviving bro buy out
deceased bro’s share; way of creating separation in the corp when
somebody dies (b/c even though two people might be able to work
together, their families may not)
2. Or life insurance policy (keyman insurance) to pay off Emma.
b. Ramos v. Estrada
i. FACTS: A merger between two Spanish language TV stations (so they could get
a hard to obtain FCC license) resulted in a merger agreement in which the two
groups of shareholders would vote for directors which the majority had agreed to.
The Estrades missed a meeting, were not elected and refused to recognize the
agreement.
ii. HELD: The Estrada’s violated the valid pooling agreement. They were
sophisticated business people who knew the arrangement they were getting into.
Their actions constituted an election to sell their shares but since the stock is that
of a closed corp. and is therefore not marketable specific performance (votes
cancelled) is ordered.
Ramos v. Estrada (1992), 632

iii. Possible black-letter rule:
1. you can agree about how you’ll vote as SHs, but
2. you can’t agree about how you’ll vote as directors
a. unless we have closely held corp and the agreement is signed
by all the SHs (and perhaps, when the nonsigning minority
SHs cannot or do not object)
• CA rule – shareholder can K to limit the discretion of the dirs., but it
must be a unanimous K, and shareholders still owe each other fiduciary
duties
• Shareholders in a closely-held corp. are free to K regarding the
management of the corp., absent the presence of an objecting minority,
and a threat of public injury – Galler (family with a K that they serve as
officers and dirs. indefinitely)
- The general rule is that majority shareholders in a corp. have the
right to select its managers
- But shareholders’ interests in a closely-held corp. must be
distinguished from those in a closely held corp.
- The shareholder in a closely-held corp. is in greater need of
protection of his investment, since he does not have the option of
selling his shares on the open market
- Moreover, shareholders in a closely-held corp. often serve as its
dirs. and officers
- Consequently, such shareholder agreements are the result of
informed decisions, and the safeguards afforded shareholders in a
publicly held corp. do not apply
- There is no reason to extend the durational limits imposed on
voting trusts to a straight voting control agreement in the absence of
fraud or disadvantage to minority interests
- The purpose of a K to provide for maintenance and support of
the families of the shareholders in a closely-held corp. is a valid

purpose and provisions for minimum earned surplus req’t and salary
continuation are valid means of protecting a corp.’s interests
- This K was not a unanimous one but there were no objecting
shareholders
- A minority shareholder must protest and show injury in order to
void this K
1. Summary of rules from Clark, Galler, and McQuade

- If a non-unanimous group of shareholders get
together, they can have a vote pooling agreement to
elect themselves to the bd. of dirs.; this is enforceable
- It will be unenforceable to, as directors, K to appoint
themselves as officers or set salaries (unless the K is
unanimous, and no one hurt or no minority shareholders
complain) You can tie the board’s hands if you are the
board and if no one else cares.
• Voting agreements binding individual shareholders to vote in
concurrence with the majority constitute valid Ks – Ramos v. Estrada
(TV station case; ∆ breached voting K in anticipation of a voting conflict)
- Voting agreements are valid even if it is not a closely-
held corp.
- Non unanimous K that penalized dirs. for not voting in
accordance with the other parties to the K
- So you aren’t forced to vote a certain way, you’re just
penalized if you don’t
- Ct. upheld the K
- This is an example of how to get around the get
around the McQuade rule.
- Epstein: she should have voted with the rest of the group to take
her off the board; then she would not have had the breach. She
breached the shareholder agreement. For Television Inc., she voted
her conscience.
- Using the broadcast group pooling agreeement against her for
something she did in Television Inc., another corporation is OK.
K. Ex Post Solutions: Heightened Fiduciary Duties among Shareholders
Wilkes v. Springside Nursing Home (Mass. Sup. Jud. Ct. 1976)

A real estate investor brought together three other individuals to acquire a
building that had formerly been a hospital, converting it into a nursing home
facility. Each shareholder made an identical capital contribution. Each was to be
a director and an officer. Each was to receive money from the corporation in
equal amounts as long as each assumed an active and ongoing responsibility for
the company’s business. Last of all, each was apportioned an area of exclusive
jurisdiction, according to their talent and inclination.
After the business had run successful for a number of years, One investor,
Quinn, wished to purchase a portion of the unused corporate real property.
Wilkes, another investor, however, prevailed on the other shareholders to force

Quinn to pay a higher price than Quinn had anticipated. Bad blood developed.
Quinn then persuaded the other shareholders to freeze Wilkes out of active
participation in the business and to cut off payments to him. They removed
Wilkes from the board and from his officer position, and eliminated his salary as
an employee-manager. Wilkes sued for reinstatement.
The court ruled in favor of Wilkes.
1. Heightened fiduciary duty among shareholders

Unlike ordinary shareholders in a public corporation stockholders of a closely
held corporation owe to one another substantially the same fiduciary duty in the
operation of the enterprise that partners owe one to another. We have defined
the standard of duty owed by partners to one another as the utmost good faith
and loyalty. Stockholders in close corporations must discharge their
management and stockholder responsibilities in conformity with this strict good
faith standard. They may not act out of avarice, expediency or self-interest in
derogation of their duty of loyalty to the other stockholders and to the corporation.
(Donague v. Rodd Electrotype 1975)
L. Wilkes Doctrine
1. S/H in closely held Corp owe each other a duty of strict good faith
2. If challenged by a minority s/h the controlling group must show a legitimate
business objective for its action
3. A π minority s/h can nonetheless prevail if it can show that the controlling
group could have achieved its goal in a manner less harmful to the π.
Conflict with majority’s managing powers?

On the other hand, the court was concerned that untempered application of the
strict good faith standard could impose limitations on legitimate actions of the
controlling group in the management of the corporation in the best interests of all
concerned. It therefore held that actions taken by the majority do not violate their
fiduciary duties as long as the controlling group can demonstrate a legitimate
business purpose for its action, the burden of proof being on the majority. If
the majority can demonstrate such a legitimate reason, it is on the minority to
demonstrate that the same legitimate objective could have been achieved
through an alternative course of action less harmful to the minority’s
interests.
Epstein’s commentaries:
• Whenever there is this sort of self-dealing, appraisal is absolutely necessary.
• Even though closely held corporations operate like partnerships, they do not
dissolve like a partnership when one of the partners sues.
• Remedy: The court shouldn’t be in the business of forcing corporations to appoint
officers it doesn’t want.
• Pro-rata salaries being drawn here were clearly dividends in the form of salaries
to avoid double taxation. This sort of arrangement may draw IRS attention.
• Other ways Springside might have been set up:
o Partnership would involve the same fiduciary duties, better tax regime
and when they want to terminate, they just dissolve.
o Joint tenancy – They could have continued on until they wanted and
gotten partition and settlement.
• Wilkes could have brought a derivative suit for over-compensating the other
partners and demanded a dividend.

• The corporate form is a limitation on the alienability of the business and the
flexibility of the owners. Courts should not be in the business of drafting or
imagining provisions for the dissolution of companies, particularly with complex
tax implications involved.
• Courts are worried about a “freeze out” where the minority shareholders in a
closely held corporation get ripped off by the dominant shareholder.
Smith v. Atlantic Properties Inc.

In Smith, by virtue of an 80% vote requirement, a 25% shareholder had a veto
power over certain transactions.
The heightened fiduciary duties cut both ways, not only in the relationship
from the majority to the minority, but also vice versa. Therefore, the minority
shareholder could not unreasonably withhold his consent. Doing so made him
liable for damages to the corporation that had resulted from his exercise of the
veto power based solely on personal tax considerations.
Ingle v. Glamore Motor Sales (NY Ct. App. 1989)

Ingle dealt with the potential conflict between the heightened fiduciary duties
akin to partners and the employment-at-will doctrine. This conflict arises
when a shareholder-employee in a close corporation has been dismissed. Under
the employment- at-will doctrine, absent a contract, an employee is an employee-
at-will who may be dismissed at any time, with or without cause.
Most courts answered by formally grafting a legitimate business purpose
requirement onto the employment-at-will doctrine in cases in which the
corporation is closely held and the dismissed employee is also a shareholder.
By contrast, the court in Ingle made a distinction between the duty owed by
the corporation to an employee and those owed to a shareholder. It held that
a minority shareholder in a close corporation, by that status alone, who
contractually agrees to the repurchase of his shares upon termination of his
employment for any reason, acquires no right from the corporation or majority
shareholders against at-will discharge.
Epstein: Ingle was primarily an employee; the shares appear to be an
employment perk.
1. Summary
Signs of danger with closed corporation

 Non-pro rata transactions – Pro rata protects you from discrimination claims. Pro rata must apply to
anything that appears to be compensation including salaries, dividends, other benefits, etc. If pro
rata is not possible, all transaction must be for fair market value appraised independently.
 Death of shifting of control – This sort of problem must be planned for and monitored. Family ties
weaken from the first generation. There are more shareholders in the second generation. Members
of the second generation may be idiots - Death and control shifts must be planned and provided
for.
 Outsider entering a family business as an owner – Trouble for the outsider.
 Difference in wealth – Different risk and tax strategies may lead to conflicts between the parties.
Possible Solutions to closed corporation problems (Epstein)

Contractual
Tax – Pay pro rata salaries and dividends, but keep in mind that minimal dividends and
large pro rata salaries may be treated as dividends.

Estate Tax – Shares are assets which are taxed. Option is a buyback, selling to outsiders,
planning in advance, life insurance policies, or advance plans for power shifts.
Business Side – buyouts
What triggers buyouts – death, decision to leave.
Does the corporation buy or do the other shareholders buy.
Corporation will make things run more smoothly and not upset balances of power.
Best solution for buyout is arbitration; use some formula of multiples of something.
Dividend regulations –
Dividends are paid when a certain amount of income is paid.
Different classes of stock, some with lower risk
Separate attorneys for all members of the family
Solutions by law.
Appraisal remedy is typically only available for fraud and deception.
Forced sales even when legally feasible are not desirable.
Business judgment shields most business decisions including dividends (exception Smith)
and hiring.
M. ABUSE OF CONTROL IN CLOSELY HELD CORPORATIONS

1. Employment Context:
Wilkes v. Springside Nursing Home, Inc. (KRB, 612–18) (Mass. ’76)

– In a closely held corporation, the majority stockholders have a duty to deal with
the minority in accordance with a good faith standard. The burden of proof is on
the majority to show a legitimate purpose for its decision related to the operation
of the business.
a. Note: Shareholders in a closely held corporation are held to a
similar standard as required between partners.
Ingle v. Glamore Motor Sales, Inc. (KRB, 619–25) (NY ’89)

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
termination of his employment. A court must distinguish between the fiduciary
duties owed by a corporation to a minority shareholder, as such, in contrast to its
duties owed to him as an employee.
N. Squeeze-out Merger
Sugarman v. Sugarman (KRB, 625–29) (1st Cir. ’86)

Shareholders in a close corporation owe one another a fiduciary duty of utmost
good faith and loyalty. Majority shareholder received excess compensation
which was designed to freeze-out the minority shareholders from the co.’s
benefits. Further, given the lowball price offered for the minority shares, there
was evidence of freeze-out. Court says minority s/h can’t invoke Wilkes just for
offer to buy out; it’s the totality of the circumstances.
O. Control of the corporation
Smith v. Atlantic Properties, Inc. (KRB, 629–34) (Mass ’81)

Stockholders in a close corporation owe one another the same fiduciary duty in
the operation of the enterprise that partners owe one another.

1. Disclosure Rules
**Jordan v. Duff & Phelps, Inc. (KRB, 660) (7th Cir. ’87)
Close corporations buying their own stock have a fiduciary duty to disclose
material facts. Where π sold his stock in ignorance of facts that would have
established a higher value, failure to disclose an important beneficent event is a
violation even if things later go sour. A π must establish that, upon learning of
merger negotiations, he would not have changed jobs, stayed for another year,
and finally received payment from the leveraged buyout. A jury was entitled to
conclude that the π would have stuck around. This case is sort of the inverse of
Page v. Page, the linen supply case in partnership. In that case, the Court relied
on an the at will employment nature to rule that his brother could dissolve the
partnership. **Epstein loves this case. Another „The perfect Storm“.
(2) Epstein: It’s Wilkes duties + 10(b)(5) duties all combined in a closely
combined corporation. So Jordan sues under 10(b)(5) saying that he
would not have sold back his shares had he known of the merger talks.
Jordan was an „“at will“ employee and could be fired at any time and be
forced to sell back his shares.
(3) Franchik resolution to keep shares for 5 years dealt w/ an employee
who was fired.
(4) TSC Industries Inc. Is the default materiality case. Ex Ante does not
count. Materiality is not measured ex ante. Rationale is just like the
Palmer v. Medtest case. But why should this not be material? Because
the value of the stock wasn’t tied to his leaving. Presumably if he’d
known of the planned sale, he would not have quit. But it won’t make
much difference because the buy back clause only entitles him to book
value as of 12/31. So he presumably would not have reaped any
windfall. So, Epstein says it’s still material, because it might have
changed his decision; but he would not have gained anything more.
(5) Easterbrook v Posner:
a. Easterbrook: abstain or disclose – see Texas Gulf Sulphur.
Applies whenever a s/h can respond. Jordan might have
changed his mind if he’d known. Wilkes like duties would have
prevented Phelps from firing Jordan if he decided to stay.
Therefore the 10(b)(5) rule required Phelps to disclose.
b. Posner: 10(b)(5) doesn’t apply because there was a
stockholder agreement. That agreement gave Jordan no rights.
He was an at will employee. That trumps any Wilkes duties.
Just like Ingal v Glamor. If they wanted to fire him they could
have. Posner says why should Phelps be penalized for being
nice to the guy and letting him work through the end of the year?
Besides, he could not have used the information.
c.

XIX. COUNTERMEASURES – CONTROL, DURATION &

STATUTORY DISSOLUTION
A. Constructive Dividends as an Equitable Remedy
Alaska Plastics, Inc. v. Coppock (KRB, 673) (Alaska ’80)
Majority shareholders in a closely held corporation owe a fiduciary duty of
utmost good faith and loyalty to minority shareholders. Although there is no
authority allowing a court to order specific performance based on an unaccepted
offer, where payments were made to directors and personal expense paid for
wives, they could be characterized as constructive dividends.
(1) Mrs. Muir wants statutory dissolution; but the appellate Court thinks she
has not met that burden of proof. However, there was an issue with
inequitable distribution of dividends.
(2) Court outlines 4 ways for s/h in a close corp to recover:
a. Articles of Incorporation specifically state remedy;
b. S/H may petition for involuntary dissolution
c. Statutory right of appraisal: applicable if significant change in
corporate structure, such as merger
d. Court has equitable power to order share purchase upon finding
of a breach of a fiduciary duty between directors and s/h and the
corporation or other s/h.
(3) §1800 of California Code; see Meiselman, infra.
B. Statutory Dissolution
Meiselman v. Meiselman (KRB, 680) (NC ’83)

Minority brother (π ) shareholder sued his brother after he was fired and lost his
salary/benefits. π invoked a NC statute allowing a court to order dissolution
where such relief is “reasonably necessary” to protect a complaining shareholder,
or alternatively order a buy-out of the π ’s shares. Held: At least in close
corporations, a complaining shareholder need not establish oppressive or
fraudulent conduct by the controlling shareholders. Rights and interests, under
the statute, include reasonable expectations, including those that the minority
shareholder will participate in the management of the business or be employed
obey the company – as long as they were embodied in express or implied
understandings among the participants.
Pedro v. Pedro (682; Minn. 1992)

(a) Facts:
(1) 3 bros started corp; s/h agreement included buyback
provision that set effectively buyback price at 75% of FMV
(2) after proceeding profitably for years one bro discovered
a $330K discrepancy in the books and was told to forget about it
or be fired; he insisted, and was fired
(3) ousted bro filed dissolution action
(4) TC awarded bro various damages aggregating ~$2M,
which included, based on a finding of breach of fiduciary duty,
$560K as the discrepancy b/w the s/h agreement buyback terms
($770K) and the FMV of the shares ($1.33M)
(b) Analysis

(1) Minn. statute allows for buyout in lieu of dissolution, but

this route would have led to damages as limited by the s/h
agreement Ex ante calculation of share value is allowed but not
granted here because of the unfair way he was treated.
(2) instead, breach analysis under the statute allowed
circumvention of the extant buyback provision upon finding of
unreasonable action—court seems really peeved in this case and
wants to award bro as much as possible for being axed for
whistleblowing
(c) Class
(3) what should he have gotten? Well, if it were a derivative
suit, he would have sued to have the stolen funds returned to the
corp. He would then get his share of the stolen money + the
buyout as per his agreement. The Court went beyond that and
took an aggressive stance.
Stuparich v. Harbor Furniture (688; Cal. 2000)

(a) facts:
(1) Siblings Malcolm Jr., Candi and Ann owned equal
amounts of HFM’s non-voting shares, but Malcolm owned a
majority of the voting shares. Malcolm, his wife and son worked in
HFM (no claim of excessive salaries), while Candi and Ann did
not.
(2) HFM had a profitable mobile home park, and an
unprofitable furniture business. The sisters wanted to separate
the two parts of the business, the brother disagreed.
(3) At a family event at the home of the father (Malcolm Sr.),
Malcolm and Candi had an altercation that resulted in physical
injuries to Candi (the fight may have been over the
sisters’unsuccessful attempt to impose an involuntary
conservatorship on their father). Police arrived, but no charges
were pressed.
(4) The sisters sued for dissolution. The California statute
states that in close corporations (<35 SH) dissolution may be
granted if it is “reasonably necessary for the protection of the
rights or interests of the complaining [SH]”.
(b) analysis
(1) The court refuses to grant summary judgment for the
sisters. The evidence they cited indicate no abuse by Malcolm.
The fight was not related to the management of the corporation.
The existence of ill will between the SH, in itself, is insufficient
grounds for dissolution.
(2) Court may have suspected that the suit for dissolution is
being used opportunistically to pressure Malcolm.
(3) In Stumpf v. C.E. Stumpf, the Court did allow
dissolution, but in that case the family member getting screwed
was not being paid his fair share. Also, the sisters in this case
never went to the board meetings. Epstein thinks this is
important. Similarly, in Bauer v. Bauer, the Court did not allow
dissolution because the minority s/h went into direct competition
with the company. See Prentiss v. Sheffel.

XX. MERGERS AND ACQUISITIONS
1. Proper motivation:
increasing overall firm value: 3 + 4 = > 7
2. Improper motivations:
- justify higher management’s compensation through expansion
- satisfy management’s ego
- control group tries to take advantage of its position by engaging in self
dealing and by acquiring another firm under its control at an unfair price
A. Mergers 1/26/2005
3. Statutory Merger
AInc. Acquires BInc. by BInc. merging into AInc.; BInc. loses its existence
drafting of a plan of merger which is approved initially by boards of directors of both
companies, followed by a vote of both shareholder bodies
Knipprath: basic exchange of stock. Alpha and Beta trade stock. It is a negotiated
deal between management of the two companies.
The survival of Alpha and the liquidation of Beta is planned in the deal. The Beta shares
cancel out and the Beta SH are now Alpha SH. Alpha has assumed both assets and
liabilities, including contingent liabilities.
Beta SH are the most drastically affected; they are now in the hands of Alpha. How can
they be forced to do this? Easy. Management of Alpha and Beta entered into a contract.
As compared to a tender offer which requires each SH to vote, a statutory merger
involves a management contract which is binding upon the SH; it’s not up to each SH to
decide whether they want in or out. The merger binds all SH. Injunctive relief to
dissenting SH is unlikely b/c they can always just sell and cash out. So, even if some SH
dissent, the merger is final if the majority consents.
While there is some argument that Alpha is the surviving corporation so their SH don’t
need to vote, the general rule is that they do get to vote. SH of both corporations get to
vote on the merger. Alpha SH right to vote goes back to the preemptive rights
argument; trying to protect their % of ownership.
If the merger involves an issuance of new stock the Alpha SH would have to vote
anyway.
Appraisal remedy: FMV of stock determined by arbitration or judicial decision.
Based on FMV immediately before the merger.
No factoring in of the control value: the minority SH don’t get extra $ just cuz they don’t
have control.
Assuming that the proportionate ownership is being reduced, appraisal rights are
something like the flip side or adjunct to the preemptive rights doctrine. Why would you
give appraisal rights to Alpha? There is still a market for their shares and proportional
ownership is not really a big issue in corporate law today. So, Knipprath says, in the
absence of fraud or other breach of fiduciary duty of the Board, there isn’t a reason for
appraisal rights. Market speculation could affect share price which would mean that
market wouldn’t reflect true fair value. Or, there might not be a market for the shares.
Tender offers usually involve a premium over market. This is b/c the company’s assets
may be undervalued. Could be due to poor management. Example: oil company with
huge untapped reserves not reflected in share price. Other reasons include economies
of scale, synergy, etc. But, in such case, why would you need an appraisal remedy?

Tax law, other regulatory laws must be considered. Securities laws? Yes, a merger is
stock-for-stock and may require issuance of new shares, thereby invoking securities laws.
4. Consolidation
both, AInc. + BInc. merge into a new company = CInc.; both are loosing their separate
existence
5. Triangular Merger (Knipprath says don’t worry about this one)

AInc (=acquiring party) forms a wholly owned subsidiary and BInc merges into that
subsidiary; reason: avoid combining assets, liabilities, etc. esp. if in different businesses
shareholders of AInc have no right to vote on the merger because they are not
shareholders of the subsidiary; solely board of AInc votes
6. Reverse Triangular Merger

AInc forms wholly owned subsidiary that merges into BInc; shares of subsidiary are
converted into shares of BInc; result: BInc = 100% owned by AInc
B. Sale of Assets
A Inc acquires substantially all of the assets of B Inc; BInc may remain in existence as a
holding company or may be liquidated
Under state law usually the boards of both corporations must approve the deal, but
generally only shareholders of B Inc have the right to vote on the sale when it
involves all or substantially all of B Inc’s assets. 1/24/2005: Argument would be that the
sale of all the shares results changes the corporate form; it’s an extraordinary transaction
resulting in dissolution. Argument against treating it as a dissolution and requiring a SH
vote: the company still exists, SH position is unchanged, assets were exchanged for
cash.
What does the raider receive? Assets, inventory, machinery, land, etc. Whatever the
assets are. Intangibles, patents, etc. What do you give? Whatever they’ll take. Cash,
stock, etc. But, could be a note or bond.
SH position is changed -- Acme s/h have changed in relation to Acme. Acme looks
different now. Let’s say ?Acme gets $ for the sale of the assets. Now they can reinvest
that cash into something else; the sh still hold shares in Acme.
X inc  $ to Acme
X sh still have x stock. Acme still has Acme stock
X has stuff. Acme has cash
Acme can go out an dbuy other stuff
They can also pay off debts or pass the $ to the sh with an extraordinary dividend
This is a classic sale of assets and subsequent dissolution.
Purchase of Liabilities
X is not required to buy the liabilities but can if they want to.
You might do this because it could reduce the purchase price.
Contingent Liabilities
Theoretically you don’t buy these
You are just buying assets.
You will pay a higher price if you buy assets only with no liabilities.
Example: X pays $15mm with no liabilities. Acme can use the excess cash to pay off the
creditors. Or X pays $10mm and ACME deals with its liabilities problems

Securities laws: probably don’t apply.

Possible 16b transaction for directors
No 10b because not a sale of securities
If fraud in connection with bond, maybe. Not likely scenario in this class.
If we acquire the assets of Acme by issuing stock, Acme Inc holds shares in X Inc. So
they are stockholders in X. Acme SH hold Acme shares. Acme isn’t doing anything but
holding a bunch of stock. But Acme value is tied to the value of the X stock that they now
are tied to.
SH approval required when new stock is issued. X may issue stock for the acquisition
price in order to make Acme SH happy. The ACME SH now hold stock in X. Acme then
dissolves. X survives.
Look at change in control.
Wednesday, 26 January 2005

EXAM ALERT: ALWAYS LOOK AT SH POSITION BEFORE AND AFTER THE TRANSACTION
Sale of Assets Recap
1. Alpha Inc.  $ to Beta, Inc.
a. Assets and Liabilities still in balance post-transaction
2. Beta, Inc.  $ to SH
a. Beta goes away post-transaction
b. In a stock deal, Beta SH hold Alpha shares; but Beta is still gone
3. Board Approval: Both Boards Must Approve
4. SH Approval - Voting Right: SH approval depends upon state law
a. Strong position that Beta SH must be included due to fundamental
(organic) change in Beta resulting from the transaction.
b. As a general rule, Alpha SH don’t have to vote b/c no change in
their position
i. UNLESS it’s a stock deal which will DILUTE their % of
ownership
5. Appraisal Remedy: Depends on state law
a. Alpha less likely to need an appraisal remedy b/c there is a market
for their share before and after th e transaction.
b. Beta SH - questionable as to what they would gain by an appraisal
remedy b/c they already got $.
i. But if it was a stock deal, they now own stock in Beta which
presumably has readily marketable stock. But, you have to
look at state law.
ii. If State law permit appraisal remedy in a merger, do they
also give it in a merger-like transaction?
1. If so, a stock deal looks more like a merger than does
a cash deal
6. Federal Legal Concerns:
a. Anti Trust: usually no concern in asset sales.
b. Securities Issues: Not likely unless new shares being issued.
c. Tax laws may be an issue

C. Tender Offer/Takeover
AInc makes an offer directly to the shareholders of BInc to buy all their shares. If AInc is
able to buy at least 51% of the shares, AInc will control BInc and BInc will become a
subsidiary of AInc. Target of takeover is usually a publicly traded corporation. Only board
approval of AInc to make the offer is required (see below)
1. Liability Issues
The directors must act in good faith and in an informed manner in making the decision
whether to sell the corporation Otherwise, the directors may breach their fiduciary duty.
Directors defending a hostile tender offer by trying to keep the public shareholders from
responding to the offer can also breach their fiduciary duty.
Acquisitions may involve self dealing when the managers or controlling shareholders
use their power to receive a benefit which excludes the minority
D. Appraisal Remedy
Under state law shareholders who dissent from the merger are granted an appraisal remedy, i. e.
the right to sell their shares back to the corporation at a price determined by the court and
reflecting the fair value of the shares
How to determine value? Delaware approach: market value, net asset value and earnings must
be weighed; and valuation techniques generally acceptable in the financial community
Note: some jurisdictions eliminate the appraisal remedy if the shares trade in the stock market;
Arg: market value substitutes for a judicial valuation
E. Defacto Merger
1/21/2005
It is common law; judge made. Legal appraisal rights result from mergers. Equitable appraisal
rights may be awarded by a Court. See TransAmerica (the tobacco case).
If an acquisition is structured in a way that it tries to preclude shareholders voting/appraisal rights
(e. g. state law provides voting and appraisal only for merger, but not for asset deals):
- some states will look at the substance of the transaction, as opposed to its form, in order to
determine if it is effect a merger with the right of appraisal for the shareholders, i. e. a “defacto
merger”, see: Farris v. Glen Alden
- other states, including Delaware, view each statutory rule as independent from the other;
therefore, an asset deal need only comply with the statutory provisions dealing with asset deals,
even if it looks and smells like a merger; see: Hariton v. Arco Electronics
Farris v Glen Alden Corp (PA 1958) 1/26/2005

List (DE corp) wanted to acquire Glen Alden (PA corp) but not thru statutory merger
because of negative tax consequences. Even though List was 3xs bigger, they decide to
make Glen Alden the surviving corp, which means PA law would apply. Since PA law
requires SH on both sides to vote and have appraisal rights, they do an asset acquisition

instead. List transfers all assets in exchange for Glen stock, List liquidates and Glen is
renamed List Alden. Π (SH Farris) wanted ct to cast this as a de facto merger so that he
could exercise his appraisal rights because he claims his share are being diluted due to
differences in book value (Glen is a losing corp with deb and high book value, while List
is a profitable corp with low book value). But this has nothing to do with real value.
Nonetheless, Ct ignores a statute that says asset acquisition should not be treated
as mergers and Π wins. Ct didn’t like corps trying to evade formalities. After this case
legislature passes another statute to clarify that acquisitions are not mergers.
List did not want to give the appraisal rights. Knipprath says that even if they agree to a
choice-of-law clause, the SH rights are still controlled by state law. In a merger there
would be appraisal rights for GA and probably for List.
PA law provided the appraisal remedy but DE did not. So, if List acquired the assets of
GA, then GA SH would get appraisal rights. Substance over form was Farris’ argument.
Knipprath says the key is that it was all done in a single transaction. In an asset sale,
you have two steps: sale of assets and then either a distribution or liquidation. In this
case, it was all done at once; there was no step two. See page 723 - the legislative
intent was to get rid of this kind of dissent. But the Court said that the Bar Committee
comments were not binding on the Court.
Hariton v Arco Electronics (DE 1963)

The doctrines of merger and asset sales are both statutory and of “equal dignity.”
The form of the transaction should be respected.
Similar fact pattern to Farris, but DE ct recognizes there are differences (especially
legal consequences) between statutory mergers and asset acquisitions/de facto
merger and doesn’t question the corps’ reasons for preferring one to the other. Knipprath
says that if you allow the Board of Hariton the shares, then they always have to worry
about block voting and control issues. The laws are of “equal dignity” there are two
separate statutes -- one for statutory mergers and the other for asset sales. This deal
was subject to approval of Loral SH. Loral can’t be sure of what the Arco SH will do if
they get a separate vote on it. In an asset sale, Loral could not be sure that there would
be a dissolution of Arco and then the whole block vote problem arises.
F. Defacto Non-Merger?
In Rauch v. RCA the plaintiff urged adoption of, and the Delaware court, following its doctrine of
independent legal significance rejected, what might be called a “defacto non-merger doctrine”; the
transaction took the form of a merger but the plaintiff argued that it was in substance a sale of
assets followed by a redemption of shares.
G. Freezouts
Freezouts involve controlling shareholders forcing the minority shareholders to relinquinsh their
equity position in the corporation. Usually, the minority shareholders receive cash (or other
shares) for their shares (special form of freezout: MBO).

