BUSINESS ORGANIZATIONS

Prof. Brubaker

Spring 1995

 

 

AGENCY

 

An agent acts on behalf of a principal, and can bind the principal to contracts.  Additionally, if the principal-agent relationship is also a master-servant relationship (the master tells the servant what to do and how to act), the master is liable for the servant's torts.

 

An independent contractor contracts to accomplish a result for an employer, and does not become a principal acting on behalf of the principal.

 

Pennsylvania Tire:  if this is a principal-agent relationship, creditors can get at the tires in Martin's store.  If it's not then Pennsylvania is not liable for Martin's debts and can take back the tires.  Court found that Martin's store was an independent store, or organization across markets, and that no principal-agent relationship existed.  A company store, or an organization within a firm, would have given rise to a principal-agent relationship.

An organization within a firm gives the principal greater control at the retail level, greater profit potential, and greater market penetration.  It also carries greater risk (liable for retailer's debts) and the retailer has less incentive to increase sales because he's just an employee, not getting a percentage of sales.  An organization across markets gives the distributor less control and profit, creates another level of administration (the retailer), but is less risky.

 

Planning       Within a firm, deal the local manager's salary, benefits, job duties, and duration.  Across markets, deal prices, discounts, credit, exclusivity, return policy, duration of relationship, and control (to assure quality and warranty).

 

ELEMENTS OF PRINCIPAL-AGENT RELATIONSHIP

An agency relationship 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 to so act.  The agreement does not need consideration.  The doctrine behind agency law is that if the principal is going to get the economic benefits of its relationship with an agent, then it must accept the economic obligations.

 

The relationship is contractual.  Although many times the agency agreement is written down, sometimes it's oral, and sometimes the relationship is implied based on the parties conduct.

 

1.  Manifestation of Consent of Principal for Agent to Act on Its Behalf

a.  agent act on behalf of principal

b.  agent subject to control of principal

2.  Consent of Agent to Act on Behalf of Principal (need no manifestation)

 

Cargill:  Warren was Cargill's agent.  1a is evidenced by Warren's procuring grain for Cargill with Cargill checks.  1b is evidenced by factors such as Cargill's constant recommendations, right of first refusal, right of entry, criticism of Warren's operation, decision to give "strong paternal guidance," and Warren's inability to enter into agreement's without Cargill's approval.  In this case, although both 1a and 1b are necessary, a high level of 1b can show 1a.  Another factor--the further into debt Warren got, the more money Cargill pumped in and the more control it exerted.

 

In cases involving torts,

1.  Establish tort liability of the alleged agent.

2.  See if there is in fact an agency relationship

3.  If so, see if it's a master-servant relationship (determined by 1b factors).

If all these exist, then the master is vicariously liable for the servant's torts even though the master himself did no wrong.  Policy:  if the principal is telling the agent how to do things, the principal should be liable for resulting torts.  If the master is only vicariously liable (did nothing wrong himself), he has a right of reimbursement from the servant (not used much).

Humble Oil:  distributor pays 75% of retailer's utility bill, rent tied to product sale, Humble bore all the risks on inventory and sales, and retailer must perform other duties as required by Humble, so there is a master-servant relationship.

Sun Oil:  retailer retains control of day-to-day operations, and so no master-servant relationship.

 

Planning       Cargill should have offered recommendations or training, rather than exerting a veto or control or assuring creditors.  Humble entered into an at-will agreement with retailer, so it didn't need all the control provisions it had in the contract, since if it didn't like what the retailer was doing it could have made "suggestions" or just threatened to pull out.  A decision to exert control brings with it liability for the agent/servant's acts.

 

 

PRINCIPAL'S LIABILITY

When the agent acts with authority, his acts bind the principal.

 

There are several sources of authority:

Express authority--authority agreed upon by the agent and principal.

express actual authority--expressly stated in the agreement.

implied, or incidental authority--authority that is reasonably and customary to accompany express authority (authority to sell includes authority to bargain price)

Apparent authority--this arises when a principal leads a third party into believing the agent has authority, even if the agent doesn't, or when it would be reasonable and customary for an agent to have authority and a third party is unaware that the agent doesn't actually have such authority.  This can't be knocked out by instructions from the principal to the agent to the contrary.

Inherent authority--this arises when a third party is unaware of the true owner, instead believing the agent is the owner and so reasonably believes the agent to have full authority.  This is not apparent authority because there is no connection between the principal and the third party.  This can't be knocked by instructions from the principal to the agent to the contrary.

 

Lind:  apparent and perhaps implied/incidental authority (although case refers to implied/incidental authority has inherent authority).  Company told employee that sales manager would set the employee's salary, and so is bound to the 1% commission the manager offered.  Apparent because of what company said.  Perhaps also implied/incidental because power to give commissions would usually accompany power to set salaries.

370 Leasing Corporations:  apparent authority.  Company led buyers to believe sales person had authority to deal, and so is bound by those deals.

Billops v. Magness:  plaintiffs reasonably relied on the Hilton name, Hilton required its name be used to the exclusion of all others, and so Hilton created apparent authority.

Watteau v. Fenwick:  principal didn't want anyone to know he owned the pub, and so sellers reasonably believed Humble had inherent authority to buy whatever he wanted.  In this case you could also argue that because Humble was not acting for the benefit of the principal (he was pocketing the profits himself), it's not even an agency case.

 

In addition to looking for authority to enter into the deal, also look to see if the principal ratified the deal.

1.  Express ratification to either the third party or to the agent, or

2.  Implied ratification, determined by looking at the principal's conduct.

a.  accepted the benefits of the deal, but knew it was unauthorized and could have rejected it

b.  failed to repudiate within a reasonable time

c.  sued to enforce the deal.

 

If the agent acted with authority, the principal is liable.  If the agent acted without authority, she alone is liable to a third party(not as a party to the contract between principal and client, but as a breach of warranty).  If the agent had authority but acted in defiance of the principal's instructions, the agent is liable to the principal, who may sue for indemnification.

 

Planning       A principal can avoid authority which is not express by individually contacting third parties (but that's burdensome), put a home office clause on sales contracts (not a contract until signed by home office), or better train agents.  Third parties can protect themselves by getting assurances from the principal that the agent has authority.

 

FIDUCIARY DUTIES

The agent has duties to the principal.

The duty to notify requires the agent keep the principal informed, since the principal is imputed to know what the agent knows.

 

The duty of loyalty and the duty to avoid conflicts of interest prevent the agent from competing with the principal.  These duties can be breached only when the principal knowingly and voluntarily consents.

Singer:  the agent decided the principal couldn't handle any additional orders, so he funneled them to his own sideline business.  As a result, the agent earns secret profits from his sideline business.

Glen:  leaving to take a better job does not violate duty of loyalty, but recruiting people you supervise is a breach, as is misleading the employer into believing you are not leaving, especially when asked point blank.

Town & Country:  customer lists are sometimes protected as a trade secret, and using them or any other confidential information on another job is a breach of your duty to your former employer.

Carron & Black:  here, customer lists are not a trade secret because not as "secretive" or deserving of protection as truly confidential secrets, and business will compile them whether protected or not.  Want to protect worker mobility, and don't want to become involved in enforcing protection of customer lists.

 

Milkman theory:  if the agent develops a close, personal relationship with a client, he gets more leeway in being able to take those clients with him when he changes jobs.  Lawyers are like milkmen.

 

Planning       To avoid duty of loyalty and conflict of interest problems,

1) get knowing and voluntarily consent from principal (only reason you wouldn't is because you're afraid he's say no),

2) contract around these default rules (prohibit use of customer lists or recruiting, etc.)

3) if you want to see if other employees will jump ship with you, asking overtly (If I left, what would bright people, like you, do?),

4) rather than take the customer list, compile one from memory, or hire a private investigator to follow your former employer to compile a list of customers, or just solicit generally.  You can even play up your former relationship with your previous employer.

 

 

PARTNERSHIP

 

A partnership consists of two or more people who

1.  Reach an agreement,

2.  On a for-profit business

3.  And are Co-Owners, meaning they

a.  share profits, and

b.  share control (usually the big issue).

 

Each partner is liable for all obligations of the partnership.

 

Partnerships don't require intent, so what may be intended as a partnership may fall short, and relationships not intended to be partnerships may become partnerships.

 

Fenwick:  parties' agreement said it was a partnership.  Sharing profits is prima facie evidence of a partnership, but here it's overcome by evidence that the sharing of profits is really just compensation.  Also significant that Mrs. Cheshire made no capital contribution and had no power.  Agreement claims only Fenwick is liable for partnership debts--not enforceable against third parties, but evidence that this really isn't a partnership.

