Chapter 29-Corporate Directors, Officers and Shareholders

"They
[ corporations] cannot commit treason) nor be outlawed nor excoTIOIDurUcated, because they have no soul."

Sir Edward Coke, 1552-1634 (English jurist and legnl scholar)

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BUSINESS ORGANIZATIONS

CHAPTER 29

CHAPTER OUTLINE

-ROLES OF DIRECTORS

AND OFFICERS

-DUTIES AND LIABIlITIES OF

DIRECTORS AND OfFICERS

-ROLE OF SHAREHOLDERS

-RIGHTS OF SHAREHOLDERS

-DUTIES AND LIABILITIES

OF SHAREHOLDERS

·-MAJOR BUSINESS FORMS COMPARED

ILEARNING OBJECTIVES!

AFTER READING THIS CHAPTER, YOU SHOULD BE ABLE TO ANSWER THE FOlLOWING QUESTIONS:

1 What are the duties of corporate directors and officers?

1 Directors are expected to use their best judgment irJ managi-ng the corporation. What must directors do to avoid liability for honest mistakes of judgment and,poor business decisions?

,

] What is a voting proxy? What is cumulative voting?

4 If a group of shareholders perceives that the corporation has suffered a wrong and the directors refuse to take action, can the shareholders compel the directors to act? If so, how?

5 From what sources may dividends be paid legally?

In what circumstances is a dividend illegal? What happens if a dividend is illegally paid?

Iiiil hen ir dward Coke observed, in the chapter-ope ling quotation, that a corporal!!J bon has no • soul," he was referring to the fact that ~corporation is not a "natural:' person but a legal fiction. No one individual shareholder or director bears ole responsibility for the corporation and its actions. Rather, a corporation joins the efforts and resources of a large number of individuals for the purpose of producing greater returns than those persons could have obtained individually,

Sometimes, actions that benefit the corporation as a whole do not coincide with the separate interests of the individuals making up the corporation. In such situations, it is important to know the rights and duties of all participants in the corporate enterprise. This chapter focuses on the rights and duties of directors, officers, and shareholders and the ways in which conflicts among them are resolved.

ROLES OF DIRECTORS AND OFFICERS

Every business corporation is governed by a board of directors A director occupies a position of responsibility unlike that of other corporate personnel. Directors are sometimes inappropriately characterized as agents because they act on behalf of the corporation. No individual director, however, can act as an agent to bind the corporation; and as a group,

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djrectors collectively control the corporation in a way that no agent is able to control a principal. Directors are also often incorrectly characterized as trustees because they occupy positions of trust and control over the corporation. Unlike trustees, however, they do not own or hold tide to property for the use and benefit of others.

Few legal requirements exist concerning directors' qualifications. Only a handful of states impose minimum age and residenc requirements. A director may be a shareholder, but this i not necessary, un Ie s required by statute or by the corporate article or bylaws.

Election of Directors

Subject to statutory limitations, the nurn ber of di rectors is set forth in lhe corporation's articles or bylaws. Historically, the minimum number of directors has been three but today many states permit fewer. Indeed, the Revised Model Business Corporation Act (RMBCA), in Section 8.01, permits corporations with fewer than fifty shareholders to eliminate the board of directo~.s.

Normally, the incorporator appoint the initial board of directors at the time the corporation is created, or the cor loration itself names the directors in the articles. The first board serves until the first annual shareholders' meeting. Subsequent directors are elected by a majority vote of the shareholders.

The term or office for a director is usually one year-from annual meeting to annual meeting. Longer and staggered terms are permissible under most state statutes. A cornmall practice is to elect one-third of the board members each year for a three-year term. In this way, there is greater management continuity.

Removal of Directors A director can be removed (or cause-that is, for failing to perform a required duty= either as specified in 'the articles or bylaws or by shareholder action, ven the board of directors itself may be given power to remove a director for cause, subject to shareholder review. In most states, a director cannot be removed without cause unless the corporation has previously au thorized such an action.

Whether shareholders should be able 'to remove a director withoul cause is part of an ongoing debate about the balance of power between a corporation and its shareholders. It was also the pivotal question at the heart of the battle for corporate control in the following case.

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CORPORATE DIRECTORS, OFFICERS, AND SHAREHOLDERS

One of the best sources on

the Web for information on corporations, including their directors, is the EDGAR database of the Securities and Exchange Commission at

www,sec.goy{edgar..shtmJ.

I:II;\W::\;(. The articles of incorporation may provide that a director can be removed only for cause.

Relational Investors, LLC v. Sovereign Bancorp, Inc.

~ .; District Court. Southern District of New York, 417 ESupp.2d 438 (2006).

~ In June 2004, 19.8 percent of its stock for $2.4 billion to Santander Central

Relational Investors, LLC, a Hispano, SA, a bank incorporated under the laws of Spain.

Delaware corporation, began acquiring a significant number of Relational responded that it intended to seek the removal of

shares of stock in Sovereign Bancorp, lnc., a Pennsylvania firm. Sovereign's entire board at the next shareholders' meeting.

By 2005, Relational held about 8 percent of Sovereign's stock Sovereign filed a suit in a federal district court against

and had become its largest shareholder. Relational expressed Relational, seeking a declaration' that its directors could be

dissatisfaction with Sovereign's management and, in May, removed only for cause. Relational filed a motion for judgment

announced that it would seek representation on Sovereign'S on the pleadings.

board at the next annual shareholders' meeting in April 2006. (Sovereign elects one-third of its six board members at each annual meeting.) Sovereign then announced that it would sell

ISS U E Could Sovereign's shareholders remove its directors without cause?

CASE 29.I-Continues next page

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BU51NESS ORGANIZATIONS

CASE 29.1-Continued

DEC I S ION Yes. The court granted Relational's motion for judgment on the pleadings, declaring that Sovereign's shareholders had the right to remove its directors without cause. "[11he tension is * * ~ resolved in favor of shareholder autonomy:'

REA SON The court pointed out that "[a]t the time of Sovereign's incorporation in 1987, Pennsylvania law expressly provided for the removal of directors without cause" The court acknowledged that "as concerns about hostile corporate takeovers grew, several states began enacting legislation to limit the ability of shareholders to remove directors," and in 1989, Pennsylvania likewise "Iimit[ed] the ability of shareholders to remove directors without cause to situations where the company's charter and bylaws permitted such actions:' In this case, Sovereign's articles of incorporation "clearly and unambiguously" allowed for directors to be

removed without cause. "Article Eighth [of Sovereign'S articles of incorporation] provides, simply and dearly, that a majority vote of qualified shareholders may remove directors from office." Sovereign argued that because Article Eighth was adopted before Pennsylvania amended its law to restrict the removal of directors, the article "could not have been intended as an 'opt out' to the revised statute which thereafter provided for a presumption of removal only for cause." The court refused to accept this argument 'The plain language of Artide Eighth, and an analysis of the law in effect at the time of its enactment in 1987, makes dear that the original Artides of Incorporation provided for removal without cause. The enactment of [the revised statute] did not alter this original intent'

FOR CRITICAL ANALYSIS-Social Consideration If you could dictate a corporation's rule with respect to the removal of its directors, what would you prescribe? Why?

I

ON THE WEB .

You can find definitions for

terms used in corporate

law, as well as court decisions and articles on corporate law topics, at

www.law.com.

QUORUM

The number of members of a decision-making body that must be present before business may be transacted.

/

Vacancies on the Board of Directors Vacancies can occur on the board of directors ir a director dies or resigns or if a new position is created through amendment of the article or bylaws. In these situations, either the shareholders or the board itself can fill the position, depending on state law or on the provisions of the bylaws. Note, however. that even when the bylaws appear to authorize all election, a court can invalidate the election if the directors were attempting to diminish the shareholders' influence in it.

I.EXAMPLE 29.1 I The bylaws of Liquid Audio, a Delaware corporation, authorized a board of five directors. Two directors on the board were elected each year. Another COI11- pany had offered to buy all of Liquid Audio' stock, but the board of directors rejected this offer. An election was coming, and the directors feared that the shareholders would elecl new directors who would allow the other company to pllr~hase Liquid Audio's assets. The directors therefore amended the bylaws to increase th~ number of directors to seven. thereby diminishing the shareholders' influence in the ~ote. The shareholders ~led <H~ action challenging the election. The Delaware Supreme COLITt ruled that the directors ac ions were illegal because they had attempted to diminish the shareholders' right to vote effectively in an election of directors. I @

Board of Directors' Meetings

The board of directors conducts business by holding formal meetings with recorded minutes. The dates of regular meetings are usually established in the articles Of bylaws or by board resolution, and no further notice is customarily required. Special meetings can be called, with notice sent to all directors.

Quorum requirements vary among jurisdictions. (A quorum is the minimum nu,~b{'r of members of a body of officials or other group that must be present in order for bustJ1ess to be validly transaeted.) Many states leave the decision as to quorum requirements to ~he corporate articles or bylaws. In the absence of specific state sta lutes, most states prOVide

1. MM Companies, Jne, v. Liquid AI/dip, Inc., 813 A.2d I J fa (Del.Supr, Z003).

that a quorum is a majority of the number of directors authorized in the articles or bylaws. Voting is done in person (unlike voting at shareholders' meetings, which can be done by proxy, as discussed later in this chapter).z The rule is one vote per director. Ordinary matters generally require a simple majority vote; certain extraordinary issues may require a greater-than-majority vote.

Rights of Directors

A director of a corporation has a number of rights, including the rights of participation, inspection, compensation, and indemnification.

Participation and Inspection A corporate director must helve certain rights to function properly in that position and make informed policy decisions for the company. The right to participation means that directors are entitled to participate in all boa rd of directors' meetings and have a right ~() be notified of these meetings. As pointed out earlier in this chapter, the dates of regula board meetings are usually established by the bylaws or by board resolution, and no notice of these meetings is required. If special meetings are called, however, notice is required unless waived by the director.

A director must have access to all of the corporate books and records to make decisions and to exercise the necessary supervision over corporate officers and employees. This righr of inspection is virtually absolute and cannot be restricted.

Compensation and Indemnification In the past, directors rarely were paid. Today, in contrast, corporate directors are often paid at least nominal sums and may receive more substantial compensation in large corporations because of the time, work, effort, and especially risk involved. Most states permit the corporate articles or bylaws to authorize compensation for directors; sometimes, the directors are allowed to set their own compensation. In many corporations, directors are a 150 chief corporate officers (president or chief executive officer, for example) and receive compensation in their managerial positions. A director who is also an officer of the corporation is referred to as an inside director whereas a director who does not hold a management position is an outside director. Directors also gain through indirect benefits, 'such as business contacts and prestige, and other rewards, such as stock options.