1. Common Mechanics of Freezouts

AInc, the controlling shareholder of Binc sets up a wholly owned subsidiary. AInc then uses its
control over the board of BInc to enter into a merger agreement where by BInc merges into the
subsidiary. AInc votes its controlling shares in favor of the merger. The merger plan provides that
minority shareholders of BInc receive cash for their shares, resulting in elimination of their
ownership in BInc.
2. Recap on freeze outs mergers

Law: Proxy solicitations, tender offers and stock purchases require individual SH’s consent. In
contrast, mergers require a SH vote, so a majority of SHs can bind all SH, including the minority.
(1) A stock for stock merger can force the minority to become SH in the merged
company. A stock for cash (cash-out) merger can force the minority to lose their
interest in the company in return for cash.
(2) To protect the minority from exploitation, they may demand appraisal, which will
result in the corporation buying out their shares at the judicially determined fair
value. The freeze out merger is analogous to eminent domain; the appraisal is
analogous to the fair compensation.
Policy: The ability to freeze out the minority creates an incentive for the majority to innovate
(since they can then capture 100% of the added value they bring to the corporation).
(1) On the other hand, if majority can acquire the minority’s shares at below fair
value, they might find it profitable to do so even if they have not added value to
the corporation. Solution: Allow freeze outs, but only at fair value.
(a) Fair value: value prior to the majority’s value-adding transaction (e.g., the
merger).
(2) Problem: Assessing fair value is very difficult.
Weinberger v. UOP, Inc. (Del.Sup. 1983)(en banc)

Signal owned 50.5% of UOP’s stock. It decided to buy the remaining 49.5% through a cash-out
merger.
Arledge and Chitiea, officers of Signal who are also UOP directors, prepare a memo for Signal
(using info received from UOP), concluding that any price up to $24/share would be good (market
price: $14).
Signal’s BoD decides to offer $21/share. UOP’s CEO, Crawford (also affiliated with Signal), gets
a fairness opinion (at the $21 price) from Lehman Brothers.
The four UOP directors who are Signal’s representatives know of the Arledge/Chitiea memo but
do not disclose it to the other directors.
UOP’s independent directors approve the merger. A minority SH challenges the merger.
Why would Signal want to eliminate the minority SH’s interest?
(1) Eliminate costs associated with regulation of public corporations (e.g., reports,
filing requirements, and the resulting difficulty to maintain confidentiality of
information).
(2) More flexibility in running the business
(a) Eliminates issues of fiduciary duty to minority SH [recall Sinclair].
(3) Could have conflict of interest issues with the minority SH
Knipprath says: SH voting agreements are OK; but BoD’s are supposed to make independent
individual judgment; therefore a BoD voting agreement could result in unqualified personnel being
appointed to the Board.
When a Board member resigns mid-term, the Board votes in a new Board member until the next
annual meeting. But in this case, the Board membership was agreed on in a contract.

This was a type of “going private” transaction.

The issue is what fiduciary duties does Signal owe to the minority SH of UOP?
3. Remedies in freeze-out mergers

Court: Relief for unfair freeze-out mergers is usually limited to the appraisal remedy. However, in
cases of fraud, misrepresentation and corporate waste other forms of relief may be available.
Why would a minority SH want a relief other than appraisal?
4. Why would a minority SH want a relief other than appraisal?

Tax: Cashing-out would require paying income taxes immediately.
If a minority SH can block a merger that creates benefits to others, she can extort a side payment
from the majority well above the share’s value.
Minority SH can ask the court to award him the amount he would have earned had he been able
to invest in the firm. Since cases take several years to litigate, it amounts to a risk-free
investment in the company.
(1) E.g.: Max is a minority SH in Acme. Just before the merger, Acme shares trade
for $5. If the merger succeeds, price will rise to $15. If the merger fails, price will
decline to $2. Max alleges failure to disclose material information to independent
directors & SH. By the time the trial concludes, Max knows if the merger
succeeded (in which case he’ll ask for $15, as if he maintained his investment); if
it failed, he’ll ask for $5 (as if he sold his interest).
Often controlling SH will bring into the company more of their resources after the freeze-out.
Allowing minority SHs to receive damages as if they maintained their investment allows the
minority to appropriate the majority’s investment.
Finally, in class actions, lawyers get much higher attorney fees.
5. Standard of scrutiny:
Entire fairness (the regular standard when controlling SH who exercise control are at a conflict of
interest, e.g., Sinclair).
Compare with Van Gorkom and Unocal, Revlon (next class’ cases).
6. Burden of proof:
If SH approved the merger:
(1) Defendant must show that all material facts relevant to the transaction were
disclosed.
(a) If defendant shows that, BoP is on the plaintiff to show that the transaction
was unfair to the minority;
(b) If the defendant does not show that, BoP on defendant to show that the
transaction was fair to the minority.
If SH did not approve the merger
(1) Plaintiff must show evidence of fraud, misrepresentation or misconduct relating to
the merger.
(2) If plaintiff did so, BoP on defendant to show that merger was fair.
(3) So, if the SH did not vote against the merger, then no appraisal remedy.
Who had BoP in Weinberger? Why?

H. Weinberger Analysis Method For Freeze Out Mergers

1. Who had BoP in Weinberger? Why?
There was a SH approval, but the vote was not an informed one – defendant failed to disclose
the Arledge-Chitea feasibility study.
2. Business Purpose
Under Weinberger, mergers do not need to meet a business-purpose test as long as they are fair
(fair process and fair price).
3. Entire Fairness
Transaction terms should be similar to those reached in an arms-length transaction (i.e., with a
disinterested, independent BoD).
Entire fairness in a freeze out merger consists of:
(1) Fair dealing (Procedural); and
(2) A fair price. (Substantive)
4. Fair Dealing
What did Signal do wrong?
(1) Lack of arms length bargaining;
(a) E.g., Crawford (who’s affiliated with Signal) arranged for the fairness opinion
(2) Misused confidential UOP information (for the valuation memo);
(3) Lacked candor (did not disclose its valuation memo).
What should Signal have done?
(1) Keep UOP’s interested directors out of any studies and discussions of Signal’s
strategy;
(a) If Arledge & Chitiea disclosed the report to UOP, they may violate DoC to
Signal; But probably not if it’s neutral information. So, probably a good idea
to have the Signal directors who have UoP seats sit in on the UoP board
meetings, even if they can’t vote. Then all the information is shared.
(2) Keep Crawford out of the negotiations;
(3) Have UOP appoint a special committee consisting of its independent directors to
bargain with Signal;
(4) Have special committee get a fairness opinion from outside financial advisor.
(5) Inform UOP SH of all material information relevant to the transaction.
Would a decision of an independent special committee be reviewed under BJR or the entire
fairness standard?
(1) Kahn v. Lynch Community Systems (Del. 1994)
(2) Approval of the transaction by an independent committee or an informed majority
of minority SHs shifts the BoP on the issue of fairness to the plaintiffs.
(a) BoP shifted only if the independent committee had “real bargaining power
that it can exercise with the majority shareholder on an arms length basis”
(quoting Rabkin).
(3) But even a decision by an independent committee (regarding cash-out) mergers
is subject to an entire fairness standard.
(a) Concern about undetected influence by the majority SH;
(b) Final period problem for the independent directors.
For next class read don’t read the steel case; but read cheffe v mathis; then read through Revlon
and Paramount.

XXI. Organic Changes in Corporations

A. Mergers
1. Comparing Mergers, Asset Acquisitions, & Stock Acquisitions
Mergers
Must be cooperative transaction (cannot merge as a hostile takeover)
Theoretically possilbe to takeover over corporate insider objections would
require gaining control of the proxy machine
Lots of corporate formalities
Universal in nature—i.e., binds all SHs in its effect, can’t opt out of merger
Asset Acquisitions
Fewer formalities than merger
High degree of cooperation req’d because the corporate insiders control decision
to transfer assets to acq’ing corporation
Coercive—totally binding (like merger); not even clear that min SH would have
appraisal rights
Stock Acquisitions
No corporate level formalities at all
Acq’d corporation’s share are being purchased; corporation has no control &
may not even have knowledge that the shares are being bought/sold
No cooperation req’d → so possibility for hostile takeover
What’s missing: element of incursive inclusiveness (not binding on the SHs who
didn’t sell, hard to round up all outstanding share; “straggling minority” of SHs
who can stick around like gadflies)
2. Statutory (Del.) Law
State law mergers are most straightforward
Del Law§ 251 & following; MBCA § 1101 & following—simple pattern = both
corporations incorporated in the same state.
How under D. Law:
Both boards adopt a merger resolution that sets the terms of merger
Changes in art. of incorp of survivor; specifies what each of the SHs of the 2
corporations will get from merger
Most common consideration for SHs of acq’d corporation = stock of
surviving corporation
Once merger agreement is adopted by BoD, SHs of both corporations must
vote
Both acq’d & acqing corporations file merger certificate with secretary of state
Transfer of Assets Once merger is final, all assets & liabilities automatically
vest in the survivor as an operation of law
Del Law§ 252: When merger with 2 corporations of 2 different states or foreign
corporation
Threshold Reqt: Del corporation can only merge with foreign/other US
corporation if the laws of the other state/country countenance merger with Del
corporation. → All U.S. state do; Almost all industrial/commercial countries
countenance merger with U.S. corporations
3. Direction of Merger
Usually direction of merger = matter of choice (esp. if both are Del. corporations) but
typically the larger corporation survives (more public visibility)
Reverse: The specific existing legal identity of corporation sometimes cannot be
changed because ownership of legal assets are uniquely tied to that entity.

Used when restrained by a regulatory element (e.g., state-issued certificates of

convenience—FCC broadcast licenses—are typically non-transferable, only
applicable to one entity, so if that entity/corporation ceases to exist, so do
they).
8) Consolidations
Neither of the initial entities survives; both dissolve into a newly created corp. Rarer
than mergers b/c SHs prefer safety of one of the corps surviving. May choose
this if want a new state of incorp
Note: Any consideration of either corporation is permissible to the SHs of the
merging corporations, so it can be
$, $+ stock: X’s SH A can be totally bought out or retain some control/hard
goods (any identifiable interest in the corporation)
stock + debt of acq’ing corporation (in which case X’s owner would continue
on as a SH & board member);
4. Economics of a Merger (Appraisal Rights)
These are the outer edges of the spectrum: Cash merger = basically an outright
purchase; Joint Venture: 50/50 split of original 2 companies
Appraisal Rights: Right to a judicial determination of fair market V if acquired stock
Most states: Don’t actually have to vote against it, just have to not vote for
merger
e.g.: C= 20% owner of X; A = 80%; wants to merge with Y corporation. C
cannot resist merger because A has outright majority but can assert
appraisal rights
Import: This dissenters right = major transactional burden because gives
dissenting SHs signif. pull esp. in corporations w. relatively small interests &
that are privately-held
SH voting rights = Another major transactional burden → would be a serious
problem for large, publicly traded diversified corporation
e.g. P%G wants to acquire privately held X corporation, could do a drop-down
X retains itself, A gets P&G stock; then P&G could contribute newly formed
subsid in exchange for stock (this deal doesn’t help eliminate P&G’s
taking in of X’s liabilities tho)
Solution: State corporation laws always retain right of acq’d corporation’s SHs to
vote BUT significantly limit the voting rights of the acqing corporation, esp. where
it’s really large
Del. § 251(f): Where the V of the acq’d corporation = 20% or less of the acq’ing
corporation, then no vote of acq’ing corporation SHs is req’d NOR do they
have appraisal rights. → if acq’ing corporation is 5x or larger the size of
acq’d, no vote.
Del. § 262(b): Curtails the appraisal rights of SHs of acq’d corporation in some
situations (but not voting rights) if the target is either (a) publicly traded or
(b) has >2000 shares (even if not publicly traded) & (c) if no SH vote req’d for
merger (if all-stock deal). DL § 262(b)(1)
Justification: Open-market remedy (selling stock) is available.
B. Asset Sales & Liquidations

5. Asset Acquisition
HOW: Asset sale from one corporation to another, followed by a liquidation to the
transferor corporation.

De Facto or “Practical” Merger Sometimes legal impediments to merging

corporations (e.g. A owns X, a Del corporation & B owns Y, a Danish
corporation).
1st step: X gives Y all its assets in exchange for Y stock. Now A still has X
stock but X has no assets
2nd step: Liquidation of X, distributes all of its assets to SH (A)—X’s assets
now = Y stock—and X disappears, leaving A& B co-owners of Y.
This assets/liquidation is the equivalent of a statutory merger.
Comparing to statutory merger:
Vesting of Liability
Statutory merger: automatic vesting of assets & liabilities (Y can’t
disclaim/protect itself)
Practical: Not exact transfer because acq’ing assets doesn’t usually
entail acqing seller’s liabilities too. Not certain exactly what
happens to X’s liabilities, but likely that they do carry over because
probably analogous to what happens re: tax implications—which
treats both practical & statutory mergers the same. Less likely in
cash for assets merger.
Formalities
Statutory merger: Almost always require target corporation SH vote
De facto/Practical: Never a SH vote on acq’d corporation side
because using its own stock, but most states don’t allow
corporations to sell all their assets.
Why Choose De facto Mergers?
Used where other mergers would otherwise be prohibited; May be
specific legal impediments to merger but not asset acquisition
Asset acquisition may be chosen in order to forestall automatic transfer of
liability.
Note that shareholder approval is not required for an asset acquisition
(unless substantially or all assets sold).
No government action required for asset acquisition.
Statutes
MBCA ⇒ No shareholder vote required if sale of all or substantially all of
corporation’s assets is in the regular course of business. MBCA §
12.01. Otherwise, shareholder approval is required. MBCA § 12.02. Note
that appraisal rights are available. MBCA § 13.02(a)(3).
DL ⇒ Shareholder approval required for sale or exchange of all or
substantially all of corporation’s assets. DL § 271. No appraisal rights
are available. DL § 262.
Farris v Glen Alden Corporation (PA 1958), p704 ⇒ De facto merger doctrine.
Held 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 statutory merger
requirements in order to protect the rights of minority shareholders.
Form ⇒ GA acquired (by issuing new shares) by List through an asset
acquisition. GA got all of L’s assets and L was liquidated.
Fact ⇒ L acquired GA (minnow swallowing whale) and L shareholders own ¾
of new corporation.
No shareholder vote for GA’s acquisition of L’s assets; no appraisal rights for
GA shareholders.
Incentive was large tax carryovers that were nontransferable.

Subsequently, PA corporation law amended to abolish de facto merger

doctrine. (Delaware Courts have much sharper grasp on these issues).
Hariton v Arco Electronics, Inc (DL 1963), p710 ⇒ Held a sale of assets involving
dissolution of the selling corporation and distribution of the shares to its
shareholders is legal. Same facts as Farris, but court gets it right.
Equal Dignity Rule ⇒ Court finds that the different statutes (sale of assets
and merger) are independent and of equal dignity. As a result, either one
can be depended upon to achieve the desired end.
6. Stock Acquisition
Nature: L corporation gets enough shares of S to control S.
More of a parent-subsid relationship than a merger:
A = X owner; B =Y owner; Y gives A its stock, A transfers X stock to Y →
now Y = parent of X, and A &B = co-owners of Y. If X then liquidates,
then exact same result as a merger.
“Group corporate environment”: parent-subsid relationship with single
culture implications
Private actions between L and S shareholders. Thus, no shareholder vote,
transfer of title, action by board.
May be followed by dissolution of S or A-type merger→ liquidation of a wholly
owned subsid = non-event
Short form merger ⇒ Authorizes corporation that owns specified percentage of
stock in corporation (90-95%) to merge subsidiary into parent without
shareholder vote.
Hostile takeovers usually use this form (tender offer) because unilateral power
of shareholders.
Offer shares of a publicly held corporation to another one.
“Hostile” only the corporate insiders, the acq’d SHs usually love this because
makes them lots of $. Absence of any formality renders insiders with no
way to fight it.
7. Subsidiary/Triangular Mergers/Acquisitions
Form: Merger between targe & subsid of an acq’ing corporation.
Combinations between parent and subsidiary corporations on acquired side.
Merger of target with subsidiary in the acquiring group. Most common
consideration received by shareholders of target is stock of parent.
Advantages of Subsid Mergers generally: Way to carry out hostile, all-
inclusive takeover & preserve specific corporate identity of target.
Types
Forward Subsidiary Merger ⇒ Merger of target into subsidiary.
B B A
P P stock A P
S Merger
X S
Reverse Subsidiary Merger ⇒ Merger of subsidiary into target. Stock of

subsidiary converted into subsidiary of target. Stock owned by A
converted into P stock. Target corporation’s assets come to rest in a
subsidiary of P. Target’s identity stays intact.

Specific Advantages of Reverse Subsid Merger:

No appraisal rights concerns ⇒ P is sole shareholder of S.
New identity is distinct from parent ⇒ Liabilities of acquired corporation
are not brought to parent, so parent is insulate from all of target’s
liabilities (great where parent = large holding co. with lots of subsids, &
constantly making acquisitions—typical of US corps)
Leaves in place a flexible management structure.
B B A
P P stock A P
S Merger
X X
X
“Acquisition Subsidiary”: A specially created subsid just to do a triangulation

merger; esp. used for reverse mergers (where subsid identity disappears
anyway)
Subsidiary mergers are now predominant form of combination (especially
reverse). Exactly the same result as a stock-for-stock acquisition-style
merger.
Why? Do it this way because where subisd has far-flung ownership, this is
the only way to acquire all the stock
Note that a degree of cooperation is required from insiders ⇒ Cannot
accomplish as a hostile takeover. Instead has to be an actual merger.
But fully coercive on shareholders of X.
8. Reverse Subsidiary “Squeeze-Out” Merger
Characteristics: Most widespread from of acquisition; can be cooperative or
hostile; all-inclusive acquisition; can preserve specific identity of target;
instrument of choice for high-tech corporate acquisitions (“gunslingers’).
However, very blunt instrument for weeding out undesirable SHs because
high transaction costs & new gadfly will emerge.
1st Stage: I wants to sell to B, but C does not. Y obtains >50% of X stock in
exchange for stock or cash, then Y will hold a 60% interest in X, setting the stage for
a subsidiary merger in which C can be forced out.
C I B
40% 60% Stock or cash
X X stock Y
2nd Stage = “Squeeze Out Merger” –Y creates a subsid & as parent merges S
into that. All C can do is dissent and get appraisal rights. Effectuates Y’s intent
to get X despite objections of incumbent C.
Y stock or cash
C Y
40% 60% 100%

X S

Merger NOTE: (this = forward merger, more common is

reverse—S into X)
Recourse for Reluctant SHs = appraisal rights

Commonly litigated issue = Valuation of Target Corporation between
steps 1&2
Effect of 1st stage of the merger may change the stock price to reflect Y’s
ownership of X and may anticipate the impending 2nd stage—
market price won’t reflect intrinsic V of corporation but will impound
concerns of investors
Also, Y now controls the transactions between S; Y could favor Y
corporation except that because of Y’s controlling SH status it
owes a fiduciary duty to A (a la Lewis v. SL&E, and Sinclair)
Duty Owed By Controlling SHs in Squeeze-Out Mergers
Principle: Post-1st stage the controlling SH is a fiduciary to minority SHs 
transactions must be held to a standard of entire fairness (same standard
that controlling SH owes to corporation itself)
Not governed BJR post 1st stage
Far more advantageous for minority SHs to sue re: fiduciary duty than for
appraisal rights because might get judge/jury
Remedies:
Rescission: Rare, but when happens very bad.
Rescission Damages: When merger = too far along to rescind. Damages =
amt the squeezed out SH could’ve had had the interaction not taken
place at all.
Weinberger v UOP, Inc (DL 1983), p727

⇒ Held freeze out merger requires that in the interim stage, where there are
common directors, fairness in dealing and price. Also duty of full
disclosure.
There is no business purpose requirement in mergers. Instead, focus
analysis on entire fairness requirement.
Here, the minority SHs got squeezed out at the same price as the stock,
but because parent had entire fairness burden, even the same price
didn’t meet this standard.
If acquiring corporation gets seat on target corporation’s board, has a
fiduciary obligation to target corporation’s minority shareholders.
Must make full disclosure of information (completeness, not
adequacy).
In this case there was the rushed nature of the fairness opinion, and
failure to share report by target corporation’s directors that suggested
higher price than the one offered.
Common directors have a dual duty of loyalty. No safe harbor for divided
loyalties. Must show good faith and inherent fairness. No dilution of
duty in parent-subsidiary relationship.
Fair dealing: How transaction timed, initiated, structured, negotiated,
disclosed to directors, approvals obtained. Similar to duty of loyalty, want
to show arms-length transaction.
Fair price: Econ and financial considerations, assets, mrkt value, earnings,
future prospects.

Also disposed of the DL block method for determining the appropriate price
of appraisal. Instead rely on techniques generally used in the financial
community.
In two-step cash out merger, control premia paid in initial step are not
considered in appraisal remedies. However, value added in interim is
considered. Cede and Co v Technicolor, Inc (DL 1996), p739.
1/31/2005 Burden of proof for breach of fiduciary duty is on π to show that a
duty existed and it was breached. So, here, π must show that the
directors of UOP owed a fiduciary obligation; if Signal owed a duty as a
majority SH, it must prove that too. π must establish a prima facie case:
there was an opportunity, in the company’s line of business, and the
company could have exploited it.
9. Burden Shifting Considerations

Burden now is shifted to the ∆ to prove that there was full and fair
disclosure, fair price. If corporate opportunity, that it was handled fairly
b/c could not exploit, or it was not in company’s line of business, or some
other rational fair dealing and fair price.
Knipprath says: that the findings of the independent directors might be
accepted by the court. But in California, the burden just shifts back to π
to prove the lack of fairness. California won’t replace the fairness test
with the Business Judgment Rule, but it will shift the burden of proof back
to the π . Burden of proof has impact on settlement negotiations and on
ultimate outcome of case as determined on the merits.
No Need For Business Purpose Rule
Why did Signal do this? Look at III on p 737. Cost and expense and
hassles of public companies. Some precedent that said a legitimate
business purpose was required, but Court in Weinberger rejected this.
Dumping Minority SH Can Be a Legitimate Purpose: Short Form Merger
California and Delaware and other states permit the short form merger.
So, there can be a merger with the singular purpose of dumping the
minority SH.
Weinberger v. UOP (pg681, n79)—Now you have to allege fraud, misrepresentation and other
items of misconduct to demonstrate the unfairness of the merger. Remedy is appraisal
Holding: A freeze out merger approved without full disclosure of share value to minority is
invalid. Have to act in good faith. Report would have been helpful to minority SH.
L: But wouldn’t they have been subject to liability from SH of the other co for sharing the
report? Yes.
Would it have helped to have outside directors look at this? Yes, fn7, pg687
Possible standards for review?
a) business judgment rule
b) entire fairness test and burden with ∆
c) entire fairness test and burden with Π
d) none of the above
e) a & b
a, but maybe c (Sinclair v. Levin)—Okay, what is the entire fairness test, and
what does Sinclair have to do with it?
KK’s outline, pg70: Entire fairness test is fair price and fair dealing
EXAM ALERT: PUT BURDEN SHIFTING CRAP IN MATRIX

B. Freeze Out Mergers: Bus. Justification Coggins v. New England Patriots

Sullivan was ousted from management, and tried to regain control by buying voting shares. He
borrowed money to do so, and the creditors wanted the company to assume the debt.
(1) Problem: this would be a breach of fiduciary duties to the non-voting stock SH.
(2) Solution: Triangular merger in which he cashes out non-voting shares.
Coggins, owner of non-voting stock, sues to void the merger.
Court: The merger is impermissible because Sullivan did not show a business purpose.
(1) But because voiding the merger is impracticable, the case is remanded to
determine damages.
Aftermath: Sullivan profited $5M from later selling the Patriots, and sued the NFL for an antitrust
violation (prohibiting him from selling the franchise’s shares to the public), settling the case for
$11M. He made more money from the antitrust suit than from the football team. Sullivan was
represented by Joe Aliotto (former San Francisco mayor who represented Al Davis in his Oakland
Raiders case).
Business Purpose
(1) What business purposes could Sullivan suggest to justify taking the company
private?
(2) Easy to build a “paper trail” backing legitimate business purposes.
(3) It’s possible that the Coggins ruling has to do with sentiments about the football
team and its owner.
C. Law in Delaware
1. Singer v. Magnavox (Del. 1977) – Court finds merger is
impermissibly because it lacks a business purpose.
2. Tanzar v. International General Industries (Del. 1977) – A business
purpose relating to the majority SH alone sufficed.
So, Sullivan’s purpose of having the company assume his debt suffices.
3. Weinberger – Expressly rejects the need for a business purpose. If
the merger is fair to the cashed-out minority, that ends the inquiry.
Coggins v NE Patriots Football Club, Inc (MA 1986), p739

⇒ Business purpose test (a merger is illegitimate if consummated for purposes
of recapitalization). Easier case than UOP because more background
manipulation. Coggins got rescission damages.
Amy Says: —He sold non-voting stock to the public, but then the owner of all the voting stock
wants to go private. Arranges a cash-out merger. A majority of the SHs approved it. ∆ has the
burden of showing that the merger does not violate his fiduciary duty to the minority. Also, MA
retains the business purpose test. Can a cash-out merger go on for the sole purpose of getting
rid of the minority SH?
Holding: No. This was only for the personal benefit of Sullivan, so there was no legitimate
business purpose. Don’t even need to consider fairness since this did not have a business
purpose. They give recissory damages because it has been to long to rescind the merger, so just
give him present value.
L: They cited Wilkes, but Wilkes was with people who knew each other.
They also cite Singer, but it’s a different jurisdiction and not binding. Knipprath says it’s weird to
sight an authority that goes against them and then choose not to follow it. Why mention it?

