October 1, 1999
How the board exercises power to manage affairs – usually by passing a resolution
A meeting is the starting point
Ways to get around notice:
- waiver of notice
- consent after the meeting
- to appear at the meeting and not object to the lack of notice
- unanimous written consent (avoids a meeting altogether); each member of the board signs off
Section 212 says number of directors
Section 307 – need a quorum; majority of the authorized board forms a quorum unless it is altered; cannot be reduced to less than one third; can also get someone to participate by telephone for quorum purposes
Can have committees appointed by board as a whole (majority) that have at least two board members on them and can carry on any business as if they were the full board
Preemptive rights – closely hold corporations, have to worry about someone getting voting control
1.. go to other partners and try to buy their shares; or if they refuse to sell
2.. somehow issue new, additional shares to the person that wants control
States usually take one of three approaches to grants of preemptive rights:
1.. the grant of rights is mandatory
2.. preemptive rights are granted unless the corporate charter provides to the contrary (opt-out provision)
3.. the rights are granted only if the corporate charter elects them (opt-in provisions)
In most closely held corporations preemptive rights should not only be preserved; they should be extended and strengthened.
In the absence of a statute or charter provision denying preemptive rights, such rights are conferred on shareholders by common law.
Hard to know which type of stocks the preemptive rights give.
- in public held companies there almost never are preemptive rights
An area the gives difficulty is when a company gives out stock options to employees. This distorts the balance of percentage of ownership for voting purposes. Stock options have not been unformily recognized as an exception to preemptive rights.
Katzowitz v. Sidler
Three people in a corporation. They wanted to get rid of one of the partners.
October 4, 1999
Exception to the preemptive rights doctrine: corporation can purchase some property for shares; this will mess things up (the balance of control)
If you choose to have preemptive rights, they must be placed in the articles of incorporation
How would a shareholder stop a company from instiuting a policy of preemptive rights?
Katzowitz v. Sidler (page 198) – review of problem in this case
The company was selling shares at below market price. The effect was to dilute the power of the existing shares.
1/1/93 – issue 3 shares at $1,000 per share (three shares now, total value $3,000)
12/3/97 – due to earnings (total corporation is now worth $30,000; each of the 3 shares is now worth $10,000)
1/1/98 – need additional capital; under preemptive rights each of 3 shareholders is offered 1 additional share at $5,000 per share
a.. if all participate there would be a new injection of $15,000 total (now there would be 6 shares of stock outstanding, and the total value would not be $45,000; each share would be worth $7,500)
b.. IF only 2 of the shareholders participated, then the new injection of capital would be only $10,000; total value of the corporation would now be $40,000; five shares outstanding, each share then would be worth $8,000; if this happened, the third shareholder would be diluted from $10,000 to $8,000 by doing nothing. His value is significantly decreased by the actions of the other shareholders.
In CA you cannot wipe out a super majority (902(e); if there is a super majority, in order to amend the articles to do away with that provision, you need the same super majority type of vote.
204(a)(8) – shareholders can reserve unto themselves the right for consideration that is supposed to be received against which shares are issued. The shareholders have this right as opposed to the board
NEW TOPIC: cumulative voting
- did not exist at common law
- when someone is elected as director of the corporation they act as a supervisor for all of the shareholders; consequently, under English view, we are not going to look to the body of the shareholders for the best interest.
- In USA we do not takes this view
USA VIEW: recognize that not all of the shareholders want the same thing; there might be different groups that want the company run for different reasons in different ways; may be a particular stance on a particular issue that a certain number, but not all that shareholders will take. Theory is that the directors will take the position of a particular constituency, particularly if those shareholders elected him.
How does this work? EXAMPLE:
Have 1,000 shares; BOD with 9 directors
This is an example ballot for 9 directors (pick from 18 in this example)
2 4,500 votes here
15 4,500 votes here
So if a person has 1,000 shares to vote for 9 people, this is 1,000 shares per person for a total of 9,000 votes. So the idea is, you can split your 9,000 votes between the candidates; give all to one or half to one, half to the other, etc…
- person with the shares has the power to spread their votes around
- makes it easier for a minority to get some representation on the board of directors
only elect a few members of the board at one time. This is in order to retain continuity on the BOD.
- usually divide a 9 board in to 3 panels of 3 directors each; elected with a 3 year term; on alternate years. HOW would this effect cumulative voting? It would decrease the power of the minority shareholder.
