Good question from a student re corporations which enter into partnership agreements.

Hi Professor Hayes,

If someone opens a corporation, then enters into a partnership to carry out the business, does that mean that the corporation becomes part of the partnership or the corporation will be a separate entity?

Response:

First a corporation, once formed, will continue to exist and be a corporation until the end of eternity unless dissolved by the state. A partnership is the same except that it ends when the agreement ends (or eternity, whichever occurs first).

If a corporation enters into a partnership with someone else, a person, a corp or another partnership, then the corp is a partner in the partnership. The corp has its assets and business, the partnership has its assets and business. Assume that Apple and Microsoft decide to build a new computer, they could form a new corporation to do that (which issue stock to each) or just agree to do it together which would create a partnership (sometimes called a joint venture). The partnership is created by the agreement to create the thing. IT has two partners.

You and I could agree to start a sports bar. We each form corps, mine is ProfHayes, Inc. Yours is “Student, Inc. The two corps then agree to buy or build a sports bar. That agreement creates a partnership which would then own and operate the sports bar. If the partnership agreement says the partners get x dollars per month, that would go to the two corps. The BOD of each corp would then decide to declare dividends or invest the money or whatever. The partners are liable for the debts of the partnership but that means the two corps, not you and I personally.

Study Sessions

I cannot meet with anyone tomorrow. For one thing, I am grading the exams. I will meet with students on Wednesday of next week by Zoom at 5pm. Send me your name and email so I can send you a Zoom invite. Next Saturday I will be out of town.

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.        

New case on the business judgment rule

Coley v. Eskaton (2020) 51 Cal. App. 5th 943

This is an action by a homeowner against the board of an HOA. The court awarded $2,300 in damages and $654,000 in attorneys fees! The plaintiff argued that the directors breached fiduciary duty and other claims, alleging directors approved actions of HOA for benefit of operators rather than HOA itself and homeowners. The court found directors breached fiduciary duty to HOA but declined to find directors liable in their personal capacities. The court of appeals reversed saying:

1 directors failed to establish HOA transactions were fair and reasonable;

2 directors had personal financial interest in transactions they approved that was distinct from interest of HOA members generally; and

3 directors breached fiduciary duty to HOA members by approving transactions in which they had material financial interest and which were not inherently fair to HOA and its members.

As to the BJR, theopinion says:

B. Application of the Business Judgment Rule

1The defendants’ next claim the court misapplied the business judgment rule. The business judgment rule is a policy of deference to a corporate board’s decisionmaking. (Lamden v. La Jolla Shores Clubdominium Homeowners Assn. (1999) 21 Cal.4th 249) But the trial court here found the rule inapplicable because the Eskaton entities’ employees who sat on the Association’s board had an “irreconcilable conflict of interest” that “preclude[d] the business judgment rule as a defense to liability in this case.” According to the defendants, rather than finding this conflict precluded the business judgment rule altogether, the court instead should have afforded the defendants an opportunity to reclaim the benefit of the rule by showing they acted in good faith after reasonably investigating material facts. We view the law differently.

1. Background law

California recognizes two types of business judgment rules: one based on statute and another on the common law.  Corporations Code section 7231 supplies the relevant statutory rule for nonprofit mutual benefit corporations like the Association. Under that statute, a director is not liable for “failure to discharge the person’s obligations as a director” if the director acted “in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.” (Corp. Code, § 7231, subds. (a)(c).) The common law business judgment rule is similar but broader in scope. It is similar in that it immunizes directors for their corporate decisions that are made in “good faith … to further the purposes of the [corporation], are consistent with the [corporation’s] governing documents, and comply with public policy.” (Nahrstedt v. Lakeside Village Condominium Assn. (1994) 8 Cal.4th 361, 374) And it is broader in that it also “ ‘insulates from court intervention those management decisions’ ” that meet the rule’s requirements. (Lamden, supra, 21 Cal.4th at p. 257.)

45A director, however, cannot obtain the benefit of the business judgment rule when acting under a material conflict of interest. Deference under the business judgment rule is premised on the notion that corporate directors are best able to judge whether a particular transaction will further the company’s best interests. (Gaillard, supra, 208 Cal.App.3d at p. 1263, 256 Cal.Rptr. 702.) But that premise is undermined when directors approve corporate transactions in which they have a material personal interest unrelated to the business’s own interest. And it is particularly undermined when a majority of these directors approve transactions while having a material conflict of interest. Under those circumstances, the directors carrying this conflict of interest are precluded from seeking the benefit of the business judgment rule. (See Everest Investors, supra, 114 Cal.App.4th at p. 430, 8 Cal.Rptr.3d 31Gaillard, supra, 208 Cal.App.3d at p. 1263, 256 Cal.Rptr. 702.)

