Corporations

Question 1

BUSINESS – Corporations

1. Duty of Care & Business Judgment Rule

★★★★★

Answer 1

BUSINESS – Corporations

1. Duty of Care & Business Judgment Rule

★★★★★

• Directors are fiduciaries of a corporation, and owe the corporation a duty of care.
• When directors act with care toward the corporation, the Business Judgment Rule protects them from personal liability for business decisions that harm the corporation.
• To be protected, the director must act:
  
  1. in good faith,
  2. in a manner they reasonably believe to be in the best interests of the corporation,
  3. as a reasonably prudent person in a like position would act under similar circumstances, and
  4. to ensure they are reasonably informed.

__________

Fiduciary Duty of Care

• Directors and officers of a corporation owe a fiduciary duty of care to the corporation and its shareholders. This duty requires directors to act:
  
  1. In Good Faith: With honesty and integrity.
  2. In a Manner Believed to be in the Best Interests of the Corporation and its Shareholders: Prioritizing the corporation’s well-being over their own personal interests or the interests of others.
  3. With Such Care as an Ordinarily Prudent Person in a Like Position Would Use Under Similar Circumstances: This is an objective standard, based on what a reasonably prudent director would do, not what the particular director actually did.
  4. Reasonable Inquiry: It includes a duty to be reasonably informed and to make reasonable inquiry when the circumstances warrant it.

Business Judgment Rule (BJR)

• The BJR is a judicial presumption that protects directors from personal liability for honest mistakes in judgment.
• It recognizes that business decisions often involve risk, and directors should not be held liable simply because a decision turns out to be wrong.

Elements of the BJR

1. Good Faith: The directors must have acted honestly, without fraud, self-dealing, or a conflict of interest.
2. Informed Basis (Due Care): The directors must have made a reasonable effort to become informed about the decision.
   
   • This requires gathering relevant information, considering alternatives, and, when appropriate, seeking expert advice.
   • The level of inquiry required depends on the circumstances.
3. Rational Belief: The directors must have had a rational belief that the decision was in the best interests of the corporation.
   
   • This does not require that the decision be objectively the best decision, only that it be a rational one, given the information available at the time.

Rebutting the BJR

• The plaintiff challenging a director’s decision has the burden of rebutting the BJR presumption. This can be done by showing:
  
  • Lack of Good Faith: Fraud, self-dealing, conflict of interest, or other bad faith conduct.
  • Lack of Informed Basis (Gross Negligence): Failure to make a reasonable effort to become informed – gross negligence in the decision-making process. Ordinary negligence is not enough to overcome the BJR.
• Irrationality: The decision was so irrational that no reasonable business person would have made it.

Effect of Rebutting the BJR

• If the plaintiff rebuts the BJR presumption, the burden shifts to the directors to prove that the transaction was entirely fair to the corporation.

Policy: The BJR encourages directors to take calculated risks and make informed decisions without fear of being held personally liable for every mistake. It promotes efficient corporate governance.

Question 2

BUSINESS – Corporations

2. Duty of Loyalty: Fiduciary Duty Owed

Answer 2

BUSINESS – Corporations

2. Duty of Loyalty: Fiduciary Duty Owed

Directors and officers of a California corporation are fiduciaries and owe a duty of loyalty to the corporation and its shareholders. This duty requires them to act in good faith and in the best interests of the corporation, and prohibits them from: (1) self-dealing (engaging in transactions with the corporation in which they have a personal financial interest); (2) usurping corporate opportunities (taking business opportunities for themselves that belong to the corporation); and (3) competing with the corporation.

__________

Directors and officers of a California corporation occupy a fiduciary relationship to the corporation and its shareholders, owing them a duty of loyalty. This duty requires them to act with undivided loyalty to the corporation and to avoid any situation where their personal interests conflict with the interests of the corporation.

Key Aspects of the Duty of Loyalty:

• No Self-Dealing: Directors and officers must avoid self-dealing transactions – transactions between themselves (or entities in which they have a material financial interest) and the corporation.
  
  • Interested Director Transactions (California Corporations Code § 310): Such transactions are not automatically void or voidable if:
    
    • The transaction is approved by a majority of the disinterested directors, after full disclosure of the material facts and the director’s interest; OR
    • The transaction is approved by the shareholders in good faith, after full disclosure of the material facts and the director’s interest; OR
    • The transaction is just and reasonable as to the corporation at the time it is authorized, approved, or ratified (i.e., it is fair to the corporation). The burden of proving fairness is on the interested director.
• Corporate Opportunity Doctrine: Directors and officers cannot usurp corporate opportunities. They cannot take for themselves (or divert to others) business opportunities that rightfully belong to the corporation. An opportunity is generally considered “corporate” if:
  
  • The corporation is financially able to undertake it;
  • Is in the corporation’s line of business or is of practical advantage to it;
  • Is one in which the corporation has an interest or a reasonable expectancy; and
  • By embracing the opportunity, the self-interest of the officer or director will be brought into conflict with the corporation
  • The director or officer learned of the opportunity through their position with the corporation, or if the opportunity is closely related to the corporation’s existing or prospective business.
  • If a corporate opportunity is found to exist, the director or officer must first present it to the corporation. They can only take the opportunity for themselves if the corporation, after full disclosure, rejects it.
• No Competition: Directors and officers generally cannot directly compete with the corporation.