Rabkin v Philip Hunt Chemical Corporation (DL 1985), p746

⇒ Held delaying a merger to avoid paying a contractual price may give rise
to liability to the minority shareholders since directors are dual
directors. Complying with contractual reqts here didn’t render acts fair per se
because got the 1 yr deal by making a deal with the majority SHs (who were
the ones selling). Here, the Ds won on remand—needed the contract as
undergirding to win.
Amy Says: —Deal to pay the minority the same if they try to buy 100% within a year. They
waited until the year was up to buy the rest. Does the company have a fiduciary duty? No
question they timed the merger to avoid the extra price, but does that trigger a duty to pay the
minority what they paid the majority? Just a premium for control.
Holding: This may be enough to trigger a duty here, so case remanded. Inequitable conduct will
not be protected merely because it is legal.
Olin buys controlling shares
Says it will “consider buying rest” but “no present intention”
Agree to pay $25/share for any other shares acquired within the next year.
The year ends up on March 1st.
Olin approved the acquisition with one week to go on the contract.
Olin thinks that $20 / share was fair and the independent investment bankers agree.
Fairness range was $19 - $25; p. 747
So, it wasn’t $25 but it was fair.
Issues: (1) was there a breach of fiduciary duty?; (2) conflict by not fair dealing and disclosure
(as in Weinberger); (3) fraud and misrepresentation; (4) breach of contract with Turner & Newall.
But, Knipprath says that they didn’t breach the contract. The K said one year.
Breach of K is the easy solution; it gets you the $5 / share remedy. Breach of fiduciary duty.
Who has the duty? Did Olin act in bad faith by not completing the deal in one year?
Unlike Weinberger, they had an independent committee and full disclosure. Everything was
disclosed in the proxy solicitation; so pretty hard to show unfair dealing.
Appraisal is the sole remedy for minority SH if there is no proof of fraud or misrepresentation.
Even if it’s based on breach of fiduciary duty. You need fraud or deceit to get anything other than
appraisal rights. You must vote against it in order
See p. 748 -- overreaching and unfair dealing are not addressed in an appraisal. ∆’s will argue
that the π ’s will be cashed out, so why do they care? After the deal is done, Olin is the SH of
Hunt Corp. So if Olin has done something wrong, then they have done harm to themselves.
Who has the underlying fiduciary duty? Hunt board had an outside evaluation and disclosed
everything. Is it Olin b/c majority SH owes a duty to treat minority SH fairly? But why not see if
majority of minority SH voted for the merger?
Is it that Turner and Newell owed a duty to share the control premium? That would be contrary to
accepted law unless it meets the Newport Steel acquisition of a corporate asset test.
Rauch v RCA Corporation (2d Cir 1988), p752

⇒ Held a cash-out merger that is otherwise legal does not trigger any right
the shareholders may have with respect to share redemption. Merger
that paid cash to all RCA shareholders. P alleged that merger was effectively
a redemption of stock, and thus he, as PSH, was entitled to redemption
value. Court holds that RCA entitled to do this as a merger, and invokes the
Hariton argument that all provisions are independent and can be construed
separately. Cannot say that this is a de facto redemption when this is simply
a merger in which specific consideration for various types of shareholders is
provided in merger agreement and dissatisfied shareholders have appraisal

rights. Similar to Farris and Hariton (follows Hariton). (mirror image of Farris).
Notes 2/12 (in binder).
Amy Says: —Π says this is just like redemption—a “de facto redemption”. Court rejects this on
the same theory as a de facto merger. See analysis afterwards, pg755.
L: Court refuses to judicially create a new protection for preferred SH
Could you give the entire premium to the common SH? To the preferred? Split it? Yes, probably
to all of them. No definitive answer here.
BOF, pg206 that Weinberger forecloses an injunction in cases where full disclosure is made and
the board has satisfied its duties of good faith, loyalty, and due care, or the board has been able
to prove the entire fairness of the transaction. Appraisal remains the only remedy (but BOF
points out that each individual SH must perfect its appraisal remedy, but under a class action,
they just have to not opt-out to get protection. Difficult to prefect, and expensive to get your own
lawyer, etc.)
Knipprath says: Board votes first. Then the SH depending on jdx. For certain, the common SH
of the target co get to vote.
4. RCA has two classes of stock: common and preferred. The preferred stock has a
$3.50 dividend preference and is redeemable at the option of the corporation, for
$100.
What might be the purpose of the redemption clause?
5. GE offers to acquire RCA in a cash-out triangular merger: RCA would merge with
Gesub (a GE subsidiary), RCA common SH would receive $66.50/share, and RCA
preferred SH would receive $40.
How is it that preferred shares are worth less than common shares?
6. Rauch, an RCA preferred SH, claims that despite dressing the deal as a merger, it
is in fact a redemption of preferred shares, so she should get $100, not $40.
Does Hariton v. Arco Electronics apply?
If this is a merger, what are Rauch’s rights?
7. Does Hariton v. Arco Electronics apply?

No, but it can be a useful analogy. Hariton holds that a deal that is not structured as a merger
would not be evaluated as a merger, even if a merger would yield the same results. Reason:
Equal dignity of the legislation authorizing each of the M&A techniques.
In Rauch, the issue is the reverse – Should a deal structured as a merger be considered
something else (a redemption of shares), if it yielded similar results from the perspective of the
SH?
Knipprath says form over substance wins again due to legislative provisions allowing such
discretion by corporations.
8. If this is a merger, what are Rauch’s rights?

Generally, mergers require a SH vote, but not individual SH consent.
Unclear from the case whether RCA’s preferred SH could vote on the merger. DGCL §251(c)
requires a vote of a “majority of the outstanding stock of the corporation entitled to vote thereon”.
Knipprath says this is important. Look in the share agreement. Always look to the statute of the
jdx to see if the preferred SH have a right to vote. Should the preferred have a right to vote?
Bondholders have no right to vote unless it’s in the specific bond agreement. Generally
bondholders don’t vote. They don’t have an equity interest; they get the face value of the bond
and move on. The PSH are in a similar position: they will get paid off. But how much? PSH will
argue that they need a right to vote in order to protect their interests and rights.

(1) The rights of preferred shares (and all other shares) should be stated in RCA’s
AoI. The case doesn’t quote the AoI on this issue, but footnote 3 indicates
preferred shares may not have voted (court rejects Rauch’s claim that a class
vote was necessary because the merger changed the AoI in a way that impaired
her preferential rights.
9. Court: The transaction is a merger, not a redemption, so Rauch is not entitled to

$100 for her share.
The court’s decision is symmetrical to Hariton. The form of the transaction is respected.
The right of redemption is the company’s, not the SH’s.
(1) RCA can artificially use a merger to bypass the redemption price. But this seems
simple to prevent contractually (when drafting the AoI section detailing the rights
of the preferred shares).
Knipprath says to look at whether PSH had a right to vote; maybe they were at the mercy of the
CSH. It’s all about who gets which piece of the premium GE is willing to pay?
10. Even if preferred SH had the right to demand $100/share to allow the merger to
commence, it would be in their best interest to waive this right.
Suppose that RCA has an equal number of preferred and common shares, and that common
trade for $61 while preferred trade for $35 (so, it’s $96 for one of each). GE is willing to offer a
10% premium (pay $106).
If preferred SH insist on receiving $100, this would leave $6/share for the common SH ($106-
$100). Since they can sell their shares for $61, they gain nothing from the merger and will vote
against it, causing the preferred SH to lose the $65 premium ($100-$35).
The common SH would vote for the merger only if they get over $61. This leaves premium SH
with under $45. Premium SH would block the merger (by not waiving their right of redemption)
unless they get over $35 (common SH get <$71).
(1) $71 < Common Share < $61
(2) $45 < Preferred Share < $35
(a) GE’s offer, at $66.50/common & $40/preferred, is within this range.
(b) This is why Rauch asks for redemption rather than appraisal.
Corporation has right to redeem PSH at any time; CSH have a position in the company. This
allows the corporation to control the value of the PS. If there is a drop in interest rates and it’s
cheaper to issue debt, then the company can just call the PS. The preference helps PSH if
company goes bankrupt. Otherwise, it’s not applicable.
D. Parent-Subsidiary Merger (Short Form)

Mechanism for combining a parent corporation with its own subsidiary, if parent’
level of stock ownership in subsidiary is 100% or very high.
Simplifies capital structure of group.
Simple liquidation of X.
Existence of outstanding minority group.
A B C
E
P
90% 10%

P can merge into X itself and provide cash for outside SHs instead of a
proportional part of X assets, or can give P shareholders stock.
Most corporation laws have a special provision for this type of merger.
DL § 253 (allows merger of subsidiary into parent if parent holds ≥ 90%
of subsidiary stock ⇒ no formality needed (no shareholder vote, may
be done through unilateral action of directors of P without notice
to E). However, E must be informed of his appraisal remedy before
actual merger is executed but after merger is entered into. Just a
letter would be sufficient .
Fiduciary rules apply to parent as controlling shareholder in a squeeze
out.
Incentive for squeezing out minority shareholders is that they present a
barrier to possible economies of scales gains that might be realized
by combining the parent with the subsidiary. With the separate
parent/subsidiary relationship, the parent’s investors are required to bear
greater risk for no increase in return.
Outstanding minority group with substantial %age of shares.
Corporate Norm: Unilateral redemption of corporate stock is beyond
corporate power. (But see Ingle below re: explicit buy-sell agreements)
So although B cannot redeem A unilaterally, what can’t be done directly
can happen via merger.
B A
B can drop a subsidiary and enact a merger between X and Y. A has been
squeezed out of the corporation (despite need for shareholder approval)
and can only receive money for his X shares.
B A
100% 80%
20%
X
Y
cash
merger
Upstream: Minority SH gets parent corporation’s stock OR Downstream: If want

to preserve specific corporation identity
Squeeze out can also be done through a short form merger if minority interest is
relatively small. e.g. min SH holds 10% or less→ don’t need to tell A in
advance, just here’s $, and goodbye
C. Recapitalizations
1) Definition
Involves a single entity & enterprise & = a change in the financial structure.
Nature of: In form, = a set of redemptions, can’t occur without voluntariness, usually
requires unanimous consent → shareholder consent is required because of
changes to their claims to the corporation’s assets and earnings
Classic pref. stock recap req’s high degree of coop. so only works in family
owned businesses (small <3 SHs, closely held) –couldn’t do with large

publicly owned corporation because SHs wouldn’t want their risk modified
unilaterally.
Simple recapitalizations ⇒ Replace debt with common stock or combination of
common and preferred. If A and B hold equal proportions of common stock and
debt, then simply convert into equal shares of common stock and preferred stock
in recapitalization
Insignificant: Two SHs with propor. stock & debt→ exchange the debt for pref.
stock
Effect: no shift in control, no shift in priority between A &B claims; BUT
probably improves credit (because no lender would want to give $ to
corporation with so much debt in cap structure)
Significant: Preferred Stock Recapitalization
A= 80% CS; B=20% CS → exchange A’s CS for pref. stock
Effect: A who had corporate control & governance & greatest risk now has
something more akin to constant income stream; B has become the
entrepenuerial partner, reaps the high upside and high downside effects
(esp. if pref. stock ≠ voting rights)
When Happens: Transfer of control from older to younger generations;
typically a family-owned business
Typically there are large arrearages of dividends for preferred stockholders
which makes corporation less attractive to creditor. Thus,
recapitalization must take place. May be done as a byproduct of a
merger, or may be the main reason for a merger or other combination.
See Bove v Community Hotel (RI 1969).
1. 2) Recapitalization as Practical Effect as Merger Byproduct: Bove
a) Bove v. Community Hotel (RI 1969)
i) Held that a parent can merge with its subsidiary for the sole purpose of
recapitalization. Corporation wants to recapitalize to eliminate claims of
preferred shareholders without requirement of unanimous vote (merger
only requires supermajority).
ii) Characteristics: downstream merger of corporation into a predominantly
owned subsidiary.
iii) No one wants to lend $ to a corporation that has large latent obligations to
PSHs; most recaps involve pref. stock usually involving cos with long-term
mediocre performances (e.g. large overhang of dividends in arrears)
iv) Court: Unhappy PSH should assert their appraisal rights if unhappy
XXII.Policy Issues
1st position: beneficial to shareholders and society as a whole
- shareholders usually receive premium over current market price
- eliminating minority ownership saves agency costs because higher incentives to run
corporation efficiently if managers have a major equity position
- economies of scale if subsidiary is taken over by parent
- more flexibility in decision making without minority shareholders
2nd position: conflict of interest and potential unfairness to shareholders; violation of fiduciary
duties

- e. g. “going private”: control group first takes advantage of a strong market to go public
and then of a weak market to eliminate the minority public shareholders and go private
again. This can be seen as a perversion of the whole process of public financing
- Combination of takeover and freezout can be unfair if tender offer price to acquire
majority position is higher than price offered to minority shareholders in following freezout
A. Liability Issues/Remedies
i. e. approval by board and shareholder vote (compliance with state merger provisions)
must comply with fiduciary duties
a question arises whether an appraisal is the appropriate and exclusive remedy for the minority
shareholders, or whether the courts may grant other remedies based upon fiduciary principles.
Generally, the minority shareholders prefer using the state fiduciary doctrine to enjoin the
transaction or seek damages greater than the limited appraisal remedy. The courts followed the
fiduciary duties approach and granted equitable relief under certain conditions. While the
Delaware courts initially held that a freezout merger, besides meeting the burden of proving entire
fairness, must pursue a business purpose other than the sole elimination of the minority positions,
in Weinberger they eliminated the requirement of a business purpose and concentrated on the
concept of entire fairness. When directors are on both sides of the transaction they must
demonstrate their utmost good faith and the most scrupulous inherent fairness in the bargain. The
court clarified that entire fairness in this context meant fair dealing and fair price.
Fair dealing requires full disclosure of share value, as well as other process issues such as
timing, initiation, negotiations and structure of the deal. In Weinberger there was a lack of full
disclosure of the share value because a report prepared on the highest price that would be paid
for the minority shares was not disclosed to the minority.
Fair price relates to all the factors which affect the value of the shares.
Under Weinberger appraisal is not appropriate for cases involving fraud, misrepresentation,
self dealing, deliberate waste of corporate assets, or gross and obvious overreaching. It is
generally not appropriate if there is a lack of fair dealing. In these cases the minority shareholders
are not restricted to appraisal remedies, but can receive rescissory damages in equity, not
restricted to the fair value of the shares at the time of their sale, but including a share of the
benefits that resulted from the merger.
XXIII. Takeovers/Tender Offers 1/24/2005

Several methods of acquiring control over another company; most common: buying shares,
buying assets, and mergers.
If, however, the board of the target corporation is not in favor of the transfer there are only two
means available: a proxy fight (the bidder solicits the target shareholders to vote for new directors
associated and in favor of the bidders plans) or a hostile tender offer where by the bidder makes
an offer directly to the target’s shareholders to buy their shares. Therefore, a tender offer does
not involve the target’s board, which can be replaced once control is gained.
A. Policy Issues
Tender Offers have raised numerous policy issues, not only if they were beneficial to the
companies involved and the economy as a whole, but also of what motivated a bidder to pay a
premium over the market price for shares of the target, whether those premiums represented
gains and, if they did, the source of these gains.

1. Proponents
Hostile tender offers are beneficial because they represent a market solution to the problems of
corporate mismanagement. Market based competitive solutions are ultimately the most efficient
and, therefore, the market for corporate control should be encouraged and facilitated. This
“market of corporate control” theory is based upon the efficient capital market hypothesis, which
assumes that by using all publicly available information the trading markets were informationally
efficient in pricing shares at levels that best represented the value of their corporations.
Therefore, any failure by management to maximize the value of a company would be reflected in
its shares’ price. These management failures would attract bidders to offer premiums over the
current market price for a controlling interest in the corporation, in the belief that the bidder itself
could run the business more efficiently and achieve benefits that would exceed the premium paid.
This possibility of a tender offer serves as an incentive for managers to run the corporation
efficiently, because if they do not they could face a hostile offer which would replace them. In this
view, tender offers are one of several market mechanisms to ensure companies are run efficiently
and in the best interests of their shareholders.
2. Opponents
- Hostile tender offers are harmful to shareholders because the future value of the corporation is
higher than the bidder’s offer. Thus, the bidder usurps shareholders gains.
- Dynamics of hostile tender offers tend to force shareholders to accept the offer, because if they
do not they are facing the risk of being left as a very small minority in an otherwise wholly owned
corporation, likely to be bought out later on unfavourable terms.
- Managers are forced to place too much emphasis on short-term profit making than on long-term
performance in order to keep the stock price high enough, so that the company would not
become the target of a hostile tender offer
- stock markets are not truly efficient; premium reflects undervaluation by the stock market rather
than mismanagement
3. Conclusion
Tender offers have produced significant gains to target shareholders by paying them large
premiums over the market value of their shares prior to the offer. On the other hand, in many
cases the bidder’s shares have not gained from the acquisition, but rather lost value. However,
since the overall amount of gain by target shareholders is much greater than the losses incurred
by bidder shareholders, some direct gains have resulted from tender offers. Asking for the
sources of these gains, it can be assumed that takeovers have finally resulted in value
maximizing efficiencies in the form of synergy gains and reduction of agency costs by replacing
inefficient management.
B. Bidder Tactics
A bidder wants to gain control, i. e. acquire at least 51%. However, it does not know how many
shareholders will accept its offer, and it does not want to end up with owning a large percentage
without the benefits of control. In order to avoid that, the bidder may set conditions for its
acceptance of the tendered shares, such as receipt of a certain percentage of the shares.
A bidder is generally not required to bid for all of the shares of a corporation, however, the
shareholders are entitled to an equal opportunity to tender their shares in the offer. If more shares
are tendered than the bidder wants, the shares tendered are purchased from the tendering
shareholders on a pro rata basis.
Bidders tend to offer cash as consideration because it is easier to value and does not require
registration under the Securities Act of 1933.

Bidders usually want complete control of the target. In order to achieve that goal, the bidder can
acquire the shares of shareholders who did not accept the tender offer in a second-step freezout
merger after the first-step tender offer is complete.
A very controversial bidder tactic is the so called front-loaded two-tier tender offer, geared to
attract as many sellers as possible in the first step tender offer: If the targets shares are selling for
$ 20 and the bidder is willing to pay $ 25 per share for all the shares, it will offer a cash premium
of $ 30 for only 51% of the shares. At the same time the bidder announces that, after the tender
offer will be successfully completed, it will use its control to merge the target and buy out the
minority shareholder at a lower price, e.g. $ 20. Since shareholders do not know how the other
shareholders are planning to respond, they have to tender their shares for fear of losing the
premium on at least 51% of their shares. Thus, this tactic has a coercive character.
At times, bidders have bought target’s shares and threatened a tender offer in order to make the
target’s management buy back the shares at a premium, so called “greenmail”. This tactic raises
issues of whether the directors are benefiting the corporation or themselves by precluding the
tender offer (Cheff v Mathes 752).
1/24/2005 Knipprath says you can’t discriminate against SH. So, if the solicitation is
oversubscribed, you have to reduce your tender only x% of each share.
SH position is now changed; you are a SH in a new company. It might still be good for the SH
because it might be more economically feasible. Also, shares in newco might be more liquid. So
that’s a case where you might want to get stock in the raiding company instead of $.
If you don’t tender, you don’t get dilution, you just are subject to the whims of the new
management. But, if you take shares, you might be in a more diluted position.
Why would you get preemptive rights? Assuming no fraud in the tender offer, you chose to be
diluted, you can’t turn around and complain about dilution.
But, the old shareholders of the acquiring (raiding) company could claim dilution.
Need to comply with Rule 14e-3
Also 13d and 14d on 5% disclosure
Not sure if there is a private right of enforcement
Those rules are to ensure notice of intention by raider.
Also need to consider anti trust laws.
Short swing profits could be an issue as well. Look at Kern County Petroleum.
Tax laws: Is it realized and recognized income? What’s the nature of the exchange?
Fraud is always a concern
SH who tendered don’t get any appraisal right
Argument for Appraisal Remedy: SH who don’t tender will argue for appraisal rights based on
decreased of liquidity after the tender; they will be trapped. They can’t sell on the market. The
tender was too low.
Argument Against Appraisal Remedy: You had your chance and chose not to take it. There’s
still a market for your share.
The Law: No Appraisal Remedy. Appraisal remedy is limited to statutory mergers.
So, if you’re against the tender and don’t want to tender, you have to make an equity argument
unless you can prove de facto merger. So, you are looking to prove fraud.
Debtor-Creditor Law: do you need to worry about that in a tender offer?
Presumably the debts of the target company are built into the stock price at the time of the tender.
But, becoming a majority shareholder doesn’t make the raider liable for it’s obligations.
Raider company votes on whether to make the tender
Target company board votes
Raiding company’s SH only have to vote if NEW shares are issued
Wednesday, 02 February 2005
Form over substance; substance over form. Handout on Time-Warner merger. Tension between
objectives of stability and predictability in the law and the desire to find ways around those rules.

C. Target Tactics
1. Tactics that require Amendments to the Corp. Articles and, therefore, a
Shareholder Vote
- staggering the terms of directors delays the bidder from taking immediate control and, therefore,
raises the cost of the bid and creates uncertainty
- an amendment to the corporate articles can require a super-majority or disinterested
shareholder vote before a successful bidder can sell assets to finance the bid
- a recapitalization of the corporation through amending the articles to create two classes of
shares from an existing single class with one supervoting class that holds the significant voting
power. If those shares are owned by the management, a hostile tender offer is virtually
impossible
2. Tactics that do not require a Shareholder Vote:

- sell of significant target’s assets in order to make it less valuable (crown jewel defense)
- self tender with target buying back its own shares makes it more difficult to acquire a majority
position; reduces shares available for purchase by raider. It also raises the price of the stock.
- search for a management friendly concurring second bidder (white knight)
- sale of a block of shares to a management friendly “white squire” who sign a stand still
agreement
- managers may takeover the corporation themselves through a (leveraged) MBO
- target can increase its debt to limit a bidders ability to finance the tender offer through
leveraging the target after gaining control
3. Poison Pills
The most significant defensive tactic is the shareholder right plan or “poison pill”: at some
triggering event, usually the purchase of a certain percentage of the target’s shares by an
outsider, the target shareholders are given rights to obtain securities (equity or debt) at a
substantial discount. These securities can be from the bidder (“flip over” plan) or from the
target (“flip in” plan). These rights have the effect of making the hostile tender offer more
expensive for the bidder by adversely affecting either the target or the bidder itself. Prior to the
triggering event, the target directors can redeem the rights, but after the event the rights become
non-redeemable. Pac Man defense: launch a counter attack and tender for all their shares.
Golden parachute: employment severance, etc. Can be a conflict of interest. Will this put you in
the position of looking out for the SH? So if it’s triggered on a change in control, it will add to the
acquisition cost. So a portion of the value of the corporation has been moved from the SH to
management.
Monday, 07 February 2005
Flip over is older and less useful. If anybody acquires a certain % of T’s shares, there is a
further offer of shares and holders of T’s shares can acquire shares in B’s shares at deep
discount, thereby diluting the B’s shares. I’m flipping over my shares in T for shares in B; but in a
massively discounted cost, thereby diluting B’s shares. Knipprath says it’s just a warrant to buy
shares if a merger occurs. It’s like saying to B, “If you want to buy my car, you can, but then you’ll
have to pay the full college tuition for my next kid; and he’s the smart one.” These can often be
redeemed pre-merger by vote of the majority of independent board members or independent SH.
These plans were upheld in Moran v. Household International, Inc. (Del. 1985).
How to Defeat A Flip Over: Of course, failure to complete the merger will defeat a flip-over plan.
Or, a requirement that the flip over rights be redeemed prior to the merger. This could keep T
from being able to attract a white knight because the flip over right is already out there. The white
knight doesn’t want to be stuck with the rights which will dilute his shares. Redemption right
allows Board to negotiate highest price available for the shares. Approval of seller’s SH depends
on state law; their circumstances are changing so strong argument. Less strong for B’s SH.
In a negotiated merger, like Glen Alden, you need agreement of both Boards and the T’s SH.
See p. 784
Who votes on merger agreements?

Measure of liability: Did Board act in best interests of the corporation.

Flip-in: Same but you can acquire shares in T instead of B. Usually triggers at 20%. Now B has
to buy twice as many shares; more difficult to gain control. Similar to Moran, one alternative that
works with a core group of cohesive owners (like Maremount’s target). You issue a class B
voting common share. And you issue it for free, just like a dividend. You say that that voting
stock may not be sold. You can sell the Class A common; but if sell your class A common, you
lose your right to class B. The control group is least likely to sell. So, over time, SH sell off their
Class A shares and the control group has a higher voting %. You can have a merger trigger that
calls for Class B SH to have 10x the voting rights of Class SH. So, in the beginning, everyone
was equal. But, over time, the control group gains a corner on the voting shares. Downside:
may keep bidders at bay and depress SH value.
D. Liability Issues
07/02/2005
When the target’s management and directors institute actions to defend the corporation from the
takeover, they are usually faced with a charge of breach of fiduciary duty to the corporation and
its shareholders. Fiduciary duty is generally divided between the duty of care, and, when there is
a conflict of interest, the duty of loyalty. With the duty of care, directors are liable only for
neglecting their duties, not for misjudgements and, thus, any judicial inquiry focuses on the
decision-making process, not the decision itself. The decisions are generally protected by the
business judgement rule, which presumes that directors have acted in good faith and in the
corporation’s best interests. Duty of loyalty generally applies when the directors are in a conflict
of interest. The important distinction between the two duties is that in a duty of loyalty analysis,
the directors usually have the burden of proof as to the fairness of their decision and thus, the
courts scrutinize the decision with a greater possibility of liability.
Those who favor hostile tender offers have argued that the target’s defensive tactics place
directors in a conflict of interest, because they are concerned with keeping their positions, and,
thus, the business judgement rule should not apply. Those who oppose hostile takeovers view
the implementation of defensive tactics as similar to other business decisions protected by the
business judgement rule. In fact, in most cases, the use of defensive tactics have resulted in a
third test involving a modified business judgement rule or proportionality test under Unocal
v. Mesa Petroleum.
Cheff v. Mathes
Rule: If the board had a good faith belief that it was acting for a proper purpose to serve
the corporation, business judgment presumptions apply in reviewing actions taken.
In Cheff a Delaware Court was faced with a greenmail case, in which the directors of the potential
target had voted to purchase the shares of a potential bidder for a premium so that the bidder
would not acquire the corporation. The potential bidder was buying shares of the corporation on
the market and seeking a seat on the board while criticizing the target’s management. The
target’s purchase of shares from the bidder was challenged in a derivative suit alleging it was a
perpetuation of control by the directors.
The decision recognized the director’s need to defend proper business practices, but also
recognized the potential conflict of interest when directors are primarily acting to perpetuate
their control. Thus it did not apply the traditional business judgement rule nor the duty of loyalty
standard. Instead it applied an intermediate standard that focused more on the motive for the
defensive measures: The court shifted the burden to the defendant directors to show whether
there were reasonable grounds to believe that the hostile tender offer constituted a danger to
corporate policy or effectiveness. This burden was satisfied by a showing of good faith and
reasonable investigation.
a. Cheff v. Mathes (Del. 1964)

1. Facts: Target corporation defended takeover by buying back its own

shares at a price above market, in order to prevent a raider from coming in and changing
its furnace sale policies.
2. Holding: The board decided in good faith that corporate policy was
threatened, so business rule applied.
a. Rule: If the board had a good faith belief that it was acting for a
proper purpose to serve the corporation, business judgment presumptions
apply in reviewing actions taken.
b. Business Purpose Test
1. if the actions of the Board were motivated by a good faith belief
that the buying out of the dissident stockholder was necessary to maintain what
the board believed to be proper business practices, the board will not be held
liable for such decision, even though hindsight indicates the decision was not the
wisest course
2. however, if the board has acted solely or primarily because of
the desire to perpetuate themselves in office, the use of corporate funds for such
purposes is improper.
c. Burden of Proof
1. Lies initially with Board of Directors, because it has a conflict of
interest this is not an ordinary situation; there is a high probability that there could
be a conflict; so this issue of entrenchment arises, it’s tough for the board to show
that it’s independent. There could be an almost subconscious bias by the board
to protect themselves. Built-in conflict of interest or appearance thereof. So, we
shift the burden of proof on the good faith issue. This is one possible solution.
This is particularly true where you have insiders and / or board members with
pecuniary interests.
2. Burden is satisfied by a showing of reasonable grounds to
believe there’s a danger to corporate policy and effectiveness presented by
hostile stock ownership. (i.e. good faith and reasonable investigation).
Coming up with a corporate purpose; or that it goes against the corporate culture.
3. Greenmail: Did Maremount ever really plan to take over the
company? The book value of the company was higher than the stock price; so
the board would be willing to pay them off to shut them up.
4. Board says they are buying back stock for a stock option plan.
5. Argument for paying greenmail: preserve the policies of the
company in the interests of the company.
6. Argument against: sets a bad precedent.
Board must meet, consider, disclose, investigate, ensure independent evaluation. Board and
perhaps maj SH have fiduciary duty nto to sell to a looter to ruin it. But, no evidence here that
this was his objective. No broad fiduciary duty to employees; so if they are going to get fired but it
helps the company, then it’s OK.
Does the share price reflect the market information about the company? If yes, then insider
trading is OK. This is one argument. You are relying on the collective wisdom of the
marketplace. Very few people are involved in insider trading. Argument is that it poisons the
market. Differentiate from fraud. Not churning or manipulation. Not Enron. Just inside trading.
Unocal v. Mesa Petroleum

