Corporations/Business Organization

Business law is the field of law concerned with companies and other form of business organization. This area of law includes corporations, partnerships and other associations that does business for some form of economic or charitable activity. The most prominent kind of company, usually referred to as a corporation, is a legal person, having a separate legal personality, and limited liability for losses from those who invest money in the company. The largest companies are usually publicly listed on stock exchanges. The different forms of companies depend on the particular law of the particular country in which they reside.

On exams, it’s nearly impossible to get crossover questions in corporations. This doesn’t mean a crossover between corporation, torts or contracts question can’t happen. But, if there is a crossover it usually is between the five pocket areas of corporate law. 95% of the time a question deals in only one of the five areas.


Individuals can do anything they want, so long as it is lawful. Corporations are artificial business entities created by state statutes that allow them to exist. Because they are artificial there are external rules that govern their conduct. Corporations also write their own internal operating rules, known as the articles of incorporation, which include bylaws that help the corporation function in an orderly manner. A corporation may only take action it is authorized to do under such rules. Certain people involved in a corporation, the owners, shareholders and managers are known as the directors. The directors write rules known as resolutions, which are documents that are prepared and approved by the board of directors regarding a corporations authorized conduct. One key element in a corporate resolution is a listing of individuals who are authorized to conduct specified actions on behalf of the company. If a corporation is doing something it’s not authorized to do the remedy is easy, stop the corporation from doing it under the ulta vires doctrine, which holds a corporation liable to its shareholders if it is doing something that it is not authorized to do.

Unlike any other business entity, a corporation when it is operating properly is separate and distinct from its owner and shareholders. Because a corporation and its shareholders are separate legal entities normally they are not responsible for each other debts. There is a shield or limited liability that separates the corporation and its officers and owners. So when the corporation is properly run, it is not liable for shareholders debts and shareholders are not responsible for the corporation’s debts as well.

  1. I. Organization and formation of a corporation.

If shareholders are seeking not to be liable for the debts of their business activity the doctrines to discuss are de jure corporation, de facto corporation and corporation by estoppel. If the examination says the state has approved the articles, do not discuss de facto or corporation by estoppel. If the exam states that shareholders are seeking not to be liable for business related activities (debts) and it doesn’t say the articles have been approved, the examiners are testing on de facto corporation and corporation by estoppel. Both are equitable doctrines that give courts great discretion whether or not to use them. However, when it comes to equity, courts will only assist those who have clean hands.

  1. Was the corporation properly formed?
    1. De jure corporation. What steps must be taken to satisfy a state’s requirement to form a legitimate corporation? Requirements:
      1. Incorporators are people that write the articles of the corporation. There needs to be least one (may be an entity) to serve as the incorporator.
      2. Articles of corporation. A valid corporation exists even if the state made a mistake in issuing it. Requirements:
        1. A corporate name. It cannot be deceptively similar to another corporate name that is used in that state.
        2. The name and address of the incorporator.
        3. A statement of specific purpose. The two functions of the purpose clause are to authorize and limit business related activities. The clause limits a corporation from taking any action not related to its specific purpose and triggers the ultra vires doctrine when it takes any unauthorized action. Shareholders may sue directors and operators who can be held personally liable for unauthorized acts.

Example: The purpose of corporation X is to sell real estate. If corporation X begins to engage in activities not related to real estate the corporation would be liable to shareholders for such acts.

  1. Capital stock paragraph. This section gives the corporation the authority to sell stock. One sentence is enough.

Example: Corporation X is authorized to sell 5000 shares of common stock.

  1. File with the secretary of state and pay the required fees. When the articles are properly filed the corporation exists. Acceptance is conclusive proof of valid formation.
  2. Registered agent of service. Some states require a registered agent to accept service of process if somebody wants to sue the corporation.
  3. Internal affairs. A choice of law rule that requires any conflicts between shareholders and management figures, such as the board of directors or corporate officers are to be governed by corporate statutes and case law of the state where the corporation is incorporated.
  4. Bylaws. Rules designed to help a corporation function in an orderly manner.
    1. They are not required at the formation stage, but are necessary to properly guide the corporate governance.
    2. Bylaws are initially adopted by the board of directors, but may be repealed or amended by the board or shareholders.
    3. Articles control if there are conflicts between articles and bylaws.
    4. Professional associations such as lawyers, MD’s and CPA’s, is a body of persons engaged in the same profession, formed to control entry into the profession and maintain standards.
      1. The corporate name must include the designation of professional association.
      2. Shareholders must be licensed professionals and are not held personally liable for each other’s malpractice or liabilities.
  1. Defenses to defective formation. De facto corporations and corporations by estoppel are used when a state has not approved the articles. Here, courts may give limited liability to people who are not de jure corporations. Exam. State that in a significant minority of states have eliminated these doctrines by statute.
    1. De facto corporations are treated as legitimate corporations if:
      1. Statute. There is a relevant state statute that allows corporations to exist. Every state has such a statute.
      2. Colorable compliance. Parties made a good faith, colorable attempt to comply. This means the people who are seeking protection believe in good faith they have followed all of the steps required to form a de jure corporation, but in fact they have not. They missed a step somewhere, but they don’t know they did.
      3. The parties acted as if a corporation existed. Here, the shareholders are holding themselves out to the world, reasonably believing that there is a corporation and acting like it. Under these facts a court may, but is not required to, afford the protection of limited liability.
      4. Corporate by estoppel. Third parties that have acknowledged the existence of a corporation, which actually does not exist, may not later deny it to gain and advantage. These be treated as a corporation if:
        1. A statute requirement.
        2. Colorable compliance.
        3. Parties acted as if there was a corporation.
        4. Third parties who transacted business treated them as if they were a corporation.
        5. If all requirements are met the third party is stopped from denying a corporation exists. Rationale: They did business with those people as if they were incorporated, so now they are stopped from denying it was a corporation. This is unavailable to tort creditors because there was no course of dealing.
      5. Modern trend: To abrogate these two doctrines under the Model Corporation Codes.
  1. Piercing the corporate veil. Once limited liability has been created how do creditors pierce the corporate veil and make shareholders liable for the corporation’s debts? If shareholders are responsible for corporate debts the exam is asking to pierce the corporate veil, which will cause the shareholders to be liable for those debts. Discuss if there was abuse to the corporation and if so state that fairness requires the shareholders to be held personally liable. How to recognize the exam is testing this issue? 1) The corporation is clearly liable. Example: The corporation breached a contract or committed a tort. 2) If the shareholders are responsible the exam is asking to pierce the corporate veil.

There are three ways to pierce the corporate veil.

  1. The fraud doctrine. Rarely tested because it’s so easy. If one uses a corporation to defraud another the court has equitable power to disregard the corporation and pierce the corporate veil.
  2. The undercapitalization doctrine. An equitable doctrine that looks back to the time when the corporation was formed and asks, was this corporation given enough capital, to conduct its intended business. Parties responsible for forming a corporation must have some idea how much money the corporation needs to conduct its intended business. If they had not given the corporation enough capital to form that purpose, the courts may hold those shareholders and subscribers personally liable. This usually applies to a corporation with high-risk liabilities and is intentionally undercapitalizing it to prevent tort recovery.

Example: A corporation that hauls nuclear waste.

Two caveats:

  1. Shareholder loans.

Example: A corporation reasonably needs 100k to conduct its business. The subscribers, the people about to become shareholders, show up at an organizational meeting with 100k, and use 2k to buy stock and lend the remaining 98k. Here, the corporation is grossly undercapitalized because 98k is a loan.

  1. Tort victims. Courts of equity are far more willing to come to the aid of a tort victim rather than a contract creditor. A tort victim trying to pierce a corporate veil would have an easier time in court over a contract creditor. The reason is that contract creditors have the opportunity to look at the corporation’s capital structure before they entered into a contract. Its almost like an assumption of risk argument, “You could have looked, and seen if the corporation was sufficiently capitalized, but you chose not to, so don’t come to court now, and ask us to give you a remedy.” On the other hand, tort victims don’t usually have the opportunity to run a credit check on the tortfeasor before they get run over in a car accident.
  2. The alter-ego doctrine/enterprise liability. Due care must be taken to preserve the separateness between the corporation and its shareholders because when a third party comes to do business they need to know whether they are doing so with the corporation or the individual shareholder. When the formalities are not followed, identities tend to merge and the courts may not be able to tell them apart. If the court cannot tell whether the third party was dealing with the corporation or the shareholders, it won’t even try. It will pierce the corporate veil and hold shareholders liable. Alter-ego issues commonly apply where the main shareholder is commingling funds, using corporate assets for personal use or treating themselves and the corporate entity as one. The corporation may be pierced if it fails to respect the separate corporate entity and has harmed creditors. Sloppy administration is not enough to pierce the corporate veil. What formalities to keep the identities separate?
    1. The corporations name must be on the door.
    2. It should use its own stationary.
    3. The assets of the corporation should not be commingled with the personal assets of the shareholders. They must use separate bank accounts.
    4. Corporations must hold meetings and keep minutes.
    5. Corporations should file their reports in a timely manner.
    6. Enterprise liability. When fraud, undercapitalization and alter ego are applied in a multiple corporate setting, such as a brother-sister, or parent-subsidiary corporation the laws don’t change, but is called enterprise liability.

