CH-35-37 Management Structure – Smith and Robersons Business Law : Book Guide

This Document Contains Chapters 35 to 37 Chapter 35 MANAGEMENT STRUCTURE ANSWERS TO QUESTIONS AND CASE PROBLEMS 1. Brown, the president and director of a corporation engaged in owning and operating a chain of motels, was advised, on what seemed to be good authority, that a superhighway was to be constructed through the town of X, which would be a most desirable location for a motel. Brown presented these facts to the board of directors of the motel corporation and recommended that the corporation build a motel in the town of X at the location described. The board of directors agreed, and the new motel was constructed. However, the superhighway plans were changed after the motel was constructed, and the highway was never built. Later, a packinghouse was built on property adjoining the motel, and as a result the corporation sustained a considerable loss. The shareholders brought an appropriate action against Brown, charging that his proposal had caused the corporation a substantial loss. What is the result? Answer: Business Judgment Rule. Decision in favor of Brown. An officer or director of a corporation is not personally liable for loss sustained by the corporation as the result of the exercise of poor or mistaken business judgment. An officer or director is liable for loss resulting from his negligence of failure to exercise reasonable care. In this case, Brown was not guilty of negligence. He merely exercised a business judgment in good faith with due care and in a manner he reasonably believed to be in the best interests of the corporation. 2. A, B, C, D, and E constituted the board of directors of the X Corporation. While D and E were out of town, A, B, and C held a special meeting of the board. Just as the meeting began, C became ill. He then gave a proxy to A and went home. A resolution was then adopted directing and authorizing the X Corporation’s purchase of an adjoining piece of land owned by S as a site for an additional factory building. A and B voted for the resolution, and A, as C’s proxy, cast C’s vote in favor of the resolution. The X Corporation then made a contract with S for the purchase of the land. After the return of D and E, another special meeting of the board was held with all five directors present. A resolution was then unanimously adopted to cancel the contract with S. May S recover damages from X Corporation for breach of contract? Answer: Exercise of Director's Functions: Quorum and Voting (Directors' Meetings). No, S may not recover from X Corporation. Even if the first special meeting of the board had been properly called upon due notice to all of the directors, a director may not act by proxy. Hence, there was no quorum present at the meeting as C's proxy to A was invalid and a majority of the five person board was not present. The contract with S was not authorized by proper board action and was not binding on the corporation. At the second meeting, the invalid contract was rescinded by unanimous action of the board, precluding any ratification or acquiescence by the corporation. 3. Bernard Koch was president of United Corporation, a closely held corporation. Koch, James Trent, and Henry Phillips made up the three-person board of directors. At a meeting of the board, Trent was elected president, replacing Koch. At the same meeting, Trent attempted to have the salary of the president increased. He was unable to obtain board approval of the increase because although Phillips voted for the increase, Koch voted against it. Trent was disqualified from voting by the charter. As a result, the directors, by a two-to-one vote, amended the bylaws to provide for the appointment of an executive committee composed of three reputable businesspersons to pass upon and fix all matters of salary for employees of the corporation. Subsequently, the executive committee, consisting of Jane Jones, James Black, and William Johnson, increased the salary of the president. Will Koch succeed in an appropriate action against the corporation, Trent, and Phillips to enjoin them from paying compensation to the president above that fixed by the board of directors? Explain. Answer: Delegation of Board Powers. Injunction granted. An executive committee of a board of directors must be composed of persons who are directors. The executive committee in this case was composed entirely of persons who were not directors. Hence, they were ineligible to act as an executive committee and the increase in salary which they voted to give the president was ineffective to bind either the board of directors or the corporation. Revised Act, Section 8.25. 4. Zenith Steel Company operates a prosperous business. In January, Zenith’s CEO and president, Roe, who is also a member of the board of directors, was voted a $1,000,000 bonus by the board of directors for valuable services he provided to the company during the previous year. Roe received an annual salary of $850,000 from the company. Black, Inc., a minority shareholder in Zenith Steel Company, brings an appropriate action to enjoin the payment by the company of the $1,000,000 bonus. Explain whether Black will succeed in its attempt. Answer: Compensation of Directors. Decision for Black and against Zenith Steel Company enjoining payment of the $1,000,000 bonus. An officer who is also a director of a corporation is not entitled to extra compensation from the corporation for past services to the company in performing the regular duties of his office. If Roe had not been a director, many courts would uphold the payment of the bonus to him, at least if the total amount paid him could be deemed reasonable compensation for his services, and in deciding what is reasonable, much weight would be given to the discretion and judgment of the board of directors. The rule is much harsher where, as here, the recipient of the bonus is a director as well as an officer. Most courts hold that a director-officer is not entitled to compensation for the performance of the regular or agreed upon duties of his office unless provision for payment was made before he actually rendered the services in question. Here, no provision for payment of the bonus to Roe was made until after he had fully performed all the services in question. Moreover, there is no evidence that the services he performed during the year were not of the type expected and agreed upon in return for his regular salary of $850,000. If Roe could demonstrate that he did perform certain extraordinary and onerous services for the company not within or incidental to the customary or agreed upon scope of the duties of his office and so not covered by the scope of the services expected for his regular salary of $850,000, then an implied agreement for payment of reasonable compensation for such extraordinary services might justify his bonus. Absent such proof, most courts would hold Roe had no right to payment of the bonus. 5. (a) Smith, a director of the Sample Corporation, sells a piece of vacant land to the Sample Corporation for $500,000. The land cost him $200,000. (b) Jones, a shareholder of the Sample Corporation, sells a used truck to the Sample Corporation for $8,400, although the truck is worth $6,000. Raphael, a minority shareholder of the Sample Corporation, claims that these sales are void and should be annulled. Is he correct? Why? Answer: Director Duty of Loyalty: Conflict of Interests. (a) Absent approval by a disinterested board of directors or the shareholders, Smith must prove that the contract is fair and reasonable to the corporation. Section 8.61, Revised Act. If the land which cost Smith $200,000 was fairly worth at the time of its sale less than the amount paid ($500,000), the transaction is unfair to the corporation and may be set aside. However, if the land had a current market value of $500,000 or more, the sale will be upheld. (b) The sale of the truck by Jones, a shareholder, to the corporation will not be set aside. A shareholder is not a fiduciary and does not occupy a position of trust and confidence merely by reason of his ownership of stock. The rules which apply to officers and directors who actually manage the affairs of the corporation do not apply to those whose only relation to the corporation is that of shareholder. A dominant shareholder who owns or controls a majority of the stock and thereby effectively controls the corporation, is a fiduciary. However, the facts do not indicate that Jones is a dominant or controlling shareholder. 6. The X Corporation manufactures machine tools. The five directors of X Corporation are Black, White, Brown, Green, and Crimson. At a duly called meeting of the board of directors of X Corporation in January, all five directors were present. A contract for the purchase of $10 million worth of steel from the D Company, of which Black, White, and Brown are directors, was discussed and approved by a unanimous vote. The board also discussed at length entering into negotiations for the purchase of Q Corporation, which allegedly was about to be sold for around $150 million. By a 3-2 vote, it was decided not to open such negotiations. Three months later, Green purchased Q Corporation for $150 million. Shortly thereafter, a new board of directors for X Corporation took office. X Corporation now brings actions to rescind its contract with D Company and to compel Green to assign to X Corporation his contract for the purchase of Q Corporation. Explain whether X Corporation should succeed on each action. Answer: Decree for D Company against X Corporation; there is not sufficient information to decide what decree should be issued regarding Green and X Corporation. (a) Duty of Loyalty: Conflict of Interests. The general rule is that a contract between corporations with common directors is not voidable by either corporation even if the interlocking directors constitute a majority of the board of the company challenging the contract, provided the contract is fair and reasonable. If defendants can establish that the contract is fair, most courts would deny rescission. (b) Duty of Loyalty: Corporate Opportunity. All courts agree that a director's fiduciary obligations impose limits on his personal business activities and prevent him from taking advantage of business opportunities in competition with the corporation. On the other hand, it is obvious that a director is not precluded from personally taking advantage of all business opportunities even if they may in some way affect the corporation. It is difficult to find any helpful criteria in judicial opinions as to where the line is to be drawn between what is permissible for a director and what is not. Sometimes the rationale used is whether or not the corporation had a "vested interest" or "reasonable expectancy" in the business matter appropriated by the director. If so, he may not acquire it for his personal profit. This test, however, seems a mere explanation of a decision reached on other grounds. Perhaps the only criterion is the rather indefinite one of whether in all fairness, the director ought to keep the opportunity for himself or turn it over to the corporation. The fact that the corporation was actually interested in the specific opportunity before the director acquired it may show his lack of good faith. The refusal of the corporation to proceed with the matter may be discounted by the possibility that the interested director may have cast the decisive vote against further action by the corporation. On the other hand, if Green voted in favor of negotiations, this would show his good faith although it still might not free him to acquire Q Corporation on his own account. The financial ability or inability of the corporation to acquire the competitor is also relevant. However, it has been indicated that consideration should be given to the possibilities of the corporation borrowing money, or obtaining assistance from the directors or shareholders in order to complete the transaction. Irving Trust Co. v. Deutsch, 73 F. 2d 121. 7. Gore had been the owner of 1 percent of the outstanding shares of the Webster Company, a corporation since its organization ten years ago. Ratliff, the president of the company, was the owner of 70 percent of the outstanding shares. Ratliff used the shareholders’ list to submit to the shareholders an offer of $50 per share for their stock. Gore, on receiving the offer, called Ratliff and told him that the offer was inadequate and advised that she was willing to offer $60 per share and for that purpose demanded a shareholders’ list. Ratliff knew that Gore was willing and able to supply the funds necessary to purchase the stock, but he nevertheless refused to supply the list to Gore. Furthermore, he did not offer to transmit Gore’s offer to the shareholders of record. Gore then brought an action to compel the corporation to make the shareholders’ list available to her. Will Gore be able to obtain a copy of the shareholders’ list? Why? Answer: Shareholders' Right to Inspect Books and Records. Yes, Gore will be able to obtain the list. A shareholder has a right to examine for a proper purpose the books and records of account, minutes and records of shareholders, and to make extracts therefrom. The list of shareholders is necessary in order to enable Gore to communicate with the other shareholders. Her purpose is to make an offer to buy stock at a price of $10 more per share than the price offered by the president. The Revised Act, however, requires that the demanding shareholder make a written demand. Section 1602, Revised Act. 8. Mitchell, Nelson, Olsen, and Parker, experts in manufacturing baubles, each owned fifteen of one hundred authorized shares of Baubles, Inc., a corporation of State X that does not permit cumulative voting. On July 7, 2010, the corporation sold forty shares to Quentin, an in-vestor, for $1.5 million, which it used to purchase a fac¬tory building for $1.5 million. On July 8, 2010, Mitchell, Nelson, Olsen, and Parker contracted as follows: All parties will act jointly in exercising voting rights as shareholders. In the event of a failure to agree, the question shall be submitted to George Yost, whose decision shall be binding upon all parties. Until a meeting of shareholders on April 17, 2017, when a dispute arose, all parties to the contract had voted consistently and regularly for Nelson, Olsen, and Parker as directors. At that meeting, Yost considered the dispute and decided and directed that Mitchell, Nelson, Olsen, and Parker vote their shares for the latter three as directors. Nelson, Olsen, and Parker so voted. Mitchell and Quentin voted for themselves and Olsen as directors. (a) Is the contract of July 8, 2010, valid, and, if so, what is its effect? (b) Who were elected directors of Baubles, Inc., at the meeting of its shareholders on April 17, 2017? Answer: Shareholder Agreements. (a) The pooling agreement of July 8, 2010, is lawful and enforceable. In most jurisdictions, shareholder pooling agreements are valid, in the absence of fraud, illegal object, or oppression of minority shareholders. In a minority of jurisdictions such agreements may violate an alleged fiduciary duty owing by shareholders or may conflict with provisions prohibiting sale of votes or separation of ownership from voting power. The agreements are usually valid even where less than all shareholders are parties. Here, a proper purpose is shown by a desire among experts in the business to keep control among themselves, and away from Quentin, a "mere" investor. Section 7.31, Revised Act. (b) Since the pooling agreement is lawful and enforceable, either the votes of Mitchell, cast in violation of the agreement, should not be counted; or Nelson, Olsen and Parker or the arbitrator had implied irrevocable proxies to cast Mitchell's votes. In the former case, 45 votes (15 votes each by Nelson, Olsen and Parker, no valid votes by Mitchell) would be cast for Nelson, Olsen and Parker and 40 votes (cast by Quentin) for Mitchell, Quentin and Olsen. Since 40 votes is a majority of the votes cast, Nelson, Olsen and Parker would be elected directors, Nelson, Olsen and Parker would be elected. In the latter case, 60 votes (15 votes each by Nelson, Olsen and Parker, plus 15 votes by Mitchell’s proxy) would be cast for Nelson, Olsen and Parker with the same result. 