Corporate directors may become involved in lawsuits by virtue of their positions and their actions as directors. lost states (and RMBCA 8.51) permit a corporation to indemnify (guarantee reimbursement to) a director for legal costs, fees, and judgments involved in defending corporation-related suits. Many state.') specifically permit a corporation to purchase liability insurance for the directors and officers to cover indernnification. When the statutes are silent on this matter, the power to purchase such insurance is usually considered to be part of the corporation s irnplied powers.

Whenever businesspersons serve as corporate directors or officers, they should be aware that they may at some point become involved in litigation as a result of their positions. To protect against personal liability, a director or officer should take. several steps. First make sure that the corporate bylaws explicitly give directors and officers a right to indemnification (reimbursement) for any costs incurred as a result of litigation, as well as any judgments or settlements stemming from a lawsuit. Second, have the corporation purchase directors' and officers' liability insurance (D & 0 insurance). Having D & 0 insurance policies

2. Except III Louisiana, which allows ;J director to vote hy proxy under certain circumstances,

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INSIDE DIRECTOR

A person on the board 01 directors who is also an officer of the corporation.

OUTSIDE DIR.ECTOR

A person on the board of directors who does not hold a management position at the corporation.

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lilolUhll1.iM Shareholders own a corporation and directors make policy decisions, but officers who run the daily business of the corporation often have significant decision-making power.

Corporate executives discuss the business of their firm. Can the same person be both a director and an officer of a corporation? (John Terence Tumer/Getty Images)

enables the corporation to avoid paying the substantial costs involved in defending a particular director or officer. The 0 & 0 policies offered by most private insurance companies have maximum coverage limits, so make sure that the corporation is required to indemnify directors and officers in the event that the costs exceed the policy limits.

Directors' Management Responsibilities

Directors have responsibility for all policymaking decisions necessary to the management of corporate affairs. Just as shareholders cannot act individually to bind the corporation, the directors must acl as a body in carrying ou routine corporate business. The aeneral areas of responsibility of the board of directors include the following:

1 Declaration and payment 0 corporate dividends to shareholders.

1 Authorization for malar corporate policy decisions-for example, the initiation of proceedings for the sale or lease of corporate assets outside the regular course uf business, ,the determination of new product lines, and the overseeing of major contract negotiations and major management-labor negotiations.

3 AppoinLment, supervision, and removal of-corporate officers and other managerial employees and the determination of their compen abon.

4 Financial decisions, sucl as the decision to issue authorized shares and bonds.

In most states, the board or directors can delegate some of its funcbons to an executive committee or to corporate officers. Tn doing so, the board is not relieved of its overall responsibility for directing the aHa irs of the corporation, but corporate officers and managerial personnel arc empowered to make decisions relating t ordinary daily corporate affairs within well-defined guidelines.

Corporate Officers and Executives

Corporate officer and other executive employees are hi~ed by the board of directors or, in rare instances, by the sh.areholders. In addition to Carr~ing. out the duties articulated ill the bylaws, corporaLe and managerial officers ~ct <IS agents or the corporation, and the ordinary rules of agency (discussed in Chapter 24) normally apply to their employment. The qualifications required of officers and executive employees are determined at the discretion of the corporation and are included in the articles or bylaws. In most states, a person can hold more than one office and can be both an officer and a director of the corporation.

Corporate officers and other high-level managers are employees of the company, so their rights are defined by employment contracts. The board of directors, though, normally can remove corporate officers at any time with or without cause and regardless of the terms of the employment contractsalthough in so doing, the corporation may be liable for breach of contract. The duties of corporate officers are the same as those of directors because both groups are involved in decision making and are in similar positions of control. Hence, officers are viewed as having the san e fiduciary duties of care and loyalty in their conduct of corporate affairs as directors have, a subject to which we now turn.

DUTIES AND LIABILITIES OF DIRECTORS AND OFFICERS

Directors and officers are deemed fiduciaries of the corporation because their relationship with the corporation and its shareholders is one of trust and confidence. As fiduciaries, directors and officers owe ethical-and legal-duties to the corporation and to the shareholders as a whole. These fiduciary duties include the duly of care and the duty of loyalty,

Duty of Care

Directors and officers must exercise due care in performing their duties. The standard of due care has been variously described ill judicial decisions and codified in many corporatien codes. Generally, a director or officer is expected to act in good faith, to exercise the care that an ordinarily prudent person would exercise in similar circumstances, and to act in what he or she considers to be the best interests of the corporation [RMBCA 8.30]. Directors and officers who 1 ave not exercised the required duty of care can be held liable for the harms suffered by tl e corporation as a result of their negligence. (Directors and officers also have a duty notJo destroy evidence in the event of a lawsuit involving tbe corporation. The Application feature at the end of this chapter discusses how due care can be exercised to preserve electronic evidence by creating an e-document-relention policy.)

Duty to Make Informed and Reasonable Decisions Directors and officers are expected to be informed on corporate matters. To be informed, the director or officer must do what is necessary to become informed: attend presentations, ask for information from those who have it, read reports, and review other written materials such as contracts. in other words, directors and officers must carefully study a situation and its alternatives before making a decision. Depending 011 thb nature of the business, directors and officers are often expected to act in accordance with their own knowledge and training. Nevertheless, most states (and Section 8.30 of the RMBCA) allow a director to make decisions in reliance on information furnished by competent officers or employees, professionals such as attorneys and accountants, or even an executive committee of the board without being accused of acting in bad faith or failing to exercise due care if such infer-

t .

rnation tums out to be faulty.

Directors are also expected to make reasonable decisions. For example, a director should not vote to approve a merger with only a moment's consideration and solely Oil the basis of the market price of the corporation's shares. As discussed in Chapter 28, a merger is the legal combination of two or more corporations into one entity.

Duty to Exercise Reasonable Supervision Directors are also expected to exercise a reasonable amount of supervision when they delegate work to corporate officers and employees. I.EXAMPLE 29.21 Dale, a corporate bank director, fails to attend rulY board of directors' meetings for five years. In addition Dale never inspects any of the corporate books or records and genera 1Jy fails to supervise the efforts of the bank presiden t and the loan committee. Meanwhile, Brennan, the bank president, who is a corporate officer makes various improper loan and permits large overdrafts. In this situation, Dale (the corporate director) can be held liable to the corporation for losses resulting from the unsupervised actions of the bank president and the loan committee. [!]

Dissenting Directors Directors are expected to attend board of directors' meetings, and their votes should be entered into the minutes of the meetings. Unless a dissent is entered. the director is presumed to have assented. Directors who dissent are rarely held individually

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812 _1I:hl1E.


liable for mismanagement of the corporation. For lhis reason, a director who is absent from a given meeting sometimes registers wi th the secretary of tile board a dissent to actions taken at the meeting.

Duty of Loyalty

Loyalty can be defined as faithfulness to one's obligation and duties. In the corporate context. the d ity of loyalty req tires directors and officers to subordinate their personal interests to the welfare of the corporation. Among other things, this means that directors may not use corporate funds or confidential corporate information for personal advantage. They must also refrain from self-dealing. For instance a director should not oppose a tender offer that is in the corporation's best interest simply because its acceptance may cost the director her or his position. Cases dealing with fiduciary duty may involve one or more of the following:

1 Competing with the corporation.

1 U urping (taking advantage of) a corporate opportunity.

3 Having an interest tl1at conflicts with the interest of the corporation.

4 Engaging in insider trading (using information that is not public to make a profit trad. ing securities, as discussed in Chapter 30).

5 Authorizing a corporate transaction that is detrimental to minority shareholders, I

Conflicts of Interest

The duty ofloyalty also requires officers and directors to fully disclose to the board of directors any potential conflict of interest thst might arise in any corporate transaction. The various state statutes contain different standards, but a contract genera lIy will not be voidable if all of the following are true: if the contract was fair and reasonable to the corporation at the time it was made, if there was a full disclosure of the interest of the officers or directors involved in the transaction, and if the contract was approved by a majority of the disinterested directors or shareholders.

I.EXAMPLE 29.3 I Southwood Corporation needs office space. Lambert Alden. one of its five directors, owns the building adjoining the corporation's main office building. He negotiates a lease with Southwood for the space, makinga fuJ] disclosure to Southwood and the other four board directors. The lease arrangemerit is fair and reasonable, and it is unanimously approved by the corporation's board of direJtors. In this situation, Alden has not breached his duty of loyalty to the corporation, and thus the contract is valid. Ifit were otherwise, directors would be prevented from ever transacting business with the corporations they serve. ~I

What happens to the duty of loyalty when a director sits on the boards of two corporotions? Corporate directors often have many business affiliations, and they may even sit on the board of more than one corporation. (Of course, directors generally are precluded from sitting on the boards of directors of competing companies.) The duty of loyalty can become cloudy, though, when corporate directors sit on the boards of more than one corporation. Because of the potential for abuse in transactions negotiated between corporations whose boards have some members in common, courts tend to scrutinize such actions closely.

For example, suppose that four individuals own a total of 70 percent of the shares 01 Company A and 100 percent of the shares of Company B. All four of these shareholders sit on the boards of directors of both corporations. Company A decides to purchase all 01 Company 8'5 stock for $6 million, when in fact it is worth only $3 million. The shareholder-

directors of both firms have not breached their duty to Company B because the $6 million price is beneficial to that company. A court would likely hold that the directors breached their duty to the other shareholders of Company A (who owned the remaining 30 percent of Company P:s shares), however, because these other shareholders had nothing to gain by the transaction and much to lose by Company Ns purchase of Company B at an inflated price."

Liability of Directors and Officers

Directors and officers are exposed to liability on many fronts. Corporate directors and officers may be held liable for the crimes and torts committed by themselves or by corporate employees under their supervision, as discussed in Chapter 6 and Chapter 24, respectively. Additionally, if shareholders perceive that the corporate directors are not acting in the best interests of the corporation, th~y may sue the directors, in what is called a shareholder's derivative suit, on behalf of the [corporation. (This type of action is discussed later in this chapter, in the context of share}10Jders' rights.)

TIle Business Judgment Rule A corporate director or officer may be able to avoid [iability to the corporation or Lo its shareholders for poor business judgments under the business judgment rule. Directors and officers are expected to exercise due care and to usc their best judgment in guiding corporate management, but they are not insurers of business SlICcess. Honest mistakes of judgment and poor business decisions on their part do not make them liable to the corporation for resulting losses.