2 tier offer: front end gets cash; back end gets junk bonds. Discriminatory tender offer
In Unocal the court reiterated the Cheff-rule, but with an additional focus (Unocal-test):
In enacting a defensive tactic the board must prove:
(1) that it had reason for believing that a danger to corporate policy and effectiveness existed,
and

(2) that the defensive tactic was reasonable to the threat posed
This test differs from the normal application of the business judgement rule by placing the initial
burden on the directors and allowing some scrutiny of not just the process but also the substance
of the decision.
The first step focuses on the directors acting in good faith after reasonable investigation. The
second step allows the court to balance the defense tactic with the threat. Thus, the courts do not
employ a fairness test following the duty of loyalty standard, but rather a modified business
judgement rule in form of a proportionality test. The directors, on the one hand, are given some
latitude to defend against tender offers, the courts, on the other hand, may exercise closer judicial
scrutiny than in the ordinary case of business decisions.
Pickens’ offer seems like an attempt to extort greenmail.
1. Unocal Corp. v. Mesa Petroleum Co. (Del. 1985) (p.885)
a. Facts: At issue is the validity of a corporation’s self-tender for its
own shares which excludes from participation a stockholder making a hostile tender offer
for the company’s stock. The directors acted in good faith in concluding, after reasonable
investigation, that Mesa’s two-step tender offer was both inadequate and coercive.
Unocal’s objective was to either defeat the tender offer, or compensate shareholder’s at
the back-end of Mesa’ proposal. Including Mesa would defeat that goal.
b. Holding: The selective exchange offer is reasonable in relation to
the threat posed by Mesa’s coercive two-tiered tender offer, therefore the board acted in
the proper exercise of sound business judgment. The Court will not substitute its views
for those of the board if that decision can be “attributed to any rational business purpose.”
c. Note:
1. In the acquisition of its shares, a corporation may deal selectively
with its stockholders, provided that the directors have not acted for the purpose of
entrenching themselves.
2. Enhanced Scrutiny
a. because of the possibility that the board may be acting in its
own interests, there is an enhanced duty which calls for judicial examination at
the threshold before the protections of the business judgment rule apply
3. For the Business Judgment Rule to apply:
a. First, the defensive measure must be reasonable in
relation to the threat posed. (Unocal)
1. possible concerns:
a. inadequacy of the price offered
b. nature and timing of the offer
c. questions of illegality
d. the impact on “constituencies” other than
shareholders
e. risk of the deal falling through
f. quality of securities offered as consideration
b. Second, directors must show good faith and a reasonable
belief that the raider will thwart corporate policy and effectiveness. Their showing
is materially strengthened by the approval of a board comprised mainly of outside
independent directors.
4. Summary: Once it is shown that the defensive measure is
reasonably related to the threat posed, if the directors are disinterested and acted in
good faith (which is plaintiff’s burden to prove otherwise), its decision in the absence
of an abuse of discretion will be upheld as a proper exercise of business judgment.
Friday, 04 February 2005
Mesa tenders for first tier to gain control. Mesa tells SH up front that they will be cashed out at
the back end with various debt instruments valued at $54 / share (same value as cash paid up
front). Mesa planned to get a majority interest, merge Unocal into Mesa and force out the
remaining SH. How can they do that? Once they have 51%, they can vote their controlling
interest. No super-majority voting requirement as in Weinberger. Minority SH might have right of

appraisal; but if Mesa gains control, they will be calling all the shots. Majority SH basically
decides whether merger is approved, absent a Weinberger type of limitation.
This is a hostile takeover. Some § of the ’34 Act apply. The Williams Act Amendment of 1968. §
16. Before the Williams Act.
In response, Unocal launched a self-tender. How would a self-tender protect self control?
The deep discount on the back end shares makes Pickens’ total offer less than it seems.
Pickens can make an immediate tender for all the shares at a cash to avoid the Unocal defense.
Court says deal must be fair; sort of like an independent judgment of the Court. Pickens had a lot
of bad press. Argument the other way is that Pickens would make the company more efficient.
Board has an obligations to the SH.
Think about Amazon, Google, or eBay. They have no hard assets; that’s not the value of the
company. Normally, businesses are worth much more as going concerns than by breaking them
up and selling the pieces. Pickens will make money by the arbitrage. If there’s no positive
spread he won’t do it. So where’s the hidden value? Economies of scale; synergies. Unocal
stock value went up when Pickens’ offer was tendered. Total restructuring of the company after
this ordeal; management woke up. Stock value went up. So the failed tender increased SH
value.
Problem of apparent conflict of interest by management who oppose deal when approving deal
will improve SH value. Bidder will argue entrenchment. But older state law cases about looters
say that management has a duty to protect SH from inadequate offers, destructive offers, break
up of the company. So, we want a defensive measure that is reasonable in response to the bid
they are defending against.
Revlon v. MacAndrews & Forbes

07/02/2005
In Revlon the court was faced with the application of its Unocal test :
Revlon had used several defense tactics to avoid a takeover. These tactics had the positive
effect of raising the bid to a higher price that could not longer be seen as unfair. The defense
tactics were: The target found a white knight who was willing to offer a competing bid for the
target in return for a guarantee that the target would not look for another bidder, a $ 25 million
cancellation fee if the bid failed, and a crown jewel lockup, i. e. the right to buy a valuable asset of
the target at a discount price if the bid would fail, knowing that the hostile bidder would not want
the target without that asset. The bidder challenged the actions as a breach of fiduciary duty.
The court held that lockups which encouraged bids are permissible while those that end
bids are not. By effectively ending the bidding and putting Revlon up for sale to the white knight
the directors had breached their fiduciary duty. Once a target is facing a sale or a break-up the
directors cannot play favorites. Their duty changes from preservation of the target to
maximization of value to the shareholders; that is, they are auctioneers.
Knipprath says that the stock was probably trading in the $30’s; the company was poorly
managed. So, the fact that Perelman was wiling to pay a $25 control premium just to oust
management tells you that the management really sucked.
Contingency clauses on the bids.
Entrenchment = Breach of Duty of Loyalty.
If sale is inevitable, Board should just have an auction.
Argument for allowing the $25mm cancellation fee: costs of the bidder; if you don’t allow them,
you might be discouraging bidders. Same for the “no shop” provision. But, the lock up is hard to
defend. Knipprath says: when a company is in play, additional suitors will come forth; therefore
the lock up will preserve the value of the assets.
Unocal says that defensive provisions must be proportionate to the attack. ON the one hand,
putting such provisions in place early, when there is no threat shows that it is not based on
entrenchment. But on the other hand, you can’t show proportionality of the threat if there is no
threat.
The lock up to Forstmann will guarantee a break up. So the answer is that the directors don’t
always have to take the highest bid if there is a better value to the company.

Paramount v. Time
In Time the target’s directors defended their company against a cash tender offer from
Paramount that climbed to $ 200 at a time where Time’s shares were trading at $ 126. Time had
originally negotiated a merger with Warner Bros. to pursue a strategic plan of expansion before
Paramount made its bid. Time’s officers feared that the shareholders would vote against the
merger because of Paramount’s substantial cash offer. Therefore, Time changed the transaction
from the original merger with Warner to Time making a friendly cash tender offer for 51% of
Warner’s shares. In contrast to a merger, there was no shareholder vote required for the tender
offer. The remaining 49% of Warner would be acquired later. Paramount argued that the original
Unocal criteria were not met because there were no reasonable grounds to believe Paramount’s
offer posed a threat and the response was unreasonable, intended solely to keep Time
management’s position. Moreover, it argued that there was a duty under Revlon to auction Time
since it was effectively put up for sale by the original merger agreement.
As to the first part of the Unocal test (the threat) the court held that inadequate value or
coercive tactics were not the only threats a target faces. There were other threats to justify
Time’s tender offer for Warner. One threat was Time’s concern that its shareholders would tender
to Paramount without an understanding of the proposed plan with Warner. Paramount’s offer had
conditions which created uncertainty and made a comparative analysis between that offer and
Time’s plan difficult. Paramount’s offer was eventually designed to upset the initial vote for the
merger with Warner and to confuse shareholders.
As to the second part of the Unocal test the reasonableness of the defense depended on the
threat. The court held that the directors had some latitude in the selection of a time frame for
achievement of corporate goals and, therefore, held the response reasonable.
The court also rejected the use of Revlon in this context. The negotiations with Warner did not
mean that a dissolution or breakup of Time was inevitable. After all, Time was allowed to pursue
its long-term strategy of combining with Warner.
Time gave a great deal of deference to directors in both identifying a threat and determining what
was the reasonable response. Time made clear that there is no general obligation to sell a
corporation just because there is a premium offered to shareholders at a fair price, when such
sale would upset a business plan. The difference to Revlon was that there was no planned
breakup of Time.
Missed Class Feb 9 - Get Nancy’s Notes
February 9, 2005
a couple more points about Revlon --- ct creates a duty on the directors…
in some ways, their actions are more confined…
in the ordinary case, they can consider what to when they want to sell, what terms… but there
comes a time in court, when the duty becomes to maximize shareholder value
the case seems to say that the point is when the sale of the company is inevitable, and the
sale is likely to break up the company
at some point, there is a duty to simply auction off the company…
white knight, in order to save you from the bitter clutches, may also require you to sell off a
desirable asset of the company… does that trigger Revlon duties?
By the directors going out and picking out a white knight for selling off assets, may trigger Revlon
duties.
If there are companies coming out of the woodwork, bidding for the corporation --- if it’s likely
that the company will be sold, and there will be a break up of the company --- even though
the company has not actively sought out a white knight, REVLON DUTIES are still
TRIGGERED!!! Just because they didn’t do anything, doesn’t mean that there are no Revlon
duties.
They should realize that the escalation of events create possible Revlon duties because the
company may be sold and chopped up.

The problem of the change in control --- Revlon duties may also be triggered here.
What do we mean by change in control? A owning the company rather than B…..
What is it that absent the scenario of the auction, what else might trigger Revlon duties when
there is a change in control?
Authors go through transaction fee --- that the lock up provision, termination fee, in particular,
were ways that a bidder might recoup some start up costs… this can be more than compensation
for the start up costs…
Courts have said that these are not per se illegal... --- look a the analysis section on page 796 for
some examples…
Do boards of directors have a fiduciary duty to the creditors? Note holders are just creditors.
General rule is NO DUTY of fiduciary obligation
However, there are K’s obligation..
And there are basic non fraudulent requirements.
Del takes the position that if a company is insolvent --- at that point, there is a fiduciary obligation
to the creditors as well as to the shareholders.
So theoretically --- INSOLVENCY creates duties to both creditors and shareholders that aren’t
normally there.
PARAMOUNT COMMUNICATIONS, INC. v. TIME INCORPORATED page 797

Corporation (P) v. Target corporation (D)
Del. Sup. Ct., 571 A.2d 1140 (1989).
NATURE OF CASE: Appeal from judgment rejecting challenge to corporate merger.
FACT SUMMARY: Directors of Time, Inc. (D), seeing a threat by a bid for control by
Paramount Communications, Inc. (P), undertook measures to defeat the takeover effort.
CONCISE RULE OF LAW: Directors 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 the corporation.
FACTS: Time, Inc. (D), publisher of a major newsmagazine, developed the intention of making
inroads into the entertainment industry.(makes it easier for them to distribute their programs…)
So then they created a special board to create a strategy for going into the entertainment
industry. They look to several potential acquisitions… After considering several established
entertainment companies, Time's (D) board began merger discussions with the board of Warner
Brothers, Inc. (D), a motion picture studio. A merger was agreed upon, consisting of a stock-for-
stock swap in which Warner (D) would be merged into Time (D) with Warner (D) shareholders
receiving 0.465 shares of Time (D) stock for each share of Warner (D) stock owned. Gerald
Levin, Time’s vice chairman becomes CEO later. Time wanted to control the board of the
resulting corporation and thereby preserve management committed to Time’s journalistic integrity.
Initially, time was insistent on a cash for stock deal --- why? Because they would then just buy
it… no need to give WB any control…and who is taking over whom in a stock for stock?
That’s why warner was adamant about stock for stock. How could he argue this to his
shareholders? To give them a stake in the company, increase the val of the company in the long
run, another thing is the tax benefits, and it also eliminates the need for the banks to be involved
and the cash is not being passed around, so the company is on firmer ground…etc.
Time and Warner both wanted defensive tactics. Automatic share exchange – similar to
a lock up provision --- 10% is still pretty big… the respective management, that this might inhibit
any attempt by any third party to take over the company. It would make it more difficult, more
expensive, etc for a third party to take over. Confidence letters: that banks are committed to
this, that they won’t finance others. It preserves the confidential relationship between Time and
the banks… No shop provision: Time can’t consider any other offers, regardless of the merits of
the other offers.
Warner was concerned that if Time withdrew, other people would try to buy Warner ---
they can’t just tell people they aren’t for sale. They have to investigate and consider all offers…
because they owe that duty to the shareholders. --- they don’t want to be put in the position to

have Revlon duties… that the company is likely to sell / break up. The no shop provision
establishes that the sale was just to be for time and warner --- not for all different people to come
and buy warner…
Unexpectedly, Paramount Communications (P) announced an all-cash offer to purchase
Time (D) for $175 per share. ALL SHARES!!! Notice how the value of the Time shares to
Paramount was VERY HIGH. Why? The value of the Time stock was undervalued in the Warner
deal, OR there are different synergies at work… but how are they going to recoup the cost? Sell
off the assets they don’t want.
This led to a restructuring of the proposed Time (D)-Warner (D) merger into a cash and
securities acquisition. --- which meant that the new plan would lead to time creating a huge debt
in buying up warner stock. Making themselves less attractive to Paramount. Time's (D) board,
citing concerns about Paramount's (P) acquisition posing a threat to Time's (D) corporate culture,
continually rejected Paramount's (P) overtures, which eventually increased to an offer of $200 per
share.
The original Time (D)-Warner (D) agreement had included a "no shop" clause which
prevented Time's (D) board from considering other options. Both Paramount (P) and various
shareholders of Time (D) filed suit, alleging breach of fiduciary duty by Time's (D) board.
The chancery court rejected the claims and dismissed. An appeal was taken.
Time shareholders were asserting Revlon duties: they base their arguments on the fact
that warner shareholders receipt of 62% of the combined company and the defensive maneuvers
time directors used to cover up the fact that Time was for sale… ---- they held in favor of Time
here, that there were no duties of Revlon triggered…there was NO change in control --- that there
was just a fluid aggregation of unaffiliated shareholders representing a voting majority…. There
was no change in control, it was just a joining of shareholders. There may have been dilution of
the position of the shareholders, but think of the numbers we’re talking about ---- we’re talking
about hundreds of thousands of shareholders…
The other claim that could have been made was that the Revlon duties were raised when
Paramount came into the picture… but time argues that this was different from Revlon’s case…
there was 2 companies trying to break up in that case, here it was just one.
Paramount asserts a Unocal claim. Paramount also argues that they are NOT a threat ---
that it was an all cash tender, no coercion like in the Unocal case (good faith, reason able
investigation, and proportional to threat). It’s not a two tier offer that they made, and this threat of
an all shares, all cash… was not the case either.
Prevention of the shareholders from voting: if it was a merger, they all had to vote on it…
but as a tender offer, only the target corporation’s shareholders would have to vote.
Paramount is arguing that Time was consciously preventing the shareholders from
voting… threat was in regards to the value of the shareholder’s investment. The court doesn’t
buy this…
UNOCAL: only when there is a defensive mechanism working.

Revlon and unocal can work together, but they are two separate things.
There can also be a regular BJR issue too.
Why does the court say that there is no Revlon duties that applied here? there was a
plan all along by time… was the court sympathetic to Paramount? Not really… because
Paramount came in at the last second… why did they wait till the last second? Everyone knew
what was going on… Maybe paramount was riding on the work of others, reflecting valuation in
the market, knowing what the other companies was doing…
The shareholders are not particularly sympathetic either --- because they weren’t
complaining about the lack of value before, not till paramount came in… and they had remedies
prior to paramount, they had appraisal remedies…
Proceeding with the Waner transaction was okay under the basic BJR principles
Courts in the subsequent page goes through the Unocal’s argument --- reasonableness
of the action… valuation of the corporate threat, measures of protection, etc. Court basically
holds that it’s not up to the shareholders to decide what is best… the fact that the board changed

from the stock to stock offer, to change to the cash for stock… depriveing the stockholders the
chance to vote, does not amt to a bad action… .because it’s within the discretion / business
judgment of the shareholders…
Therefore, the shareholders didn’t lose anything that they had a right to… because the
board always had the right to do a cash for stock offer… in fact, that’s originally what they wanted
to do in the first place!!!!
ISSUE: May directors of a corporation involved in an ongoing business enterprise take into
account all long-term corporate objectives in responding to an offer to take over the corporation?
HOLDING AND DECISION: [Judge not stated in casebook excerpt.] Yes. Directors 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 the corporation. When a corporation is
an ongoing enterprise, and is not effectively "up for sale," directors are more than a mere
auctioneer trying to obtain the highest price possible. A board's decision to reject a takeover
offer will be upheld under the business judgment rule if the directors can show that their
decision was not dictated by a selfish desire to retain their jobs, but rather was in the best
interests of the corporation. Share price is a component of this analysis, but is not the sole
criterion. If the directors arrived at the decision to reject an offer after appropriate analysis and
consideration of legitimate factors, a court will not substitute its judgment for that of the directors.
Here, the directors elected to continue with a deliberately conceived corporate plan for long-term
growth rather than accept an opportunity for short term profits, which is a legitimate decision. The
acts of Time's (D) board were therefore appropriate. Affirmed.
EDITOR'S ANALYSIS: The court here applied what is know as the "Unocal" analysis, after the
case Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985). In that opinion, the
Delaware Supreme Court established the rule that a board's defensive tactics will not be given
the deferential business judgment rule test, but will be subject to a higher level of scrutiny due to
the possibility of self-interest
REVLON DUTIES: LOOK FOR ---

• ABANDONMENT OF COMPANY’S LONG TERM STRATEGY
• BREAK UP OF COMPANY IS INEVITABLE
• CHANGE OF CONTROL OF COMPANY
Paramount v. QVC
In QVC Paramount agreed to be acquired by Viacom and put several defensive tactics against
competing bidders in place. Although Paramount’s shareholders would own equity in the
new company, the controlling shareholder of Viacom would hold 70% of this new
company. Then, QVC came and offered a price for Paramount that was $ 1.3 billion higher than
the Viacom bid. Paramount’s directors did not give up their defensive tactics. QVC sued to enjoin
the defensive tactics. Paramount’s directors relied on the Time decision on the basis that it too
had a strategic merger, that there was no planned break-up of the company, and that the merger
with Viacom fitted best in Paramount’s long term business plan
Defensive Measures Adopted by Paramount:
1. No Shop Provision
2. Termination Fee of $100mm
3. Stock Option Agreement
a. 29% of Paramount’s CS @ $69
b. Not a cash deal; sr. subordinated debentures
i. Cash for options
ii. Current creditors of Viacom will be senior to Paramount’s

iii. Viacom has a put option on the options; can force

Paramount to pay cash for any market value loss to $69.
Knipprath says this looks like a lock up.
The court decided that Time did not apply and that instead the auction duty under Revlon was
triggered. The court found that not only a planned break-up, but also the change of control that
would have resulted from the merger with Viacom justified the application of Revlon. When
there is change of control the target shareholders become minority shareholders and their voting
rights become a formality. The majority shareholder could cash them out in a subsequent freeze
out merger. Thus, in a change of control context, as in the case of a planned break-up,
directors must focus on securing a transaction offering the best price available for the
shareholders.
QVC and Paramount boards decide to meet b/c QVC makes an initial showing of financing so the
“no shop” provision of the pending Viacom deal is not triggered. So they talk on-and-on and
finally QVC tenders $80 for 51% w/ stock on the back-end. We guess this is similar in value to
QVC’s first offer but just re-structured to accommodate the stock:cash ratio that Paramount
wanted. QVC says that the tender is contingent upon Paramount’s revocation of the stock option
agreement with Viacom (valued at ≈ $200mm.) QVC also sues to enjoin the option plan in case
it’s not voluntarily withdrawn.
So now Paramount and Viacom meet again and amend their agreement. The new provisions
are: $80 per share with securities on the back end. Same general form as QVC. Also, included a
restriction on Paramount’s board from revoking unless it thinks its in the best interests of the SH.
Seems like the Board of Paramount now has better bargaining power. Court says that
Paramount Board should have done a better job of extracting more concessions from Viacom.
The Court sees all these provisions as preclusive to a true bidding process.
Knipprath says that if the provisions are inherently bad, then they are void and the board cannot
honor them. So, what’s the big deal? Stick to the K or suffer breach. Why should the Board
have to keep negotiating on provisions that they are not required to recognize or follow (if they
are inherently bad).
QVC complains that they are not being treated equally with Viacom. Court applies Revlon duties.
Revlon applies because …
Revlon applies when: Board seeks bidders (puts company in play); or solicits alternative bids to
an unsolicited offer. (Someone else puts the company in play and a break up my occur). Time
vs. Revlon: You have to maximize SH value when it becomes inevitable that there will be a
change in control or a break up. So, it seems as though Knipprath is saying that Paramount
would not be broken up by either deal. Both offers were cash & stock. No indication that Viacom
needed to incur huge debt or sell assets to finance the deal.
Court invokes Revlon because they think that there is a control premium issue. Who is selling a
control premium? Viacom is taking over Paramount; so Paramount is selling the control premium
belonging collectively to the Paramount SH. In other words, the court decided that Time did not
apply and that instead the auction duty under Revlon was triggered. The court found that not only
a planned break-up, but also the change of control that would have resulted from the merger
with Viacom justified the application of Revlon. When there is change of control the target
shareholders become minority shareholders and their voting rights become a formality. The
majority shareholder could cash them out in a subsequent freeze out merger. Thus, in a change
of control context, as in the case of a planned break-up, directors must focus on securing
a transaction offering the best price available for the shareholders. Post-transaction, any
control premium paid for control of Paramount would go to the controlling SH (Sumner Redstone).
In Time Warner there was no control premium issue because after that deal, had the merger
been consummated, Paramount would still not be able to acquire the control premium from a
single SH because the control premium was too widely diffused. The counter to that argument is
that the cost of the newly combined Time Warner would be (a) much more expensive; and (b)

would be restricted to far fewer bidders; and (c) SH value was lost b/c the bid was $200 and TW
lost a big chunk of its valuation when the deal failed.
So, there’s a control premium being lost by Paramount SH that they can never recover. But
Knipprath says that the control premium has not really been lost. If there is really an impact in a
large publicly traded SH of having a dominant SH; presumably the buyer could have just bought
the controlling SH. In other words, doesn’t it all work out. If the stock is cheaper at Viacom b/c it
has a dominant SH, then presumably the Paramount SH got more when they receive their
Viacom shares than they would have if the Viacom corp did not have a control premium
depressing its price.
Van Gorkum duty to properly investigate might have been a better fit for the Court rationale than
Revlon. But maybe Van Gorkum was too controversial (it spurred many director protection
statutes immediately after).
1. Knipprath’s Hypo
How does a board maximize SH value if Revlon is invoked? The board could put the company
up for sale and try to attract bidders. Then they have a Van Gorkum duty to stay informed. Then
they should try to run up the bids.
Does the Board have to take the highest cash bid? No. Contingent financing, debt financing,
other considerations as to the quality of the offers. Maximize SH value; but value is not just the
offer price. Value of corporate culture may matter in a potential break up.
Summary
When shareholders challenge the actions of directors there are generally three levels of review:
(1) business judgement rule, (2) Unocal’s enhanced scrutiny test, and (3) the duty of loyalty.
In the takeover context, under Unocal, the initial burden is on the directors, and the courts look
first at the reasonableness test that focuses on the good faith determination of the threat to the
target. The threat is often based on the belief that the bidder has offered insufficient value, but
other threats are possible. It could involve the hostile bid depriving target shareholders of a
superior alternative, treating non-tendering shareholders differently and distorting their choice
(factual coercion).
The second test looks at the proportionality of the target’s response to the threat. If the
defense tactic is viewed as draconian, i. e. either preclusive to tender offers or coercive to
shareholders, it will be closely scrutinized and will likely fail. If the response is less than
draconian, then the judicial scrutiny looks at the range of reasonableness, i. e. whether the
tactic was proper and proportionate. In that case, there will be judicial restraint and the court
will not usually substitute its judgement for that of the directors.
If the corporation seeks to sell itself, abandons a long-term strategy and seeks alternatives that
include the break-up of the business (Revlon), or attempts to effect a change of control (QVC),
then the Revlon duty of getting the best price for the shareholders applies. Without a change of
control or break-up, there appears to be no general obligation to sell the corporation, even if
a substantial premium that reflects a fair price is offered by the bidder. This is especially true
when the tender offer upsets a business plan.
The level of scrutiny will be higher if directors unilaterally and unduly interfere with shareholder
voting and corporate democracy. On the other hand, it will be lower if shareholders are involved
in the approval of the defensive tactics.
Knipprath says: the no-shop provision included an inclusion of the fiduciary duty of the board; a
recognition that the board’s no-shop provision was more nuanced than in past cases.
Hilton v. ITT
1) Facts: In response to a hostile tender, ITT split up the firm into 3 firms with 1 of
them having 90% of the old assets which were the best assets. Crown

Jewel Because this created a new Corporation, the board was able to
rewrite the Certificate of Incorporation, and classified the board so that it
takes 80% vote to declassify. This was done 2 months before an annual
meeting. All of the old ITT board was on the board of the new Corporation.
2) Analysis: Purposefully disenfranchising Shareholders such as changing the
consequences of a Shareholder vote so that Shareholders cannot throw
out the old board requires a compelling interest.
(a) There was no such compelling interest here so the classification was
enjoined.
(b) This is distinguished from the Time where board took the power of approval
from the Shareholders because in Time Shareholders vote still had its
basic quality even though they were not able to exercise the vote.
3) Unitrin – Board action that affects Shareholder vote consequence may be
thrown out, even if the change is not preclusive of future deals.
Knipprath says: Sale of a crown jewel ≠ a break up and does not necessarily invoke Revlon.
Does a staggered Board hinder all takeovers? Don’t staggered Boards ensure stability of the
Board? What if a bidder is successful but there is a staggered board. So the Buyer has 3 on the
board and the other 6 are entrenched. So, they only need to turn 2 of the 6 existing directors to
get control. That shouldn’t be too hard. Once you get some of your people on the board, you
start throwing your economic weight around and the psychological reaction is to cooperate;
especially if you are an outside director. They will bribe the inside directors with more benefits,
job title, etc.
Amy Says:
Hilton Hotels Co. v. ITT Co. (supp107)—As a defensive mechanism, ITT created 3 subsidiaries
w/o SH approval. Hilton challenges the action, and that implicates Unocal (because it was action
taken in response to a takeover bid). Was there a threat here? Directors said the price was
inadequate. Ct took a substantive view and analyzed the price (DE wouldn’t have done that).
Assumes the threat and goes to part 2, reasonableness of the action. Is the response excessive?
Holding: yes. Blasius is about increasing the board size—court thinks this is Blasius, is it? ∆ s
have to show a compelling justification, which is a difficult hurdle, so they lose.
L: Is the sale to 3 different co. all of your assets? Court didn’t reach it, assumes ITT can
do it.
What is Blasius? Go over this entire case again.: It’s Unocal (BJR+)
Good Faith (Unocal)
Reasonably Proportionate Response (Unocal)
Compelling Interest (Blasius)
2. Knipprath Review of Board Duties

Duty of Care
(1) Ordinary Duty of Care Allegation: Defend with BJR (Courts don’t second guess
Board decisions) rational basis
Duty of Loyalty
(1) Intrinsic Fairness Test
Unocal
Defensive Tactics are not intrinsically bad; need to protect company from looters.
But, it could become a tool for entrenchment. Potential for a conflict of interest.
Apply BJR + the following: Incorporates Cheff v Mathes
(1) Is response reasonable and proportionate to the threat? Lower level
intermediate scrutiny test.
(2) (1) that it had reason for believing that a danger to corporate policy and
effectiveness existed, and

