MODEL ANSWERS AND COMMENTS

BUSINESS ORGANIZATIONS

FINAL EXAMINATION

FALL, 1994 (KLEINBERGER)

This memo repeats the exam questions from the fall 1994 exam, provides model answers for those questions and lists the most frequent mistakes. The model answers are aspirational. I did not expect anyone to produce an exam that reached the level of completeness and succinctness reflected in the model answers.

Part One

A. Aslan, Inc. is a Delaware corporation, whose stock is publicly traded and which has a nine-member board of directors. Last year, Edmund acquired a substantial block of Aslan stock and then led a proxy fight that resulted in Edmund and eight hand-picked associates gaining seats on the board. Each of those eight associates is an employee of some business owned or controlled by Edmund. Among its first official actions, the new board adopted a resolution calling for Aslan to reimburse all of Edmund's expenses in the proxy fight. A disgruntled shareholder has filed a derivative suit, alleging that the reimbursement constitutes a waste of corporate assets. Is demand excused?

Model Answer: This dispute concerns a matter internal to the corporation. Therefore, under the "internal affairs" doctrine, the law of state of incorporation applies-- i.e., the law of Delaware.

Delaware law excuses demand when the shareholder plaintiff can meet the demand futility test of Aronson and Perot. That test focusses on the underlying, challenged transaction; in this case -- the decision to reimburse Edmund. The plaintiff must plead with particularity facts that, if true, would raise a reasonable doubt that either (i) the board was disinterested in approving the underlying transaction, or (ii) that the business judgment rule protects the board's conduct in the underlying transaction.

In this situation, the plaintiff can certainly plead facts to satisfy the test's first prong. The underlying decision substantially benefitted Edmund, and Edmund dominated the other eight board members. Those eight owed not only their seats on the board to Edmund but also their livelihoods as well.

Demand is therefore excused:

Common Mistakes: failing to explain why Delaware law applies; failing to specify that both prongs of the Delaware test relate to the underlying transaction; stating the two prongs in the conjunctive; failing to consider that the other eight board members worked for organizations controlled by Edmund; wasting time by explaining the nature of a derivative suit; going beyond the question of demand to consider Zapata; using Zapata to determine the demand futility issue

B. Narnia, Inc. ("Narnia") is a Minnesota corporation. As part of its efforts to be "a good corporate citizen," Narnia encourages its employees to volunteer their services to community organizations. Many of Narnia's top executives serve in prominent volunteer positions for organizations such as United Way. Narnia's public relations department regularly informs both Narnia's employees and the general public of the public-spirited activities of Narnia's employees.

Lucy is a mid-level management employee of Narnia, who serves as a volunteer member of the board of directors of Shelter Group, a nonprofit corporation that provides temporary housing to battered women.⁽¹⁾ Lucy's supervisor at Narnia is aware of Lucy's involvement with Shelter Group, has occasionally given her "release time"⁽²⁾ to attend important Shelter Group meetings and has included in Lucy's periodic performance appraisals favorable comments about Lucy's "public spirited volunteer activities with Shelter Group."

Shelter Group and all of its directors have been sued by a woman who was attacked while in Shelter Group housing. Lucy wants Narnia to indemnify her against the suit. Assume that (i) in all matters described in this question Lucy's supervisor has acted with actual authority, and (ii) Minnesota corporate law provides in relevant part that:

a [Minnesota] corporation shall indemnify a person made . . . a party to a proceeding [including a lawsuit] by reason of the former or present official capacity of the person . . .

"Official capacity" means . . . (3) with respect to a director, officer, or employee of the corporation who, while a director, officer, or employee of the corporation, is or was serving at the request of the corporation or whose duties in that position involve or involved service as a director, officer, partner, trustee, employee, or agent of another organization or employee benefit plan, the position of that person as a director, officer, partner, trustee, employee, or agent, as the case may be, of the other organization or employee benefit plan.

Is Narnia obligated to indemnify Lucy? Answering this question requires no knowledge about nonprofit corporations beyond the information provided in footnote 1. Do not concern yourself with whether the suit against Lucy will succeed.

