BUSINESS ORGANIZATIONS OUTLINE

AGENCY PRINCIPLES Basic Concepts of Agency: - Agency = an informal, consensual relationship o May be contractual; even unpaid agents can nonetheless be agents o Artificial entities at and carryout functions through agents so a principal can be an artificial entity - Two Requirements for an agency relationship: o FIRST: the principal manifests that he is willing to have another act for him, AND o SECOND: the agent manifests a willingness to act - Agency is a Fiduciary relationship relationship of trust and confidence o But note: only the agent is a fiduciary of the principal principal is NOT a fiduciary of the agent  Agent is accountable to the principal for any profits that arise from the agency; the agent cannot act for his own benefit or for the benefit of a third party; cannot compete with the principal on aspects of the agency; must protect property entrusted to him by the principal - Key thing in agency Principal has to have control over the agent (i.e. employer/employee) the agent is controlled by the principal and the principal can direct how the agent performs his function - Independent contractors: o Can be agents whether an independent contractor is an agent depends on a fact by fact inquiry look to the degree and kind of control over the work being done by the independent contractor. Sources of Agents authority: - Actual Authority (principal to agent) the principal tells the agent to act in a certain way and the agent assents to do so o Aka express authority manifestation of the principal can be through conduct or words o Note: a principal cannot put limitations on an agents ability to do jobs that are a normal part of the agency - Apparent Authority (principal to 3rd party) the principal tells a 3rd party (directly or indirectly) that another person is authorized to act as an agent for the principal o Only the principal can create apparent authority!!! Agent cannot - Incidental Authority authority to do incidental acts that relate to a transaction that is authorized - Implied Authority may be inferred from prior course of conduct - Note: the difference between actual and apparent authority o Actual authority flows directly from the principal to the agent o Apparent authority flows from the impression created by (or permitted to exist by) the principal in the mind of a 3rd person  Based on estoppel principles remember: the impression in the mind of the 3rd person must be reasonable!!

Disclosed and Undisclosed Principals: - Disclosed/Fully Disclosed Principals the principal is the contracting party (i.e. the 3rd party knows the identity of the principal at the time the transaction is entered into) o Only the principal is bound! o The Agent is NOT bound! - Partially disclosed principal the 3rd person is on notice that the agent is acting on behalf of some principal but 3rd party does not know who the principal is o Both agent and the principal are bound by the contract entered by agent!!!!! - Undisclosed Principal the 3rd party does not even know that there is a principal o The agent is immediately bound o But the principal is bound as well if the agent is acting w/in his authority  So the 3rd party can sue both the agent and the principal on the K o Tricky part: if the 3rd party does not perform his obligations under the K, the principal cannot sue the 3rd party directly can only sue the 3rd party through the agent Class Hypotheticals and notes: - Hypo: A is providing capital and B is providing services. What is the relationship between A and B? o Remember: investment can be anything of value (your name; sweat equity; etc) - (1) B is not an employee in the traditional sense A cannot really direct B and A cannot really fire B - (2) there is no agency relationship (which is a fiduciary relationship) because there is not enough control by A over B Veto power could give A enough control to form an agency relationship but the fact that A and B split profits would be a red flag sharing profits is a presumption of a partnership - (3) no creditor/debtor relationship here because A doesnt expect to be paid back this is not a loan - (4) this is a partnership! the default form of business - partnership is a separate legal entity: AB Software - (5) the agreement that A will not be asked to increase his investment if a 3rd party sues both A and B, such agreement will gave no effect to help A in a suit against the 3rd party o remember: agreements between partners are enforceable as between themselves But cannot bind 3rd parties to the partners individual contracts! - Class Note: o Self Corporations corporations that are set up and ready to go (filed papers, etc) firms have them hot and ready for clients who need them
Butler v. McDonald Corporation - Facts: parents of injured kid brought suit against franchisor for franchisee negligence - Rules: agency 3 elements: (1) principal manifests that agent will act for him; (2) agent accepts, (3) parties agree that the principal will be in control of the undertaking o Apparent Authority 3 requirements question of fact!!  First: that the franchisor acted in a manner that would lead a reasonable person (obj. test) to conclude that the operator and or/employees or agents of the franchise restaurant were employees or agents of the franchisor (the D)  Second: the plaintiff actually believed this  Third: P relied on this to his detriment - Clarks opinion every franchise relationship seems to be an agency/principal relationship - When Court decides that a certain legal relationship exists, they are determining the rights and obligations of parties to each other. In finding agency relationship affected the rights of s and Us and any 3rd parties

INTRODUCTION TO BUSINESS FORMS CHOICE OF ENTITY 1. The Sole Proprietorship: a. Definition: Owned by one individual b. Formation: No filing c. Duration: sole proprietor determines d. Liability: sole proprietor has full and unlimited liability; e. Management: sole proprietor has full control; the owner is the biz you basically do what you want to do f. Taxation: Not a taxable entity; pass through taxation g. Biggest advantage: you are in total control h. Biggest Disadvantage: your business AND your personal assets are at risk i. all control and all the liability 2. General Partnership a. Formation: no filing required (oral K Ok) i. Default business form sharing of profits is a presumption of partnership ii. Can create a partnership without even knowing even if you say in the K that you are not creating a partnership, the court looks to the economic reality and may find a partnership iii. No limitations on how many partners can have iv. Individuals or entities can be partners v. Need at least two people vi. Dont need a partnership agreement but its best if not one, then the UPA governs 1. One man one vote; profits split evenly per the UPA b. Duration: upon dissolution for a number of possible reasons c. Liability: Partners have unlimited liability jointly and severally liable d. Management: ea partner has equal voice unless otherwise specified e. Tax Issues: Not a taxable entity! Pass through taxation! 3. Limited Partnership: a. Formation: Must file with the state (filing fee) i. UPA formation is @ the time of filing certificate of LP! ii. Need one General Partner (who is fully liable for the debts and obligations of the partnership) and however many Limited Partners (who are only liable for their investment limited partners are passive investors!) iii. The Risk for Limited Partners: If limited partner takes too much control in the biz, the limited partner can become a general partner 1. A Limited partner is NOT liable for the obligations of the limited partnership UNLESS: a. He is also a general partner, OR b. In addition to his rights and powers as a limited partner, he participates in the control of the business. However, when he participates in the control of the business, he is liable only to persons who transact biz with the partnershipreasonably believing based on the limited partners conduct that the limited partner is a general partner

2. A limited partner who knowingly permits his name to be used in the LP name is liable to creditors who extend credit to the partnershipwithout actual knowledge that the limited partner is not a general partner b. Management: General Partner controls the biz c. Taxation: Pass through taxation d. Variation LP with a Corporate General Partner 4. Limited Liability Partnership a. Formation: Need to file with state (filing fee) b. Taxation: Pass through taxation c. Liability: Each partner is liable for own acts and acts of those under his direction and control BUT NOT typically liable for the debts of the LLP d. Generally old partnership convert to LLPs and not LLC because it is simpler to do so e. LLP mainly used for law partnerships f. Note: no need for general partner like for LPs! 5. Limited Liability Companies a. Formation: Must file Articles of Organization with the Secretary of State (filing fee) i. Need Operating Agreement preferably in writing; specifies how the organization will be managed b. Under MI law can have an LLC with only one member! not all states though; note: even when only one member only the assets of the LLC are at stake c. Separate legal entity d. Liability: limited liability for all participants whether or not they are active in the management of the biz e. Operation and management: very flexible! i. Can be member-managed (default) or manager-managed f. Taxation: check the box can be taxed however you would like 6. C Corporation: a. Formation: filing of Articles of Incorporation with the Secretary of state existence begins upon the filing! i. Bylaws the corporate governance doctrine; the law of the corporation; ii. Shareholder Agreement K among the SHs (like OA) b. New legal entity! Can buy, sell, sue, etc c. Must follow statutory procedures; formal meetings etc d. Types: i. Publicly held shares on public market ii. Closely held no public shares e. Duration: perpetual f. Can have a single person corporation g. Individual and entities can have shares in the corporation h. Liability: Shareholders are NOT personally liable for the debts of the corp only their capital investment is at risk i. Management board of directors who are elected by the SHs i. Three layers: 1. shareholders: owners who elect the board; 2. board of directors: run the corps affairs and select the officers; and 3. officers: act for the corp to implement the decisions of the directors j. Taxation: double taxation! Corporation profits are taxed to the corporation AND taxed once more when they are distributed to the SHs as dividends

k. Zeroing-out describes the common income tax strategy in C-Corps of reducing taxable income to zero by paying out all earnings in the form of tax-deductible pmts to the SHs 7. S Corporation: a. Formation: Filing of Articles of Incorporation with the state b. Eligibility for S-Corp status requirements: i. Domestic corporation ii. Must not be ineligible corp (i.e ins. Co.) iii. No more than 100 SHs iv. Must not have a SH who is not an individual v. Must not have more than one class of stock, etc c. Everything is the same as regular C-Corp except that if the above requirements are met, then there is pass-through taxation!! Takes care of the problem of double taxation Check the Box Taxation: - you can choose which way you would like your business to be taxed you check the box and let the IRS know - An unincorporated entity (LLC, partnership, limited partnership) may elect the form of taxation can elect to be taxed as a partnership (pass through) or as a corporation (double taxation). HOWEVER, a corporation must be taxed as a C-corp (double taxation) UNLESS it meets the requirements of S-Corp!!!!! - Class Note: o With pass through taxation, the members of an LLC (for example) are taxed EVEN IF the LLC does not pay out dividends  Minimum distribution clause the organization agrees that it will distribute to the members the minimum amount needed to pay tax liabilities. **Vocabulary** Corp v. LLC Corporation Articles of Incorporation Shareholder Agreement Shareholders Shares

LLC Articles of Organization Operating Agreement Members Membership Interests

Choosing a business concerns: - Tax Treatment; - Liability exposure; - Management flexibility - Capital where is the money coming from - Exit strategy - Questions to ask client: o Is business going to be capital intensive? Labor intensive? o Who are the participants? Will everyone have the same interests? o What are the functions of each investor? o Who intends to contribute what? o Who is going to manage? Equal voice? Passive investors? o How much money needed to start the business? Wheres the money coming from? o How will the profits be distributed/utilized? o Transfer restrictions?

How do you want to be taxed?

PARTNERSHIPS Introduction to Partnership: - partnership is a separate legal entity every partner is an agent of the partnership! - Partners have equal right to bind the partnership; partners owe fiduciary duties to each other - partnership is default entity dont even need a partnership agreement - The Need for a Written Agreement o In the absence of an agreement, the relationship between the partners will be governed by the provisions of the applicable state partnership statute  i.e. unless agreement says otherwise: (UPA) y Profits are split equallyregardless of individual contributions and y one party one vote partners who dont have an agreement may not like this o General rule: all partners are jointly and severally liable unless otherwise agreed - Sharing Profits and Losses o Profits split equally under the UPA!!! Unless otherwise specified in an agreement  sharing of profits creates a presumption that a partnership exists o Class Note:  Can you agree that only a person in the partnership will take all the losses? YES; this is basically an indemnification agreement so basically, a third person can go after either one of the partners and afterwards the partners can look to the indemnification agreement y agreement between the partners does not bind third parties!  Even if there is no such agreement there are still common law contribution protections where one partner can go after the other one for wrongs - 3d party Suit (UPA) states that a judgment creditor must first exhaust the partnership assets before proceeding directly against one or more partners individually o What could a bank do to go after a partner first in case of a default of a loan? (3)  (1) can have the partner guarantee the loan;  (2) can have the partner become a co-burrower;  (3) can have a K clause whereby partner agrees that in case of default partners agrees to allow bank to go after him first Partnership Management - Each partner is an agent of the partnership for the purpose of its business - An act of a partner for apparently carrying out the ordinary business of the partnership, binds the partnership UNLESS: o The partner had no authority to act for partnership in the particular matter, AND o The person with whom the partner was dealing KNEW or received NOTIFICATION that the partner lacked authortity - If the act was NOT for apparently carrying out the ordinary biz of the partnership, the act of the partner binds the partnershiponly if the act was authorized by the other partners - NOTE: how do you know what the biz of the partnership is?? o Can look to the partnership agreement which generally says: the purpose of this biz is to engage in etc

Partnership Agreement - Defines the relationship between the parties (if not covered in PA UPA applies) - PA may NOT: o Unreasonably restrict right of access to books and records of the partnership o Totally eliminate the duty of loyalty; duty of care of the obligation of good faith and fair dealing Statement of partnership authority (UPA) - Filing of a certificate of authority is binding on 3rd parties BUT ONLY IN real estate transactions the certificate is filed in the office where deeds are filed o So if there is a filing in the office, the 3rd party presumed to have knowledge of it - For any other transactions, the certificate is NOT binding UNLESS the 3rd party is AWARE of such certificate! o Can give notice to creditors BUT make sure that they acknowledge receipt of letter
National Biscuit Co v. Stroud Rule: The acts of a partner, if performed on behalf of the partnership and within the scope of its business are binding upon all co-partners! One partner cannot unilaterally restrict the authority of another partner for matters in the ordinary course of biz of the partnership o Notes: buying bread in this case was in the ordinary course of biz of the partnership and Stroud could not restrict Freemans authority because:  There were no restrictions on his authority to act, and  There was an even division of partners y The scope of the biz cannot be limited EXCEPT by the vote of majority! Here there were only 2 partners o Stroud could have withdrawn and dissolved the partnership o Nabisco would have been paid anyways quantum meruit!  If there were 3 people and Nabisco knew this and two went to it and told it that they voted and they no longer will be buying bread there would be an issue of actual knowledge Nabisco probably bound! Smith v. Dixon Rule: the Acts of a partner are binding upon the partnership if he acted within the scope or apparent scope of his authority! o The existence of apparent authority is ordinarily established according to an objective test the 3rd partys belief that the agent has authority to act must be reasonable if the principal is to be bound. o Here, Smith had actual authority from the family to sell the land for $225K; but he had apparent authority to sell it for $200K  Note: the apparent authority here came from prior acts in the past Class Note: To determine whether one has authority (actual or apparent) look to: o The partnership agreement recitation of biz purpose o Past actions o Industry custom Roach v. Mead Rule: Ea partner is responsible to 3rd parties for the acts of the other partners when such acts could reasonably have been thought to by the 3rd party to be within the purpose of the partnership! OBJECTIVE TEST o The Ds law partner took out to loans from a client one was for investment advice and the other one was a personal loan from the client; o Held: the investment loan was reasonably thought by the 3rd person to be within law partners authority, committed in the ordinary biz of the law partnership so the D here was bound; but the personal loan was not within law partnership ordinary course of biz so D not bound Peed v. Peed P. 34 o Raises the question of what happens when spouses go into business together o N.C. Statute: Partnership = an association of two or more persons to carry on as co-owners of a business for profit. Involves inferences drawn from an examination of the circumstances

 

Not partnership making repayable advances and loans to another. If one person is an employee of another and receives wages. Court: Based on the facts that they shared profits, talked about the management together, cows registered in both of their names, the deed was registered in both names. y As a matter of law they are not a partnership. y Issue of partnership should of to the jury (Mr was moving for SJ, trying to say that his wife was not a partner)

Duties of Partners to Each Other: - Duties of Partners o Duty of care in the winding up of the partnership biz o Duty of loyalty to account to the partnership for property of profit (horse race!) in the conduct of winding up of the partnership biz; refrain from having adverse interest in the conduct of or winding up of the partnership biz; to refrain from competing w/the partnership until dissolution o Obligation of good faith and fair dealing o A partner does not violate a duty under the Act or partnership agreement merely because the partners conduct furthers the partners own interest o Standard of care Grosse negligence (not ordinary care) cont engage in reckless conduct, intentional misconduct, or knowing violation of the law. - Note: this section does not talk about the formation of partnership no fiduciary duties to putative partners when the partnership is forming!!! Fiduciary duties only in the conduct of or winding down of the partnership! Records o partnership books and records must be kept at the chief executive office o Partners must have reasonable access
Meinhart v. Salmon Rule: Copartners/joint adventurers owe to one another, while their enterprise continues, the duty of the finest loyalty (very high standard) o This case was much about full disclosure! o The court found that the new deal was just an extension of the old one what if it was two weeks later or at a different site? matter of degree; case by case o What could have been done to avoid this result?  Put in agreement that would only be a partner in this project. Put in provision whether or not they owe each other a duty to give opportunity to compete in other projects. o Rememberthe property is a continuation of the other property already developed. If property was across town or other location or other type of project, the decision might have been different. This Court saw this as a continuation of the same venture. Singer v. Singer Rule: partnership Agreement can vary the UPA can modify and waive some duties of partners by the agreement BUT CANNOT eliminate completely (upa) Sommers v. Dooley if partners cant agree in matters if buz it decided by majority vote. If it is outside the ordinary course of business of the partnership the decision must be unanimous. (must be equality between partners with respect to management of biz affairs)

Dissolution(v. Dissasociation) of partnership 1914 Act Partners are not a separate legal entity - Aggregate of all its individual owners Creditorgo after partner directly (even if P-ship has assets Dissolution dissolving the partnership ; disposition of the partnership assets BUT really meant a change in legal relationship among the partners. Result winding up and termination of partnership. Partnership would be reformed with the remaining partners

1997 Act Partnership is a separate legal entity - P-ship owns title to all its property CreditorFirst exhaust assets of p-ship dissociation Change in the legal relation of partners. Event that causes a partner to cease being a participant in the partnership (occurs at death, withdrawal, cessation of existence, or expulsion of a partner) Result: P-ship either continues with remaining and partner out is paid value of interest, or if partners agree then the partnership can wind down and terminate (is not automatic).

Partners have no interest in partnership property because of the difference of entity v. aggregate (Under RUPA) Disassociation o When a partner is expelled from a partnership for wrongful behavior, that partner usually owes damages (the damages are usually higher than the buy-out he would receive from the partnership. o Disassociated partner can still bind the partnership!!! because of apparent authority, up to 2 years after his disassociation (UPA) the partnership should file a public statement of disassociation to limit this apparent authority (UPA) : the partnership can continue in existence despite the disassociation of a partner Withdrawal: o A general partner may withdraw at any time by giving written notice if the withdrawal violates the partnership agreement the partner may be liable for damages o A limited partner may withdraw at any time or upon the happening of eventsin the agreement  If the agreement does not specify the time or the events upon the happening of which a limited partner may withdraw, the partner may withdraw on 6 months notice to the Lpartnership Winding up and Termination o Winding up (Liquidation) partnership business continues while its operations are in the process of being terminated. o Termination Occurs when Ps assets are liquidated (turned into cash), debt satisfied and any remaining assets distributed to partners.  receive back initial contribution and then share equally in the profits and surplus after liabilities are paid off. (UPA)  Each partner is liable for the P losses to the extent of his share of profits.  Does not affect the J & SL of each partner o Distribution of partnership property when breach of P agreement.(UPA)  Breaching partner is given the value of his interest in cash less any damages.