October 6, 1999
Control Devices (other than one share, one vote)
- cumulative voting
- voting trust
- class voting
- non voting shares
- shareholder voting agreements
- irrevocable proxies
- super majorities
- restrictions on transfer
- shareholder agreements
CA rules on cumulative voting: it is okay. There are minimums though. If you want to break up the board into panels voted on at different times you have to have all directors on that panel voted on at the same time. Section 300 says all directors shall be elected for one year. This was the law for a long time. But now you can get around this: 301.5 was added.
3 person board
shareholders are A, B, C; also are on BOD
A – 400 shares
B – 400 shares
C – 200 shares
C wants to know if A and B can keep C off the BOD
A and B have 2400 votes between them (3 * 800)
C has 600 votes
Since they have so many votes, they WILL be able to keep C off the board.
Now C has 300 shares, so he has 900 shares
C can now put all his shares (900) on one candidate, but since A, B only have 2400 they could not put enough votes between three candidates to keep him off.
Expanding the board makes it easier for a minority to get a seat on the board
Now it is a 5 person board
A, B – 4,000 votes between them now
(C has 200 shares) C – 1,000 votes total
For five candidates, it is not possible for A and B to put more than 1000 votes on each candidate, so the minority would be able to assure itself a spot on the board
Section 303 – if you want to get rid of less than all of the shareholders there is a problem; the majority could just easily remove directors; in order to save a director that was voted in by cumulative voting, that director has been protected; if there are votes against the removal that would have been sufficient to get that director in, then the director cannot be removed
Trust – a mechanism that came out of English law; device whereby property that belongs to someone is put in the hands of someone else on the agreement that the person (trustee) will deal with the property in a certain way. The trustee is supposed to look out for the best interests of the trustor.
Voting trust – an arrangement whereby the owners of stock transfer the title ownership to a trustee; the trustee agrees to do something with the stock; the trustee gets the right to vote the stock; as far as the corporation is concerned, the trustee is the real owner of the shares; the corporation pays dividends to the trustee; separates the voting power from the stock
A.. the document usually provides that all the other rights of ownership remain with the person that put the stock in trust
- therefore if a dividend is paid, the trustee is obligated to pay that out to the true owner
B.. reasons people would want to use a voting trust:
1.. if a minor owns stock;
2.. lending arrangements: if the creditor lends money, he can have some control
over the company. TWA example: bank loaned company $100 million, in exchange for the majority of the shares in a voting trust with the bank as trustee
a.. part of the problem is how do you pay the bank back and then get the voting rights back? Here the bank wanted to keep control even after it got its money back
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October 8, 1999
Voting trusts (§ 706B) - limits duration to 10 years, but can be renewed
- self executing
- once voting power transferred to the trustee, there is no question that it is the trustee that has the right to vote
How do you use stock to skew control of the company
1.. can you have non-voting stock?
a.. yes, provided there is at least one class of stock that is voting
2.. can control be skewed by assigning a certain number of directors to a class of stock
3.. approval of outstanding shares (§ 152) - what happens when you have certain types of shares that cannot be permitted without approval of a certain class
Shareholding voting agreement -contract between two or more shareholders that they are going to vote their shares in a certain way; as a block. Whatever the parties agree to.
A.. policy - ought this be permitted?
1.. there are clearly problems about whether these ought to be enforcible; they are destructive in a certain sense of the democratic process
2.. on the other hand, people argue that they are MY shares and I can do what I want with them. This is the overwhelming majority view today.
1.. A has 40 shares
2.. B has 20 shares
3.. C has 40 shares
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October 13, 1999
More about proxy
If the agency is coupled with an interest, the agency is no longer terminable, it becomes irrevocable.
When is an agency coupled with an interest?
- when you have extended credit; security interest in the company for repayment of the loan
When determining if a proxy is irrevocable it is best to think about for whose benefit the proxy has been given.
- it is the proxy been given for the benefit of the agent; in this case, then the proxy should be irrevocable
next area is restrictions on transferability of shares
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October 15, 1999
Control devices continued
Irrevocable proxies - basic principle is that the principle can always terminate the agency, but there are exceptions: the courts tried to identify when the agency or the proxy is coupled with an interest.
- someone purchasing stock over an extended period of time
- someone extending credit
- if you have a proxy in a shareholding voting agreement it can be made irrevocable (under § 705(b) of the code)
Possibility of restrictions on the transferability of stock (important to people who are putting together a closely held corporation); don’t want to wake up and find out that suddenly there is a new owner of the close corporation; present shareholders want to make sure they retain control
- first thing to ask is are there any policy considerations as to why a shareholder ought not be able to limit the transferability of the shares?