Model Answer: Two possible grounds exist for requiring Narnia to indemnify Lucy: the statute and the common law of agency.⁽³⁾

As to the statute, Lucy is certainly " a person made . . . a party to a proceeding ." The question is whether Lucy's work for Shelter Group meets the "official capacity"criterion. "Official capacity" can include a corporate employee's "position . . . as a director of [an]other organization [i.e. Shelter Group]," if the "employee . . . is or was serving at the request of the corporation" or if the employee's "duties in that position [of employee] involve or involved service as a director . . . of another organization.".

Thus, the statute will require Narnia to indemnify Lucy if either (i) Lucy was serving as a director of Shelter Group "at the request" of Narnia, or (ii) Lucy's duties as a Narnia employee involved service as a Shelter Group director.

Although the question is a close one, the statute probably does not apply. Narnia did much to encourage Lucy's work: release time, favorable comments on her performance appraisals, a corporate culture that supported volunteer work and a corporate PR department that praised and promoted such work. However, encouragement is not the same as a request. Likewise, Lucy's duties as a Narnia employee did not involve serving as a Shelter Group director. Although Narnia occasionally permitted Lucy to do Shelter Group work on "company time," the corporation never required her to volunteer. She was not duty-bound to volunteer at Shelter House or at any other organization.

For similar reasons, common law indemnity probably does not apply.⁽⁴⁾ As Lucy's principal, Narnia has a duty to indemnify Lucy against third party tort claims if Lucy was acting with actual authority and was unaware that her conduct was tortious. As indicated above, Lucy can point to several manifestations that Narnia supported and encouraged Lucy's volunteer activity. Those manifestations do not, however, support a reasonable belief that Narnia was seeking to have Lucy act on Narnia's behalf as a volunteer. Since the creation of actual authority requires such a reasonable belief, Lucy's Shelter House service was not within her actual authority and does not trigger a common law right to indemnification.⁽⁵⁾

Common Mistakes: ignoring the statute; considering only the "request" prong of the statute and omitting the "whose duties involved" prong; properly construing the statute but failing to apply the rule to the facts; discussing and even relying on respondeat superior and the borrowed servant doctrine [both of which relate to the liability of a principal to a third party -- not to whether the principal must indemnify the agent]

C. You enter a sporting goods store and see the owner talking to a pleasant-looking individual who is standing near the cash register. You hear the owner say, "Okay, I'll be right back." The owner then goes into the back room. You select a pair of high-priced athletic shoes, bring them to the cash register and offer the money to the pleasant-looking individual. The individual takes your money, and puts your purchase in a bag. You leave, only to discover later that the individual was not an employee of the store but rather another customer who pocketed the money you paid and left the store immediately after you. The store demands that you either return the shoes or pay for them. Are you obliged to?

Model Answer: Probably. Your best theories are apparent authority and authority by estoppel, and both will likely fail.

To establish apparent authority, you must show (i) some manifestation attributable to the apparent principal [the store owner], (ii) that reached you and (iii) on account of which you reasonably believed that the apparent agent [ the pleasant-looking individual] was genuinely authorized to act for the store owner. You can certainly show a peppercorn of manifestation; the store owner spoke to the individual in your presence and left the room with that individual in proximity to an unguarded cash register. This manifestation certainly reached you; the events took place in your presence. You certainly believed the individual to be the owner's authorized agent; you turned over the money. The dispositive question is whether your belief was reasonable.

It probably was not. On the sparse facts stated, the situation you faced was at best ambiguous. The store owner's conduct was just as consistent with serving a customer as with instructing a cashier or clerk. If the individual had been wearing a store uniform or a name tag, your claim would have been stronger. In the circumstances, however, you had a duty to inquire before relying on your perception. Without that inquiry, and without further facts buttressing your belief, your belief was unreasonable. Therefore, you should not succeed on a claim of apparent authority.

Most likely, you will also fail with an estoppel claim. You can make two of three required showings: that the individual purported to act on the store owner's account and that you changed your position because you believed the individual was indeed acting for the owner. However, you probably cannot make the third showing; i.e. that the store owner was responsible for your misapprehension. The store owner did not know of your misapprehension and certainly did not intentionally cause it. Your only hope is to show that the store owner carelessly caused your belief.