Remedies for Breach: A breach of the duty of loyalty can result in:

• Damages (to compensate the corporation for losses).
• Disgorgement of profits (requiring the director/officer to return any profits made from the breach).
• Rescission of the transaction (if it was a self-dealing transaction).
• Injunctive relief (to prevent a threatened breach).
• Removal from office.

Policy: The duty of loyalty is essential to ensure that directors and officers act in the best interests of the corporation and its shareholders, rather than for their own personal gain.
Comparison to Duty of Care: The duty of loyalty is distinct from the duty of care (which requires informed, good-faith decision-making). The Business Judgment Rule generally does not protect breaches of the duty of loyalty.

Question 3

BUSINESS – Corporations

3. Duty of Loyalty: Conflicting Interest Transaction

Answer 3

BUSINESS – Corporations

3. Duty of Loyalty: Conflicting Interest Transaction

California Corporations Code § 310 provides that a transaction in which a director has a material financial interest is not automatically void or voidable if: (1) the transaction is approved by a majority of the disinterested directors after full disclosure of the material facts and the director’s interest; (2) the transaction is approved by the shareholders in good faith after full disclosure; or (3) the transaction is just and reasonable as to the corporation at the time it is authorized, approved, or ratified.

__________

California Corporations Code § 310 addresses the issue of ‘interested director transactions’ (also called ‘conflicting interest transactions’). These are transactions between a corporation and one or more of its directors, or between a corporation and another entity (corporation, partnership, etc.) in which a director has a material financial interest. The core concern is that a director’s personal interest might conflict with their duty of loyalty to the corporation.
General Rule: Such transactions are not automatically void or voidable solely because of the director’s interest. This recognizes that interested director transactions can sometimes be beneficial to the corporation.
Safe Harbors (§ 310): Section 310 provides three “safe harbors” that protect a transaction from being voided solely due to the director’s interest:
- Disinterested Director Approval:
- Full Disclosure: The material facts of the transaction and the director’s interest must be fully disclosed to the board of directors.
- Disinterested Vote: The transaction must be approved by a sufficient vote of the disinterested directors (usually a majority of a quorum, but the articles or bylaws may require a greater number). The interested director’s vote does not count.
- Shareholder Approval:
- Full Disclosure: The material facts of the transaction and the director’s interest must be fully disclosed to the shareholders.
- Good Faith Approval: The transaction must be approved by the shareholders in good faith. Shares owned by the interested director are not counted in determining the shareholder vote.
- Fairness:
- The transaction must be just and reasonable as to the corporation at the time it is authorized, approved, or ratified. This is a fairness test, looking at both the terms of the transaction and the process by which it was approved.
Burden of Proof: If neither disinterested director approval nor shareholder approval is obtained, the interested director has the burden of proving that the transaction was fair to the corporation.
“Material Financial Interest”: This means an interest that is significant enough that it would reasonably be expected to influence the director’s judgment in the matter. A trivial or indirect interest is not enough.
Examples:
- A director selling property to the corporation.
- A director loaning money to the corporation.
- A corporation entering into a contract with another company in which a director is a major shareholder.
Policy: Section 310 balances the need to protect corporations from unfair self-dealing by directors with the recognition that some interested director transactions can be beneficial.
Relationship to Duty of Care: Even if a transaction satisfies § 310, directors still have a duty of care (under Corporations Code § 309) to make informed decisions in good faith. The Business Judgment Rule may protect the process, but § 310 addresses the substance of the transaction itself.

Question 4

BUSINESS – Corporations

4. Shareholder Liability & Piercing the Corporate Veil

Answer 4

BUSINESS – Corporations

4. Shareholder Liability & Piercing the Corporate Veil

Shareholders of a corporation enjoy limited liability, meaning they are generally not personally liable for the corporation’s debts. However, California courts may ‘pierce the corporate veil’ under the alter ego doctrine to hold shareholders liable when there is such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, and adherence to the fiction of separate existence would sanction a fraud or promote injustice.

