Corporations

Question 1

Promoters

Answer 1

• Liability: Promoters are PERSONALLY LIABLE for KNOWINGLY ACTING on behalf of a corporation ahead of incorporation (liability for acts before incorporation remains after incorporation).

– EXCEPTION: If the corporation, promoter, and 3P create a NOVATION to put CORP in place of the promoter.

• Duties: Owes duties of care and loyalty to the corporation. May be liable to corporation for violation (e.g., making a secret profit)

Question 2

Corporation Liability During Promotion Stage

Answer 2

• GENERAL RULE: A corporation is NOT liable for pre-incorporation transactions entered into by a promoter. No P-A relationship because the corporation isn’t a formed legal entity yet.
• • EXCEPTION: Can be liable when the corporation adopts the K. Adoption: When corporation accepts the benefits of the transaction or gives express acceptance of liability for the debt.

Question 3

Incorporator Liability

Answer 3

• RULE: An incorporator is NOT liable for Ks entered into by promoters.
• They sign, file, and pay a fee.

Question 4

Articles of Incorporation Requirements

Answer 4

• Must be filed w/ secretary of state w/ fees paid
• Must have NAME, AUTHORIZED NO. OF SHARES, name and address of REGISTERED AGENT, and name and address of each INCORPORATOR.
• Corporate name must have “corporation,” “company,” “incorporated,” “limited,” or abbreviation thereof
  Must have CORPORATE PURPOSE STATED (usually “to engage in any lawful activity”) (RMBCA presumes broadest lawful purpose unless narrower is stated)
• Must state CORPORATE DURATION

Question 5

Effective Date of Incorporation

Answer 5

Once the requirements are met, some states treat the corporation as having been formed as of the date of the filing, while other states consider the corporation a legal entity only when the state has accepted the articles of incorporation.

Question 6

Ultra Vires Actions

Answer 6

When a corporation that has stated a narrow business purpose in its articles of incorporation subsequently engages in activities outside that stated purpose, the corporation has engaged in an ultra vires act. When a third party enters into a transaction with the corporation that constitutes an ultra vires act for the corporation, the third party generally CANNOT assert that the corporation has acted outside those powers in order to escape liability.
- CHALLENGES: Brought by SHs or STATE. Can (1) sue to enjoin action, (2) take action against director, officer, employee who engages in such action, or (3) STATE can initiate a proceeding against the corporation.

Only enjoined if equitable to do so.

Question 7

De Facto Corporation

Answer 7

Applies when incorporation is unsuccessful. Must (1) make a GOOD FAITH effort to comply and (2) have no ACTUAL KNOWLEDGE of failure to incorporate.

• IF APPLIES, treated as a corporation and still has LL.

Question 8

Corporation by estoppel

Answer 8

A person who deals with an entity as if it were a corporation is estopped from denying its existence and is thereby prevented from seeking the personal liability of the business owner. This doctrine is limited to contractual agreements. In addition, the business owner must have made a good-faith effort to comply with incorporation requirements and must lack knowledge that the requirements were not met.

Question 9

Issuance of stock

Answer 9

• AUTHORIZATION: By Board of Directors (some states allow SHs to authorize if the AoI provide for it)
• CONSIDERATION: Acceptable consideration includes money, tangible or intangible property, and services rendered to the corporation. A shareholder who fails to pay the consideration is liable to the corporation, and any issued stock may be canceled. If stock has not been fully paid, then the corporation or a creditor of the corporation may be able to recover the unpaid amount from the shareholder. Under the RMBCA, the board of directors must merely determine that the consideration received for the stock is adequate. Moreover, once the board makes such a determination, the adequacy of the consideration is not subject to challenge.

Question 10

Par Value Stock

Answer 10

A corporation may, but is not required to, issue par value stock. For such stock, the corporation is required to receive at least the value assigned to that stock (i.e., par value), which need not be its market value and which can even be a nominal amount.

Question 11

Watered Stock

Answer 11

When corporation sets par value amount and then sells the stock for less than the stated amount; SHs who bought for less than PV are liable to the creditors of the corporation.

Because stock is deemed validly issued, paid in full, and non-assessable once the corporation receives adequate consideration (as determined by the board of directors), the RMBCA does not recognize or address the issue of “watered stock.”

Question 12

Revocability of pre-incorporation subscription

Answer 12

Unless the subscription agreement provides otherwise, a pre-incorporation subscription is irrevocable for six months from the date of the subscription, but a revocation can happen if all subscribers agree to it.

Question 13

Nonpayment by a subscriber

Answer 13

A corporation can pursue normal collection methods when a subscriber fails to pay the subscription amount. In addition, the corporation can sell the stock to someone else, provided the corporation has made a written demand for payment and given the subscriber at least 20 days to comply with the demand.

Question 14

Stock rights and options

Answer 14

In addition to stock, a corporation may issue rights, options, or warrants to buy its stock. Generally, the board of directors has the authority to issue these instruments and to dictate their terms.

Question 15

Preemptive Rights

Answer 15

When the board of directors decides to issue new shares, the rights of shareholders to purchase those shares in order to maintain their proportional ownership share in the corporation are known as “preemptive rights.”

RULE: Shareholders automatically had such rights at common law, but the RMBCA explicitly precludes preemptive rights unless the articles of incorporation provide otherwise.

WAIVER: If the corporation elects to have preemptive rights, then a shareholder may waive that right. A waiver evidenced by a writing is irrevocable, regardless of whether it is supported by consideration.

EXCEPTION: Do not apply to shares that are

i) Issued as compensation to directors, officers, agents, or employees of the corporation;
ii) Authorized in the articles of incorporation and issued within six months from the effective date of incorporation; or
iii) Sold for payment other than money (e.g., property).

Question 16

SEC Registration Rules

Answer 16

a. Public offerings

In general, registration is required only for public offerings of stocks or other securities that are considered public offerings. Offerings that are considered private, called “private placements,” are exempt from the registration requirements. Private placements include stock sold by a corporation to institutional investors, sophisticated investors, and companies with annual sales of less than $1 million.

b. Civil liabilities

The purchaser of a security from a corporation that has not complied with the registration requirements may sue the corporation to rescind the transaction. In addition, the purchaser can sue for compensatory damages caused by a material misrepresentation or omission in the registration statement. The purchaser need not have relied on the error or omission, but she cannot have purchased with knowledge of the error or omission. Any of the following individuals may be liable:

i) The issuer;
ii) Any other signer of the registration statement (generally senior executives of the issuer);
iii) A director of the issuer at the time the statement is filed;
iv) An expert whose opinion is used in the registration statement; or
v) The underwriter of the issue.

The issuer is strictly liable, but the other defendants may defend on the basis of the reasonableness of their actions. This is referred to as a “due diligence” defense.

Question 17

Distribution

Answer 17

POWER: The power to authorize a distribution rests with the board of directors. Having authorized a distribution and set sufficient parameters, the board may delegate to a board committee or corporate officer the power to fix the amount and other terms of the distribution.

COMPULSION BY SHs: In general, a shareholder cannot compel the board of directors to authorize a distribution, because that decision is usually discretionary. When a board acts in bad faith and abuses its discretion by refusing to declare a distribution, however, a court may order the board to authorize a distribution.

