Some more thoughts about bar exam question 5

I thought I would give you a little insight into my thought process in answering question 5. It a good lesson I think in how to answer a law school question and how practicing law really works.

I spent about 40 minutes I think doing the answer I uploaded, maybe a little longer. I changed my mind a bunch of times about the analysis, taking arguments out completely and adding new ones that kept coming to me, going back and forth between the various parts. Even discussing Betty made me think of arguments for or against Arnold so I went back and made changes. I always, always, review. review, review. Refine, refine, over and over.

I uploaded it and went for a walk. During my walk I thought about my answer. It occurred to me that I should have been more clear about the fraud analysis. The false statement was that Arnold told Betty he thought the patent was worth a $100,000. If he really thought that, it’s not a false statement. Plus a belief in something may not even be a statement at all. So the issue really was the failure to disclose the previous attempts to sell the patent. Failure to disclose is not a “false statement” and is fraud only if there is a duty to disclose. Until they were partners I’m not sure there was a duty to disclose. That’s what made me think of Rule 10b5. That has a duty to disclose which I think clearly applies.

The point of this is this is how it works in the lawyer world. You think about something, reach a conclusion, think some more, massage your analysis. There are rarely clear answers to anything. Good lawyers write want they want to tell the judge or the client, then set it aside and look at it again tomorrow. It’s so much more clear the next day.

The second point in this post is when I later reviewed the answer I uploaded I quickly found a typo. I put in the answer that a partnership is when “one or more persons” agree to operate a business. It’s obviously two or more. It’s a stupid mistake and I kick myself. If I had read that in one of your answers, I would have wondered if you knew what the rule was. I likely would have pointed out that it can’t be that one person can be a partnership. Typos happen but it is sooo important they be limited.

The point of my second point is that it is the rare student, from what I can see, that reviews his/her answer at all. That is such a big mistake! What you say in your answer matters. I only know what I am reading. The bar exam reader spends about 3 minutes per exam before giving it a grade. We are trying to figure out how well you know the subject matter by reading your words.

My third point is that when I thought about the answer to part 2 – Betty, I wondered what I would say. The answer is really the same. So I thought about what made the Betty answer different than the Arnold answer which I spent so much time on. Many students these days would have copied and pasted the entire answer re Arnold into the answer re Betty. That is such a bad idea! If Betty were sitting there in your office, you would not just literally repeat what you just told Arnold. You would say, “well Betty, your position is a little different.”

Oh well, the Kings game is about to start. I have to reread this before I upload it. JH

Analysis of California Bar Exam, February 2022

This question is probably a contract, business associations and torts (fraud) cross-over. Below is the question and my analysis. Note that in a real answer, there would be more space spent stating the relevant rules.

Question 5

Arnold and Betty agreed to launch a business selling a durable paint that Arnold had developed and patented. They agreed to share all profits and to act as equal owners. Betty agreed to contribute $100,000 to the business venture. Arnold agreed to contribute his patent for durable paint. Arnold told Betty that he thought the patent was worth $100,000. He did not tell Betty that he had previously tried to sell the patent to several reputable paint companies but was never offered more than $50,000. Arnold and Betty agreed that Betty would be responsible for market research and marketing and Arnold would be responsible for incorporating the business and taking care of any other steps needed to start the enterprise.

Arnold first located a building within which to operate the business, owned by Landlord Co., and entered into a one-year lease in the name of Durable Paint, Inc.  Subsequently, after Arnold took the necessary steps, Durable Paint, Inc. was incorporated. At the corporation’s first board of directors meeting, Arnold and Betty were named as sole directors and officers. During that meeting, Arnold and Betty voted for the corporation to assume all rights and liabilities for the lease and to accept assignment of Arnold’s patent rights.

Over the next six months, Durable Paint, Inc. faced unforeseen and costly manufacturing and supply problems. At the end of the first six months, the corporation had exhausted all its capital and was two months behind on rent. To make matters worse, a competitor developed a far superior product, making Durable Paint, Inc.’s patent effectively worthless. Durable Paint, Inc. had no other assets.

Landlord Co. sued Arnold and Betty personally for damages for breach of the lease.  Betty sued Arnold.