The business [udgment rule generally immunizes directors and officers from liability for the consequences of a decision that is withi~ managerial authority, as long as the decision complies with management's fiduciary duties and as long as acting on the decision is within the powers of the corporation. Consequently, if there is a reasonable basis for a business decision, it is unlikely that a conrt will interfere with that decision, even if the

corporation suffers as a result. '

I •

Requirements for the Rule to Apply To benefit from the business judgment rule, direc-

tors and officers must act in good faith, in what they consider to be the best interests of the corporation, and with the care that an ordinarily prudent pe son in a similar position would exercise in like circumstances. This requires an informed decision, with a rational basis, and with no conflict between the decision maker's personal interest and the interest of the corporation.

ROLE OF SHAREHOLDERS

The acquisition of a share of stock makes a person an owner and shareholder in a corporation. Shareholders thus own the corporation. Although they have no legal title to corporate property, such as buildings and equipment, they do have an equitable (ownership) interest in the [irm.

fu a general rule, shareholders have no responsibility for the daily management of the corporation, although they are ultimately responsible for choosing the board of directors, which does have such control. Ordinarily, corporate officers and directors owe no duty to individual shareholders unless some contract or special relationship exists between them

3. See, lor example, Gries Sports Entemrise«, ','IC. ", Cteveland Browns Football Co., 26 Ohio SUd 15.496 N.E.2d 95'1 (1986)_

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CORPORAT£ DIRECTORS, OmCERS, AND SHAREHOLDERS

BUSINESS JUDGMENT RULE

A rule that immunizes corporate management from liability for actions that result in corporate losses or damages if the actions are . undertaken in good faith and are within both the power of the corporation and the authority of management to make.

1:(IlWnUI Shareholders normally are not agents of the corporation.

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Starbucks Corporation board member James G. Shennan, Ir; waves as he is introduced by Chairman Howard Schultz at the company's annual shareholders' meeting. Shareholders meet to vote on corporate issues. (AP Pholo/Elaine Thompson)

in addition to the corporate relationship. Their duty is to act in the best interests of the corporation and its shareholder-owners as a whole. In tum, as you will read later in this chapter, controlling shareholders owe a fiduciary duty to minority shareholders. Normally, there is no legal relationship between shareholders and creditors of the corporation. Shareholders can, in fact, be creditors of the corporation and thus have the same rights of recovery against the corporation as any other creditor.

In this section, we lopk at the powers and voting rights of shareholders, which are generally established in the articles of incorporation and under the state's general incorporation law.

Shareholders' Powers

,

Shareholders must approve fundamental changes affecting the corporation before the changes can be implemented. E-Ience, shareholders are empowered to amend the articles of incorporation (charter) and bylaws, approve a merger or the dissolution of the corporation, and approve the sale of all or substantially all of the corporation's assets. Some of these powers are subject to prior board approval.

Members of the board of directors are elected and removed by a vote of the shareholders. The first board of directors is either named in the articles of incorporation or chosen by the incorporators to serve until the first shareholders' meeting. From that time on, the selection and retention of directors are exclusively shareholder functions.

Directors usually serve their full terms; if they are unsatisfactory, they are simply not reelected. Shareholders have the inherent power, however, to remove a director from office for cause (breach of duty or misconduct) by a majority vote." M mentioned earlier, some state statutes (and some corporate articles) even pe(;"iL removal of directors without cause by the vote of a majority of the holders of outstan ing shares entitled to vote.

Shareholders' Meetings

Shareholders' meetings must occur at least annually. In addition, special meetings can be called to deal with urgent matters.

Notice of Meetings Each shareholder must receive written notice of the date, time, and place of a shareholders' meeting.5 The notice must be received within a reasonable length of time prior to the date of the meeting. Notice of a special meeting must include a statement of the purpose of the meeting, and business transacted at the meeting is limited to thai purpose.

4. A director call often demand court review of removal for cause.

5. The shareholder elm waive the requirement of written notice by igning a waiver form. In some states. ~ shareholder who does not receive written notice, but who learns of the meeti ng and attends without prot ling the lack of notice, is said to have WlI ived notice by such conduct. State statutes and corporate bylaws typically set forth the time within which notice musl be sent, what methods can be used, and what the notice must contain.

Proxies Because it is usually not practical for owners of only a few shares of stock of publicly traded corporations to attend shareholders' meetings, such shareholders normally give third parties written authorization to vote their shares at the meeting. This authorization is called a proxy (from the La tin procHram, "to manage, take care of"). Proxies are often solicited by managemenl, but any person call solicit proxies to concentrate voting power. Proxies have been used by a group of shareholders as a device for taking over a corporation (corporate takeovers were discussed in Chapter 28). Proxies are normally revocable (that is, Lhey an be withdrawn), unless they are specifically designated as irrevocable. Under RMBCA 7.22(c), proxies last for eleven months, unless the proxy agreemenL provides for a longer period.

Proxy Materials and Shareholder Proposals When shareholders want to change a company policy, they can put their idea up for a shareholder vote. They can do this by submitting a shareholder proposal to the board of directors and asking the board to include [he proposal in the proxy materials hat are sent to all shareholders before meetings.

The Securities and Exchan~e Commission (SEC), which regulates the purchase and sale of securities (see Chapte 30), has special provisions relating to proxies and sharebolder proposals. SEC Rule 14a-8 provides that all shareholders who own stock worth aL least $1,000 are eligible to submit proposals for inclu ion in corporate proxy materials. The corporation is required to include information on whatever proposals will be considered atthe shareholders' meeting along with proxy materials. Only those proposals that relate to significanL policy considerations rather Ihan ordina business operations must be included. For a discussion of how the SEC is adapting its rules regarding proxy solicitation to take advantage of today's communications technology, see this chapter's Adapting the Law to the Online Environment feature on the lollowing Lwo pages.

Shareholder Voting

Shareholders exercise ownership control through the power of their votes. Corporate business matters are presented in the form of resolutions, which hareholders vote to approve or disapprove. Each shareholder is entiLled to one vote per share, although the voting techniques that will be discussed shortly aJI enhance lhe power of the shareholder's vote. The articles of incorporation can exclude or limit voting rights,1 particularly for certain classes of shares. For example, owners of preferred shares are lISL1<111y denied the right to vote [RMBCA 7.21). If a slate statute requires specific voting procedures, the corporation' articles or bylaws must be consistent wilh the statu teo

Quorum Requirements For hareholders to conduct business al a meeting, a quorum musL be present. Generally, a quorum exists when shareholders holding more than 50 percent of the outstanding shares are present. In some states, obtaining the unanimous written consent of shareholders is .1 permissible alternative to holding a shareholders' meeting [RMBCA 7.25].

Once a quorum is present, voting call proceed. A majority vote of the shares represenled at the meeting is usuall required to pass resolution. I.EXAMPLE 29.41 Novo Pictures, Inc." has l 0,000 outstandi ng shares of voting stock. lts articles of incorporation set the quorunl at 50 percent of outslanding shares and provide that a majority vote of the shares present is necessary to pass resolutions concerning ordinary matters. Therefore, for this Ii rm, a quorum of sha rcholders represcnti ng 5,000 (Julstalldillg shares must be present at a shareholders' meeting to .onduct business. If exactly 5,000 shares are represented al the meeting, a vote uf al least 2,501 of those sha res is needed to pass a resol u tion. IF 6,000 shares are represented, a vote 0 3,001 will be required, and so on. @

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PROXY

In corporate law, a written agreement between a stockholder and another party in which the stockholder authorizes the other party to vote the stockholder's shales in a certain manner.

For information on the SEC's rulings, including

rulings on proxy materials, go to

www.s&.gov/rules/final.shtml.

1:ltJ!1@jll, Once a quorum is present, a vote can be taken even if some shareholders leave without casting their votes.

816 _":"111:.


a significant development that will reduce the printing and mailing costs associated with furnishing proxy materials to shareholders. Because the rules are voluntary, a company may still provide paper proxy documents if it so chooses.

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ADAPTING THE LAW TO

THE ONLINE ENVIRONMENT

The SEC Adopts New E-Proxy Rules

III n the past, anyone L!J wishing to solicit proxies from shareholders had to mail each shareholder numerous paper documents relating to the proxy. Required materials often include notice of the meet- ~ ing, proxy statements and consent solicitation statements, pro),.'Y cards, information statements, annual reports, additional soliciting materials, and any amendments made to these materials. Providing all of these documents in paper form can be very costly.

In Jariuary 2007, the Securities and Exchange Commission (SEC) adopted voluntary e-proxy rules that I went: into effect on July I, 2007.a Essentially, the new rules allow companies to furnish proxy materials to shareholders by posting them on a Web site and providing shareholders with notice of the availability of the proxy materials online. This is

a. 17 CER. Parts 240, 249. and 274.

The Notice and Access Model

Under the SEC's new rules, a company may now furnish proxy materials to shareholders using the notice and access model, which includes the foHowing steps:

• 11,e company posts the proxy materials on a publicly accessible Web site.

• The company then sends a (paper) notice to each hareholder at least forty calendar days prior to the date ofthe shareholders' meeting for which the proxy is being solid ted.

• No other materials (such as a proxy card) can be sent along with the initial notice (unless the proxy is being combined with a meeting notice required by state law),

• The notice must be written in plain English and include a prorninen statement of the following: the date, time, and location of the sh~reholders' meeting; the specific Web site

I

At times, more than a simple majority vote will be required either by a state statute or

by the corpora te articles. Extraordinary corporate matters, such as a merger, consolidation, or dissolution of the corporation (as discussed in Chapter 28) require a higher percentage of all corporate shares entitled to vote [RMBCA 7.27].

Voting Lists The corporation prepares voting lists prior to each meeting of the shareholders. Ordinarily, only persons whose names appear on the corporation's hareholder records as owners are entitled to vote.6 The voting list contains the name and address of each shareholder as shown on the corporate records on 'a given cutoff, or record, date. (Under RMBCA 7.07, the record date may be as much J; seventy days before the meeting.) The voting list also includes the number of voting ~hares held by each owner. The list is usually kept at the corporate headquarters and is available for shareholder inspection [RMBCA 7.20].

Cumulative Voting Most states permit or even require shareholders to elect directors by cumulative voting, a voting method designed to allow minority shareholders to be rep-resented on the board of directors.t With cumulative voting, the number of board members to be elected is multiplied by the number of voting shares a shareholder owns. The result equals the number of votes the shareholder has, and this total can be cast for one or mare nominees for director. All nominees stand for election at the same time. When cumulative voting is not required either by statute or under the articles, the entire board can be elected by a simple majority of shares at a shareholders' meeting.

6. When the legal owner is bankrupt, lncornpetent, deceased, or in some other way under a legal disability, his or he! vote can be cast by a person designated by law to control and manage the owner' property,

7. See. rOT example. California Corporate Code Section 708. Under RMBCA 7.28, however. no cumulative voting rights exist unless the articles of incorporation so provide,

817 13UU;i'*m

CORPORATE DIRECTORS, OFFICERS, AND SHAREHOLDHS

al which 81e shareholders can access the proxy materials; an explanation of how they can obtain paper copies of the pro,,), materials at no cost (by calling a toll-free phone number, for instance); and a clear and impartial description of each matter La be considered at the shareholders' meeting.