Page v. Page P51 Right to Dissolution y Brothers entered partnership; One provided linen and machinery through a wholly owned corporation, which held a partnership note; While business was unprofitable, there were no issues; When business became profitable, partner controlling note wished to terminate partnership and take over business y RULE Partnership is at will; When no term or undertaking is specified, partnership may be dissolved at will; Partner may not dissolve partnership to gain business benefits for self, unless partner compensates others for their prospective business opportunity y When a partner advances money to partnership with understanding that amount contributed is a loan to be repaid from profits, partnership is for term required to repay loan

Inadvertent Partnerships - A partnership can be created unintentionally! Common law UPA 1914 UPA 1997 sharing of profits was conclusive of the existence of a partnership a sharing of profits is prima facie evidence that a partnership exists a person who receives a share of profits of a biz is presumed to be a partner

Basically if a person acts like a partner, and a 3rd party enters into biz with the purported partnership, then the purported partner is liable to that 3rd person like a real partner
Smith v. Kelley Rule: Between the parties, a partnership is a contractual relationship and the intention to create it is necessary; as to third parties, a partnership may arise by estoppel o The suit was between partners the court found that although the P was held to the public as a partner, between P and D a partnership relationship was not intended and so it did not exist. o Different story if this suit was brought by a 3rd party

Law Firm Partnerships: - generally two-tiered structures: (1) income partners no equity or ownership, salary; (2) Equity partners owners of the firm share profits and loses - 3 types of people in law firm: (1) finders; (2) minders; (3) grinders - Bane v. Ferguson Rule: retired partners could not sue the firms managing council for the losses of his retirement benefits (pension was unfounded not by the firm; and noncontributory not by him) after management made a bad decision (but not in bad faith) to merge with another firm o Held: because the P was now a former partner, no duties owed to him; dissolution was protected by the BJR Limited Partnerships: - Permits investors to share the profits of a business, with their risk of loss limited to their investment - Limited partnership with corporate general partner o Many limited partners and ONE general partner that is a corporation this is the norm today o Cases state that the corporation that is the sole GP owes the duty of utmost good faith, fairness and loyalty to the limited partnership seems to suggest that the officers and directors of the corporate GP favor the duties to the limited partnership and the limited partners above any duty to the SHs

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2 classes of partners 1) General (one or more)MUST have at least 1

y y y y y Doesnt have to be an individual complete control manage the enterprise subject to full liability Owe fiduciary obligations to limited partner

2) Limited (one or more)

     subject to limited liability ordinarily does not take part in day to day control. Normally not agent of the partnership Do not have the authority to bind the partnership Fiduciary duties owed to general partner if taking active role

Formation: comply with statutory formalities & file a certificate of limited partnership with the state. Uniform limited Partnership ActStatutory changes Old statute 4-19-76- if limited partner took to much control the limited partner can be recategorized as general and then subject to full liability of the partnership. provided safe harbors, things that limited partner could do that Revised (RULPA)wouldnt change him into a general partner limited partners have no liability for the partnership debts even if the 2001 Statute 303 limited partner participates in the management of the partnership - Have to look at the statute into he state you are in because not all states have adopted this statute. - Not responsible for liability solely because they are limited partners

Red River Wings, Inc. v. Hootp61 - Court decided under certain circumstances, the limited partner may owe some fid duties if they did certain kinds of things. - Language of the agreement o Not carefully drafted o Statute says if the partnership cant agree then they can have a majority vote o Agreement said a majority of the limited partnership interest can remove general partner.  Didnt cover removal  Doesnt cover death As a lawyer you must be able to think of every possible contingency and draft carefully! Borrows from a lot of corporate law concepts. o Oppression of the minority o Fiduciary Duty concept Duty of loyalty and care (in the ND statute) o Piercing Principals  If you want the shield of limited liability then you have to treat that entity and run your business as an entity. o Business judgment Rule  Creates a presumption that when officers and directors are acting in good faith after reasonable investigation in the interests of the corporation (protects them from liability with actions in regard to the corporation).

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LIMITED LIABILITY COMPANIES General Info on LLCs - Purpose to create an entity that offers investors the protections of limited liability (of corps) and the flow through taxation status of partnership - best of both worlds - Came into existence in 1977 in Wyoming; now all 50 states have LLC laws but there are substantial difference between state law to state law : check-to-box applies to LLC most LLCs choose to be taxed as a partnership - Biggest Advantages of LLCs: o Limited liability o Pass-through taxation; note: allowed even for one member LLC! o Chameleon management can be member managed (default) or manager managed (if so must be in the Articles of Organization filed with the state) o Creditor-protection provisions o Flexibility! (taxing, voting, management)  Ican have formalities like in corporations but that sort of defeats the flexibility incentive of LLCs however, such formalities (i.e. notice of meetings, keeping meeting minutes, etc) are good to guard against veil-piercing arguments - NOTE:In case of conflict:  For corporations the articles of incorporation control over the bylaws!  For LLCs the Operating Agreement controls over the articles of organization! Contractual Aspects of LLCs Fiduciary duties require that a person who owes such duties (such as a majority or controlling investor) act in the best interests of the party to whom such duties are owed (such as a minority investor) o Basic duties: duty of care; good faith; loyalty; fair dealing; candor and complete disclosure Limiting Fiduciary duties by K the Del LLC statute allows this can expand, limit or even eliminate a persons duties by specifying so in the LLC operating agreement o However: cannot eliminate the implied covenant of good faith and fair dealing!
Blackmore Partners LP v. Link Energy Rule: whether the LLC directors breached their duty of loyalty is determined on a case-by-case analysis; Operating Agreement can modify the provisions of the State statute can limit some fiduciary duties by agreement! o In this case, the directors of the LLC sold off the LLC assets and distributed them all first to the creditors so nothing was left over for the members which sued. The suit was for a breach of loyalty, not duty of care because agreement had exculpatory clause for no suits under duty of care. Issue before the court was whether the complaint alleged sufficient facts to support a case Yes. Clark says that the directors breached their fiduciary duty not necessarily because they put the interests of the creditors first (this is actually ok) but by not considering other alternatives Elf Atochem North America Inc. v. Jaffari and Malek LLC: Rule: Because of the policy of the ULLCA is to give maximum effect to the principle of freedom of contract and to the enforceability of LLC Agreements the parties may contract to avoid the applicability of certain provisions of the LLC Act o Only when the agreement is inconsistent with mandatory provisions (rare) will the agreement be invalidated o Two issues in this case: (1) arbitration clause per agreement court said this is OK flexibility of LLC statute; and (2) whether arbitration clause can be enforced when the LLC did not sign the agreement

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Yes, even though LLC did not sign (through a member on behalf of the LLC, the clause is enforceable because the real parties at interest are before the court two members  BUT NOTE: Bubbles and Bleach, LLC v. Becker there a third party was suing on a contract (not OA) and the court held that because the LLC itself did not sign the contract and thus did not agree to the arbitration clause there the LLC was not bound by it! Crucial difference this was brought by a third party Class Note although you can change a lot in the OA, you generally cannot change anything in the LLC Act that impacts third parties cannot waive all of fiduciaryduties

Characteristics of an LLC
Poore v. Fox Hollow Enterprises Rule: The formation of an LLC creates a special legal entity that must be represented by legal counsel in court so, just like corporations, LLCs are legal entities that must have licensed atty to represent them in courts; members (unless themselves attys) cannot represent their organization Meyer v. Oklahoma In Oklahoma LLCs are not eligible to receive liquor licenses because the limited liability involved with LLCs a shield from the very responsibility and accountability that alcohol laws seek to impose partnership can have liquor licenses

Membership Interests in LLCs - Note: when you get a membership interest in an LLC there is generally no certificate given out (although you can get one); also, while membership interests are generally transferable a transferee may only get the economic interest and not the rights of a member Michigan LLCA - 301: members; contribution o A contribution of a member can be tangible OR intangible property (cash, property, sweat equity, Bill Gates name, or other biding obligations: i.e. promissory note) KEY: something of value or a benefit to the company o A contribution may be in exchange for a present or future membership interest 302: promise by a member to contribute o a promise of a member to contribute enforceable ONLY if in writing  promise to perform enforceable EVEN IF member cant perform because of death or disability obligation can be enforced against the estate unless the OA says otherwise but under the statute, the obligation must be performed  if member cant make the required contribution member must pay equivalent value in cash o A members obligation to contribute may be waived only by unanimous vote of the members who can vote  HOWEVER a creditor who extends credit in reliance of the members obligation as written in an OA (a writing) can enforce the original contribution. Note: writing does not have to be addressed to the creditor; just something that you sign y This is pretty much based on detrimental reliance notions 501: Member Admission o a person may be admitted as a member of an LLC in the following ways:  At formation by signing the initial OA  After formation: y By acquiring a membership interest directly from the LLC o By complying with the applicable provisions of the OA, or

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o In the absence of OA requirements for admission by unanimous vote of the members who can vote y Assignment of membership interest: o 506:  unless otherwise provided in the OA: y for an LLC with more than one member need unanimous vote y for an LLC with one member per the agreement between assignee and the member  Assignee who becomes member is subject to the same restrictions and liabilities, has the same rights and powers as the assignor not liable for unknown obligations of the assignor. o IMPORTANT: An LLC can admit members who DO NOT make any contribution or who dont incur any obligation to make contribution to the LLC!! 502: Voting Rights o Each member has ONE vote! o Only members of LLC, and NOT its managers can authorize the following by vote:  Dissolution of the LLC  Merger of the LLC  An Amendment to the articles of organization  A managers use of property of the limited liability based on full disclosure  The sale, exchange or other transfer of all or substantially all of the assets of the LLC, other than in the ordinary course of biz o Usually a majority vote is required for any matter submitted to vote unless otherwise provided in the Act or in the Articles of Organization 504: Membership Interest is personal property and may be held in any manner in which personal property is held 509: Withdrawal a member may withdraw ONLY as provided by the OA may be entitled to withdrawal distribution o OA can provide for other events which can be basis for expulsion

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FORMING A CORPORATION AND AN LLC

Pre Incorporation Issues: 1. Where to Incorporate:  Two considerations: y (1) actual dollar cost of incorporating, y (2) advantages and disadvantages of the substantive corporation laws of the state  State of Domicle y (1) the jurisdiction where the biz is to be conducted or y (2) Del (downsides: costly and have to defend suit there) y Internal Affairs Doctrineif you file article in a particular state, the entity is domiciled in that state, with respect to internal affairs of he corporation look to the state where the corporation filed its articles of incorporation.  Foreign Corporation if you incorporate in a state where you are not doing biz have to qualify as a foreign corporation y Costly y Have resident agent y Qualify: file with the state; look to state statute for reqs y Possibly pay taxes in both states How to incorporate: o Online Filing services CT-Corp; ok for noncomplex standard incorporations o Considerations when incorporating:  trend is to simplify the process;  limiting the articles to provisions required by the statute and other provisions left for the bylaws, or shareholders agreement Forming a Michigan Corporation: o 3 things are necessary: 1. People y An incorporator and a shareholder Someone who is not a SH can sign the articles of incorporation (like a legal assistant or a secretary; anyone can sign as the incorporator) 2. State statute (Act): y not a problem all 50 states now have Corp Acts. 3. Articles of Incorporation: y Filed with Sec of State y remember: in MI the corporation comes into existence the moment the articles are filed with the state! y When filed and accepted de jure corporation (properly formed corporation for all purposes) o Articles of Incorporation must contain ( 202)  Name must be distinguishable; must have limited or corp for notice  Purpose General purpose Clause is ok; y Decline of Ultra Vires (beyond the powers) used to describe acts that exceed the stated purpose of the corporation or restrictions on the power of the board of.

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Common Law Ultra Vires transactions were void because the corporation lacked the power to enter into the transaction; didnt matter that the SHs ratified an ultra vires transaction void!  Number of authorized shares; classes, series, rights and preferences if more than one kind of shares. y Authorized shares usually you authorize more than needed y Classes of stock you have to specify the classes in the articles of incorporation! How may in each class, series, etc y Blank Check Preferred Stock if you want to authorize some preferred stock down the road the blank check will say that the rights and preferences of the stock will be determined when stock is issued  Registered agent in MI y Usually a corporate officer or employee  Registered Office in MI y The office must be in the state of incorporation y Both registered agent and registered office reqs are designed to ensure that every corporation has publicly stated a current place where it may be found for purposes of service of proves, tax notices and the like  Name and address of the incorporators  Duration if not perpetual  May also contain anything else NOT inconsistent with the Act (i.e. raincoat provisions, preemptive rights, etc) o Note: No minimum capitalization of the corporation is set forth in the Act o In addition to the Articles, also need:  Corporate bylaws not signed by anyone; internal rules of governance; define the rights and obligations of various officers, person, etc; provides the rules for routine matters such as meetings and the like y Checklist for bylaw provision pertaining to directors: Number and qualifications Increase or decrease in number Resignation and removal Filling vacancies Powers and duties Meeting of directors Committees Compensation and indemnification  Share Certificates  Minute Book  Corporate Seal  Taxpayer ID  Corporate Bank Account  Meeting to appoint the Board, officers, etc  Shareholders agreement (if closely held) or other employment contracts  S Corp Status if S status is desired Forming a Michigan LLC o File Articles of Organization - 203 which must contain:  Name must include LLC can file a reserved name certificate 16

Purpose general purpose clause is ok Registered Agent in MI Registered Office in MI If manager managed, a statement saying so Duration if not perpetual Anything else not inconsistent with the Act (i.e. provisions limiting the liability of managers) o In addition to the Articles, need:  Taxpayer ID  Bank Account  Operating Agreement y Should include provisions re -- voting rights; Transfers of Interests/restrictions/exit strategy; contributions; profit distribution; dispute resolution; indemnity agreement Transfer Restrictions Shareholder Agreements (corp) and Operating Agreements (LLCs) o Most closely held corps have a SHs agreement and LLCs have OAs which specify the voting rights of the SHs (or members) and restrictions of transfers o Class Note: In LLCs you can have members that are not allowed to vote per the OA; but in a corporation, generally all SHs have a vote! o Transfer Restrictions permitted but strictly construed; restraint on alienability  Triggering Events per agreement: (normally impact a transfer restriction) y Death; disability; Divorce; retirement; Willful termination of employment; termination of employment for cause; bankruptcy; desire to sell and exit business y Note must be very careful when drafting! i.e. restrictions that cannot transfer to 3rd parties have been construed to mean outside 3rd parties but not family members  Examples of restrictions on transfers: y Right of First Refusal have to offer to shareholders or co the same offer as that of a third party (so there is an offer on hand); if you change the terms its a new offer y Option No offer on hand; if you want to sell must first go to co or shareholders and offer to them if they say no, find any buyer you like y Buy-Sell Agreements most common; this is an obligation for you to sell and for the entity to buy under certain triggering events  Price Determination (specified in agreement) y Book Value dividing the value of the stock to the number of shares tends to be arbitrary so many dont like it y Fair value certificate at the end of every year, the accountants issue new certificates must be constantly updated y Independent Third Party Appraiser probably the best way; can agree before hand who will be appraising

     

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CORPORATIONS

DEVELOPMENT OF CORPORATE LAW IN THE US Louis K. Liggestt Co. v. Lee (1933) dissent talks about the history of corporate law o There used to be a wide fear and distrust of corporations so many limitations were imposed on corps. o However, these limitations were circumvented by foreign corporations could just incorporate in a different state Remember: Corps are creatures of state law! With the advent of incorporation statutes, no longer need specific legislative approval. Internal Affairs Doctrine provides that foreign courts should apply the law of the state of incorporation to issues relating to the internal affairs of a foreign corporation remember, this is an important aspect of the decision of where to incorporate o Rule: the rights of the SHs are determined by the laws of the state of incorporation

PROMOTERS promoter = a person who, acting alone or in conjunction with one or more persons, directly or indirectly takes initiative in the founding and organizing of a corporation o aka: founder, organizer brings people together who are interested in the corporation; aids in inducing people to become members of the corporation and in procuring membership fees; generally the startup guy who will become a SH RULE: Promoters have fiduciary duties!!! Basically the same duties as an agent to a principal. o These duties are owed to:  The corporation as a separate legal entity, AND  The members, including those persons who it was to be anticipated would make application to and would become members of the corp o Very important duty duty of full disclosure!  Promoters have to advise the corp and the solicited persons of any interest of the promoter that could affect the corp the promoter cannot profit has to fully disclose  Must make all disclosures which would influence one to become a members in the corp or not; cannot misrepresent material facts Potential liability: o Promoters can be liable for breach of fiduciary duty to:  (1) other promoters;  (2) subsequent investors;  (3) creditors;  (4) the corporation itself y Old Dominion Copper Mining v. Lewisohn the corp there sued one promoter. Held: since the promoters and the SHs were identical at the time of the transaction there was no one who was misinformed so no suit

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RULES on Liability of promoters: o Pre-Incorporation the promoter is liable on the contract even after the corporation is formed, and even if the corporation adopts the contract  Exception: promoter not liable to 3rd party if there is a clear and specific language in the K that the 3rd party agrees to look ONLY to the corporation. Also, wise to put in there that if the corp will never be formed the other party understands that there will be no one to collect from  If the corporation is never formed and no such clause as above then the courts will try to do equity and will probably find the promoter liable o Post-Incorporation if the K is entered into AFTER incorporation, the rule is that BOTH the promoter and the corporation are liable  Promoter should make sure that the corporation assumes the contract fully by a novation Stanley K How & Assoc., Inc. v. Boss Rule A promoter will be personally liable on a K he entered into on behalf of the corporation yet to be formed UNLESS the other party agreed to look to some other person or fund the pmt. Held promoter liable o If I were the promoters atty, should have told him to:  Incorporate first if K entered after incorporation, then get a novation for the corp to assume the contract fully  If pre-incorporation make the K specifically state that the 3rd party agrees to look only to the corporation; AND that if no corporation will be formed that the 3rd party understands that there will be no one to collect from o If I were the P (3rd party)s atty:  Dont enter the K!  Or make sure that the K says that the promoter expressly assumes personal responsibility for the performance of the K get a personal guarantee  Ask for pmt upfront  Even if the corp forms still want to have the promoter on the hook in case the corporation will fail.

How the K should be signed Clark Clones, Inc (Company Name) By: ___signature___ Carol Clark Its President. or By: ___signature___ Carol Clark, Pres

this is the standard form signing like this makes it clear that youre signing on behalf of the company

DEFECTIVE INCORPORATION De Jure Corporation

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o Results when there has been conformity with the mandatory conditions precedent established by a statue o So a properly formed corporation according to the requirements of a given States corp Act o Not subject to any collateral attacks De Facto Corporation o One that has been defectively incorporated some error somewhere during incorporation process. Requisites for de facto incorporation:  Valid law under which a corp can be lawfully organized  A good faith attempt to organize and comply with the law  Actual user of the corporate franchise so have to act and think like a corporation  Good faith in claiming to be a corporation (like forgetting to put stamps on the letter to the secretary of state, etc) o Valid for all purposes except where there is a direct attack by the state Corporation by estoppel o When a party contracts with what it believes a corporation, incurring obligations to that entity, he is estopped from denying the existence of that entity especially when those obligations are trying to be enforced essentially, cannot get off the hook just because there is a technical error Roberston v. Levy Rule: A corporation is formed only upon the proper filing of the articles of incorporation; so the rule of de facto incorporation or corporation by estoppel are no longer applicable. The directors and officers are liable until the corporation is legally formed o So the directors here were personally liable even though they argued corporation de facto o In MI - the same rule: incorporation when articles are properly filed; however some courts still apply the common law when justice calls for it.  Cranson v. IBM the court did not allow the P there to go after the directors because they did not KNOW that the articles were incorrectly filed (they were innocent) whereas Levy KNEW that the articles had been rejected

LIMITED LIABILITY - Legal doctrines to reach assets : o Enterprise liabilitygo for assets of entity o Respondeat Superiorgo for assets of agent (parent company, president, owners, etc.) If principal of respondeat superior is appropriate, would be entitles to whole enterprise responsible for actions of agents o Piercing the corporate veil

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PIERCING THE CORPORATE VEIL General Notes on PCV: - General rule: Corportion and SH are separate and distinct no personally liability for SHs - Exception PCV everybody agrees that there is a valid corporation issue is whether th coporation will be disregarded and go after the assets of the SHs. o this is contrary to the basic premise of corporations to avoid personal liability for the owners o So remember: PCV has nothing to do with the officers and directors it has to do with the owners whose bottoms are on the line - Courts rarely pierce the corporate veil! o PCV happens more often in contract cases than in tort cases although this seems wrong because in K cases, the parties know who they are dealing with and have the opportunity to bargain for the lack of liability; while in tort cases, there is no such opportunity to find out who you are dealing with or bargain for the lack of liability o The reluctance to PCV is diminished some in parent-subsidiary cases - Just because the court pierces the veil in one case does not mean that all the SHs are personally liable for all the obligations of the corporation ea creditor will have to go through the PCV proofs - PCV is always applied in the context of closely held corporation! o Passive investors are usually insulated from liability - Situations when PCV is NOT applied: o Knowingly and voluntarily dealing with undercapitalized corp where 3rd party agrees to deal with a marginally financed corporation without requesting assurance from the SH personally cannot hold the SHs personally liable o Sophisticated Creditors who continue to extend credit despite delinquencies in pmt in violation of its own internal policies w/ respect to extension of credit could not PCV - RULE: Factual investigation (Fraud, misrepresentation or illegality present) (Minton v. Cavaney) o Equitable owners of a corporation are personally held liable when : 1) Alter Ego Doctrine: (corporation [subsidiary] is alter ego of its SH [parent] total dominance. y Comingling of funds o they treat assets of the corporation as their own AND o add or withdraw capital from the corporation at will when they hold themselves out as being personally liable for the debts of the corporation or y Undercapitilization (insurance can = capital) y Participate in the conduct of corporate affairs. y Failure to keep corporate formalities. 2) Injustice and unfairness elements presentrecognizing corporation as legal entity would sanction a fraud or injustice. o A person may not divorce the responsibilities of a director from the statutory duties and powers of that office

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Common Law PCV: - Bartle v. Home Owners Co-Op Rule: where there has been neither fraud, misrepresentation, not illegality, the doctrine of PCV will not be invoked. o Westerlea was a subsidiary of Home Owners but it was not set up for profit; all the income was drained off to the parent this raised a red flag for fraud. However the court felt bad because Home Owners was made up of WWII vets so no PCV if it was someone else who owned Home Owners it may have been a different story - Dewitt Truck v. W.Ray Flemming Fruit Co. Rule: A court will PCV when recognition of the corporate form would extend the principle of incorporation beyond its legitimate purpose and would produce injustice or inequitable consequences. o Whether to PCV is a fact by fact analysis considering the following factors:  Whether all the stock is held in the hands of a few  Whether the corporation was grossly undercapitalized  Failure to observe corporate formalities (keep minutes, etc)  Non-pmt of dividends  Siphoning of funds of the corporation by the dominant SH  Non-functioning of the other officers and directors  Absence of corporate records  The fact that the corporation is merely a faade for the operations of the dominant SH o Applying these factors, the court did PCV finding that:  the D here did not act like a corporation but more like a sole proprietorship  there was severe undercapitalization in this case  there were no corporate formalities; one director was just a figure head  no one ever got a salary; Ds own pmts were not authorized by any board Baatz v. Arrow Bar Rule: In determining whether to PCV, the court must regard the corporation as a separate legal entity in the absence of sufficient evidence o the contrary o the Dram Shop case after going through all the factors, the court did not PCV o court went through the factors that courts weigh to determine whether to PCV:  alter ego argument failed no facts to show that the Ds were transacting personal biz thought the corporation  undercapitalization arg there was evidence that the corp was capitalized P just said that it is not but the court said you gotta substantiate your argument  failure to observe corporate formalities not true here; that the corp improperly used its name is not sufficient to PCV Radaszewski v. Telecop Corp Tort case; P wanted to go after the parent company but needed personal jurisdiction and the only way to do this was to PCV. o Rule: to PCV for tort action, the P must show: (1) that the parent had complete dominion over the subsidiary such that the subsidiary doesnt do anything independently, (2) the domination is used for an improper motive, such as fraud or a wrong, and (3) this domination caused the Ps injury o The court did not PCV the elements were not met Fletcher v. Atex, Inc. Rule:Under applicable state law, a court may PCV and hold SHs personally liable only in cases involving fraud, or where the co is a mere instrumentality or alter ego of the parent co. o This was another attack on the parent of the subsidiary; the court went through the factors to determine whether the subsidiary was just the alter ego of the parent NO, no PCV here o Parent managed the subsidiary cash management system: when the parent is in charge of the subsidiary accounts (cash is upstreamed to parent who pays bills of the subsidiary) this is ok as long as the parent keeps clear separate records of the parent vs. those of the subsidiary here there were separate records o The fact that parent had dominating presence on the subsidiary board is OK; parents and subsidiaries frequently have overlapping boards while maintaining separate biz operations

Important Notes: - PCV does NOT apply to corporate divisions !!! they are separate divisions not corps! - According to internal affairs doctrine the law of state of incorporation applies to PCV!

