Corporations

Question 1

Promoters

Answer 1

1. A promoter is one who causes a corporation to be formed, organized, and financed.
2. The promoter’s function is to set up the corporation and establish it on firm footing.
3. Typically, the promoter will:
   a. manage the initial financing of the corporation;
   b. arrange for a meeting of the investors;
   c. negotiate and prepare the pre-incorporation agreements;
   d. lease office and factory space; and
   e. contract for the initial needs of the business.

Question 2

Promoters’ Relationship to the Corporation

Answer 2

Promoters stand in a fiduciary relationship to the corporation.

Question 3

Promoters’ Relationship with Other Promoters

Answer 3

1. If there is more than one promoter of a corporation, the promoters are, in effect, joint venturers and owe each other a fiduciary duty.
2. There is a mutual agency among the promoters, such that each can bind the others on contracts within the scope of the promotion.

Question 4

Pre-incorporation Contracts

Answer 4

1. Before incorporation, promoters frequently enter into consensual agreements with third parties relative to the proposed corporation.
2. Liability of the Corporation:
   a. As a general rule, a corporation is not liable on any pre-incorporation agreements its promoters entered into on its behalf, unless it assumes liability by its own act after it comes into existence.
   b. The corporation may adopt the contract after its formation by:
   (1) passing the resolution (formally); or
   (2) accepting the benefits of the contract
3. Liability of the Promoter:
   a. As a general rule, the promoter is personally liable on any contract he enters into on behalf of the still-nonexistent corporation, absent contrary intent of the parties, unless the corporation expressly or impliedly adopts the contract after formation and discharges the promoter through a valid novation.

Question 5

FORMATION OF CORPORATIONS

Answer 5

Articles of Incorporation:

1. A corporation is ordinarily created by filing: articles/certificates of incorporation (charter document) with the Secretary of state
2. Under the Model Act, the articles of incorporation must include:
   a. the incorporators’ names and addresses;
   b. the name of the corporation;
   c. the name and address of the initial registered agent; and
   d. the number of shares the corporation is authorized to issue.

Question 6

Piercing the Corporate Veil

Answer 6

1. The most central feature of a corporation is that it provides: limited liability for the owners (the shareholders are not liable for the debts and obligations of the Corporation)
2. Even if a corporation is properly formed, a court may disregard its separate entity and hold shareholders or affiliated corporations liable on corporate obligations. This is known as piercing the corporate veil.
3. As a general rule, a corporation will be looked upon as a separate and legal entity, unless the entity is used to commit fraud or to achieve inequitable results.

Question 7

Alter Ego

Answer 7

Alter Ego

a. Two-Prong Test
(1) there is no distinction between the separate person of the Corporation and the corporation’s shareholder or shareholders.

(2) some type of injustice or fraud like conduct (that’s a little bit harder to show).
To have to violate the alter ego doctrine means that under the law the Corporation a separate person that needs to be treated as a separate person and how do we do that we do that by following corporate formalities.

Question 8

Failure to Comply with Corporate Formalities

Answer 8

(1) The corporation must take actions with some level of formality, such as:
• the Corporation has meetings and there are minutes of those meetings and
• the Corporation issues stock and the Corporation takes actions with some level of formality even though this seems like a silly step especially in closely held corporations that might only have one shareholder it’s a very important step because that step creates a separation between the individual owner in the Corporation;
• not co-mingling of funds: separate bank accounts, separate books and records for the Corporation.

(2) Inadequate Capitalization
(a) Adequate capital is not precisely defined, but generally, capital must be sufficient for the corporation’s prospective needs and for meeting corporate debts as they become due.

Question 9

Fraud or Fraud-Like Conduct

Answer 9

Veils do not get pierced for merely failing to follow formalities. There needs to be something more: like bad behavior, some type of injustice (taking money from the company, alleging that it will pay its bills when it can’t, sometimes even tax fraud - these things all constitute sufficient fraud to pierce the corporate veil.)