LIMITATIONS: A corporation may not make a distribution if it is insolvent or if the distribution would cause the corporation to be insolvent. A corporation must pass two tests to be deemed solvent and, as such, capable of making a distribution: an equity test and a balance-sheet test.

1) Equity test

Under the equity test, a corporation must be able to pay off its debts as they come due in the usual course of business.

2) Balance-sheet test

Under the balance-sheet test, a corporation’s total assets must exceed its total liabilities plus liquidation preferences of senior securities.

In the case of a dividend, a corporation’s solvency is measured on the date the dividend is declared; in the case of a stock purchase, it is measured on the date the purchase price is paid.

Question 18

Liability for unlawful distributions

Answer 18

A director who votes for or assents to an unlawful distribution, in violation of the director’s duties of care and loyalty, is personally liable to the corporation for the amount of the distribution in excess of the lawful amount.

a. Contribution from directors

A director is entitled to contribution from any other director who also is liable for the unlawful distribution. RMBCA §8.33(b)(1).

b. Recoupment from shareholders

If a shareholder knowingly accepts an unlawful distribution, then a director is entitled to recoupment from that shareholder’s pro rata portion of the unlawful distribution.

Question 19

Dividend Distributions

Answer 19

Dividends are distributed to persons who are shareholders on the record date set by the board of directors. If the board does not set a date, then the dividend is payable to persons who are shareholders on the date that the board authorized the dividend.

ENFORCEMENT: A shareholder can sue to enforce her individual right; this is not the same as a derivative lawsuit that the shareholders bring on behalf of the corporation. To prevail in a suit to compel a dividend distribution, a shareholder must prove the existence of (i) funds legally available for the payment of a dividend and (ii) bad faith on the part of the directors in their refusal to pay.

Question 20

Reacquisition of Stocks

Answer 20

Stock authorized and issued by the corporation is known as “outstanding stock.” Such stock may be reacquired by the corporation through purchase or redemption (i.e., stock acquired by a forced sale). Upon repurchase or redemption, that stock constitutes authorized but unissued shares. If the articles of incorporation prohibit the reissuance of stock, then the number of authorized shares is automatically reduced by the number of shares purchased.

Question 21

Debt Distribution

Answer 21

Distribution of a corporation’s indebtedness, such as bonds or promissory notes, is subject to the same requirements as other distributions. When indebtedness is to be repaid over time (i.e., on an installment basis), the lawfulness of the distribution is tested as of the date of distribution.

Question 22

General rule for the sale of securities

Answer 22

Generally, a shareholder is free to sell his stock to anyone at any time or price. Such freedom is subject to two significant restrictions: limitations imposed on shareholders of closely held corporations and penalties imposed on transactions that violate federal securities law.

Question 23

Restrictions on sale of stocks by close corporations

Answer 23

CONSPICUOUSLY NOTED: If the corporation issuing the shares imposes a restriction on transferability, the stock certificate must contain either a full and conspicuous statement of the restriction or a statement that the corporation will provide a shareholder with information about the restriction upon request and without charge.

LIMITS ON RESTRICTION: A restriction on the transfer of a security, even if otherwise lawful, may be ineffective against a person who has no knowledge of the restriction. Unless the security is certified and the restriction is conspicuously noted on the security certificate, that restriction is not enforceable against a person who has no knowledge of it.

Question 24

Forms of restrictions on sale of stocks

Answer 24

i) An outright prohibition on transfers;
ii) Transfers requiring consent from the corporation or its shareholders;
iii) Options to buy the stock held by the corporation or its shareholders;
iv) A right of first refusal (i.e., stock must be offered to the corporation or its shareholders before selling it to another person);
v) The corporation requires or has the right to buy back the stock; or
vi) A buy-sell agreement with either the corporation or its shareholders being obligated to buy the stock.

Question 25

Challenges to restrictions on sale of stocks

Answer 25

Stock-transfer restrictions have been subject to challenge as unreasonable restraints on alienation. Of the various forms noted above, the outright prohibition on transfer and the need for prior consent are the most susceptible to attack. However, because the test is one of reasonableness, even these two forms may be justified in particular circumstances, such as when a corporation seeks to preserve its status because it is dependent on the number or identity of its shareholders. RMBCA § 6.27(c).

Because many of these restrictions are created through contractual arrangements, they may be subject to contractual defenses. In addition, the restrictions may be narrowly interpreted and subject to equitable challenges such as abandonment, waiver, or estoppel.

Question 26

Persons bound by restrictions

Answer 26

Parties to an agreement that restricts stock transfers are bound by the terms of the contract. Other parties are not subject to a transfer restriction unless they are aware of it. If the restriction is noted on the face of the stock certificate, then the buyer may be treated as having had constructive notice of the restriction.

A transfer restriction imposed through an amendment of the articles of incorporation or corporate bylaws raises the question of whether persons who were shareholders before the restriction was imposed are subject to it. The RMBCA does not subject such shareholders to a restriction unless the shareholders voted in favor of the restriction or were parties to the restriction agreement.

Question 27

Rule 10b-5 action

Answer 27

The fraudulent purchase or sale of any stock or other security (e.g., bonds, stock options, and warrants) can give rise to a Rule 10b-5 action. For a private person to pursue a Rule 10b-5 action, each of the following requirements must be met:

i) The plaintiff purchased or sold a security;
ii) The transaction involved the use of interstate commerce;
iii) The defendant engaged in fraudulent or deceptive conduct;
iv) The conduct related to material information;
v) The defendant acted with scienter, i.e., with intent or recklessness;
vi) The plaintiff justifiably relied on the defendant’s conduct; and
vii) The plaintiff suffered harm because of the defendant’s conduct.

To maintain a Rule 10b-5 action, the plaintiff must have either bought or sold a security. A person who refrains from buying or selling a security because of the defendant’s conduct cannot bring a Rule 10b-5 action for damages. Note: Courts are split as to whether a private action for injunctive relief is possible by someone who did not buy or sell stock. However, the SEC can bring such an action

Question 28

Forms of deceitful/fraudulent conduct (10b-5)

Answer 28

The defendant can engage in such conduct by (i) making an untrue statement of a material fact or (ii) failing to state a material fact that is necessary to prevent statements already made from being misleading.

Question 29

Bespeaks-caution doctrine

Answer 29

Under the bespeaks-caution doctrine, a statement of opinion or prediction accompanied by adequate cautionary language does not constitute a false or misleading statement.

Question 30

Insider Trading

Answer 30

The mere possession of material information that is not public knowledge does not give rise to Rule 10b-5 liability; a person who has such insider knowledge does not incur liability unless he also trades stock or other securities on the basis of such knowledge. This is often referred to as the “disclose or abstain” rule.

Question 31

Affected Traders under 10b-5

Answer 31

Affected traders

There are four types of traders who may be liable for failure to disclose information: (i) insiders, (ii) constructive insiders, (iii)tippees, and (iv) misappropriators.

(a) Insiders

An insider is a director, an officer, or other employee of the corporation who uses nonpublic information for personal gain.