Pickens:  Pickens can get rid of any other partner and has all control.  However, court finds this is a partnership, probably just to punish Frank for trying to dissolve partnership in effort to get more than just book value of his stock.

 

Planning       Tinker with the allocation of power in the contract.  Fenwick should have given Mrs. Cheshire some control, but only over irrelevant things.  That's what Picken did, and he got away with it.

 

CREDITORS VS. PARTNERS

Creditors must be careful not to become too entangled with borrower's businesses or they might exert so much control they form a partnership.

Martin v. Peyton:  creditor lent business some securities, and in exchange exerted control and received profits.  Creditor had not formed a partnership, however, because the control and profits related only to the securities, not the overall business, so not liable to other creditors.  Court let creditor get away with quite a bit of control without becoming a partner, but it was because the borrower was being so risky with the securities.

Cargill:  discussed earlier.  Here, the creditor exerted much more control, and ended up forming a partnership.

Kaufman-Brown:  this case finds a partnership by putting more weight on the word "partner" than the issue of control.

 

Planning       to avoid forming a partnership, instead of including clauses mentioning consultation, veto power, resignation clauses, substitute with strict prohibition with possibility of waiver.

 

FIDUCIARY DUTIES

Since every partner is an agent of the partnership, each owes the partnership a fiduciary duty.  UPA ' 9(1), RUPA ' 301(1).

 

The duties are as follows:

1.  Duty not to compete with the partnership.  ' 404(b)(3).

2.  Refrain from secret profits and taking partnership opportunities.  ' 404(b)(1).

3.  Don't act against the partnership's interests.  ' 404(b)(2).

However, just because a partner's conduct furthers his own interests does not make the conduct a breach of fiduciary duty.

 

Meinhard:  one partner breaches fiduciary duty because he renewed lease himself, thereby taking a partnership opportunity to renew the lease.  Dissent disagrees, saying this was a joint venture limited in scope to the initial lease.  Majority uses a broad sweep when unsure about agreement's scope...encourages notification, although it's not clear that mere notification overcomes fiduciary duty.  Cardozo says being a partner is total self-denial, but that's exaggerated.

Bassan:  limited partnership agreement allowed general partner to engage in other business ventures of any type, and work for an outside business that deals with the limited partnership.  The general partner did, but court finds that agreement did not entitle general partner to a profit, and so should have sought limited partner's consent.

Meehan:  lawyer leaving firm breaches fiduciary duty by using old firm's letterhead to convince clients to leave with him, not giving client's the chance to choose between his old and new firm, and misleading other partners about his departure.

 

The remedy for breach of fiduciary duty is disgorgement.  UPA ' 21(1)

 

Planning       To avoid these problems,

1) get knowing and voluntarily consent from principal (only reason you wouldn't is because you're afraid he's say no),

2) contract around these default rules

3) if you want to see if other employees or clients will jump ship with you, asking overtly (If I left, what would bright people, like you, do?),

4) rather than take the customer list, compile one from memory, or hire a private investigator to follow your former employer to compile a list of customers, or just solicit generally.  You can even play up your former relationship with your previous employer.

 

RAISING CAPITAL

Partners can contribute whatever capital they want.  Their share of the profit equals their share of capital contribution. UPA ' 18(a), RUPA ' 401(b).  Partners aren't paid for their contribution to partnership business.  UPA ' 18(f), RUPA ' 401(h).  Losses are divided the same as profits.  Changes to these default rules can be made orally under the Revised UPA.  RUPA ' 103(a) & ' 101(5).

 

Admission of new partners must be unanimous.  UPA ' 18(g), RUPA ' 401.

 

Partners are tenants in partnership of all partnership property.  UPA ' 25(1).  They've no right to use it for personal gain, or assign or transfer it with anything less than a unanimous vote.  The RUPA arrives at the same result with different language.  RUPA '     .  Because of that, an individual's creditors cannot get at partnership property.  UPA ' 25(2)(c).  However, creditors of the partnership can go after partnership property.  Partnership creditors can also go after partner's assets.  UPA ' 15, RUPA ' 306.

 

A partner can transfer only his or her share of income from the partnership (' 24(2)), and so the assignee gets no right to participate in the partnership...the transferor retains those rights (' 27).  Upon dissolution, a partner is entitled to receive profits and surplus (' 26).

 

To bring in new capital, options include

1.  selling assets

2.  borrow money

3.  additional equity, from existing or new partners.

 

However, current partners may be reluctant to allow in new partners, and it may be difficult to find new partners because investing in corporations is more popular.

 

Planning       this should be discussed beforehand.  Put something into agreement that either forces current partners to contribute, or makes it easier to add new partners by requiring less than a majority vote or by letting the managing partner do it.

 

 

MANAGEMENT

The default rule is one vote for each partner.  UPA ' 18(e)., RUPA ' 401(j).  Majority rules, except a unanimous vote is required for any act in contravention of the partnership agreement.  UPA ' 18(h), RUPA ' 401(j).  Partners are free to deviate from these default rules however they want, even where one partner always wins a vote.

Sidley & Austin:  a partnership can override default rules by requiring less than a unanimous vote for adding partners and amending the partnership agreement.

 

In fact, partnerships are free to deviate from any rule in the RUPA except for those areas listed in RUPA ' 103(b).  Most the areas are boring--those that are interesting are--

1.  can't eliminate the duty of loyalty, although a partnership agreement can specify types of categories of activities that don't violate the duty, if not unreasonable,

2.  unreasonably reduce the duty of care,

3.  vary the power to dissociate as a partner, and

4.  restrict the rights of third parties.

 

AUTHORITY

Like in principal/agent, if a partner is acting with authority, he binds the entire partnership.

 

Partners can have regular principal/agent type authority:

1.  Actual

a.  express

b.  implied

2.  Apparent

3.  Inherent

They can also have special partnership authority (UPA ' 9, RUPA ' 301)

4.  Implied actual authority

5.  Apparent authority from custom.

Number 4 is not actual authority granted by the partnership--it's authority implied in just being a partner.  Likewise, number 5 has nothing to do with the actions of the principal, it's apparent authority based on custom.  So they cannot be gotten rid of by express instructions from the principal otherwise, unless also communicated to the third party involved.

 

UPA ' 9(3) lists things no single partner can have authority to do--each requires a unanimous vote of partners:

a.  assign partnership property to creditors

b.  dispose of business good-will

c.  any act making impossible the carrying on of partnership business

d.  confess a judgment (admit partnership liability)

e.  submit a partnership claim to arbitration.

 

UPA ' 9 is a mandatory rule and cannot be changed.  Therefore, authority third parties would expect partners to have cannot be taken away, and decisions which should be made only by an entire board cannot be made by only one partner.  This protects third parties.

 

National Biscuit Co.:  there's two partners, so there can be no majority to allow one to restrict the actual authority of the other, here to order bread.  The fact that one sent a letter to Nabisco telling it the other had no authority to order bread is irrelevant.  This is deadlock.

 

Planning       To avoid deadlock, divide up the power by assigning authority over certain areas, or create a veto power.  But these restrictions must be communicated to third parties.

 

 

DISSOLUTION

Dissolution is not the same thing as going out of business.  It changes the relationship of the partners, usually upon the departure of one or more.

 

Dissolution occurs when--

1.  if created for a term or purpose, when the term is up or purpose accomplished.  UPA ' 31(1)(a)

2.  if created for a term or purpose, if all partners who haven't assigned away their interest agree.  UPA ' 31(1)(c)

3.  if no term or purpose, then the partnership is at-will and can be dissolved at anytime by any partner.  UPA ' 31(1)(b)

4.  by the expulsion of a partner bona fide in accordance with the partnership agreement.  UPA ' 31(1)(d)

5.  by death of a partner.  UPA ' 31(4)

6.  by bankruptcy of a partner or partnership.  UPA ' 31(5)

All of the above dissolutions are "rightful."  No damages result.

7.  by a partner who has no good reason under 1-6 above.  UPA ' 31(2)

Number 7 results in damages against the partner who, although he had the power to dissolve, did not have the right.

8.  by judicial order.  UPA ' 31(6).  Under UPA ' 32, that's appropriate when--

a. partner declared a lunatic

b. partner incapable of performing his part of partnership contract

c. partner guilty of conduct prejudicially affecting ability to carry out business

d. partner willfully or persistently commits breach of partnership agreement

e. partnership business can be carried out only at a loss

f. other circumstances render dissolution equitable.

 

If the partnership was dissolved "rightfully" (#1-6), the partnership is wound up, with the assets (or liabilities) being distributed according to partner's respective interests.  However, under #4, if remaining partners pay off and indemnify the expelled partner, they don't have to wind up and continue running the business.

