Corporate bargain—limited liability
I.CHARACTERISTICS OF A CORPORATION
A.PRINCIPAL CHARACTERISTICS OF A CORPORATION
a)Entity Status—a corporation is a legal entity created
under the authority of legislature
b)Limited Liability—as a legal entity, a corp is
responsible for its own debts; its sh’s liability is limited to their
c)Free Transferability of Interest—shares, representing
ownership interests, are freely transferable;
d)Centralized Management and Control—a corp’s management
is centralized in a board of dirs and officers. Shs have no direct
control over the board’s activities;
e)Duration—Continuity of Existence—a corp is capable of
f)Taxation—a corp, as an entity, pays taxes on its own
income; shs are taxed only on dividends;
g)Remember Attributes of the Corporation—CLIFF:
1)Centralization of management;
3)Forever (perpetual duration);
4)Freely alienable (shares can be sold).
B.CORPORATIONS DISTINGUISHED FROM OTHER FORMS OF BUSINESS
1.GENERAL PARTNERSHIPS—in most states, p’ships are governed
by the Uniform Partnership Act (UPA). However, the Revised UPA (RUPA)
has been adopted by a few states
a)Aggregate Status—a p’ship is an aggregation of two or
more persons who are engaged in business as co-owners. Although not a
legal entity, a p’ship is treated as one for certain purposes, e.g.,
ownership and transfer of property. RUPA confers entity status on
b)Unlimited Liability—every partner is subject to
unlimited personal liability on p’ship debts;
c)Transferability of Interests—a partner cannot make a
transferee a member of the p’ship. She can, however, assign his interest
in the p’ship, thus permitting the assignee to receive distributions of
profits. Because the assignee does not become a member of the p’ship, he
is not entitled to participate in p’ship business or management.
d)Duration and Dissolution—a p’ship cannot have perpetual
existence. It is terminable at will unless a definite term is expressed
or implied, and is also dissolved by death, incapacity, or withdrawal of
1)Wrongful dissolution—p’ships can also be dissolved
in contravention of the p’ship agreement, by the express will of any
partner, by a court or by a partner’s conduct. Upon wrongful
dissolution, nonbreaching partners may seek damages for breach and, if
they choose to do so, may continue the p’ship upon payment to the
breaching partner of the value of his interest.
1)Compare—dissociation under RUPA—termination results
in either the winding up of the p’ship or buyout of the dissociating
partner, depending on the event triggering the termination. A buyout may
be reduced by damages if dissociation was wrongful.
e)Management and Control—absent a contrary agreement,
every partner has a right to participate equally in the partnership
f)Autority—each partner, as an agent of the firm, may
bind the p’ship by acts done for the carrying on, in the usual way, the
business of the p’ship.
1)RUPA—a p’ship is bound by a partner’s act for
carrying on in the usual way either the actual p’ship business or a
business of the kind carried on by the p’ship.
g)Ownership of Property—title may be held in the name of
the p’ship, but property is owned by the individual partners as tenants
in p’ship. There is no tenancy in p’ship under RUPA, which provides that
property acquired by p’ship is owned by p’ship, not individual partners.
h)Capacity to Sue and be Sued—under the UPA, a lawsuit
may be brought by or against individual partners, rather than p’ship.
Partners are jointly and severally liable for wrongful acts and breaches
of trust; they are only jointly liable for debts and obligations of the
1)Statutory reforms—many state statutes specifically
allow a p’ship to be sued in its own name. Other states make all p’ship
liabilities joint and several. Other reforms provide that not all joint
obligors need to be joined in a suit.
2)RUPA—a p’ship may sue and be sued in its own name,
and partners are jointly and severally liable for all p’ship
obligations. A claim against the p’ship cannot be satisfied from a
partner’s personal assets unless p’ship assets have been exhausted.
2.JOINT VENTURE—a p’ship formed for some limited investment
or operation, as opposed to a continued business enterprise. Joint
ventures are governed by the rules applicable to p’ships
3.LIMITED PARTNERSHIP—this is a p’ship consisting of two
classes of partners: general partners (with rights and obligations as in
an ordinary p’ship) and limited partners (with no control and limited
4.LIMITED LIABILITY PARTNERSHIPS—in a LLP, a general partner
is NOT personally liable for all p’ship obligations arising from
negligence, wrongful acts, and misconduct absent his involvement in the
misconduct. There is no exclusion for liability for contractual
5.LIMITED LIABILITY COMPANIES—LLC is a non-corporate business
entity whose owners (members) have limited liability and can participate
actively in its management. An LLC may be either for a term or at will.
It can be managed either by its members or nonmember managers. Depending
on the statute, distributions are made either equally to each member or
in proportion to each member’s contribution.
a)Withdrawal and Dissolution—some statutes provide that
any event that terminates a member’s membership (death, resignation)
causes dissolution. Other statutes distinguish between fault
events(member misconduct…) and non-fault events (death, bankruptcy),
and some provide that dissolution can be avoided by paying the
withdrawing member fair value for his interest.
b)Advantages of LLCs—An LLC for a business association,
not publicly held, has strong advantages: partnership taxation,
virtually no restrictions in structuring ownership interests and
management, limited liability for owners and managers, and no
limitations on the number or nature of owners.
C.DISREGARD OF CORPORATE ENTITY—since a corp is a distinct legal
entity, shs are normally shielded from corporate obligations. In certain
instances, however, the corporate entity will be disregarded.
1.PIERCING THE CORPORATE VEIL—(Suits by corporate creditors
against shs)—it’s more common in contract claims than in tort claims.
The most important elements considered by the courts:
a)Commingling of Assets—commingling of corp assets and
personal assets of shs (e.g., paying private debts with corp funds) may
lead to piercing of the corporate veil;
b)Lack of Corporate Formalities—whether basic corp
formalities (e.g., regular meetings, corporate records maintained,
issuance of stock) were followed is also relevant. Statutory close corps
are permitted more flexibility regarding corp formalities;
c)Undercapitalization—if the corp was organized without
sufficient capital or liability insurance to meet obligations reasonably
expected to arise, the corp veil may be pierced;
d)Domination and Control By Shareholder—the corp veil is
often pierced when an individual or other corp owns most or all of the
stock, so that it completely dominates policy or business decisions.
e)”Alter Ego,” “Instrumentality,” “Unity of
Interest”—when no separate entity exists and the corp is merely the
alter ego or instrumentality of its shs (could be a corporate
shareholder), or when there is a unity of interest between the corp and
its shs, the corp veil is often pierced. These terms are usually applied
only if other grounds are present;
f)Fraud, Wrong, Dishonesty, or Injustice—generally, the
veil will be pierced only if one of these elements is available, e.g.,
no piercing of veil if there is a lack of corp formalities without
resultant injustice. Piercing the veil usually involves corps with a
small number of shs.
2.PIERCING HAPPENS MOST OFTEN WHEN:
1)The number of shs is small—the chance of one sh
dominating the corp is greater;
2)Deception—There is some kind of deception;
3)Agency—individual is a “principal” and corp is his
4)Estoppel—outsider was led to believe that he was
dealing with an individual, while in fact he was
dealing with the corporation.
5)Direct tort—individual and corp acted together and
should be jointly/severally liable
6)Instrumentality requirement is satisfied:
I)control of a subsidiary by parent
ii)to commit fraud
iii)to cause loss or injury.
3.PIERCING THE WALL BETWEEN AFFILIATED CORPORATIONS—this
occurs when a P with a claim against one corp attempts to satisfy the
claim against the assets of an affiliated corp under common ownership.
This type of aggregation is permitted only when each affiliated corp is
NOT a free-standing enterprise but merely a fragment of an entity
composed of affiliated corps.