Question 10

Liability

Answer 10

a. If the corporate veil is pierced, liability is generally imposed only upon shareholders active in management, although it is sometimes imposed on inactive shareholders as well.
b. Liability is for the full amount of the debt, not merely for the amount that would have constituted adequate capital.

Question 11

Enterprise Liability

Answer 11

Enterprise Liability (more like agency)

(1) Liability may be imposed where there is an intermingling of activity of corporations engaged in a common enterprise, with substantial disregard of the separate nature of the corporate entities, or serious ambiguity about the manner and capacity in which the corporations and their representatives are acting.
(2) This is sometimes referred to as: horizontal piercing - the test is different: it’s more about liability of the enterprise.

Question 12

FIDUCIARY DUTIES OF MANAGEMENT AND CONTROLLING SHAREHOLDERS (Most tested)

Answer 12

A. Duty of Care

B. Duty of Loyalty

Question 13

Duty of Care

Answer 13

1. An individual must act with the standard of care of an ordinarily reasonable and prudent person, and
   must have at least a minimum level of skill and competence for the specific business.
2. The duty of care usually applies to officers as well as directors.

Question 14

Business Judgment Rule (Analysis: Is there protection of BJR?)

Answer 14

a. The business judgment rule shields directors from liability and insulates board decisions from review.
b. It creates a rebuttable presumption that directors are honest, well-meaning, and acting through decisions that are informed and rationally undertaken in good faith.
c. Usually, a director or officer who makes a good faith error of business judgment will not have breached his duty of care.
d. Losing Protection of the Rule

Question 15

Losing Protection of the Rule (BJR)

Answer 15

1) Substantive:
(a) fraud - I engage in fraud – I lose the business judge rule protection
(b) illegality – OK, I’ve done something illegal: my business judgment is that we should break the legs of our competitor, is my decision protected? – no, it’s not protected.
(c) egregious decision – it does not mean just a dumb decision, it means a terrible decision: some people will call this waste and some people will kind of mix these all altogether - egregious decision or waste and what they mean is a decision for which there is no business justification.
(d) bad faith - if you act in bad faith you do not get the protection of the business judgment rule
(e) a conflict of interest then that takes us out of duty of care analysis and moves us into a duty of loyalty analysis and therefore if there is a conflict of interest the business judgment rule does not apply.
(2) Procedural:
(a) The rule does not protect judgments made by an uninformed board of directors (Van Gorkom case)

Question 16

Is it possible for an individual to not have the protection of the business judgment rule, but still not have violated the duty of care?

Answer 16

Yes!
(Ex. Delivery company owner tells the driver to park illegally in order to deliver packages on time, owner pays for the parking tickets – BJR protection is lost, but NO violation of duty of care)

Question 17

Bad Faith

Answer 17

b. Bad faith acts include:
(1) conduct motivated by an intent to do harm;
(2) intentional dereliction of duty;
(3) conscious disregard for responsibilities; and
(4) an act with a purpose other than advancing the best interest of corporation.

Question 18

A violation of the duty of care can be cleansed by:

Answer 18

a. fairness - fair results, no damages

b. informed vote of shareholders (fully informed, majority (not all) of shareholders)