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Common Enterprise Theory sideways piercing - TaxiCab Case (Wakoski) o Facts: one guy started a taxi cab co with 10 subsidiaries one garage for 10 companies; someone got injured and sued the guy personally. o Held: the court would not PCV (so guys personal assets were ok) but told the P to amend his complaint based on the Common Enterprise Theory an sue the other 9 cab sister-subsidiaries o Rule: Common enterprise theory:  Not actually piercing the veil; just a way to go after the brother and sister corporations side-ways piercing  P must show (prima facie case) that all the subsidiaries are all part of the same common enterprise very factually intensive inquiry y All the companies are doing the same biz; interchange employees; etc y So interrelated that it is one and the same biz y Must have a common owner  So if A cant pay debt of A then B will pay with its assets. o The rationale is that it is almost like committing fraud where the biz should really have been set up as one giant business o NOTE: make sure you differentiate between common enterprise theory (sideways piercing) vs. continuing enterprise (in successor liability context) Gen Rule: Corporation and its SHs are separate and distinct no personal liability for SH! - Exception: PCV doctrine: which applies in appropriate cases and in the furtherance of the ends of justice! - Whether to PCV is fact intensive inquiry the courts take two routes to PCV: o The Alter Ego Doctrine the corporation (subsidiary) is the alter ego of its SH (the parent) do dominated that in reality no separate entity is in existence. Such as:  Undercapitalization not enough money to cover liabilities that may arise or to cover the cost of doing biz; Insurance can be capital! y Note: generally look to corp capital when corp is formed  Subsidiary is insolvent  No dividends are paid  No corporate records or formalities kept failure must be continues; not just one time  Subsidiary funds siphoned to parent  Payment by the corporation of individual obligation commingling of funds  No separate accounts for the parent and subsidiary  In essence the corp (subsidiary) functions as a faade for the dominant SH (the parent)  Not one factor is controlling (courts look a lot to commingling of funds and undercapitalization) o Injustice and Unfairness Elements present:Essentially that recognizing the corporation as a legal entity would sanction a fraud or injustice. PIERCING IN LLC

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Rule: Same PCV principles apply in the context of LLCs o Kaycee and Livestock v. Flahive Notes: o Most courts have held that there is no reason why PCV should not be applied to LLCs it is a judicial-created remedy; the determination of whether PCV applies is the same: whether there is an element of injustice, fundamental unfairness, or equity o What can you do to avoid PCV for LLC?  Dont commingle funds keep separate accounts; dont use co checkbook for own expenses or the other way around  Make sure you have sufficient start up money  Always sing in the proper way sign things in LLCs name y i.e. Clark Cones signed by Carol Clark, its President

Cox & Hazen on Corporations - 3 primary variants within Piercing the veil jurisprudence: o (1) Instrumentality Doctrine  Presence of 3 factors:  1. Control: complete domination of finances, policy and business practices with respect to the transaction attacked, thus the entity had no separate existence on its own  2. Control must have been used by U to commit fraud or wrong in contravention of s legal rights  3. The control and breach must proximately casue the injury or unjust lost o (2) Alter Ego Doctrine: appropriate to pierce the veil when:  1. Unity of ownership and interests exists beween the corporation and its controlling stockholder such that the corporation has ceased to exist as a separate entity and the corporation has been relegated to the status of the controlling stockholders alter ego and  2. To recognize the corporation and its controlling stockholder as separate entities would be sanctioning fraud or would lead to an inequitable result. o (3) Identity Doctrine

DEEP ROCK DOCTRINE (aka Equitable Subordination) Rule:Based on its equity power, a bankruptcy court has the power to disallow or subordinate a claim of a SH (insiders) against his bankrupt corporation to the claim of other creditors. o principle in bankruptcy law by which unfair or inequitable claims presented by controlling SHs of a bankrupt corporation are subordinated to cliams of general or trade creditors (creditors ahead of you get paid first) o Test whether or not under all the circumstances, the transaction carries the earmarks of an arms length transaction  if not, the equity will set it aside essentially if it smells bad to the court o It is not a matter of piercing the veil, its a defensive doctrine Pepper v. Litton applied the above rule

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o When Litton saw the co was going under after the co was sued, he also sued his own corporation for back salary and obtained a judgment. In bankruptcy, he sought to enforce his judgment and collect before the creditors  Note: usually claims for salary have higher priority in bnkptcy BUT in this case the court subordinated his claim because the D was praying on his own company; so equity called for his claim to be set aside. y It was a planned and fraudulent scheme he waited so long for these back pay claims Key things to take out: o He should have come up with a good excuse for why he waited so long to get his salary that the co was already in trouble, etc, etc o To protect client against ES should have a promissory note and a loan agreement /contract with obligations to pay you (to make sure youd be in line in case of bankruptcy)  remember courts dont ALWAYS subordianate!  Nothing wrong with SHs making loans to the corp but if you do, make sure protected!!

SUCCESSOR LIABILITY General Rule: A corporation which acquires all or part of the assets of another corp DOES NOT acquire the liabilities and debts of the predecessor UNLESS (exceptions): - (1) there is an EXPRESS or IMPLIED agreement to assume the liabilities - (2) the transaction amounts to a consolidation or a merger (or stock sale) - (3) the successor entity is a mere continuation or reincarnation of the predecessor entity, OR - (4) the transaction was fraudulent, not made in good faith, or made without sufficient consideration Nissen Corp v. Miller: Rule: Corporate successor liability does NOT include an exception for continuity of enterprise o In this case the court rejected a fifth exception that of the continuity of enterprise  Continuity of enterprise focuses on the continuation of the biz operation or enterprise where there is no continuation of ownership; this is different than the already established exception of:  Mere continuation which focuses on ownership focus on corporate entity not the continuation of biz operations Foster v. Cone Blanchard (MI CASE) o Court in that case held that the continuing enterprise theory MAY be applicable in MI but the facts in the particular case where not there o RULE: Prima Facie case for continuing enterprise  (1) Same management, employees, location, assets, operations  (2) While the buyer does not assume all the liabilities, it assumes all the liabilities necessary to operate biz uninterrupted  (3) Seller stops doing business after the sale and there is no one else to go after

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BALANCE SHEETS and INCOME STATEMENTS Balance Sheet vs. Income Statement - Balance Sheet: shows what you own and what you owe a snapshot o Formula: Equity = Assets Liabilities  Equity = ownership or net worth of the biz o Basically shows the assets and liabilities at a point in time o Remember: assets (left hand side) and liabilities (right hand side) have to balance!!!  Key: on the liabilities side after you list the liabilities (i.e. accounts payable, notes payable) must add on the Shareholders Equity (what the co owes to the shareholders) this makes it balance! o Equity line on the balance sheet different depending on the type of biz that you have  In partnerships capital accounts is maintained for each owner shows how much the individual partner put into the partnership  In corporations there is no separate equity account for each SH its all in a big pot, capital stock or stated capital o Par value states  Par value totally arbitrary; the minimum amount that a corporation can accept for the stock; no longer in many states including MI  Example: y Par value = 1 dollar y But you sold 1,000 for 50,000 y The line item would be like this: o Capital stock 1,000 (the par value) o Paid in capital 49,000 the excess over the par value - Income Statement: shows what a company did over a period of time (usually over the course of an year) a movie o Formula: Revenue Expenses = Net Income (the money that is left over for the company at the end of the day) Accounting Principles - accounting: the process of recording and classifying financial information - GAAP generally accepted accounting principles; not rules but general standards o Key: consistency! o Examples for accounting inventory: FIFO (First in first out); LIFO (last in first out) - However the SEC has its own accounting principles: Regulation SX so if you want to go public you have to change your accounting practices to comply with this reg - SOX also has its own accounting principles Accrual Accounting the biz records credits and debts (income and expenses) when the right to receive or the liability arises NOT when the cash is actually received most often used Cash Basis Accounting dont record right to receive or liabilities until the cash is paid out; so you would not have an account receivable line

Note: Zeroing Out some corps choose not to elect S status but still dont pay tax on income because of zeroing out corp pays its SHs money in deductible business expenses (i.e. leasing fees; salary; etc) so you use up all your revenue by paying deductible expenses in the same amount that you

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would with a dividend. Works only for closely-held corporations when everyone is working for the business.

BASIC FEDERAL INCOME TAX PRINCIPLES Basic Principles: - Taxable Income = receipts expenses - Gain = amount realized adjusted basis o Basis (what you paid); Gift donors basis; Inheritance FMV at time of death (stepped up) - Biz Expenses must be a necessary and reasonable expense - Corporate Taxation: o Chapters S and C while partnership taxation is in chapter K o C-Corp taxation the income is taxed at the rates stated in the schedules in chapter C; when the dividends are paid out the SHs, the SHs are also taxed on this amount at their individual tax rates.  Note: board decides whether or not to distribute dividends if no distribution, double taxation does not arise o S-Corp taxation the corp does NOT pay tax at the entity leve; the shareholders pay the tax at their personal tax rates so even if there are no dividends paied out, the SHs are still taxed on the income for the particular year  Remember: minimum distribution clause corp agrees to pay SHs the minimum amount to satisfy the tax DEBT; EQUITY Definitions: - Capital = the financing that firms used to fund their business. Can come from (1) capital contributions from the owners; (2) burrowing from friends; banks; etc; (3) capital investments from outside investors active or inactive; (4) retained earnings that are not distributed to the owners - Equity Capital v. Debt o Debt (fixed claims)burrowing; must be repaid with interest; not contingent on the success of the biz o Equity (residual claims) ownership; what you invest in a co can lose it all but can also grow it  Equity = Assets Liabilities  The value of an owners equity in a piece of property = the market value the market value of the debts and liens against that property - Trade Debt: normal every day debt incurred for doing biz; unsecured account payable - Dividend = a distribution from current or retained earnings - Distribution = payments to the owners out of capital TYPES OF EQUITY SECURITIES 1. Authorized capital:

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a. the number of shares that the corporation is allowed to issue must be specified in the articles of incorporation cannot issue one more than so specified! i. If the corp wants to issue more than specified in the articles has to go to the SHs and get the articles amended ii. Blank check shares bd has the power to determine how those shares will be divided into classes and set the limitations and preferences this determination is done upon issuing the stock 2. Issued Shares: a. Shares that are issue to the SHs you may have 1000 authorized shares but only 500 issued the other 500 are outstanding shares. 3. Treasury Shares: a. Shares that were once issued but have been bought back are now retired i. i.e. if a SHs retires and the corp buys his shares back, they are now in the treasure of the corp can be issued back. 4. Common Shares: a. Most corps have only common stock one class of stock b. Common shares have certain attributes (per the SC) i. The right to receive dividends contingent on when the bd determines that the dividends should be issued and if they are allowed under the law ii. Negotiability a stock certificate is a negotiable instrument (absent transfer restriction) iii. Ability to be pledged as collateral iv. Voting rights in proportion to the number of shares also voting rights 4 directors v. Shares have capacity to increase in value. 5. Preferred Shares: a. Classes of shares with rights that are preferential to the common shares b. Have priority in pmt as against the common shares this means that the holders of preferred stock are entitled to specified distributions before anything can be paid out on the common shares. i. This priority may be either in the pmt of dividends or capital distributions or both. c. Generally, nonvoting! i. Exceptions voting power often assigned to preferred shares if the co misses scheduled dividend pmts or fails to meet some other financial obligations 1. Common to provide that nonvoting preferred shares get to vote for the election of a specific number of directors IF dividends have not been paid for a specified period. ii. Also: cant change the preferences without the holders vote! d. Remember: With preferred stock you generally cannot profit from the profits of the co (unlike common stock who may get a lot or nothing depending on the profits in the particular year) preferred get fixed amts! e. 2 Major types of preferred stock: i. Cumulative: 1. If a preferred dividend is not paid in any year, it accumulates and must be paid, along with the following years unpaid cumulative dividends,

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BEFORE any dividend is paid out on the common shares; most common in public corps. a. Example: I have 5-dollar cumulative stock in 2006, no dividend paid out. In 2007, if bd pays out dividends, I get 10 dollars before any common shares are paid out. ii. Noncumulative: 1. not carried over from one year to the next; if no dividend declared during the year, the preferred SH loses the right to receive the dividend for that year simply disappears. a. Example: (above) in 2007 you only get 5 dollars. iii. Partially cumulative: 1. typically cumulative to the extent that there are earnings in the year and noncumulaive w/respect to any excess dividend preference. iv. Participating Preferred: 1. Shares entitled to a specific dividend, and after the common shares receive their amounts, the participating preferred share with the common in additional distribution on some predetermined basis 2. This is the best of both worlds example: 100 dollars available to be distributed for dividends. You would get your preferred 25%, 50% would go the common SHs and the rest that remains (25%) both the common and the participating would get equally. f. Some typical rights associated with preferred stock: i. Redemption rights: 1. The corporation has the power to buy back the redeemable shares at any time at a fixed price; the price is set when the preferred stock is issued and the holder has no choice to accept that price a. Lingo: the corp calls the stock for redemption b. Usually the redemption right is of the corp (rarely, the holder will have the right to call the stock) ii. Conversion rights: 1. Sometimes preferred stock can be converted into common stock (there will be a certain conversion ration that will say if you own X amounts of preferred stock, u can convert them into so many amounts of common stock) a. Always at the option of the preferred SH b. Right to convert common into preferred usually prohibited 2. NOTE the corporation must set aside enough common stock to honor the convertible stock have to have the shares aside in case someone wants to convert 3. Convertible stock can be redeemed at the option of: a. Company (most common) i. The redemption price is listed right on the certificate (its usually higher) the longer you wait the lower redemption price will be ii. CALL if a corp has the right to redeem the stock at the option of the corp the corp calls the stock (the call is across the board, all SHs of the redeemable stock affected)

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b. Holder i. PUT the SH has the right to put their stock back into the co whenever they want ii. Sinking fund the corp must put aside money so that if someone wants to redeem their stock, they have money to pay them iii. Liquidation preference: 1. Usually fixed price payable upon the dissolution of the corp before anything may be paid to the common shares. Because fixed amt, holders dont benefit from appreciation of stock. g. Blank Check Preferred Stock Gives the Board the discretion to set out the rights and preferences of the preferred stock when issued h. Note preferred shares can be further dividend in classes or series preferred classes can be junior and senior to each other BUT all preferred are senior to the common stock

ISSUANCE OF SHARES Share Subscriptions and Agreements to purchase securities: - this was the old way of raising capital people would agree ahead of time to purchase a specific number of shares preincorporation subscriptions o after the corp was formed, it would call the subscribers for them to actually pay up - many problems so no longer used except extremely rarely Authorization and issuance of Common Shares Under the Model Biz Corp Act: - any number of shares may be issued at any price so long as the combination (number of shares X price) totals the capital o example: $10,000 capital may issue 5,000 at 2 dollars each; may issue to two people 500 shares at $10 each. - The price must be the same for buyers who receive the same class of shares! - Authorizing more shares than the corp plans to issue perfectly ok and actually a good idea! Remember: can never issue more than authorized in the articles Par Value and Stated Capital WATERED STOCK - Par Value = an arbitrary value; a fictional number below which the stock cannot be sold. o Basically the stated par value (in the articles) assured the population that the shares had real value that the corp had in fact been capitalized as advertised by the part value of the shares issued - No par value in MI!!! so shares can be sold for any value! - If par value shares are issued for consideration worth less than par, the recipient remains obligated to pay the corporation the difference between par value and the amount actually paid. Shares so issued are called watered sharesor watered stock. o Bonus shares: for which nothing was paid for o Discount Shares: shares issued for cash but for less than par o Watered Stock: shares issued for property less than their par value

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Hospes v. Northwestern: Rule: The capitalization of the par value of its issued shares is a public representation on which creditors might rely; When you get watered stock, you are responsible to the corporation for the water! o The parent co never intended to pay for the subsidiarys stock the court however required the parent to pay for the par value even though there was an agreement that the stock was free the court relied on the trust fund doctrine to say that the corp is basically a trustee for the creditors and it would just be unfair to the creditors who relied on the stated par value when extending credit. basically that it would be a fraud on the creditors.  So unless the creditors KNEW that the stock was watered down, the court can force the owners of such stock to pay up to the stated par value of the stock Class Note: o Del and NY still have par value! but even in par value states, you can put in your articles that the par value is ZERO or one cent nominal so it really doesnt even matter o Remember: you can issue shares for anything (tangible or intangible) that is of benefit to the corporation HOWEVER in par value states you CANNOT issue stock for services to be performed in the future but only for services already performed  Not so under MI law where pretty much anything can be consideration o In nonpar value states As long as there is no collusion and the buyers pay what the board asks the buyers are not responsible when the board gives them a good deal the BOARD however can be responsible and they could be breaching their fiduciary duties (see MBCA 314(3))  NOT SO in par value states the buyers of such discounted stock are responsible for the water!!!!! Hanewald v. Bryans Inc. Rule: A shareholder is liable to corporate creditors to the extent that his stock has not been paid for. o The SH is liable to the extent of the difference between the par value and the amount specifically paid and to such an extent only as may be necessary for the satisfaction of the creditors claim o The court held that for a corp to issue free stock is a violation of (1) SHs who do not consent, and (2) the creditors who deal with it on the faith of its capital o So the court held that the failure of the D to pay for his shares made him personally liable to creditor o Note: basically, the idea is that if you want limited liability in corporate form, then you better pay the minimum you are required for the stock Michigan Business Corp Act o 306, 307 the corporation has the right to enforce a subscription agreement; corp has security interest in the shares until they are paid for o 314(2) the board can accept unsecured promissory notes o 314(3) this provision protects a person who paid for the shares for less than the market value (shareholders CANNOT come after this person because he paid what the board asked him to cuz he got a good deal; unless he colluded with the board  protection for person who receives the shares in good faith BUT the board could be on the hook for fiduciary duty violations!

