Corporations • miller • fall 1999/spring 2000

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corporations • miller • fall 1999/spring 2000

  1. Firm as Organization of Business

Fowler v. Pennsylvania Tire consignment v. sale w/r/t availability of assets to satisfy claims of creditors, notice of consignment based on course of dealing

  • indicia of buy/sell arrangement: financing (payment of interest as service charge on inventory), provisions for taxes, insurance payment; no segregation of merchandise accounts; not all financial reports filed

  • UCC § 2-326: consigned goods subject to claims of buyer’s creditors while in the buyer’s possession

  1. Agents and Employees

  • appearance not as relevant in tort scenarios as in contract (where there is choice)

  1. Exercise of Control

Master/Servant v. Independent Contractors

R2 Agency § 2 Master & Servant. S has agreed (a) to work on behalf of the M, and (b) to be subject to M's control or right to control the “physical conduct” of S (manner of performance).

  • respondeat superior: M (employer) is liable for the torts of S (employees).

R2 Agency § 1 Agency. 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.

  • § 1, comment (b): continuous subjection to the will of the principal which distinguishes the agent from other fiduciaries and the agency agreement from other agreements.

1. Control over Agent's Day-to-Day Operations Liability

Humble Oil (oil company liable for gas station owner and attendant's negligence despite express repudiation in K; M-S where contract gave oil company control over operation of station, shares operational expenses, furnishes station equipment, location and advertising, gives station owner little business discretion except for employment decisions (hiring, firing, payment)

Billops v. Magness Construction hotel franchisor could be held liable for extortion by banquet manager at hotel, ruining party, due to franchisor's control through manual with explicit directions regarding parties, despite fact that intentional tort harder to control than negligence of agents

2. No Control over Agent's Day-to-Day Operations No Liability

Hoover v. Sun Oil (oil company not liable for accident at gas station when no control over day-to-day operations)

accident occurred in course of service governed by agency relationship but while Sun owned station and equipment, advertising display, and sent its representatives to inspect and offer advice, oil company did not have control over day-to-day operations, operator set its own hours of operation, and either party could terminate agreement at any time

Murphy v. Holiday Inns (no liability for accident when no control over day-to-day activities of franchisee)

  • franchise K does not insulate the contracting parties from an agency relationship. If a franchise K so regulates the activities of the franchisee as to vest the franchisor with control within the definition of agency, the agency relationship arises even though the parties expressly deny it.

  1. Control and Liability of Creditors

Cargill C becomes principal, liable for claims against D, when assumes de facto control over day-to-day operations

  • course of dealing: debtor’s inability to enter into mortgages, to purchase stock or to pay dividends without creditor’s approval; creditor’s right of entry onto debtor’s premises to carry on periodic checks and audits; financing of all debtor’s purchases of grain and operating expenses; creditor’s power to discontinue the financing of debtor’s operations.

R2 Agency § 14 O: mere veto power over business acts of D by preventing purchases or sales above specified amounts does not make C a principal; C becomes a principal when assumes de facto control over D, directs what contracts may or may not be made, whatever the terms of the formal contract may be.

  1. Scope of Authority

actual v. apparent (holding out by company or act/speak as if having authority and company does nothing to stop such behavior)

R2 § 8 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

  1. implied - agent acted/recognized by principal in such a manner so that agent has authority (actual or apparent), though no explicit manifestation of consent by principal

  2. inherent - authority of office/position, normally carries certain responsibilities

Lind v. Schenley Industries company held to immediate supervisor's promise of commission to employee who had no reason to doubt manager's apparent authority to make such representation, despite practical implications and lack of actual reliance

Three-Seventy Leasing v. Ampex computer manufacturer for computer leasing agent's acceptance of offer due to apparent authority; agent has apparent authority sufficient to bind the principal when:

  • reasonably prudent person would believe agent to have authority

  • absent knowledge on the part of third parties to the contrary

  • usual and proper to the conduct of the business

  1. Inherent Agency Power

Watteau v. Fenwick brewery liable for debts of pub manager, exceeding actual authority, though third parties dealt only with pub manager with no reliance upon brewery; undisclosed principal liable for agent's actions if

  1. within scope of agency and

  2. usual in course of business

  • to limit liability of principal for actions of which principal has no knowledge

  • higher risk assumed by third parties when activities outside normal scope

Kidd v. Thomas Edison principal held liable to artist for lack of payment despite agent's lack of authorization, because such authority would normally be in scope of entertainment agency

  • would defeat purpose of delegated authority if still necessary to have constant recourse by third persons to the principal as a result of denying agent any latitude beyond exact instructions

Nogales Service Center v. ARCO inherent agency power found in job description/title by which principal held out agent

R2 Agency § 8A: Inherent agency derived solely from the agency relation for the protection of persons harmed by or dealing with a servant or other agent. comment b:

(a) The other type of inherent power subjects the principal to contractual liability or to the loss of his property when an agent has acted improperly in entering contracts or making conveyances.

(b) There are three types of situations in which this power exists:

(i) general agent does something similar to what he is authorized to do, but in violation of orders. In this case the principal may become liable as a party to the transaction, even though he is undisclosed.