Question 19

Failure to Monitor

Answer 19

(Caremark Claims)
Standard of Liability
(1) Absent suspicion, there is no duty to monitor or install a system to find wrongdoing. Directors do not need to be hyper-vigilant to find everything that might be going wrong absent suspicion and that absence suspicion is critical now even though we say absent suspicion there’s also a requirement that there is a reasonable system in place to provide corporate information to the board of directors so you can’t put. your head in the sand and plug your ears and say: “Oh, well, I have no suspicion and therefore I have no duty.” You have to have reasonable operations.
(2) Once there is suspicion, the standard is: gross negligence so if we’re asking whether the board violated their duty of care in these instances by failing to monitor what we’re going to look at is were they grossly negligent in those actions. Now be aware of the fact that the Sarbanes Oxley Act imposes certain duties on corporations and this is you know when Sarbanes Oxley was passed it was huge in the corporate world and all of the law professors said oh we need to talk about it in our classes and so all of us do we all mentioned Sarbanes Oxley, some people go far into it, some don’t some of us just mention the obligations that it creates on lawyers, because lawyers have obligations to report wrongdoing that they find. But how do you test about it? In the way you might test about Sarbanes Oxley is by including it in this failure to monitor because Sarbanes Oxley creates obligations on senior officers: the CEO and the chief financial officer have to actually sign off on financial statements that are filed with the SEC saying I’m aware of the facts that led to the statement and I affirm that they are true kind ( I approve this message type of type of logic) and what that means is that what I was just saying about absent suspicion there is no there’s no duty to monitor that now there’s legislation that is designed to provide more information or the responsibility of more information to senior executives and some of that might provide either a known or should have known type of a standard to a board of directors that may be monitoring or have a duty to monitor merely because they had to provide statements consistent with Sarbanes Oxley

Question 20

Duty of Loyalty

Answer 20

1. The fiduciary duty of officers, directors, and employees requires that they be loyal to the corporation and not promote their own interests in a manner injurious to the corporation.
2. A conflict of interest constituting a breach of the duty of loyalty may arise where the individual:
   a. has business dealings with the corporation;
   b. takes advantage of a corporate opportunity; or
   c. enters into competition with the corporation.

Question 21

An action involving a conflict of interest may be cleansed by:

Answer 21

a. approval of a majority of the disinterested (those who do not have a conflict) directors;
b. approval by the (disinterested) shareholders (fully informed); Delaware law-majority of shareholders
c. Intrinsic fairness (depends on the transaction: use fairness test-price) Some courts use substantive and procedural test. If you have merger – then use a whole test: entire price and fair procedure

Question 22

Corporate Opportunity:

Definition

Answer 22

(1) Classic (OLD) test: interest, necessity, expectancy
(2) New test: line of business test: what they are working now and what they are expecting
HYBRID TEST

Question 23

Corporate Opportunity:

Defenses

Answer 23

(1) INCAPACITY DEFENSE (inability to pay…

2) SOURCE DEFENSE (THEY WERE NOT ABLE TO COME TO YOU, THEY CAME TO ME

Question 24

A transaction involving a conflict of interest is voidable, unless the interested person can prove that:

Answer 24

a. the material facts of the conflict were disclosed and fully described to the board, and the transaction was validly approved by a majority of disinterested directors; GOLD STANDARD: board approves take an opportunity!
• If they do not approve or there is no full disclosure - it is a violation of fiduciary duty!
• No response after full disclosure (some states) = board approval
b. the material facts of the conflict were disclosed and fully described to the shareholders, and the transaction was validly approved by a majority of disinterested shareholders;
or
c. a court determines the transaction was fair and reasonable to the corporation. SHOW FAIRNESS

Question 25

Remedies

Answer 25

show fairness, it will cleanse Corporate opportunity

b. ….

Question 26

Damages

Answer 26

constructive trust (fictional trust); everything you made belongs to Corp.
If you ruined Corp. opportunity for Corp. you can be sued!

Question 27

Duties of Controlling Shareholders

Answer 27

1. Majority or controlling shareholders of a corporation have a fiduciary duty to refrain from exercising their control to obtain a benefit from the corporation not shared proportionally with the minority shareholders.
2. A majority shareholder’s fiduciary duty is usually enforceable by the corporation, by means of a shareholder’s derivative action, or by an individual shareholder’s action for a direct breach of fiduciary duty to him.
   a. The controlling shareholder has the burden of proving the entire fairness of the transaction.
   Example: Dominant shareholder wants to sell 70% to another company to cash out, and use money for something else 30% minority shareholders are against=dominant shareholder can sell! It triggers BJR!

