Corporations – Fall 2013

Outline

Professor Clarke

Table of Contents

Introduction & Agency Issues

Economics & Legal Aspects of Business Associations

Agency

Partnerships

Introduction

Fiduciary Duty

Dissolution & Disassociation

Statutory Framework

Wrongful Dissociation

Corporations

Introduction

Corporate Roles

Shares & Voting Rights

Shareholder Action

Shareholder Investment & Governance (Publically Held Corporations)

Directors’ Duties & The Business Judgment Rule

Business Judgment Rule

Fiduciary Duty of Loyalty

Fiduciary Duty of Care

Derivative Suits

Overview

Demand Requirement

Aronson Test – Prong 1

Aronson Test – Prong 2

Demand Requirement Analysis

Close Corporations

Contracting as a Device to Limit Majority Discretion

Contracting Regarding Director Decisions

Contracting Regarding Voting

Enhanced Fiduciary Duty and the Partnership Analogy

Share Repurchase Agreements (SRAs)

Limited Liability Corporations

Overview

Planning for the LLC

Fiduciary and Contractual Duties

Overview

Conflicting Interest Transactions

Judicial Dissolution

Third Parties

Introduction

Piercing the Corporate Veil

Introduction

In Contract

In Tort

Where the Shareholders are Corporations

De Facto Incorporation

Veil Piercing Analysis

Acquisitions

Introduction

Statutory Mergers

Sale of Assets

Triangular Mergers

Compulsory Share Exchanges

De Facto Mergers

Cash-Out Mergers

Hostile Takeovers

Overview

Poison Pills

Hostile Takeover Analysis

Federal Law & Insider Trading

Federal Securities Law

Overview

Rule 14a-9 (Proxy Statements)

Rule 10b-5 (Issuance of Securities)

Insider Trading

Insider Trading Analysis

Appendix – Flow Charts

Partnerships – Fiduciary Duty

Partnerships – Dissociation

Business Judgment Rule – General Application

Corporate Opportunities Doctrine – ALI

Corporate Opportunities Doctrine – Guth Test

Conflicting Interest Transactions

Duty of Care

Duty of Good Faith

1

Corporations Outline

Introduction & Agency Issues

Economics & Legal Aspects of Business Associations

-Classical firm: a business that is owned and managed by one person; also known as a sole proprietorship.

  • Sole proprietor: the owner of a classical firm/sole proprietorship.
  • Entrepreneur: a person who organizes and operates a business; has two main tasks that it must do:
  • The entrepreneur directs the business and exercises ultimate business judgment , and
  • The entrepreneur accepts full responsibility for his or her business decisions by being the residual guarantor and claimant (i.e. has unlimited liability).
  • Firm: a set of relations that arise when the entrepreneur allocates resources via commands to his employees.
  • Coasean firm: includes the entrepreneur and his employees, but excludes customers, suppliers, and creditors with whom the entrepreneur does business via contract or market exchanges.

-Business association: a collection of firms that are jointly owned – ranging from two owners (closely held corporation) to thousands of owners (publically traded corporation).

  • Modern corporation: characterized by a complete separation of ownership from control; shareholders own and managers control.
  • Berle-Means Critique: the modern corporation destroyed the theoretical underpinnings of the free enterprise system; the main concern of this critique is the problem of power.
  • The modern firm represents a consensual choice by shareholders (principals) and managers (agents) to cede authority and power over the corporation almost entirely to the managers.
  • Principals may be tempted to shirk responsibilities because they do not have to worry about managing the business.
  • There are ways to limit the cost of principals shirking their duties:
  • Direct monitoring of the managers’ actions,
  • Agreements by managers that will result in the imposition of penalties or other costs if certain objectively verifiable events do or do not occur,
  • Incentive schemes to align managers’ interests with those of the shareholders.
  • But there are costs of these cost-limiting devices as well.
  • So the shareholders’ gain from owning the corporation must be reduced by the sum of: the cost of the cost-limiting devices plus the residual loss from shirking.