• After sending the initial notice, the company must wait at least ten days before sending a (paper) proxy card to the shareholders. This ten-day waiting period is designed to provide shareholders with sufficient time to access the proxy materials online or request paper copies.

• If a shareholder requests paper proxy materials, the company must send them to the shareholder within three business days.

• After receiving the inilia 1 paper notice, a shareholder can permanently elect to receive ,n future proxy materials on

paper or bye-mail. }

Shareholders and other parties conducting their own proxy solicitations can also use the notice and access model with slight modifications. The notice must still be sent forty days before the meeting date and include substantially the same information, but the notice need not be provided to all shareholders. III contrast to company solicitations, other parties can selectively choose the shareholders from whom they

wish to solicit proxies without sending information to all other shareholders.

Should E-Proxy Rules Be Mandatory?

The SEC has also proposed making the new -proxy rules mandatory for all proxy solicitations in the future. The mandatory notice and access model would operate substantially the same a iust outlined, except that the initial notice could be accompanied by a paper or e-mail copy of the proxy statement, annual report, and proxy card. The main difference between the mandatory and voluntary models is that under the voluntary rule, the company (or other party seeking proxies) can choose whether to use electronic or paper means, whereas under a mandatory rule, the SEC would require he use of electronic means. Under either rule, the shareholder can always hoose to receive paper documents rather than accessing the materials online.

FOR (R IT I (A LAN A LV 5 I 5 Why might a company or other party choose to solicit proxies the old-fashioned way. by providing paper documents instead of Internet access, despite the added costs?

,

Cumulative voting can best be inderstood by an example. I.EXAMPLE 29.51 A corporation has 10,000 shares issued and outstanding. One grOU]) of shareholders (the minority shareholders) holds only 3,000 shares, and the other group of shareholders (the majority hareholders) holds the other 7,000 shares. Jfhree rnern bers of the board are to be elected.

The majority shareholders' nominees are Acevedo, Barkley, and Craycik. The minority shareholders' nominee is Drake. Can Drake be elected by the minority shareholders? .

If cumulative voting is allowed, the answer is yes. Together, the minority shareholders have 9,000 votes (the number of directors to be elected times the n~mber of shares held by the minority shareholders equals 3 limes 3,000 which equals 9,000 votes). All of these votes can be cast to elect Drake. TI1C majority shareholders have 21,000 votes (3 times 7,000 equals 21,000 votes), but these votes have. to be distributed among their three nominees. The principle of cumulative voting is that no matter how the majority shareholders cast their 2l,000 votes, they will not be able to elect all three director if the minority shareholders cast all of their 9,000 votes for Drake, as illustrated in Exhibit 29-1 n page 818. ~

Other Voting Techniques Before a shareholders' meeting, a group of shareholders can agree in writing to vote their shares together in a specified manner. Such agreements, called shareholder voting agreements, are usually held [0 be valid and enforceable. A shareholder can also appoint a voting agent and vote by proxy. As mentioned previously, a proxy is a written authorization to cast the shareholder's vote, and a person can solicit proxies from a number of shareholders in an attempt to c ncentrate vuting power.

Another technique is for shareholders to enter into a voting trust, which is an agreement (a trust contract) under which legal title (record ownership on the corporate books) is transferred to a trustee who is responsible for voting the shares. The agreerncnt can specify how the trustee is to vole, or it can allow the trustee to use his or her discretion. The lrustee takes physical possession of the stock certifies te and in return gives the shareholder

VOTING TRUST

An agreement (trust contract) under which legal title to shares of corporate stock is transferred to a trustee who is authorized by the shareholders to vote the shares on their behalf.

818 .11:"411.


This exhibit illustrates how cumulative voting gives minority shareholders a greater chance of electing a director of their choice .. By casting all of their 9,000 votes for one candidate (Drake), the minority shareholders will succeed in electing Drake to the board of directors.

MAJORITY MINORITY DIREcroRS

BALLOT SHAREHOLDERS' VOTES SHAREHOLDERS' VOTES ELECTED

Acevedo Barkley Craydk Drake
1 10,000 10,000 1,000 9,000 Acevedo/Barkley/Drake
2 9,001 9,000 2,999 9,000 Acevedo/Barkley/Drake
3 6,000 7,000 8,000 9,000 Barkley /Craycik/Drake STOCK CERTIFICATE

A certificate issued by a corporation evidencing the ownership of a specified number of shares in the corporation.

PREEMPTIVli: RIGHTS

Rights held by shareholders that entitle them to purchase newly issued shares of a corporation's stock, equal in percentage to shares already held, before the stock is offered to any outside buyers. Preemptive rights enable shareholders to maintain their proportionate ownership and voice in the corporation.

Stock certificates are displayed. To be a shareholder. is IT necessary to have physical possession of a certiiicate? Why or why not? (PhotoDisc)

a voting trust certificate. The shareholder retains all of the rights of ownership (for example, the right to receive dividend payments) except for the power to vote the shares.

RIGHTS OF SHAREHOLDERS

Shareholders possess numerous rights.;\ significant right-the right to vote their shareshas already been discussed. We now look at some additional rights of shareholders.

Stock Certificates

I

A stock certificate is a certificate issued by a corporation that evidences ownership of a specified number of shares in the corporation. In jurisdictions that require the issuance of stock certificates, shareholders have the right to demand that the corporation issue certificates. ln most states and under RMBCA 6.26, boards of directors may provide that shares of stock will be uncertificated-that is no actual, physical stock certificates will be issued. When shares are uncertificateel, the corporation may be required to send each shareholder a letter or some other form of notice that contains the same information that would normally appear on the face of stock certificates.

Stock is intangible personal property, and the ownership right exists independently of the certificate itself. If a stock certificate is lost or destroyed, ownership is not destroyed with it. A new certificate can be issued to replace one tJ'tat has been lost or destroyed! Notice of shareholders' meetings, dividend. s, and operational and financial reports are all distributed according to the recorded ownership listed il~the corporation's books, not on the basis of possession of the certificate.

Preemptive Rights

With preemptive rights, which are based on a common law concept, a shareholder receives a preference over all other purchasers to subscribe to or purchase a prorated share of a new issue of stock. In other words, a shareholder who is given preemptive rights can purchase the same percentage of the new shares being issued as she or he already holds in the company. This allows each shareholder to maintain her or his proportionate control, voting power,

8. The Uniform Commercial Code (UCC) provides lhnt for a lost or destroyed certificate 10 be reissued, <I shareholder normally rnusl furnish an indemnity bond. An indemnity bond is a written promise to reimburse the holder for any actual or claimed loss caused by the issuer's or some o~ler person's conduct. The bond protects the corporation against potential loss should the origillal certificate reappear al some future time in the hands of a bonn fide purchaser [UCC 8---302, 8-405(2)].

or financial interest in the corporation. Most statutes either (1) grant preemptive rights but allow them to be negated in the corporation's articles or (2) deny preemptive rights except to the extent that they are granted in the articles. The result is that the articles of incorporalion determine the existence and scope of preemptive rights. Generally, preemptive rights apply only to additional, newly issued stock sold for cash, and the preemptive rights must be Ifxercised within a specified time period, which is usually thirty days.

(.EXAMPlE 29.61 Tran Corporation authorizes and issues 1,000 shares of stock. Lebow purchases 100 shares, making her the owner of 10 percent of the company's stock. Subsequently, Tran, by vote of its shareholders, authorizes the issuance of another 1,000 shares (by amending the articles of incorporation). This increases its capital stock to a total of 2,000 shares. If preemptive rights have been provided, Lebow can purchase one additional share of the new stock being issued for each share she already owns-or 100 additional shares. Thus, she can own 200 of the 2 000 shares outstanding, and she will maintain her relative position as a shareholder. If preemptive rights are not allowed her proportionate control and voting power rna be diluted [TOm that of a 10 percent shareholder to that of a 5 percent shareholder becau e of the issuance of the additional) ,000 shares. ~

Preemptive rights are most important in close corporations because each shareholder owns a relatively small number of shares but controls a substantial interest in the corporation. Without preemptive rights, it would be possible for a shareholder Lo lose his or her proportion a e control over the firm,

Stock Warrants

Usually, when preemptive rights exist and a corporation is issuing additional shares, each shareholder is given stock warrants, which are transferable options to acquire a given

,

number of shares from the corporation at a stated price. Warrants are often publicly

traded on securities exchanges. When the option to purchase is in effect for a short period of time, the stock warrants are usually referred to as rights.

Dividends

As mentioned in Chapter 28, a dividend is a distribution of corporate profits or income ordered by the directors and paid to the shareholders in proportion to their respective shares in the corporation. Dividends can be paid in cash, property, stock of the corporation that is paying the dividends, or stock of other corporations,"

State laws vary, but each state determines the general circumstances and legal requirements under which dividends are paid. State laws also control the sources of revenue to be used; only certain funds are legally available for paying dividends. Depending on state law, dividends may be paid from the following sources:

1 Retained eammgs. All states allow dividends to be paid from the undistributed net profits earned by the corporation, including capital gains from the sale of fixed assets. As mentioned in Chapter 28, the undistributed net profits are called retained earnings.

1 Net profits. A few states allow dividends to be issued from current net profits without

regard to deRcits in prior years.

3 Surplus. A number of states allow dividends to be paid out of any kind of surplus.

lllega} Dividends Sometime, dividends are improperly paid From an unauthorized account, or their payment causes the corporation to become insolvent. Generally, in such

9. Technically, dividends paid in stuck are not dividends, They maintain each shareholder's proportionate Interest in the corporation. On one occasion, a distillery declared and paid •• "dividend" in bonded whiskey.

819 Bl@Utm

CORPORATE DIRECTORS. OFFICERS, AND SHAREHOLDERS

STOCK WARRANT

A certificate that grants the owner the option to buy a given number of shares of stock, usually within a set time period.

820 .I1:hI1£.


A General Motors sharehokler asks a question at the company's annual stockholders'meeting. Shareholders also have a limited right to inspect and copy corporate books and records, provided the request is mode in advance and is not impromtu in on open forum like

a shareholders' meeting. What other limitations are placed on shareholders' inspection rights?

(AP Photo/Chris Gardner)

situations, shareholders must return illegal dividends only iF they knew that the dividends were illegal when rhe payment was received. A dividend paid while the corporation is Insolvent is automatically an illegal dividend, and shareholders may be required to return the payment to the corporation or its creditors. Whenever dividends are illegal or improper, the board of directors can be held personally liable for the amount of the payment. When directors can show that a shareholder knew that a dividend was illegal when it was received, however, the directors are entitled to reimbursement from the shareholder.