Even assuming that the owner was careless, as discussed above you were careless as well. Indeed, your carelessness was at least as much of the cause of your misapprehension as was the store owner's conduct. You should therefore not be able to claim estoppel.⁽⁶⁾

Common Mistakes: omitting estoppel; discussing actual authority at great length [thereby wasting a lot of precious time]; asserting that apparent authority could not apply because there was no manifestation [this assertion short-circuited the answer, precluding discussion of the reasonableness issue]

D. A uniformed, on-duty police officer threatens to arrest a woman for violating the law prohibiting prostitution and then offers to relent if the woman has sexual intercourse with him. The woman accedes. She later sues and holds the police officer for battery, successfully arguing that her consent was coerced and therefore ineffective. According to the doctrines studied in this course, can the woman also hold the police department liable?

Model Answer: The woman's best claim is respondeat superior. This doctrine holds a master strictly and vicariously liable for torts committed by servants in the scope of employment if the tort involves physical conduct that causes physical injury. The tort of battery certainly qualifies. Just as certainly, the officer is a servant of the police department. Servant status depends on the principal having the right to control the manner in which the agent performs its duties. The department not only controls when and where the officer works but also, most likely, has detailed procedures governing numerous aspects of the officer's duties (e.g., weapons policies, uniform requirements; arrest procedures).

The more difficult question is whether the battery comes within the officer's scope of employment. Many courts would say no, simply because in committing the battery the officer was not actuated by a purpose of serving the master. Some courts have, however, gone beyond the actuated/purpose test. These courts have applied respondeat superior to intentional torts that are incidental to a servant's tasks or a foreseeable consequence of a servant's authorized employment. Under this approach the strongest case is one in which the servant's employment facilitates the abusive conduct or makes the victim especially vulnerable.

Arguably at least, the incidental/foreseeable rule should apply in this case. The officer's employment did more than facilitate the coercion. Without that employment, and the power and authority incidental to it, the coercion would not have been possible. Moreover, that power and authority made the victim especially vulnerable to coercion.⁽⁷⁾

Common Mistakes: ignoring the special issues involved because battery is an intentional tort; failing to consider the incidental/foreseeable approach; focussing the scope of employment analysis on the officer's legitimate conduct (e.g. patrolling, stopping a suspected prostitute) rather than on the tortious conduct; noting that scope of employment could include criminal acts, but failing to consider that this assault was seriously criminal

Part Two

In answering the questions in this Part, assume that (i) Minnesota has adopted the UPA without changes, (ii) Minnesota's corporate statute consists of all Minnesota corporate statutes included in the materials (including class handouts), plus any provisions of the Revised Model Business Corporation Act assigned during the semester, and (iii) Minnesota's courts would follow all corporate cases assigned this semester, if relevant. DO NOT CONSIDER TAX ISSUES. IN FACT, ASSUME THAT THERE ARE NO TAXES INVOLVED.

The following fact pattern is intricate, and there are numerous questions to answer. BUDGET YOUR TIME.

Jill, a research biologist, developed technology with significant potential value in the biomedical field. Needing capital to develop her ideas, she approached Eustice and they decided to combine efforts to develop the technology. They formed a Minnesota corporation, named Dawntreader, Inc. ("Dawntreader") to house their business. They agreed that:

Eustice would put up $2 million of capital to be used in developing the business, would serve as CEO and would have day-to-day management responsibility for all aspects of the business other than the research work.

Jill would work fulltime in the research part of the business. Dawntreader would employ Jill as Vice President of Research and Development and pay her an annual salary of $75,000. Any technological developments made by Jill would belong to Dawntreader.

Dawntreader would have 100 shares of common stock, with Jill owning 40 shares and Eustice owning 60. Certain important decisions would require a vote of 65% of the shares. Those decisions would include: (i) terminating Jill's employment except for misconduct, (ii) selling the technology owned by the corporation; and (iii) commencing any litigation on behalf of the corporation.

Jill and Eustice memorialized their understanding about their corporation in a written agreement (the "Dawntreader Shareholders Agreement"), which they both signed. They then implemented their agreement. Eustice paid Dawntreader $2 million in cash for his shares of stock. Jill paid for her stock by assigning to Dawntreader the technology she had developed.