 

If the partnership was dissolved by a partner who had the power but not the right (#7), the remaining partners can get damages and have the right to continue the partnership by buying out the wrongful partner.  Payment can be by cash or by bond, to be paid when the partnership is wound up (whenever that is).  Under the UPA, but not the RUPA, the payment will not include the value of good will (the difference between value as going concern and value if liquidated).  If the remaining partners don't pay up, then the wrongful partner has a right to a share of the profit or interest on his asset.  Thus, a partner who wrongfully dissolves risks--

1.  paying damages

2.  other partners get to continue the partnership

3.  he may not get his money until the partnership finally winds up, and under UPA won't get value of good will

4.  other partners will be in charge of winding up

 

When a partnership is wound up, the revenue is applied to

1.  partnership debts

a.  outside loans

b.  partner loans

2.  repayment of partner's capital contribution

3.  distribution according to each partner's share.

UPA ' 40(b).   BOF 79-84.

 

Pav-Saver:  partner which wrongfully pulls out is liable for breach (court applies the liquidated damages agreement).  Other parties can continue the business, so wrongful partner loses the patent he contributed despite clause which gives back the patent upon expiration of the partnership (since he forced dissolution, he can't take advantage of the 'expiration' clause).  Court erroneously considers patent good will, so his payment doesn't include its value.

Owen v. Cohen:  court orders dissolution of bowling alley partnership where one partner was a "real ass."  There was a question over whether the partnership was at-will or for a purpose (it was found to be a term partnership based on "until profits pay off loan" language).  In either case, good partner was smart to seek judicial dissolution, so he could make sure the bad partner complied and could get damages.

Prentiss v. Sheffel:  two partners shutting out the third is grounds for dissolution (UPA ' 32(1)(d)), but damages amount to $0 because it's an at-will partnership.

Collins v. Lewis:  30-year term partnership so partner seeks judicial dissolution on basis that partnership can operate only at a loss.  But that partner is causing the loss and so is acting in "bad faith."  Court won't order dissolution.

Page v. Page:  another good faith case.  In this case, after years of losses, partner tries to dissolve at-will partnership as it begins to make money.  If he's doing it to take over Santa Maria's linen market himself after dissolution, it's in bad faith and won't be ordered.  It's a breach of his fiduciary duty.

Monin v. Monin:  another breach of fiduciary case.  Mutually decided to dissolve and conduct auction among themselves for assets (contract & equipment).  Losing partner violated fiduciary duty by convincing former customers to go with him.  In essence he got a company asset without paying for it.  He also violated an agreement not to compete, which would support contract damages.

Lawlis:  expelled partner paid off and indemnified, and remaining partners want to continue business.  Expelled requires it to be a "bona fide" expulsion.  Court says it won't look to see if they had a good reason, as long as they didn't violate fiduciary duties.

 

Planning       --If one partner is being a "real ass," even though you can rightfully dissolve, seek a judicial dissolution so you can get damages from the "real ass."

--Don't shut out a partner.  Give them minimum management necessary to avoid grounds for judicial dissolution.

--Include a buy out or continuing agreement in the partnership agreement to avoid these headaches.  Text p.168:

a.  what event will trigger the buy/sell agreement

b.  is there an obligation or an option to buy out the partner

c.  how will the price be set

d.  what will the method of payment be

e.  indemnification or old or new partners

f.  who will set the price.

 

The RUPA changes the UPA rules in the following areas--

A.  Only a majority of the partners after a wrongful dissolution must agree to continue the partnership, instead of a unanimous decision required by the UPA, and

B.  If the business continues after a wrongful dissolution, the wrongful partner does get the value of good will.

 

 

 

CORPORATIONS

 

Attributes

1.  It's a fictional legal entity.  It files its own tax returns and pays its own taxes.

2.  Shareholders are not personally liable for corporation debts.

3.  Centralized management by a board of directors, rather than all partners

4.  Ownership is easily transferrable

5.  Corporations last indefinitely

6.  Flexible capital structure

 

Public corporations have a large number of shareholders.  Close corporations have just a few, and those few usually also comprise the board of director and employees of the corporation.

 

Because the corporation is its own entity, it files and pays its own taxes on earnings.  Earnings distributed as dividends are taxed twice--once when earned by the corporation and again when earned by the stockholder.  Where stockholders are also employees, it's advantageous to earn compensation as salary, because that's tax deductible to the corporation, and is taxed only once.

 

Shareholders elect the board of directors.  The board of directors delegates day-to-day operations to officers, who actually run the corporation.  Outside directors' only role is to serve on the board of directors; inside directors both serve on the board and work for the corporation.  Some statutes don't require closely held corporations to have a board of directors.

 

Shareholders also amend the articles of incorporation (although the board can make some amendments without shareholder approval--RMBCA ' 10.02(4)), share power to amend bylaws, and approve reorganizations (mergers (where one company survives), consolidations (both neither company survives), sale of substantial assets, and liquidation).

 

A corporation can raise money by issuing securities (debts such as bonds and notes) or equity (shares of stock).  Stocks constitute ownership, entitling owners to residual claims, or what's left over after other creditors are paid.  Securities are not owners, and get only interest and return of principal.

 

A corporation is more advantageous than a partnership if owners want to limit their liability, want to freely transfer their interests (shares of stock), where centralized management is important, and where continuity of existence (despite death or withdrawal) is important.

 

A partnership is more advantageous where simplicity and inexpensiveness are important, where partners don't want to be forced to accept other owners, and where there are big earnings or losses so that they will be attributed to the partners rather than the company.

 

The idea of unlimited liability sometimes sounds better than it is.  Banks are reluctant to lend to an entity from which it may not be able to recover.  In practice, then, banks may require personal guarantees.

 

 

Classes Of Stocks

 

A corporation can issue different types of stock.  Stocks typically have two attributes:  1) voting, 2) economic rights.  The issuance of stock can split those attributes, as long as someone gets to vote and someone gets assets upon dissolution.  Stroh:  corporation can issue stocks which have only a vote and no economic rights.  In this case, the board of directors sold only to itself stock which carried one vote and sold for 34 apiece.  However, a board which does this fraudulently or in breach of a duty can be punished for the fraud or breach.

 

The types and authorized amount of each type are set forth in the articles of incorporation.  Changing either the type or the amount requires amending the articles of incorporation, which usually requires shareholder approval (except for a stock-split, which can be done by board of directors).  The right to increase or create shares is the only role shareholders have in the issuance of stock.

 

Even if a stock has no right to vote, if stockholders vote to change the attributes of a type of stock to the disadvantage of that stock, the owners of that stock as a class can veto the change.  For example, preferred stock usually gets no vote, but has greater economic rights (cumulative dividends, fixed liquidation value).  If a majority of the holders of all stock votes to decrease those economic rights, the owners of preferred could by majority vote of preferred stock holders veto the change.

 

The outstanding shares are shares sold and not repurchased by corporation.  Authorized but unissued shares are shares authorized by the articles of incorporation but not yet sold.

 

 

 

The Incorporation Process

 

Corporations must be created pursuant to state statutes.

The first decision is then which state to choose.  Choose either your home state (which is less costly), or Delaware.  Delaware has well developed case law and permissive statutes, which means few statutes are mandatory and can be bypassed by articles of incorporation or bylaws.

 

ARTICLES OF INCORPORATION

The articles of incorporation must be filed with the Secretary of State, along with an appropriate fee.  The articles must include the following:

1.  Corporate name (with Incorp., or Corp., or Inc., or some such designation at the end)

2.  The number, classes, and rights of stock.

3.  The registered agent (who will accept process of service)

4.  The names and addresses of the incorporators, who act on behalf of the corporation until a board of directors is seated

5.  The number of directors who will eventually be elected, as well as the names of the initial directors who will serve until they vote in a board of directors, although in some states the initial directors can just be the incorporators.

6.  Some states require a vague statement of purpose

 

ORGANIZATION MEETING

If incorporators conduct the organizational meeting, their duty is to issue initial shares, so that the shareholders can elect a board of directors to take over the organizational meeting.

 

The board of directors adopts bylaws.  Bylaws govern how the corporation operates, can be adopted and amended by the board of directors without shareholder approval, and are not filed with the Secretary of State.

 

The bylaws specify where and when the annual shareholders meeting is held, the number of directors of the corporation, a listing of corporate officer positions, what shall constitute a quorum of directors, etc.

 

Initial shares are issued if not already done so by incorporators.

 

Officers are elected.

 

Enterprise Liability and Piercing the Corporate Veil

 

An exception to limited liability of shareholders is RMBCA ' 6.22(b), which makes a shareholder liable by reason of his own acts or conduct, or imposed by the articles of incorporation.  The "acts or conduct" language is a statutory enactment of the common law "enterprise liability."  A court would do this when it seems fair to subject an owner to liability rather than letting him escape behind the shield of corporations he's built.