Directors' Failme to Declare a Dividend When directors fail to declare a dividend, shareholders can ask a court Lo compel the directors to meet and 10 declare a dividend. To succeed, the shareholders must show that the directors have acted so unreasonably in withholding the dividend lh,ll their conduct is an abuse of their discretion.

Often, a corporation accu mutates large cash reserves for ,1 bona fide purpose, such as expansion, research, or other legitimate corporate goals. The mere [act that the firm has sufficient earnings or surplus available 10 pay a dividend I not enough to compel directors to distribute funds that, in the board's opinion, should not be distributed. The courts are reluctant to interfere with corporate operations and will not compel directors to declare dividends unless abuse of discretion is clearly shown.

Inspection Rights

Shareholders in a corporation enjoy both common law and statutory inspection rights. The shareholder's right of inspection is limited, however, to the inspection and copying of corporate books and records for a proper purjJose, provided the request is made in advance. The shareholder can inspect in person, or an attorney, accountant, or other type of assistant Can do so as the shareholder's agent. The RMBCA requires the corporation to maintain an alphabetical voting lisl of shareholders with addresses and number of shares owned; Ihis lisl must be kept open at the annual meeting for inspection by any shareholder of record [RMBCA 7.20].

The power of inspection is fraught with potential abuses, and the corporation is allowed to protect itsclffrom them. For example;a shareholder can properly be denied access to corporate records to prevent harassment or to protect trade secrets or other confidential COLpOrate inforruution. Some stales require that a shareholder must have held his or her shares for

}

821 IfI:t!W4ifPl


a minimum period of time immediately preceding the demand to inspect or must hold a rninirnurn number of outstanding shares. The RMBCA provides, though, that every shareholder is entitled 1.0 examine specified corporate records [RMBCA 16.02]. A shareholder who is denied the right of inspection can seek a COIlTt order lo compel the inspection.

The question in the following case was whether a shareholder W110 obtains access to corporate books and records that the company regard. as confidential should be fre to dissernina le information in those documents publ icly.

mll~_ Disney v. Walt Disney Co.

Court of Chancery of Delaware, 857 A.2d 444 (200<1).

FJ\CTS Roy Disney is a sh~reholder of Walt Disney Company, a Delaware corporatioh with its principal offices in

,

Burbank, California. Roy Disney was a director of the company

until he resigned in November 2003. After his resignation, Disney began a campaign to encourage other shareholders to vote "no" on the reelection of Michael Eisner and three other members of the board of directors at the company's March 2004 annual meeting. As part of this effort, in January, Disney sought access to corporate books and records related to compensation for the company's five senior executives. Before

I

honoring this request, the company designated some of the

information "confidential" and asked Disney not to disseminate it publicly. He agreed only to hold it in "strict confidence:' On review of the material, however, Disney objected to the confidentiality designation. He filed a suit in a Delaware state court against the company, asking thle court to rule that the information was not appropriately designated "confidential."

ISS U E Is a shareholder who obtains access to corporate books and records that the company regards as confidential tree to disseminate information in those documents publicly?

DEC I S ION No. The court denied Roy Disney's request to remove the confidentiality designation from the documents on which the company had imposed it, and dismissed the case.

REA SON The court acknowledged that "Section 220 of the Delaware General Corporation Law provides every stockholder of a Delaware corporation acting for a proper purpose a powerful right to inspect the company's books and records." But the exercise of this right is subject to a "reasonable confidentiality order," which is meant to "protect the corporation's legitimate interests" and "prevent the dissemination of confidential business information:' Disney sought the public disclosure of information that related to '!the bases for a compensation committee's decisions to award enormous compensation packages to a public company's top executives" so that the company's shareholders could "know the whole truth." The court reasoned that removing the confidentiality limit in this case would lead to the disclosure of non public information in other cases-"snippets of information gleaned from a few e-rnails or internal memoranda"-which would cause a company to disclose even more otherwise

non public information to place the material in its "proper" context. This would not "advance the best interests of the cdrporation or its stockholders,"

WHAT IF THE FACTS WERE DIFFERENT?

If the information that Disney sought to disseminate publicly-via a Web site, for example-hod been previously disclosed ina limited manner, such as in a company newsletter, would the result have been different? Explain.

Transfer of Shares

Corporate stock represents un ownership rigbt in intangible personal property. The law generally recognizes the righl Lo transfer slack to another person unless there .ITe valid restrictions n its transferability. Although slock certificates are negotiable and freely transferable by indorsement and delivery, transfer of stock in closely held corporations usually is restricted. These restrictions musL be reasonable and may be set out in lhe bylaws or in <I hareholdcr ag cement. The existence of any restrictions on transferability must always be indicated on lhe face of the stock certificate.

B12.il~1i11i.


RIGHT OF FIRST REFUSAl

The right to purchase personal or real property-such as corporate shares or real estate-before the property is offered for sale to others.

SHAREHOLDER'S DERIVATIVE SUIT

A suit brought by a shareholder to enforce a corporate cause of action against a third person.

Sometimes, corporations or their shareholders restrict transferability by reserving the option to purchase any shares offered for resale by a shareholder. This right of first refusal remains with the corporation or the shareholders for only a specified time or a reasonable period. Variations on the purchase option arc possible. For example, a shareholder might be requ ired to offer the shares to other shareholders first or to the corporation first.

When shares are transferred, a new entry is made in the corporate stock book to indicate the new owner. Until the corporation is notified and the entry is complete, all rights- including voting rights, the right to notice of shareholders' meetings, and the right to dividend distributions-remain with the current record owner.

Rights on Dissolution

When a corporation is dissolved and its outstanding debts and the claims of its creditors have been satisfied, the remaining assets are distributed to the shareholders in proportion to the percentage of shares owned by each shareholder. Certain classes of preferred stock can be given priority. If no class of stock has been given preferences in the distribution of assets on liquidation, then all of the stockholders share tl e remaining assets.

In some circurnstarices, shareholders may petition a court to have the corporation dissolved. If, for example, the minority shareholders know that the board of directors is mishandling corporate assets, those shareholders can petition a court to appoint a receiver who will wind up corporate affairs and liquidate the business assets of the corporation (see Chapter 28 for the duties of a receiver). The RMBCA permits any shareholder to initiate

,

such an action in any of the following circumstances [RMBCA 14.301:

1 The directors are deadlocked in the management of corporate affairs. The shareholders are unable to break that deadlock, and irreparable injury to the corporation is being suffered or threatened.

2 The acts of the directors or those in control of the corporation are illegal, oppressive, or fraudulent.

1 Corporate assets are being misapplied or wasted.

4 The shareholders are deadlocked in voting power and have failed, for a specified period (usually two annual meetings), to elect successors to directors whose terms have expired or would have expired with the election of successors,

!

The Shareholder's Derivative Suit

When those in control of a corporation-the corporateirectors-fail to sue in the corporate name to.redress a wrong suffered by the corporation shareholders are permitted to do so "derivatively" in what is known as a shareholder's derivative suit. Before a derivative suit can be brought, some wrong must have been done to the corporation, and the shareholders must have presented their complaint to the board of directors. Only if the directors fall to solve the problem or to take appropriate action can the derivative suit go forward.

The right of shareholders to bring a derivative action is especially important when the wrong suffered by the corporation results from the actions of corporate directors or officers. This is because the directors and officers would probably want to prevent any action agajnst themselves.

The shareholder's derivative suit is unusual in that those suing are not pursuing rights or benefits for themselves personally but are acting as guardjans of the corporate entity. Therefore, any damages recovered by the suit normally go into the corporation's treasury. not to the shareholders personally. This is true even if the company is a small, closely held corporation. '.EXAMPLE 29.71 Zeon Corporation is owned by 1:\"'0 shareholders, each holding 50 percent of the corporate shares. Suppose that one of the shareholders wants to sue the other for misusing corporate assets or usurping corporate opportunities. The plaintiff-

BEYOND

OUR BORDERS

Derivative Actions in Other Nations

Today,. most of the claims brought against directors and officers in the United States are those alleged in shareholders' derivative suits. Other nations, however, put more restrictions on the use of such suits. German law, for example, does not provide for derivative

litigation, and a corporation's duty to its employees is just as significant as its duty to the shareholder-owners of the company. The United Kingdom has no statute authorizing derivative actions, which are permitted only to challenge directors' actions that the shareholders could not legally ratify. Japan authorizes derivative actions but also permits a company to sue the plaintiff-shareholder for damages if the action is unsuccessful.

F ~ R] (R I T I (A ~ A N A L y\~ I S Do corporations benefit from shareholders' derivative

suits. If so, how. :

~

shareholder will have to bring a shareholder's derivative suit (not a suit in his or her own name) because the alleged harm was suffered by Zeon, noL by the plaintiff personally. Any damages awarded will go to the corporation, nol to the plaintiff-shareholder. ~ (Derivative actions are less common in other countries than in the United States, as this chapter's Beyond Our Borders feature explains.)

• I

DUTIES AND LIABILITIES OF SHAREHOLDERS

One of the hallmarks of the corporate organization is that shareholders are not personally 'liable for the debts of the corporation. If the corporation fails, shareholders can Jose their investments, but that is generally the limit of their liability. As discussed in Chapter 28, ill certain instances of fraud, undercapitalization, or careless observance of corporate formalities, a court will pierce the corporate veil (disregard the corpor,te entity) and hold the shareholders individually liable. These situations are the exception, however, not the rule.

A shareholder can also be personally liable in certain other rare instances. One relates to illegal dividends, which were discussed previously. Another relates to watered stock. Finally, in certain instances, a majority shareholder who engages in oppressive conduct or attempts to exclude minority shareholders from receiving certain benefits can be held personally liable.

Watered Stock

When a corporation issues shares for less than their fair market value, the shares are referred to as watered stock. 10 Usually, the shareholder who receives watered stock must pay tile difference to the corporation (the shareholder is personally liable). In some states, the shareholder who receives watered stock may be liable to creditors of the corporation for unpaid corporate debts,

[!IEXAMPLE 29.01 During the formation of a corporation, Gomez, one of the incorporators, transfers his property, Sunset Beach, to the corporation for 10,000 shares of stock.

10. The phrase watered steel: was ongina lIy used 10 describe cattle thai were kept th irsty dun ng a long drive and 111en Were allowed to drink l~rge quantities or water ill~' prior 10 their sale. TIle increased weight of the "watered stock" allowed the seller to reap a higher profit.

823 ttllt:1i01Oi'U

CORPORATI= DIRECTORS, OFFICERS, AND SHAREHOLDERS

WATERED STOCK

Shares of stock issued by a corporation for which the corporation receives, as payment, less than the stated value of the shares.

