Business associations
BUSINESS
ASSOCIATIONS
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 investment;
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 perpetual existence;
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;
2)Limited liability;
3)Forever (perpetual duration);
4)Freely alienable (shares can be sold).
B.CORPORATIONS DISTINGUISHED FROM OTHER FORMS OF
BUSINESS ASSOCIATIONS.
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
p’ships;
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 any partner.
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 management.
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 p’ship.
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 liability).
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
obligations.
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 “agent”
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 ego)
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 sought.
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;
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 requirements.
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;
2)Good faith;
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 unsettled issue.
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 promoters themselves.
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 successor.
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 business;
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.
B.AGENCY
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 undertaking.
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 things:
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 business.
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
arise.
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 proper
purposes.
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.
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 their concern.
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.
B.DIRECTORS
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
services.
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 absolute.
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 (Shlensky)
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
reasonable regularity).
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 his dissent.
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)Self-dealing transactions
I)Common Law:
(1)early absolute prohibition
against self-dealing renders transactions void or voidable;
(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 concerned.”
[1]--burden of proof is on the
dir to establish good faith, honesty & fairness;
[2]--courts weigh self-dealing
transactions with “closest scrutiny”
(3)self-dealing prohibition also
applies to intercorporate transactions where
dirs are common.
ii)Statutory (example):
(1)quasi-safe harbor approach (Iowa
statute)--transaction is not void or voidable
because of dirs’ interest, if either:
[1]--interest is disclosed and
approval is made without counting the vote of
the interested dir.
[2]--interest is disclosed to
shs and shs authorize
[3]--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
Oil):
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
3)Manager’s compensation:
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.
C.OFFICERS
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.
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
interested.
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
approval.
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 damages.
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 subsidiary’s shares.
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 was rejected).
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 usurpation.
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.
2)Interest/expectancy test
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
opportunity.
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 compensation.
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 the services.
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 market
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:
1)Common Law;
2)10b-5 traditional;
3)10b-5 misappropriation theory (O’Hagan);
4)Mail or wire fraud;
5)14e-3;
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 transaction.
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 security.
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
injunctive relief.
a)Recklessness Defined:
1)D knew the hazard and proceeded
nonetheless (subjective test);
2)D proceeded despite what a reasonable
person would perceive (objective test);
1)Knowing conduct-- yields jointly
and severally liable;
2)Non-knowing conduct (e.g.,
recklessness)--yields fair share (proportionate liability), found in accordance
with special interrogatories.
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 10b-5.
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 is
satisfied.
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 facts.
a)Exceptions--a corp has a duty
to:
1)Correct misleading statements
(even if unintentional);
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 statements;
and
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.
15.DEFENSES
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.
16.REMEDIES
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 granted.
b)Restitutionary Relief--this
may be sought instead of conventional damages:
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 held stock.
c)Remedies Available to the Government--although
the SEC cannot sue for damages, it can pursue several remedies including
special monetary remedies:
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
loss avoided).
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 lives.
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 inapplicable.
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 section 12.
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 issuer.
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% beneficial owners.
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
sale.
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 company;
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 and sale.
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 and sales.
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 seller.
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
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
A.VOTING RIGHTS
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.
3.SHAREHOLDER VOTING
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 approval.
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 irrevocable.
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 500 words.
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 policy.
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
construed.
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 proper purpose.
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.
E.SHAREHOLDER SUITS
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 the demand.
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 suit.
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 derivative suit.
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.