1.. England when it broke from the church of Rome they had a great interest in not transferring the property; wanted the property not to stay with Rome; English monarchs wanted to make sure that all property was freely alienable
2.. fundamental principle that property ought to be freely transferable
3.. on the other side of the argument is that this is my stock and I can do what ever I want with it; I bought it, and it is MINE
4.. this conflict has not been totally resolved
B.. CA situation - a shareholder can restrict the transferability of the stock; according to § 204 shareholders can have reasonable restrictions; no definition of “reasonable” so must look to case law
1.. generally a restriction that a shareholder will not transfer stock to a certain person is interpreted as an unreasonable restriction
2.. Delaware does permit consent restrictions; but CA does NOT
3.. under state laws there are restrictions on corporation to make
distributions to the shareholders; corporations can do it up to a point
a.. creditors do not want the corporation to give out all their
money; the restriction on the ability of the corporation is for the protection of the creditors; a certain type of financial cushion is supposed to be kept within the corporation
b.. when a corporation buys back shares it is economically identical to a distribution; the corporation is paying out money; assets have left the corporation and the creditor is in the same situation
Can make arrangements to veto any activity of majority
Distinguishing the role of shareholders as contrasted with directors.
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October 18, 1999
Devices for shifting control of a corporation continued.
Ability to restrict the transfer of shares; cannot do this in an unlimited fashion - the restriction must be “reasonable” (§ 204)
- such as right of first refusal
- not reasonable is: consent restrictions (when there is NOT tied to that consent some objective criteria that can be used); when left to the whim of an individual, this is the kind of unreasonable restriction
MCQUADE CASE: Agreement among shareholders that does more than just exercise rights among shareholders. If the shareholders in their capacity as shareholders agreed to something that is going to restrict the uninhibited exercise of discretion to sterilize the board, that is against public policy and will be void.
- when directors are elected, they are not simply the agents of the people that elected them; they are more like a senator (in that they are supposed to independently assess the particular problem); they are supposed to exercise their discretion - not just what the constituents want
how can shareholders stop the BOD from making business decisions?
- the shareholders might say in certain situations that they want to be able to control management on certain issues
- so they would have an agreement to that effect; would have to have 100% participation by the shareholders
- nothing bad about shareholders wanting to prearrange their corporation
NEW case: 5 people wanted to build a railroad terminal; said they were concerned about the management and would rotate the CEO once a year; if any of the 5 do not want that particular CEO they can veto the selection
- this is totally outside of the what is dictated by the code
- the court upheld this agreement
Dividend case - dividends must be paid equally to all shareholders - in shipping by rail, the rate for an entire carload is much less than if you shipped less than a carload; a group of retailers got together and said it was crazy to keep paying the less than carload rates; they wanted to form a corporation and all the merchants will ship through the corporation; the corporation would fill the carload; worked out fine and they saved lots of money; then the question came up of how to split dividends
- the question came up of how to pay dividends; they wanted the amount of dividends to be tied to how much merchandise each merchant put through the system
- perfectly reasonable and the court upheld it
CA close corporation; how do you create one?
- no more than 35 shareholders
- must say in articles “This corporation is a close corporation.” Also must be written on certificates.
- Maximum number must be identified in the articles .
- Also must place in the name “corporation, inc, etc…” This is only under a close corporation (??)
Why do we want to create a close corporation?
- can do what ever you want
- 158 c - how to get rid of close corporation
- agreements among all the shareholders are enforceable
if more shareholders are created than the maximum allowed, the close corporation will terminate; will loose all the benefits of the close corporations; the agreement is terminated
- can put a statement in agreement that in the event that the close corporation is terminated, then the corporation might continue
- best thing to do is to amend the articles before the number of shareholders exceeds the maximum number (as long as less than 35)
NEXT time: whether a pooling agreement is binding on a subsequent owner or transferee of the shares.
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October 20, 1999
Monday November 29 1999 - 9:00 am REVIEW SESSION
Multiple choice; after each answer you have to justify each answer in a sentence or two
Generally speaking the courts will safeguard an individual shareholder’s expectation that they will have working for them the unfettered discretion of the BOD.