(3) (2) that the defensive tactic was reasonable to the threat posed
Revlon
(1) If Company sale or break up is inevitable, or change in control, Board must
maximize SH value
Paramount v. QVC
(1) examine critically the offers
(2) act in good faith
(3) obtain and act with due care
(4) negotiate actively and in good faith with both Viacom and QVC.
Blasius /Unitrin
(1) Board cannot unilaterally act to disenfranchise the SH without a compelling
interest; this is strict scrutiny
SEE CORPORATE REGULATION (WILLIAMS ACT) BELOW.
CTS v. Dynamics (pg767, n93, SC)—IN enacted a statutory scheme requiring SH approval prior
to significant shifts in corporate control. The practical effect of this requirement is to condition
acquisition of control of a corporation on approval of a majority of disinterested SH (what exactly
is a disinterested SH?)
Holding: This statute is constitutional. Entities can comply with both the Williams Act and the
Indiana Act, and the purpose of the Williams Act is not frustrated by it. The IL statute that was
struck down in MITE was different because it gave the company an advantage in communicating
with SH, while the IN statute just protects SH against both sides in a takeover. The additional
delay in the IN act is not fatal unless it is unreasonable. And the IN statute doesn’t go against the
commerce clause. Hindering tender offers is not enough reason to invalidate the statute
Concurrence: Statute may not be wise, but as long as it doesn’t discriminate against out of state
interests, then it is fine.
Dissent: It undermines the Williams Act.
Control thresholds suspend voting rights unless the majority of disinterested SH.
See analysis, pg777, Should DE be dictating the law for half of the US corporations?
DE’s anti-takeover legislation, pg778

FOR FEB 14: OVERVIEW OF SECURITIES MARKETS; THEN GET INTO SECURITIES
REGULATION. DO FIRST 3 CASES OF SECURITIES REGULATIONS PACKETS.
Monday, 14 February 2005
State anti-takeover acts; control share laws. Other states followed the Indiana law from CTS.
Edgar v. Mite. This case gave the green light to such laws. Included companies with a mere
presence in the state, not just companies incorporated there. There was an opt-in provision for
companies there before the law was passed; and an opt-out provision so mgmt could opt out of
the scheme. This was a stand-down provision for the acquirer; the acquirer lost its right to vote
but that lost right could be restored by a vote of the SH w/in 50 days of the offer. So, the buyer
could force a SH mtg NLT 50 days after the offer.
Two problems:
1. Williams Act; preemption
2. Dormant Commerce Clause
If not direct conflict or intent of Congress to occupy the field, you can still have a DCC issue.
EXAM ALERT: LOOK FOR PREEMPTION AND DORMANT
COMMERCE
ACE v. Capital Re (p. 824)

a) ACE and Capital Re entered a merger agreement which bound Capital Re to a no-talk
clause (highly restrictive)

b) XL Corp. made a hostile bid for Capital Re and Capital Re discussed terms with XL, in
violation of no-talk clause
c) ACE brought suit to enjoin Capital Re from doing so
d) Court ruled against ACE on grounds that no-talk clause required Capital Re directors not
to maximize shareholder value by discussing another more profitable merger with XL,
in violation of duty to shareholders, and was thus illegal
e) ACE ended up winning ensuing auction
 r uling makes it very difficult for a company that has been trying to sell itself for a long time
and that finally finds a buyer to grant that buyer restrictive terms if such are necessary to
get the buyer to go ahead with the deal
d.
B. Takeovers
(1) Introduction
a. Williams Act:
(i) 5%+ – Requires disclosures of stock accumulations of more
than 5% of a target’s equity securities so the stock market
can react to the possibility of a change in control;
(ii) Tender offers – By anyone who makes a tender offer for a
company’s equity stock so shareholders can make buy-sell-
hold decisions; and
(iii) Structure of tender offers – Regulates the structure of any
tender offer so shareholders are not stampeded into
tendering.
(iv) Same price - Tender offeror must give same price to all
shareholders, and that must be the highest price ever
offered.
b. De GCL § 203 – Directed at 2-stage freeze-outs
(i) A controlling shareholder of a corporation that has recently
acquired an interest in the corporation must wait 3 years
from the time he created the interest to the second stage
squeeze-out.
 Exceptions: If the controlling shareholder has over 85%
of the co. or without 85%, if 2/3 of the other 49%
shareholders vote, the 2d stage squeeze out may
proceed.
 Incumbent waiver – Incumbents can waive these
requirements under §203.
(2) Greenmail.
a. Cheff v. Mathes (KRB, 743–51) (Del ’64) – Corporate fiduciaries
may not use corporate funds to perpetuate their control of the
corporation Corporate funds must be used for the good of the
corporation, although activities undertaken for the good of the
corporation that incidentally function to maintain directors’ control
are permissible. But acts effected for no other reason than to
maintain control are invalid.
C. Takeover Defenses
(1) Dominant Motive Review
a. Under this standard, courts readily accepted almost any
business justification for defensive tactics. The target board only
had to identify a policy dispute between the bidder and
management. (Cheff v. Mathes)

(2) Intermediate Due Care Review – Heightened standards of deliberative

care in takeover fights, requiring directors to probe into the business and
financial justifications for takeover defenses.
(3) Intermediate “Proportionality” Review – Intermediate substantive
standards – between intrinsic fairness and rational basis.
a. Unocal Corporation v. Mesa Petroleum Co. (KRB, 755–64) –
2 Prong test:
(i) Dominant purpose. Board must reasonably perceive the
bidder’s action as a threat to corporate policy – a threshold
dominant-purpose inquiry into the board’s investigation; and
(ii) Proportionality. Any defensive measure the board adopts
“must be reasonable in relation” to the threat posed.
b. Revlon v. MacAndrews & Forbes Holdings (KRB, 766–76) –
Requires Board to conduct a fair and impartial auction when
management-friendly bidder plans to bust up the company.
c. Paramount [I] v. Time Incorporated (KRB, 778–87) – Permits
a target board to block an unsolicited (but attractive) cash bid.
d. Paramount [II] v. QVC Network Inc. (KRB, 788–801) –
Prohibits a target board from preferring one all-cash offer for
another without looking at the alternatives.
(4) Reconciling the Unocal–Paramount Doctrine:
a. Incumbent resistance – A corporation threatened with takeover
move to resist the takeover.
(i) No Business Judgment Rule applicable.
b. Intermediate Standard of Enhanced Scrutiny- Unocal
(i) Incumbents need not prove entire fairness of takeover
defenses but must satisfy 2 prongs:
 Purpose. Incumbents may defend if they first engage in
adequate review (Business Judgment Rule) and on the
basis of full information;
 Proportionality. The defenses must be proportional to
the threatened takeover.
(ii) Purely defensive situation. Did the incumbent take any
steps toward transfer/shift of control or significantly depart
from previous corporate policy?
 If no (Paramount I) → Comes very close to the
enhanced business judgment rule and incumbent
defenses are highly protected.
 If yes (Paramount II → Incumbents must maximize
shareholder wealth, and corporate concerns fall apart:
1. Action! (Revlon)
(5) Nevada
a. Hilton Hotels Corp. v. ITT Corp. (KRB, 802–13) (D. Nev ’97) –
ITT had come up with a bankruptcy reorganization plan in which
it broke up into several parts. Preemptively, it was doing what
Revlon had intended to do. The corporate operations nerve
center was going to be reshuffled. Although not significant, the
court construed this as a step toward shift in control in favor of
incumbents ∴ the Revlon rule was triggered.
(6) State & Federal Legislation

a. CTS Corporation v. Dynamics Corporation of America (KRB,

816–28) – Indiana Statute under which a corporate raider loses
voting rights. That makes it very difficult to set up a 2-stage
takeover, because without voting rights in the acquired company,
control is very difficult.
b. Amanda Acquisition Corporation v. Universal Foods (KRB,
828–35) – WI law similar to DE law imposing an absolute 3-year
waiting period before a 2d stage freeze-out of a significant voting
bloc of the corporation.
E. Federal and State Regulation of Takeovers
1. Federal Regulation: The Williams Act

Friday, 04 February 2005
In 1968 the Williams Act amended Sections 13 and 14 of the ’34 Securities Act:
Every person who acquires more than 5% of a class of equity security of a public corporation
must file a disclosure statement with the SEC within 10 days. The statement must include the
identity of the purchaser, the number of shares owned, when purchased, how paid for, and the
intentions of the purchaser with regard to the company. Moreover, the buyer has a duty to update
if there are changes in the disclosed information.
Reason: provide target, its shareholders and market with notice of a possible takeover attempt.
Prevent secret accumulations of control.
Once a tender offer has commenced bidder must file a similar, but more extensive disclosure
statement with the SEC and distribute it to the shareholders. Target management must make a
recommendation to the shareholders regarding the tender offer.
Tender offer must remain open for at least 20 business days in order to give shareholders
enough time to make an informed decision. Shareholders who tender have the right to withdraw
their shares at any time while the tender offer remains open. This enables them to tender into a
competing bid during the time the offer remains open.
Section 14 (e) prohibits material misstatements, omissions, manipulation and fraudulent practices
in connection with any tender offer. Very broad, major source of litigation. Usual claim that parties
have failed to fully disclose all material facts.
Knipprath says that cash offers can be launched much more quickly. Bidders can try to buy any
shares available on the open market before they launch their hostile tender. Bidder can move
stealthily if it has the time to do so. The Cash gives you a high ability to hide in a way that a
stock-for-stock tender would not. So, 13d and 14d of the Williams Act were passed to force
disclosure of acquisitions in excess of determined levels. Under 14d, if you have plans to launch
a tender offer, even if you have less than 5%, you must disclose your intentions. Cheff v. Mathes
- Maremount acquired his holdings by simply buying on the open market. But, this was pre-
Williams. Creeping acquisition.
§ 14 requires that if you have a tender offer pending, and then you decide to adjust the price; you
must retroactively compensate anyone who has already tendered. The small piece of stock block
you need to get over the 50% mark and gain control might be worth a lot more than the cost of
the initial acquisitions. So, disclosure can raise the acquisition cost. Choice was cash versus
junk bonds. Junk bonds need to be valued so you can factor in the risk and adjust for it.
Implied right of private action: Target Board could bring a private action. But then, what’s the
remedy? Notify us? An SEC warning?
Tender offer must be held open for 20 days in order to avoid the stamped effect.

2. State Regulations
Many states have enacted statutes that generally have the effect of restricting hostile tender
offers. This raises the question of how these state regulations relate to the federal law and
the Constitution. One question is whether the federal takeover regulation preempts state
regulation under the Constitution’s supremacy clause. Since congress did not explicitly preempt
state law, the issue becomes whether compliance with both federal and state law is impossible or
the state law is an obstacle to the purpose of the federal law. The other question is whether state
statutes violate the Constitution’s commerce clause by unreasonably burdening interstate
commerce:
CTS v. Dynamics
In CTS the supreme court dealt with an Indiana statute that had the practical effect of limiting a
bidder’s ability to conduct a hostile tender offer. Although the statute did not legally prohibit one
from trying to acquire control, it provided that if anyone bought more than a certain percentage of
shares, constituting “control shares”, they would need to get shareholder approval from the other
disinterested shareholders in order to have voting rights in those shares. Without voting rights, an
acquisition of even a majority of the shares does not procure control.
The court upheld the statute. It rejected the preemption argument because the statute did not
favor either side in the tender offer, but instead protected shareholders, which was also the basic
purpose of the Williams Act. The statute was also found not to unreasonably burden interstate
commerce because voting rights were a traditional state corporate law concern. So long as both
residents and nonresidents had equal access to shares, the court would not interfere with state
regulation of corporations internal affairs. CTS means that most tender offer statutes that do not
directly regulate the tender offer and that involve only corporations incorporated in the state will
not be found unconstitutional. Opposite argument is that Williams Act is an anti-takeover act and
that therefore the Indiana statute was favoring management and was thus in violation of the
Williams act.
F. Preemption Review
Fed Const ↓ Fed Const Fed Const↓
Fed Statute↓ Fed Statute↓
State Statute↑ State Statute↑ State Statute↑
How do you find preemption conflicts?
1. I. Direct Conflict Preemption

a) Direct Conflict in the Language of the State Statute or Federal Statute.
That is not the case here; no federal law against control shares.
b) Is it impossible to comply with the Williams Act and the Indiana Act at the same time?
Williams Act says tender offer must be open at least 20 days. Indiana law says you must have a
meeting within 50 days. So, compliance with both is possible.
c) You can also comply with federal and state notice laws at the same time.
2. II. Area Preemption: Did Congress Intend to Occupy This Field?

a) Williams Act regulates takeovers. Is the Indiana law regulating in the same field?
Seems so.
3. III. Did Congress Intend to Keept the States Out of This Field?
a) Assuming that both federal and state laws occupy the same field, is it apparent that Congress
intended to preempt a state law in that area? Usually a judicial determination.

4. IV. Has Congress Implied Its Intent To Occupy The Field By Pervasive Regulation?
a)Is there a comprehesive and pervasive pattern of regulation in the field?
Depends on how you define “the field.” Securites law - yes. But takeovers is a narrow field and
there is not a comprehensive and pervasive pattern of federal legislation on takeovers.
5. Is there such a need for NATIONAL UNIFORMITY that any act by congress means
they intend to occupy it?
No, because the historically states are allowed to regulate corporations. No historical national
regulation. National Uniformity Not required.
G. Dormant Commerce Clause Review

1. What is the purpose of the law?
It’s OK to create an economic advantage for attracting businesses. But they can’t create an
economic moat to protect their state for out-of-state competition. In CTS the purpose was to
deter hostile takeovers. We are not really concerned with big companies taking over small
companies. We are more concerned with minnows swallowing whales (per Knipprath). But the
Court here was concerned with highly leveraged buyouts. Highly leveraged deals amplify
problems when there is an economic downturn.
So the advantage is that the law will slow things down and help the SH avoid being “stampeded”
into a hostile tender (like a tiered offer).
The counter-argument is that the T Boone Pickens’ of the world keep management on their toes
and to maximize SH value by hostile takeovers and break ups. Greater efficiency, better for the
companies, market, and raiders.
But laid off employees leads to less government tax revenue. Suppliers, vendors, and other
supporting businesses will not be happy.
Remember Revlon where the Court chided the Board for siding with Forstmann when the
noteholders complained. Revlon Court said that Board could not favor note holders over SH.
Maximize SH value. Duty of Board is to maximize SH value. So, all these “stakeholders,” such
as creditors, suppliers, etc are not owed a duty. It’s improper under Revlon to consider the
interests of non-SH. But this Indiana statute in CTS says that the Board can consider the
stakeholder interests. What if the SH decide “to hell with the stakeholders, I want the deal?”
The Court says that the Board can frustrate the SH if it sides with Stakeholders over SH. This
law allows and encourages management to prefer Stakeholders above SH. But SH can vote w/in
50 days to decide if raider can make the offer. Therefore the bid will go ahead.
Bottom Line: SH vote makes it OK that the law preferes Stakeholders over SH.
2. Knipprath DCC Analysis of CTS Corp

Purpose is not commerce, it is police power, to protect health, welfare of community by
regulating takeovers; protects stakeholders, state has ligitimate interest. So, not protectionist.
Neutrality: If not protectionist, is it neutral or discriminatory? It is neutral b/c it appleis equally to
all SH (Indiana or outsiders). Slowing down bid doesn’t necessarily hurt non-Indiana bidders.
Application to only Indiana corps who have an Indiana choice of law clause. So, appears neutral.
Counter-Argument: we know it will have the greatest effect on out-of-staters. But, as we know
from Equal Protection analysis, discriminatory effect alone is not enough to prove an equal
protection violation. The law does not directly discriminate against outsiders.
Undue Burden Test: If it was disriminatory, then the state would have to show that the law was
the least burdensome method. But, since it’s not discriminatory, it is subject to a balancing test.
Pike Church balancing test is required. Under Pike, the law is not unduly burdensome on ICC
b/c companies can opt in, opt out, relocate, etc.
Multiple Inconsistent Burdens Test: Bibb v Navajo Freight Lines: Court says this law only
applies to Indiana Corporations, so no multiple inconsistent burdens.
1. Bibb vs. Navajo Freight Lines (1959)

a. state law requireing all trucks in state use curved mudguards to prevent
spatter and enhance road safety was unconstituitonal.
b. Straight mudguards were legal in 45 other states and curved mudguards
were illegal in one other state.
c. Burden on interstate commerce too great.
The law just says that 10% of the shares are in Indiana. So the law touches a lot of out-of-state
SH.
CONCURRENCE: (Scalia, J.) As long as a state's corporation law governs only its own
corporations and does not discriminate against out-of-state-interests. it should survive this Court's
corporate anti-takeover law. scrutiny under the Commerce Clause.
Amy says:
CTS v. Dynamics (pg767, n93, SC)—IN enacted a statutory scheme requiring SH approval prior
to significant shifts in corporate control. The practical effect of this requirement is to condition
acquisition of control of a corporation on approval of a majority of disinterested SH (what exactly
is a disinterested SH?)
Holding: This statute is constitutional. Entities can comply with both the Williams Act and the
Indiana Act, and the purpose of the Williams Act is not frustrated by it. The IL statute that was
struck down in MITE was different because it gave the company an advantage in communicating
with SH, while the IN statute just protects SH against both sides in a takeover. The additional
delay in the IN act is not fatal unless it is unreasonable. And the IN statute doesn’t go against the
commerce clause. Hindering tender offers is not enough reason to invalidate the statute
Concurrence: Statute may not be wise, but as long as it doesn’t discriminate against out of state
interests, then it is fine.
Dissent: It undermines the Williams Act.
Control thresholds suspend voting rights unless the majority of disinterested SH.
See analysis, pg777, Should DE be dictating the law for half of the US corporations?
DE’s anti-takeover legislation, pg778

a)
II. The Dormant Commerce Clause
A. Introduction: What is the Dormant Commerce Clause?
1 Idea that state laws that burden or discriminate against interstate or foreign
commerce may still be invalidated on the ground that they violate the dormant or
negative Commerce Clause
2 3 types of state laws potentially against DCC:
a) Laws whose purpose is to regulate interstate commerce, or whose affect is to
control out-of-state transactions
b) Laws that discriminate against interstate commerce
c) Laws that do not discriminate against, but nonetheless burden interstate
commerce
3 Questions to consider
a) Is the law rationally related to a legitimate state purpose?
b) Does the law have the practical effect of regulating out-of-state transactions?
c) If the law discriminates against interstate or foreign commerce, does it
represent the least discriminatory means for the state to achieve its purpose?
d) Are the burdens the law places on interstate commerce clearly excessive in
relation to the benefits which the law affords the state?
e) Does the law represent the least burdensome means for the state to achieve
its goals?
4 Pike Balancing Test
a) Pike v. Bruce Church (275) TEST: Where the statute regulates even-
handedly to effectuate a legitimate local public interest, and its effects on

interstate commerce are only incidental, it will be upheld unless the burden
imposed on such commerce is clearly excessive in relation to the putative
local benefits. If a legitimate local purpose is found, then the question
becomes one of degree. And the extent of the burden that will be tolerated
will of course depend on the nature of the local interest involved, and on
whether it could be promoted as well with a lesser impact on interstate
activities.
B. Rational Relationship to a Legitimate State Purpose
1 Legitimate State Purpose: Under their police powers the states may regulate and
tax for the health, safety, morals, and general welfare of the public.
2 Economic Protectionism: DCC bars a state from seeking to benefit its people by
shielding them from the economic consequences of free trade among the states
(strict scrutiny)
3 Rational Relation: Under the rational basis test it is assumed that facts were known
to the legislature that would make the challenged law a reasonable way of
achieving the state’s ends (Rarely struck down on these grounds)
C. Market Configurations
1 Market Configurations: The Commerce Clause protects interstate dealers or
traders from state discrimination designed to insulate in-state competitors, but it
does not protect particular configurations or arrangements or the market.
a) Exxon Corp. v. Maryland (292) FACTS: Court upheld a law prohibiting
producers or refiners of petroleum products, all of whom were out-of-staters,
from operating retail service stations in Maryland. Since no producers or
refiners in Maryland, in-state dealers would have no competitive advantage
over out-of-state dealers. HELD: 1) Not invalid simply because it causes some
business to shift from a predominantly out-of-state industry to a predominantly
in-state industry.
b) Minnesota v. Clover Leaf Creamery (293) FACTS: Upheld a state law that
banned the retail sale of milk products in plastic non-returnable containers but
permitted sales in non-returnable containers, mainly made of pulpwood.
Pulpwood was a major instate product. HELD: 1) Does not effect simple
protectionism, but regulates evenhandedly by prohibiting all milk retailers from
selling their products in plastic, regardless of state. 2) Most dairies package in
more than one type of container 2) Out-of-state pulpwood may still benefit
2 Business entry and regulation of corporate affairs
a) CTS Corp v. Dynamics Corp. of America (295) FACTS: Indiana law
providing that a purchaser who acquired “control shares” in an Indiana
corporation could acquire voting rights only to the extent approved by a
majority vote of the prior disinterested stockholders HELD: 1) On its face, the
Indiana Act evenhandedly determines the voting rights of shares of Indiana
corporations. 2) To the limited extent that the Act affects interstate commerce
(M&A), this is justified by the State’s interests in defining the attributes of
shares in its corporations and in protecting shareholders.
b) Bendix Autolite v. Midwesco Enterprises (299) FACTS: Struck down an
Ohio law providing for unlimited tolling of the statute of limitations wrt entities
located outside of Ohio that had not designated an Ohio agent for service of
process. HELD: 1) Places an unreasonable burden on commerce 2) Leave
balancing approach to negative commerce clause cases and legislative
judgments to Congress
D. Market Participant Exception
1 If a state enters the marketplace as a participant, its actions are treated as being
like those of a private party, and the state is exempt from the restraints of the
dormant Commerce Clause
a) Applies when state engages in the buying, selling, or dispensing of goods or
services

2 Reeves, Inc. v. Stake (1980) South Dakota was a market participant when, in
selling cement from a state-owned cement plant, it restricted sales to residents of
South Dakota
3 Exception to the market participant exception: Applies only to a state’s
activities in the particular market, narrowly defined, in which it is a participant. A
state may not impose conditions that have substantial regulatory effects outside, or
“downstream” of the market in which it is participating.
South-Central Timber v. Wunnicke (301) FACTS: Special provision to Alaska timber sale
contracts requiring the purchaser to partially process the timber in Alaska before shipping out of
state. Alaska participated in sale of timber, but not processing. HELD: 1) If a State is acting as a
market participant, rather than as a market regulator, the dormant Commerce Clause places no
limitation on its activities 2) When a state imposes “downstream” conditions, restrictions on resale
or use, it no longer acts as a market participant but as a regulator 3) Restricts what purchaser
does after it makes purchase from State, when State no longer has an interests in transaction 4)
Within virtual-per-se rule of invali
1. CTS Corp. v. Dynamics Corp. of Am., (U.S. 1987)

2. Facts: Indiana passed a corporate takeover law which stated that should any party acquire a
controlling interest in the number of shares he held, he could only acquire voting rights on those
shares to the extent approved by a majority vote of the prior disinterested stockholders.
3. Procedural Posture: The lower court held that the law was unconsitutional as being a
hindrance to tender offers, and thus an interstate commerce burden.
4. Issue: Whether the Indiana law is unconstitutional as being in conflict with the dormant
Commerce Clause.
5. Holding: No.
6. ∆ Argument: Tender offers should generally be favored because they represent a shifting of
property rights to their highest value use. Also, the state of Indiana has no interest in protecting
non-resident shareholders.
7. Majority Reasoning: A state has the fundamental right ot pass laws concerning the regulation
of corporations it establishes. They are only unconsitutional if they discriminate against interstate
commerce. Since this law has the same effect on interstate commerce as well as intrastate
commerce, meaning that all shareholders and tender offers are treated the same regardless of
locality, then it does not discriminate. The state regulation of corporations necessarily has some
effect on interstate commerce, since the shares are traded internationally. However, there is
stability in knowing that the corporation is subject to one set of regulations - that of its home state.
8. Concurrence Reasoning: [Scalia] stated that there was no consitutional basis for any
balancing test when determining whether a local interest outweighs a federal interest. Whether
the burden on commerce imposed by a statute is excessive in relation to its benefit is a question
for the legislature, not the judiciary.
FOR FEB 14: OVERVIEW OF SECURITIES MARKETS; THEN GET INTO SECURITIES
REGULATION. DO FIRST 3 CASES OF SECURITIES REGULATIONS PACKETS.
EXAM ALERT: LOOK FOR PREEMPTION AND DORMANT
COMMERCE
Amanda v. Universal Foods

In Amanda the state statute limited a bidder, who had not received the target director’s approval,
from merging with the target or using the target’s assets for three years. This delay substantially
affected a bidder who planned to use the target assets to fund the offer and to restructure the
target.
The court (Easterbrook) upheld the statute because, although it had clearly a limiting effect on
hostile tender offers, it did not adversely affect the process of the actual tender offer itself that the

Williams Act was intended to protect. Thus statutes that affect tender offers but do not directly
interfere with the tender offer itself, and that limit their application to corporations incorporated in
their state, should be constitutional.
Note: from a law and economics standpoint these state regulations have an adverse effect
because they have a limiting affect on the market for corporate control.
XXIV. CORPORATE DEBT
Sharon Steel v. Chase Manhattan

UV Industries had issued debentures that bore interest at rates lower than the prevailing market
rates and, therefore traded at a price less than their face amount. UV then adopted a plan to
liquidate by selling all its assets to different companies. After ca. 70% had already been sold to
other corporations, UV sold a minor business unit and all its cash, that was almost completely
subject to the claims of the debenture holders, to Sharon. Sharon assumed UV’s debenture
obligations. There was a boilerplate provision in the indenture that, if UV would sell all or
substantially all of its assets, its successor would assume all of UV’s obligations towards the
bondholders. Chase, a debenture holder, asserted that, by virtue of the liquidation of UV, the
debentures had become due and payable. Chase would be better of this way because it could
claim immediate repayment of the principal (the face amount), being higher than the market value
at that time. Sharon’s view was that it was entitled to assume UV’s obligations under the
aforementioned provision.
The court ruled in favor of Chase. It held that the transaction between UV and Sharon was in fact
more an assignment of the debentures than the acquisition of a business. Sharon did not acquire
all or substantially all of UV’s assets. The way UV’s liquidation and the transaction was
structured, it impaired the interests of lenders by assigning a public debt in a cash for cash
transaction.
The court, therefore, stated the rule that boilerplate successor obligor clauses do not permit
assignment of the public debt to another party in the course of a liquidation unless all or
substantially all of the assets of the company at the time the plan of liquidation is determined
upon are transferred to a single purchaser.
Metropolitan Life Insurance v. RJR Nabisco

After Nabisco had issued bonds it entered into a $ 24 billion leveraged buy out (LBO). In order to
finance the LBO it incurred massive additional debts. As a result, the value of the previously
issued bonds plummeted. There was no restriction in the indenture that limited the assumption of
additional debt. To the contrary, it was expressly allowed. Metropolitan, a highly sophisticated
investor, claimed that Nabisco violated an implied restrictive covenant of good faith and fair
dealing not to incur the debt necessary to facilitate the LBO. It asserted that Nabisco had
consistently reassured its bondholders that it would maintain its preferred credit rating.
The court held in favor of Nabisco. There being no express covenant that would restrict the
incurrence of new debt, and no perceived direction to that end from covenants that are
express, the court will not imply a covenant to prevent the recent LBO and thereby create an
indenture term that, while bargained for in other contexts, was not bargained for here and was not
even within the mutual contemplation of the parties.

