BUSINESS ORGANIZATIONS

Fall Semester - 1991

Professor Iijima

Final Examination

Additional Instructions

I. MATERIALS PERMITTED FOR THIS EXAM: You may use your textbook, the statutory supplement, Problems & Materials, notes, and student-prepared outlines. No other commercially prepared outlines, texts, hornbooks, etc. are allowed, e.g. Soloman & Palmiter, Corporations.

II. Mechanics:

A. Use pen only.

B. Write on only one side of bluebook (left or right).

C. Start each question in a new bluebook. Label each answer in your bluebooks clearly, using the number that appears before each question.

D. Your answers must be legible!

III. This 3-hour exam consists of 3 questions, of varying weight. Use these percentages in allocating your time. Question I is worth 40%, Question II is worth 35%, and Question III is worth 15% 10% of the grade will be based on the clarity of organization and analysis. (Read the questions carefully and outline your analysis before you begin.)

IV. Address only issues covered in Business Organizations (assigned readings, lecture, and discussions) . No points will be awarded for answers focusing on material from other courses, e.g. U.C.C., contracts, civil procedure.

V. SPECIAL PROCEDURES FOR GRADUATING SENIORS: Because only a few of you are graduating this semester, I have adopted special procedures to protect your anonymity. DO NOT WRITE "GRADUATING SENIOR" ON YOUR BLUE BOOKS, OR IN ANY OTHER WAY INDICATE YOUR STATUS AS A GRADUATING SENIOR. The registrar has given me a list of 10 exam numbers, including those of the graduating seniors, that I will grade by the deadline for senior grades. (I also will include all ten of these initial examinations in the final curve.)

Question I.

(40%)

In 1985, Albert, Luis, and Zenobia opened a bookstore called Novel Ideas in St. Paul, Minnesota. They filed a certificate of incorporation for the business, in the name Novel Ideas, Inc., with the Secretary of the State of Delaware. Albert, Luis, and Zenobia were the sole shareholders (each owned 100 shares of stock) and directors. By 1990, the business was doing very well. One morning, Albert, Luis, and Zenobia were out shoveling their front sidewalk. The manager of the needlework shop next door, who was also shoveling, mentioned that she was going to be retiring at the end of the year. That afternoon, Albert, Luis, and Zenobia discussed the possibility of buying the space and opening a gift shop. They did not come to a decision either to pursue the matter or to drop it.

One month later, Luis and Zenobia were working alone in the bookstore and began discussing the gift shop idea again. They decided to go ahead with the idea and agreed that they would not invite Albert or Novel Ideas, Inc. to participate. Accordingly, in 1991, Luis and Zenobia opened Novel-Ties in the shop next to Novel Ideas, Inc. Both Novel Ideas, Inc. and Novel-Ties did well financially. Although Novel Ideas, Inc.'s profits on gift books decreased, its overall profits increased, due, in part, to the increased number of customers attracted by the new store.

Discuss the following actions against Luis and Zenobia. Include a discussion of potential claims, defenses, and, to the extent covered in this class, procedural issues that may arise. To save time, you may cross-reference your answer to Part B to relevant portions of your answer to Part A.

A. Derivative action by Albert on behalf of Novel Ideas, Inc. against Luis and Zenobia.

B. Direct action by Albert against Luis and Zenobia.

Question II.

(35%)

In August, Mike opened a tavern called "Mike's Place." Although the business initially did very well financially, its primary clientele consisted of law students, and in November, as final exams approached, students began spending more time in the library and less time at the tavern. Business fell precipitously.

On Monday, November 18, Mike sold the business to Sarah, an acquaintance. Sarah decided not to change the tavern's name, thereby enabling her to continue to use the "Mike's Place" neon sign and the existing supply of "Mike's Place" napkins, promotional T-shirts, etc.

Sarah hired Mike to manage the tavern. Mike was to receive a regular salary and 10% of any profits. Mike would generally make the day-to-day business decisions, subject to the following restrictions: (1) when Sarah and Mike did not agree on a particular matter, Sarah would have final decision-making authority; and (2) all supplies (except beer and wine) were to be ordered from XYZ Restaurant Supply Co. Mike could order beer and wine from whomever he wished.