4.USE OF CORPORATE FORM TO EVADE STATUTORY OR CONTRACT
OBLIGATIONS—the corp form may be ignored when it is used to evade a
statutory or contractual obligation. The issue is whether the contract
or statute was intended to apply to the shs as well as the corporation.
Only third parties, not the corp or its shs, are generally allowed to
disregard the corp entity.
5.TWO EXTREMES TO AVOID IN PIERCING THE CORPORATE WALL:
a)Old model—Superman (sh) used corp as his puppet;
b)New Model—Superman (sh) and corp are inseparable (alter
D.SUBORDINATION OF SHAREHOLDER DEBTS—”DEEP ROCK” DOCTRINE—if a
corp goes into bankruptcy, debts to its controlling shs may be
subordinated to claims of other creditors. When subordination occurs,
shareholder loans are treated as if they were invested capital (stock).
Major factors in determining whether to subordinate include fraud,
mismanagement, undercapitalization, commingling, excessive control, etc.
II.ORGANIZING THE CORPORATION—generally, corps are created under and
according to statutory provisions of the state in which formation is
A.FORMALITIES IN ORGANIZING CORPORATION:
1.CERTIFICATE OR ARTICLES OF INCORPORATION—state law governs
the content of the articles, which are filed with the secretary of the
state. Usually, the articles must specify the corp name, number of
shares and classes of stock authorized, address of the corp’s initial
registered office, name of initial registered agent, and the name and
address of each incorporator.
a)Purpose Clause—under most statutes, no elaborate
purpose clause is needed. It is sufficient to state that the purpose of
the corp is to engage in any lawful business activity.
b)State of Incorporation—incorporators need to consider
how flexible the state’s corporate law is versus the costs associating
with incorporating in that state
2.ORGANIZATIONAL MEETING—filling the articles in proper form
creates the corporation, after which an organizational meeting is held
by either the incorporators or dirs named in the articles. Matters
determined at meeting:
1)Incorporators elect directors, if no dirs are named
in the articles;
2)Directors choose officers;
3)Directors ratify pre-incorporation transactions;
4)Directors authorize issuance of shares
5)Directors adopt by-laws (if necessary), corporate
seal and stock certificate
B.DEFECTS IN FORMATION PROCESS—”DE JURE” AND “DE FACTO”
CORPS—when there is a defect or irregularity in formation, the question
is whether the corp exists “de jure,” “de facto,” “by estoppel,” or not
at all. This issue usually arises when a third party seeks to impose
personal liability on would-be shs. Another method of challenging
corporate status, used only by the state, is a quo warranto proceeding.
Note: where there has not been compliance with the statute, we apply
principles of de facto, de jure and corp by estoppel. Where there has
been compliance with the statute, we apply principles of disregard of
corporate fiction, a/k/a “piercing the corporate veil,” which is an
exception, rather than a rule.
1.DE JURE CORPORATION—this exists when the corp is organized
in compliance with the statute. Its status cannot be attacked by
anyone—not even the state. Most courts require only “substantial
compliance”; others require exact compliance with the mandatory
2.DE FACTO CORPORATION (substantially abolished)—this exists
when there is insufficient compliance as to the state (i.e., state can
attack in quo warranto proceeding), but the steps taken are sufficient
to treat the enterprise as a corp with respect to its dealings with
third parties. Requirements:
1)Colorable or apparent attempt;
3)Some use of corporate franchise; Then ct will
recognize status as to all but state
3.CORPORATION BY ESTOPPEL
a)Definition—estoppel is an equitable evidentiary rule
which prevents a party from denying the existence of a fact
notwithstanding that he fact is not true. Thus, certain parties are
estopped from asserting defective incorporation when they have dealt
with the corp as though properly formed.
b)Example—shs who claimed corp status in an earlier
transaction are estopped to deny that status in a suit brought against
the corp. The estoppel theory normally does NOT apply to bar suits
against would-be shs by tort claimants or other involuntary creditors.
c)Overlap With De Facto—many of the facts which we would
point to support a claim of de facto status are the same ones we point
for estoppel. However, substantial abolition of de facto concept doesn’t
necessarily abolish estoppel.
d)De Facto is For All; Estoppel is For One—estoppel
depends on relationship between party and corp.
4.WHO MAY BE HELD LIABLE—when a would-be corp is not a de
jure or de facto or a corp by estoppel, the modern trend imposes
personal liability against only those owners who actively participated
in management of the enterprise.
5.EFFECT OF STATUTES:
a)On De Facto Doctrine—states following the prior version
of the Model Act have abolished the de facto doctrine, thus making all
purported “shs” jointly and severally liable for all liabilities
incurred as a result of the purported “incorporation.” However, statutes
based on Revised Model Business Corporation Act require a person acting
on behalf of the enterprise to know that there was no incorporation
before liability attaches.
b)On Estoppel Doctrine—the effect of both acts is an
c)On Liability—under the prior Model Act, liability
extends to investors who also exercise control or actively participate
in policy and operational decisions. It is expected that the Revised
Model Act will be interpreted in the same manner.
III.LIABILITIES FOR TRANSACTIONS BEFORE INCORPORATION.
A.PROMOTERS—a promoter participates in the formation of the corp,
usually arranging compliance with the legal requirements of formation,
securing initial capital, and entering into necessary contracts on
behalf of the corp during the time it’s being formed.
a)Fiduciary Duties to Each Other—Full disclosure and fair
dealing are required between the promoters and the corp and among
B.CONTRACTS MADE BY PROMOTERS ON CORP’S BEHALF
1.RIGHTS AND LIABILITIES OF CORPORATION:
a)English Rule—the corp is not directly liable on
pre-incorporation contracts even if later ratified. Rationale: the corp
was not yet in existence at the time the promoter was acting.
b)American Rule—the corp is liable if it later ratifies
or adopts pre-incorporation K.
c)Corporation’s Right to Enforce Contract—under either
rule, the corp may enforce the contract against the party with whom the
promoter contracted, if it chooses to do so.
2.RIGHTS AND LIABILITIES OF PROMOTERS.
a)Liability on Pre-incorporation Contract—generally,
promoters are liable if the corp rejects the pre-incorporation contract,
fails to incorporate, or adopts a contract but fails to perform, unless
the contracting party clearly intended to contract with the corporation
only and not with the promoters individually.
b)Right to Enforce Against the Other Party—if a corp is
not formed, the promoter may still enforce the contract.
C.OBLIGATIONS OF PREDECESSOR BUSINESS—a corporation that acquires
all of the assets of a predecessor business does not ordinarily succeed
to its liabilities, with exceptions:
a)Exceptions—the successor corp may be liable for its
predecessor liabilities if:
1)the new corp expressly or impliedly assumes the
predecessor obligations (the creditors of the old corp may hold the new
corp liable as third-party beneficiaries);
2)the sale was an attempted fraud on the creditors; or
3)the predecessor is merged into or absorbed by the
IV.POWERS OF THE CORPORATION.
A.CORPORATE POWERS—generally, corporate purposes and powers are
those expressly set forth in the corporation’s articles, those conferred
by the statute, and the implied powers necessary to carry out the
express powers. Transactions beyond the purposes and powers of the
corporation are ultra vires.
1.TRADITIONAL PROBLEM AREAS—the following three powers are
particularly significant express powers, since older statutes did not
specifically confer them:
a)Guarantees—modern statutes confer the power to
guarantee the debts of others if it is in furtherance of the corporate
b)Participation in a Partnership—present-day statutes
explicitly allow the corp to participate with others in any corp,
partnership, or other association;
c)Donations—because the general rule is that the
objective of a business corporation is to conduct business activity with
a view to profit, early cases held that charitable contributions were
ultra vires; the modern view permits reasonable donations without
showing the probability of a direct benefit to the corp.
1.DEFINITION—agency is the fiduciary relation which results
from the manifestation of consent by one person to another that the
other shall act on his behalf and subject to his control, and consent by
the other to so act.» Rest2dAg
a)Parties to an agency relationship—Principal & Agent.