1. On what theory or theories might Arnold be found personally liable for damages to Landlord Co.? Discuss.
2. On what theory or theories might Betty be found personally liable for damages to Landlord Co.? Discuss.
3. On what theory or theories might Arnold be found personally liable for damages to Betty? Discuss

My Analysis

Part 1:

Arnold and Betty seem to have formed a partnership by agreeing to operate a business selling paint.  They could argue that their agreement at the outset was to form a corporation which would then operate a business.  In other words, they did not intend and did not in fact operate a business until the corporation was formed.  At that point it would own the patent and would have some money and start operating.  But the landlord would argue that the execution of the lease was in furtherance of operating the business so it was “operating.” And courts generally hold that activities by one or more persons before incorporation constitute a partnership. 

There is probably a partnership so they are both personally liable for the debts of the partnership.  Is the lease a “debt of the partnership”?  It was if the partnership was a party to the contract and Arnold had authority to enter into the lease on behalf of the partnership.  The contract indicates that the tenant was a corporation which had not yet been formed.  The corporation cannot be a party to the contract, at least when the contract was entered into.  That leaves it that a contract was entered into by the partnership since it is in furtherance of the partnership business.  Did Arnold have authority to enter into the contract?  There are no facts suggesting he and Betty agreed that he would do that so there is no express authority to enter into the contract.  But they agreed Arnold would be “taking care of any other steps needed to start the enterprise.”  From that Arnold could have reasonably believed he had authority to enter into the lease and thus he had implied authority.  It could also be implied since general partners generally have authority to enter into contracts for the entity.  Thus the partnership is liable and both Arnold and Betty are liable for partnership debts. 

Arnold could also be liable for the debt because he was a promoter of the corporation to be formed.  The general rule is that the promoter is liable for contracts entered into by the promoter on behalf of a corporation to be formed.  Arnold might argue that there was simply no contract because there was no corporation.  He would argue that the parties, i.e., he and the landlord, intended the contract to apply only once the corporation was formed (and not until then).  That would depend on the facts.  He could also argue that the corporation was de facto.  A de facto corporation is one where the parties mistakenly believe a corporation exists.  But here Arnold knew he did not form the corporation.  He could also argue that when the corporation ratified the lease later, that ended his liability for the lease.  But the corporation’s ratification of the lease does not absolve him from the liability unless the landlord agreed to exonerate him.  He might argue that the fact that the landlord intended to enter into the contract with the corporation in the first place, and not with Arnold and/or Betty, and the corporation did in fact assume it, that shows that the parties intended the contract to be enforceable only against the corporation.

If the debt is a corporate debt and not personal to Arnold, the landlord could seek to pierce the corporate veil to make Arnold personally liable for the corporate debt.  But there are no facts that suggest that the corporation and Arnold were alter egos of each other.  There may be an argument that it was undercapitalized since it ran out of money quickly.  But they seemed to have complied with the formalities of operating a corporation, did not form it for any fraudulent purpose and it is not unfair therefore to allow him to be protected by the corporate shield.

Part 2:

The analysis as to Betty is largely the same.  In addition to Arnold’s arguments, she would argue that Arnold had no authority to enter into the lease because the agreement was that they would form a corporation so until then there was either no partnership or there was no authority to enter into a lease.  She would also argue that she was not a “promoter” of the unformed corporation because they agreed Arnold would take care of that part of the business.  Further she did not sign or negotiate the lease.  She is therefore not liable as a promoter.  She would have a little better chance at the de facto argument as she probably believed that the corporation was formed.  The de facto corporation concept does not work in most states.  But it is an equitable argument and the equities are in Betty’s favor, certainly more than Arnold. 

Part 3:

Arnold has definitely misled Betty as to the value of the patent.  Forgetting what kind of entity this might be, if his statements to her about the value of the patent were false, and he knew they were false and intended to deceive her, he has committed fraud and is liable for her damages.  Once a partnership was formed, Arnold also owed Betty a fiduciary duty of loyalty meaning he had an obligation to disclose everything to her that she might need to know, meaning tell her about his prior efforts to sell the patent.  So he has also violated that duty to her and must pay all damages caused by the violation.  If he made false statements to her as part of setting up the corporation, in other words as part of the process of her receiving stock in the corporation, he has an obligation under Rule 10b5 to disclose anything necessary so that the statements he made about the patent was not misleading.  Arnold might argue that the company failed because a competitor created a better product which is not uncommon.  In other words, his lack of candor and disclosure did not cause the injury.   