__________

A fundamental principle of corporate law is that a corporation is a separate legal entity, distinct from its shareholders. This ‘corporate veil’ generally shields shareholders from personal liability for the corporation’s debts and obligations – this is limited liability. However, in exceptional circumstances, California courts may ‘pierce the corporate veil’ and hold shareholders personally liable. The most common theory is the alter ego doctrine.
Alter Ego Doctrine (Two-Prong Test):
- Unity of Interest and Ownership: There must be such a unity of interest and ownership between the corporation and its shareholders that the separate personalities of the corporation and the individual(s) no longer exist. The corporation is essentially the ‘alter ego’ of the shareholders – a mere instrumentality or conduit for their personal affairs.
- Inequitable Result: Adherence to the fiction of separate corporate existence must sanction a fraud or promote injustice. It must be inequitable to allow the shareholders to escape personal liability by hiding behind the corporate form.
Factors Indicating Unity of Interest (No Single Factor is Determinative):
- Commingling of funds and other assets.
- Failure to segregate funds of the separate entities.
- The unauthorized diversion of corporate funds or assets to other than corporate uses.
- Treatment by an individual of the assets of the corporation as the individual’s own.
- The holding out by an individual that the individual is personally liable for the debts of the corporation.
- Undercapitalization (insufficient capital to meet reasonably foreseeable business liabilities). This is a very important factor.
- Failure to observe corporate formalities (e.g., not holding meetings, not keeping minutes, not issuing stock).
- Disregard of legal formalities and the failure to maintain arm’s length relationships among related entities.
- Non-functioning of other officers or directors.
- Absence of corporate records.
- The corporation being a mere shell or conduit for the shareholders’ personal business.
- Same individuals, officers, and ownership
Both Prongs Required: Both the unity of interest and the inequitable result must be present to pierce the veil.
Other Theories (Less Common): While alter ego is the most common, other theories might be used to pierce the veil, such as:
- Agency: If the corporation is acting as a mere agent of the shareholder.
Policy: Piercing the corporate veil is an extraordinary remedy, used cautiously and only when necessary to prevent fraud or injustice. The corporate form is respected unless it is abused.
Examples:
- A sole shareholder uses the corporate bank account as their personal checking account, paying personal expenses directly from corporate funds, and fails to hold any corporate meetings. This might support piercing.
- A corporation is formed with minimal capital, far less than what is reasonably necessary to cover its potential liabilities. This undercapitalization might be a factor supporting piercing.
- A corporation fails to issue stock, hold meetings, or keep any corporate records. This disregard of corporate formalities might be a factor supporting piercing.

Question 5

BUSINESS – Corporations

5. Liability for Pre-Incorporation Contracts

Answer 5

BUSINESS – Corporations

5. Liability for Pre-Incorporation Contracts

A promoter is someone who takes the preliminary steps to form a corporation and enters into contracts on its behalf before it exists. The promoter is personally liable on pre-incorporation contracts, even if the contract was made in the name of the future corporation. The corporation, once formed, is not automatically liable, but may become liable by adopting the contract (expressly or impliedly) or through novation (a new agreement substituting the corporation for the promoter, with the consent of all parties).

__________

Promoters are individuals who take the preliminary steps in organizing a corporation, often entering into contracts on behalf of the planned entity before it legally exists. The rules governing liability for pre-incorporation contracts balance the need to protect third parties who deal with promoters with the principle that a corporation cannot be bound by acts that occurred before its existence.
Promoter’s Liability:
- General Rule: A promoter is personally liable on any pre-incorporation contract they enter into, even if the contract is made in the name of the future corporation and even if the corporation is later formed. This is because the promoter cannot be an agent for a non-existent principal.
- Continuing Liability: The promoter remains liable even after the corporation is formed and adopts the contract, unless there is a novation.
- Novation: A novation is a new agreement in which the third party agrees to release the promoter from liability and substitute the corporation as the liable party. This requires the express consent of all three parties (promoter, corporation, and third party). A mere adoption by the corporation is not a novation.
- Agreement Otherwise: The promoter is not liable if the contract clearly shows that the parties did not intend the promoter to be personally bound (e.g., the contract explicitly states that only the future corporation will be liable).
- Unformed Corporation If the corporation is never formed, the promoter remains liable.
Corporation’s Liability:
- Not Automatically Liable: A corporation is not automatically bound by pre-incorporation contracts made by its promoters.
- Adoption: The corporation becomes liable only if it adopts the contract after its formation. Adoption can be:
- Express: By a formal resolution of the board of directors explicitly accepting the contract.
- Implied: By the corporation’s conduct, such as knowingly accepting the benefits of the contract with full knowledge of its terms. This requires knowledge and some affirmative act by the corporation indicating acceptance.
Examples:
- A promoter signs a lease for office space in the name of a corporation that has not yet been formed. The promoter is personally liable on the lease.
- After incorporation, the corporation occupies the leased space and pays rent. This would likely constitute implied adoption of the lease, making the corporation liable.
- To release the promoter from liability, a novation would be required, with the landlord, the promoter, and the corporation all agreeing to substitute the corporation for the promoter as the party to the lease.
Unjust Enrichment: Even if the corporation does not formally adopt the contract, it may be liable to the promoter under quasi-contract principles (unjust enrichment) for the reasonable value of any benefits it knowingly received under the contract.
Policy: These rules protect third parties who deal with promoters by ensuring someone is liable on the contract. They also protect promoters from being perpetually liable by allowing for novation, and they protect corporations from being bound by unauthorized pre-incorporation acts unless they choose to adopt them.