678But although the business judgment rule is inapplicable under these circumstances, that is not to say that corporate decisions affected by these types of conflicts are improper as a matter of law. As with the business judgment rule generally, statutory and common law requirements are again relevant in this context. Corporations Code section 7233 supplies the relevant statutory rule. It provides, among other things, that an interested director who casts a deciding vote on a transaction must show the “transaction was just and reasonable as to the corporation at the time it was authorized, approved or ratified.” (Corp. Code, § 7233, subd. (a)(3).) Section 7233, however, only applies to transactions “between a corporation and one or more of its directors, or between a corporation and any domestic or foreign corporation, firm or association in which one or more of its directors has a material financial interest.” (Corp. Code, § 7233, subd. (a).) The common law rule, as before, is similar but broader in scope. It is similar in that it requires interested directors to “prove that the arrangement was fair and reasonable”—a rigorous standard that requires them “ ‘not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein.’ ” (Tenzer v. Superscope, Inc. (1985) 39 Cal.3d 18, 31-32, 216 Cal.Rptr. 130, 702 P.2d 212 (Tenzer).) And it is broader in that, unlike Corporations Code section 7233, it is not concerned only with transactions between a corporation and either its directors or a business in which its directors have a material financial interest. (See Corp. Code, § 7233, subd. (a).) Rather, recognizing the potential for self-dealing may also exist outside this particular context, courts have found directors must also satisfy the common law requirements when they approve other transactions in which they have a material financial interest distinct from the corporation’s own interest.

Questions re first mid-term

1- Did Jack own 100% of the shares and was he the sole member when he decided to sell the SSI stock, or he did sell the stock while he owned 87% and without going back to the BOD?

2- Does a derivative suit on behalf of the company include causes of actions that arises before the shareholder bought his shares in the company? 

Answer:

  1. I’m not sure why students are asking about the timing of the sale of the shares and who sold the shares to the new shareholders. He is a shareholder and a bunch of other people are shareholders. If you think the timing of the sales of the shares matters, you have to say why and explain what the result would be first if he sold his own shares and second if the corp sold new shares. For whatever it’s worth; a sale of shares by the corp must be approved by the BOD (therefore what is the consequences if the BOD does not approve?). A sale by a shareholder of his personal shares does not have to be approved by the corp or anyone else – forgetting securities laws. These are not issues in this question. If you think they are, by all means explain why. I will listen.
  2. The answer to this is no. But don’t worry about whether the derivative suit was procedurally proper. I should have said that in the question, although again it could be answered easily; “if she didn’t own shares when the bad things happened, she cannot be the plaintiff.”

Note: I have been thinking about this as I’m writing the response. The question says S wants her investment back. That’s a good question when we get to securities laws. Can she get it back from Jack? Your answer should say “yes, if ——-.” “No, if ———.” Can she get it back from the corp? Same.

But the question says (you forced me to look at the question): Suzie files a derivative suit against Jack and the BOD. It doesn’t ask you if she can get her investment back directly from Jack.

Good questions.

Study Sessions

I am not going to do a study session this Saturday because of the exam answers that are due next Tuesday. As I said in class last night, I am willing to spend an hour to 90 minutes with students by Zoom one evening a week for the next five weeks – starting next week. I can do it at 5pm or at 7pm, any night obviously except Tuesday night. Please send me an email if you are interested in attending telling me which days and times you prefer. I will pick a time which the most people can attend. That is the best I can do.

Question re first mid-term

Hello Professor Hayes, 

I have a question, in regard to the assignment did Jack sell his own common stock or issue new stock? the facts are not clear and I’m confused. 

Answer, I’m not sure it matters. If you think it does, you should say, “If Jack sold his own stock, then such and such, but if the corp sold new stock, then such and such.”

Study session tomorrow 10-10-20 if anyone is interested

I will hold a study session tomorrow by Zoom from 10:00am to 11:30am if I get at least three people who request it. Send me an email and if I get three, I will send the Zoom instructions.

We can review your answers to the short essay questions if you wish as long as I can give copies of your answers to whoever else is on Zoom so that they can follow along.

We can also review whatever areas we have already studied so far this year.

Let me know. Prof Hayes.