824 .Iun",:_


The stock has 8 specific face value (/)[n value} of $1 00 per share, and thus th total price of the 10,000 shares is $1 million. After the property is transferred and the shares are issued, Sunset Beach is carried all the corporate books at a value of $1 million. On appraisal, it is discovered that the market va lue of the property at the time of transfer was only $500,000. The shares issued to Gomez are therefore watered stock, and he is liable to the corporation [or the diFference. [!J

Duties of Majority Shareholders

In some instances, a majority shareholder is regarded as having a fiduciary duly to lhe Corporation and to the minority shareholders. This occurs when a single shareholder (or a few shareholders acting in concert) owns a sufficient number or shares Lo exercise de facto (actual) control over the corporation. In these situations, majority shareholders owe a fiduciary duty to the minority shareholders.

A breach of Iiduciary duty can also occur whenthe majority sharehnlders or a closely held corporation use their control to exclude the minority From certain benefits of participating in the firm. '.eXAMPlE 29.9 LThree brothers, Allred, Carl, and Eugene, each owned a one-third interest in a corporation and had worked for the corporatir n for most of their adult lives. When a dispute arose conceming discrepancies in lhe corporation's accounting records, Carl and Eugene fired Alfred and told the company's employees that Alfred had had a nervous breakdown, which was not true. Alfred lied Car] and Eugene, alleging that they had breached their fiduciary duties. The brothers argcled that because there was no reduction in the value of the corporation or the value of Alfred's shares in the company, they had not breached their fiduciary duties. The court, however, held that the brothers' conduct was unfairly prejudicial toward Alfred and supported a Ilnding of a breach of fiduciary duty. I I f!]

Such a breach of fiduciary duties by those who control a closely held corporation may constitute oppressive conduct. The court in the following case was asked to review a pattern or allegedly oppressive conduct by the person in control and determine whether that conduct fell within a two-year statute a limitations.

\

11. See, for example, Swunsoll v. Upper Midwest luduetrie«, 1111: .• _ N. '.\'.2d _ ltv] inn.App. 20(2).

Supreme Court of Alabama. 890 So.2d 998 (2004).

FACTS James and Mary Bailey owned fifty-three acres of land, subject to mortgages totaling $450,000, in Birmingham, Alabama. The Baileys rented buildings on the property and used part of the land as a landfill. tn 1988, an underground fire broke out in the landfill. Pete Robbins offered to

extinguish the fire and to pay the mortgages. The parties formed Corridor Enterprises, Inc., to which the Baileys contributed the land. Half of the stock-one thousand shareswas issued to Robbins. In 1991, the Baileys agreed to sell their thousand shares to Robbins at the rate of two shares per month. The Baileys both died in 1997. Terrill Sanders was appointed administrator of their estates. Over the next twelve months, Sanders had problems obtaining information from

Robbins and uncovered discrepancies in Corridor's corporate records. On the estates' behalf, Sanders filed a suit in an Alabama state court, alleging, among other things, oppression of minority shareholders. The court assessed more than

$4 million in damages against Robbins, who appealed to

the Alabama Supreme Court, arguing in part that a two-year statute of limitations barred the suit

ISS U E Were the minority shareholders entitled to recover for their claim of oppression?

DEC I S ION Yes. The Alabama Supreme Court held that Sanders's claims on behalf of the Baileys' estates were timely. The court remanded the case, though, so that the lower court

CASE 29.3-Continued

could clearly state how the damages should be apportioned among the estates and Corridor."

REA SON The state supreme court rejected Robbins's statute-of-limitations argument. The court explained that the Baileys' estates became minority shareholders after the Baileys died in 1997. The court pointed out that Robbins engaged in oppressive conduct after this event. "For example, in 1998, Robbins used funds of Corridor Enterprises to purchase real estate in his own name, to invest in other businesses in his own name, and to purchase personal property for himself; he refused to provide an accounting of the corporate finances when he was requested to do so; he failed to pay the

"

a. This case was remanded and tried agatn and appealed again on different issues. The court's holding in this case sti!1 stands. The subsequent decision Involving the same parties is located at 9b So.2d 777 (Ala.Sup.Ct 2005).

825 13:r,'Qj3r'P'

CORPORATE D1REOORS, OFFICERS. AND SHAREHOLDERS

corporate property and income taxes, failed to have tax retums prepared and filed, and failed to maintain proper corporate records; he entered into a contract to sell property belonging to Corridor Enterprises without notice to or approval of the minority shareholders; and he failed to declare dividends during the entire time the estates were shareholders while he paid himself an exorbitant salary and drained the corporate funds." Sanders initiated this suit on the estates' behalf in the same year that many of these activities occurred. "Therefore, the estates' claims of * '" '" oppression were not time-barred to the extent those claims sought to recover damages for injuries occurring to the estates."

FOR CRITICAL ANALYSIS-Economic Consideration What should be the basis for determining the specific amount of damages to be awarded to the minority shareholders in this case?

MAJOR BUSINESS FORMS COMPARED

As mentioned in Chapter 25, when deciding which form of bus mess organization would be most appropriate, businesspersons normally take into account several factors including ease of creation the liability of the owners, fax considerations, and the need for capital. Each major form of business organization offers distinct advantages and disadvantages with respect to these and other fa tors. Exhibit 29-2 on pages 826 and 827 summarizes the essential advantages and disadvantages of each of the forms of business organization discussed in Chapters 25 through 28, as well a in this chapter.

David Brock is on the board of directors of Firm Body Fitness, Inc., which owns a string of fitness dubs in New Mexico. Brock owns 15 percent of the Firm Body stock, and he is also employed as a tanning technician at one of the fitness clubs. After the January financial report showed that Firm Body's tanning division was operating at a substantial net loss, the board of directors, led by Marty Levinson, discussed terminating the tanning operations. Brock successfully convinced a majority of the board that the tanning division was necessary to market the club's overall fitness package. By April. the tanning division's financial losses had risen. The board hired a business analyst who conducted surveys and determined that the tanning operations did not significantly increase membership. A shareholder, Diego Pefiada, discovered that Brock owned stock in Sunglow, Inc, the company from which Firm Body purchased

its tanning equipment. Penada notified Levinson, who privately reprimanded Brock Shortly afterwards, Brock and Mandy Vail, who owned 37 percent of Firm Body stock and also held shares of Sunglow, voted to replace Levinson on the board of directors. Using the information presented in the chapter, answer the following questions.

1 What duties did Brock, as a director, owe to Firm Body? 1 Does the fact that Brock owned shares in Sunglow

establish a conflict of interest? Why or why not?

3 Suppose that Firm Body brought an action against Brock claiming that he had breached the duty of loyalty by not disclosing his interest in Sunglow to the other directors. What theory might Brock use in his defense?

4 Now suppose that Firm Body did not bring an action against Brock. What type of lawsuit might Penada be able to bring based on these facts?

826 _ .. :11111:.


U3i!i:li'¥" Major Forms of Business (Qml!arell

CHARAcrERlsnc

Method of creation

Legal position

Liability

Duration

Transferability of interest

Management

Taxation

Organizational fees, annual license fees, and annual reports

Transaction of business in

other states

SOLE PROPRIETORSHIP

Created at will by owner.

Not a separate entity; owner is the business.

Unlimited liability.

Determined by owner; automatically dissolved on owner's death.

Interest can be transferred, but individual's proprietorship then ends.

Completely at owner's discretion.

Owner pays personal taxes on business income.

None or minimal.

Generally no limitation.

PARTNERSHIP

Created by agreement of the parties.

ls a separate legal entity in most states.

Unlimited liability.

J Terminated by agreement of

. the partners, but can continue to do business even when a partner dissociates from the partnership.

,

Although partnership inferest can be assigned, assignee does not have full rights of a partner.

Each general parther has a direct and equal voice in management unless expressly agreed otherwise in the partnership agreement

Each partner pays pro rata share of income taxes on net profits, whether or not they are distributed.

None or minimal.

Generally no limitation. a

a. A lew states have enacted statutes requiring that foreign partnerships qualify to do business there.

CORPORATION

Authorized by the state under the state's corporation law.

Always a legal entity separate and distinct from its owners-a legal fiction for the purposes of owning property and being a party to litigation.

limited liabilIty of shareholders-shareholders are not liable for the debts of the corporation.

Can have perpetual existence.

Shares of stock can be transferred.

Shareholders elect directors, who set policy and appoint officers.

Double taxation-corporation pays income tax on net profits, with no deduction for

!dividends, and shareholders I pay income tax on disbursed \ dividends they receive.

All required.

Normally must qualify to do business and obtain certificate of authority.

82l 13tt,10i4;'P]


EXHIBIT 29-2

LIMITED LIMITED LIMITED
CHARAcrERISTIC PARTNERSHIP LIABILITY COMPANY LIABILITY PARTNERSHIP
Method of creation Created by agreement to carry Created by an agreement of Created by agreement of the
on a business for a profit At the member-owners of the partners. A statement of
least one party must be a company. Artides of qualification for the limited
general partner and the organization are filed. Charter liability partnership is filed.
other(s) limited partner(s). must be issued by the state.
Certificate of limited
partnership is filed. Charter
must be issued by the state.
Legal position Treated as a legal entity. Treated as a legal entity. Generally, treated same as a
general partnership.
Liability Unl'mited liability of all general Member-owners' liability is Varies, but under the Uniform
pa~ners; limited partners are limited to the amount of capital Partnership Act, liilbility of a
lia ' Ie only to the extent of contributions or investments. partner for acts committed by
capital contributions. other partners is limited.
Duration By agreement in certificate, or Unless a single-member LLC, Remains in existence until
by termination of the last can have perpetual existence cancellation or revocation.
general partner (retirement, (same as a corporation).
death, and the like) or last
limited partner.
Transferability Interest can be assigned (same Member interests are freely Interest can be assigned same
of interest as general partnership), but if transferable. as in a general partnership.
assignee becomes a member
with consent of other partners,
certificate mus) be amended.
J
Management General partners have equal Member~wners can fully Same as a general partnership.
voice or by agreement.llimited participate in management; or
partners may not retain limited management is selected by
liability if they actively metljlber-owners who manage
participate in management. on behalf of the members.
Taxation Generally taxed as a LLC is not taxed, and members Same as a general partnership.
partnership. are taxed personally on profits
"passed through" the LLC.
Organizational fees, Organizational fee required; Organizational fee required; Fees are set by each state for
annuall.icense fees, usually not others. others vary with states. filing statements of
and annual reports qualification, foreign
qualification, and annual
reports.
Transaction of Generally no limitations. Generally no limitation, but Must file a statement of forejgn
business in may vary depending on state. qualification before doing
other states business in another state. • This Application is not meant to substitute for the services of an attorney who is licensed to practice law in your state.