9. Acme Corporation’s articles of incorporation require cumulative voting for the election of its directors. The board of directors of Acme Corporation consists of nine directors, each elected annually. (a) Smith owns 24 percent of the outstanding shares of Acme Corporation. How many directors can he elect with his votes? (b) If Acme Corporation were to classify its board into three classes, each consisting of three directors elected every three years, how many directors would Smith be able to elect? Answer: Election and Removal of Directors: Cumulative Voting. (a) Smith elects 2 directors. The formula is X  ac/(b + 1) + 1. Substituting 24 for "X", 100 for "a", and 9 for "b" yields: 24 = – (100)(c) 9+1 + 1 24 = 100c 10 + 1 23 = 10c 2.3 = c (b) Smith may elect no director. Using the same formula but substituting 24 for "X", 100 for "a" and 3 for "b" yields: 24 = – (100)(c) 4 + 1 23 = 25c .92 = c = less than 1 10. A bylaw of Betma Corporation provides that no shareholder can sell his shares unless he first offers them for sale to the corporation or its directors. The bylaw also states that this restriction shall be printed or stamped upon each stock certificate and shall bind all present or future owners or holders. Betma Corporation did not comply with this latter provision. Shaw, having knowledge of the bylaw restriction, nevertheless purchased twenty shares of the corporation’s stock from Rice, without having Rice first offer them for sale to the corporation or its directors. When Betma Corporation refused to effectuate a transfer of the shares to her, Shaw sued to compel a transfer and the issuance of a new certificate to her. What result? Answer: Transfer of Securities. Decree for Betma Corporation and against Shaw. Section 8-204 of the Uniform Commercial Code provides: "Unless noted conspicuously on the security a restriction on transfer imposed by the issuer even though otherwise lawful is ineffective except against a person with actual knowledge of it." A purchaser with actual knowledge of an unnoted restriction certainly has notice of an adverse claim. Section 8-304 and Comment, U.C.C. 11. Neese, trustee in bankruptcy for First Trust Company, brings a suit against the directors of the company for losses the company sustained as a result of the directors’ failure to use due care and diligence in the discharge of their duties. The specific acts of negligence alleged are (a) failure to give as much time and attention to the affairs of the company as its business interests required; (b) abdication of their control of the corporation by turning its management entirely over to its president, Brown; (c) failure to keep informed as to the affairs, condition, and management of the corporation; (d) failure to take action to direct or control the corporation’s affairs; (e) permission of large, open, unsecured loans to affiliated but financially unsound companies that were owned and controlled by Brown; (f) failure to examine financial reports that would have shown illegal diversions and waste of the corporation’s funds; and (g) failure to supervise properly the corporation’s officers and directors. Which, if any, of these allegations can constitute a breach of the duty of diligence? Answer: Liability of Officers and Directors. Judgment for Neese. The general allegations of negligence and mismanagement are each sufficient to constitute negligence if proven. Liability of officers and directors of a corporation is not limited to acts constituting a willful breach of trust or power but also extend to acts that are merely negligent. The directors must be something more than just figureheads. Although they are not responsible for simple errors in judgment, as fiduciaries the directors have the duty of caring for the property of the corporation and the additional duty of managing its affairs honestly and in good faith. The directors must exercise their best judgment and act solely and always with reasonable care to promote the welfare of the corporation. Therefore, the directors can be held liable for inaction where such inaction was the proximate cause of a loss to the corporation. Neese v. Brown, 218 Tenn. 686, 405 S.W.2d 577 (1964). 12. Minority shareholders of Midwest Technical Institute Development Corporation, a closed-end investment company owning assets consisting principally of securities of companies in technological fields, brought a shareholder derivative suit against officers and directors of Midwest, seeking to recover on Midwest’s behalf the profits the officers and directors realized through dealings in stock held in Midwest’s portfolio in breach of their fiduciary duty. Approximately three years after commencement of the action, a new corporation, Midtex, was organized to acquire Midwest’s assets. May the shareholders now add Midtex as a party defendant to their suit? Why? Answer: Fiduciary Duty of Officers and Directors. Judgment for the shareholders. A stockholder derivative suit is an invention of equity designed to supply a remedy where none existed at law to redress breaches of fiduciary duty by corporate officers and directors. The action is a derivative or secondary one that can be brought by a shareholder on the corporation's behalf if he can show that the corporation refused to bring the action itself after a proper request or that such a request would be futile. Here, the allegation is that the directors realized profits personally that were a result of a breach of their fiduciary duties, so the derivative suit is appropriate. When all of Midwest's assets were transferred to the newly organized corporation, Midtex, this did not end the stockholders' right to seek relief. The stockholders of Midwest did not lose the right to recover for a breach of fiduciary duty simply because the assets were transferred to a new corporation. McMenomy v. Ryden, 286 Minn. 358, 176 N.W.2d. 876 (1970). 13. Riffe, while serving as an officer of Wilshire Oil Company, received a secret commission for work he did on behalf of a competing corporation. Can Wilshire Oil recover these secret profits and, in addition, recover the compensation Wilshire Oil paid to Riffe during the period that he acted on behalf of the competitor? Explain. Answer: Breach of Duty. Yes. Judgment for Wilshire Oil Company. Riffe's actions in accepting the secret commission from a competing corporation constitute both a willful breach of his employment contract and a breach of his fiduciary duty to the corporation stemming from his position as a corporate officer. Either action alone is sufficient to justify denying Riffe compensation for the period of his misdealing. Riffe, then, is not only liable to the corporation for the profits realized but also must refund all compensation paid to him by the corporation during the period in which the breaches were committed. Wilshire Oil Co. of Texas v. Riffe, 406 F.2d 1061 (10th Cir. 1969). 14. Muller, a shareholder of SCM, brought an action against SCM over his unsuccessful negotiations to purchase some of SCM’s assets overseas. He then formed a shareholder committee to challenge the position of SCM’s management in that suit. In order to conduct a proxy battle for management control at the next election of directors, the committee sought to obtain the list of shareholders who would be eligible to vote. At the time, however, no member of the committee had owned stock in SCM for the six-month period required to gain access to such information. Then Lopez, a former SCM executive and a shareholder for more than one year, joined the committee and demanded to be allowed to inspect the minutes of SCM shareholder proceedings and to gain access to the current shareholder list. His stated reason for making the demand was to solicit proxies in support of the committee’s nominees for positions as directors. Lopez brought this action after SCM rejected his demand. Will Lopez succeed? Answer: Right to Inspect Books and Records. . Yes. Lopez's demand was clearly set forth so there was no procedural basis for the defendant's rejection. The inspection of shareholder lists to facilitate a proxy challenge to incumbent directors is a valid purpose and the burden is on the corporation to show an improper purpose for the demand. Lopez’ involvement with Muller, who is engaged in litigation with SCM, does not constitute a lack of good faith in his request. Further, it would even be proper to discuss such litigation with shareholders. Application of Lopez, 420 N.Y.S.2d 225, 71 A.D.2d 976 (N.Y. 1979). 15. Pritchard & Baird was a reinsurance broker. A reinsurance broker arranges contracts between insurance companies so that companies that have sold large policies may sell participations in these policies to other companies in order to share the risks. Pritchard & Baird was controlled for many years by Charles Pritchard, who died in December 2014, controlled Pritchard & Baird for many years. Prior to his death, he brought his two sons, Charles Jr. and William, into the business. The pair assumed an increasingly dominant role in the affairs of the business during the elder Charles’s later years. Starting in 2011, Charles Jr. and William began to withdraw from the corporate account ever-increasing sums that were designated as “loans” on the balance sheet. These “loans,” however, represented a significant misappropriation of funds belonging to the corporation’s clients. By late 2016, Charles Jr. and William had plunged the corporation into hopeless bankruptcy. A total of $12,333,514.47 in “loans” had accumulated by October of that year. Mrs. Lillian Pritchard, the widow of the elder Charles, was a member of the corporation’s board of directors until her resignation on December 3, 2016, the day before the corporation filed for bankruptcy. Francis, as trustee in the bankruptcy proceeding, brought suit against United Jersey Bank, the administrator of the estate of Charles, Sr. He also charged that Lillian Pritchard, as a director of the corporation, was personally liable for the misappropriated funds on the basis of negligence in discharging her duties as director. Is Francis correct? Answer: Duty of Diligence. Yes. All corporate directors, as fiduciaries, are responsible for managing the business and affairs of the corporation. They must exercise their duties in good faith and with the diligence, care, and skill of an ordinarily prudent individual. At the very least, a director should have some basic understanding of the corporation’s business and activities. A director should also keep abreast of the financial status of the enterprise by a regular review of the financial statements. This review may result in a duty to investigate any suspicious matters. After such an investigation, a director may have a duty to object to any improprieties, to resign if the objection goes unheeded, and even to seek the advice of counsel. Here, Mrs. Pritchard should have known that Pritchard & Baird was in the reinsurance business as a broker and that it annually handled millions of dollars belonging to, or owing to, ceding companies and reinsurers. Charged with that knowledge, a director in Mrs. Pritchard’s position had, at the bare minimum, an obligation to ask for and read the annual financial statements. She would then have the obligation to react appropriately to what a reading of the statements revealed. Mrs. Pritchard never knew what Charles, Jr. and William were doing because she never made any effort to discharge any of her responsibilities as a director. Nonetheless, her negligence does not result in liability unless it is a proximate cause of the corporation’s losses. Mrs. Pritchard, however, had the power and the duty to prevent the losses. Her objection to the “loans” might well have deterred her sons, and even if it had not, her consultation with an attorney and the threat of a lawsuit would certainly have averted the losses. Therefore, since Mrs. Pritchard breached her duty as a director of Pritchard & Baird, she is liable for the misappropriations. Francis v. United Jersey Bank, 87 N.J. 15, 432 A.2d 814 (1981) 16. Donald J. Richardson, Grove L. Cook, and Wayne Weaver were stockholders of Major Oil. They brought a direct action, individually and on behalf of all other stockholders of Major, against certain directors and other officers of the corporation. The complaint stated twelve causes of action. The first eight causes alleged some misappropriation of Major’s assets by the defendants and sought to require the defendants to return the assets to Major. Three of the remaining four causes alleged breaches of fiduciary duty implicit in those fraudulent acts and sought compensatory or punitive damages for the injury that resulted. The final cause sought the appointment of a receiver. Richardson, Cook, and Weaver moved for an order certifying the suit as a class action. Decision? Answer: Derivative Suits. This is a derivative action, not a class action suit. The critical distinction in this case is that between a derivative action and a class action. Derivative actions seek to enforce rights belonging to the corporation, and may be initiated by a stockholder only after the corporation has failed to do so. The shareholder has no right, title, or interest in the claim itself and recovers nothing. Class actions seek to enforce the individual rights of the representative of the class and all other class members. In a class action against a corporation, the injury sued upon is an injury to the individual plaintiff shareholders, and the recovery belongs directly to the shareholders. In this case, the first eight causes of action concern injury to the corporation only, which the plaintiff stockholders can assert only derivatively on behalf of the corporation. The ninth, tenth, and eleventh causes of action, which allege breaches of the defendants’ fiduciary duty to the corporation and its stockholders, are also based upon claims for relief that belong to the corporation only and not to the individual stockholders. Generally, the directors and other officers of a corporation owe a fiduciary duty to the corporation and to the stockholders collectively, but breach of this duty results in a corporate claim only. The ninth cause of action also accused the defendants of mismanaging the business affairs of Major Oil. Again, however, corporate mismanagement gives rise to a cause of action in the corporation and not with the stockholders individually, even though the mismanagement may injure the stockholders by reducing the value of the corporation’s shares. Richardson v. Arizona Fuels Corp., 614 P.2d 636 (1980). 