(ii) agent acts purely for his own purposes in entering into a transaction which would be authorized if he were actuated by a proper motive.

(iii) agent is authorized to dispose of goods and departs from the authorized method of disposal.

R2 Agency § 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.

comment b: Rule applies regardless of whether there is apparent authority. Thus, the principal may be liable upon a contract made by a general agent of a kind usually made by such agents, although he had been forbidden to make it and although there had been no manifestation of authority

to the person dealing with the agent.

  1. Fiduciary Obligation of Agent to Principal

General Automotive Manufacturing v. Singer failure to disclose opportunities and retention of profits from side orders held to constitute violation of fiduciary duty of an employee to employer to exercise utmost good faith and loyalty to not act adversely to the interests of the employer by serving or acquiring any private interest of her own; to act for the furtherance and advancement of the interest of the employer; employee liable for the amount of the profits he earned in his side line business.

Bancroft-Whitney v. Glen corporate officer/director liable for breach of fiduciary duty in negotiating with principal's competitor while still employed by principal and taking principal's top managers upon leaving principal; mere fact that officer makes preparations to compete before he resigns office is not sufficient to constitute a breach of duty; nature of preparations is significant

R2 Agency § 393, comm. e: agent can make arrangements to compete with his principal even before the termination of the agency, but that he cannot use confidential information peculiar to employer’s business and acquired therein.

Town & Country House & Home v. Newberry (breach of fiduciary duty in taking customer list where customers are not openly engaged in business in advertised locations or whose availability as patrons cannot readily be ascertained as trade secret due to pre-screening, large number of cold calls involved in assembling list; other competitive means available

Corroon & Black-Rutters & Roberts v. Hosch no breach of fiduciary duty in insurance agent's taking names and addresses of own customers with expiration lists; unlike home-cleaning business, easier to gain customers

Rst, 4 Torts, § 757, comment b: factors to consider in determining whether trade secret:

  • the extent to which the information is known outside of his business

  • the extent to which it is known by employees and others involved in his business

  • the extent of measures taken by him to guard the secrecy of the information

  • the value of the information to him and to his competitors

  • the amount of effort or money expended by him in developing the information

  • the ease or difficulty with which the information could be properly acquired or duplicated by others.

  • Route-nonroute distinction less protection when no particular enduring relationship developed between a customer and agent


partners are both principals and agents

Uniform Partnership Act definition of partnership: association (sustained interaction; common purpose) of two or more persons (humans, firms) to carry on as co-owners a business for profit

  1. Partners v. Employees

Fenwick v. Unemployment Compensation Commission not partnership because lacking co-ownership

elements to be considered: intent of parties; right to share in profits; obligation to share in losses; ownership and control of property; community of power in administration; language of agreement; conduct towards 3d parties; rights upon dissolution

  • social policy to prevent such easy formation of partnerships to evade legal consequences of employee designation

Frank v. Pickens & Son terms of partnership agreement (e.g., share of book value rather than total assets upon termination of partnership) generally trump standard rules of partnership, unless other social policies involved as in Fenwick

  1. Partners v. Lenders

Martin v. Peyton no partnership in provisions of agreement intended to safeguard interests of the creditor, though had veto power, inspected books, consulted on important decisions, just as much control as necessary to protect security interest but could not initiate any transaction as a partner could nor bind the firm by any action of their own

Kaufman-Brown Potato v. Long creditors became partners with farmers under agreement by which they were repaid upon harvest and split any additional profits; mere agreement to share profits and losses does not make a partnership but both the sharing of profits and losses are usual in partnership agreements and practices.

  1. Partnership by Estoppel

Young v. Jones no partnership by estoppel between Bahamas office and U.S.-based audit firm holding self out as international firm elements of estoppel claim: (1) holding out; (2) reliance upon partnership and advice, and (3) 3d parties give credit

UPA § 7(1) persons who are not partners as to each other are not partners as to third persons.

UPA § 16(1) person who represents self as partner to 3P liable to 3P who has given credit to partnership

  1. Fiduciary Obligations of Partners

Meinhard v. Salmon managing partner breached fiduciary duty by failing to disclose new lease opportunity to financing partner and taking lease for himself

  • Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the finest loyalty. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.

  • remedy creates deadlock or suppression

Revised Uniform Partnership Act § 404

  1. only fiduciary duties a partner owes to the partnership and the other partners are duty of loyalty and duty of care . . . .

  2. A partner's duty of loyalty to the partnership and the other partners is limited to the following:

  1. to account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the partnership business or derived from a use by the partner of partnership property, including the appropriation of a partnership opportunity;

  2. to refrain from dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest adverse to the partnership; and

  3. to refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership

  1. A partner's duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.

  2. . . . obligation of good faith and fair dealing

  3. not violate a duty or obligation . . . merely because the partner's conduct furthers the partner's own interest

Meehan v. Shaughnessy breach of fiduciary duty in lying 3 times by declining that partner would leave, sending one-sided letters to clients that did not make clear that clients could have stayed with firm, secrecy concerning which clients he intended to take until had obtained authorization from majority of clients; through substance and method of communications with clients, obtained an unfair advantage over former partners in breach of their fiduciary duties; fact-intensive inquiry)

UPA § 20: obligation to render on demand true and full information of all things affecting the partnership to any partner.