Question 6

BUSINESS – Corporations

5. Duty of Loyalty: Usurping a Corporate Opportunity

Answer 6

BUSINESS – Corporations

5. Duty of Loyalty: Usurping a Corporate Opportunity

Under the corporate opportunity doctrine, a director or officer of a California corporation may not take personal advantage of a business opportunity that ‘belongs to the corporation’ without first offering it to the corporation. An opportunity ‘belongs to the corporation’ if it is within the corporation’s line of business, the corporation has an interest or expectancy in it, and the corporation is financially able to pursue it.

__________

The corporate opportunity doctrine is a specific application of the duty of loyalty, which requires directors and officers to act in the best interests of the corporation and avoid conflicts of interest. This doctrine prohibits directors and officers from taking personal advantage of business opportunities that rightfully belong to the corporation.
Elements of a Corporate Opportunity:
- Line of Business: The opportunity must be within the corporation’s current or reasonably foreseeable line of business, or be closely related to its activities. This includes opportunities the corporation is actively pursuing, as well as those it might reasonably be expected to pursue in the future.
- Interest or Expectancy: The corporation must have an existing interest in the opportunity (e.g., a contractual right, a right of first refusal) or a reasonable expectancy of pursuing it. This expectancy can arise from the corporation’s past practices, plans, or the nature of the opportunity itself.
- Financial Ability: The corporation must be financially capable of taking advantage of the opportunity. A director or officer is not required to offer an opportunity the corporation cannot afford.
- Fairness: It must be fair, under all the circumstances, to require the opportunity to be offered to the corporation. This considers the overall equities of the situation.
- How opportunity discovered: Through their role in the corporation.
Procedure: If a director or officer becomes aware of a potential corporate opportunity, they must:
- Full Disclosure: Disclose the opportunity to the corporation’s board of directors, including all material facts.
- Corporation’s Decision: Allow the corporation to decide whether to pursue the opportunity.
- Rejection Required: Only if the corporation, after full disclosure, rejects the opportunity (typically by a vote of disinterested directors) may the director or officer pursue it personally.
Examples:
- A director of a software company learning of a valuable patent that would be useful to the company and purchasing it for themselves.
- An officer of a real estate development company secretly buying land that the company was planning to develop.
- A director starting a competing business that directly targets the corporation’s customers.
Defenses:
- Not a Corporate Opportunity: The opportunity does not meet the elements above (not in the line of business, no interest/expectancy, corporation financially unable).
- Full Disclosure and Rejection: The opportunity was fully disclosed to the corporation, and the corporation (through disinterested directors) rejected it.
- Incapacity of Corporation: The corporation’s financial condition prevents taking the opportunity.
Remedies for Usurpation:
- Constructive Trust: The court may impose a constructive trust on the opportunity (or its profits) for the benefit of the corporation.
- Damages: The corporation may recover damages for any losses suffered as a result of the usurpation.
- Disgorgement of Profits: The director or officer may be required to disgorge any profits they made from the opportunity.
- Injunctive Relief: The court may enjoin the director or officer from further exploiting the opportunity.
Policy: The corporate opportunity doctrine prevents directors and officers from using their positions of trust to enrich themselves at the corporation’s expense. It promotes loyalty and ensures that business opportunities are pursued for the benefit of the corporation, not for individual gain.

Question 7

BUSINESS – Corporations

6. Formation of a Corporation & Articles of Incorporation

Answer 7

BUSINESS – Corporations

6. Formation of a Corporation & Articles of Incorporation

A de jure corporation (a corporation formed in compliance with all mandatory statutory requirements) is formed in California when one or more incorporators file Articles of Incorporation with the Secretary of State that comply with California Corporations Code § 200. The Articles must include the corporation’s name, a statement of purpose, the name and address of its initial agent for service of process, and information about its authorized stock.