 

There are two types of enterprise liability -- enterprise based on agency principles and piercing the corporate veil.

ENTERPRISE LIABILITY

Enterprise based on agency principles usually applies to a horizontal line of corporations (between subsidiaries), but can apply to vertical (parent/subsidiary).

 

Enterprise liability arises when several corporations are actually operated as one, so that the liability of one can be applied to the others.  Evidence of this would be operating the enterprises under a single name, advertising them under a single name or with a single phone number, commingling their assets.

Walkovsky:  taxi corporation owner created ten corporations, each with assets of only two cabs.  All other assets except the two cabs would be shielded from liability.  If the corporations were operated as one company, with assets commingled, this might result in enterprise liability (plaintiff did not plead that, though).

 

PIERCING THE CORPORATE VEIL

This is more likely to arise in parent/subsidiary relationships.  Its holds personally liable the owner of a corporation.

 

A court will be more likely to pierce the corporate veil when

1.  There's been a disregard for corporate formalities

a.  corporate procedures have not been followed (no board of directors, no stock issued, meetings not held)

b.  corporate books and records are not kept

c.  corporate assets are commingled

d.  the parent and subsidiary are represented to third parties as one and the same

2.  The corporation is undercapitalized

3.  Not piercing results in injustice

 

A court may require injustice above and beyond any other showing.  Victoria Elevator:  this case, however, seems to indicate that if you make the other showing, there necessarily is injustice.  Sea-Land:  says just the opposite, or else limited liability would always serve as an injustice (to creditors).  Need some further showing, such as unjust enrichment.

 

A court is more likely to pierce in the interests of justice in a tort claim rather than a contract claim, because torts can't be prepared for, but parties to a contract should check each other out before entering into an agreement.  Kinney:  a "dummy corporation" which leased a plant but then had no money to pay the lease was a contract relationship, and Kinney should have checked how the corporation was set up.  While trial court refused to pierce for that reason, appeals court reversed, saying the contract issue is a permissive, not mandatory, reason to deny piercing.

 

Undercapitalization is a factor, but is not dispositive.  There's no statutory requirement that a corporation be adequately capitalized, and it is difficult to know ahead of time what capital will be adequate.

 

Reverse piercing involves piercing one corporation's corporate veil to get to the owner, and then reverse piercing the corporate veils of the other corporations he owns.  You go after his personal assets, as well as the assets of other corporations he owns.  This requires the regular corporate piercing showing between the initial corporation and its owner, and then between the owner and his other corporations.  Sea-Land:  owner's many corporations are his "playthings"--none has held a meeting, all are run out of the same office with single phone line, he borrows substantial sums from each interest free, and the corporations borrow from each other, and the corporations pay owner's personal expenses.

 

When you follow corporate formalities, courts will respect the corporate veil.  Frigidaire:  defendants were limited partners in limited partnership, whose general partner was a corporation run by the defendants.  Defendants argue they have no personal liability because they're limited partners, and because the corporation shields them from the general partner's liability.  Court accepts that argument, where all corporate formalities are followed.

 

Planning       Follow all the corporate formalities, and the courts usually won't look any further.

 

 

DUTY OF CARE

 

The only decisions made by corporate directors or officers that will be scrutinized by a court are those made--

1.  involving fraud,

2.  illegality, or

3.  a conflict of interest.

All others will be given the benefit of the business judgment rule.

 

The business judgment rule protects decisions made in good faith which an ordinarily prudent person in a similar situation would reasonably believe to be in the best interest of the corporation.  RMBCA ' 8.30(a).

 

The policy behind the business judgment rule is that courts are not competent to second guess businessmen, shareholders assume the risk of their board's decisions, putting risk on directors might make them too cautious, and it facilitates centralized management by preventing fear of investing power in a few.

 

Wrigley:  controlling shareholder's decision not to play night games is upheld under business judgment rule.

American Express:  decision to give stocks which had plummeted in value to shareholders as a dividend, rather than claim them as a loss for tax purposes, is upheld under business judgment rule, even though the decision was dumb.

 

When the business judgment rule does not apply, directors and officers have a duty not to act--

1.  grossly negligent

2.  recklessly, or

3.  intentionally engage in misconduct.

 

Avoiding gross negligence requires meeting the duty to be informed, which includes a duty to set up a general monitoring scheme to help discover misconduct.

Francis:  brothers were fraudulent in running corporation.  Third board member, the mother, ignored what was going on.  Since she did nothing, business judgment rule did not apply (it does not cover inaction).  Since she did not keep herself informed, she was grossly negligent.  Court also rejects argument that because sons could outvote her, there's no causation:  her inaction encouraged their fraud.

Allis-Chalmers:  directors are allowed to rely on subordinates until they are put on notice that they shouldn't rely on them.  Here the only notice of misconduct was an anti-trust investigation 30 years ago, so no gross negligence (just plain negligence).  However, once put on notice, must implement an oversight program.

Van Gorkem:  this case holds that being uninformed defeats the business judgment rule (a fourth way in which the rule is defeated).  Being uninformed also constitutes gross negligence.  The board was uninformed when it believed Van Gorkem's representations about a buy out, approving the sale after a 20 minute presentation.  Shareholders ratified the sale, but that was an uninformed vote as well.

 

Planning       To avoid duty to be informed problems, boards should follow regular procedures before voting.  Those procedures include--

1.  consulting with knowledgeable people and board members,

2.  making sure prices are correctly set--i.e., fair market value

3.  conduct negotiations

4.  follow reasonable timing--don't rush things through

5.  follow proper board procedures by allowing directors to questions and contemplate

6.  be informed

 

If a director or officer is found to have violated the duty of care, they will owe damages to the corporation.

 

To help insulate directors (Del. 102(b)(7)) and officers even further, statutes allow corporations to limit directors' and officers' liability to the corporation (but not to third parties).

 

Other statutes allow corporations to buy insurance or indemnify directors' and officers' liability.  Some statutes also allow reimbursement for directors' and officers' successful defenses.

 

 

DUTY OF LOYALTY

 

The duty of care pertains to mistakes; the duty of loyalty pertains to self-dealing.  It's similar to agency principles against agents advancing their own interests.

 

Three situations are covered by the duty of loyalty:  interested directors, compensation, and taking corporate opportunities.

 

INTERESTED DIRECTORS

A director is interested if he has a financial or other gain in a transaction.  If it benefits himself, it's a direct interest.  If it family, friends, or someone else like a boss, it's an indirect interest.

 

These cases arise when one director or a group of directors benefit from a transaction, to the detriment of any group of shareholders.  A common situation is when a board controls two corporations, one of which it wholly owns, and the other which it doesn't.  If the board sets up transactions between the two corporations, the minority of the one corporation may complain.

 

Initially, any interest made the transaction voidable, but some interests benefit the corporation (a director who will loan the corporation money when no one else will).  The test then became one of "fairness."

 

Fairness is determined by

1.  he circumstances of the situation,

2.  whether it was an arm's length bargain (as opposed to compelled), and

3.  whether an outside board would have approved the transaction.

RMBCA ' 8.31.

Lewis:  minority in the non-wholly owned corporation complained about leasing with wholly-owned corporation for below market value.  Directors were unable to show renting for below market value was fair.

 

Now the test includes approval of informed directors or shareholders.

A transaction is not automatically voidable if

1.  the directors' conflict of interest, and the effect of the transaction is known by

a. directors and approved by a majority of disinterested directors,

b. shareholders and approved by a majority (disinterested for RMBCA), or

2.  If it's fair to the corporation.

Del. 144.

 

Approval can come after the transaction has been entered into (a ratification).

 

A majority of disinterested directors will constitute a quorum, even if that number wouldn't constitute a quorum for a vote of all directors (in essence, the quorum requirement is waived).

 

If the transaction is director or shareholder approved, the majority rule (which includes Delaware) shifts the burden to the plaintiff to the transaction is unfair.  The minority rule gives approval of the transaction the benefit of the business judgment rule.

 

If the transaction is not director or shareholder approved, the burden is on the interested director to prove the transaction is fair.  This is a higher degree of fairness required than if there's director or shareholder approval.

 

Just because directors or shareholders approved the transaction doesn't mean it will automatically be upheld.  If a plaintiff can show the transaction is unfair, a court will strike it.

 

If a transaction is found unfair, the interested director(s) must pay damages to the corporation.