After about two years, the technology still looked promising but Jill and Eustice needed more capital. They approached a large, wealthy corporation, Scrubbs, Inc. ("Scrubbs"), and made the following arrangement:

Dawntreader and Scrubbs would form a general partnership to further develop the technology ("the D/S Partnership"). Dawntreader would contribute its technology to the D/S Partnership, as well as furnish the services of Dawntreader's employee, Jill. The partnership would value the technology at $2 million. Scrubbs would contribute $10 million in cash.

As partners in the D/S Partnership, Dawntreader and Scrubbs would each have a 50% profit share. Profits would be calculated and distributed annually, unless both partners agreed to the contrary.

The D/S Partnership would have a term of 25 years, but Scrubbs would have the right at any time to dissolve the partnership and acquire all its assets by paying its partner an amount equal to $25 million minus 1/2 of any outstanding debts or other obligations of the D/S Partnership ("the Buyout Option").

Dawntreader and Scrubbs memorialized the arrangement in a written partnership agreement and then implemented their agreement.

A. For Dawntreader to enter into and perform its part of the agreement, was it necessary for Jill to agree?

Model Answer: Yes. By requiring a vote of 65% of the shares, the Dawntreader Shareholder Agreement in effect required Jill's agreement to any sale of the corporation's technology. Contributing the technology is tantamount to selling it, because contribution involves the transfer of ownership from the partner to the partnership in return for an interest in the partnership.

Common Mistakes: stating that a contribution constitutes a sale but not explaining why; not seeing that the contribution itself constituted a sale and arguing that the Buyout Option made the technology subject to sale; treating the contribution as a disposition of substantially all the corporation's assets, thereby requiring a shareholder vote;⁽⁸⁾ arguing that joining the partnership required Jill's consent under the Dawntreader Shareholder Agreement simply because that decision was an "important decision";⁽⁹⁾ asserting that the facts do not provide information about the voting power of the stock [see the third "bullet" ("Dawntreader would have . . . common stock . . . ."]; asserting that Jill's right to agree rested on the articles of incorporation or by-laws rather than the Dawntreader Shareholder Agreement; spending a lot of time demonstrating that the Dawntreader Shareholder Agreement complied with Minn.Stat. § 302A.457 [a point not worth too much time, since there are no facts to suggest to the contrary]

B. If Scrubbs wishes to exercise the Buy-Out option, who will Scrubbs pay?

Model Answer: Scrubbs will pay Dawntreader. The Option requires Scrubbs to pay its partner, and Scrubbs' partner is Dawntreader.

Common Mistakes: not explaining why Scrubbs would pay Dawntreader; ignoring Dawntreader and asserting that Scrubbs would pay Jill and Eustice; providing a lengthy discussion of the consequences if Scrubbs exercises the Option, including various ramifications following from dissolution of the D/S Partnership [not called for by the question]

C. Assume that in some year of its existence the D/S Partnership makes a profit of $2 million and Eustice wants to get his hands on "my share," what should he do? If successful, how much will he receive?

Model Answer: For Eustice to get his hands on this money, he must cause the money to flow first to Dawntreader and then to him. The D/S Partnership agreement controls the first step, calling for annual distribution of profits unless both partners agree to the contrary. As CEO and 65% shareholder of Dawntreader, Eustice can make sure that Dawntreader does not agree to the contrary. Then, according to the partnership agreement, D/S Partnership will distribute 50% of $2 million to each partner; that is, $1 million to Dawntreader.

For Eustice to get his hands on "his share" of the $1 million, he will have to cause Dawntreader's board to distribute the funds as a dividend. Eustice holds 60% of the single class of common stock, so he will receive 60% of the amount distributed -- i.e. $600,000.⁽¹⁰⁾

Common Mistakes: ignoring the partnership agreement provision on profits; noting that provision, but only as to its 50/50 allocation of profit shares; asserting that Eustice would have to cause the partnership to dissolve; ignoring the need to have Dawntreader declare dividends; failing to answer the "how much will he receive" part of the question

D. By its fifth year of operation, the D/S Partnership has made significant progress. A break-through appears close. The technology is now worth $18 million, but the D/S Partnership only has $1 million in cash left. Scrubbs and Jill hatch a plan to "run right over Eustice." As the first step of the plan, Jill quits as an employee and officer of Dawntreader and comes to work directly for Scrubbs. Scrubbs then formally notifies Eustice, in his capacity as CEO of Dawntreader, that (i) the dissociation of Jill has dissolved the D/S Partnership, (ii) Scrubbs has a right to a return of its contribution, (iii) since the Partnership cannot return the $10 million in cash, Scrubbs has lost far more than Dawntreader and has a right to receive in winding up all the Partnership's technology, plus additional funds from Dawntreader so as to equalize losses, and (iv) Dawntreader is liable for damages caused by the premature dissolution. Is Scrubbs correct?