Thus, three essential elements of an agency relationship:
1)Manifestation by principal that agent shall act for
him in some undertaking;
2)Acceptance by the agent; and
3)Understanding that the principal is in control of the
I)Note that these are factual issues; if they are
satisfied, then the relationship is one of agency, regardless of what
the parties themselves call it (but the parties’ labels may provide
evidence of their intent)
2.CATEGORIES OF AGENCY
a)Actual Express Authority—authority is the power of the
agent to affect the legal relations of the principal by acts done in
accordance with the principal’s manifestations of consent to him.» Rest
§7. Operative word is «manifestation» . If he says, do something, it’s
express but the manifestation may include implied assent to other
things as well, which is—>
b)Actual Implied Authority—unless otherwise agreed,
authority to conduct a transaction includes authority to do acts which
are incidental to it, usually accompany it, or are reasonably necessary
to accomplish it.» Rest § 35
c)Apparent Authority a.k.a. «ostensible
authority»—apparent authority is the power to affect the legal
relationships 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.» Rest §8. But note
that the manifestation includes allowing the agent to represent
accurately his own authority.
d)Inherent Authority—this is the authority that inheres
in an office. General agent (agent authorized to conduct a series of
transactions involving continuity of service): P is bound if A is acting
in the interests of P and A does an act usual or necessary with respect
to the authorized transactions ;
1)Unusual activities—depositing corporate checks on a
personal account is an unusual activity, and the bank should make
inquiry if the person is authorized to do that; otherwise, the bank is
liable to the principal for lost money (Mohr)
e)Ratification—ratification is the affirmance by a person
of a prior act which did not bind him but which was done or professedly
done on his account, whereby the act, as to some or all persons, is
given effect as if originally authorized by him.» Rest § 82. The
principal can affirm by words, or by deeds. This includes the failure to
repudiate the subject matter when presented, suing to enforce the
obligation, retaining the benefits of the transaction. Note several
1)Ratification assumes that the principal was not
previously bound. If the principal had been previously bound, then the
liability would be based on another agency theory.
2)It doesn’t matter to whom the affirmance is made. It
could be to the agent, to the third party, or anyone else or nobody at
all. Why? Because what was lacking in the original contract was merely
his expression of assent to the relationship of agency. The terms are
fixed, the third party believes he has an agreement, all that’s missing
is the opposite party. So the President of the firm’s note to himself
that the affirms may be sufficient. If there are some formalities
required to authorize an act e.g., sealed instruments, deeds then there
might be additional formality required for affirmance.
f)Estoppel—purported principal either (a) intentionally
or carelessly causes the belief that a purported agent is acting on his
behalf, or (b) sits silently knowing that such belief exists without
taking reasonable steps, and the third party relies detrimentally.
C.ULTRA VIRES TRANSACTIONS—those beyond the purposes and powers,
express and implied, of the corporation. Under common law, shareholder
ratification of an ultra vires transaction nullified the use of an ultra
vires defense by the corporation.
1.TORT ACTIONS—ultra vires is NO defense to tort liability.
2.CRIMINAL ACTIONS—claims that a corporate act was beyond the
corp’s authorized powers are NO defense to criminal liability.
3.CONTRACT ACTIONS—at common law, a purely executory ultra
vires contracts were NOT enforceable against either party; fully
performed contracts could NOT be rescinded by either party; and, under
the majority rule, partially performed contracts were generally
enforceable by the performing party, since the nonperforming party was
estopped to assert an ultra vires defense.
4.STATUTES—most states now have statutes that preclude the
use of ultra vires as a defense in a suit between the contracting
parties, but permit ultra vires to be raised in certain other contexts:
a)Suits Against Officers or Directors—if performance of
an ultra vires contract results in a loss to the corp, it can sue the
officers or dirs for damages for exceeding their authority.
b)Suit By State—these limiting statutes do NOT bar the
state from suing to enjoin a corp from transacting unauthorized
c)Broad Certificate Provisions—when the certificate of
incorporation states that the purpose is to engage in any lawful
activity for which corp may be organized, ultra vires is unlikely to
V.MANAGEMENT AND CONTROL
A.ALLOCATION OF POWERS BETWEEN DIRECTORS AND SHAREHOLDERS
1.MANAGEMENT OF CORPORATION’S BUSINESS—corporate statutes
vest the power to manage in the board of directors, except as provided
by valid agreement in a close corp. He board’s power is limited to
2.SHAREHOLDER APPROVAL OF FUNDAMENTAL CHANGES—shs must
approve certain fundamental changes in the corp, e.g., amendment of
articles, merger, sale of substantially all assets, and dissolution.
3.POWER TO ELECT DIRECTORS—shs have the power to elect dirs
and to remove them for cause, absent provisions for removal without
cause in the certificate, bylaws, or in statutes. Some statutes also
permit the board or the courts to remove a dir for certain specific
reasons (e.g., felony conviction).
4.POWER TO RATIFY MANAGEMENT TRANSACTIONS—shs have the power
to ratify certain management transactions and insulate the transactions
against a claim that managers lacked authority, or shift the burden on
the issue of self-interest.
5.POWER TO ADOPT PRECATORY RESOLUTIONS—shs may also adopt
advisory but nonbinding (precatory) resolutions on proper subjects of
6.BYLAWS—shs usually have the power to adopt and amend
bylaws, although some statutes give the board of dirs the concurrent
power to do this.
7.CLOSE CORPORATION—this is a corp owned by a small number of
shs who may actively manage; it has no general market for its stock, and
it has some limitations regarding transferability of stock.
8.STATUTORY CLOSE CORPORATION STATUS—the basic requirements
to qualify for special treatment under the statutes are that, in its
cert of incorp’n, a statutory close corp must identify itself as such,
and must include certain limitations as to the number of shs,
transferability of shares, or both.
a)Functioning As a Close Corporation—there may be sh
agreements relating to any phase of the corp affairs.
1.APPOINTMENT OF DIRECTORS—initial dirs are either designated
in the articles of incorporation or elected at a meeting of
incorporators. Subsequent elections are by shs at their annual meetings.
The number of dirs is usually set by the articles or bylaws.
a)Qualifications—absent a contrary provision in the
articles or bylaws, dirs need not be shs of the corp or residents of the
state of incorporation.
b)Vacancies—statutes vary, but under Model Act, a vacancy
may be filled by either the shs or dirs.
1)Compare—removal: some statutes require that
vacancies created by removal of a dir be filled by the shs unless the
articles or bylaws provide otherwise.
2.TENURE OF OFFICE
a)Term of Appointment—under most statutes, office is held
until the next meeting, although on a classified board, dirs may serve
staggered multi year terms.
b)Power to Bind Corporation Beyond Term—unless limited by
the articles, the board has the power to make contracts biding the corp
beyond the dirs’ term of office.
c)Removal of Director During Term—at common law, shs can
remove a dir for cause (e.g., fraud, incompetence, dishonesty) unless an
article or bylaw provision permits removal without cause. a dir being
removed for cause is entitled to a hearing by shs before a vote to
remove. a number of statutes permit removal without cause.
1)Removal by Board—board can NEVER remove a dir unless
authorized by statute;
2)Removal by Court—there is a split authority as to
whether a court can remove a dir for cause.
I)Statutes—some statutes permit courts to remove a
dir for specified reasons. Usually, a petition for removal can be
brought only by a certain percentage of shs or the attorney general.
3.FUNCTIONING OF BOARD
a)Meetings—absent a statute, dirs can act only at a duly
convened meeting consisting of a quorum. In most jurisdictions, a
meeting can be conducted by telephone or other means whereby
participants can hear each other simultaneously. Most statutes also
allow board action by unanimous written consent without a meeting.