Bassan v. Investment Exchange (GP sold property to LP at or below market price but still at profit to GP; agreement authorized reasonable profit with consent of LPs, not implied from prior course of dealing and consent to prior profits)

  • remedy - establish common fund; no damages because no showing of damage since property sold at market value

  1. Rights of Partners in Management

National Biscuit v. Stroud each P liable for debts of other P within scope of partnership, even if not authorized; non-consenting partner could dissolve partnership with notice to third parties to avoid liability

  • UPA § 9 Every partner is an agent of the partnership for the purpose of its business, and the act of every partner including the execution in the partnership name of any instrument, for apparently carrying on in the usual way the business of the partnership of which he is a member 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 authority.

Day v. Sidley & Austin no breach of fiduciary duty in Executive Committee's failure to reveal information regarding changes in the internal structure of the firm and decision to eliminate chairmanship, which did not produce any profit for the offending partners nor any financial loss for the partnership as a whole.

  1. Dissolution of Partnership

  1. Reason /Breach

Owen v. Cohen profitable partnership dissolved because one partner impossible to work with; dissolution an equitable remedy when there are quarrels and disagreements of such a nature and to such extent that all confidence and cooperation between the parties has been destroyed or where one of the parties by his misbehavior materially hinders proper conduct of the partnership business.

UPA § 32 whenever: partner has been guilty of such conduct as tends to affect prejudicially the carrying on of the business, partner willfully or persistently commits a breach of the partnership agreement, or otherwise so conducts himself in matters relating to the partnership business that it is not reasonably practicable to carry on the business with him.

Collins v. Lewis court refuses to dissolve partnership at request of C because managing partner L competent to manage though C interfering; C seeks to dissolve because as financing partner in superior position for accounting, could use L's debt to make credit bid for partnership; legal right to dissolution rests in equity, as does the right to relief from the provisions of any legal contract.

Prentiss v. Sheffel court orders judicial sale of assets of partnership in which 2 partners squeeze out minority P, dissolution of at-will partnership practical considering purpose is long-term financing of shopping center

  • term of partnership may be inferred from purpose (as in term of lease), specified in agreement, or at-will

  1. minority partner objects to majority partners' use of paper dollars in judicial sale, but still bid less than other bidders so not necessarily advantaged though other bidders may have come forward if majority Ps excluded; minority partner had same right to bid as majority partners

Page v. Page Partner who is creditor as well seeks to dissolve profitable partnership to make credit bid; P made loan rather than capital contribution so as not to disturb management/division of interests; P'ship not for term of loans because would convert any P'ship with debt into indefinite duration and swallow up concept of P'ship at will

Monin v. Monin after milk hauling partnership dissolved, former partner who did not win milk routes proceeds to compete with partner who won partnership and effectively deprive partnership of value; continuing fiduciary duty beyond dissolution to winding up

  • also violation of partnership sale agreement which included covenant not to compete and clause providing that sale null and void if dairy business did not approve milk hauling contract

  1. Damages

Pav-Saver v. Vasso as a result of wrongful termination of permanent-term partnership by partner owning patents and trademarks, breaching partner gets value of interest in partnership less damages and release from liability, but not value of goodwill which includes most of value of intellectual property assets; non-breaching partner allowed to continue business with use of valuable IP

Uniform Partnership Act § 38 damages for breach of the agreement against P who wrongfully caused dissolution

  • non-breaching Partners may continue business during the agreed term for the partnership and retain partnership property, so long as they pay breaching Partner value of his interest in the partnership at the dissolution, less any damages and in like manner indemnify him against all present or future partnership liabilities

  • breaching Partner has right to receive value of his interest in the partnership, not including value of goodwill, less any damages caused by dissolution, and to be released from all existing liabilities of the partnership

Lawlis v. Kightlinger & Gray no breach of fiduciary duty in expulsion of alcoholic law partner from partnership, despite lack of hearing, notice, and right to defense, because partnership agreement provided for no cause expulsion so long as not wrongful withholding of money or property legally due expelled partner at time of expulsion

Jewel v. Boxer in the absence of partnership agreement providing otherwise, the UPA requires that attorney’s fees received on cases in progress upon dissolution of a law partnership are to be shared by the former partners according to their prior partnership interest, regardless of which former partner provides legal services in the case after the dissolution.

  • two paradigms for allocation of ongoing sources of income:

  1. quantum meruit: source (how case came to partnership) plus split element based on pre/post-dissolution labor

  2. prior partnership interest

Meehan v. Shaughnessy law firm's partnership agreement deals with allocation of post-dissolution work by providing that partners get capital contributions plus share of accounts receivable at time of dissolution and partners can remove cases whether brought to firm through own efforts or not, with all pre-dissolution fees/costs back to partnership and post-dissolution fees to partner with "fair charge" back to partnership; former partners no longer have a continuing fiduciary obligation to wind-up for the benefit of each other the business they shared in their former partnership

  • remedy for improperly removed cases is sharing rule where departing attorneys share income of those cases with former partners but do not get benefit of cases left behind