 

 

COMPENSATION

This is similar to interested director situations, in that directors would be voting on their own pay raise.  This is avoided four ways--

1.  Shareholder approval (but that's embarrassing),

2.  Vote on each director's salary by the other directors, while director leaves the room (making himself disinterested),

3.  Have a compensation committee of outside directors (directors not employed by the corporation) make such decisions,

4.  Hire a consulting firm to set salaries.

 

 

CORPORATE OPPORTUNITIES

Directors and officers are prohibited from taking for themselves an opportunity which belongs to the corporation.  A corporate opportunity is--

1.  something he learned about "on the job" if the person offering the opportunity expects it to be offered to the corporation,

2.  obtained through use of corporate property, if director or officer would think it of interest to the corporation

3.  is an opportunity closely related to the corporation's business (this doesn't apply to directors)

 

If it's a corporate opportunity, the director or officer can take it for himself only if he offers it to the corporation and makes full disclosure of the conflict of interest and the effects of the transaction, and--

A.  there's advance rejection by a majority of disinterested directors, or in the case of a non-board member, with approval of a disinterested supervisor (their decision gets the benefit of the business judgment rule), or

B.  there's advance rejection, or ratification after the fact, by a majority of disinterested shareholders, with the burden shifting to the plaintiff to show it's unfair (a waste of corporate assets), or

C.  in all other situations, including ratification by a board, the transaction is fair, with the burden on the defendant to show it's fair.

 

 

DUTIES OF DOMINANT SHAREHOLDER

 

In most cases, a shareholder has no duty to the corporation.

 

An exception to that rule is when a shareholder is a controlling shareholder--owns so much stock, though not necessarily more than half, that he controls the board of directors.  Courts impose 1) the same fiduciary duty as on officers and directors, and 2) the controlling shareholder must be "fair" to minority shareholders.  Situation two comes up in two scenarios:  1) in the day-to-day activities of the corporation, and 2) when the controlling shareholder sells his control.

 

DAY-TO-DAY GENERAL FIDUCIARY DUTY

The majority may not wreck the marketability of the minority's shares.

Ahmanson:  corporation had so few shares, each was worth thousands of dollars and virtually unmarketable.  Majority of shareholders formed a holding corporation with their shares, and sold more reasonably priced stock in that corporation.  Minority shareholders convinced court that the majority thereby breached a fiduciary duty by making the minority's stock even more unmarketable (who'd want to spend thousands on one share when you could buy cheaper shares in the same investment).

 

The majority must make full disclosure of the expected impact of corporate actions.

Zahn v. Transamerica:  the majority offered to buy minority's Class A shares of stock at a pre-set price, without telling the minority that if they'd instead traded in their Class A stock for Class B stock, the shares would have four times as valuable.  Calling in Class A stock wasn't a breach just because it would have benefited the majority.  But by not disclosing what the majority knew, it breached its fiduciary duty to the minority.

 

Transactions involving dividends affect all shares equally, and so are not a source of a breach of fiduciary obligation (based on director/officer duty of loyalty--duty against self-dealing).

Sinclair Oil:  court applies business judgment rule to issues concerning dividends.  However, Sinven's decision not to sue Sinclair for breach of contract hurts minority owners of Sinven, is self-dealing, and so must be fair (since there was no disinterested approval).  The decision to deal only with Venezuelan companies is not self-dealing and so subject to business judgment rule.

 

Planning       In these cases where one corporation controls but doesn't wholly own the other corporation, the controlling owner can insulate itself from liability by  1) seeking the minority's approval, but that's impractical, 2) appoint non-employee board members, who will be disinterested, 3) hire an outside consulting group who can suggest "fair" decisions, or 4) buy out the minority.

 

 

SALE OF CONTROL

Buyers are willing to pay a premium for control of a company.  It's financially advantageous for good reasons (they can turn around the company and increase its value) and for bad reasons (they can give themselves a huge salary, or loot corporate assets).

 

Since buyers pay a premium, the controlling shareholder ends up making much more money per share than minority shareholders would make selling their shares.  Nonetheless, controlling shareholders get to keep that premium in the absence of--

1.  doing so knowing the buyer will loot corporate assets,

2.  it involves a conversion of a corporate opportunity,

3.  fraud,

4.  other acts of bad faith.

Zetlin.

 

Conversion of a corporate opportunity will rarely be found.  The fact that the controlling shareholder is receiving a premium for his shares does not fall under this.

Perlman v. Feldmann:  steel was scarce but prices were kept down as part of the War effort.  Wilport paid a huge premium for Feldmann's control of a steel plant so he could divert the steel to his own needs at market prices.  Court found that Feldmann cashed in on this unique situation which should have benefitted entire corporation (perhaps because at the end of the war, prices would skyrocket, as would the value of the shares).  This decision has been criticized, however, because Wilport actually turned the company around and increased the value of minority shares, so there really was no injury.

 

Another conversion of corporate opportunity situation occurs when a buyer offers to buy an entire corporation, but the controlling shareholder talks the buyer into purchasing just his--the buyer gets control for a cheaper price, but the minority loses an opportunity to sell.

 

A controlling shareholder cannot baldly sell his vote, or, in other words, the director positions he's able to vote in--there must be an accompanying sale of stock.  It's also not smart to list in the contract the price being paid for the shares and a separate price paid for board seats.

 

Directors can resign at anytime.  Del. 141(b).  Remaining board members vote in replacements, even if only one board member remains.  Del. 223(a)(1).  However, there may be limits on removing directors.  Some states require cause; some don't (Del. 141(k)).  Even in states where cause is required, special board meetings can be called to vote in a new board.  Sometimes a meeting isn't even required--it can be done through paperwork consisting of written approval of a majority of shareholders.

 

Because it's so easy for a majority shareholder to change board members, a court will not scrutinize a change of board members made by a majority shareholder.  A court will scrutinize a change of board members when the controlling shares are less than a majority.

Essex Universal:  this case espouses two views:  Lombard view--changes to the board will not be questioned if the seller has control, and the buyer would also have control, with the burden of showing the buyer wouldn't have control on the plaintiff.  Friendly view--don't allow the changes if the controlling share is less than the majority of shares.  Friendly believes if the buyer does have control, he can elect his board at the next board meeting.

 

Planning       If you foresee a potential problem in selling controlling shares, take the minority along with you.

 

 

SHAREHOLDER ACTIONS

 

The substantive state law will be applied, even if the action is in federal court as a federal question (but which doesn't address whether demand is required, for instance).  Kamen v. Kemper.

 

Suits by shareholders are either direct or derivative.

Direct suits seek compensation for a harm caused to certain shareholders.  Typical suits involve dilution of votes, a change in dividends, protection of minority shareholders.

Derivative suits seek compensation for harm caused to the entire corporation.  Typical suits involve director self-dealing, failure to use due care, stealing corporate opportunities, or excessive compensation.

 

It usually benefits a shareholder to file a direct suit, since derivative suits include procedural hurdles difficult to clear.  Eisenberg:  by pleading that interested directors' actions diluted his vote, court accepts this as a direct suit.  However, to avoid the business judgment rule, he'll have to show the directors engaged in self-dealing, which could result in it being declared a derivative suit.

 

DERIVATIVE SUITS

 

Derivative damages go to the corporation, rather than individual shareholders.  However, if the wrongdoers in a derivative action are controlling shareholders, the court may award damages just to minority shareholders so that the wrongdoers don't get back part of the damages they had to pay.

 

Losing plaintiffs in a derivative suit must pay the defendant's legal costs, usually having to put up a bond upon filing the complaint.   This discourages single-share owners from filing "strike suits," which are usually meritless but corporations settle to avoid the nuisance.

 

Most states require a plaintiff to make a demand upon a corporation before the suit is allowed.  Demand asks the corporation to take over the suit on its own or take some other action to repair the damage done to the corporation.

 

If demand is made and refused (as it usually is), a court applies the business judgment rule to the board's decision to refuse demand, unless--

1.  the board participated in the wrong, or

2.  the directors were dominated or controlled by the wrongdoer.

So unless one of those two conditions apply, the plaintiff cannot proceed unless he can show the business judgment rule is violated (which never happens).

 

If it's obvious from the start that making demand would be futile, the court will excuse demand (except under the RMBCA, demand is always required--procedures discussed below).  The standard necessary to show futility varies.

Delaware  A very particularized pleading is necessary to excuse demand.  It must create a reasonable doubt that--

1.  the directors are disinterested and independent, or

2.  that they validly exercised business judgment.

It will, of course, be impossible to show that the board violated the business judgment rule, so the test focuses on the first prong.  It is insufficient that the pleading name the board in the complaint and allege that more than a majority of them were interested directors.  The pleading must detail that the defendants failed to consult, or keep informed, etc.  Heineman.

New York  Pleading requirements are much more liberal.  Alleging that the board participated, acquiesced, or failed to act, is enough to defeat disinterested status.

 

If demand is excused, the plaintiff can proceed to trial.