(b) Constructive insiders

A constructive insider is a person who has a relationship with the corporation that gives that person access to corporate information not available to the general public. Such individuals include lawyers, accountants, consultants, and other independent contractors.

(c) Tippees

A tippee is a person who is given information by an insider or a constructive insider (the “tipper”) with the expectation that the information will be used to trade the stock or other securities. The tipper must receive a personal benefit from the disclosure or intend to make a gift to the tippee.

To be liable, the tippee must have known (or should have known) that the information was provided to him in violation of the insider’s duty to the corporation. Dirks v. SEC, 463 U.S. 646 (1983).

(d) Misappropriators

A misappropriator is a person who uses confidential information in order to trade stock or other securities in violation of the duty of confidentiality owed to the corporation. United States v. O’Hagan, 521 U.S. 642 (1997).

Question 32

Materiality for insider trading purposes

Answer 32

A fact is material if a reasonable investor would find the fact important in deciding whether to purchase or sell a security.

Question 33

10b-5 Damages

Answer 33

Generally, a plaintiff is entitled to recoup his “out-of-pocket” loss, which is the difference between the stock’s value at the time of the fraud and the price that the plaintiff paid or received for the stock. In determining the stock’s value at the time of the fraud, the value cannot exceed the mean average market price of the stock during the 90-day period after disclosure of such fraud.

NO PUNITIVE DAMAGES

May also seek rescission if defendant was involved in the transaction

Question 34

16(b) - short-swing profits

Answer 34

1) Applicable corporations

Only the following publicly traded corporations are protected by Section16(b): (i)corporations that have securities traded on a national securities exchange or (ii)corporations that have assets of more than $10million and more than 500shareholders of any class of stock or other equity security.

2) Corporate insiders

Only corporate directors, officers (e.g., president, vice president, secretary, treasurer, or comptroller), and shareholders who hold more than 10 percent of any class of stock are subject to a Section 16(b) action. Generally, transactions made before becoming a corporate insider are not considered in determining short-swing profits. However, transactions made after ceasing to be a corporate insider are considered in determining short-swing profits.

3) Short-swing profits

During any six-month period, a corporate insider who both buys and sells his corporation’s stock is liable to the corporation for any profits made. Profits are computed by matching the highest sale price with the lowest purchase price, then the next highest sale price with the next lowest purchase price, and so on, during the six-month period. Any loss is not taken into account, and all shares are matched with other shares only once.

4) Reporting

A corporate insider is required to report a change in his stock ownership to the SEC to encourage compliance with the short-swing profits rule.

Question 35

Tender Offers

Answer 35

Tender Offer

A tender offer is an offer to shareholders of a publicly traded corporation to purchase their stock for a fixed price, which is usually higher than the market price. It is frequently used to effect a hostile takeover of a corporation (i.e., a takeover that is opposed by the current management of the corporation).

a. For more than five percent

A person who acquires more than five percent of any class of stock must file a statement with the SEC that reveals his ownership interest, the source of his funding, and his purpose in acquiring the stock.

b. Persons subject to disclosure rules

A tender offer made by a person subject to the disclosure rules must also provide specific shareholder rights.

Question 36

Amendment of articles of incorporation

Answer 36

The corporation can amend its articles with any lawful provision. The procedure for securing approval to amend the articles of incorporation varies depending on whether the corporation has issued stock. Once the necessary approval is obtained, articles of amendment must be filed with the state.

1) No stock issued

If the corporation has not issued stock, the board of directors—or, if the board does not exist, the incorporators—may amend the articles of incorporation. RMBCA §10.02.

2) Stock issued

If stock has been issued, then corporations generally must follow a two-step approval process:

i) The board of directors must adopt the amendment to the articles of incorporation; and
ii) The board must submit the amendment to the shareholders for their approval by majority vote.

Question 37

Bylaws rules

Answer 37

CONFLICTS: When there is a conflict between the articles of incorporation and the bylaws, the articles of incorporation control.

ADOPTION, AMENDMENTS, REPEAL: Generally, the board of directors adopts the initial bylaws. RMBCA § 2.06(a). However, a majority vote by either the directors or the shareholders can adopt, amend, or repeal a bylaw, unless (i) the corporation’s articles reserve that power exclusively to the shareholders, or (ii) the shareholders, in amending, repealing, or adopting a bylaw, expressly provide that the board of directors may not amend, repeal, or reinstate that bylaw. RMBCA § 10.20(b).

Generally, shareholders may amend the bylaws to limit the board of directors’ ability to amend, repeal, or reinstate a shareholder-approved bylaw. However, a shareholder-approved bylaw dealing with director nominations may not limit the board’s power to amend, add, or repeal to ensure an orderly process. Thus, if shareholders approve a bylaw amendment that limits further board changes, the board could only amend or add to the bylaw to safeguard the voting process; it could not repeal the shareholder-approved bylaw.

Question 38

Meetings

Answer 38

ANNUAL: A corporation is required to hold a shareholders’ meeting each year. Generally, the time and place of the meeting are specified in the corporate bylaws. The primary purpose of the annual meeting is to elect directors, but any business that is subject to shareholder control may be addressed.

SPECIAL: A corporation may also hold a special meeting, the purpose of which must be specified in the notice of the meeting. Generally, a special meeting may be called by the board of directors or shareholders who own at least 10 percent of the shares entitled to vote at the meeting.

NOTICE: To properly call a meeting, the corporation must notify all shareholders entitled to a vote at the special meeting in a timely manner. A shareholder may waive notice either in writing or by attending the meeting. Usually, notice must be given no less than 10 days and no more than 60 days before the meeting date. The notice must include the time, date, and place of the meeting.

Question 39

Action by unanimous written consent

Answer 39

Instead of voting at a meeting, all shareholders may take any action that could have been undertaken at a meeting by unanimous written consent.

Question 40

Voting Eligibility

Answer 40

• Voting rolls normally determined by voting rolls as of “record day”
• voting is usually apportioned by shares, not shareholders.
• BENEFICIAL OWNER: A person who is not a record owner may nevertheless be entitled to vote. For example, a beneficial owner of the stock may compel the record owner to recognize the beneficial owner’s right to vote. See RMBCA § 7.23. Similarly, a guardian for an incompetent or a personal representative of a decedent’s estate may compel the corporation to allow her to vote in lieu of the record owner. Voting rights issues may also arise when stock is jointly held.

Question 41

Record date

Answer 41

Typically, the record date is fixed by the board of directors, although the date can be set by reference to the articles of incorporation or the corporate bylaws and, failing corporate guidance, by statute. The record date can be no more than 70 days prior to the meeting. Only the owner of the stock at the close of business on the record date has the right to vote the stock at the upcoming meeting.

Question 42

Quorum

Answer 42

Usually, the required quorum is a majority of votes entitled to be cast on a matter. A share that is present for any purpose at a meeting is deemed present for quorum purposes

Question 43

Cumulative Voting

Answer 43

When more than one director is to be elected, corporations can allow shareholders to cumulate their votes and cast all those votes for only one (or more than one) of the candidates. The effect of cumulative voting is to allow minority shareholders to elect representatives to the board.