  1. Limited Partnerships

Limited Partner not liable for debts and torts of partnership beyond extent of investment in partnership, while General Partner has unlimited liability and management responsibility

Holzman v. DeEscamilla LPs liable as GP to creditors, regardless of creditors' knowledge of their role, because acted substantially the same as a general partner in management (GP had no power alone though both LPs could withdraw money; controlled crop-planting selection; required GP to resign and chose successor)

  • set up as Corporation of which LPs are shareholders and Board of Directors, hire GP as employee

  • make GP a Corporation to avoid personal liability so that only assets of corporation are available to shareholders

Frigidaire Sales v. Union Properties (Wash. 1977) LPs do not incur general liability simply because they are officers, directors or shareholders of corporate GP and thereby exercise day-to-day management and control of limited partnership

  • when shareholders of a corporation who are also officers and directors conscientiously keep affairs of corporation separate from personal affairs, and no fraud or manifest injustice is perpetrated upon third persons who deal with the corporation, the corporation's separate identity should be respected

  • limited partnership statutes permit parties to form LP with a corporation as the sole GP, therefore concern about minimal capitalization, standing by itself, does not justify a finding that the limited partners incur general liability for their control of the corporate general partner

  • If a corporate general partner is inadequately capitalized, the rights of a creditor are adequately protected under the “piercing the corporate veil” doctrine of corporation law

RULPA §303(a) LP is not liable for the obligations of a limited partnership unless he or she is also GP or, in addition to the exercise of his or her rights and powers as LP, he or she participates in control of business, and then only to persons who transact business with the limited partnership reasonably believing, based upon the limited partner's conduct, that LP is GP

RULPA § 303(b): LP does not participate in control solely by consulting with and advising a general partner with respect to the business of the limited partnership.


  1. Promoters

Southern-Gulf Marine v. Camcraft corporation by estoppel - prevent opportunism in escaping valid obligations with de facto corporations where process failed/delayed for some reason unless substantial rights are affected by character of organization. If a party have no other objection to oppose to the enforcement of the K than that the obligee is incompetent to sue, for reasons anterior to his K, not permitted to escape liability.

  1. Limited Liability - Piercing the Corporate Veil

ex post capital rules - after the fact, when assets not sufficient to cover liabilities

  1. piercing the corporate veil - grossly undercapitalized corporation without regard for formalities, some element of unfairness; extremely rare

  2. transfers in contemplation - recaptured through bankruptcy process to recapitalize corporation with assets transferred inappropriately within one year of insolvency

  3. equitable subordination - company buys stock from creditor and gives loan in return to convert equity claims into debt reconverted back to stock after insolvency to recapitalize

ex ante capital rules - require corporation to maintain assets sufficient to prevent or deter insolvency and meet claims of creditors

  1. European (civil law) system - minimum amount of capital required

  2. par value system - company stated with certain amount of paid-in capital for which par value stock issued; but par value might not be sufficient or be excessive in the future; largely vestigial

  3. financial service/banking capital regulation - reservation of capital percentage of assets; requires bureaucracy for monitoring and enforcement

  4. bankruptcy per se - allocates loss according to order of priority without attempting to keep any capital on hand

Walkovszky v. Carlton (court refuses to pierce corporate veil of individual taxi corporation to larger enterprise of 10 such corporations owned by same individual D because no fraud by corporation in complying with law by holding only minimum liability insurance; if insurance coverage inadequate, remedy lies with legislature establishing minimums, not court)

  • piercing corporate veil because corporation is undercapitalized would destroy concept of limited liability

  • whenever an individual shareholder uses control of the corporation to further his own rather than the corporation’s business, the individual will be liable for the corporation’s acts

Sea-Land Services v. Pepper Source two element test for removing limited liability:

(a) shared control/unity of interest and ownership, based on 4 factors:

  1. failure to maintain adequate corporate records

  2. commingling of funds or assets

  3. undercapitalization

Kinney Shoe v. Polan (4th Cir. 1991)

corporate veil pierced when grossly inadequate capitalization combined with disregard of corporate formalities; owner of corporation bought no stock, made no capital contribution, kept no minutes and elected no officers for corporation

  1. one corporation treating the assets of another corporation as its own

(b) separate corporate existence would sanction a fraud or promote injustice beyond creditor's inability to collect

Kinney Shoe v. Polan (4th Cir. 1991)third prong in determining whether corporate veil should be pierced (permissive, not mandatory, because equitable remedy): when it would be reasonable for party such as bank or lending institution entering into a contract with the corporation to conduct an investigation of credit prior to entering into contract, such party will be charged with the knowledge that a reasonable credit investigation would disclose and to have assumed the risk of gross undercapitalization

Perpetual Real Estate Services v. Michaelson Properties (4th Cir. 1992) something more than proof that some person may dominate or control corporation, or treat it as a mere instrumentality or agency, is required to pierce corporate veil; P must also establish that corporation was a device or sham used to disguise wrongs, obscure fraud or conceal crime

  • courts extremely reluctant to lift veil in contract case, unlike torts case, where party voluntarily and knowingly entered into agreement with corporate entity and is expected to suffer consequences of limited liability associated with corporate form

