FINAL EXAMINATION

CLOSELY HELD BUSINESSES

FALL, 1996

PROFESSOR KLEINBERGER

General Instructions

This exam is a limited open book exam. You may use only the following materials ("Permitted Materials"):

the assigned photocopied materials (including the Supplemental Materials) and any additional photocopied materials distributed by the professor during the semester,

any notes you have personally made or developed in studying for the course or the exam (including notes you have made while studying the Supplemental Materials), and

outlines or other notes developed by a group of students enrolled in this course this semester if: (a) you played a substantial role in the development of the group outline or notes, (b) neither the group outline nor other notes discuss or make reference to the Supplemental Materials or their subject matter, and (c) the group discussions that led to the group outline or notes strictly excluded any consideration of the Supplemental Materials and their subject matter.

Except for Permitted Materials, you may not use treatises, hornbooks, commercial outlines, other commercial works or any other materials prepared by others.

This examination lasts three hours and has two parts. Each part is of equal weight in the grading. How you allocate your time between the two parts is your decision. Remember, however, that the two parts count equally.

Please keep in mind that "spotting issues" is only the first step in doing a legal analysis. You must also take the issues you identify and organize them into a coherent structure. Then, within that structure, you must examine those issues (by applying the law you see as relevant to the facts you see as relevant) and argue for some conclusion.

Please do not write about subjects that are not germane to your analysis. Writing a "treatise" on some area of law that the question does not put in issue wastes your time and conveys the unfortunate impression that you do not understand which issues are relevant.

To the extent that your analysis involves a particular statutory provision, you MUST cite that provision. If your analysis involves the construction (as distinguished from mere application) of a particular word, phrase or provision, it may make sense to quote that word, phrase or provision. Otherwise, do not waste your time quoting the statute at length. (On the other hand, if you can quote a piece of a statute faster than you can paraphrase it, feel free to do so.)

You are not required to cite case names. If citing case names helps you, feel free to do so. Do not, however, use case names as a substitute for stating the law.

The grading rewards coherence. It will probably be worth your while to take some time to think about the organization of your answer before you begin writing. Ask yourself:

whether you have identified all the necessary parts to your analysis;

whether all the issues you have identified are actually necessary; and

whether you have organized your issues in a way that is likely to make sense to your reader.

Please write legibly. Please write on only one side of each page. If legibility is not your strong point, please skip every other line as you write.

Part One

Imagine yourself to be a law clerk for the Minnesota Supreme Court. The Court has granted a petition for further review and heard oral arguments on the case of Neophyte et al. v. Entrepreneur and XYZ, Inc. The justice for whom you clerk has been designated to write the majority opinion and has instructed you to prepare a draft.

As further explained in the Stipulated Facts (below), this case arose out of a dispute involving a Minnesota corporation, its majority and minority shareholders and several bond holders of the corporation. The minority shareholder and bond holders sued the majority shareholder ("the individual defendant"), asserting that he had breached duties owed to them. The suit named the corporation as a defendant, because the plaintiffs sought relief involving the corporation.

The individual defendant moved for summary judgment, asserting that neither the minority shareholder nor the bond holders had any legally cognizable injury. For the purposes of the summary judgment motion, the parties agreed to a set of Stipulated Facts. Based on those Facts the trial judge granted summary judgment, stating, "The Court need not reach the difficult question of what manner of relief might be appropriate, because none of the plaintiffs has a cause of action. This case is controlled by Association of Mill and Elevator Mutual Ins. Co. v. Barzen International, Inc."

The plaintiffs appealed to the Court of Appeals, which affirmed in an extremely brief, unreported decision. That decision echoed the trial court's holding that, under Association of Mill and Elevator Mutual Ins. Co. v. Barzen International, Inc., none of the plaintiffs had a cause of action.

The Supreme Court granted the plaintiffs' petition for further review, with review limited to the question of whether under the Stipulated Facts the plaintiffs had stated any grounds for relief. At oral argument it was apparent that the Supreme Court views Association of Mill and Elevator Mutual Ins. Co. v. Barzen International, Inc. as (i) interesting, (ii) important, (iii) not necessarily correctly decided and (iv) not necessarily dispositive even if correctly decided.