828 .~H"'1t.


IT] fa corporation becomes the target of a civil lawsuit or criminal investigation, the company may be required to turn over any documents in its files relatillg to the matter during the discovery stage of litigation. These documents may include legal documents, contracts, e-mail, faxes, letters, interoffice memorandums, notebooks, diaries, and other material, even if Lhey are kept in personal files in the homes of directors or officers. Under the current Federal Ru les of Civil Procedure, which govern civil litigation procedures (see Chapter 3), a defendant in a lawsuit must disclose all releval11 electronic data compilations and documents, as well as all relevant paper documents.

Although certain documents or data might free a company of any liability arising from a claim, others might serve to substantiate a civil claim or criminal charge. It is also possible that information contained in a document-an interoffice e-mail memo, for example (or even a memo referring to that memo)-could be used to convince a jury that the company or its directors or officers had condoned a certain action that they later denied condoning.

Which E·Documents Should Be Retained?

How does a company decide which e-docurnents should be retained and which should be destroyed? By law, corporations are required to keep certain types of documents, such as those specified in the Code of Federal RegLtialiolls and in regulations issued by government agencies, such as the Occupational Safely and Health Administration. Most businesses today have a document-retention policy. Generally, any records that the company is not legally required to keep or that the company is sure il will have no legal need for should be removed from the files and destroyed. A partnership agreement, for example, should be kept. A memo about last year's

company picnic, however, should be removed &om the files and destroyed; obviously, it is just taking up storage space.

Modifications May Be

Necessary during an Investigation

if the company becomes the targeL of an investigation, it usually must modify its document-retention policy until the investigation has been completed. Company officers, after receiving a subpoena to produce specific types of documents, should instruct the appropriate employees not to destroy relevant papers or e-docurnents that would otherwise be disposed of as part of the company's normal document-retention program.

Generally, to avoid being charged with obstruction of justice, company officials must always exercise good faith in deciding which documents should or should not be destroyed when attempting to comply with a subpoena. The specter of criminal prosecutiof would appear to encourage the retention of even those documents that are only remotely related to the dispute-at least until it has been resolved.

I

CHECKLIST FOR AN

E-DOCUMENT-RETENTION POLICY

Develop guidelines that let employees know not only which e-documents should be retained and deleted but also which types of documents should not be created in the first place.

2 Find out which documents must be retained under the Code Df Federal RegiJlations and under other government agency regulations to which your corpo-

ration is subject. \

3 Retain other e-documents only if their retention is in the corporation's interest

4 If certain corporate documents are subpoenaed, modify your document-retention policy to retain any document that is even remotely related to the dispute until the legal action has been resolved.

business judgment rule 813 inside director 809

outside director 809 preemptive rights 818

prox.y 815 quorum 808

right of first refusal 822 shareholder's derivative suit 822

stock certificate 818 stock warrant 819 voting trust 817 watered stock 823

829 14:t!1Q'*'PI

CORPORATE DIRECTORS, DFfICERS, AN D SHAREHOLDERS

Roles of Directors and Officers

(See pages 806-810.)

Duties and Liabilities of

Directors and Officers (See pages 811-813.)

Role of Shareholders (See pages 813-818.)

1. Directors' qualifications-Few qualifications are required; a director may be a shareholder but is not required to be.

2. Election of directors-The first board of directors is usually appointed by the incorporators; thereafter, directors are elected by the shareholders. Directors usually serve a one-year term, although the term can be longer, and staggered terms are permitted under most state statutes.

3. Board of directors' meetings-The board of directors conducts business by holding formal meetings WITh recorded minutes. The date of regular meetings is usually established in the corporate articles or bylaws; special meetings can be called, with notice sent to all directors. Quorum requirements vary from state to state; usually, a quorum is a majority of the corporate directors. Voting must usually be done in person, and in ordinary matters only a majority vote is required.

4. Rights of directors-Directors' rights include the rights of participation, inspection, \compensation, and indemnification. Compensation is usually specified in the corporate articles 'pr bylaws.

5. {Directors' management responsibilities-Directors are responsible for declaring and paying corporate dividends to shareholders; authorizing major corporate decisions; appointing, supervising, and removing corporate officers and other managerial employees; determining employees' compensation; and making financial decisions. such as the decision to issue authorized shares and bonds. Directors may delegate some of their responsibilities to executive committees and corporate officers and executives.

6. Corporate officers and executives-Corporate officers and other executive employees are normally hired by the board of directors. As employees, corporate officers and executives have the rights define? by their employment contracts. The duties of corporate officers are the same as those of directors.

1. Duty of care-Directors and officers are obligated to act in good faith, to use prudent business judgment in the conduct of corporate affairs, and to act in the corporation's best interests.

If a directof fails to exercise this duty of care, she or he can be answerable to the corporation and to the shareholders for breaching the duty.

2. Duty of loyalty-Directors and officers have a fiduciary duty to subordinate their own interests to those of the corporation in matters relating to the corporation.

3. Conflicts of interest-To fulfill their duty of loyalty, directors and officers must make a full disclosure of any potential conflicts between their personal. interests and those of the corporation.

4. Uabilfty of directors and o(ficef.5-Corporate directors and officers are personally liable for their own torts and crimes; additionally, they may be held personally liable for the torts and crimes committed by corporate personnel under their supervision (see Chapters 6 and 24).

5. The business judgment rule-- This rule immunizes directors and officers from liability when they acted in good faith, acted in-the best interests of the corporation, and exercised due care. For the rule to apply, the directors and officers must have made an informed, reasonable, and loyal decision.

1. Shareholders' powers-Shareholders' powers include the approval.of all fundamental changes

affecting the corporation and the election of the board of directors. '

2 Shareholders' meetings-Shareholders' meetings must occur at least annually; special meetings can be called when necessary. Notice of the date, time, and place of the meeting (and its purpose, if it is specially called) must be sent to shareholders. Shareholders may vote by proxy (authorizing someone else to vote their shares) and may submit proposals to be included in the company's proxy materials sent to shareholders before meetings.

(Continued)

830 M"U_'I":.


Role of ShareholdersContinued

Rights of Shareholders (See pages 818-823.)

Duties and Liabilities of Shareholders

(See pages 823-825.)

3. Shareholder voting-Shareholder voting requirements and procedures are as follows:

a. A minimum number of shareholders (a quorum-generally, more than 50 percent of shares held) must be present at a meeting tor business to be conducted; resolutions are passed (usually) by simple majority vote.

b. The corporation must prepare voting lists of shareholders of record prior to each shareholders' meeting.

c. Cumulative voting mayor may not be required or permitted. Cumulative voting gives minority shareholders a better chance to be represented on the board of directors.

d.A shareholder voting agreement (an agreement of shareholders to vote their shares together) is usually held to be valid and enforceable.

e. A shareholder may appoint a proxy (substitute) to vote her or his shares.

f. A shareholder may enter into a voting trust agreement by which title (record ownership) of his or her shares is given to a trustee, and the trustee votes the shares in accordance with the trust agreement

Shareholders have numerous rikhts, which may include the following:

I. The right to a stock certificate, preemptive ri?hts, and the right to stock warrants (depending on

the articles of incorporation).

2. The right to obtain a dividend (at the discretion of the directors).

3. Voting rights. "

4. The right to inspect the corporate records.

5. The right to transfer shares (this right may be restricted in close corporations).

I

6. The right to a share of corporate assets when the corporation is dissolved.

7. The right to sue on behalf of the corporation (bring a shareholder's derivative suit) when the directors fail to do so.

1. Shareholders may be liable for the retention of illegal dividends and for the value of watered stock.

2. In certain situations, majority shareholders may be regarded as having a fiduciary duty to

minority shareholders and will be liable if that duty is breached.

I

I

\

Answers for the even-numbered questions in this For Review section con be found in Appendix f at the end of this text. I What are the duties of corporate directors and officers?

1 Directors are expected to use their best judgment in managing the corporation. What must directors do to avoid liability for honest mistakes of Judgment and poor business decisions?

1 What is a voting proxy? What is cumulative voting?

4 If a group of shareholders perceives that the corporation has suffered a wrong and the directors refuse to take action, can the shareholders compel the directors to act? If so, how?

5 From what sources may dividends be paid legally? In what circumstances is a dividend illegal? What happens if a dividend is illegally paid?

831 IIIWhmi'O

CORPORATE DIREaORS, OFFICERS, AND SHAREHOLDERS

The following multiple-t:hoice question. is representative of the types of questions available in one of the four sections of ThomsonNOW for Business Law Today. TllomsonNOW also provides feedback for each response option, whether correct or incorred, and refers to the location within the chapter where the correct answer can be found.

A major power held by shareholders is the power to a appoint corporate officers.

b manage and supervise daily operations of the corporation. C declare dividends.

d amend the articles of incorporation or the corporate bylaws.

QUESTIONS AND CASE PROBLEMS

HYPOTHETICAL SCENARIOS

19.1 Voting Techniques. Algonquin Corp. ha issued and has outstanding 100,000 shares of common stock. Four stockholders own 60,000 of these shares, ami for the past six years Lhey have nominated a slate of people for membership on the board, all of whom have been elected. Sergio and twenty other shareholders, owning 20,000 shares, are dissatisfied with corporate management and want a representative on the board who shares their views. Explain under what circumstances Sergio and the minority shareholders can elect their representative 10 the board.

19.2 Hypothetical Question with Sample Answer. Starboard, Inc .. has a board of directors consisting of clue; members (Ellsworth, Creen, and Morino) and approximately five hundred shareholders. At a regular meeting of the board, the board selects Tyson as president of the corporation by a twoto-one vote, with Ellsworth dissenting. The minutes of the meeting do not rcgisler Ellsworlh's dissenting vote. Later,

during all audit. it is discovered that Tyson is a former convict and has openly embezzled $500,000 from Starboard, This loss is not covered by insurance. The corporation wants to hold directors Ellsworth, Creen, and Morino liable. Ellsworth claim 110 liability. Discuss the personal liabilityof lhe directors La the corporation.

~ For a sample answer to Question 29.2. go to Appendix F at the !l!I end of this te.xt.

19.3 Lucia has acquired one share of common slack of a rnulurrullion-dollar corporation with more than 500,000 shareholders. Lucia's ownership is so small thai she is questioning whaL her rights are as a shareholder. For example, she wants to know whether owning this one share entitles her to (1) attend and vote at shareholders' meetings,

(2) inspect the corporate books, and (3) receive yearly dividends. Discuss Lucia's rights in these three matters.