Example: Corporation P is the controlling shareholder. They own enough stock to control the business and affairs of another corporation, Corporation S. When one corporation owns the controlling interest of another, the controlling corporation is known as the parent and the controlled corporation is known as the subsidiary. If the parent has more than one subsidiary, then the subsidiaries are known as brother-sister corporations.

Examiners tend to use multiple corporation settings when dealing with piercing a corporate veil. Each corporation is pierced separately in examine analysis.

Example: X is a creditor of a subsidiary of P. The subsidiary does not have much money and neither does the parent. However, the parent corporation has shareholders with a lot of money. How does X get into the pockets of the shareholders?

  1. Pierce the corporate veil of the subsidiary. Once you do that you get into the pocket of the parent corporation.
  2. Pierce the veil of the parent corporation will get into the pockets of the shareholders with the money.
  3. Watered stock. An asset with an artificially inflated value. The term refers to a form of securities fraud under older corporate law that placed a heavy emphasis on the par value of stock.
  1. II. Capital stock structure describes the amount of a company’s capital, or operating money obtained through debt versus equity. Debt includes loans and other types of credit that must be repaid, usually with interest. Equity involves selling a partial interest in a company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part owners in the business and earn a return on their investment as well as exercising some degree of control over how the business is run.

Authorized. All stocks must first be authorized before issuance. Once they are issued, they are outstanding. Somewhere in the third paragraph of the articles, it must say the stocks are authorized, because a corporation can only do what it is authorized to do. Authorized is not a sale. It means it’s legal to sell them when the corporation decides to do it.

Issuance. Instead of using the term sale, the term that is used is called issuance. This merely means the corporation is selling stock that it is authorized to sell. Issuance issues arise when the corporation is selling or about to sell stocks. The two types of stocks are common and preferred stocks. Common stocks pay out at the same time to everybody. Preferred stocks get paid first. This applies to dividends or payments in case of bankruptcy or liquidation.

Capital stock are shares authorized for issuance by a company’s charter, including both common and preferred stock. They are normally listed on the company’s balance sheet. Increasing capital stock is a sign of economic health since the company may use the additional proceeds to invest in projects or machinery that may increase corporate profits and/or efficiency.

Common stock is a security representing a legal claim to a percentage of a company’s earnings and assets. Holders of common stock have some input in choosing management, but do not have much say in the day to day operations. Holders of common stock may participate in an annual meeting, where the company shares its vision for the future. Investors may purchase common stock if they believe a company will be worth more in the future than it is valued at in the present. Common stock does not always pay a dividend. If the company goes bankrupt, common stockholders generally lose their entire investment.

Preferred stock are capital stocks that provide a specific dividend that is paid before any are paid to common stock holders and which take precedence over common stock in the event of a liquidation. Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, a preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay if it lacks the financial ability to do so. The main benefit to owning preferred stock is that the investor has a greater claim on company assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders.

Par value is the face value of a stock. The nominal dollar amount assigned to a security by the issuer. For an equity security, par value is usually a very small amount that bears no relationship to its market price, except for preferred stock, in which case par value is used to calculate dividend payments. For a debt security, par value is the amount repaid to the investor when the bond matures (usually corporate bonds have a par value of 1000.00, municipal bonds 5000.00 and federal bonds 10,000.00). In the secondary market, a bond’s price fluctuates with interest rates. If interest rates are higher than the coupon rate on the bond, the bond will be sold below par value (at a discount). If interest rates have fallen, the price will be sold above par value also called face value or par.

  1. Subscription agreements. Exam. There is only one testable subscription issue. How is the subscription enforced?
    1. Purchases from shareholders. There are no special rules to purchase stocks from a shareholder. Analyze under contract law.
    2. Purchases from a corporation. A subscription agreement is an application process by an investor who wishes to purchase stock in a company. The investor fills out a form created by a general partner who evaluates the investor’s suitability for investment in the company. Being a limited partner rather than a full partner is an attractive option since investor liability is limited to the amount they have invested in the company.
      1. Subscriptions. A written agreement to purchase stocks from a corporation that has not yet come into existence. The persons who have them are called subscribers. At common law the courts had a hard time enforcing such agreements because there was no mutual assent, or a “meeting of the minds” which was required for an agreement to be valid.
      2. Pre-incorporation subscription agreement offers are irrevocable for six months.

Theories to enforce subscription agreements:

  1. Statutory theory. Majority modern rule. Most states have statutes that say if you sign a pre-incorporation subscription agreement it is irrevocable for six or twelve months. There is no requirement of mutual assent.
  2. The contract theory of subscription. Minority rule. A common law legal fiction courts made up so corporation subscription agreements could be enforced. Offers to purchase are irrevocable unless all subscribers agree to release each other. When there is more than one subscriber the courts will imply consideration.
  1. Consideration for stock. A corporation is about to issue shares. All states set a minimum amount that a corporation may sell its stocks. Exam. The question will describe the property being used to pay for stocks. Here, the examiners are testing whether the price paid is valuable consideration.
    1. Traditional rule permits all types of property to be used to purchase stock, except unsecured promissory notes, which is a promise to pay at a later date and future services.
      1. Money.
      2. Tangible or intangible property.
      3. Service already performed. Past services were permissible as a type of consideration. However, promises to pay with some type of future service was not permissible consideration.
      4. Modern trend allows anything to be construed as valuable consideration including:
        1. Promise of future service.
        2. Promissory notes.

Par value. Stated or face value. The minimum price a corporation must sell its stock. This minimum price is assigned in the articles of incorporation.

Exception. A corporation may sells its stocks at less than par value if the directors have formally passed a resolution authorizing such a sale.


  1. Treasury stock. Stock the corporation was authorized to sell but were bought back and now the corporation wants to reissue it. Treasury stock can be sold for any price.
  2. No par stock. A stock that doesn’t have a par value assigned to it in the articles. It will still have a number assigned to it and is called stated value. No par shares have a stated value, which is determined by the board of directors in good faith. All stock is going to have some number assigned to it, its either going to be par value of par shares, or the stated value of no par shares. Once this number is assigned it becomes the minimum price the corporation may sell its stocks.

Watered stock. Stocks the corporation has sold for property, or anything other than cash for less than its par or stated value.

Discount stock. Stocks a corporation sold for cash for less than its par or stated value.

Bonus stock. Stock transferred for no valid consideration.

Example: It’s the director’s birthday and shareholders voter them 50 shares of stock as a gift. What result? Void or voidable depending on jurisdiction.

Where a creditor has a remedy are situations where there is watered or discount stocks.

If a corporation sells its stocks for less than par or stated value and are not within one of the two exceptions, treasury stock or no par stock there is a remedy to recover.

The remedy belongs to creditors of the corporation. However, before they can exercise their remedy, creditors must do everything they can to first collect from the corporation before going after the shareholders.

  1. They must first file a lawsuit, receive a judgment and execute on it.
  2. If they don’t collect from the debtor corporation they may proceed against the shareholders that own of watered or discounted stocks.
  3. Creditors may recover the difference between what was paid on the watered or discounted price and what should have been paid, the par or stated value.
  1. Redemptions and repurchases of stock.

Share redemptions can occur through one or more activities. A shareholder can sell their shares (redeeming them for cash) or the stock may be redeemed at the discretion of the company who owns the shares. Shareholders who wish to redeem their shares for cash may do so by going through a reputable broker/dealer to facilitate the transaction, by turning in their stock certificate and ask for the shares to be sold. Once the transaction has been completed and the shares are sold, the settlement date will determine when the shareholder receives their funds. A shareholder’s ability to sell shares may be dictated by market conditions but are part of their rights as a stockholder.

