Chapter 1: Legal Ethics 1

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Learning Objectives 1.What are the duties of corporate directors and officers? 2.Directors are expected to use their best judgment in managing the corporation. What must directors do to avoid liability for honest mistakes of judgment and poor business decisions? 3.What is a voting proxy? What is cumulative voting?  2

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Learning Objectives 4.If a group of shareholders perceives that the corporation has suffered a wrong and the directors refuse to take action, can the shareholders sue their own corporation? 5.From what sources can dividends be paid legally? What happens if a dividend is illegally paid?

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Roles of Directors and Officers 4  A corporation is governed by a board of directors elected by shareholders. – Individual directors are not agents of corporation, only the board itself can act as a “super-agent” and bind the corporation. – A director can also be a shareholder, especially in closely-held corporations.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Roles of Directors and Officers 5  Election of Directors. – Generally, the number of directors is set forth in the articles of incorporation: – Directors appointed at the first organizational meeting. In closely held companies, directors are generally the incorporators and/or the shareholders. – Term of office is generally for one year. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Election of Directors. – Removal of Directors: directors can be removed for cause. – Vacancies on Board: if director dies or resigns or new position created by the articles or bylaws.  Roles of Directors and Officers 6

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Roles of Directors and Officers 7  Compensation of Directors. – Inside director (officer), vs. outside director. Often the same person is both an officer and director, and receives compensation as an officer.  Board of Directors’ Meetings. – Quorum must be present to conduct official business. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Roles of Directors and Officers 8  Rights of Directors. – Participate in corporate decisions and inspect corporate books and records. – Compensation (usually a nominal sum). Corporation should guarantee reimbursement (indemnification) or purchase liability insurance to protect the board from personal liability.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Roles of Directors and Officers 9  Committees of the Board. – Executive Committee. – Audit Committee. – Nominating Committee. – Compensation Committee. – Litigation Committee.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Roles of Directors and Officers 10  Corporate Officers and Executives. – Officers serve at the pleasure of the Board of Directors but have fiduciary duties to company as well. – Their employment relationships are generally governed by contract law and employment law. – Officers may be terminated for cause.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 11  Directors and officers are fiduciaries and owe the company ethical and legal duties.  Duty of Care. – Duty to Make Informed Decisions. Directors are expected to be fully informed on corporate matters. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 12  Duty of Care (cont’d). – Duty to Exercise Reasonable Supervision. Directors are expected to supervise officers when delegated work. – Dissenting Directors: rarely held individually liable to the corporation.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 13  Business Judgment Rule. – Immunizes a director or officer from liability from bad decisions. Court will not require directors or officers to manage “in hindsight.” As long as decision was reasonable, informed, made in good faith and in the best interests of the corporation, BJR will apply. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 14  Business Judgment Rule. – CASE 25.1 H ENRICHS V. C HUGACH A LASKA C ORP. (2011). – CASE 25.1 H ENRICHS V. C HUGACH A LASKA C ORP. (2011). Did Henrich’s conduct violate the business judgment rule?

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 15  Duty of Loyalty: subordination of personal interests to the welfare of the corporation. – No competition with Corporation. – No “corporate opportunity.” – No conflict of interests. – No insider trading. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 16  Duty of Loyalty (cont’d). – No transaction that is detrimental to minority shareholders.. – CASE 25.2 G UTH V. L OFT, I NC. (1939). – CASE 25.2 G UTH V. L OFT, I NC. (1939). What were the two parts of the duty test the court used to determine whether the corporate executives had violated their duty of loyalty

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 17  Conflicts of Interest: full disclosure of any potential conflicts of interest and abstain from voting on any transaction that may benefit the director/officer personally. – However, if transaction was fair and reasonable, it can be approved by majority of disinterested directors.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Directors and Officers 18  Liability of Directors and Officers. – Directors and officers may be liable for crimes and torts committed individually and/or those committed by employees under their supervision. – Shareholder derivative suits where shareholder(s) sue directors on behalf of corporation].

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Role of Shareholders 19  Acquisition of shares grants an equitable ownership interest in a corporation. – Shareholders generally have no right to manage the daily affairs of the corporation, but do so indirectly by electing directors. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Role of Shareholders 20  Controlling shareholders owe a fiduciary duty to minority shareholders.  Shareholders’ Powers include: – Approving all fundamental changes to the corporation. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Role of Shareholders 21  Shareholders’ Powers (cont’d): – Amending articles of incorporation or bylaws. – Approval of mergers or acquisition. – Sale of all corporate assets or dissolution. – Shareholders also elect and remove the board of directors.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Role of Shareholders 22  Shareholders’ Meetings must occur at least annually. Voting requirements and procedures are: – Notice of Meetings. – Proxies. – Shareholder Proposals.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Role of Shareholders 23  Shareholder Voting. – Quorum Requirements: shareholders representing more than 50% of shares must be present to conduct business. – Voting Lists: record of stock ownership. – Cumulative Voting: Cumulative Voting allows minority shareholders to get a board member elected. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Role of Shareholders 24  Shareholder Voting (cont’d). – Other Voting Techniques. Shareholder Voting Agreements. Voting Trusts—Trustee votes the shares.

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rights of Shareholders 25  Shareholders may have various rights, depending on the articles and bylaws:  Stock Certificates.  Preemptive Rights: allows each shareholder to maintain his proportional control.  Stock Warrants: buy at a stated price. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Rights of Shareholders 26  Dividends: distribution of corporate profits or income ordered by the board. – Illegal Dividends. – Directors’ Failure to Declare a Dividend.  Inspection Rights. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Transfer of Shares.  Rights on Dissolution.  Shareholder’s Derivative Suit. – Shareholders sue a third party on behalf of the corporation, if the Directors fail or refuse to correct the wrong or injury. – Shareholders must first ‘make demand’ on the board which then has 90 days to decide.  Rights of Shareholders 27

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Shareholder’s Derivative Suit. – When shareholders bring a derivative suit, they are doing so in the name of the company, not individually. – CASE 25.3 B EZIRDJIAN V. O’R EILLY (2010). – CASE 25.3 B EZIRDJIAN V. O’R EILLY (2010). Why did the court grant summary judgment to the director (O’Reilly)? Rights of Shareholders 28

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Shareholders 29  Shareholders are generally not liable for the contracts or torts of the corporation. – If the corporation fails, shareholders generally cannot lose more than their investment. 

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Shareholders  Watered stock. – Worth less than fair market value. Shareholder is personally liable for difference.  Duties of Majority Shareholders. – Majority shareholders own enough shares to exercise de facto (actual) control over the corporation.  30

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Duties and Liabilities of Shareholders  Duties of Majority Shareholders. – Majority shareholders owe a fiduciary duty to corporation and the minority shareholders and creditors when they sell their shares because of the possibility of transfer of control. 31

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Major Business Forms Compared 32

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Major Business Forms Compared 33