 

However, the corporation may have one more trick up its sleeve.  Even if demand is excused, some corporations appoint special litigation committees, composed of disinterested directors, who decide whether to take over the plaintiff's suit.  What a court does with that decision varies by state.

Delaware  The decision will be followed if--

1.  the committee truly is disinterested

2.  it conducted an adequate investigation

3.  the inquiry was conducted in good faith

4.  the court would have made a similar decision.

Number four is, in essence, a rejection of the business judgment rule.  In sum, a court will accept the committee's recommendation to dismiss only if the court is convinced the committee is disinterested, and if the court would have recommended dismissing itself. Zapata.  (This applies only where demand is excused--if a committee, rather than the board, refuses demand when demand is required, like the board, as long as the committee is truly disinterested, its decision gets the benefit of the business judgment rule).

New York  The committee decision will be followed if it meets the first three prongs above--in other words, if the court's convinced the committee is truly disinterested, and if it follows the business judgment rule (which it always will).  Auerbach.  Otherwise the court will apply its own judgment about whether the suit should go ahead.

In essence, Delaware and New York end up in the same place.  Delaware is less reluctant to excuse demand, but if it does it's pro-plaintiff.  New York freely excuses demand, but after it does it's anti-plaintiff.

 

Other jurisdictions refuse to so freely apply the business judgment rule to decisions made by corporations.  Alford v. Shaw:  Iowa would refuse to apply the business judgment rule even where demand is required and refused by the board.  Iowa also gets rid of committees altogether.

 

Under the RMBCA, demand is always required.  After 90 days, or if the demand was rejected earlier or the corporation would be harmed by waiting, the plaintiff can file a derivative claim.  RMBCA ' 7.42.

 

The claim will be accepted by the court if its particular in alleging disinterest among the board and that the following paragraph hasn't happened:

However, the claim will be dismissed if called for by a majority of disinterested directors, a majority of a committee of disinterested directors, or by an independent panel appointed by the court, if the bodies conducted themselves in good faith and after conducting a reasonable inquiry.

 

 

 

PROXIES

 

It would be unfeasible for most shareholders to attend annual meetings.  Instead, they vote with proxy cards (like absentee ballots).

 

As a result, factions within the corporation may want to solicit shareholders proxies so they'll have more votes supporting their side.  Because the incumbent board has a tremendous advantage in soliciting proxies (resources, and the shareholder list), the SEC regulates how proxies are solicited.

 

The corporation must send out an annual report before each meeting.

 

A solicitation for a proxy must be accompanied by a proxy statement, which lists the proxy's conflict of interest, details of what's being voted on, and where the proxy stands on the issue.  SEC Rule 14a-8.

 

A proxy card must include--

1.  a statement if you're soliciting on behalf of the corporation,

2.  boxes indicating how the shareholders wants the proxy to vote,

3.  the backup rule of what will happen if the shareholder marks nothing,

4.  a statement that discretionary authority will exercised in unexpected situations  SEC Rule 14a-4c.

5.  a place to date the card,

6.  the proxy card is good for only one meeting, not indefinitely.

 

A corporation must either provide an insurgent a list of its shareholders, or, if the insurgent is a shareholder, must offer to mail out the insurgent's material to shareholders at cost.  Some states don't give corporations a choice, and require lists of shareholders be made available.

 

The board of directors can pay for its proxy solicitation with corporation money if the solicitation relates to policy (rather than an attempt to keep their jobs) and the costs are reasonable.  Board members bear the burden of showing both.

 

Insurgents can be reimbursed for their proxy solicitation costs if they win, the fight related to policy matters, and the costs were reasonable.  Insurgents who lose pay their own way.

 

MGM:  fight related to policy, so board could pay for fight with corporation money.

Rosenfeld:  insurgents can reimburse themselves with shareholder approval where fight was over policy (excessive compensation of president--iffy).

 

Because of the risk to insurgents of paying their own costs if they lose, proxy contests are rare.

 

 

CONCERNS FOR CLOSELY HELD CORPORATIONS

 

In regular corporations, if shareholders don't like what the majority is doing, they can easily sell their shares.  Closely held corporation stock is not easily sold, and usually does not give dividends.  Therefore, shareholders are unusually reliant upon the actions of controlling shareholders for jobs with the corporation.  States, therefore, offer more protection to shareholders of closely held corporations, either through common law and/or statutes.

 

Statutes dealing with closely held corporations are rarely used, in part because they're untested, and in part because some of the techniques discussed below have proven just as effective.  If a state offers a statute, it usually involves creating a statutory close corporation.  A close corporation can opt to be declared a statutory close corporation, or it can choose not to pursue it.

 

SHAREHOLDER VOTING AGREEMENTS AND TRUSTS

Shareholders may enter into vote pooling agreements, voting trusts, or rely on proxies to insure representation.

 

A vote pooling agreement will be upheld if it's between shareholders.  Ringling Bros.:  two of three shareholders agreed to vote together.  Court upheld the agreement when one of the parties defied the agreement.  Unlike modern courts, this court was reluctant to grant specific performance by forcing the defiant shareholder to vote as agreed (as determined by an arbitrator--their lawyer).  Instead, he invalidated the shareholders votes.  This case also serves as a lesson to lawyers not to represent more than one shareholder in a closely held corporation (puts him in an awkward position).

 

An irrevocable proxy (which is a proxy coupled with an interest) grants a third party the right to vote shares.  The court could have recognized an implied irrevocable proxy in Ringling Bros. with the lawyer as the proxy holder, as most modern courts would.  (Maybe not Delaware, though, where Ringling Bros. was decided).

A proxy coupled with an interest rests upon this idea.  A regular proxy, as discussed earlier under publicly held corporations, can be revoked by the shareholder by a later dated proxy or by voting in person.  In essence, the proxy is revocable.  A revocable proxy would be worthless in this context because as soon as a disagreement arose, the shareholder would revoke the proxy.  An irrevocable requires an exchange of consideration.  In a proxy couple with an interest, the interest is the consideration.  Usually shareholders make each other their proxies, which simultaneously creates an interest.

 

A voting trust is similar to an irrevocable proxy.  Legal title is given to the trustee allowing him to vote, while equitable title remains with the shareholder, entitling them to dividends and income.  Statutes govern voting trusts, and so aren't so easily set up.  The statutes limit the terms of trusts (proxies can be indefinite) and require public disclosure of the trust's terms.  If any statutory term is not met, the trust is invalid.

 

Other vote agreements have been held valid.

 

Different classes of stock can be created, each shareholder holding his own class.  By allotting each class a designated number of seats, each shareholder is guaranteed representation, even if it's disproportionate to the shares he owns.

 

Cumulative voting allows a shareholder to pool all his votes for one person--presumably himself.

 

Voting can be weighted so that minority shareholders are given voting rights equal to majority shareholders.  For instance, a minority's shares are worth three votes each, whereas a majority's shares carry only one vote.  This scheme could even include non-voting shares.

 

The vote required to constitute a quorum, or to approve action, can be increased to effectively provide each shareholder a veto.  For instance, if no shareholder owns less than 25% of the shares, then requiring a super-majority of 80% gives each shareholder a veto.  There would also have to be protection against changing the super-majority or quorum requirement by anything less than the super-majority or a lesser quorum.

 

Each of these options can result in deadlock.  One option to avoid deadlock is to appoint a tie-breaker.  This can be done by giving him a share of stock entitled to nothing but a vote.

 

 

 

DIRECTOR VOTING AGREEMENTS

A vote pooling agreement may not be upheld if it involves agreements on how to vote as members of the board of directors (which in a closely held corporation, most shareholders will be).  The policy is that it sterilizes the board by constraining the board's judgment.  McQuade:  the majority shareholder and two minority shareholders agreed to elect each other as directors, and to use best efforts to elect each other as officers.  This differs from Ringling Bros. because it involves an agreement on what they'll do as directors rather than just shareholders.  The agreement to elect each other officers sterilizes their role as directors by tying their hands.

 

New York subsequently backed off that harsh rule, and other states have liberalized it even further.

Clark v. Dodge:  there are no minority shareholders that could be hurt, and the agreement to elect one of them general manager does not apply if the general manager is not "faithful, efficient, and competent."  No one's hurt and hands aren't tied.

Galler v. Galler:  This agreement did not include an "out-clause" like "faithful, efficient, and competent," yet was upheld.  Illinois holds that director agreements are valid if--

1.  there is no injury to minority interest,

2.  there is no injury to the public or creditors, and

3.  the agreement does not violate statutory prohibition.

Under Galler, however, it can be difficult for a minority to object to a directors' agreement because he's not a party to the agreement and has no standing.

 

 

SHARE TRANSFER AGREEMENTS

Another concern among shareholders in closely held corporations is having control over who holds the other shares.  States generally uphold restrictions on how shares can be disposed of.