Model Answer: Scrubbs is flat out wrong on all points. (i) Most fundamentally, he is wrong about dissolution. Jill is not a partner in the partnership. Her departure therefore does not cause dissolution. See UPA § 29 (dissociation of a partner causes dissolution).⁽¹¹⁾ (ii) If the partnership were dissolved, Scrubbs would have the right to receive a payment equal to original value of its contribution, minus any deductions for Scrubbs' share of the losses. See UPA § 40(b)(III) (at dissolution partnership pays out amount owing to partners in respect of capital) and (d) (if dissolved partnership cannot meet its obligations, partners must contribute according to their loss-sharing percentages). (iii) If the partnership were dissolved, it would liquidate its assets, not return them in kind to any partner. UPA § 38(1) (liquidation the default consequence of dissolution). Moreover, sale of the technology would produce a net profit, not a net loss. (iv) Dawntreader is not liable for damages, because Dawntreader did not cause dissolution.

Common Mistakes: asserting that Jill's departure caused dissolution; missing the "in-kind" issue

E. Incensed at Scrubbs' conduct, Eustice wishes to have Dawntreader bring suit against Scrubbs to (i) determine that the D/S Partnership is not dissolved, and (ii) hold Scrubbs responsible for "sabotaging the D/S Partnership just when it was about to become profitable." Jill invokes the Dawntreader Shareholder Agreement, votes against Dawntreader bringing suit and asserts that the Agreement prevents Eustice from causing Dawntreader to sue. Does Eustice have any recourse that will allow him to cause Dawntreader to bring suit?

Model Answer: Eustice should bring suit against Jill under Minn. Stat. § 302A.751, subd. 1(b)(2), asking the court to restrain Jill from barring the suit. Under Minn. Stat. § 302A.751, subd. 1(b)(2), a court may grant equitable relief when "those in control of the corporation have acted in a manner unfairly prejudicial toward one or more shareholders in their capacities as shareholder . . . of a corporation that is not a publicly held corporation."

With only two shareholders, Dawntreader is closely, not publicly held, and Jill's conduct -- conspiring with Scrubbs to "run right over Eustice" -- is unfairly prejudicial to Eustice. See Minn. Stat. § 302A.751, subd. 3a (shareholders in closely held corporation "owe one another [the duty] to act in an honest, fair, and reasonable manner"). The unfairness prejudices Eustice in his capacity as a shareholder of Dawntreader. The Jill/Scrubbs scheme will deprive Eustice (but not Jill) of the fruits of Dawntreader's investment in the D/S Partnership.

But is Jill "in control of the corporation"? The answer is yes -- despite her position as minority shareholder. The Dawntreader Shareholder Agreement gives Jill veto power over a decision crucial to the corporation's future. In this matter, therefore, Jill is the controlling shareholder. See Smith v. Atlantic Properties (minority shareholder with veto over dividend policy had fiduciary duty not to wrongfully exercise veto).

Common Mistakes: failing to invoke Minn.Stat. § 302A.751; failing to explain how a minority shareholder could control a corporation; arguing that the Shareholder Agreement is invalid because it sterilizes the board of directors [thereby ignoring Minn.Stat. § 302A.457 (validating such sterilizing agreements)]

F. Assuming that Dawntreader does bring suit, what are Dawntreader's best claims against Scrubbs?

Model Answer: All of Dawntreader's best claims relate to a partner's duty of loyalty. Scrubbs' scheme violates that duty in several ways. The secrecy of Scrubbs' arrangements with Jill violate a partner's duty of candor, as does Scrubbs' disingenuous claim that Jill's departure dissolved the partnership. The arrangements themselves, if successful, will allow Scrubbs to usurp an opportunity that properly belongs to the partnership. Moreover, the arrangements threaten to expropriate benefits that would normally go to one partner (Dawntreader) and transfer those benefits to another (Scrubbs). That expropriation would violate a partner's duty of fair dealing.⁽¹²⁾

Common Mistakes: merely mentioning the duty of loyalty and neglecting to give any specifics; discussing claims against Jill

G. How, if at all, would your answer to Part F change if the D/S Partnership had been registered as a limited liability partnership?