1)Notice—although formal notice is unnecessary for a
regular meeting, special meetings require notice to every dir of date,
time, and place. Usually, notice can be waived in writing before or
after a meeting. Attendance waives notice unless the dir attends only to
protest the meeting.
2)Quorum—a majority of the authorized number of dirs
constitutes a quorum. Many statutes permit the articles or bylaws to
require more than simple majority or less than that.
3)Voting—absent a contrary provision, an affirmative
vote of a majority of those present, not a majority of those voting, is
required for board action.
b)Effect of Noncompliance With Formalities—today, most
courts hold that informal but unanimous approval of a transaction is
effective, as is a matter receiving the explicit approval by a majority
of dirs without a meeting, plus acquiescence by the remaining dirs.
c)Delegation of Authority—the board has the power to
appoint committees of its own members to act for it either in particular
matters or to handle day-to-day management between board meetings.
Typically, these committees cannot amend the articles or bylaws, adopt
or recommend major corporate changes (e.g., merger), recommend
dissolution, declare a dividend, or authorize issuance of stock unless
permitted by the articles or bylaws. Note that while the board may
delegate operation of the business to an officer or management company,
the ultimate control must be retained by the board.
d)Provisional Directors—some statutes allow them to be
appointed by court if the board is deadlocked and corporate business is
endangered. a provisional dir serves until the deadlock is broken or
until removed by a court order or by majority of shs.
e)Voting Agreements—an agreement in advance among dirs as
to how they will vote is void as contrary to public policy. There are
certain exceptions for statutory close corps.
4.COMPENSATION—dirs are NOT entitled to compensation unless
they render extraordinary services or such compensation is otherwise
provided for. Officers are entitled to reasonable compensation for
5.DIRECTORS’ RIGHTS, DUTIES, AND LIABILITIES
a)Right to Inspect Corporate Records—if done in good
faith for purposes germane to his position as dir, this right is
b)Duty of Care—dirs must exercise the care of an
ordinarily prudent and diligent person in a like position, under similar
circumstances. There is no liability (absent a conflict of interest, bad
faith, illegality, or gross negligence) for errors of judgment (business
judgment rule—the rebuttable presumption that action was taken on an
informed basis, in good faith and exercising reasonable care), but the
dir must have been reasonably diligent before the rule can be invoked
1)The duty of care requires:
I)Education—a dir should acquire at least a
rudimentary understanding of the business of the corporation;
ii)Information—a dir is under a continuing
obligation to keep informed about the activities of the corp;
iii)Participation—dirs must “generally monitor”
corporate affairs, but need NOT involve themselves in the day-to-day
operations; (i.e. they should attend board of dirs meetings with
iiii)Inquiry—a dir has a duty to inquire when
circumstances would alert a reasonable person for the need of inquiry.
iiiii)Action—where wrongdoing is revealed, a dir
should object, correct, or resign. Object to the course of conduct,
steer toward correction, and resign if it isn’t corrected.
2)Extent of liability—dirs are personally liable for
corporate losses directly resulting from their breach of duty or
negligence in falling to discover wrongdoing. a director may seek to
avoid being held personally liable for acts of the board by recording
I)Many statutes permit the articles to abolish or
limit dir’s liability for breach of the duty of care absent bad faith,
intentional misconduct, or knowing violation of law.
3)Defenses to liability—these include good faith
reliance on management or expert’s reports. Disabilities may be
considered in determining whether the dir has met the standard of care.
c)Duty of Loyalty—a catch-all duty designed to prevent
unfairness—the duty to act in good faith (BJR applies). Application:
(1)early absolute prohibition against
self-dealing renders transactions void or
(2)permissive self-dealing: dirs and officers
may contract with the corp if (a)done in
“strictest good faith.”; (b)with full disclosure; and (c)consent of “all
—burden of proof is on the dir to
establish good faith, honesty & fairness;
—courts weigh self-dealing transactions
with “closest scrutiny”
(3)self-dealing prohibition also applies to
intercorporate transactions where dirs
(1)quasi-safe harbor approach (Iowa
statute)—transaction is not void or voidable
because of dirs’ interest, if either:
—interest is disclosed and approval is
made without counting the vote of the
—interest is disclosed to shs and shs
—transaction is fair and reasonable
(2)Note—dir must still establish that he acted
in good faith, honesty, and fairness
2)Domination of subsidiary by parent—courts look at
the transaction to see if self-dealing has occurred. Example (Sinclair
I)declaration of dividends shared pro rata was NOT
self-dealing; BJR applies
ii)contract between parent and sub was
self-dealing; apply intrinsic fairness test
I)Ordinary corporations—conflicts are inevitable
but all firms need to set compensation. The burden of proof is placed on
challengers as a matter of convenience.
ii)Close corporations—the income generated by the
firm may be diverted to salaries, so there is an option for self-dealing
by the parties in control to take tax-advantaged compensation in the
form of salaries (taxed once) as opposed to dividends (taxed twice).
d)Statutory Duties and Liabilities—in addition to general
duty of care, federal and state laws also impose certain duties and
liabilities, e.g., registration requirements under the Securities Act of
1933, liability for rule 10b-5 violations, liability for illegal
dividends. Some statutes also impose criminal liability on corporate
managers for unlawful corporate actions.
1.ELECTION—officers are usually elected by the board of dirs.
Some statutes permit election of officers by shs.
2.AUTHORITY OF CORPORATE OFFICERS (liability of corp to
outsiders)—only authorized officers can bind the corp. Authority may
be: actual (expressed in bylaws or by valid board resolution), apparent
(corp gives third parties reason to believe authority exists), or power
of position (inherent to position). If ratified by the board, even
unauthorized acts can bind the corp.
a)Authority of President—the majority rule is that the
president has the power to bind the corp in transactions arising in
regular course of business.
3.DUTIES OF CORPORATE OFFICERS—the duty of care owed by a
officer is similar to that owed by dirs ( and sometimes higher).
D.CONFLICTS OF INTEREST IN CORPORATE TRANSACTIONS.
1.DUTY OF LOYALTY—because of their fiduciary relationship
with the corp, officers and dirs have the duty to promote the interests
of the corp without regard for personal gain.
2.BUSINESS DEALINGS WITH THE CORPORATION—conflict of interest
issues arise when a corp transacts business with one of its officers or
dirs, or with a company in which an officer or dir is financially
a)Effect of Self-Interest on Right to Participate in
Meeting—most statutes permit an “interested” dir to be counted toward
quorum, and interested dir’s transactions are NOT automatically voidable
by the corp because the interested dir’s vote was necessary for
b)Voidability Because of Director’s Self-Interest—today,
such transactions are voidable only if unfair to the corporation. The
burden of establishing fairness is on the interested director. Note that
a dir’s failure to fully disclose material facts may be per se unfair.
1)Unanimous shareholder ratification—if, after full
disclosure, shareholder ratification is unanimous, the corp will be
estopped from challenging the transaction with the interested dir
(except at to creditors).
I)Less-than-unanimous ratification—courts then
will look at whether the majority shares were owned or controlled by the
interested director. Courts are more likely to uphold ratification by a
disinterested majority so as to preclude the transaction from being
attacked by the corp or by a sh in a derivative suit.
2)Statutes—most statutes provide that such
transactions are NOT voidable if: (1)approved, after full disclosure, by
a disinterested board majority or by majority of shs, or (2)the
transaction is fair to the corp notwithstanding disclosure.