[multiply shares by number of candidates]

Question 44

Proxy Votes

Answer 44

A shareholder may vote in person or by proxy. A proxy vote must be executed in writing and delivered to the corporation or its agent. A proxy is valid for 11 months unless otherwise specified. A proxy is revocable unless it expressly provides that it is irrevocable and the appointment of the proxy is coupled with an interest. Any act by the shareholder that is inconsistent with a proxy, such as attending a shareholder meeting and voting the shares, revokes the proxy. RMBCA §7.22. In the case of multiple proxies given, the last given revokes all previous proxies.

Whether a proxy is coupled with an interest depends on whether the proxy holder has (i)a property right in the shares or (ii) a security interest given to him to protect him regarding any obligations he incurred or money he advanced. Typically, proxy holders who have a property interest in the shares or a security interest are those who have purchased the shares or otherwise have a business arrangement with the corporation (such as a creditor or an employee of the corporation).

Question 45

Voting pool

Answer 45

Shareholders may enter into a binding voting agreement, also known as a “voting pool,” which provides for the manner in which they will vote their shares. Under such an agreement, shareholders retain ownership of their stock. Such an agreement is a contract that may be specifically enforced.

Question 46

Management agreements

Answer 46

Generally, shareholders may agree to alter the way in which a corporation is managed even though the agreement is inconsistent with statutory provisions. Among the matters on which shareholders may agree are:

i) Elimination of the board of directors or restrictions on the discretion or powers of the board of directors;
ii) Authorization or making of distributions;
iii) Determination of who is a member of the board of directors, the manner of selection or removal of directors, and the terms of office of directors;
iv) The exercise or division of voting power by or between the shareholders and directors or by or among any of them, including director proxies;
v) A transfer to one or more shareholders or other persons all or part of the authority to exercise corporate powers or to manage the business and affairs of the corporation; and
vi) The manner or means by which the exercise of corporate powers or the management of the business and affairs of the corporation is affected.

The agreement must be set forth either (i) in the articles of incorporation or the corporate bylaws and approved by all persons who are shareholders at the time of the agreement or (ii) in a written agreement that is signed by all persons who are shareholders at the time of the agreement and is made known to the corporation. The agreement may be amended only by persons who are shareholders at the time of amendment

Such an agreement cannot be entered into with respect to a corporation that has shares listed on a national securities exchange, and such an agreement ceases to be effective for a corporation when its shares are listed on such an exchange.

If the agreement limits the discretion or powers of the board of directors, then the directors are relieved of liability for acts or omissions to the extent of the limitation, and the persons in whom such discretion or powers are vested are subject to liability.

Question 47

Inspection Rights

Answer 47

Test: PROPER PURPOSE (can inspect and copy). The shareholder has the burden of showing credible evidence of improper conduct, and must show the documents or records are essential to the stated proper purpose.

• Some states restrict access to corporate records to SHs who have owned for long enough/own enough shares.
• Beneficial owner also usually owns shares.

Question 48

Limits on inspection rights

Answer 48

The inspection right is usually restricted to normal business hours at the corporation’s principal place of business. Five days’ advance written notice is required.

Generally, a shareholder can inspect any corporate records, but the inspection may be limited to specified records, such as excerpts from the minutes of a board meeting.

Question 49

Enforcement of Inspection Rights

Answer 49

Some states enforce a shareholder’s inspection right indirectly by imposing fines on the corporate official who improperly refuses a shareholder access to the corporate records. Under the RMBCA, direct enforcement of a shareholder’s inspection right is recognized in an expedited court proceeding, under which the shareholder can secure access to the corporate records and reimbursement for litigation costs.

Question 50

Direct SH action

Answer 50

A shareholder may sue the corporation for breach of a fiduciary duty owed to the shareholder by a director or an officer. Typical actions are based on the denial or interference with a shareholder’s voting rights, the board’s failure to declare a dividend, or the board’s approval or failure to approve a merger.

Question 51

Derivative Actions

Answer 51

STANDING: maintain contemporaneous ownership

In addition to being a shareholder at the time the action is filed and continuing to be a shareholder during the litigation, a plaintiff must also have been a shareholder at the time of the act or omission (or one who receives the shares through a transfer by operation of law from such a shareholder) to bring a derivative action. This is known as the “contemporaneous ownership” rule. In addition, the shareholder must fairly and adequately represent the interests of the corporation.

DEMAND: written demand upon the board of directors in order to take action. A derivative action may not commence until 90days have passed from the date of demand. BUT - The plaintiff may be excused from waiting a reasonable time for the board to respond to the demand if the delay would result in irreparable injury to the corporation.

FUTILITY: Some states. Factors for determining futility include whether the directors are disinterested and independent and whether the transaction was the product of a valid exercise of business judgment.

Question 52

Board rejection of demand

Answer 52

If the board specifically rejects the demand, then the rejection is tested against the business judgment rule. If there is a business justification for the rejection, then the plaintiff must establish that the board’s rejection was due to a lack of care, loyalty, or good faith to persuade the court to override the board’s refusal.

Question 53

Litigation expenses for SH

Answer 53

Although the plaintiff-shareholder is usually not entitled to share in a recovery, she can seek reimbursement from the corporation for reasonable litigation expenses, including attorney’s fees, if the lawsuit has resulted in a substantial benefit to the corporation. If the court finds that the proceeding was commenced or maintained without a reasonable cause or for an improper purpose, then it may order the plaintiff-shareholder to pay the defendant’s litigation expenses.

Question 54

Dismissal of derivative action

Answer 54

The board can seek dismissal of the shareholder’s derivative action if a majority of the board’s qualified directors (i.e., directors without a material interest in the action) determine in good faith, after conducting a reasonable inquiry upon which its conclusions are based, that maintaining the action is not in corporation’s best interests.

Question 55

Piercing the corporate veil

Answer 55

In most jurisdictions, no bright-line rule exists for piercing the corporate veil, and courts look at the “totality of circumstances.” Courts generally look to whether the corporation is being used as a “façade” for a dominant shareholder’s personal dealings (i.e., whether the corporation is an “alter ego” of the shareholder). Additionally, courts look to whether there is “unity of interest and ownership” between the entity and the members to ensure that the corporation in fact did not have an existence independent of the members.

In general, a plaintiff must prove that the incorporation was merely a formality and that the corporation neglected corporate formalities and protocols, such as voting to approve major corporate actions in the context of a duly authorized corporate meeting. This is often the case when a corporation facing legal liability transfers its assets to another corporation with the same management and shareholders. It also happens most often with single-person or small, closely held corporations that are managed in a haphazard manner.

Question 56

PV factors

Answer 56

Factors considered by the courts when piercing the corporate veil include:

i) Undercapitalization of the corporation at the time of its formation;
ii) Disregard of corporate formalities;
iii) Use of corporate assets as a shareholder’s own assets;
iv) Self-dealing with the corporation;
v) Siphoning of corporate funds or stripping of corporate assets;
vi) Use of the corporate form to avoid existing statutory requirements or other legal obligations;
vii) A shareholder’s impermissible control or domination over the corporation; and
viii) Wrongful, misleading, or fraudulent dealings with a corporate creditor.