Model Answer: The answer would not change. In an ordinary general partnership, the mere fact of partner status makes each general partner automatically liable to partnership creditors for partnership debts. An LLP shield removes that automatic liability, but does not affect claims against an individual partner based on the partner's own actions.

Common Mistakes: confusing a limited liability partnership with a limited partnership; overstating the effect of an LLP shield

1. Under Minnesota law, a nonprofit corporation is governed by a board of directors.

2. I.e. time away from work that does not cause any decrease in salary and does not count as vacation time.

3. From the context -- i.e., the lengthy quotation from the statute -- it is obvious that a proper answer involves application of the statute. In fact, when I drafted this question, I anticipated answers based exclusively on the statute. However, since some students discussed the common law indemnity issue as well, this model answer incorporates both approaches.

4. It may be that the statute has preempted the common law. However, the course never dealt with that issue of statutory interpretation, and the problem does not provide sufficient background to consider the issue.

5. On both the statutory and common law issues, almost all students argued in favor of indemnification. Reasonable minds can differ, and the number of points awarded for an answer depended on the quality of the analysis, not the ultimate conclusion.

6. Reasonable minds could (and did) differ as to the conclusion on both apparent authority and estoppel. The number of points awarded for an answer depended on the quality of the analysis, not the ultimate conclusion.

7. This answer does not discuss a principal's direct duty to properly retain, train and supervise its agents, because the facts do not provide any basis for analyzing a claim based on that duty.

8. This argument is plausible, but not responsive. The argument means that the shareholders would have a right to vote, but Jill's agreement would not be necessary. A majority vote suffices. See Revised Model Business Corporation Act § 12.02(e). Jill's agreement is necessary only if a supermajority is needed, and that need arises only under the Dawntreader Shareholders Agreement.

9. This approach is problematic for two reasons. First, the approach invokes vague, general language ("important decisions") and ignores a specific rationale expressly created by the Dawntreader Shareholder Agreement (sale of technology). Second, the importance of joining the partnership is not self-evident, and most responses that used this approach failed to explain that importance. There are at least two possible explanations: (i) because joining involved giving up ownership in the technology, (ii) because the corporation would be liable for the debts of the partnership.

10. Some answers subtracted Jill's $75,000 salary from the $ 1 million and calculated the distribution based on the remainder. This approach is plausible, since a board cannot properly declare dividends without paying or providing for the debts of the corporation. However, the facts do not indicate that the corporation lacked other funds with which to pay Jill.

11. This analysis is the crux of the entire answer. Anyone who made this analysis got at least the lion's share of the points available on this question. Anyone who made this analysis plus at least one other of the following arguments received all points available.

12. The question asked only about claims, not remedies, so the model answer does not discuss remedies. Most student answers took the same approach. Following is a remedy analysis.

As a remedy, Dawntreader could seek disgorgement of any profits Scrubbs realizes from its machinations. See UPA § 21 (partner must account for any profits realized through breach of duty of loyalty). Dawntreader could also seek lost profits, if it could prove the loss. In addition, Dawntreader might apply to a court to have the D/S Partnership dissolved and Scrubbs characterized as a wrongful dissolver. See UPA § 32(1)(c) (court ordered dissolution when partner's wrongful conduct tends to prejudice the carrying on of the business) and (d) (court ordered dissolution when partner's wrongful conduct makes it impractical to carry on the business with that partner). In the settling of accounts that would follow, Dawntreader could seek either damages for Scrubbs' wrongful dissolution, UPA § 38(2)(a)(II), or to freeze in Scrubbs' interest for the remainder of the 25 year term. UPA § 38(2)(b). Dawntreader might also argue that the Buyout Option provides the best remedy for Scrubbs' wrongful dissolution and that the court should require Scrubbs to exercise the Option.