17. Klinicki and Lundgren, both furloughed Pan Am pilots stationed in West Germany, decided to start their own charter airline company. They formed Berlinair, Inc., a closely held Oregon corporation. Lundgren was president and a director in charge of developing the business. Klinicki was vice president and a director in charge of operations and maintenance. Klinicki, Lundgren, and Lelco, Inc. (Lundgren’s family business) each owned one-third of the stock. Klinicki and Lundgren, as representatives of Berlinair, met with BFR, a consortium of Berlin travel agents, to negotiate a lucrative air transportation contract. When Lundgren learned of the likelihood of actually obtaining the BFR contract, he formed his own solely owned company, Air Berlin Charter Company (ABC). Although he continued to negotiate for the BFR contract, he did so on behalf of ABC, not Berlinair. Eventually BFR awarded the contract to ABC. Klinicki commenced a derivative action on behalf of Berlinair and a suit against Lundgren individually for usurping a corporate opportunity of Berlinair. Lundgren claimed that Berlinair was not financially able to undertake the BFR contract and therefore no usurpation of corporate opportunity could occur. Who is correct? Explain. Answer: Duty of Loyalty/Corporate Opportunity. Judgment for Klinicki. There is no dispute that the corporate opportunity doctrine precludes corporate fiduciaries from diverting to themselves business opportunities in which the corporation has an expectation, property interest, or right, which should otherwise belong to the corporation. The doctrine follows from a corporate fiduciary’s duty of undivided loyalty to the corporation. A director or senior executive may take advantage of a corporate opportunity only after full disclosure and only if the opportunity is rejected by a majority of the disinterested directors, or if there are no disinterested directors, then by a majority of the disinterested shareholders. If, after full disclosure, the disinterested directors or shareholders unreasonably fail to reject the offer, the interested director or principal senior executive may proceed to take the opportunity if he can prove the taking was otherwise “fair” to the corporation. Lundgren, as director and principal executive officer, owed a fiduciary duty to Berlinair and to Klinicki, a minority shareholder. Lundgren’s failure to disclose the BFR opportunity to Berlinair and his appropriation of the opportunity for ABC were clearly an illegal taking of a corporate opportunity. Klinicki v. Lundgren, 298 Or. 662, 695 P.2d 906 (1985) 18. Horton owned 112 shares of common stock in Compaq Computer Corporation (Compaq), a Delaware corporation. Horton and seventy-eight other parties sued Compaq, fifteen of its advisers, and certain management personnel, alleging that Compaq and its codefendants had (1) violated the Texas Security Act and the Texas Deceptive Trade Practices Consumer Protection Act and (2) committed fraud and breaching their fiduciary duty. All these claims arise from the contention that Compaq misled the public regarding the true value of its stock at a time when members of management were selling their own shares. Horton delivered a letter demanding to inspect Compaq’s stock ledger and related information. The demand letter stated that the purpose of the request was to enable Horton to communicate with other Compaq shareholders to inform them of the pending shareholders’ suit and to ascertain whether any of them would desire to become associated with that suit or bring similar actions against Compaq and assume a pro rata share of the litigation expenses. Compaq refused the demand, stating that the purpose described in the letter was not a “proper purpose” for inspecting corporate books and records. Explain who should prevail and why. Answer: Right to Inspect Books. Horton should prevail. Horton’s desire to contact other stockholders and solicit their involvement in the litigation is a purpose reasonably related to his interest as a stockholder. This problem is based on Compaq Computer Corp. v. Horton, 631 A.2d 1, Supreme Court of Delaware, (1993). In Delaware, a shareholder has the statutory right during the usual hours for business to inspect for any proper purpose the corporation's stock ledger upon written demand under oath stating that purpose. A proper purpose is a purpose reasonably related to such person's interest as a stockholder. When a shareholder complies with the statutory requirements as to form and manner of making a demand, then the corporation bears the burden of proving that the demand is for an improper purpose. If there is any doubt, it must be resolved in favor of the stockholder's statutory right to inspect. Essentially, Horton alleges that it is in the interests of Compaq's shareholders to know that acts of mismanagement and fraud are continuing and cannot be overlooked. Thus, it is assumed that the resultant filing of a large number of individual damage claims might well discourage further acts of misconduct by the defendants. In this specific context, the antidotal effect of the Texas litigation may indeed serve a purpose reasonably related to Horton's current interest as a Compaq stockholder. Even though a purpose may be reasonably related to one's interest as a stockholder, it cannot be adverse to the corporation's interests. Nevertheless, because law and policy require corporations and their agents to answer for the breaches of their duties to shareholders, Compaq has no legitimate interest in avoiding the payment of compensatory damages that it, its management, or its advisers may owe to those who own the enterprise. Thus, common sense and public policy dictate that a proper purpose may be stated in these circumstances, notwithstanding the lack of a direct benefit flowing to the corporation. Compaq's burden of showing an improper purpose is not impossible to bear. Previous cases provide valuable examples of the degree to which a stated purpose is so indefinite, doubtful, uncertain, or vexatious as to warrant denial of the right of inspection, leading to the conclusion that when the person making the demand is acting in bad faith or for reasons wholly unrelated to his or her role as a stockholder, access to the ledger will be denied. That simply is not the case here. Horton seeks in good faith to solicit the support of other similarly situated Compaq stockholders, not only to seek monetary redress for their individual economic injuries, but also to prevent further acts of fraud or mismanagement from disrupting the fair market value of Compaq's stock. Compaq's arguments fail to meet its burden to show that Horton acts from an improper purpose. Compaq's contention that Horton's purpose is contrary to the best interests of the corporation and its current stockholders is both speculative and specious. Any harm that may accrue to the corporation as a result of releasing the list is too remote and uncertain to warrant denial of the stockholder's statutory right to inspection. If anything, the corporation and its stockholders, as well as public policy, will best be served by exposure of the fraud, if that is the case, and restoration of the stock to a value set by a properly informed market. ANSWERS TO “TAKING SIDES” PROBLEMS Sinclair Oil Corporation organized a subsidiary, Sinclair Venezuelan Oil Company (Sinven) for the purpose of operating in Venezuela. Sinclair owned about 97 percent of Sinven’s stock. Sinclair nominates all members of Sinven’s board of directors, and none of the directors were independent of Sinclair. A minority shareholder of Sinven brought a derivative action on behalf of Sinven against Sinclair seeking to recover damages sustained by Sinven. The derivative suit alleged that Sinclair had caused Sinven to pay out such excessive dividends that the industrial development of Sinven was effectively prevented. (a) What are the arguments that the transactions between Sinclair and Sinven should be subjected to judicial scrutiny and upheld only if Sinclair shows them to have been entirely fair and entered in good faith? (b) What are the arguments that the transactions between Sinclair and Sinven should be subjected to the business judgment rule and overturned only if Sinven shows that Sinclair had not acted with due care, in good faith, and in a manner reasonably believed to be in the best interests of Sinven? (c) Explain which standard should apply. Answer: (a) Sinven would argue that because of Sinclair’s fiduciary duty and its control over Sinven, Sinclair is in a conflict of interest relationship with Sinven. Therefore, Sinclair’s dealings with Sinven must meet the test of intrinsic fairness: its dealings must be entirely fair and entered in good faith. The standard of intrinsic fairness involves both a high degree of fairness and a shift in the burden of proof. Under this standard the burden is on Sinclair to prove, subject to careful judicial scrutiny, that its transactions with Sinven were objectively fair. (b) Sinclair would argue that the transactions between it and Sinven should be tested by the business judgment rule under which a court will not interfere with the judgment of a board of directors unless there is a showing that Sinclair had not acted with due care, in good faith, and in a manner reasonably believed to be in the best interests of Sinven. A board of directors enjoys a presumption of sound business judgment, and a court should not disturb the board’s decisions if they can be attributed to any rational business purpose. A court under such circumstances should not substitute its own notions of what is or is not sound business judgment. (c) The test of intrinsic fairness applies to this case. This problem is based on Sinclair Oil Corporation v. Levien, 280 A.2d 717, Delaware Supreme Court (1971). When the situation involves a parent and a subsidiary, with the parent controlling the transaction and fixing the terms, the test of intrinsic fairness, with its resulting shifting of the burden of proof, is applied. * * * The basic situation for the application of the rule is the one in which the parent has received a benefit to the exclusion and at the expense of the subsidiary. * * * A parent does indeed owe a fiduciary duty to its subsidiary when there are parent-subsidiary dealings. However, this alone will not evoke the intrinsic fairness standard. This standard will be applied only when the fiduciary duty is accompanied by self-dealing—the situation when a parent is on both sides of a transaction with its subsidiary. Self-dealing occurs when the parent, by virtue of its domination of the subsidiary, causes the subsidiary to act in such a way that the parent receives something from the subsidiary to the exclusion of, and detriment to, the minority stockholders of the subsidiary. Chapter 36 FUNDAMENTAL CHANGES ANSWERS TO QUESTIONS AND CASE PROBLEMS 1. The stock in Hotel Management, Inc., a hotel management corporation, was divided equally between two families. For several years the two families had been unable to agree on or cooperate in the management of the corporation. As a result, no meeting of shareholders or directors had been held for five years. There had been no withdrawal of profits for five years, and last year the hotel operated at a loss. Although the corporation was not insolvent, such a state was imminent because the business was poorly managed and its properties were in need of repair. As a result, the owners of half the stock brought an action in equity for dissolution of the corporation. Will they succeed? Explain. Answer: Judicial Dissolution. The court should order a liquidation of the assets of the corporation by reason of a deadlock in the management, the inability of the shareholders to break the deadlock, and the irreparable injury threatened to the corporation. See Section 14.30, Revised Act. 2. (a) When may a corporation sell, lease, exchange, mortgage, or pledge all or substantially all of its assets in the usual and regular course of its business? (b) When may a corporation sell, lease, exchange, mortgage, or pledge all or substantially all of its assets other than in the usual and regular course of its business? (c) What are the rights of a shareholder who dissents from a proposed sale or exchange of all or substantially all of the assets of a corporation other than in the usual and regular course of its business? Answer: Combinations: Purchase or Lease of All or Substantially All of the Assets. (a) When the board of directors authorizes such a sale, lease, exchange, mortgage, or pledge of all of the assets in the usual and regular course of the business. Section 12.01, Revised Act. (b) A sale, lease, exchange, mortgage, or pledge of all of the assets of a corporation otherwise than in the usual and regular course of its business can be done only by resolution of its board of directors approved by the vote of the holders of at least a majority of the outstanding shares of stock of each class entitled to vote as a class and the total shares entitled to vote thereon. See Section 12.02, Revised Act. (c) The rights of a dissenting shareholder who objects to the sale or exchange of all, or substantially all, of the assets of the corporation, and who preserves his objection as provided in the statute, is to be paid the fair value of his shares immediately prior to the effectuation of the sale or lease of assets. See Section 13.02, Revised Act. 3. Cutler Company was duly merged into Stone Company. Yetta, a shareholder of the former Cutler Company, having paid only one-half of her subscription, is now sued by Stone Company for the balance of the subscription. Yetta, who took no part in the merger proceedings, denies liability on the ground that, inasmuch as Cutler Company no longer exists, all her rights and obligations in connection with Cutler Company have been terminated. Explain whether she is correct. Answer: Combinations. No, Yetta is not correct. Decision in favor of the Cutler Company. The unpaid balance due upon the subscription by Yetta of stock in the Cutler Company was an asset of the Cutler Company. The Stone Company succeeded by operation of law to all of the assets of the merged Cutler Company, including this one. 4. Smith, while in the course of his employment with the Bee Corporation, negligently ran the company’s truck into Williams, injuring him severely. Subsequently, the Bee Corporation and the Sea Corporation consolidated, forming the SeaBee Corporation. Williams filed suit against the SeaBee Corporation for damages, and the SeaBee Corporation argued the defense that the injuries Williams sustained were not caused by any of SeaBee’s employees, that SeaBee was not even in existence at the time of the injury, and that the SeaBee Corporation was therefore not liable. What decision? Answer: Consolidation. Decision for Williams whose tort claim against the Bee Corporation was assumed by operation of law by the new consolidated SeaBee Corporation. 