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DEBT FINANCING Class Notes: - you can capitalize your corporation by burrowing money! - Most businesses have a revolving line of credit there is always a line of credit available to you; generally there is a commitment fee to the bank to have that line available to you - Term debt when you pay it back you cannot reburrow - Securities remember NOT just stock but also debt!!!!!!!!! Bonds - unconditional promises to pay a stated sum in the future and to make pmts of interest periodically until them - usually secured by a lien or mortgage on corporate property if the corp doesnt pay you, you can force the corp to liquidate assets and pay you - Two Typical types of bonds: o (1) Zero bonds zeros pay no interest at all; usually sold below face value example: 100 bucks bond zero coupon you buy for 50 bucks and get the whole 100 bucks upon maturity o (2) Junk Bonds below investment grade debt instruments risky - COUPON = the interest on the bond! Debenture - an unsecured corporate obligation Both (bonds and debentures) are usually referred to communally as bonds - Bearer Bonds bonds and debentures were historically paid to the bearer anyone in possession of the piece of paper could obtain pmt for the debt - Registered Bonds bonds registered in the name of a specific individual; all bonds today are registered to minimize tax evasion; all bonds are freely transferable; o IMPORTANT: Have to inform corporation when you sell your bonds!!  If I sell my bond to Clark and none of us tells the corp the corp can pay me interest; its up to us to tell the corporation otherwise the corp is entitled to rely on the books as they are!!!!! Debt financing is considered more important than equity financing!!! - Concept of leverage o Debt owed to 3rd persons creates leverage leverage is favorable to the burrower when the burrower is able to earn more on the burrowed capital than the cost of burrowing o Leverage Ratio ratio between debt and equity; basically you should be making more on burrowed funds than the cost of burrowing if your debt becomes so high that you cannot get a return on the burrowed funds that is greater than the cost of burrowing, there is a problem - Tax Treatment of Debt o In C corps more advantageous for SHs to lend to the corp than make capital investments  Interest pmts by corp are deductible to the corp where dividends are not reduces the problem with double taxation o However there is a risk that the IRS will characterize the SH loan and say that its really capital contribution and the interest pmt is actually a divident o ALSO if the corp goes belly up, remember the Deep Rock Doctrine the court could subordinate the loan the corp owes to the SH so the SH could be screwed

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PREEMPTIVE RIGHTS Definition: preemptive rights give holders of outstanding shares the right to buy a proportionate part of any new issue of securities by the corporation before the shares are offered to other persons Protect existing SHs against the dilution of value and control of financial interest in the corp when new shares are issued to non-shareholder o Example: 100 shares authorized: I won 50 (50%) if the corporation issues another 100 shares for a total of 200 and I still own 50 shares my interest is diluted to 25% ownership in the co with preemptive rights the corp would have to allow me to buy extra stock in order to allow me to maintain my percent ownership to keep my 50%. Common Law Rule: Preemptive rights were considered inherent rights that a corp had to afford SH whenever new stock was issued for cash Stokes v. Cont. Trust Co. of City of NY o There is no longer the rule!!! Preemptive rights are NOT inherent in the ownership of the shares so your percentage in a corp CAN be diluted!! a corp may grant or withhold preemptive rights in the articles of incorporation MiBCA 343 No preemptive rights exist UNLESS expressly provided for in the articles of incorporation! In other words, in MI preemptive rights are an OPT IN provision!  Opt in you get the right if LISTED in the Articles  Opt out bound by the statute unless the articles say that you dont want to be bound o So, in MI, you only get preemptive rights if your articles say that you do dont have to say much in the articles: simple provision, one liner, saying that the corp has preemptive rights o REMEMBER: even when you do get preemptive rights in MI the preemptive rights apply only for shares that are issued for CASH or CASH EQUIVALENT!  If its anything else you dont get the preemptive rights to kick in; (i.e. if the selling SH wants to sell the shares for property or service, etc then no preemptive rights) also no preemptive rights when corps issue stock as compensation (which is a good incentive for the person receiving it to desire the corp to do well)

LEGAL RESTRICTIONS ON DISTRIBUTIONS Remember: the board of directors decides when to pay out dividends! - MiBCA 345 o 2 tests have to met in order for the board to make dividends/distributions BOTH TESTS HAVE TO BE MET:  Equity Insolvency Test: If the corporation cannot pay its debts as they come due, then the corporation cannot distribute any longer, AND y Note: even if you have property assets, that is not enough if you dont have liquid CASH to pay your debts  Balance Sheet Test: If after distribution, the corporations total assets would be less than the total liabilities. o To determine whether these tests are met, the Boar can rely on financial statements prepared on the basis of accounting practice that are reasonable in the circumstances

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Could be any reasonable accounting practice also the board may rely on info presently in their hands not responsible as a matter of hindsight for unforeseen developments Delaware uses the Nimble Dividend Test o This test is really hard to understand the crucial thing is that if the board issues dividends that are in violation of the applicable tests the BOARD is responsible for paying that dividend back to the corporation (Cant go after the SHs to pay it back!)  So its awful to have very complicated tests such as this the Board has a lot riding on the decision of whether or not to pay out dividends  AND generally RAIN COAT provisions in the articles DO NOT protect the directors from liability for paying out illegal dividends!!!!!!!!

TRADITIONAL ROLES OF SHAREHOLDERS AND DIRECTORS Three types of players in corporation: - Shareholders: o Get to vote on major fundamental changes in the corporation only not day to day activities o Elect the board of directors o Note in most closely held corporations, the SHs also fill other roles (can be on the board and officers as well, at the same time too!) make sure you know which role is up  Remember: SH acting unilaterally cannot bind the corporation!!! - Directors: o Two basic functions:  Decision making function  Overseeing function o They have the ultimate power to run the corporation o Elect the officers o Important Note A director cannot unilaterally bind the corporation need to get the other directors to vote on the matter this is different than in partnership where one partner can bind the partnership without any approval of the other partners - Officers: o President CEO (Chief Executive Officer) o Chief Operating Officer (COO) o Chief Financial Officer (CFO) o Vice President; Treasury, Secretary, etc o NOTE: the board can authorize officers to enter into K on behalf of the corp, but board still not off the hook The places to look for governing law in internal disputes are: - (1) state law of incorporation -- Internal Affairs Doctrine all internal matters within a corporation are governed by the law of the state in which you are incorporated - (2) Articles of incorporation; - (3) Bylaws; - (4) The powers of the directors outside directors; inside directors; - (5) the powers of the officers; - (6) employees

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Traditional Common Law Rule: McQuade v. Stoneham Rule:Agreements among SHs that abrogate the power or independent judgment of the board of directors are VOID! - Basically, corporation law is designed to protect minority SHs who are not parties to the K by assuring that they receive the protections of the unfettered (objective/neutral) best judgment of the board - In this case there was an agreement where P was to be kept in office as an officer the court invalidated this because it undercuts the boards rights and obligations to act in the best interests of the corporation (what if P turned out to be a lousy officer?) o The directors are fiduciaries of the corporation! - There were no exceptions carved out to these rules in the context of closely held corporations - Note: P could have protected himself with an Employment K Exceptions to the McQuade rule for closely-held corps Clark v. Dodge modified the common law rule in McQuade. - Holding: an SHs agreement which would have been void under McQuade because it stated that a specific officer would be kept in office, was upheld in this close corporation context because: o these were only minor infringements on the statutory scheme; o no one was hurt, and o the two directors in this co were the only two shareholders (small corp and the parties at interest are all before the court) Long Park v. Trenton-New Brunswick Theatres Co. this case went too far! - Facts: the SH gave one specific SH the full authority to direct the management of certain theatres - Rule: While in the context of closely held corporations, some infringement on the powers of the directors is acceptable, a K that deprives the board of all of its powers in re the selection and supervision of the management of the corp is VOID!!! - Held: these limitations were beyond the scope of Clark - the agreement took all of the power of the directors this was more than just a slight infringement and thus void Galler v. Galler Important case - Rule: In the context of a closely-held corporation, a SH agreement that impinges on the powers of the board of directors is enforceable IF: o There is no public injury o There is no injury to creditors, and o There are no minority shareholders harmed - In this case the shareholder agreement did the following: o Allowed the SHs to change by law Ok, they can do that o Allowed SHs to pool votes for directors Ok o If director died, wife would nominate for the vacancy usually when a directors dies, the other directors fill the vacancy until the next SH voting meeting; court oked o Dividends would be paid upon certain goals being met NOT generally ok because the SHs took the decision to pay dividends out of the boards hands; court oked o Legend on shares that there is a SH agreement in place ok, provides notice

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o Agree to pay wife salary of director-husband dies this impinges on directors duties because they determine salaries; court oked The court relaxed the corporate formalities for closely held corps in order to accommodate them and allow them more flexibility in corporate governance SO, the SHs got the benefit of their bargain even if they technically violated corporate law because no one was harmed! No harm no foul!

NOTES: - Some corporate statutes have closely held sections o In Delaware (and other states) you can select closely held status in the articles of incorporation this allows closely held corps to depart dramatically from the statutory scheme of SHs/Directors/officers in certain circumstances o MI does not have such a special section for closely held corps BUT it has many highly favorable provisions for closely held corps throughout the entire Act  MiBCA 461 permits SH agreements  MiBCA 209 allows management of corporation by shareholders vs directors but have to specify in the articles! o SO in MI dont have to elect closely held status but have to put the-opt in favorable provisions in the articles so you gotta fish them out and put them in the articles!!! - Can boards bind future board? o YES a contract entered by one board is valid even after a new board takes over o The new board could breach and pay damages if it really didnt like the K Zion v. Kurtz Rule: When all SHs agree in some way to limit the powers of the directors, the agreement is, as between the original parties to it, enforceable even though all formal steps required by the statute have not been met - Facts: the SH agreement in this case essentially gave one SH final say for everything. This would have been ok if they complied with the local law and selected closely held status in the articles of incorporation but they failed to do this! - However, this court cut a lot of slack for these guys pretty much said no one was hurt and told them to go amend the articles to comply with the law - MI Statute o 10% of SH can petition the court to remove the directors if directors are engaging in fraudulent or other misconduct.  Often used when Directors are SH or related tot hem (in collusion), they aren t going to remove themselves - What are we getting out of these cases? o In a corporation issue--Look at statute, articles of incorporation and bylaws  Bylaws may change the statute o Old days, SH had inherent powers that are now given to them by statute Board Functions and Compensation o (class) Main Functions: making decisions and overseeing/modifying  Decisions y appoint the officers y setting officers compensation y reviewing and approving financial objections of the corp

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Monitoring y Put in a system of adequate internal controls and recording to ensure compliance with laws and company policies o Must act by consensus, generally by majority vote  Super majority voting req s y By laws can require more then moajrity  Single member can not make a decision on behalf of the other board members  Usually must act at a meeting o Compensation  Usually a stipend and expenses for attending the meetings o Rights  Informational rights- needs to be able to inspect the books and records in order to do their jobs o (book) 5 groups of functions normally associated with directors:  Select, evaluate, and when appropriate, replace the chief executive officer (monitoring the management). Determining management compensation. Review planning for the future  Review and, when appropriate, approve financial objectives, Strategies and plans. Provide advice to shareholders on votes concerning strategic issues facing the corporation such as a merger with another corporation.  Provide advice and counsel to top management  Select and recommend to shareholders for election the slate of directors.  Review adequacy of internal controls and other systems to assure compliance with applicable laws and regulations. also internal controls are useful for monitoring management and the use of assets. Housekeeping Requirements o Directors meetings  State corp statute require that board action be taken at a duly convened meeting  generally believed that directors should only act after complete airing of all views y better assures informed decisions y directors cant vote by proxy y MBCA 8.20(b) and Del. 141(i): unless the articles of incorporation or by laws state otherwise, a meeting can be held by means of a communication which can be heard by all directors with 2-ways communication. y State statute usually allow corporate action to be taken without a meeting where there is unanimous approval by all members of the BOD (MBCA 8.21) o THEORY a meeting is not required if everyone is in agreement o Must be in writing

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o Can be restricted by bylaws or articles o Notice of Director Meetings  MBCA 8.22(a): regular meetings of the BOD may be held without notice to the directors of the date, time, place, or purpose of the meeting y Theory since the meeting is a regularly scheduled one, no further notice is deemed necessary  Under MBCA, If articles of incorporation are silent the y Directors can act by unanimous consent on the issue without a meeting. o Opt out provision o If nothing about it in art of inc then you have it o Can act only by unanimous y SH right to act by consent without a meeting = Opt in provision o Valid as long as the same % of SH that could pass a resolution at a meeting passed resolution by consent  special meetings 2 days notice is required, purpose need to be describes  Waiver may be waived by a director in writing y Unless you show up to protest your lack of notice for the meeting y Attendance with participation for any other purpose is = waiver o Quorum & voting Requirements  Normally majority of the total number of directors on board  Super majority quorum provision, including requirement of unanimity can be established y articles or bylaws y Must be stated in the articles of inc o May fix a directors quorum of less than majority approval, even unanimity o At least a presence of 1/3 directors  MI Statute y Remaining board members can fill a vacancy if fewer than a forum by affirmative vote by the rest of the directors in office y Allows super majority voting rights y Does not let you have less than a majority o Extraordinary Circumstances ( how do you know if person has authority to bind the company in an extraordinary circumstance)  BOD would have to act on it y Would approve transaction y Then appoint someone to follow through and negotiate the transaction y In the minutes of BOD o Minutes would authorize the transaction  Evidence that the board has acted Certified resolution y Take out the portion of the minutes where the corp approved the cont and someone to sign the cont. usually the sec signs the resolution 38

o Person that takes the resolution can rely on it instead of going through the min books. false Certification o If secretary makes up the resolution and falsely certifies, and you rely on it then they would have apparent authority in the case company held liable o Secretarys job to do these, courts would say under apparent authority, by appointing her as secretary you gave her the appearance to 3rd party that they can certify resolutions

Board Committees o State statues authorize the BOD to divide into committees that have the powers of the full board with respect to certain types of director action  May not fill vacancies on the BOD or adopt amend or repeal bylaws  Specialization of the board with increasing accountability  Board may appoint advisory committees with non directors y Can be made up of anyone, only advisory in nature  Operates more effectively and expeditiously  Most Common committees include: y Executive y Compensation y Audit y Special litigation y Nominating o Inside and outside Directors  Inside: y Have enough voting control to be appointed as officers y Elect board memebers for the purpose of protecting the interests of the large shareholder o Directors still owe duties to all shareholders when acting into heri capacity as a board member  Ouside: y Not employees, reps of large shareholders or otherwise affiliated with the corporations stock o Typically own small amounts of the corporations stock y Often former gov officials, successful business people, or law professors y Bring independence, broadened expereience and perspective to the corporate decision maing process even though they have no day to day involvment into he corps affairs y Boards often delegate authority to committees on outside boards to reduce potential conflict of interest concerns raised by inside director/managers that have a personal interest in corp actions o Director s informational rights Officers and their sources of power 39

o Officers manage the corporation and act under the BOD o Positions  Uusally president, vice president, secretary and tresurer  Often many vice presidents o Authority derives from agency law  From the bylaws, resolution of the BOD, or job description or duties approved by the board o Doctrine of APPARENT AUTHORITY If board elects you as pres and then tells you that you cant make any commitment on behalf of the corp without the boards approval unless board notifies everyone then it is not binding with regard to 3rd parties Distributions o BOD makes dividends (discretionary), Legal restrictions when it can give dividends  State satutes are all over the place of when you can give them o ModelBCA- 2 tests ( 345MI-BCA is identical)  Equity Insolvency Test--corp may not give dividens to shareholders if after giving effect to the dividend, the corp would not be able to pay its debts as they become due  Balance Sheet Test--If after giving effect to dividends or distribution the corporations total assets would be less than the corporations total liabilities can not legally pay a dividend (Preferential rights are considered a liability)  Either test failed cannot pay the dividend y If you pay a dividend that not legally entitled to pay (violates the two tests), BOD is personally liable for the amount of the dividend paid  Both tests met BoD has power to declare dividend but not obligated/required to declare it y If stock is cumulative then board must make up all past dividends before it can pay anything o DE s Test Nimble Dividend Test  Can pay diversity out if this years earnings or out of earnings from the proceedings year  MI does not practice this

SHAREHOLDER VOTING AGREEMENTS General Notes: - shareholder voting agreements SHs can come together and agree to vote for certain people as directors (you can do this even in a state that doesnt have close corps statues like in MI) - Proxy a person authorized to vote someone elses shares Depending on the context, the word proxy may refer to: o (1) the grant of authority itself o (2) the document granting the authority, or o (3) the person granted the power to vote the shares. Record Owner v. Beneficial Owner:

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Record Owner the person in whose name the shares are listed as the owner in the books of the corporation. o May or may not be the actual owner of the shares; o The corporation is entitled to treat the record owner as the owner of the shares for purposes such as voting and pmts of dividends so the corp books and records are prima facie evidence as to who can get dividends or vote o Street Name sometimes stock is held in street name this means that the stock record owner is a brokerage firm you would keep your stock in street name because (1) convenience want the broker to be able to take immediate action, and (2) anonymity dont want the world to know that you hold stock Beneficial Owner The actual owner of the shares. o Where the record owner and the beneficial owner are different persons, the beneficial owner can compel the record owner to:  Execute proxy appt in the name of the beneficial owner so he could vote his shares,  To turn over any distributions made by the corporation, and  To register the shares in the name of the beneficial owner when requested to do so The reason why there is this distinction between the record and beneficial owners has to do with the record date: o Record Date the date that the identify of the SH entitled to vote, receive dividends or receive notice, is determined  Basically, a cutoff date a corporation sets regarding the right to vote and/or the right to receive dividends  If the record owner is listed on the books at the time of the record date, for all intents and purposes, that person is considered the owner of the stock  The corp has the right to set the record date and whoever is listed on the books of the corporation this day, these are the people that have the right to receive dividends and vote.

