Corporations - Shareholder liability and derivative suits Flashcards
Can shareholders manage the corporation?
Generally, no - the board usually manages
However, in CLOSELY HELD corporations, they can manage the business directly
What is a close corporation?
(1) Few Shareholders (no magic #)
(2) the stock is NOT publicly traded
Note: almost every bar ? uses closely held corps bc special rules apply to them
management of CLOSE corporations
In a close corporation, you do not have to have shareholder management. You can have a board of directors.
BUT, if you WANT TO have shareholder management, you have a provision in the certificate restricting or transferring board power to shareholders (or others). you also need:
(1) ALL incorporators or shareholders (voting and nonvoting) approve it
(2) It is CONSPICUOUSLY noted on front and back of all shares
(3) all subsequent shareholders have NOTICE; AND
(4) Shares are not listed on an exchange or regularly quoted over-the-counter (i.e. not publicly traded)
In a close corporation run by shareholders, Who owes the duties of Care and Loyalty?
the MANAGING SHAREHOLDERS owe duties of care and loyalty to the corporation in a close corporation
DUTY OF UTMOST GOOD FAITH - In a close corporation, there is a trend toward imposing fiduciary duties on shareholders in their dealings with EACH OTHER.
–Especially, controlling shareholders cannot use their power for personal gain at the expense of minority shareholders or the corporation or to oppress minority shareholders or the corporation. They are said to owe a DUTY OF UTMOST GOOD FAITH.
Why do courts protect minority shareholders in a close corporation? – to give them a remedy for behavior that defeats reasonable expectation for investing
e..g Curly, Moe and Larry each own 1/3rd of XYZ corp stock and all three have jobs with XYZ corp. After disagreement, Curly and Moe fire Larry from his job. They kick Larry off the corporate premises. They refuse to pay dividends or to repurchase Larry’s stock. They have XYZ corp. purchase supplies at exorbitant prices from another corp, which curly and moe own. — Curly and Moe have BREACHED their duty of “utmost good faith” to Larry (so in this respect treating a close corporation like a partnership)
DUTY OF UTMOST GOOD FAITH
In a close corporation, there is a trend toward imposing fiduciary duties on shareholders in their dealings with EACH OTHER.
–Especially, controlling shareholders cannot use their power for personal gain at the expense of minority shareholders or the corporation or to oppress minority shareholders or the corporation. They are said to owe a DUTY OF UTMOST GOOD FAITH.
Why do courts protect minority shareholders in a close corporation? – to give them a remedy for behavior that defeats reasonable expectation for investing
e..g Curly, Moe and Larry each own 1/3rd of XYZ corp stock and all three have jobs with XYZ corp. After disagreement, Curly and Moe fire Larry from his job. They kick Larry off the corporate premises. They refuse to pay dividends or to repurchase Larry’s stock. They have XYZ corp. purchase supplies at exorbitant prices from another corp, which curly and moe own. — Curly and Moe have BREACHED their duty of “utmost good faith” to Larry (so in this respect treating a close corporation like a partnership)
Professional Service Corporations (P.C.s)
Members of a licensed profession, like doctors and lawyers, cannot practice the profession through a general business corporation. But they CAN form a professional service corporation, abbreviated “P.C.”
SHAREHOLDER, OFFICERS, and DIRECTORS of a P.C. MUST BE LICENSED PROFESSIONALS, but they can hire nonprofessionals as employees
The professionals are liable for their own malpractice, but NOT for that of others, so in this sense it is better than a partnership (limits their liability for acts of other professionals)
Further, the professionals are NOT personally liable for contracts entered by the entity for rent due on leases in the P.C.’s name etc. - the ENTITY is liable - like normal corp.
In general, the PC is governed by the rules of the business corporation. Certificate must meet the general corporation requirements except for the USE of “P.C.” and
(i) must indicate the profession to be practiced and
(ii) include the names and addresses of the original shareholders, directors and officers
(iii) there must also be certification that each shareholder, director and officer is LICENSED to practice the profession
In the event that a shareholder in a P.C. DIES or is disqualified from the practice, the P.C. MUST BUY the stock.
Shareholder liability
Shareholders are NOT liable for what the corporation does because THE CORPORATION is liable for what it does. This is true even if there is only ONE shareholder
Exception:
“Piercing the Corporate Veil” (PVC)
“Piercing the Corporate Veil”
why in this section? because it is an exception to shareholder limited liability
Can only happen in Closed Corporations
To Pierce the Corporate Veil and hold shareholders personally liable:
(1) they must have ABUSED the privilege of incorporating and
(2) fairness must require holding them liable
ie. the defendant “abused the privilege of doing business in the corporate form to perpetrate a wrong or injustice.”
NY book
In NEW YORK, a party seeking to pierce the corporate veil must establish that:
(1) the defendant(s) exercised COMPLETE DOMINATION over the corporation in the transaction in question; and
(2) such domination was USED TO COMMIT FRAUD OR WRONG AGAINST THE PLAINTIFF, which resulted in the plaintiff’s injury
FACTORS TO BE CONSIDERED:
(i) failure to adhere to corporate formalities (ie failure to issue stock, elect directors, keep corporate records)
(ii) INADEQUATE CAPITALIZATION
(iii) COMMINGLING of personal and corporate assets
(iv) use of Corporate Funds for PERSONAL EXPENSES
“Alter Ego”
Classic “Piercing the Corporate” Fact patterns
(1) the “Alter Ego” (identity of interest, agency, excessive dominion)
e. g. - X and Y are SHs of C-Corp. X COMMINGLES personal and corporate funds, uses the corporate care as her own, and use the corporate credit card for PERSONAL purchases. Can a creditor of the corp who has been unable to collect its claim from the corp collect from either X or Y?