5. The Johnson Company, a corporation organized under the laws of State X, after proper authorization by the shareholders, sold its entire assets to the Samson Company, also a State X corporation. Ellen, an unpaid creditor of the Johnson Company, sues the Samson Company on her claim. Is Sampson liable? Explain. Answer: Combinations: Purchase of Assets/Shares. If Johnson Company received from Samson Company cash or other consideration (not shares of stock of Samson Company) Ellen has no rights against Samson Company to recover the amount of her claim against Johnson Company. A sale of assets is not a consolidation or merger and consequently the quoted provision of the Business Corporation Act of the State of X would not apply. If, however, Johnson Company received shares of stock in Samson Company as consideration for the sale of its entire assets to Samson Company, there is a conflict in the authorities as to whether such a sale of assets is the equivalent of a merger. If the transaction is treated by the courts as the equivalent of a merger, Ellen may recover from Samson Company. 6. Zenith Steel Company operates a prosperous business. The board of directors voted to spend $20 million of the company’s surplus funds to purchase a majority of the stock of two other companies—Green Insurance Company and Blue Trust Company. Green Insurance Company is a thriving business whose stock is an excellent investment at the price at which it will be sold to Zenith Steel Company. The principal reasons for Zenith’s purchase of Green Insurance stock are to invest surplus funds and to diversify its business. Blue Trust Company owns a controlling interest in Zenith Steel Company. The Blue Trust Company is subject to special governmental controls. The main purpose for Zenith’s purchase of Blue Trust Company stock is to enable the present management and directors of Zenith Steel Company to continue their management of the company. Jones, a minority shareholder in Zenith Steel Company, brings an appropriate action to enjoin the purchase by Zenith Steel Company of the stock of either Green Insurance Company or of Blue Trust Company. What is the decision as to each purchase? Answer: Purchase of Shares. (a) Decision for Zenith Steel Company against Jones denying injunction against purchase of the stock of Green Insurance Company. A corporation may purchase a majority of the stock of another corporation, provided the purchase is made in good faith, and for a legitimate purpose. The purchase by Zenith Steel Company of the Green Insurance stock would be upheld, provided the purchase was made in good faith, with a reasonable hope of financial benefit to the Steel Company, and provided further that the purchase was reasonably related to the authorized objects and business of the Steel Company. The circumstances of the purchase must be carefully examined to see if the transaction is a proper means of accomplishing the business objectives of the Steel Company. A purchase made as an investment for surplus idle funds is clearly proper. Therefore, purchase of the Green Insurance Company stock by Zenith Steel is a legitimate investment and should not be enjoined. (b) Decision in favor of Jones and against Zenith Steel Company enjoining the purchase of the stock of Blue Trust Company. The purchase by one corporation in order to perpetuate in office the management of the first corporation is improper. The proposed purchase of the stock of Blue Trust Company was not for investment purposes. Although a controlling interest in other corporations may be purchased by business corporations in order to further and assist the business of the purchasing corporation, here there is no evidence of any such relationship between the business of the Steel Company and of the Trust Company. Indeed, the business of the Trust Company not only differs widely from that of the Steel Company, but is of a fiduciary nature and subject to special government controls and regulations not applicable to the steel business. The primary aim of the purchase of the Blue Trust Company stock was to carry out a plan to maintain in office the present management of the Steel Company and to advance the interests of that management as a group of individuals, not as representatives of the shareholders. Such a purpose is a violation of their fiduciary duties. The burden of proof should be on the directors of the Steel Company to justify this purchase as in the best interest of the Steel Company and its shareholders. Upon their failure to sustain this burden, the contemplated purchase should be enjoined as improper. 7. Mildred, Deborah, and Bob each own one-third of the stock of Nova Corporation. On Friday, Mildred received an offer to merge Nova into Buyer Corporation. Mildred, who agreed to call a shareholders’ meeting to discuss the offer on the following Tuesday, telephoned Deborah and Bob and informed them of the offer and the scheduled meeting. Deborah agreed to attend. Bob was unable to attend because he was leaving on a trip on Saturday and asked if the three of them could meet Friday night to discuss the offer. Mildred and Deborah agreed. The three shareholders met informally Friday night and agreed to accept the offer only if they received preferred stock of Buyer Corporation for their shares. Bob then left on his trip. On Tuesday, at the time and place appointed by Mildred, Mildred and Deborah convened the shareholders’ meeting. After discussion, they concluded that the preferred stock payment limitation was unwise and passed a formal resolution to accept Buyer Corporation’s offer without any such condition. Bob files suit to enjoin Mildred, Deborah, and the Nova Corporation from implementing this resolution. Explain whether the injunction should be issued. Answer: Dissenting Shareholders. Bob can probably have the resolution set aside due to failure to provide him with adequate notice of the shareholders' meeting at which it was passed. (a) The first question is whether proper notice of the shareholders' meeting was given. Shareholders are entitled to receive a lawful and authentic notice of any shareholders' meeting. The question of what constitutes proper notice is usually governed by a specific provision in the applicable corporation statute, or the certificate of incorporation or the bylaws of the corporation. Even in the absence of a specific provision, common law principles require that shareholders receive reasonable notice of any corporate meeting. Toombs v. Citizens' Bank of Waynesboro, 281 U.S. 643. The notice given in this instance appears to be deficient in two respects. It was probably improper for Mildred to give notice of the meeting to Deborah and Bob by telephone. Written notice of a shareholders' meeting, especially a special meeting, is usually required. See Section 1.41, Revised Act. The notice given was probably also invalid because it was not given sufficiently far in advance. Unless specific requirements are contained in the applicable statutes or bylaws, the period of notification to shareholders of a special meeting must be reasonable under the circumstances. Here, the notice was given only four days (of which only two were working days) before the meeting itself. This would probably be held not to be a reasonable time. The Revised Act requires at least ten days' notice for shareholders' meetings the purpose of which is to consider a proposed plan of merger. Section 7.05. (b) The second question is, may Bob have the resolution adopted on Tuesday set aside because of the insufficient notice? Insufficient notice does not render a shareholders' meeting void, but only renders it voidable at the instance of shareholders adversely affected thereby. Bob was adversely affected even though he held only a minority interest in the corporation because he was deprived of his right to participate in the discussion of the resolution and the vote thereon. Had he been present at the meeting, he could have presented his point of view and tried to convince the other shareholders to vote differently. It is possible for a shareholder to waive his right to notice of a specific meeting of shareholders, but Bob did not do so here. (c) The third question is whether the corporation is bound by the agreement reached by Mildred, Deborah, and Bob at their Friday meeting. Bob might argue the meeting held on Friday to be a valid action by the shareholders, which was in effect the meeting originally called for Tuesday. Here, there is nothing to indicate that the parties intended their Friday meeting to be a corporate meeting rather than informal conference. There were no written consents or written proposals drawn up for filing, nor was there any evidence of prior informal corporate action. The fact that Mildred and Deborah appeared on the following Tuesday at the time and place specified militates against any argument that they thought the necessary meeting had previously been concluded. Moreover, Section 11.01 of the Revised Act requires a resolution by the board of directors approving a plan of merger before that plan may be submitted to the shareholders for approval. 8. Tretter alleged that his exposure over the years to asbestos products manufactured by Philip Carey Manufacturing Corporation caused him to contract asbestosis. Tretter brought an action against Rapid American Corporation, which was the surviving corporation of a merger between Philip Carey and Rapid American. Rapid American denied liability, claiming that immediately after the merger it had transferred its asbestos operations to a newly formed subsidiary corporation. Can Rapid avoid liability by such transfer? Explain. Answer: Merger. No. Judgment for Tretter. If the parties effect the transfer of a corporate enterprise through a merger, consolidation, or sale of stock, the transferee assumes its predecessor's liabilities, including product liability claims. Therefore, when Rapid American merged with Philip Carey, Rapid American assumed the liability for Tretter's claim. This fact was recognized in the "General Assignment & Assumption of Liabilities" agreement between Rapid American and its subsidiary. That document specifically referred to liabilities "to which Rapid American became subject as a result of the [merger between Rapid American and Philip Carey]." That Rapid American subsequently transferred this liability to its subsidiary does not defeat Tretter's cause of action; it merely gives Rapid American a claim for indemnity. Therefore, Rapid American, as the successor corporation, may be held for the liabilities of Philip Carey, its predecessor. Tretter v. Rapid American Corp., 514 F.Supp. 1344 (E.D. Mo. 1981). 9. All Steel Pipe and Tube is a closely held corporation engaged in the business of selling steel pipes and tubes. Leo and Scott Callier are its two equal shareholders. Scott is Leo’s uncle. Leo is one of the company’s two directors and is president of the corporation. Scott is the general manager. Scott’s father and Leo’s grandfather, Felix, is the other director. Over the years, Scott and Leo have had differences of opinion about various aspects of the operation of the business. However, despite the deterioration of their relationship, the company has flourished. When negotiations aimed at the redemption of Scott’s shares by Leo began, the parties could not reach an agreement. The discussion then turned to voluntary dissolution and liquidation of the corporation, but still no agreement could be reached. Finally, Leo fired Scott and began to wind down All Steel’s business and to form a new corporation, Callier Steel Pipe and Tube. Leo then brought an action seeking a dissolution and liquidation of All Steel. Should the court order dissolution? Explain. Answer: Dissolution. No, the court should not order dissolution. Corporations are creatures of statute and, therefore, can be dissolved only according to the applicable statute. Corporate dissolution is a drastic remedy, and it must not be lightly invoked. Its grant requires proof of an inalterable deadlock in the management and of irreparable injury to the corporation. The record here does not show such proof. Although Leo and Scott were not able to get along, this is not equivalent to an inability of the corporation to operate. In fact, All Steel continued to operate profitably during the disputes and the redemption negotiations, as both Scott and Felix refrained from interfering in the management of All Steel and allowed Leo to operate the company on his own. Accordingly, the requested order to dissolve All Steel must be denied. Callier v. Callier, 61 Ill.App.3d 1011, 378 N.E.2d 405 (1978). 