Stock issuers right of redemption. A feature known as a “call” typically protects these rights. This allows the corporation (or municipality) that issued the stock (bond) to force shareholders to surrender them in return for cash.

When a company (or municipality) wishes to redeem shares, they provide notification to the shareholder. This notification is typically sent out to all shareholders of a specific issue. This is often done to increase the amount of treasury stock that a company holds, while reducing the amount of shareholder equity that is in the open market.

There are a number of reasons why shares may be redeemed and this is often depending on who is redeeming them. Shareholders will redeem shares for the purposes of investing in other companies or to obtain cash. Shareholders who redeem shares are typically trying to protect themselves against greater loss.

Companies that have issued preferred shares often do so with a feature that allows a shareholder to convert their shares to common stock at a later date. In this instance, the shareholder redeems the preferred shares for common shares. Bonds that are issued by a company may also have a call feature that allows the company to encourage redemption prior to the date of maturity. In this case, the shareholder (or bond holder) would typically receive a premium (higher price) for the bond due to losing interest through the life of the bond.

  1. Redemption. The corporation is exercising a right to repurchase stocks, which it has reserved to itself in the articles. It must do so in a proportionate and non-discriminatory manner. Shareholders do not have the option of refusing and the corporation cannot discriminate by redeeming 10% to X shareholder, 5% to Y shareholder and none to Z shareholder.
  2. Repurchase. The redemption rules don’t apply to repurchases. Here, a corporation can discriminate and repurchase from X shareholder and none form Y or Z. In repurchase each side has equal negotiation power. The offer can be accepted, rejected or negotiated.

Issues regarding redemption and repurchase.

  1. Permissible amount. May the corporation lawfully distribute the amount of money it wants to redeem or repurchase its shares? The same rules that apply to dividends apply here, with one change. On the lower right-hand portion of the balance sheet, a corporation may always use earned surplus, rarely may it use revaluation surplus, occasionally it may use paid in surplus. Some states allow stated capital to be used for redemption purposes only.
  2. Equitable doctrines. Court has broad discretion as to whether they apply or not. Both apply to fiduciary duties of incumbent officers.
    1. Redemption to perpetuate control. Redemption is one way to try and cut off a tender offer. To get stocks back into the corporation’s possession before insurgents get them. This is done to prevent a corporate takeover. This happens where there is a fight for control by insurgents and existing incumbents.

Example: President of X corporation who is also a director see’s a full page add that states: “To all shareholders in X corporation, if you tender us your shares by Feb. 18, we will pay you 50.00 a share because the officers and directors are doing a shabby job. We want to take over the corporation and vote them out.”

One way to stop a tender offer and to stop a takeover is to purchase the stocks first before the insurgents can. If the officers don’t want to use their own money and decide to use the corporation’s money, they redeem the stock to perpetuate control. Insiders that use a corporation’s money to protect it from people who will hurt the corporation is permissible. However, to use the corporation’s money to protect their own personal interest such as to keep their position of power, are taking care of themselves rather than the corporation and this is a breach of fiduciary duty and they will be held liable for it.

The rule is redemption for the corporate good is permissible. If it is done for personal gain there is a breach of fiduciary duty to the corporation. Enforcement of an improper redemption is very difficult.

  1. The equal opportunity doctrine. Arises where there is no public market for their shares in a closely held corporation where a controlling shareholder owns more than half the controlling stock and wants to sell some of their shares. They can’t call a stockbroker to sell it because it is not publicly traded. One thing they might do is turn to the corporate director and say, “I want you to cause the corporation to repurchase my shares because I need some cash.” This is a preference given to a controlling shareholder only. This was OK in the past, however states started changing their position. Under the majority rule a controlling shareholder cannot seek this type of preferential repurchase. The corporation is not solely at the mercy of a controlling shareholder. In fact, if the controlling shareholder does cause a preferential repurchase to happen, the other shareholders must be given an equal opportunity to have the same percentage of their stock repurchased at the sale price. Before examiners can trigger this issue, there has to be a repurchase.
  1. III. Stock transaction and transfer liability. The second most tested area. All the examiners need to trigger this entire area of law is that stocks have changed hands. This area can crossover into other pocket areas. Make it a habit to think about three doctrines. The common law rules, Rule 10b-5, and §16(b).

Pre-securities act common law enforcement.

Strong v. Repide, 213 U. S. 419 (1909). In 1909, the Supreme Court gave impetus to the trend allowing recovery by plaintiffs. Strong v. Repide was an insider trading case arising from the sale of stock in the Philippine Sugar Estates Development Company to one of the directors of the company. The defendant, while negotiating the purchase of the plaintiff’s stock, was simultaneously negotiating the sale of the corporate land assets to the Philippine government. The defendant took extraordinary efforts to conceal the information about the negotiations. As a result, the purchaser was able to obtain the stock from the stockholder for about one-tenth of its actual value. Justice Peckham, refused to follow the majority or minority rule, instead adopted a third approach holding that, under the particular facts of the case, “the law would indeed be impotent if the sale could not be set aside or the defendant case in damages for his fraud.”

This “special facts or special circumstances” rule meant that although directors generally had no duty to disclose material facts when trading with shareholders, as the majority rule held, a duty might arise where there were special circumstances, such as concealment of the defendant-purchaser’s identity (the corporate officer had used an agent go-between to avoid detection of his actions by the seller here) and a failure to disclose significant facts that materially affected the price of the stock. Over the next twenty years, state courts that continued to follow the majority rule paid deference to the special circumstances rule in insider trading cases. States used the three theories as they developed their own unique approaches to insider trading regulation. But neither the special circumstances nor the minority rules applied to stock transactions involving impersonal or non-face-to-face trades. During that time, the stock market evolved into a national market where the majority of trades were impersonal, with sellers and buyers having little or no contact with one another.

The Securities Exchange Act of 1934. Principles of full disclosure.

Most states today regulate stock transactions much as they did in the 1930s. While state common law provided the original framework in which the federal rules regarding insider trading operated, after the passage of the Securities Exchange Act of 1934, the SEC entered the debate about insider trading. Yet because the Act did not include a general prohibition or even a definition of insider trading, the SEC did so at first in a way that was both tentative and overly specific.

Instead of a direct frontal attack on insider trading, the SEC promoted the values of full disclosure for investors to insure a high standard of fairness and ethical business dealing in the securities industry. Specific fraud and manipulation prohibitions supported the Exchange Act’s disclosure requirements. The core of modern insider trading regulation is Section10(b) of the Exchange Act, which makes it unlawful for “any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails” to use or employ in connection with the purchase or sale of registered or unregistered securities “any manipulative or deceptive device or contrivance” in contravention of the rules and regulations of the SEC. Yet that provision did not specifically define who was an insider or what kinds of transactions the statute covered. Thomas Corcoran, one of President Franklin Roosevelt’s advisors who spearheaded the lobbying effort in support of the Act, testified that Section 10(b) was intended as a catchall to prohibit the creation of other devices not covered by more explicit sections of the Exchange Act.

In fact, Congress explicitly addressed insider trading, if at all, only in Section 16(b) of the Exchange Act, which permits the issuer of stock to recover insider short-swing profits, profits earned on purchases and sales that occur within six months of each other. That provision applies only to officers, directors or shareholders who own more than 10 percent of the company’s stock, and only if they trade in that company stock. Furthermore, its applicability is limited to firms that must register under the Securities Exchange Act and applies to any equity security. In addition, Section 16(c) prohibits short sales by insiders, an early example of the overall intent of the Exchange Act’s regulation prohibiting perceived unfair trading practices.

In a 1965 interview, Ferdinand Pecora recalled how he, Corcoran, James Landis and Benjamin Cohen had drafted § 16 as “the anti-Wiggin section,” named after Albert H. Wiggin, who headed the Chase Manhattan Bank from 1921 to 1933. Wiggin testified that he short-sold Chase National Bank stock that he didn’t own but expected to repurchase at a lower price and thereby took a profit through six different private investment corporations he had established. One of them had taken a profitable position with Sinclair Oil at a time when Sinclair had a large line of credit with Chase Bank. The securities trading abuses of such people, said Pecora, “were the reason that we drafted § 16 of the Act.”