Question 57

Controlling Shareholder

Answer 57

Anyone controlling 50percent of a corporation’s shares, plus one, is automatically a controlling shareholder.

A much smaller interest can be controlling if the remaining shares are widely dispersed (as in a large, publicly traded corporation) and not actively voted. Additionally, a corporation that requires a two-thirds supermajority of shares to vote in favor of a motion can effectively grant control to a minority shareholder or block of shareholders that owns just more than one-third of the shares of the corporation.

Question 58

Resignation or removal of director

Answer 58

Director may resign at any time by delivering a written notice to the board, its chair, or the corporation.

The current trend in most states and the RMBCA is to allow shareholders to remove a director with or without cause, unless the articles of incorporation provide otherwise.

MEETING REQs: A director may be removed only at a meeting called for the purpose of removing the director, and meeting notice MUST SAY that removal is at least one of the purposes of the movement.

NOTE: A director who is elected by a particular voting class can be removed only by the same class.

NUMBER REQs: If cumulative voting is not authorized, then a shareholder vote removes a director if the number of votes for removal exceeds the number of votes against removal. RMBCA § 8.08(c).

If cumulative voting is authorized, then a director may not be removed if the votes sufficient to elect the director are cast against the director’s removal. RMBCA §8.08.

Question 59

Replacement of director

Answer 59

When there is a vacancy on the board or an increase in the number of directors, either the shareholders or the directors may fill the vacancy. When the vacancy leaves the board without a quorum, the directors remaining can elect a replacement director by a majority vote.

Question 60

Director’s presence at meetings

Answer 60

Not required to be physically present. Meeting may be conducted by conference call or any other method that allows all directors to communicate.

MAY ACT W/O MEETING BY UNANIMOUS WRITTEN CONSENT.

But MUST BE PRESENT for a vote for quorum purposes (inc. by online)

Question 61

Pooling agreement

Answer 61

Generally, an agreement between directors as to how to vote (i.e., a pooling agreement) is unenforceable. Each director is expected to exercise independent judgment. A director also may not vote by proxy.

Question 62

Committee powers

Answer 62

May generally exercise whatever powers given to it by the board.

BUT - my not i) Declare distributions, except within limits set by the board;

ii) Recommend actions that require shareholder approval;
iii) Fill vacancies on the board or its committees; or
iv) Adopt, amend, or repeal bylaws.

Question 63

Duty of care standard

Answer 63

Directors have a duty to act with the care that a person in a like position would reasonably believe appropriate under similar circumstances. As an objective standard, the director is presumed to have the knowledge and skills of an ordinarily prudent person. In deciding how to act, the director is also required to use any additional knowledge or special skills that he possesses.

Question 64

Reliance protection of directors

Answer 64

A director is entitled to rely on the performance of—as well as on information, reports, and opinions supplied by—the following persons if the director reasonably believes them to be reliable and competent:

i) Officers and other employees of the corporation;
ii) Outside attorneys, accountants, or other skilled or expert individuals retained by the corporation; and
iii) A committee of the board of which the director is not a member.

Question 65

BJR

Answer 65

rebuttable presumption that a director reasonably believed that his actions were in the best interests of the corporation. The exercise of managerial powers by a director is generally subject to the business judgment rule. A typical decision protected by the business judgment rule includes whether to declare a dividend and the amount of any dividend.

Question 66

Overcoming

Answer 66

i) The director did not act in good faith (e.g., consciously allowing conduct that violates the law or legal norms; intense hostility of the controlling faction against the minority; exclusion of the minority from employment by the corporation; high salaries or bonuses given, or corporate loans made to, the officers in control; and the existence of a desire by the controlling directors to acquire the minority stock interests as cheaply as possible);
ii) The director was not informed to the extent that the director reasonably believed was necessary before making a decision;
iii) The director did not show objectivity or independence from the director’s relation to or control by another having material interest in the challenged conduct;
iv) There was a sustained failure by the director to devote attention to an ongoing oversight of the business and affairs of the corporation;
v) The director failed to timely investigate a matter of significant material concern after being alerted in a manner that would have caused a reasonably attentive director to do so; or
vi) The director received a financial benefit to which he was not entitled, or any other breach of his duties to the corporation.

Question 67

Overcoming the presumption of good faith

Answer 67

Overcome when challenger shows fraud, dereliction of duty, condoning illegal conduct, or a conflict of interest.

Question 68

Dereliction of duty

Answer 68

Must show CONSISTENT or SYSTEMIC FAILURE.

OVERSIGHT LIABILITY: i) directors failed to implement any reporting or information system or controls, or
ii) notwithstanding these controls, directors failed to monitor or oversee operations.

Must show director knew they were not discharging their fiduciary obligations.

Question 69

Conflict of interest transactions

Answer 69

• any transaction between director and corporation that would normally require boar approval and is of SUCH FINANCIAL SIGNIFICANCE that it would reasonably be expected to influence the director’s vote on the transaction. Interest must be FINANCIAL and MATERIAL

NOTE: applies to corporate dealings wih persons related to a director. Also applies to entities the director is also affiliated with.

Question 70

Safe Harbors for Interested Transactions

Answer 70

i) Disclosure of all material facts to, and approval by a majority of, the board of directors without a conflicting interest;
ii) Disclosure of all material facts to, and approval by a majority of, the votes entitled to be cast by the shareholders without a conflicting interest; and
iii) Fairness of the transaction to the corporation at the time of commencement.

FAIRNESS = substance (did corporation receive something of comparable value?) and procedure (was process appropriate)

NOTE AS DEFENSE - not necessarily compete defense, and some corporations instead hold that the burden then shifts to the challenging party to show unfairness.

Question 71

BJR, interested transactions

Answer 71

Approval of a conflict-of-interest transaction by fully informed disinterested directors triggers the business judgment rule and limits judicial review to issues of gift or waste, with the burden of proof on the party attacking the transaction.

Question 72

Corporate Opportunities

Answer 72

• directors cannot usurp a corporate opportunity.

TWO TESTS:
1.) Interest or expectancy - did the corp. have an existing interest or expectancy arising from an existing right in the opportunity?

2.) “Line of business” - was the opportunity w/in the current or prospective lines of business of the corp.?

OTHER FACTORS: (i) the relationship between the person offering the opportunity and the director and corporation, (ii) how and when the director acquired knowledge of the opportunity, and (iii) the relationship of the director to the corporation.

Question 73

Mandatory Indemnification

Answer 73

MUST indemnify a director for any reasonable expense incurred in SUCCESSFUL defense of proceeding against director in role as director. OR when ordered by the court.

Question 74

Prohibited Indemnification

Answer 74

Cannot indemnify against liability arising from receipt of improper personal benefit.

Question 75

Permissive indemnification

Answer 75

i) The director acted in good faith with the reasonable belief that his conduct was in the best interests of the corporation, or that his conduct was at least not opposed to the best interests of the corporation; AND
ii) In the case of a criminal proceeding, the director did not have reasonable cause to believe that his conduct was unlawful.