Katz v. Oak
Oak had issued long-term debt. Katz held some of the debt securities issued by Oak. Being in
severe financial problems, Oak made certain restructuring and recapitalization efforts. Among
them, Oak made Payment Certificate Exchange Offers (PCEO).
The PCEO is an any and all offer. Under its terms, a payment certificate with a cash value of
under the face but above the market value is offered in exchange for the debt securities. The
PCEO is subject to a couple of conditions. Among those is that one may not tender unless at the
time one consents to certain amendments to the underlying indentures that would have the effect
of removing certain significant negotiated protections to holders of Oak’s debt securities including
deletion of all financial covenants. These modifications may have adverse effect to debt holders
who decide not to tender pursuant to either exchange offer.
Katz alleged that this condition to consent to the amendments constituted a breach of contract
because rational bondholders in fact had no choice but were forced to tender and, therefore, to
accept the amendments to the indentures. Failure to do so would face a bondholder with the risk
of owning a security stripped of all financial covenant protections and for which it is likely that
there would be no ready market. Furthermore, Katz complained that the purpose and effect of the
exchange offers is to benefit Oak’s common stockholders at the expense of the holders of its
debt.
The court rejected Katz’ claim. First, since there are no fiduciary duties between
the corporation/directors and its debtholders, but between them and the shareholders, it is not
unusual and does not itself constitute a breach of duty if the directors are acting in favor of the
shareholders.
The other issue was if the exchange offer was wrongfully coercive. The court
acknowledged that there is a duty between parties to a contract to act with good faith towards the
other with respect to the subject matter of the contract. It stated further that this duty would have
been breached if it would be clear from what had been expressly agreed upon that the parties
would have agreed to proscribe the act later complained of as a breach of this duty.
The court held that this was not the case here. There were nothing in the indenture
provisions granting the bondholders power to veto proposed modifications in the relevant
indenture. In the court’s words, such an implication would be wholly inconsistent with the strictly
commercial nature of the relationship.
Under another provision of the original indenture Oak was not allowed to vote debt
securities held in its own possession. Katz urged that the conditioned offer had the effect of
subverting the purpose of that provision. It permitted Oak to “dictate” the vote on securities which
it could not vote itself. The court held that this provision was designed to prevent the issuer to
vote as a bondholder on modifications that would benefit it as an issuer, but be detrimental to the
other bondholders. However, here only bondholders other than the issuer were offered to
exchange their shares and therefore vote on the amendments.
Another provision granted to Oak the power to redeem the securities at a price set
by the relevant indentures. Katz asserted that the attempt to force all bondholders to tender their
securities at less than the redemption price constitutes a breach of the contractual good faith
duties. However, the court held that the present exchange offer was not functional equivalent to a
redemption. Redemption is unilateral; bondholders have no choice. Here, however, they have;
the success of the offer depends ultimately of the financial attractiveness of the offer, i. e. the
premium offered over the current market value.

XXV.New Class: Business Transactions

Monday, January 10, 2005
New class; new approach. Build on materials already learned. Also, some BAR
review stuff and business law stuff. Also, advanced concepts on change in
control and in securities law. M&A is often financed by the issuance of securities.
A. Forms of Business Entities:
1. Corporations
Shield of liability is prime advantage of a corporation.
Officers, Directors, Employees, generally shielded from liability
3rd parties dealing with a corporation, such as tort victims, had no recourse in the old days.
Review rights of shareholders in original notes above.
Centralized management structure
Taxed as a separate legal entity
No Constructive Receipt issues; you can retain cash
2. General Partnerships
Can be a voluntary partnership based on intent.
Can also arise as a function of law.
2 or more persons in association for profit.
Co-ownership
(1) Control is shared; profit is shared
(2) Different from agency relationship.
(3) Agency must be intentional.
(4) Liability is shared
(5) Tax: Partnership files an informational return but they are taxed at the individual
level of the partners.
(a) Partners receive K-1’s.
(b) Constructive Receipt: you pay taxes on funds you fail to disburse.
(6) Raising Capital:
(a) Add more partners
(b) Capital Call
(c) Debt
3. Joint Venture
Almost always the same as a general partnership
Partnership is a bit more open-ended; thought of as on-going
JV - more of a limited term
4. Limited Liability Companies
5. Sole Proprietorships
Advantage is complete control;

liability is a downside.
Access to capital markets is limited
No real tax advantage
6. Limited Liability Limited Partnership

Everyone in the LP gets limited liability. You maintain the form of the LP but you also give limited
liability to the GP.
Similar to a limited partnership, but grants general partner limited liability as well (somewhat
similar to making a corporation the general partner).
7. Professional Corporations
Less likely to be used today
Used to be for doctors and lawyers who couldn’t use traditional corporate form due to restrictions
on investors (couldn’t have non-lawyer financing a law firm).
Liability Shield
(1) Traditionally, NO. No shield from a PC. The states would typically would not
allow a PC to shield the principals from acts of negligence.
(2) Might protect you from slip-n-fall or other light liability, like debts
(3) Other states required liability insurance up to a limit, beyond which the liability
shield kicked in.
(a) Knipprath says this is similar to piercing the corporate veil. Example: you
set up an explosives company. Explosives explode, so it’s foreseeable that
you might have an accident. Therefore, if you set up a company that is
undercapitalized such that it can’t meet foreseeable liability claims, you could
pierce the corporate veil.
(b) If you practice law without malpractice insurance, aren’t you running an
undercapitalized business? So the legislature just makes it a law.
Advantages of a P.C. -- Tax and Pension Planning
(1) Partnerships were pretty much limited to IRA contributions
(2) Keogh plans (HR 10)
(3) But corporate pension plans were much better
(4) In the ‘80’s, Reagan imposed greater non-discrimination requirements on
corporate pension plans which limited their attractiveness.
8. Closely Held Corporations (see analyses supra)

State Law Concept
2 Approaches:
(1) Court determines that close corp treatment applies; or
(2) You elect to do so and follow the statutory requirements
Advantages:
(1) Limited liability
(2) Less formality: California doesn’t require a B of D’s.
Disadvantages
(1) Judicial Interference
(2) Courts allow liability veil to be pierced.
Company is managed by the shareholders
(1) There is a written shareholder agreement (similar to partnership)
(2) Looks like a decentralized form of management (partnership)

9. Limited Partnership
Centralized Management similar to a corp
Investment vehicle; not a mechanism for people to work together
Separation of management and investment functions
Caps on number of limited partners have largely been abandoned.
Decent vehicle to raise capital for a small-medium project
Typically, the GP is the promoter
Investors’ roles are proportionate to the amount of their investments
Beyond their economic investments, limited partners can influence management; but, the GP
runs the day-to-day operations.
LP acts (ULPA and RULPA) blurs the roles of the general and limited partners to meet the
desires of many of the investors who want to have limited liability but at the same time not be
restricted as much from participating in management.
Be sure to have a limited partnership agreement
As a practical matter, the GP drafts the agreement, so he will be sure the LP’s don’t have too
much power
Thus, the legal blurring of the lines between lp and gp are not much of a problem.
Liability:
(1) Varies directly with control. Less control = less liability.
(a) GP has most liability. He is fully personally liable.
(b) LP has least liability. He is liable for the amount of his investment +
unanswered calls.
(c) This call right can be limited by the partnership agreement. So, if GP does
not call, the LP can be personally liable for unanswered calls.
Management
(1) Very similar to partnership but GP has most power.
(2) Quasi-centralized management; not as centralized as a corporation, but more
than a partnership.
Existence
(1) Can’t just “happen”
(2) Formalities of formation required
(3) Worst case - Court could declare it a partnership
(4) If other GP’s exist, the LP continues to exist even if the LP’s die
(5) If the last GP dies, it must be wound up unless the LP’s elect a new GP within
the statutory time period
(6) Thus, you could have perpetual existence if the LP’s keep meeting and voting in
a new GP each time one dies
Transferabilty
(1) Not easily alienable shares
(2) No real public market for LP’s
(3) Right of first refusal typical protection
(4) If a LP sells his interest, the buyer is a mere assignee unless the other LP’s
agree to accept the new owner as a partner. LP’s only sell their right to share
profits, not their actual partnership interests.
(5) Partnership is a voluntary association and you must be invited in.

10. Business Trust

Not used anymore.
Trust set up to exchange $ or other assets for trust interest (entity run by trustee(s)). Sounds like
a corporation. A cartel is not an efficient way to leverage economies of scale. In that sense,
cartels are unstable. You want centralized control. One way to do this is with a business trust
because you have the corporate heads sit as trustees of each others’ companies. Sugar trusts,
oil trusts, etc. Not used anymore.
11. Joint Stock Company

No liability shield. Not used anymore.
Investors share ownership of the shares. But, no liability shield. Not used anymore.
12. Holding Company

Succeeded business trusts. It exists to hold the shares of other companies. Example: you must
have insurance from a company chartered within the state. If you have those kinds of state laws,
and you open a company in multiple states, you might set up a holding company to hold the
shares of all those different state companies. It would issue stock in exchange for stock in the
state companies. That way the holding company controls all the subsidiary companies.
Centralization of knowledge and control helps make a better monopoly. So, some states
outlawed holding companies.
13. Sub S Corps Not used much anymore.

Used to be a big deal b/c it gave you the corporate form for state law (liability shield) but you
could avoid double taxation of dividends by use of flow-through taxation.
Usually small; limited number of shareholders
Not important today because the IRS changed its approach to a “check the box” approach
You can choose partnership or corporate tax treatment
B. Comparing Partnerships and Corporations (Knipprath Analysis)

1. Liability
Control: Varies Directly With Liability
Tax on distributions of corporations (dividends)
2. Management
3. Existence: dissolution or winding up

Partnerships do NOT have perpetual existence; corps do
UPA: partnership dissolves upon death or withdrawal
4. Transferability
Hard to transfer a partnership interest
Can’t sell partnership interest without approval of other partners.
But can sell the economic right to receive profits
Easy to sell stock
Access to Capital Markets

Wednesday, January 12, 2005
5. Not For Profit Corporations

Cannot be a partnership (b/c partnership must be “for profit”
You can have a corporation
You can have a charitable corporation or an association.
XXVI. Federal Securities Law

Focus not on ’34 Securities Exchange Act. Focus is on ’33 Act (Truth in Securities Act).
The ’33 Act deals with original issues; ’34 Act deals with secondary transactions. We look at a
regime of disclosure. Not any other industry regulated like securities. Sales of cars, real estate,
futures, not all regulated.
Rationale: Consumer protection. 84 million Americans invest in corporations; so there is a real
legitimate state interest in ensuring the nation’s economic health. Corporations’ reputations are
benefitted by and reflected in their stock price. But too much disclosure might be antithetical to
management’s goals and helpful to competitors. So, mandatory disclosure can help overcome
management reticence to disclose.
Allocative efficiency: discussed the importance of price. Price in very shorthand fashion gets
across in a fairly standardized way, a whole lot of information that the market translates into price,
allowing consumers to compare information on a variety of levels about how the company is
doing. If the price is based on undisclosed information, the analysis may be skewed.
Market eficiency theory. Price must be accurate or there will be an inefficient allocation of capital.
Is there a pro-efficiency argument to insider trading?
A. Financial Markets Do 3 Things
1. Match Lender And Borrowers
2. Allow Investors To Reduce Risk By Diversification And Hedging
3. Provide Liquidity
B. Different Markets
1. Money Markets: Commercial Paper, T Bills, Etc. (“Private Money”)

Commercial Paper works b/c corporations pay a higher rate than banks give but less than banks
charge corporations for a loan.
You can do through a broker or through the company.
Rating by Moody’s or S&P.
2. Government Securities Market

Relatively little public participation.
Mostly participation by foreign governments and those used for risk free investment. As long as
foreign governments are willing to buy our securities and finance our trade deficit, we are OK.
We care, b/c mortgage rates may be tied to one of the short term treasury rates.
Typically sold at auction. Based on supply & demand.
Secondary trading in government securities.
Market is concentrated. Higher potential for “cornering the market.” 1991 Salamon Brothers
accusation.

Social Security Fund invests in federal securities. Government uses the Social Security $ and
replaces the case with government securities. Taxes will generate cash to pay the obligations as
they come due.
3. Municipal Securities Market

Similary to federal government: New York, Orange County, WPS (Washington Power). All of
those went bankrupt at one time or another. So, not as safe as federal securities. Typically no
direct disclosure requirement imposed on a municipal issuer. Some disclosure requirement on
political contributions.
4. Corporate Debt Market

5 x bigger than the corporate equity market. Mostly issued in private placements. ’33 Act
Oversight is diluted in private placements.
Secondary corporate bond market is largley unregulated; dealer-to-dealer transactions.
Tuesday, 15 February 2005
5. Options in Derivatives, Futures, Etc. Can be Securitized and Traded

Basic Concept Rooted In Commodities
The value of these futures and options is derived from the underlying instrument or commodity
such as a stock or a futures contract for oil. Among th e derivatives, only options are treated as
securities. Only options and futures are traded on exchanges. It all started on the CBOT
(commodities).
Commodities Theory
Idea was to protect the farmers with futures contracts. Farmer needed to get cash to cover
present expenses. So, by selling futures, farmer generates cash immediately. Alternatively, he
could take the futures that he sold and collateralize it at the bank. So, the futures give farmers
access to cash. It protects the buyer of the futures contract against price fluctuation. So, if the
spot price spikes, the futures holder is protected.
Stock Theory
In relation to a non-commodity, such as stock futures and options, this does not raise cash. What
you are doing is trying to hedge against market price fluctuations. You bet against interest
fluctuations, for example. Example: as interest rates rise, people invest in interest-bearing
instruments, thereby depressing the stock market. Options can protect you aginst price level
changes. These stock options can also be used speculatively.
(1) Advantages of Stock Options: Higher Leverage and Lower Margin Limits
Example: if you think that a certain stock will go up, you can buy stock or you can buy options to
buy stock. You can also trade on margin but you might bump up against a 50% margin limit. But
if you buy stock options, you can probably enjoy a much higher leverage rate and a much lower
margin limit.
(2) Calls and Puts
Option to buy or sell at an agreed strike price. Options clearing corporation acts as a clearing
house; it’s a middleman between the buyer and seller. Escrow middleman reduces risk of default
and encourages investment by larger organizations who seek stability and assurances of
performance.
(3) Stock Index Options
Options in a collection or pool of stocks. Example: S&P 100 index funds.
(4) Options Risk
You can lose the entire cost of the option
(5) Futures
Futures are far riskier than options. Remember, options are just rights. Futures, technically
require you to come up with something. If you sell a wheat future, you better have some wheat.
Someone ultimately will want some wheat.
(6) Stock Index Futures

Big loss potential; almost unlimited risk. With options, you lose your option premium. But with
futures, you need to deliver full cash value of the promised future. Example: You sell a future in
the S&P 500; you have to pay the value of that index at the time of delivery x $500. So, you sell
an index future. Today it’s at $250. I promise to deliver it at $250. If it goes down to $248 at the
time of delivery, it goes down $2. I just lost $2. If it’s $500 for each point drop, I need to come up
with $1,000.
How do I know which way the stock will move? I can get caught in a squeeze. Some argue that
it’s just pure gambling. The point is that it allows you to hedge against stock price fluctuations. It
just cushions (hedges) the loss; it does not prevent or equalize the loss.
(7) Currency Futures
Same concept.
Note: you can get a margin of 25%; and if you register as a speculator, you can get an 11%
margin. So, even if you are a futures trader, you can’t leverage it as much as stock futures
because index futures are much riskier.
6. Structural Differences Between Futures & Stock Exchanges

No restriction on futures short sales
No obligation of futures exchanges to try and stabilize the markets.
However, the volatility of the futures market gives a more immediate indication of where the
market is going. So, the futures market can help predict how the stock market will go. This
makes the stock price less sensitive as predictors of the future economy. In other words, the
stock market as a leading economic indicator is somewhat behind the futures markets.
7. New Markets
Pollution rights
Energy Contracts
Insurance Futures to stabilize health care costs
C. Equity Markets
1. Primary Issuer Market
Far more (30:1) volume than secondary market. Those companies may not trade on
secondary transactions. They might not have a lot of trading in their stocks.
Venture Capital Market:
Can provide private placement money to new firms with no track record that would
allow them to participate in an IPO.
Venture Capitalist will invest directly in the firm and assume some form of
management control. Their objective is to make $, profit. May have veto rights or
ability to limit management salaries.
VC - they make their $ on the transaction, especially if the company launches an
IPO. VC don’t normally take debt instruments; they expect a profit on the future
offering.
(1) Preferred Shares
So, they will use preferred shares. The company probably won’t have dividends
as a start up. But later, when they do have the $ to pay dividends, the PSH have
a preference.
(2) Convertible PS
Allows VC to cover if the IPO looks good and they want to capture the market
gain.
Knipprath asks: why would anyone else take CS? The answer is that if you
don’t do it the way the VC wants, you won’t do it at all b/c you probably have a
really risky idea that no bank or other traditional lender will finance.
Types of Venture Capital Firms

(1) Investment Banking Firms

They raise $ by selling to angels (investors). Other times they might have their
own investment fund.
(2) Corporations making strategic investments
(3) Mutual or Hedge Funds
Promoter of the fund seeks $. He promises to invest the $ in start-up ventures.
2. Secondary Markets
Auction Markets
(1) Concept of Auction Markets
NYSE is a secondary market. They are auction markets. Example: Rocky
Mountain Exchange; very risky auction market.
(2) Specialist Markets
These are known as specialist markets. Every stock has a specialist assigned to
it with a seat on the exchange. It is these specialists who auction the stocks.
The more the stock is traded, the easier it is to match buyer and seller. You can
buy at market (get it now) or you can have a limit order (cap and floor on
purchase).
(3) Duty of Specialists To Maintain Stable Market
In some cases, the specialist might have to become a market maker because he
has a responsibility to maintain a stable market. At some point the specialist may
have to step in and sell from its own shares. At that point, the specialist
becomes a dealer in the stock.
(4) Risk of Default Minimized - Faith In Markets Increased
By stepping in and making a market by selling its own shares, the specialist
helps reduce the risk of default by one of the parties thusfar unable to match a
buy or sell requirement.
Dealer Markets
(1) Preeminent is the NASDAQ
Not every transaction is included. The index only tracks dealer trades. There
are a few firms listed both on the NASDAQ and the NYSE. The NYSE tends to
be dominated by older, more traditional firms. NASDAQ is more high tech,
newer companies.
(2) Dealer and Auction Market Movement
Usually move in same direction; but sometimes go in different directions. When
tech stock suffer, the NASDAQ usually leads the movement before the NYSE.
(3) Role of the Dealer
Buyer buys or sells directly to a dealer in those securities. The dealer can also
be a brokerage firm for other transactions. Dealer will have a bid-ask range for
the stock.
(4) Best Execution and Market Efficiency Theory
You can be a dealer, selling a security, and you have a price quotation. But
another dealer may quote a different price. So how does the investor know the
price difference between dealers? Your broker might be able to get quotes more
easily than you can. Broker has a legal duty of best execution. Idea is that inter-
dealer competition on the bid-ask spread will maximize market efficiency. The
spread today after the introduction of the decimal system in 1998, is down to 3
cents. Also, due in part to SEC reforms after dealer collusion investigation.
Electronic Direct Markets (Non-Dealer Markets)
Used to be limited to institutional investors dealing directly in the stock. In such
cases, you have known actors and the risk of default is less. The difficulty is that you
can’t really move large blocks of stock through non-dealer markets.

D. Regulatory Framework
SEC is an indepent non-partisan agency of 5 members, no more than 3 members from either
party. Sometimes jurisdictional gray areas between SEC and CFTC. Also, between the SEC and
the NYSE or NASDAQ. And there are the state securities commissioners.
1. SEC
SEC acts pursuant to several statutes. Really set up under the ’34 act; but also functions
under the ’33 act for issuer transactions. ’34 act deals with secondary transactions; has
been amended by the Williams Act, Insider Trading Act, blah blah blah. Safe harbour
provisions of ’95 legislation for private …
Sarbanes Oxley Statute
Draconian rules regarding regulation of accounting profession and corporate
reporting. Enhanced liability for corporate CEO’s and CFO’s. Faster § 16b (insider
transaction) reporting; restrictions on corporate loans; restrictions on compensation
and bonuses during periods where earnings were misstated.
Other Influential Acts
SEC works subject to a shitload of statutes, including the APA (from admin law).
Criticisms of the SEC
Influence of special interest groups. Desire to expand bureaucratic turf. Lawyers
complain that the SEC avoids bright lines in order to entrench their positions.
Example: SEC has never defined “insider trading.”
2. Self Regulatory Agencies

NYSE
State Commissioners acting under Blue Sky Laws
To some extent it was a reaction to the novel concept of offering stocks to the public.
Government thought the public couldn’t be trusted to participate in the markets.
Government was worried about scams in the late 1800’s early 1900’s. But this was
the period when there were finally enough persons with cash to invest that you could
actually have an effective market system. Formerly, it was only the power elite.
This was a new financing device for corporations; since it was being marketed to the
public and not just the wealthy, the entrenched bureaucracy wanted to slow it down.
(1) Merit Regulation vs. Disclosure Regulation
SEC is a disclosure regime. They don’t care about little old ladies buying stock,
as long as the company discloses fairly. State Blue Sky Laws regulate the merits
of the transactions. The states want to be sure that there is really a viable
business underlying the transaction. You can’t sell issues that give too much to
the company versus to the investor. You can’t sell issues that are excessively
risky (how do we know there is oil down there?). It’s a more paternalistic system
of regulation.
(2) (Revised) Uniform Securities Act of 1956
Adopted in 37 states to provide uniform regulations. The Revised version of this
act restrict Merit regulation. California and New York have followed neither Act.
California is very paternalistic. They do tell companies that they can’t sell to
widows and orphans. N.Y. hasn’t adopted either Act but is very relaxed in its
enforcement; with two exceptions. Real Estate and Theatre Production, where
the merit system is enforced.
(3) North American Securities Administrators Association
Helps states administer Blue Sky Laws. You need coordination among the
states to help when companies want to issue shares in several states. You also
need coordination with the federal regulators. One argument is that business will

avoid states with tough Blue Sky laws. But, what if it’s California, with 12% of the
nation’s capital?
(4) State - Federal Coordination
(a) Federal Registration Must Be Honored
§ 18 of the ’33 Act: if you are listed on the NASDAQ, and you want to issue
another security, states cannot require a new registration.
(b) Federal Exemption Must Be Honored
E. Distribution of Securities
Intel could simply market and distribute its own stock if it wanted to. Sometimes companies
actually do that. Could be to save a lot of money on transaction costs. Example: you might
be marketing your shares to your employees as part of a retirement plan. Since you are only
targeting your employees, you market directly.
But, normally, companies are not very good at marketing securities and they leave it to the
professionals.
1. Underwriters
Dealers in securities who are large enough to handle the chore and risk of marketing a
security on behalf of a corporation. Investors like the system because they trust the
underwriters. Underwriters have a name that they have made; a reputation. They can
get compensated based on that kind of position they have; the trust they have earned.
Most people who buy initial issue distributions are large institutional investors or high
wealth individuals. Often these are parties who deal frequently with the broker-dealer.
Liability of Underwriter
Liable if fraud and there is a lack of due diligence in discovering.
Various Types of Offerings
Direct issuer offering (pension plan scenario). This might become more common in
the future b/c so much more investing is now done through the internet. And the
political parties have shown that one can raise a lot of $ through the internet. So, if
you’re a start-up company, there might be a chance to raise $ here. The SEC is
looking into potential abuses here. Requirements of the law still apply; it’s just a
different device that allows the issuer to avoid the cost of using an underwriter.
Preemptive Rights Doctrine
To buy a proportional share of what they had prior to the offering; today this is seen
as an interference in marketability. Sometimes a company can make a deal that
because they may not have access to a large public, but they do know who their s/h
are
Dutch Auction
The company offers the security at a minimum price. Buyer may bid for any number
of shares. So, if buyer #1 bids for 100 shares, #2 for 1000 shares, etc. If the
issuance is over-subscribed, a bidding will develop and the price rises accordingly.
Final price is the maximum price at which all shares can be sold. And all shares will
be sold at that price. So if you’re trying to sell 1,000 shares and you get an offer of
$35 for 900 shares and $42 for 300 shares; you end up selling all 1,000 shares at
$35. Shares are issue proportionally. This is common in the U.K. You still need an
underwriter. The benefit of it is that it puts the initial appreciation into the pocket of
the issuer, not the underwriter. In a traditional issue, $ left on the table go to the
underwriter.
There is one market in the U.S. where this type of market is used: U.S. Treasury
securities.
Wednesday, February 16, 2005

Next Wednesday at 12:30 will be an exam review.

All or None Offering
Issuer says “I need a minimum of funds.” Otherwise the deal makes not sense. This
concept can be combined with the other types of offerings. Receipts from the
offering are escrowed and if they fall short, investors are refunded; if the minimum is
met (fully subscribed), then it goes through.
Private Placement
Usually sophisticated, high wealth investors, sometimes institutional. Sometimes no
underwriter to save $. Reasons to use: (a) necessity: there is no public market for
your stock, so no underwriter will touch it. So you look for private placement. (b)
secrecy: if the $ are needed for some secret trade secret crap, you can raise funds,
especially with institutional investors, with less disclosure. (c) speed: you need to
raise the funds in a hurry; (d) cost issue: fewer costs associated with private
offerings versus registered public offerings.
Role of the Underwriter
Important component of the ’33 Act.
§ 2(a)(11): Any person who has purchased from an issuer with a view to, or offers or
sells for an issuer, in connection with a public distribution of stock. Three types of
underwriting arrangements:
(1) Firm Commitment: Underwriter guarantees success of offering. The syndicate
agrees to purchase all or some share of an offering for cash. Lead underwriter(s)
will tell about the offering and then list all the names of the underwriters. The
lead underwriters are in big print. Tombstones. May be national firms. Or
specialists in that type of security or industry. The smaller members of the
syndicate may be regional players.
(a) The various underwriters in the syndicate agree in contract as to how much
each will commit to buy
(b) Lead underwriter will lead negotiations with the issuer
(c) The underwriters will ‘test the waters’ to see if there is a market for the
securities;
(d) Price and Quantity for the issue will be developed for both the firm
commitment buy and the offer prices
(e) If the issue doesn’t pan out, the underwriters are to some degree at risk
(f) The concept is that the underwriters buy the shares and undertake a public
distribution; buy and re-sell.
(2) Best Efforts: Underwriter acts as almost an agent of the issuer.
(a) Unsold shares stay with the issuer
(b) So, why would an issuer undertake a firm commitment? Depends on the
attractiveness of the issue. Risk and reward.
(c) Difference between firm commitment and Dutch Auction is that spread in bid
ask inures to the issuer in a Dutch Auction but to the underwriter in other
cases
(3) Standby: Issuer issues to current SH and underwriter undertakes to market any
unsold shares.

F. Public Offerings vs. Private Offerings

1. Public Offerings must be registered
2. ’33 Act Registration Provisions.
3. Must register and disclose basic information
4. ’34 Act Reporting Requirements
5. Continuing reporting requirements for issued shares
6. Penalties for failure to properly disclose under both or either Act
7. Direct Ant Fraud Provisions: § 17A of ’33 Act; § 10b of ’34 Act
8. Stages of Registration Reporting Requirements [§ 5 of ’33 Act]

Pre-Filing Post-Filing/Pre-Effective Post-Effective
No offers [§ 5(c)] No sales [§ 5(a)] Sales OK
But OK to discuss w/
Offers OK [§ 5(c)] Offers OK
underwriters
Road shows start here. Final amendment of
Discussions with outsiders
prospectus; underwriting
can’t be offers; be sure not to Caution about projections;
syndicate may shift a bit
discuss price non-public information
depending on demand in
SEC may want some changes various regions.
or amendments here.
Rule 430A - Amendment must
No prospectus [§ 5(b)] unless be w/in 15 days of the final
OK under § 2(a)(10). Oral registration statement.
communication OK. Written
not OK.
§ 10 of the ’33 Act says what
you must put in the prospectus
to offer or to sell the security.
§ 10(a) full prospectus
§ 10(b) short “red herring”
prospectus.
§ 5(c) unlawful for any person to directly or indirectly make use of the use of the mail or
instrumentality of interstate commerce offer to sell or buy through any means unless
registration has been filed. Not supposed to do anything to arouse interest in the offering. Under
§ 2(a)(3) covers everything except preliminary discussions or negotiations or agreements

between an issuer or any person directly or indirectly controlling or controlled by an issuer or
under direct or indirect common control with an issuer and any underwriter or among
underwriters.
Other problem: ’34 Act and NYSE disclosure requirements for material changes in corporate
condition or material events. So, if a company starts discussing an offering, does it trigger
disclosure requirements of ’34 Act? It’s a tension between ’33 and ’34 Acts. SEC says no hard
and fast rules: will be decided case-by-case.