Over the next five decades, the SEC promoted a securities law regime meant to ensure that all parties to stock market transactions had roughly equal access to material information about the company in which they were trading. To that end, the principal goals of the federal acts were to protect individual investors engaged in stock transactions and to assure broad public confidence in the integrity of the stock market. Yet the common law of fraud and the soon-to-be-created theories of insider trading would conflict as the SEC developed and administered a regime of securities law meant to promote those goals in a sophisticated and growing national market

Rule 10b-5 is one of the most important rules promulgated by the SEC, pursuant to its authority granted under the Securities Exchange Act of 1934. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.

“Rule 10b-5: Employment of Manipulative and Deceptive Practices”:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”

In order to establish a claim under Rule 10b-5, plaintiffs (including the SEC) must show:

  1. Manipulation or deception.
  2. Materiality in connection with the purchase or sale of securities; and
  3. Scienter.

Private plaintiffs have the additional burden of establishing:

  1. Standing. A purchaser and seller relationship is required.
  2. Reliance.
  3. Loss.
  4. Causation.
  5. Damages.

Insider trading. Anyone who uses insider information can be held liable. The tippee can be liable if the tipper breached their duty and the tippee knew that tipper was breaching that duty. The SEC has long advocated an “equal access theory” with regard to 10b-5, arguing that anyone who has material, non-public information must disclose that information or abstain from trading. However, the Supreme Court rejected the strongest version of that theory in Chiarella v. U.S., holding a person with no fiduciary duty to shareholders have no duty to disclose information before trading on it. Recently, the Supreme Court has embraced a “misappropriation” theory of omissions, holding in U.S. v. O’Hagan, that misappropriating confidential information for securities trading purposes, in breach of a duty owed to the source of that information, gives rise to a duty to disclose or abstain. In order for Rule 10b-5 to be invoked, there must be intentional fraud or deceit by the party charged with the violation. Furthermore, for a private party to recover damages, they must be able to show that they were injured because they relied on the fraudulent claim. If the defendant had publicly made a fraudulent statement, every investor could sue if it could be shown that the statement affected the market as a whole. This is the “fraud on the market” theory enunciated by the Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224 (1988). This “fraud on the market” presumption of the plaintiff’s reliance upon the deceit is only available in situations where the security is traded on a well-organized and presumably efficient, market. Various cases have held that a statement that “bespeaks caution” is sufficient to absolve the defendant of liability. If the defendant had prefaced remarks about the health of the company with a disclaimer that he might be wrong, these subsequent statements cannot be held against him.


Both the SEC and private citizens can enforce the requirements of the rule through lawsuits. The defendant need not be the seller of the stock – any person who fraudulently induces a person to purchase any stock may be held liable.

§ 16 of the Exchange Act, with respect to any company whose securities are registered on a national securities exchange, imposes certain obligations and restrictions on the company’s officers, directors, and every person who is directly or indirectly the beneficial owner of more than 10% of any class of any equity security (other than an exempted security),” 15 U.S.C. § 78p(a)(1). “Defining directors, officers, and such beneficial owners as those presumed to have access to inside information,” Foremost-McKesson, Inc. v. Provident Securities Co., 423 U.S. 232, (1976).

Congress enacted § 16(b) of the Act, which provides: Profits from purchase and sale of security within six months. For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer (other than an exempted security) within any period of less than six months, shall be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into such transaction of holding the security purchased or of not repurchasing the security sold for a period exceeding six months.

The general purpose of Congress in enacting § 16(b) is well known. See Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S. 582 (1973). Congress recognized that insiders may have access to information about their corporations not available to the rest of the investing public. By trading on this information, these persons could reap profits at the expense of less well-informed investors. In § 16(b) Congress sought to “curb the evils of insider trading by taking the profits out of a class of transactions in which the possibility of abuse was believed to be intolerably great.” Reliance Electric Co., supra, at 422.

Congress left enforcement of § 16(b) cases to shareholders and to the attorneys who represent the shareholders who consent to be plaintiffs. The SEC was given no role in enforcing section 16(b). As a result, § 16(b) can be enforced, and the market’s integrity can be protected, only if attorneys are willing to invest the time and energy and assume the risk, that is involved in investigating numerous SEC filings in the search to uncover insiders who make improper short-swing profits, and filing lawsuits against those unwilling to return such profits.

As stated by the U.S. Supreme Court: The only textual restrictions on the standing of a party to bring suit under § 16(b) are that the plaintiff must be the “owner of a security” of the “issuer” at the time the suit is “instituted.”

Profits resulting from purchase-and-sale, or sale-and-repurchase, transactions within a period of less than six months are commonly known as “short-swing” transactions. As indicated by the “irrespective of any intention” clause in § 16(b), that section is a strict-liability provision; it “requires the inside, short-swing trader to disgorge all profits realized on all ‘purchases’ and ‘sales’ within the six-month period, without proof of actual abuse of insider information, and without proof of intent to profit on the basis of such information,” Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S. 582 (1973). The Exchange Act recognizes persons acting not individually but in combination with others may accomplish the abuses it targets. 17 C.F.R. § 240.16a-1(a)(1) Section 13(d) of the Act provides, in pertinent part, that when two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a “person” for the purposes of this subsection.

  1. Common law rules. Duties owed to a corporation and its shareholders by corporate insiders at common law. State rules (not federal) related to stock transfer liability.
    1. Sale of controlling shareholders.
      1. Charging a controlling premium is OK.
      2. Controlling shareholders owe a duty not to:
        1. Sell to looters. There must be at least a reasonable investigation into the buyers.
        2. Sell to someone who is only buying to get at a crown jewel corporate asset because shareholders don’t have the power to sell corporate assets.
        3. Sell a board position in exchange for a promise to resign from the board.
        4. Generally, a majority shareholder cannot subject a minority shareholder to detriment.
      3. Common law insider trading.
        1. Minority rule. insiders owe no fiduciary duty to existing shareholders. If there is no duty owed, there is no duty that can be breached.
        2. Majority rule. In a majority of jurisdictions they follow either:
          1. Insiders owe a fiduciary duty to its existing shareholders. If insiders trade on inside information they have breached their fiduciary duty.
          2. Special facts doctrine. Insiders owe a fiduciary duty to disclose special facts to existing shareholders. Special facts are those a reasonable investor would consider important in making an investment decision. Any non-public information that relates to the value of the stock.

Privity. Common law applies to existing shareholders only.

Example: A is a non-shareholder and X enters into a transaction, having inside information that the corporation is about to fail. A has no knowledge of this and the information has not yet been publicly reported. X says, I’d like to sell you my stock. I’m thinking of fleeing the jurisdiction. What do you think? A agrees and purchases. A was not an existing shareholder at the time X sold the stock to A. Under common law X owes no duty to A because there is no privity.

Example: A company is engaged in exploring minerals. The company has a geologist who takes a core sample and says, “This is the richest oil strike the world has ever seen.” The geologist then calls the directors discloses this information. The geologist and directors now have information nobody else has in the entire world. They purchase a large amount of stocks and then subsequently tell the world about their discovery and the stock value shoots up. Traditionally somebody inside a corporation that has knowledge that the market place does not have and they then go to the market place and buys or sells the stocks either to make a profit or to avoid a loss and subsequently the rest of the world finds out. Here, there was no fiduciary relationship, no privity, therefore no duty to disclose. This situation applies to common law rules before federal regulation.

Caveat to avoid and examination trap: The essay will give facts where stocks are changing hands. While the stocks are changing hands, the test taker is ready to discuss Rule 10(b)5 and § 16(b) but then the call of the questions states: Do not discuss any aspects of federal securities law in answering this question. What they are saying is discuss common law, state rules. If common law applies, discuss the aspects of the fiduciary duties owed by corporate insiders. A fiduciary duty is the highest degree of trust and loyalty owed by insiders under the law where an insider goes to the market place and buys or sells stocks with information outsiders do not have. Under common law there must be privity between insiders and shareholders.

Fiduciary duties owed just to the corporation at common law.

The Diamond doctrine. If an insider makes a profit from a transaction by using inside information that profit is a corporate asset. The theory is that the inside information is actually a corporate asset and if anyone should profit from that information, it should be the company.