 

The right of first refusal allows the corporation or other shareholders the chance to buy shares at the price offered by a third party.  Generally the corporation gets first dibs so the remaining shareholders retain their proportion of control.

 

First options at fixed price does not depend upon an offer by a third party.  It fixes a price either at book value (assets minus obligations) or by some sort of mutual agreement.  Unlike right of first refusal, this can be used to prevent transfers by gift or bequest.

 

The seller may have to seek consent, i.e. approval of the new buyer.  This can lead to unreasonable withholding of consent.

 

Buy-back rights are triggered by some agreed-upon event (i.e. death or deadlock), whether the holder wants to sell or not, and gives the corporation a right to purchase.

 

Buy-sell agreements are also triggered by an event, but obligate the corporation to purchase the shares.

 

 

DISSOLUTION AND DEADLOCK

Sometimes those transfer restrictions are employed when shareholders experience deadlock or dissension.

 

Dissension occurs when one shareholder wants out.  He has no right to dissolve the corporation by himself, so he may be stuck with his situation unless he has entered into a share transfer agreement which compels the repurchase of his shares.  Ramos v. Estrada:  combined vote pooling agreement with a buy-sell agreement so they could get rid of the dissenter.

 

Deadlock occurs when a vote is equally split or a shareholder has exercised his veto power and nothing can get done.  This may also trigger a share transfer agreement.

 

If no agreement had been reached on what to do in deadlock or dissension, a court will enter the scene and impose a remedy.

 

One remedy is dissolution.  This is an appropriate judicial remedy when--

1.  There's director deadlock causing injury to the corporation or shareholders,

2.  The directors are acting in a manner that's "illegal, oppressive, or fraudulent,"

3.  The corporation's assets are going to waste, or

4.  There's shareholder deadlock, failing for two years to elect directors.

RMBCA ' 14.30(2) & Close Corporation Supplement ' 43 (referring to RMBCA ' 14.30)

 

Oppression includes many of the things considered fiduciary duties owed by majority shareholders:  self-dealing, and squeeze-outs.  A squeeze-out occurs when the majority attempts to deny the minority an economic benefit (a job with the corporation) or decision-making powers.  Evidence includes firing, denying dividends, and offering well below value to buy out the shareholder.

 

Other remedies include a judicially forced buyout, appointment of provisional directors, or a custodian, or receiver (includes power to liquidate), or reliance upon the fiduciary obligation.

Alaska Plastics:  if court can order dissolution, it ought to be able to order a lesser remedy as well.

 

A fiduciary obligation in this context arises from the general fiduciary duty of controlling stockholders to be "fair" to the minority.  It applies in close corporations when--

1.  the majority enjoys a benefit

2.  to the detriment of the minority,

3.  for which there is no legitimate purpose, or

4.  if there is a legitimate purpose, the purpose can be achieved by a less injurious course of action.

 

As discussed above, this includes self-dealing and squeeze-outs.  It can be defended with a legitimate business purpose when that purpose could not have been achieved by a different course of action.

Donahue:  if corporation repurchases some shares, it must make a similar offer to all shareholders.

Wilkes:  three stockholders gained up on fourth, violating an employment agreement by terminating his salary and dropping him from the board.  This amounted to a violation of majority's fiduciary duty to allow shareholder a return on his investment, with no legitimate business purpose (he was doing a good job).

Sugarman:  the majority took excessive salary (which by itself is just an interested director/derivative suit claim) and discriminatory dividends.  That amounts to a shut out of the minority shareholder.  The majority also offered to buy back the shares at a low price.  *If you have a case involving only excessive salaries for all but the minority, claim they're disguised discriminatory dividends to find breach of fiduciary duty.

Meiselman:  denying job to shareholder is oppression.

Pedro:  forcing a sell-out at 75% of book value is probably oppressive (court didn't actually find this, but ruled for plaintiff on other, shakier grounds).

Glamore Motors:  this was at-will employment before he became a shareholder, and so the firing was not tied to ownership of stock and there is no breach of fiduciary duty.  Besides, Glamore bought back the stock at a fair price.

Jordan v. Duff & Phelps:  when he quit, a buy-back agreement took effect.  Soon after the buy-back, though, the shares' value skyrocketed.  He attempts to argue a fiduciary duty to disclose that company knew the price would skyrocket.  But here his employment was not wrapped up in share ownership (he received the shares as compensation), and so no duty.

Atlantic Properties:  even a minority shareholders, if he's exercising his veto, owes other shareholders a fiduciary duty.  However, the analysis of this case was flawed.  It approached it as a freeze-out, which isn't possible by a minority.  It's more of a deadlock case, where the deadlock is caused in bad faith.  That bad faith defeats the business judgment rule.

 

One thing to keep in mind when drafting a buy-sell agreement is how available assets will be to purchase the shares.  To be able to make any disbursements, either as dividends or as share repurchases, the corporation must have both equity and balance sheet solvency.

Equity solvency concerns the cash flow into the corporation. To be solvent in this regard, the corporation=s income must exceed its bills.

Balance sheet solvency concerns the corporation=s assets.  To be solvent in this regard, assets must exceed liabilities. Stated capital is the number of shares times their par value (as articulated in the articles of incorporation); capital surplus is the value of each stock over its par value, times the number of stocks; earned surplus compares the profits and losses.

--In some states, the corporation must have equity and balance sheet solvency only at the time an obligation is made; in other states equity and balance sheet solvency must exist both when the obligation is made and when it=s due.

--Whether a shareholder owed money from a share repurchase is considered a creditor so that he=s among the first to get paid after a bankruptcy varies by state.

Northwest Oxygen:  there was a buy-back agreement with the purchase price to be made in installments.  In the meantime, the company went bankrupt.  Because Northwest wasn=t solvent both at the time of obligation and when the obligations came due, the plaintiff isn=t a creditor.

 

 

 

Planning       --Plan for contingencies in advance.  This includes voting agreements, buy-sell agreements, and employment contracts to guarantee what it is you're looking for.

--For instance, in Northwest Oxygen, the seller should have gotten a note from a majority shareholder personally securing the payments due, whether he sold the shares to the corporation or to the majority shareholder personally.  Additionally, he could have just gotten cash.

The Tests

 

 

 

Principal/Agent Requirements

1.  Manifestation of Consent of Principal for Agent to Act on Its Behalf

a.  agent act on behalf of principal

b.  agent subject to control of principal

2.  Consent of Agent to Act on Behalf of Principal (need no manifestation)

 

 

Types of Authority -- Principal/Agent

There are several sources of authority:

Express authority--authority agreed upon by the agent and principal.

express actual authority--expressly stated in the agreement.

implied, or incidental authority--authority that is reasonably and customary to accompany express authority (authority to sell includes authority to bargain price)

Apparent authority--this arises when a principal leads a third party into believing the agent has authority, even if the agent doesn't, or when it would be reasonable and customary for an agent to have authority and a third party is unaware that the agent doesn't actually have such authority.  This can't be knocked out by instructions from the principal to the agent to the contrary.

Inherent authority--this arises when a third party is unaware of the true owner, instead believing the agent is the owner and so reasonably believes the agent to have full authority.  This is not apparent authority because there is no connection between the principal and the third party.  This can't be knocked by instructions from the principal to the agent to the contrary.

 

In addition to looking for authority to enter into the deal, also look to see if the principal ratified the deal.

1.  Express ratification to either the third party or to the agent, or

2.  Implied ratification, determined by looking at the principal's conduct.

a.  accepted the benefits of the deal, but knew it was unauthorized and could have rejected it

b.  failed to repudiate within a reasonable time

c.  sued to enforce the deal.

What Constitutes A Partnership

A partnership consists of two or more people who

1.  Reach an agreement,

2.  On a for-profit business

3.  And are Co-Owners, meaning they

a.  share profits, and

b.  share control (usually the big issue).

 

 

Fiduciary Duties of a Partner

The duties are as follows:

1.  Duty not to compete with the partnership.  ' 404(b)(3).

2.  Refrain from secret profits and taking partnership opportunities.  ' 404(b)(1).

3.  Don't act against the partnership's interests.  ' 404(b)(2).

 

 

Authority Sources for Partners

Partners can have regular principal/agent type authority:

1.  Actual

a.  express

b.  implied

2.  Apparent

3.  Inherent

They can also have special partnership authority (UPA ' 9, RUPA ' 301)

4.  Implied actual authority

5.  Apparent authority from custom.

 

 

Things a Partner Cannot Have Authority To Do By Himself

UPA ' 9(3) lists things no single partner can have authority to do--each requires a unanimous vote of partners:

a.  assign partnership property to creditors

b.  dispose of business good-will

c.  any act making impossible the carrying on of partnership business

d.  confess a judgment (admit partnership liability)

e.  submit a partnership claim to arbitration.