__________

A de jure corporation (a corporation formed in full compliance with the law) is formed in California when one or more incorporators file Articles of Incorporation with the California Secretary of State that comply with the requirements of California Corporations Code § 200 and § 202.
Articles of Incorporation (Fundamental Governing Document):
- Mandatory Provisions (§ 202):
- Name: Must comply with statutory requirements (not misleadingly similar, generally include a corporate designator like “Inc.,” “Corp.,” “Limited,” or “Ltd.”).
- Purpose: A statement that the purpose is to engage in any lawful activity.
- Agent for Service of Process: Name and California address of the initial agent.
- Stock Structure:
- Total number of authorized shares.
- If multiple classes/series, the number of shares in each and a statement of their rights, preferences, privileges, and restrictions.
- Optional Provisions: The Articles may include provisions regarding:
- Limiting or defining the corporation’s powers.
- Management of the business and regulation of corporate affairs.
- Director and shareholder liability (to the extent permitted by law).
- Initial directors’ names and addresses (not required).
- Par value of shares (not required).
- Preemptive rights (shareholders’ right to purchase a proportionate share of new issuances to maintain their ownership percentage).
Effect of Filing: Corporate existence begins upon the filing of the Articles with the Secretary of State, and this is conclusive evidence of formation, except as against the State.
Defective Formation: If the Articles fail to comply with the mandatory requirements, a de jure corporation is not formed. However, the entity might still be recognized as a de facto corporation or a corporation by estoppel (see separate rules).
Bylaws: After incorporation, the corporation must adopt bylaws, which are the internal rules governing the corporation’s operations. Bylaws are not filed with the state, but they are essential for corporate governance. They typically cover matters such as shareholder meetings, director elections, officer duties, and stock issuance.
Policy: The formation requirements are designed to provide public notice of the corporation’s existence and basic structure, to protect those who deal with the corporation, and to establish a clear framework for corporate governance.

Question 8

BUSINESS – Corporations

6. Corporation by Estoppel

Answer 8

BUSINESS – Corporations

6. Corporation by Estoppel

Corporation by estoppel is an equitable doctrine that prevents either: (1) a third party who has dealt with an entity as if it were a corporation from later denying the entity’s corporate existence to avoid liability; or (2) an entity that has held itself out as a corporation from denying its corporate status to avoid liability.

__________

When there has been a defective attempt to form a corporation, California courts may, in limited circumstances, recognize the entity’s corporate status for certain purposes under the doctrines of de facto corporation or corporation by estoppel. Corporation by estoppel is relevant to this situation.
Corporation by Estoppel: This is an equitable doctrine that prevents a party from denying the corporate existence of an entity when that party has dealt with the entity as if it were a corporation and would be unjustly enriched or gain an unfair advantage by denying corporate status. It is based on fairness and preventing unjust enrichment.
Requirements (Generally):
- Holding Out: The entity claiming to be a corporation must have held itself out as a corporation, or the third party must have reasonbly believed he or she was dealing with a corporation.
- Reliance: The party asserting estoppel (either the third party or the entity itself) must have relied in good faith on the representation or belief of corporate existence.
- Injustice/Unfairness: Denying corporate existence must result in injustice or unfairness. It’s about preventing a party from taking advantage of a technical defect after treating the entity as a corporation.
Two Sides of the Doctrine:
- Third Party Estopped: A third party who contracts with an entity believing it to be a corporation, receives the benefits of that contract, and then tries to sue the individual owners personally by claiming the corporation doesn’t exist, may be estopped from denying the corporation’s existence.
- Entity Estopped: An entity that holds itself out as a corporation, enters into contracts, and conducts business as a corporation, may be estopped from denying its corporate status to avoid liability on those contracts.
Comparison to De Facto Corporation:
- De facto corporation requires a good-faith attempt to incorporate under a valid statute, colorable compliance with the statute, and use of corporate powers. It protects the entity from challenges to its corporate status by anyone (except the state in a quo warranto proceeding).
- Corporation by estoppel is fact-specific and applies only between the parties to a particular transaction. It does not create a corporation for all purposes.
Policy and Limitations: Corporation by estoppel is applied cautiously and only when necessary to prevent a clear injustice. It is less frequently invoked than in the past, given the ease of modern corporate formation. The modern trend is to hold individuals personally liable when there has been a significant failure to comply with incorporation requirements, unless there is a very strong equitable reason to do otherwise.

Question 9

BUSINESS – Corporations

6. Ultra Vires Acts

Answer 9

BUSINESS – Corporations

6. Ultra Vires Acts

California Corporations Code § 208 significantly limits the ultra vires doctrine. A corporation’s act is generally not invalid solely because it exceeds the corporation’s stated purpose or powers. However, ultra vires may still be asserted in limited situations: (1) by a shareholder in a derivative suit; (2) by the corporation itself against current or former officers or directors; or (3) by the Attorney General.