- but when the courts are presented with closely held corporations, when the shareholders are trying to usurp part of the domain, the courts have held that they will enforce that type of arrangement between the shareholders, provided that the shareholders ALL agree that is what they want to do
- first the court must see that ALL the shareholders agree to it; then the court will look at other types of notions
- CA statute created a special category in order to accommodate some of the reasonable types of requests by closely held corporations and their shareholders; as long as the requests are reasonable
1.. if we have close corporation
2.. shareholder agreement is then enforceable
3.. but only if the “shareholder agreement” is as defined in § 186
4.. close corporation status will be lost if number of shareholders exceed maximum number of shareholders as specified in articles and if by operation of law (§ 158(e))
5.. attempted voluntary, inter vivos transfer is VOID if it increases the number of shareholders in the above max in articles (§ 418(d))
6.. if lose close corporation status, the shareholder agreement terminates (unless provision in shareholder agreement to continue and then only as permitted under common law) §300(b)
Don’t want to loose status as a close corporation because you don’t want to loose the protection of the shareholders agreement; can place in shareholders agreement any type of provision about the internal governance of the corporation
EXAMPLE: if we have a close corporation and there is no question about too many shareholders, and we decide we need more money, we decide to sell more stock, and we do, but the new shareholder REFUSES to sign the shareholder agreement, what is the consequence of that?
- if the new shareholder does not sign, then the shareholder agreement will terminate; no longer would have 100% of the shareholders agreeing
- this is all in §300(b); can put a clause that it would not terminate
Problem with shareholder voting agreement (remember you don’t need 100% - just some shareholders that got together and decided to vote their shares a certain way)
- question is the transferee bound by a prior voting agreement (if a person in a voting agreement transfer their shares, is the new shareholder bound by that voting agreement?)
ANSWER: courts are confused on this. Basically comes down to whether the new shareholder had notice of the agreement
Will transferees be bound by shareholder agreements of a close corporation? (similar to question above, but this is for the shareholder agreement)
- the shareholder agreement would terminate if the transferee were not bound (because not all 100% of the shareholders would be agreeing)
Piercing the corporate veil - courts will disregard the corporation and the shareholders will be personally liable
Ways to pierce the corporate veil:
1.. if the shareholders are not holding meetings regularly
- but this does NOT apply to close corporations (section 300e); shareholders in a close corporation can agree not to have meetings and this will not make them vulnerable to being pierced
Things that are particular to a close corporation:
1.. EXAMPLE: a friend has started a business to sell law student outlines; Go to a friend of yours for money; he has been offered a 20% ownership share in this new company; what types of things should you tell this person that they should think about ?
- need to find out about how easy it would be to get out if needed; exit strategy
- minority ownership concerns - won’t have much control; being in the minority sometimes is a potential disaster: a). dissolving the corporation because you only need 2/3 vote to dissolve, b).. if the majority takes out further debt your initial investment might not be worth much
- also have to worry about majority shareholders giving themselves big salaries and special bonuses
- it is very hard for a minority shareholder to sell his shares to anyone other than to the majority shareholders
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October 22, 1999
So called oppression of minority shareholders
Do not have to treat shareholders equally all the time. Sometimes it is best to treat people unequally depending on situation. Fair does not necessarily mean equal.
What motivated the majority in the Donahue case?
- wanted to take care of a retirement fund for their Dad
In the Nixon case, they wanted to make sure the business was okay.
Different jurisdictions require different things for voluntary dissolution. CA is very liberal:
- 50% or more of the shareholders must agree to have a dissolution
Radom v. Needorf
- started a business of publishing sheet music
- brother in law died - his shares went to the other 50% shareholder
- brother and sister did not get along (the two main partners)
- brother tried to buy out his sister but she said no
- brother finally went into court and petitioned for an involuntary dissolution
- the court said (NY case) we will NOT grant a dissolution; as long as the corporation is economically sound the court will not dissolve it; it is not good enough reason that the directors do not get along;
- there is a very strong bias in all the jurisdictions that economic adversity must exist in order for a court to grant a dissolution
What do you think the outcome would have been in CA?