Salgo v. Matthews Rule: Shares of stock may be voted only by an authorized representative of the party designated in the corporate records as the legal owners of the shares. - Beneficial ownership does not carry the right to vote without having the shares transferred on the books!! - SO eligibility to vote is determined by the corporate records!!!!! If the beneficial owner wants to vote his shares, he has to get a proxy from the record owner (can do so by court action too) - Election Inspectors resolve disputes as to entitlement to vote on the basis of statutory voting rules and records of the corporation must look to the books and records! - In this case the inspector was trying to figure out who actually held title to the stock all he had to do is look to the records and determine (1) who the record owner was, and (2) who if anyone had proxy to vote for the record owner. Voting Requirements: - Quorum

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o Definition: the minimum number needed to hold a valid election (that number is provided in the articles or bylaws) o 415 Quorum provision a majority is a quorum by default can be modified in bylaws or articles o if a quorum is not present then no business can be conducted! Notice o SHs must be provided with notice of meetings  If the meetings are set (i.e. every first Tuesday of the month) then no notice needed o 404 the SH must be given at least 10 days but no more than 60 days notice before the date of the meeting

Action without meetings: - Shareholders action w/o meeting o 407 OPT IN provision this basically says that SHs can take action without a formal meeting only need a majority to vote - Directors action w/o meeting o 427 OPT OUT provision need consent resolutions that are unanimous! Voting: - Straight if there are 5 nominees (for 5 seats) and the SH own 10 shares, the person can only put 10 votes for each nominee (for total of 50 votes) o If someone has 30 shares, they can put 30 votes for each nominee and thus win - Cumulative you can pool your votes; So if you own 10 shares and there are 5 candidates, you can vote 50 shares for your favorite candidate and 0 for the other four o Formula: number of shares X number of seats open for election (NOT # of nominees) o Cumulative voting gives the minority SHs opportunity to be heard! o In MI, cumulative voting is an OPT-IN provision!!! 451 (like in most states)  Have to put in the articles of incorporation but even when the articles allow for cumulative voting, you can still vote straight if you want to; Stancil v. Bruce Stancil Refrig., Inc Fact: Two brothers (Bruce and Howard), each owned of shares. Howard announced that he was voting cumulatively but Bruce voted straight. Result: Because Bruce didnt understand how cumulative voting works, he got outvoted! Note: o Staggered Boards Where a board is composed of three or more directors, several states permit the staggering of elections if the corp does not have cumulative voting this means that each director serves for three years and only one director stands for election each year. o No pooling agreements for directors! because they would be breaching their fiduciary duties to the corporation! Ringling Bros v. Ringling Rule: A group of SHs may lawfully contract w/each other to vote in such a way as they determine; Stock Pool Agreements are lawful but strictly construed!! o Facts: 2 ladies contracted that they would vote together (to always outvote Mr. North) and if they could not agree they would go to an arbitrator. They couldnt agree on a

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vote and so the arbitrator told them who to vote for. However, one of the ladies, Mrs. Haley, did not listen, and the other lady sued. o Held: the court found the agreement enforceable but strictly construed its language said that the parties intended to bind each other but DID not empower the arbitrator to enforce the decisions he may make so arbitrator could not vote!  The court just threw out Mrs. Hs votes Clark says this is bad because it punished Mrs. R (the innocent party) as well because now she was outvoted too the court should have just called a new election o Lessons from this case:  Voting pool agreements are legal  Make sure that you are carefully drafting these agreements because they are strictly construed if one party breaches that partys votes could be thrown out BUT all the parties would be hurt because the benefit of the agreement would be lost  Remember: its better to give the arbitrator proxy rights to just vote for the parties when they cannot agree they should have made the arbitrator a trustee Voting TrustsMiBCA 461 o MI Act allows voting agreements and voting trusts! o Voting Trusts turning the right to vote to a trustee and the trustee decides for who to vote; usually 10 year duration; NOTE: should be in writing

Transfer Restrictions RULE: Restrictions of stock are lawful as long as they are: (Ling v. Trinity Savings) - Conspicuous to put unwary purchases on notice o A corp may impose restrictions on transfer of stock if they are expressly set forth in the articles AND copied at length or in summary form on the face or on the back with reference on the face of the certificate. o Conspicuous a question of law  Whether it is so written to be noticed by a reasonable person (caps, bold print) o Restrictions that are NOT conspicuous are nonetheless enforceable against persons with actual knowledge of the restrictions o Note: if the restrictions are not conspicuous, you are creating Bona Fide Purchaser rights who takes without restrictions - Reasonable The restrictions may not unreasonably restrain or prohibit transferability o Example of unreasonable: buy sell agreements that dont ever allow transfers It is always a good idea for minority SHs to protect their interests in a closely held corp BUT too often close corp investors fail to take advantage of such contracting because of relationship-oriented concerns Note: - Valuation concerns: When you have buy-sell agreements, determining the method of valuation is extremely important Can have: o Third party appraiser best way o Fair Price Certificate attached to your certificate and issued every year; problem  Problem: a lot of time people do not update their certificates so you get stuch with the price from the last time you updated.

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DEADLOCKS General Notes: - Can be either at (1) shareholder level, or (2) director level. - Deadlocks = where the directors/shareholders cannot function because of disagreement and no one can take action. - What can cause deadlocks? o An even # of directors o SHs who hold the same amount of votes (even cumulative voting can create deadlocks) o A high quorum number o Supermajority requirements (usually just need a simple majority) o Unanimous requirements - A way to over come possible deadlocks: o Have agreements that address the course of action to be taken in case of a deadlock such as (1) buy-out provisions; (2) Easy dissolution provision; (3) Arbitration o Note: in MI, court can order dissolution but better that YOU determine what happens Deadlock Cases: - Gearing v. Kelly Rule: Where a shareholder-director deliberately causes a lack of a quorum required for a directors meeting by purposefully refusing to attend, equity will refuse to set aside a board decision held at such meeting for lack of quorum. o Mrs. M purposely stayed away from a board member election meeting so there wouldnt be a quorum she acted in bad faith the court would not condone such behavior so ct. upheld the decision of the meeting even though there wasnt a quorum. o Board vacancies Under MI Law:  Vacancies on the board in the middle of the term can be filled by: y A vote of the SHs would require special meeting called hard to do y The remaining directors can vote to fill the vacancy even if the remaining directors would not make a quorum. In re Radom & Neidorff, Inc Rule: Even where corporate dissolution is authorized by statute in case of a deadlock or other specified circumstances, the existence of the specified circumstances does NOT mandate dissolution. So, there is no absolute right to dissolution under such circumstances. o The court will exercise discretion and mandate dissolution only when competing interests are so discordant to prevent efficient management and the object of its corporate existence cannot be attained. o Courts inquiry as to necessity of dissolution: Whether it will be beneficial to the (1) stockholders and (2) non-injurious to the public. o Facts: this is the case where the brother and sister were the sole SHs of the co and they hated each other. o Held: the corporation was doing well and the salary issue that the two could not agree on could be resolved in a different way where the public and the creditors would not be injured so the dissolution here would have been too drastic o Class Notes:

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This situation could have been prevented by an agreement Clark thinks the court should have allowed dissolution because the brother here was in a really tough position regardless of what happened best: try to buy sister out but give her a reasonable price that she would accept.

MODERN REMEDIES FOR OPRESSION, DISSENTION OR DEADLOCK General Notes: - Remember: involuntary dissolution was the original statutory remedy developed for deadlocks - Recent developments have broadened the available remedies in the closely held corp. context o In MI (and most other states) there are a LOT of remedies that a court can impose on the corporation where there is a deadlock  Dissolution granted extremely rarely courts do consider the public interest and the interests of the creditors; granted only when the competing interests are so strong that the corp literally cannot do business.  In MI, the courts have power to fashion an appropriate remedy tailored on a case b y case basis under the facts of the particular deadlock at issue y Courts can order a buy-out (preferred remedy)  Appoint a provisional director - BUT REMEMBER: you can dissolve a corp anytime without the court if all the shareholders agree! o Here we are talking about dissolution in the context of deadlocks where some want out and some do not when there is such dispute the courts will get involved. Modern Cases for Deadlocks - Davis v. Sheerin Rule:Buyouts are a remedy that can be imposed by statute, or where not so specifically stated for, by judicial decision. o The courts have the equitable power to order a buyout for oppressive conduct even where there is no such provision in the statute! o In this case the court found that the Ds conspired to deprive the Ps of their ownership in the co squeezing them out so the court just ordered a buy-out at a fair price! o Oppressive conduct = essentially means a lack of fair play; some kind of harsh, wrongful conduct/unfair treatment towards the minority. Oppressing is not synonymous with illegal or fraudulent!  What kind of conduct constitutes majority oppression? y Majority can take the minority SHs off the payroll y Majority can refuse to pay out dividends (minority is screwed because there is no market for their stocks closely held corps - Class Notes: o The P in Davis wanted to look at the corp records because the directors were doing some fishy things under MI law, a SH has the right to look to corporate records for a valid business purpose o Affidavit of Lose certificate = you sign an affidavit saying that you lost your certificate and cannot find it (or got stolen, etc) and you ask the corp to issue you a new certificate the corp will do that, however it will have a clause in there saying that the SH will indemnify the corp if someone shows up with the original.

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o Remember: with oppression, there is usually some bad faith! Also, oppressed minority usually want to leave but cant because the majority wont offer a fair price Abreu v. Unica Indus. Sales, Inc. Rule: As an alternative to judicial dissolution of a corporation, the court may in its discretion appoint a provisional director. o In evaluating provisional director candidates, the court can consider:  Degree and quality of past involvement in the corporation  Understanding of corps history and current situation  Degree of impartiality (no req of total impartiality)  Experience and capabilities  True interest in the advancement of the corp no allegiance to deadlocked fractions o The court kicked some off the board it can do this! o Note: In MI, courts can appoint provisional directors as well can even kick out the entire board if it deems in the best interests of the corp.

Remedies available in LLCs - Basically, the same principles apply to LLCs when we talk about deadlocks, oppression, etc - In the OA can state how a member withdraws from LLC and how funds will be distributed - In LLC you can also have derivative lawsuits where a member sues on behalf of the LLC - MI LLC Act 515 provides what a member of an LLC can do: o Dissolution and liquidation of the assets and biz of the LLLC o Cancellation or alteration of a provision in the Articles of Org or OA o Direction, alteration or prohibition of an act of the LLC, or of the members/managers o Purchase at a fair value the members interest in the LLC, either by the co, the managers or the members o Award damages to the LLC or the member - When you withdraw form an LLC you are entitled to get the value of your interest unless the withdrawal was wrongful - 307 if the corp cannot legally make a distribution at the time of withdrawal, then it has a right to make that pmt over time - Remember: LLC can be member or manager managed but the same fiduciary duties apply to whomever is in control! o Also directors of LLCs dont have to have an interest in the LLC!

THE BUSINESS JUDGMENT RULE / DUTY OF CARE The Business Judgment Rule (BJR) IS: - an evidentiary presumption that directors, in making their decisions, have acted (applies only to decisions made not shouldhave made: o On an informed basis o In good faith, and o In a manner they believe to be in the best interests of the shareholders (and not their own) - The presumption can be rebutted - BJR applies to both directors AND officers (unlike the raincoat provisions which ONLY protect the directors and NOT the officers). - Remember: the BJR focuses on the PROCESS (acted in GF to get informed and investigate and believed in GF that the decision was in the best interests of the corp) doesnt matter if the decision turns out to be horrible if the process was in good faith 46

Directors and Officers owe fiduciary duties to the corporation generally unless these duties are breached, the courts dont interfere with the judgment or actions of the board. - The duty of care: o this is really a negligence standard you breach this when you are negligent (dont have to be grossly negligent) breach when you are dumb and lazy o BJR covers this! - The duty of loyalty o When there are conflict of interest; this is worse because you are doing something bad intentionally breach this when you are greedy BJR in the context of Closely Held Corporations NOTE: o Closely held corp is a corporation that has:  (1) a small number of SHs;  (2) no ready market for the corporate stock; and  (3) substantial majority SH participation in the mgmt, direction and operation of the corporation Gottfried v. Gottfired Rule: If an adequate corporate surplus is available, the directors may not withhold the declaration of the dividends in bad faith. o HOWEVER the mere existence of an adequate corporate surplus is NOT sufficient to invoke court action to compel such dividend so need to look what the directors did, their motives, etc. o Directors have WIDE discretion in their decision to issue dividends there are numerous legitimate reasons why a board would not pay out dividends even when the money is available! decision to issue dividends is within BJR o Courts will only compel dividends if there is a showing of BAD FAITH  Bad Faith test whether the policy of the directors is dictated by their own personal interests rather than the welfare of the corporation y Factors to consider: o (1) Exclusion of minority from employment remember, there could be good reasons to exclude them if they bring no benefit to the corp cant pay them for nothing! o (2) Intense hostility against the minority o (3) high salaries for the officers in control o (4) whether majority would be subject to great taxes if dividends were paid out o (5) the desire of the majority to buy out minority as cheaply as possible Dodge v. Ford Motor Co Rule: A corp is organized and carried on primarily for the profit of the SHs! So board cannot seek to devote profits to any other party; SHs interests come first (not the public!) o Held: the court made D pay out dividends because directors put the public interest 1st o This case in an anomaly Ford wasnt acting in bad faith for wanting the public to benefit but his testimony seemed to say that the SHs are rich enough

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o General Rule: there is no right to dividends for any SH (except where dividends are mandatory for preferred SHs by the Articles and proper sources are available)

Wilderman v. Wilderman o Rule: The authority to compensate corp officers is normally vested with the board (and is usually a matter of K).  A corporate executive may receive only reasonable compensation that is reasonable proportional to his functions. While courts dont generally scrutinize salaries, when the recipient himself sets his own salary, the burden of showing reasonableness of compensation is on the recipient. o Notes: the zeroing out strategy between H and W worked while they were together but after they divorced H continued to pay himself the surpluses. He made no effort to look at other execs compensations, other previously received amts, etc he was only looking out for his own interest.  Because the D breached his duties the IRS ended up saying that his compensation was de facto dividends and taxed him. BUT this means that the corp as well had to be taxed for it as profits income. Donahue v. Rodd Electric (important case re closely held) Rule: Close corporation SHs are like partners in a partnership - they owe each other the duty of the utmost good faith and finest loyalty! o Equal Opportunity Rule: Equal access to benefits and opportunities to ALL SHs in a closely held corp! So, the controlling SHs cannot establish a market for their shares at the exclusion of the minority and must offer the same equal opportunity for the minority to liquidate their shares. o Facts father (director) was allowed by the others (his sons) to be bought out when he retired. P was minority SHs and wanted the same opportunity. Based on the rule above, the court made the corp offer the same terms and price for the Ps shares. o Notes: Ways to freeze out minority SHs: (1) fire them if officers; (2) deny employment; (3) stop paying them dividends majority would do this to try to get the minority SHs to sell their stock for below FMV Retreating from the Donahue Rule Situations when treating majority better is OK: o Wilkes v. Springside Nursing Home Rule: (1) Corp has to show that there is legitimate purpose for treating the minority differently (2) Then the burden shifts to the minority to show that the same legitimate objective could have been achieved through an alternative course of action less harmful to the minority interest. Shelensky v. Wrigley (baseball stadium lights case) Rule: A SHs derivative suit can only be based on conduct by the directors which borders on fraud, illegality, or conflict of interest. o The court here applied the BJR (even though it did not specifically said so) to hold that the decision of the board not to install lights for nighttime baseball is upheld

Michigan Biz Corp Act codification of BJR - 541a - A director or officer SHALL discharge his duties in the following way:

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o In good faith o With the care an ordinarily prudent person in like position would exercise under similar circumstances o In a manner that he or she reasonably believes to be in the best interest of the corp - In discharging his or her duties can rely on all kinds of info if director reasonably believes is reliable. This is a pure negligence standard (dont need gross negligence!) - Francis v. United Jersey Bank: Rule: Liability will be imposed on a director for the directors substantial inattention (gross negligence) the director in this case did not do anything at all in her job as a director! o Also raincoat provisions do not protect bad directors if grossly negligence, not covered BJR cont. Smith v. Van Gorkom (Del) Facts: Trans Union had a lot of spare cash; VG, the CEO approached Pritzer, an M&A specialist about buying Trans Union in a leveraged buy-out at VGs suggested price of $55 per share. VG kept these negotiations secret, did not get informed as to whether the price was fair and then presented it to the rest of the board who hastily, without information, approved the buy out. The cashed out SHs sued. o Rule: The BJR Board must make decisions in good faith and in an informed manner o Held: because the board did not act on an informed manner, they breached their duties to the corporation they should have gotten a fairness opinion = expert independent opinion that the price for the shares is fair o It does not matter if the SHs ultimately approved the merger their decision was based on inaccurate info! o Remember: courts really scrutinize boards when their decisions are essentially bought out and no longer SHs! o Effects of Van Gorkom:  Came as a shock to directors the court pierced the BJR and imposed liability on independent outside directors because the court thought that they had not been careful enough and had not acquired enough information, before deciding to accept and recommend to the SHs a cash-out merger  This decision created more formalism and transaction costs (attys, banker, experts, etc) for a board when executing a deal costs of compliance increased because of the exposure to liability!  Raincoat provisions increased!

Notes: - Leveraged buy-out a sale of the corp in which at least part of the purchase price is obtained through debts assumed by the target corp. - Appraisal Rights Shareholders who dont believe the purchase price in the buy-out is fair can exercise their appraisal rights in court get a different valuation. Raincoat Provisions: - Were added to corp statutes in almost all states to limit DIRECTORS liability (not officers) o so that directors would not be discouraged from fully and freely carrying out their duties including responsible entrepreneurial risk taking

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In MI OPT IN provision! NOTE: protection from liability is limited ONLY to MONEY damages! Can still get injunctions against the directors Exceptions to Raincoat provisions (MiBCA 209(c)) o Financial benefits received by directors to which they were not entitled o Intentional infliction of harm on the corp or shareholders o Payment of dividends o An intentional criminal act Emerald Partners v. Berlin Once a SH/P overcomes the presumption of the BJR, the directors raincoat protections do not kick in until there has been discovery, a trial and a decision so the raincoat protection does not instantly dismiss claims against directors.

More BJR notes: - There is no need to show tort principles of causation when applying the BJR Cede v. Technicolor Derivative Actions: Derivative action vs. Direct Action o Derivative Actions SH is suing on behalf of the corp if there is money recovery, it recovered for the corp and not for SH personally!  Basically saying that the corp has been wronged in some way and so SH is bringing the action because (for some reason) the corp hasnt done so  The SH tries to recover for waste of corporate assets  Remember: state court actions o Direct Action SH is suing to recover on his own behalf (he has personally been wronged) Procedural Requirements for Derivative Suits o FIRST: Contemporaneous Ownership Requirement (In MI) have to be a SH when you bring the action AND ALSO when there is a judgment entered  Exception: youre not a SH bcuz youve been bought out in a cash out merger o SECOND: The SH fairly and adequately represents the interests of the corp o THIRD: Demand  In MI Have to make demand on the corporation in all cases (have to ask the directors to sue on behalf of the corporation basically to sue themselves); if the corporation rejects the demand, then SH can proceed with the derivative suit  In DEL Do not have to make demand if it would be futile (like when you are complaining about something that was done by ALL directors) y Zapata Corp v. Maldonado Rule: (1) when demand is made the BJR applies; (2) when demand is excused two step test: a). Whether the disinterested directors or special committee acted in good faith in its conclusion if so, suit is dismissed. If no b) the court applies its own judgment rule consider the total fairness; corp interest and public policy In MI, FOUR groups of people can dismiss derivative suits - 495 (BJR)

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o Court MUST dismiss if the court finds that these groups have made a GF determination after a reasonable investigation and conclusion that the suit would not be in the best interests of the corp:  Majority vote (quorum) of disinterested directors  Majority vote of committee of 2 or more disinterested directors appointed by disinterested directors at a meeting (no quorum needed)  Panel of 1 or more disinterested persons appointed by the Court upon motion of corp  By all disinterested and independent directors. o Disinterested directors = those that were not involved in making the decision complained about In MI, a derivative suit cannot be dismissed or settled without the court getting involved! 496 o Court must determine that the settlement is fair to everyone o Court can order directors or SHs to pay litigation expenses for the other party o Security for expenses requires that SHs set up a bond to cover expenses if the SHs lost  In MI (and most other states) not required because it would have a chilling effect on derivative actions if the SHs do not have the money

Directors Duty has to functions: (1) decision making, and (2) monitoring/overseeing function! - In re Caremark Rule: A board of directors has the affirmative duty to attempt in good faith to assure that a corporate information and reporting system exists and is adequate to keep the board reasonably informed o A duty to monitor does not require that the board be aware of everything excusable if there is a GF effort to have a reporting system and remain informed o Prima Facie Case for Breach of duty of Care by failing to monitor:  The directors knew, or  Should have known that the violations of law were occurring,  Did not take any steps in good faith to prevent or remedy the situation, and  Such failure proximately resulted in the losses complained of. Note: need sustained & systematic failure to assure that a reporting system exists o Held: for the board there was GF attempt to have monitoring system in place; and the issue before the court was whether the settlement was fair, and court said yes. o This decision brought into focus the responsibility of the board to monitor corporate operations oversight responsibility NOTE: all that the board needs to do to comply with this rule is put a monitoring system in place the system that is put into place falls under the BJR

Independent litigation committees - Gall v. Exxon Corp o Facts SH derivative action against directors directors appointed a special committee of disinterested directors to investigate whether the suit would be contrary to the interests of the corp yes, it said o Rule: Since the interests of the corp are at stake, the directors have the responsibility to determine whether the action should be brought on the corps

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behalf this decision is protected by the BJR; To this end, the board may establish special litigation committees o Held: upheld the committee but allowed the Ps discovery to determine whether the committee was really independent.  Remember: in MI, can ask the court to appoint a committee but would be harder to argue that they are not independent DUTY OF LOYALTY / CONFLICTS OF INTEREST - Comes into play when the directors are greedy; BJR not available 1. Self Dealing General Notes: o Definition: The conduct of a trustee, atty, corporate officer, or other fiduciary that consists of taking advantage of his position in a transaction and acting for his own interest rather than for the trust, client or corporation.  May involve misappropriation or usurpation of corporate assets or opportunities; or exec compensation o Courts scrutinize self-dealing transactions because it provides for direct pecuniary interest at the expense of the corporation by a self-dealing director Common Law Rule:Per Se voidability when directors enter into a biz transaction with the corporation, such transaction is voidable at the instance of the corporation or its SHs without regard to the fairness or unfairness of the transaction. o Marciano v. Nakash case that specifically did away with the common law rule and held that the Del statute replaced it self-serving transactions CAN BE beneficial to the corporation!  This case dealt with a loan made by some of the directors to the corp issue: whether or not that should be set aside. (no)  SOX rules on loans made new prohibitions on loans to corp execs; exceptions for credit cards or when loans are part of ordinary biz of the corp MI RULE 545a A transaction will not be set aside because of self-interest alone! Three ways to validate a self-dealing transaction in MI: o By proving that the transaction was fair to the corporation at the time it was entered into o That after all material facts of the transaction (including conflict of interests) were disclosed, either a majority of disinterested directors OR all of the independent directorsapproved or ratified the transaction o Those after all material facts were disclosed, a majority of disinterested shareholders approved the transaction. After ONE of these requirements have been met, the transaction can only be set aside for fraud, waste, or illegality  So, in MI, even if you did not get a vote from the directors or SHs you could still go to court and prove that the transaction is fair.  Also note: the interested SH cannot be part in the vote