What is an investment contract? For securities laws purposes?

This case is not in the textbook but is helpful I think.

1.  Name of the Case and case cite. 

Smith v. Gross, 9th Cir Court of Appeals, 1979

2.  Who is the plaintiff or movant?  Who is the defendant or respondent?

            Plaintiff is an investor in an earthworms farm

            Defendant is the promoters/sellers 

3.  Exactly what relief has the plaintiff requested?

            Plaintiff seeks damages for violations of “federal securities laws.”   Note:  that is how the federal court got jurisdiction.  

4.  What is the legal basis for the request?

            They entered into an investment contract with the defendants.  The contract was a security which was not registered or exempt.            

5.   What facts does the plaintiff provide that support the request?

            Plaintiffs bought an “earthworms farm.”  The seller defendant’s told them that “very little work was required” and defendants would buy the worms produced which would “guarantee success.”  They said also that they were mislead by representations about how fast worms multiply each year.     

6.   How did the case end at the trial court level?

            The trial court dismissed the complaint “for lack of subject matter jurisdiction” saying the transaction did not involve federal securities laws.  The Court of Appeals reversed.     

7.  Given how the case ended, what is the standard that the court used to resolve the issue?

               Plaintiff did not state a claim for relief.  It’s not clear how or when the trial court dismissed the case.    

8.   What is the defendant’s opposition? 

            The transaction was not a security therefore could not be brought in federal court.   Sellers were simply selling worms and a business concept.  Plaintiffs ran their own business, made profits based on their own abilities.      

9.   Who won and Why?  What is the court’s reasoning for giving the plaintiff what she requested or denying the request. 

            The plaintiffs won at least sending the case back to federal district court.  The C/A said this was an investment contract because it is 1. an investment of money, 2. in a common enterprise, 3. with profits to come solely from the efforts of others.   A big factor was that the deal plaintiffs made was that they would buy worms and that defendants would buy them back at a guaranteed price which guaranteed a certain profit.  The buyers of the worms were not the public but the defendants.        

Summary of the Duties of the Board of Directors

This is such a great summary of the duties of the board of directors from three attorneys at Sidley Austin LLP – Claire H. HollandHolly J.Gregory and Rebecca Grapsas:

Responsibilities of the board (supervisory)

Board’s legal responsibilities

What are the board’s primary legal responsibilities?

The primary legal responsibility of the board is to direct the business and affairs of the corporation (see DGCL, section 141). While the functions of a board are not specified by statute, it is generally understood, as noted in the ALI’s Principles of Corporate Governance and other codes of best practice, that board functions typically include:

  • selecting, evaluating, fixing the compensation of and, where appropriate, replacing the CEO and other members of senior management;
  • developing, approving and implementing succession plans for the CEO and senior executives;
  • overseeing management to ensure that the corporation’s business is being run properly;
  • reviewing and, where appropriate, approving the corporation’s financial objectives and major corporate plans, strategies and actions;
  • understanding the corporation’s risk profile and reviewing and overseeing the corporation’s management of risks;
  • reviewing and approving major changes in the auditing and accounting principles and practices to be used in preparing the corporation’s financial statements;
  • establishing and monitoring effective systems for receiving and reporting information about the corporation’s compliance with its legal and ethical obligations, and articulating expectations and standards related to corporate culture and the ‘tone at the top’;
  • understanding the corporation’s financial statements and monitoring the adequacy of its financial and other internal controls, as well as its disclosure controls and procedures;
  • evaluating and approving major transactions such as mergers, acquisitions, significant expenditures and the disposition of major assets;
  • providing advice and counsel to senior management;
  • reviewing the process for providing adequate and timely financial and operational information to management, directors and shareholders;
  • establishing the composition of the board and its committees, board succession planning and determining governance practices;
  • retaining independent advisers to assist the board and committees;
  • assessing the effectiveness of the board, its committees or individual directors; and
  • performing such other functions as are necessary.

Continue reading

Agency question from student

Hello Professor, I had a quick question regarding agency law, or more specifically the ratification portion.


Principal will be liable to a third party for an unauthorized contract entered on its behalf, if the principal accepts benefits of the contract. The principal must have knowledge of the contract, the terms and nevertheless accept the benefits.