(1) did shareholders abuse privilege of incorporating? – YES, X treated corp assets as his own , BUT to PCV in NY** the shareholder must exercise COMPLETE DOMINION over the company to perpetrate a fraud or injustice against the plaintiff (ie tougher standard in NY)
(2) Does fairness require PCV? – here, creditors are not being paid BUT must have COMPLETE DOMINION and fraud or injustice (on BAR just make argument and come to reasonable conclusion)
- if ct did PVC here, would probably only hold X liable bc Y did nothing wrong
Undercapitalization
Classic “Piercing the Corporate” Fact patterns
S is shareholder of Glowco, Inc. G, a corp that hauls and disposes of nuclear waste. G has initial capitalization of $1,000. V is injured when one of G’s trucks melt down. Can V sue S?
SH CLEARLY failed to invest enough to cover prospective liabilities, but in NY, undercapitalization alone is not enough, also need COMPLETE DOMINION and Fraud or Injustice
PVC more likely to occur in a torts case than a contracts case
WAGES in a closed corporation
Another exception to limited shareholder liability in general
In a close corporation, the TEN LARGEST SHAREHOLDER are PERSONALLY liable for the wages and benefits of the company’s employees
SHAREHOLDER DERIVATIVE SUITS
Shareholder as plaintiff
In a derivative suit, a shareholder is suing to enforce the CORPORATION’s claim, not her own personal claim. Its a case in which the corporation is not pursuing its own claim, so the shareholder steps in to prosecute the claim
Always ask: Could the corporation have brought this suit? if ues, it is a DERIVATIVE suit (ie you are suing in the right of the corporation)
e. g. S sues the board of directors of C Corp. for usurping a corporate opportunity. Is this a derivative suit? – YES, bc the corporation could sue for breach of duty of loyalty OR duty of care
(note: most derivative suits on the bar are BREACH OF DUTY cases, bc those duties are owed TO THE CORPORATION)
e. g.2 - S sues board of directors of C Corp.for issuing stock without honoring HER preemptive rights - derivative suit? –NO this suit is a DIRECT SUIT for S’s PERSONAL CLAIM
e. g. 3 - S sues to compel declaration of a dividend. Derivative? - Probably NOT, maybe, though, if it could be arguably based upon a breach of duty to corporation. If might be derivative if it is part of mismanagement by directors (bc this would be breach of duty of care) - but if JUST suing for the dividend, probably not derivative, just trying to put $$ in your own pocket as a shareholder
e. g. 4- S sues regarding WASTE of a corporate asset - DERIVATIVE - breach of duty of loyalty (e.g. would be set too much compensation for themselves)
What happens if a shareholder WINS a derivative suit?
Generally, the CORPORATION recovers for a successful derivative suit
Shareholder receives costs and attorney’s fees, usually from the judgment won for the corporation. (theoretically - bc she conferred a benefit on the corp by suing and winning)
Shareholder MIGHT be able to recover the damages directly in a derivative suit if the recovery by the corporation would return money to the BAD GUYS
e.g. Close corporation has 3 shareholders, who each own 1/3rd of shares and participate in mgt. One breaches duty of loyalty by engaging in competing venture. In derivative suit, the corp wins a judgment to recover the bad guy’s profit. But giving the recovery to the corp returns 1/3rd of it to the bad guy — in this case COURT MIGHT let the other shareholders recover directly, even though this is a derivative suit (on bar make the argument and come to reasonable conclusion)
What happens if shareholder LOSES a derivative suit?
Shareholder CANNOT recover the costs and expenses of the litigation, but shareholder is probably NOT liable for defendant’s costs
Also, other shareholders cannot later sue the same defendants on the same transaction - that claim is barred because it has already been asserted
What are the requirements for bringing a shareholder derivative suit?
(1) Stock ownership WHEN THE CLAIM AROSE
- -the person bringing suit must have owned stock (or held a voting trust certificate) at the time the claim arose OR have gotten it by OPERATION OF LAW from someone who owned the stock when the claims arose.
(e. g.s of OPERATION OF LAW - Inheritance, Divorce Decree, uncle dies and leaves you stock, for instance)
- IN ADDITION, she must own the stock when the action is BROUGHT and THROUGH entry of judgment
(2) she must ADEQUATELY REPRESENT the interests of the corporation and shareholders
(3) can also be required to POST A BOND for defendant’s costs. She does not have to, though, if she owns 5% or more of the stock or her stock is worth more than $50,000
(4) SH must MAKE A DEMAND ON DIRECTORS that the corporation sue
– but she does not need to make this demand if it would be FUTILE to do so.
when futile? - if
(i) the majority of the board is interested or under the control of interested directors [this one most likely]; or
ii) the board did not inform itself of the transaction to the extent reasonable under the circumstances; or
(iii) the transaction is SO EGREGIOUS on its face that it could not be the result of sound business judgment
(5) Plaintiff must PLEASE with particularity her efforts to get the board to sue OR why the demand was FUTILE
(6) the corp must be joined in the litigation - as a defendant (even though it is the corporation’s claim - weird bc in this sense corp is sort of the P and the D but that’s the rule)