__________

The ultra vires doctrine historically allowed a corporation, its shareholders, or the state to challenge corporate actions that exceeded the powers or purposes stated in the corporation’s articles of incorporation. However, California, like most jurisdictions, has drastically limited the doctrine’s application through California Corporations Code § 208.
California Corporations Code § 208(a): This section states that ‘no limitation upon the business, purposes, or powers of the corporation or upon the powers of the shareholders, officers, or directors…shall be asserted as between the corporation or any shareholder and any third person, except’ in three specific types of proceedings:
- Shareholder Derivative Suit: A shareholder may bring a derivative suit on behalf of the corporation to enjoin an unauthorized act, but only if:
- Third-party rights have not been acquired (i.e., the contract has not been fully performed).
- It is equitable to do so (the court has discretion).
- All parties to the contract are parties to the court proceeding.
- Action Against Officers/Directors: The corporation itself (directly, derivatively, or through a receiver or trustee) may sue current or former officers or directors for exceeding their authority. This is typically a breach of fiduciary duty claim, not a pure ultra vires claim.
- Action by Attorney General: The California Attorney General may bring an action to dissolve the corporation or to enjoin it from engaging in unauthorized business.
Modern Significance: The ultra vires doctrine has very limited practical significance today. This is because:
- Most corporations have very broad purpose clauses in their articles (e.g., “to engage in any lawful business”).
- Section 208 restricts the doctrine’s application to the three specific situations listed above.
- Even in those situations, the court has discretion to uphold the act if it is equitable to do so.
Policy: The modern limitations on ultra vires reflect a policy of protecting third parties who deal with corporations in good faith, and of promoting the stability of corporate transactions.
Examples:
- Historically, if a corporation chartered to operate a railroad tried to open a restaurant, that act could be challenged as ultra vires. Today, this would almost certainly not be a valid challenge, given broad purpose clauses and § 208.
- A shareholder might be able to bring a derivative suit to enjoin the corporation from entering into a clearly unauthorized contract before it is performed, but not after a third party has relied on it.
- The corporation could sue a former director for breach of fiduciary duty for authorizing a transaction that exceeded the corporation’s powers, even if the transaction itself is not voidable under ultra vires.

Question 10

BUSINESS – Corporations

6. Shareholder Voting Agreements & Trusts

Answer 10

BUSINESS – Corporations

6. Shareholder Voting Agreements & Trusts

California Corporations Code allows shareholders to enter into two primary types of agreements to control voting:
- Shareholder Voting Agreements (Cal. Corp. Code § 706(a)): Agreements between shareholders specifying how their shares will be voted. These are generally enforceable.
- Voting Trusts (Cal. Corp. Code § 706(b)): Shareholders transfer legal title of their shares to a trustee, who votes the shares according to the terms of a written trust agreement. Voting trusts have specific statutory requirements, including a limited duration (in CA, it used to be limited).

__________

California law permits shareholders to enter into agreements to control the voting of their shares, recognizing that shareholders may have legitimate reasons to combine their voting power. There are two primary mechanisms:
- Shareholder Voting Agreements (Cal. Corp. Code § 706(a)):
- Definition: A written agreement among shareholders specifying how their shares will be voted on any matter (election of directors, amendments to articles, mergers, etc.).
- Enforceability: Generally enforceable between the parties to the agreement.
- Duration: No statutory limit on duration.
- Close Corporations: Particularly useful in close corporations (those with few shareholders, often family-owned), where they can be used to allocate control and protect minority shareholder interests. In a statutory close corporation (Cal. Corp. Code § 158), a shareholder voting agreement can even override the statutory rules of corporate governance. To be enforceable in a close corporation, must be in writing.
- Specific performance: Can get specific performance.
- Voting Trusts (Cal. Corp. Code § 706(b)):
- Definition: A formal trust arrangement where shareholders transfer legal title to their shares to one or more trustees, who then vote the shares according to the terms of a written trust agreement.
- Requirements:
- Written trust agreement.
- Transfer of legal title to shares to the trustee(s).
- Filing of a copy of the agreement with the corporation.
- Duration: Used to be limited, but not anymore.
Key Differences:
| Feature | Voting Agreement | Voting Trust |
|—|—|—|
| Ownership | Shareholders retain legal and beneficial ownership of shares. | Shareholders transfer legal title to trustee(s); retain beneficial ownership. |
| Formality | Less formal; generally just requires a written agreement among shareholders. | More formal; requires a written trust agreement, transfer of legal title, and filing with the corporation. |
| Duration | No statutory limit. | No statutory limit. |
| Typical Use | More common in close corporations to allocate control, protect minority shareholders, or ensure continuity of management. Can also be used in larger corporations, but less common. | Less common; often used in specific situations like bankruptcy reorganizations or when lenders require control over voting. |
| Enforcement | Enforceable between parties. Specifically Enforceable | Enforceable through trust law. |
Policy: These mechanisms allow shareholders flexibility in structuring their voting arrangements, particularly in closely held corporations. They can promote stability, protect minority interests, and facilitate corporate governance.