I)”Interested”—an “interested” dir or officer is
one who has a business, financial, or familial relationship with a party
to the transaction that would reasonably affect the person’s judgment so
as to adversely affect the corp.
c)Remedies—the corp may rescind, or affirm and sue for
3.INTERLOCKING DIRECTORATES—generally, transactions between
corps with common dirs are subject to the same rules of interested
director transactions. There is no conflict of interest if one corp is
the wholly owned subsidiary of the other. However, a question of
fairness arises where the parent owns only a majority of the
4.CORPORATE OPPORTUNITY DOCTRINE (Also see duty of loyalty)
a)Definition—COD bars dirs from taking any business
opportunity belonging to the corp without first offering it to the
corp.. If the corp is unwilling to pursue an opportunity (after an
independent board is fully informed of the opportunity), then the dir
may pursue it.
b)Defenses (available in most, but not all jurisdictions):
1)Inability—If the corp is legally or financially
unable to take the opportunity, then the dir generally may take
advantage of it. (But the question of who caused the financial inability
is quite relevant. Example: Irving Trust Co—the defense of inability
2)Rejection, abandonment, or approval—then the
fiduciary has a valid defense.
c)Remedies—constructive trust or damages—the fiduciary
must account to the firm for all the profits he has made as a result of
d)Definition of a Corporate Opportunity:
1)Line of business test—does the firm have fundamental
knowledge, practical experience, and ability to pursue the opportunity?
If yes, then it is within the firm’s line of business. It should be a
natural fit, and not a mere desire by a firm to pursue the opportunity.
e)Application—Guth Rule and Corollary:
1)Guth rule (offered in corporate capacity)—if there
is presented to O/D a business opportunity which the corp is
(1)financially able to undertake, which is from its nature (2a) in the
line of business and is of practical advantage to it OR (2b)is one in
which the corp has an interest or reasonable expectancy (under an
established corporate policy or plan), and, (3)by embracing the
opportunity the self-interest of the dir will be brought into conflict
with that of his corp, then officer or dir may NOT take the opportunity.
2)Guth corollary (a safe harbor; satisfy all provisions
and dir can take)—if a business opportunity (1)comes to O/D in his
individual capacity and (2) is not essential to the corp and is (3)one
in which corp has no interest or expectancy, then the O/D can treat it
as his own, IF he has not taken corporate resources to pursue the
I)”Essential”—indispensably necessary to the
continued viability of the firm;
ii)Individual or corporate? Look at O/D capacity to
determine how offer was made
5.COMPETING WITH CORPORATION—such competition by a dir or
officer may be a breach of fiduciary duty even when the competing
business is not a corporate opportunity
6.COMPENSATION FOR SERVICES TO THE CORPORATION—the
compensation plan must be duly authorized by the board, and its terms
must be reasonable. Good faith and the BJR ordinarily protect
disinterested dirs from liability to the corp for approving
a)Publicly Held Corporations—The SEC has authorized shs
to make proposals about executive pay in management’s proxy statements.
Further, the tax code now limits expense deductions for executive pay
over $1mln, unless it is tied to the corp’s performance.
b)Past and Future Services—compensation for past services
is generally invalid. Compensation for future services is proper if
there is reasonable assurance that the corp will receive the benefit of
VI.INSIDER TRADING—purchase or sale of securities by someone with
access to material
nonpublic information. It may be illegal. It affects corps with more
than $1 mln in total assets and with at least 500/750 shs.
a)Who may be hurt by insider trading:
1)Target shareholders—they sell too early;
2)Other arbitrageurs—they lose a portion of the gain
that they make from honest effort
3)Other issuers—they lose confidence in the stock
4)The acquiring company—insider trading drives up
their cost of acquisition, since the target may adopt defensive measures
otherwise not in place.
b)Possible Sources of Liability:
3)10b-5 misappropriation theory (O’Hagan);
4)Mail or wire fraud;
6)Statutory liability under 16(b)—insiders are forced
to give their profits to the corp, if the y buy and sell securities
within a 6-month period regardless of whether they are using insider
info. (Need to know 2, 3, 6)
c)O’Hagan—insider trading violation where a partner in
law firm took info rom his firm regarding the firm’s client’s plans for
acquisition of Pillsbury and used that info to buy shares in Pillsbury
d)Penalties For Insider Trading—ITSA (Insider Trading
Sanctions Act)—3 measures:
1)Out-of-pocket measure—if a sh buys a share for $10,
while in fact it costs $9, his out-of-pocket expense is $1.
2)Causation-in-fact—because an insider engaged in
insider trading, it caused a loss
3)Disgorgement—we look at D’s profit. ITSA measures
the damage to sh by the amount of profit that D received from the
2)SEC civil penalties—treble damages; SEC may seek
penalty capped by three times profit gained or loss avoided.
A.COMMON LAW—under the majority rule, there was no duty to
disclose to the shs inside info affecting the value of shares.
Therefore, the protection of investors was very weak.
a)For lability to exist there should be:
1)At least fraud or deceit upon purchasers;
2)May also be a device or scheme;
3)May also be an implied misrepresentation.
b)Two Elements (relationship and unfairness):
1)Relationship—existence of a relationship giving
access, directly or indirectly, to information
intended to be available for a corporate purpose and no other.
I)Insiders include at least officers, dirs,
controlling shs (In re Cady Roberts)
ii)Persons charged with confidentiality by
contractual or fiduciary relationship
2)Unfairness—inherent unfairness that results when a
party takes advantage of such information knowing it is unavailable to
person with whom he is dealing.
B.SECURITIES EXCHANGE ACT OF 1934—IN GENERAL—the act superseded
common law. Section 12 of the Act requires registration of any security
traded on a national exchange, or any equity security (held by 500 or
more persons) of a corp with assets exceeding $5 million.
C.SECTION 10(B) AND RULE 10B-5—section 10(b) prohibits any
manipulation or deception in the purchase or sale of any security,
whether or not it’s registered. Rule 10b-5 prohibits the use of the
mails or other instrumentality of interstate commerce to defraud,
misrepresent, or omit a material fact in connection with a purchase or
sale of any security.
1.COVERED CONDUCT—rule 10b-5 applies to nondisclosure by dirs
or officers, as well as to misrepresentations. It applies not only to
insider trading but also to any person who makes a misrepresentation in
connection with a purchase or sale of stock.
2.COVERED SECURITIES—rule 10b-5 applies to the purchase or
sale of any security, registered or unregistered. a jurisdictional
limitation requires that the violation must involve the use of some
instrumentality of interstate commerce.
3.WHO CAN BRING SUIT UNDER 10B-5—private plaintiffs and the
SEC. Private plaintiffs must be either purchasers or sellers of
4.MATERIALITY—for rule 10b-5 to apply, the information
misrepresented or omitted must be material (i.e., a reasonable sh would
consider it important in deciding whether to buy or to sell).
5.FAULT REQUIRED (SCIENTER)—a defendant is not liable under
rule 10b-5 if he was without fault or merely negligent. The scienter
requirement is satisfied by recklessness or an intent to deceive,
mislead, or convey a false impression. Scienter is also required for
1)D knew the hazard and proceeded nonetheless
2)D proceeded despite what a reasonable person would
perceive (objective test);
b)Recklessness Under PSLRA:
1)Knowing conduct— yields jointly and severally
2)Non-knowing conduct (e.g., recklessness)—yields fair
share (proportionate liability), found in accordance with special
6.CAUSATION AND RELIANCE—a plaintiff must prove that
violation caused a loss (i.e., he must establish reliance on the
wrongful statement or omission). However, in omission cases, there is a
rebuttable presumption of reliance once materiality is established.
a)Fraud On The Market—where securities are traded on a
well-developed market (rather than in a face-to-face transaction),
reliance on a misrepresentation may be shown by alleging reliance on the
integrity of the market.
b)Face-to-Face Misrepresentations—a plaintiff can show
actual reliance in these cases by showing that the misrepresentation was
material, testifying that he relied upon it, and showing that he traded
soon after misrepresentation.