  • courts require proof of some misrepresentation to the creditor in contract cases, otherwise courts will not rewrite contracts which parties themselves could have negotiated regarding limited liability and allocation of risk

In re Silicone Gel Breast Implants Products Liability (N.D.Ala. 1995) ordinarily the fact-intensive nature of issue of veil-piercing will require that it be resolved only through trial; totality of circumstances must be evaluated in determining whether a subsidiary may be found to be the alter ego or mere instrumentality of the parent corporation; factors showing substantial domination:

  • parent and subsidiary have common directors or officers

  • parent pays salaries and other expenses of subsidiary

  • parent and subsidiary have common business departments

  • parent and subsidiary file consolidated financial statements and tax returns

  • daily operations of two corporations not kept separate

  • parent finances subsidiary

  • parent caused incorporation of subsidiary

  • parent uses subsidiary's property as its own

  • subsidiary does not observe basic corporation formalities, such as separate books/records and holding shareholder and board meetings

  • subsidiary operates with grossly inadequate capital

  • subsidiary receives no business except that given by parent

  • courts do not require showing of fraud, injustice or inequity in tort case where limitations on corporate liability were fortuitous and non-consensual

  • parent may also become directly liable by virtue of its participation in activities of subsidiary (such as placing parent's name on packaging of product manufactured by subsidiary and issuing press releases regarding safety of product) under Rest. 2d Torts § 324A One who undertakes, gratuitously or for consideration, to render services to another which he should recognize as necessary for the protection of a third person or his things, is subject to liability to the third person for physical harm resulting from his failure to exercise reasonable care to perform his undertakings, if:

(a) his failure to exercise reasonable care increases the risk of harm,

(b) or, he has undertaken to perform a duty owed by the other to the third person,

  1. or, the harm is suffered because of a reliance of the other or the third person upon the undertaking.

  1. Shareholder Derivative Actions

violate fundamental rule of corporation of "shareholders sharehold; managers manage" because gives shareholders right to represent corporation for purposes of lawsuit, in effect act as management

Filters in Derivative Actions to ensure in best interests of Corporation

1. Security for Costs

Cohen v. Beneficial Industrial Loan requirement that P shareholder posts bond to pay for D's attorney fees if suit fails as security for costs; effect is to discourage shareholder derivative actions; creates a new liability so substantive not merely procedural, applies in diversity actions)

Eisenberg v. Flying Tiger Line (security for costs requirement applies only to derivative actions, not direct actions; complaint that reorganization deprived stockholder of right to vote on operating company affairs is individual not brought on behalf of corporation) matter of pleading: derivative action only if brought in the right of a corporation to procure judgment in its favor; direct if allege personal harm (beyond mere loss of value of shares) and not ask for recovery in favor of corporation, may take the form of a representative class action

2. Demand on Directors

  1. shareholder must first go to Directors and demand that Directors sue corporation (generally required but almost universally ignored)

  • if demand refused, courts review Directors' refusal under business judgment rule, very generous to management

Kamen v. Kemper Financial Services (reversed adoption of rule of universal demand because would increase power of directors to control corporate litigation)

(b) demand excused if futile

Spiegel v. Buntrock (if make demand waive argument that Board of Directors is disinterested so falls under business judgment rule)

Heineman v. Datapoint (high threshold for excuse of demand: futile where reasonable doubt exists that Board has ability to exercise its managerial power in relation to decision to prosecute, that

  1. Directors are disinterested and independent, and

  2. challenged transaction was otherwise product of valid exercise of business judgment

  1. particularized facts (hard to show in pleading prior to discovery)

  • allegation of controlling stock ownership or interlocking directorships do not raise, per se, a reasonable doubt as to the board’s independence; party must advance particularized factual allegations from which the court can reasonably infer that the board members who approved the transaction are acting at the direction of the alleged dominating individual or entity

  • must be some nexus between domination and resulting personal benefit to controlling party

  1. standard for review is abuse of discretion, so chancery court almost never overturned

  1. Special Litigation Committee

Auerbach v. Bennett (NY case, not law in DE; SLC hires outside counsel, concludes that action not in best interest of corporation so business judgment rule applies and shareholder loses)

court's review of SLC decision limited to:

  1. methodology/procedures of data collection for report

proof that the investigation has been so restricted in scope, so shallow in execution, or otherwise so halfhearted as to constitute a pretext or sham, would raise questions of good faith or conceivably fraud not shielded by business judgment rule

  1. disinterested independence and good faith of SLC, not tainted by same bias as Directors

to disqualify entire board would render corporation powerless to make any effective business judgment w/r/t prosecution of derivation action

Zapata v. Maldonado (DE case)

even if demand excused, Board of Directors not completely ousted from control of lawsuit or returned to same power as before, now has power to appoint SLC of disinterested directors to investigate lawsuit ad make recommendation to court; refusal of demand upheld unless wrongful;

court's standard of review of SLC recommendation:

  1. SLC good faith and good procedures (support in record, methodologies)

  2. court's own business judgment (additional step from NY rule)

Alford v. Shaw modified Zapata rule, requiring judicial scrutiny of merits of SLC recommendation

  1. signal a shift from pro-SLC to pro-shareholder; less deference to SLC decisions whose institutional symbiosis with corporation necessarily affects its ability to render decision fairly considering P's interests