Indemnification can extend to liability as well as expenses when the action is brought by a third party, but only to expenses if the action is brought by or on behalf of the corporation.

Question 76

Advance of expenses

Answer 76

A corporation may, upon a petition by the director, advance litigation expenses to the director. Upon termination of the action, the director must repay such expenses if he is not entitled to indemnification for them.

Question 77

Liability insurance

Answer 77

A corporation may acquire insurance to indemnify directors for actions arising from service as a director. The insurance can cover all awards against a director as well as expenses incurred by him, even though the corporation could not otherwise indemnify the director for such amounts.

Question 78

Selection of officers

Answer 78

The primary officers of a corporation are elected by the board of directors. These officers may in turn be empowered by the board of directors or the bylaws to select other corporate officers and employees.

Question 79

Officer Authority

Answer 79

Actual authority wielded by an officer is defined by the corporate bylaws or set by the board of directors. An officer has implied authority to perform those tasks that are necessary to carry out the officer’s duties by virtue of her status or position, so long as the matter is within the scope of ordinary business.

However, the officer does not have the authority to bind the corporation by extraordinary acts. In determining whether a transaction is extraordinary, the court might consider the economic magnitude of the action in relation to corporate earnings and assets, the extent of the risk involved, the time span of the action’s effect, and the cost of reversing the action.

Finally, an officer has apparent authority if the corporation holds the officer out as having authority to bind the corporation to third parties.

Question 80

Officers and financial reports

Answer 80

The chief executive officer (CEO) and chief financial officer (CFO) of a publicly traded corporation must certify the accuracy of the corporation’s financial reports that are filed with the SEC. Sarbanes-Oxley Act 302. In addition to facing criminal penalties for filing a false report, when financial reports must be restated because of such misconduct, a CEO and CFO must forfeit incentive-based pay and must return profits from stock sales for one year.

Question 81

Liability of officers

Answer 81

As an agent of the corporation, an officer does not incur liability to third parties merely for the performance of duties for the corporation. Of course, an officer can be liable to a third party if the officer has acted in his personal capacity (e.g., guaranteed a corporate loan) or has engaged in purposeful tortious behavior.

Question 82

Indemnification and insurance - officers

Answer 82

An officer is entitled to indemnification to the same extent and subject to the same restrictions as a corporate director. Similar insurance rules apply as well.

Question 83

Removal of officers

Answer 83

An officer may be removed at any time, with or without cause. RMBCA §8.43. The existence of an employment contract between an officer and the corporation does not prevent the removal of the officer, but it may give rise to contractual remedies such as damages if removal constitutes a breach of contract.

Question 84

Merger

Answer 84

To merge:

i) The board of directors for each corporation must approve of the merger;
ii) The shareholders of each corporation must usually approve of the merger; and
iii) The required documents (e.g., plan of merger, amended articles of incorporation) must be filed with the state.

shareholder approval requires a majority vote, meaning a majority of the votes cast, but the shareholders’ meeting at which the vote is taken is subject to a quorum requirement, which is usually a majority of shares entitled to vote.

If the corporation has more than one class of stock, and the amendment would affect the rights of a particular class of stock, then the holders of that class of stock must also approve of the amendment.

Question 85

Parent-subsidiary merger

Answer 85

A merger between a parent corporation and a subsidiary corporation when the parent owns at least 90% of the voting power of each class of outstanding stock of the subsidiary may occur without the approval of the shareholders of the subsidiary. A parent corporation may also effect a merger between two 90% or more owned subsidiary corporations without the need for approval by the shareholders of either corporation. In all these mergers, approval by a subsidiary’s board of directors is also not required.

Question 86

Minnow-whale merger

Answer 86

A merger of a small corporation (i.e., a “minnow”) into a large corporation (i.e., a “whale”) may not require approval of the shareholders of the surviving large corporation. Approval is not required if the merger cannot result in an increase of more than 20% in the voting power of the outstanding stock of the surviving corporation, if the articles of incorporation of the surviving corporation will not differ from the articles before the merger, and if the premerger shareholders of the surviving corporation are otherwise unaffected by the merger.

Question 87

Asset Acquisition

Answer 87

asset transfers that resemble a merger may require approval by both the board of directors and the shareholders of the transferor corporation.

1. Applicable Transfers

A transfer involving all, or substantially all, of the corporation’s assets outside the usual and regular course of business is a fundamental corporate change for the transferor corporation. Thus, the corporation must follow the fundamental change procedures.

2. Approval Procedure

The approval procedure for an asset transfer follows the approval procedure for a merger, except that only the transferor corporation’s board of directors and shareholders are entitled to vote on the transaction. RMBCA §12.02.

Question 88

Stock-for-Stock Exchange and Stock Purchase

Answer 88

A corporation may offer its own stock to shareholders in another corporation in exchange for their stock in that corporation (i.e., a stock swap). Generally, a shareholder in the other corporation may retain his stock and not participate in the stock swap. However, the RMBCA sets out a procedure, labeled a “share exchange,” which parallels the procedure for a merger. If followed, this procedure requires all shareholders to participate in the stock swap. As with a merger, with such an exchange, dissenting shareholders are given the right of appraisal.

A corporation may purchase stock in another corporation on the open market or make an offer to buy the stock from the current shareholders (i.e., a tender offer).

Question 89

Right of Appraisal

Answer 89

A shareholder who is entitled to vote on a merger, an acquisition, or an amendment of the corporation’s articles of incorporation has appraisal rights. In addition, a minority shareholder in a short-form merger can exercise appraisal rights, even though such a shareholder cannot vote on the merger. RMBCA §13.02(a).

If a shareholder can sell his stock in a market that is both liquid and reliable, such as the New York Stock Exchange or the American Stock Exchange, the shareholder does not have a right of appraisal, because the market is providing him with the opportunity to sell his stock at its fair value.

PROCEDURE: Must send written notice of intent to exercise (BEFORE the vote).

Then, abstain or vote no.

Then, make WRITTEN DEMAND for payment.

The corporation must pay shareholders what it estimates as fair market value. If the corporation and the shareholder do not agree on a price for the shareholder’s stock, then the fair value of the stock is determined through a court action.

A shareholder who has an appraisal right cannot challenge the corporate action except on the grounds of fraud or illegality.

Question 90

Dissolution

Answer 90

Prior to the issuance of stock, a corporation may voluntarily dissolve by a majority vote of the incorporators or initial directors

A corporation that has issued stock may voluntarily dissolve if (i) the board of directors adopts a proposal for the dissolution of the corporation and (ii) the majority of shareholders approve.

Question 91

Winding up

Answer 91

A dissolved corporation may continue to exist as a corporation for the limited purpose of winding up its affairs and liquidating its business. This includes (i)collecting assets, (ii) disposing of property that will not be distributed to shareholders, (iii) discharging liabilities, and (iv) distributing property among shareholders according to their interests.

It does not include (i) transferring title to the corporation’s property, (ii) preventing transfer of shares or securities, (iii) changing quorum or voting requirements, (iv)terminating the authority of the registered corporate agent, or (v) preventing commencement of a proceeding by or against the corporation.