-A firm can be described using one of several theories:

  • Nexus of contracts theory: a firm is a nexus of contracts between the various claimants to a share of the gross profits generated by the business.
  • Nexus of patrons theory: everyone who transacts with the firm is a patron, and a select number of patrons are owners who control the business and have a right to profits and the residual.

-The goal of business planning is to minimize the use of litigation as a governance tool while preserving the availability of litigation to deal with circumstances that cannot appropriately be governed by private ordering.

-The goal of informed rational choice between competing investment options is to determine the likely return from alternative investment choices and to choose based on the individual’s risk preference and portfolio diversification.

-In state provided governance structures, such as the employer-employee relationship, the corporation, the partnership, and the LLC, default rules govern the relationship unless the parties provide otherwise.

  • Immutable rules cannot be contracted around.
  • Tailored rules are rules that the parties would have chosen had they been able to bargain over the matter in dispute with zero transaction costs.
  • Majoritarian rules are rules that are designed to provide investors with the result that most similarly-situated parties would prefer.
  • Penalty default rules are rules that are designed to motivate one or more of the contracting parties to contract around the default rules.

Agency

-There are three types of authority that an agent may have to act on behalf of the principal:

  • Actual authority: where the principal manifests consent directly to the agent.
  • Apparent authority: where a third party reasonably believes that the agent is authorized to act on behalf of the principal as a result of the principal’s manifestations.
  • Inherent authority: where the agent derives authority from the agency relation itself
  • This is designed to protect third parties where the doctrine of apparent authority fails.
  • But normally assurances of the purported agent are not enough to bind the principal.

-The principal has a duty to the agent with regard to discharge:

  • Foley: An employer may not discharge an employee for refusing to act in a way contrary to public interest. The employee here has to show that there is a public interest in seeing firms operate efficiently and honestly, and that courts can make this policy judgment.
  • There is a presumption that employment is at-will. This presumption can be overcome by showing an express agreement to the contrary or by showing evidence of contrary intent (looking at the length of employment, the employer’s general policies and practices, and the employer’s actions with regard to this particular employee).
  • There is no tort remedy for actions done in bad faith. This is a contract remedy.

Partnerships

Introduction

-General partnership: an association of two or more persons to carry on as co-owners a business for profit. UPA 202(a).

  • This is the only business association that parties can enter into without a filing – no written agreement is needed.
  • GPs are governed by a standard set of default form rules.
  • Defining characteristics of ownership:
  • The right to the residual claim,
  • Management rights,
  • Actual authority to bind the partnership,
  • Share of the profits and a responsibility for the losses.
  • The ideal firm for a GP structure is:
  • Small and intimate,
  • One in which each partner participates in all aspects of the business, and
  • One in which there is trust among the partners.
  • GPs are subject to the following default rules:
  • Equal sharing of ownership and management,
  • If the partnership wants to terminate its association with a partner, it may only do so by dissolving the partnership and paying the partner his interest in cash,
  • All partners are jointly and severally liable for all obligations of the partnership,
  • Each partner owes a fiduciary duty to the others.

-Joint venture: a legal relationship between two or more persons who seek a profit jointly in some specific venture without the existence of any actual partnership.

  • JVs are generally government by the same rules as GPs.
  • There are a few key differences:
  • Third parties may not assume that joint venturers have agency powers equal to those of general partners.
  • There is less fiduciary duty in a JV.

-Limited partnership: a business association of one ore more general partners and one or more limited partners.

  • An LP is formed by filing a certificate of limited partnership with the secretary of state in the jurisdiction that the partners in control choose.
  • General partners: active participants in the firm, empowered to make and carry out the firm’s business policies
  • GPs are jointly and severally liable for the firm’s obligations.
  • GPs may withdraw from the partnership at will, and this will not trigger dissolution.
  • Limited partners: passive investors with no management power and no authority to act as agents.
  • LPs are not personally liable for the partnership’s obligations.
  • They may not withdraw from the partnership at will.