- probably would have been dissolved (but still have to show economic adversity so maybe not)
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October 25, 1999
Review of last class:
- Donahue case: minority shareholders must be treated fairly
- Delaware case: minority shareholders should be treated fairly in a close corporation; there is no ready market for their stock and there is big potential for them to be treated quite unfairly
Dissolution - one alternative for a minority shareholder to get a return and get something out of the business
- must differentiate between a voluntary (§ 1900) and involuntary (§ 1800) dissolution; if more than 50% want dissolution it is voluntary and don’t need courts; if you have LESS than 50% that want dissolution, you must go into court and meet the statutory grounds for dissolution:
- grounds for dissolution: courts are very hesitant to dissolve a corporation that is doing financially well; reason that partners are not getting along is usually not enough of a reason to grant a dissolution
- when there is economic adversity then the courts are usually willing to grant dissolution; in 1800(b)(2) - if you have an even number of directors who are deadlocked, that cannot conduct business properly, AND the shareholders are so divided that they cannot get an uneven number of directors, then this IS grounds for dissolution; 1800(b)(3) - internal dissention OR if the shareholders have simply failed in 2 consecutive directors to elect directors that in of it self (don’t need economic diversity) is grounds for granting dissolution
- other grounds: where controlling parties are permitting pervasive and persistent kinds of mismanagement or fraud, or persistent unfairness to the shareholder this is grounds for dissolution
- also is special statute for closely held corporation - just have to show that the liquidation is reasonably necessary to protect the interest of the shareholder
- should any shareholder be able to walk into court and ask for a dissolution? NO - you won’t have standing unless you own a certain amount of shares. In CA the number is 331/3 percent; if you have 33 1/3 percent of the outstanding stock, then you have standing;
- EXCEPTIONS to the standing rule - can have a smaller amount of shares in fraud cases; if you have a close corporation one of the characteristics is that any single shareholder can petition for involuntary dissolution - still have to show grounds
- Directors can go into court; can also name someone in particular in the articles that has the right to go into court
Partnerships - if a partner wants to leave the other partners have the option of paying the partner off; or the assets can be liquidated; this is disassociation
In a close corporation - if a shareholder wants to leave the person must have grounds to leave; cannot just say “I quit” like you can in a partnership;
A - 50%
B - 40%
C - 10%
The above are shareholders and have only had losses for 3 years. A wants to get out. He calls for the dissolution of the corporation; in CA he can cause a voluntary dissolution.
If B wanted to get out he would have a harder time because he only has 40%. He would have to go into court for a petition for an involuntary dissolution. Under §2000 the other shareholders can buy B out. The other parties have the power to force a buyout in situations where there is more than 50% who want to continue the corporation. They can buyout the minority that wants to dissolve.
§ 308 and § 1802 - provisions that permit a court to appoint a temporary director in the deadlock situations; § 308 - the shareholders can ask the court for an extra director; § 1802 - the court on its own can decree a director to break the deadlock
Fiduciary obligations of controlling shareholders - the problems come up in lots of different fact patterns; people are always trying to figure out ways to improperly take something from someone else
Standard Oil case - SO had a subsidiary called Creol; SO owned 80%. SO elected the board and through the board decided business policy. SO also had another subsidiary - International Marketing. SO owned 100% of IM. The procedure was that all the oil companies would sell their oil to the IM company. The price at which Creol was selling the oil to IM was substantially less than the market price.
- the minority 20% shareholders of Creol were not happy because the oil was being sold at too cheap a price; but the majority liked it because it was as if they were selling the oil to themselves at low price
- HOLD: the difference between the price at which Creol was selling to IM was way too low; more than could be substanitiated by savings of marketing expenses
- Court said there was a breach of the fiduciary obligations of the controlling shareholders and the minority shareholders - SO was causing Creol to sell the oil at too low a price; the controlling shareholders were benefiting at the expense of the minority shareholders
- This is a very typical circumstance; see this situation quite often
Zahn v. Transamerica Corporation
October 27, 1999
Finished dissolution last time
NEW TOPIC: fiduciary obligations of controlling shareholders in regard to the minority shareholders
NEW TOPIC: piercing the corporate veil
- disregarding corporateness
- 95% of the reason why corporations are formed is to limit liability; however, sometimes their liability will not be limited if the people in the corporation do not behave themselves
Factors that indicate injustices and inequitable consequences that allow a court to pierce the corporate veil:
1.. fraudulent representation by corporation directors
3.. failure to observe corporate formalities
4.. absence of corporate records
5.. payment by the corporation of individual obligations
6.. use of the corporation to promote fraud, injustice, or illegalities
This area of the law has no clear lines, rational, as to when a court will permit the piercing of the corporate veil.
Alter ego - the courts often say that the corporation is a mere alter ego. Situations where the owners themselves disregard the corporateness:
1.. may not conform to corporate formalities (no board meetings, shareholder meetings, etc)
2.. commingling of funds - mix corporate funds and personal account; spend corporate funds as if they were your own
Instrumentality - corporation is a dummy/puppet of the owner; corporation is being run that is not in its own self interest
Inadequate capitalization - not enough money to cover liabilities; hard to define;
October 29, 1999
Piercing the corporate veil (continued)
Claimant gets to owner of corporation
In all circumstances you have to have some kind of equitable argument; that it is somehow unfair or unjust to recognize the corporation; if you recognize the corporation the unjust situation will occur
Undercapitalization - generally looked at when the corporation is formed
Suppose everything has been done up to code, can you nonetheless have some kind of justification for piercing the corporate veil?