On Wednesday, November 20, Mike placed his usual order for mineral water and other non-alcoholic beverages with Bev's Beverages, his former supplier. Mike mentioned to Bev: "Oh, by the way, I sold the tavern, but I'm the manager and still order the supplies." Bev delivered the order on Thursday. The next day, Sarah noticed the new cases of non-alcoholic beverages. She angrily reminded Mike that he was only to purchase such supplies from, XYZ Restaurant Supply Co., and would not allow Mike to pay the invoice.

Bev sued Mike and Sarah. Who, if anyone, should be liable to Bev and why? (Please answer on the basis of principles covered in this class; e.g. disregard any UCC issues.)

Question III.

(15%)

The following article appeared in Fortune magazine. Assume that Ben & Jerry's Inc. is a publicly held corporation. Do you see any potential business organization problems for the management of Ben & Jerry's? How would you advise the management?

SAMPLE ANSWERS

I. General Guidelines

A. These answers are outlines of possible issues. Exams should be written in complete sentences.

B. Students need not cover all issues to receive the total points possible. Additionally, students may receive points for issues not outlined below.

II. Question I.

A. Delaware law applies, as Novel Ideas, Inc. ("Ideas") was incorporated in Delaware.

B. Derivative action by Albert on behalf of Ideas

1. Before Albert could attack the underlying action of 's in a derivative lawsuit, he would first have to overcome a number of hurdles.

a. He would satisfy the contemporaneous ownership rule, as he was a shh at the tine of the challenged action. He should continue to be a shh in Ideas throughout any proceedings.

b. Albert might have to post a bond to cover 's expenses if Albert were ultimately

unsuccessful.

c . Because of the basis of the lawsuit, the 's director's breaches of their duties to the corporation of care and loyalty, this clearly would be a derivative action.

d. In Delaware, the is required to make a demand on the corp to bring suit before proceeding on his own. The exception is if demand would be futile.

(1) If Albert were to make a demand on Idea's board (Albert, Luis & Zenobia), and the board voted to not pursue the action against Luis & Zenobia, Albert would have the burden of showing that the decision to reject the demand did not meet the requirements of the BJR.

(a) Good faith - Albert might be able to show that Luis & Zenobia were self-interested. But the mere fact that Luis & Zenobia participated in the challenged transaction may not be sufficient to show self-interest. Here, however, the fact that the underlying claim is for corporate opportunity, self-interest is more clear.

(b) Rational - It would be difficult for Albert to show that the decision to drop the lawsuit was irrational. The time, expense and adverse publicity might be legitimate reasons to drop the matter.

(c) Albert would not be able to show that the decision to reject the demand was grossly negligent, as the decision would be based on adequate information.

(2) Albert probably would be better off initiating the derivative action without making a demand on Idea's board.

(a) He would need to plead that he was excused from making an initial demand because such demand would be futile. He could claim that Idea's directors would not be the proper persons to conduct the litigation, as 2 or 3 of them were 's.

(b) If Albert were able to convince the court that demand would have been futile and that demand should trfr be excused, Ideas would have the burden of proving that the decision to dismiss the action was independent, in good faith and upon reasonable investigation. 's would have a difficult time particularly showing an independent judgment. The votes against the action would be from the 's. If they appointed Albert as a disinterested committee of one, he would have decided to proceed with the action.

(c) Even if Ideas were able to meet its burden of proof, the court still would be able to apply its own independent business judgment to determine whether the action should continue:

(i) Whether the decision to dismiss the action met the criteria of independence, good faith and reasonable investigation, but did not satisfy the spirit;

(ii) Whether Albert's underlying claims deserve further consideration;

(iii) Law and public policy-This consideration may support fiduciary duties between shhs.

2. Breach of duty of care-Albert might claim that the 's failure to cause Ideas into the gift shop breached a duty of care.

a. Albert would claim a lack of good faith-Although there was apparently no fraud or illegality involved, Albert could claim that the 's were self-interested, since they took the opportunity for themselves. This would invoke a duty of loyalty analysis. See below.

b. Albert would claim that their failure to act was irrational. This would be a very difficult thing to prove. Even though Ideas missed out on what turned out to be a good business opportunity, the failure to pursue the opportunity was probably not totally unreasonable.

c. There was apparently no gross negligence in the decision-making process. The basic information apparently was available to all three. But Albert could claim that the 's failure to inform him of their intention to pursue the gift shop idea was material information and that the failure to share it created a faulty process. But directors are generally not held liable where the decision was otherwise rational and in good faith.