10. The shareholders of Endicott Johnson who had dissented from a proposed merger of Endicott with McDonough Corporation brought a proceeding to fix the fair value of their stock. At issue was the proper weight to be given the market price of the stock in fixing its fair value. The shareholders argued that the market value should not be considered because McDonough controlled 70 percent of Endicott’s stock and the stock had been delisted from the New York Stock Exchange. Are the shareholders correct? Answer: Dissenting Shareholders. Yes. Judgment for the shareholders. Shareholders who dissent from an impending merger are entitled to be paid the "fair value" of their stock. The elements to be considered in appraising the stock's value are its net asset value, investment value, and market value. All three elements should not be taken into account in every case, however. Here, it would be inappropriate to look at net asset value, since the corporation was not being liquidated. Furthermore, the stock has no meaningful market value because McDonough controlled 70 percent of the outstanding shares and because the stock was delisted. The stock's investment value then is the only remaining determinant of its fair value in this case. Endicott Johnson Corp. v. Bade, 338 N.E.2d 614 (N.Y. 1975). 11. Ray fell from a defective ladder while working for his employer. Ray brought suit in strict tort liability against the Alad Corporation (Alad II), which neither manufactured nor sold the ladder to Ray's employer. Prior to the accident, Alad II succeeded to the business of the ladder's manufacturer, the now-dissolved "Alad Corporation" (Alad I), through a purchase of Alad I's assets for an adequate cash consideration. Alad II acquired Alad I's plant, equipment, inventory, trade name, and goodwill, and continued to manufacture the same line of ladders under the "Alad" name, using the same equipment, designs, and personnel. In addition, Alad II solicited through the same sales representatives with no outward indication of any change in the ownership of the business. The parties had no agreement, however, concerning Alad II's assumption of Alad I's tort liabilities. Decision? Answer: Purchase of Assets. Judgment for Ray. Generally, a purchaser does not assume a seller’s liabilities unless: (1) there is an express or implied agreement of such assumption; (2) the transaction is a consolidation or merger; (3) the purchasing corporation is a mere continuation of the seller; or (4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts. Here, there was no express or implied agreement of an assumption of tort liability, nor were the assets transferred for a fraudulent purpose. Also, the second and third exceptions were not met, because the purchase of Alad I’s assets did not amount to a consolidation or merger. Since the general rule did not render Alad II liable, the court looked to the policy considerations underlying strict tort liability — the protection of otherwise defenseless victims of manufacturing defects and the spreading throughout society of the costs of compensating them. Justification for imposing strict liability upon Alad II rests upon (1) the virtual destruction of Ray’s remedies against Alad I due to the purchase; (2) Alad II’s ability to assume Alad I’s risk-spreading role; and (3) the fairness of requiring Alad II to assume the responsibility for the defective product since it continued to enjoy Alad I’s good will. The presence of these three factors renders Alad II strictly liable. 12. Kemp & Beatley was a company incorporated under the laws of New York. Eight shareholders held the corporation’s outstanding 1,500 shares of stock. Petitioners Dissin and Gardstein together owned 20.33 percent of the stock, and each had been a longtime employee of the corporation. Kemp & Beatley had a longstanding practice of awarding compensation bonuses based upon stock ownership. However, when the policy was changed in 2015 to compensation based on service to the corporation, not on stock ownership, Dissin resigned. The company terminated Gardstein in 2016. Dissin and Gardstein brought a suit in 2017, seeking involuntary dissolution of the corporation and alleging that the corporation’s board of directors had acted in a “fraudulent and oppressive” manner toward them, rendering their stock virtually worthless and frustrating their “reasonable expectations” regarding this business venture. What result? Explain. Answer: Involuntary Judicial Dissolution. Judgment for Petitioners Dissin and Gardstein. Oppressive action within the meaning of the statute exists when the conduct of the majority serves substantially to defeat the objectively reasonable expectations of minority shareholders. Shareholders in a closely held corporation such as Kemp & Beatley often are involved in the day-to-day operations of the business as officers or employees, and usually look to their salaries, bonuses, and retirement benefits rather than to dividends for a return on their investment. Here, petitioners reasonably expected that their ownership in the corporation would entitle them to certain benefits. Kemp & Beatley had a tradition of awarding de facto dividends to shareholders in the form of compensation bonuses based on stock ownership. Shortly before petitioners' complaint was initiated, this policy was changed. The fact finder did not err in finding that change in policy was, in effect, an attempt to exclude petitioners from gaining a return on their investment in the company. Once petitioners had shown that the directors' conduct was oppressive, the corporation had the burden of demonstrating the existence of an adequate alternative remedy short of dissolution or buy-out. The stock of closely held corporations is not readily salable. Thus, unless the corporation buys petitioners' shares, petitioners will be stuck with what is to them worthless stock. Therefore, the trial court did not abuse its discretion by ordering the dissolution of Kemp & Beatley, subject to the opportunity to buy out petitioners' shares. 13. In early 1984, Royal Dutch Petroleum Company (Royal Dutch), through various subsidiaries, controlled approximately 70 percent of the outstanding common shares of Shell Oil Co. (Shell). On January 24, 1984, Royal Dutch announced its intention to merge Shell into SPNV Holdings, Inc. (Holdings), which is now Shell Petroleum, Inc., by offering the minority shareholders $55 per share. Shell’s board of directors, however, rejected the offer as inadequate. Royal Dutch then withdrew the merger proposal and initiated a tender offer at $58 per share. As a result of the tender offer, Holdings’ ownership interest increased to 94.6 percent of Shell’s outstanding stock. Holdings then initiated a short-form merger. Under the terms of the merger, Shell’s minority stockholders were to receive $58 per share. However, if before July 1, 1985, a shareholder waived his right to seek an appraisal, he would receive an extra $2 per share. In conjunction with the short-form merger, Holdings distributed several documents to the minority, including a document entitled “Certain Information About Shell” (CIAS). The CIAS included a table of discounted future net cash flows (DCF) for Shell’s oil and gas reserves. However, due to a computer programming error, the DCF failed to account for the cash flows from approximately 295 million barrel equivalents of U.S. proved oil and gas reserves. Shell’s failure to include the reserves in its calculations resulted in an understatement of its discounted future net cash flows of approximately $993 million to $1.1 billion or $3.00 to $3.45 per share. Moreover, as a result of the error, Shell stated in the CIAS that there had been a slight decline in the value of its oil and gas reserves from 1984 to 1985. When properly calculated, the value of the reserves had actually increased over that time period. Shell’s minority shareholders sued in the Court of Chancery, asserting that the error in the DCF along with other alleged disclosure violations constituted a breach of Holdings’ fiduciary “duty of candor.” Was the error in the DCF material and misleading? Answer: Minority Shareholders. Yes, the error was material and misleading. The question whether the disclosures to Shell's minority shareholders were adequate is a mixed one of law and fact, requiring an assessment of the inferences a reasonable shareholder would draw and the significance of those inferences to the individual shareholder. Holdings' duty with respect to disclosure is clear. As the majority shareholder, Holdings bears the burden of showing complete disclosure of all material facts relevant to a minority shareholders' decision whether to accept the short-form merger consideration or to seek an appraisal. Thus, the question is one of materiality. A fact is considered material if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available. While it need not be shown that an omission or distortion would have made an investor change his overall view of a proposed transaction, it must be shown that the fact in question would have been relevant to him. The Court of Chancery concluded that the understatement of Shell's oil and gas reserves by 294.6 million barrel equivalents, with a value of approximately $1 billion or $3.00 to $3.45 per share would have been viewed by a reasonable investor as significantly altering the total mix of information available. It is clear from the Vice Chancellor's decision that he applied the proper legal standards and carefully considered the evidence presented. Holdings contends that the billion dollar error was insignificant because it resulted in only a 5.5% understatement in the total discounted cash flows reported. However, the significance of the error is clearly demonstrated by the fact that a Shell executive vice president stated in the Wall Street Journal that a 220 million barrel discovery in the Gulf of Mexico was considered a major find. Thus, it is difficult to accept Holdings' argument that the failure to report cash flows from 295 million barrels was insignificant. Holdings also argues that a $3 per share error was not significant enough to make a reasonable stockholder change his decision and seek an appraisal. However, the question is not whether the information would have changed the stockholder's decision to accept the merger consideration, but whether the fact in question would have been relevant to him. We cannot agree that a billion dollar understatement of the value of Shell's reserves would have been anything but highly relevant and material to a reasonable stockholder. Finally, Holdings contends that the DCF is only an estimate of future cash flows and, therefore, it would be unreasonable for a shareholder to conclude that Shell's oil and gas reserves were worth the amount presented in the DCF. In fact, according to Holdings, a reasonable shareholder should anticipate a certain margin of error simply due to the uncertainties inherent in the estimate process. Although the DCF presents an estimate of future cash flows, a shareholder could reasonably conclude that the DCF was accurately prepared based on all available information. Moreover, a reasonable shareholder could conclude that the 1985 DCF was prepared in a manner consistent with the 1984 DCF. Thus, a comparison of the 1984 and 1985 DCFs should present an accurate indication of whether the value of Shell's reserves was increasing or decreasing. Such was not the case. A comparison of the 1984 and 1985 DCFs inevitably leads to the erroneous conclusion, as stated in the CIAS, that the value of Shell's reserves had declined. Most importantly, the misleading statement that the value of the reserves had declined was not based upon the inherent inaccuracies of the estimate process, but upon an error made by Shell. The fact that the error was included in a schedule which contained estimates does not diminish its materiality. Shell Petroleum v. Smith, 606 A.2d 112 (1992). 14. McLoon, Morse Bros., and T-M Oil Companies were closely held companies entirely owned by members of the Pescosolido family, under the leadership of Carl Pescosolido, Sr. His sons, Carl, Jr. and Richard, each held shares in McLoon, Morse Bros., and T-M. Together, their shares constituted 50 percent of the McLoon and Morse Bros. common stock and 14.3 percent of the T-M common stock. Carl, Sr. proposed to merge all of the family-held companies into Lido Inc., over which he would exercise sole voting control. Carl, Jr. and Richard (the dissenters) objected in writing to the proposed merger. The parties executed a merger agreement in which the dissenters expressly preserved their statutory appraisal rights. The dissenters individually wrote to each of the three Maine companies and requested payment for their shares. Lido responded by offering each dissenter an amount that both dissenters rejected. The dissenters filed a suit for valuation of their stock in all three companies. The referee held that the fair value of each dissenter’s stock was his proportionate share of the full value of each company, as determined from the expert testimony. The fair value thus determined was 2.6 times the amount that Lido had offered. Lido objected to the report, contending that the referee should discount the full value of each company because of the minority status and lack of marketability of the dissenters’ stock. Explain whether the court should accept the referee’s report. Answer: Appraisal Remedy. The court should accept the referee’s report. In determining the fair value of shares in a close corporation for the appraisal remedy, the court should prorate among the shares the highest price a single buyer would reasonably pay for the whole enterprise. This problem is based on In Re Valuation of Common Stock of McLoon Oil Co., 565 A.2d 997, Supreme Judicial Court of Maine, 1989. Lido contends that the referee’s finding of fair value was inaccurate since it did not consider any minority or nonmarketability discount. The appellate court rejected this argument. The appraisal remedy for dissenting shareholders evolved as it became clear that unanimous consent was inconsistent with the growth and development of large business enterprises. Under the appraisal statute, the shareholder who disapproves of a proposed merger or other major corporate change gives up his right to veto the change in exchange for the right to be bought out—not at market value but at “fair value.” Although courts use the discount method in valuing stock for tax, probate, and other purposes when the market value is essential, the discount method has no place in the dissenter-shareholder situation. The purpose of applying discount variables is to determine the investment value or fair market value of a minority interest in the context of a hypothetical sale between a willing seller and buyer. The involuntary change of ownership caused by a merger, however, requires