7.WHEN NONDISCLOSURE CONSTITUTES a VIOLATION
a)Mere Possession of Material Information—generally,
nondisclosure of material, nonpublic information violates rule 10b-5
only when there is a duty to disclose independent of rule 10b-5
b)Insider Trading—insiders (dirs, officers, controlling
shs and corporate employees) violate rule 10b-5 by trading on the basis
of material, nonpublic info obtained through their positions. They have
a duty to disclose before trading.
c)Misappropriation—the liability of noninsiders who
wrongfully acquire (misappropriate) material nonpublic info has not been
ruled upon by the US Supreme Court, although some lower level federal
courts have imposed criminal liability.
1)Duty to Employer—using the misappropriation theory,
criminal liability under rule 10b-5 has been imposed where an employee
trades on info used in violation of the employee’s fiduciary duty to his
employer. An employee’s duty to “abstain or disclose” with respect to
his ER does NOT extend to the general public. However, the Insider
Trading and Securities Fraud Enforcement Act of 1988 makes any person
who violates rule 10b-5 by trading while in possession of material,
nonpublic info liable to any person who, contemporaneously to the
transaction, purchased or sold securities of the same class. Liability
is limited to the defendant’s profit or avoided loss.
2)Mail and wire fraud—the application of the federal
mail and wire fraud statute to this situation lessens the importance of
the misappropriation theory in imposing criminal liability under rule
3)Special rule for tender offers—once substantial
steps toward making a tender offer have begun, it is a fraudulent,
deceptive, or manipulative act for a person possessing material
information about the tender offer to purchase or sell any of the
target’s stock, if that person knows that the info is nonpublic and has
been acquired from the bidder, the target, or someone acting on the
bidder’s or the target’s behalf.
d)”Disclose or Abstain”—nondisclosure by a person with a
duty to disclose violates rule 10b-5 only if he trades (Cady rule)
8.LIABILITY OF NONTRADING PERSONS FOR MISREPRESENTATION—a
nontrading corp or person who makes a misrepresentation that could cause
reasonable investors to rely thereon in the purchase or sale of
securities is liable under rule 10b-5, provided the scienter requirement
9.LIABILITY OF NONTRADING CORPORATION FOR NONDISCLOSURE—the
basic principle is “disclose or abstain.” Thus, a nontrading corp is
generally not liable under rule 10b-5 for nondisclosure of material
a)Exceptions—a corp has a duty to:
1)Correct misleading statements (even if
2)Update statements that have become materially
misleading by subsequent events; 3)Correct
material errors in statements by others (e.g, analyst’s report) about
the corp, but only if the corp was involved in the preparation of the
4)Correct inaccurate rumors resulting from leaks by the
corp or its agents.
10.TIPPEE AND TIPPER LIABILITY—a person, not an insider, who
trades on info received from an insider is a tippee and may be liable
under rule 10b-5 if he received info through an insider who breached
fiduciary duty in giving the info, AND the tippee knew or should have
known of the breach (Dirks)
a)Breach of Insider’s Fiduciary Duty—whether an insider’s
fiduciary duty was breached depends largely on whether the insider
communicated the info to realize the gain or advantage. Accordingly,
tips to friends or relatives and tips that are a quid pro quo for a past
or future benefit from the tippee result in fiduciary breach. Note that
if a tippee is liable, so is the tipper.
11.”TEMPORARY INSIDERS”—corporate info legitimately revealed
to a professional or consultant (e.g., accountant) working for the corp
may make this person a fiduciary of corp
12.AIDERS AND ABETTORS—liability cannot be imposed solely
because a person aided and abetted the violation of the rule.
13.APPLICATION OF RULE 10B-5 TO BREACH OF FIDUCIARY DUTY BY
DIRECTORS, OFFICERS, AND CONTROLLING SHAREHOLDERS.
a)Ordinary Mismanagement—a breach of fiduciary duty not
involving misrepresentation, nondisclosure, or manipulation does NOT
violate rule 10b-5;
b)Misrepresentation or Nondisclosure—if this is the basis
of a purchase from or sale to the corp by a dir or officer, the corp can
sue the fiduciary under rule 10b-5 and also for breach of fiduciary
duty. If the corp doesn’t sue, a minority sh can maintain a derivative
suit on the corporations behalf.
c)Purchase or Sale By Controlling Shareholder—when a corp
purchases stock from or sells stock to a controlling sh at an unfair
price, and material facts aren’t disclosed to minority shs, a derivative
action may lie if the nondisclosure caused a loss to the minority shs.
The plaintiffs must establish causation by showing that an effective
state remedy (e.g., injunction) was foregone because of nondisclosure.
14.BLUE CHIP RULE—PRIVATE PLAINTIFF—a plaintiff can bring a
private cause of action only if he actually purchased or sold the
relevant securities. “Sale” includes an exchange of stock for assets,
mergers and liquidations, contracts to sell stock, and pledges. The SEC
can bring action under rule 10b-5 even though it has neither purchased
or sold securities.
a)Due Diligence—if a plaintiff’s reliance on a
misrepresentation or omitted fact could have been prevented by his
exercise of due diligence, recovery may be barred. Mere negligence does
NOT constitute a lack of due diligence, although a plaintiff’s
intentional misconduct and his own recklessness (if D was merely
reckless) will bar recovery.
b)In pari delicto—a private suit for damages under rule
10b-5 will be barred if:
1)The plaintiff bears substantially equal
responsibility for the violations, AND
2)Preclusion of the suit would not significantly
interfere with the enforcement of securities law.
a)Out-of-pocket Damages—this is the difference between
the price paid for stock and its actual value.
1)Compare—benefit-of-the-bargain damages—these are
measured by the value of the stock as it really is and the value it
would have had if a misrepresentation had been true.
2)Standard measure of conventional
damages—out-of-pocket damages is the standard measure in private
actions under rule 10b-5; benefit-of-the-bargain damages are usually not
b)Restitutionary Relief—this may be sought instead of
1)Rescission—returns the parties to their status quo
before the transaction
2)Rescissionary or Restitutionary damages—money
equivalent of rescission
3)Difference between conventional damages and
Restitutionary relief—out-of-pocket damages are based on the P’s loss,
while Restitutionary relief is based on the D’s wrongful gain.
Rescission or Rescissionary damages may be attractive remedies when the
value of the stock changed radically after the transaction. However,
Restitutionary relief is usually unavailable in cases involving publicly
c)Remedies Available to the Government—although the SEC
cannot sue for damages, it can pursue several remedies including special
1)Injunctive Relief—the SEC often seeks injunctive
relief accompanied with a request for disgorgement of profits or other
payments that can be subject to criminal sanctions (fines and jail
sentences) and civil penalties (up to three times the profit gained or
17.JURISDICTION, VENUE, AND SERVICE OF PROCESS—suits under
10b-5 are based on the 1934 Act, and exclusive jurisdiction is in the
federal district courts. State claims arising out of the same
transactions may be joined with the federal claim under the supplemental
jurisdiction doctrine. Venue can be wherever any act or transaction
constituting a violation occurred, or where the D is found or transacts
business. Process can be served where the D can be found or where he
18.STATUTE OF LIMITATIONS—the 1934 Act contains no SOL;
however, the SCt has held that private actions must be brought within
one year after discovery of the relevant facts and within three years
following accrual of the cause of action. The tolling doctrine is
a)Exceptions—the time limitations don’t apply to all rule
10b-5 private actions, e.g., SEC limitations period of five years for
private suits by contemporaneous traders against purchasers or sellers
who violate rules regarding trades while in possession of material,
nonpublic information. Further, the SEC is not subject to any
limitations period in civil enforcement actions.
D.SECTION 16 OF THE 1934 ACT—Section 16 concerns purchases
followed by sales, or sales followed by purchases, by certain insiders,
within a six-month period.