Question 92

Distribution following dissolution

Answer 92

The directors of a corporation are responsible for distribution of the corporate assets and may be liable for improper distributions. Such assets must be distributed in the following order:

i) To creditors of the corporation to pay the debts and other obligations of the corporation, including bona fide obligations owed to shareholders;
ii) To shareholders of stock with preferences in liquidation; and
iii) To shareholders of other stock.

Question 93

Involuntary Dissolution

Answer 93

Modern corporate statutes allow minority shareholders to ask the court to dissolve the corporation. A court may order involuntary dissolution if the shareholder shows one of the statutory grounds.

1. Petitioner

Either a shareholder or a creditor of a corporation may bring an action for involuntary dissolution of a corporation.

a. Creditor

A creditor may pursue the involuntary dissolution of a corporation only if the corporation is insolvent. RMBCA § 14.30(c).

b. Shareholder

A shareholder may pursue the involuntary dissolution of a corporation if:

i) The corporate assets are being misapplied or wasted;
ii) The directors or those in control of the corporation are acting illegally, oppressively, or fraudulently;
iii) The directors are deadlocked in the management of the corporation’s affairs, the shareholders are unable to break the deadlock, and irreparable injury to the corporation is threatened or being suffered; or
iv) The shareholders are deadlocked in voting power and have failed to elect successors to the directors whose terms have expired.

RMBCA § 14.30(b). In a minority of states, deadlock is the exclusive ground for involuntary dissolutions. In some states, other grounds are available only to close corporations.

Question 94

Oppression doctrine

Answer 94

The doctrine of shareholder oppression protects the minority from the improper exercise of majority control. Recent cases have made involuntary dissolution easier by interpreting statutory provisions regarding involuntary dissolution to refer to protecting the reasonable expectations of the shareholders in the corporation. Matter of Kemp & Beatley, Inc., 473 N.E.2d 1173 (N.Y. 1984).

Other courts have indicated that dissolution should be considered in light of the feasibility of protecting the expectations the parties originally had with regard to agreements about various forms of compensation. Meiselman v. Meiselman, 307 S.E.2d 551 (N.C. 1983).

Upon the petitioner’s establishment of the necessary grounds, the court may dissolve the corporation. RMBCA § 14.30(a). The court has equitable powers to issue injunctions, appoint a receiver, and take other steps necessary to preserve the corporation’s assets. RMBCA § 14.31. If the court orders the dissolution of the corporation, then the distribution of the corporation’s assets generally adheres to that of a voluntary distribution unless equity requires otherwise.

Question 95

Closely Held corporations

Answer 95

The terms “closely held corporation” and “close corporation” are frequently used interchangeably to refer to a corporation with only a few shareholders and a more relaxed style of governance. Shareholders often serve as both directors and officers of the corporation. Stock of such a corporation is not publicly traded, and many states allow shareholders to do away with many of the corporate formalities.

Question 96

Foreign corporations

Answer 96

A foreign corporation is a corporation that is incorporated in another state. To do business in a state other than its state of incorporation, a corporation is required to register with that state and receive a “certificate of authority.” Failure to do so prevents the foreign corporation from suing, but not from being sued, in state courts until registered. However, it does not impair the validity of corporate acts or contracts or prevent the corporation from defending any proceeding within the state. Many actions, such as holding board meetings, maintaining bank accounts, and selling through independent contractors, do not constitute doing business within a state.

Question 97

Professional corporations

Answer 97

A professional corporation is a corporation with a purpose that is statutorily limited to the rendering of a professional service. A shareholder in a professional corporation must be a member of the applicable profession. In addition, a professional corporation does not shield an employee from liability arising from her own malpractice. However, it may provide protection against vicarious liability arising from malpractice by other professionals in the corporation.

Question 98

S Corps

Answer 98

A corporation is usually subject to tax as a “C corporation,” which is a separate taxable entity from its shareholders, causing the corporation to face double taxation. The corporation pays taxes first on profits and again as shareholders on distributions received from the corporation. However, a corporation may elect to avoid double taxation as an “S corporation,” in which the income and expenses of the corporation are passed through to shareholders (who are then taxed on such items directly). 26 U.S.C. § 1361, et seq.

To become an S corporation for federal tax purposes, a corporation must file Internal Revenue Service (IRS) Form2553, and the IRS must approve the application. Companies that file as Scorporations can have no more than 100 shareholders. Only individuals, estates, certain exempt organizations, or certain trusts may be shareholders, and the shareholders must all be either U.S. citizens or resident aliens (nonresident aliens are not permitted). The Scorporation may not have more than one class of stock. Each shareholder must consent to the S corporation election for a corporation to become an S corporation.

Question 99

LLCs

Answer 99

1. Articles of Organization

An LLC is created by filing articles (certificate) of organization with the state, which merely reflects the existence of an LLC. Note that this document is different from articles of incorporation, a document that has a substantially greater power to affect the rules for the corporate entity and its owners. The articles of organization must include the LLC’s name, mailing address, and, if there are no members upon filing, a statement to that effect.

2. Operating Agreement

An LLC may adopt an operating agreement that governs any or all aspects of its business. The operating agreement generally takes precedence over contrary statutory provisions, and statutory default provisions apply when the operating agreement is silent on an issue. An operating agreement is considered a contract that is governed by contract principles of law.

a. Form of agreement

The agreement can be oral, in a record, or implied by conduct, or any combination thereof, which is why the ULLCA refers to the agreement as a “record” rather than a writing.

b. Modification

Unless the operating agreement provides otherwise, the assent of all the persons then members is required for something to be considered part of the operating agreement. An agreement among fewer members might be enforceable among those members, but it would not be part of the operating agreement.

3. Membership

Many LLC statutes require that there be at least two members; however, one-member LLCs are possible. However, a person cannot become a member of an LLC without the consent of all other members of an LLC.

a. Transferability of membership

Unless the members otherwise agree, most LLC statutes provide that a member cannot transfer her LLC interest unless all members consent. The transfer of a membership interest to another person does not automatically give that person the right to participate in the management of the LLC. Instead, the transferee merely acquires the transferor’s right to share in the LLC’s profits and losses. ULLCA § 503. Some LLC statutes permit the articles of organization to provide standing consent for new members.

1) Charging order

Many statutes also permit transfer of financial rights to creditors, who can obtain a charging order against the member’s interest. ULLCA § 503. A charging order constitutes a lien on a judgment debtor’s transferable interest and requires the LLC to pay to the judgment debtor any distribution that otherwise would be paid to the member. A charging order is the sole method by which a judgment creditor of a member or transferee can extract any value from a member’s ownership interest in an LLC. ULLCA §503(h). The operating agreement generally has no power to alter the provisions of this section to the prejudice of third parties.

b. Termination of membership

Withdrawal of a member from an LLC does not automatically trigger dissolution of the LLC. The LLC may elect to liquidate the fair value of that person’s interests, as of the date the person ceased to be a member, based upon the person’s right to share in distributions from the LLC. The continuing members of the LLC following the withdrawal of a member will be deemed to have entered into an operating agreement in effect immediately prior to the withdrawal, and the members bound by the operating agreement shall be only those members who have not withdrawn.

c. Allocation of profits and losses

Typically, the operating agreement of the LLC determines the manner in which profits and losses will be allocated among the members of the LLC. In the absence of such an agreement, profits and losses are allocated and distributions are made according to each member’s contributions to the LLC.

d. Inspection rights

Most LLC statutes provide LLC members with inspection rights similar to shareholders (i.e., for a proper purpose and upon reasonable request). Whether a request is reasonable depends on the scope, reasons, importance of the information to the member, etc.