as a matter of fairness that a dissenting shareholder be compensated for the loss of his proportionate interest in the business. The valuation focus under the appraisal statute is not the stock as a commodity but the stock as a proportionate part of the enterprise as a whole. The question is simply, What is the best price a single buyer could reasonably be expected to pay for the firm as an entity? After answering that question, the court simply prorates the value among the shares, as was done in this case. ANSWERS TO “TAKING SIDES” PROBLEMS Wilcox, chief executive officer and chairman of the board of directors, owned 60 percent of the shares of Sterling Corporation. When the market price of Sterling’s shares was $22 per share, Wilcox sold all of his shares in Sterling to Conrad for $29 per share. The minority shareholders of Sterling brought suit against Wilcox demanding a pro rata share of the amount Wilcox received in excess of the market price. (a) What are the arguments to support the minority shareholders’ claim for a pro rata share of the amount Wilcox received in excess of the market price? (b) What are the arguments to reject the minority shareholders’ claim for a pro rata share of the amount Wilcox received in excess of the market price? (c) Which side should prevail? Answer: (a) The minority shareholders would argue that the amount Wilcox received in excess of the market price represents the value of control over the corporation. Since control is a corporate asset, it is owned proportionately by all of the shareholders who are therefore entitled to a pro rata share of the amount Wilcox received in excess of the market price. (b) Wilcox would argue that ownership of a controlling interest entitles him to elect at least a majority of directors. Therefore, it is his right to derive a premium from the sale of a controlling block of stock. There is no impropriety per se in the fact that Wilcox received more per share than the generally prevailing market price for his Sterling stock. (c) Wilcox would most likely prevail. When one or a few shareholders own a controlling interest, the shareholder(s) may privately negotiate a sale of such interest, although the courts require that these transactions be made with due care. The controlling shareholders must make a reasonable investigation so as not to transfer control to purchasers who wrongfully plan to steal or “loot” the corporation’s assets or to act against its best interests. In addition, purchasers frequently are willing to pay a premium for a block of shares that conveys control. Although historically some courts have required that this so-called control premium inure to the benefit of the corporation, today virtually all courts permit the controlling shareholders to retain the full amount of the control premium. Chapter 37 SECURED TRANSACTIONS AND SURETYSHIP ANSWERS TO QUESTIONS AND CASE PROBLEMS 1. Victor sells to Bonnie a refrigerator for $600 payable in monthly installments of $30 for twenty months. Bonnie signs a security agreement granting Victor a security interest in the refrigerator. The refrigerator is installed in the kitchen of Bonnie’s apartment. There is no filing of any financing statement. Assume that after Bonnie has made the first three monthly payments: (a) Bonnie moves from her apartment and sells the refrigerator in place to the new occupant for $350 cash. What are the rights of Victor? (b) Bonnie is adjudicated bankrupt, and her trustee in bankruptcy claims the refrigerator. What are the rights of the parties? Answer: (a) Other Buyers. Victor has the right to recover the unpaid balance of the price from the original buyer Bonnie, but he no longer has a security interest in the refrigerator if the new occupant of the apartment who purchased it from Bonnie had no knowledge of Victor's security interest and bought it for value for his own personal, family, or household purposes. In such cases the new bona fide purchaser takes the refrigerator free of the perfected security interest as no financing statement was filed. Section 9-320 (a)(b). No filing is required to perfect a purchase money security interest in consumer goods, Section 9-309 (1); but, such automatically perfected security interest is defeated when the goods are transferred to a bona fide consumer purchaser (i.e., a consumer to consumer sale). §9-320 (b). (b) Retention of Collateral. Victor may repossess the refrigerator from Bonnie's trustee in bankruptcy. Victor's purchase money security interest in consumer goods is perfected upon attachment, Section 9-309 (1)), and defeats the trustee in bankruptcy's interest. Section 9-317, 9-322. Upon retaking possession of the refrigerator Victor may resell it as provided in Section 9-610, or inasmuch as Bonnie has not paid sixty per cent of the price, retain the refrigerator in satisfaction of the debtor's obligation as provided in Section 9-620. 2. On January 2, Burt asked Logan to loan him money “against my diamond ring.” Logan agreed to do so. To guard against intervening liens, Logan received permission to file a financing statement, and Burt and Logan signed a security agreement giving Logan an interest in the ring. Burt also signed a financing statement that Logan properly filed on January 3. On January 4, Burt borrowed money from Tillo, pledging his ring to secure the debt. Tillo took possession of the ring and paid Burt the money on the same day. The next day, January 5, Logan loaned Burt the money under the assumption that Burt still had the ring. Who has priority, Logan or Tillo? Explain. Answer: Priorities of Secured Creditors Logan has priority. A security interest is perfected when it has attached and when all of the applicable steps required for perfection have been taken. A security interest may be perfected by filing a financing statement authenticated by the debtor or by possession of the collateral by the secured party. Priority, however, between conflicting security interests rank according to time of filing or perfection. Priority dates from the time a filing is first made covering the collateral or the time the security is first perfected, whichever first occurs. Section 9-322 (a). In this case, in which both Tillo and Logan have perfected their security interest, Tillo's priority dates from the time of perfection (January 4) while Logan's dates from the time of filing (January 3). 3. Joanna takes a security interest in the equipment in Jason Store and files a financing statement claiming “equipment and all after-acquired equipment.” Berkeley later sells Jason Store a cash register, taking a security interest in the register and (a) files nine days after Jason receives the register, or (b) files twenty-five days after Jason receives the register. If Jason fails to pay both Joanna and Berkeley and they foreclose their security interests, who has priority on the cash register? Answer: Priorities of Secured Creditors: Conflicting Perfected Non-Inventory Interests. (a)(i) If Berkeley files 9 days after Jason received the register (i.e.,within 20 days or whatever the statutory period has been amended to) Berkeley has priority over Joanna. (ii) If he files after 20 days (or the statutory period ), he does not. Section 9-324 (a), U.C.C. Note that Berkeley has a purchase money security interest under Section 9-103(a) and as such a grace period after receipt of the collateral in which to perfect a security interest in non-inventory goods in order to take priority over conflicting security interests. Accordingly, in (i) Berkeley would prevail, while in (ii) Joanna would prevail under the 20 day period. 4. Finley Motor Company sells an automobile to Sara and retains a security interest in it. The automobile is insured, and Finley is named beneficiary. Three days after the automobile is totally destroyed in an accident, Sara files a petition in bankruptcy. As between Finley and Sara’s trustee in bankruptcy, who is entitled to the insurance proceeds? Answer: Proceeds. Assuming that Finley has done whatever was required to perfect his security interest in the automobile, Finley has a perfected security interest in the insurance proceeds as proceeds of the collateral under Section 9-315 (a) (2), and would prevail. 5. On September 5, Wanda, a widow who occasionally teaches piano and organ in her home, purchased an electric organ from Murphy's music store for $4,800, trading in her old organ for $1,200 and promising in writing to pay the balance at $120 per month and granting to Murphy a security interest in the property in terms consistent with and incorporating provisions of the UCC. A financing statement covering the transaction was also properly filled out and signed, and Murphy properly filed it. After Wanda failed to make the December or January payments, Murphy went to her home to collect the payments or take the organ. Finding no one home and the door unlocked, he went in and took the organ. Two hours later, Tia, a third party and the present occupant of the house, who had purchased the organ for her own use, stormed into Murphy's store, demanding the return of the organ. She showed Murphy a bill of sale from Wanda to her, dated December 15, that listed the organ and other furnishings in the house. (a) What are the rights of Murphy, Tia, and Wanda? (b) Would your answer change if Murphy had not filed a financing statement? Why? (c) Would your answer change if the organ had been principally used to give lessons? Answer: Perfection/Priorities. (a) Murphy would prevail. Murphy has properly perfected his security interest and would prevail against both Tia and Wanda. Tia, of course, has a cause of action against Wanda based upon breach of warranty of title and possibly fraud. Tia may also have a cause of action against Murphy for breaking and entering. (b) Yes, if the goods are consumer goods. Murphy's perfection would be automatic upon attachment: a purchase money security interest in consumer goods, Section 9-309 (1)), and would be cut off by the purchase of the organ by a bona fide purchaser for value. Section 9-320 (b). (c) Yes, if the organ was equipment then Murphy would have had to perfect the security interest at the time Wanda took possession or within the statutory grace period. Section 9-322. The facts as presented are intentionally ambiguous in order to allow discussion of the result, and its variance, under both possibilities. 6. On May 1, Lincoln lends Donaldson $200,000 and receives from Donaldson his agreement to pay this amount in two years and takes a security interest in the machinery and equipment in Donaldson’s factory. A proper financing statement is filed with respect to the security agreement. On August 1, upon Lincoln’s request, Donaldson executes an addendum to the security agreement covering after-acquired machinery and equipment in Donaldson’s factory. A second financing statement covering the addendum is filed. In September, Donaldson acquires $50,000 worth of new equipment from Thompson, which Donaldson installs in his factory. In December, Carter, a judgment creditor of Donaldson, causes an attachment to issue against the new equipment. What are the rights of Lincoln, Donaldson, Carter, and Thompson? What can the parties do to best protect themselves? Answer: Priorities of Secured Creditors. Lincoln's security interest in the after-acquired equipment installed in the debtor's factory has priority over the attachment by the judgment creditor Carter. The Code Section 9-204 (a) provides "a security agreement may create or provide for a security interest in after-acquired collateral." Thompson can protect his interest in the equipment by perfecting the purchase money security interest at the time Donaldson takes possession or within twenty days. Section 9-324 (a). Failing this, Thompson could take separate action against Donaldson to collect on the amount owed. Thus, if Thompson perfected his security interest (PMSI) within the statutory period Thompson would prevail against all parties. If he did not properly perfect his PMSI Lincoln would prevail against all parties under his perfected after-acquired property clause. 7. Anita bought a television set from Bertrum for her personal use. Bertrum, who was out of security agreement forms, showed Anita a form he had executed with Nathan, another consumer. Anita and Bertrum orally agreed to the terms of the form. Anita subsequently defaulted on payment, and Bertrum sought to repossess the television. (a) Explain who would prevail. (b) Explain whether the result would differ if Bertrum had filed a financing statement. (c) Explain whether the result would differ if Anita had subsequently sent Bertrum an e-mail that met all the requirements of an effective security agreement? Answer: Perfection by Possession. a) Decision for Anita. Bertrum has neither perfected nor attached his security interest. In order for a security interest to be enforceable against the debtor it must attach, i.e.: (1) value has been given (2) the debtor has rights in the collateral, and (3) there must be an agreement between the debtor and secured party which in most instances must be authenticated by the debtor. Section 9-203(a). In the problem at hand Bertrum neither took possession of the collateral nor obtained an authenticated record; accordingly Bertrum's security interest in the television set never became enforceable against Anita. b) The decision would not differ if Bertrum had filed a financing statement unless the financing statement satisfied the requirements of a security agreement. Section 9-203 (1), 9-102. c) If the e-mail satisfied the requirements of an authenticated record, sections 9-203, 9-102, Bertrum would prevail. 8. Aaron bought a television set for personal use from Penny. Aaron properly signed a security agreement and paid Penny $125 down, as their agreement required. Penny did not file, and subsequently Aaron sold the television for $800 to Clark, his neighbor, for use in Clark’s hotel lobby. (a) When Aaron fails to make the January and February payments, may Penny repossess the television from Clark? (b) What if, instead of Aaron's selling the television set to Clark, a judgment creditor levied (sought possession) on the television? Who would prevail? (c) What if Clark intended to use the television set in his home? Who would prevail? Answer: Automatic Perfection. a) Yes. Penny has automatically perfected her security interest in the television set he sold to Aaron. Section 9-309(1): a purchase money security interest in consumer goods. Since Clark bought the television from Aaron for Clark's hotel lobby and not for his own family, household or personal use, Penny's security interest continues in the goods. b) Penny. Penny's automatically perfected security interest would also take priority against the judgment creditor. c) Clark would prevail, because a consumer purchaser (one who buys for his own family, personal, or household purposes) who buys for value without knowledge of the security interest defeats a purchase money security interest that was automatically perfected. Section 9-320 (b). 