  1. Rule 10(b)5. Federal securities law. Not part of the 1933 Act, but part of the 1934 Act. One of the examiners favorite testing areas. Rule 10(b)5 related actions cannot be brought in state court. The rule requires:
    1. Interstate commerce. Any instrumentality of interstate commerce (mail, telephone, email, etc. even if the call or email was made intrastate it meets this requirement because the instrumentality is capable of being used interstate) or using one of the national stock exchanges. This gives federal court jurisdiction.
    2. Fraudulent act. An overt act or omission when there is a duty to disclose. Applies to fraud, manipulation, deception, omission or misstatement of a material fact. The actor must be in a trust or fiduciary relationship with the corporation such as an officer, director, shareholder or controlling shareholder.
      1. Insiders or temporary insiders have a duty to disclose or refrain from trading.
      2. Tipping. Passing along material inside information for a wrongful purpose.
      3. Materiality. A fact that a reasonable investor would consider important in making an investment decision.
      4. Scienter. Mere negligence is not enough.
      5. Chiarella. A corporation sent documents to a printing company where two corporations were planning a merger. They left the names of the companies off of the documents because it was confidential inside information and they didn’t want the printer to know of this merger. However, there was a smart printer and as he was going through the documents he was clever enough to know that the balance sheets showed the names of the corporations involved. He knew there would be a merger and had information the rest of the world did not have. He went out and purchased a lot of stock from each company. Action was brought against him for violating Rule 10(b)5 saying he used the facilities of the stock exchange and that the act was non-disclosure of material information. The Supreme Court held there was no violation because he was an outsider, not an employee and did not owe a fiduciary duty and that the corporation had not given him the names, he came up with them on his own. The law is you must be in a trust relationship with the company and be a fiduciary to be liable under the rule.
      6. Causation requirement. The act must have a nexus with the purchase or sale of a security.

Answer approach to Rule 10(b)5 questions. Treat it as two questions.

Has there been a violation of the rule? Analyze the three-part rule.

  1. If yes. There is a violation.
  2. Is there anyone who has standing to sue upon the violation? If the suit is for money damages the person must have been a purchaser or seller of the securities.
  3. If all the person is seeking is an injunction to stop the violation of the rule either the corporation, a shareholder or the SEC can be plaintiffs. Someone who was defrauded not to sell or purchase would not have standing. However, there would be an action in state court for fraud or misrepresentation, but not in federal court because they lack standing under Rule 10(b)5.

Insider trading requires a fiduciary relationship.

Tippers must have an improper purpose.

Tippees are liable if the tipper breached and the tippee knew of that breach.

Misappropriation theory. States that anyone who misappropriates (steals) information from their employer and trades on that information in any stock (not just the employer’s stock) is guilty of insider trading.

Example: if a journalist who worked for Company A learned about the takeover of Company B while performing their work duties and bought stock in Company B, illegal insider trading has occurred if this information was not public knowledge, even though the journalist did not have a fiduciary duty to Company B’s shareholders.

  1. § 16(b) of the Exchange Act. A strict liability rule to prevent short swing profits designed to discourage insiders from making quick transactions.
    1. Applies only to large corporations whose shares are traded on a national securities exchange, or a corporation having 500 or more shareholders with 5 million dollars or more in assets. (In contrast with Rule 10(b)5 that covers all corporations.)
    2. Statutory defendants. There must be an insider who is an officer or director, or a more than 10% shareholder who bought or sold stock within the same six-month period and made a short swing profit.
    3. Remedy. All profits must be returned to the corporation.

Under these facts it’s presumed inside information was used and only the corporation may recover profits the insider made from short swing transactions. The officer or director only needs to have held the position during one of the transactions.

Example: A buys shares with no ties to the corporation. One month later A is elected as a director. One month later A sells the stock. Assuming the corporation is larger enough and all other rules fit, A is liable.

Example: A more than 10% shareholder that person must have held the position immediately prior to both the purchase and the sale to be liable under § 16(b). The percentage requirement does not apply to a director.

The order of the transaction doesn’t matter. The order of transactions can be reversed to produce a profit. Match the highest selling price to the lowest selling price.

Example: Prior to the transaction the director owned no stock in the corporation. First, the director purchases stock at 5.00 a share. Next, within that 6-month period, the director sells the stocks at 4.00 a share taking a loss. Then the director purchases those stocks back at 3.00 a share. The rule would say there was a purchase at 3.00 and a sale at 4.00 at a profit of 1.00 a share. The corporation would have standing to recover the profit.

IV. Operation and management of a corporation. The  most tested area.

  1. Promoters. People who set up a corporation and raise money before it comes into existence. The corporation is never liable for acts of the promoter prior to its formation. For a corporation to be liable for promoter actions, it must adopt (novation), what existed between the promoter and the third party. Adoption is implied if the corporation accepts any benefits of a contract.

Examiners will use language like “A person acting on behalf of a corporation not yet formed.” Are the promoters doing something causing themselves to be personally liable?

  1. Promoter liability.
    1. If a binding contract is formed between a promoter and a third party, prior to the corporation being formed the promoter is personally liable.
    2. Promoters cannot make a secret profit on their dealings with a corporation.
    3. A promoter may have transactions with another promoter of the same corporation. However, both are fiduciaries to each other. If they breach that duty they are liable for damages.
    4. If the promoter was only in discussions or negotiations there is no liability.
    5. If an offer has been made but not yet been accepted? There is no liability.
    6. Promoter transactions with the now formed corporation.

Is the corporation liable for the acts of the promoter? Has the promoter done something to cause the corporation to be held liable?

  1. A promoter is a fiduciary to the corporation. However, they may also make a profit.
  2. Promoters have the duty to disclose any transaction and it must be fair. If a profit is disclosed and fair there is no breach. If a profit is not disclosed or unfair there is a breach of fiduciary duty.
  3. Promoters remain personally liable unless the contract has a novation or substitution for a new third party, which is the corporation. Under such circumstances the promoter’s duties will be discharged. If there is no novation and the corporation takes some kind of benefit, both the promoter and corporation will be held liable.
  4. Remedy is damages.


if promoters buys all stock in the company back for themselves the breach is cured. However, promoters have a special duty to disclose to any subsequent shareholders until they no longer own any shares in the corporation.

Caveat. If stocks are changing hands discuss common law, Rule 10(b)5 and § 16(b).

  1. Shareholders. Own the corporation, but don’t manage it.  The only voice in management shareholders have is the right to vote for directors and fundamental corporate changes. On most exams shareholders are abused by a controlling shareholder or the director
    1. Voter meetings.
      1. Unanimous written consent. There is no meeting requirement. However, voting has to be unanimous and in writing.
      2. Annual meeting. There is an annual meeting to elect the directors.

Special meetings are called by the board of directors, the president or 10% or more voting shareholders, or anyone else that is designated in the bylaws. The meeting must be for a proper purpose. There is a notice requirement of no more than 50 or less than 10 days for special meetings. If this requirement is not met, all the actions at the special meeting are voidable unless shareholders waive this requirement.

How may shareholders attend these meeting?

  1. Proxies. Shareholders may attend meeting personally, or by sending someone to vote in their place. These are known as proxies.
    1. To be valid it must be in writing and signed. Proxies expire by statute in eleven months unless otherwise stated.
    2. Proxies are revocable unless they are coupled with an interest.

Example: Shareholder A gives individual B a proxy. Individual B went to the shareholder meeting, listened to the discussion and was all set to vote and just prior to the vote A showed up and said, “Hi, I’m A.” That act alone revoked the proxy. Just showing up and stating that he is there is enough to revoke the proxy.

  1. Irrevocable proxy coupled with an interest. An irrevocable proxy is where a vote has been bought. Some form of consideration related to that stock has been given to get that proxy.
  2. Voting mechanism. How shareholders vote. Examiners favorite area.

Example: Shareholder A owns 51 shares of stock. Shareholder B owns 49 shares of stock. There are 3 directors to be elected and no other shareholders in this corporation.

The rule: The number of votes is equal to the number of shares owned multiplied by the number of directors to be elected. A has a total of 153 votes. B has 147 votes. They’re at the annual meeting and ready to elect directors. A nominates 3 people. B nominates 3 people. They each nominate 3 different people for the directorships. The 3 names with the highest vote wins. The votes are cast. Two methods used:

  1. Straight voting. A shareholder may not cast for any one candidate a number of votes greater than the number of shares owned.

Example: A casts 51 votes for each of his 3 candidates. B casts 49 votes for each of his 3 candidates. The numerical majority shareholder A would elect the entire board of directors. A would win in all 3 cases by casting 51 to 49 votes.

  1. Cumulative voting. The purpose is to make it easier for a significant minority shareholders to get at least one representative on the board. Here, the difference from straight voting is that a shareholder may cast all their votes for one candidate.

Example: A has a total of 153 votes. B has a total of 147 votes. Each may cast all their votes for any one candidate. B casts all votes for candidate 4. A casts 148 votes for candidate 1 with 5 votes remaining for candidate number 2. A votes two directors on the board and B has elected one.