3. Breach of duty of loyalty - Corporate opportunity doctrine

a. In Delaware, the courts follow the "line of business" approach. A corporate opportunity is one which embraces activity as to which the corporation has fundamental knowledge, practical experience and the ability to pursue, which is adaptable to its business having regard for its financial position, and is consonant with its reasonable needs and aspirations for expansion.

(1) The Ideas corp probably had the fundamental knowledge and experience necessary to run a gift shop, as both a bookstore and the gift shop are small retail businesses.

(2) Moreover, Ideas was doing well financially, and probably had the financial ability to pursue the new business.

(3) The gift shop apparently was consonant with Idea's needs and aspirations for expansion, given the fact that business picked up after Novel-ties opened.

b. Albert could argue that the 's learned of the opportunity because of their relationship to Ideas. The 's however, would point out that there was really no offer made, but that they only obtained a useful piece of information. Moreover, they did not receive the information in their official capacity, but only informally as a result of their physical proximity to the information source.

C. Direct action by Albert - Breach of fiduciary duty

1. Shhs in close corps have a fiduciary duty to one another, a duty of trust, utmost good faith, confidence and loyalty.

2. Ideas is a close corp, as it apparently has the typical attributes of a close corp

a. There are a small # of shhs (3)

b. The 3 shhs apparently manage the corp, as the three of them discussed whether or not to expand into a gift shop.

c. There is no reason to believe that there is a ready market for the stock of the corporation, due to its closely-held nature.

3. There are two basic approaches to claims of breach of fiduciary duty.

a. Under the Donahue approach, shhs in close corps must offer each other equal opportunities in relationship to the business of the corp.

(1) Here, Albert would claim that Luis and Zenobia did not give him an equal opportunity to participate in the new venture.

(2) 's would argue that had a chance to participate when the 3 of them initially discussed the idea, and that both Albert and Ideas failed to take action.

b. Under the Wilkes approach, a court would balance the interests of Albert in fair treatment by the 's with the 's right to self-interest. Under the Wilkes balancing test, the B/P would shift between the parties:

(1) Albert would have to show unequal treatment. Here, he would show that he was not given an opportunity to participate in the new venture. 's would raise the same defense that Albert and Ideas had an opportunity of which they did not take advantage.

(2) If Albert succeeded in showing unequal treatment, 's would be given a chance to assert a legitimate business purpose for their actions. They might claim, for example, that Albert had not been pulling his weight in the bookstore, and that the new business would be better off without him.

(3) If 's succeeded in their legitimate business purpose defense, Albert would still be able to prevail if he were able to show a less harmful means of addressing the 's concerns. For example, if the 's were concerned about Albert's work habits, the three of them could set up a work schedule.

The Wilke's balancing approach is probably more applicable than the equal opportunity approach, as the dispute involved matters implicating employment and the management of a business, not just a strictly economic matter such as the discriminatory redemption of shares.

d. Luis and Zenobia's best defense would be that there was no unequal treatment, as the new venture was unrelated to the old one.

(1) The situation is similar to the one in Meinhard, where the court held that joint venturers, owing each other a fiduciary duty, owed a duty to disclose information related to the extension and expansion of the venture.

(2) That duty would probably apply here, in the close corporation situation, as the courts meant to apply partnership-like duties. The distinction in the two cases, however, is that the expansion here was more separate from the original business, where in Meinhard the new venture involved a lease renew covering the same property, plus additional property.

II. Question II

A. Agency law

1. Was Mike Sarah's agent? Yes

a. Manifestation by Sarah (P) that Mike (A) to act for Sarah? Yes.

Direct: Sarah directly asked Mike to work for her as her manager.

b. To Mike? Yes.

c. Reasonable interpretation by Mike that Sarah consented to agency? Yes, Sarah's intent clear.

d. Mike's consent to act as Sarah's agent? Yes. Accepted position.

e. Understanding that P in control of outcome? Yes. Agreement that Sarah to have final say re management of tavern.