Draft the majority opinion in light of the Stipulated Facts, the Supplemental Materials (to the extent to which you consider them relevant) and any other doctrines or materials encompassed in this course (to the extent you consider them relevant) excluding securities law issues. It is not necessary to begin your draft opinion with a summary or other recitation of the Stipulated Facts. Of course, your draft opinion should refer to and integrate the facts that you consider important to your legal analysis.

Stipulated Facts

1. XYZ, Inc. ("XYZ") is a corporation incorporated under the laws of the state of Minnesota. XYZ was incorporated in 1990.

2. Throughout its existence, XYZ has had one class of stock and two shareholders. Neophyte, the shareholder plaintiff, owns 25% of the outstanding stock. Entrepreneur, the individual defendant, owns 75%.

3. The board of directors has three members. Under a shareholder control agreement, Neophyte is regularly elected to the board and the two other board members are elected as designated by Entrepreneur. Entrepreneur also selects XYZ's CEO (with that selection routinely approved by the board). The CEO reports in a formal sense to the board but also provides regular reports to Entrepreneur. Neither Entrepreneur nor Neophyte serve as officers or employees of XYZ.

4. XYZ was formed to develop and commercially exploit an idea developed by Neophyte. Neophyte sought Entrepreneur's financial backing, commercial contacts and expertise in making the idea marketable. Neophyte received his 25% stake in the corporation in return for assigning all right, title and interest to his idea. Entrepreneur received his 75% stake in return for significant capital contributions, the use of his commercial contacts and the expectation that he would be involved on an on-going basis in guiding the corporation. Entrepreneur has supplied that on-going guidance through regular interactions with board members and the CEO.

5. When the corporation was first organized, Neophyte understood that his would be an essentially passive role and that the operation of the corporation would be controlled by Entrepreneur. Neophyte was particularly concerned with whether the corporation would follow what he called "principled business practices" and discussed that issue several times with Entrepreneur. Entrepreneur several times assured Neophyte that the company's business practices would always be "above board and consistent with what an honest business person would do."

6. As XYZ was being organized, Neophyte was eager to have several of his close family members share in the potential for success. Entrepreneur, however, was unwilling to allow any other shareholders -- at least during the start-up phase of the corporation. Entrepreneur did agree to borrow some of the corporation's start-up funds from three of Neophyte's relatives. Each of these relatives loaned the corporation $50,000. Each loan was evidenced by a separate bond, paying 7% interest, due quarterly, with the principal due in 10 years. To provide the bond holders the possibility of participating in appreciation, each bond was accompanied by a warrant to buy a specified number of shares of common stock at book value. These warrants were not exercisable until the date set for the repayment of the bond principal.

7. Neophyte encouraged three of his relatives to buy the bonds. When he did so, Neophyte was acting in reliance on Entrepreneur's assurances as described in Paragraph 5 of these Stipulated Facts. Neophyte accurately reported those assurances to his relatives, and they relied on those reported assurances when they decided to invest.

8. The start-up work initially went as well as could have been hoped. However, three years ago a change occurred in the dominant technology, and, as a result, the corporation needed substantial new capital in order to survive. Neophyte was unable to provide any further capital. Entrepreneur was unwilling to invest any further capital, but was willing to guarantee additional debt. Acting at the direction of Entrepreneur, the board of directors arranged to borrow $1,000,000 from a venture capitalist fund. Entrepreneur personally guaranteed the loan, and the corporation granted the venture capitalist fund a first lien on all the corporation's assets. Entrepreneur received no compensation from the corporation for providing the personal guarantee.

9. Last year Entrepreneur determined that the corporation (a) still had a substantial chance of success, but (b) was facing an immediate cash flow problem that threatened its existence. To respond to the situation, Entrepreneur decided to cease all payments to the bond holders, but to continue to make periodic payments on the loan from the venture capitalist fund.