-Byker v. Mannes: If partners associate themselves to carry on as co-owners a business for profit, they will be deemed to have formed a partnership relationship regardless of their subjective intent to form such a legal relationship.

-Hynasky v. Vietri: To prove the existence of a partnership, one must show intent to divide the profits of the venture. Evidence in the form of a partnership agreement is strong by not conclusive proof of intent. The court looks to the actions of the parties.

  • The requirement to share losses is, in some jurisdictions, indispensible to the existence of a partnership, and sometimes a joint venture.

-Under the UPA, the default rule for profits is that they are divided equally among the partners.

  • The default rule for losses is that it must be the same as that for profits, whether it is the default rule (split evenly) or another one agreed to by the parties.

-Under the UPA, the default rule for services is that a partner is not entitled to receive compensation for his services or interest on capital.

-Kovacic v. Reed: The general rule is that, in the absence of an agreement to the contrary, the law presumes that partners and joint venturers intended to share profits and losses equally, regardless of actual contribution.

  • There is an exception however. Where one partner or joint venturer contributes money against the other’s services, neither party is liable to the other for contribution for any loss sustained.

-Each partner is an agent of the partnership for the purpose of its business (UPA 301), subject to the effect of a statement of partnership authority under UPA 303.

  • UPA 306: Generally, partners are jointly and severally liable for all obligations of the partnership.
  • PAP v. Moss: The joint venture is liable for the obligation of its joint venturer, even if the action taken was not allowed and even if the joint venturer did not disclose the existence of the joint venture, where the action taken was for the benefit of the joint venture and where the action taken was within the scope of the joint venturer’s duties and powers.
  • Haymond v. Lundy: The partnership agreement said that a partner could not dispose of a material asset worth more than $10,000 without the consent of the partnership. A $150,000 referral fee was a material asset, so the partnership was not liable.

-It is not reasonable to assume that joint venturers have granted each other the authority of a general manager because a joint venture is for a limited purpose only.

  • The party seeking to bind the joint venture must establish the extent of the agent’s actual authority.
  • Conversely, third parties without knowledge to the contrary can rely on the presumption that all general partners have the actual authority of a general manager.
  • Matanuska Valley Bank v. Arnold: The power of one joint venturer to bind another must come from express authority to do what he did, or by implication from the nature of the agreement. Here, Davis had never been given authority to borrow money nor was authority implied, so the joint venture was not responsible for the borrowed money.

-A finding that the partnership is liable for the unauthorized actions of a partner in an LLP will normally not expose other partners to the risk of liability.

  • Dow v. Jones: The partner had apparent authority and could therefore bind the LLP (though not its partners) even though the firm dissolved prior to the alleged malpractice.
  • Partnership by estoppel: a person who represents himself or is represented by others as a partner in an existing partnership is an agent of the persons consenting to such representation.
  • A partnership may be held liable for the malpractice of a partner committed after dissolve under two theories:
  • The malpractice concerned an open case that had to be wound up, or
  • The third party never had proper notice of the dissolution, so the partner’s agency powers continued after dissolution with respect to the third party.

Fiduciary Duty

-Partners have a duty of loyalty to one another.