Question 11

BUSINESS – Corporations

6. Direct & Derivative Actions

Answer 11

BUSINESS – Corporations

6. Direct & Derivative Actions

Shareholders can bring two distinct types of lawsuits:
- Direct Action: A suit brought by a shareholder in their own name and own right to redress an injury sustained directly by the shareholder individually.
- Derivative Action: A suit brought by a shareholder on behalf of the corporation to redress an injury sustained by the corporation. Any recovery generally goes to the corporation, not directly to the shareholder.

__________

Shareholders in a California corporation have two distinct avenues for legal redress related to corporate wrongs: direct actions and derivative actions.
- Direct Action:
- Definition: A lawsuit brought by a shareholder in their own name and own right to redress an injury sustained directly by the shareholder as an individual. The injury must be distinct from any injury to the corporation.
- Examples:
- Suit to enforce voting rights.
- Suit to compel payment of properly declared dividends.
- Suit to inspect corporate books and records (if the right is improperly denied).
- Suit to challenge a denial of preemptive rights (if they exist).
- Suit challenging a transaction that specifically harms the shareholder’s individual rights (e.g., a discriminatory share issuance that dilutes only that shareholder’s voting power).
- Derivative Action (Cal. Corp. Code § 800):
- Definition: A lawsuit brought by a shareholder on behalf of the corporation to redress an injury sustained by the corporation itself. The shareholder acts as a representative of the corporation, and any recovery generally goes to the corporation, not directly to the shareholder.
- Examples:
- Suit alleging breach of fiduciary duty (duty of care, duty of loyalty) by directors or officers.
- Suit to recover corporate assets that were wrongfully diverted or wasted by insiders.
- Suit to challenge an improper corporate transaction (e.g., self-dealing, usurpation of corporate opportunity).
- Requirements:
- Contemporaneous Ownership: The plaintiff must have been a shareholder at the time of the alleged wrongdoing (or have acquired the shares by operation of law from someone who was).
- Demand Requirement: Generally, the plaintiff must first make a written demand on the board of directors to take action to redress the alleged wrong. This gives the board an opportunity to investigate and address the issue.
- Demand Futility Exception: The demand requirement is excused if the plaintiff can demonstrate that making a demand would be futile. This usually requires showing that a majority of the board is interested in the transaction or is otherwise incapable of making an independent decision.
- Security for Expenses (California): Under Cal. Corp. Code § 800, the corporation or the defendant directors may move to require the plaintiff to post security (a bond) for the defendants’ reasonable expenses, including attorneys’ fees, if there is no reasonable possibility that the prosecution of the cause of action will benefit the corporation or its shareholders. This is a significant hurdle for derivative plaintiffs in California.
- Court Approval: Requires for settlement.
- Special Litigation Committees: If a demand is made and refused, the board may appoint a special litigation committee (SLC) of disinterested directors to investigate the claims and determine whether pursuing the lawsuit is in the corporation’s best interests. If the SLC, acting in good faith and after reasonable inquiry, determines that the suit is not in the corporation’s best interests, the court may dismiss the derivative action based on the SLC’s recommendation (this is subject to judicial review, with varying levels of scrutiny depending on the jurisdiction).
Policy: Derivative suits are a powerful mechanism for holding directors and officers accountable for their actions, but they also pose a risk of strike suits (meritless lawsuits brought to extract a settlement). The procedural requirements (demand, security for expenses) are designed to balance these competing concerns.

Question 12

BUSINESS – Corporations

7. Federal Securities Law – Rule 10b-5

Answer 12

BUSINESS – Corporations

7. Federal Securities Law – Rule 10b-5

Rule 10b-5, promulgated under Section 10(b) of the Securities Exchange Act of 1934, makes it unlawful for any person, directly or indirectly, in connection with the purchase or sale of any security:
- To employ any device, scheme, or artifice to defraud;
- To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading; or
- To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.
The plaintiff must show scienter, materiality, reliance, and loss causation.