2. Did Mike have actual authority to buy the non-alcoholic beverages from Bev? No. Sarah specifically told Mike that he was only to buy from her, which he did not do. Trfr, Mike could not reasonably have interpreted his authority to include buying such beverages from Bev.

3. Did Mike have apparent authority to buy the nonalcoholic beverages from Bev?

a. Were there any manifestations by Sarah that Mike had such authority? Yes.

(1) Mike told Bev that he no longer owned the tavern, but that he was manager.

(a) Sarah became a partially disclosed principle.

(b) To the extent that Mike's statement was authorized, it could be considered a manifestation by Sarah. Therefore, statement that he was manager and had some authority to order supplies would be Sarah's manifestations. Any statements by Mike that were unauthorized (e.g. that he had total authority over ordering nonalcoholic beverages) would not be Sarah's manifestation.

(c) Under the authority of position doctrine, if it were normal for tavern managers to have full authority over ordering, Sarah's appointment of Mike as manager would be a manifestation of her authorization that Mike undertake such responsibilities.

(2) Sarah continued to use the "Mike's Place" neon signs, napkins, T-shirts etc.

b. Perceived by Bev? Yes, Bev heard that Mike was manager and had some ordering authority. She may or may not have seen the napkins, T-shirts, etc. She probably saw the neon sign, or at least probably would have noticed if the sign had been changed.

c. Did Bev reasonably interpret Sarah's manifestations to authorize Mike to order f rom Bev? Possibly.

(1) It would be reasonable for Bev to believe that Mike, as manager, had authority to order from her. Sarah's manifestations could reasonably be interpreted to mean that Sarah wanted the business to go on as it had in the past.

(2) Any interpretation of Mike's position as manager that was consistent with standard business practices would be reasonable.

d. Did Bev rely on her interpretation of Mike's authority? Yes, she sold the beverages.

4. Who is liable?

a. Because, as to Bev, Mike probably had the apparent authority to order from her, Sarah would be liable to Bev for the beverages.

b. Mike would also be liable to Bev. Where the principal is partially disclosed, the agent generally is bound to the third party even though the principal is also bound.

B. Partnership law

1. Could Mike and Sarah be considered partners?

a. Although pshp clearly was not intended by either Sarah or Mike the existence of a pshp, is not dependent on intent, but rather the existence of a relationship that qualifies under the law as a pshp.

b. Under UPA § 6 (1) , a partnership is an association of two or more persons to carry on as co-owners a business for profit.

(1) Mike and Sarah are "two or more persons" - "Persons" includes individual natural people.

(2) This would be a voluntary organization, as either could end the relationship at any time.

(3) Sarah could exclude others from the association. Mike probably could not.

(4) They are carrying on an on-going business for profit.

(5) It is unclear whether Sarah & Mike would be considered to be co-owners. The UPA does not define "co-owners."

(a) There is no joint ownership of property, as Sarah is sole owner of the tavern. But under UPA § 7 (2), joint property ownership would not be sufficient to establish pshp.

(b) Mike and Sarah share profits. Under UPA § 7 (4), this is prima facie evidence of pshp.

(c) UPA § 18 (e) talks of equal management rights. Although neither control nor lack of control would be determinative, control would be evidence of pshp. Mike has considerable day-to-day control. Here, the fact that Sarah's control is mainly through veto power, may help establish pshp.

(d) Both Sarah and Mike could be considered to have invested in the tavern- Sarah contributed $, and Mike contributed sweat equity.

(6) This is a business for profit.

2. If Sarah & Mike are prs, would the pshp be bound by Mike's agreement with Bev?

a. Fact that Mike was not actually authorized discussed previously. But Mike may have had apparent authority. If so, under UPA §9 & §4(3), the pshp, would be bound.

Both Sarah and Mike would be jointly liable to Bev under § 15 (b) . Bev would have to sue both Sarah and Mike to recover against either of them. If she sued both, she could recover the full judgment against either of them.

b. Even if Mike were not apparently authorized to enter into K w/ Bev, pshp still may be bound under § 9, if Mike were apparently carrying on in the usual way the business of the pshp, as long as Bev did not know of Mike's lack of authority.

(1) Bev had no knowledge of Mike's lack of authority.