How much voting power is necessary to elect one director?
Formula: 100/X(the number of representatives to be elected)+1 = the percent of votes required to elect one director.

Example: Three-member board. 100/(3+1) = 100/4 = 25+1=26. 26% would be the number of percentage stock required to elect one director to a three-person board.

Example: Nine-member board. 100/(9+1) = 100/10 = 10 +1 + 11%. 11% of the voting stock would be required to elect one director if there is a nine-person board.

How is this tested?

Staggering of director elections.

Example: Corporation is electing directors and is using cumulative voting. The corporation will do something that mimics cumulative voting. That something is called staggering of director elections. Staggering is a device that has the effect of defeating cumulative voting.

A corporation with a nine person board of directors, and we know from the formula that 11% of the voting stock will guarantee the election of one of the nine directors. X is a shareholder of the corporation who owns 12% of the stock. Every year X shows up at the annual meeting and elects himself as a director. X is the minority elected director. The other directors don’t like X, because he makes them do things like complying with the law. They want him off the board, but there is nothing they can do as long as they elect nine directors at every annual meeting. As long as X owns 12% of the stock they are stuck with X. Now, rather than electing all nine directors at each annual meeting for a one year term, they now stagger the elections and only elect three directors each year for a three-year term. There is still a nine-member board, but only three are elected each year. With only three elected each year, the number goes up to 26%. Now X doesn’t have enough voting power to elect himself and the board has denied X any benefit from cumulative voting.

For this reason staggering of director voting is suspect. Meaning that if someone challenges it in court, the corporation has the burden to prove that there is a valid business purpose other than by diluting the minority the benefits of cumulative voting.

Valid business purpose.

Example: The corporation could show that it was causing too much trouble to elect all nine new directors each year. The corporation wanted some continuity on the board and problems arose when the entire board was removed each year. So, if the board can convince the court that there was a valid business purpose for staggering other denying the benefit of cumulative voting then staggering elections would be proper.

  1. Shareholder inspection rights. Shareholders have a right to inspect the books and records of the corporation. Shareholder have no right to inspect the physical plant and have only a limited right to inspect the share register, which is the names and addresses of all the shareholders. Who can make an inspection demand?
    1. Common law. One who owns stock at least six months or 5% or more outstanding shares.
    2. Modern view. Any shareholder.
    3. Proper purpose. To inspect there must be a written demand and a proper purpose related to the economic status to the shareholder.

Example: X shareholder wants to start a competing business and to gain access to the list of the companies customers. Does this purpose relate to X’s economic status? Yes, as a competitor not a shareholder. X shareholder would not have a proper purpose to gain access to the companies customers.

Example: X shareholder wants to inspect the books and records because their company makes phosphorous grenades that he doesn’t like and thinks they are inhuman. X shareholder wants to inspect the records and books to communicate with other shareholders and tell him of his outrage as to what this corporation does. Does this purpose relate to X’s status as a shareholder? Yes, but not to their economic status. So the conclusion is that this is an improper purpose.

  1. In some states, by statute if a shareholder owns 5-10% of the voting stock they automatically get to inspect without having to prove proper purpose.
  2. If the inspection is wrongfully denied the remedy is damages imposed by way of fine and court ordered supervised inspection.
  3. Courts may also threaten with contempt.
  4. Shareholder agreements. The ways shareholders attempt to control their conduct. Examiners cannot hide shareholder agreements, they must say shareholder agreements and there is only one testable issue. Is the agreement valid? If so, it is enforceable.

Shareholder agreements to control voting.

  1. Pooling agreement. Voters combine their interests to have more power in decision-making than as mere individuals.

Example: X corporation has three board of directors and three shareholders, each having 10% of the voting stock. It would take 26% of the voting stock to elect one director. Therefore, one 10% voter is not a political force. However, if they pool their interest and agree to always vote as a 30% block they can vote someone onto the board and be a political force within the corporation.

  1. Voting trust. The most formal type of shareholder agreement. In order for a voting trust to be valid, it must:
    1. Be in writing.
    2. On file in the corporation for inspection.
    3. Legal title of shares must be transferred to a voting trustee.
    4. By statute voting trusts expire in 10 years.

To be valid a pooling agreement or voting trust must be within the shareholders sphere of authority. If it interferes within the director’s sphere of authority it is invalid including:

  1. Directors declare dividends.
  2. Directors appoint officers.
  3. Shareholders elect directors.

Example: A voting agreement that says, “We the undersigned always agree to elect Palmer as the director of the corporation” this is a valid shareholder sphere of authority.

If the shareholder function intrudes into the director’s functions it is not valid and not enforceable.

If the agreement says, “And we will always vote our stock to assure that Palmer is always voted as corporate president,” or “A two dollar per share dividend is paid.” Those are not shareholder functions, those are director functions and would be invalid.

Exception. Closely held corporations. If all of the shareholders sign the agreement and all the directors are also shareholders then sphere of authority does not matter.

  1. Stock transfer restriction agreements. These are agreements that attempt to keep stocks in the family. Shareholders have agreed that they don’t want anyone to sell stocks to an outsider without their consent, or when a shareholder dies, the remaining shareholders don’t want to deal with their spouse or child. How can they restrict a shareholders ability to transfer their stocks in life or at death?

Majority rule. Are the restrictions reasonable? If the restrictions are absolute, they are unreasonable and unenforceable. The following is an absolute example that is unreasonable.

Example: All of the undersigned shareholders agree we will never sell our stock without prior written consent of all the other shareholders.

  1. Right of first refusal/first person purchase option. An agreement that states, if a shareholder wants to sell their shares, or if they die and their estate wants to transfer it to their heirs, the corporation is given the first option to purchase the stock for a stated period of time. A reasonable time such as 60 or 90 days. And if the corporation does not exercise this option the estate is free to transfer the stocks.
  2. Derivative suits. A lawsuit brought by a shareholder on behalf of a corporation against a third party. Often the third party is an insider such as an officer or director. Shareholder derivative suits are unique because under traditional corporate law, management is responsible for bringing and defending the corporation against suit. Shareholder derivative suits permit a shareholder to initiate a suit when management has failed to do so.

Procedural requirements:

  1. Must be enforcing the corporation’s rights.
  2. A shareholder at the time the suit was brought and throughout litigation.
  3. Make a prior demand on the board of directors unless it would be futile. The requirement often most tested.

If the shareholders make the demand and the directors in good faith decide that the lawsuit should not be brought. This would be a total bar to a derivative suit. However, shareholders always claim futility.

Example: A shareholder is exercising their shareholder rights and detected that directors are shoveling the assets of the corporation into U-Haul vans to flee the jurisdiction. Here, there is no point in demanding the directors to cause the corporation to sue. They would be suing themselves and an example of futility demand.

Some states require a bond to be posted to inhibit frivolous derivative suits.

If the suit is successful shareholders are reimbursed costs. The rest goes to the corporation. If the shareholder loses they may be liable for directors costs and attorney’s fees if the suit is shown to have been brought for an unreasonable purpose.

  1. Controlling shareholders. A controlling shareholder is one who owns enough voting stock to elect a majority of the board of directors. They must refrain from obtaining a special advantage or to cause the corporation to take an advantage that prejudices the rights of a minority shareholder.

A general shareholder may indulge in selfishness. They can vote for their own interest. However, a controlling shareholder is a fiduciary to the corporation and to its other shareholders. As a fiduciary they may not take any action that is to their own benefit, to the detriment of the corporation and other shareholders. Most breaches of fiduciary duties require breach of these two elements. Simply deriving a benefit is enough to breach a duty.

  1. Numerical control. Own more than half the voting stock and they will always be able to elect at least the majority of the board.
  2. Working control. It’s possible to be a controlling shareholder owning less than half the voting stock.

Example: A significant shareholder who owns less than half, but owns a 35% significant block of stock. The other shareholders are so numerous and spread out that they never get together for concerted action. They don’t attend meetings and don’t send their proxies. In such a setting a significant shareholder usually has enough voting power to elect a majority of the board at the annual meeting. Once a person is labeled a controlling shareholder either by numerical or by working, a special responsibility is imposed on them.