  • Under UPA 404(b), partners must:
  • Account to the partnership and hold its property, profit, or benefit as a trustee,
  • Refrain from dealing with the partnership as or on behalf of a party with an adverse interest, and
  • Refrain from competing with the partnership before its dissolution.
  • Meinhard v. Salmon: Partners, like trustees, owe to each other a strict standard of loyalty – “not honesty alone, but the punctilio of an honor the most sensitive.”
  • UPA 405 recognizes a partner’s formal right to an accounting to enforce fiduciary duties or contractual rights.
  • Fiduciaries carry the burden of proof by clear and convincing evidence that they have fulfilled their fiduciary obligations.
  • Self-dealing: when a partner does not inform other partners of business opportunities that should belong to the partnership; a violation of the duty of loyalty.
  • Vigneau v. Storch Engineers: A partner who breaches his duty of loyalty is still entitled to the value of his partnership interest.
  • However, a partner that breaches his duty of loyalty by self dealing may have to pay the following damages:
  • Always any profits earned as a result of the breach, plus interest,
  • Sometimes payment by the partnership for services rendered as a partner.
  • Some courts say that the partner is not entitled to his compensation even if he performed the services properly.
  • Most courts, however, hold that the discretion rests with the trial court and that this type of penalty should only be used if the services were performed improperly.
  • Always losses that the partnership sustained as a result of the breach.
  • Sometimes punitive damages, and
  • Sometimes reasonable attorney’s fees.
  • In the absence of a mutual agreement, the remedy for an impasse between partners is dissolution of the partnership. The impasse itself is not a breach of fiduciary duty of loyalty.
  • Covalt v. High: The conflict of interest existed at the time of partnership formation, and both parties were complicit in it. Therefore it is not a breach of fiduciary duty. The fact that a business proposal may benefit the partnership does not mandate acceptance by all partners, and failure to accept the business proposal does not result in a breach of the duty of loyalty.
  • But the key here is that both Covalt and High knew about the conflict of interest before partnership formation and still went ahead.
  • UPA 401(f): each partner has equal rights in the management and conduct of the partnership’s business.
  • UPA 401(j): ordinary business decisions are decided by a majority vote.

-Partners may sometimes attempt to contract for absolute discretion by way of a partnership agreement.

  • UPA 103(b)(3): A partnership agreement may not eliminate the duty of loyalty.
  • UPA 404: A partner’s fiduciary duty is limited to a duty of loyalty and a duty of care.
  • Starr v. Fordham: Once it is shown that a partner has engaged in self-dealing, that partner has the burden of proving the fairness of his actions and to prove that his actions did not result in harm to the partnership.
  • Business judgment rule: If the allegedly violating partner can demonstrate a legitimate business purpose for his action, there is no breach of the duty of loyalty.
  • The business judgment rule does not apply if the plaintiff can demonstrate self-dealing on the part of the allegedly violating partner.
  • An unfair determination of a partner’s respective share of a partnership’s earnings is a breach of both one’s fiduciary duty and the implied covenant of good faith and fair dealing.
  • Note: Not a UPA jurisdiction.
  • UPA 404(e): A partner does not violate his fiduciary duty of loyalty merely because his conduct furthers his own interest.

-Partners all owe to each other a duty of care.

  • UPA 404(c): General partners owe to each other and to limited partners a duty of care, using a gross negligence standard.
  • Limited partners in a limited partnership do not owe general partners a duty or care of loyalty.
  • Ferguson v. Williams: A general partner does not owe other partners a duty of care under a negligence standard. The standard is gross negligence.
  • This decision is a bit contrary to the UPA.

Dissolution & Disassociation

Statutory Framework

-The general partnership is an at-will relationship that can continue only as long as every member assents.

-In an at-will general partnership, any partner may dissociate and thereby cause a dissolution of the partnership by simply expressing his will to cease association with the partnership.

-As soon as the partnership’s affairs are wound up, the partnership terminates.

-Article 8 of the UPA says that any partner normally has the right to require that the partnership’s assets be liquidated via a judicially supervised auction only if the partnership is at-will and has been dissolved by a partner’s express will to dissociate (unless there is an agreement to the contrary).

-Article 7 of the UPA says that the partnership interest of a deceased or otherwise dissociating partner will be purchased by the partnership for a buyout price based on the greater of the partnership’s liquidating or going-concern value. But courts are tempted to avoid the buyout rules of Article 7.