  1. The Role and Purposes of Corporations

Smith v. Barlow corporate contribution to university; not intra vires because not made indiscriminately or to a pet charity of corporate directors in furtherance of personal rather than corporate ends; made in reasonable belief that it would aid public welfare and advance interests both as a private corporation and as part of community

Dodge v. Ford Motor (MI 1919) minority shareholders compelled declaration of special dividend; court has power to compel declaration of dividend if refusal amounts to fraud or breach of good faith

Ford's defense is expansion plan, but price drop intended to benefit humanity rather than shareholders, also makes competition by minority shareholders Dodge more difficult

incidental humanitarian expenditure or plan to benefit mankind at expanse of corporation

Shlensky v. Wrigley dominant figure imposing own will on directors; court does not interfere with Wrigley's refusal to follow example of other baseball teams and install lights for night games; Wrigley alleges concern for neighborhood, might reduce attendance and property value

  1. The Duties of Officers, Directors and Insiders

1. Duty of Care

  • implied term of proper care, reasonable diligence in managing corporation's affairs

  • standard of liability is gross negligence (mere negligence never enough to violate BJR); courts may develop general business judgment but can never recapitulate specific situation in which business decision was made, reluctant to exercise hindsight bias

A. 2 Means of Violation

  1. willful blindness - ignorance is breach; directors who willingly allow others to make major decisions without supervision

Graham v. Allis-Chalmers Directors not liable for employees' violation of antitrust laws because structure of corporation, a large company with number of divisions, heavily decentralized management in which authority delegated down to lowest level, prevented directors from knowledge of activities (but, decision encouraged decentralization)

  • absent inquiry notice, no duty upon Directors to investigate and ferret out wrongdoing which they have no reason to suspect may exist

Francis v. United Jersey Bank (N.J. 1981) elderly and alcoholic widow of corporation's founder held personally liable for corporation's insolvency due to her breach of duty of care as Director for failing to notice and put an end to sons' siphoning from client accounts; receipt of financial statements gave rise to duty to inquire

  • Directors not responsible for day-to-day involvement or audit but general monitoring of corporate affairs and policies

Smith v. Van Gorkom (Del.Sup.Ct. 1985) Directors not entitled to BJR because they had not adequately informed themselves about or considered proposed takeover bid with strict 3-day deadline for approval because materials were delivered too late for study either before or after meeting, and no opinion of investment bank re reasonableness of price was presented; Directors approved offer without asking questions and without extended discussion; basic test of duty of care is gross negligence

  1. no-win situation - director chooses greater risk at lower rate of return

Joy v. North Bank, dominated by single Director, continues making loans to failing developer in no win situation, higher risk at lower rate of return; BJR relieves Director of liability; prevent hindsight bias; ignorance not a defense unless active concealment by dominant Director

Kamin v. American Express Directors chose to distribute shares of devalued stock as dividend rather than sell at loss, which would have offset capital gains and saved millions in taxes, so as not to reduce net income and hurt reputation by admitting bad investment; business judgment rule so no liability unless fraud, oppression, arbitrary action, or breach of trust
B. Shareholder Ratification

In re Wheelabrator (Del.Ch. 1995) sh ratification cures failure of board to reach informed business judgment

  • fully informed board: statement in proxy that board had "carefully considered" merger not materially misleading, though board meeting lasted only 3 hours, because board meeting included presentations by investment bankers and outside counsel, proxy statement described in detail factors that board considered; directors already had substantial working knowledge of merger object

2. Duty of Loyalty

rigorous scrutiny, not BJR, applies when transaction involves self-dealing

  1. Directors and Managers

Bayer v. Beran rigorous scrutiny, not BJR, applies when transaction involves self-dealing; burden on Directors to prove good faith of transaction and fairness to corporation; individual consent rather than formal meeting/resolution usually allowed due to practical difficulties in convening board in timely manner, though group dynamics affect decisions and directors unlikely to reverse momentum for steps already taken by management

Lewis v. S.L. & E. (2d Cir. 1980)transaction voidable between corporation and entity in which directors are interested:

  1. unless approved by disinterested directors upon full disclosure/knowledge (though ignores dynamics of personal relations among directors so that even non-conflicting directors may have some interest in transaction), or

  2. proved by interested party to be fair and reasonable to corporation at time approved by directors

  1. Corporate Opportunities

Energy Resources Corp. v. Porter breach of fiduciary duty in failure to disclose DoE grant opportunity to firm

  1. Did opportunity knock?

  • circumstances in which opportunity came to individual (due to own reputation or position at company)

  • setting (while individual at work or at social event)

  • nature of contact (professional relationship or social acquaintance or family connection)

  1. If opportunity knocked, would firm have invited it in?

  • line of business

  • financial position of company (current earnings, opportunities; contacts, ability to raise additional funds)

  1. Dominant Shareholders

Sinclair Oil Corp. v. Levien (Del. 1971) tranactions between dominant shareholder/parent company and subsidiary

  • intrinsic fairness standard for decisions involving self-dealing to detriment of minority shareholders