Does this mean that the principal, after giving either actual (implied or express) or apparent authority, and having knowledge of the contract its terms and its acceptance be ratified or must it be that he must have knowledge of the contract and terms and be required to accept the benefits?

Response: Continue reading

Nice Discussion of Shareholder Proposals

We did not spend much time on this in class.  We discussed that anyone seeking a proxy in a public corporation must first prepare a “proxy solicitation statement” which has a huge amount of information and is therefore very expensive to prepare.  Shareholders therefore can ask the corporation to include a proposal into the proxy solicitation statement that the company is preparing anyway.   The BOD can refuse to do that on specific grounds.  Below is a nice discussion of the shareholder proposal rules. Continue reading

Nice Article on How to Keep Board Minutes – Some Thoughts on Board Meetings

“A well-documented board meeting creates an important historical record that can guide future deliberations and may prove useful during Board disagreements, litigation, Attorney General investigations, other governmental enforcement actions, or an audit by the IRS.”

The article, A Minute Guide to Minutes, by Patterson Belknap Webb & Tyler LLP – Justin Zaremby and Tomer J. Inbaris is here.  

Many students struggle in Biz Orgs because they cannot conceptualize a board meeting.  I have tried to figure out how to have a board meeting in class or a part of a board meeting.  I once had a make believe board meeting where the CEO of a very successful company demanded a huge bonus or she would quit.  She left the room so the board members (the class) could deliberate.  The corp was very profitable and the bonus would not “hurt” the corp.  The CEO was a big part of the reason for the success of the company.  After some discussion, I passed around 3×5 cards and had everyone vote in secret.  The vote was overwhelmingly to reject the requested bonus – all but unanimous.

I then “advised’ the CEO out in the hall of the rejection – and she “advised” me that she quit and left in a huff.  Now there are shareholders who are saying that the board blew it by letting her leave.  Profit is down.

What result?   What would go in the minutes?  What would you, as a board member, want in the minutes?

Stockholder’s Demand for Books and Records

Nice discussion of a shareholder’s rights to review a corporation’s books and records, by K&L Gates.    The article is here.  The basic rule is that a shareholder may review books and records if he has a “proper purpose.”  The article discusses the recent case of Haque v. Tesla Motors, Inc., C.A. No. 12651-VCS (Feb. 2, 2017) where the Delaware Court refused to order Tesla to turnover certain records saying :

The Court acknowledged that use of corporate records to investigate potential wrongdoing or mismanagement at a company is a proper purpose under Section 220.  However, before compelling production of records in such cases, the Plaintiff must present evidence to establish a “credible basis” from which the Court can infer that mismanagement, waste, or wrongdoing may have occurred.

The opinion is here.

More Thoughts on Laker Family Feud

Two more things have caught my eye about the Laker feud which provide me a teaching moment for my Biz Org students.

Thing one is that according to some ESPN blog, AEG is a minority owner that “controls” two seats on the corporate board of directors.   The BOD remember is Jeanie, Johnny, and Joey Buss and two others.  I’m not sure how AEG “controls” the two seats.  It is either because it owns enough shares to vote in two seats using cumulative voting, or there is some shareholders agreement between the Buss Trusts and AEG that gives AEG two seats (completely enforceable as it would relate to voting at a shareholder meeting), or there could be more than one class of stock which allocates the board seats among the classes.

Thing two is that I heard someone this morning on the radio assuring everyone that “the documents” make it clear that Jeanie is firmly in control of the Lakers.    As I said in the last blog, she seems to be firmly in control as the “controlling owner” for NBA participation purposes, but why can’t AEG use its two board seats to support Johnny and Joey and Jim and appoint someone else as President of the Lakers corp leaving her on the board.  Unless the corp is a “statutory closed corp” in California, a shareholder’s agreement making Jeanie the President is unenforceable.  The BOD must do that.  Why can’t AEG join with Johnny etc to make someone else the “controlling owner”?  I assume they can but that would apparently violate Johnny etc’s fiduciary duties owed to these trusts.  That seems to raise a serious conflict issue if Johnny cannot vote as a board member on what is best for the Lakers’ corp because of duties he owes to some trust.  And it cannot be that the BOD’s hands are tied as to removing Jeanie (again unless there is an enforceable shareholder’ agreement – enforceable being the key word in that sentence).  Continue reading