Question 100

Management of LLCs

Answer 100

An LLC can be member-managed (direct management of the LLC by its members) or manager-managed (centralized management of the LLC by one or more managers who need not be members). Unless the operating agreement or certificate of incorporation provide otherwise, the default management arrangement is a member-management. Nonetheless, a manager-managed LLC that does not designate a manager is still manager-managed with the manager position vacant

Question 101

Liabilities of members in an LLC

Answer 101

A member of an LLC is generally not liable as a member for an LLC’s obligations. If a member renders professional services in an LLC, the member, as well as the LLC, may be liable for torts committed while rendering such services.

A manager or a managing member of an LLC is not personally liable for obligations incurred on behalf of the LLC. Members of a manager-managed LLC do not have the right to maintain a direct action against the manager of the LLC when the alleged misconduct caused harm only to the LLC.

PV: Most states allow PV - must exist some circumstances that would justify it - commingling, undercapitalization, confusion of business affairs, deception of creditors. Failure to follow formalities is less relevant

Question 102

Theories of piercing the veil, LLCs

Answer 102

1) Mere instrumentality

Under the “mere instrumentality” test, a member would have to show that (i) the members dominated the entity in such a way that the LLC had no will of its own, (ii)the members used that domination to commit a fraud or wrong, and (iii) the control and wrongful action proximately caused the injury.

2) Unity of interest and ownership

Under the “unity of interest and ownership” test, a petitioner must demonstrate that there was such a unity of interest and ownership between the entity and the members that, in fact, the LLC did not have an existence independent of the members and that failure to pierce the veil through to the members would be unjust or inequitable.

Question 103

Duties, LLC

Answer 103

a. Duty of loyalty

The duty of loyalty of a member in a member-managed LLC includes the duties to account to the company for any benefit derived by the member related to the company’s activities or property, to refrain from dealing with the company on behalf of one having an adverse interest in the company, and to refrain from competing with the company. See ULLCA § 409 (b).

b. Duty of care

A member’s duty of care is subject to the business judgment rule; it requires the member to act with the care that a person in a like position would reasonably exercise under similar circumstances and in a manner the member reasonably believes to be in the best interests of the company. See ULLCA § 409 (c).

Though managers (or members in a member-managed LLC) owe a duty of care to the LLC, they are not liable for simple negligence. The duty of care consists of refraining from engaging in grossly negligent conduct or reckless conduct, intentional misconduct, or a knowing violation of law. However, some state statutes reject the “gross negligence” standard and impose an ordinary negligence standard when determining breaches of a duty of care. In these states, the business judgment rule may apply to protect LLC managers from liability when decisions are made in good faith.

Question 104

Fiduciary Waiver

Answer 104

Although courts generally frown upon corporate agreements that attempt to waive the duty of loyalty in self-dealing transactions, because LLCs are seen as more contractual in nature than corporations, fiduciary waivers are recognized in LLCs. Many LLC statutes even allow members to agree to specific types or categories of activities that do not violate the duty of loyalty, as long as the agreement is not manifestly unreasonable.

Question 105

Authority to bind, LLCs

Answer 105

a. Member-managed LLC

Members of a member-managed LLC have broad authority to bind the LLC similar to that of a partner in a general partnership. ULLCA § 301(a). Each member has equal rights with respect to the management of the LLC. Unless the operating agreement otherwise provides, an act outside the ordinary course of the activities of the company may be undertaken only with the consent of all members. ULLCA § 407(b)(4).

b. Manager-managed LLC

Members of a manager-managed LLC do not have authority to bind the LLC. Matters relating to the activities of the company are decided exclusively by the managers.

Question 106

Dissociation, LLCs

Answer 106

A member can withdraw or dissociate at any time and without reason, even if doing so violates the operating agreement, by providing notice to the LLC. Written notice is not required under the ULLCA. Dissociation does not discharge the member’s interest or liability, and does not necessarily trigger dissolution and winding up. Rather, by dissociating the member relinquishes his right to participate in the LLC and is entitled to distributions by the LLC only if the continuing members receive payment.

Question 107

Direct and Derivative Actions, LLCs

Answer 107

The direct/derivative distinction as an important safeguard to the members’ agreed-upon arrangements in the operating agreement.

1. Direct Suits

Members may bring direct actions against the LLC and other members to enforce their rights as members under the operating agreement and the state LLC statute. To do so, a member must plead and prove an actual or threatened injury, which is not solely the result of an injury suffered by the LLC. ULLCA § 901. Although a member may sue the LLC or another member to enforce the member’s rights under the operating agreement, members of a manager-managed LLC do not have the right to maintain a direct action against the manager of the LLC when the alleged misconduct caused harm only to the LLC. See also Wright v. Herman, 230 F.R.D. 1, 10 (2005).

2. Derivative Suits

Members may bring a derivative action on behalf of the LLC to enforce rights of the LLC. To do so, demand must be made on the other members or manager to bring an action if the member fails to do so, unless such demand would be futile. ULLCA § 902. The members must further allege in their complaint the efforts that they made to secure the manager’s initiation or the reasons for not doing so. ULLCA § 904.

Question 108

Dissolution

Answer 108

Many of the more recent LLC statutes do not limit the duration of LLCs; duration is perpetual unless the operating agreement provides otherwise. ULLCA § 203. As is the case for other business entities, an LLC may merge with another LLC or another business entity (e.g., partnership, corporation).

1. Events Causing Dissolution

An LLC may dissolve upon the occurrence of various events, such as upon:

i) Consent of all the members;
ii) Passage of 90 consecutive days without members;
iii) Court order; or
iv) An event causing dissolution per the terms of the operating agreement.

ULLCA § 701.

2. Involuntary Dissolution

Some LLC statutes allow a member to seek a court order for involuntary dissolution if a controlling member acts in a way that is oppressive and directly harmful to the member seeking the order. ULLCA § 701(a)(5). Whether the member is successful depends on whether the action violated the member’s reasonable expectations. Unless the operating agreement provides otherwise, the court may also order a remedy other than dissolution. ULLCA § 701(b). Finally, some states allow LLC members to contractually waive their right to petition for judicial dissolution.

3. Winding Up

In winding up its activities, the LLC must (i) discharge the company’s debts, obligations, or other liabilities and (ii) settle and close the company’s activities, and marshal and distribute the company’s assets.

In addition, the LLC may perform acts necessary or appropriate to the winding up, including:

i) File a statement of dissolution or statement of termination;
ii) Preserve the company activities and property as a going concern for a reasonable time;
iii) Prosecute and defend actions and proceedings, whether civil, criminal, or administrative;
iv) Transfer the company’s property; or
v) Settle disputes by mediation or arbitration.