9. Jones bought a used car from the A–Herts Car Rental System, which regularly sold its used equipment at the end of its fiscal year. First National Bank of Roxboro had previously obtained a perfected security interest in the car based upon its financing of A–Herts’s automobiles. Upon A–Herts’s failure to pay, First National is seeking to repossess the car from Jones. Does First National have an enforceable security interest in the car against Jones? Explain. Answer: Priorities of Secured Creditors Against Buyers. The answer depends upon whether Jones is buyer in the ordinary course of business and/or buyer of consumer goods or whether he has knowledge of the perfected security interest of the First National Bank of Roxboro. A buyer in the ordinary course of business is defined in 1-201 (9) as "a person who in good faith and without knowledge that the sale to him is in violation of the ownership rights or security interest of a third party in the goods buys in the ordinary course from a person in the business of selling goods of that kind." It seems likely that Jones is a buyer in the ordinary course of business here, although the facts as stated are vague as to whether he qualifies for this status. If Jones qualifies as a buyer in the ordinary course of business, he takes the collateral free of any security interest created by A-Herts even if the security interest is perfected as here and even if he knows of its existence. §9-320(a). However, if he does know of its existence, this knowledge may raise an issue as to whether Jones is in fact dealing in good faith and as to whether he is buying with knowledge that the sale to him is in violation of the security interest of the bank. In the case of consumer goods, a buyer who buys without knowledge of a security interest, for value, and for his own personal, family or household use takes the goods free of any purchase money security interest automatically perfected, but takes the goods subject to a security interest perfected by filing. Thus, if Jones does not qualify for buyer in the ordinary course of business status, but is purchasing the goods as consumer goods, he takes them free of the bank's security interest. If the bank for some reason neglected to file its financing statement, Jones will have priority. However, if the bank has filed a financing statement, then the bank will prevail. This problem is a good illustration of how important it is for the holder of a purchase money security interest to file a financing statement even though that holder may have an automatically perfected security interest. This problem is loosely based on Hempstead Bank v. Andy's Car Rental System, 312 N.Y.S.2d 317 (1970), in which the court found against the purchaser and held that "a buyer in the ordinary course of business" does not include a buyer of used cars from a rental agency that regularly sold its cars, since rental agencies are in the business of leasing, not selling cars. 10. Allen, Barker, and Cooper are cosureties on a $750,000 loan by Durham National Bank to Kingston Manufacturing Co., Inc. The maximum liability of the sureties is as follows: Allen—$750,000, Barker—$300,000, and Cooper—$150,000. If Kingston defaults on the entire $750,000 loan, what are the liabilities of Allen, Barker, and Cooper? Answer: Contribution. Their liabilities are as follows: Allen–$468,750; Barker-$187,500; and Cooper–$93,750, but it is important to understand the difference between their liabilities and the amount that a creditor may collect. When there is more than one surety, the cosureties are jointly and severally liable for the principal debtor's default up to the amount of each surety's undertaking. The creditor may proceed against any or all of the cosureties and collect the entire amount of the default from any of them, limited to the amount that surety has agreed to guarantee. As a result, it is possible that one cosurety (Allen, in this example) may pay the creditor the entire amount of the principal debtor's obligation. When a surety pays her principal debtor's obligation, she is entitled to have her cosureties pay to her their proportionate share of the obligation paid. So, if Allen had paid the whole $750,000, she would be able to demand reimbursement of $187,500 from Barker and $93,750 from Cooper. This right of contribution arises when a surety has paid more than her proportionate share of the debt even if the cosureties originally were not aware of each other or were bound on separate instruments. All that is required is that they are sureties for the same principal debtor and the same obligation. The right and extent of contribution can be determined by contractual agreement among cosureties. In the absence of such agreement, sureties’ obligations for equal amounts share equally; where they are obligated for varying amounts, the proportion of the debt that each surety must contribute is determined by proration according to each surety's undertaking. The total undertakings of the cosurities is $1,200,000 ($750,000 + $300,000 + $150,000). Allen = $750,000 $1,200,000 x ($750,000) = $468,750 Barker = $300,000 $1,200,000 x ($750,000) = $187,500 Cooper = $150,000 $1,200,000 x ($750,000) = $93,750 TOTAL $750,000 11. Peter Diamond owed Carter $500,000 secured by a first mortgage on Diamond’s plant and land. Stephens was a surety on this obligation in the amount of $250,000. After Diamond defaulted on the debt, Carter demanded and received payment of $250,000 from Stephens. Carter then foreclosed upon the mortgage and sold the property for $375,000. What rights, if any, does Stephens have in the proceeds from the sale of the property? Answer: Subrogation. Stephens may recover $125,000 from the proceeds. Upon the creditor's full payment of the principal debtor's obligation, a surety is subrogated to the creditor's rights against the principal debtor including any security interests . Carter had been paid $250,000 by Stephens so Carter is only entitled to $250,000 of the proceeds of the sale of the property. Stephens is entitled to the remainder of $125,000 ($375,000–$250,000). 12. Paula Daniels purchased an automobile from Carey on credit. At the time of the sale, Scott agreed to be a surety for Paula, who is sixteen years old. The automobile’s odometer stated 52,000 miles, but Carey had turned it back from 72,000 miles. Paula refuses to make any payments due on the car. Carey proceeds against Paula and Scott. What defenses, if any, are available to (a) Paula and (b) Scott? Answer: Defenses of Surety. (a) Paula as principal debtor may properly assert the defenses of (i) infancy and (ii) fraud, which consisted of Carey's setting back the odometer. (b) Scott as surety may not assert Paula's infancy which is a personal defense of the debtor but he may assert the fraud practiced upon Paula by Carey in setting back the odometer. 13. Stafford Surety Co. agreed to act as the conditional guarantor of collection on a debt owed by Preston Decker to Cole. Stafford was paid a premium by Preston to serve as surety. Preston defaults on the obligation. What are Cole’s rights against Stafford Surety Co.? Answer: Nature and Formation. Because Stafford has agreed to act only as a conditional guarantor of collection, it is liable only if Cole first obtains a judgment against Preston and then is unable to collect under the judgment. 14. Campbell loaned Perry Dixon $70,000, which was secured by a possessory security interest in stock owned by Perry. The stock had a market value of $4,000. In addition, Campbell insisted that Perry obtain a surety. For a premium, Sutton Surety Co. agreed to act as a surety for the full amount of the loan. Prior to the due date of the loan, Perry convinced Campbell to return the stock because its value had increased and he wished to sell it to realize the gain. Campbell released the stock and Perry subsequently defaulted. Is Sutton released from his liability Answer: Defenses of Both Surety and Principal Debtor. Sutton is released from his liability as a surety to the extent of the value of the security released by Campbell. 15. Pamela Darden owed Clark $5,000 on an unsecured loan. On May 1, Pamela approached Clark for an additional loan of $3,000. Clark agreed to make the loan only if Pamela could obtain a surety. On May 5, Simpson agreed to be a surety on the $3,000 loan, which was granted that day. Both loans were due on October 1. On June 15, Pamela sent $1,000 to Clark but did not provide any instructions. (a) What are Clark's rights? (b) What are Simpson's rights? Answer: Defenses of Both Surety and Principal Debtor. (a) Clark may apply the $1,000 payment to whichever loan he pleases. (b) Simpson has no right to direct the application of the payment. 16. Patrick Dillon applied for a $10,000 loan from Carlton Savings & Loan. Carlton required him to obtain a surety. Patrick approached Sinclair Surety Co., which insisted that Patrick provide it with a financial statement. Patrick did so, but the statement was materially false. In reliance upon the financial statement and in return for a premium, Sinclair agreed to act as surety. Upon Sinclair’s commitment to act as surety, Carlton loaned Patrick the $10,000. After one payment of $400, Patrick defaulted. He then filed a voluntary petition in bankruptcy. Does Sinclair have any valid defense against Carlton? Answer: Personal Defenses of Surety. Carlton may recover from Sinclair who has no defense. Fraud exercised by the principal debtor upon the surety may not be asserted against the creditor if the creditor is unaware of the fraud. 17. On June 1, Smith contracted with Martin d/b/a Martin Publishing Company to distribute Martin’s newspapers and to account for the proceeds. As part of the contract, Smith agreed to furnish Martin a bond in the amount of $10,000 guaranteeing the payment of the proceeds. At the time the contract was executed and the credit extended, the bond was not furnished, and no mention was made as to the prospective sureties. On July 1, Smith signed the bond with Black and Blue signing as sureties. The bond recited the awarding of the contract for distribution of the newspapers as consideration for the bond. On December 1, payment was due from Smith to Martin for the sum of $3,600 under the distributor’s contract. Demand for payment was made, but Smith failed to make payment. As a result, Martin brought an appropriate action against Black and Blue to recover the $3,600. What result? Answer: Types of Sureties. Decision for Black and Blue. The promise of a surety is not binding without consideration. Here, the surety's promise was made after the principal debtor (Smith) received an extension of credit from Martin Publishing Company. Consequently, Black and Blue's suretyship promise must be supported by new consideration, which it was not. The extension of credit by Martin is not sufficient consideration because it was not contemporaneous with the sureties' promise. 18. Diggitt Construction Company was the low bidder on a well-digging job for the Village of Drytown. On April 15, Diggitt signed a contract with Drytown for the job at a price of $40,000. At the same time, pursuant to the notice of bidding, Diggitt prevailed upon Ace Surety Company to execute a performance bond indemnifying Drytown on the contract. On May 1, after Diggitt had put in three days on the job, the president of the company refigured his bid and realized that if his company were to complete the job it would lose $10,000. Accordingly, Diggitt notified Drytown that it was canceling the contract, effective immediately. What are the rights and duties of Ace Surety Company? Answer: Exoneration/Reimbursement. Ace Surety Company is liable to the Village of Drytown on the performance bond. Ace Surety has the right of reimbursement and exoneration against Diggitt Construction Company and is subrogated to Drytown's rights against Diggitt. 19. National Cash Register Company (NCR), a manufacturer of cash registers, entered into a sales contract for a cash register with Edmund Carroll. On November 18, Fire-stone and Company made a loan to Carroll, who conveyed certain property to Firestone as collateral under a security agreement. The property outlined in the security agreement included “[a]ll contents of luncheonette including equipment such as . . . ‘twenty-five different listed items,’ . . . together with all property and articles now, and which may hereafter be, used . . . with, [or] added . . . to . . . any of the foregoing described property.” A similarly detailed description of the property conveyed as collateral appeared in Firestone’s financing statement, but the financing statement made no mention of property to be acquired thereafter, and neither document made a specific reference to a cash register. NCR delivered the cash register to Carroll in Canton between November 19 and November 25 and filed a financing statement with the town clerk of Canton on December 20 and with the Secretary of State on December 21. Carroll subsequently defaulted both on the contract with NCR and on the security agreement with Firestone. Firestone took possession of the cash register and sold it at auction. Discuss whether Firestone has a security interest in the cash register. Answer: After-Acquired Property. The question to be decided is whether or not Firestone’s security interest includes the after-acquired cash register. There are two documents to examine: the security agreement and the financing statement. The language of the security agreement appears to cover all the contents of the luncheonette, not just the listed items, and is therefore broad enough to include the cash register. The first potential problem for Firestone is that its financing statement did not mention property to be acquired subsequently. This problem is diffused by the UCC’s “notice filing” system in which only a simple notice describing the collateral must be filed by the secured party. This system is designed to “give subsequent potential creditors and other interested persons information and procedures adequate to enable the ascertainment of the fact they need to know.” The Firestone financing statement met this requirement. The words, “All contents of the luncheonette ...” were enough to put NCR on notice to determine what those contents were. The second potential problem for Firestone is that under Revised Section 9-108(c) a reasonable description of collateral in a security agreement cannot be a super generic description, such as “all my personal property,” thus this type of description could be questioned. It appears that in this case, Firestone’s description is not too generic. Listing twenty-five examples and using terms such as “equipment” seems to be specific enough for Firestone to prevail. (Note: a super-generic description is acceptable for a financing statement). 