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ANSWER A TO ESSAY QUESTION 2

Shareholder Derivative Suits

To bring a shareholder's derivative suit, the plaintiff must be a sha~t~holder at the time

the claim arose and throughout the course of the litigation. The sharehold\lr must be asserting

a claim for which the corporation could sue. He must make a demar,d on the Board of

Directors to rectify the situation unless he can show that it would be fvtile, and may be

required to make a demand on the shareholders to rectify unless th~ majority of the

shareholders are also wrongdoers. He must then file a verified complaint With the corporation

as a nominal defendant and post a bond.

l;lere, Pat, is seeking to rescind this agreement as it deprives Buildc;o any ability to 'pay

shareholders' dividends. The company is not making a profit so no( only is Pat as a

shareholder injured but so is Buildco. Since Buildco's Board of Directors alrt~ady approved the

Buildco-Sellco arrangement it would be futile to demand of them to rescind it. Also, Sellco is

the majority shareholder, which in turn is owned by Adam, who is on thE:jfiloard of Directors

of Buildco; thus, to ask Sellco to rescind this profitable agreement would t~lso be futile.

Pat v. Sell co

Pat can sue Sellco in his individual capacity as a shareholder or unilllr a shareholder's

derivative suit if Sellco's actions as a majority shareholder injure the corpor:a1:ion. Traditionally

a majority shareholder had no duty to minority shareholder; however, there ill a trend to im'p ose

such a duty, particularly in close corporations. Close corporations are thCj'!l!l that ·have' a few

number of shareholders and are not traded on national exchange. Here, SE:j1JI:O and Pat are the

shareholders of Buildco. Nothing in the facts indicate whether Buildco is traded on

exchange.

The trend is to impose a duty on the majority shareholder, not to act to the detriment

minority shareholder. The court will look to the Entire Fairness Test, i.e., 1) fair price and

Sellco as a company is reaping great profits at the expense of Buildco making no

Buildco cannot issue dividends to its shareholders, who are Sellco and Pat. Since

is already making money, it is only Pat who suffers. Thus, Sellco by making this

has breached its duty of fairness to Pat and·its duty of fairness to the corporation.

Pat should be able to disgorge the profit made by Sellco, but he will want the recovery

rather than to Buildco; otherwise, Sellco would benefit as the majority shareholder.

Adam, as a member of the Board of Directors of Buildco, owes the fiduciary duties of

and loyalty to the corporation.

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The,duty of care is the. standard a reasonably prudent person would'use in the course

own busiqess aff'!irs. The plaintiff bears the burden of proof to stiow this.fiduclary duty

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has been breached. Adam urged the other directors to vote for the agreement with Sellco •

saying that it "made sense." He made no further statements.

Adam may argue the Business Judgment Rule as a defense. The Business Judgment

Rule excludes a director from liability where 1) he acted in good ·faith, 2) the decision was

reasonable, and 3) it was supported by a rational basis. "To be reasonable, a decision must be

made after the directors investigate, analyze and deliberate over a corporate action.

Other than the statement that the agreement "made sense," there is no indication'that

Adam, Betty or Evan further discussed or questioned the agreement. Thus none of them

abided by their duties of care. Thus, Adam may be liable for lost profits to Buildco as a result

of the Buildco-Sellco Agreement.

Duty of Loyalty

The duty of loyalty is such that a director must act in good faith belief that his actions

or decisions are in the best interest of the company. The duty of loyalty prohibits directors

from self dealing, i.e, profiting at the expense of the company.

C~!f1pany

The Interested Director's Rule forbids a director from any transactions with his company.

unless he fully discloses the arrangement in which he has an interest and the deal is approved.

by a majority of the disinterested directors or shareholders. Some jurisdictions count the

invplved,directors for purpose.s of a quorum; others do not.

problem here is that Buildco's board consists of Adam and his wife Betty, both of

interested in the transactions. Evan, the only disinterested director, was not made

Betty and Pat's involvement with Sellco. Thus there was no disclosure of the

involvement of Adam and Betty with Sellco, and 2 of 3 board members were

persons. Adam, as owner of Sellco, and therefore 90% owner of Buildco, could've

the agreement to Pat, but Pat's dissent would not have mattered.

ISi11ce Adam violated his duty of loyalty to Buildco, any loss suffered by Buildco he will

liable for. However, if the corporation receives the profits, Adam will benefit as a

shareholder, so Pat may want to sue personally to recover.