1.FIRMS AND SECURITIES AFFECTED UNDER SECTION 16—Section 16
applies to those firms and securities that must be registered under
section 12 of the 1934 act.
a)Reason—16(a) references registered securities under
S12; S12(a) and 12(g) create the registration requirement for
securities; S12(g)creates an asset ($1 mln total) and distribution (500
to 700 depending on timing); 16(b) references “such” officers, etc.,
which refers to sub(a)
b)Note—trading in all of a corp’s equity securities is
subject to section 16 if any class of its securities is registered under
2.DISCLOSURE REQUIREMENT—Section 16(a) requires every
beneficial owner of more than 10% of the registered stock and directors
and officers of the issuing corp to file periodic reports with the SEC
showing their holdings and any changes in their holdings.
a)Who is an Officer (16a-1f)—issuer’s president,
principal financial director, principal accounting officer, any
vice-president of the issuer in charge of a principal business unit, any
other officer who performs similar policy-making functions for the
3.LIABILITY—to prevent the unfair use of information, section
16(b) allows a corp to recover profits made by an officer, dir, or
more-than-10% beneficial owner on the purchase and sale or sale and
purchase of its securities within a six-month period.
a)Coverage—Section 16(b) does NOT cover all insider
trading and is NOT limited to trades based on inside info. The critical
element is short-swing trading by officers, dirs, and more-than-10%
1)Note—beneficial owner must own 10% or more BOTH at
he time of sale and purchase to be liable under 16(b).
b)Calculation of short-swing profit—the profit
recoverable is the difference between the price of the stock sold and
the price of the stock purchased within six month before or after the
1)Multiple transactions—if there is more than one
purchase or sale transaction within the six-month period, the
transactions are paired by matching the highest sale price with the
lowest purchase price, the next highest price with the next lowest
price, etc. a court can look six month forward or backward from any sale
to find a purchase, or from any purchase to find a sale
c)Who May Recover—the profit belongs to the corp alone.
Although not a typical derivative action, if the corp fails to sue after
a demand by a sh, the sh may sue on the corp’s behalf. The cause of
action is federal, so there is no posting of security requirement, and
no contemporaneous sh requirement. Remedy:
1)All sales and purchases within 6 months are included;
2)Damages calculated as to maximize the gain to he
3)Match highest sale price against lowest purchase
price within relevant period; continue until you can go no further.
d)Insiders—insiders are officers (named officers and
those persons functioning as officers), dirs (actually serving or who
authorized deputization of another), and beneficial owners of more than
10% of the shares. Insider status for officers and dirs is determined at
the time they made a purchase or sale. Transactions made before taking
office is NOT within section 16(b), but those made after leaving office
are subject to the statute if they can be matched with a transaction
made while in office. Liability is imposed on a beneficial owner only if
he owned more than 10% of the shares at the time of both the purchase
e)”Purchase or Sale”—this includes any purchase of stock.
Unorthodox transactions that result in the acquisition or deposition of
stock (e.g., merger for stock, redemption of stock) are also purchases
E.SECTION 16(B) COMPARED TO RULE 10B-5:
a)Covered Securities—Section 16(b) applies to securities
registered under the 1934 act; rule 10b-5 applies to all securities.
b)Inside Information—Section 16(b) allows recovery for
short-swing profits regardless of whether they are attributable to
misrepresentations or inside info; rule 10b-5 recovery is available only
where there was a misrepresentation or a trade based on inside info.
c)Plaintiff—recovery under section 16(b) belongs to the
corp, while rule 10b-5 recovery belongs to the injured purchaser or
d)Overlapping Liability—it is possible that insiders who
make short-swing profits by use of inside info could be liable under
both section 16(b) and rule 10b-5.
F.COMMON LAW LIABILITY FOR INSIDER TRADING—insider trading
constitutes breach of fiduciary duties owed to the corp, so the corp can
recover profits made from insider trading
a)Common Law Liability Compared To Section 16(b)
Liability—both common law and section 16(b) liability run against
insiders and in favor of the corp. However, unlike section 16(b), the
common law theory applies to all corps (not just those with registered
securities), recovery can be had against any corporate insider, the
purchase and sale is NOT limited by a six-month period, and the
transaction must be based on the inside info.
b)Common Law Liability Compared to Rule 10b-5
Liability—the theories of recovery are similar except that under the
common law recovery runs to the corp (not to the injured purchaser or
seller), there is no purchaser or seller requirement, and noninsiders
(tippees) have not yet been held liable.
VII.RIGHTS OF SHAREHOLDERS
1.RIGHT TO VOTE IN GENERAL—shs may generally vote for the
election and removal of dirs, to amend the articles or bylaws, and on
major corporate action or fundamental changes.
a)Who May Vote—the right to vote is held by shs of record
as of the record date;
b)Restrictions on Right—shares may be either voting or
nonvoting, or have multiple votes per share.
2.SHAREHOLDER MEETINGS—generally, shs can act only at
meetings duly called and noticed at which a quorum is present.
a)Compare—informal action—statutes permit sh action
without a meeting if there is unanimous written consent of all shs
entitled to vote.
a)Straight Voting—this system of voting allows one vote
for each share held and applies to all matters other than director
elections, which may be subject to cumulative voting. Certain
fundamental changes (e.g., merger) frequently require higher shareholder
b)Cumulative Voting For Director—this system allows each
share one vote for each director to be elected, and the votes may be
cast all for one candidate or divided among candidates as the sh
chooses, thereby helping minority shs to elect a dir. Cumulative voting
may be mandatory or permissive.
4.VOTING BY PROXY—a proxy authorizes another person to vote a
shareholder’s shares. The proxy usually must be in writing, and its
effective period is statutorily limited unless it is validly
a)Revocability—a proxy is normally revocable by the sh at
any time, although it may be made irrevocable if expressly stated and
coupled with an interest in the shares themselves. Absent written notice
to the corp, the death or incapacity of a sh does NOT revoke a proxy. a
sh may revoke a proxy by notifying the proxy holder, giving a new proxy
to someone else, or by personally attending the meeting and voting.
b)Proxy Solicitation—almost all shs of publicly held
corps vote by proxy. Solicitations of proxies are regulated by the
Securities Exchanges Act of 1934 Section 14a, federal proxy rules and,
in some cases, state law. Federal proxy rules apply to the solicitation
of all proxies of registered securities, but NOT to nonmanagement
solicitation of 10 or fewer shs. The term “solicitation” is broadly
interpreted by the SEC to include any part of a plan leading to a formal
solicitation, e.g., inspection of shareholder list.
1)1992 amendments—the SEC revised the proxy rules to
make it easier for shs to communicate with each other. Significant
changes include: a safe harbor for communications that don’t involve
solicitation of voting authority, relaxation of requirements involving
broadcast of published communications, relaxed preliminary filing
requirements for solicitations, and removing communications between shs
concerning proxy voting from definition of “solicitation.”
2)Requirement of Full Disclosure—the proxy rules
require full and accurate disclosure of all pertinent facts and the
identities of all proxy participants, disclosure of compensation paid to
certain officers and dirs, and disclosure of conflict-of-interest
transactions involving more than $60, 000.
3)Inclusion of Shareholder Proposal—shareholder
proposals must be included in corporate proxy materials if the proponent
is a record owner or beneficial owner of at least 1% or $1000 worth of
securities entitled to vote on the matter. The proposal must not exceed
I)Exceptions—a proposal need NOT be included if
it: is not a proper subject for shareholder action, would be illegal, is
false or misleading, seeks redress of a personal claim, relates to
operations accounting to less than 5% of the corp’s total assets and is
not otherwise related to the corp’s business, concerns a matter beyond
the corp’s power to effectuate, relates to ordinary business
operations, relates to an election to office, is counter to a proposal
submitted by the corp at the same meeting, is moot or duplicate, deals
with the same subject matter as a very unsuccessful prior proposal, or
relates to specific amounts of cash or stock dividends.
ii)Private right of action—a private right of
action is available to a sh whose proposal was rejected by the corp on
the ground that it fails within one of the exceptions.
iii)Providing shareholder lists—a sh has a right
to obtain a list of shs or to have his communication included with the
corporate proxy materials.