10. When Neophyte learned of this decision, he immediately complained to Entrepreneur and remonstrated that the plan was not fair, honest or decent with regard to the bond holders. Entrepreneur responded that the plan was necessary in order to prevent the venture capitalist firm from declaring its loan in default and foreclosing on the collateral. Entrepreneur acknowledged that the bond holders also could call a default, but noted that, given the superior position held by the venture capitalist fund, that action by the bond holders would be "shooting themselves in the stomach."

11. Distressed and incensed by Entrepreneur's decision, Neophyte filed suit seeking relief including an order directing the corporation not to follow Entrepreneur's plan. The bond holders also joined the suit as plaintiffs, alleging that Entrepreneur's plan violated their rights.

12. Nothing in the loan agreement between the bond holders and the corporation undermines, supports or otherwise relates to the bond holder's claims.

Part Two

Our client is one of five shareholders in a Minnesota corporation organized ten years ago to manufacture and sell framjet-doohickeys.⁽¹⁾ Each shareholder owns 20% of the corporation's one class of stock. The corporation has a board of directors consisting of five members. Each year the shareholders all vote to elect directors, and each year each of the shareholders has been elected as a director.

Each of the other shareholders purchased their stock by investing money in the corporation. Our client had no money to invest but did have considerable technical expertise. The other shareholders wanted her expertise and agreed for her to get "sweat equity." That is, for the first three years of the corporation's existence she worked full-time for the business at a salary approximately 50% below her market value. Those three years of below-market compensation constituted her payment for her stock, and that understanding was reflected in a subscription and employment agreement between the corporation and our client.

That agreement had a three year term. When the term ended, our client received full title to her shares. Just before the term ended, the corporation and our client entered into a two-year employment contract. That contract provided that: (a) our client would be employed at a market-rate salary (at a specified in dollar amount), and (b) if our client's employment were to end for any reason whatsoever, our client's stock would be purchased by the corporation at a specified price per share ("the mandatory stock repurchase provision").

The employment contract did not provide for automatic renewal. However, to date each time the contract has been about to expire the corporation and our client have negotiated a new contract, containing precisely the same terms except for an appropriate increase in salary and a renegotiated price applicable to the mandatory stock repurchase provision.

There are no other agreements between the corporation and any shareholder and no agreements among the shareholders. No other shareholder has worked for the corporation.

The corporation is making money and seems to be on the verge of a significant breakthrough in the marketplace. A multinational corporation recently approached the corporation seeking to acquire it or its assets. It is unclear whether the acquisition will take the form of a merger or a purchase of assets. What is clear, however, is that:: (a) all the shareholders except our client strongly favor the acquisition, (b) the "per share value of the acquisition"⁽²⁾ will exceed the price stated under the mandatory stock repurchase provision in our client's current employment contract, (c) whatever deal is offered to the other four shareholders will also be offered to our client, (d) the multinational has no interest in continuing the employment of our client after the acquisition and plans simply to buy out any remaining portion of the employment contract and (e) unless a court intervenes, the acquisition will take place in some way or other.

A. Assuming that the merger or stock acquisition goes through, our client will have appraisal rights. Most likely, the corporation will tender a price equal to the "per share value of the acquisition." If so, can we successfully argue within the appraisal proceeding that the tendered price reflects only the value of the corporation and that our client should be compensated for losing the expectation of future employment?

B. Assuming that the corporation follows all the proper mechanics with regard to the acquisition and fully discloses all material information, can our client: go outside the appraisal proceeding and:

1. prevent the transaction from proceeding, or

2. force the corporation to buy her stock at a price higher than the price stated in the employment contract's mandatory stock repurchase provision?

1. It is not necessary to understand what a framjet-doohickey is in order to answer this problem. However, in case you are curious, a framjet-doohickey is an essential piece of tooling in the fabrication of widgets.

2. I.e., the total price to be paid, less any expenses, divided by the number of outstanding shares. This value approximates the value each shareholder will receive for each of his or her shares.