§ 5(a) says you can’t sell until registration statement is in effect; but you can start making offers.
This helps regional underwriters meet their due diligence duties; the road show gives them a
chance to ask questions. Caution at these presentations: investors will care about return. Are
you making projections or promises? Be careful not to disclose any non-public information. Can
also disseminate information through certain newsletters, etc.
§ 5(b) says no mailing of prospectus unless meets requirements of § 10. Under § 2, a prospectus
includes just about everything (written, by radio or television). Only allowed oral communication.
§ 10(a) Prospectus Requirements:
§ 10(b) Short, Summary “Red Herring” prospectus; cannot contain price. Why not? When issuer
goes touting an offer w/o price then it’s not an offer. Under common law, this is a solicitation; an
invitation to bid. Real reason they don’t talk about price is b/c this is the first time the issuer has
had direct communication w/ the public. Issuer wants to gauge interest. Also, if the issuer puts a
price on the issue at this early stage, there might be a big change in the market and you won’t be
able to sell the deal. Price goes in at the last moment.
Knipprath asks: is email OK? Yes, cause written. But maybe a chat session is not? The SEC
position is that as long as it’s a brief exchange, it will be treated like a telephone conversation.
But, if you have a document attached to the email, it’s a prospectus.
§ 5(b) tells you it’s unlawful to sell a security unless it’s accompanied or preceded by a
prospectus that meets the full prospectus requirements of § 10(a).
Final terms sheet per 430A bridges the preliminary and final prospectus.
Usually highly sophisticated investors. Who are we trying to protect?
One problem is the problem of soft information. Soft information is the whisper quote.
Projections and forecasts and expected rates of return. But, that is what investors most want.
The judgment of investors as to what it most likely to happen. Many investors view prospectus’s
without soft information as borderline irrelevant. So, today, MD&A is allowed. Rule 175 issued in
1979 encouraged the use of forward looking statements unless issued without reasonable basis.
Courts have become very tolerant of forward looking statements. π has burden of proof on claim
of insufficient basis for projections. Investors are expected to know there is inherent ambiguity
and risk in projections. Investors in these types of offerings are likely to be sophisticated. ’33 Act
was added to include safe harbors for such projections as long as meaningful cautionary
statement was included. § 17A. safe harbor only applies to § 12 (exchange traded) companies.
So, no safe harbor for IPOs.
Few more points to cover on registration process and then we will discuss what is a security.
Friday, February 18, 2005

Registration Statements and Prospectuses Cont’d.
SEC was formerly hostile to soft information (forecasts, estimates)
1979 SEC began allowing prospective statements
Now SEC requires predictions if mgmt is aware of trends, events, uncertainties that it cannot
conclude will not have a material effect on the company’s finances. So, if you have any idea
and you can’t disprove it, you must disclose it.
Materiality: what is it? Basic Inc. v. Levinson defines materiality; but for the SEC the requirement
is even more stringent.
Mgmt must try to quantify effect of possible trends that you believe may have a material effect on
the company and you must provide a basis for your determinations.
This has become an issue for disclosures of accounting policies in light of Enron.

Plain English Rule: One other SEC requirement is the “plain English” requirement; short
sentences, definite concrete every day language, active voice, simplification of complex materials
into tables, avoid multiple negatives, no legal jargon or technical business language. Applies only
to front, back, summary, and risk analysis and projections.
XXVII. DISCLOSURE AND FAIRNESS: FEDERAL SECURITIES REGULATION
A. Definition of a Security
1. § 2 (1) of the ‘33 Act
“The term “security” means any note, stock, treasury stock, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-
trust certificate, preorganization certificate or subscription, transferable share, investment
contract, voting- trust certificate, certificate of deposit for a security, fractional undivided interest in
oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security,
certificate of deposit, or group or index of securities (including any interest therein or based on the
value thereof), or any put, call, straddle, option, or privilege entered into on a national securities
exchange relating to foreign currency, or, in general, any interest or instrument commonly known
as a “security”, or any certificate of interest or participation in, temporary or interim certificate for,
receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing”.
The statutory definition is divided into 2 broad categories:

A list of specific instruments such a stock, bonds, notes...
A list of general catch-all phrases such as evidence of indebtedness, investment contracts, any
instrument commonly known as a security... etc.
Requires with very few exceptions all publicly traded companies to register their securities with
the SEC. Part of that registration is a prospectus.
Many people don’t read them b/c they are long and boring and full of boilerplate language
disclosing risks.
The company is selling security which is a piece of paper representing an ownership interest in
the enterprise. It is different from a partnership agreement b/c shareholders or security holders
don’t have a management role in the company.
Howey Test – how much control do you have? This will tell us if it is a security.
Landreth – stock is automatically a security
It is tough to tell if it is a security if there is no writing.
Was it disclosed.
2. Investment Contract
An investment contract means a contract, transaction or scheme whereby a person

Invest his money, in
A common enterprise and is led to
Expect profits predominantly from the efforts of the promoter or a third party.
These 3 factors are not exclusive.

The Supreme Court has interpreted it broadly to reach “novel, uncommon or irregular devices,
whatever they appear to be”.
Koch v. Hankins (9th Circuit, 1991)

The fact that the investments are structured as general partnerships is not determinative
of their status as securities; rather we must examine the economic realities of the
transactions to determine whether they are in fact investment contracts.
Most issues are raised regarding the third element, “control”.
Test to determine where “control” exists: The critical determination is whether

(3) The investor retains substantial control over his investment and
(4) An ability to protect himself from the managing partner.
“A general partnership or joint venture interest can be designated a security if the investor
can establish, for example, that
(iv) An agreement among the parties leaves so little power in the hands of partner or
venturer that the arrangement in fat distributes power as would a limited
partnership; or
(v) The partner or venturer is so inexperienced and unknowledgeable in business
affairs that he is incapable of intelligently exercising his partnership or venture
powers; or
(vi) The partner or venturer is so dependent on some unique entrepreneurial or
managerial ability of the promoter or manager that he cannot replace the
manager of the enterprise or otherwise exercise meaningful partnership or
venture powers.”
In determining whether the investors relied on the efforts of others, we look not only to the
partnership agreement itself, but also to other documents structuring the investment, to
promotional materials, to oral representations made by the promoters at the time of the
investment and to the practical possibility of the investors exercising the powers they
possessed pursuant to the partnership agreement.
SEC v. W.J. Howey Co. (U.S. 1946)

Selling tourists orange trees, profits go to the buyer of the tree. SEC
claimed they should have to register with the SEC. Called it an
investment K, not a purchase with a service K. But that describes almost
every AND it involves a lot of investment schemes. Reeves court rejects
this.
R: Howey Test: an investment contract is a security, the conditions for an
investment contract are:
1. an investment of money;
2. in a common enterprise; and
a. a common enterprise is one in which the fortunes of the
investor are interwoven and dependant upon the efforts and
success of those seeking the investment of third parties.
3. with profits to come solely from the efforts of others.
a. the word solely in this element means whether the efforts
made by those other than the investor are undeniably
significant ones, those essential managerial efforts which
affect the failure or success of the enterprise.
Start with the statute: § 2(a)(1). See above. This case defines an
investment contract.

SEC v. Koscot Interplanetary, Inc. (U.S. 1946)

Adopts SEC v Turner definition of “Solely” for purposes of Howey Test.
United Housing Foundation v. Forman (pg445, note1, n47)

/why is this footnote important?
I. Definitions
Get Amy’s notes from today, 2/18/2005, b/c I’m not listening.
“security”
Under §2(1).
Investment contract:
1. common enterprise
2. profits solely from the efforts of others
SEC v. WJ Howey Co. (Sup. Ct, 1946) ACCEPTED DEFINITION

land sale contracts gave purchasers small parcels of a citrus grove, with a
service contract for harvesting and marketing the fruit and receiving a
portion of the profits. Held to be a security.
Test: An investment contract for purposes of the 33 Act is a
“contract, transaction, or scheme whereby a person invests his
money in a common enterprise and is led to expect profits solely
from the efforts of the promoter or third party”
elements of an investment contract:

1. investment of money
2. common enterprise
3. expect profits
4. solely from efforts of others
SEC v. Glen Turner Enterprise (9th Cir)

“pyramid scheme”: GTE offered to buyers the oppty of earning
commissions on the sale of other such contracts.
Held: “solely” language of Howey not meant literally, rather the real test is
whether the efforts of those other than the investor are significant.
Common enterprise = one where the fortunes of the investor are
interwoven with and dependent on the efforst of those seeking the
investment or of thirs parties.
*LLC interests are securities unless every member is a manager (for Cal.). For FED look at HOWEY test.
“sale” and “offer to sell”

§2(3) – applies to all sales of securities, not just IPO’s. Includes most mergers, stock for stovk exchnages and pledges.
“prospectus”
any prospectus, notice circular, advertisement, letter, or communication written or by radio, television which offers any
security for sale or confirms the sale of any security. Lambert: prospectus is a selling doc, but really it is a disclosure doc.
Who does it really protect? Not the buyer, but the issuer. It is unrealistic to think that buyers make decisions based on

prospectuses (Yahoo’s said in bold type “ this is a shitty risk, we don’t have any capital and we are not making any
promises”)
“Stock”
Stock is a security, but just because you call something “stock” does not make it a security (United Housing Foundation v.
Forman)
Housing Foudnation v. Foreman

Look at the substance of the transaction –
Condos—each tenant had to buy stock that was linked to condo – no dividend, no profit. they got it back when
they left.
Landreth Timber v. Landreth (Sup. Ct. 1985)

Sale of all of the stock of Landreth Timber, held by trial court to be sale of the business, and not sale of stock.
Trial ct. interpreted Howey as requiring an examination of the economic realities of the situation. Reversed by
S. Ct—if it is called stock, and it is stock, there is a per se rule that it is a security. How to tell if it is really
stock:
1. dividends
2. negotiability
3. ability to pledge/ hypothecate
4. voting rights
5. ability to appreciate in value.
Forman is the exception. Read Barchris Construction.
II. 1933 Act

§2(1): The term “security” means any note, stock, treasury stock, bond,
debenture, evidemce of indebtedness, certificate of interest or participation in any
profit-sharing agreement, collateral trust certificate. . . investment contract . . .any
put, call, straddle, option, or privilege on any security . . . etc. . .
§2(2): The term “person” means an individual, corporation, partnership, association. . . etc. . .
§2(3): The term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security for
value. The term “offer to sell”. . . shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a
security or interest in a security for value. . . etc. . .
§2(4): The term “issuer” means every person who issues or proposes to issue any security. . .
§2(11): The term “underwriter” means any person who has purchased from an issuer with a view to, or offers or sells for
an issuer in connection with, the distribution of any security. . . etc. . .
§ 3(a)(11) ??
Administrative safe harbor exemptions to protect issuers of small issues. What is this all about? Why are we talking
about § 3? They have many similarities to transactional exemptions; but they are not. They are admnistrative
exemptions.
§4: Exempted Transactions

The provisions of §5 of this title shall not apply to:
(1) transactions by any person other than an issuer, underwriter, or dealer.
(2) transactions by an issuer not involving any public offering. Private issue expemption
(3) ...
(4) brokers’ transactions executed upon customers oredrs on any exchange or in the over the counter market but not the
solicitation of such orders
(5) etc. . .
(6) Issuer exemption private issue to institiutional or credit exemptions; duplicitive of 4(2); usually used where securities
are being issued to a limited number of institutional investors (pension funds); limited to $5mm. 4-2 is broader so
why use 4-6? The advantage is that the SEC has put in more lenient disclosure rules for 4-6 than 4-2; the
assumption being that if you are selling $5mm to a pension fund, they know what questions to ask; less need for
protection of the buyer who is presumed to be more sophisticated.
(7)
§5: Prohibitions Relating to Interstate Commerce and the Mails

(a) unless a registration statement is in effect it is unlawful to use mails or

interstate commerce to sell through the use of prospectus or otherwise.- - or
to deliver after sale
(b) prospectus has to meet requirements in §10
(c) sell, buy or offer any security that isn’t registered
§11: Civil Liabilities on Account of False Registration Statement
§12: Civil Liabilities in Connection with Prospectuses and Communications
§15: Liability of Controlling Persons
§17: Fraudulent Interstate Transactions
1. Howey Test: to determine if an investment K is a security

a) Investment of money AND
• Investment vs Use/Consume Test: primary
purpose must be as an investment.
b) Commonality of enterprise AND
1) Horizontal Commonality: the pooling of investors at the same level
2) Vertical Commonality: a symbiotic reciprocal dependency btwn the promoter/mgr &
people who invest money for obtaining the profits.
• Like Howey's Hills cause had to hire
them
i Koscot: Cosmetics sales in a pyramid scheme. There were 3 levels. Level I sold
cosmetics and recruited. Levels II & III got cosmetics at a discounted rate
& sold to the lower levels.
Analysis: The crts found that levels II & III had vertical commonality. They were
dependant on the success of the co to get more people to sign up. The
people who bought in brought in potential recruits but the co. took over
from there. Script & sales pitch. Level II & III profits were tied in
SUBSTANTIALLY from the efforts/profits of the co.
Conclusion: A security.
c) Profits derived "substantially" from the efforts of others
i Howey: Fl orange grove sold off segments to mostly out-of-state patrons of the Howey
Hotel. They also sold a service K to cultivate & harvest the crops. All but 15%
bought the svc K.
Analysis: the crt thought the 15% was insignificant & looked at this situation as an
investment of money, in a common enterprise since the crop sales were pooled
and from the efforts of others since most of the owners were out of state.
Conclusion: This investment K was a security.
2. Economic Realities Test:

a. Characteristics of a stock:
1. Rt to dividends as an apportionment of profits
2. Negotiability
3. Ability to be pledged or hypothecated [pledge as security for debt w/o
delivery]
4. Voting rts in proportion to shares
5. Ability to appreciate in value.
b. If the primary purpose is use or consumption, then it's not a stock/investment cuz
lacking characteristics of a stock even though it's called a stock. (This isn’t really used
by Fed Crts)

i Forman: Selling shares in a coop. People were buying a rt to get a low income apt from a
nonprofit corp. They paid a deposit & then pay rental fees. No dividends. Can
only sell to Coop for cost plus what you've paid down on mortgage or someone
approved by Coop.
Analysis: Just cuz called a stock doesn't mean it's a stock. No free transferability cuz can't
bequeath it, can't hypothecate it, don't get a voting rt proportionate to your share
from it but rather you get a place to live.
Conclusion: not a stock even though it's called a stock.
ii Landreith Timber: If someone buys all the stock in a co. from someone else. Does that
come under SEC? It's called a stock.
Analysis: Appellate court said, NO cuz people can't get exploited since they are in control.
Supremes said that it doesn't matter cuz if you look at the instrument itself, it is
a stock, voting rights, dividends, transferable, etc.
Conclusion: Look at it functionally, so a stock.
Friday, February 25, 2005
Issuer  Registration
Exempted Securities  Public
Distribution / Sales
§ 4(2) private issue

§ 4(6) private issue to inst. / bige investor
§ 3(a)(11) Rule 147 INTRA state
[§ 3(b) / Reg. A]
Reg D - 504
Before you can have any resales you have to know the issuer.
Transactional exemptions talk about the issuer.
§ 4(1) is not an issuer exemption.
§ 4(2) is.
§ 5 does not involve transactions by an issuer
Friday, March 04, 2005

Akerman v. Oryx Communications [2nd Cir. 1987]: Plaintiff challenged misinformation in IPO
registration statement. Price went down between IPO and filing of suit. Price went up, however,
between disclosure to public and the suit. Held: No causation.
§11 deals with an offering
§ 12 deals with the prospectus
Issue $4.75
Before SEC Disc $4.00
Before Public Disc $3.25
After Discl to date of suit $3.50
Akerman v. Oryx Communications, Inc. (1987) page 35

PROCEDURAL POSTURE: Plaintiffs appealed an order of the United States District Court for
Southern District of New York granting summary judgment for defendants, a securities issuer and
underwriters, on plaintiffs' claims under § 11 of Securities Act of 1933, 15 U.S.C.S. § 77k, and for
defendant issuer on a § 12(2) claim, 15 U.S.C.S. § 77l(2).
OVERVIEW: Defendant issuer had incorrectly posted a substantial transaction by its subsidiary to
the wrong month. The prospectus, therefore, overstated earnings for a one-month period. The

issuer's price subsequently declined, and, after a public disclosure of the mistake, the price rose.
Plaintiffs alleged that the error rendered defendant issuer liable for the stock price decline.
The court dismissed parts of the appeal for lack of appellate jurisdiction, affirmed
summary judgment for defendants on the Securities Act claims, and remanded. Defendants
established that the error in the prospectus did not cause the stock price decline. The
misstatement was an innocent bookkeeping error, and the prospectus had expressly stated
that the issuer expected the subsidiary's sales to decline. Plaintiffs lacked privity to maintain
an action against defendant issuer because § 12(2) of the Securities Act granted standing only to
the person who purchased securities from the seller. Title to the securities had passed from
defendant issuer to defendant underwriters and then from defendant underwriters to plaintiffs.
Thus, defendant issuer was not in privity with plaintiffs for purposes of § 12(2).
OUTCOME: The court dismissed parts of the appeal for lack of jurisdiction. The court affirmed the
judgment for defendants on plaintiffs' Securities Act claims where defendants established that an
error in the prospectus did not cause a stock price decline and where plaintiffs lacked privity to
maintain the action against defendant communications company as a securities issuer. Finally,
the court remanded case.
PINTER V. DAHL (US 1988)

This is an unregistered security, so § 11 does not apply.
There is an express private right of action; under 12(a)(2) any buyer can sue any person who
offers or sells
Prima Facie Case
a. State of Mind: Strict Liability Offense; no mention of state of mind; 12(a)(1) is strict liability; not
due diligence defense.
b. So the prima facie case is “ you sold an unregistered security.”
c. Damages: amount paid less proceeds + out-of-pocket; so you become an insurer of the stock
if you violate 12(a)(1)
So, if Pinter can estalish that Dahl was a seller, then Pinter limits his liability as a seller to only
Dahl and not all the people Dahl sold to. Then, he (pinter) can claim that since Dahl has unclean
hands he should not be allowed to recover.
This is like a best efforts underwriter, not a firm commitment. Pinter confers title so he’s for sure
a seller. To bring Dahl in under 12(a)(2) you need scienter which is like an aider & abetter
argument.
Pinter defends against the aider & abetter allegation by asserting unclean hands (in pari delicto).
SC says they don’t know if the parties were equally culpable, so they remand for determination.
a. ISSUES:
1) Whether the CL in pari delicto defense is available in private action
under 12(1) for the rescission of the sale of unregistered securities and
2) whether one must intent to confer a benefit on himself or on a third
party in order to qualify as a seller within the meaning of 12(1) (was
Dahl a seller and liable under 12(1)).
b. FACTS: Pinter finds Dahl and Dahl solicited others to invest. venture fails. investors want
$ back or rescission. Pinter alleges Dahl has unclean hands (in pari delicto). As a defense,
Pinter wants contribution from Dahl if Pinter has to pay

c. Holding:
1) Yes in pari delicto defense available, remand to see if works
here. Nothing in statute prohibits it and statute denies recovery to
ppl that viol the law. (Note Bateman Eichler defnse available in
10(b))
2) Seller under 12(1)= one who passes title; one who
particpiates in sale for value (broker participates and gets
commission) Ct rejected substantial factor defense - one who
participates in deal and was a substantial factor to getting deal
done. (so Lawyers who drafted deal aren’t liable based on this
particular theory)
d. Notes:
1) subsequent cases held that the decision applies equally to
an action under 12(2) as to one under 12(1). no aider and abettor
liablilty under 12(2).
2) ftnt 8 - ct expressed no view as to whether equitable defense
of estoppel is avilable in 12(1).
3) ftnt 9 Unlike section 11, §12 does not expressly provide for
contribution. ct expresses no view.
4) the terms” offers or sells” may or may not be the same for
12(1) &12(2)
5) ftnt 21 - §12(1) (and 12(2)) imposes liability on only the
buyer’s immediate seller; remote purchasers are precluded from
bringing actions ag remote sellers. Thus a buyer cannot recover ag
his seller’s seller. no privity Therefore, can’t leapfrog over
underwriter to reach issuer uinder §12(1).
a) Collins 3rd cir - held the issuer in a firm commitment
underwriting is not liable to the investors under 12(2) bec the issuer
sells to the underwrtiers who in turn resell simultaneously to
selected dealers or ultimate investors and therefore the ultimate
investors do not purchase from the issuer.
b) o
6) §12(2) does cover private placements of securities
Pinter v. Dahl [SCt. 1988]: Pinter had an oil and gas venture. Dahl purchased shares in the
venture and then recommended to his friends that they buy shares. Venture failed, investors
sued Pinter for recission. Pinter tries to get Dahl on the hook, too. Question was whether Dahl
himself was an offeror or just gratuitous promoter. Blackmun Held: Anyone who solicits for their
financial interest is a seller (broker etc). Giving gratuitous advice doesn’t make one a seller.
I) In Pinter v. Dahl, the Court applied the Bateman analysis to ALL securities laws, not just
10b5.
A) Note that the in pari delicto defense is unavailable to 12(1) suits where Π is an investor.
It remains available if Π was a promoter.

(i) Supreme Court’s resolution.

(I) Pinter v. Dahl, 486 U.S. 622 (1988). Sellers include those who
transfer title. Sellers also include those of SOLICIT securities
purchases. However, sellers do not include those who URGE A
PURCHASE BUT WHOSE MOTIVIATION IS SOLELY TO BENEFIT
THE PURCHASER.
(ii) Thus, sellers are any one of the following:
(I) Transfer title
(II) Agents/ brokers who solicit the purchase for the owner
(III) One who solicits a purchase with an intent to benefit personally
thereby (e.g., commissions)
(IV) One who solicits a purchase, without financial benefit to himself,
but with a benefit to the owner’s financial interest.
(iii) The following are NOT sellers:
(I) Friends, family members etc. who gratuitously provide advice on
investment matters, so long as they are not motivated by a desire to
benefit the securities owner or themselves
(II) Lawyers, accountants, etc. (who presumably would be covered under the
rejected “substantial factor” test).
(iv) My thoughts. The statute says “offers or sells” – this is pretty straightforward.
The Court simply doesn’t want liability to extend to the family
members/friends who provide gratuitous advice with no benefit to the owner
of the security.
§12(a)(1) is a strict liability section, to recover the plaintiff need only establish that
the defendant sold the security to him and that it was not registered – D must
then establish the availability of an exemption. Limiting principle is that there
must be privity between buyer & seller. Look at 12(a)(1) and don’t read into it
portions of 12(a)(2). “Shall be liable” who can sue, privity notion, applies to both
12(a)(1) and 12(a)(2) as does the “out of pocket loss” as the proper measure of
damages.
12(b) applies to both portions of the section. The bad guy’s actions must have
caused the loss and the bad guy will be liable only for the loss which he caused.
So if market changes caused the loss, the bad guy can escape or reduce
damages. But in 12(a)(1) it’s strict liability; so by its terms 12(b) won’t cover it.
So, 12(b) does NOT apply to 12(a)(1).
Primary liability flows only to a seller – to a person who sells a security. The
following case extends this language to include those who solicit with intent to
benefit themselves
In Pinter v. Dahl, Pinter, an oil and gas producer and registered securities
dealer, sold unregistered securities consisting of fractional undivided
interests in oil and gas leases to respondent Dahl, a real estate broker
and investor who was experienced in oil and gas ventures. Dahl touted
the venture to the other respondents--his friends, family, and business
associates--and assisted them in completing subscription agreement
forms. Interests were being sold without the benefit of registration under
the Securities Act, in reliance on SEC Rule 506 (exemption for limited
offerings – still requires notice of sale be filed). The venture and buyers
sought rescission under 12(a)(1). Pinter argued that Dahl was a seller
and should be liable. Court says that a “seller”: is not just limited to a
person who passes title but also includes persons who solicit offers.

Solicitation can render a person liable if there is an actual sale and the
person who successfully solicits must be motivated by a desire to serve
his own financial interests or those of the securities owners. (Court
remands for a determination as to Dahls motivation/interests in soliciting
the others) So Knipprath wants to know if there is an agency argument
here; was Dahl an agent of Pinter?
Liable as long as person gets some kind of benefit

§12(a)(2) person can be liable who sells a security by means of a prospectus or
oral communication which contains a material misrepresentation or omission
• government securities are exempt

• P cannot win if he knew about the misstatement or omissions SCIENTER
• an action under 12(a)(2) must be brought within one year of discovery
The following case addresses the question of whether section 12(a)(2) applies
only to initial sales of securities by issuers or also to secondary trading
transactions:
3/9/2005 In Gustafson v. Alloyd Co., Inc. (U.S. 1995), Buyers, who

purchased substantially all of corporation's stock from sellers in private
sale agreement, brought action under § 12(2) of Securities Act of 1933,
seeking rescission of private sale agreement on ground that written sale
agreement was a "prospectus" and contained material misstatements,
which gave rise to liability under 12(a)(2). The parties executed a contract
of sale. However the earnings estimates were lower than those originally
relied upon. The sellers argued that 12(a)(2) claims can only arise out of
the initial stock offerings. The issue is whether the contract is a
“prospectus”? The court holds that held that term "prospectus" in
provision of securities statute which gives buyers of securities express
right of rescission against sellers who make material misstatements or
omissions by means of prospectus, referred to document that describes
public offering of securities by issuer or controlling shareholder, not
private agreements to sell securities. Knipprath says: look at the law in its
intended operation. § 17 exemption. The argument is that the Act is
intended to regulate initial offerings. So, should a private placement be
covered by 12(a)(2)? No. But, what’s the counter-argument? The
prospectus gives all kinds of information. Is a prospectus part of a
registrations statement? Yes. What is the point of § 11 and § 12(a)(2) if
they are the same thing. If it only covers public offerings wouldn’t it be
covered under § 11?
The court holds that 12(a)(2) does not reach secondary trading,
moreover it does not even apply to initial offerings unless they are made
publically by means of a statutory prospectus. Thus, there is no liability
under the ’33 Act for written or oral misstatements in offerings which are
exempt from that Act’s registration requirements
Potentially liable person under §11 have a “due diligence” defense if they
conducted a reasonable investigation

Under §12, the seller has an affirmative defense if he can establish that he did
not know, and in the exercise of reasonable care could not have known, of the
untruth or omission
Ambrosino v. Rodman (7th Cir. 1992)

ii Ambrosino: Oil drilling venture where Berry, the expert geologist, didn't disclose that the well
had been waterflooded twice. Rodman, the broker, didn't know about the waterflood
until after the sale but when they heard rumor, they researched & found the info.
Analysis: A 12(2) violation. Must establish an agency relationship if didn't sell directly. Under
§12, there is no investigation required. So Rodman was okay cuz lawyer said they
used due care greater than industry standard. Berry should have known cuz he was a
leaseholder & an expert in waterflooding as well as a history in this area.
Conclusion: Berry is liable under 12a2.
PROCEDURAL POSTURE: Plaintiff oil-and-gas investors appealed a decision from the United
States District Court for the Northern District of Illinois, which entered judgment in favor of
defendant securities dealer in plaintiffs' action under federal and state law, including § 12(2) of
the Securities Act of 1933, 15 U.S.C.S. § 77l(2).
OVERVIEW: Plaintiff oil-and-gas investors brought a securities fraud action against defendant
securities dealer and defendant promoter for alleged violations of federal and state securities
laws, including § 12(2) of the Securities Act of 1933, 15 U.S.C.S. § 77l(2); § 10(b) of the
Securities Exchange Act of 1934, 15 U.S.C.S. § 78j(b); S.E.C. Rule 10b-5; and the Illinois
Securities Law of 1953, Ill. Rev. Stat. ch. ch. 121 1/2, § 137.1 et seq. The district court entered
judgment against defendant promoter, but not against defendant dealer.
On plaintiffs' appeal, the court affirmed. As to the claims under § 12(2), the court upheld
the district court's finding that, although defendant securities dealer failed to discover and
thus disclose a prior waterflood on one of the oil fields, it had exercised due diligence in
investigating this material fact. Applying the contract law principle that a written statement
controlled an oral statement, the court held that defendant securities dealer's alleged
misrepresentations and omissions in oral statements to plaintiffs were "immaterial" for
purposes of § 12(2) because the true and/or missing information was provided in the
written offering memoranda.
OUTCOME: Finding that the district court did not misunderstand the applicable securities law,
was not clearly erroneous in its findings as to "materiality" or "due diligence," and did not abuse
its discretion, the court affirmed its judgment in favor of defendant securities dealer in plaintiff oil-
and-gas investors' securities fraud action. What is due diligence for purposes of 12(a)(2)?
Where did we see this defense before? § 11 allows a due diligence defense. They explain it
under § 11(b) regarding experts and non experts regarding expertise portion of a statement. If
you can show that you had reasonable ground after reasonable investigation reasonably believe,
then you’ve got a due diligence defense. 12(a)(2) is a specific reference to investigation? § 11
requires an investigation. § 12(a)(2) does not mention an investigation. So, is an investigation
required under § 12(a)(2)?
Court says that the application of the test is the same, regardless of the difference in wording.
Exercise of reasonable care is the requirement. Court balancing restrictive versus expansive
readings.
B. § 17 Anti Fraud Provision

§ 17 no exemption for fraud, even in the marketing of securities. So exemption from registration
is not an exemption from fraud statutes. No express private right of action. No implied right of
action either. Why? It’s available under § 10(b)(5). Why not under § 17? Timing of case says
Knipprath. Only SEC can bring action under § 17.
Anyone can be a defendant under § 17. Scienter is required for 10(b)(5).