Question 28

SHAREHOLDER LITIGATION

Shareholder Actions

Answer 28

1. There are two basic types of shareholder actions.
2. One is a direct suit, in which a shareholder sues on his own behalf to redress an injury to his interest as a shareholder (examples: to compel the payment of the dividend; vote issue)
3. The second type of action is a derivative suit (ACTUALLY: TWO LAW SUITS: 1. AGAINST CORP, 2. AGAINST AN INDIVIDUAL), in which a shareholder sues on behalf of the corporation to redress a wrong to the corporation when it fails to enforce its right. A derivative suit is an equitable action, and often involves breach of fiduciary duty.

Question 29

Derivative Suits

Answer 29

When a corporation fails to bring an action to redress a wrong, shareholders have the right to compel the corporation to take action.

Question 30

Conditions Precedent

Answer 30

a. Contemporaneous Ownership
b. Demand upon Directors
c. Dismissal

Question 31

Contemporaneous Ownership

Answer 31

In a derivative suit, the plaintiff must allege in his complaint that he was a shareholder at the time of the transaction complained of, or that his shares thereafter devolved upon him by operation of law (e.g., inheritance) from a person who was a shareholder at that time. (some states require to post a bond) - to pay attorney’s fees of the Corp.)

Question 32

Demand upon Directors

Answer 32

(1) Since a derivative suit is based on a corporate cause of action, a shareholder must first attempt to persuade the board of directors to enforce the corporation’s right, by making a written demand upon the board.
(2) Demand is excused if it would be futile. Demand is considered futile when:
(a) a majority of the board is interested in the transaction (financial or familiar interest-conflict of interest)
(b) the directors fail to inform themselves of the transaction; or
(c) the directors fail to exercise their business judgment in approving the transaction.

Question 33

Dismissal

Answer 33

(1) A special litigation committee has the power to: GO INTO the COURT AND ASK THE COURT TO DISMISS THE SUIT. Requirement: 2 independent committee members-strict scrutiny!
(2) Upon a motion by the corporation, a court will dismiss a derivative proceeding if a majority of independent directors, or a majority of
a committee consisting of two or more independent directors (a special litigation committee appointed by the board of directors), has determined in good faith, after conducting a reasonable inquiry upon which its conclusions are based, that a derivative proceeding is not in the best interests of the corporation.

Question 34

Shareholder Litigation

Expenses

Answer 34

In its discretion, the court may order the corporation to pay expenses, including counsel fees, to a successful derivative action plaintiff.

Question 35

CLOSE CORPORATIONS OR CLOSELY HELD CORPORATIONS

Characteristics

Answer 35

A close corporation, or closely held corporation, is defined as one having:

a. a small number of shareholders;
b. no ready market for the corporate stock; and
c. substantial majority shareholder participation in the management, direction, and operations of the corporation.

Question 36

Freeze-Out

Answer 36

1. A freeze-out occurs when an owner of the close held Corp cannot participate in the management of Corp; they have passive role, they receive no dividends in that role; they ARE frozen out of the benefits of the Company
2. The money from the company goes to the shareholders who are employed by the corporation, and not to the passive shareholder.
3. The underlying problem is that the employee shareholders are being compensated as employees and as a return on investment.
4. Evaluation of Claims
   a. Delaware Standard:

b. Massachusetts (Wilkes) Standard
(1) Did the majority group have a legitimate business purpose for its actions?
(2) Even if there was, then the minority shareholders still have an opportunity to show that there was an alternative course of action that was less harmful to the interest of the minority shareholders.

Question 37

TAKEOVERS AND CORPORATE CONTROL TRANSACTIONS

Answer 37

Tender Offers and Acquisitions

1. An individual, group, or corporation seeking to acquire another corporation normally attempts to do so by negotiating with the board of directors.
   a. If this fails, the would-be acquirer will often go directly to the shareholders and make a tender offer.
2. In hostile transactions, the traditional deference given to decisions of the board under the business judgment rule is limited.
3. Unocal Rule