CASE PROBLEMS

29.4 Business Judgment Rule. Charles Pace and Maria Fuentez were shareholders of Houston Industries. Inc. (Hll), and employees of Houston Lighting & Power, a subsidiary of rot when they lost their jobs because of a cornpanywide reduction in its workforce. Pace, as :J shareholder, three times wrote to HlI, demanding that the board of directors terminate certain I-Ill directors and officers and file a suit Lo recover damages for breach of fiduciary duty. Three times, the directors referred the charges to board committees and an outside law firm, which found that the facts did not support the charges. The board also received input from federal regulatory authorities about the [acts behind some of the

charges. The board notified Pace that it was refusing his demands. In response, Pace and Fuentez filed a shareholder's derivative suit in a Texas state court againsl Don Jordan and the other HTI directors, COil tending that the board's investigation was inadequate. The defendants filed.a motion for urnrnary judgment, arg11ing that the suit was barred by the business judgment rule. Are the defendants right? How should the court rule? Why? [Pace v. Jordan.. 999 S,W,2d 615 (Tex.App.- Houston. p Dist.j 1999)J

29.S Duties of Majority Shareholders. Atlas Food Systems & Services, lnc., based in SouLh Carolina, was a food vending

812 .11:"1',:.


service that provided refreshments to factories and ollier businesses. Atlas Wi.1S a closely held corporation. John Kiriakides W.1S <I minority shareholder of Atlas. Alex Kiriakides was the majority shareholder. Throughout most of Alias's history, Alex was the chair of the board, which

.mcluded [ohn as a director, 111 1995, while John was the president of the finn the board and shareholders decided to convert Atlas to all corporation. A few months later. however, Alex, without calling a vote, decided that the firm would not convert. In 1996, a dispute arose over Atlas's COIItract to buy certain property. John and others decided nol La buy it. Without consulting anyone, Alex elected to go tlHough with the sale. Within a few days. Alex refused 10 allow John to stay on as president. Two months later, Atlas offered to buy John's interest in the firm for almost $2 million. John refused, believing the offer was too low. John

filed a suit in a South Carolina state court against Atlas and Alex. seeking, among other things, to force a buyout or John's shares. On what basis might the court grant John's request? Discuss. [Kiriakides v. Allas Food Systems & Services, lnc., 343 S.C. 587,541 S.E.2d 257 (2001))

29.6 lnspedion Rights._ Craig Johnson Founded Distributed Solutions, Inc. (OSI). in 1991 to make software and provide consulting services. including payroll services, for small companies. Johnson was the sole officer and director and the majority shareholder. Jeffrey Hagen was ~ minority shareholder. In 1993, Johnson sold OSI's payroll services to himself and a few others and sci up Distributed Payroll

Solutions, Inc. (DPS!). In 1996, DS] had revenues of

. $ 739 .OH a nd assets of $ 54l ,168. DSI's revenues in 1997 were $934,532. Withrn <I year, however, .111 of DSl's assets were sold, and Jol1l150n told Hagen that he was dissolving the linTl because, among oilier things, it conducted 110 business and had no prospects for future business. Hagen asked for corporate records to determine Ihe value of DSJ's stock,

DSl's financial condition. and "whether unauthorized and oppressive acts had occurred in connect ion with the operalion of the corporation which impacted the value of" lhe stock. When tircre was no response. Hagei filed a sui: ill all Illinois stale court against DSI and Johnson, seeking an order to compel the inspection. The defendants filed a motion 10 dismiss, argu.ing thai l lagen bad failed to plead <I proper purpose. Should the court grant Hagen's request? Discuss.

r Hagen v. Distributed Solutions, lnc., 328 I1I.App3d 132. 76-+ N.K2d l14l, 262 m.Dee. 24 (I Disl 2002)1

29_7 Case Problem with Sample Answer_ Digilal Commerce, Ltd., designed software to enable its clients to sell their products or services over the Internet. Kevin Sullivan served as a Digital vice president until 2000, when he became presidenL Sullivan was dissatisfied Ihat his compensation lid not include stock in Digital, but he was unable to negotiate a deal lhat included equity (referring to shares of ownership in the company). In May, Sullivan solicited ASR Corp.'s busine s for Digital while he investigated employment opportunities with ASR [or himself When ASR would not include an "equity component" ill ;] job offer, Sullivan refused to

negotiate further 011 Digilnl's behalf. A few months later, Sullivan began to rorm his OWII firm to compete wilh Digital, eonc1ucling organizational and marketing activities 011 Digital's time. including sol icil ing ASR's business. In August, Sullivan resigned after Hrst having aile-mail pertaining to the new fi rill deleted from Digital's computers. ASR signed OJ contract with Sullivan's new firm and paid it $400,000 for work through October 2001. Digital filed a suit in a federal district court against Sullivan. claiming that he had usurped a corporate opportunity. Did Sullivar: breach his fiduciary duty to Digital? Explain. [In re Sullivan, 305 Hankr. 809 (WD.Mich. 2004)]

After you have answered Problem 29_7, compare your answer with the sample answer given on the Web site that

accompanies this text_ Go to www.thomsonedu_com/westbuslaw/bll. select "Chapter 29," and dic:k on "Case Problem with Sample Answer."

29_8 Duties of Majority Shareholders. Steve and I .. rie Venturini

were involved in the operation of Steve's Sizzling Steakhouse in Carlstadt, New Jersey, frOI11 the day their parents opened it in the 19305. By the 1980s, Steve, Marie, and her husband, Joe, were running it. The business was a corporation with Steve and Marie each owning half of the stock. Steve di~d in 2001, leaving his stock in e'1m11 shares

to his sons Steve and Gregg. Son teve had never worked there. Gregg did occasional maintenance work until his father's death. Despite their lack of participation, the sons were paid more than $750 per week each. In 2002, Marie's son Blaise, who had obtained a college degree in restaurant management while working part-time at the steakhouse, took over its rnanagement.When his COliS ins became threatening, he denied them access to the business ami its books. Marie refused Cregg and Steve's offer of about $1.4 million Ior her stock in the restaur; III and Ihey refused her offer of about $800,000 for theirs. They filed a suit in a New Jersey stale court againsl her, claijlling, aillolig other lhings, a breach of fiduciary duty. SllOuld the court order the aunt to buyout the nephews or th~ nephews to buy oul thc aunt,

0( neither? Why? WenturiJi v, Steve's S!eClkhouse, Inc.,_ N.j.Super. ~ _ A.Zd _ (CII.Div. 2006)J

29.9 Fidudary Duties and Uabilities. Harry l-loaas and Larry Criffiths were shareholders in Grand Casino, Inc., which owned and operated a casino ill Watertown, South Dakota. Griffiths owned 51 percent of the stock and Hoaas 49 percent. Hoaas managed the casino, which Griffiths typically visi ted once a week. At the end of 1997, an accoun ti ng showed that the cash on hand was less than the amount posted in the casino's books. Later, more shortfalls were discovered. In October 1999, Griffiths did a complete audit. Hoaas was unable to account for $135",500 in missing cash. Griffiths then kept all or lhe casino's most recent profits, including Hoaas's $9,447.2.0 share, and, without telling HO<la5, sold the casino for $100,000 and kept all or the proceeds. Hoaas filed a suit ill a South Dakota stale court against Griffilhs, asserting, among other til ings. a breach of 5duciaJY duty. riffiths countered with evidence of Hoaas's misappropriation or cor-

porate cash. What duties did these parties owe each other/ Did either Griffiths or Hoaas, or both of them, breach those duties? How should their dispute be resolved? How should their finances be reconciled? Explain. [Hoaas v. Criffiths. 2006 SO 27,714 N.W.2d 61 (2006)1

29.10 A Question of Ethics. Nell' Orleans Paddlewheets. Inc.

(NOP), is a Louisiana corporation fanned in 1982 when Tames Smith, Sr., and Warrell Reuther were its only shareholders, Wial each holding 50 percent o{ the slock. Nap is pari of a sprawling enterprise of tourism and hospitality companies in New Orleans. The f)ositions on tile board of each compan)/ were split equally between the Smith and Reuther (ami lies. Ai Smith 's request, his son James Smilh, /r, (JES), became involved ill the businesses. In 1999, NOP's board elected IES the president. in charge of day-lo·da)' opetaiions, and Reuther the chier~xeclltive officer (CEO), in charge o[ motketing and development. Oller the next few )'ears, animosity developed be,hveell Reuther and IE . In October 2001, IES terminated Reiuher as CEO and denied him access to the olJices and books o[ NOP and the other companie«. literall), changing the locks on the doors, At the

833 l!lm4Ujm

(ORPORATt DIRECTORS, OFRCERS, AND SHAREHOLDERS

next meetings of the boards of Nor and the overall anterprise, deadlock ensued, with the directors voting along famil), lines on eve')' issue. Complaining that the meetings were a "waste or ti me," 1 ES began to Til n the entire enterprise by lak. ing advantage of an unequal balance of power all the combarues' executive committees. In NaP's subsequent bankruptcy proceeding, Reuther (iled a motion {or the appointmenl of a trustee to [omtulate a plan {or the {inn's reorganization, alleging. among other things, misconduct b)' NOP's management. nil re Ncw Orleans Paddlewheels, lnc., 350 Bankr. 667 (E.D.La. 2006)J

Was Reuther legall entitled to have access to the books and records of NOP and the other companies? JES maintained, among other things, that NaP's books were "a mess." Was J !.Ss denial of that access unethical? Explain,

1 flow would you describe J ES's attempt to gain control of Nap and the other cal npanies? Were his actions dllPJ icitous and self-serving in the pursuit of personal gain or legitimate and reasonable in the pursuit of a business goal? Discuss,

CRITICAL THINKING

AND WRITING ASSIGNMENTS

29.11 Critical Legal Thinking. In general, courts are reluctant La grant shareholders' petitions for corporate dissolution except in extreme circumstances, such as when .,.corporate directors

or shareholders are deadlocked and the corporation suffers as a result, Rather, a court will attempt to "save" the corporate entity whenever possible, Why is tl, is?

I PRACTICAL INTERNET EXERCISES

Go to this text's Web site al www.thomsonedu.com/westbuslaw/blt. select "Chapter 29," and click on "Practical internet Exercises." There you will find the following h Iern l resear h e crcises that you can perform to learn more about the topics covered in this chapter.

PRACTICAL INTERNET EXERCISE 29-1 I.EGAL PERSPECTIVE-Liability of Directors and Officers PRACTICAL INTERNET EXERCISE 29-2 MANAGF.MENT PERSPECTfVE-D & a Insurance

BEFORE THE TEST

Cu Lo this text's Web site at www.thomsonedu.com/westbu5Iaw/blt. select "Chapter 29," and click 011 "Interactive Quizzes." You will find a number of interactive questions relating to this chapter.

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