20. National Acceptance Company loaned Ultra Precision Industries $692,000, and to secure repayment of the loan, Ultra executed a chattel mortgage security agreement on National’s behalf on March 7, 2011. National perfected the security interest by timely filing a financing statement. Although the security interest covered specifically described equipment of Ultra, both the security agreement and the financing statement contained an after-acquired property clause that did not refer to any specific equipment. Later in 2011 and in 2012, Ultra placed three separate orders for machines from Wolf Machinery Company. In each case it was agreed that after the machines had been shipped to Ultra and installed, Ultra would be given an opportunity to test them in operation for a reasonable period. If the machines passed inspection, Wolf would then provide financing that was satisfactory to Ultra. In all three cases, financing was arranged with Community Bank (Bank) and accepted, and a security interest was given in the machines. Furthermore, in each case a security agreement was entered into, and the secured parties then filed a financing statement within ten days. Ultra became bankrupt on October 7, 2014. National claimed that its security interest in the after-acquired machines should take priority over those of Wolf and Bank because their interests were not perfected by timely filed financing statements. Discuss who has priority in the disputed collateral. Answer: Purchase Money Security Interest. Judgment for Wolf and Bank. Wolf and Bank provided funds for Ultra to purchase the machines and, therefore, had an interest classified as a purchase money security interest in equipment. National, on the other hand, had an ordinary secured interest in the equipment that it had properly perfected. Between these two conflicting interests, the purchase money security interest in the equipment has priority if it was perfected at the time that the debtor, Ultra, received possession of the collateral or within twenty days thereafter. . Section 9-324 (a). Here, Wolf and Bank filed financing statements long after the debtor received physical delivery of the machines but within twenty days of when Ultra completed testing and secured financing and thereby incurred the obligation to purchase the machines. Only when Ultra executed and delivered the security agreements on the machines did it become a debtor. Therefore, since the financing statements were filed within twenty days of that date, Wolf and Bank had properly perfected purchase money security interests in the machines that take priority over National’s claims. 21. Elizabeth Tilleraas received three student loans totaling $3,500 under the Federal Insured Student Loan Program (FISLP) of the Higher Education Act. These loans were secured by three promissory notes executed in favor of Dakota National Bank & Trust Co., Fargo, North Dakota. Under the terms of these student loans, periodic payments were required beginning twelve months after Tilleraas ceased to carry at least one-half of a full-time academic workload at an eligible institution. Her student status terminated on January 28, 2014, and the first installment payment thus became due January 28, 2015. She never made any payment on any of her loans. Under the provisions of the FISLP, the United States assured the lender bank repayment in the event of any failure to pay by the borrower. The first payment due on the loans was in “default” on July 27, 2015, 180 days after the failure to make the first installment payment. On December 17, 2016, Dakota National Bank & Trust sent notice of its election under the provisions of the loan to accelerate the maturity of the note. The bank demanded payment in full by December 27, 2016. It then filed FISLP insurance claims against the United States on May 6, 2017, and assigned the three Tilleraas notes to the United States on May 10, 2017. The government, in turn, paid the bank’s claim in full on July 5, 2017. The government subsequently filed suit against Tilleraas. Discuss whether the United States will prevail. Answer: Rights of Creditor and Surety. Judgment for the United States. A surety is responsible for the payment of the debt of another should the principal debtor fail to repay the creditor. The purpose of the arrangement is to induce the creditor to extend a loan where he might otherwise be unwilling to do so. The benefit thus received by the debtor places the debtor under an implied legal obligation to reimburse the surety for any payment made by the surety to the creditor. In this case, Tilleraas was able to borrow money from Dakota National with no collateral and upon favorable terms. The United States insured repayment to Dakota National in the event of default by Tilleraas. Therefore, a surety-principal-debtor-lender relationship was created. When Tilleraas in fact defaulted and the United States, the surety-guarantor, paid Dakota National’s claim, it obtained the right to sue Tilleraas on the underlying loan. 22. New West Fruit Corporation (New West) and Coastal Berry Corporation are both brokers of fresh strawberries. In the second half of 2015, New West’s predecessor, Monc’s Consolidated Produce, Inc., loaned money and strawberry plants to a group of strawberry growers known as Cooperativa La Paz (La Paz). In September 2015, Monc’s and La Paz signed a “Sales and Marketing Agreement” to allow Monc’s the exclusive right to market the strawberries grown by La Paz during the 2015-2017 season. The agreement did not mention the advances of money or plants, but did give Monc’s a security interest in all crops and proceeds on specified property in the 2016-2017 season. The financing statement was properly signed and filed. Monc’s closed down in January 2017, and its assets were assigned to New West. In April, New West learned that La Paz had agreed to market its 2017 crop through Coastal Berry. New West immediately arranged a meeting to advise the Coastal Berry officers of its contract with the growers. New West requested that Coastal Berry either pay New West the amounts owed by the growers or allow New West to market the berries to recover the money. Coastal Berry did not respond. After Coastal Berry began marketing the berries, New West sent letters demanding payment of the proceeds. In August 2017, New West filed suit against Coastal Berry, La Paz, the individual growers, and a berry-freezing company that its security interest was valid and that it had duly notified Coastal Berry both through the financing statement on file and through the letters it had sent to Coastal Berry directly. Coastal Berry claimed that the security agreement was not effective because it did not specifically identify the debt (money and plants) being secured. Discuss. Answer: Security Agreements. Judgment for New West. A security agreement in some form is necessary to create a valid security interest. Although the writing does not need to be formally designated “Security Agreement,” it must contain language that grants rights in the collateral. A nonpossessory security interest becomes enforceable when (1) the debtor has signed the agreement containing a description of the collateral (including a description of the land in the case of crops), (2) value has been given, and (3) the debtor has rights in the collateral. In this case, the Sales and Marketing Agreement, though poorly written, was sufficient to create a security agreement because it did grant to New West rights in the collateral (the crops). The agreement described the crops and the land and was signed by a representative from La Paz, New West (Monc’s) had given value, and La Paz had rights in the crops. Additionally, Coastal Berry was given sufficient notice of the debt and should have retained funds from the sales to cover the debt. The security agreement was therefore enforceable. 23. Standridge purchased a Chevrolet automobile from Billy Deavers, an agent of Walker Motor Company. According to the sales contract, the balance due after the trade-in allowance was $2,282.50, to be paid in twelve weekly installments. Standridge claims that he was unable to make the second payment and that Billy Deavers orally agreed that he could make two payments the next week. The day after the double payment was due, Standridge still had not paid. That day Ronnie Deavers, Billy’s brother, went to Standridge’s place of employment to repossess the car, which the Walker Motor contract permitted. Rather than consenting to the repossession, Standridge drove the car to the Walker Motor Company’s place of business and tendered the overdue payments. The Deavers refused to accept the late payment and instead demanded the entire unpaid balance. Standridge could not pay it. The Deavers then blocked Standridge’s car with another car and told him he could just “walk his . . . home.” Standridge brought suit, seeking damages for the Deavers’s wrongful repossession of his car. The Deavers deny that they granted Standridge permission to make a double payment, that Standridge tendered the double payment, and that they rejected it. They claim that he made no payment and that, therefore, they were entitled to repossess the car. Discuss whether the car was properly repossessed. Answer: Default. Judgment for Standridge. Unless otherwise agreed in the contract, the secured party on default has the right to repossess the collateral without judicial process. Here, the sales contract specifically provided for repossession upon Standridge's default of any payments. The Deavers were then entitled to repossess without judicial process. However, the repossession must be done without breaching the peace. The jury determined that the Deaver's combined acts of blocking-in Standridge's car and speaking to him in offensive, insulting language were sufficiently provocative of violence to be a breach of the peace. Therefore, the Deaver's repossession was unlawful and Standridge is entitled to recover damages. Deaver's v. Standridge, 144 Ga. App. 673, 242 S.E.2d 331 (1978). 24. In July of 2016, Edward Slater purchased a new Galaxy boat primarily for personal purposes. To finance the purchase Slater obtained a loan from Howell State Bank, agreeing to repay the loan in 96 monthly installments of $151.41. The Galaxy boat was purchased in the state of New Jersey, and Howell State Bank filed a copy of the Financing Statement Agreement in the office of the Secretary of State of New Jersey. Subsequently, the boat was moved to the state of New York. Explain whether Howell has a perfected security interest in the boat. Answer: Automatic Perfection. Howell has a perfected security interest in the boat. Since the Galaxy boat was a consumer good, it was unnecessary for Howell State Bank to file a financing statement to perfect its purchase money security interest. Notwithstanding the moving of the boat to New York, because Howell State Bank’s security interest was a purchase money security interest, that security interest remained perfected without the need for any further action under Part 3 of Article 9 of the Uniform Commercial Code. Howell State Bank v. Jericho Boats, Inc., 141 Misc.2d 314, 533 N.Y.S.2d 363 (N.Y. Supreme Court, 1988). ANSWERS TO “TAKING SIDES” PROBLEMS James Koontz agreed to purchase a Plymouth Sundance from Chrysler Credit Corporation (Chrysler) in exchange for sixty payments of $185.92. Koontz soon thereafter defaulted, and Chrysler notified Koontz that, unless he made the payments, it would repossess the vehicle. Koontz responded by notifying Chrysler that he would make every effort to make up missed payments, that he did not want the car repossessed, and that Chrysler was not to enter his private property to repossess the vehicle. A few weeks later, Chrysler sent the M & M Agency to repossess the vehicle. When he heard the repossession in progress, Koontz, dressed only in his underwear, came outside and yelled, “Don’t take it!” The repossessor ignored him and took the car anyway. Koontz did not physically challenge or threaten the repossessor (a) Discuss the arguments that Chrysler legally repossessed the automobile. (b) Discuss arguments that Chrysler illegally repossessed the automobile. (c) Who should prevail? Answer: (a) The repossession was legal. Whether a given act provokes a breach of the peace depends upon the accompanying circumstances of each particular case. In this case, Koontz testified that he only yelled, “Don't take it,” and that the repossessor made no verbal or physical response. He also testified that although he was close enough to the repossessor to run over and get into a fight, he elected not to because he was in his underwear. Furthermore, there was no evidence in the record that Koontz implied violence at the time of or immediately prior to the repossession by holding a weapon, clenching a fist, or even vehemently arguing toe-to-toe with the repossessor so that a reasonable repossessor would understand that violence was likely to ensue if he continued with the vehicle repossession. We think that the evidence, viewed as a whole, could lead a reasonable fact finder to determine that the circumstances of the repossession did not amount to a breach of the peace. (b) Koontz argues that Chrysler breached the peace by repossessing the vehicle under circumstances which would constitute a Class C misdemeanor, criminal trespass to real property. In this case, Koontz testified that he notified Chrysler prior to the repossession that it was not permitted to enter onto his property. (c) Chrysler should prevail. There was no testimony that Chrysler entered through any barricade or did anything other than simply enter onto the property and drive the car away. Chrysler enjoyed a limited privilege to enter Koontz's property for the sole and exclusive purpose of effecting the repossession. So long as the entry was limited in purpose (repossession), and so long as no gates, barricades, doors, enclosures, buildings, or chains were breached or cut, no breach of the peace occurred by virtue of the entry onto his property. Solution Manual for Smith and Robersons Business Law Richard A. Mann, Barry S. Roberts 9781337094757, 9780357364000, 9780538473637