  1. Managing shareholders. Applies only to non-publicly traded corporations with only a few shareholders.
    1. A close corporation that vote not to have a board of directors, instead it’s managed by shareholders.
    2. The shareholders have a fiduciary duty and a duty of care and loyalty to each other.
    3. Dividends.
      1. Shareholders have no right to dividends. This is a director’s discretion.
      2. Irrevocable once declared.
      3. Insolvency exception. Payable out of:
        1. Earned surplus (net profits) always.
        2. Stated capital (par value of issued stock) never.
        3. Capital surplus (amount over stated capital form stock sales) permissible if the shareholders are told that is where the money is coming from.
        4. Nimble dividend rule. Paid out of current earnings when business has a net loss for the year (the business is on the upswing, but not yet there).
        5. A corporation cannot make a dividend if it is insolvent or would become insolvent because of the payout.
        6. Directors are personally liable for unlawful distributions. Shareholders that knew are personally liable as well.
        7. Preemptive rights. The right of existing shareholder to maintain their % ownership when new stock is issued. If a shareholder has a 20% stake and a secondary offering is made, they have a right to buy 20% of it. Applies to:
          1. Newly authorized stock.
          2. Stocks sold for cash.

If preemptive rights are not mentioned in the articles:

Traditional rule. Preemptive rights exist unless articles say otherwise.

Modern trend. Preemptive rights do not exist unless article provides for them.

  1. Directors. The most tested area on the bar. A board of directors is a body of elected members who jointly oversee the business activities of a corporation. Their activities are determined by the powers, duties, and responsibilities delegated to them in the bylaws. The bylaws commonly specify the number of board members, how they’re chosen and when they must meet. In an organization with voting members, the board acts on behalf of and is subordinate to the shareholders, which choose the board members.

Typical duties of boards of directors include:

  1. Establishing policies and objectives.
  2. Selecting, appointing, supporting and reviewing officers.
  3. Ensuring the availability of adequate financial resources.
  4. Approving annual budgets.
  5. Accounting to shareholders for the corporation’s performance.

Theoretically, company control is divided between the board of directors and shareholders that attend general meetings and voting on corporate issues. In practice, the amount of power exercised by the board varies with the type of company. In private companies, the directors and shareholders are normally the same people and as a result there is no real division of power. In large public companies, the board tends to exercise more of a supervisory role and individual responsibility and management is delegated downward to individual professional executive directors (such as a finance director or a marketing director) who deal with particular areas of the company’s affairs.

Another feature of boards of directors in large public companies is that the board tends to have more de facto power. The board can comprise a voting bloc that is difficult to overcome, because shareholders elect proxies to the board who represent their voting power at general meetings.


A board of directors is a group of people elected by shareholders that are given decision-making responsibilities. Directors are individual members within the board. Directors can be owners, managers, or any other individual elected by the shareholders. Directors who are owners and/or managers are referred to as insiders or interested directors. Directors who are not owners or managers are referred to as outside or disinterested directors.

The appointment and removal of directors is voted upon by shareholders in general meeting or through a proxy statement. Nominations occur at the general meeting or through the process of mailing out ballots separately. In practice for publicly traded companies, the managers (inside directors) who are accountable to the board of directors have historically played a major role in selecting and nominating the directors who are voted on by the shareholders.

  1. Election. Shareholders elect directors with a majority vote through straight or cumulative voting. There are no requirements to be a director. However, bylaws may add qualifications such as being a shareholder or residing where the corporation has its principle place of business. Directors may be removed with our without cause before their term expires. There are no minimum or maximum number of directors. However, most states have a three-person board.
  2. Director authority and powers. Directors are charged with the duty and responsibility to manage the business and affairs of the corporation. The exercise by the board of directors of its powers usually occurs at board meetings. A quorum must be present before any business may be conducted. A failure to give notice may negate resolutions passed, on the rational that a persuasive minority of directors might have persuaded the majority to change their minds and vote otherwise. At common law the powers of the board are vested in the board as a whole and not to individual directors. However, an individual director may still bind the company by their acts by virtue of their ostensible authority.
  3. Effective board action. Directors don’t have the authority to act alone.  When they act they must do so as a board. An individual signing a contract on behalf of the corporation does not bind it. When a board acts it must act as a quorum, which is a majority of directors that are present to case a vote at a meeting. Unanimous written consent is required. No meeting is actually necessary. Conference calls are permissible. If there is a quorum and anyone walks out of the meeting there is no quorum and no further action can be taken.

Modernly voting agreements and proxies are not allowed for directors. Example: Nine members of a board get proper notice to attend a meeting, but only five show up. Five is a majority of nine. There is a quorum, the board may conduct business. Three of the five may vote to pass a corporate resolution. If all nine showed up five votes would be needed to pass a resolution.

It’s permissible for the bylaws to change the voting scheme. Bylaws could require all directors present to be a quorum.

  1. Removal.
    1. Court removal. Courts may only remove a director for fraud or gross abuse of discretion.
    2. Straight voting removal. A majority vote of shareholders is required to remove a director with or without cause.
    3. Cumulative voting removal of the entire board. A majority vote of shareholders is required to remove a board with or without cause.
    4. Reverse cumulative voting. This applies to removal of less than the entire board. If allowed the minority shareholders would vote a director in on day one and on day two the majority shareholders would vote them out. To protect cumulative voting there is a special removal process of less than the entire board.


  1. Identify the minimum percentage of voting stock necessary to elect one director. (26% if it is a three director board, 11% if it is a nine-member board.)
  2. If the number of votes cast against removal is sufficient to elect that director by cumulative voting then the director would not be removed.
  3. Example: Shareholders are seeking to remove one of nine directors elected by cumulative voting. 88% of the voting stock votes would be required to remove this person. But 12% are cast against removing the person. Result: They are not removed since 12% would have been sufficient to elect that director by cumulative voting.
  4. Director duties. Directors exercise control and management over a corporation, but is operated for the benefit of shareholders. The duties imposed on directors are fiduciary duties, similar to those that the law imposes on those in similar positions of trustees that over see a trust for the beneficiary. The duties apply to each director separately, while the powers apply to the board jointly. The duties are owed to the corporation, not to any other entity. As fiduciaries, the directors may not put themselves in a position where their interests and duties conflict with the duties that they owe to the company. The law takes the view that good faith must not only be done, but must be manifestly seen to be done, and zealously patrols the conduct of directors in this regard; and will not allow directors to escape liability by asserting that his decision was in fact well founded.

Ultra vires. Directors may not cause a corporation to do ultra vires acts. The responsible directors and officers are held personally liable.

Loans. A corporation may not make improper loans to directors or officers. Banned under Sarbanes-Oxley for public companies.

Common law conflict of duties. Traditionally, the law has divided conflicts of duty and interest into three areas.

  1. Transactions with the company. When a director enters into a transaction with a company, there is a conflict between the director’s interest (to do well for himself) and his duty to the company (to ensure the company gets as much as it can out of the transaction). This rule is strictly enforced that, even where the conflict of interests is purely hypothetical, the directors can be forced to disgorge all personal gains arising from it.
  2. Competing with the company. Directors cannot compete directly with the company without a conflict of interest arising. Similarly, they should not act as directors of competing companies, as their duties to each company would conflict with each other.

Modernly a director may engage in unrelated business so long as there is no conflict of interest.

Remedies if the director is found to be competing against the corporation is a court ordered constructive trust, profits made turned over to the corporation and possibly damages.

  1. Common law duties of care and skill. Traditionally, a director need not exhibit a greater degree of skill than may reasonably be expected from a person of their knowledge and experience. Remedies for breach of duty:
    1. Injunction or declaration.
    2. Damages or compensation.
    3. Restoration of the company’s property.
    4. Rescission of the relevant contract.
    5. Account of profits.
    6. Summary dismissal.
    7. Stock transfer liability.
      1. Special facts doctrine. At common law a corporate officer with superior knowledge gained by virtue of being an insider owes a fiduciary duty to a shareholder in transactions involving transfer of stock. If a director even showed up at a meeting the remedy was rescission.
      2. Modernly the majority rule is that it is OK for an interested director to participate at meetings and be counted as part of the quorum. Remedies. Rescission, damages or both.

Defenses to avoid rescission. An interested director must disclose their interest to other directors and the disinterested directors must approve.

Example: I bought this property for 30k and will sell it to the corporation for 50k and I will make a 20k profit on the transaction. If the disinterested directors approve it, that will save the transaction from being rescinded.

  1. Disclosure to shareholders with approval. The transaction must be fair. Used when directors or shareholders will not approve. A last resort for the courts. “it’s fair and this is why.”

Remedy is damages or injunction or both.

Example: The director is diverting customers or employees from the corporation over to his own business.