IR .. ttv, as a director and officer of Buildco, owes the fiduciary duties of care and loyalty

discussed above. She is in violation of both duties for the same reason as her

Adam, and will be held liable to Buildco and Pat for damages.

also owes the fiduciary duties of c~;~re and loyalty to Build co as discussed above.

, as he had no personal interest in the Sellco-Buildco arrangement he will not l:ie liable

of the duty of loyalty. However, Pat will be able to show that Evan breached the

C!lfe,

reasonably prudent person would have further inquired of Adam ahd Betty about the

transaction, particularly where he knows Sellco is the majority shareholder in Buildco.

knew Buildco would not be making any profit. Evan failed to act with the care a

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reasonably prudent person would in his own business affairs and, 'th~S, is liable for any

damages to Buildco.

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ANSWER B TO ESSAY QUESTION 2

Pat v. Sellco

Pat will bring both a derivative shareholder action and a personal actjon against Sellco

on behalf of Buildco.

In a personal action against Sellco, Pat will claim that Sellco, a11 a majority and

·cpntrolling shareholder of Buildco, breached its fiduciary duty to him, a min~Jrity shareholi:ler.

A controlling shareholder has a general duty to deal fairly with the other shj!reholders and to

no~ take any action that will affect their interest. Here, Sellco entered into a: deal with Buildco

that was unfair to Buildco and deprived Build co of the only source of money ~vith which to pay

dividends. Thus, this will not only cause Pat as a minority shareholder to recl'jive no dividends,

bu~ it will greatly decrease the value of his stock.

Action to Declare a Dividend

Pat may also attempt to bring an action against the company deman~ing tMat it pay a

dividend. The facts tell us that the company has not been able to pay·divi~ends·because of

the arrangement between Sellt:o and Buildco.

A shareholder is generally not entitled to a dividend until it is declart~d. Furthermore,

1 a·dividel']d can only properly .be:paid out of net earnings or, in some states

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excess capital. I Here, there were no net earnings because the company was not making am{momiy. Thus;

payment of a dividend was not warranted.

Nonetheless, some courts may entertain an action demanding a dividend where a

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areholder can show Board misconduct. For the reasons discussed below Pat can show that

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r Board acted improperly. Thus, the Court may require the corporation to declare a dividend.

bre likely, however, the court will order a buyout of Pat's shares at a reasonable price.

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I f (on behalf of Buildcol v. Sellco- Shareholder Derivative Suit

Pat will also bring a shareholder's rlerivative action against Sellco on behalf of Buildco.

lhareholder can bring a derivative action on behalf of the corporation if he was an owner of

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ck both at the time of the action complained of (here, the entering in the contract with

Ideo) and throughout the course of the lawsuit. Before bringing such a suit, a shareholder

~t generally either make a demand on the Board of Directors to bring the suit themselves

lin some states, make a demand 1o the shareholders to bring a suit. A shareholder is

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\sed from this requirement where the making of such a demand would be futile. Here, the

fing of the demand would be futile since a majority of the Board (both Adam and Betty)

b an interest in the deal. Adam is the 100% owner of Sellco and thus would not likely

rove an action to sue the company. Betty is Adam's wife and is thus indirectly interested

fllco. Pat will have to file a complaint alleging that the dE!mand was futile with specificity

~hen he will have to likely post a bo~d. If Pat is successful in his suit, he will be entitled

~ award of attorney's fees and the company will receive an~ damages.

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I Pat's suit will allege that Sellco, as a majority shareholder, breached its duty of loyalty

bare to Buildco. A majority shareholqer such as Sellco stands ~n a fiduciary felations~ip

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Buildco, since it in essence has control of the Board. Here, 'Sellco bre"aclied its duty of

~Y to Buildco by entering into a deal that was entirely unfair to Buildco and which will

~ Buildco to lose a lot of money.

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Unjust Enrichment

Pat will also sue Sellco derivatively alleging that the contract between oSellco and

Buildco is unenforceabl_e because it was unconscionable when made. He will bring an action

~gainst Sellco in equity to rescind the contract and for restitution in the 11mount that Sellco

was unjustly enriched at Buildco's expenses. This would include any apd all profit which

Sellco made on the sale of Buildco homes, which, according to the facts, yvas a considerahle

profit. Pat may also seek a constructive trust on the profits made off pf Sellco's sale of

Buildco-built homes. Because the deal was unfair to Buildco, Pat is likely t'! succeed on these

claims.