§ 17(a)(1) SCIENTER
§ 17(a)(2) NO SCIENTER
§ 17(a)(3) PROBABLY NO SCIENTER
Negligence standard applies because the potential problems are limited due to only the SEC
being able to bring aaction for injunction; you aren’t exposed to $ damages in private suits.
Agency can’t act ultra vires. The statute does not apply a scienter requirement so it can’t be
expanded.
§ 16 -- only cares if you are an insider; not if you traded on inside information. Liability is
premised on 10b and 14(e)(3).
§ 10b liability - see Santa Fe Industries v. Green (ordinary breach of fiduciary duty is not a federal
action under 10b; 10b only deals with fraud and stock manipulation.) Reputational injury to the
corporation. Then fraud on the market theory. So what’s the liability? 10b insider trading liability:
who can bring action? SEC, dept of treasury. Private right of action is implied. But there is a
purchaser or seller requirement. § 20A said you can have contemporaneous purchasers bringing
private rights of action. STANDING IS HARD TO ESTABLISH SO THAT’S WHY THE ACTION
IS USUALLY BROUGHT BY THE SEC. Courts don’t like private actions under 10b.
Potential defendants:
Did you have a fiduciary duty to the corporation whose shares were bought or sold? If you’re an
insider, then for sure you have this duty. Even a mere employee owes a fiduciary duty to the
corporation.
XXVIII. III. Liability under 1933 Act
A. 1. Section 11
§ 11 is a cause of action directed at fraud committed in connection with the

sale of securities through the use of a registration statement. § 11 cannot be
used in connection with an exempt offering.
(vi) Neither reliance nor causation is an element of the plaintiff’s prima facie
case. The defendant has the burden of proving that his misconduct didn’t
cause plaintiff’s damages.
(vii) No privity requirement, the list of defendants can be quite expansive. It
includes: everyone who signed the registration statement (the issuer, its
principal executive officers and a majority of the board of directors); every
director at the time the registration statement became effective, including
directors who didn’t sign the registration statement; every person named in
the registration statement as someone about to become a director; every
expert named as having prepared or certified any part of the statement;
every underwriter involved in the distribution.
(viii) The issuer has a strict liability.

(ix) As to defendant other than the issuer, the degree of fault required is
essentially a negligence standard.
(x) No need to prove scienter, the defendant’s state of mind is irrelevant.
(xi) Due diligence defenses: §11 (b) (3) have you left no stone unturned?
Due diligence is not an affirmative obligation.
Escott v. BarChris Construction (SDNY 1968), p.80
Distinctions expertised non-expertised information Insider/outsiders
B. 2. Section 12(a)(1)
It imposes strict liability on sellers of securities for offers or sales made in violation of § 5,
i. e. when the sellers improperly fails to register the securities, to deliver a statutory prospectus,
violates the gun-jumping rule. The term seller also encompasses persons who successfully solicit
offers to purchase securities motivated at least in part by a desire to serve their own financial
interests or for those of the securities’ owner. Main remedy: rescission, unless the buyer is no
longer the owner of the securities then damages.
C. 3. Section 12(a)(2)
It is a general civil liability provision for fraud and misrepresentation. Liability under this
section may be imposed where defendant made oral statements, used written selling materials
containing a material misrepresentation or omission. Liability may generally also be imposed in
exempt offerings, but after Gustafson only if the sale occurred in a public offering, i. e not in
secondary market nor privately negotiated transactions. Liability is limited to the seller of a
security (like § 12(a)(1)).
Pinter v. Dahl (S.Ct 1988)

12(1): statutory seller: buyer-seller PRIVITY + solicitation has to be for value in pari delicto
defense
• Pinter sells fractional undivided shares in oil well. Dahl invests his own money, and
gets his friends to invest as well.
• Offering to Dahl’s friends/relatives is under Rule 146 – w/o reg’n st’nt
• Pinter’s defense: sec’s don’t have to be registered, bec under Sec 4(2) it’s not a
public offering
• Then Pinter is suing Dahl for contribution
it is undecided whether there is right to contribution under Sec 12
• Another issue: Pinter says that Dahl is also in violation of Sec 12(1), bec they both
sold sec’s
• Dahl’s threshold defense: doctrine of in pari delicto positiv defendentis potrir
est: bet persons w/equal fault, the position of D is stronger. Dahl says: if I violated
Sec 12, so did Pinter – I can’t be sued. Dist ct said that doctrine doesn’t apply
• Ct of App reversed on that issue: it applies, but only to persons w/approximately
equal fault
• Under Sec 12(1), if you still own the sec, you can rescind

• Who transferred ownership of leases (title) to Ps – Pinter. Dahl’s defense: you can’t
rescind trans’n ag person w/whom you didn’t deal. Court: disapproves this transfer
of title test – 12(1) includes solicitation – under 12(1), any person who offers or sells
in violation of Sec 5 is liable
• Other cts of app: liability ran ag smb who was a subst’l factor in a sale. Court
disapproves subst’l factor test.
• S.Ct adopts test: person is liable under 12(1) if he is
1. Statutory seller under 12(1): only persons w/whom P directly dealt

privity idea: smb w/whom P is in contact - not in the sense of smb who
transferred title, but smb who sold P the deal
• Say, issuer sells in a 4(2) trans’n; I resell to smb else not in a 4(2)
trans’n. Can buyer rescind as ag me? – Yes – Sec 5 applies. Can
buyer rescind ag my seller? - No
Footnote 21: 12(1) imposes liability on only the buyer’s
immediate seller; remote purchasers are precluded from bringing
actions ag remote sellers. Thus, a buyer cannot recover ag his
seller’s seller.
2. After we’ve decided that Dahl is a statutory seller, is he liable under

12(1)? – only if his motivation is to get personal financial benefit (or benefit the
securities owner); if he only wants to lead other investors to the deal for their benefit – he
is not liable
• S.Ct remands the case to determine whether Dahl was trying to get money or was
just being a nice guy
Sec 2(3)
“Sale” – every K of sale or disposition of a security or interest in a security, for value.
“Offer to sell” – every attempt or offer to dispose of, or solicitation of an offer to buy, a
security or interest in a security, for value.
• Issue: whether one must intend to confer a benefit on himself or on 3rd party in order to qualify
as a “seller” w/n the meaning of Sec 12(a) – solicitation has to be for value (for financial
gain)
• Sale of unregistered sec’s (fractional undivided interests in oil and gas leases)
• Pinter sold those sec’s to Dahl (real estate broker and investor) and his friends and family:
Dahl invested, then recommended investment to others. Each investor completed the
subscription-agreement form – that participating interests were being sold w/o the benefit of
reg st’nt under Rule 146 of 33Act.
• Venture failed; investors brought suit ag Pinter, seeking rescission under Sec 12(1) of 33 Act
for unlawful sale of unregistered sec’s
• Pinter argued that Dahl fraudulently induced Pinter to sell sec’s, that he assured Pinter that
he would provide sophisticated investors
• Dist ct: for investors – Pinter had not proved that oil and gas interests were entitled to
private-offering exemption from reg’n – so rescission under Sec 12(1)
• Ct of App: whether Dahl was himself a “seller” w/n meaning of Sec 12(1). If he was, he
could be held liable in contribution for other Ps’ claims ag Pinter. Seller is
(1) one who parts w/title to sec’s in exchange for consideration or

(2) one whose participation in the buy-sell trans’n is a subst’l factor in causing the trans’n
to take place
here, Dahl conduct – yes, subst’l factor
but still Dahl – not seller w/n 12(1)
Court refined the test to include a threshold req’nt that one who acts as a promoter be motivated
by a desire to confer a direct or indirect benefit on someone other than the person he has advised
to purchase
Here, Dahl didn’t seek or receive any fin benefit in return for his advice – so, not seller –
no liability
• Cert:
• At the very least, 12(1) contemplates a buyer-seller relationship not unlike trad’l
K-tual privity – it imposes liability on owner who passed title, or other interest in the
security, to the buyer for value
Dahl – not a seller in this sense – not liable
• Sec 2(3) defines “sale” as “K of sale of sec for value”: range of persons
potentially liable under 12(1) is not limited to persons who pass title –
also person who engages in solicitation (not only actual owner)
• Plus, P has to purchase sec’s from D/seller – purchase req’nt confines Sec 12
liability to those sit’ns in which sale has taken place; but it doesn’t exclude solicitation
from the category of activities that may render a person liable when a sale has taken
place
statutory seller includes at least some persons who urged the buyer to purchase
broker can be such seller
• Solicitation of a buyer is perhaps the most critical stage of the selling trans’n – it’s
the stage at which investor is most likely to be injured – by being persuaded to
purchase sec’s w/o full and fair info
• But Congress did not intend to impose rescission based on strict liability on a
person who urges the purchase but whose motivation is solely to benefit the buyer
Liability extends only to person who successfully solicits the purchase, motivated at least in
part by a desire to serve his own fin interests or those of the sec’s owner
• Pinter argues for subst’l factor test – too broad – wrong. Plus: it might expose professionals
to liability. Plus, it reaches participants in sales trans’n who don’t fit w/n definitions in Sec
2(3). This test – not sufficient to render D liable under 12(1).
• S.Ct: unable to determine whether Dahl may be held liable as a statutory seller under 12(1).
Gustafson v. Alloyd Sec 12(2) claims can only arise out of the initial stock
offerings
(S.Ct 1995) Stock purchase agr’nt here is not prospectus w/n 33 Act
• Seriously flawed concept of materiality. Here, deal was seriously negotiated. In K,

parties expressly contemplated pos’ty that estimates were wrong and provided for
liquidated damages in case they were.
• This case involves the sale of all or subst’ly all of stock of closed corp.
• Everybody agrees that if deal doesn’t turn out right – it’s material – you’d want to
know about this. But is this smth that would change the investment decision in this
case – no – they negotiated that such case would be covered w/liquidated damages
– so, it was not material to them. It’s outrageous that P seeks rescission while it
expressly negotiated for damages. This is unreasonable materiality standard; this
case shouldn’t have gone forward.
• Slain doesn’t disagree w/the result in this case, but for different reasons. K in
this case is a prospectus, and if there is misrepresentation – Ps should
recover. But here parties expressly negotiated that deal might not turn out to

be right and provided for liquidated damages. So, for them it plainly didn’t
make a difference – not material. Here – far too low standard of materiality.
• In 1933, no one questioned that 12(2) covers any sec’s trans’n. Then 1 case held
that 12(2) only covers public offerings – obviously wrongly decided. S.Ct granted
Cert in this case.
• Massive error from the outset of the opinion: Court first looks at architecture of the
statute w/o reference to definition (unorthodox) + doesn’t get it right
Court says: “Sec 11 provides for liability on account of false registration st’nts;
Sec 12(2) for liability based on misstatements in prospectuses.”
But Sec 11 applies to defective info in a prospectus – complete
misunderstanding of structure of the Act
• S.Ct: Sec 12(2) only applies to public offerings; public offerings that are
exempt are also covered by Sec 12(2) (prospectus is not provided when exempt
sec’s – but still covered)
• S.Ct: the only oral communication covered by 12(2) is oral communication that
relates to prospectus. Slain: there is no basis for that.
• J. Thomas’s dissent is right; Majority opinion is wrong.
• J. Ginsburg’s dissent: heavy reliance on leg history, so Slain is less supportive of it.
• Both Thomas and Ginsburg say: start w/definition to figure out what smth in the
statute means. Slain: right. Here, definition is clear and plainly covers this trans’n.
Other issues:
• Basis for saying that there is no implied right of action under 17(a) has always been
that conduct which is made illegal under 17(a) is made actionable under 12(2) – that
died w/this case, bec it narrowly reads 12(2).
• Definition of prospectus expressly covers confirmation. You can’t send confirmation
w/o final prospectus. Does this survive this opinion? S.Ct – w/o selling doc’nt, you
don’t have a prospectus – reads confirmation out of prospectus – can send
confirmation w/o final prospectus, bec confirmation is not a selling document.
• What if make a false “oral communication” not related to prospectus? Salin: you
should be able to bring action under 12(2). But S.Ct seems to restrict it as oral
communication relating to a prospectus.
• J. Thomas is right in saying that court started w/bias in favor of narrow reading, and
then justified it
In sum:
• S.Ct limited 12(2)’s application to public offerings by issuers or their
controlling s/hs. Thus, 12(2) may be invoked only by purchasers in registered
offerings under 33 Act and perhaps by purchasers in Sec 3 exempt offerings
provided that such exempt offerings take on a public nature.
• 12(2) does not extend to the secondary market other than public offerings by
controlling s/hs.
• Oral communication must relate to prospectus.
• By interpreting the term “prospectus” as “a term of art referring to a document that
describes a public offering of sec’s by an issuer or controlling s/h”, S.Ct significantly
limited the scope of 12(2).
• 12(2) applies only to public offerings.
• Issue: whether right of rescission under 12(2) extends to a private, secondary trans’n, on the
theory that recitations in the purchase agr’nt are part of a prospectus – No.

• Gustafson and other were the sole s/hs of Alloyd, Inc. Wind Point Partners agreed to buy
subst’ly all stock through Alloyd Holdings – new corp formed to effect the sale of Alloyd’s
stock. K of sale was executed. Then the year-end audit of Alloyd revealed that Alloyd’s
actual earnings for 1989 were lower than estimates. Under K, buyer had the right to recover
the adjustment amount from sellers. But buyers brought suit, seeking outright rescission of K
under 12(2) of 33 Act.
• Buyers said that K of sale was a prospectus, so any misstatements there gave rise to liability
under 12(2).
• Dist ct: sum j’nt for sellers: Sec 12(2) claims can only arise out of the initial stock
offerings. Private sale agr’nt cannot be compared to initial offering bec purchasers had
direct access to fin and other co doc’s, and had the opp’ty to inspect seller’s property.
• 7th Cir: decision in Pacific Dunlop: the term “communication” in definition of “prospectus” –
includes all written communications that offered sale of sec. Held: 12(2) right of action for
rescission applies to any communication which offers any sec for sale, including stock
purchase agr’nt in the present case.
S.Ct: Reverse – for Ds.
• Assuming stock purchase agr’nt contained material miss’nts of fact made by sellers and that
D would not sustain its burden of proving due care, P would have right to obtain rescission if
those misst’nts were made by means of prospectus or oral communication. Issue: whether K
here is prospectus w/n 33 Act - No.
Sec 10 sets forth info that must be contained in a prospectus

• K here was not required to contain info contained in reg st’nt; no stat exemption
was required – K is not a prospectus
• Prospectus under Sec 10 is confined to doc’s related to public offerings by issuer
or its controlling s/hs
Sec 12 imposes liability based on misst’nts in a prospectus
• Term “prospectus” must have the same meaning under Sec 10 and Sec 12 –
term “prospectus” relates only to doc’nts that offer sec’s sold to the public by an
issuer
• Liability imposed by 12(2) cannot attach unless there is an obligation to distribute
prospectus in the first place (or unless there is an exemption)
• But Sec 12 refers to a broader set of communications that the same term in Sec
10
• The Act uses one term – “prospectus’ – throughout
Sec 2(10) defines prospectus
• Word “communication” is one word in a list; has to be read in context. So, the
term prospectus refers to a doc’nt soliciting the public to acquire sec’s
• 17(a) does not contain the word “prospectus” – broad construction. In contrast, 12(2)
contains limiting language (“by means of prospectus or oral communication) that limits 12(2)
to public offerings – narrow construction
• Held: the work “prospectus” is a term of art referring to a doc’nt that describes a
public offering of sec’s by an issuer or controlling s/h. The K of sale, and its
recitations, were not held out to the public and were not a prospectus as the term is
used in 33 Act.
Thomas dissent:
• Begin with 12(2), and then turn to 2(10), before consulting structure of the Act as a whole.
12(2) should apply to secondary or private sales of sec as well as to initial public offerings.
• Majority is motivated by policy references – that Congress could never have intended to
impose liability on sellers engaged in secondary trans’ns. But Congress did so w/r/t 17(a) of
33 Act and 10(b) of 34 Act.
• Yes, can be increase in sec’s litigation, but that’s for Congress to resolve.

Ginsburg dissent:
• Drafting history: 12(2), like 17(a), is not limited to public offerings.
• Drafters borrowed from British Companies Act of 1929, but didn’t include “offering to the
public” w/n definition of “prospectus”
Primary offering – an offering of newly issued securities

Secondary offering – an offering of previously issued securities
Pinter v. Dahl (1988) page 45

PROCEDURAL POSTURE: Petitioner challenged the judgment of the United States Court of
Appeals for the Fifth Circuit, which held that the doctrine of in pari delicto was inapplicable to
actions under § 12(1) of the Securities Act, 15 U.S.C.S. § 771(1), and that respondent was not
considered a seller within the meaning of § 12(1).
OVERVIEW: The controversy arose out of the sale prior to 1982 of unregistered securities by
petitioner to respondent investors. When the subject venture failed, respondents brought suit
against petitioner, seeking recission under § 12(1) of the Securities Act, 15 U.S.C.S. § 771(1),
for the unlawful sale of unregistered securities. Petitioner counterclaimed, alleging that
respondents' suit was barred by the doctrine of in pari delicto. The lower court granted
judgment for respondents and held that the doctrine of in pari delicto was inapplicable in an
action under § 12(1) and that respondent was not considered a seller within the meaning of §
12(1).
The Court reversed and held that the common-law in pari delicto defense was
available in a private action brought under § 12(1). Moreover, the Court held that one did
not have to confer a benefit on himself or on a third party in order to qualify as a seller
within the meaning of § 12(1). Thus, the Court remanded for a determination of whether
respondent bore substantially equal responsibility for the failure to register and distribute the
securities and whether respondent was primarily a promoter of the offering.
OUTCOME: The Court vacated and held that the defense of in pari delicto was available and that
one was not required to confer a benefit on oneself or a third party to qualify as a seller of
securities. The Court also remanded for a determination of whether respondent bore substantially
equal responsibility for the failure to register and distribute the securities and whether respondent
was primarily a promoter of the offering.
Gustafson v. Alloyd Co (1995) page 65

PROCEDURAL POSTURE: Petitioners, the former shareholders of a corporation, sought review
of the judgment of the United States District Court of Appeals for the Seventh Circuit, which
reversed a grant of summary judgment in their favor in a suit filed by respondent corporation that
sought recission of its private purchase of petitioners' stock under § 12(2) of the Securities Act of
1933, 15 U.S.C.S. § 771(2), for financial inaccuracies in the purchase agreement.
OVERVIEW: Petitioners, the sole shareholders of a corporation, privately sold all of the issued
and outstanding stock of the corporation to respondent, a corporation created to effect the sale of
the stock. After the financial recitations provided for in the purchase agreement were discovered
to have been inaccurate, respondent sought recission of the purchase under § 12(2) of the
Securities Act of 1933, 15 U.S.C.S. § 77l(2), even though petitioners agreed to pay an
adjustment. The court below reversed a grant of summary judgment in favor of petitioners after
finding § 12(2)'s right of action for recission applied to any communication that offered any
security for sale, including the stock purchase agreement at issue.
On appeal, the Court found that the word "prospectus," as used in the Securities Act of
1933 (Act), was a term of art referring to a document that described a public offering of
securities by an issuer or controlling shareholder. Therefore, the judgment of the court below
was reversed because the contract of sale, and its recitations, were not held out to the
public and were not a prospectus as the term was used in the Act.
OUTCOME: The judgment was reversed after the Court concluded that the word "prospectus," as
used in the Securities Act of 1933, was a term of art referring to a document that described a

public offering of securities by an issuer or controlling shareholder. Since the contract of sale at
issue was a private, secondary transaction, the right of recission did not extend to respondents.
Wednesday, March 09, 2005

§ 16 reporting requirements vs. § 14 reporting.
§ 16 - traded on a national exchange OR have $10mm in assets OR 500 s/h
If no registration statement, can’t violate § 11 of ’33 act b/c that only deals with registration
violations.
Tipper: must breach fiduciary duty and reasonably should have foreseen that tipee would trade
on the information.
Fiduciary Duty Review

 Insider
 Functional Insider
 Derivative Insider
 Tipper
 Tippee
 Misappropriation
 Damages
 Treble damages under 21A
 20A private rights of action - disgorgement
 14(e)(3) creates a liability for anyone trading on the basis of confidential inside information
connected with a tender offer. This is the furthest that the SEC has pushed the inside
information liability issue.
Exam
 Essay
 2 1 hr essays
 is solely on the ’33 Act.
 Registration
 Exemption
 Civil Liability 11, 12, 17
 Previous Case materials
 Mergers
 Appraisal Rights
 DeFacto Merger
 Take Over Cases
 Ordinary Businsess Judgment in Light of the Smith v Van Gorkem test
 Unocal
 Revlon
 Multiple Choice
 Anything said in class
 1 hour
 Review
 Mergers
 Statutory:
• 1 corp acquires stock of another corp pursuant to an agreement
• S/H must vote

• Maj of S/H can bind min

• Cash or stock exchange
 Triangular
• New entitiy created
• Target and Acquirer merge into the new entitty
 Sale of Assets
 Could acquire assets, liabilities, or both
 Seller winds up with cash
 Residue is passed to S/H in dissolution
 Dissolution is a separate decision of the selling corportation
 In a merger the dissolution of the target is usually part of the initial deal
 Who Votes?
• Merger
♦ Both Boards
♦ S/H depends on jurisdictions
♦ Target in merger
♦ Acquiring Corp is questionble
 Look at dilution on shares of acquiring company
• Sale of assets
♦ Buying corp S/H don’t vote
♦ Selling corp S/H might vote depending on jdx due to change in business
 Appraisal Rights
 Minority can opt out of the merger; vote against it and demand appraisal rights
 Or stick with it
 Or sell
 Or vot against it and demand appraisal rights
 You may have to file suit
 You could lose appraisal rights if you don’t perfect them within the statutory period
 You then lose unless you can prove fraud in the transaction.
 Courts don’t like to unwind mergers
 You might get fraud damages (hard to prove)
• Courts will usually just give appraisal value
 You can try for an injunction (courts don’t like this in absence of fraud)
 Short Form Merger
 California and many states have this
 If corp owns 90% of subsidiary, then it can merge by motion of the Board
 No consent of minority needed
 General Rules of Mergers is that all S/H vote, so minority can’t change majority
decision anyway
 Appraisal rights apply
 DeFacto Merger Doctrine
 Generally disfavored
 Looks like a merger so appraisal remedy should apply
 Majority view is against this remedy
 Tender Offer
 Can result from negotiation
 But doesn’t have to be
 S/H vote individually
 S/H not tendering retain old shares
• Differs from merger where maj binds min
 Rules
• Offeror may not discriminate among S/H

• No stampeding of target S/H

• Tender must remain open for 20 days
• If price changes, the price increase must be retroactively available to those who
already tendered or it is discriminatory tender
• Can tender for all, part, or minimum
• If tender is oversubscribed, must pro rata reduce shares sold
• No fraud, misrep, material misrep allowed
• Problem if it is a hostile tender
 Hostile Tender Issues
• Management may advise S/H to vote against it
• Mgmt may reject advances of a suitor
• BJR protects that decision
♦ Unless self dealing or conflict of interest
♦ Then fairness test applies due to breach of duty of loyalty
• Smith v Van Gorkum is BJR test threshold
• Entrenchment is a bad motive and would be a breach of the duty of loyalty
♦ Tough to prove this as a clear motive; no clear evidence; always there as a
potential
♦ Therefore, defensive measures must meet heightened Unocal test
 Unocal
 Defensive measures must be proportional to threat imposed by hostile suitor
 Will there be looting or financial mismanagement?
 Continued existence of corp?
 Corp culture?
 Revlon
 2 scenarios
• Bidder is interested in target
♦ Target mgmt resists
♦ But in resisting, mgmt engages in a course of conduct that will ultimately
result in the dismemberment of the corp or at least a substantial change in
form
• Alternatively, management may decide to sell, mgmt puts company in play
♦ Breakup or change in form is likely
 We looked mostly at scenario #1; someone trying to buy and mgmt rebuffing
• White knights
• Bidding war errupts and terms of bidding war are such that it becomes clear that
the company will be sold or broken up
• Company will have to sell divisions or assets such that it loses its character as an
independent entity
 Revlon Duties now kick in (up for sale voluntarily or involuntarily)
 Revlon Duties are:
• No longer mgmt duty to look at l/t benefit of corp; must maximize S/H value
• No requirement to take highest $ offer
 Revlon Duties now kick in if Change of Control
• Change in nature of control
• Corp is owned by a bunch of different S/H
• If that corp were sold, then the price that’s gained for the corp would be split
among all the S/H proportionally
• If bidding corp has anything other than a 100% all cash offer for all stock, now
the fact that you get stock in bidder, you get stock and your position is not really
changed
♦ Bidder stock in exchange for target stock is no big deal

♦ UNLESS you have a controlling S/H in the bidder; so now you are a S/H in a
large corp dominated by a single S/H
♦ Your potential to sell your shares is diminshed
♦ CONTROL PREMIUM
 Review the exemptions diagram
 Get from issuance to public distribution
 Go through elements regarding private right of action and prima facie case for § 11 &
12
 Also look at ’34 act and § 17
 Send questions to: swconlaw@netscape.net
 Up to 3:00 on Sunday he will call you with the answer; leave name,number,and question.


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E. Summary - Introduction to Partnerships/ Partners’ Fiduciary Duties....................................38

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I. Overview of Business Associations

2. Expand the Pie – Reduce Transaction Costs Theory

3. Addressing Opportunism Costs Through Structure of Business Association

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B. The Transaction Cost Trade-Off

C. Structuring a Business Association

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1. Table: Rates of Return for Debt vs. Equity Investments

Bus iness Im proves 50% & is Sold

Bus iness Breaks Even & is Sold

Bus iness Fails: Drops 50% & is Sold

D. Summary: Introduction to Business Associations

2. Transaction Costs and Business Organization

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II. AGENCY – THE BUILDING BLOCK OF FIRMS

2. § 3(1) General Agent

4. How Cases With Similar Fact Patterns are Determined Differently

5. A. Gay Jenson Farms Co. v. Cargill, Inc. (p. 7)

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2) Cargill’s right of first refusal on grain;

II. Liability of Principal to Third Parties in Contract

1. § 7. Actual Authority (Principal  Agent)

2. § 26. Creation Of Authority; General Rule

3. Mill Street Church of Christ v. Hogan,

1. § 8. Apparent Authority (Principal  3rd Party)

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2. § 27. Creation Of Apparent Authority: General Rule

...apparent authority to do an act is created as to a third person by written or spoken

3. Lind v. Schenley Industries, Inc.

4. Three-Seventy Leasing v. Ampex

1. Inherent Authority (Agent  3rd Party Foreseeable Act By Agent)

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2. Watteau v. Fenwick (The I Feel Your Pain Case) P. 25

Justifications for this rule?

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3. Kidd v. Thomas A. Edison, Inc. (The Is It Live Or Is It Memorex? Case) P. 28

4. Nogales Service Center v. ARCO (The Pumped for Success Case) P. 31

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1. Apparent Authority – Elements:

2. Mitigating Risks of Apparent Authority

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3) Why do we have inherent authority?

4. Botticello v. Stefanovicz (What Do You Mean I Bought Half A Farm?) P. 36

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5. Ratification: Limits on Valid Affirmance

6. Ratification’s Effect on Authority

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2. Estoppel Defined in Plain English:

3. Hoddeson v. Koos Bros. (The Phantom Furniture Salesman) P. 40

H. Agent’s Liability on Contract

1. Atlantic Salmon A/S v. Curran (The Fishy Fish Dealer) P. 43

I. Summary – Agency Relationship/Liability of Principal in Contracts

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b. Apparent Authority: P’s behavior causes T to reasonably believe he has

III. Liability of Principal to Third Parties in Tort

2. Flaws in the justifications: Counter-Arguments to Tort Liability of Principal to 3rd

3. Counter-Counter-Arguments to Tort Liability of a Principal to 3rd Parties

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