  • business judgment rule (upheld unless gross or palpable overreaching) for business decisions such as payment of dividends in excess of earnings (because minority shareholders also received dividends) and channeling of business opportunities to other subsidiaries (because no showing that opportunity ever came to subsidiary)

Zahn v. Transamerica (3d Cir. 1947) majority shareholder causes directors to call one class of stock without disclosing appreciation in value so minority shareholders would not convert to other class

transactions involving different classes of stock held to principle of fairness to minority shareholders--directors required to treat fairly each class of stock and may not take actions which are designed to enhance the value of one class at expense of another

  1. Ratification by shareholders or majority of disinterested directors

In re Wheelabrator (Del.Ch. 1995) sh/board ratification shifts burden of proof

  1. transaction between corporation and controlling shareholder (parent-subsidiary merger) - upon approval by majority of minority shareholders, standard of review remains entire fairness, but burden shifts to P

  2. interested transactions between corporation and director (or entity in which director is also director or has financial interest)

DE Corporation Act § 144: approval in good faith upon disclosure of material facts by majority of disinterested directors or shareholders, or is fair as to corporation when approved by board of directors or shareholders, shifts burden of proof to party challenging transaction to show that no person of sound business judgment would deem fair; standard remains business judgment rule

  1. Federal Law

Santa Fe Industries v. Green

  • federal law does not override state corporate law except where federal law expressly requires certain responsibilities of shareholders w/r/t shareholders

  • Rule 10b-5 does not apply to breach of fiduciary duty where transaction not manipulative or deceptive within meaning of statute; no omission or misstatement in notice of short-form merger permitted under DE law

  • once full and fair disclosure has occurred, fairness of transaction not concern of statute

  1. Inside Information

disclose or abstain from trading/recommending rule functions as implied warranty

Goodwin v. Agassiz (Mass. 1933) no liability of insider who purchased shares knowing likely would be more valuable based on geologist's theory, though seller would not have sold if had known of theory, because mere theory

  • directors have no duty to inform shareholders of aspirations, faith and plans for future

  • impersonal transactions v. personal transactions

  • impersonal on stock exchange--insider not required to seek out other ultimate party and disclose all material information when identity not known or readily ascertainable

  • personal transactions between insider and stockholder subject to close scrutiny

Elements of Rule 10b-5 Action:

  1. standing - SEC enforcement or implied private right of action

  2. insider

  1. corporate officer or director, employee

  2. tippee - purpose of communication based on context

Chiarella employee of printer not liable for trading based on information in tender offer documents because not an insider of corporation whose shares he traded; duty to disclose/abstain arises from relationship of trust between shareholders and employees; thief not tippee, though may be liable to employer for misappropriation

Dirks v. SEC (S.Ct. 1983) securities analyst passes on inside information about major fraud in corporation received from former officer and advises clients to sell stock; tippee assumes fiduciary duty to shareholders of corporation only when tippee knows of insider's breach

  • breach of duty only when insider will personally benefit, directly or indirectly, from disclosure, such as through pecuniary or reputational gain; gift of personal information may involve reciprocal expectation of return

  • no duty to disclose for market analyst because in nature of information that cannot be made available to general public but only to analyst's clients; better rule if market analysts permitted to disclose only general buy/sell recommendations or predictions, rather than specific information

Carpenter v. United States (S.Ct. 1986) newspaper columnist shared advance information as to timing and contents of WSJ column and shared profits from trades with tippees; liable under Rule 10b-5 and mail fraud statute due to breach of duty to newspaper employer

United States v. O'Hagan (S.Ct. 1997) misappropriation theory, breach of duty to source of information, may be basis of criminal liability under Rule 10b-5; designed to prevent abuses by outsiders who have access to inside information but owe no duty to corporation or shareholders

  • Rule 14e-3 does not require specific proof of breach of fiduciary duty, though fair assumption that trading on the basis of inside information about tender offer involves breach of duty to bidder or target company

Rule 14e-3 fraudulent, deceptive or manipulative act for any person in possession of nonpublic material information relating to tender offer acquired directly or indirectly from offering person, target issuer; any officer, director, partner or employee of any other person acting on behalf of the offering person or such issuer, to purchase or sell or cause to be purchased or sold any of such securities . . . unless within a reasonable time prior to any purchase or sale such information and its source are publicly disclosed

United States v. Chestman (2d Cir. 1991) fiduciary duty or similar relationship of trust and confidence does not arise simply from marriage or entrusting confidential information, therefore no liability of broker tippee who traded on inside information received from nephew-in-law of corporation's president under Rule 10b-5, though liable under Rule 14e-3 for trading on material nonpublic information relating to tender offer

  • explicit promise not to share or act upon inside information may give rise to fiduciary duty

  • why not hold broker liable for breach of duty to client--fraud on the source?