Dissolution of a Partnership

Dissolution occurs when--

1.  if created for a term or purpose, when the term is up or purpose accomplished.  UPA ' 31(1)(a)

2.  if created for a term or purpose, if all partners who haven't assigned away their interest agree.  UPA ' 31(1)(c)

3.  if no term or purpose, then the partnership is at-will and can be dissolved at anytime by any partner.  UPA ' 31(1)(b)

4.  by the expulsion of a partner bona fide in accordance with the partnership agreement.  UPA ' 31(1)(d)

5.  by death of a partner.  UPA ' 31(4)

6.  by bankruptcy of a partner or partnership.  UPA ' 31(5)

All of the above dissolutions are "rightful."  No damages result.

7.  by a partner who has no good reason under 1-6 above.  UPA ' 31(2)

Number 7 results in damages against the partner who, although he had the power to dissolve, did not have the right.

8.  by judicial order.  UPA ' 31(6).  Under UPA ' 32, that's appropriate when--

a. partner declared a lunatic

b. partner incapable of performing his part of partnership contract

c. partner guilty of conduct prejudicially affecting ability to carry out business

d. partner willfully or persistently commits breach of partnership agreement

e. partnership business can be carried out only at a loss

f. other circumstances render dissolution equitable.

 

 

 

 

 

Distribution of Partnership Assets

When a partnership is wound up, the revenue is applied to

1.  partnership debts

a.  outside loans

b.  partner loans

2.  repayment of partner's capital contribution

3.  distribution according to each partner's share.

The Articles of Incorporation

1.  Corporate name (with Incorp., or Corp., or Inc., or some such designation at the end)

2.  The number, classes, and rights of stock.

3.  The registered agent (who will accept process of service)

4.  The names and addresses of the incorporators, who act on behalf of the corporation until a board of directors is seated

5.  The number of directors who will eventually be elected, as well as the names of the initial directors who will serve until they vote in a board of directors, although in some states the initial directors can just be the incorporators.

6.  Some states require a vague statement of purpose

 

 

When A Court Is Likely to Pierce the Corporation Veil

1.  There's been a disregard for corporate formalities

a.  corporate procedures have not been followed (no board of directors, no stock issued, meetings not held)

b.  corporate books and records are not kept

c.  corporate assets are commingled

d.  the parent and subsidiary are represented to third parties as one and the same

2.  The corporation is undercapitalized

3.  Not piercing results in injustice

 

 

Corporate Duty of Care

The only decisions made by corporate directors or officers that will be scrutinized by a court are those made--

1.  involving fraud,

2.  illegality, or

3.  a conflict of interest.

All others will be given the benefit of the business judgment rule.

 

Decisions not given benefit of the business judgment rule must not be made with--

1.  gross negligence

2.  recklessness

3.  intent.

Duty of Loyalty--Interested Transactions

An interested transaction will not be struck if the following applies--

A transaction is not automatically voidable if

1.  the directors' conflict of interest, and effect of the transaction is known by

a. directors and approved by a majority of disinterested directors,

b. shareholders and approved by a majority (disinterested for RMBCA), or

2.  If it's fair to the corporation.

 

Fairness is determined by

1.  he circumstances of the situation,

2.  whether it was an arm's length bargain (as opposed to compelled), and

3.  whether an outside board would have approved the transaction.

 

If the transaction is director or shareholder approved, the majority rule (which includes Delaware) shifts the burden to the plaintiff to the transaction is unfair.  The minority rule gives approval of the transaction the benefit of the business judgment rule.

 

If the transaction is not director or shareholder approved, the burden is on the interested director to prove the transaction is fair.  This is a higher degree of fairness required than if there's director or shareholder approval.

 

 

Corporate Opportunities

A corporate opportunity is--

1.  something he learned about "on the job" if the person offering the opportunity expects it to be offered to the corporation,

2.  obtained through use of corporate property, if director or officer would think it of interest to the corporation

3.  is an opportunity closely related to the corporation's business (this doesn't apply to directors)

 

If it's a corporate opportunity, the director or officer can take it for himself only if he offers it to the corporation and makes full disclosure of the conflict of interest and the effects of the transaction, and--

A.  there's advance rejection by a majority of disinterested directors, or in the case of a non-board member, with approval of a disinterested supervisor (their decision gets the benefit of the business judgment rule), or

B.  there's advance rejection, or ratification after the fact, by a majority of disinterested shareholders, with the burden shifting to the plaintiff to show it's unfair (a waste of corporate assets), or

C.  in all other situations, including ratification by a board, the transaction is fair, with the burden on the defendant to show it's fair.

Controlling Shareholder Fiduciary Oblations

Courts impose

1.  the same fiduciary duty as on officers and directors, and

2.  the controlling shareholder must be "fair" to minority shareholders.

Situation two comes up in two scenarios--

1. in the day-to-day activities of the corporation, and

2. when the controlling shareholder sells his control.

 

The majority may not wreck the marketability of the minority's shares.

 

The majority must make full disclosure of the expected impact of corporate actions.

 

Controlling shareholders get to keep that premium in the absence of--

1.  doing so knowing the buyer will loot corporate assets,

2.  it involves a conversion of a corporate opportunity,

3.  fraud,

4.  other acts of bad faith.

 

 

Demand In Derivative Suits

Most states require a plaintiff to make a demand upon a corporation before suit is allowed.

 

If demand is made and refused (as it usually is), a court applies the business judgment rule to the board's decision to refuse demand, unless--

1.  the board participated in the wrong, or

2.  the directors were dominated or controlled by the wrongdoer.

So unless one of those two conditions apply, the plaintiff cannot proceed unless he can show the business judgment rule is violated (which never happens).

 

If it's obvious from the start that making demand would be futile, the court will excuse demand (except under the RMBCA, demand is always required--procedures discussed below).

Delaware  A very particularized pleading is necessary to excuse demand.  It must create a reasonable doubt that--

1.  the directors are disinterested and independent, or

2.  that they validly exercised business judgment.

It will, of course, be impossible to show that the board violated the business judgment rule, so the test focuses on the first prong.  It is insufficient that the pleading name the board in the complaint and allege that more than a majority of them were interested directors.  The pleading must detail that the defendants failed to consult, or keep informed, etc.  Heineman.

New York  Pleading requirements are much more liberal.  Alleging that the board participated, acquiesced, or failed to act, is enough to defeat disinterested status.

Shareholder Proxies

A proxy card must include--

1.  a statement if you're soliciting on behalf of the corporation,

2.  boxes indicating how the shareholders wants the proxy to vote,

3.  the backup rule of what will happen if the shareholder marks nothing,

4.  a statement that discretionary authority will exercised in unexpected situations  SEC Rule 14a-4c.

5.  a place to date the card,

6.  the proxy card is good for only one meeting, not indefinitely.

 

 

 

 

Director Voting Agreements Are Acceptable Under Certain Conditions

1.  there is no injury to minority interest,

2.  there is no injury to the public or creditors, and

3.  the agreement does not violate statutory prohibition.

 

 

 

 

Share Transfer Agreements

1.  right of first refusal

2.  first options at fixed price

3.  consent

4.  buy-back rights

5.  buy-sell agreements

 

 

Judicial Dissolution of Corporations

This is an appropriate judicial remedy when--

1.  There's director deadlock causing injury to the corporation or shareholders,

2.  The directors are acting in a manner that's "illegal, oppressive, or fraudulent,"

3.  The corporation's assets are going to waste, or

4.  There's shareholder deadlock, failing for two years to elect directors.

 

Other remedies include a judicially forced buyout, appointment of provisional directors, or a custodian, or receiver (includes power to liquidate), or reliance upon the fiduciary obligation.

 

Oppression includes self-dealing squeeze-outs, and any other fiduciary duty.

 

A fiduciary obligation in this context arises from the general fiduciary duty of controlling stockholders to be "fair" to the minority.  It applies in close corporations when--

1.  the majority enjoys a benefit

2.  to the detriment of the minority,

3.  for which there is no legitimate purpose, or

4.  if there is a legitimate purpose, the purpose can be achieved by a less injurious course of action.

 

 

 

 

 

Corporate Disbursements

 

To be able to make any disbursements, either as dividends or as share repurchases, the corporation must have both equity and balance sheet solvency.

Equity solvency concerns the cash flow into the corporation. To be solvent in this regard, the corporation=s income must exceed its bills.

Balance sheet solvency concerns the corporation=s assets.  To be solvent in this regard, assets must exceed liabilities. Stated capital is the number of shares times their par value (as articulated in the articles of incorporation); capital surplus is the value of each stock over its par value, times the number of stocks; earned surplus compares the profits and losses.