Executive Compensation

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o Heller v. Boylan -- Rule: What is reasonable compensation is for the SHs to decide. While the courts do posses the equitable power to prune excessive salaries or bonuses, it has no set standard on how to prune and thus courts should stay out.  However, if a bonus pmt has no relation to the value of the services it is really a gift in part, and the majority stockholders have no power to give away corporate property against the protest of the minority  Held: even though the pmts to the directors were huge, the court did not disallow them because the corp was doing well and the pmts were ratified several times by the SHs o MiBCA 545a(4)  Board may establish reasonable compensation for officers or directors need SH approval only IF required by the articles, bylaws or other provisions  Decisions on compensation shall not be set aside UNLESS it is shown that they are unreasonable at the time established. o Brehm v. Eisner (Disney Case) this was really a duty of care case; at issue was an allegedly extravagant employment contact for a well sought after officer the K had a crazy severance packet which cost the corp a lot of money when the officer left.  The Ps argued that one Ovitz was self-dealing when he offered this packet to the officer but the court found that he was not because the officer had stock options which, if exercised, would have diluted Ovitzs own interest so no self dealing  Waste Test: - A corporate transaction is considered wasteful when the exchange is so one sided that no reasonable person could conclude that the corp has received adequate consideration o Claim arises only in rare cases where directors give away corporate assets - HOWEVER, any substantial consideration received by the corporation plus GF judgment (that in fact this was a rational biz decision) no waste, even if the transaction was risky, or not smart.  The court held that there was no self dealing, so the BJR applied not violated  Also, the court noted that the board relied on an experts advice as to proper compensation malpractice claim against expert! o Breshm v. Eisner (on appeal to the SC) the court disagreed with the Ps argument that the board breached the duty of care no evidence of bad faith here o Note: IRS passed 162(m) disallowing corporate deductions for exec compensation in excess of $1 mill but corps go around it with deferred compensation plans and other incentives; or simply accept not being allowed the deduction Parent Subsidiary Self Dealing o Sinclair Oil Corp v. Levin  Rule: A parent co owes a fiduciary duty to its subsidiary when there are parent/subsidiary dealings. - When there is self dealinginvolved (parent receiving a benefit at the expense or exclusion of the subsidiary minority, the subsidiary would show this) THE INTRINSIC FAIRNESS TEST APPLIESwhich shifts

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the burden on the parent to prove that the transaction was intrinsically fair to the minority SHs - When there is NO self-dealing involved THE BJR APPLIES! (burden on the subsidiary to overcome BJR) In this case the minority SHs were arguing that the parent caused the subsidiary to pay out dividends when the subsidiary was in need for cash Held: there was no self dealing in this case because (1) the dividends were lawful, (2) they were paid out to the minority, so the minority was not excluded - Because no self-dealing the court applied the BJR! Note: Hypo if dividends were declared only on common A stock (majority) the intrinsically fair test would apply because this is self dealing (minority is excluded)

Weinberger v. UOP Cash out merger by the parent of the subsidiary. Rule: Directors who serve on both the parent and the subsidiary boards have a duty of loyalty to BOTH companies!!!! o In a cash out merger or self dealing transaction, a dual director (one who stands on both sides of the transaction) has the burden of establishing:  Entire Fairness Doctrine two parts: - Fair Dealing imposing a duty of disclosing relevant info of the merger (info that a reasonable SH would consider important in deciding whether to sell or retain the stock) - Fair Price Relates to economic and financial considerations or the proposed merger by looking at all the relevant factors o The SHs were awarded an appraisal remedy  Recessionary damages value of the damages AFTER the transaction occurs  Appraisal damages value of damages BEFORE the transaction occurs o Practice Point should have had independent disinterested directors negotiation the transaction, not the guys who were directors for both cos OR should have had a majority vote of the minority SHs o Lots of things were done improperly in this case: the Lehman Bros fairness opinion was hastily done (price left blank); Subsidiary directors were left in the dark; used insider info to determine the price o Business Purpose Rule  No longer exists! Variant treatment between the majority and the minority could be justified by a showing of a valid biz purpose but test would be so easy to meet! MI Provisions o 711 Short Form Merger  A domestic corp who owns 90% or more of another corp, may merge with that corporation WITHOUT the approval of the SH of ANY of the corporations involved - The board of the parent approves the plan of merger and the approval of the board of subsidiary NOT required; nor the SHs vote of either corp o Dissenter Rights (aka Appraisal Rights)

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The only remedy that a SH has in a cash out merger if SH thinks that the cash out price is unfair, it can petition the court to get an independent appraiser and you get the money in the amount that the appraiser valued the stock  BUT NOTE: there are some hoops you have to go through to do this (like you cannot vote for the transaction and then say that it was not fair) AND you are also stuck with what the appraiser determined o 701 When there is a merger, or a cash-out, the shares eliminated could be paid out in cash or in another stock or other consideration (so can be more than just cash) 2. Corporate Opportunity Doctrine COD there are many rules for the corporate opportunity doctrine but the only rule we need to know is MIs test o Guth Test (line of biz test) Corp. Opportunity Rule all elements have to be met:  The corporation has to have been financially able to take advantages of the corporate opportunity  The opportunity must be in the line of biz of the corporation and have some practicable advantages for it  Has to be an opportunity in which the corporation has an interest and a reasonable expectancy, and  By taking the opportunity, the director has become in direct conflict with the corporation o If these prongs are not met, then the director does not even have to offer the opportunity to the corp Northeast Harbor Golf Club v. Harris the lady director bought land adjacent to the corp/club and the court determined that under a diff test (full disclosure and not line of biz test), she did usurp corp opportunity. COD usually applied in hindsight and favors corps over the officers and directors

FIDUCIARY DUTIES IN LLCs basically the same duties apply to manages or controlling members of LLCs as to corps Harbison v. Striker Rule: The provisions in the OA cannot totally limit fiduciary duties o The LLC statute controls fiduciary duties which are applicable even in the absence of their express provision MI LLC provisions o 401 LLCs are member managed by default; if manager managed must put in Articles  when member managed the members have all the rights, duties and liabilities of the managers o 404 sets out the duties of the managers (good faith, as a reasonable person in like position would act)  BJR applies o 407 can have raincoat provisions (limiting monetary damages) in the Articles of Organization or the OA  Exceptions from raincoat protections: - Illegal distributions - Knowing violation of the law - Benefit received by not entitled to the manager

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ACTIONS BY OFFICERS AND DIRECTORS In the matter of Drive-In Development Corp. Officer furnished to Bank a doc that looked like a certified resolution to guarantee a loan but there was never a resolution. When the Board sought to collect on the guarantee, Bank argued that the officer had no authority for it. o Rule: Statements of corporate officers (or agents), if made during the course of normal biz transactions and while acting within the scope of his authority, are biding on the corporation.  so when a 3rd party relies on the actions of an officer who appears to be authorized to so act, even if the officer does not have the authority, the corp is estopped from denying that such officer did not have authority to bind the corp.  Only if 3rd party had actual knowledge would the corp not be bound  Held: the corp bound by the acts of the officer because the Bank could reasonably rely on the certified copy of the resolution doc o Note:  Certified copy of a resolution almost like an excerpt of the directors meeting minutes  Incumbency certificate secretary has the officers signatures and certifies that they are authentic signs for the officers when they are too busy o Practice Points:  If representing the Bank should ask for a certified copy  If you as an atty were asked to prepare a legal opinion for the Bank about the status of the corp, look to: - Internet websites - State filing office get copies of articles and see if any amds need to be made - Get good standing certificate from the state says that the corp paid taxes - Get certificate from the secretary of the corp; bylaws; articles Remember: when you draft legal opinions, state all the docs that you relied upon to protect yourself from malpractice; the only reason why the Bank would get the fairness opinion in the first place is to have someone to sue in the first place Clark doesnt like fairness opinions. Lee v. Jenkins Bros. Rule: A president has the authority to bind the corp only by acts arising in the usual and regular course of business BUT NOT for contracts of an extraordinary nature o Only in circumstances of extraordinary nature the court determines as a matter of law that the officer could not bind the corporation. Otherwise, whether there is apparent authority is a question of fact. o At issue in this case was a pension plan, which unlike lifetime employment Ks, the court found NOT to be extraordinary. o Lifetime employment Ks entered by officers are extraordinary in nature and do not bind the corporation as a matter of law because:  Undue restriction on SH power and that of the future boards  Substantial liability on the corp

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 Undercut managerial powers of directors and against the best interests of corp o However, pension K are different and are NOT extraordinary and NOT invalidated as a matter of law  No unreasonable restraint to future boards or the corporation  Note: could be unreasonable under some circumstances matter of fact! MI BCA provisions o 501 the biz affairs of the corp shall be BY OR UNDER the direction OF the board  Directors dont have to be a SH (outside directors) unless articles say otherwise o 531 can hold more than one office but can only sign in the capacity of one o Also remember: SHs can take consent action w/o a meeting (OPT IN) by majority vote; and directors can take consent action w/o meeting (OPT OUT) by unanimous vote

TRANSACTIONS IN CONTROLLING SHARES General Rule: In the absence of restrictive covenants, SHs can transfer their shares to whomever they wish!! No fiduciary duties to the other SHs - EXCEPTION:(the suspicion/investigation rule) o A SH that owns a controlling block of shares (and thus would be transferring control) may NOT sell the shares without further investigation (reasonable investigation with due care) IF there are reasonable grounds for suspicion that the purchaser of control would harm the corporation!!! o DeBaun v. First Western Bank and Trust Rule above  In this case there were many facts that came to Banks (controlling SH) attention that would have alerted a reasonable person that the buyer would be hurting the company. Once the suspicion is awakened, the selling SH has an affirmative duty to investigate to dispel the suspicion.  Held: Bank should have looked at public records which would have easily showed that the buyer is a crook who would loot the company to insolvency (which is what happened in this case) SO, once a reasonable person would be put on suspicion that the seller would harm the corp, MUST use due care and reasonably investigate by: o Doing a credit check o Checking state filings for liens o Dun & Bradstreet report Also, just because a potential buyer has rep for being an aggressive investor is by itself not sufficient to trigger suspicion and duty to investigate

DIRECTORS IN PUBLICLY HELD COMPANIES General Notes: - Outside/independent directors those that have no relationship to the co - Inside directors major SHs who are on the board or are some other way connected to the corp - Remember two main functions of directors: (1) decision making, and (2) monitoring/overseeing - Modern Corp Directors: o Have increasingly more responsibility more outside directors than inside

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o Do get paid nice, but have a LOT of potential liability thats why they have to be on top of what is going on (or have monitoring systems in place) o Protections:  Raincoat provisions (only limit monetary damages; not for criminal liability)  D&O Insurance (in case of derivative suits; there are exceptions)  Indemnification Corporate Governance After ENRON Ethical Considerations Enron Scandal: o A lot of creative accounting going on not accounting for certain liabilities in one period and push them to another period o Arthur Anderson, LLP, Enrons accounting firm, was making ton of $$ at the same time making things look nice for Enron when scandal broke out, destroyed docs not smart o Enrons senior mgmt looked the other way so deep in, no one could come out Sarbanes Oxley Act (enacted post Enron by Bush gives power to SEC to implement it) o What the act did:  Created a body called the Public Accounting Supervisory Board to set uniform auditing standards and oversee accountants  Mandates that every public co have an auditing committee made up of independent directors and at least one of those has to be a financial expert  Requires that CEO and CFO of publicly held corps certify as to the accuracy of financial statements to my knowledge there are no misrepresentations, and they fairly represent the financial condition, etc - Imposes criminal liability if you make untrue representations  Only audit committees can hire and fire and determine the compensation for the outside auditors the outside auditors would have to be switched every five years. o Lawyers affected by the SOX as well!  17 CFR part 205 - sets standard of conduct for attys that are practicing and appearing before the SEC o that does not mean that you actually have to appear before the SEC only giving securities advice is sufficient to come under it o Up the Ladder Reporting  If an atty becomes aware of suspicious of material violations (violation of state or fed law) of an agent (accountants, attys, etc) or officer of the corp, he must take the following steps: - FIRST: He MUST report to the CEO - SECOND: If nothing happens after reporting to the CEO, then MUST report to the Audit Committee (or some other committee composed of independent directors; or if no committee to the Board) - THIRD: If nothing happens still, then MUST send a letter to the above people essentially putting in writing that you reported this info and nothing has been done - FOURTH: If still nothing happens then you MAY report directly to the SEC under the following circumstances:

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o To prevent the issuer from material violation likely to cause harm to the investors o To prevent the issuer from committing perjury or fraud, or o To rectify the consequences of a material violation If you are an associate atty then you HAVE to FIRST report to the supervising atty, then if nothing happens you go through the above steps. When you do the steps and report, you are not breaching client confidences same principles as PR Rules of disclosure w/o consent.

CORPS GOING PUBLIC INITIAL PUBLIC OFFERINGS (IPOs) SECURITIES ACT OF 1933 General Notes: - IPOs the first time that you make a public offering - Going public has many benefits: o (1) raise additional capital; (2) Reducing a corps need to rely on debt pay debt down with the money receives from going public; (3) give SHs liquidity invest in other corporations; (4) better compete for employees with stock-based compensation plans - Costs of going public: o (1) Huge compliance costs have to comply with regulation SX: very complex accounting rules; need lawyers, accountants; underwriters; (2) Lots of disclosure involved; have to clean up balance sheet; (3) Substantial legal risks have to make sure that everything on the registration is correct strict liability if incorrect (only defense: that the P had actual knowledge of the inaccuracy. - More costs after having gone public Must: o (1) Have public SHs meeting every year have to deal w/ proxies; (2) must prepare reports to the SEC each year: 10 K (yearly); 10 Q (quarterly) and Interim reports if anything significant happens in between; (3) subject to a whole bunch of new laws (Sox); (4) can be victim of hostile take over; (5) public scrunity Registration under 1933: 1. Registration Statement on Form S-1: a. Must be filed with the SEC when the co is doing an IPO; remains on file public doc b. Contains the prospectus (reg stmt w/o exhibits) and all the exhibits i. The exhibits can be voluminous and they are also public docs ii. Preliminary Prospectus has everything except the price (which is determined the day before the offer is made) 1. Red Herring Warning in red on the preliminary prospectus saying that the securities have not yet been approved by the SEC c. Note: Tombstone Ad another way that the SEC lets somebody market an offering before its filed with the SEC appears in the Wall Street Journal. 2. 1933 Act = Truth in Securities Act premised on full disclosure a. If there is an offering made in a public manner or to numerous people presumption that compliance with federal law is necessary UNLESS there is an exemption available.

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b. Liability Exposure: i. RULE: the issuer is strictly liable for any misrepresentations to the SEC ii. Only defense the suing party had actual knowledge of the misrepresentation iii. Who could be strictly liable? (1) attorneys; accountant; officers, directors, underwriters all who were involved in the preparing or reviewing 1. DEFENSE due diligence defense: reasonable investigation - essentially that one reasonably relied on reasonable information and experts, etc 2. Note: the issuer does not have a due diligence duty because it is an entity the people working for the issuer are liable! iv. Note: inside directors generally have a higher standard for liability than outsiders c. Jurisdictional basis: Interstate commerce easy to meet Blue Sky Laws State Securities Laws - focus on disclosure requirements but some also require that all the securities registered qualify on a merit basis - started in Kansas at first had to register in all 50 states because you never knew who would buy your offering and from what state - Federal Preemption for registration: 1996 National Securities Market Improvement Act o If you SELL securities under a valid federal registration law, then you do not have to register in every other state federal registration is sufficient! o HOWEVER if you are selling pursuant to a federal exemption, then you must find a local state law exemption so the preemption does not apply when you are selling pursuant to an exemption 1933 Act Exemptions There are three bases for exemptions: (1) types of securities: i.e. short term papers; govt securities; securities issued by non-profits or charitable orgz; securities issued under Bankruptcy Act; (2) certain kinds of transactions: i.e. private placement; intrastate exemption and small offering exemption (reg D); and (3) Special Exemptions by application to the SEC Main Exemptions under 1933 Act: o Private Placement Exemption (4(2))  Rule: exemption for offerings to persons who are shown to be able to fend for themselves in a transaction NOT involving a public offering when the offer is for situations where the investors, because of their positions, dont need the protection of the Act because they have access to the same kind of info that the Act would make available in the form of a registration stmt. y Because the exemption turns on the particular class of persons affected and whether they need the full disclosure protection of the act y Burden of proof the issuer: need to show that there is no need for the protection of the Act for the particular offerees  Remember: just because you are offering to a small # of persons does necessarily mean that it is not a public offer; just as just because you are offering to a large # does not mean that it is a public offer to be public, the offering does not have to be made to the whole world.

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Ralston Purina in this case the offer was allegedly made to key employees but the problem was that that was actually pretty much everyone in the co.

o Intrastate Offering Exemption:  Exempts any security offered and sold only to persons resident and doing biz in a single state  Requirements: y Stock offered exclusively to persons resident within the State o An offer or sale to a single non-resident will destroy the exemption for the entire issue y Issuer must be a citizen of the State (incorporated there) y Issuer must be doing major biz there (predominant biz there) y Substantially all proceeds of the offering must be used in the State  Theory is that because of the close proximity to the issuer, the local inventors do not need the protections of the Act o Small Biz Initiative (reg D)  Came into existence because it became difficult for small business to raise capital; lots of small bizs use this  Accredited Investors officers, directors, people with substantial network and income people who have ability and resource to seek out info and thus dont need the protections of the Act  Rule 504: available to issuer who is not subject to SEC reporting reqs (someone who has never done a public offering before) so this exemption can be used over and over again BUT not once you have made a public offering y Exempts up to $1 mill worth of securities in 12 month period  Rule 505 and 506 available to you even when you made a public offering at some point before y 505 can sell $5 mill dollars worth of securities to accredited investors and to no more than 35 others who are NOT accredited investors y 505 can sell unlimited amount to accredited investors and to 35 other who are not accredited investors IF you reasonably believe that those other 35 have enough knowledge to fend for themselves and not need protection of the Act y note: under both; dont actually have to find the extra 35 people usually there are no such 35 people, just the investors. Investment Contracts are securities!!!

Rule: Investment Contracts are a scheme that involves: o (1) An investment for money o (2) In a common enterprise one in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of another (those seeking the investment of third parties) o (3) With the profits coming predominantly (not solely) from the efforts of others

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Remember Have to look at the economic reality of what is going on if it meets the above test, it is an investment contract and it is subject to the federal securities laws!!!!!!! Smith v. Gross in that case the court found that there was an investment contract because the Ds persuaded the Ps to invest by telling them that their efforts in raising worms would be minimal and that even if the Ps diligently exerted themselves, they would not gain the promised profits, because those profits were dependent on Ds efforts. o Note: the court noted that this was not a franchise agreement franchise agreements are NOT securities because they independently determine their own success. But in Gross, the Ps were not independently responsible for their own success, it was tied up to what the Ds were doing Robinson v. Glynn LLCs investment contracts? o The court in this case held the P had too much control for the LLC membership interests to qualify as an investment K he had meaningful control over his investment o Court also noted that the membership interest did not qualify as stock within the meaning of definition of security interest:  The members did not share profits in the LLC in proportion to the number of shares  The interests were not freely negotiable: even if you did transfer, you would not transfer control but only the economic benefit this is unlike stock  Voting was not proportionate to the number of membership interests o HOWEVER, the court left open door under some facts LLC interests COULD POSSIBLY qualify as stock/investment K  The SC has never addressed this question but will eventually AKs Daks Communications held that there is no presumption that membership interests in LLC are not investment contracts; they can be!

REGISTRATION REQUIREMENTS UNDER 1934 Registration Requirements: 12(g) -- Under the 1934 Act, MUST register under the act if the issuer has: o (1) Securities issued on the national securities exchange OR  regardless of the assets or number of SHs o (2) Has 500 SHs or more ANDmore than $10 million in assets  So, even if not registered on the securities exchange, if this condition is met, must register! If one of these requirements is met, the corporation is said to be a 12(g) corp!