  1. security no liability in case of bank check, CD, insurance policy

Reves v. Ernst & Young (S.Ct. 1990) demand notes issued by farmer's cooperative with undetermined maturity falls within definition of security under § 3(a)(10) (which excludes notes with maturity not exceeding 9 months); liquidity of investment does not eliminate associated risk

factors in deciding whether transaction involves security:

  1. motivations prompting reasonable seller/buyer to enter into transaction (security when seller's purpose is to raise money for general use of business enterprise or finance substantial investments rather than temporary cash-flow or other commercial or consumer purpose; security when buyer's purpose to generate profit

  2. plan of distribution for instrument, common trading for speculation for investment

  3. reasonable expectations of investing public

  4. existence of another regulatory scheme reduces risk of instrument, rendering securities acts unnecessary

  1. in connection with purchase or sale

Blue Chip Stamps no cause of action if did not buy shares because misled by pessimistic prospectus

loophole: investor who would have sold/bought but for inside information; just as fraudulent but difficult to prove subjective intent, potentially limitless class of plaintiffs (though applies even when current shareholders do not sell); failure to buy/sell does not utilize market so not regulated by statute

Deutschman v. Beneficial Corp. (3d Cir. 1988) purchaser of option contracts has standing to bring cause of action under Rule 10b-5 for affirmative misrepresentations; options deemed securities because market price for options directly responsive to changes in market price of underlying stock and information affecting that price

  • Chiarella and Dirks rules limiting affirmative duty to disclose or refrain from trading to outsiders and nonfiduciaries in some special relationship of trust of confidence toward plaintiff not applicable to cases involving affirmative misrepresentations which affected market price of securities

  1. misleading disclosure

Deutschman v. Beneficial Corp. (3d Cir. 1988) Chiarella and Dirks rules limiting affirmative duty to disclose or refrain from trading to outsiders and nonfiduciaries in some special relationship of trust of confidence toward plaintiff not applicable to cases involving affirmative misrepresentations which affected market price of securities

SEC v. Texas Gulf Sulphur (2d Cir. 1968) impression made on reasonable, not sophisticated, investor, in the exercise of due care

when is trading permitted?

  1. medium of disclosure - broadest medium generally available to investing public (e.g., Bloomberg, AOL)

  2. timing - reasonable waiting period so that market can absorb/react to information

  • time of day/week

  • whether market responded

  1. type of information - ease of translation into market action (e.g., news of a revolution more difficult)

  1. materiality

balance costs and benefits of disclosure; if threshold too low, burden investing public with too much information

Basic Inc. v. Levinson (S.Ct. 1988) substantial likelihood that disclosure of omitted fact would have been viewed by reasonable investor as having significantly altered total mix of information made available

  • where event is contingent or speculative in nature (such as preliminary merger negotiations), reasonable investor might not have considered significant; probability/magnitude approach based on size of two corporate entities and potential premiums over market value, as well as indicia of interest in transaction at highest corporate levels based on board resolutions, instructions to investment bankers and actual negotiations between principals

SEC v. Texas Gulf Sulphur (2d Cir. 1968) whether reasonable investor would attach importance; any fact which in reasonable and objective contemplation might affect value of securities

  • no justification for insider activity that disclosure prevented by legitimate corporate purpose of purchasing surrounding land

  • materiality depends upon both indicated probability that event will occur and anticipated magnitude of event in light of totality of company activity

  • insider behavior gives some indication of whether information material; timing of purchases by individuals who ad never before purchased compels inference of materiality

Jordan v. Duff and Phelps (7th Cir. 1988) special facts doctrine (background rule of state law) that close corporations buying their own stock, like knowledgeable insiders of closely held firms buying from outsiders, have fiduciary duty under Rule 10b-5 to disclose material facts including new events such as merger that substantially affect value of stock

  • parties may contract around special facts doctrine but in the case of employment at will, company did not obtain express or implied agreement releasing it from duty to disclose, and course of dealing suggests regard for value of shares in employees' decision to leave

  1. scienter

Ernst & Ernst v. Hochfelder person making false statement must be shown to have made it with intent to deceive, manipulate, or defraud

  1. reliance

Basic Inc. v. Levinson (S.Ct. 1988) presumption of reliance of individual plaintiffs upon public material misrepresentation because most publicly available information is reflected in market price

  • market acts as unpaid agent of investor, informing as to value of stock given all information available to it

how to rebut:

  1. misstatements did not affect market price

  • price change relative to nature of disclosure

  • price change of market as a whole and other stocks in sector

  • trading volume

  • historical movement of stock with/against market

  • other information/disclosures from company that may cancel out misstatement

  1. market was not efficient

  • NYSE efficient because heavily traded, followed by analysts

  • thinner markets, OTC, might be less efficient so market price would not necessarily reflect all publicly available information

  1. P did not actually rely on market price or disclosure

  • knowledge of untruth of statement

  • other reasons for trading

Pommer v. Medtest (7th Cir. 1992)

  • no presumption of reliance in personal transaction, no fraud on the market but sale between individuals

  • generic warnings or boilerplate that shares may become worthless do not enlighten investors as to specific risks or prevent reliance on false oral statements

  • ex ante perspective of securities laws: just as a statement true when made does not become fraudulent because things unexpectedly go wrong, so a statement materially false when made does not become acceptable because it happens to come true

  1. damages

Pommer v. Medtest (7th Cir. 1992) damages under Rule 10b-5 are actual damages under loss causation principle, difference between price of stock and its value on the date of transaction if full truth were known, not full rescissionary damages which imply that stock did become worthless

  1. Short-Swing Profits

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