4)Remedies for violation of proxy rules—these include
suit by the SEC to enjoin violations or to set aside an election and
individual suits, class actions, or derivative suits by the shs (In a
private suit, the P must show materiality and causation, but causation
is normally presumed from materiality. Fairness to the corp is NOT a
defense to a violation of proxy rules ). The court may rescind corporate
action resulting from a misleading proxy solicitation or award damages.
c)Expenses Incurred In Proxy Contests—corporate funds may
be used by management with respect to reasonable proxy solicitation
expenses incurred in order to obtain a quorum for the annual meeting or
regarding controversy over corporate policy (as opposed to a personnel
controversy). The corp may, with sh approval, voluntarily pay the
reasonable expenses to insurgents who win a proxy contest involving
5.OTHER METHODS TO COMBINE VOTES FOR CONTROL (CLOSE
CORPORATIONS)—other methods include shareholder voting agreements which
may be enforced by specific performance, agreements regarding
greater-than-majority approval, shareholder agreements binding the
discretion of dirs, and voting trusts.
B.RESTRICTIONS ON TRANSFER OF SHARES—although most frequently used
in close corps, stock transfer restrictions may also be imposed by
larger corps (e.g., to restrict ownership to employees). The two most
common types of restriction are a right of first refusal and a mandatory
sell-buy provision. Restrictions must be reasonable and will be strictly
a)Notice Requirements—a lawful stock transfer restriction
is of no effect unless noted conspicuously on the stock certificate. If
there is no such notice, an innocent transferee is entitled ti have the
shares transferred to him.
C.SHAREHOLDERS’ INFORMATIONAL RIGHTS:
1.TYPES OF BOOKS AND RECORDS—these include shareholder lists,
minutes, financial records, and business documents.
2.COMMON LAW—at CL, a sh has a right to inspect records for
3.STATUTES—statutes govern these rights in most states. Many
statutes apply only to certain shs but are usually interpreted to
supplement the common law. Most statutes preserve the proper purpose
test, but place the burden on the corp to prove improper purpose.
4.PROPER VERSUS IMPROPER PURPOSES—the test is whether the sh
is seeking to protect the sh interest. Multiple purposes that include a
proper one usually will not preclude inspection. Generally, a sh can
inspect the sh list because it is often necessary to the exercise of
other rights like proxy fights, sh litigation, etc. Inspection of a sh
list for proxy contest is a proper purpose. However, it has been held
that corporate records cannot be examined solely for the purpose of
advancing political and social views or to aid a sh as a litigant on a
personal, non-shareholder claim.
5.COMPARE—MANDATORY DISCLOSURE OF INFORMATION—a sh’s
inspection right is separate and distinct from the statutory
requirements governing the affirmative disclosure of certain information
by corps (e.g., Section 12 of Securities Exchange Act of 1934, proxy
rules, state statutes).
D.FIDUCIARY OBLIGATIONS OF CONTROLLING SHAREHOLDERS—a controlling
sh owes a fiduciary duty in his business dealings with the corp, in
taking advantage of corp opportunities (rules more lenient than those
applied to dirs and officers), and in causing fundamental changes.
1.ACTIONS ENTIRELY IN SHAREHOLDER CAPACITY—a controlling sh
must NOT act to benefit himself at the expense of the minority shs;
i.e., in a transaction where control of the corp is material, he must
act with good faith and inherent fairness toward the minority.
2.OBLIGATIONS OF SHAREHOLDERS IN CLOSE CORPORATIONS—both
majority and minority shs owe each other an even stricter duty (utmost
good faith and loyalty) than is owed by controlling shs in publicly held
corps. This duty has been interpreted to mean that there must be equal
treatment of all shs, i.e., they must be afforded equal opportunities.
3.DISCLOSURE—a controlling sh must make full disclosure when
dealing with minority shs.
4.SALE OF CONTROL—in most jurisdictions, a controlling sh is
permitted to sell his stock at a premium, i.e, a price not available to
other shs. Exceptions to these rule include a bare sale of office
(invalid), the corporate action theory, sales involving fraud or
nondisclosure, and knowing sales to transferees who plan to loot or deal
unfairly with the corp.
1.DIRECT (INDIVIDUAL) SUITS—a direct suit may be brought by a
sh on his own behalf for injuries to sh interests. If the injury affects
a number of shs, the suit may be brought as a class action.
2.DERIVATIVE SUITS—if a duty owed to the corp has been
abridged, suit may be brought by a sh on behalf of the corp.
a)Distinguish Direct From Derivative Suits—the test is
whether the injury was suffered by the corp directly or by the sh, and
to whom the D’s duty was owed
1)Close corporations—in some cases, minority shs have
been allowed to bring a direct action against controlling shs for breach
of fiduciary duty
b)Prerequisite to Suit—Exhaustion of Corporate
Remedies—the P-sh must specifically plead and prove that he exhausted
his remedies within the corporate structure
1)Demand on directors—the P-sh must make a demand on
the dirs to remedy the wrong, unless such demand would have been futile.
Note that in the absence of negligence, self-interest, or bias, the fact
that a majority of dirs approved the transaction does NOT itself excuse
I)Model statutes—under both model statutes, demand
should be excused only if it is shown that irreparable injury to the
corp would result;
ii)Effect of rejection of demand—if the matter
complained of does not involve wrongdoing by the dirs, the board’s good
faith refusal to sue bars the action, unless the P-sh can raise a
reasonable doubt that the board exercised reasonable business judgment
in declining to sue. If the suit alleges wrongdoing by a majority of
dirs, the board’s decision not to sue will NOT prevent the derivative
2)Demand on shareholders—in most states, the p-sh must
also make a demand on shs unless excused (e.g., the alleged wrongdoing
is beyond the power of the shs to ratify). Where demand on shs is
required, a good faith refusal to sue by the majority of disinterested
shs will preclude the suit.
c)Qualifications of Plaintiff—a few states require the P
to be a registered sh; most states also allow a beneficial owner of
shares to bring suit. Also, a sh of a parent corp can bring a derivative
suit on a subsidiary’s cause of action. Shs cannot complain of wrongs
committed before they purchased their shares except:
1)where the P acquires shares by operation of law;
2)in section 16(b) violations;
3)where serious injustice will result;
4)where the wrong is continuing in nature.
The P must fairly and adequately represent the interests of all shs
d)Securities For Expenses—in a number of states, the P,
under certain circumstances, must post a bond to indemnify the corp
against certain of its litigation expenses, including attorney’s fees,
in the event the P loses the suit. a p-sh who loses may also be liable
for the court costs incurred by the parties.
e)Defenses—defenses to derivative suit include the SOL
and equitable defenses (laches, unclean hands, etc);
f)Settlement And Recovery—any settlement or judgment
belongs to the corp, absent special circumstances. Settlement or
dismissal of the suit is generally subject to court approval after
notice to all shs.
g)Reimbursement to Plaintiff—a victorious plaintiff may
be entitled to reimbursement from the corp for litigation expenses;
h)Indemnification of Officers And
Directors—indemnification issues arise when officers and dirs are sued
for conduct undertaken in their official capacity. If the officer or dir
wins on the merits, he may be indemnified. Most statutes also authorize
the corp to advance (not pay) expenses in defending against the claim.
Statutes vary where the officer or dir settles or loses; they are most
liberal concerning indemnification in a third-party suit as opposed to a
I)Liability Insurance—in most states, a corp can obtain
liability insurance for its indemnification costs and for any liability
incurred by its officers in serving the corporation.