  1. Corporate opportunity doctrine. An opportunity the corporation might reasonably be interested in. Before taking the opportunity the director must tell the corporation about it and wait for the corporation to reject it. A corporate opportunity must be related to the corporation’s line of business. The corporation must be able to afford the opportunity if not, a director is free to take it without any repercussions.

Example: A business opportunity for the corporation exists, but the directed diverts it for their own benefit.


  1. The corporation can recover profits from the director.
  2. Damages.
  3. A court may impose a constructive trust.
  4. Recover the opportunity at cost and reimburse director’s cost.
  5. Duty of loyalty. In corporation law a fiduciary duty exists where there is a conflict of interest that requires a director to put the corporation’s interest above their own. Directors breach this duty when they divert corporate assets, opportunities or information for personal gain. The burden is on the director to show they acted in good faith and with a reasonable belief that what they did was in the corporation’s best interest. Applies to insider trading, selling out, executive compensation and usurping a corporate opportunity.

Example: A director is individually acting and profiting while the board is not.

Self-dealing may be a breach of loyalty, but is permissible if it is objectively fair and proved after full disclosure of material facts by a majority of disinterested directors or a majority of shareholders.

  1. Duty of care. Tests competence in office. A legal duty that requires a board of directors to adhere to a prudent person standard while performing acts that could foreseeably harm the corporation. The standard applies to a board of directors acting as a whole. If the board has caused a corporation to lose profits, but acted in good faith, the board is not automatically liable. Strict liability does not apply because directors are not insurers of corporate profits. Even if the director’s conduct has fallen below the prudent person standard, or violated the business judgment rule, they have defenses, cures or remedies before being liable for damages.

Example: Acting as a board, it passed a resolution and the corporation lost money. If no individual director transaction has occurred and the board can show they acted as a prudent person, the board will not be liable for corporate losses under the business judgment rule.

  1. Prudent person standard. A corporate board must act as they would when dealing with their own business affairs.


Business judgment rule. Courts will not second-guess a business decision if it was made in good faith, was informed and has a rational basis. Does not apply to inaction. This rule determines a director’s duty of care. If the following elements are satisfied a director is not liable:

  1. Directors act in good faith.
  2. They’re acts were not negligent.
  3. The acts are in the corporation’s best interest.

Remedies. If there’s a transaction directors are concerned about they may submit it to shareholders and let them unanimously ratify the action. Here, there is no breach of duty of care.

Defense. Blame somebody else.

Example: A director says they don’t know much about corporate accounting so they brought in an accountant to research whether or not to pay a 2.00 a share dividend to shareholders. The accountant reviewed the books and records and an opinion letter was written that said its proper to do so. It turns out the accountant was wrong. As a result, the directors would not be liable if they can show in good faith, that they relied on the non-negligently selected experts to make that determination.

  1. Director liabilities. A director is presumed to have concurred with the board of director’s action unless they dissent or absence is recorded, in writing, in the corporate records. If there is a violation what director is liable? A director can defend against liability by showing a good faith reliance on:
    1. Book value of assets.
    2. Opinion of competent employees or experts.
    3. Financial statements by auditors.
    4. Indemnification. The corporation must reimburse a director who is sued for damaging the corporation, but the director wins. A corporation can choose to indemnify in any situation, as long as the director has acted in good faith and with a reasonable belief their acts were in the company’s best interest.


  1. Director who receive an improper benefit.
  2. Breach of duty, loyalty or intentional misconduct.
  1. Duties of corporate officers. These are the people appointed by the director that owe a duty of loyalty in managing the corporation. They are agents of the corporation who have authority to bind it through their acts. Officers are selected and removed by directors never the shareholders.


Close corporations. There doesn’t have to be a board of directors. Shareholders may unanimously agree to shareholder management.

Managing shareholders owe a duty of care and a duty of loyalty to each other.

  1. In most states corporations need a president or CEO, vice president, treasurer and a secretary.
  2. Multiple offices are permitted. It’s not required to have multiple people fill these offices. Many states prohibit the same person from being the secretary and president.
  3. There are no minimum or maximum amounts of officers.
  4. There must be recognition as to what capacity a person is acting because officers are both agents and employees of the corporation.
  5. Respondeat superior. If an officer is acting within the scope of their employment and commits a tort or breach of contract, the corporation is going to be held liable under respondeat superior. On the other hand a director cannot act as an individual and bind the corporation. But an officer acting within the scope of their authority, and they sign a contract for that corporation they bind it to the terms of the contract.
  1. V. Fundamental corporate changes to the power structure. A corporation comes into existence, merges or consolidates with another corporation and/or ceases to exist.

Standard approval procedures. To approve a fundamental change the board must pass a resolution.

Shareholders must vote to approve the resolution by a special vote. Each class must approve the transaction by a 2/3 majority in most states.

The corporation then must file the papers and pay the appropriate fees to the state.

  1. Mergers. When a survivor corporation is absorbing a target corporation.
    1. Approval. Directors and shareholders of both corporations must approve a merger. Exception. A short-form merger where a parent wit a 90% share absorbs a subsidiary.

Example: A corporation is going to merge with B corporation. When they are done the name and identity of corporation A is the only name that survives.

  1. Distinguished from consolidation. A consolidation is where all corporations that was merged ceases to exist as a separate and identifiable entity.

Example: A corporation and B corporation merge and when they are done, neither exists, but a new corporation C Corporation is formed.

  1. Short form merger. Arises when there is a parent and subsidiary relation. One is the controlling shareholder of the other. The controlling shareholder is the parent. The controlled corporation is the subsidiary. When a parent has super control (at least 85% of the voting stock) to merge all that is needed is approval of the parent’s board of directors.
  2. Disgruntled shareholder who doesn’t want to participate in a merger or consolidation.

Example: A corporation is merging into B Corporation. C shareholder of corporation B, the target doesn’t want to be involved, even though everyone else has approved the merger/consolidation.

  1. A dissenting shareholder must submit a written objection before the meeting.
  2. Abstain or vote against the merger.
  3. After the vote file a written claim for appraisal. The corporation has no choice, it must appraise the value of the shareholders stock and exchange the stock value for cash.
  1. Sale of assets or share exchange. Sale or exchange of substantially all business assets that are outside of the normal course of business.
    1. Triggers appraisal rights for minority shareholders.
    2. Majority of the board of directors and majority shareholders must approve.
    3. De facto merger. If it’s a disguised merger, the minority shareholder may be entitled to rescission or appraisal rights.
  1. Amendments to the articles of incorporation or bylaws. Changing the corporate rules. A corporation may subsequently change anything in the articles as long as it follows the standard approval procedures.
    1. There are no appraisal rights.
    2. To amend the board of directors must give notice to shareholders with a majority of approval.
    3. The board of directors may amend or appeal the bylaws unless the articles exclusively reserve the power to shareholders.

Examples. Changing the corporation’s name, authorizing new stocks, expanding or extracting the corporate purpose, add or delete preemptive rights.

  1. Dissolution and liquidation. Dissolving the corporation. Is the dissolution voluntary or involuntary?
    1. Voluntary. The corporation that chooses to cease to exist must follow the standard approval procedure.
      1. A majority of directors and a majority of shareholders must approve.
      2. Shareholders can petition the courts for dissolution because of:
        1. Director abuse.
        2. Waste of assets or misconduct.
        3. Director deadlock that harms the company.
        4. Shareholder deadlock and failure for at least two annual meetings to fill a vacant board position.
        5. Creditors can petition if a corporation is insolvent.
      3. Involuntary. The corporation is dissolved against its will if fees are not paid, reports are not filed, fraud or dissention exists, there is deadlock, or gross mismanagement. Arises where the courts do it. The courts have broad equitable power to dissolve a corporation and when they do so they do it usually in a situation where there is a deadlock in an even number board. If a deadlock occurs and it’s hurting the corporation, directors or shareholders that own 1/3 or more of the voting stock may ask the courts to dissolve the corporation. Whether the corporation has voluntary or involuntarily dissolved it is at this point assets begin to be liquidated.
      4. Liquidation. The gathering in of all the corporate assets and their appropriate distribution. Who gets paid and in what order?
        1. Governments. Federal and state claims get paid first.
        2. Creditors. Secured creditors have priority over unsecured creditors. (Rarely when a corporation is in dissolution will the corporation get to creditors.)
        3. Shareholders. Shareholders with preferred stock get paid first. (Those who have a liquidation preference.) General shareholders get paid last.

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  1. #1 by JV on December 25, 2017 - 11:36 am

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