Once registered under the 1934 Act, a whole host of regulations are now subject for the corp: - Must file periodic reportssuch as the: o 10-K Annual Report  financial report plain; basic goes to the SEC  also goes to the SHs but its prettier and has pictures (marketing doc) o 10-Q Quarterly Report

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 Sent to SHs and the SEC o 8-K Interim Report  has to be filed if there are material events that come up in between  material events = if officers or directors leave; if you change the fiscal year; amendment of bylaws; entering into material agreements; getting de-listed from the SEC (usually means co is in trouble) o MD&A report Managements discussion and Analysis of Financial Condition and Results of Operations  very important report!! Sent with the annual report  it is a narrative discussion of the financial condition, objectives and future goals and projections y NOTE: used to be that mgmt could not talk about future projections now the SEC requires it!! y BESPEAKS CAUTION DOCTRINE o Safe harbor Forward looking information is ok and not as long as you provide notice and cautionary language that these are only projections and may not turn out to be accurate then you are not liable if the projections turn out to be false o Applies only to soft facts! o Cannot have blanket protection!  In the Matter of Caterpillar Caterpillar knew that the election in Brazil could have adverse impacts on the Brazil subsidiary but did not disclose that in the reports; OK to talk about the subsidiaries in consolidated financial statements but only as long as they are not misleading; here Caterpillar should have talked about Brazil separately had to disclose, based on: y Form 10 K Item 303(a) info relevant to the subsidiary total picture y Form 10 Q Item 303(b) disclosure of unique events affecting operations the Brazil election! EDGAR SEC allows you to file electronically so you dont have to sent boxes of docs Integrated Disclosure Rules SEC allows you to send exhibit list of all other exhibits that you previously filed and refer to those so you dont have to re-send exhibits every time Subject to the SOX! o Must restate financial records according to Reg SX if fin. records have to be restated cuz they failed to comply w/ disclosure reqs, bonus 4 CEO that year must be returned o Subject to criminal and civil liability for misrepresentations

Termination of Registration - Rules allow termination of registration under the following circumstances: o (1) Securities now have less than 300 SHs of record regardless of assets, OR o (2) less than 500 SHs AND total assets have not exceeded $10 mill for the last three fiscal years. - But remember: if you sell on the national exchange, you have to remain registered!!

PROXY REGULATIONS (14(a)) 1. General Notes:

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Proxy = giving someone else the ability to vote ur shares; like absentee ballot sent b4 meeting APPLY TO 12(g) COMPANIES! Whenever the corp has public SH meetings it must send proxies which comply with the regs: o Full and fair disclosures must be contained in the proxies so that the SHs can vote on them in an intelligent manner  i.e. when meeting is for directors election should have info on ea nominee Proxy Rules do Four Major Things: o Require Full and Fair disclosure o Material misstatements or omissions in proxy stmt or solicitation = fraud & prohibited  Courts recognize implied private right of action; both SEC and SH can sue o The proxy rules govern any solicitation of proxy by anyone, not just management!  So, the proxy solicitation between the SHs themselves MUST also comply o SH proposals must also comply there are rules that say that if a SH proposal meets the reqs for a proposal then the mgmt MUST include it in their proxy materials. What is solicitation of proxies? o Solicitation defined broadly applies to any communications under circumstances reasonably calculated to obtain the SHs votes i.e. letter, newspaper, press release  Studebaker v. Gittlin D wanted access to corp records but needed more SHs in order to get access Held: this was solicitation! D just wanted the other SHs to join in to demand the records this was the first step in a scheme for solicitation and he violated the proxy rules by not complying with them y Note: this could be considered a safe harbor today o Safe harbors that protect certain kinds of communications from proxy compliance:  Between institutional investments good for diff corps to be talking  Certain public speaking type solicitation because of 1st amd The Proxy Provisions 14(a) o 14a-9 covers both disclosures and omissions to disclose rule prohibits omissions and misleading statements; cannot give half-truths; must fully and fairly disclose  applies to SH proxies not only to mgmt o 14a-3 requires that SHs be supplied with extensive info on the corporation o 14a-6 requires that the extensive info supplied to the SH must first be filed w/SEC

2. False and Misleading Statements in connection with Proxy Statements * Who can bring action for misleading proxy statements? - SEC and private SH - Rule: There is a private rights of action for violation of the proxy fed regulations EVEN THOUGH such right of action is not specified in the statute! o JJ Case Co. v. Borak created the private right of action for proxy rules violation. Court held that the rules were designed to protect the investors and allowing for private right of actions furthers that purpose SEC cant catch all the violations by itself!  Note: this case is still good law although now the SEC provides for private action if it wants to - NOTE: 27 of the Act Nationwide Service of Process:

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o If there is a material omission or misrepresentation, the corp can be sued all over the nation!!!!

* Example of False and Material Misleading Stmts within the meaning of 14(a) - Predictions as to specific future market values - Material which directly or indirectly impugns character, reputation, integrity w/o a factual foundation - Failure to identify a proxy stmt from other solicitation material - Claims made prior to a meeting regarding the results of a solicitation

* Materiality Requirement: - For an action of violation of the proxy rules, the misstatement or omission of fact must be material!!! o Material = if there is a substantial likelihood that a reasonable SHswould consider the fact important in deciding how to vote Objective test  TSC Industries established this test; court noted that you dont want to make the threshold for disclosure too low because that will flood the SHs will a ton of info not good either y Court narrowed the test from might to would made it more difficult to prove materiality - So, not every misrepresentation is actionable has to be material! * No need to prove Scienter for proxy violations!!! - It is also NOT strict liability either - All you have to show for proxy rules violation claim ordinary negligence!! * Causation two theories: - Lost Causation where the misstatements have a direct effect on the actual economic harm that you suffer - Transaction Causation essential link test the misstatements or omissions were related to the occurrence of the transaction; in other words, the transactions could not have been approved w/o the (P) SHs vote o Mills v. Electrical Auto-Lite there the SHs vote was essential to the occurrence of the transaction; the SC said that there is no need for the SH to show that the transaction was not fair (cannot assume that SHs will always vote for fair transactions;  Rule: To establish Causation for proxy violation all that a SH has to prove: y (1) that the statement or omission was material, and y (2) that the proxy solicitation was an essential link to completing the transaction the vote was necessary for the transaction to be approved. o Virginia Bankshares v. Sandberg  Rules: y (1) a proxy statement couched in conclusory or qualitative terms such as high value purporting to explain the directors reasons for recommending corporate action CAN BE materially misleading!

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o The problem here is that the Directors didnt even believe that the price was high this didnt not qualify as an opinion anymore because they actually did not believe it it was a FACT, a misleading one. y (2) to establish causation the vote of the complaining SH must have been an essential link to the approval of the transaction o VBI owned 85% and the minority 15% -- even if the minority voted NO on the transaction, it would have still gone through because their votes were not necessary o Cannot say that but-for the votes = no transaction o IMPORTANT NOTE:  The court left the door open for when even though vote may not be essential, there would still be causation IF the SHs lost valuable state rights y i.e. SHs gave up appraisal rights or right to sue in derivative action o NOTE: In MI, in a short merger form the minority could not bring a suit for proxy violation because their vote for such short form merger is not necessary not an essential link

RULE 10-b5

SECURITIES FRAUD / REMEDY UNDER FEDERAL LAW

Section 10 of the 1934 Act: - Purpose: philosophy of full disclosure anti-fraud statute - Makes it unlawful for any person to use the IC instrumentalities or mails (gets you fed jurisdiction: check; phone; mail) to purchase or sell any security registered or not in a manipulative or deceptive manner - SEC created 10b-5 from this o 10b-5 makes it unlawful for any person directly or indirectly, by means of IC instrumentality to:  employ any device, scheme or artifice to defraud  to make any untrue statements of material fact OR omissionswhen necessary to make the statement not misleading, or  to engage in an act, practice, or course of biz that would operate as fraud or deceit o note: 10b-5 is broader than common law fraud because it covers omissions as well o SEC came up with 10b-5 because regular common law fraud was not sufficient to cover all securities abuses in securities transactions to be liable for common law fraud, you have to make affirmative material misrepresentations; 10b-5 is broader!  NOTE re disclosures under 10b-5: No affirmative disclosure requirements have to disclose only to make prior statements not misleading: y 3 circumstances under 10b-5 when you have to disclose: o (1) to make prior statements not misleading o (2) if you think insider trading is going on o (3) if there are rumors sweeping the market then you have to respond to correct the rumors. 66

RULE:There is an implied right of private action under 10b-5even though not specifically stated in the statute Kardon v. National Gypsum Co. - Aiding and Abetting: o Rule: There is no private right of action for aiding and abetting. HOWEVER, the SEC can have an enforcement action for aiding and abetting.  It used to be that even accountants and attys could be sued under the theory of aiding and abetting but in Ernest v. Hochfelder, the court moved back and held that a P would have to make a case for scienter against every single D. - Secondary Violators: o Rule:Even secondary actors (such as accountant, attys, banks, etc) can be held liable under 10b-5 as primary violators assuming that a case for 10b-5 liability can be met against each secondary actor.  In re Enron the SHs sued all these other secondary actors who helped out in the scheme to defraud. Ps successfully showed that these Ds violated 10b-5 on their own, as primary violators not that they aided and abetted!!! Elements of a 10-b5 claim (note: can sue in fed court) 1. SCIENTER intentional or willful conduct designed to defraud or deceive investors by controlling or artificially affecting the price of securities. - Recklessness can be sufficient to satisfy the intent to defraud element; SC never addressed but lower courts so have held - Aaron v. SEC Rule:scienter required for ALL 10b-5 actions, including 4 injunctive relief - Santa Fe Indus v. Green Rule: Breach of fiduciary claims DO NOT come within 10b-5 claims need to show some fraud, deception or manipulation; o 10b-5 does not deal with fairness of transactions just with full and fair disclosure; breaches of fiduciary duties are for state court actions!! 2. THE PURCHASE OR SALE OF ANY SECURITY - Brinbaum Rule held: person who was offered an opportunity to buy but did not cannot bring 10b-5 suit o Rule: 10b-5 Ps have to be actual purchasers or sellers of securities  But note: this does not necessarily apply to Ds - Remember: 10b-5 is not just for securities that are on the public market but for ANY securities (investment Ks, bonds, debentures) 3. MATERIALITY: - Fact or omission is material (substantial likelihood that a reasonable SH would consider the info important in deciding whether or not to buy or sell) 3. RELIANCE - Fraud on the market theory of reliance: o Rule: Where materially misleading stmts have been disseminated into an impersonal, well-developed market for securities, the reliance of the individuals Ps on the integrity of the market price may be presumed.  Would have to prove 3 things to get the benefit of the presumption: y First: info is material y Second: the market is sufficiently active trading going on

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y Third: the info must have been disseminated publicly o The presumption can be rebutted!!!!  By truth on the market defense (below) or  Showing that (1) the misrepresentation in fact did not lead to the distortion of price or (2) that the individual P traded or would have traded despite his knowing that the statement was false - But note: Truth on the Market defense o If there is materially misleading info in the public market and then accurate info enters the market, it would dissipate the effect of the misleading info o If there is correct info out there the Ds dont have to show that the Ps have heard it presumed just like in the fraud-on-the-market theory o It kills the reasonable reliance requirement of the fraud-on-the market because if there is correct info out there, it is no longer reasonable to rely on the incorrect info 4. CAUSATION: - US v. Teicher the appropriate standard for causation is knowing possession of insider information at the time of the trade; (1) loss causation; (2) transaction causation per Clark 5. DAMAGES - Usually out of pocket loss; usually not hard to prove; the difference in price Statute of Limitations for securities fraud 2 years from discovery of fraud but no more than 5 years form the time of the violations (imposed by the SOX) Note: Sale of business Doctrine no longer exists; meant that if you sell your whole biz it is not a security, so not covered under 10b-5 INSIDER TRADING UNDER STATE LAW Special Facts Doctrine Special Facts Doctrine - Only applies to state court actions; developed by the SC; not used often - Basic Rule: An officer or director is under an affirmative duty to disclose special facts when buying from or selling shares to existing SHs in a face to face transaction - Elements: o Only applies to officers and directors who have some special info/facts o Applies to both purchases and sales o Any material nonpublic information will trigger the doctrine o There must be privity must be face to face transaction (or equivalent: phone, email but the buyer and the seller must know each other and the buyer or seller must be a SH) does not apply to impersonal transactions over the stock exchange market.  Goodwin v. Agassiz There some directors (Ds) found out that there could be coal under some land and then bought Ps (SHs) stock over the Boston Stock Exchange. Held: there was no duty on the D to disclose to the Ps because there was no privy the directors did not know that they were buying from individual shareholders. y *Directors owe a fiduciary duty to the corporation not to individual SH! INSIDER TRADING UNDER FEDERAL LAW 10b-5 General Notes:

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In the Matter of Cady Roberts First insider trading case brought by the SEC against a broker who learned from a director of a corp that the corp planned on reducing dividends. Broker was a tipper when he told his customers to liquidate their stock before the announcement of the dividend cut was made o Held: Broker violated 10b-5! o Rule: 10b-5 provisions apply to any person officer, directors and SHs but can also include others, like tippers SO, insider trading violates 10b-5!  The obligation under 10b-5 rests on two principal elements: y FIRST: the existence of a special relationship giving access, directly or indirectly, to information intended to be available only for corp purpose and NOT for the personal benefit of anyone, and y SECOND: the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing. o Note: no privity requirement for 10b-5 claims NOTE: three ways to go after someone for 10b-5 violations: o DOJ dept can come after you criminally o SEC can impose fines or injunctions o Private right of actions

SEC v. Texas Gulf Sulphur Co. - Rule: Anyone who is in possession of material insider information must either: o Disclose it to the investing public, OR o If he cannot disclose it because it is confidential, must abstain from trading in or recommending the securities while such info remains undisclosed.  In other words, cannot use the info or rely on it to benefit. - Material info info that a reasonable investor would have found important in deciding whether or not to sell or but the stock info which, if available, might have affected the price of the stock - So basically the rules says Anyone, who trading on his own account the securities of a corporation, has access directly or indirectly to information intended to be available only for corporate purpose and not for the personal benefit of anyone may not take advantage of such information knowing that it is unavailable to those with whom he is dealing. - Facts in this case, the stock was initially low at $11/share; after the Ds found out that there was copper in the land and before they told anyone they put in calls to purchase stock stock eventually sold for $140/share the stock spilt for three cuz so high a jump. Note the Ds had a duty to the corporation. How long do you have to wait before you can trade on the information? - Rule: Before insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to insure its availability to the investing public o Have to wait not only until the press release but until the news could be reasonably expected to appear over the media of widest circulation not an exact time  Time that an insider places the order, rather than the time of its ultimate execution is determinative for purpose for Rule 10b-5

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Rule 10b-5-1 - Came about as a result of the disagreement in enforcing rule 10b-5 The question was: Do you have to show that the person USED the info or is it merely possession of insider info that is violative of 10b-5? o Many courts held that possession is NOT sufficient HOWEVER, there is a presumption that if you make a transaction while in possession of the information, you are PRESUMED to have used that info (rebuttable presumption) - The SEC responded with Rule 10b-5-1 which states that: o The D must have used the info in making the challenged trade o Someone in possession of material nonpublic who has made a transaction is presumed to have used that that insider info UNLESS:  You have a preexisting binding K to enter into the trade in question;  You have given prior instructions to a 3rd party to make the trade in question;  You have previously adopted a written plan specifying the trade in question o Remember: there must be a sale or purchase of securities to be liable under 10b-5; If you cancel a preexisting order, you DID NOT violate the rules because it is not a sale or purchase!!!!! Chiarella Facts: D was a printer in a newspaper, who figured out the night before which two companies were about to merge; he traded on the info and made a nice returned but the SEC went after him. Held D got away; not liable under 10b-5 because: - Rule: Liability under 10b-5 is premised on the existence of a duty to disclose! o Duty to disclose arises from a fiduciary relationship of trust and confidence between the parties to a transaction. - Held: the duty to disclose does not arise from mere possession of insider information; D here was not an insider he had no duty to the corporation; o The only person that D hurt was his employer thats where his duty lay, but the court looked to whether or not he had a duty to the corporation which he did not - Burgers dissent Misappropriation theory - 10b-5 violation can be found even in the case of outsiders regardless whether there is a duty that runs to the issuer duty to the source of info is sufficient Rule 14e-3 (Williams Act) Note: After Chiarella, the SEC passed Rule 14e-3 (part of the Williams Act) - Applies only in the context of tender offers KEY: No duty needed like in 10b-5 - Imposes a duty to disclose or refrain from trading on (elements): o ANY PERSON who trades on securities which will be sought or are being sought in a tender offer, o While that person is in possession of material information o Which he knows or has reason to knowis nonpublic AND has been acquired directly and indirectly from the offering person, from the issuer or from any other person acting on behalf of the offering person or the issuer (that the info is confidential and the people who give the info are officers or directors)

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SO because the duty can run to anyone (not just the issuer) Chiarella could have been liable under 14e-3!

Carpenter v. US the SC there did not accept the misappropriation theory for 10b-5 but upheld a conviction for mail fraud US v. OHagan the Current Rule Adoption of the Misappropriation Theory for 10b-5 - Facts: Atty was indicted for insider trading based on confidential info he received from a client - Rules: o Liability for 10b-5 can be predicated on two theories:  (1) Traditional theory of insider trading when a corporate insider trades on the securities of his corporation; duty runs from insider to his corporation whose inside info belongs y protects from abuses from insiders  (2) Misappropriation Theory When a person misappropriates (steals) confidential information for securities trading purposes, in breach of a duty owed to source of information y protects from abuses from outsiders y So, it requires a fiduciary relationship between (1) the person who has the inside information (person charged with fraud) and (2) the source of the information that has been misappropriated  But remember: for both theories, there has be an element of deception (scienter) o 14e-3 (Williams Act) makes it unlawful for ANY person to engage in any fraudulent, deceptive or manipulative acts or practices, in connection with ANY tender offer  the act creates a duty in those traders who fall within the statute to abstain and disclose info, without regard to whether or not the trader owes a pre-existing fiduciary duty to respect the confidentiality of the information.  The court upheld the rule SEC did not exceed its authority - NOTE: o Under this rule Chiarella would have been liable because he owed a fiduciary duty to his employer (the source of the info) o Remember: Full disclosure forecloses liability!! (Deception is essential)  So if Chiarella would have told his employer that he plans on trading he would have been ok. Rule 10b-5-2 - The SEC defined three situations where there is a fiduciary duty for liability purposes (besides the regular fiduciary relationships: employer/employee; atty/client; doctor/patient, etc): o Where the person agrees to keep the info confidential o Where the person has a history of sharing confidences with you and you have a reasonable expectation that the other will keep your confidences o The person who provided the info was a spouse, parent, child or sibling Tippee Liability - Rule:Test for tippee liability: 71

o A tippee assumes a fiduciary duty to the SHs of a corp (essentially the duty of the insider) when:  The INSIDER has breached HIS fiduciary duty to the corporation by disclosing the information to the tippee,  The tippee KNOWS or SHOULD KNOW that there has been a breach, and  The insider (the tipper) received or hoped to receive some personal benefit (tangible or intangible) y Absent some personal gain, there has been no breach of duty by the insider (note: gain is generally easy to find tipping a mistress; friendship; tipping daughter so she could get rich) o Dirks v. SEC applied the above rule  A tippees duty to disclose or abstain from trading is derivative from the insiders duty!!  The tippees obligation is viewed as arising from his role as participant after the fact in the insiders breach of a fiduciary duty.  In this case, there was no tippee liability because the insider did not breach his own duty he was the person who tried to expose the fraud; so since there was no personal benefit for the insider, he did not breach his duty to the corporation and therefore no tippee liability! If tipper didnt breach his duty, then no tippee liability  Remember: the tippee to be liable had to have traded on the info Remember: there are three groups that are covered by the insider - trading ban: - Insiders (officers/directors those who have access to non-public info) - Temporary Insider o Used to cover attys, accountants, reporters, printers - Chiarella o Those who have access to inside info by means of their proximity to the insiders; not clear on how long these people have to hang on to the info before acting on it - Tippees those who get the information improperly can be in more than one category