__________

Rule 10b-5, promulgated under Section 10(b) of the Securities Exchange Act of 1934, is the principal anti-fraud provision of federal securities law. It prohibits any manipulative or deceptive device or contrivance used in connection with the purchase or sale of any security, whether registered or not. While there is no express private right of action, courts have long recognized an implied private right of action under Rule 10b-5.
Elements of a Private 10b-5 Claim:
- Material Misrepresentation or Omission:
- The defendant made a false statement of a material fact, or omitted a material fact that was necessary to make the statements made not misleading, in light of the circumstances.
- “Materiality”: A fact is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision.
- Scienter:
- The defendant acted with scienter – an intent to deceive, manipulate, or defraud.
- The Supreme Court has held that scienter requires at least recklessness (a highly unreasonable omission or misrepresentation, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it). Negligence is not enough.
- Connection with Purchase or Sale: The misrepresentation or omission must be “in connection with” the purchase or sale of a security. This is broadly interpreted.
- Reliance:
- The plaintiff must have relied on the misrepresentation or omission in making their investment decision.
- Fraud-on-the-Market Theory: In cases involving publicly traded securities, reliance may be presumed under the “fraud-on-the-market” theory. This theory assumes that in an efficient market, the price of a security reflects all publicly available information, including any misrepresentations. Therefore, investors are presumed to have relied on the integrity of the market price, even if they did not directly see or hear the misrepresentation.
- Omission Cases: In cases involving primarily omissions of material facts, reliance is often presumed.
- Economic Loss: The plaintiff must have suffered an actual economic loss as a result of the defendant’s conduct.
- Loss Causation: The plaintiff must show that the defendant’s misrepresentation or omission proximately caused the plaintiff’s economic loss. This is often described as showing that the loss was a foreseeable result of the fraud.
Insider Trading: Rule 10b-5 is also the primary basis for prohibiting insider trading – trading on material, nonpublic information in breach of a duty of trust or confidence.
Policy: Rule 10b-5 is designed to promote fair and honest securities markets, protect investors, and ensure full and fair disclosure of material information.

Question 13

BUSINESS – Corporations

7. Federal Securities Law – Section 16(b)

Answer 13

BUSINESS – Corporations

7. Federal Securities Law – Section 16(b)

Section 16(b) of the Securities Exchange Act of 1934 is a strict liability provision designed to prevent insider trading based on short-term market fluctuations. It requires statutory insiders (directors, officers, and beneficial owners of more than 10% of any class of equity security) of a company with a class of equity securities registered under Section 12 of the 1934 Act to disgorge to the corporation any ‘profit’ realized from any purchase and sale, or sale and purchase, of the company’s equity securities within any period of less than six months.

__________

Section 16(b) of the Securities Exchange Act of 1934 is a prophylactic rule designed to prevent unfair use of inside information by corporate insiders who may have access to non-public information about the company. It imposes strict liability for ‘short-swing’ profits, regardless of the insider’s actual intent or possession of inside information.
Elements:
- Reporting Company: The corporation must have a class of equity securities registered under Section 12 of the 1934 Act (generally, companies listed on a national securities exchange or with assets exceeding $10 million and 500 or more shareholders of record of a class of equity securities).
- Statutory Insider: The defendant must be a statutory insider at both the time of the purchase and the time of the sale:
- Director: A member of the corporation’s board of directors.
- Officer: Defined by function, not just title; includes president, vice presidents in charge of principal business units, divisions or functions, and other policy-making officers.
- Beneficial Owner of More Than 10%: A person who directly or indirectly owns more than 10% of any class of the corporation’s registered equity securities. Beneficial ownership includes shares held through family members, partnerships, trusts, etc., where the insider has a pecuniary interest. The 10% ownership must exist immediately before both the purchase and sale.
- Purchase and Sale (or Sale and Purchase): There must be a purchase and sale (or sale and purchase) of the corporation’s equity securities. “Purchase” and “sale” are broadly defined and can include unconventional transactions.
- Within Six Months: The purchase and sale (or sale and purchase) must occur within a period of less than six months.
Strict Liability: Section 16(b) imposes strict liability. The insider’s intent, good faith, or actual use (or lack) of inside information is irrelevant. If the elements are met, the profit is recoverable.
Profit Calculation (Maximizing Disgorgement): The recoverable “profit” is calculated in a way that maximizes the amount to be disgorged. The courts match the highest sale price with the lowest purchase price within any six-month period, regardless of the actual order of transactions or the insider’s overall trading gains or losses.
Recovery by the Corporation: Any profit realized is recoverable by the corporation. Shareholders can bring a derivative suit on behalf of the corporation to enforce Section 16(b) if the corporation fails to do so.
Exemptions: The SEC has adopted some exemptions from Section 16(b) for certain transactions that do not pose a risk of speculative abuse of inside information (e.g., certain transactions under employee benefit plans).
Policy: Section 16(b) is a blunt instrument designed to deter insider trading by creating a bright-line rule that is easy to administer. It avoids the difficulty of proving actual use of inside information.
Examples:
- A director buys 1,000 shares of the company’s stock at $10 per share in January and sells 1,000 shares at $15 per share in April. The $5,000 profit is recoverable under Section 16(b), even if the director had no inside information.
- An officer sells 1,000 shares at $20 in February and buys 1,000 shares at $15 in May. The $5,000 “profit” is recoverable, even though the officer sold before buying.
- A 10% shareholder buys shares. Three months later the corporation registers a class of securities, subjecting them to section 16. Then two months after that the shareholder sells their shares. This sale would not be subject to Section 16 because they were not a statutory insider at the time of both purchase and sale.