Pat !on behalf of Buildcol v. Adam

Pat will bring a shareholder derivative action against Adam on behalf pf Buildco. Again,

he will be able to show that a demand on the Board is futile because Adam i5i a Board Member.

Adam is a member of the Board of Directors of Buildco, and as Sf!Ch owes ceitain

fiduciary duties to the corporation. A board member owes the corporatio,n a duty'of care,

which requires that he act with respect to the corporation as ·a reasonable Pl!rson would with

respect to ,their own business affairs. ;He. also owes a duty of loyalty which requires 'that he

act in good faith, jlnd with the reasonable belief that ~e is acting in the best interest of the

company.

Breach. of the Quty of Loyalty

Adam engages! ,in self1iealing when he urged the other Build co direct'!rs to ·approve an

arrangement whereby Buildco would build houses and sell them to Sellco at cost. The facts

that Adam made a representation that the arrangement "made sense" and thus the

unanimously approved the arrangement. Adam clearly had much to gain from the

~s;~ction as he was the 100% shareholder of Sellco. A transaction benefiting a Board

is a breach of the duty of loyalty unless: (1) it is fair to the corporation; or (2) the

Board member makes a full disclosure of his interest to the Board and a majority of

ntF!rF!"t"rl Board members or shareholders approve the deal. Here, it is not clear that Adam

plo,sed his interest in Sellco to Evan (presumably Betty knew of his interest since she was

. Furthermore, this deal was not fair to Sellco as it took away all of its profits.

Adam also breached his duty of care to Buildco because, as discussed above, the deal

not fair to the corporation. As a result of his breaches of care and loyalty, Pat is likely

1uc,~ee1d on his claims and Adam will be liable to Buildco for the losses it sustained as a

of ~he bad deal with Sellco.

Adam is also a 100% owner of Sell co. Pat will sue Ad~m directly, arguing' that the

veil should be pierqed and that Adam should be directly liable for the same causes

Buildco has against Sellco discussed above. A court will hold a sliareh61der directly

where there is evidence ,thflt the corporation was: a mere sh'ell for thS'shareholder. The

will consider factors such as 'the amount of control of the shareholder al'ld the· amount

the company maintains. Here, Sellco's Board of Directors consists' of Adam and'his

Betty. Thus, it is clear that Adam controls Sellco. It also appears that Sellco· is merely

company, as the facts do not indicate that: Sellco has any purpose other tfian liolding

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Buildco stock and reselling Buildco homes. Thus, the interests of justice would allow Pat to

pierce the corporation veil and bring a direct cause of action against Adam.

Pat (on Behalf of Buildcol v. Betty

Pat will also bring a shareholder derivative suit on behalf pf BuildcO .against Betty.

Again, because Betty and her husband are on the Board, Pat will be able to show that a

d,emand on the Board would be futile.

Betty is both a President and Board Member of Buildco. In both roles, she also owes

duties of care and loyalty to the corporation. Betty, as Adam's wife, also engaged' in selft;

jealing, because she stands to benefit from any profit made by Adam. Thus, for tHe reasons

d,iscussed above with respectto Adam's breach of the duty of loyalty, Betty alsO breaclied this

duty.

Betty breached a duty of good faith [to] the col'(lpany also. The facts indicate that the

Board approved the action "based.solely. on Adam's representation that the agreement made

sense. •

Business Judgment Rule

Under the Business Ju~grnent Rule, a Board member will not be held tO breach' the dufy

of good faith if the facts show that the judgment was made in good faith, reasonably

informed, and rationally based. Here, the decision was not reasonably informed or rationally

based. Furthermore, Betty cannpt claim th,at she relied in goo~ faith upon the representations

of another Board member, because this was not reasonable under the circumstances,

Particularly since Betty knew that Adam (and she) had an interest in the deal.

Pat may also be able to bring an action against Betty based upon the theory of piercing

tnr>r"1'A veil if she has an ownership interest in the stock (e.g., based on her community

interest).

Fin1aill'l. Pat will bring a shareholder derivative suit against Evan. Pat will again argue

of involves both Adam and Betty.

was a Board member and thus owed Buildco duties of care and loyalty. For the

llS(lOS discussed above with respect to Betty, Evan acted in an uninformed and

manner in approving the deal with Sellco. Thus, he is liable to Buildco for any

result of the above actions, Pat will successfully bring shareholder derivative suits

the company and will be able to seek damages against all of the defendants

court will rescind the Sellco-Buildco contract. In addition, the company will be

unjust enrichment against Sellco and damages from the Board Members, which

damage caused to the company as a result of the· contract.