1934 ACT SECTION 16: SHORT-SWING PROFITS General Notes: - This section basically prevents in-and-out trading by officers, directors and large SHs within a six month period! - Who does it apply to? o 12(g) corporations o Officers, directors, and beneficial owners of more than 10% of the company stock - What must you do if it applied to you? o You must file a Form 3 a one liner pretty much, saying that on X day I became an officer or director, etc; must file this form within 10 days this is a public filing! o Once you file Form 3 if there are any changes, you gotta file Form 4. - 16(a) deals with reporting requirements - 16(b) Short-swing profit rule

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o Rule: If you are covered under this section, you cannot sell and buy OR buy and sell in a six month period (so 2 transaction) theory : this prevents insider trading o If you violate this rule Strict Liability no defense available  Remedy for violation: must disgorge your profits to the corp give the profits you made to the corp o The problem with this statute was that you never knew who were the officers; it was unclear when did you buy or sell within the meaning of the statute no guidance from the SEC, so innocent people would get caught up o Today, there is more guidance from the SEC; not many violations under 16 anymore; (people who this statute applies know the rule now and plan accordingly)

JUDICIAL DEVELOPMENT OF LIABILITY FOR SECURITIES FRAUD Materiality for Preliminary Merger Discussions and Reliance tests for 10b-5 claims - Basic Inc. v. Levinson o D corp made three public statements denying that it was engaged in merger negotiations (even though this was not true). Two issues on appeal: (1) What is the standard for materiality applicable to preliminary merger discussions, and (2) Whether the reliance element in a 10b-5 claim may be met under the Fraud on the Market theory of reliance? o Rules:  Gen Rule for materiality substantial likelihood that a reasonable SH would consider the fact important in deciding how to vote. y However, in the context of preliminary merger negotiations: o Materiality depends upon the balancing of both the indicated probability of the mergerthat the event will occurand the anticipated magnitude of the event in light of the totality of the company activities  With respect to probability look to the indicia of interest in the transaction at the highest corporate level  With respect to magnitude of the transaction look to the size of the two corporate entities and the potential premiums over market value. o Very fact intensive test! y Court rejected agreement in principle test way too much could be withheld under that test.  In order to establish reliance of the misrepresentations for purposes of a 10(b) claim, the Fraud on the markettheory can be used: y Rule: Where materially misleading stmts have been disseminated into an impersonal, well-developed market for securities, the reliance of the individuals Ps on the integrity of the market price may be presumed o So, because most publicly available info is reflected in market price, an investors reliance on any public misrepresentation may be presumed for purposes of a 10b-5 claim y Remember this is just a presumption which can be rebutted!! o By the truth on the market defense! (see above)

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Other judicially created doctrines - Remember: Bespeaks Caution Doctrine o A way to protect oneself from making predictions or future assumptions that turn out to be false o Would defeat the element of reliance! because if you provide cautionary language, cannot say that you reasonably relied on the forward looking info provided o Applies only to soft facts forward looking info o Applies to Press Releases as well, not just written docs o Remember: MD&A requires forward looking discussions!!! This doctrine insulates the corp from liability! Private Securities Litigation Reform Act (PSLRA) - After cases like Levinson there was a big increase in class action suits attys would look for puppet Ps and search for inaccurate info - This act was passed by congress to stop the massive flow of lawsuits o Created a lot of procedural requirements that you had to go through to bring a class action suit o Codified the Bespeaks Doctrine

TAKEOVERS INTRODUCTION TO TAKEOVERS: Friendly Takeovers 1. Mergers a. Two companies who decide to come together and become one company b. One company survives the merger so A and B merge into B (B survives the merger and A no longer exists after the merger) c. All assets and all liabilities of A become Bs by operation of law automatic by statute d. The S shareholders can get B stock in exchange for their A shares e. Generally, the SH of the co that is going out of existence (A shareholder) get to vote on the merger; B shareholders dont vote usually unless as a result of the merger Bs articles of incorporation are going to be amended f. NOTE: if there are preemptive rights, you generally cannot do a merger this applies to the surviving co (so B in this case) i. Merger would dilute the B SHs interests so what would happen is that the B SHs would vote to amend the articles of incorporation to delete the preemptive rights so B could merge with A 2. Cash Out Merger a. Same as above except A would get cash for their shares in A b. The merger document says whether or not the SHs of A get cash or new shares in B 3. Consolidation a. A and B merge into C. C now owns everything that A and B did 4. Stock Sale

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a. B buys all the stock in A so at the end of the day Co A is a wholly owned subsidiary of co B b. The only thing that changes is the ownership of the stock 5. Asset Sale: a. If you structure the sale as an asset sale vs. a stock sale, you can choose which assets you would like to take b. So co B would be buying all of A or some of As assets plants, equipment, - and could reject to buy asset X which is got environmental problems, for example c. A is still in existence after the asset sale but now A has only a bunch of liabilities and cash; usually the cash is paid to creditors and SHs and A goes out of biz. d. Reason why people choose asset sale over merger because dont want to worry about all of the liabilities; you can pick and choose which liabilities you assume Hostile Takeovers 1. Proxy Fights a. Definition = A struggle for control of a public corporation in which most of the high cards are held by management b. Most important traditional device used to oust incumbent managers c. The nonmanagement group (minority holders) aka insurgent competed with management in effort to obtain sufficient proxy votes to elect a majority (or all) of the board and thereby take over control of the corporation d. Essentially a political campaign for control like an election e. Very expensive: i. Management was able to charge the corp for expenses, and ii. Insurgents could also charge the corp IF they won in such case corp would pay twice f. Remember: must comply with the proxy regulations during proxy fights!!! g. No longer common any more 2. Cash-Tender Offers a. Definition = A public invitation to the Shs of the target co to tender their shares to the bidder for purchase for cash. b. Bidders often sought enough shares to gain control or all the shares c. Saturday Night Special (pre Williams Act) tender offers after the close of the market on Friday and expiring on Sunday i. This had the advantage from the bidders perspective of denying target SHs any information from the directors or the reaction of the market d. Williams Act (part of the 1934 Act) i. Did two major things: a. Must make certain disclosures when making a tender offer b. Established certain rules regarding making tender offers (did not stop tenders but made some rules no more sat night specials) c. There is a minimum time for how long the tender must be open i. it gives the SHs enough time to think about it and it gives mgmt time to talk to the SHs d. It have SHs withdrawal rights so until the offer closes, you can rescind acceptance e. All of the SHs who accept the tender must get the same price so cant give the first 50 SHs the highest price

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f. There is no longer a rush to tender if the tender is oversubscribed, then all SHs get a pro-rata of the tender offer ii. Remember: only cos that are subject to the Williams Act are 12(g) companies (just like the proxy rules) *the only thing that covers everything is 10b-5 iii. Purpose of Williams Act a. Not to stop tender offers, but instead to slow down the process, give SHs more info about the offer and give target mgmt a chance to respond, and b. Assure that the SHs would be treated equally and get the highest price possible, in part by increasing the chances for competing bids to arise. 3. Leveraged Buyouts (LBOs) a. Aggressor purchases all of most of the outstanding stock of the target for a substantial premium over the market price b. The way it is works: transaction is structured so that the repayment of this newly created debt is ultimately repaid by the target co TAKEOVER DEFENSES Three Sources 1. State Legislation - Shareholder Acquisition Statutes o Basically says that the buyers who acquire a certain level of stock in a co do NOT get the right to vote that stock UNLESS the other shareholders in the corp vote to allow such votes  Essentially, those who acquire a level of stock could be disenfranchised under such statute bad!  If the SHs do not grant the voting rights, the board could but is not obligated to redeem your shares. o Purpose it forces the buyer to sit down and talk to the co and come up with a deal that works for both parties. o Most states vary somehow on these statutes o CTS Corp v. Dynamics there Indiana had a shareholder acquisition statute which was challenged; Held:  (1) The Williams Act does not preempt the Indiana SH acquisition Statute y The statute allowed the SHs to vote as a group protects them from coercive tenders y It does not give either mgmt or the offeror an advantage in communicating to the Shs about the impending offer doesnt impose an indefinite delay y Does not allow the state govt to interpose its views of fairness instead the SHs decide whether the tender was fair the way Williams Act would have it  (2) the Indiana statute does not violate the Commerce Clause o MI Control Acquisition Statute 7B OPT OUT provision!  Applies to an issuing public corp which is: y 100 or more SHs, and y principal office or substantial assets in MI (substantial MI presence)  AND have to have one or more of the following: 76

10% of SHs residing in MI more than 10% of the shares owned by MI residents, or 10,000 SHs of record reside in MI Similar to the Indiana statute three levels of ownership which trigger it y So basically, once the control level reaches a certain point, then the SHs get to vote on whether or not the buyer can vote those shares

y y

MiBCA 7A (Fair Price Amendment Statute) once you become an interested SH over 10% stock then you cannot enter into certain transactions unless u meet certain reqs like you pay at least as much as you pay for the highest stock value

2. Defensive Measures that Boards can take (Poison Pills) Shareholder Rights Plan (aka Poison Pills) o Provide the existing SHs who are tendered offered certain rights to acquire a large number of new securities (usually common or preferred; or favorable debts) o The rights generally have the affect of diluting the percentage of the target stock which makes it co more unattractive and more expensive to acquire o There are two kinds of rights that can be issue (two types of poison pills)  Flip in Rights allow the existing SHs of the target co to buy something of value in the target at a bargain price y Such as favorable debt that is superior to other debts; or new shares, etc  Flip over Rights allow the SH to get rights to purchase shares in the bidder (acquirer) not the target IF the bidder does a merger with the target y So there must be a merger! if the bidder merges the target into itself, it assumes that contract that gives the flip over rights o The Board has the right to redeem these rights!!! o Dead Hand pills and No hand pills unlawful because they interfere with the fiduciary duies of the board  Dead Hand pills the pill can only be redeemed by a vote of the continuing directors (those who authorized the pill are the only ones who can redeem it) y Has the effect of preventing authorizing directors from being removed.  No Hand pills the pill cannot be redeemed for X (fixed) amount of time. y Mentor Graphics Corp court struck down a pill that could not be redeemed for six months (no hand pill) o Tender offers can create conflict of interest between the boards (who want to keep their lucrative jobs) and the SHs (who may profit nicely from tender offers)  Entrenchment defensive tactic that is designed to defeat a tender offer solely in order to preserve mgmts position; a breach of duty of loyalty  Other Justifications Boards use to defeat an offer: y Price is too low doesnt reflect the true value of the corp y Aggressor has a bad rep y Just say no defense its simply not good for the corp y Proposed offer is in violation of some other law antitrust y Its an unfair offer coercive

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Maran v. Household Rule: The BJR applies to board of directors decision to adopt takeover defenses! o BJR in re takeover defenses In order to have the BJR presumption, the DIRECTORS must first show  FIRST: (threat) That they had reasonable grounds for believing that there danger to the corporation  SECOND: (proportionality) That the defense mechanism was reasonable in relation to the threat posed o If the Directors show this, then the BJR applies (that they acted in good faith, informed manner, honestly believing to be acting in the best interests of the corp) and the Ps have the burden of rebutting the presumption. o Important Note:  In this case there was no immediate threat but the court said that the poison pill plan was ok because the board could reasonably believe that the corp was a good target for takeovers. y So even if there is no offer on the table if you have reasonable belief that your corp is an easy target thats sufficient y But in such case, if there is an offer on the table later on the Board is judged AGAIN at this stage!!! So board is judged at two different times.

3. Corporate Governance (staggered boards; super-majority requirements) Note: provisions in the bylaws that are antitakeover in nature are called porcupine provisions. Bylaws that require SH approval for Poison Pills o MI Rule (and most other states)  The SHs have the right to adopt bylaws that put requirements or restrictions on poison pillsIF the articles of incorporation do not restrict the SHs right to do so can have bylaw that says that the poison pills have to be approved by the SHs  231 SHs (or directors) may amend or adopt new bylaws UNLESS the articles of incorporation or the bylaws provide that the power to adopt bylaws is reserved exclusively to the Board (or SHs) o International Brotherhood of Teamster v. Fleming the court allowed the SHs to pass a bylaw that made poison pills be subject to SH approval because (1) the Corp Act did not prohibit such and (2) the articles of incorporation also did not preclude this Staggered Boards o Board usually divided in three groups with one group being elected each yearso only a minority of directors are elected each year and directors stand for election only every third year o Defensive characteristic prevents a hostile acquirer from gaining control of the co in a single election Supermajority o Some stock can have more voting rights;

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Unocal Defense; Revlon Mode and Unitrin: Unocal Defense o A corporation does not have absolute powers to defeat a perceived threat by any Draconian means available (cannot entrench themselves) o Test to bring the defensive tactic within the BJR  FIRST: (threat) The board must prove that it determined in good faith, after reasonable investigation, and with the SHs interest in mind, that there was a threat to the co and the SHs, AND  SECOND: (response) The Board must also show that the protective measures that it took were reasonable in light of the perceived threat. o If these are met the BJR presumption is afforded to the Board and Ps must rebut it Revlon Mode o RULE: Even though poison pills permit mgmt to negotiate with potential aggressors, once it is clear from the facts that the co in its present mode will no longer be in existence in its current form, the Board must switched into Revlon Mode (bidding mode) and try to obtain the best value for the SHs  Note: the highest bid is not necessarily the best deal for the SHs o So, the Board can use defensive tactics up until the point where it appears that the corp will no longer exist in its present from after that it has to switch into Revlon Mode o Revlon v. MacAndrews once the original threat of the aggressor became a reality which even the Board embraced (got a White Knight Co), the roles of the Directors changed from defenders of the corp to auctioneers of the corp charged with getting the best price for the SHs o White Knight a friendly bidder who comes and essentially stops the hostile takeover  Revlon Corp offered the two most valuable assets to a white knight co the theory is that the original acquirer will no longer want the co without the two most valuable assets called the Crown Jewel Defense  Usually there is an agreement that the white knight will assign those assets back to the target after the hostile takeover goes away Unitrin Rule new twist on the BJR re defensive tactics o FIRST: directors must prove legitimate threat o SECOND: Directors must prove that the defensive tactics are proportionate to the perceived threat  Draconian measures will automatically fail because they are not proportional y Draconian measures defensive measures that are either preclusive or coercive (stops the tender or coerces the SHs not to tender)  If the measures are not draconian, the proportionality test requires a factual analysis into the range of reasonableness y In other words, the boards are given latitude in defending the corporation o If the Board proves all these then the P must rebut the BJR by showing that the measures taken:  Were motivated by entrenchment (to perpetuate themselves in office) 79

  LOCKUPS

Some other breach of duty fraud, overreaching, lack of good faith, or Being uninformed

Lockups = negotiated agreement between the potential acquirer and the corp to pay the potential acquirer in some way if the target co either breaches the deal or if for some other reason the deal doesnt go through - Purpose: to compensate the potential acquirer for cost spent if on a failed deal and to protect the initial bidder (stocking horse) by adding extra costs for the subsequent bidders o Expensive to be the stocking horse! - Types of Lockups (aka Break-up fees) o Irrevocable stock option  The target corporation usually grants the acquirer the right to purchase ten to twenty percent of the targets stock at a favorable price o Asset option or crown jewel  The target grants the acquirer the option to purchase a particularly desirable asset of the target at a negotiated price  If the deal is not consummated, this option compensates the prospective acquirer, because it will still acquire the desirable assert at a price below FMV  This may also deter bidder because they wont want to buy the co without the truly valuable asset o Topping Fees  Expense reimbursement provisions similar to liquidated damages  The target reimburses the initial prospective acquirer for any costs incurred during the initial merger effort o Expense Reimbursement:  Pay the bidder any out of pocket expenses Standstills: - Similar to lockups - Get the buyer to agree not to negotiate with someone else for a certain period of time - If the deal is a stock acquisition, the seller may want a standstill so depending on the situation, either seller or buyer could want a standstill Lockups and the BJR - central inquiry for lockups: whether the lockup is preclusive o if the lock-up is not preclusive and it does not involve a change in control the BJR applies and the decision to have the lock up will not be disturbed if in making the decision, the directors:  acted in an informed basis  in good faith, and  in the honest belief that the action was taken in the best interest of the company - Under Revlon if the lockup takes the form of a defense tactic to a takeover, the Revlon Rule applies and the courts must enjoin preclusive lock-ups that prevent the target corporations SHs from obtaining the max value for their shares.

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INDEMNIFICATION AND DIRECTORS AND OFFICERS (D&O) INSURANCE Indemnification: - Merritt-Chapman & Scott Corp. v. WolfsonRule: Corporate agents, criminally charged for their conduct in regards to their corporation, are entitled to indemnification for the costs of their legal defense only on those indictment counts on which they are successful. o Facts: (and associates) criminally charged; ultimately copped a plea (pleaded no contest doesnt admit youre guilty). They went to the corporation and wanted indemnity. o Issue: What does success on the merits mean? o Holding: In a criminal proceeding, if youre found not guilty, then you have success on the merit complete success is not required. NOTES:  MI allows indemnification in a shareholders derivative suit (but its discretionary) some states do not allow indemnification at all in such suits y Does MI allow advancement of expenses? 564(b) says YES the corporation can advance expenses to the s (directors) to fight the suit although the directors have to agree to pay back the corporation if indemnification later proves to be wrong. o This is discretionary if you as the officer or director take a written undertaking that youll pay them back if you end up not being successful not meeting the requirements y Remember: 1. Under MI law, there are times when a corporation must/may indemnify you: a. When you are successful you are entitled to indemnification (no discretion). b. If you are not successful on the merits the corporation MAY indemnify you but it is discretionary. c. Also you may indemnify a director even when they are criminally liable (this is judged by the BJR note: if you are liable for some crime against the corporation, the Board may not be able to justify indemnification for that probably not within the protections of the BJR) 2. Indemnification is for both criminal and civil actions 3. Under MI law, the BJR is used 4. If you plead no content to a particular charge in an effort to have other charges dismissed you are entitled to indemnification for the dismissed charges but not for the no contest charges. a. But you can still ask the board to indemnify you for the no contest charges (discretionary) and if the board doesnt want to indemnify you can go to court and try to show that being indemnified would be fair 5. Note it is in the best interests to indemnify the directors because you want competent people on the board; otherwise no one would want to be a director; it is also in the best interests of the corp to settle a suit even if you are in the right because of the expenses 6. Remember: rain-coat provisions do not cover officers.

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O&D Insurance: McCullough v. Fidelity & Deposit Co.Rule: An insurer must provide coverage for claims made after a policy expires so long as the insured bank notifies the insurer of any specified wrongful act, error, or omission that may later give rise to a claim being made against its directors or officers. o Insured needs to give its insurer specific notice of the specific claim against the insured. o Class Notes: Most insurance policy have a notice provision that is the triggering event for coverage the problem in this case was that the notice had to have been given during the claims made period. When you have a threat of suit you should notify right then!!!  In this case the policy never got the notification so they denied the coverage because it was a claim made policy and the notification came after the policy expired. Types of Insurance Policies: o Claims made policy provides coverage for claims first made against an insured during the policy period. (ALL D&O policies are now this).  If you get any hint that somebody is unhappy and they say they may sue you in the future for malpractice, you should go to the firms ethics committee and tell them so the firm is on notice and then the firm can tell the insurance company so the company is on notice for any potential suits in the future (and thus you will be covered under your malpractice insurance)  Claims made insurance opens up the possibility that an insured who retires or leaves an employer may not have any insurance in force at the time a claim arising out of an earlier period is first asserted. y Example A claim that arose from conduct in 1997 may first be asserted in 1999; this claim is covered only by the 1999 claims made policy. An employee who was covered in 1997, but has retired, may not have any coverage in 1999. o Occurrence policy provides coverage for injuries that take place during the policy period regardless of when the claim is asserted. D&O Policies Exclusions o Conduct exclusions eliminate coverage for certain conduct which is deemed to be sufficiently self-serving or egregious  Dishonesty, fraud, short-swing profits, traded on inside information, etc.  Director/Officer did something to receive an illegal personal benefit o Other insurance category implements the concept that the D&O policy is the ultimate backstop protection for directors and officers  Things like torts bodily injury, libel, slander, pollution (D&O policies expect you to have general liability insurance for things like this) o Laser exclusions intended to address specific risks unique to the insured corporation which the insurer has identified as inconsistent with its underwriting principle specific risks that are specific to specific companies  Depends on what your industry is 82

Bodily injury/property damage not covered ERISA (employee benefits/retirement benefits) not covered Environmental pollution not covered Endorsements o Not going to cover existing or impending claims Reservation of Rights you sent us a notice, well accept responsibility for it, but we reserve our rights to continue investigation of the issue and if we find something that gives us a reason not to cover you, we reserve that right to not cover you.

y y y y

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