(2) Was Mike apparently carrying on in the usual way? Possibly. Two different approaches:

(a) Whether pshps of that type generally do business in that manner. If the managers of taverns generally do the ordering, then the pshp, may be bound.

(b) Whether Sarah & Mike's pshp generally did business, in that manner.

(i) In general, Mike did the ordering. Also, Mike previously did the ordering of non-alcoholic beverages.

(ii) On the other hand, the situation changed, as Mike sold the business. Now, it was no longer the practice of the pshp for Mike to order non-alcoholic beverages.

IV. Question III.

A. Ben & Jerry's has taken a number of actions that might be challenged under the corporate purpose doctrine.

1. Pays suppliers more than is absolutely necessary

a. Voluntarily pays milk producers above-market rates.

b. Uses brownies from bakery staffed by homeless people and blueberries picked by Native Americans, instead of going to the least expensive supplier.

2. Contributes to:

a. Nut shellers' cooperative in Amazonian rainforest (using profits from sales of Rainforest Crunch).

b. EarthFair

c. Affiliated Media Foundation (organization aims to give media access to poor people)

d. Burlington Peace & Justice Coalition

B. The facts do not indicate where Ben & Jerry's is incorporated, therefore the applicable law is unknown.

C. The first question would be whether Ben & Jerry's policies reflect an appropriate corporate purpose.

1. In general, a corporation's management is, expected to act in a manner intended to maximize corporate profits. I would advise Ben & Jerry's management to document any positive effects the above policies have on corporate profits. I would expect that the good public relations created by its policies may be valuable advertising. The fact that the Small Business Administration named the co-founders the Small Business Persons of the Year in 1988 indicates that the business is doing well.

2. Even if the policies do not enhance short-term profitability, one could still argue that the policies are appropriate corporate purposes.

a. Although there is no need for a direct corporate benefit, the corporation's interests must be a motive.

I would advise the management to document that they have the best interests of the corporation in mind. I would discourage them from making any statements that the corporation's major purpose is to benefit the poor, Amazon rain forests, Native Americans, dairy farmers, world peace, etc. I would advise them to emphasize the fact that the corporation's long-term financial health should be the major purpose of the corporation, as this would be the only way to continue their good works.

b. Most jurisdictions provide that corporations may make donations for public welfare or for charitable, scientific or educational purposes.

(1) The donations to the nut shellers' cooperative in Amazonian rain forest might be considered to be for the public welfare, although, generally, such donations might be expected to be to a "public"closer to the corporation's business.

(2) The donations to EarthFair could be considered public welfare or educational.

(3) The donations to Affiliated Media Foundation could be considered public welfare or educational.

(4) I would also argue that paying suppliers (dairy farmers, homeless bakeries, Native Americans) more than is absolutely necessary constitutes a donation. There would be little effective difference in buying elsewhere to increase profits, then contributing such profits to farmers, the poor, Native Americans, etc. Ben & Jerry's manner of donations is probably more beneficial, in that it aids self-sufficiency and self-esteem in a way that cash donations would not.

c. Some jurisdictions allow contributions for political, as opposed to merely charitable causes, as long as such contributions are lawful.

In such jurisdictions, donations to the Burlington Peace & Justice Coalition would be appropriate even if no case could be made out for increased profits through positive public relations.

d. Because of a lobbying effort by Dayton's, Minnesota has a very broad corporate purpose statute. Directors may, in considering the best interests of the corporation, consider the interests of the corporation's employees, customers, suppliers, creditors, the economy of the state and nation, community and societal considerations, and long-term as well as short-term interests of the corporation and its shhs. Minn. Stat. §302A.251 subd. 5.

Under such a broad provision, all of Ben & Jerry's policies would be acceptable, as long as the directors made a record of the fact that they considered the policies to be in the best interests of the corporation. Once again, they should document the benefits of the favorable public opinion.

3. Reasonability

a. Donations should be reasonable in amount light of the corporation's financial condition.

The management should keep track of their profits to show that their donations, etc., are reasonable. They should also keep records regarding any positive tax effects.

b. Donations must bear reasonable relation to the corporation's interest, and should not be so remote and fanciful to excite the opposition of its shhs.

Ben & Jerry's management might want to document the favorable response of its shhs to its policies. They should show that their policies are not "remote and fanciful," in relation to the interests of their shhs.